Bankers are fallible but not replaceable

Wall Street enters 2008 in disgrace. During 2007, the US subprime housing crisis triggered bigger problems in credit markets. Several bank leaders including Chuck Prince of Citigroup and Stan O’Neal of Merrill Lynch lost their jobs. Banks in the US and Europe are struggling to recover and to raise the capital to stay healthily in business.

This has big repercussions for the financial services industry. Investment banks have been growing rapidly for the past 30 years, with occasional upsets. The volatility of the industry often distracts from its rise as a contributor to post-industrial economies – particularly that of the UK. It finances public spending through corporate taxes and pays many of its employees richly.

There is no mistaking the impact that the Wall Street machine has had on Main Street in the past few years. The clearest evidence of Wall Street and City wealth has been the escalation of house prices in New York and London, driven by multimillion dollar, and pound, bonuses. Low interest rates and inflation created the conditions for banks to extend credit on easy terms to investors and homeowners.

This spree has now come to an abrupt halt, affecting not only investment banks through job losses and retrenchment but everyone else too. The US is poised on the edge of recession as the housing downturn threatens to spill into cutbacks in both consumer spending and corporate credit.

Plenty of the blame lies with the banking industry. Innovation in credit derivatives led to borrowers being offered loans that they could not hope to repay once initial low interest rates reset to higher ones. Investment banks wanted new loans that could be securitised into collateralised debt obligations. Many investors did not grasp the risks of complex securities approved by ratings agencies.

Bankers are not the only ones at fault. Easy credit terms led many individuals to speculate on rising home prices in the hope of making money. Although banks provided capital with which to take the bet, borrowers should have known that profits were not guaranteed.

But that will not stop Wall Street from being held responsible. Previous episodes in which retail investors have lost money because they have been led astray by banks, including the Wall Street analysts’ scandal following the dotcom boom, have ended in the banks being fined and being forced by regulators to change their ways.

The bigger question is whether the relationship between Wall Street and Main Street will shift as a result. There is no question that people have been taken aback by the degree to which the financial system has proved frail. The queues of depositors outside Northern Rock were shocking phenomena.

The role of Wall Street in provoking a US recession, or something close to it, is also likely to figure in the presidential election. Hillary Clinton has signalled that she will attack “Wall Street” despite the financial support she is receiving from investment bankers.

It would, however, be surprising if government or ordinary investors fully turned their backs on Wall Street and the City or pushed for banks’ activities to be substantially curtailed. The rise of financial services in the US and UK economies has helped to ease the move from manufacturing to services and Wall Street banks, despite their extravagances, are eagerly courted by other countries and cities.

If the new heads of big financial institutions manage to persuade regulators and politicians that they will not make the same housing finance mistakes again and have learnt their lessons, they will probably be allowed to keep going on a similar course to the one they have pursued for several decades.

Even on Main Street, where many people are feeling – or are about to feel – the painful aftermath of financial exuberance, Wall Street still has its uses. So, at least, its chastened bankers must hope.