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Wall Street's New Shape

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http://www.economist.com/opinion/displaySt...e=hptextfeature

AT THE press of a button, the double doors sweep open. Welcome to the office in downtown Manhattan of Lloyd Blankfein, chief executive of Goldman Sachs. A couple of years ago, such smooth gadgetry would have seemed a fitting symbol of the power of Wall Street. These days it stirs more sinister thoughts: of a screen villain rather than a hero of high finance. As it happens, it is rumoured that an institution not unlike Goldman will appear unflatteringly in Oliver Stone’s sequel to “Wall Streetâ€, due in cinemas next spring.

Economists continue to debate the ultimate causes of the collapse of Lehman Brothers, Wall Street’s fourth-biggest firm, a year ago on September 15th, and of the havoc that followed. The public and most politicians, however, are clear: the blame lies with bankers, venal and incompetent in equal measure. “It’s like pre-Thatcher Britain out there,†sighs the head of a New York bank. At a hearing in February a congressman addressed JPMorgan Chase’s boss, Jamie Dimon, as “Mr Demonâ€. Deliberate or not, it captured the mood.

The name-calling may have died down a bit lately, but the Street will struggle to regain its swagger. Reforms proposed by Barack Obama’s administration would, if passed, introduce an array of penalties for bigness and boldness. Regulators, too, are determined to clip finance’s wings, even musing about reducing the “swollen†financial industry to a more acceptable size (see Buttonwood), a sentiment echoed by self-flagellating bankers. This week the arch-capitalist Mr Blankfein chastised Wall Street for letting “the growth and complexity in new instruments outstrip their economic and social utilityâ€. Reducing banks’ leverage and their leeway to splash out on star traders will be a priority at the G20 summit in Pittsburgh this month.

The politicians are driven in part by populist urges and in part by a genuine wish to avoid a repeat of the week in which global finance suffered a near-fatal heart attack. In the space of two days Merrill Lynch fell into the arms of Bank of America (BofA), Lehman went bust and American International Group (AIG), a mighty insurer, buckled under suicidal derivatives bets and had to be bailed out. Lehman’s demise marked the onset of the worst financial crisis and global recession since the 1930s.

To be sure, the seeds of trouble had been sown years earlier, with the relaxation of lending standards in mortgages, corporate buy-outs and much more, and with the enthusiasm for using borrowed money to enhance returns. The debts of American financial firms rose steadily from 39% to 111% of GDP in the 20 years to 2008. But many of the subsequent policy choices—not least the $700 billion Troubled Asset Relief Programme—stemmed from Lehman’s demise.

Some believe there would have been less pain had Lehman been bailed out. Others think it was coming anyway (see Economics focus). Either way, the episode shattered market expectations that large firms would not be allowed to fail—a few months before, the stricken Bear Stearns, New York’s fifth-biggest investment bank, had been forcibly married to JPMorgan. With no one sure who could be trusted, lending froze, most abruptly in short-term markets, such as that for commercial paper, that many had come to rely on to support long-term assets. Such was the panic that the government was forced to backstop supposedly rock-solid money-market funds. By October the large, free-standing investment bank, the pride of Wall Street little more than a year earlier, was extinct.

Among the most important decisions was that no other big financial firm would be allowed to suffer Lehman’s fate. The consequences were too frightening. This approach extended to the stress tests for 19 “systemically important†institutions, completed in May. Those found wanting were promised capital from taxpayers if they could not tap private sources.

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Not-so-great expectations

However, the days when finance accounted for 40% of corporate America’s profits are over. Mr Winters thinks investment banks’ average return on equity will settle at a hardly dazzling 10-12% (though the best firms will do much better than that). At leverage of 15 times equity—the reduced level at which investment banks now typically operate—large parts of the fixed-income business fail to cover their cost of capital, reckons Brad Hintz, an analyst with Alliance Bernstein.

Rising interest rates will provide further drag—and probably ensure that credit grows more slowly than the economy for some years. “Everyone was running downhill for 15 years,†says Michael Poulos of Oliver Wyman, a consultancy. “Now we’ll see who the real athletes are.â€

How much of this 40% get into the tax system? A 10% return so if the best returns are reserved for those in the know what have us proles got to put up with?

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