Kill or cure for the Wall Street malaise

The world has not ended. The international economy has not yet collapsed. But one thing is now quite clear: the banking system as we know it has failed.
Following the disappearance of Bear Stearns in March, and now the bankruptcy of Lehman Brothers and the surprise plans for Bank of America to absorb Merrill Lynch, three of Wall Street's five big independent investment banks have disappeared inside six months. After an astonishing weekend it is too early to predict the future shape of investment banking with confidence, but business as usual is not one of the possibilities.
Lehman is entering bankruptcy because the US Treasury refused to subsidise a rescue. That is a change of policy after Bear Stearns and a stark contrast to the nationalisation of Fannie Mae and Freddie Mac. It is emphatically a courageous call. The Bear Stearns bail-out was motivated, and probably justified, by the fear that a collapse of Bear would wreck the entire financial system, so interconnected was the bank with its peers.
Those concerns also apply to Lehman Brothers. But the US government does not have limitless resources; even if it did, the challenge in a serious financial panic is for the government to choose the right place to draw the line. Allow a Fannie Mae to collapse, and the US economy might well collapse with it. Yet bailing out anyone who asks nicely is a recipe for promoting (even more) recklessness and yet another crisis in the future.
So while the Treasury's decision is hugely risky, that risk may pay off. An important distinction between Lehman and Bear is that, while Bear failed suddenly, Lehman Brothers has been struggling for months. Those exposed to its failure have had time to hedge their risks and tidy up their transactions, so the financial system, rocky as it is, may be able to handle the unwinding of Lehman's financial contracts in an orderly fashion. If so, the decision by Hank Paulson, the Treasury secretary, will be seen as the moment when investors and bankers had at last to take responsibility for their own risky decisions.
That is the potential reward for courage. Still, it is rather early to pronounce the tough love policy a success. Wall Street has not seen the bankruptcy of an investment bank since Drexel Burnham Lambert in 1990, and the sector's interconnectedness through the credit derivatives market has since grown beyond recognition. These are uncharted waters.
The immediate market reaction has been restrained. Equities fell when markets opened yesterday, with some European bank stocks particularly hard hit. The gold price rallied and the cost of insuring against defaults by big banks has shot up. Yet panic would be too strong a word to describe this – the US authorities will be hoping that it is the return of realism.
If the markets survive the immediate aftermath of the disappearance of Lehman Brothers, that will be a big step away from the precipice. The likely takeover of Merrill Lynch is another one. While it may seem disturbing that the “thundering herd” feels vulnerable enough to seek a stable at the Bank of America, the truth is that, with Lehman gone, attention would have turned next to Merrill. Whatever influenced John Thain, Merrill's chief executive, he has proved himself more pragmatic and more flexible than Dick Fuld, the chairman and chief executive of Lehman. In finding shelter he has helped to create a welcome firebreak against panic.
The future of Goldman Sachs and Morgan Stanley, the last two independent investment banks, is now an open question. Goldman has survived not because of a fundamental difference between it and Bear, Lehman and Merrill, but because it took more successful bets. Investors may be happy to bet that the run of success will continue, but regulators may not: expect capital requirements to be tightened.
There will now be renewed calls for more regulation, and understandably so. But it is naive to think that the right regulatory response is obvious. From poor governance to flawed incentives, incompetent risk management to foolish strategies, the failures of the financial system have been so widespread as to render a coherent regulatory riposte impossible. The likely outcome is that tight capital requirements will be forced to serve as a catch-all response to risk. If so, the banking sys- tem will look more like that of the 1960s – a low-risk, low-return utility business. The ambitious and the avaricious will no doubt seek more ex- citing hunting grounds with hedge funds and private equity groups.
For now, the Treasury's calculated risk looks better judged than those of a banking system intoxicated by bail-outs. Yet even well-judged gambles often fail.