FOR a few tense weeks in 2008, as investment-bank executives huddled behind the imposing doors of the New York Federal Reserve, Wall Street seemed to be collapsing around them. Lehman Brothers filed for bankruptcy, Merrill Lynch collapsed into the arms of Bank of America. American International Group (AIG) and Citigroup had to be bailed out and the rot seemed to be spreading. Hank Paulson, the treasury secretary at the time, recalled in his memoir that: "Lose Morgan Stanley and Goldman Sachs would be next in line -- if they fell the financial system might vaporize."
Across the Atlantic, European politicians saw this as the timely comeuppance of American capitalism. Angela Merkel, Germany's chancellor, blamed her peers in Washington for not having regulated banks and hedge funds more rigorously. European banks saw the crisis as their chance to get one up on the American banks that had long dominated international finance. Barclays quickly pounced on the carcass of Lehman Brothers, buying its American operations in what Bob Diamond, the head of its investment bank at the time, called "an incredible opportunity" to gain entry to the American market. Deutsche Bank, a German giant, also expanded to take market share from American rivals. The dominance that American firms had long exerted over global capital markets seemed to have come to an abrupt end.
Almost five years on, it is Europe's banks that are on their knees and Wall Street that is resurgent. Switzerland's two biggest banks, UBS and Credit Suisse, which were expanding fast before the crisis, are still shedding assets. The Royal Bank of Scotland, which for a brief time broke into the ranks of the world's 10 biggest investment banks, remains a ward of the British government. The share of the investment-banking market held by European banks has slumped by a fifth since the crisis, with many of the gains going to Wall Street's surviving behemoths. JPMorgan Chase, Goldman Sachs and Citigroup alone account for a third of the industry's revenues. Two European outfits, Barclays and Deutsche Bank, have managed to share in some of these spoils since the crisis. Both, however, face hostile regulations at home and abroad that seem likely to crimp their global ambitions. And although HSBC has increased its share of some investment-banking markets, it is still well behind Wall Street's titans.
The industry over which Wall Street is reasserting itself is very different from the one it dominated half a decade ago. Revenues globally have fallen by about $100 billion, or almost a third. Employment has plunged, with London alone shedding 100,000 jobs. Pay has fallen, too. Higher capital requirements and other regulations, including America's absurdly complicated (and still unfinished) Dodd-Frank act, are likely to erode the profitability of the industry. The stellar returns earned by banks before the crisis and the massive rewards paid to their employees are unlikely to recur soon, if at all.
One of the reasons American banks are doing better is that they took the pain and dealt with it faster. The American authorities acted quickly, making their banks write down bad debts and rapidly raise more capital. Those that proved unwilling or unable, and even those such as Goldman that claimed they didn't need it, were force-fed additional capital. As a result, America's big banks have been able to return to profitability, pay back the government and support lending in the economy. This has helped them contribute to an economic revival that, in turn, is holding down bad debts.
European banks, in contrast, are continuing to shrink their balance sheets and limp along with insufficient capital. Citigroup alone has flushed through $143 billion of loan losses, but no euro-zone bank has set aside more than $30 billion. Deutsche Bank, which had insisted it did not need more equity, has at last faced reality and is raising almost $4 billion.
European regulators have also contributed to their banks' decline in two ways. First, they are specifying how much banks can pay in bonuses relative to base pay. Second, they are trying to force banks to hold more capital and to make it easier to allow them to fail by, for instance, separating their retail deposits from their wholesale businesses.
The first approach is foolish. It will drive up the fixed costs of Europe's banks and reduce their flexibility to cut expenses in downturns. They will therefore struggle to compete in America or fast-growing Asian markets with foreign rivals that have the freedom to pay the going rate for talent. The second approach is sensible. Switzerland and Britain are making progress in ending the implicit taxpayer subsidy that supports banks that are too big to fail. The collapse of Ireland's economy is warning enough of what happens when governments feel compelled to bail out banks that dwarf their economies.
Some European bankers argue that the continent needs investment-banking champions. Yet it is not obvious that European firms or taxpayers gain from having national banks that are good at packaging and selling American subprime loans. Indeed, it is American taxpayers and investors who should worry about the dominance of a few Wall Street firms. They bear the main risk of future bailouts. They would benefit from greater competition in investment banking. IPO fees are much higher in America than elsewhere (seven per cent versus four per cent), mainly because the market is dominated by a few big investment banks.
Wall Street's new titans say they are already penalized by new international rules that insist they have somewhat bigger capital buffers than smaller banks because they pose a greater risk to economies if they fail. Yet the huge economies of scale and implicit subsidies from being too big to fail more than offset the cost of the buffers. Increasing the capital surcharges for big banks would do more for the stability of the financial system than the thicket of Dodd-Frank rules ever will.
Five years on from the frightening summer of 2008, America's big banks are back, and that is a good thing. But there are still things that could make Wall Street safer.