Public anger at the 2008 Wall Street bailout, concerns about debt, and a deep and pervasive fear that another financial crash is just a matter of time create an important moment of opportunity for a long overdue public conversation about the purpose of financial services and the necessary steps to assure that the financial sector fulfills that purpose.

Much of the recent discussion of financial reform has centered on limiting Wall Street excesses to curb fraud and reduce the risk of another financial crash. This is vitally important, but it does not address the issue raised by Sheila Bair shortly before she stepped down last year as FDIC chair:

“In policy terms, the success of the financial sector is not an end in itself, but a means to an end—which is to support the vitality of the real economy and the livelihood of the American people. What really matters to the life of our nation is enabling entrepreneurs to build new businesses that create more well-paying jobs, and enabling families to put a roof over their heads and educate their children.”

It is very straightforward. The proper purpose of the financial services sector is to serve the real economy on which everyone depends for their daily needs, their quality of life, and their opportunity to be creative, contributing members of their communities.

By this standard of performance, Wall Street does not serve us well. Indeed, Wall Street’s most lavish rewards go not to those who enable others to create wealth, but rather to those most skilled and ruthless in expropriating the wealth of others—behavior condemned as immoral by every major religion. To justify their actions, Wall Street players and their apologists turn reality and logic on their heads by treating growth in the size and profitability of the financial sector as an end in itself, and a measure of increasing sector efficiency.

Because financial services are a means, not an end, they are properly treated as an overhead cost to be minimized. By this reckoning, growth in the size of the financial sector as a percent of GDP represents growth in Wall Street’s overhead burden on the real economy from a highly efficient one percent in 1850 to a grossly inefficient 8.5 percent in 2010:

The following graph gives us a similar perspective on the growth in Wall Street profits. From 1929 to the mid-1980s, profits of the financial sector tracked right along with those of the profits of non-financial (read real economy) corporations. As Wall Street became increasingly predatory in the 1980s, its profits relative to profits in the real economy began to grow exponentially. That may look like an increase in efficiency from a Wall Street perspective. From the perspective of the society, however, it is another measure of Wall Street’s increasing overhead burden. 

Market advocates correctly note that markets have a wonderful ability to self-regulate in the public interest. When market advocates go on to argue, however, that the solution for market failure is to get government out of the way, they demonstrate remarkable ignorance of basic market economics. Markets self-organize in the public interest only if incentives align with the public interest.

As Nobel Economist Joseph Stiglitz correctly observes: “When private rewards are well aligned with social objectives things work well; when they are not, matters can get ugly.”

As the 2008 crash revealed, Wall Street’s reward system renders it incapable of self-regulation in the public interest. Furthermore, Wall Street financial institutions have become so over leveraged and so interconnected that the collapse of one threatens the collapse of all—and thereby potential total collapse of the global economy. Corrective action necessarily falls to government, which can deal with Wall Street’s failure to self-regulate in one of four ways.

1. Continue to bail out failed banks at taxpayer expense.
2. Build a countervailing external regulatory system equal to or greater than the size and power of the financial system, spell out detailed lists of prohibited behaviors, and impose fines and jail sentences for each violation sufficient to make good behavior more attractive than bad behavior.
3. Implement a system of taxpayer funded financial incentives for good behavior to achieve the same outcome, or
4. Create a system of incentives that drive a reorganization of the financial system and a realignment of its internal rewards to favor transparency, accountability, and public service. A basic framework for such a reorganization is spelled out in the New Economy Working Group report, Liberating Main Street from Wall Street Rule.

The first option rewards ever greater risk-taking and will ultimately bankrupt even the wealthiest government. Options two and three are enormously complex, set up an intense competition between private and public institutions, invite massive corruption, and require huge public expenditure.

Only the fourth option can create a system that is adaptive, self-regulating, and relatively inexpensive to maintain with modest government oversight. Here are two examples. 

• Basic Banking Services. This need is best met by a system of small and locally owned banks that function as well-regulated public utilities supported by deposit insurance and access to low cost credit. To provide appropriate incentives to keep individual banks relatively small, insurance fees, interest rates, and reserve & capital requirements should be based on the bank’s total assets. Larger banks will pay higher fees and interest rates and be required to maintain higher reserves and capital to loan ratios—thus giving an inherent competitive advantage to banks that remain small. 

Banks organized as cooperatives, such as credit unions and cooperative banks directly accountable to those they serve, might enjoy especially favorable terms to encourage cooperative ownership.
• Proprietary Trading. If a group of investors or money managers chose to join together to create a firm to engage in proprietary trading, they could do so. The firm must, however, be organized as a partnership with all debts and losses backed by the personal assets of the partners to provide a powerful incentive for responsible self-regulation. Propriety trading would be its only allowed function. Such firms would not enjoy any government guarantee or tax incentive and they would be prohibited from accepting investments from retirement or other funds held and managed in trust.

The Wall Street experience has demonstrated why it is important to confine different financial functions to separate smaller institutions that hold managers accountable to those who bear the risk.

Get the system’s internal incentives right and the priorities and risk calculations of the financial sector will shift dramatically, its size will shrink, real efficiency will increase, and regulatory costs and failures will plummet. Restructuring to get the internal incentives right should be a foundation of all future financial reform efforts.