How much banking does America need? James Saft

-- James Saft is a Reuters columnist. The opinions expressed are his own --

By James Saft

LONDON (Reuters) - Few will argue with the idea that the U.S. financial services industry is shrinking; the big question is whether the credit crisis marks a cyclical downturn or a long-term change.

By most measures, the growth and profitability of banking and financial services in the United States has been astounding in recent years. Through most of the post World War 2 period profits by financial firms averaged about 0.75 percent of gross domestic product (GDP), but tripled to as much as about 2.5 percent as banks moved away from old-fashioned portfolio lending and remade themselves into intermediaries that made loans and sold them on, often to bank-controlled entities.

Bank profits have been hit badly in 2008 as house prices tumble, but in the first quarter financial profits were still around 2 percent of GDP, a figure far higher than anything seen between 1947 and the turn of the century.

How far that falls and where it settles will have a huge influence on how many people work in the financial industry, what they are paid, what shares in their companies will fetch and even conceivably on the long-term capacity of the U.S. economy to grow.

The answers at this point are simply unknowable.

We don't know what business model banks and investment banks will follow, for one thing. Will they make and sell loans, slicing and dicing them to make them better matches for what the market wants, or will the ice-cold securitization market prove dead, leaving them as portfolio lenders?

We also don't know what the regulatory backlash will be, though it's safe to assume new official oversight will be costly and will make firms, perhaps properly, much more cautious.

Ben Inker, director of asset allocation at GMO in Boston, which manages $126 billion, thinks profits in relation to GDP might halve from the recent past, and even that might be an upper estimate. When financials plunged in July they were trading at about Inker's halved level of profitability, but that's not taking into account the potential for substantial future writedowns and the need to raise more capital, he said.

"Is it a moderate financial crisis or is it a really serious financial crisis?" Inker said.

"If it's an honest-to-god systemic crisis you should not touch financials now or really until current equity holders are more or less wiped out."

GET RICH SLOW

There is also, of course, the possibility that the growth of financial services reflects a move to a more service-oriented economy, and that greater profits might be fair in comparison to the value they create.

Growth of financial value added as a proportion of GDP has been steady and seemingly relentless since World War II, not just during the bubble years. You could argue that, even laying aside the current debacle, people will continue to need to borrow, save and buy and sell companies and will pay a premium price in hopes they come out ahead on the deals.

But that will need to be proved and until it is investors, even optimistic ones, will apply a big uncertainty penalty on shares in financial services firms.

How the industry evolves will also affect who gets paid what in banking. Richard Koo, chief economist at the Nomura Research Institute in Tokyo and a former Federal Reserve economist, points out that commercial bankers earned more than investment bankers between the onset of the Depression and the 1970s, a situation that has since been decisively reversed as investment banks' advisory business grew in profitability.

Perhaps if we go back to old-fashioned lending the commercial bankers will again make more, though very likely that would happen because of a fall in salaries rather than a rise.

It is likely too that the turbo-charged lending of the past decade allowed the economy to grow at an unsustainable rate. If securitization does not return and banks become more careful in lending their own money, the natural rate of growth could prove to be less.

"It would certainly lead to structurally lower economic growth, but that probably would be a good thing," Koo said.

Fewer loans would be made, at higher rates of interest. This would retard growth but growth would be more stable and less subject to the kinds of upsets we are now observing, according to Koo.

The idea of a smaller financial sector, making fewer loans and paying its employees less, certainly sounds reasonable, especially as we suffer the impact of the lousy loans made on the way up.

But it also discounts the influence of innovation and hope.

Smart people will come up with new financial products, many of which will work admirably, at least for a while. Smart people will also, as this incident fades from memory, reach for that little extra yield, or take big risks in hopes of getting rich.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund --

(Editing by Ruth Pitchford)