05/21/2012 02:03 pm ET Updated Jul 21, 2012

Why a Banker Thinks Wall Street Should Be Regulated

As a follow up to my previous post "Capitalist Revolution: Forget the Deficit and Learn From Europe," and as a banker, I now want to discuss Wall Street reform.

The most contentious issue in the debate about Wall Street reform involves fairness. Many bankers and Republicans complain that the Obama Administration has unjustly targeted the financial sector in imposing restrictions, and that the regulations themselves contradict free market principles. But while people bicker about fairness, they are forgetting one basic tenet of capitalism -- if someone can make a lot of money doing something, even if that something could hurt others, they probably will.

In fact, during the Congressional hearings on the subprime crisis, there was a pivotal moment when Lloyd Blankfein, the CEO of Goldman Sachs, told the committee in no uncertain terms that the bank's actions that eventually played into the market collapse was simply how Wall Street does business and that without regulation, they would do the same thing again. It was a statement of startling candor and one that the press should have paid more attention to. What he essentially said was that the banking industry makes its money by gaming the system and there is no way to stop that except through reform.

Coming from Wall Street myself, I can safely say that the demonization of bankers is unfair and populist. Most bankers are not the unethical and blindly greedy creatures that politicians and the media make them out to be; and there is no doubt that without the productive activities of the banking sector, no other industry in our nation would be able to survive or thrive.

But that does not mean there isn't a ghost in the machine.

While a fair amount of what Wall Street does enables both small and big investors to make money, and every industry from consumer products, food and pharmaceuticals to electronics and airlines relies on banks for business capital, the primary focus of the banking industry is on itself. In other words, the main priority of Wall Street is personal profits for bankers.

In order to achieve that goal, the banking industry is moving further away from activities such as investment banking and lending -- which benefit the economy, and towards more lucrative and self-serving businesses like trading and the creation of exotic securities (which then necessitate even more such activities to hedge against risk). These pseudo-"games" should theoretically be harmless to everyone but the players themselves but in reality they are not. In the globally connected and financially interdependent world of today, everyone from commercial banks, hedge funds, mutual funds and foreign governments down to your neighbors and grandma are linked through a massive financial network, whose complex transactions are hard to track, difficult to predict and nearly impossible to control. And these transactions collectively run into trillions of dollars. The net result is a colossal domino effect when something goes wrong.

Jamie Dimon, the CEO of JPMorgan Chase, said last week that the bank's staggering losses will not impact its customers. While the bank may shield its customers from the trickle-down effects of this fiasco, I don't see how several billions in losses cannot have an adverse effect on the broader financial system. In this case, the impact may not be crippling but in a chain of dominoes, even a wobbly domino can cause a collapse; and so the mere possibility is too much of a risk for the U.S. to allow.

The only way to guard against this is to intelligently regulate Wall Street, with a particular focus on the market for exotic financial instruments, popularly known as derivatives. More than a decade ago, a woman named Brooksley Born, the head of the Commodity Futures Trading Commission, had first sounded the alarm for the need to monitor and regulate derivatives trading in America, but was purposefully and maliciously sidelined by Federal Reserve Chairman Alan Greenspan and Treasury Secretary Robert Rubin, both of whom were extremely fiscally conservative and ideologically motivated. That short-sightedness by Greenspan and Rubin (not to mention Rubin's deputy Lawrence Summers and numerous other culprits) created an environment conducive to the type of financial engineering that would eventually lead to the subprime mortgage crisis.

The justification for the government's inaction back then is the same as the one being used by the banking lobbies and Republicans today: regulations disrupt the natural flow of business and so are counter-productive, not to mention that restricting private enterprise is immoral. That may be, but in my opinion, it is even more unfair to allow Wall Street to do things that endanger the entire financial system. It would be one thing if the effects of the banking industry's actions were limited to its own sphere, but they are not anymore. When Goldman Sachs or JPMorgan Chase decide to take a risk for the sake of profit, those risks spill over into the wider economy because of the interconnectedness of banks to every other industry and part of the world, as well as the sheer size of the transactions.

Of course, to criticize the banks for doing what they do is silly. Bankers, like everyone else, want to make money and there is nothing wrong with that. Wall Street provides the fuel for the American economy. But if certain activities have proven to be overly dangerous, then it is not only prudent but acceptable to regulate those activities. As Blankfein so bluntly told us, there is no other way to stop Wall Street from taking oversized risks, which can then jeopardize the economy. The money that can be made through trading and other risky activities is so vast that to expect bankers to police themselves in the face of such temptation is unrealistic and naive. Greenspan and Rubin made a grave mistake that should not be repeated.

It may be anti-capitalistic to impose regulations on Wall Street but, unfortunately, it is also imperative. That is not to say that excessive regulation will not hurt our economy, but a sensible and balanced approach to financial regulation can go a long way in reining in excess without crippling the business of banking. It may not be ideal, but after the carnage of 2008, idealism is not a luxury we can afford. Serious times require serious solutions, not ivory tower moralizing.