The Bear Stearns bailout was not quite unprecedented; Continental Illinois Bank in 1984 and Citicorp in 1991 were both beneficiaries of Fed-orchestrated rescue operations. And notoriously, the hedge fund Long Term Capital Management was not allowed to fail in 1998. However since the mortgage crisis is by no means over, and further financial difficulties seem likely to appear as the US recession deepens, it raises the interesting question of what kind of US financial system we can expect to see in 2013, after the storm has passed.

Economically, we can expect to be climbing out of the current unpleasantness by 2013 — it may be prolonged, but probably not quite that prolonged. This is not Japan, and given the choice of a short sharp shock or 15 years of stagnation, most US voters would choose the short sharp shock. In any case, capital spending has been depressed since 2001 and corporate balance sheets have markedly improved; thus we are to some extent already seven years into the process of recovering from the dot-com bubble. Nevertheless, the financial system in 2013 will have a memory of a debt crisis, followed by a sharp decline in housing prices, followed by inflation, followed by a decline in stock prices,. It will not have been a pleasant five years, and financial market participants, both institutional and individual will have been scarred by the experience.

Financial market structure in 2013 will probably be very different from today. How different depends on the degree of pain suffered by market participants in the intervening five years, and the actions taken by the authorities in their attempts to clean up the mess and return markets to an even keel. Those matters are intrinsically unknowable; while one can forecast with some assurance the general shape of an economic downturn, one cannot be sure of its depth, nor of the order in which traumas occur, nor of the political position, economic resources and sheer basic competence of the authorities attempting to deal with problems.

It is just possible that the impending downturn will be relatively mild, in which case the financial market structure and ethos will be only modestly changed, as it was by the 2001-02 downturn. That outcome is however fairly unlikely given the apparent scale of impending losses. In what follows I have assumed that serious and repeated losses will have provided Teaching Moments for market participants and regulators, and will have pushed the market structure beyond the “tipping point” at which fundamental change occurs and a new equilibrium structure shakes itself out.

In that event, of a recession and financial crisis that takes Wall Street beyond the “tipping point” at which a new structure appears, the risk-tolerant, even risk-seeking culture prevalent on Wall Street for the last generation will be gone. In addition, government will have stepped in with new regulations, some of which like the Glass-Steagall Act of 1933 that separated banking and investment banking, will decades later prove to have been counterproductive.

In all probability the most structurally significant of those regulations will involve the “too big to fail” doctrine that has repeatedly brought the Fed to rescue of ailing behemoth banks and investment banks. If an institution is too big to fail, so that taxpayers are ultimately at risk for its actions, then well designed legislation would also prevent it from taking excessive risks. The ludicrous structure of the – hopefully now moribund — Basel II bank capital regulations allowed large banks to take more risks than small ones, while relying on their own dodgy risk management systems to monitor the mess. The huge checks that taxpayers will be forced to write in the downturn will bring huge political demands for legislation forcing “too big to fail” banks and brokers to act in a highly conservative manner in order to preserve their “too big to fail” status.

Under this new legislation, banks and brokers with more than a certain volume of deposits, capital or total assets will be compelled to register as “mega-institutions.” They will benefit from an automatic Fed bailout, but in return will be compelled to submit to very strict capital ratios and restrictions on the businesses they will be permitted to carry out. In particular, they will be permitted to carry out new businesses to a total principal amount of only 10% of their assets, until those businesses have been registered with and approved by the Fed for mega-institution activity. Thus credit derivatives, for example, would not have been a permissible business for mega-institutions except in small amounts until the Fed on behalf of the public was completely satisfied their risk management problems had been solved.

With these restrictions, the mega-institutions would be neither risk-seeking nor innovative. They would be conservative in outlook, and their management would be paid respectably but not lavishly, perhaps somewhat above the level of Federal civil servants of equivalent responsibility. Fannie Mae and Freddie Mac, which by 2013 will probably have received at least one taxpayer bailout, will be registered as mega-institutions, and compelled to follow the stringent capital regulations for “too big to fail” banks. (If this put them out of business, tough; the home mortgage market would be the better if it lacked their quasi-public participation). In that event they would probably pay their top brass like the GS-15 civil servants they truly are.

Given the draconian restrictions on mega-institutions, new financial innovations would have to come from somewhere else, as would the risk-seeking that has been so successful in the last couple of decades. In the latter area, current structures would probably survive, to a limited extent, in hedge funds and private equity funds. These would have difficulty raising large amounts of capital, since the mega-institutions would not be allowed to invest in them, and would be very limited in their lending. Moreover fiduciaries such as pension funds will by 2013 have discovered the hard way the legal dangers of subjecting beneficiaries’ money to the risks of hedge fund investment and the Pharaonic remuneration standards of hedge fund managers.

As at present, hedge funds and private equity funds would be short-term in their orientation, and would continue to supply capital to the riskier areas of arbitrage and venture capital and psychic and occasionally financial satisfaction to the greedier “bankers.” Their area of productive operation might theoretically be increased by removing the competition from the mega–institutions, but their profitability would alas be severely affected by this elimination of a class of enormously rich suckers.

There would then remain a need for intelligence, to carry out true financial innovation, profit from new product areas while their volume is still relatively small and their margins high and advise on merger and acquisition transactions and on financial re-organizations generally. This business would be increased by the elimination of many large “profit center” finance departments in major corporations. The losses and indeed bankruptcies due to ill-judged speculation by profit center finance departments will have demonstrated to even the doziest Boards of Directors that at best such departments are an expensive, poor quality and unnecessary duplications of Wall Street, while at worst they are an invitation to ignore the firm’s core business and “make the numbers” through value-subtracting speculation. Eddie Lampert, he of the attempt to turn Sears Roebuck into a hedge fund, will no longer be a revered name by this point.

This intelligence will be provided by much smaller houses, generally private partnerships, living on their wits rather than their capital, which will navigate between the hedge funds and mega-institutions to make money for themselves and provide service to their corporate and wealthy individual clientele (private banking is an intellectual-value-added business only at the very top of the wealth spectrum.) They will perform the functions of the pre-1986 London merchant banks or some of the pre-1975 Wall Street investment banks, and will operate in the same way, living primarily on the fees they earn. By removing the temptation to “principal investing” inherent in the current behemoths, these institutions will eliminate a huge conflict of interest and allow for the reduction in the share of national income devoted to financial services. Naturally, to deal effectively with giant corporations and the very rich they will have to have what the 1960s Bank of England Governor Rowland, Lord Cromer called “prestige and standing.” As their market develops they will quickly discover that they will not get this by operating hedge funds, or by risking scarce capital in speculation.

Finally, there will be the “minnows,” those banks and brokerage houses not large enough to be “mega-institutions” but still providing banking and/or brokerage services to a limited clientele, generally regionally. They will not be permitted to grow beyond a certain point without registering as “mega-institutions” but will otherwise operate with fewer restrictions and more generous capital ratios than the mega-institution fraternity. Since regulation will have eliminated much of the economies of scale from growing “too big to fail” these entities will be highly competitive in their limited markets, surviving by means of lower capital costs, lower top management salaries and better customer service. Indeed, since securitization will have fallen largely out of favor, they may find a profitable new line of business in home mortgage lending, which they will perform more efficiently than the Wall Street machine. (Research has shown that the move from direct home mortgage lending to securitization between 1970-75 and 2000-05 added about 50 basis points per annum (0.50%) to the cost of every home mortgage in the United States – the new market was pure rent seeking.)

The new Wall Street will be less exciting for the greedy, but provide a better service for customers, while shrinking the financial services sector back towards its historic level and eliminating most rent seeking behavior. As such, its emergence will be one of the few unequivocal benefits of the miserable recession ahead.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)