What are they thinking?

With the announcements of record Wall Street bonus pools, and rising credit card fees, it is time to sit back and see where we go from here.

In the wake of the near collapse of the US financial sector one year ago, Hank Paulson and Ben Bernanke took extraordinary measures to avert collapse. Turning caution to the wind, they arranged shotgun mergers, decided who would live and who would die, and brought the word trillions into our every day vocabulary. By the time they were done, the landscape of American banking has been transformed. Today, the six banking organizations that received $160 billion between— JP Morgan, Bank of America, Citigroup and Wells Fargo, and the former investment banks Goldman Sachs and Morgan Stanley—are now looking to a future in which they can dominate the financial services landscape.

But perhaps the term financial services is misleading in this context. After all, as bank earnings reports were rolled out for the most recent quarter, and news headlines announced the record bonus pools that the banks were preparing to pay, it became clear that these earnings derived from trading activities, rather than traditional commercial bank lending activities. Before our eyes—and with the full support of the Federal Reserve and the US Treasury—the transformation that we have witnessed is not of the conversion of major investment banks such as Goldman Sachs and Morgan Stanley into commercial banks, but rather of each of these firms into government guaranteed hedge funds.

I readily concede that I am using the term hedge fund loosely. After all, hedge fund is a generic term for a relatively unregulated investment vehicle, that is permitted to invest in a wide range of unregulated derivatives and other investments, and whose returns are dedicated to a limited universe of investors. And certainly, the practices of JP Morgan or Goldman Sachs, who undertake massive proprietary trading activities, run huge derivatives books, and dedicate the preponderance of their earnings to senior employees, should not be lumped into the same category.

But on the other hand, if it walks like a duck…

Today, the commercial banking world is sharply divided. With over eight thousand commercial banks and savings institutions, these six firms hold less than 50% market share. Therefore, by traditional measures of market concentration, they are far from monopolistic. But as individual firms, their size dwarfs their cohorts, even considering that two of them, Goldman and Morgan Stanley are not traditional depository institutions. Together, the six boast total deposits of $2.7 trillion, or an average of $444.8 billion per firm. This compares with an average of $107.2 billion for the next six largest banks, and $76.0 billion for the following six. The fiftieth largest—well within the top 1% among all banks—Associated Bank of Wisconsin, has deposits of $16.4 billion.

At the same time, as JP Morgan and its brethren have increasingly concentrated on derivatives trading, loan securitization, securities underwriting and proprietary trading—and as these activities have contributed disproportionately to profitability—the share of bank assets dedicated to traditional commercial bank lending—the type that is most directly linked to the local economy in towns across the nation—has similarly decreased. Therefore, it is not a stretch to suggest that even as the Federal Reserve and Treasury have concentrated for the past year on addressing the risks to the financial system that largely emanated from the largest firms, these firms have at the same time migrated the farthest from the tradition public mission of the commercial banking industry.

It may be hard in the face of the drumbeat of stories about the banks and their problems and their bonuses to remember that commercial banking is an industry with a specific public mission: To take deposits and make loans. It was in the wake of the Great Depression, that the Glass-Steagall Act was passed to restore confidence in the commercial banking industry. Glass-Steagall forced the separation of commercial banking (lending) and investment banking (trading, underwriting), and created the FDIC to insure the deposits of commercial banks.

Beginning around 1980, the banking industry began a steady assault on Glass-Steagall, as investment banking firms sought access to the large pools of commercial bank deposits and commercial banks sought to expand into trading activities that would allow each type of firm larger profit and bonus opportunities. These efforts finally culminated in the Financial Services Modernization Act of 1999, which finally ended the Glass-Steagall restrictions and allowed the complete merger of investment and commercial banking organizations. However, the 1999 Act left FDIC insurance in place, resulting in the hybrid creature that emerged, able to attract government-insured deposits, and utilize those deposits across a range of lending, securities trading, and newly emerging derivatives trading activities.

Today, the financial policy brain trust of Ben Bernanke, Larry Summers and Tim Geithner have rejected calls for structural reforms to the banking system and to reinstate the Glass-Steagall restrictions. Despite the experience of the past several years, culminating in the financial crisis one year ago, they are suggesting that the concentration of power represented by these six firms is acceptable and desirable, and reform efforts should focus instead on the creation of a single systemic risk regulator to oversee those institutions deemed too big to fail.

Standing alone against Bernanke, Summers and Geithner within the Obama administration is former Fed chairman Paul Volcker. Volcker continues to call for the reinstatement of the Glass-Steagall restrictions, and recognizes the imperative of maintaining the link between deposit insurance and commercial bank lending.

It is hard to imagine what Bernanke, Summers and Geithner are thinking, and how they can look at the devastating experience of the past two years, and not conclude that something is fundamentally wrong. Financial modernization did little to help those thousands of commercial banks who have stuck to their knitting, and who now have been sorely disadvantaged by the federal bailouts of their large competitors. Proponents of financial deregulation argue that Volcker and other advocates for turning back the clock are recalcitrant Luddites, yet they have been hard pressed to demonstrate how the creation of the new class of hybrid commercial-investment banks and unregulated derivatives trading have added value to the economy.

Can Bernanke, Summers and Geithner seriously believe that a systemic risk regulator can control the risks that are embodied in these massive firms? Recent history suggests that the risks entailed in the trading strategies, quantitative models, complex derivatives and contract risks were never fully understood by the risk managers, bank CEOs and directors of their own organizations. Bank regulators were captive of the banks themselves as they sought to understand the information that was provided to them. Capital requirements other traditional tools for containing risk proved to be of only marginal value in the face of derivatives with nearly unlimited leverage, and collateralization requirements buried deep in unregistered and unregulated contracts.

Furthermore, political influence over regulators is a fact of life in Washington, and over time will undermine whatever independent structure these three wise men might have in mind. One need only point to Summers’ own success in 1998 in silencing Brooklsey Born—the head of the independent Commodity Futures Trading Commission—when she argued the inconvenient truth of the growing systemic risks presented by the unregulated derivatives market, at a time when Summers and the Clinton administration were arguing the merits of financial deregulation.

It is mind boggling that we can continue down this road. Paul Volcker must be applauded and supported for his unflagging efforts to bring attention to this issue. He is a wise man standing against smart men. And he is right.