It's fire season for finance, writes Ken Miller . A former senior banker predicts that an unreformed wage system and deregulation will precipitate the next financial crisis, writes The Economist.
It's been a little over 17 years since the financial crisis caused by the bankruptcy of Lehman Brothers, and US stock markets are once again at or near historic levels.
The two main drivers of investor optimism are Artificial Intelligence and a significantly relaxed regulatory environment. These factors, combined with a compensation system on Wall Street that has remained essentially unchanged since 2008, have now come together to set the stage for the next financial collapse.
After the 2008 crisis, the Dodd-Frank legislation that President Barack Obama signed into law in 2010 strengthened big banks by raising capital requirements and imposing other restrictions on risk-taking. But Section 956 of that law, the provision that instructed regulators to curb incentive payments that encourage excessive risk, was shelved in practice during Donald Trump’s first administration and exists only on paper today. The most significant Wall Street stimulus reform never took effect.
Bonuses are the beating heart of the modern financial system. While most Americans think of a bonus as a small percentage of base pay, on Wall Street, bonuses are typically multiples of a salary that itself can be several hundred thousand dollars. There was talk of “clawbacks,” the clawback of bonuses for bad deals, with the aim of aligning negotiators’ incentives with the long-term health of their employers.
But clawbacks remain rare and largely symbolic. Traders, investment bankers and asset managers continue to be rewarded for profit growth in the current year, even when the transactions they execute result in losses later.
This culture of big, short-term incentives is no longer limited to the traditional banks that Dodd-Frank sought to regulate. Payments at nonbank institutions, today the vital engines of finance, are equally driven by the logic of short-term profit. Talent has shifted to small, easily regulated trading institutions built around automated models, statistical arbitrage, and ultra-high-speed execution.
Partners receive a share of the annual profits. No deferrals. No clawbacks. Most trade with borrowed funds and have no regulatory oversight body.
Dodd-Frank never envisioned a world where much of the market making and intraday liquidity would be managed by automated systems, overseen by financial engineers whose bonuses are tied to the profitability of the models, not to market stability.
Private credit, now a multi-trillion dollar shadow banking sector, compensates its negotiators on an even more asymmetrical basis than banks did before 2008.
Executives at these firms receive large “carried interest” payments tied to loan volume and fund returns in the early years of a strategy, even though the actual performance of these illiquid loans may not be known for a decade. Today’s private credit industry has recreated the incentive structure that fueled the subprime mortgage boom, only more powerful and with less oversight.
The mortgage and consumer lending businesses operate under similar incentives, with no long-term exposure to the risks they create. This was precisely the dynamism that produced the recent crisis, reborn through new channels.
All of this is happening in an era of extreme deregulation. Early in his first term, Donald Trump ordered that for every new regulation he issued, two existing regulations would be removed. Large parts of Dodd-Frank were rolled back, exempting all but the largest banks from increased oversight and shifting regulators’ focus from rules to innovation and growth.
In Trump’s second term, his approach has shifted from changing the rules to replacing the enforcers. Top positions throughout the regulatory architecture have been filled with anti-regulators, agency heads drawn from the industries they now oversee, enforcement chiefs whose careers were built on opposing the rules they are tasked with enforcing, and oversight officers who openly oppose the very concept of oversight. The rules remain; the arbiters disappear.
As Russell Vought, director of Trump’s Office of Management and Budget and one of the architects of this administration’s strategy, put it: “Personnel is politics.” In February, after firing the director of the Consumer Financial Protection Bureau, Trump named Vought as the agency’s interim director. Immediately, Vought ordered a broad suspension of its operations, halting investigations, enforcement, rulemaking, and even the provision of additional funding. Entire categories of predatory lending were effectively treated as unreviewable.
At the Securities and Exchange Commission, cases against major crypto and fintech firms have been dismissed or suspended indefinitely. The oversight arms of the Office of the Comptroller of the Currency and the Federal Reserve have reassigned or sidelined career examiners who once looked into liquidity mismatches and operational risks.
This gives financial institutions the freedom to buy higher-yielding, hard-to-sell long-term assets and finance them with cheaper short-term liabilities, increasing profits through a balance sheet structure with a dangerous mismatch between assets and liabilities.
Meanwhile, politically connected financial offenders are pardoned. White-collar crime has become negotiable.
When Lehman went bankrupt, its failure caused an estimated $10 trillion loss in global stock market capitalization in a matter of weeks. It is impossible to know what will be the spark that will ignite the next fire. A sudden consensus that Artificial Intelligence will not live up to expectations?
A massive corporate fraud? Something else entirely? What is clear is that once the flames start, there will be plenty of fuel to spread them, thanks to Wall Street's obsession with bonuses, hidden illiquidity, asset-liability mismatches and unregulated markets./monitor
