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How to Deregulate Wall Street (Without Causing a -2-

22 Jul 2017 5:43 am

Indeed, Steve Eisman, a portfolio manager at Neuberger Berman, says that for the first time since 1992, when he started his career analyzing the banking industry, he isn't worried about the "safety and soundness" of the U.S. financial system. He has an eye for spotting banking crises -- his prescience about the 2008 collapse earned him millions and a starring role in The Big Short, Michael Lewis' best seller about the crash.

Still, the pendulum is swinging. On June 8, the House passed the Financial Choice Act, designed to gut much of the post-financial-crisis legislation. Presumably referring to the stagnant economy, Rep. Jeb Hensarling, a Texas Republican and chairman of the House Financial Services Committee, said, "Every promise of Dodd-Frank has been broken." His bill passed along party lines. Four days later, Mnuchin's Treasury issued a 149-page report calling for many of the repeals found in the House bill, including a reduction in bank capital requirements and an easing of Volcker rule restrictions.

Such moves have infuriated Trump's most vocal critics, including Sen. Elizabeth Warren (D., Mass.), who said in a recent interview, "The Goldman appointments are the tangible demonstration of Donald Trump turning his back on virtually every campaign promise he made....Donald Trump said over and over that he wanted Glass-Steagall, and that he would break up the banks. And now his Treasury secretary says, 'No, we're not gonna do that.' "

Even if getting the House bill through the Senate won't be possible without support from Democratic senators, there is much that the Trump administration can do on its own to loosen banking regulations and make it easier for Wall Street to get back to the business of providing capital to people who want it and are willing to pay a fair price for it. For starters, the administration could have the Securities and Exchange Commission roll back certain Dodd-Frank rules and pull regulators out of Wall Street firms.

SOME WALL STREET EXECUTIVES, including Blackstone's Schwarzman, applaud what Trump is trying to do. "It was natural you were going to see an increase in regulation after the financial crisis," Schwarzman, chairman of Trump's Strategic and Policy Forum, which advises the president, wrote Barron's in an email. "But I'm not sure anyone really took full account of the unintended, negative consequences that these layers and layers of new rules have had. When you look at the totality of the impact -- such as a reduction in liquidity and the number of market makers, which could cause the system to freeze up during a crisis -- a number of these regulations have actually made things less safe."

While some on Wall Street would like Trump to take a sledgehammer to Dodd-Frank, others expect the changes to be incremental. Eisman expects Quarles to make changes on the margins. Regulating the banking industry is "an iterative process," he says. "There are no tablets from Sinai on how to do that. You have to do it by trial and error. The industry probably does have excess capital. You can do with a little bit more leverage and a little bit more bond liquidity. That's basically what's going to happen."

In all of the talk of Wall Street reform, there has been almost no discussion of changing the industry's compensation structure, which has been good at rewarding bad behavior and swing-for-the-fences bets with other people's money, but poor at rewarding prudent risk-taking and accountability. There's no mention of Wall Street's problematic incentive system in the Hensarling bill, nor in the Mnuchin report. Few regulators have raised it as a concern, let alone a problem desperately in need of a fix. Addressing the compensation system has become something of a third rail on Wall Street: Everyone knows it's a problem, but no one dares go near it.

Indeed, on Thursday the SEC and several banking regulators backed off from such a push, which had been mandated by Dodd-Frank, in the interest of moving forward with other deregulation priorities.

And yet it is indisputable that Wall Street's compensation structure is broken, and has been since 1970, when Donaldson, Lufkin & Jenrette raised capital in the public markets. One Wall Street partnership after another tapped the public equity markets, substituting other people's money for the partners' money. In turn, what had been a partnership culture that rewarded prudent risk-taking on Wall Street has been replaced with a bonus culture, rewarding big revenue generators with multimillion-dollar bonuses. Lots of things were lost along the road from private partnerships to pubic companies, but foremost among them was any sense of accountability for individual bankers, traders, and executives for the consequences of their inevitable bad behavior.

In the years leading up to the 2008 financial crisis, bankers, traders, and executives were rewarded with big bonuses for manufacturing questionable mortgage-backed securities. By the time they blew up, necessitating a government bailout of the banking system, the bonus checks had been cut, dispensed, and cashed. Not a single bonus was clawed back or repaid.

In my 2009 book, House of Cards, about the collapse of Bear Stearns, a conversation I had with Jimmy Cayne, the longtime CEO of the firm, proves the point. When I asked him what it was like to lose a billion dollars of his net worth -- after Bear's stock collapsed -- he didn't respond the way I thought he would. "The only people [who] are going to suffer are my heirs, not me," he said. "Because when you have a billion six and you lose a billion, you're not exactly like crippled, right?" Maybe he would have thought differently about the risks Bear Stearns was accumulating if his full net worth was on the line, as it was before the firm went public in 1985.

Nearly a decade after the second-worst financial crisis in U.S. history, bankers, traders, and executives are still rewarded for taking big risks with other people's money. In exchange for the comprehensive changes sought by Wall Street executives, Trump should insist that the top 500 or so executives at every big bank -- the ones who decide how to deploy capital, which business lines to be in, and who gets promoted and paid -- have a significant portion of their net worth on the line every day, as was de rigueur in the days when Wall Street firms were partnerships and imprudent decisions could put an entire firm at risk almost overnight.

There are many ways that lawyers could construct this obligation -- giving creditors and shareholders a "contingent value right" tied to their collective net worth, for instance -- but regardless of the particulars, the important thing is for Wall Street's leaders to have skin in the game, just as they once did, to act as a brake on dangerous practices and ensure accountability when things go wrong.

IT WON'T BE EASY to get Wall Street to go along. Why should the industry voluntarily change an incentive system that pays employees millions of dollars a year to take big risks with other people's money? But that's just the point. It's time for Wall Street to do something that will benefit the whole system, and changing the rewards on Wall Street will do just that.

Trump must make this grand bargain. Not only would it be wildly popular across the political spectrum, but also it would be the right thing to do. "Incentives -- compensation and promotion, in particular -- are powerful tools for communicating the conduct and culture you desire for your firm," said the New York Fed's Dudley in his London speech. "A commitment to the long term must be at the core of banking. Incentives within a firm should support that goal, not undermine it."

WILLIAM D. COHAN, a special correspondent at Vanity Fair and a former investment banker, is the author of Why Wall Street Matters, Money and Power, House of Cards, and other best-selling books.

Email: editors@barrons.com

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July 22, 2017 01:43 ET (05:43 GMT)

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