How the next financial crisis might happen

Report: A new financial order

Part 7
May 23rd 2025

The Economist

The trends outlined in this report have transformed finance. Many of them will only intensify. Private-equity firms will keep diversifying away from buy-outs into lending and life insurance. Hedge funds will continue consolidating and reaping the benefits of scale. The brain drain from banks to hedge funds and other asset managers will carry on. So will the quest of some on Wall Street to rip off Main Street. The craze in cryptocurrencies and leveraged exchange-traded funds is already making the meme-stock madness of 2021 look quaint by comparison. President Donald Trump, for his part, seems more keen to profit personally from the gamification of markets than to protect investors through regulation.

The instinct of regulators will be to disadvantage the new titans of Wall Street by cutting red tape for their competitors in the banking industry. Michelle Bowman, the Fed governor responsible for financial regulation, said recently that rules had pushed “foundational banking activities out of the banking system into less regulated corners of the financial system”. She wants to change that. Daniel Tarullo, a former bank regulator at the Fed, likens the competition between asset managers and banks to pressures faced by banks in the late 1970s from the growth of capital markets, such as bond markets and money-market funds. “The answer then was to deregulate the banks so they could more effectively compete,” he says.

But deregulation would probably accelerate rather than halt the transformation. Eroding supervision and capital requirements for banks will merely allow them to lend even more to asset managers and hedge funds than they do now, supercharging the growth of the new, less-regulated giants of finance.

Proceeds at your peril

Rapid growth in financial markets often fosters and obfuscates weaknesses which become visible only during periods of crisis. How might a crisis play out? Danger could emerge from inside these high-flying firms—due to, say, sloppy lending by private-credit outfits or big hedge-fund trades going sideways. The holdings in both industries are large enough to worry about. The five top players in private credit manage $1.9trn of credit assets across funds and insurance balance-sheets. Assets of the five biggest multi-manager hedge funds sit at $1.6trn, including huge leverage.

Even where these firms do not rely on short-term funding their failure would risk infecting the banking system, which does. Some have been so successful that they have become too big to fail, raising the possibility that they should be designated as systemic institutions like the largest banks, which would give regulators more oversight. GE Capital received this designation in 2013 (it was revoked in 2016). Apollo, the firm which most closely resembles the industrial conglomerate’s lending arm today, could be one candidate given its uniquely important role in debt markets.

A shock could also come from outside these firms. Fragile regional banks, falling commercial property prices and highly valued technology stocks are all causes for some concern. More so is Mr Trump, who in his second term has already proved to be an agent of chaos for financial markets. As the tariffs-induced turmoil showed in April, the state of American finance is vulnerable to the country’s corroded politics. Any sustained bout of worry about the safety of America’s government debt, where a flood of borrowing flows through creaky pipes, could trigger a meltdown on Wall Street. Highly leveraged hedge funds have come to play a critical role in this market.

Wall Street beguiles foreigners. Governments abroad look on American finance with a mixture of jealousy and concern. Jealousy because the country’s capital markets are rich and dynamic. Britain curses the exodus of its firms to stockmarkets in New York. Europe pines for a day when its members are as financially integrated as American states, a hopeless wish.

Indecent exposure

They worry because they are more exposed to American assets than ever before. The flip-side of America’s current-account deficit is increasing foreign ownership of its assets, since the dollars America pays for things made elsewhere are invested in dollar-denominated assets. That means a blow-up on Wall Street would mean a blow-up for the world. They worry too because the state of American leadership is much degraded since the last financial crisis. The response then was marked by global co-ordination as the world’s economy collapsed. This time will be different. When the next crisis does come, American financial institutions will undoubtedly be at the centre of it. The world will be left to contend with the fallout. ■