Another crisis is inevitable. What will cause it?

October 9, 2018 10:00 PM

With the spate of financial crisis 10th-anniversary stories over the past month, it’s only natural that people are beginning to ask where in the system trouble could be lurking.

For now, the economy is growing strong, and many fundamentals look good — but there are still potential risks.

“Post-crisis, everybody wants to look for the next shoe to drop,” said Jason Ware, chief investment officer and chief economist at Albion Financial Group. “The good news is that I don’t have a high-probability scenario, although there are certainly possibilities out there.”

Guessing where the next crisis could emerge can be tricky given how fast events can unspool, but following are several of the top contenders right now:

Corporate debt

Perhaps the biggest sector for potential risk is the market for corporate debt. Junk bonds, riskier investment-grade bonds and leveraged loans have all exploded in recent years. Companies have loaded up on debt in the low-interest-rate years following the crisis, but with rates now rising, defaults could soon tick up, generating concern about possible instability down the line. It’s not clear yet that we’re on a collision course for another crash, but this is an area experts are watching. If current trends continue apace for another few years, the system could find itself in greater trouble.

“We have some pretty record high corporate debt at interest rates that don't always seem to match the potential risk,” said Edward Mills, a policy analyst at Raymond James.

Shadow banking

James Bullard, president of the Federal Reserve Bank of St. Louis

James Bullard, president and chief executive officer at the Federal Reserve Bank of St. Louis, poses for a photograph in Tokyo, Japan, on Tuesday, May 30, 2017. Bullard said the new administration in U.S. will need to fulfill the expectations that have driven the stock market higher. Photographer: Akio Kon/Bloomberg

Akio Kon/Bloomberg

While the Dodd-Frank Act and other post-crisis rules have vastly expanded oversight of banks, considerably less has been done on the nonbank side.

That wasn’t supposed to happen. The 2010 reform law took some steps to keep better tabs on nonbank institutions, but regulators made only tentative moves to regulate these entities — and some of those actions, including designation of systemically important nonbanks, have largely been reversed at this point.

Even some policymakers are getting worried.

“It’s that shadow world where the next crisis will be brewing,” James Bullard (pictured), president of the St. Louis Federal Reserve Bank, said last month in an interview.

If anything, the danger may be growing with the introduction of newer entrants into the market — including fintech startups and behemoths like Google and Facebook. For example, experts have speculated about the risks of cloud computing as banks and government entities become more reliant on such services.

“The current thinking is that if a fintech company goes down, they don’t have leverage and investors take the loss,” said Justin Schardin, a fellow at the Bipartisan Policy Center. “But as new technologies become more bound up in how the financial system works, they become more core to the functioning of the system.”

Student loans

Of course, there may be trouble spots that get hyped that don’t actually pose much of a systemic risk. For example, student loans and other consumer spending categories like subprime auto lending are sometimes mentioned as areas of potential weakness, but these are unlikely (at this point) to spur the kind of instability that the country witnessed with the housing market a decade ago.

That’s because more niche markets like subprime auto lending or retail credit cards are too small to create systemwide damage, the likes of which the country experienced with the mortgage crisis. They also aren’t being securitized and continually repackaged with exotic financial instruments as happened with mortgages in the mid-2000s.

And while the student lending market has grown quite large — worth roughly $1.5 trillion — the risk to the banking system is minimized by the fact that the vast majority of those loans are backed by the government. This debt burden could very well become a drag on economic growth — delaying how long it takes for younger generations to get married and buy homes — but it’s unlikely to become what Mark Zandi, chief economist at Moody’s Analytics, calls a “cliff event for the economy.”

“It's not a financial system problem, it's a taxpayer problem,” he added.

Cybersecurity

One of the threats that remains the most difficult to track — let alone put odds on — is something like a major cyberattack. The most worrisome scenario would be a coordinated attack on the country’s financial infrastructure, perhaps the payments system or one of the stock exchanges.

In this case, banks and policymakers are alert to the danger. Ask any bank CEO for their number one concern, and most will answer cybersecurity.

“I think [‘too big to fail’ is] mostly over, but you should always be on the lookout for things that cause problems in the system,” Jamie Dimon, head of JPMorgan Chase, recently said. “Cyber might be one of them.”

Banks and other financial players have also increased their attention, and put more resources, into this issue in recent years. But is it enough? There’s a real question of whether it can ever be so.

“There are a number of tech, IT and financial security experts working on this around the clock that are trying to stay one step ahead of hackers,” said Ware.

Deregulation

For some experts, the threat to the system is less about what we can predict than it is about what we can’t. Many on the left, in particular, are concerned about the rollback of banking rules by President Trump’s regulators — a move they see as potentially increasing the risk that any shock to the system will be more difficult to absorb.

The easing of capital rules, lending requirements and other reforms potentially leave the door open to new threats that can’t yet be observed. The concern is reminiscent of the fact that so few people recognized the potential depth and breadth of the last crisis before it fully took root.

“We're never going to be able to predict with any sort of concrete high level of confidence what the next shock is going to be,” said Gregg Gelzinis, a research associate for economic policy at the Center for American Progress. “That's why it's so important to have safeguards in place.”

That concern isn’t just limited to the left, however. Sheila Bair, the former chair of the Federal Deposit Insurance Corp. and a Republican, has also warned about the risks of the current deregulatory push.