Every banker knows in his or her heart of hearts that the cycle will turn, and we will have some form of a recession in the months or years ahead. Forces are building that suggest that the next recession could be more like 2007 than simply an ordinary cyclical turn down.

In fact, the last 100 years of finance suggest that tail-risk events that seriously impact finance are more common than many believe — and may be more frequent.

Like most down cycles, the next one will be hard to call. And the depth, severity and triggering event isn’t yet clear. But the fact that the current recovery has lasted this long suggests that a downturn is not so far off. Increasing technological speed, global interconnectivity and froth emerging in the markets suggest greater volatility ahead and thus a potentially more severe down-event.

The Dow Jones ticker in Times Square displays news about the stock market on Sept. 29, 2008, as U.S. stocks plunged and the Standard & Poor's 500 Index tumbled the most since the 1987 crash.
Any number of triggers, including rising rates or a major cyber attack, could send the economy reeling once again. Bloomberg News

Aside from negative events that might befall any individual institution, I fear that a major tail event that will shock the financial industry is likely in the foreseeable future.

There are just too many potentially endogenous and exogenous variables emerging. And contemplating that our economy is indulging in an increasingly intoxicating sugar high, beset by too much leverage and stimulus right now, has to give anyone cause for concern.

While triggering events are always hard to identify, some more general scenarios are reasonably obvious right now: rising interest rates are likely to mean harder times for borrowers than many suspect and that means negative surprises; ongoing findings of poor conduct by individuals and institutions will continue to crop up; cyber incidents impacting specific firms and possibly the economy as a whole remain a top threat; and, of course, there’s the social, political and military risk on the horizon.

A good dose of paranoia helps. As the old saying goes, “just because you’re paranoid doesn’t mean they aren’t after you.”

As with most tail events, the issue is not only anticipating them. The triggering event may be devilishly hard to ferret out. But the more important issue for any individual institution may be what to do about it when it begins to emerge.

It is important to target our healthy paranoia productively. First, an institution’s senior officials should hold periodic meetings to consider potential risks as well as the defenses against them. In this regard, whether mandated by the government or not, we all benefit by reasonably frequent stress tests.

Second, jumping on anything that looks like a tail event to your institution will pay dividends. In every situation in which I’ve been involved, at some point one could see the tail fatten before its most explosive manifestation. Cutting off the risk earlier rather than later is always a good idea.

Yes, “ 'tis the season to be jolly.” So, I hate to appear to be the Grinch Who Stole Christmas.

However, a number of recent events have me more paranoid than usual: the meteoric rise in the price of bitcoin; the stock market that only knows how to go up; the significant and seemingly daily cyber events; and an ever more stimulated economy. Despite these risks, many market observers continue to claim there is nothing but better times in sight.

Perhaps over eggnog, latkes, or whatever makes your holiday, we should consider a New Year’s resolution that we all act a bit more paranoid than usual in 2018.

Eugene Ludwig

Eugene Ludwig

Eugene Ludwig is the founder and chief executive officer of Promontory Financial Group, an IBM Company. He was formerly comptroller of the currency under the Clinton administration.

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