Flooded

The financial crisis showed just how wicked such a chain reaction can become and how many bystanders it can hurt. In its aftermath, governments around the world pushed for reforms to minimize the chances of a repeat meltdown. But policymakers failed to shore up critical vulnerabilities that lurk in the system—areas where risk is underpriced and thus over-embraced. Those are the potential triggers of the next crippling chain reaction.

“The problem is, we didn’t change much of the structure, and we didn’t change much of the regulation of the risk market,” says Christian Gollier, an economics professor at the University of Toulouse and the head of the social decision-making program at Georgia State University’s Center for the Economic Analysis of Risk. “My impression is that the risk has not been reduced after the crisis—quite the contrary.”

Gollier was one of more than two dozen economists who agreed to talk to National Journal about pinpointing the “time bombs” of incorrectly priced risk that pose the greatest threat to the U.S. and global economies. A few mentioned terrorist attacks, nuclear warfare, or science-fiction-style terrors such as asteroids or rebellion by sentient computers. But most respondents focused on two broad—and decidedly more concrete—categories: financial and environmental risk. A third frequent suggestion, the risk of a precipitous spike in oil prices, bridged the two.

Economists and lawmakers hotly debate the degree to which the United States has defused its financial risks. Perhaps the best way to think about the crash’s aftermath is that government officials did all they could have been expected to do but not everything they needed to.

In the wake of the financial bust, U.S. and world leaders adopted a series of stricter rules for financial institutions to guard against risky behaviors that could bring the system to its knees. They agreed to raise the amount of capital that banks are required to hold, through the so-called Basel III agreement. That higher bar is an attempt to shore up a business model that matches often-illiquid assets with cheap, short-term financing. When the value of the assets falls unexpectedly, as it did quite infamously with Lehman Brothers, financial institutions cannot afford to pay their short-term debts—unless they have a sufficiently large cushion of capital.

Some economists worry that the real-estate market, despite price plunges, remains artificially inflated and in jeopardy of further collapse.

Problem is, many economists contend that it remains relatively easy for financial institutions to elude those capital requirements. That’s particularly true among the large foreign-owned financial institutions that buy U.S. Treasury bonds and make up much of the Federal Reserve Board’s “primary dealer” market. Many of those institutions have restructured their holdings to keep their seat in the market without actually complying with the increased capital standards, says Robert Eisenbeis, a former research director at the Federal Reserve Bank of Atlanta who is now the chief monetary economist for Cumberland Advisors.

Such evasion leaves the United States exposed to a domino-like rerun of the last crash. If asset prices plunged, debts were called in, and several primary dealers failed at once, the federal government’s ability
to borrow would evaporate. Eisenbeis and others say that this risk gives the government a vested interest in keeping the dealers solvent, reinforcing the “too big to fail” mentality that incents the financial giants to risky behavior.

Other reforms, including the Dodd-Frank financial-regulation bill, were designed to shine a light on the risky assets in financial institutions’ portfolios. But as the law is being implemented, it’s still far from clear how much risk individual institutions—including the nation’s largest banks—are carrying. The 10 largest U.S. banks now hold a bigger share of total bank deposits, handle a bigger share of financial transactions, and buy a bigger share of U.S. Treasuries than they did before the crisis.

Alth0ugh the financial-reform law attempts to fix that risk by regulating the “systemically important” institutions much more tightly, these giant banks are fighting to wriggle free, with some support on Capitol Hill. Transparency remains a problem with regulators, too: The next round of the Federal Reserve’s vaunted “stress tests” of large banks’ ability to withstand a crisis is widely expected to result in passing grades across the board, with little documentation to back them up.

“The soundness of the largest financial institutions and the systemic risks they continue to pose is no better” than it was before the crisis, warned Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, Mo.,  in a speech on February 23. “In my view, it is even worse.” Hoenig, a conservative, argued that the only way to reduce risk would be to prohibit banks from trading their own accounts in the securities markets.