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What could cause the next financial crisis

April 26, 2013: 12:37 PM ET

It's not clear regulators are taking their own worst case scenarios list seriously.

No bailout: Lehman Brothers employees take leave in 2008.

Lehman Brothers employees take leave in 2008.

FORTUNE -- Too big to fail. Interest rates. Borrowing. Fire-sales. The Flash Crash. Risky loan deals. Libor. Cyber attacks. Europe. Japan. China.

Cattle plague was not on the list.

On Thursday, the super council of bank regulators created after the financial crisis put out a list of their best guesses as to what could cause the next financial crisis. The most surprising thing about the list: It's length.

That alone should be enough to rattle your faith in Dodd-Frank, the set of banking regulations that were passed in 2010. Nearly three years later, the number of things that could blow up the financial system still seems way too high.

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What we are better at is making lists. Beside the Financial Stability Oversight Council, which put out the current list, the Treasury Department also has a new research group that studies financial innovations for potential problems. The Consumer Financial Protection Bureau details areas where banks could be ripping people off, most recently auto and payday-like lending. And in a few months the FSOC is about to disclose the financial firms so important that a failure of one of them could hurt the economy and possibly cause another crisis, which is another list.

The question is whether all this list-making is helpful.

One of the biggest issues on yesterday's list of financial risks is too big to fail. The council's report says big banks may be able to borrow more and cheaper if there is an assumption that the government will bail them out if they get into trouble. That extra money could result in banks taking on excessive risk.

The problem is that the government itself doesn't seem to be taking this risk seriously. Treasury Secretary Jack Lew has been mum on the subject. Other Treasury officials have tried to downplay it. Last week, Mary Miller, a top Treasury official, said there could be a number of reasons big banks get lower lending rates. They may just be less risky, which is of course why they ended up on the FSOC's list.

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Rising interest rates, which also shows up on the FSOC's list, does seem like a concern. JPMorgan Chase's Jamie Dimon in his recent annual letter to shareholders said that his bank was giving up a significant amount of income in order to protect itself from rising interest rates. If rates were to rise like they did back in 1994, Dimon said JPMorgan (JPM) could make $5 billion.

While it's on the list, regulators don't seem as concerned. The FSOC says that there does appear to be some reaching for yield and that a sudden rise in interest rates could causes losses at the banks. But it dismisses the risk by saying banks have more capital than they used to, which is true. But that still doesn't mean banks have enough.

The FSOC says they are also worried about the recent increase of issuance of riskier bonds in particular collateralized debt obligations, which are deals that package up leveraged loans and sell them off to investors. But they also say that CLOs seem less risky than they did before the financial crisis. That seems to ignore recent reports that say more than half of the loans in CLOs carry few protections for investors, which is higher than before the lending bust.

The risk of slowdowns or recession in Europe, Japan, and China are on the FSOC's list as well, even though there is little U.S. regulators can do about that. The fact that Libor and other lending rates may be inaccurate is also on the list. The reason being that manipulation may make people more-or-less worried about the banks and the economy than they should be. But what we are worried about here is banks. The fact that Libor was being manipulated seems to be one of Wall Street's worst-kept secrets, so is any bank really being tricked by it? Also on the list: The risk that the fake Libor rate could disappear, giving banks nothing to trick themselves with. Go figure.

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Other things that show up on the list - money laundering for one - are bad, but not really things that would cause a major bank to fail, unless there was a massive fraud. Widespread fraud, however, is not on the list.

But the biggest problem with listing the things that will result in our financial doom is that inevitably we get it wrong. The things that result in our financial doom are the ones we didn't see coming -- black swans. And while the FSOC does detail what could go wrong, they spend much of their time saying why it won't. Perhaps the best thing we could do is hop a time machine back to early 2007 (the pre-financial-crisis era) and ask regulators to produce a list of things that could cause the banking sector to blow up. My guess is the list would be just as dismissive.

This week Senators Sherrod Brown and David Vitter proposed a bill that significantly ups the amount of money banks have to have on hand to cover bad bets and soured loans. Currently, we are at 9%. The senators would like more like 15%. I can't say I am a huge fan of this. There are unintended costs, and there seems to be no limit to the thinking. (Why not make it 200%? That's really safe.)

But the senators' point and ones who support the measure is a good one. We don't know where the risks are going to come from. The only answer is holding more capital than we think necessary. Lists, however, give the impression that regulators and banks know what's out there. The first step in making our banking sector safer is acknowledging that this is impossible.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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