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No Guarantees for the “If” in SIFI
In the aftermath of the 2008-09 financial crisis, the Democratic Congress pushed through a law commonly known as Dodd-Frank. It was effectively Obamacare for the financial services industry: An unwieldy 2,300-page grab-bag of a bill, much of which irrelevant to the problems it purported to address, full of self-contradictory provisions, ineffective in dealing with the problems it purported to address, written vaguely and giving great power to regulators to flesh out the details. The stated motivation of the law was to make sure no financial institution would again be “too big to fail”. However, it instead codified the notion in “systemically important financial institutions”, or SIFIs. Once designated a SIFI, an institution is subject to extraordinary federal oversight. But there is an upside: Everyone in the market understands SIFI designation as an admission that the government will take extraordinary measures, if necessary, to ensure that company stays a going concern.
Most SIFIs are banks. Three, however, are insurance companies. AIG and Prudential have welcomed their designation. MetLife, in contrast, has fought it at every opportunity. The company sued the government to be taken off the list. And on Tuesday, the company announced plans to break itself up.
MetLife’s lawsuit takes issue first with the opaque process used to designate SIFIs. This process should be an outrage in a democratic republic. SIFIs are designated by the Financial Stability Oversight Council, a group created by Dodd-Frank. Its ten voting members represent the alphabet soup of federal banking and securities regulation: The Secretary of the Treasury, who chairs the FSOC; the Chairman of the Federal Reserve; the Comptroller of the Currency; the Director of the CFPB (a new Dodd-Frank job); Chairpersons of the SEC, FDIC, and CFTC; the Director of the Federal Housing Finance Agency; and the Chairman of the National Credit Union Administration Board. This group decides which institutions are and are not SIFIs. They do not give reasons for these decisions. They do not reveal who voted which way. There is no appeals mechanism.
You’ll note that there are no voting members with any responsibility for insurance regulation, or any institutional knowledge of insurance businesses. In practice — and this is MetLife’s other major objection — insurance liabilities are sufficiently different from banking liabilities that it’s hard to understand how insurers constitute systemic threats. Policyholderss are protected by state regulation that requires insurers to hold assets well in excess of expected claims, and test hypothetical solvency under adverse scenarios. Even then, most adverse scenarios for insurers play out over a long time horizon, and do not threaten immediate collapse.
The FSOC is most likely concerned about these insurers’ large investment portfolios, or more likely, their derivative transactions with investment banks. Insurers do use financial derivatives to hedge certain market risks. But insurers’ participation in derivatives markets is highly circumscribed, and they are bit players in those trading markets. Moreover, AIG’s near-bankruptcy during the crisis, caused by non-insurance activities in a non-insurance subsidiary, was not systemically threatening; it threatened Goldman Sachs’s bottom line, and nothing more.
Ironically, though, while it’s a stretch to think that MetLife would need a bailout, its designation as a SIFI is producing some perverse incentives to increase risk in the system.
MetLife’s proposed breakup is targeted: It will spin off its US life insurance and annuity business into a new company. This business is the one that most intensively employs derivatives for risk management. The remainder will primarily consist of MetLife’s international business, and US property and casualty (e.g. auto and homeowner’s insurance). Analysts believe that MetLife is taking this step so that both resulting companies will be smaller, have smaller investment portfolios, and thus no longer be considered too big to fail.
But it’s a well-established tenet of risk management that diversification reduces overall risk. Today, if the combined entity struggles in the auto business, there may be offsetting gains in the annuity business, and vice versa. Diversification makes MetLife’s policyholders more secure by stabilizing the company’s financial position and ability to pay claims from one year to the next. By breaking up the company, MetLife is creating two riskier companies from one more secure company. But both companies will be smaller.
It remains to be seen whether MetLife’s gambit will succeed, and FSOC will rescind the company’s SIFI designation. Meanwhile, whether MetLife wins or not, there will be other losers: policyholders, consumers — and American prestige, as our successful companies voluntarily downsize. Such are the unintended consequences of centralized planning.
Published in Culture, Domestic Policy, Economics, General
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Interesting. Yes, even brilliant minds like Dodd and Frank could not foresee all of the consequences of their bill, which is why some things are best handled by the markets.
Yikes! That’s very disturbing.
I expect my MetLife auto and homeowners insurance will go up.
Thanks, Big Brother!
Hmm. I know one of these companies quite well. I’d say “welcomed” is a stretch. But all in all – great post! Thanks.
Can’t wait for the Voxsplainer: “Why Regulatory Capture Isn’t Bad When It’s Done By Democrats”
The reason limited government is good? Unintended consequences.
SoS, any thoughts on whether/how a split-up might impact operations costs in Asia, especially in the newly-acquired Japan operation?
(I’m re-relocating back to Tokyo in a couple of months, and will resume focus on insurance-industry client companies’ needs in IT/Ops.)
My initial reaction is that it surely must portend a heavier operating-cost burden for Asia/Japan, for at least two possible reasons:
What are your thoughts on this?
It’s not clear to me. One outstanding question I have is whether the Japanese annuity business would stay with MetLife, or be spun off with the new life & annuity company. If it stays, it could need to build out its IT infrastructure to handle more of the investment & risk management activities (I believe these are handled centrally today).
Regardless, any breakup will take a while to implement. I am guessing that the company’s approach will be to separate operations internally, and create the separate legal subsidiaries, and only once that is complete they will look at an IPO of the riskier US businesses.
Excellent post SOS. Agree with the premise. One note:
In ’09 there was much debate about whether the AIG bail-out was necessary (I was against it). Many have said GS hedged their bets against an AIG default, although, in my mind, the cozy relationship between Blankfein and Geithner makes the bail-out dubious.
The argument for the bail out: Letting AIG collapse may have made things so much worse. Besides the CDS losses, AIG still provided life insurance, annuities, etc and that would have been a huge mess.
My opinion of the matter: I think the biggest incentive for the bail out was political and psychological: letting AIG fail right after Lehman could have turned a crisis into a full fledged panic.
I guess it depends on whose systems you’re threatening.
David, if my understanding is correct, nearly all of AIG’s insurance business was in ring-fenced subsidiaries that were fully capitalized. Other insurance companies could have bought these units without disruption to the policyholders. And in the event other insurers would not, or they couldn’t come to terms on pricing, it would not have been the first bankrupt insurer to undergo resolution. Messy, for sure. Systemic? Highly unlikely.
I think the psychological explanation carries a lot of weight. But if that’s so, then “systemic importance”, as defined by regulators, is more psychological than financial. Which might explain designation of MetLife as a SIFI….
Great post. Dodd Frank was purportedly passed to address a crisis caused by the collision of (in rough order of responsibility):
So Dodd and Frank, asserting their combined brilliance, rewarded the Fed, ignored 2 and 3, and decided to set out to eliminate greed from Wall Street. That is so obviously insane it can’t be right, even for progressives. But if we look at what Dodd Frank does – extend government control over huge swaths of the economy – and assume that was the intent, then it makes much more sense.
Maybe that’s not a bug, but a feature. Because then you need more government intervention.
Thanks, John. I’m not quite ready to say that FSOC is deliberately creating the conditions for further centralization, even if that is the effect. Rather, I think its behavior reflects the central conceit of all central planners: that the market can’t be trusted to deliver the “right” outcome, so we need to give some smarter person the power to pull the strings as necessary. Of course, that was the philosophy behind the disastrous housing regulation as well as the philosophy behind FSOC.
Great post.
There is great enmity between the citizens of the State of Montana and Goldman Sachs. Montana Power used to be the largest and best employer and corporation in the state, and Montanan’s enjoyed near the lowest utility costs in the country. Then Goldman Sachs convinced the board of Montana Power they should become a telecom company right before the telecom bust of 2000. Montana Power and the telecom company it turned into went bust and is no more, thousands of employees and retirees lost their savings in Montana Power stock, but GS walked away with $100’s of millions of dollars in fees. While this deal was small in the grand scheme of things for GS, to MT is was huge.
GS tends to always land on its feet, and not necessarily because of their investing skill.
Any financial organization that is too big to fail should be regulated like a public utility. Or better yet be like the Post Office, a government owned public corporation.
Luckily, not even the Fed is too big to fail.
Great post. Thank you and your clarity on a topic like this is truly admirable.
As a met life policy holder, I say break up. Freaking Feds have no business interfering with me and my insurance company
Frank Dodd should be yanked out with obama care. ASAP. This is near pure Communism.
@SOS and David Sussman- Where do you stand on breaking up banks that are ‘too big to fail.’ Some have argued it would weaken banks, or that it would be difficult to know what size was too big, etc.
I’ve never come to a firm conclusion on this question, and it would probably take a new post for me to explain my thinking on this. But in brief, FWIW:
1. I’ve never seen a compelling case for why breaking up the banks actually works.
2. Researchers, academics, and risk practitioners have been working on a definition of systemic risk for nearly a decade now, and are still struggling. The reason is that TBTF is circular, ultimately a question of government policy as much as financial economics. As you hint at, there is no objective measure of “too big”; it is whatever the government says is “too big”. My opinion is that if government would let banks fail, there would probably be no such thing as TBTF, because market participants would take prudent steps to mitigate their risk.
3. Post-crisis, market participants became MUCH more sophisticated about measuring and managing credit risk. They have gone to measuring second-order and even third-order exposures. (E.g. Before lending to XYZ, I determine what arrangements XYZ has in place with ABC; when I simulate a crisis, I measure the additional risk of ABC’s failure cascading to XYZ.) For better or worse, though, Dodd-Frank has rendered some of this analysis moot, because…
4. A large amount of banks’ counterparty risk has been shifted to centralized exchanges (which is really where systemic risk has shifted, and where people ought to focus their attention). There is little risk that some new innovation will bring new headaches, because (pace Steve C) banks have in fact been turned into utilities. Their products and investment opportunities are effectively defined by the government. Ditto the prices. As a result, to the extent that breaking up banks may have been a solution to systemic counterparty risk in the pre-Dodd-Frank world, today it’s irrelevant.
5. Because banks are now utilities, the only way for them to beat the competition is with back-end efficiencies. Which requires economies of scale. Which favors bigger banks. If anything, Dodd-Frank has punished small banks and led to more industry consolidation. Trying to make them smaller is difficult when regulation is making them bigger.
Viruscop brought up something interesting last night on the AMU – he had been listening to a lecture by a prospective candidate for a professorship, and this prof proposed a different concept than TBTF:
Too Networked To Fail
The base concept being that some institutions are spread through so many different areas that their failure would cause severe systemic damage. Size alone (“Bigness” if you will) is a misnomer, as there are plenty of large corporations whose collapse would be isolated to a few industries.
Yes, though neither concept alone is sufficient. A highly networked company can still be inconsequential if the many exposures are small ones. A company needs to be big AND have its tentacles everywhere for its failure to matter.
I’ve been looking at MET as a buy low candidate given its drop since the first of the year (it’s now yielding just under 3.5%), but this break-up “threat” adds extra noise to the picture that I really can’t evaluate.