“The Council’s decision today follows extensive engagement with [Prudential] and a detailed analysis showing that there is not a significant risk that the company could pose a threat to financial stability.” Treasury Secretary Steven T. Mnuchin, October 17, 2018.
“Insurers and banks also don’t pose the same risk to the financial system. An insurer collects premiums to invest and then pays out in the case of an insured event. A bank takes deposits and promises to repay depositors at any time they choose.” The Wall Street Journal Editorial Board, “Jack Lew’s Last Defeat,” October 18, 2018.
In the aftermath of the financial crisis of 2007-2009, the U.S. Congress created the Financial Stability Oversight Council (FSOC – pronounced “F-Sock”)—a panel of the heads of the U.S. regulatory agencies—“to identify risks to the financial stability of the United States”; “to promote market discipline” by eliminating expectations of government bailouts; and “to respond to emerging threats” to financial stability.
Despite these complex and critical objectives, the law limited FSOC’s authority to the designation of: (1) specific nonbanks as systemically important financial intermediaries (SIFIs), and; (2) critical payments, clearance and settlement firms as financial market utilities (FMUs). Nonbank SIFIs are then supervised by the Federal Reserve, which imposes stricter scrutiny on them (as it does for large banks), while FMUs are jointly overseen by the Fed and the relevant market regulators. Designation authority also created incentives for those firms wishing to avoid greater scrutiny to adjust their business models accordingly.
At the peak of its activity in 2013-14, the FSOC designated four nonbanks as SIFIs: AIG, GE Capital, MetLife, and Prudential Insurance. Following evidence that they had substantially reduced the riskiness of their businesses, the designations of GE Capital (in June 2016) and AIG (in September 2017) were rescinded. And, following MetLife’s 2017 divestiture of its U.S. retail business, Treasury decided early this year to withdraw its appeal of a 2016 court ruling that overturned the FSOC’s designation (see our earlier post).
As a result, following the Council’s October 16 rescission of the Prudential designation, there are no longer any nonbank SIFIs. Not only that, but by making a future designation highly unlikely, the Mnuchin Treasury and FSOC have undermined the deterrence effect of the FSOC’s SIFI authority. At this point, we see little standing in the way of de-designated SIFIs or other large nonbank intermediaries from amassing risk with potential consequences for financial stability. And, it is easy to imagine circumstances in which a large bank would seek to restructure its business model to avoid stringent oversight.
In short, by taking the sock out of FSOC, recent actions seriously weaken the post-crisis apparatus for securing U.S. (and global) financial stability. By reinforcing the natural tendency to regulate by legal form rather than economic function, they invite destabilizing regulatory arbitrage. In the remainder of this post we review the Treasury’s revised approach to SIFI designation in the context of the Prudential rescission.
Before continuing, we should emphasize that the extraordinary breadth of redaction (with nearly 700 expurgated items in a 66-page report!) in the FSOC Notice of rescission makes it nearly impossible to use the document to judge how much Prudential’s riskiness has changed since the 2013 FSOC designation. Partly as a consequence of this lack of transparency, we focus on market-based measures of Prudential’s leverage and risk, concluding that these stand in stark contrast to what we see as Secretary Mnuchin’s complacency in the opening citation.
Treasury on SIFI designation. Nearly a year ago, in response to the President’s call on the Secretary to review the designation process (and the FSOC’s work more generally), Treasury issued a report on FSOC Designations (see our earlier post). That Treasury report encouraged the FSOC to prioritize the regulation of activities—affecting whole sectors of the financial industry—over regulation of entities (including the designation authority). For the most part, we agree with this approach: serious regulation and supervision of activities—including restrictions on maturity and liquidity mismatches, uses of collateral and size of margin—can go a long way to reducing the systemic risk arising from the behavior of a wide variety of intermediaries and markets.
The case for activities-based (over entity-based) regulation is greatest in the asset management industry, where the beneficial owners of the assets in mutual funds or in segregated accounts are the investors, who have no guarantees from the fund managers (aside from a few exceptions, like money market mutual funds). That is, the asset managers do not assume market risk. Mutual funds also face key restrictions, including limits on leverage, liquidity mismatch, and derivatives use. Adjusting these rules can be an effective way of reducing threats to the financial system (see our earlier post on open-end funds and ETFs).
Activities restrictions—say, constraints on the use of collateral from securities lending or limits to the reliance on affiliated (“shadow”) reinsurance—also can reduce threats that might emanate from the life insurance industry. Similarly, improved disclosure of exposure to variable annuities, of interest-rate risk and of derivatives positions would allow counterparties to impose more effective discipline on what could be very risky life insurers.
Unfortunately, we have not witnessed a wave of activities-based regulation since the 2017 Treasury report. This is not surprising: regulation that influences large swaths of the financial system would encounter fierce industry resistance. Moreover, in the case of insurance, the limited federal role in regulation makes it very difficult to impose consistent rules nationwide.
In any case, we doubt that activities-based regulation alone is sufficient to limit the threats to the financial system arising from the largest, most complex, most interconnected, most opaque, and most leveraged nonbank intermediaries. The agency model of asset managers generally does not apply to insurers. Moreover, while life insurers once insured only idiosyncratic longevity risk, the “minimum return guarantees” they now offer means that they are now insuring market risk as well (see Koijen and Yogo).
Indeed, in contrast with the Wall Street Journal’s wildly-outdated description of the largest U.S. insurers (see the opening citation), large life insurers typically engage in a range of nontraditional activities—including the provision of guaranteed returns, the reliance on short-term funding, and the use of captive reinsurers—that add to their overall risk and make a significant portion of their liabilities runnable (see Acharya and Richardson and Foley-Fisher, Narajabad and Verani). Indeed, McMenamin et al. estimate that more than one-half of life insurer liabilities are of “moderate” or “high” liquidity. Consequently, doubts about life insurer viability can precipitate runs that lead to fire sales in episodes of widespread financial stress.
Against this background, we believe that the 2017 Treasury report sets the bar for an FSOC designation too high—especially for complex life insurers and other nonbanks that can conceal the risks that they take (see also here). A transparent designation process should allow firms to de-risk to preempt designation, or to seek removal of a designation, as we saw with GE Capital and AIG. But it is critical that the FSOC routinely monitor these and other large non-SIFIs to ensure that they do not cross the risk threshold that merits designation (or re-designation). Otherwise, how could the FSOC ever be confident that rescinding a designation will not threaten financial stability? We should not have to wait for a complex insurer to fail in a crisis (as AIG did in 2008!) to prove that these risky nonbanks can threaten the financial system as a whole.
Prudential’s Rescission. FSOC reevaluations of a SIFI designation “focus on any material changes with respect to the nonbank financial company or the markets in which it operates” (FSOC Notice, page 9). The question is whether a SIFI has de-risked sufficiently to warrant rescission.
The FSOC based its designation of Prudential in 2013 on threats to financial stability through the “exposure” and “asset liquidation” channels. It found that material distress at Prudential could “aggravate losses to large, leveraged financial firms and contribute to material impairment in the functioning of key financial markets or the provision of financial services” (FSOC Notice, page 4). Similarly, it observed that “increased redemption and withdrawal requests with regard to life insurance and annuity product […] could result in a forced liquidation of a significant amount of assets at fire sale prices” (FSOC Notice, page 5). And, importantly, it identified the challenge of safely resolving Prudential as a threat to financial intermediation.
Due to the widespread redactions in the recent FSOC Notice, we are unable to discern from the document how the risks posed by Prudential have changed over the past five years, if indeed they have. The Notice states that Prudential’s “aggregate capital markets exposures do not appear to have changed significantly” (page 6) and that its “complexities continue to present obstacles to the resolvability of the firm” (page 7). Yet, according to the Notice, Prudential’s submissions to FSOC assert improvements in liquidity management, reduced leverage, simplified corporate structure, and de-risking of its annuity business (page 8).
If all these risk management improvements had in fact occurred, we would expect a market-based measure of Prudential’s leverage ratio—the ratio of the market value of its equity to the sum of its debt and the market value of its equity—to have risen, reflecting a combination of increased investor confidence in its business model and a reduction in the overall riskiness of its balance sheet. Yet, we see no evidence of such an improvement. The chart below shows that Prudential’s October 2018 market-based leverage ratio of 8.0% is virtually unchanged from the level when it was designated in September 2013. Moreover, Prudential’s leverage ratio today is below that of either AIG or MetLife, as it has been consistently since its SIFI designation. (We note that our market-based measure also is well below the 10%-plus end-2017 accounting-based ratio reported in Table 1 on page 11 of the Notice.)
Market-based leverage ratios of AIG, MetLife and Prudential (end-month, percent), 2005-October 2018
Notes: The numerator of each ratio is the market value of equity. The denominator is the sum of debt and the market value of equity. These leverage measures exclude “separate accounts” that are segregated from the firm’s “general account.” Final observation as of October 12, 2018.
Source: NYU Stern Volatility Lab.
Similarly, our preferred measure of systemic risk—the NYU Stern Volatility Lab’s SRISK—shows broad stability since 2013 in Prudential’s estimated shortfall of capital in the event of a crisis (proxied by a 40-percent drop in the equity market). In contrast, the SRISK of AIG has been close to zero, while that of MetLife has been more volatile around a possibly falling trend (see chart below).
SRISK of AIG, MetLife and Prudential (end-month, billions of dollars), 2002-October 2018
Notes: Final observation as of October 19, 2018. The SRISK measures use the Volatility Lab’s default inclusion ratio of 40% for “separate accounts.” Excluding all separate accounts lowers measured SRISK, but changes neither the pattern over time nor the relationships among the three largest insurers.
Source: NYU Stern Volatility Lab.
While Prudential and MetLife have shown no clear tendency to reduce their SRISK over the past five years, the estimated U.S. aggregate shortfall of capital has plunged. As a consequence, Prudential’s and MetLife’s shares of total U.S. SRISK have surged. Indeed, the table below shows that Prudential and MetLife rank numbers two and four in the overall U.S. SRISK rankings as of the latest reading.
U.S. SRISK Rankings (October 26, 2018)
Source: NYU Stern Volatility Lab. The data are based on the V-Lab default settings for capital requirements (8%) and for the percentage of “separate accounts” to include for insurers (40%).
To be sure, one should take care in comparing the SRISK of banks and insurers. For example, the “default” SRISK measures shown in the above chart and table include 40% of insurers’ separate (segregated) accounts. As is the case with the asset managers, the market risk of separate accounts is largely borne by their owner. However, for those accounts that have guarantees, as in the case of many variable annuity products, the perceived loss of the insurer’s viability in a period of broader financial distress could induce the holders of these assets to withdraw. And, any effort by state insurance regulators to delay withdrawals (and slow the resulting fire sales) could prompt greater anxiety about the industry as a whole, precipitating even more withdrawals. Finally, even if we exclude these separate accounts completely from the estimates of SRISK, Prudential and MetLife still rank fourth and fifth—just behind Citigroup, Morgan Stanley and Goldman Sachs—accounting for a combined 20.2% of the U.S. total. In other words, large life insurance companies are far more like other big intermediaries than the traditional model implies.
Conclusion. Market-based measures cast substantial doubt on the FSOC’s decision to remove the SIFI designation from all nonbanks. However much we respect state insurance regulators, we doubt that they have the resources to maintain sufficiently stringent oversight over complex, sprawling, broadly international institutions like MetLife or Prudential. State-level insurance guarantee funds also appear inadequate to resolve such large institutions.
By undermining the credible threat to designate a future nonbank, the Trump Administration is encouraging intermediaries to take on additional risks that could very well increase the likelihood of a crisis. And, intentionally or not, the actions of Treasury and the FSOC invite some bank SIFIs to consider restructuring their businesses to ease regulatory costs. Furthermore, by adding to the politicization of financial stability policy, the elimination of nonbank SIFIs weakens the credibility of any future government’s effort to revive this useful regulatory tool.
As for the FSOC itself, its only remaining de facto binding authority is to designate FMUs. Reflecting the widespread recognition of the potential catastrophic impact of an FMU failure—say, due to a hostile cyberattack—that authority still appears intact. Let’s hope it stays that way. Otherwise, we will write a post titled: “FSOC R.I.P.”
Acknowledgements: We are very grateful to the NYU Stern Volatility Lab for providing the data on SRISK and market-based leverage. We also thank our friend and Stern colleague, Richard Berner, for very helpful comments.