Despite the best of intentions, paving the way for the next financial meltdown part II: getting ready

As discussed in Part I of our Client Alert, “Despite the Best of Intentions, Paving the Way for the Next Financial Meltdown,” dated August 22, 2013, the Financial Stability Board (FSB) is studying the application of the key attributes of effective resolution regimes for financial institutions to insurance companies (Key Attributes). The Key Attributes, which set out the core elements considered essential to make possible the resolution of failing financial institutions without severe systemic disruption and without exposing taxpayers to loss, are central to measures endorsed by G-20 members to address the “too big to fail” problem associated with “systemically important financial institutions” (SIFIs). SIFIs are entities that, upon experiencing financial difficulty, may adversely affect the stability of the U.S., and possibly the world, economy.

According to the FSB, its study of the Key Attributes and its August 12, 2013, statement, Application of the Key Attributes of Effective Resolution Regimes to Non-Bank Financial Institutions, are intended to assist jurisdictions and regulators in implementing the Key Attributes with respect to resolution regimes for systemically important participants in the financial market infrastructure, banks and non-banks, and including without limitation insurers.

Adding to a November 2011 list of 28 global SIFIs that were all banking institutions, in July 2013 an initial list of nine global “systemically important insurers” was published by the FSB, including U.S.-based insurers American International Group, Inc. (AIG); Prudential Financial, Inc.; and MetLife, Inc., as well as foreign-based insurers Aviva PLC; Axa S.A.; Ping An Insurance (Group) Company of China, Ltd.; Allianz SE; Assicurazioni Generali S.p.A.; and Prudential plc. Insurers on this list face tighter regulatory scrutiny and additional capital charges that would act as a safety buffer to insolvency. In the same month, the G-20 announced that it would require large insurers to hold more capital beginning in 2019 to cover risks they pose to the financial system should they become insolvent.

Prior to the G-20 announcement, the Financial Stability Oversight Council (FSOC), a U.S. federal government organization established by Title I of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), named non-bank firms AIG, GE Capital and Prudential Insurance Group as SIFIs. This designation burdened the firms with greater regulatory oversight by the Federal Reserve Board as well as potentially greater risk-based capital requirements and other restrictions. The Dodd-Frank Act provides FSOC with broad authorities (1) to identify and monitor excessive risks to the U.S. financial system arising from the distress or failure of large, interconnected bank holding companies or non-bank financial companies, or from risks that could arise outside the financial system; (2) to eliminate expectations that any American financial firm is "too big to fail"; and (3) to respond to emerging threats to U.S. financial stability.

In July 2013, Met Life, Inc. was nominated by FSOC for the same designation, and in January 2014 Berkshire Hathaway, Inc., which is a multinational conglomerate and holding company for GEICO, General Re and other insurers and reinsurers (Berkshire), was nominated for the same designation.¹ As permitted by Dodd-Frank ² companies and groups designated as “too big to fail” warrant Federal Reserve Board supervision as a SIFI.

As discussed in Part I of our Client Alert, the initial pronouncements by the G-20 and FSOC naming so-called “systemically important” insurers came shortly after the release in June 2013 of a report by the U.S. Government Accountability Office entitled Insurance Markets: Impacts of and Regulatory Response to the 2007–2009 Financial Crisis (GAO Report). The GAO Report largely absolved the $1 trillion insurance industry (including AIG’s insurance underwriting units) of blame for AIG’s losses and heaped praise upon (1) the insurance industry and (2) the proactive policies of state and federal regulators, including the National Association of Insurance Commissioners (NAIC) for successfully mitigating the impact of the crisis (before and after its onset) on the insurance industry and for shielding most policyholders from the negative effects of the global recession.

Despite the insurance industry’s lack of culpability for the 2008 Great Recession, as confirmed by the GAO Report, MetLife had to sell its banking assets to GE Capital Finance Inc. after failing the Federal Reserve Board’s Comprehensive Capital Analysis and Review (CCAR) in 2012. This is a powerful recent reminder of the growing influence of the Federal Reserve Board in nonbank activities. By leaving the banking business, MetLife hoped to escape the specter of federal restrictions on its broader operations. MetLife did not take any bailout money during the 2008 financial crisis, but because of the company's overall size, it qualified as one of the nation's largest bank holding companies.³

Thus, its proposed designation by FSOC as “too big to fail” will likely eventually keep MetLife within the Federal Reserve Board’s orbit of influence. That orbit of influence in insurance regulation grew still further when the Federal Reserve Board was approved in February 2014 as a provisional member of the International Association of Insurance Supervisors (IAIS), subject to a full vote by the IAIS in fall 2014. This further intensifies the growing power struggle between the federal government and state regulators over regulation of the U.S. insurance industry.⁴

More Calls for a New Glass-Steagall Act

In the meantime, calls grow for a “New Glass-Steagall Act,” which would once again separate investment banks and commercial banks. An impressive and growing list of economists, financial experts, bankers and U.S. senators are advocating the orderly breakup of big banks. The list includes, among others, former Citigroup CEO Sandy Weill and investor Carl Icahn.⁵ In addition, Senators Elizabeth Warren and John McCain are among the political figures who maintain that Wall Street banks still pose a threat to the economy and taxpayers because they take too many risks. According to Senator Warren, we should “make banking boring again.”⁶

IMF Working Paper Suggests a Broader Definition of “Shadow Banking”

On February 11, 2014, the IMF Working Paper: “What Is Shadow Banking?” was published by the Research Department of the International Monetary Fund (IMF),⁷ an organization with the original primary purpose of ensuring the stability of the international monetary system – the system of exchange rates and international payments that enables countries to transact business with one another. The purpose of the IMF was subsequently expanded to cover the full range of macroeconomic and financial-sector issues that bear on global stability. The Working Paper purports to clarify and expand the definition of “shadow banking,” which most believe consists of non-traditional banking activities that can cause systemic risk, generally equating the term “shadow banking” with securitization or non-bank lending. However, in so doing, the Working Paper suggests for the first time that the “crucial feature” of “shadow banking” is the requirement for “a private or public backstop to operate.”

An abstract of the Working Paper states as follows: “Backstops can come in the form of a franchise value of a bank or insurance company, or in the form of a government guarantee. The need for a backstop is in our view a crucial feature of shadow banking, which distinguishes it from the ‘usual’ intermediated capital market activities such as custodians, hedge funds, leasing companies, etc.”

The authors of the Working Paper suggest that (1) all activities that need a backstop come within the definition of “shadow banking,” (2) all shadow banking activities always need a backstop and (3) this need for a backstop – either private by using the franchise value of existing financial institutions, or public by using government guarantees – should be a “litmus test” for “shadow banking.” The suggestion, however, potentially captures many more classes of financial activities within the definition of “too big to fail.” The Federal Reserve Board, which by virtue of Dodd-Frank’s expansion of its powers to include regulation of non-bank SIFIs, finalized a massive set of new rules for banks in late February 2014. These rules govern everything from capital and liquidity requirements to stress tests, but leave unaddressed: (1) how these new regulations would apply to nonbank firms, including insurance groups such as AIG, GE Capital and Prudential (soon to include MetLife and, quite possibly, Berkshire) and (2) what new standards they would face.⁸

As stated in the Working Paper: “For example, the usual capital market activities do not need external risk absorption capacity (because some, like custodian or market-making services, involve no risk transformation, while others, like hedge funds, have high margins and investors that do not seek to avoid specific risks), and so are not shadow banking. Only risks that need a backstop – because they combine risk transformation, low margins and high scale with residual ‘tail’ risks – are systematically important shadow banking.”⁹

Yet, this newly promulgated definition of “shadow banking” is potentially overly broad, and without further analysis may not be applicable to the same types of financial activities that commonly take place in countries other than the United States, such as “wealth management products” offered by banks in China and lending by bank-affiliated finance companies in India, which are also labeled as “shadow banking.” It is unclear how much these activities have in common with U.S. shadow banking.

Reactions by U.S. State Regulators and Industry to the IMF Working Paper

To date, much, if not all, of the attention of U.S. state regulators on “shadow banking” in the context of efforts to reconcile the stricter financial and capital standards of the United States with those of international standards has been focused on the ceding of reinsurance to affiliates, including captives, special-purpose vehicles and other affiliates, by the nation’s largest life insurance companies, magnifying concerns that a potential “shadow insurance industry” is emerging.

After the NAIC and the New York State Department of Financial Services launched investigations into the practice of ceding reinsurance to affiliated captives, the NAIC’s Captives and Special Purpose Vehicle Use Subgroup issued a White Paper that referenced as its reason for studying the issue the role of a “shadow banking system” in fomenting the 2007–2009 financial crisis. The paper described an increased use of captives and "potential concern that a shadow insurance industry is emerging, with less regulation and more potential exposure than policyholders may be aware of as compared to commercial insurers.” The issues highlighted in the White Paper are still being investigated, even as the percentage of reinsurance cessions by the nation’s largest life insurance companies to such affiliates continues to grow each year.¹⁰

With publication of the IMF’s suggestions, however, there are significant policy implications not only for the insurance industry but also for the financial system generally, and the focus on captives and SPVs appears narrow by comparison.

Conclusion

Despite all efforts by U.S. federal and international regulators to identify and eliminate the causes of the global financial meltdown of 2007–2009 and to impose increasingly burdensome regulatory regimes and financial reporting requirements on some of the largest financial institutions in the world, the megabanks appear more than ever “too big to fail.”

In testimony before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Washington, DC on February 14, 2013, Federal Reserve Board Governor Daniel K. Tarullo reminded the Senate committee that considerable work remains to complete implementation of the Dodd-Frank Act and the post-crisis global financial reform program. Over the coming year, the Federal Reserve Board will be working with other U.S. financial regulatory agencies and with foreign central banks and regulators to propose and finalize a number of ongoing initiatives. Tarullo added, “we are focused on the monitoring of emerging systemic risks, reducing the probability of failure of systemic financial firms, improving the resolvability of systemic financial firms, and building up buffers throughout the financial system to enable the system to absorb shocks.”¹¹

Since banks and insurance companies are regulated differently and are subject to different solvency margins, the resistance by most state regulators and the NAIC and most insurance trade groups to growing federal efforts to insert the Federal Reserve Board into state and global regulation, including efforts to replicate bank solvency requirements in the insurance industry, will likely continue. The NAIC and individual state insurance regulators and insurance trade groups have not yet reacted to the proposed expansion of the definition of “shadow banking” by the IMF Research Department in the IMF Working Paper or the policy implications of the proposal; however, such reaction may be anticipated.