As reported in a previous post on this forum (see Fed Proposes Definitions for Systemically Important Nonbank Financial Institutions) the Fed proposed a rule on February 8th regarding when a company would be considered “systemically important.” This rule is significant because the designation would be accompanied by a large number of regulatory requirements (which would be accompanied by increased compliance costs), including the ominous authority/responsibility the FDIC will have to “wind down” the company in the event it nears failure.
Financial institutions are now engaged in a major lobbying effort to shape the definition of systemically important institutions in order to avoid the accompanying regulatory requirements. The decision is left up to the Financial Stability Oversight Council, which is scheduled to discuss this issue at its next meeting in May. Large bank holding companies, such as Bank of America, are clearly set to come under the umbrella of the regulation, due to the size of the assets they control (greater than $50 billion). However, insurance companies that fall under this threshold are looking to avoid the list, arguing that they do not present the same systemic risks that banks do because they are not susceptible to a run on their assets.
One position taken on this issue is that the purpose of the legislation being enacted should determine whether a company is considered “systemically important.” If the goal of the Dodd Frank Act was to protect these financial institutions from failing, the insurance companies have a valid argument, as clients could not (nor would they be prone to) “cash in” their car or homeowner’s insurance policies when the market goes south. However this argument does not hold the same weight if a) the insurance companies were insuring against credit events, such as a default of a company or a credit instrument, such as a Mortgage-Backed Security, or b) if the goal of the legislation was to recognize and account for the interconnectedness of financial institutions in order to intervene when their rational, individual activities create a concentration of risk that each firm individually is unable to identify or appreciate.
Another position is that, if the best and brightest business practitioners that money can buy are unable to identify and properly account for this systemic risk in making investment decisions, what chance do government regulators have of being able to accurately do so? Hypothetically speaking, if regulators had access to information (particularly the details of the investing strategies of large, systemically important firms) which executives at other financial institutions did not have, they could be in a unique position to be able to identify and account for concentration of risk across firms’ investment strategies which the executives at those firms would be blind to. However, in the previous financial crisis, to say that Lehman Brother’s only problem was that it didn’t realize that Goldman Sachs was concentrating a large amount of capital in the same, risky investment tools would be naive. The problem could be more accurately characterized as the failure of major financial institutions (and just about everyone else, for that matter) to recognize that the models being used to guide investment decisions were relying on a faulty assumption: that the price of housing would neither plateau nor decrease. Unless government regulators would be able to be one of the few “soothsayers” that could have recognized this flaw before it was too late (and were confident enough that they’d be willing to bet their careers on it), then the idea that this regulation would be able to prevent the same crisis that the U.S. experienced just a few years past is not realistic.