The Feds Exploit the 'Systemic Risk' Myth To Suffocate Insurers

"She had suffered the loss of many millions of her strongest young men and had seen a great part of her homes, factories and business buildings destroyed. City after city had been reduced to a mere skeleton and people were living in caves, cellars, quonset huts and three or four families crowded into a dwelling intended for one....In spite of these handicaps, in a few short years Germany became the most prosperous country in Europe..." - Howard E. Kershner, Dividing the Wealth, p. 133

In the above passage Howard Kershner was describing Germany in the aftermath of World War II. It's a passage worth reviving every time the notion of ‘too big to fail' is trotted out by commentators, politicians, and federal bureaucrats.

Simply put, no financial institution's bankruptcy could ever wreck the financial system, let alone set back the economy for any lengthy period. Probably the opposite. Capitalism is equal parts success and failure, but that's a digression. If Germany can come back from the horrid death and destruction of war, the U.S. economy can more than survive the bankruptcy of that which the markets will no longer support.

The false notion of ‘systemic risk' or ‘systemically important' financial institutions is rooted in the economy suffocating view that markets are often wrong. Since they are they need to be guided by politicians and bureaucrats who will tax away and borrow your money in order to prop up large and politically connected financial entities, and as will soon be discussed, insurance companies. Not only is ‘systemic risk' a myth, but it's an arrogant one underlay by the laughable assertion that Ben Bernanke, Tim Geithner, Henry Paulson, and Jack Lew know better than we do such that we must place our trust in them to save the economy from itself.

Back to reality, an economy that's constantly adjusting, constantly fixing itself through the allowance of failure, is a healthy one. Assuming what's false, that the failure of one or many financial institutions could eventuate the ‘Mother of All Great Depressions' (Bernanke), it's safe to say that the Financial Stability Oversight Council (FSOC) is making the problem worse. Indeed, as evidenced by the implicit bailout protection offered by Dodd-Frank and FSOC to $50 billion+ financial institutions, the very entities charged with ridding the system of ‘systemically important' institutions are creating the incentive for more of them.

If ‘big' when it comes to finance really is bad, and it's not, the single best way to minimize problems relating to size is for the federal government to get out of the way altogether. If so, as in if all financial institutions were made aware that failure is perfectly allowable, counterparties to big banks would quickly adjust their exposure such that banks would quickly ‘right-size' themselves.

What's even more comical about this is that the very federal regulatory apparatus caught totally unaware by the problems bubbling up in banks five years ago has now been empowered to oversee large insurance companies too. A few years ago Bernanke explained away the failure of federal bureaucrats to pick up on banking problems as a function of a "huge gap in the Regulatory System," which was an example of our vastly overrated Fed Chairman stating the supremely obvious.

Of course there was a gap in the regulatory system, but what's not understood very well by left and right is that there's no way to plug such a gap. Much as the naïve in our midst might wish otherwise, financial regulators are the people who couldn't get jobs on Wall Street. They're the equivalent of the little league player who constantly finds himself in right field while batting ninth.

Looking back on the banking crackup that was turned into a crisis thanks to the intervention of the very government individuals who couldn't the see trouble coming to begin with, even those with money at stake in the private sector (meaning, those who actually could get Wall Street jobs) were caught flat-footed by problems in the banking sector. John Paulson didn't make billions for no reason. He did because a lot of the marketplace disagreed with him. The point here is that if so many market players couldn't see the future, the notion that federal bureaucrats had a clue about what was ahead brings new meaning to absurd. Applied to the future, and revived federal attempts to ensure that nothing like 2008 will happen again, lots of luck there.

Regarding insurance companies such as MetLife and Prudential that are properly resisting a ‘systemically important' designation, much ink has already been spilled about how insurance companies can't be regulated in the way that banks are. While banks often labor under an asset mismatch of short-term liabilities paired with long-term assets, insurance companies do not. The funds they take in are long-term liabilities matched with long-term assets. Simply put, while depositors and creditors can call in their funds deposited in the very near-term, that doesn't apply to buyers of insurance policies.

Despite this, the feds at least for now expect MetLife et al to labor under the same capital requirements that banks are - wrongly - forced to operate under. Explicit in such a regulation is that by federal decree, the profits and return on capital for insurance companies will decline.  Reduced profits will drive lower pay, and lower pay means talent will walk. By definition. If insurance companies are forced to hold more capital than they need, their returns will fall, as will their share price, as will their commercial viability thanks to an outflow of talent. 

One editorial that commented on the above suggested that absent an ability to pass rising costs of operation and lower returns onto customers and investors, MetLife and Prudential might exit the space altogether. Certainly they wouldn't be able to pass their rising costs of being ‘important' onto their customers given competition from insurers not caught in regulatory hell, and then investors simply won't accept lower returns as evidenced by MetLife's presently sagging multiple. They could presumably exit the business, but with money nothing if not fungible, it seems they would to the extent possible move their operations away from the meddling hand of the federal government. If so, ‘systemic risk' would find a foreign address.

The easy response to all of this is that perhaps none of it matters. Whether financial institutions are based here, Bermuda, Hong Kong, or Singapore, regulators will always be the last to reach the scene of any presumed accident. And then assuming the failure of a large institution not hindered by regulations, we needn't worry there either. See the Germany example.

What should bother us is what a waste all of this is. Indeed, one would think that particularly after 2008 that there would be a sheepish admittance by the regulatariat that it was and always will be totally unequal to the job set before it. Nothing of the sort revealed itself, and as government is the only place where failure brings with it more money and more power, the same individuals who didn't see the last ‘crisis' coming will be caught blind yet again when the next financial crisis comes our way.

The waste is that regulations that don't work will distract profit-motivated businesses. Put very plainly, regulations on financial institutions are very costly and inimical to profits, and they're this way without enhancing the wellbeing of the companies which suffer them, nor the economy overall. In the case of MetLife and Prudential, and assuming they're ultimately regulated like banks, it's not just that the rules will distract them at best, and seriously crimp their profits at worst, it's that as a rule these arrogant steps taken to make the financial system less risky will achieve nothing of the sort. Probably the opposite.