There Is No Rational Basis For MetLife's SIFI Designation
Earlier this month, the Financial Stability Oversight Council (FSOC) preliminarily designated MetLife as a systemically important financial institution, or SIFI. The FSOC is a new agency created by the Dodd-Frank Act, consists of all the federal financial regulators, and is chaired by the Secretary of the Treasury. Under the Dodd-Frank Act, the FSOC is authorized to designate a financial firm as a SIFI if it believes that the firm's future "financial distress" could cause instability in the U.S. financial system. Once it is designated, the firm is turned over to the Fed for bank-like prudential regulation.
MetLife has the opportunity for an administrative appeal, and then an appeal to the courts, but firms previously designated by the FSOC - AIG, Prudential Financial and GE Capital - have not appealed. Of all these firms, MetLife - the nation's largest life insurer - would appear to have the strongest grounds for appeal; its business is almost entirely plain vanilla life insurance, a business that principally invests in fixed maturity government debt and pays out according to liabilities that are actuarially determinable.
Nevertheless, the designation of MetLife was entirely predictable, indeed a foregone conclusion. The Treasury and the Fed are both key members of the Financial Stability Board (FSB), a largely European group of financial ministers and bank regulators that was deputized by the G-20 in 2009 to reform the international financial system. It has been carrying out this mandate by designating banks and nonbanks as global SIFIs, relying on the member agencies to carry out its decisions within their respective jurisdictions. Both the Fed and the Treasury are key members of the FSB as well as the FSOC and thus the FSOC is committed to carry out the decisions of the FSB within the U.S.
It has done this dutifully. That's why MetLife's designation was so predictable. In July 2013, the FSB designated three U.S. insurers - AIG, Prudential Financial and MetLife - as global SIFIs. Following suit, in September 2013 the FSOC designated AIG and Prudential as SIFIs and began an investigation of MetLife that resulted in the preliminary designation of MetLife this month.
The FSOC has never established any publically available standards for its SIFI designations - that's one of the reasons that the agency should be criticized or even abolished - so it is difficult to determine the basis on which the FSOC's MetLife decision was made.
IAIS Methodology
Nevertheless, there are standards for whether an insurer like MetLife could be regarded as systemically important. But if either the FSB or the FSOC actually used them it is difficult to see how MetLife could have been designated.
In July 2013, the International Association of Insurance Supervisors (IAIS), responding to a request from the FSB, published a methodology for determining whether an insurer could create systemic disruption if it failed. The IAIS methodology is worth considering because it was prepared by insurance supervisors, and thus is likely to be more informed about the business of insurance than the central bankers and bank regulators that dominate both the FSB and the FSOC.
For example, while the common denominator of the three U.S. insurers that were designated as SIFIs by the FSB and the FSOC is their size - all are the largest in the U.S. market - the IAIS methodology treats size as insignificant in determining the likelihood of systemic effect. The reason, as the IAIS explains, is that in insurance size reduces the likelihood of failure. "Insurance," the IAIS reports, "is founded on the law of large numbers, which basically states that the aggregation of a large number of idiosyncratic risks ultimately results in a normal curve of distribution....It should be recognized... that in an insurance context size is a prerequisite for the effective pooling and diversification of risks. " This was probably a revelation to the bank regulators and central bankers who dominate the FSB and the FSOC.
Ordinary insurance activities - the kind in which MetLife is engaged - are not considered systemically risky by the IAIS. "In general," they report, "insurance underwriting risks are not correlated with the economic business cycle and financial market risks and the magnitude of insurance events is not affected by financial market losses." MetLife, for example, was never in trouble in the financial crisis and never sought any financial support from the government.
While giving size a risk weight of 5 percent in their methodology, the IAIS puts the risk-weight for non-traditional insurance and non-insurance (bank-like) activity at 45 percent, and the risk-weight for "interconnectedness" at 40 percent. Because these two categories constitute 85 percent of the risk-weights the IAIS accords to the systemic risks that might be presented by insurers, it makes sense to review both of these categories when considering whether the FSB and the FSOC were correct in designating MetLife as a potential source of systemic risks.
Nontraditional or Bank-Like Activities at MetLife
Non-traditional insurance or bank-like risks are difficult to find in the 2013 year-end financial statements of MetLife. Like all insurers, its assets are investments, and its balance sheet shows investments of $489 billion, most of which are fixed maturity securities, including about $58 billion in mortgages. This makes sense for a life insurer that has long-term liabilities. Its securities holdings are principally governments and and investment grade corporates, as well as fixed income corporates. Its liabilities include benefit obligations and shareholders equity of about $443 billion. (This calculation leaves out separate account assets and liabilities of $317 billion that are included in insurer balance sheets for technical reasons but are neither assets nor liabilities of the firm. If that $317 billion were included, all the percentages used below would be smaller. )
Of MetLife's $443 billion in liabilities, what percentage might be considered nontraditional or bank-like under the IAIS methodology? One area cited in the IAIS methodology is derivatives not used for hedging purposes. The fair market value of the liability associated with those on MetLife's balance sheet is $5.3 billion, a little over one percent of its total liabilities, and on the asset side the fair market value is $6.1 billion, also a little over one percent of assets.
Another activity that is deemed to have nontraditional or bank-like characteristics is securities lending. Here, MetLife shows a payable (an amount of cash collateral provided by borrowers) of $30 billion, about seven percent of its liabilities, but the potential systemic effect of even this relatively small number is reduced by the fact (as reported in a recent speech by MetLife's CEO Steve Kandarian) that 75 percent of the securities loaned are U.S. government securities. It is highly unlikely that these securities will be returned, for a return of the cash collateral, at a time when the market is in trouble. Thus, it is exceedingly difficult to find anything in the MetLife financial statements that threatens a systemic effect as defined by the IAIS methodology.
MetLife's Interconnections
"Interconnections," which are accorded a 40 percent risk-weight in the AIAS methodology, look even less significant in MetLife's financial statements than the non-traditional or bank-like activities. The first thing to be said about interconnections, even before looking at MetLife's numbers, is to point out that interconnections have already been shown to be unimportant in the case of commercial and investment banks. This was demonstrated when Lehman Brothers suddenly filed for bankruptcy in September 2008. Although this started a chaotic period in the financial world, no other large financial institution failed because of its interconnections with Lehman.
In other words, although Lehman, at about $650 billion, was a financial firm even larger than MetLife, and was a major player in the credit default swap market, no other firm was so exposed to Lehman that it failed because of Lehman's collapse. What this means is that large financial institutions are generally sufficiently diversified that even the sudden collapse of a firm as large as Lehman would not cause a financial crisis because of interconnections, even if it were to occur - as Lehman's collapse did - at a time of high market anxiety about the health of the largest financial firms.
Apart from the deficiencies of the whole interconnections idea, the IAIS cites as a source of interconnectedness the degree of reinsurance provided by an insurer. In MetLife's case, this was $4 billion in 2013, less than one percent of total liabilities. Derivatives are also considered an element of interconnections in the IAIS methodology, but as we have seen these have a fair market value of only a little over one percent of MetLife's assets and liabilities.
Finally, other elements of interconnection are holdings of the securities of other financial institutions or borrowings from other financial institutions. As noted above, MetLife's holdings of securities are predominantly governments. Investments in other financial institutions are only $20 billion, or about 4 percent of its assets, while its borrowings from others at 2013 year end amounted to $26 billion, about 6 percent of MetLife's liabilities.
Conclusion
Although the FSOC has not made public any standards for how it determines whether a financial firm should be designated as a SIFI, the IAIS methodology provides compelling evidence that MetLife should not have been designated. Nevertheless, as noted above, the MetLife designation was foreordained, because the FSOC appears to be following the directions of the FSB rather than making its own independent decisions. The irony of all this is that the FSB, which commissioned the IAIS methodology, also seems to have ignored it when it designated MetLife as a global SIFI in July 2013.
This suggests that both the FSB and the FSOC are following largely political agendas when they make these SIFI designations, and not any rational or objective standards.
