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On May 17, the House Committee on Financial Services conducted a hearing, entitled either:

  • "Implementing Title I of the Dodd-Frank Act: The New Regime for Regulating Systemically Important Nonbank Financial Institutions", or

  • "The Impact of the Dodd-Frank Act: What It Means to be a Systemically Important Financial Institution"

The first title is from the written testimony of the Treasury's representative: the second, from the committee website. There seems to be a misunderstanding here: the Treasury's attitude is, that the regime has been implemented, and here's how it is. The committee's version seems more exploratory, a search for understanding.

The written testimony of Lance Auer, Deputy Assistant Secretary for Financial Institutions, U.S. Dept. of the Treasury, provides an alternate version of a previously promulgated regulation. When providing information on stage one of the process for identifying SIFI's, his version does not seem to agree with the actual regulation. Here are the alternate versions:

  • 15 to 1 leverage ratio, as measured by total consolidated assets to total equity; or

  • 15 to 1 leverage ratio of total consolidated assets (excluding separate accounts) to total equity; and

This reference (or lack thereof) to separate accounts is significant, because life insurance companies frequently have separate accounts, for which the policyholder bears the market risk. Both Prudential Financial (PRU) and MetLife (MET) have pointed out that considering these amounts when computing leverage is not justified.

It should be noted that Mr. Auer's boss, Tim Geithner, has considerable abilities in the area of studied carelessness, as demonstrated by his Turbo Tax gaffe. Now studied carelessness has insinuated itself into the text of regulations, to the detriment of those who are potentially subject to it.

Sour Notes at the Hearing

The hearing had two panels - the first of which was composed of Mr. Auer and Michael Gibson, Director, Division of Banking Regulation and Supervision, Board of Governors of the Federal Reserve System. Both of these gentlemen departed after their testimony, apparently to avoid contaminating their thought processes by hearing other opinions on their points of view.

William Wheeler, President, Americas, MetLife, when questioned, remarked that he had spent considerable time trying to interact with the Fed but had experienced considerable reluctance on their part to looking at MetLife as anything but a bank. He also said "I have yet to meet somebody (at the Fed) who I thought had a sophisticated knowledge of the insurance industry."

In his written testimony, Thomas Quaadman, Vice President, Center for Capital Markets Competitiveness, U.S. Chamber of Congress, had the following to say:

In looking at means of managing systemic risk, Congress recognized that with respect to nonbank companies, it was crucial to provide a clear delineation between nonbank financial institutions, and those companies whose financial activities are incidental to a primary commercial focus.

We believe that Congress did a good job in striking that balance. However, we are very concerned that the implementation of Title I of the Dodd-Frank Act by regulators is being done in a manner that is manifestly contrary to the clear and unambiguous language Congress used to strike this important balance.

During the questioning, he stated that the FSOC (Financial Services Oversight Committee) and Fed should follow the law. Also, that the Fed is applying a bank centric set of regulations to non-bank financial services firms.

AIG - The Source of the Problem

AIG, by placing AIGFP, the unit that wrote CDS protection, under the supervision of the now defunct and little mourned OTS, evaded insurance regulators, who would not have permitted the company to write insurance without adequate capital.

AIG's security lending business had already been identified as a problem area by state insurance regulators, who were in the process of winding down the operation when the financial crisis hit.

Bank regulators were totally ineffective in regulating AIG. There is no reason to anticipate that they will do better in the future. After all, when you try to talk to them about the differences between banking and insurance, they don't understand, and walk away from the conversation.

The Ultimate Irony

Neither MetLife nor Prudential Financial accepted government aid during the financial crisis. MET was the only major bank holding company to decline assistance. Both MET and PRU were able to contribute to AIG's recovery by buying its life insurance subsidiaries. MET bought ALICO, and PRU bought Star and Edison. These purchases were done from retained earnings, and capital raised without government support or assistance.

It's bizarre - two firms that cruised through the Financial Crisis with flying colors are now in danger of being regulated in ways that will distort the insurance marketplace, and may damage their competitiveness, not to mention their shareholders. Meanwhile, the banks, which were and are the problem, are managing to resist corrective action designed to prevent a recurrence.

Banking regulators who failed miserably on the portion of AIG they regulated, are working to extend their reach to encompass more insurance companies.

A Simple Solution

Insurance companies, when writing conventional insurance, do not pose systemic risk. They are capably and effectively regulated by the states, and have been for over 100 years. The system is not broke, and there is no reason to fix it.

The Fed should defer to the NAIC (National Association of Insurance Commissioners). The Fed might legitimately inquire as to whether any insurance companies are engaged in non-insurance activities, and could get involved at that point. Hopefully they will be more effective than OTS was when supervising AIGFP. The NAIC could refer any insurance company that gets involved in non-insurance activities to the Fed.

If the Fed won't back off, Congress should intervene with corrective legislation.

CDS Are Insurance

Reinstating Glass-Steagall would resolve a lot of issues, as would repealing CFMA. CFMA is the legislation that exempted CDS from regulation as insurance, or as gambling, while Glass-Steagall was designed to keep banks out of the insurance business. It was a good idea, and it worked. Now we have a bank regulator going after the insurance business. It's a bad idea.

CDS are insurance, and should be regulated as such, with a requirement of insurable interest for the buyer, and adequate capital for the seller. It's just that simple.

The banks should be required to discontinue the writing of naked CDS. They should be required to divest their remaining CDS business, and disentangle it from its reliance on FDIC insured deposits as a source of capital. Then, and only then, will the US financial system be safe for capitalism.

Now is the time

The poster child for banking self-regulation, JPMorgan's (JPM) Jamie Dimon, has stepped in doodoo. Writing CDS protection has created a large and unmanageable loss. It is a propitious time to revisit CFMA and Glass-Steagall.

Source: Fed Regulation Of Non-Bank Financials Developing Very Poorly