There is a new parlour game in the geekier circles of Washington’s regulators, academics and lobbyists: who should be on the list of companies deemed so important to the financial system that they must be subject to tighter standards?
After financial groups built up risk that threatened to bring down the entire financial system, the Obama administration decided to identify future AIGs and Lehman Brothers and subject them to tougher capital and liquidity standards and closer supervision.
As Congress debated the law that became Dodd-Frank, lawmakers wrangled over this systemic risk designation. Some warned it would crystallise the “too big to fail” funding advantage enjoyed by the largest groups by underlining the fact the government considered them crucial. Others said it would instead be a “scarlet letter”, a sign that profits would be hit by the new standards.
Nine months after the designation became law, it looks like the scarlet letter brigade has won. Disclosures show a long list of companies and industry trade groups engaging in lobbying efforts – people involved with the talks say they are desperate to prove they do not deserve to be branded.
Viral Acharya, a professor at New York University’s Stern School of Business, has developed a daily league table of systemically risky companies, which measures the correlation between a stock market fall and that of an individual company and also takes into account how much debt it has. It is an elegant way of measuring how tightly bound to the broader system a group is and how vulnerable it is to failing.
As Mr Acharya points out: “In the end, it wasn’t a regulator who woke up one day and said ‘Listen, we are having a subprime crisis’, it was the market.”
Bank of America is top of the list. Like all bank holding companies with more than $50bn in assets, it is automatically designated, but the top 10 also includes four insurance companies: MetLife, which is structured as a bank holding company and is therefore expected to be designated; AIG, which is also expected to be designated even though its supporters say it has shed its risky businesses; Prudential; and Hartford Financial Services.
How to treat the latter two businesses shows the difficulties of the designation: they are both large and the NYU-Stern calculations show them to be systemically risky. On the other hand, the insurance industry is arguing that its companies enjoy stable funding and are therefore not susceptible to bank-type “runs” and that unlike AIG, they are not dangerously intertwined with other financial companies.
“It’s absolutely the number one outstanding issue that we have,” David Sampson, chief executive of the Property Casualty Insurers Association, told a Chamber of Commerce conference last week. “Clearly it’s fundamentally a size-based threshold … [and] a bank-centric view of how they [regulators] approach their work. You’re not going to have a run on [insurers] … unless everyone in the country crashes their car at the same time.”
Mr Acharya notes though that it is very difficult to argue convincingly that there is no systemic risk in insurance. As big buyers of corporate bonds, if they stopped buying in a crisis then corporate America would be forced to turn to credit lines with banks, having knock-on effects for banks’ funds. Mr Acharya’s league table only includes public companies – asset managers, private equity firms and hedge funds that are not on the stock market are therefore exempt.
That might not be the case in the real designations. But in 2009, both Ben Bernanke, chairman of the Federal Reserve, and Tim Geithner, Treasury secretary, separately expressed the view that no individual hedge fund was risky enough for inclusion.
That might not suit the purposes of the Federal Deposit Insurance Corporation. The agency has been given powers to wind down a failing systemically important financial group to complement its existing powers to wind down banks. Officials there, in contrast to their counterparts at the Fed and the Treasury, want a longer list because they think the designation, particularly the requirement to draw up a living will, is important to the FDIC’s ability to wind down a future AIG or Lehman Brothers. But the FDIC is only one vote on the council of regulators.
Daniel Tarullo, the Federal Reserve governor, said last week that the initial list should be short and “treating financial firms of all sorts as banks could be both ineffective and inefficient”.
Although some lobbyists worry that the council will ultimately opt for broader inclusion for fear of missing a company that later roils markets, the indications so far are that a decisive majority of its members will opt for a smaller list.
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