Too Big to Fail: MetLife v. FSOC

"The disorderly failure of AIG would have put at risk...the entire global financial system."

Ben S. Bernanke, Speech at Morehouse College, April 14, 2009

Last week, a Federal District Court overturned the Financial Stability Oversight Council’s (FSOC) designation of MetLife—the nation’s largest insurer by assets—as a systemically important financial intermediary (SIFI). Until the Court unseals this decision, we won’t know why. If the ruling is based on narrow grounds that the FSOC can readily address, it will have little impact on long-run prospects for U.S. financial stability.

However, if the Court has materially raised the hurdle to SIFI designation—and if its ruling holds up on appeal—“too big to fail” nonbanks could again loom large in future financial crises, making them both more likely and more damaging.

In this post, we explain why the FSOC’s ability to designate SIFIs is so important for the stability of the financial system. We also argue that the broad case for designating a large, interconnected and leveraged entity like MetLife is anything but “arbitrary and capricious,” the standard that the law sets for the judicial review of an FSOC designation (Dodd Frank Act, Title 1, Sec. 112 (h)).

The FSOC was created by the Dodd-Frank Act “to identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities of large interconnected, bank holding companies or nonbank financial companies” (Title I, Sec. 112 (a) (1) A). Designation of a nonbank as a SIFI—which subjects it to tighter regulatory requirements under the supervision of the Federal Reserve—is the FSOC’s most important authority. Aside from MetLife, the FSOC has designated three other nonbanks (AIG, GE Capital, and Prudential), including two insurers, as SIFIs since its creation in 2010.

Why is nonbank SIFI designation so important? The answer is that there are three key economic problems that, unless properly addressed, boost the probability of a devastating financial crisis in the future. The first is regulatory arbitrage—the ability of financial firms to circumvent regulation by shifting systemically risky financial activities to legal entities that face less stringent regulatory standards. The second is the potential for the largest, most complex intermediaries to conceal systemic risk-taking. And the third is the challenge of time consistency: unless large, interconnected intermediaries believe that their creditors will not be bailed out in a crisis, their shareholders and managers have incentive to take risks that put the financial system in jeopardy when a crisis strikes.

Consider each of these three problems in turn. First, the U.S. tendency to regulate by legal form, rather than economic function, promotes regulatory arbitrage. Shadow banking, for example, is the result of such arbitrage. Firms like money market mutual funds (MMMFs) offer bank-like services without being subject to bank regulation (such as capital requirements). As regulators raise capital and liquidity requirements on banks to make them more resilient, the incentive to shift systemic risk-taking out of banks and into less regulated legal entities rises. Such risk-shifting adds to financial fragility both directly—through the actions of nonbanks—and indirectly by making bank regulators too hesitant. If bank regulators are nonetheless resolute, over time, systemic risk will concentrate in large nonbanks, including insurers like MetLife. (See our earlier post for a more detailed discussion of regulation by function.)

Second, concealment of systemic risk is why AIG, then the nation’s largest insurer, became infamous in 2008. It used over-the-counter derivatives to “insure”—without reserves or a collateral backstop—nearly half a trillion dollars of mortgage-backed securities. When AIG became unable to meet its contractual obligations, the losses of its large counterparties could have brought the already-fragile global financial system down. As then Chairman Bernanke argued, the Fed’s choice to intervene was “the best of the bad options available” (see here).

But the Fed’s loan to AIG created enormous moral hazard: going forward, large nonbanks know that, if their failure poses a serious risk to the financial system, the authorities will go to extraordinary lengths to support them. While Dodd-Frank rules out Fed loans to individual nonbanks (like AIG) in the future, the central bank can always lend to a solvent bank.

That brings us to the third problem: time consistency. Until authorities let a major intermediary fail in the midst of a severe crisis—risking another Lehman debacle, or worse—it will be difficult to convince the largest financial firms that they would not be bailed out in such circumstances. And so long as there is any doubt about the government’s commitment to allow the creditors of large intermediaries to be wiped out in a crisis, these creditors will lack the incentive to charge a funding cost commensurate with the borrower’s risk. Over time, these distortions favor the buildup of systemic risk, just as they did in the decades before 2007.

In promoting financial stability, one alternative to SIFI designation is to regulate the range of activities that are systemic. For example, one could mandate margin and collateral minimums for all derivatives contracts; require that collateral received from a securities loan be invested only in liquid, default-free assets; and impose serious haircuts on collateral used in the repo market. We have argued elsewhere that activities regulation of this kind can make sense in the asset management industry, primarily because the risks of the funds they manage are borne by the fund shareholders.

But it is far from clear how activities regulation—unless it severely circumscribes their behavior—would reduce and control the systemic risk associated with the largest insurers. As Acharya and Richardson explain, in recent decades, insurers have engaged increasingly in nontraditional activities, boosting direct exposure to risky assets that threaten their solvency in a crisis. For example, after Lehman collapsed, the cost of using credit default swaps (CDS) to buy protection against MetLife’s senior, subordinated bonds rose above 500 basis points. Furthermore, by offering investment accounts that can be withdrawn, insurers have created a large volume of runnable liabilities. They even use “shadow insurers” in less regulated locales to limit their capital needs. What this all means is that the difference between intermediation by insurers and banks has narrowed.

So what is the impact of the FSOC’s SIFI designation (or the threat of it)? Some critics, like the Wall Street Journal editorial page, argue that it identifies those institutions that the U.S. government will bail out in a crisis, creating a “too-big-to-fail club.” Were that the case, one might have expected the CDS premium on MetLife debt to jump following the March 30 Court decision: instead, the premium edged lower. That market response may reflect investor doubt that the decision will be upheld, but it also is consistent with the view that too big to fail developed well before the creation of FSOC and SIFIs and exists independently of them.

In the 2007-2009 disruptions that preceded Dodd-Frank, the U.S. government already made clear that it would use all available legal tools to support the creditors of large, interconnected financial intermediaries when an acute crisis threatens to become another Great Depression. And, while a few tools used in the crisis are no longer available—most notably the Fed’s authority to lend to an individual, solvent nonbank—most still are. And, in our view, they should be: would anyone seriously recommend eliminating fire departments as the best means to promote fire prevention?

Thus, the moral hazard arising from institutions that are too big to fail already exists. The unavoidable problem is that the government cannot credibly commit to sit by if the failure of a systemic intermediary threatens a financial collapse and a depression.

The good news is that SIFI designation seems to work. It both encourages large and complex intermediaries to make themselves less systemic, at the same time that it discourages nonbanks from becoming bigger and more interconnected. Having shed most of its formerly vast financial services business, GE last week formally applied to the FSOC for the removal of its SIFI designation. And, at least until last week’s court decision, MetLife was moving to separate its retail life insurance business to limit the “risk of increased capital requirements” that its SIFI status presented.

It should already be clear that an economic rationale for designating a large, interconnected and leveraged insurer as a SIFI need not be “arbitrary and capricious.” In the case of MetLIfe v. FSOC, the amicus brief filed on behalf of defendant FSOC by our NYU Stern School friends and colleagues, Professors Acharya, Engle, Philippon, and Richardson, provides just such a rationale that is closely linked to the methodology underpinning the Stern Volatility Lab’s systemic risk rankings.

The brief notes that MetLife engages in activities that boost systemic risk, including “funding agreements, securities lending arrangements, guaranteed investment contracts, variable annuity contracts, derivatives portfolio, and withdrawable liabilities.” As evidence corroborating the FSOC decision, it highlights quantitative measures of MetLife systemic risk, including market indicators of MetLife’s distress during the financial crisis and the V-Lab’s SRISK indicator (see chart below). SRISK is the capital shortfall, measured in billions of dollars, that MetLife would be expected to experience in a crisis when the financial sytem as a whole is short of capital. Notably, MetLife’s estimated SRISK has not declined in recent years, even as aggregate U.S. SRISK plunged by more than half from a 2008 peak above $1 trillion.

MetLife SRISK (Billions of U.S. dollars), 2008-March 2016

Source: NYU Stern Volatility Lab. For a definition of SRISK, see here.

Source: NYU Stern Volatility Lab. For a definition of SRISK, see here.

For several years now, MetLife has been identified by the V-Lab rankings as one of the leading contributors to systemic risk in the United States (see table and chart below). Because they contribute significantly to the estimated shortfall of capital in the U.S. financial system as a whole, firms that account for a sizable share of aggregate U.S. SRISK “are not only the biggest losers in a crisis but also are the firms that create or extend the crisis” (see here). (To be sure, accounting issues complicate the direct comparison of banks and insurers, but MetLife probably would remain a significant contributor to aggregate SRISK even if a substantial portion of its nonequity liabilities were excluded as not fixed in measuring its SRISK.)

Stern Volatility Lab Systemic Risk Rankings (April 1, 2016)

Source: NYU Stern Volatility Lab. For a definition of SRISK, see here.

Source: NYU Stern Volatility Lab. For a definition of SRISK, see here.

Shares of Aggregate U.S. Financial SRISK (Percent), January 2008-March 2016

Source: NYU Stern Volatility Lab. For a definition of SRISK, see here.

Source: NYU Stern Volatility Lab. For a definition of SRISK, see here.

We should note that a significant contribution to systemic risk as measured by something like SRISK does not automatically follow from a firm’s size alone. For example, at the end of 2015, despite being the third largest bank holding company by assets, Wells Fargo & Co was near the bottom of the SRISK rankings. High SRISK also is not simply a result of assuming a systemwide capital shortfall. Indeed, to assess a firm’s contribution to systemic risk, it is necessary to examine situations when it suffers financial distress precisely when there is a system-wide shortage of capital. What drives the V-Lab SRISK measure is a mixture of size, financial interconnectedness (proxied by the conditional correlation in a crisis of a firm with the market) and leverage.

Returning to the original challenge, we don't know the rationale for the District Court’s decision. But even if it is on purely procedural grounds, it can still raise the hurdle for SIFI designation sufficiently to be seriously damaging to long-run financial stability. For example, were the courts to require that the FSOC provide in advance details of every test and every threshold that it applies in assessing SIFI status, financial intermediaries would then proceed to game the rules. Over time, that would lead to a collection of large intermediaries with characteristics just shy of SIFI status, but nevertheless quite systemic, and with the ability to jump (temporarily or otherwise) over the SIFI threshold on short notice when profit opportunities arise.

The bottom line: without a credible threat to designate large nonbanks as SIFIs, the FSOC, which already has had limited success in compelling recalcitrant regulators to counter systemic risk (think of MMMFs and the SEC), would lack the authority to carry out the other two parts of its legislative mandate: (1) “to promote market discipline, by eliminating expectations on the part of shareholders, creditors, and counterparties of such companies that the Government will shield them from losses in the event of failure”; and (2) “to respond to emerging threats to the stability of the United States financial system.” Over time, the U.S. financial system would grow more fragile as systemic risk taking shifts to large nonbanks. When the next AIG is revealed, it will be too late to avoid a crisis.

(Note: We thank our friends and colleagues, Viral Acharya, Thomas Philippon, and Larry White, for taking the time to discuss SIFI designation with us. We are always grateful to Rob Engle for the Stern Volatility Lab’s systemic risk analytics that we use frequently on this blog. We also thank Rob Capellini for helping us understand the V-Lab’s systemic risk measures and Michael Robles for providing the data for this post.)