On Risk-Based Liquidity, and Financial Regulation

People forget how crises happen after the events have passed, and begin to believe comforting fictions thereafter.  Companies typically fail when they can’t meet a call for cash to be paid.  With financial companies, it typically means that the company financed long-term, illiquid assets, with liabilities that would have to be rolled over regularly.

If you have to roll over your financing too regularly, you leave yourself open to the market environment where financing is not available.  Those environments happen more often when a lot of people are trying to finance long assets with short debt.  Eventually something fails, and all of the short-term lending markets tighten, leading to more failures, and falling asset prices, rinse, lather, repeat, etc., until finally, there are no unquestionable short debts.

Now I write this for several reasons: one is that Prudential is considered to be systemically risky by the FSOC [Financial Stability Oversight Council].  But Prudential has a long liability structure, and is not subject to runs on their company, unlike banks that play in the repo markets, or have to post a lot of margin for futures, or derivatives.

Further, solvency for insurers is governed by the states and does not consider transitory variations in asset prices to be a factor in solvency.  Solvency is a question of how asset cash flows will cover liability cash flows over numerous scenarios over the life of existing business, without new sales.  (I.e. they don’t consider the possibility that the company could sell its way out of  insolvency.  That has happened in practice infrequently, but you can’t rely on it.)

Only companies that borrow short are at risk in a crisis situation, because they have to produce cash NOW.  That is not true of Prudential.

Then there is this article at Bloomberg.  I agree with it for the most part, but many commercial and investment banks not only took liquidity risk, but credit risk as well.  There is need for rules that drive the amount of capital that a financial institution should have, and it should reflect credit risk, illiquidity, and the degree that liquidity need to be renewed regularly.  Elizabeth Warren’s proposals are well-intentioned, but too simplistic.

Better to try to emulate the good regulation of insurance by the states.  I know it is radical, but banks would be better regulated if regulation were given back to the states, and interstate branching ended.  This would end “too big to fail” in an instant. Get the Federal government out of banking regulation.  One regulator is easy to control; fifty are hard to control.  That’s on big reason why insurers are far better regulated than banks.

Now all that said, it is possible for a financial company with a long liability structure to die.  An insurer underwrites long-tailed coverages badly, but the claims aren’t coming for a long time.  Year-by-year, they raise their claim estimates, bit-by-bit.  A company that only writes the bad insurance will meet its end, but it will take claim development in excess of resources to do so, and that will take years.

Banks have around a year to react to  a growing loss of liquidity, insurers have far more time, leaving aside clauses that allow for the agreement to be canceled after a credit downgrade.

One final note: Wall Street may be learning to co-operate with its regulators. I would encourage them to again, look at the insurance industry.  Actuaries, who have a serious ethics code, are usually on every serious study committee together with regulators.  The actuaries, while not fully neutral, get treated honest dealers as industry issues get discussed.  Part of the reason here, is that so many different state regulators have to be convinced in order for anything uniform to be proposed to the state legislatures, that it takes a while for the discussions to complete, with some state regulators with a little more savvy making the case to those with less.

Fifty heads are better than one.  To the degree possible, hand financial regulation over to the states.  It is far harder to co-opt fifty state regulators than one in DC.  If that ‘s not possible, Wall Street should adopt the idea of using ethics-bound professionals like Actuaries of CFA Charterholders to interact with regulators to craft regulations that are fair for companies and the Public at large.

About David Merkel 144 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website RealMoney.com (http://www.RealMoney.com). Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

Visit: The Aleph Blog

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