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.

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