When Insurers and Asset Managers Become ‘Too Big to Fail’

When the Financial Stability Oversight Council meets on July 31, it is widely expected that it will label MetLife, the largest life insurer in the United States, as “Too Big to Fail,” or more formally as a Systematically Important Financial Institution. The designation would subject MetLife to new stricter capital, leverage, and liquidity requirements that are generally reserved for the largest banks.

Essentially, fearing that the insurance giant could, someday, pose a threat to the nation’s interconnected financial system, regulators want the ability to treat the non-bank as though it is, in fact, a big bank. MetLife won’t be the first non-bank to earn the SIFI badge. It will join Prudential, AIG, and GE Capital in the exclusive club no one wants to join.

When the Dodd-Frank Act created the FSOC, it was molded as a super group of sorts for financial regulators, with the heads of the SEC, Commodity Futures Commission, bank regulators, and the Federal Reserve joining forces to detect and mitigate threats to the nation’s financial system. Initially, much of the pushback was on how it would take control of liquidating failed SIFIs. Barney Frank, the namesake former congressman of the legislation that created FSOC, recently quipped that while Affordable Care Act foes complained of “death panels” in that legislation, they tended to overlook the benefits of having a judge, jury, and executioner in the financial sector.

Now, however, the debate is less on those worst-case scenarios, as it is the front end SIFI designation process. Frank himself, returning to his old House stomping grounds to testify on the fourth anniversary of the Dodd-Frank Act, conceded that he is not convinced that FSOC should be designating non-banks as systemically important.

Concern about the SIFI label, and the related stricter reporting requirements, already raging in the insurance world, is spreading through the realm of asset managers. Some speculate that BlackRock and Fidelity are in the crosshairs and next on the SIFI designation hit list. That possibility has many asset managers fearing that new requirements and restrictions will make it harder to profit from managing mutual funds.

Banking Regs for Non-banks

Many are critical of FSOC's plan to designate registered and unregistered funds as SIFIs because the criteria for SIFI designation is heavily skewed towards banking concepts like capital instead of factors more germane to mutual funds and hedge funds, says Bibb Strench, counsel in the Investment Management practice at law firm Seward & Kissel. “The investment objectives and the types of strategies and transactions funds engage in to achieve those objectives are more important factors to examine when analyzing the systemic risk of a given fund, Strench says. “Such activities are already subject to a comprehensive regulatory scheme.”

While there is “a lot of noise from Congressmen and trade groups,” Strench doesn’t think it will have much influence. “You apply traditional bank type regulations to a product like a mutual fund and that causes all kinds of potential problems, potentially making them more difficult to market,” he says. “It’s a less ideal financial product.”

What is Too Big to Fail? What is systemic risk? Perhaps the regulators need to be a better job of being more definitive as to what they are.
Todd Cipperman, Founding Principal, Cipperman Compliance Services

As for political pressure, U.S. Rep. Scott Garrett (R-N.J.), in speeches and testimony, has been the face of FSOC opposition in Congress. Among the questions he has posed:

Should the FSOC be structured in a way that increases White House political control over financial regulation?

Should the foreign Financial Stability Board, the Treasury Department, and the Board of Governors of the Federal Reserve System designate U.S. companies as global SIFIs before our domestic process through the FSOC makes a determination?

Should the FSOC provide clear criteria to U.S. companies regarding the parameters used to determine how and why a designation is made and what steps a company can take to avoid designation? There are currently no clear rules or criteria to determine when a nonbank financial institution qualifies as a systemic risk to the financial system and little guidance about how to avoid or reverse a designation. 

“Do we really need more regulation from an FSOC level? Is that really necessary? There is a lot of validity to those questions,” says Todd Cipperman, founding principal of Cipperman Compliance Services, a consultant in the asset management sector. “But, I think people in the industry are raging against the machine and this is the way the world is going.” In his view, FSOC’s ever-expanding plate isn’t as radical as it may seem, it is merely catching up with the rest of the world.

“This idea of systemic risk and entity-level regulation as opposed to product-specific regulation is really something that the U.S. is behind on compared to the rest of the world,” Cipperman says. “Look at the U.K, where they have been looking at this whole idea of systemic risk and entity level regulation for some time. They are far ahead of us, as is the Far East and Japan.” He says that asset managers are going to have to accept the fact that this is the way the world is going.

As firms evolved beyond product lines, a modernization of the regulatory regime was predictable, Cipperman says. “The problem is that there is a lot of subjectivity around it,” Cipperman says. “What is Too Big to Fail? What is systemic risk? Perhaps the regulators need to be a better job of being more definitive as to what they are.”

DESIGNATING NON-BANKS

The following is from the Financial Stability Oversight Council’s rulemaking for evaluating non-banks as systemically important financial institutions.
Pursuant to the provisions of the Dodd-Frank Act, the Council is required to consider the following statutory considerations when evaluating whether to make this determination with respect to a nonbank financial company:
 (A) The extent of the leverage of the company;
(B) The extent and nature of the off–balance-sheet exposures of the company;
(C) The extent and nature of the transactions and relationships of the company with other significant nonbank financial companies and significant bank holding companies;
(D) The importance of the company as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the U.S. financial system;
(E) The importance of the company as a source of credit for low-income, minority, or underserved communities, and the impact that the failure of such company would have on the availability of credit in such communities;
(F) The extent to which assets are managed rather than owned by the company, and the extent to which ownership of assets under management is diffuse;
(G) The nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company;
(H) The degree to which the company is already regulated by one or more primary financial regulatory agencies;
(I) The amount and nature of the financial assets of the company;
(J) The amount and types of the liabilities of the company, including the degree of reliance on short-term funding; and
 (K) Any other risk-related factors that the Council deems appropriate.
The Stage 1 Thresholds
In Stage 1, the Council intends to apply six quantitative thresholds to a broad group of nonbank financial companies. The thresholds are:
• $50 billion in total consolidated assets;
• $30 billion in gross notional credit default swaps outstanding for which a nonbank financial company is the reference entity;
• $3.5 billion of derivative liabilities;
• $20 billion in total debt outstanding;
• 15 to 1 leverage ratio of total consolidated assets (excluding separate accounts) to total equity; and
• 10 percent short-term debt ratio of total debt outstanding with a maturity of less than 12 months to total consolidated assets (excluding separate accounts).
Source: Financial Stability Oversight Council.

“There is no industry more regulated than the asset management industry,” Cipperman says. “Does anybody that is regulated really want more regulation? Probably not. But the industry can’t be too myopic. Whether we like it or not there was a loss of confidence in the asset management world and the securities markets in 2008. You want the investing public to feel safe and that will lead to more investment.”

Ensuring Stability

The FSOC, in concept, is a noble experiment and an important step towards ensuring the stability of financial markets, says Aaron Klein, director of the Financial Regulatory Reform Initiative at the Bipartisan Policy Center. Nevertheless, his organization has several suggestions for how it can be improved. First and foremost, he says, its lack of transparency is troubling. “I’m old enough to remember when the Fed wouldn’t tell the market whether it raised interest rates or not,” he says. “After repeated calls for transparency, they have taken a series of steps that, cumulatively, have been a fantastic improvement.” The same, he says, is needed for this newest of agencies.

Greater transparency doesn’t mean that behind-the-scenes details of the SIFI designation process will make public company-specific deliberations, surely a development that could torpedo stock prices, Klein says. But FSOC members would do well to show the nation that their eye is well-placed on broader issues. “Over the last year, a lot of people have wondered whether problems in Puerto Rico will cause a systemic problem in the municipal debt market,” he explains.

“One must imagine that, focused on systemic risk, it has discussed the scenario. The Fed minutes from its January meeting made reference to Puerto Rico’s potential impact on financial system, but FSOC didn’t reveal that discussion until its annual report. Why couldn’t they say it? I think the government was paying attention, but nobody knows. Increasing their transparency will improve their credibility.”

Klein and his organization also want FSOC to work more closely with international regulators; properly set different prudential standards, including capital requirements for non-banks that are subject to enhanced supervision requirements; creating a federal insurance charter  that would be mandatory for SIFI insurance companies, and a federal insurance regulator to oversee firms holding that charter; setting long-term debt holding requirements that will enable large financial institutions to better absorb losses; and raising the SIFI threshold for banks from a hard-and-fast $50 billion in assets to a more flexible $250 billion.