Fed Governor Tarullo speaks on regulating insurers liability sensitive activities, including sec lending, repo, and collateral management

The theme this week has been regulators looking beyond the banks for risks to to the financial system. We saw the SEC take aim at mutual funds and ETFs with proposed rules to require investment managers to characterize how liquid are their assets. The FSB did something similar; examining (among other things) the potential mismatch between redemption terms and asset liquidity, leverage within funds and fund involvement in securities lending. Finally this week was a speech by Federal Reserve Governor Tarullo at the Banque de France Conference “Financial Regulation–Stability versus Uniformity; A Focus on Non-bank Actors”. The speech was called “Capital Regulation Across Financial Intermediaries” . One focus of the speech was on how some of insurance companies’ non-traditonal/non-insurance activity — sec lending, repo, and collateral management — is not adequately regulated. 

Tarullo asked what aspects of an institution should determine the regulation? The question would suggest that, perhaps, an insurance company that owns the same loans as a bank should be regulated the same way. From the speech:

“…the risk of loss associated with a particular corporate loan or mortgage-backed security or, indeed, any other asset does not vary just because its legal owner is an insurance company or mutual fund, rather than a bank. Yet we all know that regulatory capital requirements sometimes do vary with the nature of the firm. And I suspect that most people in this room believe there are good reasons why they should vary under at least some circumstances…”

Tarullo thinks that it is a firm’s liabilities which should be the driving factor. He said:

“…The scope and nature of a firm’s liabilities provide the justifications for capital requirements regulation. Differences in liabilities can, accordingly, sometimes warrant different capital requirements for portfolios of similar assets across firms….”

This should be a familiar argument for anyone involved in securities financing and managing runnable liabilities. Solvency and funding are closely related. Yet some liabilities, according to Tarullo, are  —  to use a popular term — sticky and as such, the focus of regulation should shift when that is the case.  Life insurance or property & casualty policies are examples of those.

“…Here the motivation for capital regulation is likely oriented toward the capacity of the company to meet these long-term claims as they come due, presumably over a fairly extended span…Thus this rationale for capital regulation focuses only on assuring sufficient assets over time to satisfy the policyholders’ claims should the company fail, with less attention to maintaining the company as a going concern…”

Tarullo brought up a third group of factors when considering regulation of liabilities: TBTF, systemic risk, and market externalities.

“…As the size of an intermediary increases, its exposures to other market actors–including many other intermediaries–may become so extensive that its failure would threaten the financial system as a whole. Believing that the government will, for this reason, prevent such an intermediary from becoming insolvent, market actors may extend credit as if a guarantee similar to deposit insurance were in place. Thus the nature and extent of the firm’s liabilities, taken as a whole, may warrant capital regulation to offset an implicit TBTF subsidy…”

Tarullo suggests that, irrespective of the type of institution, capital amounts ought to be tailored to the structure of liabilities. He also thought liquidity risk might be part of the stress testing process.

“…Conceptually, the cleanest approach might be to integrate capital and liquidity requirements in a single regulatory framework, which would establish minimum levels of capital and liquidity and then increase the capital requirement for intermediaries with more vulnerable funding structures. Higher capital levels would be especially warranted for intermediaries using large enough amounts of short-term debt that their response when funding liquidity is constrained–either selling assets or withholding funding from their own customers–could adversely affect the financial system as a whole…”

But in the same breath Tarullo said that this kind of coordinated approach is not likely anytime soon. “…For one thing, it is hard to imagine all the relevant banking, market, and insurance regulators converging on such a novel approach anytime soon…”

While applying the same set of regulation across different financial segments hasn’t been practical (although as evidenced of these recent speeches and proposed rules, regulators seem to be beating that drum now), it has been possible to tailor regulations to specific actors within the banking world. Tarullo cited that the higher capital required for US GSIBs as an example of tailored rules.

Certainly insurance polices are not prone to be runnable like a bank deposit or repo. But not all insurance company activities are so benign. The investment management arms of insurance companies have many of the same characteristics as stand-alone money managers, allowing withdrawal on demand. And the capital markets & treasury areas of many insurers are hard to distinguish from banks. We are talking repo, sec lending, and collateral demands from derivatives. By and large, insurance regulation does not address this activity via LCR type liquidity regulations. Is the insurance industry, traditionally regulated by individual states,  the next Fed target?



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