The Banking Industry Should Learn from the Insurance Industry

I can’t comment on everything, at least above the degree of quality that I try to impose on myself.? (I know, the standards could be raised. 😉 )? But I did want to comment on a paper on banking capital regulations that came out of the Jackson Hole conference.? Odd Numbers and Naked Capitalism commented on it, and I thought both had good things to say.? I have my own twist to share, having been a risk manager inside two insurance companies.

The basic idea of the paper is that risk levels have to be reduced at banks, but banks want to stay highly levered so that they can earn high returns on equity, so asking them to reduce debt levels or internal leverage is not feasible.? Instead, why not have them buy insurance policies that pay out during banking crises?? Then they will have the capital when it is needed, and they can continue to lend in all environments.

(SIgh.)? I have oversimplified their arguments, but I have done it to help make some points, which are:

1) The cost of the insurance policy will get factored into the equity calculation for return on equity, at least at far as a prudent bank manager would view it.? The insurance policy is illiquid, and its cost should be reckoned as a part of the surplus it replaces, which may allow for a reduction in overall surplus levels carrying the business.? (Note to regulators: anytime you allow a financial entity a reduction in required surplus from a risk transfer agreement, you should analyze the alternative of using the premium(s) paid to add to surplus, and ask, which looks better.? Also, these are collateralized agreements, but in uncollateralized agreements, analyze the counterparties, and deny surplus credit frequently.)

2) Do the authors realize how expensive these agreements should be?? Consider:

  • The insurer is asked to post the collateral, which takes money out of its surplus.
  • The insurer is asked to be ready to lose an asset at a very bad point in the credit cycle.
  • The monies are invested in Treasury securities, so there is no possiblity for the insurer to make money from investing the premium more aggressively, but still safely.
  • Large banking crises happen about once every 20 years or so, with smaller ones more frequent.? With a long enough agreement, the loss of the Treasury collateral is almost certain, making the cost high.
  • If these were common, a sort of moral hazard would develop, similar to what has happened with the financial guarantors.? Banks would conduct business aggressively, realizing that they have the capital backstop.? Initial results would look good, until the crisis. Then, double surprise! The insurers figure out that they didn’t charge enough for the insurance, and the banks find out that their losses were larger, because of their aggressive behavior.? Wound banks be willing to pay premiums around 5-15% of the face amount insured, depending upon where the risk trigger kicks in?

3) Beyond that, there would probably be a scarcity of providers.? Few want to dedicate a large portion of their capital bases to the events that are entirely a process of human action.

Take a lesson from the reinsurance industry.? Ideally, you would want an agreement that took the risks directly off of your books, such that the capital would come when you specifically had losses above a threshold.? That’s been done in the insurance industry for reinsuring companies as a whole, and the reinsurers have usually come off the worse for it.? The insurers almost always know their risks better than the outsiders.? Reinsurers prefer to reinsure specific risks that they can underwrite, not companies as a whole.

But, lest I merely seem to be a critic, let me offer three suggestions for how to try to make this work.

1) Call Ajit Jain at Berkshire Hathaway.? They have the capital.? Give him a detailed proposal of what you want, and let him give you the quote that makes your jaw drop, or, watch him decline the business, unless you put your bank into a straitjacket of terms and limitations of coverage.

2) Try setting this up through an Industry Loss Warranty.? You would get paid capital during bad times if the industry has suffered losses past a threshold, and you have suffered losses in excess of a threshold as well.

3) Or, try setting this up as a catastrophe bond.? Borrow money through the bond at a high rate of interest.? Junk bond buyers will fund you.? During a crisis, if the banking industry losses exceed a threshold, the principal of the notes gets written down, and voila!? You have capital when you need it.? Note that the junk bond buyers should require more of a premium here, because bank losses tend to be correlated with other junk bond losses — no big benefit from diversification here.

I will leave aside the idea of setting up captive reinsurance sidecars, because those are just regulatory arbitrage.

My main point here is that I don’t think that this type of insurance will work.? Even for those willing to contemplate the structure, the true price will be too high for the banks to gain any benefit.? Perhaps this could be done on a limited basis for one more turn of the credit cycle, but I think for those that offer the insurance, the banks that buy it, and the regulators, they will be less than happy with the results.

In my opinion, we need to bring down leverage ratios for the banks, slowly but inexorably.? If that hurts their ROEs, well, I’m sorry.? If we are going to do a leveraged fiat money system, the leverage must be considerably lower than where we are now, and all synthetic exposures (derivatives) must be brought on balance sheet as if they were cash transactions.? It is that lack of transparency and increase in leverage that has made our financial system so much more risky, as this other paper from the Jackson Hole conference states.? I did not feel that the discussants really understood what they were talking about, because they could see the micro level risk reductions from derivatives, but miss the added leverage, lack of transparency, and concentration of risk in the hands of parties that were greedy for yield, and may not be able to make good on all agreements in a crisis.

Much complexity and leverage will need to be unwound before this credit crisis is over.? The era of high ROEs for banks should be over for some time, that is, until the regulators fall asleep again during the next boom phase.? Some things rarely change.

6 thoughts on “The Banking Industry Should Learn from the Insurance Industry

  1. You must be an actuary. I see your posting rules, and let me say #%!# #$&*!

    I’m not a financial or life actuary (although I am an actuary), but that won’t stop me from commenting.

    1. Spain supposedly varies capital requirements based on the phase in the cycle. You could do this or vary FDIC premiums based on the phase in the cycle.

    2. Right now a lot of the risk stems from systemic problems. Consumers have way too much debt because the system is broken by years of easy credit. Banks should act now to ensure that they end up with more control of the system when this is over. This means restrictions on subprime and banks should figure out how to increase their control over FNM/FRE.

    3. Otherwise, higher capital ratios should mean PE expansion because we would be paying a lower risk premium for these companies. BRK has capital because they are vulture investors taking advantage of panics and because they save relentlessly for a rainy day.

  2. Good comment. I have been a critic of the insurance industry and its regulators in the past, so I know where you are coming from. If the life industry had not been savaged 2001-2002, the survivors would not be in good shape today. Same for those in P&C that survived the storms of 2004-2005.

    I’m not so much saying that the insurance industry is filled with bright regulators, and the banking industry not. I’m saying that in considering an insurance scheme, look at how similar ideas have not succeeded in the insurance industry.

    Oh, and I like the Spanish regulatory idea… I just wonder if the industry would go for it here.

  3. the catastrophe bond idea….junk money will find/fund them…..

    Thats already happening to – espeically – the worst financials right now. Look where their preferred’s rates stand as a barometer for new funding……yuk.

  4. Wells Fargo (WFC) is doing a hybrid deal around $1 billion.

    Price talk is 9 1/2-9 3/4%.

    And this is a ‘good bank’.

  5. TV – right, things are bad now even for “good” financials… though WFC is a complex institution. I’ve mentioned that before.

    My contention in this piece is that a “cat bond” done for banking industry losses would carry high yields even if executed in good times like 2004, 1995, etc.

  6. Commercial Banks seek to minimize their volume of non-earning reserve assets through the bank?s projections on (1) levels of surplus vault cash, (2) the future balance of payments, (3) the structure of the bank?s deposits, (4) it’s correspondent balances, (5) its compensating balances, (6) currency outflows, (7) the prospective demand for loan-funds, and (8) borrowings in the inter-bank market, etc.

    Through it?s asset-liability management strategy, banks initially monitor and make adjustments to: (1) surplus vault cash, (2) excess clearing balances, (3) contractual arrangements, (4) earnings credits, and (5) excess reserves at the 12 District Federal Reserve Banks (inter-bank demand deposits -IBDDs), etc.

    These balances make up the member commercial bank Liquidity-Reserves, or the commercial bank?s Primary-Working Reserves, (its overdraft protection, adverse clearings, and credit reservoir in the event of the forced liquidation of assets), etc.

    In addition, bankers must hold sufficient liquid assets, Secondary-Working Reserves. to meet daily, seasonal or unexpected contingencies.

    Bankers meet these obligations through their ?managed liabilities? (i.e., earning assets which can be converted into cash quickly and without loss – short-term governments, federal funds, repurchase agreements, commercial paper, certificates of deposits, etc.).

    Both Primary and Secondary Reserves represent a member commercial bank?s Prudential-Reserves (the Working-Reserves dictated by ?p-r-u-d-e-n-c-e?, not by any legal requirement administered by a monetary authority). These are the reserves bankers must hold to help meet the bank?s obligations under their lines of credit and other ?extra? demands on their clearing balances.

    What has Congress and their advisors wrought? What they have legislated is an unregulated, Prudential-Reserve banking system – (see Financial Services Regulatory Relief Act of 2006). And all Prudential-Reserve banking systems have heretofore ?come a cropper? (zero-bound banks with zero-reserve requirements).

    Where did the rarefied galaxy of theorems, lemmas, proofs, and assumptions come from? It originated from the prevailing hubris on the Fed?s technical staff stemming from their Keynesian training. Lord Keynes advised them that interest was the price of money, not the price of loan-funds (see Alfred Marshall?s money paradox).

    They therefore decided that the money supply could be controlled through the manipulation of the federal funds rate (the rate paid by banks to banks holding excess legal reserves in the District Reserve Banks).

    The Fed can reduce federal funds and other money market rates temporarily; but only at the cost of losing control of member bank legal reserves. In other words, it is impossible to use interest rates as a vehicle to effect monetary policy ? unless the objective is to feed a rampant inflation.

    The function of legal reserves in modern commercial banks is to provide a basis for limiting credit expansion. Reserves no longer serve the traditional function of a source of liquid funds which can be ?tapped? in an emergency. In fact, the only part of the legal reserves which a commercial bank can ?cash? is its excess reserves.

    It’s beyond correcting. Nationalize the banks.

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