Editors’ Note: MarketMinder does not recommend individual securities; the below is simply an example of a broader theme we wish to highlight.
Ever since 2008’s financial crisis led the US and other governments to bail out many banks, the issue of bigness—as in, too big to fail (TBTF)—has been a prime source of consternation. At issue: The belief some firms are simply too big, complex and/or interconnected to be allowed to fail, granting these firms an unfair taxpayer backstop. This, many allege, was at the heart of the crisis, because many TBTF banks and insurers took too many risks, ensuring a systemic crisis and bailouts. For years post-crisis, officials have dialed up regulation on these firms, dubbed “systemically important financial institutions” (SIFI), ostensibly to prevent the next crisis. But last week, news got more interesting when one firm applied to escape SIFI designation—and another was released under court ruling. While it’s uncertain whether this starts a trend of SIFI rollbacks, it could be a sign the financial regulatory climate is thawing at last—an incremental positive for Financials stocks.
In the US, the post-crisis reform—2010’s Dodd-Frank Wall Street Reform and Consumer Protection Act—created the Financial Stability Oversight Council (FSOC), an organization authorized to identify and monitor potential financial system risks. The FSOC in turn got the power to dub the biggest, most interconnected financial firms SIFI—thus sticking them with higher capital requirements, stress tests and stricter oversight from the Federal Reserve, including having its share buyback and dividend payment plans subject to regulatory review.
Whether you cheer or jeer this expanded oversight, SIFI limits firms’ flexibility and boosts their compliance costs. From an investor’s standpoint, it’s also less than optimal because the criteria aren’t exactly crystal clear. While higher capital requirements aim to minimize bank runs, they won’t prevent panics—firms will just have a bigger buffer, giving them more time to ride out the storm. But if depositors demand their money back en masse, the firm will still have a big problem when the additional capital runs out. Now, some suggest these firms actually benefit from SIFI status, as lenders see them as safer and charge lower rates. That, however, is a theory lacking a counterfactual. Compliance costs are more explicit, and there is ample evidence firms want to reduce them.
General Electric is one such firm. After shedding much of its legacy finance business, GE filed a request with the FSOC to remove its SIFI designation. GE claims cutting its finance division by more than half since 2012 means it no longer qualifies as “systemically important.” If you think TBTF is an issue, this is probably something to see as a success, as GE is a non-bank (notwithstanding the finance unit) that restructured itself to avoid being a SIFI. Or, in other words, the rules inspired the firm to get smaller, which is part of the intent. That said, it remains to be seen if it will escape SIFI status.
GE’s finance arm was indeed a bank. But regulators, seeing insurer AIG’s 2008 collapse as proof banks don’t have the monopoly on panic-inducing failures, wanted to rope in non-bank financials (asset managers and insurers). Hence, they designated insurance firm MetLife a SIFI in 2014, and considered expanding oversight to mutual fund firms and others. That push is now in question.
MetLife sued the FSOC in 2015, claiming it didn’t warrant SIFI designation. Last week US District Court Judge Rosemary Collyer agreed. The opinion was issued under seal, but Judge Collyer’s comments during a February hearing offer insight into her decision. She appeared to side with Metlife, noting the FSOC’s decision to designate them SIFI began with an assumption Metlife will fail, instead of determining the likelihood it would fail. Collyer retorted, “That’s not risk analysis. That’s assuming the worst of the worst of the worst.”
It’s a valid point, and also one calling into question the entire idea of bank stress tests, as they also assume the worst case scenario will happen and then determine if banks have enough capital to survive. Other SIFIs, if this ruling establishes sufficient precedent, could conceivably use this as a rationale to challenge their SIFI designation as well. The judge also commented that the SIFI designation didn’t take into account the economic effect on the insurer—a cost-benefit analysis. If this ruling survives an appeal, the FSOC may be forced to consider this as part of their process for determining whether a firm is SIFI. Combined, the ruling may lead to the FSOC developing stricter guidelines for how they deem a firm SIFI, or perhaps just quell the push into non-banks generally.
While oversight of Financials is important, SIFI was always a solution seeking a problem. Banks already have lots of oversight, at the state and national level. This covers a slew of regulations, including minimum capital and reserve requirements. Even with all this oversight, bank runs can still happen, and when they do they can be disruptive. But those runs rarely occur outside of financial crises, which are themselves rare. There is little to suggest tightening requirements and constraining dividend payments for only the biggest banks would prevent a crisis. It wouldn’t have prevented 2008’s financial crisis, which resulted from the one-two punch of an accounting rule requiring banks to needlessly write down trillions in capital and the government’s haphazard response.
As applied generally to non-banks, SIFI makes little sense. Banks are subject to runs because they borrow short-term funds (account deposits) to extend longer-term loans—a maturity mismatch that could leave an otherwise viable business short of liquidity. This is why the Fed, you know, exists. Traditional insurers aren’t subject to customer runs. Their long-term obligations (claims) are funded by premiums, which are invested in accordance with their long-term obligations. The impetus for considering some insurers SIFI is AIG, which was imperiled by its securities lending business’s big exposure to Lehman. But no Lehman, no AIG, so it was an aftereffect—not a cause. Some argue that short-term financing issues in the commercial paper market justify the status. But here again, banks’ troubles in 2008 resulted from the crisis—they didn’t cause it—which is pretty much the primary quibble we have with TBTF or SIFI or whatever four-letter acronym you like.
Anyway, there is more to come on this, as Judge Collyer’s ruling will be unsealed soon. That said, it may be heavily redacted, so details might be scant. Still, the ruling may have broad consequences for the seemingly never-ending quest to end “too big to fail.” It’s a small thing, in our view, but coupled with Bank of England chief Mark Carney’s recent comment that reactionary post-2008 bank regulations—well-intentioned or not—may have had unintended negative consequences, there is a notable shift in tone. Perhaps US regulators will soon think similarly. Time will tell, but that would be a welcome development for markets and bank shareholders, who have long operated under the shadow of regulation.