Perspective on Risk - Oct. 6, 2024
The Changing Financial System; Life Insurance & Financial Stability; Twisting Ourselves In Knots (on liquidity); Problems at American Transit Insurance
The Changing Financial System
I’ve recently read a quintet of articles that are all touching on the evolution of the financial system and financial stability, and in particular the effects, intended or otherwise, of the post-GFC reforms. We’ve talked a lot about the retraunching of credit1 origination and the rise of “private credit;” now let’s do the same with trading.
Two are from Yale’s Steve Kelly, one from Oliver Wyman’s Huw van Steenis, one from my former NY Fed colleagues, and lastly from two good reporters at the FT.
New titans of Wall Street: How trading firms stole a march on big banks (FT)
Shadow Banks Can Run—But Not Hide—From Bank Supervisors (WithoutWarning)
Is Private Credit 'So 2022'? (Without Warning)
“We’ve already crossed the Rubicon,” said one former trader at a global bank. “The only question is how far we’ll go.”
Several key themes and relationships between them emerge.
The impact of post-crisis regulations on traditional banks is evident across multiple articles.
This regulatory pressure has significantly altered the banking landscape.
As a result of these regulatory changes, banks have had to adapt their business models.
This regulatory pressure on banks has created opportunities for less regulated entities.
In turn, these institutional shifts have led to changes in how various markets function.
Coming full circle, while the post GFC changes may have addressed some pre-crisis issues, they've also created new potential sources of systemic risk.
Post-GFC Regulation Leads To Industry Structure Changes
Starting with the FT’s New titans of Wall Street. This piece details the demise of the traditional Wall Street houses and the rise of trading firms like Jane Street and Citadel Securities in a wide swath of markets.
They argue that the unregulated trading firms have leveraged technological innovation and regulatory changes to dominate in areas like US stock trading and are expanding into other markets.
It all starts with regulatory reform:
The ground shifted … when regulators in 2010 heavily restricted banks’ proprietary trading — making bets with their own money — under Dodd-Frank’s Volcker rule.2
While [banks, including Goldman and Morgan Stanley] could still be market makers, compliance considerations and capital requirements meant they could no longer trade as freely. Instead, banks evolved to focus on fewer, larger trades for big clients such as initial public offerings or debt issuances.
The FT article quotes Gary Cohn, former Goldman president:
Prior to Dodd-Frank we had the advantage that we could be a risk taker and a liquidity provider... We could provide liquidity and hold it. Once Dodd-Frank came in, we became movers not storers.
Yup, Goldman and Morgan Stanley were, either by design or de facto, de-fanged. Citadel, Jane Street and others existed before the GFC, but now they saw the removal of major competitors, and were free to enlarge in the vacated space.
“The fact that the regulators did not want as much risk to reside in [more highly] regulated entities was pretty obviously a big opportunity,” said Wilson.
The FT article also argues that, to a degree, the banks (including GS and MS), were slow to adapt to the electronification of markets.
… a handful of highly secretive trading firms … have capitalised on the electronification of financial markets to seize market share from less nimble and more heavily regulated banking stalwarts
Banks made big money quoting trades on the phone and didn’t care to prioritise a low-margin business like electronic market making — it was hardly going to pay for the new headquarters in Manhattan.
Changes Coming Happening In Credit Markets
Huw van Steenis argues that the rise of private credit is analogous to the changes we have seen in equity trading.
… something important about capital markets … is now playing out in the bond markets in earnest. This shift underscores just how much the market structure of finance is changing.
He cites four factors driving change:
Investors are demanding more for far less.
public bond markets are becoming increasingly automated which is enabling specialist slices of risk or blends to be packaged into bond ETFs.
banks around the world are under pressure from a range of new regulations such as new capital requirements, driving another wave of disintermediation.
private credit players are seeking to reduce their cost of capital to enable them to be relevant for even more higher quality, investment grade assets on banks’ balance sheets.
The net effect:
Since the Fed started raising rates, the share of US bond funds managed in ETF format has surged from 21 to 28 per cent, according to Morningstar data. …
ETFs are ever more becoming the primary source of bond liquidity.
It is also prompting a Cambrian explosion of innovation. The tie up between KKR and Capital Group to create one of the first public-private fixed income funds, and the partnership between Blackrock and Partners Group to create blended private markets portfolios, are critical to watch. As is the intriguing agreement between Apollo and State Street Global Investors to create a hybrid ETF fund to invest in both public and private credit. These mark significant bets on the mainstreaming of private credit.
For The Banks, It’s All About Prime Brokerage
So for the banks, the angle here is that they control the credit spigot.
From the FT’s New titans of Wall Street:
Executives at Wall Street banks argue that their best defence is continuing to offer products that trading firms do not, such as extending financing to hedge funds through prime brokerage. Banks also control the calendar for new issues of securities via stock offerings and debt deals.
Steve Kelly of Yale has written intelligently on this. From Is Private Credit 'So 2022'?:
Despite what some private credit executives would have you believe, there are limits to how much bank activity can move to private credit (in private credit’s current form). You can’t recreate a 10x (or more) leveraged system funded by deposits in a world of 1x leverage and long-term funding. (That’s not to say banks can’t dump all their credit risk outside the banking system, but the ultimate funding will need to come from the banking system.)
I highlight that last phrase because it harkens back to one of the seminal documents for a central banker\bank supervisor: Corrigan’s 1983 Are Banks Special? In Corrigan’s own words:
The essay suggests that banks perform three essential functions:
they issue transaction accounts (i. e., they hold liabilities that are payable on demand at par and that are readily transferable to third parties);
they are the backup source of liquidity to all other institutions, financial and nonfinancial; and
they are the transmission belt for monetary policy.
In Is Private Credit 'So 2022'? Kelly raises the question of whether the rise of private credit could be temporary, driven by the rise in interest rates resulting in clogged bank balance sheets (and I would add preemptory capital raising by banks faced with Basel III changes and expected increased ALLL builds).
As the banks became competitive again and high rates persisted, private credit began facing an erosion of “illiquidity premiums” and increasing defaults. As a result, private credit is also having to do more loan modifications, such as payment-in-kind transactions and “extending and pretending.” This is impacting the ability to return funds to investors and to put money into new loans.
I tend to side with van Steenis; there are longer term forces at play.
In Shadow Banks Can Run—But Not Hide—From Bank Supervisors Kelly goes further:
… we’re seeing increasing bank-provided leverage in private credit/equity—while banks’ prime brokerage businesses become their crown jewels. Banks are re-tranching: moving the capital risk to an external balance sheet that can be funded with a market-determined amount of capital rather than a (higher) bank-regulation-determined amount—and taking a protected stake in that risk by providing the senior funding.
Here he hits on an important tautology: when the market requires less capital than regulators, the regulated will seek to move the risk from their balance sheet to the markets.3
He does note (without displaying the incredulity that I might display) the completion of the Fed’s “first exploratory analysis” that purports to show that the failure of each GSIB’s five biggest hedge fund counterparties would not affect regulatory ratios (!!!!)45
Still, as we’ve commented before, this is a good place for the supervisors to focus.
Does The New Industry Structure Lower Systemic Risk
The NY Fed note takes a look at banks and NBFIs through the lens of the NYU Stern VLab’s SRisk construct. SRisk6 is a marginal expected shortfall measure developed by Robert Engle and other economists:
In this post, we provide a quantitative assessment of systemic risk in the nonbank sectors. Even though these sectors have heterogeneous business models, ranging from insurance to trading and asset management, we find that their systemic risk has common variation, and this commonality has increased over time. Moreover, nonbank sectors tend to become more systemic when banking sector systemic risk increases.
Bank and nonbank systemic risk may move together because they have common exposure to the macroeconomy and to funding difficulties (because, for example, banks often fund nonbanks). …
Bank and nonbank systemic risk co-move, rising during the past two recessions (the Great Financial Crisis (GFC) and the COVID-19 pandemic), as well as around June 2011 at the start of the European debt crisis. As further evidence of co-movement, we estimate using principal components analysis (PCA) that a single factor explains 88 percent of the common variation in bank and nonbank systemic risk and this factor is correlated with macroeconomic outcomes such as the NBER recession indicator and changes in the tightness of financial conditions broadly.
Some of these conclusions may surprise the lay reader (but not me and hopefully not you):
Since September 2008, the SRISK shares of the non-depository credit sector and the insurance sector have generally been the highest of all nonbank sectors. Moreover, since the Federal Reserve started to hike interest rates in the first quarter of 2022, the SRISK share of the non-depository credit sector has spiked, mainly due to firms engaged in loan servicing. Interestingly, while there has been much interest in the systemic risk of the asset management sector, its SRISK share is relatively low.
… each nonbank sector has become increasingly correlated with the banking sector. The two most systemic nonbank sectors (non-depository credit and insurance) also have high correlations with the banking sector systemic risk.
So…
The evolving financial landscape will fundamentally reshape risk distribution and market dynamics in the coming years. The growth of non-bank financial institutions and private credit markets will continue to erode the traditional boundaries between regulated banking and shadow banking, forcing regulators (hopefully before it is too late) to expand their oversight beyond conventional institutions.
Banks' pivot towards prime brokerage and other specialized services will redefine their role in the financial ecosystem, altering the channels of monetary policy transmission and reshaping their relationships with both regulators and clients. While these changes promise increased market efficiency and innovation, they also demand a more agile and comprehensive regulatory approach to maintain financial stability in this new era (something the regulatory community is not known for). The challenge for policymakers will be to foster innovation while preventing the buildup of hidden risks that could trigger the next financial crisis.
Life Insurance & Financial Stability
Shifting landscapes: life insurance and financial stability (BIS Quarterly Review)
A good overview piece by the BIS. Might have seen a little bit of this while at AIG. Who am I kidding, saw a lot of this. Just like in banking, capital optimization is a critical function.
To sustain profitability, life insurers have increased exposures to riskier and less liquid asset classes. Some have also offloaded risks through complex reinsurance agreements, often to offshore centres, partly with an eye to economising on capital. Private equity firms have been a driving force behind these trends. They have funnelled investment into private markets by acquiring or partnering with life insurers or assuming insurance portfolios through affiliated reinsurers. While more diversified investments and greater risk-sharing can, in principle, support insurers’ resilience, losses in private markets could propagate risks across an increasingly interconnected and complex insurance landscape.
Private Equity Enters The Game
Private equity (PE) firms have been a driving force behind these trends. By acquiring or partnering with insurers, these firms have been instrumental in channelling insurers’ investments into private markets and other alternative asset classes. PE firms have also contributed to insurers’ rising reliance on asset-intensive reinsurance (AIR). In these complex reinsurance agreements, life insurers fully or partly owned by PE firms (“PE-linked life insurers”)2 assume part of the liabilities from other life insurers in exchange for the assets backing them
PE firms’ investment in the life insurance sector has surged over the past 14 years. Cumulative investment has grown nearly sevenfold since 2010, outpacing by a large margin the growth rates of total PE investment in other firms, including financials.
There are three main benefits to be gained by PE firms acquiring or partnering with life insurance companies.
First, PE firms can channel the largely predictable cash flows from insurance premiums into assets originated by PE firms, such as structured credit, direct lending and infrastructure. For PE firms, this generates fixed income from fees related to originating and managing the assets. In line with this benefit, PE-linked insurers were twice as likely to invest in assets originated by PE firms compared to other insurers.
Second, PE firms have proven more effective in exploiting opportunities arising from cross-jurisdictional differences in regulatory frameworks and corporate taxation
Third, PE firms can leverage their investment expertise and management capacity. This allows them to give a boost to life insurers’ returns. They do so by directing their investment in often opaque private markets, where they have a comparative advantage in assessing credit and liquidity risks
Reinsurance Games
Asset intensive reinsurance … seeks to free up capital of life insurers by transferring risks associated with capital-intensive policies to other insurers. … cross-jurisdictional AIR can leverage differences in corporate and dividends taxation, valuation of technical provisions and capital requirements. … In some jurisdictions … the regulatory framework may prescribe a lower valuation of technical provisions … In addition, regulation may also grant greater investment flexibility, imposing less stringent constraints on insurers with regard to investments in riskier assets with higher expected yields … This, in turn, could also raise the discount rate applied to the calculation of technical provisions.
Under these assumptions, the cedant and reinsurer could agree on a transfer of assets and risks that creates a gain for both parties.
Financial Stability Considerations
Reinsurance chains have become more complex. The life insurance sector has become more interconnected, with rising amounts of risks migrating across entities and jurisdictions. It has therefore become more difficult to assess how risks could propagate through the system …
AIR agreements may result in the same amount of risk being backed by less capital and in riskier assets
Risks could also arise from increasing concentration. The complexity of AIR suggests that these agreements are most economically viable when conducted at significant scale.
Conflicts of interest, if unaddressed by robust governance frameworks, could raise additional risks. Such conflicts loom large where asset managers, including PE firms, have an incentive to allocate insurers’ funds to assets they originate. The risks are magnified given the potential for strategic mispricing of illiquid and hard-to-value assets.
Interesting/disturbing that no US regulators were involved in the writing of this piece.
Twisting Ourselves In Knots
I remember a time when we expected banks to be able to fund themselves in times of stress without relying on the Discount Window. Yes it was there, but you shouldn’t rely on it.
Then there came a time when it was fashionable to emphasize that banks could use the Discount Window (in particular to arbitrage the Fed Funds market, though no one ever did), and also that banks should periodically\annually “test” their Discount Window plumbing (few did).
Then came the GFC, and during the crisis, to show banks that it WAS available to use, we talked the biggest banks into making a symbolic draw from the Discount Window. During the crisis, the Window was open.
Then we followed on by imposing a new set of liquidity regulations, and forced banks to raise the amount of high-quality liquid assets (HQLA) that they held to meet sudden liquidity demands.
Then SVB and the others failed, and we found that the banks weren’t actually prepared to pledge collateral at the Window, and besides that the operating procedures for the Window were antiquated and insufficiently flexible.
So the solution to SVB was to encourage, nay “require”, banks to pre-position collateral at the Discount Window, in many cases the types of collateral that could easily receive private market funding.
Now, in the latest revision, comes Gov. Barr’s speech Supporting Market Resilience and Financial Stability
We had been hearing that some were confused about how banks could incorporate ready access to the discount window and the SRF into their contingency funding plans and internal liquidity stress tests.
We provided clarity to the public in August on permissible assumptions for how firms can incorporate the discount window and the SRF into their internal liquidity stress-test scenarios.
There are a couple of principles that underlie our response in the frequently asked questions we posted on the Board's website.3
One principle is that our tools are readily available to firms. This means that we see it as acceptable and beneficial for firms to incorporate our facilities to meet liquidity needs in both planning and practice. If firms plan to use our facilities, we expect them to demonstrate ex ante that they are fully capable of doing so, including through test transactions.
An additional principle underlying our approach is that, while firms should be ready to use a range of funding sources, firms need to hold sufficient highly liquid assets to meet their potential liquidity needs. That is, they need to self-insure against their own liquidity risks.
A third principle is that firms should be ready and able to use private channels to turn these assets into cash, in addition to any public channels they may plan to use.
So… it is acceptable … for firms to incorporate [the Discount Window] to meet liquidity needs in … practice. However, firms need to hold sufficient highly liquid assets … to self-insure against their own liquidity risks … [and] should be ready and able to use private channels to turn these assets into cash, in addition to any public channels they may plan to use. O-kee-dokey.
And more regulation…
Many firms have taken steps to improve their liquidity resilience, and the regulatory adjustments we are considering would ensure that large banks maintain better liquidity risk–management practices going forward.
I love how new regulations are now “regulatory adjustments.’
What are we doing? Let’s move to a “liquidity insurance” regime where all firms purchase upfront liquidity puts from the Fed and stop all of the gymnastics.
Problems at American Transit Insurance
Much of regulation is about how to handle bad outcomes. In finance, that is generally about limiting the fallout to other firms and markets (externalities) and protected classes of customers (insured depositors and insurance contract customers). Much of this is legal.
Capital standards, liquidity regulations and the like all fundamentally follow from what happens to a failing firm. Banking tends to get “resolved” over a weekend, so that there is continuity for depositors. Insurance frequently relies first on rehabilitation, and only progressing to liquidation if rehabilitation fails.
The rehabilitation process is a legal procedure initiated by state insurance regulators when an insurance company faces financial difficulties but is deemed potentially salvageable. It's an intermediate step before liquidation, aimed at protecting policyholders while attempting to restore the insurer to financial health.
The state insurance commissioner petitions a court to place the troubled insurer into rehabilitation. Upon court approval, the commissioner is typically appointed as the rehabilitator. The rehabilitator assumes control of the insurer's assets and operations and has broad powers to manage the company, often replacing existing management.
A detailed analysis of the insurer's assets, liabilities, and overall financial health is conducted. Based on an assessment of the quality of investments, adequacy of reserves, and potential for future profitability , the rehabilitator creates a plan to address the company's issues. This may include restructuring debt, renegotiating contracts, selling off non-core assets, or adjusting policy terms. During rehabilitation, efforts are made to continue honoring existing policies and pay claims.
Which brings us to American Transit. American Transit’s problems date back to at least 2021: Actuary says NY livery insurer's reserves 'inadequate' by more than $500M
Ronald Kuehn of Huggins Actuarial Services in a statement of actuarial opinion said the $190 million provision for unpaid losses and loss-adjustment expenses made by American Transit Insurance Co. is $508.8 million less than the $698 million he considered the minimum necessary. …
Using his estimate, Kuehn said American Transit's statutory policyholders surplus would render it insolvent by $430.9 million. While the company reported a surplus of $91.8 million as of March 31, increasing its reserves to the independent actuary's low point would reduce the level of insolvency to about $417 million.
This is not the first instance in which American Transit has received inadequate opinions on the status of its reserves. …
The state regulator in 1991 moved to put American Transit into rehabilitation after its own examination, but the company asked for an injunction to halt the proceeding. In September 1995, a special referee assigned to arbitrate the case recommended that the petition to liquidate be denied and recommended that American Transit seek "an infusion of capital." The regulator and the company in August 1996 reached a confidential settlement that ended the state's actions and allowed the company to remain in business.
David Merkel has an even longer perspective in When Should the New Yew York Department of Financial Services have Rehabilitated American Transit Insurance? (Aleph) citing an Insurance Journal story Update: NYC’s Largest Cab Insurer Ordered to Explore Sale After Losses
DFS said regulators made significant efforts to address ATIC’s financial problems, including filing multiple petitions to put the company into liquidation, starting back in 1979. … The state Insurance Department filed another petition attempting to put ATIC into rehabilitation in 1987 ... In 1991, the Insurance Department again tried to put the company into rehabilitation, prompting ATIC to seek an injunction to halt the proceeding.
Merkel writes:
Their consulting actuary said in her 2013 review: “In my opinion, based on the information available for my review, the stated reserve amount does not make a reasonable provision for the liabilities associated with the specified reserves. …” The surplus of ATI was a little less than $31 million. ATI was insolvent. This information was available to the NYDFS. This was the last moment to rehabilitate ATI without taking significant losses. …
ATI chose to ignore the consulting actuary, and did two things. First they rolled the dice and likely said, “Let’s grow our way out of the problem!” And so they doubled their underwriting over the next five years. … The second thing they did was lower reserving on new business.
2019-2023 was the last gamble for ATI, again akin to a Ponzi, where you rob the future to pay the present. They lowered the implied expected loss plus LAE rate for new business to 27.6%. No P&C insurance company has a loss rate that low. As such the under-reserving continued to build.
The NYDFS has publicly released a letter it sent to ATI. The letter conveys the final reports of examination from 2019 and 2019 (!!!). The letter states:
… your consulting actuary agrees that the Company’s reserves are massively deficient.
Absent a substantial capital infusion, the Company can only use current premiums to pay past claims. This dangerous practice leaves no assets to pay for the claims incurred by current policyholders.
Back to Merkel:
NYDFS has told ATI to find a buyer. I can tell you they will not be able to sell the joint until after the guaranty association covers the claims that ATI cannot cover. I don’t think there is any franchise value in ATI, as their only selling point was an overly cheap premium that could not cover losses, much less generate a profit. They will go into liquidation, and other insurance companies writing auto business in New York will have to cover the tab.
The NY Times in Looming Insurance Crisis Threatens Taxis and Ubers in New York City describes the implications of a failure:
Were the company to collapse altogether, thousands of taxis, Ubers, Lyfts and livery cars would be immediately taken off the road until they could find other insurance, which is likely to be difficult and costly since most large insurers do not offer this specialized insurance in the city.
More realistically, insurance rates for taxis and Ubers will rise significantly (as will the cost to take a taxi or Uber). There will be new entrants once firms will no longer be forced to cover the cost of ATIC’s failure. Regulatory forbearance significantly distorted market pricing and insurance competition.
Credit Steve Kelly of Yale for the term.
While I’m a huge fan of Paul Volcker, I have long thought the Volcker Rule was a mistake. We need firms that can act as principals, and not only as agents, which is what Volcker tried to restore.
As an aside, the original Basel II proposal was an attempt to make the amount of capital institutionally-specific based on market-derived inputs. Basel III is about raising capital levels in regulated institutions.
I would note that this conclusion is at odds with a quote in the FT article:
“Regulators need to look at the top 15 players in trading volume, and should be agnostic if it’s a bank or a hedge fund or proprietary trading group, because there is inherent risk when somebody has too big of a market share,” said the head of a proprietary trading firm.
“If they go down, they could take liquidity and cause stress in the market.”
According to Cohn, the firms have grown so large that there will only be one cohort big enough to rescue them in a crisis.
“If one of these large non-bank market makers got into a huge financial problem, the only entity that could bail them out would be one of the major banks,” he said. “They’re that big.”
I’ve got a bridge for sale, real cheap. Give me a call.