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Financial Planning > Behavioral Finance

Disability Insurance Observer: Correlation

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As I write this, some members of the House are trying to shut down the U.S. government over the fact that, in their view, the Patient Protection and Affordable Care Act (PPACA) exchange program and the individual mandate are dumb as rocks.

Raising the question: If the House shut down the government every time the government had a program that was dumb as rocks, could we have a government that was ever fully open? Would anyone ever, ever get to go into the Statue of Liberty?

A case in point: The idea that U.S. financial regulators and financial regulators outside the country are beating up on banks and insurers for allegedly creating “systemic risk.”

One reason insurers are coming up with investment strategies that the regulators might not like (or might like too much) is that the regulators and their friends have lowered interest rates so much that the only way financial services companies can support products with long-term perspectives, such as long-term disability insurance, is to invest in weird things.

Meanwhile, the regulators are trying to minimize the risk that some newspaper columnist will make fun of them same day by making the insurers invest in the “safest possible investments.” Flavors so bland that Plain Vanilla would give them to her babies.

One Federal Reserve Board governor, Daniel Tarullo, recently observed, in a speech posted on the Fed website, that “migration of financial activities outside the regulatory perimeter must be closely monitored.”

But he admits a little earlier that regulators ought to try to avoid regulating financial services companies in a way that forces them to all collapse at the same time, like houses of lemming cards.

“Stress tests must be modified so as to avoid incentivizing firms to correlate their asset holdings or adopt correlated hedging strategies,” the governor says.

On the one hand: Duh.

On the other hand: First the governor admits that regulators should try to bless financial services companies’ efforts to try different, risk-de-correlating strategies, then he calls on regulators to hunt the companies down if they try to come up with some new way to diversify risk. He also talks about the need for the companies to go come up with a ton more capital to reduce the probability the companies will fail if things go wrong.

On the third hand: It looks as if the Fed wants to put financial services companies in a strait jacket even tighter than they’ve been wearing, then make them go out and grab for more capital, with their arms in the strait jacket.

There can’t possibly be an extra risk embedded in that idea. Can there?

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