a time bomb The economists contend that, in a crisis, investors in a market where all banks are similar come to expect all banks to run into problems at about the same time, and that investors’ timing expectations can make the crisis worse. (Credit: Shutterstock)

Life insurers support their life insurance policies and annuities with trillions of dollars in investments.

Insurance regulators and insurance financial strength rating agencies encourage life insurers to invest in large, diversified portfolios of high-quality corporate bonds, with a sprinkling of mortgages, mortgage-backed securities, and securities backed by assets such as private equity investments, hedge fund investments, or credit card payment streams, to add some excitement.

Now four economists are suggesting that encouraging many big financial institutions to all invest in the same way may actually increase the risk that the whole financial system will have problems, by increasing the odds that the financial institutions will rush to sell assets at the same time.

Resources

  • A copy of investment heterogeneity paper is available here.
  • An article about life and annuity issuers’ headwinds is available here.

Itay Goldstein, a researcher at the University of Pennsylvania’s business school, and three colleagues at other universities have published the paper, as a working paper, on the website of the National Bureau of Economic Research.

A working paper is a paper that has not yet been through a full peer review process.

Goldstein and his colleagues focused on banks, and the risk that banks will face bank runs, rather than on life insurers.

Life insurers have argued that they are less prone to “runs,” or sudden spikes in customer demands to withdrawal cash, because life and annuity products are usually designed to spread any need to return cash to the customers out over time.

But many life insurers use big derivatives arrangements, or contracts with values tied to the performance of investment market indexes or other financial instruments. Depending on how life insurers have set up their derivatives arrangements, they could face a sudden increase in the need for cash to top off the pots of collateral used to support the derivatives arrangements. The derivatives counterparty collateral watchers are the ones who, in effect, may mount runs on the life insurers.

Goldstein and his colleagues created a theoretical of how banks might perform in a crisis, if they had to liquidate their assets in a common asset market, which would lead to them creating a “fire sale” atmosphere, by competing with one another to sell assets at the same time.

Investor assumptions and behavior appear likely to amplify that problem, Goldstein and his colleagues contend.

“A homogeneous financial system is fragile because bank investors expect problems within their own banks and other banks to synchronize,” the economists write.

Within this framework, “an increase in heterogeneity makes all banks more stable…. as long as investors are uncertain about the run behaviors of investors in other types of banks,” the economists write.

“An increase in heterogeneity enlarges the wedge between weak and strong banks, making the former relatively more fragile than the latter,” the economists write. “But, it pulls all banks to an equilibrium of greater stability in absolute terms, due to its effect on the indirect interactions across banks in the asset market where assets are being sold. In the face of greater heterogeneity, strong banks’ stability is challenged by the greater pressure that weak banks impose on liquidation prices, and weak banks’ fragility is alleviated by the lower pressure that strong banks impose.”

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