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Treasury Secretary Worries About Leverage at Life Insurers

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What You Need to Know

  • The Fed says a spike in interest rates could hurt life insurer asset values and drive up contract surrenders.
  • Sen. Elizabeth Warren asked about Trump-era limits on the ability of federal regulators to track nonbanks.
  • Yellen said she wants the old authority back.

Federal regulators could try to regain their authority over nonbank financial institutions that look as if they could hurt the U.S. financial system.

Treasury Secretary Janet Yellen talked about regulators’ thoughts on designating some nonbanks as “systemically important financial institutions,” or SIFIs, on Tuesday at a Senate Banking Committee hearing on the Financial Stability Oversight Council’s annual report to Congress.

“We’re looking at this very carefully and examining what our options are,” Yellen told Sen. Elizabeth Warren, D-Mass., at the hearing, which was held in Washington and streamed live on the web. “We’ll be discussing this with other members of the council.”

Later, Yellen mentioned life insurers, in response to a question from Sen. Sherrod Brown, D-Ohio.

Although the Senate Banking Committee held the hearing to discuss the FSOC report, the Federal Reserve Board released its own financial stability report Monday.

Yellen — a former Fed chair — noted that the Fed expressed concerns about the possible effects of rapidly rising interest rates on banks.

The Fed “noted insurance companies and some hedge funds as leveraged entities that could could be vulnerable in a rising interest rate,” Yellen said.

The Great Recession and FSOC

Problems with mortgage lending, and securities and other instruments backed by mortgages, helped bring about the 2007-2009 Great Recession, including the financial system liquidity crunch that became apparent in 2008.

One of the central players was AIG.

Life insurers have argued that the AIG operations that ran into problems were involved in mortgage-related derivatives transactions, not traditional insurance or insurance portfolio management activities.

But when Congress developed the Dodd-Frank Act in response to the crisis, it noted that nonbanks had been involved.

The Dodd-Frank Act created the Financial Stability Oversight Council, or FSOC, to coordinate federal regulators’ efforts to track and regulate entities that looked as if they might pose a threat to U.S. financial stability.

FSOC has the authority to classify some entities that would normally be outside federal regulators’ reach as SIFIs. FSOC has a voting member with insurance expertise, and it also includes a nonvoting representative from the National Association of Insurance Commissioners.

Many life insurers originally accepted the idea that they could be “designated as SIFIs,” but they found that in practice, being designated was cumbersome, and they ended up fighting to escape from SIFI designation.

In 2019, during the administration of then-President Donald Trump, FSOC said it would back away from trying to designate nonbanks as SIFIs and rely mainly on regulating activities that looked dangerous, not the nonbanks themselves.

The Fed Report

Fed officials said in their financial stability report that life insurers’ level of leverage, or ratio of assets to equity, appears to be near its highest level in the past two decades.

“Life insurers continued to invest heavily in corporate bonds, collateralized loan obligations (CLOs), and CRE [commercial real estate] debt, which leaves their capital positions vulnerable to sudden drops in the value of these risky assets,” Fed officials wrote.

“Gradually rising interest rates improve the profitability outlook of life insurers, as their liabilities generally have longer effective durations than their assets, and higher interest rates may reduce life insurers’ incentives to invest in riskier assets,” officials added. “However, a large and unexpected increase in interest rates could induce policyholders to surrender their contracts at a higher-than-expected rate If the increase in surrenders is substantial enough, it could put downward pressure on life insurers’ financial performance.”

Officials also took note of life insurers’ increased use of nontraditional liabilities, such as funding-agreement-backed securities, Federal Home Loan Bank advances, and cash received through repurchase agreements and securities lending transactions.

“These liabilities, which are generally more vulnerable to rapid withdrawals than most policyholder liabilities, have grown steadily in recent years,” officials said.

Warren’s Concerns

Sen. Warren — who was active in efforts to develop the Dodd-Frank Act approach to financial services regulation — noted at the hearing that, in 2019, Yellen had joined with former Fed Chair Ben Bernanke and two former treasury secretaries, Tim Geithner and Jack Lew, to write a letter opposing the 2019 limits on FSOC’s ability to designate nonbanks as SIFIs.

In the letter, Yellen and her colleagues said the new limits would make it impossible to prevent the buildup of risk in some nonbank financial institutions.

Warren said she believes that one of the most powerful tools Congress gave FSOC was the ability to designate nonbanks as SIFIs, and that hedge funds, private equity funds and other nonbank asset managers are now overseeing trillions of dollars in assets “in the shadows of the financial system.”

“Those companies control huge amounts of the U.S. and the worldwide economy, which means their mismanagement or failure could threaten the entire economic system,” Warren said.

Warren asked Yellen whether she still agreed with the 2019 letter.

“Yes, I do,” Yellen told Warren.

Yellen on the Activity-Based Approach

But Yellen added that FSOC continues to have the ability to regulate activities involving nonbanks, such as administration of money market funds, that look as if they involve concerns about financial stability risks.

“Sometimes designation is clearly the right tool when there is an institution whose failure could threaten financial stability,” Yellen said.

But Yellen said certain activities, such as offering money market funds, occur throughout the financial system, and an activities-based oversight is appropriate for handling  those activities.

FSOC has been watching money market funds, run-on-the-mutual-fund risk and other activities closely, Yellen said.

Yellen said that regulators need to have both institution-based tools and activities-based tools, and that regulators should look carefully at the SIFI designation rules.

Correction: An earlier version of this article described the Fed’s leverage indicator for life insurers incorrectly. The Fed focuses on the ratio of assets to equity.

The Federal Reserve Building in Washington (Photo: Shutterstock)