One big reason the global financial system nearly collapsed in 2008 was that banks had shifted risks into the shadows, relying on insurance-like instruments that proved incapable of absorbing losses.
They’re at it again. It’s a trend that officials should discourage, not endorse.
The foundation of a resilient financial system is simple: Require banks to have ample equity, the ultimate all-purpose capital. Contrary to popular belief, equity isn’t a reserve that must be set aside. It’s upfront funding from shareholders, money to invest. Unlike debt, it absorbs losses automatically, allowing banks to inspire confidence even when the unexpected happens.
Banks typically operate with as little equity as possible, mostly for bad reasons. More debt, or leverage, boosts certain measures of profitability in good times (and magnifies losses in bad times). Also, raising equity can be relatively expensive, because the government subsidizes debt (via tax breaks and emergency backstops) and because many banks suffer from a persistent lack of investor confidence.
As a result, banks are always devising ways to get by with less. Before the 2008 crisis, they did so in part by buying inexpensive loss insurance from third parties, notably American International Group Inc. By reducing the measured risk of subprime mortgage securities, this reduced regulatory equity requirements. It of course didn’t end well. The actual losses overwhelmed the insurers, contributing to a broader meltdown that forced governments to bail out all the financial institutions involved.
This time around, the name has changed — the insurance is now called synthetic (or significant) risk transfer — but the basic idea hasn’t. Banks reduce their equity requirements by bundling corporate or consumer loans into securities, then purchasing partial protection against losses from third parties such as investment funds or insurers. By one estimate, the deals covered more than €43 billion in potential losses as of 2022. That’s mostly in Europe, though US banks have been ramping up their own risk-transfer deals.
To be sure, there’s nothing wrong with buying insurance to adjust exposures or hedge certain risks. And in some ways, this time is different: Regulators vet the deals, the third parties often provide cash collateral to cover losses, and the amounts involved are so far smaller than in 2008.
That said, the insurance is primarily used as an alternative to equity — a task for which it is poorly suited. For one, it doesn’t automatically absorb losses. It applies only to specific assets and depends on the third party’s ability to pay. Highly rated insurers are typically exempted from collateral requirements — exactly what allowed AIG to wreak so much havoc. Also, banks must keep paying premiums: They can’t, as with equity, suspend dividends to conserve cash in a crisis.
What’s particularly odd is that official institutions are increasingly involved in such deals. The European Investment Bank, for example, is looking to provide discounted insurance in return for more lending to renewable-energy projects. It’s bad enough that governments are opting for subsidies over a carbon tax to encourage green investment; helping banks subvert capital requirements in the process is foolish.
No amount of subterfuge can get around a fundamental fact of finance: The true cost of capital is inextricably tied to risk. If the level of equity funding increases, its cost will fall because banks will be less likely to fail. The result will be a more resilient financial system and a stronger economy.
Article by The Editorial Board of Bloomberg News, Advisor Perspectives
