Later today, the FSOC will consider the fate of the remaining two designated SIFIs: Prudential and AIG.  Odds are that both giant insurers will be de-designated after prolonged closed-door battles – and a good thing too.  In the seven years since Dodd-Drank followed the global lead to demand non-bank SIFI designations, it is widely and correctly understood that simply sewing a scarlet “S” on one or another conspicuously large company solves for little with regard to systemic risk.  However, ending designation does nothing to address underlying systemic risk outside the banking system – and there’s even more of that in 2017 than ten years ago.  So, celebrate de-designating AIG and Prudential in concert with MetLife, but watch your back. 

The reason AIG, Prudential, and MetLife were designated as SIFIs by Obama’s FSOC has little to do with logic.  Indeed, I’m more than skeptical that there was any with regard to MetLife; a close read of the Collyer decision rejecting FSOC’s reasoning shows how FSOC cooked its books to come up with a SIFI designation.  AIG was designated because it was a crisis disaster and MetLife and Prudential were designated because their business models looked sort of like AIG’s in that they were large, complex, cross-border, and thus way scary. 

Asset managers are actually riskier in my view than these life insurers in that they have little prudential regulation, hold vast sums in uncertain operational-risk circumstances, increasingly take balance-sheet risk, and create huge correlated-risk positions across the global financial system.  The asset-management industry refutes this on various grounds, most notably by saying that they play only with other people’s money.  Maybe, but the reason life insurers were designated and not, say, Fidelity or BlackRock is as simple as the fact that AIG failed, the other insurers were caught off guard, asset managers mounted a very effective campaign against designation, and FSOC took so long to think about designating companies other than insurers that, by the time it might have moved on, the court threw its entire designation operation into disarray.

Between the MetLife decision’s damning verdict and the asset-management industry’s valiant self-defense, SIFI designation was dubious well before President Trump’s orders to Treasury heaped scorn on it.  Indeed, Hillary Clinton’s finreg platform eschewed designation in favor of taking a hard look at how “shadow banks’ posed systemic risk.  This would have led to the activity-and-standards approach with which global regulators now are fumbling, but the odds for either a U.S. or substantive global protocol were slim even before the U.S. election turned global financial policy upside-down.  Just as the reason why insurers were designated and asset managers is simple – bad luck and poor politicking – so too is the reason why activity-and-rules are unlikely: the global framework now is falling apart and these rules are just too hard and contentious for anyone to attempt.

In short, there’s a policy vacuum.  The very uncertain and largely inappropriate regulatory framework that designation might have wrought is gone, but so too is any path to addressing still-critical risks such as the ability of some life-insurance companies to maintain a sound business model in periods of prolonged ultra-low rates. 

On Wednesday, the FOMC again dropped its median guess at the longer-term neutral rate, lowering it to 2.75 percent versus the three percent forecast at its June meeting and the four percent ratio envisioned in 2013.  Many economists think a two percent neutral rate might be high given redefined U.S. macroeconomic circumstances.  How can insurance companies meet projected claims with neutral rates about half of those on which their business models are premised? 

Yield-chasing has been part of the industry’s solution along with increasingly large positions in direct credit risk (AIG), capital-markets operations (MetLife), and asset management (all three).  All of this makes sense for shareholders, but it’s another clear case of business-model transformation without accompany regulatory redesign.  We learned how risky this is for banks in 2008 because big-bank prudential models were still premised on small-bank style deposit-taking and lending, not on complex trading activities and liquidity transformation.  We’ll see the same sorry results of business innovation combined with regulatory stalemate if we allow designation to die as it should without reconsidering whether current rules work as new risks demand.

Is insurance regulation fit for purpose given this transformation?  What about orderly resolution given the diversity of intra-group risk at large insurers and the patchwork of state guaranty associations?  So much time and trouble has gone into destroying SIFI designation, limiting Fed authority over insurance companies, and battling global rules that scant time has been dedicated to examining what large insurers do now, how well their rules reflect these activities, and what would happen if any of the increasingly frightening bubbles were to burst.  As a Deutsche Bank paper this week makes frighteningly clear, every day without new risk is another close call.