The "too Big to Fail" Penalty: a New Era of Insurance Regulation in the Wake of the Financial Crisis

• Publication year: 2016

The "Too Big to Fail" Penalty: A New Era of Insurance Regulation in the Wake of the Financial Crisis

Ben Pierce

THE "TOO BIG TO FAIL" PENALTY: A NEW ERA OF INSURANCE REGULATION IN THE WAKE OF THE FINANCIAL CRISIS

Introduction

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act") into law, advancing one of the most far-reaching efforts in financial reform since the Great Depression.¹ The Dodd-Frank Act, created in response to the financial crisis of 2008, has as one of its main goals the end of excessive risk-taking in the financial services industry.² The Dodd-Frank Act created several new regulatory agencies and rules to further this goal.³ This new regulatory regime seeks to rein in "systemically important financial institutions," or "SIFIs," which are financial institutions so large that their downfall would cause wide-ranging damage throughout the entire American economy.⁴

The Financial Stability Oversight Council ("FSOC"), one of the agencies created by the Dodd-Frank Act, has the authority to label non-bank financial companies as SIFIs.⁵ Once FSOC labels a non-bank financial company as a SIFI, the Federal Reserve can impose strict regulations upon the company, such as the requirement to hold a greater amount of capital in order to absorb potential losses.⁶ In June 2013, FSOC designated large insurers, such as American International Group Inc. and Prudential Financial Inc., as SIFIs.⁷ In

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December of that year, FSOC designated MetLife, the largest life insurance company in North America,⁸ as a SIFI.⁹ In January 2015, MetLife became the first non-bank to challenge its SIFI status when it filed suit against FSOC in D.C. federal court.¹⁰

MetLife has also pursued another tactic in its fight to ease its regulatory burden: it plans to divest itself of a major part of its U.S. life insurance unit.¹¹ By placing higher capital requirements on SIFIs, the regulatory regime created by the Dodd-Frank Act is indirectly encouraging large firms like MetLife to break up.¹² The once "too big to fail" companies are being penalized for their size, as SIFI status results in a regulatory burden that brings down profits.¹³ This Essay will examine the development of the new regulatory regime established by the Dodd-Frank Act and will argue that the indirect breaking up of SIFIs has resulted in less systemic risk in the financial services industry. Furthermore, the Dodd-Frank Act and the Federal Reserve's intervention in the insurance industry may signal the beginning of a new era of regulation: one where federal regulators take a more active role in the state-dominated insurance regulatory system.

I. Background on the Dodd-Frank Act

In the years leading up to the Dodd-Frank Act, the world economy was marked by low, stable interest rates.¹⁴ Such an environment of low interest rates spurred on investors like commercial banks, investment banks, and hedge funds to seek novel ways of generating profits.¹⁵ Investors were drawn to

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certain high-yielding assets, such as collateralized debt obligations ("CDOs").¹⁶ CDOs were a form of mortgage-backed security that were backed by pools of mortgages.¹⁷ CDOs had received high credit ratings from prominent rating agencies such as Moody's and Standard & Poor's, and appeared to be relatively safe assets that produced higher returns.¹⁸ The stability of the low interest rate environment made investors more attracted to leverage, or the use of borrowed money to bolster returns.¹⁹ Investors assumed that returns would be greater than the cost of borrowing, so firms took on more debt to fund their investing operations.²⁰ This left many large financial services companies highly levered.²¹

CDOs and other mortgage-backed securities were greatly affected when the American housing bubble burst.²² Although CDOs had received safe credit ratings, they became worthless and unsellable when the mortgages supporting them failed to be paId.²³ The largest commercial and investment banks in the U.S., who both issued and invested in mortgage-backed securities, were gravely hurt by their failure to accurately value these securities.²⁴ The SEC later charged many of these firms for defrauding investors and misrepresenting their true losses.²⁵ Insurance companies were also caught in the chaos. The massive insurance company, AIG, used a financial instrument called a "credit default swap" to insure the CDOs, promising to indemnify the holder of the CDO in the event of default.²⁶ When the CDOs failed, AIG needed to reimburse the buyers of the credit default swaps, but AIG did not have enough capital to pay its claims.²⁷ The heavy use of leverage in the financial services industry left many firms with too much debt to withstand the downturn in the

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market.²⁸ As banks and other lenders lost faith in the creditworthiness of borrowers, short-term lending came to a halt.²⁹ Without the availability of credit, the American economy in general began to suffer.³⁰

The Dodd-Frank Act creates a raft of new rules designed to stop Wall Street firms from dealing in and exposing themselves to the dangerous assets characteristic of the pre-crisis years. § 619, or the "Volcker Rule," prohibits commercial banks from engaging in proprietary trading (the trading of securities by a bank on its own account rather than on behalf of customers³¹ ), and from investing in hedge funds and private equity funds.³² The principle behind the rule is to stop deposit-taking banks, which are insured by taxpayer dollars through the FDIC, from engaging in the type of speculative activity characteristic of investors like hedge funds.³³ The Dodd-Frank Act also grants authority to the SEC and Commodity Futures Trading Commission to regulate the derivatives market, which had only been lightly supervised.³⁴ Credit default swaps, a form of derivative, fall under this umbrella of authority.³⁵

The Dodd-Frank Act also established a host of new federal agencies tasked with the objective of preventing another crisis like the one in 2008.³⁶ The Consumer Financial Protection Bureau was created as a new enforcer of federal consumer financial law.³⁷ It specifically deals with consumer deception and abuse by financial companies, such as the sort of predatory lending that led to the housing bubble.³⁸ But most important to this Essay's discussion of non-bank regulation is the Dodd-Frank Act's creation of the Financial Stability

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Oversight Council. Through the Dodd-Frank Act, the Federal Reserve has the authority to impose greater capital requirements on "systemically important financial institutions," which are financial institutions that regulators don't want to become "too big to fail."³⁹ The Dodd-Frank Act never actually uses the term "SIFI," but it does refer to the concept of the institution whose collapse would destabilize the U.S. economy.⁴⁰ The Financial Stability Board, an international body, was the first to use the label "SIFI" to refer to such institutions.⁴¹ However, experts and journalists now use the term SIFI to refer to the entities that the Dodd-Frank Act seeks to rein in. § 165 of the Dodd-Frank Act authorizes the Federal Reserve to designate a commercial bank as a SIFI if its total assets are over $50 billion. On the other hand, the newly created FSOC will determine whether a non-bank financial company is a SIFI.

FSOC has the broad mandate of "identifying risks to the financial stability of the United States; promoting market discipline; and responding to emerging risks to the stability of the United States' financial system."⁴² Lawmakers and regulators recognize that many of the firms whose financial distress caused widespread damage during the crisis were not traditional commercial banks, but were rather non-banks engaged in a variety of activities that were not regulated as heavily as banking.⁴³ In order to address the gap in oversight over these large, interconnected entities, and to ensure that distress at these firms would not again cause instability in the economy, Congress has used the Dodd-Frank Act to broaden the authority of the federal regulatory apparatus over non-bank financial companies.⁴⁴ Under § 113 of the Dodd-Frank Act, FSOC has the authority to designate a non-bank financial company as a SIFI if it determines that financial distress at the non-bank financial company, or the nature of the activities conducted by the company, could threaten the financial stability of the United States.⁴⁵

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As a SIFI, the non-bank financial company is subject to supervision by the Federal Reserve, and must comply with heightened standards on capital reserves, liquidity, and risk management.⁴⁶ FSOC and the Federal Reserve follow a multi-step framework for imposing SIFI status on nonbank financial companies: (i) first, FSOC determines if the nonbank is "predominately engaged in financial activities;" (ii) if FSOC so determines, then FSOC applies a three-step analysis for determining whether the nonbank financial company is "systemically important;" (iii) if FSOC deems that company as systemically important, then FSOC labels the company as a SIFI; and (iv) the Federal Reserve places heavy regulatory burdens on the SIFI.⁴⁷

II. THE SIFI DESIGNATION PROCESS

At the first step of the framework, FSOC analyzes whether the non-bank is actually a financial company. § 102 of the Act defines a "U.S. nonbank financial company" as a company other than a bank holding company, national securities exchange, or certain types of entities involved in the swap and derivatives markets, that is "(i) incorporated or organized under the laws of the United States or any State; and (ii) predominantly engaged in financial activities."⁴⁸ The Act goes on to state that a company is "predominately engaged in financial activities" if (i) 85 percent or more of the company's annual gross revenues are derived from activities that are defined as financial in nature in the Bank...