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Global Scale by Coletta Kemper Domino Theory

If AIG is too big to fail, then we had no choice but to save it to save the economy. But how do regulators know it was too big?

By  Coletta Kemper

Can regulators really regulate complex multinational corporations? That certainly is being asked about AIG’s regulatory oversight, or lack thereof. There’s been a lot of finger pointing over the fact that no one was minding the store. How could this happen? Because of the way AIG was structured, it fell through the cracks. State regulators were watching the insurance units, the feds had some loose oversight, but the truth is no one had responsibility for watching what the holding company was doing and how actions in one unit could threaten the solvency of the entire operation (and that of our entire financial system). Oops!

Well, you know how the story goes. AIG got so far out on the limb guaranteeing bad mortgage-backed securities held by third parties that it couldn’t pay on the guarantees when the housing bubble burst and the collateral calls came in. AIG went to Uncle Sam with hat in hand. The fed agreed because AIG was “too big to fail.”

Now regulators are struggling with how to plug the regulatory gap so this doesn’t happen again. Enter stage left, the debate on systemic risk regulation and the theory of “too big to fail.”

What is systemic risk, and what constitutes a systemically risky company? That’s the $170 billion question. There isn’t really a definition of systemic risk beyond the broad notion that some companies are so big that their failure will cause major collateral damage to other financial institutions and the economy at large. In other words, they are financially contagious.

That certainly sounds like what set off the worldwide financial crisis. Economists will be arguing for years whether the Lehman Brothers failure and the Bear Stearns and AIG near-failures were systemic triggers. Some conservatives say we are suffering from a solvency crisis that is not systemic. We’re in this mess because a lot of companies invested in the same bad assets. One company did not bring down the next. They all did the same stupid thing at the same time. Now banks are hoarding their cash in case there is a run on the bank by depositors and counterparties—fueled not by reality, but panic.

OK, but weren’t some of the events linked? Housing market collapse, collateral calls, AIG guarantees? That aside, it seems to me that panic can be a systemic risk (flashback to the Great Depression). But that’s all well above my pay grade. The public’s and the world’s perception is that Bear Stearns and AIG were too big to fail and posed a risk to the financial system. And as we well know, perception is reality—particularly in Washington, D.C.

Speaking at the annual Federal Reserve Bank of Kansas City’s annual economic symposium, Federal Reserve Chairman Ben Bernanke called for the strengthening of our financial system but warned of the moral hazard of government intervention. “In this regard, some particularly thorny issues are raised by the existence of financial institutions that may be perceived as ‘too big to fail’ and the moral hazard issues that may arise when governments intervene in a financial crisis.”

Thorny or not, they drank the Kool-Aid, and regulators and lawmakers are now calling for systemic risk regulation. Regulating in a more macro way does make some sense. Currently, regulators focus on the financial condition of an individual financial institution as a standalone company. Bernanke suggests an alternative approach that includes more consideration of potential systemic risks and weaknesses in the financial chain.

Legislation to create a systemic risk regulator is under discussion in Congress. There is little doubt that the legislation will include some form of insurance oversight. The AIG situation is too big for regulators to ignore; although, arguably there probably aren’t a lot of AIGs out there, at least of which we’re aware.

Still, there are a lot of unanswered questions. One certainly is what constitutes a systemic risk? Is it a matter of too big to fail or the intertwined nature of our global financial system? For our own industry, when the federal regulator decides that an insurer is systemically risky, does that give it an unfair advantage over the insurer that doesn’t have the government’s implied guarantee? No one seems to know.

Looking at the risk one financial institution poses for others may prevent future failures. But as Bernanke implied, there are winners and losers when government intervenes, and we need to be aware of it before we enact reforms.

Whether the economic crisis was the result of a lot of bad management decisions or systemic risk is debatable. What is clear is that there is a worldwide loss of public and institutional confidence in the financial system. Whether the government can regulate that remains to be seen.

Kemper is The Council’s vice president of Industry Affairs.

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