The future of Insurance & Regulatory Reform

The factory of the future will have only two employees, a man and a dog. The man will be there to feed the dog. The dog will be there to keep the man from touching the equipment.

Absent the dog, this future is evident in the present insurance industry – and, in that regard, the various proposals to reform the nation’s financial regulatory system fall short.

Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System and the related Testimony of the Acting Comptroller General; Natural Hazard Mitigation and Insurance:  The United States and Selected Countries Have Similar Natural Hazard Mitigation Policies but Different Insurance Approaches; and Blueprint for a Modernized Financial Regulatory Structure collectively offer around 400 well written pages of bureaucratese.

Over the past few days, I’ve read or read over all 400  along with related news articles, blog posts and the like.  Without belaboring the point, I’ll add that I read all with the eyes of someone both trained and experienced in the design/redesign of systems of service.

The “official” publications propose to “modernize the outdated U.S. Financial Regulatory System” with the usual problem-based approach to system development/reform of government that results in the more things change, the more they stay the same. In this case, however, the proposed changes are based on a misunderstanding of the problem.

Among those in government or entities of or linked to the financial system, there appears to be almost universal agreement the problem is the patchwork of state/ federal regulatory oversight over a collection of entities that make up a financial system but that there is no real system.

The graphic below is from the Framework report. With my editing in red, it illustrates what I consider to be “the real problem” – off-balance sheet Special Purpose Entities developed by banks, insurers, investment firms and others in the financial system.pages-from-financial-regulation-a-framework2

If you link to either the Framework or the Blueprint, you’ll see a list of agencies and organizations that participated in the process of developing each proposal.  These lists are intended to demonstrate the proposals have met the holy grail of system planning – the all-stakeholders-at-the-table collaboration.  Such collaborations, IMO, act as a smokescreen until it’s no longer possible to conceal the more things change, the more they stay the same.

For planning system change, my preference is futuristic planning.  By that I do not mean developing various scenarios of the future with a set of relation action plans. Instead, the futuristic planning approach I endorse (and practice) constructs a preferred future and then does backward planning to identify the steps needed to produced the desired outcome at the desired time.  That’s a very different sort of framework and blueprint than anyone has on the table thus far.

For example, looking 20 years ahead, if the world envied our nation’s  financial system, describe the components and how each functioned in relationship to one another and what sort of regulatory system was in place.

With that start point, instead of the traditional all-stakeholders-at-the-table collaboration, it will take a great group to develop a path, not a framework.

[Great Groups]…manage conflict by abandoning individual egos to the pursuit of the dream. At a critical point in the Manhattan Project, George Kistiakowsky, a great chemist who later served as Dwight Eisenhower’s chief scientific advisor, threatened to quit because he couldn’t get along with a colleague. Project leader Robert Oppenheimer simply said, “George, how can you leave this project? The free world hangs in the balance.” So conflict, even with these diverse people, is resolved by reminding people of the mission.

They are protected from the “suits.” All Great Groups seem to have disdain for their corporate overseers and all are protected from them by a leader — not necessarily the leader who defines the dream. In the Manhattan Project, for instance, General Leslie Grove kept the Pentagon brass happy and away, while Oppenheimer kept the group focused on its mission. At Xerox PARC, Bob Taylor kept the honchos in Connecticut (referred to by the group as “toner heads”) at bay and kept the group focused. Kelly Johnson got himself appointed to the board of Lockheed to help protect his Skunk Works. In all cases, physical distance from headquarters helped.

Who should be in the great group we so desperately need?  A good place to start IMO would be with those who about the people that figured out we were living on borrowed time and tried to warn us years before the economy went on a $700billion-and-counting system of life support.

Not all are household names but all are great thinkers:

…Securitization is a fabulous tool invented by the financial industry to survive and evolve under existing banking regulations. As they were first envisioned, these transactions had– and still have — great potential as a safety net to insure healthy lender risk. Unfortunately, and probably through lack of experience, the financial community has let them evolve into a monstrous money-making machine. Here’s how it works.

1. A bank receives deposits, and its function is to lend that money out at a profit. (We won’t go into fractional reserve banking here, although this multiplies the problem when things go awry. For now, however, let’s just assume the bank lends a fixed multiple of what it takes in.)

2. The bank (or other type of financial institution with access to funds) finds good borrowers with at least a decent credit score to whom they lend the money for purchases, say for a house, a car, or whatever the borrower fancies.

3. Instead of following up on the repayments through their own loan department like they used to, the banks now transfer those loans to an agency that will fulfill this task. At the same time, they package the loans according to the degree of risk, and then they sell the loans to the general marketplace.

4. The buyers of these packaged loans can then buy “insurance” to cover the risk, from individuals and companies who want to assume that risk for a price (a piece of the interest action) and who are supposedly able to come up with the cash should a default occur. So far so good.

5. The bank now no longer has any loans on the books, so it is free to make a second set of loans based on the same fractional-reserve multiple of the deposits it holds — but this time in effect using 100% of the loan-package buyers’ funds to do so, i.e. so far, this is still a good thing; but as we’ll see, it’s good only up to a point.

6. As you can imagine, this doubling, tripling or quadrupling of loans allows for an expansion of the lending industry; and the market pool of good borrowers (and the good borrowers’ credit appetite) eventually maxes out. To palliate this inconvenience, and since the bank is no longer shouldering the risk from its own loans, the bank now lowers the bar for borrowing so that those with a lower credit score may become borrowers. This expansion has presently extended into what some believe is dangerous territory; but this is only half of the problem.

7. The other half occurs when the buyers of these packaged loans either do so with what is called leveraging, i.e. they buy on credit themselves; or they sell these loans to others who do the leveraging. Hedge funds, for example, have sometimes been a source of unwisely leveraged funds that are not yet under industry control. And hedge funds are very popular these days.

…much of the credit risk involved at this higher level is also “insured” in the same manner as in Stage 4, only this time the insurers never actually pay for the loans they are “insuring.” As with real “insurance,” they only need to pay in case of default. And this so-called “credit derivative” process is repeated over and over again, in effect allowing the loan-package insurers to borrow to the degree of the “insurance” market’s willingness to take on risk.

The fundamental unknown here is that because this type of risk insuring is a new industry, there are few standards such as those found in the ordinary insurance industry or in banking, where safety-net reserves are required. Therefore, the loan and credit insurers…who do not have to come up with the principal of an insured loan unless there is a default, are leveraged beyond reason. It’s true, when things are booming in the economy, defaults are rare. But what happens if things start to turn sour?

Nassim Taleb is certainly a household name at SLABBED and, as Matthew Cooper reports, Taleb sees a future with banks becoming utilities.

We’ve already lost our virginity by partially nationalizing the banks when we put taxpayers money into them and we’re likely to do much more before it’s over. With it’s connotations of South American guerrillas in fatigues, nationalization carries a lot of dire implications. It’s also a misnomer…

The better metaphor may be the idea that banks will become utilities, like ConEd in New York or Duke Energy in the south and midwest…

Nassim Nicholas Taleb, the author of The Black Swan: The Impact of the Highly Improbable, an investment adviser, philosopher academic, trader and prescient gloom and doomer about the current economy has used this metaphor. On Charlie Rose, late last year he said:

It will be very different. Number one, banks will be utility companies, because we no longer will tolerate privatizing the gains and socializing the losses anymore. If you and I are going to bear the losses of bankers, we don’t want to pay them bonuses for five or six or seven years, and then bail them out. No more of that. Banks are going to converge with utility companies, because if you go to Detroit or LA you want to be able to get cash from a cash machine. It’s a utility.

People will still be able to take risks but there will be no government bailout. As he told TIME:

I think that we’ve got to progressively become a society where banks are deemed to be too precious for us, for our currency, to take too much risk. We need to have a banker who is just as responsible as someone working for the water company. Banks are going to become a utility. And banks probably will not have a lot on their balance sheet, and the risks taken will be borne by individuals like myself who have capital, and who know the risks, with their own money. Otherwise you’re going to keep having a cycle that’s deeper every time.

One sure not to be included in the great group is former Merrill CEO John Thain whose ten greatest moment are contribution enough for everyone, including, suggest some, President Obama.

President Obama and his Treasury Secretary appointee, Tim Geithner, are none too pleased with Wall Street. The shenanigans foisted upon Bank of America by John Thain and others at Merrill Lynch prior to the closing of their recent merger has set tongues-a-wagging in Washington (see below).

With the regulatory climate in D.C. turning chillier than a Chicago winter, I’m hoping someone in either the White House or Treasury Department will consider creative solutions in lieu of simply imposing a set of stifling regulations on Wall Street. My “matching gift” idea for the TARP is one such proposal, and I’ve seen some other good ideas bandied about in recent days.

If the writer has seen some of the same “good ideas” I’ve seen, IMO they appear very “here and now” but they are geared to a future that’s not being openly discussed or decided – a global financial system larger than any one nation, including ours.

Many (most) of these ideas come from yet another report.  In this case, the report is Financial Reform: A Framework for Financial Security from the Group of  Thirty.

The Group of Thirty, established in 1978, is a private, nonprofit, international body composed of very senior representatives of the private and public sectors and academia. It aims to deepen understanding of international economic and financial issues, to explore the international repercussions of decisions taken in the public and private sectors, and to examine the choices available to market practitioners and policymakers.

While there are some great people in the group, this is not a great group; but, according to this report in today’s Washington Post, it has attracted Congressional attention :

Congress is moving to create strong new oversight of the financial sector that would likely give the Federal Reserve authority to examine the workings of a wide range of companies in an attempt to address one of the key failures that led to the financial crisis…

The legislation envisioned by House Financial Services Committee Chairman Barney Frank (D-Mass.) would put the Fed, or less likely another government agency, in charge of protecting the stability of the entire system, Frank and other congressional sources said.

An abundance of federal agencies regulate the financial industry. But no agency is responsible for understanding or containing risks affecting the financial system as a whole. In fact, none even has a complete picture of the financial markets.

Under Frank’s legislation, the new regulator would likely be given the power to gather information about the inner workings of banks, investment firms, insurance companies, hedge funds and any other entity big enough or so intertwined with other companies that it creates the risk of a systemic collapse. These companies would have to provide detailed information about how they manage risk, their derivative contracts and the extent to which they use borrowed money.

“We need to give some regulator the power to restrain risk-taking that is excessive,” Frank said. He said he intends to move quickly, explaining that the Obama administration is eager to be able to show the Group of 20 [sic] finance ministers progress on financial regulation at a meeting in early April.

Apparently, it has the President’s attention and the support of the finance industry as well.  According to the Post,

President Obama…has not specifically endorsed the idea of making the Fed a financial system regulator, his administration has sent clear signals to Congress that they should proceed on that path. The idea was first widely discussed last spring as part of a blueprint for regulatory reform issued by then-Treasury Secretary Henry M. Paulson Jr.

“Someone needs to have all of the information,” said Scott Talbott of the Financial Services Roundtable, an industry group that represents 100 of the largest financial companies and that supports the plan.

It does not appear to be as well received among creative thinkers in the blogosphere.

It was as if a short, precise document had been washed through a “committee” until it achieved an acceptable level of fuzziness, that all could agree on and implement in their own separate, broken ways, arriving at … pretty much what we have today. But then I suppose that is exactly what happened.

Matthew Yglesias connects the dots – no wonder he calls his place Think Progress.

Initial ideas about the new financial regulatory regime are getting floated in the press. Perhaps not surprisingly, a lot of the material seems similar to the Group of 30 recommendations.

This all sounds pretty good to me. My main comment, though, would be that we shouldn’t put too much confidence in any regulatory regime. One of the things we’ve seen recently, I think, is that there’s a bit of a paradox around these kind of regulations. If they have any teeth, then there’ll be people who stand to make money from relaxing them or from finding and exploiting loophopes. And if they work, then for a long time there won’t be any major problems. And if you go for a long time without major problems, people are bound to get complacent and start not caring that loopholes are being exploiting. Indeed, they’ll start seeing the loopholes as a reason to relax the regulations. And then eventually you get a blow-up and a renewed interest in regulation.

Long story short, one of the big things we were missing heading into this crisis was not just prophylactic regulation but any clear guidelines for what happens if things go bust. One of the main virtues of the FDIC process is simply that it’s a well-understood crisis. FDIC regulations don’t always work, but bank failures on an FDIC level don’t lead to “bank panics” anymore because everyone understands that the FDIC has a process in place and is comfortable for letting it unfold. We need, I think, some more general prescription for what’s supposed to be in the box if the Fed Chairman or Treasury Secretary needs to reach behind the “break glass in case of emergency” barrier.

The dot he missed – and he was close – is that people will make money from whatever happens.  He also missed the big picture as did everyone else as far as I can see.  A rose by any name, so to speak; but while we talk banking and national regulatory control, insurance is walking in the backdoor and it, too, will be regulated nationally.

Mr. President, we really need to talk about where all of this is leading.

2 thoughts on “The future of Insurance & Regulatory Reform”

  1. The reason there are so many agencies is because the financial entities used to be seperate institutions.

    We don’t need less regulators, we need more, and smaller institutions.

    This would be less efficient, but far less vulnerable to catastrophic collapse. More collapses its true, but smaller in size.

  2. Russ I do love cross pollination. Excellent points btw.

    Remember the old IV board for GEMS, you kick started it.. The folks at Deepcapture seem to like it. John Mack you are one glorious SOB.

    It’s killing me but I ain’t gonna pump it. At least not yet. Back up the truck, how about the dumptruck.

    Sign me incorrigible.


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