As lawmakers and regulators contemplate the staggering costs of the credit crisis, policymakers are seeking ways to ensure that Wall Street is never again in a position to gamble with America's fundamental financial stability. Among the issues being debated, reportedly, is whether the Treasury should expand its rescue program to include insurance companies. And looking beyond the immediate situation, debate is brewing over whether the federal government or the states can do a better job of regulating insurance companies.
Arguments over which jurisdiction should take the lead run the risk of obscuring the most important factor determining the efficacy of financial regulation. Today's crisis proves that strong capital requirements are critical for safeguarding consumers and the financial system, whatever level of government oversees insurers.
Even the most knowledgeable and assiduous regulators have limited capacity to halt irresponsible risk-taking and speculation. Booms, manias and bubbles, such as the one that led to the collapse of the subprime mortgage market, are as old as markets themselves. Cycles of excessive market exuberance and greed pose a grave risk to the general economic well-being when market players have a nearly unlimited capacity to leverage their risks -- that is, to take on financial obligations far greater than their capacity to make good on their promises if their bets go bad.
Capital requirements are like speed limits. The police, of course, cannot guarantee that every driver on the road is alert and acting cautiously. But if authorities post and enforce prudent speed limits, every driver and pedestrian is safer.
Effective regulation built around sound capital standards will limit leverage and risk. For example, the investment banks that are reconfiguring to become bank holding companies will become subject to capital standards that reduce the magnitude of the risk they are allowed to take. The capital standards they were subject to previously allowed them to leverage their balance sheets 30 to 1 and higher, meaning that for every dollar in their coffers, they could place bets of $30. In contrast, the rigorous capital requirements and standards to which insurance companies are subject have effectively limited the risks that insurers can take.
Insurance companies must set aside reserves using a formula that calculates future obligations based on conservative risk and interest-rate assumptions. A further layer of protection comes from the requirement to set aside additional "risk-based capital" for other contingencies. Insurance regulations also prescribe a prudent and diverse mix of investments whose expected cash flows reasonably match future obligations.
No regulatory regime can prevent all failures, particularly when the capital markets are dysfunctional. But these three layers of capital protection greatly limit the systemic risks and costs to taxpayers when something goes wrong.
A case in point for strong insurance capital standards is the collapse of AIG, the nation's largest insurer. The losses that necessitated a more than $100 billion, taxpayer-supported federal takeover occurred in the company's non-insurance subsidiaries, whose capital requirements were far less rigorous than those for its insurance subsidiaries. The insurance subsidiaries are solvent, and the controls in place limited the opportunities to use the capital inside these subsidiaries to pay off the bad bets accumulated elsewhere.
Just as changing police officers' uniforms would do nothing to make our roads safer if speed limits were not set appropriately and enforced, the rigorous enforcement of prudent capital requirements, not which layer of government is chosen to do the job, determines the quality of financial regulation. Rebuilding America's financial system will be challenging and costly. If a new regime were to ease the high capital standards enforced on insurance companies at the state level, we would be throwing the baby out with the bath water and creating a vast risk to the soundness of our financial system. Whatever shape the new U.S. financial and regulatory structure takes, we must build it on a foundation of solid capital requirements.
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