Another week, another wave of worries about U.S. regional banks. Thankfully, since the FDIC appears to be supporting the system, the level of panic has declined — if not by law, then by precedent. But one of the problems now is attrition: Weak banks are losing deposits and watching funding costs rise while their loans to commercial real estate and risky companies go sour.
That means more consolidation is on the horizon. While this is welcome in the long run (because it’s crazy that the US has over 4,000 banks), it could be a shock in the short term.
Yet while investors — and US politicians — watch these banks with unease, there’s another area that deserves our attention: life insurance.
Insurance has largely been out of the headlines in recent months. No wonder: These companies tend to be boring because they’re supposed to hold long-term assets and liabilities. Logic dictates that they should win in a world of rising rates because they have large portfolios of long-dated bonds that typically don’t need to be marked to market, meaning they can gain income gains from rising rates without losing money.
However, their balance sheets are now becoming increasingly unpredictable. While that’s no reason for investors to panic, it highlights a larger problem: A decade of extremely low interest rates has created distortions across the financial world that could take a long time to unwind. This attrition problem extends far beyond banks.
Buried in some of the Fed’s charts is the key question recently released financial stability report. These data suggest that insurance groups held approximately $2.25 trillion in assets deemed risky and/or illiquid at the end of 2021, including commercial real estate or corporate loans (obviously the latest data available). In aggregate, that’s almost double their holdings in 2008 and accounts for about a third of their assets.
This level of exposure is not unprecedented. While the proportion of risky assets has risen in recent years as life insurers frantically chase yield in what was then a low-rate world, it is on par with levels seen before the 2008 financial crisis.
But it’s worth noting that there is also a growing reliance on what the Fed calls “nontraditional liabilities — including securities backed by financing agreements, Federal Home Loan bank advances, and cash received through repo and securities lending transactions.” These transactions often “offer some investors an opportunity to withdraw their funds at short notice.”
It’s not clear how big this mismatch is because there are large data gaps — as the IMF noted in its report myself recently Report. For example, “exposure to illiquid private credit exposures, such as mortgage obligations, can mask embedded leverage in these structured products”. In plain English, this means that insurers may be much more sensitive to credit losses than thought.
But the key, the Fed noted, is that “over the past decade, the liquidity of life insurers’ assets has steadily declined and that of their liabilities has slowly increased.” That could make it harder for life insurers to respond to sudden increases in claims — or even withdrawals.
Maybe it doesn’t matter. After all, insurance contracts are stickier than bank deposits.When the industry was last hit, during the panic of the Covid outbreak in 2020, it managed to (quietly) orchestrate a cash boost of “up to $63.5bn”, avoiding austerity, as a separate fed research show.
Fed analysts acknowledged that it was unclear exactly how this cash surge occurred because “statutory documents are silent on the details.” But revenue from derivatives trading played a role, and the main source appears to be loans from the federal home loan banking system.
This is interesting because it highlights another key point that is often overlooked: the powerful quasi-national entity FHLB is underpinning many parts of U.S. finance today, not regional banks. Or to quote the Fed again: “Life insurance companies are increasingly reliant on FHLB funding.” So much for free market capitalism in the US.
This reliance also raises questions about the future, especially if funding sources do flee, or risky and illiquid assets suffer, or both. The latter seems likely, since higher interest rates have hurt commercial real estate and risky corporate lending.
Again, I’m not saying this is cause for panic. It’s a slow-moving saga.although a recent report A report from Barings suggests that a “record 26% of life insurers are in negative rate administration” by the end of 2022 (in other words, they have paper losses on bonds), which need not materialize unless companies go bankrupt.
But if nothing else, regulators clearly need better data and strict asset-liability matching standards. While the National Association of Insurance Commissioners is clearly working to implement such a move — for example by restricting insurers from holding CLOs — it will take time.
That’s why “today’s environment makes liquidity management so important”, as Barings notes, not least because “rising interest rates can be a factor in insurers going bust”. In other words, it’s not just U.S. regional banks that are at risk of falling victim to today’s shrinking credit bubble.
gillian.tett@ft.com