Prudential’s Silitch on the blindspots in Basel III

Risk30 profile: Post-crisis reforms have failed to fully address systemic risk, Prudential’s CRO warns

Nick Silitch 3
Nick Silitch: “There’s nothing I can put this company through that gets us to within $25 billion to $30 billion of our economic capacity”
Alex Towle

This is the third of 10 interviews marking Risk’s 30th anniversary. An introduction to the series is available here.

Nick Silitch has tried time and again to bankrupt Prudential Financial. The chief risk officer of the Newark, New Jersey-based insurance company runs periodic economic risk projections to identify loss scenarios that could bring the firm to its knees. So far, he’s come up empty.

“There’s nothing I can put this company through that gets us to within $25 billion to $30 billion of our economic capacity,” says Silitch. “And I’m really trying.”

Not everyone agrees with Silitch’s assessment of the firm’s risk profile. Prudential is currently the only non-bank designated as a systemically important financial institution (Sifi), which identifies it as a firm whose failure might trigger a financial crisis.

Sifis are subject to additional regulatory oversight at the federal level.

Silitch argues concerns around the systemic risk of insurers are overstated and rooted in misconceptions about the industry’s loss-absorbing capacity.

Most measures of systemic risk compare a firm’s equity value to its assets and liabilities. Prudential had a market capitalisation of $47 billion and assets of $766 billion at the end of the second quarter, a ratio of 6%. But that includes almost $300 billion of separate account assets, where the investment risks are borne by clients. It also holds roughly $60 billion of pre-tax margins in reserve – essentially future profits that can be used to absorb losses – which are recognised as liabilities under US accounting rules.

As a result, a cursory assessment of the firm’s financial statements presents a misleading view of its systemic risk profile. “The capital is understated, while liabilities and assets are way overstated,” says Silitch. “The combination of the three guarantees that large insurers will be considered systemic.” If separate accounts are excluded from total assets, and margins in reserve are recognised as capital, Prudential’s loss-absorbing capacity would stand at roughly 23%.

The risk-based capital framework for US insurance companies has been remarkably stable and sound over time
Nick Silitch, Prudential Financial

Regulators seem to be coming around to the view that insurers may be less risky than they appear. MetLife successfully challenged its designation as a Sifi in the courts and the Financial Stability Oversight Council (FSOC) voted to remove AIG from the Sifi list in September.

Prudential has long disputed its Sifi designation and is widely expected to shed the label soon, making the New Jersey Department of Banking and Insurance its primary regulator once again.

That would suit Silitch, who is a strong proponent of the risk-based capital regime developed by US state insurance regulators in the early 1990s.

“The RBC framework for US insurance companies has been remarkably stable and sound over time,” he says. “It may be overly conservative but it is absolutely even handed.”

The RBC regime faces its own challenges, however. International standard-setters are working on a global insurance capital standard (ICS), similar to the Basel rules for banks, which has the potential to change the economics of spread-based products such as annuities and life insurance for US companies.

While Silitch says there is “nothing wrong with the notion of having an international capital standard”, he worries it could have unintended consequences – much like the original Basel Accord.

Silitch started his career as a trainee in the credit department at Bank of New York in 1983. The loan portfolio represented the core asset risk for banks at the time. “There was no secondary market for loans, and the corporate bond and commercial paper markets were nascent. So banks lent money to the full spectrum of creditors, from double-A companies to single-B borrowers,” he says. “I would get in at 8am in the morning and call 20 treasurers and say ‘How much money do you need today?’, and we would do their overnight funding. We were dependent on origination and we had very high-grade loans on our books.”

Nick Silitch 2
Alex Towle
Basel I created the shadow banking system
Nick Silitch, Prudential Financial

By the mid-1980s, foreign banks with a different capital construct were entering the US market and competing with domestic firms for loans. Silitch recalls speaking with a long-standing client about renewing a letter of credit. “He said, ‘I’m sorry but we’ve got an offer from Sumitomo for a third of the price’.”

The Basel capital standards – which came out in 1988 – were designed to level the playing field. “It was engaged in with the best of intentions, but the unintended consequences were epic,” Silitch says.

Basel I slapped an effective 8% capital charge on all credit assets, with the exception of cash, government securities and residential mortgages.

The market soon found workarounds. For instance, a funded loan attracted an 8% capital charge, even if it was overnight. However, an unfunded commitment of more than 364 days required zero capital. So companies began issuing commercial paper backed by 365-day revolving lines of credit to meet their short-term funding needs. “Overnight funding was taken away from the banks. That was the first thing,” says Silitch. “Then we saw the securitisations of receivables and commercial mortgages. It forced all those assets off the bank’s balance sheets.”

Much of the credit business ultimately moved to the shadow banking system. “Basel I created the shadow banking system,” says Silitch. “It was the single most systemic thing to ever happen to the financial industry.”

Basel II, finalised in 2004, sought to address some of these issues and was “materially better”, says Silitch, who led the Basel II implementation project at Bank of New York. Still, he urged regulators to consider the second and third order effects of the capital rules. “We were telling them, ‘It’s not just the banks anymore, it’s the markets’. And they said, ‘No, we regulate banks, the markets will take care of themselves.”

The financial crisis proved Silitch’s point. “If Lehman Brothers or Bear Stearns had gone under as a result of an idiosyncratic event, it wouldn’t have affected the rest of the world. The fact Citi and Wachovia were going to have to take writedowns on the same assets that caused Lehman and Bear to be so deeply wounded is what made it a systemic event. The linkage for all the firms is markets.”

Silitch worries regulators have not done enough to address these systemic risks. Since the financial crisis, at least 51 financial companies have been designated as Sifis by prudential regulators around the globe. The list includes 34 banks, nine insurers and eight market utilities. One of the designated firms, Dexia Group, collapsed in 2011 after suffering big losses on Greek government debt. The European Banking Authority had given the Belgian bank a clean bill of health only months earlier.

Nick Silitch 1
Alex Towle
Pushing well-capitalised firms out of systemically important markets does not end well
Nick Silitch, Prudential Financial

And while large financial institutions have become highly regulated, many systemically important markets and activities – including housing finance and student lending – continue to function in much the way they always have. “FSOC’s charter is to seek out sources of financial instability and mitigate them,” says Silitch. “When I think about sources of financial instability, I think about public pensions, mortgages and student lending. Has any attention been paid to them?”

The over-the-counter derivatives market may be the exception to the rule. Post-crisis reforms such as mandatory central clearing of standardised swaps have made the market safer, Silitch says. At the same time, the Basel III capital rules have forced some banks to withdraw from the derivatives business and created an opening for non-bank market-makers such as Citadel Securities to enter.

“A year-and-a-half ago, the Bank of New York got out of interest rate derivatives. How does it benefit the market to have one fewer derivatives dealer – a very safe, stable, well-managed and well-capitalised institution at that?” says Silitch. “We need to have access to interest rate hedging capabilities – whether you’re a pension fund, a corporation or an insurance company – and there are fewer and fewer broker/dealers we can do business with.”

The benefits of post-crisis reforms have come at the cost of reduced liquidity and credit intermediation. “You’re seeing a scarcity of banks making markets across all instruments,” says Silitch. The same goes for credit origination. Banks are making fewer loans to small and medium-sized enterprises and pulling out of leveraged transactions. The void is being filled by private equity and hedge funds, which have raised large sums of capital for private lending strategies. These non-bank lenders could be a source of instability when the credit cycle turns.

“Private equity firms will cut off borrowers at the first sign of trouble,” says Silitch. “A good bank – especially a small bank – will say, ‘Let’s talk about the ways we can get through this together’.”

Detrimental impact

The proposed ICS could have a similarly detrimental impact on the market for long-duration credit, which is a core holding for many insurers. Long-term liabilities backed by credit assets of a similar duration could attract an 18% capital charge under one of the valuation approaches currently being field-tested by the International Association of Insurance Supervisors. That could significantly raise the cost of long-term insurance for consumers and sap demand for long-duration credit among insurers.

The irony is that the treatment of credit spreads in the ICS is widely seen as a roundabout effort to address liquidity risk in bond markets, which has been exacerbated by Basel III’s capital requirements for banks.

Silitch’s point is that subjecting an institution – or a class of institutions – to heightened supervision often results in the systemic risks housed within those firms being transferred to entities that are more lightly regulated. This game of pass the parcel can mean poorly capitalised firms end up holding the riskiest assets.

“Whenever a regulation is put in place, we need to look at the consequences. If all the high-grade loan exposures are flying away from the banks, stop and ask yourself, ‘is this what was intended?’ If not, then maybe you did something wrong,” says Silitch. “We need to think about the systemic implications of markets rather focusing on the institutions. Pushing well-capitalised firms out of systemically important markets does not end well.”

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