Bad Regulation: AIG and When Chickens Come Home to Roost

Just how out-of-date is our regulatory system? Given the current economic crisis, we are finally hearing calls for fixes to the government oversight of banks and other financial institutions. If we start with the deregulation of financial services companies that was accomplished in the Gramm-Leach-Bliley Act of 1999, we’re about a decade behind in terms of financial regulation. Why? Because the old structure was retained, with the Federal Reserve System and the Comptroller of the Currency regulating the commercial banks, the Securities and Exchange Commission overseeing the securities industry, and state insurance commissions responsible for the insurance industry.

Meanwhile, financial companies could enter any financial business in the search for profits and market share. That’s what got AIG (the American International Group) into trouble. It established an investment bank behind its rather dull but competently managed insurance businesses, which managed to eventually lose more than $18 billion (the reports for the most recent three quarters of operations). This AIG unit wrote credit-default swaps (CDS), a guarantee against default, with an exposure based on the notional (face or stated) value of nearly one-half trillion dollars! A CDS is a contract between two counterparties – that is, buyers and sellers – in which the buyer makes regular payments to the seller in exchange for the right to compensation if there is a default or “credit event” in respect of a third party (sometimes called a “reference entity”).

As poor credits including subprime securities began to fail, AIG hit the wall. The company couldn’t pledge enough collateral with its counterparties, prompting credit rating downgrades and more calls for margin. The New York State Insurance Commission actually did a fine job in regulating the insurance groups of AIG, and it appears unlikely that any loss will occur in those businesses. It is the investment bank – not subject to the insurance regulators – that was the culprit, and the cause of the requirement for an $85 billion credit facility bailout from the Federal Reserve.

This is the time for Americans to reconsider our approach to financial regulation, and indeed, to all business regulation. For the financial industry, we need the appropriate level of consolidated governmental oversight, probably by categories of risk. In my next blog, I will discuss a more thoughtful approach to regulation and suggest appropriate organizational ideas.

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