Systemic Risk Due To Asset-Liability Mismatches, Not Size

Systemic Risk Due To Asset-Liability Mismatches, Not Size
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Systemic Risk Caused By Asset-Liability Mismatches by David Merkel, CFA of Aleph Blog

What happens when a crisis hits?  There are demands for cash payment, and the payments can’t be made because the entities have short liabilities requiring immediate payment, and long illiquid assets that no longer can be sold for a price consistent with average market conditions.  When there are many firms for which this is true, and they rely on each other’s solvency, that creates a systemic crisis.

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Whether through:

  • Owning long assets, and financing short, or
  • Using the repo market to hold long assets, thus disguising it for accounting purposes as short assets
  • Taking deposits, and investing long,

it creates an imbalance.  It is almost always more profitable in the short-run to finance short and lend long.  But when there is a demand for cash, such institutions are on the ropes and might not survive.  Less than half of the major American investment banks existing in 2007 were alive in 2009 to today.

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But what if you were clever as a financial institution, and had liability structures that were long, or distributed the risk of what you were doing back to clients.  You would always have adequate liquidity, and would not be in danger of default for systemic reasons.

Thus, I think the Financial Stability Oversight Commission [FSOC] is nuts to regulate insurers such as MetLife, Prudential, AIG and Berkshire Hathaway.  They do not face the risk of a run on the bank.  Look at the history of insurers: those that failed due to a run on the bank were those that:

  • Issued guaranteed investment contracts that would be immediately payable on ratings downgrade.
  • Issued P&C reinsurance contracts that would be immediately payable on ratings downgrade.

Aside from that, there were badly run companies that failed but no systemic risk.  There was also American International Group Inc (NYSE:AIG), which faced a call on cash from its derivatives counterparty, but not the insurance entity.

As for investment managers, they have no systemic risk.  It does not matter if BlackRock, Inc. (NYSE:BLK), Pimco, Fidelity and Vanguard would all fail.  Mutual fund holders would find their funds transferred to solvent entities, and any losses  they might receive are the ordinary losses they could receive if the management  firms were still solvent.

Someone lend the FSOC a brain.  Big size does not equal systemic risk.  Systemic risk stems from a call on liquidity at financial firms that borrow short and lend long for their own accounts.  That does not include asset managers and insurers, no matter how big they are.

What this says to me is that financial reform in DC is brain-dead.  (Surprised?  Nothing new.)  They have fixated on the idea that big is bad, when the real problem is asset-liability mismatches, amplified by size and connectedness.  Big banks are a problem.  Big insurers and asset management firms are not.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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