Since AIG’s bailout in September 2008, the role of large, complex insurance firms in the global financial system has received much attention. Concern about the global operations, interconnectedness, and non-traditional activities of these large firms prompted the Financial Stability Board to formally designate 9 life and full insurance firms in six countries as Global-Systemically Important Insurers (G-SII) in July 2013. In the US, where insurance industry assets equal roughly half the size of total assets held by all financial institutions covered by the Federal Deposit Insurance Corporation, the Financial Stability Oversight Council has confirmed the designation of AIG, MetLife and Prudential Financial as G-SII, thereby subjecting them to heightened oversight.
While enhanced G-SII oversight entails additional compliance costs, it also carries with it an implicit “Too Big to Fail” (TBTF) guaranty, which could lower borrowing costs and also encourage the designated firms to engage in riskier activities via moral hazard. In an attempt to mitigate the moral hazard effects of the TBTF guaranty, the FSB has adopted numerous rules and regulations, such as the writing of living wills and the imposition of higher capital requirements. Getting a full, realistic assessment of these costs and benefits is important. Regulators, investors, and the firms need to know the effect of the new rules and regulations. For example, do the benefits and costs vary in a systemic way across firms, do the regulations create wealth transfers between equity holders and creditors, and are there any unintended consequences from the new rules?
Academic interest in the implications of a TBTF guaranty really began in 1984 when the US Comptroller of the Currency testified before Congress that 11 US banks were “too big to fail,” and that the government would provide them total deposit insurance. The biggest challenge in banking industry studies that try to use regulatory announcements to tease out the value of a TBTF guaranty is adequately accounting for the effects of assumed government support that were likely already embedded into investor expectations and management behavior before any announcements. Nevertheless, prior studies have generally concluded that the benefits of a TBTF guaranty outweigh the costs.
Before the AIG bailout, no national government had ever bailed out a large, national insurance firm. As a result, it is likely that investors and insurance firm managers did not believe that the TBTF guaranty extended to insurance firms. Thus, we are presented with an opportunity to more cleanly measure investor expectations of the full effects of a TBTF guaranty than was the case with banking. Moreover, we can examine the effects in a setting where regulators are explicitly imposing rules to try to limit the moral hazard effects of the guaranty.
We conduct an event study that calculates abnormal equity returns around 8 G-SII-related announcements that begin with the AIG bail-out and end with the final, formal announcement of the G-SII firms. Over these announcements, we document an average abnormal equity return of 11.7%, corresponding to a net increase in market capitalization of US$17.2 billion. Despite the enhanced supervision and compliance costs, investors still perceive the TBTF benefits to outweigh the costs. Similar to the results in banking studies, we show that the abnormal returns are positively related to firm measures of risk – i.e. the riskiest firms benefit the most.
We conduct parallel event studies on firm CDS spreads, bond returns, and implied assets risk from option prices. We find no evidence that, on average, default probability perceptions drop, but do find that bond returns fall 2.5%, suggesting investors expect bond holders to bear at least some of the costs of the new regime, and that perceived asset risk rises approximately 15%, consistent with the moral hazard effects of the guaranty.
We also conduct a similar analysis on a natural comparison set: other large insurance firms from the same countries. While these firms provide a benchmark, interpretation of different responses is complicated by the fact that the new regulatory regime could also affect them. Indeed, across the 8 regulatory announcements, we find no significant average abnormal financial asset price movements for these firms. However, the cross section of price responses suggests that investors do expect the new regulatory regime to affect these firms. We find that default probabilities rise the most for the riskiest firms, bond prices fall the most for the riskiest firms, and implied asset risk falls the most for the riskiest firms. These changes are consistent with investors expecting these other large insurance firms to fall outside the TBTF umbrella.
Finally, we find evidence that the value of the TBTF guaranty varies systematically with the quality of each country’s insurance regulations, measured as how well the country has adopted the International Association of Insurance Supervisors insurance core regulatory principles. The value of the TBTF promise is strongest in the relatively weak institution countries.
In sum, we find that investors view the TBTF guaranty as providing more benefits than costs, despite increased compliance requirements. We also find that investors incorporate their beliefs about these benefits and costs into financial asset prices early in the discussions about the design of the new regulatory system, in this case as much as one year prior to the revelation of the designated firms.
The preceding post comes to us from Kathryn L. Dewenter, Associate Professor of Finance at University of Washington – Michael G. Foster School of Business and Leigh A. Riddick, Associate Professor at Department of Finance and Real Estate, American University – Kogod School of Business. It is based on their article, which is entitled “What’s the Value of a TBTF Guaranty? Evidence from the G-SII Designation for Insurance Companies” and available here.