The Return of the Regulators

The sudden banking crisis will usher in an era of stiffer regulation and may even slow the Fed's attack on inflation while lowering investment returns.

Two men at work

That whoosh you felt coming out of Silicon Valley on Friday and then out of Washington, DC, on Monday was the wind shifting on regulation. And you can expect the wind to keep blowing in the direction of stricter regulation for quite some time, likely years.

The collapse of Silicon Valley Bank could also cause the Fed to slow its aggressive raising of interest rates, which would complicate life for insurers. Their investment portfolios have been benefiting from the higher rates, and they've seen the increases in costs, such as for replacement parts, moderate as the Fed attacked inflation. Any change in interest rate policy could slow or even reverse those recent gains. 

I should note up front that the regulatory backlash to the banking crisis may not affect insurers directly. Sean Kevelighan, CEO of the Insurance Information Institute, told me: "I doubt insurance will get wrapped into any of this. The insurance industry has worked hard since the crisis of '08/'09 to help better inform policy makers about the different model that is insurance, and why, because it’s built more on long-term capital trajectories, there is little to no likelihood of 'runs.' Nonetheless, we will be keeping a close eye on things to ensure there are no misperceptions."

I hope he's right, but I still wanted to call attention to the change in regulatory climate, because history suggests that, when one occurs, it's profound and long-lasting. 

The stock market crash in 1929 led to the Glass-Steagall Act and decades of strict regulation of banks. The Enron and WorldCom scandals in the early 2000s led to Sarbanes-Oxley and much tighter reporting requirements for businesses. The Great Recession of 2008 and 2009 led to stricter controls on financial institutions, including insurers, via Dodd-Frank. 

We seemed to be headed toward a tougher regulatory environment even before banks started failing. The derailment in East Palestine, Ohio, raised all sorts of calls for heightened regulation of trains, even from some members of the Republican party, which has for so long been pro-business and anti-regulation but which has headed in a more populist direction in recent years.

Newly elected Sen. J.D. Vance (R-Ohio) criticized “people who seem to think that any public safety enhancements for the rail industry is somehow a violation of the free market. Well, if you look at this industry and what's happened the last 30 years, that argument is a farce. This is an industry that enjoys special subsidies that almost no industry enjoys.”

Now, we not only have banks failing but have what looks like a total mess at SVB. During the Trump administration, it lobbied hard for and won exemption from the sort of regulatory scrutiny that Dodd-Frank established for the biggest banks and that looks like it could have prevented the bank's collapse. Democrats are already pouncing--for example, here is Sen. Elizabeth Warren (D-Mass.) writing an "I told you so" column in the New York Times. For good measure, SVB executives were paying themselves and their employees bonuses on Friday, just hours before the FDIC took over the bank.

While, as Sean says, insurers have a different business model than banks, the mess that is the homeowners insurance market in Florida has been getting national attention. And the Washington Post just led the paper with a major investigation into what it says is insurers cheating customers in the aftermath of Hurricane Ian. That's the sort of story that has prize potential written all over it, and we're still early in the year, so I'd expect the Post to lean into that story several more times as 2023 progresses. (Major prizes are awarded based on work during a calendar year.)

Because insurers are regulated primarily by states, even a major shift in attitude in Washington wouldn't necessarily affect our industry. But I still think it's worth being aware that, while the pendulum swung hard away from regulation during the Trump administration, it seems likely to swing just as hard in the other direction now. 

In any case, the bank failures may cause the Fed to at least slow its increases in interest rates, given that SVB collapsed because management somehow missed all the signals that interest rates were going to rise quickly. The worry is that continuing the rapid increases could expose other vulnerabilities in the U.S. financial system, as this Washington Post article explains in detail. 

It's not clear, at least to me, how much slowing the increases would diminish the attack on inflation. In a conversation I had recently with Michel Leonard, the chief economist at the Triple-I, he made an interesting point on the topic. He said that raising interest rates diminishes demand, which is why higher rates are the typical means for attacking inflation--but said today's inflation is driven by lack of supply, which high interest rates do nothing to address.

He cited supply chain disruptions, mostly because of COVID but also because the Russian invasion of Ukraine and broad geopolitical tensions are leading to "reshoring" and forcing supply chains to be reimagined. He also cited the disruption to oil and gas supplies and the lack of access to Ukraine's normally bountiful grain harvests for creating key shortages that raising interest rates won't ameliorate. (I'll share the transcript of our conversation here when it becomes available, likely in the next day or two.)

But the Fed certainly thinks that the fight against inflation would suffer if it has to slow interest rate increases. In any case, lower rates would decrease returns on insurers' massive investment portfolios. 

Just when it seemed inflation might be settling down, with job creation still robust, we seem to be back in that old Ray Charles song: "If it wasn't for bad luck, I wouldn't have no luck at all...."