One big reason the global financial system nearly collapsed in 2008 was that banks had shifted risks into the shadows, relying on insurance-like instruments that proved incapable of absorbing losses.
They’re at it again. It’s a trend that officials should discourage, not endorse.
The foundation of a resilient financial system is simple: Require banks to have ample equity, the ultimate all-purpose capital. Contrary to popular belief, equity isn’t a reserve that must be set aside. It’s upfront funding from shareholders, money to invest. Unlike debt, it absorbs losses automatically, allowing banks to inspire confidence even when the unexpected happens.
Banks typically operate with as little equity as possible, mostly for bad reasons. More debt, or leverage, boosts certain measures of profitability in good times (and magnifies losses in bad times). Also, raising equity can be relatively expensive, because the government subsidizes debt (via tax breaks and emergency backstops) and because many banks suffer from a persistent lack of investor confidence.
As a result, banks are always devising ways to get by with less. Before the 2008 crisis, they did so in part by buying inexpensive loss insurance from third parties, notably American International Group Inc. By reducing the measured risk of subprime mortgage securities, this reduced regulatory equity requirements. It of course didn’t end well. The actual losses overwhelmed the insurers, contributing to a broader meltdown that forced governments to bail out all the financial institutions involved.
This time around, the name has changed — the insurance is now called synthetic (or significant) risk transfer — but the basic idea hasn’t. Banks reduce their equity requirements by bundling corporate or consumer loans into securities, then purchasing partial protection against losses from third parties such as investment funds or insurers. By one estimate, the deals covered more than €43 billion in potential losses as of 2022. That’s mostly in Europe, though US banks have been ramping up their own risk-transfer deals.
