THE FINANCIAL CRISIS,SYSTEMIC RISK, AND THE

CTheJournalofRiskandInsurance,2009,Vol.76,No.4,785-819DOI:10.1111/j.1539-6975.2009.01330.xTHEFINANCIALCRISIS,SYSTEMICRISK,ANDTHEFUTUREOFINSURANCEREGULATIONScottE.HarringtonABSTRACTThisarticleconsiderstheroleofAmericanInternationalGroup(AIG)andtheinsurancesectorinthe2007–2009financialcrisisandtheimplicationsforinsuranceregulation.Followinganoverviewofthecausesofthecrisis,IexploretheeventsandpoliciesthatcontributedtofederalgovernmentinterventiontopreventbankruptcyofAIGandthescopeoffederalassistancetoAIG.Idiscusstheextenttowhichinsuranceingeneralposessystemicriskandwhetherasystemicriskregulatorisdesirableforinsurersorothernonbankfinancialinstitutions.Thelasttwosectionsofthearticleaddressthefinancialcrisis’simplicationsforproposedoptionaland/ormandatoryfederalcharteringandregulationofinsurersandforinsuranceregulationingeneral.INTRODUCTIONTheburstingofthehousingbubbleandresultingfinancialcrisishavebeenfollowedbytheworsteconomicslowdownsincetheearly1980sifnottheGreatDepression.Assubprimemortgagedefaultsrosein2007,theFederalDepositInsuranceCorpora-tion(FDIC)closeddownanumberofmajorsubprimelenders.TheFederalReserverescuedinvestmentbankBearStearnswitha$30billionguaranteetofacilitateitsacquisitionbyJ.P.MorganinMarch2008.September15–16,2008sawinvestmentbankLehmanBrothersfileforbankruptcy,thedistressedsaleofinvestmentbankMerrillLynchtoBankofAmerica,andtheannouncementofan$85billionfederalgovernmentbailoutofAmericanInternationalGroup(AIG).Congressenactedthe$700billionTroubledAssetReliefProgram(TARP)inOctober,whichwasfollowedbymassiveinfusionsofcapitalintonumerousbanks,includingtheninelargest,alongwithlargeguaranteesofbankdebt.OtherfederalinterventionsincludedhundredsofScottE.HarringtonistheAlanB.MillerProfessorofHealthCareManagementandInsuranceandRiskManagement,TheWhartonSchool,UniversityofPennsylvania.Hecanbecontactedviae-mail:financialsupport,RobertDetlefsenofNAMICforencouragingmetoundertakethisprojectandformanyhelpfulcomments,TerrieVaughanandMaryWeissforhelpfuladvice,andGeorgesDionne,theeditor.785786THEJOURNALOFRISKANDINSURANCEbillionsofdollarsofguaranteestosupportmoneymarketmutualfunds,commercialpaper,andnumerousasset-backedsecurities.Theunderlyingcausesofthefinancialcrisisandhowitwastransmittedacrossfirms,sectors,andborderswillbestudiedanddebatedforyears.Whateverthecauses,thecrisishasledtonumerousproposalsforchangesinfinancialregulation,includingtheproposedcreationofasystemicriskregulatorandexpandedfederalgovern-mentauthoritytoresolvefinanciallydistressednonbankinstitutions.Theproposedchangeshavebeenmotivatedinsignificantpartbythefinancialdistress,bailout,andquasi-nationalizationofAIG,formerlytheworld’slargestpubliclytradedinsuranceorganization.Inadditiontoprovidingimpetusforthecreationofasystemicriskregulatorandexpandedfederalauthoritytoresolvefinanciallydistressednonbankentities,proponentsoffederalcharteringandregulationofinsurersarguethattheAIGinterventionmakessomeformoffederalcharteringessential.ThisarticleconsiderstheroleofAIGandtheinsurancesectorinthefinancialcrisis,theextenttowhichinsuranceinvolvessystemicrisk,andtheimplicationsforinsuranceregulation.Ibeginwithabriefoverviewofthecausesofthefinancialcrisis.IthenexploretheeventsandpoliciesthatcontributedtotheAIGintervention.Thissynopsisisfollowedbyanelaborationofwhatconstitutessystemicriskandwhetherinsuranceingeneralposessystemicrisk.Idiscusswhetherasystemicriskregulatorisdesirableforinsurersorothernonbankfinancialinstitutions.Thelasttwosectionsaddresstheimplicationsofthecrisisforfederalcharteringandregulationofinsurersandforinsuranceregulationingeneral.CAUSESOFTHEFINANCIALCRISISWhilethevariedandcomplexcausesofthe2007–2009financialcrisiswillbestudiedanddebatedfordecades,thepopularmediahaveoftenfocusedonalleged“WallStreetgreed”and,toalesserextent,theallegedevilsoffinancial“deregulation.”Theearlyconsensusamongresearchersandpolicyanalystsisthatincentivecompensationarrangementsinthefinancialsectorcontributedtoaggressiverisktakinginresidentialmortgagesandrealestate,anditispossiblethatcertainrelaxationsinregulationplayedarole.Itisclearthatmanypartiesmadeaggressivebetsthathousingpriceswouldcontinuetoriseoratleastnotfall,contributingtothehousingpricebubbleandleadingtowidespreadfinancialdistresswhenthebubbleburst.Itisalsoclearthatanumberofgovernmentpolicyandregulatoryfailurescontributedtothecrisis.Whiletheirrelativeimportanceisdebatable,thefollowingfactorsallcontributedtothecrisis:1•Federalgovernmentpoliciesencouragedthegovernment-sponsoredenterprisesFannieMaeandFreddieMactoexpandrapidlythroughtheearly2000s,insig-nificantparttosupportlendingtolow-incomehomebuyers.TheCommunityReinvestmentActandpressurefromtheDepartmentofHousingandUrbanDe-velopmentsimilarlyencouragedcommercialbankstoexpandmortgagelendinginlow-income,minorityneighborhoods.1See,forexample,Taylor(2008),Blundell-Wignall,Atkinson,andLee(2008),Brunnermeier(2009),Schwarcz(2008),andWhite(2008).AlsoseeGorton(2008).THEFINANCIALCRISIS