Prudential hasn't earned the right to shed SIFI label

Prudential is the last remaining “systemically important financial institution,” and most observers expect that it will shed that designation by the end of the year.

Prudential’s case for dedesignation, however, is far weaker than any of the three former SIFIs.

In response to the dramatic collapses of Lehman Brothers and Bear Stearns, Congress created the Financial Stability Oversight Council to identify lightly regulated nonbank companies whose failure could trigger another financial crisis. Exercising this authority, FSOC designated American International Group, GE Capital, MetLife and Prudential as SIFIs, subjecting them to consolidated regulation by the Federal Reserve.

Victor J. Blue/Bloomberg

Almost immediately, most of the SIFIs began shrinking and simplifying their balance sheets in an effort to escape Fed oversight. AIG and GE Capital each shrank by more than half from their pre-crisis peaks and substantially reduced their reliance on short-term funding. As a result, FSOC agreed to undo their designations and free them from heightened regulation. While MetLife successfully challenged its designation in court, it also shrunk, spinning off its $240 billion retail segment. FSOC, in turn, dropped its appeal of MetLife’s legal victory.

Yet in stark contrast to its peers, Prudential has neither shrunk nor substantially simplified itself.

To the contrary, Prudential has grown by more than $100 billion since its designation.

Meanwhile, Prudential’s interconnectedness with other financial companies has increased: Its notional derivatives exposures and repurchase agreements have each swelled by more than 30% since its designation. In sum, Prudential’s financial data certainly do not suggest that it has become less systemically important.

In order to warrant dedesignation, therefore, Prudential must convince FSOC that Federal Reserve oversight is unnecessary for some other reason.

One thing has changed since FSOC designated Prudential in 2013. The following year, Prudential’s home state of New Jersey adopted a new law authorizing the New Jersey Department of Banking and Insurance to supervise Prudential and other New Jersey-based insurance companies on a consolidated, groupwide basis. This unique policy represented a dramatic departure from traditional insurance regulation. The DOBI and other state insurance commissioners typically supervise only insurance subsidiaries located in their states, leaving top-tier insurance holding companies and their noninsurance affiliates largely unregulated.

In pleading its case to FSOC, Prudential will likely point to this new law as evidence that it does not pose a threat to the financial system. One of the factors that FSOC considers as part of its review process is the extent to which Prudential is subject to existing regulatory scrutiny. Prudential will argue that the DOBI is perfectly capable of overseeing Prudential’s groupwide activities and, therefore, continued Federal Reserve oversight would be superfluous.

Since Prudential’s case for dedesignation may hinge on this contention, it is worth evaluating whether the DOBI and the Federal Reserve are, in fact, equally qualified to supervise Prudential. Upon close examination, Prudential’s case for dedesignation is deeply flawed for four distinct reasons.

First, despite the New Jersey regulator’s new statutory authority, it still lacks the Federal Reserve’s powerful tools to regulate Prudential. Although New Jersey law authorizes the DOBI to supervise Prudential’s worldwide operations, the law does not clearly permit DOBI to regulate its groupwide activities. The Fed, by contrast, has undisputed authority to both supervise Prudential and establish rules regarding its capital, liquidity, stress tests and counterparty exposures.

Even if the New Jersey regulator were authorized to establish groupwide standards for Prudential, its supervisory objectives are considerably narrower than the Fed’s. The Dodd-Frank Act gives the Fed a broad mandate to protect the financial system from Prudential’s potential failure. By contrast, the DOBI’s sole objective is protecting Prudential’s policyholders, as is customary for a state insurance agency. The DOBI, therefore, has neither the regulatory power nor the supervisory mandate to limit Prudential’s systemic footprint.

Second, the New Jersey regulator has little incentive to supervise Prudential aggressively. Indeed, if Prudential were to fail, the costs of that failure would be borne, in large part, by counterparties outside of New Jersey to whom the DOBI is unaccountable. Moreover, if the DOBI were to impose onerous requirements on Prudential, the company could simply relocate to a different state with weaker standards. As Prudential’s only federal supervisor, the Fed is not susceptible to this regulatory race to the bottom.

Third, even if the DOBI had appropriate incentives to supervise Prudential, resource constraints would limit its effectiveness. Last year, the DOBI employed just 33 financial institution supervisors, with an examination budget of $4 million. The Fed, by comparison, employs hundreds of supervisors at its Washington headquarters and the Federal Reserve Bank of New York. Admittedly, the Fed’s personnel are spread over a larger number of institutions. With limited personnel and funding, however, the DOBI cannot match the Fed’s ability to inspect Prudential’s U.S. operations, let alone its significant activities in Japan, Korea and Brazil.

Finally, as a practical matter, the Fed’s leaders are eminently better qualified than the New Jersey Commissioner of Banking and Insurance to supervise a firm as large and complex as Prudential. The three sitting members of the Federal Reserve Board collectively have more than 20 years of experience overseeing multinational financial firms at both the Fed and Treasury Department. Newly appointed DOBI commissioner Marlene Caride, by contrast, is a former zoning board attorney whose only financial sector experience is three terms on the New Jersey General Assembly’s financial institutions committee.

All of this is not to say that the DOBI’s new legal authority to supervise Prudential on a groupwide basis is unwelcome. Indeed, the DOBI’s supervisory activities could be a meaningful complement to the Fed. However, the state agency’s oversight of Prudential suffers from serious limitations, and supervision by the DOBI is therefore not an appropriate substitute for the Fed.

In sum, Prudential’s case for SIFI dedesignation may turn on whether FSOC believes that Prudential is subject to sufficient scrutiny at the state level. It is not.

FSOC should insist that Prudential follow the lead of AIG, GE Capital and MetLife by substantially shrinking or simplifying itself to earn dedesignation. Until that happens, Prudential must remain a SIFI.