Remarks of New York Superintendent of Financial Services Benjamin M. Lawsky at the 22nd Annual Hyman P. Minsky Conference on the State of the U.S. and World Economies in New York City
April 18, 2013
I am deeply honored to have the opportunity to address you today. This year’s conference has brought together an impressive list of speakers and panelists and I’m sure the discussions and speeches during this three-day conference will provide valuable insights on improving the state of our global economy.
I very much appreciate Dimitri Papadimitriou’s introductory remarks and the opportunity to address the members of this conference.
Also, it is important to recognize the Levy Institute at Bard College and the Ford Foundation for hosting this conference.
The theme of what I want to talk with you about today, “Regulating in an Evolving Financial Landscape,” speaks to a unique set of challenges that we now face together as financial regulators and as a country.
In the wake of a devastating financial crisis, lawmakers, regulators, the financial industry, consumer advocates, and a wide range of other stakeholders are building the new architecture of a reformed Wall Street.
That’s a dynamic, ongoing process.
As you well know, it didn’t end the day – three years ago, on July 21, 2010 – when the President signed Dodd-Frank into law.
Through Dodd-Frank, the President and Congress provided regulators in Washington with a robust framework for reform. But they left the specific contours of those new rules of the road up to a set of federal agencies writing regulations on matters as diverse as the Volcker Rule, living wills, orderly liquidation authority, risk retention, qualified residential mortgages – and a whole long list of other terms and acronyms that were foreign to us only a few short years ago.
While regulators in Washington have made important progress implementing those critical reforms – the rules of the road are still not yet fully written.
And, of course, even when the ink is dry on every last regulation, there will remain – as there always is – a constant push and pull between regulators and the financial industry as market participants adjust to the new rules of the road.
Regulators need to remain vigilant. Because there is a constant danger that putting a thumb in the dyke in one part of the financial system will cause a leak to spring somewhere else.
A danger that well-intentioned reforms could push risk to ever-darker corners of the financial system. To financial products not yet envisioned by even the most far-sighted of regulators.
The lure of potential profits is too great. And the dynamism of the global economy is too strong, for the financial system to stand frozen in time.
This is not to say – as some suggest – that the art of financial regulation is a futile endeavor. That we should resign ourselves to a financial system that forever careens from crisis to crisis.
Far from it.
It just means that we should approach the constantly evolving landscape of the financial sector with a deep sense of humility about the capacity of any one set of reforms or safeguards to permanently preserve the stability of our kinetic, frenetic global financial system.
And this deep sense of humility shouldn’t fade with the passage of time – when the 2008-09 financial crisis becomes a page in the history books rather than a fresh wound.
To be sure, Dodd-Frank represents the most far-reaching set of reforms to our financial system since the Great Depression.
But we can’t become complacent.
And one critical part of avoiding that fate – avoiding complacency – is what I will call “healthy competition in financial regulation.”
A dose of healthy competition among regulators is helpful and necessary to safeguarding the stability of our nation’s financial system. Not just today – but for the long term.
Healthy Competition in Financial Regulation
So what do I mean by healthy competition in financial regulation?
It’s not so dissimilar to what economists talk about when they discuss healthy competition in the broader economy.
Or what Supreme Court Justice Louis Brandeis meant when he called the states “laboratories” of democracy during the Progressive Era.
The New York State Department of Financial Services – or DFS as we like to call it – was recently created through the merger of two existing state agencies with long histories: the New York State Banking Department (which was founded in 1851) and the New York State Insurance Department (which was established in 1859).
However, DFS – in its current, unified structure – is only about eighteen months old. So, in many ways, we’re the new regulator on the block.
The Federal Reserve has been around for about a century. The FDIC has been protecting depositors since the Great Depression. And the U.S. Treasury Department has served a vital role in managing our nation’s finances since the founding of our republic.
At DFS, we’re fortunate to work with federal partners who have a deep well of institutional knowledge and expertise – which complements our own.
We’ve collaborated with our federal partners closely and cooperatively on a number of issues of common interest.
Moreover, at DFS, like our other regulatory partners, we have a commitment to thorough, thoughtful, diligent work.
But we also have another key attribute at DFS.
We’re nimble. And we’re agile. And we’re able to take a fresh look at issues across the financial industry – both new and old.
Sometimes financial regulators find that moving in a new direction is akin to turning a battleship in a bathtub. Institutional inertia can stymie even the most well-intentioned of watchdogs.
But as a newly created regulator, DFS isn’t necessarily wedded to existing ways of doing business.
Indeed, similar to the example of the broader economy, when there’s a new entrant into the marketplace, it often spurs others to reexamine existing processes and practices. To innovate.
At DFS, we can shine a spotlight wherever we think it needs shining.
When banks are engaging in practices that threaten our country’s financial stability and national security – we can take swift action.
When consumers are being abused – we can move rapidly to right those wrongs.
Sometimes, that means DFS may be out in the lead on a particular issue.
But I think that’s healthy. Not only for the financial regulatory community, but for the long-term strength of the financial industry and our nation’s economy.
Problems with Unhealthy Competition
Indeed, it may also be helpful to define healthy competition in opposition to the type of unhealthy competition that we saw during the lead up to the financial crisis.
When the system turned on its head and the debate turned to who could water down standards the most.
Who could provide the “lightest touch” regulation at the firms they oversaw.
In many ways, this created a race to the bottom in which both regulators and Wall Street firms were willing participants.
At DFS, we hope our activism at the state level will at least sometimes do the reverse and spur a race to the top.
Now, some people claim that being a strong and independent regulator is at odds with the goals of promoting economic growth and job creation.
That you have to be a laid back or passive regulator to be pro-growth and pro-business.
We fundamentally disagree.
When Governor Cuomo – who himself played a vital role as a financial watchdog when he was Attorney General – proposed creating DFS, he gave us a clear mission.
He wanted the industries DFS regulates – banking and insurance – to thrive. He wanted to keep New York the financial capital of the world.
And he also wanted to protect consumers and investors better than ever before by using all the tools in our tool-belt.
Those two goals can fit together. They are not mutually exclusive.
When consumers, entrepreneurs, and investors have confidence in the integrity – the safety and the soundness – of their banks and insurers. When they know they’re getting a fair deal. They’ll do more business here.
That’s better for the long-term health of the financial industry and our economy. And it is certainly better for the long-term health of our system to prevent future crises through smart and active regulation.
And it’s certainly not pro-business to regulate so lightly that we run the risk of another meltdown.
With that in mind, I wanted to discuss a couple recent examples of DFS actions that we hope will play an important, constructive role in strengthening the long-term health of the financial system: First, a corner of the insurance industry called ‘force-placed insurance.” And second, anti-money laundering enforcement.
Additionally, I wanted to highlight a few other areas in financial regulation that DFS is taking a hard look at right now – where healthy competition may play a vital role going forward. Those include: (1) conflicts of interest in the consulting industry; and (2) the troubling role private equity firms are playing in insurance markets.
Let’s start with force-placed insurance.
In October 2011, the New York State Department of Financial Services launched an investigation into the force-placed insurance industry.
Force-placed insurance is insurance taken out by a bank – on behalf of the homeowner – when a homeowner does not maintain the insurance required by the terms of a mortgage.
This occurs most frequently when a homeowner allows their policy to lapse – usually due to financial hardship.
So, these are folks who are already teetering on the edge of financial disaster.
And, as the name implies, the insurance is forced upon them.
Now, in certain circumstances, this makes sense because the mortgage holder has a right to protect their collateral. (In this case, the house.)
But when we conducted our investigation, we found that there was very little competition and very high rates in the force-placed insurance industry.
Sometimes when a homeowner who was already in financial trouble got ‘force-placed’ into an insurance policy their rate jumped 2 to 10 times higher – despite the fact that force-placed insurance provides far less protection for homeowners than voluntary insurance.
Our investigation looked at why this was happening.
Normally, you’d expect that the bank would do what any of us would do when they shop something. That they’d look for the best product at the lowest price.
What we found is that the banks and the insurers had set up what is essentially a form of reverse competition.
Banks were looking for high prices and high premiums. And they were happy to pay them.
Why? Because a good portion of the premiums were being funneled back to the banks in the form of commissions.
All of this, mind you, at the expense of homeowners and investors, who ultimately got stuck with the bill.
In May, we held public hearings where we brought the industry and homeowners to testify. And that hearing – along with our broader investigation – really tore the cover off this issue.
DFS’s investigation has already produced a recent, major settlement with the country’s largest force-placed insurer: Assurant.
Assurant controls 70 percent of the market in New York.
That settlement includes restitution for homeowners who were harmed, a $14 million penalty paid to the State of New York, and industry-leading reforms that will save homeowners, taxpayers, and investors millions of dollars going forward through lower rates.
Indeed, through those reforms, we’re banning the type of practices that drove premiums sky-high.
We’re kicking the kick-backs out of this industry.
Today, we announced an additional settlement with the nation’s second-largest force-placed insurer, QBE, which that includes a $10 million penalty, restitution for homeowners, and New York’s industry-leading reforms. Now, companies representing more than 90 percent of this market in New York have signed onto our reforms.
When DFS began its investigation, force-placed insurance wasn’t an area to which many regulators were paying close attention.
It was essentially a dirty little secret in the insurance industry.
But that’s started to change – at least in part – because DFS has pushed very hard on this issue.
Soon after DFS announced its settlement with Assurant, the Federal Housing Finance Agency, which regulates mortgage giants Fannie Mae and Freddie Mac, followed our actions by filing a notice to ban the lucrative fees and commissions paid by insurers to banks on force-placed insurance.
To spur further action, DFS also recently urged other state regulators to use our settlement with Assurant as a national model. Every regulator should be asking, “If you can clean up things in New York, why can’t you clean it up nationwide.
We’ve received a good response from a number of states so far. But the proof will be in the pudding.
If other states follow through, it will help end the kickback culture that has pervaded this industry and hurt far too many homeowners and investors.
Anti-Money Laundering Enforcement
Another area where I think DFS has begun to play an important and constructive role is anti-money laundering – which is so vital to our country’s national security.
This was an area where we felt that, at times, the industry and our regulatory structures had gotten used to a certain playing field. A certain silently acknowledged level of consequences tied to a certain quantum of illegal and immoral behavior.
And we felt that this was serious, serious conduct justifying more potent action. And we wanted the banking industry to take it a lot more seriously given the threat it posed not only to our financial system, but to our national security.
Banks were sometimes effectively serving as financial conduits for terrorists, other enemies of our country, and perpetrators of some of the most vile human rights abuses anywhere on earth.
DFS took action against a particular bank last summer.
We felt like it was the right thing to do.
And we did it based on the facts and the law.
Our investigation uncovered that the bank had hidden from U.S. and other regulators roughly 60,000 secret transactions involving at least $250 billion – reaping the company hundreds of millions of dollars in fees.
This conduct had left the U.S. financial system vulnerable and deprived law enforcement investigators of crucial information used to track all manner of criminal activity, including terrorism.
New York ended up securing a $340 million settlement and a set of reforms to help put a stop to this behavior.
Initially, there was what we believed to be a misplaced focus on the fact that DFS had acted more quickly, more robustly, and more independently than some people were used to from a state banking regulator.
That focus was misplaced because it distracted everyone from the very real issues at stake when it comes to international money laundering on a massive scale for nations like Iran.
Ultimately, though, we certainly stimulated a debate nationally and internationally on this issue.
And, more importantly, I think we started an alteration or, better yet, a recalibration of the regulatory playing field going forward in this area.
Now, you’re seeing more robust action taken – at both the state and federal level – to root out this type of illegal money-laundering
That’s good for our national security. And it’s good for the integrity – and the safety and soundness – of the broader financial industry.
And it was driven in part by the sort of healthy competition I mentioned earlier.
Now let me turn to a new set of issues on which DFS is very focused right now. And where we hope, again, to play an essential role in the weeks and months ahead.
The independence and integrity of monitors and independent consultants is another area of vital concern to DFS.
These consultants are installed at banks and other companies usually after an institution has committed serious regulatory violations or broken the law. The intent is that monitors assist companies in improving controls and ensuring that violations do not reoccur.
All too often, however, the outcome of a monitorship is disappointing, as we recently saw in the context of the national mortgage reviews. This can be blamed on a number of factors, but it is worth considering that our current system significantly undermines the independence of the monitors—the monitors are hired by the banks, they’re embedded physically at the banks, they are paid by the banks, and they depend on the banks for future business.
If the monitors or consultants are simply puppets of the big banks that pay their fees – rather than independent voices – then their work-product can hardly be deemed reliable.
There is also insufficient communication between monitors and regulators. Frequently, monitors never hear from regulators once they are put in place at a bank. This is a problem we can and must fix.
It’s largely about “managing the monitors” and that is up to regulators. There need to be regular meetings between regulators and monitors. Expectations must be set. Weekly updates on progress should be happening.
A good monitor can truly improve a troubled company when there is a problem, but an ineffective monitor can make the situation much worse by creating a false sense of security in the regulator and the public.
At DFS, we have already instituted a more robust process in the selection of monitors, and we will be pushing more broadly for change in the dynamics between regulators, monitors, and institutions.
You will likely be seeing some innovative initiatives from DFS in this area in the coming weeks and months. And we expect that those actions will help propel reform at both the state and federal levels.
One very important question we all need to be asking is when monitors or consultants perform poorly or, worse, when they intentionally obscure problems at banks: What should the consequences be? Because if we allow intentional conduct aimed at quietly sweeping problems at banks under the rug, we are truly undermining our whole system of prudential regulation. At some point, we must take action that has real consequences or the problems in our system will continue to be perpetuated rather than deterred.
Private Equity Buying Annuity Companies
I’d now like to turn to an emerging trend in the insurance industry that DFS has become concerned about.
Private equity firms are becoming active in the acquisition of insurance companies. In the last few years, private equity firms have been targeting fixed and indexed annuity writers.
For those who are unfamiliar with annuity companies -- they sell insurance products that essentially promise a certain payment every year or month (whatever the terms of the policy may be) over a particular period of time.
If you look at the deals completed or announced to date, private equity-controlled insurers now account for nearly 30 percent of the indexed annuity market (up from 7 percent a year ago) and 15 percent of the total fixed annuity market (up from 4 percent a year ago).
These are large numbers, and they indicate a very rapid growth in market share. As you may expect, that’s driving DFS to take a close look at these transactions and these firms – to ensure that the safety and soundness of these companies and consumers both remain protected.
Now, as you probably know, annuities are very popular products that a significant number of Americans rely on to help finance their retirements.
The risk that we’re concerned about at DFS is whether these private equity firms are more short-term focused – when this is a business that’s all about the long haul.
That their focus is on maximizing their immediate financial returns, rather than ensuring that promised retirement benefits are there at the end of the day for policyholders.
And – because of their potential short-term focus – there is a risk that these companies may not be delivering the level of compliance and customer service that we’d expect of them given the importance of this product to so many seniors on fixed incomes.
There can be exceptions, but generally private equity firms follow a model of aggressive risk-taking and high leverage, typically making high-risk investments. If just a few of these investments work out, then the firm can be very successful – and the failed ventures are just viewed as a cost of doing business.
This type of business model isn’t necessarily a natural fit for the insurance business, where a failure can put policyholders at significant risk.
Private equity firms typically manage their investments with a much shorter time horizon -- for example, 3-5 years -- than is typically required for prudent insurance company management. They may not be long term players in the insurance industry and their short-term focus may result in an incentive to increase investment risk and leverage in order to boost short-term returns.
Now, at DFS, we regulate both banks and insurance companies. And the differences between these two industries are quite striking when it comes to private equity investments.
Private equity firms rarely acquire control of banks, not because they are prohibited from doing so, but because the regulatory requirements associated with such acquisitions are more stringent than a private equity firm may like. These regulatory requirements in the banking industry are designed – in part – to encourage a long-term outlook, and ensure that the person controlling the company has real skin in the game.
The long term nature of the life insurance business raises similar issues, yet under current regulations it is less burdensome for a private equity firm to acquire an insurer than a bank.
We need to ask ourselves whether we need to modernize our regulations to deal with this emerging trend to protect retirees and to protect the financial system.
This is an area that not too many regulators are looking at. But it’s one where DFS is moving to ramp up its activity.
And we hope that other regulators will soon follow suit.
Another area that we’re hard at work on relates to the use of what are called captive insurance companies, used to quietly off-load risk and increase leverage at some of the world’s largest financial firms.
In July 2012, the New York State Department of Financial Services initiated a serious investigation into this somewhat obscure area that – we believe – could put insurance policyholders and taxpayers at greater risk.
Insurance companies use these captives to shift blocks of insurance policy claims to special entities – often in states outside where the companies are based, or else offshore (e.g., the Cayman Islands) – in order to take advantage of looser reserve and oversight requirements. (Reserves are funds that insurers set aside to pay policyholder claims.)
In a typical transaction, an insurance company creates a “captive” insurance subsidiary, which is essentially a shell company owned by the insurer’s parent. The company then “reinsures” a block of existing policy claims through the shell company – and diverts the reserves that it had previously set aside to pay policyholders to other purposes, since the reserve requirements for the captive shell company are typically lower. (Sometimes the parent company even effectively pays a commission to itself from the shell company when the transaction is complete.)
However, this financial alchemy, let’s call it ‘shadow insurance,’ does not actually transfer the risk for those insurance policies off the parent company’s books, because in many instances, the parent company is ultimately still on the hook for paying claims if the shell company’s weaker reserves are exhausted (“a parental guarantee”).
That means that when the time finally comes for a policyholder to collect their promised benefits after years of paying premiums – such as when there is a death in their family – there is a smaller reserve buffer available at the insurance company to ensure that the policyholders receive the benefits to which they are legally entitled.
We believe that shadow insurance also puts the stability of the broader financial system at greater risk. Indeed, in a number of ways, shadow insurance is reminiscent of certain practices used in the run-up to the financial crisis, such as issuing subprime mortgage-backed securities (MBS) through structured investment vehicles (“SIVs”) and writing credit default swaps on higher-risk MBS. Those practices were used to water down capital buffers, as well as temporarily boost quarterly profits and stock prices at numerous financial institutions. And ultimately, those practices left those very same companies on the hook for hundreds of billions of dollars in losses from risks hidden in the shadows, and led to a multi-trillion dollar taxpayer bailout.
Similarly, shadow insurance could leave insurance companies less able to deal with losses. The events at AIG’s Financial Products unit in the lead up to the financial crisis demonstrate that regulators must remain vigilant about potential threats lurking in unexpected business lines and at more weakly capitalized subsidiaries within a holding company system.
We are hard at work on our continuing investigation into shadow insurance. And we hope to shed light on and further stimulate a national debate on this important issue to our financial system.
Now, I've highlighted a number of areas where DFS has taken a leadership role and sought to push reform.
But the role of state regulators can and should vary based on the particular context.
It really comes down to a question of federalism – the relationship between the states and the federal government.
What I will call collaborative or cooperative federalism is usually the best kind of federalism. When we work closely and together and symbiotically with our federal partners.
A great example of this is what DFS has been doing to partner with the Consumer Financial Protection Bureau (CFPB) in the areas of debt collectors and payday lending.
In other areas, where there has been less focus on a particular issue at the federal level, a form of persuasive federalism sometimes emerges – where the state tries to lead by example and stimulate national reform. DFS’s work in the force-placed insurance industry is a great example.
On the far end of the spectrum is what I’ll call, for lack of a better term, coercive federalism.
Coercive federalism should be rare. But sometimes it’s necessary. Sometimes a state must act alone to change the rules of the game. DFS’s work on anti-money-laundering enforcement is a good example here.
Now, I listed three types of federalism. But if I had to give them an overarching label, I would call DFS’s overall approach going forward catalytic federalism.
We will continue to evaluate the appropriate role of the state regulator on an issue by issue basis, depending on the context.
As I noted at the beginning of the speech, we inhabit a constantly evolving financial ecosystem. And we will remain nimble and agile as we attempt to affect change wherever our ever-changing markets need that stimulus.
Change is good. And a robust marketplace of ideas among financial regulators is a key strength of our system.
Indeed, our federal regulators are leading on a number of important issues.
Today, the Federal Reserve and Treasury – for example – are leading the charge on two areas of vital concern to long-term financial stability: money market reform and addressing potential sources of risk in the tri-party repo market.
The SEC – together with its law enforcement partners – has fought hard to crack down on insider trading. And the SEC is also working to modernize investor disclosures in an era of Twitter, Facebook, and other social media products that didn’t even exist a decade ago.
The Commodities Futures Trading Commission (CFTC) has taken a leadership role in cracking down on past abuses in LIBOR and proposing future reforms so that they don’t happen again.
The CFPB – led by Richard Cordray, who is just one of the bright, shining stars of the Obama Administration – has staked out new ground in the fight to arm families with the clear, concise information they need to make the financial choices that are best for them.
In recent years, the FDIC has really been ahead of the curve on the issues of providing relief to struggling homeowners and ensuring banks have the capital they need to withstand unexpected financial shocks and losses.
The critical point is that through healthy competition – in this marketplace of ideas – the best ideas will hopefully rise to the top.
That the ideas that withstand the informed scrutiny of fellow regulators, the media, the public, and other stakeholders will one day win out. (Even if it’s not today.) And that those ideas come out better for being battle tested.
I think our financial system, our economy, and our country will ultimately be better for it. When regulators speak their mind, say their peace, and engage in a vigorous debate through healthy competition.
Thank you. And I look forward to taking your questions.