Amidst the ongoing concerns surrounding American regional banks, the level of panic has somewhat subsided thanks to the Federal Deposit Insurance Corporation’s potential backstopping of the system, even if not legally mandated. However, a new issue has emerged, characterized by attrition.

Weaker banks are experiencing deposit outflows, witnessing rising funding costs, and grappling with deteriorating loans tied to commercial real estate and risky companies. This scenario points to the likelihood of further consolidation, which, while beneficial in the long run (considering the excessive number of over 4,000 banks in the United States), could result in short-term challenges.

While investors and American politicians closely monitor these banks, it’s crucial to direct our attention to another sector: life insurance. Although insurance companies have mostly stayed out of the headlines in recent months, it’s worth noting that these companies are typically considered stable entities due to their focus on long-term assets and liabilities. Logically, they should fare well in a rising interest rate environment since they hold significant portfolios of long-term bonds that are not frequently marked to market, allowing them to benefit from income gains without incurring losses.

However, the predictability of their balance sheets has slightly diminished at present. This isn’t a reason for investors to panic, but it does shed light on a larger problem: a decade of remarkably low interest rates has created distortions throughout the financial world, and it may take a considerable amount of time for these distortions to unwind. The attrition issue extends beyond the banks and is reflected in charts buried within the recently released financial stability report by the Federal Reserve. These charts reveal that insurance groups held around $2.25 trillion of assets classified as risky and/or illiquid, including commercial real estate or corporate loans, by the end of 2021 (the latest available data). This amount is almost double the level seen in 2008 and represents approximately one-third of their total assets. While this level of exposure is not unprecedented, as the proportion of risky assets had risen in recent years when life insurance companies pursued higher yields in a low-rate world, it was comparable to the levels observed just before the 2008 financial crisis. However, what stands out is the increasing reliance on what the Fed refers to as “non-traditional liabilities.” These include funding-agreement-backed securities, advances from the Federal Home Loan Bank, and cash obtained through repurchase agreements and securities lending transactions. Some of these deals provide investors with the option to withdraw funds on short notice. The extent of this mismatch is uncertain due to significant data gaps, as noted by the International Monetary Fund (IMF) in its recent report. For instance, “exposures to illiquid private credit exposures such as collateralized loan obligations can disguise the embedded leverage in these structured products.” In simpler terms, insurance companies may be more sensitive to credit losses than previously thought. However, the key point highlighted by the Federal Reserve is that “over the past decade, the liquidity of life insurers’ assets steadily declined, and the liquidity of their liabilities slowly increased.” This could potentially make it more challenging for life insurers to handle a sudden surge in claims or withdrawals. While insurance contracts are generally more stable than bank deposits, it’s worth noting that during the sector’s previous shock during the onset of the COVID-19 pandemic in 2020, it managed to avoid a crisis by quietly orchestrating a significant cash increase of $63.5 billion, as revealed by separate research conducted by the Federal Reserve. The exact details of this cash influx remain unclear since statutory filings do not provide specific information. However, income from derivative transactions played a role, with loans from the Federal Home Loan Bank system being the primary source. This highlights another crucial but often overlooked issue: it’s the mighty quasi-state entity, the Federal Home Loan

Bank, that is currently supporting many parts of the US finance industry rather than the regional banks. This reliance raises questions about the future, especially if funding sources retreat or if risky and illiquid assets become impaired, or perhaps both. The latter scenario seems highly likely, given that higher interest rates are already impacting commercial real estate and risky corporate loans. It’s important to reiterate that this is not a reason for panic as it is a slow-moving saga. A recent report from Barings indicates that “a record 26 percent of life insurers were in a negative interest rate management position” by the end of 2022, meaning they had paper losses on bonds. However, these losses don’t need to be realized unless the companies go bankrupt. Nevertheless, regulators need better data and stricter asset-liability matching standards. Although the US National Association of Insurance Commissioners is attempting to implement these measures, such as curbing insurers’ holdings of collateralized loan obligations (CLOs), it will take time. Therefore, effective liquidity management becomes critical in the current environment, as rising interest rates can contribute to insurer insolvency. Hence, it’s not only the US regional banks that face the risk of becoming victims of the deflating credit bubble in today’s landscape.