One big reason the global financial system nearly collapsed in 2008 was banks relying on insurance-like instruments. They’re at it again.

 Buying insurance is no substitute for loss-absorbing equity.

The foundation of a resilient financial system is simple: Require banks to have ample equity, the ultimate all-purpose capital.

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). 

Before the 2008 crisis, they did so in part by buying inexpensive loss insurance from third parties, notably American International Group AIG.

This time around, the name has changed — the insurance is now called synthetic (or significant) risk transfer — but the basic idea hasn’t. 

Bloomberg editorial 25 March 2024

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The Financial Stability Board, comprised of the world’s top finance ministers, central bankers and regulators, warned that some hedge funds had “very high levels of synthetic leverage”.

In 2008, financial panic here at home took down, in succession, Countrywide Financial, Bear Stearns, Fannie Mae, Freddie Mac, Merrill Lynch, Lehman Brothers, AIG, and Washington Mutual.

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