Illustration: Lazaro Gamio/Axios

The most likely cause of a future financial crisis isn't the banks, it's the non-banks. They're enormous, they're much less regulated than banks are, and they tend to have much greater leverage.

Flashback: Never forget that when the U.S. financial system fell apart in September 2008, the bank (Lehman Brothers) was deemed small enough to fail. It was the insurance company (AIG) that was too big to fail and needed a $182 billion government bailout.

  • Today, the most systemically dangerous non-bank in America is Prudential, the insurance company. Prudential remained on Treasury's "too big to fail" list of systemically-important financial institutions even after all the other non-banks fell off it: GE Capital, AIG, MetLife.
  • Now, even Prudential is officially considered no longer systemically dangerous. The Financial Stability Oversight Council, under the leadership of Treasury Secretary Steven Mnuchin, has officially removed the insurer from the list.
  • "We are pleased with this decision, which affirms our longstanding belief that Prudential never met the standard for designation," said Prudential in a statement. "Prudential’s approach resulted in the Council’s appropriate conclusion that Prudential does not pose systemic risk."

The official explanation for why Prudential fell off the list is not very helpful, since a lot of important numbers have been redacted. But the numbers that remain are scarily large.

  • Prudential is not huge by conventional stock-market standards: Its market capitalization is just $42 billion, and its book value (assets minus liabilities) is $48 billion.
  • But those assets and liabilities are truly enormous: According to the FSOC report, Prudential has $832 billion of assets, and $778 billion of liabilities. Compare its rival Berkshire Hathaway, which has $702 billion in assets but a much more modest $350 billion in liabilities.
  • Prudential also has an eye-popping $1.4 trillion in financial assets under management.
  • The biggest number of all: Prudential has $3.7 trillion of life insurance. That's about 20% of U.S. GDP.

The weirdest part about the FSOC's decision is that they all but say explicitly that Prudential is systemically important. A couple of quotes:

"The Council therefore determined that the negative effects of Prudential’s material financial distress could be transmitted to other financial firms and markets through the exposure channel, which could cause an impairment of financial intermediation or financial market functioning sufficiently severe to impose significant damage on the broader economy.
The Council concluded that such a forced liquidation of assets could cause significant disruptions to key markets, including corporate debt and asset-backed securities markets, particularly during a period of overall stress in the financial services industry and in a weak macroeconomic environment."

Why it matters: Expect further migration of risk from banks to non-banks now that the FSOC has made it clear that it has no interest in regulating the latter.

Insurance companies are regulated primarily at the state level — which, in Prudential's case, means New Jersey. They're also inherently extremely dangerous.

  • Prudential's entire market capitalization could be wiped out with $42 billion of unexpected losses on its life insurance portfolio. That's just 1.1% of its portfolio.
  • Can such a thing happen? Yes. Look at the number of healthy men, in their prime earning years, who dropped dead during the AIDS epidemic of the 1990s. Most of those men didn't have life insurance. But if they had, a lot of insurers would have become insolvent.

If a large unexpected mortality event saddled Prudential with a lot of claims, its massive life-insurance claims would only be the beginning of its — and the country's — problems.

  • Millions of policyholders would start moving their life insurance somewhere more stable, precipitating the insurance equivalent of a run on the bank.

The bottom line: Prudential could be forced to start liquidating its assets at fire-sale prices, which could set off a chain reaction in the rest of the financial markets and even the economy as a whole.

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