Efficient Risk Transfer Between Financial Institutions: Back to the - PowerPoint PPT Presentation

Efficient Risk Transfer Between Financial Institutions: Back to the future? Moody’s Analytics Tamar JOULIA-PARIS Practitioners Conference TJ Capital Chicago, October 2012 Senior Risk Advisor 1

Content Solvency 2 Basel 3 IFRS Economic Unintended downturn consequences Investor Deleveraging confidence Consumer Shadow confidence Banks Risk Transfers

Content Understanding the regulatory context for F inancial’s 1. Regulations for Banks & Insurers: similitudes, differences, impact  Next to regulatory reforms: Accounting reforms  The need to revive a robust risk 2. transfer market between F inancial’s Impact on Capital & Liquidity requirements  Impact on Risk Management  The case to facilitate lending risk transfers  Current initiatives and case for enabling investment 3. ECB European DataWarehouse (ED)  Legal Entity Identifier (LEI)  Prime Collateral Securities (PCS)  Registry of credit risk transfers (Credit Utility)  Conclusion 4. 3

1. Regulation for all Financials: Pillar 1 - Similitudes All Financials : Banks (B3), Insurers (S2), Fund managers, soon also shadow  banks 3 Pillars structure: Min Financial resources, governance, disclosure  Minimum Financial Resources : Capital for all Financials, plus Liquidity for banks  2 levels of Capital requirements :  Gone -Concern, for mandatory regulatory intervention  (CET 1 for Banks, MCR for Insurers) Going -Concern, for submission of a recovery plan  (Total Capital for Banks, SCR for Insurers) One year time horizon  2 capital formulae :  Standard formula and Stress Tests  Internal Models (if validated)  Etc  But regulations are entity-based, and not functional (activity-based): What about regulatory arbitrage ? 4

Basel 3 : RWA-based Capital, Liquidity,Leverage Increased amount & cost of capital, combined with additional cost of liquid assets & long term funding, make some banking products more expensive or reduce banks ROE More Less favorable favorable Low risk assets Financials, High risk Tier 1 Trading (mortgages, govt securitization, assets, re- ratio activities debt) wrong-way risk securitization Low risk assets, Leverage Central clearing High risk assets undrawn ratio of derivatives commitments LCR Cash, central bank Low risk Unsecured bank reserves, govt corporate and (short term bonds bonds covered bonds liquidity) Funding from Term deposits>1yr Stable savings Wholesale savings Financials NSFR (long term LT debt, high Low LTV High LTV Liquidity funding) quality bonds mortgages mortgages facilities “Both banks and financial regulation need to be simplified if another crisis is to be averted”, according to Andy Haldane, head of financial stability at the Bank of England (Telegraph, Aug 31, 2012) 5

Solvency 2 : A Value-Based Capital Both assets and liabilities should be valued at the level at which they could be transferred to a “knowledgeable willing party in an arm’s length transaction”. 2 levels of capital requirements:  . MCR = Minimum Capital Requirement (85% 1 yr, 25-45% of SCR) . SCR = Solvency Capital requirement (99.5% 1yr) A fair value principle-based approach, with recognition  of risk mitigation and of diversification (+/- 30%) A valuation of Assets different from accounting valuation  A distinction between hedgeable / non-hedgeable Liabilities : Technical Provisions =  the Best-Estimate , PV of the probability-weighted average future cash flows, plus  a Market Value Margin (MVM), calculated as the cost of providing funds equal to the SCR  to support the run-off of the liabilities. unless they can be replicated using financial instruments with observable market values. Capital requirements for Insurers will be more volatile 6

Last but not least…. Accounting changes for Financials Changing accounting regimes will impact differently banks and insurers: IAS 39 migrating to IFRS 9 for Financial Products probably in  2015 : Accounting in fair value (via P/L) or amortized cost, no accounting in Available for Sale (Value change accounted via Capital) anymore, IASB Exposure draft for accounting of Insurance Contracts :  migration from book value to fair value IASB Exposure Draft for accounting of impairments of assets at  amortized cost (ex: Loans) : from Incurred to Expected Losses Insurers: Higher earnings volatility (thereby also of available capital) , complexity due to differences in IFRS/ S2 valuations Banks: Lower earnings volatility, complexity due to differences in regulatory/accounting EL 7

Regulation for Banks and Insurers Main consequences on B/S management On Banks: Increased cost of holding a balance sheet, Loan retention discouraged: Extensive  deleveraging, affecting general economic recovery, Challenge of the bank’s maturity transformation role in the economy, through balance-  sheet intermediation (NSFR), Expensive reverse fragmentation for combined management of capital,  leverage & liquidity ratios across all business lines, Introduction of a new operational framework to optimize  balance-sheet and capital efficiency On Insurers: Restructuring Life Insurance, to increase risk sharing with policy holders,  Increased demand for re-insurance of tail non-life risks,  Asset Management to become a key part of Insurance businesses, Trend towards  purchasing shorter-term investment portfolios, more bonds & loans, Incentive for higher product diversification (int/ext) : Increased consolidation ,  More active ALM management : IR/spread and longevity derivatives, securitizations  As with banking, this requires a new operating framework to improve balance-sheet  optimization and capital efficiency 8 8

Content Understanding the regulatory context for financial’s 1. Regulations for Banks & Insurers: similitudes, differences, impact  Next to regulatory reforms: Accounting reforms  The need to revive a robust risk 2. transfer market between F inancial’s Impact on Capital & Liquidity requirements  Impact on Risk Management  The case to facilitate lending risk transfers  Current initiatives and case for enabling investment 3. ECB European DataWarehouse (ED)  Legal Entity Identifier (LEI)  Prime Collateral Securities (PCS)  Registry of credit risk transfers (Credit Utility)  Conclusion 4. 9

Regulation for all Financials: Impact on Capital Management Capital requirements increase for all Financials, but Cost of capital will differ between banks and insurers • Regulatory capital requirement for same risks will differ between banks • and insurers Geographic coverage of regulations differ (EU versus RoW), • Banking and Insurance entities within the same financial conglomerate • will be impacted very differently, Minimum SCR and eligible capital for Insurers will be more volatile than • minimum and eligible Capital for Banks Active balance-sheet management will be critical, to comply with regulations while adjusting business models and products for clients Unintended capital arbitrage will be considered: Insurers will probably develop banking products (mortgages, guarantees, • loans, credit protection, etc), Interconnectedness between banks & insurers will increase, thereby • extending systemic risks across both the bank and insurance sectors 10

Regulation for all Financials: Impact on Liquidity Management Short term liquidity requirements (LCR) is a concern for Banks,  Regulators and Central Banks (ECB) Increased demand for sovereign debt, but insufficient supply  of AAA bonds after the European sovereign crisis Pressure to revisit LCR eligibility criteria  (One single level of eligible assets, ABS/MBS if eligible as collateral for funding by the ECB, ..) Long term liquidity / funding requirements is a concern for both  Banks (NSFR) and Insurers (FV of liabilities in capital calculation) Increased demand for sovereign debt by both Banks and Insurers  Increased issuance and demand for covered bonds vs unsecured debt :  depositors will be less protected in case of bank’s default Reduced incentive for long term assets (5-10 yrs for banks, > 20 yrs for  Insurers) 11

Regulation for all financials Impact on Risk Management The “new” risk paradigm : managing risk together with return on a pro-active basis, while improving risk coverage, earnings from portfolio assets, as well as capital and liquidity analytics … Importance of Scenarios and Stress Tests  Plausible best/worst scenarios for business, finance and risk planning,  Stressed scenarios for capital, liquidity and appetite for risk management.  Importance of Risk Appetite :  Risk tolerance defined at the top, aligned with strategy and planning,  Cascaded down via Indicators connected to Capital, Liquidity, Earnings & Value,  Integrated contingency plans for capital, liquidity and recovery/resolution  Break-up of silo-based Risk Management at portfolio level  Competences are improving for Active Balance-Sheet Management … 12