Monday, August 8, 2011

Possible Unintended Consequences of Basel III and Solvency II

Some IMF staff published some ideas about the financial regulatory regime in a paper titled as this post:
In today’s financial system, complex financial institutions are connected through an opaque network of financial exposures. These connections contribute to financial deepening and greater savings allocation efficiency, but are also unstable channels of contagion. Basel III and Solvency II should improve the stability of these connections, but could have unintended consequences for cost of capital, funding patterns, interconnectedness, and risk migration.

Efforts to strengthen the quality of capital for banks and insurers through Basel III and Solvency II are well advanced. On the one hand, the Basel Committee on Banking Supervision (BCBS), the organization responsible for developing international standards for banking supervision, adopted the Basel II framework in 2004 and, in response to the financial crisis, has taken steps to strengthen it in an incremental fashion to form what is now known the Basel III framework (BCBS 2009, 2011a, 2011b, and 2011c). On the other hand, the European Commission (EC) is leading the Solvency II project, in close cooperation with the European Insurance and Occupational Pensions Authority (EIOPA), to develop harmonized standards for insurance supervision within the European Union. A directive was adopted in 2009, and work—which included a series of quantitative impact studies—has been underway to develop supporting rules.

The regional scope of application of the two accords varies. Basel is an  “accord”/agreement with no legal force but potentially global applicability, whereas Solvency II is a legal instrument that will be binding in 30 European Economic Area (EEA) countries4 (27 European Union (EU) states plus Iceland, Liechtenstein, and Norway).  However, Solvency II has also implications beyond Europe through, for example, its influence on the international standards being developed by the International Association of Insurance Supervisors (IAIS), and because external insurance groups will be more easily able to operate in the EU if their home supervisory regimes are considered equivalent.

Although these standards have much in common, differences do exist. Both take a risk-based approach to minimum capital requirements and supervision and promote the integrated use of models by institutions in managing risks and assessing solvency. However, their objectives overlap only partially. In particular, Basel III attempts to increase the overall quantum of capital and its quality as a means of protecting against bank failures, including improved quantification of risks that were poorly catered for under Basel II. However, Solvency II attempts to strengthen the quality of capital and tailor the quantity of capital within the sector as a whole. Finally, the two accords have been tailored to the business characteristics of the respective sectors, often as a result of bilateral negotiations, and shaped by the views of those involved in their development in a piecemeal manner. Accordingly, they have generated long and complex documents which define the same concepts in different ways and often deal differently with the same or similar issues.

Paper objectives: (i) to present similarities and differences among Pillar 1 requirements of the two accords; and (ii) to discuss possible unintended consequences of their implementation. In order to ensure focus in the analysis, this paper is intentionally limited to aspects related to Pillar 1 (minimum capital requirement) in the two capital accords. The paper acknowledges that there can be significant overlap in the business activities of banks and insurers. For example, consumers save with banks through deposits and with life insurers through annuity with savings products. In addition, banks and insurers invest in many of the same types of assets and they compete with one another in raising capital, both in the capital markets and within the financial conglomerates of which many are members. Due to this overlap, differences in the two accords can generate unintended consequences in the area of cost of capital, funding patterns, and interconnectedness, and promote risk/product migration across or away from the two sectors. These unintended consequences are summarized in the conclusions together with policy considerations. Finally, the paper acknowledges that other sources of arbitrage not analyzed in this paper, like differences in Pillar 2 (supervisory approach) and Pillar 3 (market discipline), as well as differences in accounting (partially discussed here) and tax treatments, could reinforce or offset the impact of differences in the capital regulatory frameworks.  required more closely to the risks of each insurer, without necessarily increasing the quantity

Conclusions (edited):
124. The nature of capital needed by banks and insurers is naturally different. [...]

125. Basel III and Solvency II both attempt to increase the quality of capital in their respective sectors, but often have different provisions for similar issues. [...]

126. Provisions that cannot be related to the intrinsic differences between the two sectors can result in unintended consequences. For instance, it is unclear whether and, if so, to what extent the cost of capital for banks is going to increase compared to the cost of capital for insurers. On the one hand (i) the lack of an explicit objective to increase capital levels under Solvency II; (ii) the more restricted geographical application of Solvency II; (iii) the less persuasive need for capital systemic risk surcharges for insurers; and (iv) the yet to be defined standards for internal models for insurers suggest that cost of capital may increase more for banks than for insurers. On the other hand, arguments in support of higher cost of capital for insurers can also be made. But in general, Pillar 1 requirements across the two sectors are too different to argue conclusively in either direction. In addition, the new liquidity standards for banks and the new credit risk charges for insurers could affect the funding patterns of banks and increase the interconnectedness of the two sectors through the sovereign balance sheet. Finally, the two accords may result in an increased use of securitization for funding purposes by both banks and insurers. Hence, these unintended consequences could translate into risk migration between or away from the two sectors. 

127. Several policy considerations stem from the aforementioned analysis:
* Basel III and Solvency II suggest a need for insurance regulators to communicate with their banking counterparts to understand the combined implications of the behavioral incentives that the two regimes may provide. This could significantly reduce the risk of unintended consequences associated with seemingly inconsistent treatment of same risks under the respective accords. This would also avoid unintentional arbitrage between internal models and the standardized approach under Solvency II, as has happened under Basel II.

* In addition, while group supervision has been strengthened, concerns about leakages still remain. This is especially a concern under Solvency II, due to its restricted geographical application and the potential use of non-equivalent jurisdictions for reinsurance. A key challenge for all groups remains what will be the approach by the EC to equivalence.

* Also, the adequacy of safety nets may need to be reviewed in the future. The likely increased use of covered bonds by banks for funding purposes would ring-fence assets so that they are unavailable to depositors and unsecured creditors in case of resolution.

* Basel III and Solvency II could further increase the need to expand the perimeter of regulation. As both Basel III and Solvency II push banks and insurers toward shorter duration and less risky business, non-regulated entities and market-based risk transfer mechanisms might evolve to fill any gap in market capacity that emerges. In addition, the likely increased use of securitization by banks and insures alike requires a strengthening in transparency and oversight of these contagion channels including securities lending-related cash collateral reinvestment programs, implementing macro-prudential measures (such as counter-cyclical margin requirements) related to securitization, repos and securities lending where appropriate, and improving market infrastructure for secured funding markets.

* Basel III and Solvency II may lead to excessive risk transfer to consumers and therefore, may require strengthening consumer protection. To the extent that the new accords increase capital and funding costs, the product mix offered by banks and insurers may change and entail additional risks for consumers. For example, excessive risk transfers could be a concern in the area of pension benefits where consumers already bear significant investment and longevity risk. Additional risk transfers to consumers may not be socially desirable from the pension policy point of view.

* Finally, there appears to be a need for empirical investigation about the magnitude of the impact of unintended consequences. There is no universally agreed set of unintended consequences and this paper is the first attempt (that we know of) to generate a set and relate it to the specifics of the Basel III and Solvency II accords. In addition, there is a general absence of empirical studies on the extent of the impact of possible unintended consequences

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