The Treasury Committee made the fatal mistake in their June letter of asking Andrew Bailey how the PRA it can determine that bond spread widening is the effect of illiquidity not anticipated defaults. NEVER ask a regulator how or why it has determined something, for then it will tell you in a way that means nothing.
Bailey replies:
The breakdown between credit and illiquidity in the MA calculation is prescribed under Solvency 2, which requires that the MA must not include “the fundamental spread reflecting the risks retained by the insurance or reinsurance undertaking” (Article 77c(1)(b), transposed in Technical Provisions 7.2(2) in the PRA Rulebook). For assets with credit ratings provided by External Credit Assessment Institutions (ECAIs), the process by which the FS is determined is relatively prescriptive. In that case, the FS depends on the Credit Quality Step (CQS) that is prescribed for the respective external credit rating that applies to the assets. The mapping of ECAI credit ratings to CQS for the purposes of Solvency 2 is set out in the Commission Implementing Regulation (EU) 2016/1799 and 2016/1800.
There you go. It’s not exactly meaningless. There are such requirements in Solvency II, and the the relevant mappings exist. But this tells us nothing about how to scientifically determine the difficult split between credit and illiquidity spread. Bailey has simply repeated what the rules say.
Likewise, we might ask how an astrologer can justify their prediction that a market crash will occur at the end of this year (2020). They will reply with something like “Well, Mars is in Aries, and will be Station Retrograde in Aries in September 2020, Aries is the House of Self, relating to personal finances, material possessions, and the concept of value, so the market will fall”.
Right, that’s what the astrological rules say. But how can those apparently arbitrary rules allow us scientifically to determine whether the market will crash?
Likewise, how can the Solvency II rules, which were a political compromise reached in 2014, give us any scientific insight into which part of the market observed spread is due to anticipated credit risk, and which part due to anything else?
Never ask a regulator to explain anything, for explanation is not its job.