Category: boe

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The Controller speaks

Speech at the Institute and Faculty of Actuaries

There is a concern that Solvency II as a negotiated compromise has created risks to our primary objectives. The Fundamental Spread does not include explicit allowance for uncertainty around defaults and downgrades, and appears low compared with ranges implied by academic literature for the credit risk portion of spreads. Second, the Fundamental Spread is not sensitive to changes in credit market conditions and changes little as spreads change over time. This means that any increase in spreads not accompanied by a downgrade is assumed to be entirely due to increased illiquidity of the assets, and therefore taken credit for as Matching Adjustment. Finally, the Fundamental Spread is not sensitive to risk and spread across asset classes, and thus assets that have the same rating but higher spreads will attract a higher Matching Adjustment despite what can appear to be a higher level of credit risk. This creates a risk of adverse selection based around the regulatory rules.

My emphasis.

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It’s official: the MA is complete crap after all

Gareth Truran speaks at some conference.

Over the last year, the PRA has highlighted publicly on a number of occasions the risk that the MA specification may not have kept up with the changing nature of the market. The MA should only include the component of asset spreads that reflects compensation for risks to which firms are not exposed by virtue of being long-term investors. But it is possible that some of the returns which are currently treated as an illiquidity premium might, in fact, reflect compensation for variability around future credit losses. If so, in adverse scenarios, these profits might not materialise. Firms might be forced into recovery actions such as fire-sales of illiquid assets to manage solvency and meet policyholder commitments, reducing their ability to support sustainable long-term investment in the economy. As firms have invested in recent years in a much wider range of assets with different risk characteristics, the basis risk between these assets and the assets originally used to calibrate the MA has also increased.

So we think we need to look again at this issue, to be confident that the MA regime can safely support our ability to widen MA eligibility, encourage further expansion into new and innovative asset classes, and streamline our upfront review of firms’ MA applications.

Oh yes!

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Dangerous addiction

The Lords report on Quantitative easing is out this morning. Incredibly it is the UK’s first independent comprehensive report into QE.

The report … calls for the BoE to outline a road map that demonstrates how it intends to unwind QE and to engage more openly about the side-effects of the programme, particularly inequality. It suggested that QE artificially inflated asset prices, such as shares and house prices, which had disproportionately benefited those owning them, exacerbating wealth inequalities. “Just ask any youngster trying to buy a flat and they will tell you about the impact of QE,” said Forsyth. (Financial Times)

Generous coverage in the popular press.

Guardian

Independent

Times

Telegraph

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Float Like a Butterfly

Brexit superhero Steve Baker MP was in fine form on the last (23 June 2021) Treascom meeting. The witness before the Committee was PRA chief executive Sam Woods. Steve began by asking (transcript here, Q69 ff)

‘Q69 Mr Baker: …can I go back to Harriett Baldwin’s question about matching adjustment? If I understood correctly … you said it is about capital being set against expected cash flows. Could you just tell me something about the risk profile of those expected cash flows?

Continue reading “Float Like a Butterfly”

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Sam plays it again

From the Treasury Committee hearing, Wednesday 23 June 2021. Steve Baker (SB) questions deputy governor Sam Woods (SW).1

This one will run for a long time, and more later.

SB: Can I just go back to Harriet Baldwin’s question about MA? So I understand correctly, you said it’s about capital set against expected cashflows. But could you just tell me something about the risk profile of those expected cashflows?

SW: Yes, so the way the MA works, crudely, is that if insurance companies can prove to us, to a fairly high – well very high – standard, that they have achieved a fixity of cashflows coming in from the assets, which maps onto what they have got to pay on the other side on the liabilities, we then allow them to use a higher discount rate for their liabilities.

SW: What we do not allow them to take over into that higher discount rate is something called the fundamental spread, because the fundamental spread is meant to capture the risk that those bonds ‘go wrong’. Now there is a lot of work that went into calibrating the fundamental spread when S2 was set up.

SW: The point that I was making was that under the construct that we currently have, there is not an allowance for uncertainty around that going forward, and I think in the context of, if we were looking at broadening elegibility somewhat, if we were looking at de-bureaucratising somewhat, if we were reducing the capital strength and the risk margin, I think in the mix of all that it would make sense to look at that question and I think that there is probably a way of making that work better, which leaves the whole thing square.

SB: So obviously there are, you know, people concerned about MA, some of them experienced in the field of prudential regulation. So the rules that you apply are in public I take it.

SW: Yes

SB: But presumably the application of those rules to individual firms is a matter that is commercially in confidence?

SW: (Pause) Yes, although you know we give you of course the aggregate figures, and the firms themselves I think to various degrees disclose how their capital figures come together and it’s plain, basically, that firms in the annuity business and with heavy credit exposures will be heavy users of the MA.

SB: So I find myself listening to various figures, and they seem to be quite alarmed at the capital position that some firms might be in, because of the MA. What would your advice be to them if they wish to bottom out this argument? What argument would you want to listen to in order to try and bottom this out?

SW: Well I think they should consider the question of, I mean, their argument is essentially – and I am glad that people make that side of the argument because the insurers make the opposite and its good to be attacked on both sides. (laughter) No honestly I think it is a good thing, because I think there should be a debate about this given how important it is. I think the argument I would make to them is, if their contention is basically that you should only ever discount liabilities at the risk free rate, now that is a perfectly respectable world view. That is a world view that in my opinion would have two negative aspects.

SW: One is I do think that that would significantly increase the pricing of annuities, and I don’t know if you have looked around but the annuity you get for £100k is not particularly appetising. But there is just a trade off in there between the degree of risk that we choose to run and the amount of benefit that consumers can get, that’s inevitable. They have a corner solution view on that. So that is one obvious downside of what they suggest.

SW: But the other big downside is that the thing that the MA does which I think is genuinely very helpful and risk reducing is the incentive it provides for them to match. It is actually a very good thing as we go through something like last year with markets going all over the place, [that] insurers can actually ride that out because they have achieved that matching. That is a good thing.

SW: So I think that those are the counterpoints to them, but I think it’s a good thing that they push us around on it.

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Could an Archegos Event Happen in the UK?

In the wake of the Archegos fiasco, Malcolm Hurlston and Mark Northway, the chairs of the UK Shareholder Association and Sharesoc respectively, wrote to the Governor of the Bank of England on April 14th to express concerns that this case raises for shareholders. We reproduce the core of their letter:

The situation which has unfolded at Archegos Capital Management recently raises serious concerns not only for private investors, many of whom own bank shares, but for any member of the public with a bank account and particularly those with savings in excess of the FSCS £85,000 threshold. We have learnt that Credit Suisse, one of six banks acting as counterparties to Archegos, may have lost $4.7 billion from the collapse.

Continue reading “Could an Archegos Event Happen in the UK?”

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OK Guv’nor?

UK Shareholders write to Andrew Bailey.

What has Archegos’ blight on Credit Suisse and five other non-UK banks got to do with UK shareholders?  If the same activity along with the same lack of transparency exists in the UK, UK banks could be greatly exposed without their shareholders and customers being any the wiser.

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Road to riches

 

See here for this letter of 29 June (but only just published) from Andrew Bailey, Governor of the Bank of England, to Mel Stride, chair of Treasury Committee, in reply to Stride’s letter of 10 June with questions following on from the Treasury Committee evidence session on 20 May.

It really is the most astonishing thing I have ever seen coming out of the Bank, and there is material for many posts. But I will start with the weirdest one.

Continue reading “Road to riches”

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The Bank’s ‘No Stress’ Stress Tests, 2019 Edition

In my earlier writings (here, here, here and here, for a start) I may have given the impression that I am not a great fan of the Bank of England’s so-called stress tests, mainly because the Bank’s stress scenarios barely break into a sweat.

My skepticism was heightened further when a little birdie from Moorgate suggested that the stress tests were really designed to ensure that the big institutions passed, ‘cos otherwise there’d be problems.

I had long known that the exercises had zero credibility, but even so, it comes as a bit of a shock to learn that people on the stress test team were more cynical about them than I was.

So now we know what I had long suspected: the stress test project is one big con job PR exercise to sell the Bank’s ‘Great Capital Rebuild’ fairy story to the public.

Continue reading “The Bank’s ‘No Stress’ Stress Tests, 2019 Edition”