Category: stress testing

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Wood’s Solvency UK comments welcomed by industry

Insurance ERM this morning on Sam Woods’ comments to the UK Treasury Committee last Monday.

“Dean Buckner, policy director of the UK Shareholders’ Association, welcomed Woods’ admission the new regime would put policyholders at more risk.

He has repeatedly argued how the use of the matching adjustment grants life insurers upfront capital against future investment returns, which may not emerge, and therefore puts firms at risk of running out of capital.

“Our members are increasingly fearful of investment in life insurance companies, given the tendency to decreasing levels of capital, and increasing levels of risk. We thank Sam Woods for speaking out. However, we are disappointed that the government appears to be ignoring these valid concerns,” Buckner said.”

At the same time, the Bank has published the results of its insurance ‘stress test’. Scare quotes, because

In the spread widening stress, the MA increases to offset most of the corresponding fall in asset values within the MA portfolio; and balance sheet deterioration through increased credit risk is not observed until assets start to downgrade. While this result is to be expected under the regime, it does illustrate that the MA does not automatically take account of market signals relating to elevated credit risk at the point where they start to come through

The exam that no firm can fail.

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Now we can all relax

“Bank of England to stress test risks in non-bank financial markets” (link)

Phew! Now we can all relax as the Bank looks at a risk that came to its attention. Hope it is also looking for risks that haven’t yet come to its attention!

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Two New Books by EUMAEUS

Two New Books by EUMAEUS

Eumaeus is pleased to announce the publication of two new books published by KSP Books. Regular readers will be familiar with draft versions of both these.

The first is The Eumaeus Guide to Equity Release Valuation: Restating the Case for a Market Consistent Approach, 2nd edition. The second is Can UK Banks Pass the Covid-19 Stress Test? Both were published on June 29th.

We thank Bilal Kargi of KSP Books for publishing these.

More publications are in the works and we will report on them as they come out.

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Sam’s Basel Bufferati

Sam Woods’ latest speech “Bufferati” given at City Week on April 26th is a real corker – and its full of dreadful jokes too.

As his colleagues were finishing of their magnus opus Basel III – a hideous monstrosity that should have been killed at birth – Sam wonders out loud about an alternative, which he calls the Bufferati model. Think of capital standards as car models, he suggests. He continues

But I have found myself thinking it might be a good idea to introduce, on the next door assembly line as it were, a new concept car version of the capital stack – radically simpler, radically usable, and a million miles away from the current debate but which might prove instructive over the longer term.

It is refreshing to see a regulator of Sam’s seniority thinking in first principles’ terms. He goes on to say

Design features

While the capital regime is fiendishly complex, its underlying economic goals are fairly simple: ensure that the banking sector has enough capital to absorb losses, preserve financial stability and support the economy through stresses. In developing the Bufferati, my guiding principle has been: any element of the framework that isn’t actually necessary to achieve those underlying goals should be removed. The Bufferati is as simple as possible, but no simpler.

With that mind, my simple framework revolves around a single, releasable buffer of common equity, sitting above a low minimum requirement. This would be radically different from the current regime: no Pillar 2 buffers; no CCoBs, CCyBs, O-SII buffer and G-SiB buffers; no more AT1. [His emphasis]

A little later he adds

“At the core of this concept is a single capital buffer, calibrated to reflect both microprudential and macroprudential risks and replacing the entirety of the current set of buffers. [Our emphasis]

And a nice summary

So in summary, the Bufferati has:

  1. A single capital buffer, calibrated to reflect both microprudential and macroprudential risks.

  2. A low minimum capital requirement, to maximise the size of the buffer.

  3. A ‘ladder of intervention’ based on judgement for firms who enter their buffer – no mechanical triggers and thresholds.

  4. The entire buffer potentially releasable in a stress.

  5. All requirements met with common equity.

  6. A mix of risk-weighted and leverage-based requirements.

  7. Stress testing at the centre of how we set capital levels.

There is some good stuff in there, but it’s still a bit of a dog’s dinner, leaving a lot of scope for regulatory discretion, gaming of metrics and most worrying of all, the adjective ‘low’ as in ‘low capital requirements’ is a massive red flag.

But in the spirit of Sam’s bufferati/buggerati/whatever model, we would like to suggest some slight improvements as follows, in bold:

So in summary, our improved Bufferati has:

  1. A single capital buffer, calibrated to reflect both microprudential and macroprudential risks.

  2. A high minimum capital requirement, with the minimum ratio of capital to leverage exposure or total assets set at (at least) 15%.

  3. No ‘ladder of intervention’; only mechanical triggers and thresholds.

  4. All requirements met with market value common equity.

  5. Only leverage-based requirements.

  6. No stress testing.

So just a couple of tweaks there, Sam, and you’re fine.

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Financial stability implications of IFRS 17 Insurance Contracts

This memorandum from the European Systemic Risk Board highlights discount rates as a key risk in IFRS 17.

IFRS 17 allows two methods (bottom-up and top-down) to calculate discount rates which, in turn, determine the ultimate amount of insurance contract liabilities. In practice, the bottom-up and top-down methods may result in different discount rates. Furthermore, IFRS 17 is going to be applied in an environment of low interest rates, with increased importance of unobservable components (expected and unexpected credit losses, as well as an illiquidity premium). Together with the level of discretion in the requirements of IFRS 17, the behavioural response of insurers may have consequences for financial stability, mainly as a result of large cross-sectoral heterogeneity in the computation of discount rates and ultimately in the valuation of insurance liabilities.

See also:

The significant weight of the unobservable component of discount rates under IFRS 17 may require close attention from audit firms, accounting enforcers and microprudential supervisors. Potential actions could include setting audit expectations, issuing guidelines on how to compute the unexpected components of the top-down and bottom-up methodologies, a benchmarking exercise across European insurers, and setting out expectations on adequate disclosures.

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The Crisis to End all Crises

The Financial Times reports:

In a letter to UK bank chief executives, the BoE said its analysis of the circumstances of the Archegos failure had found “significant cross-firm deficiencies” in the way bank prime brokerage businesses allowed the fund to build up huge loans that it ultimately defaulted on.

Interesting. Perhaps our UK Shareholders’ letter had some effect! Or was it Eumaeus, who wrote.

We should also keep in mind that the regulatory models are calibrated to give a 1 in 1,000 years probability of default, so the suspicion arises that the models might not have been calibrated properly. In any case, it would be wise for Bailey and his fellow regulators overseas to look into this issue. Granting a little time to investigate, Bailey then needs to make a statement that he is either confident in the effectiveness of UK regulation in this regard or he is not: the Archegos/Credit Suisse episode is a warning shot across the bow.

?

It now looks as though he is not “confident in the effectiveness of UK regulation in this regard “.  Oh dear. We thought the new and improved system of regulation would make the GFC the “crisis to end all crises”. But I am sure they will sort it all out.

[EDIT] The corresponding Dear CEO letter from Nathanaël Benjamin is here.

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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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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”