Category: stress testing

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Definitely a cushion

More to follow but  see below for a partial transcript of the Treasury Committee hearing yesterday, with Harriett Baldwin quizzing Jon Cunliffe and others about the effect of Covid on life insurers.

Does Sir Jon agree with Sir John Vickers “when he says that, er, the Matching Adjustment is more of a  mask than a cushion“?

A lot of waffle from Sir Jon. He says that ‘market liquidity risks’ are not suffered if assets are held to maturity, which is correct, then says “if you were to price the assets that insurance companies hold on their balance sheets at market prices, you would be picking up how liquid the assets were, whether you could sell them in stress etc”,  which is clearly false, but at least confirms that he thinks it is a cushion.

Baldwin complains that she is out of time, and Stride (Chair) closes with the remark that he senses “a slight frustration there, and you might have valued a little more time to probe”

I think on that basis we might write to the panel after this session, and if we do if I can ask the members of the panel to respond very promptly to any letter we might send on the issue of insurance and stress testing.

Clearly more to follow. Stay tuned.

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If stress tests are on pause, then so too should be insurance company dividends

The Times, today.

Sir John Vickers, the architect of the financial regime put in place after the 2008 crisis, has expressed concern about the Bank of England’s decision to abandon stress tests for insurers and said that Legal & General’s imminent dividend of more than £750 million should be blocked. Sir John, former chairman of the Independent Banking Commission, said: “If stress tests are on pause, then so too should be insurance company dividends, notably L&G’s, until the future is clearer.”  The Bank’s decision on Thursday not to publish its 2019 stress test of insurers was a mistake, he said, and came at a time when companies’ balance sheets and their ability to withstand the shock of the pandemic should be under scrutiny.

https://www.thetimes.co.uk/article/abandoning-stress-tests-for-insurers-is-a-mistake-txt2kjx92

More to come.

[Edit] See also, my emphasis:

Sir John criticised an accounting rule that enabled insurers to flatter their capital positions. This is the so-called matching adjustment rule, which allows insurers to use a higher discount rate to value their liabilities when their assets yield more. “The fall in yields and widening of spreads will have eroded insurers’ capital levels but accounting methods partly obscure this,” he said. “The matching adjustment to capital may be more of a mask than a cushion.”
The PRA and L&G declined to comment.

 

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What to Expect from the 2019 Bank of England Stress Tests

The sixth set of Bank of England stress tests for the UK banking system will be released on December 10th.

So what to expect? UK banks’ CET1 ratios better than ever, long march to higher capital is long over, UK banks are now so strong that they can undergo a crisis that is worse than the last one and still come out in good shape.

I am confident about these predictions because that’s what the Bank always says.
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The Bank’s ‘Stress’ Tests

My report on the Bank of England’s latest (November 2018) stress tests was published by the Adam Smith Institute on August 3rd.

The purpose of the stress tests is, in essence, to persuade us that the banking system is in good shape on the basis of a make-believe exercise which purports to show what might happen in the event of a supposed severe stress scenario as modelled by a central bank with a dodgy model and a vested interest in showing that the banking system is in great shape thanks to its own wise policies.

We are expected to believe that the central bank has managed to rebuild the banking system despite enormous pressure placed on it by the institutions it regulates, whose principal objective is to run down their capital ratios (or equivalently, maximise their leverage) in order to boost their returns on equity and resulting short-term profits, and never mind the systemic risks and associated costs imposed on everyone else or the damage their high leverage did in the Global Financial Crisis.

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A Back of the Envelope House Price Stress Test for ERMs

by Kevin Dowd

A scenario analysis is a hypothetical ‘what if’ exercise in which we examine what might happen to some variable of interest (e.g., a NNEG or ERM valuation) if some future scenario were to occur.

For example, we might examine what would happen according to our model if future house prices were to behave in a particular way.

A stress test is a scenario analysis in which the posited scenario is an adverse one (e.g., a large drop in house prices).

One type of scenario analysis/stress test is to model the impact of an immediate one-off house price fall. We assume that house prices fall five minutes after the ERM loan has been made. This exercise is ridiculously easy to carry out and can be very revealing. It should therefore be an essential tool in every ERM risk manager’s toolkit.

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Stress tests apply not only to banks

Sir John Vickers kindly mentioned us last week (6 June 2019) in his keynote address to the 19th Annual International Conference on Policy Challenges for the Financial Sector in Washington. Most of the speech is about bank stress tests – he has long insisted that market-based measures should play a greater role in regulatory assessment than is current practice – but he mentions the insurance stress tests towards the end, citing the PRA’s current consultation on its stress test for insurers.

For the valuation of pension scheme liabilities, firms should assume that the discount rate would change by the level of any change in the risk-free rate plus 50% of the change in spread on AA rated corporate bonds. Under the proposed stress the risk-free rate decreases by 100bps and 50% of the spread on AA rated corporate bonds is an increase of 85bps. Therefore, both elements combined result in a 15bps fall at all tenors to the discount rate.1

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Barclays Case Proves that UK Banks are NOT Adequately Capitalised

Shortly after the Adam Smith Institute/Cochrane/Dowd bank capital report came out on May 1st, the Bank of England has inadvertently confirmed our report’s core message – that UK banks are far from being adequately capitalised.

Sir John Vickers and I have been trying to tell the Bank this for years, and yet the BoE still remains in denial on this most important of prudential questions.

To quote a story in today’s Financial Times (“Bank of England warned criminal charge could destabilise Barclays” 15 May 2019):

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UK Banks Still Need Much Higher Minimum Capital Standards

What with all the recent excitement about Matching Adjustment, Age Co and the PRA’s unfailable insurance stress tests, I clean ran out of time to report on the Adam Smith Institute’s new report on bank capital (report, press release) released last week. This new report includes chapters by John Cochrane, ASI research director Matthew Lesh and yours truly.

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It’ll Never Happen Here

By DB and KD

Our friends Tony Jeffery and Andrew Smith have some wise advice that the PRA should consider in their new insurance stress tests. Our advice was not to bother, but assuming the PRA chooses for once not to follow our advice, they might look at the following passage from Andrew and Tony’s recent Society of Actuaries in Ireland (SoAI) report on NNEG valuation:

In 1995 a SoAI paper (Demographic Margins for Prudence – Jeffery & Quinn, 1995) suggested that a valid approach to setting margins was to consider how it would look to a public with the benefit of hindsight if it has gone wrong, noting that with the clarity that hindsight brings can be harsh.

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