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Superfunds

There were a few reports out over the weekend, e.g. here, about the The Pensions Regulator’s new interim guidance on superfunds.

The sheer lack of detail here is breathtaking. No formula,  no apparent regime for internal model approval, no regulatory returns.  Of course, they will “need to be comfortable that the investment and risk models superfunds intend to use are appropriate, robust and capable of accurately measuring and monitoring risks that the scheme is exposed to”, but no further details given yet.

The requirement to demonstrate “expected returns for various asset classes, attributable to the scheme and in the capital buffer” is ominous, but what else did you expect?

 

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Eumaeus Guide, 2nd Edition

Eumaeus is pleased to announce the release of the second edition of our equity release valuation report, THE EUMAEUS GUIDE TO EQUITY RELEASE VALUATION Restating the Case for a Market Consistent Approach.

The new edition involves some simplification and tidying up, including: a simpler treatment of volatility estimation; a simpler treatment of the Market Consistent approach reflecting our more recent work on option pricing (of which more later); a brief discussion of Professor Mario Wüthrich’s 2011 European Actuarial Journal article on market consistent valuation; and a discussion of the IFoA Equity Release Working Party’s magnificently flawed approach (“A Discussion Note on the Economic Valuation of Equity Release Mortgages as Part of the PRA’s Effective Value Test”) to the PRA’s Principle III (“The present value of deferred possession of a property should be less than the value of immediate possession”).

As always, we thank the many people who have contributed to it.

Please keep the comments flowing in through our contact box.

 

 

 

 

 

 

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UK Banking System is One Big Impaired Asset

An interesting passage from the IFRS accounting standards

The core principle in IAS 36 is that an asset must not be carried in the financial statements at more than the highest amount to be recovered through its use or sale. If the carrying amount exceeds the recoverable amount, the asset is described as impaired. The entity must reduce the carrying amount of the asset to its recoverable amount, and recognise an impairment loss. IAS 36 also applies to groups of assets that do not generate cash flows individually (known as cash-generating units). [My emphasis]

IAS 36 applies to all assets except those for which other standards address impairment. The exceptions include inventories, deferred tax assets, assets arising from employee benefits, financial assets within the scope of IFRS 9, investment property measured at fair value, biological assets within the scope of IAS 41, some assets arising from insurance contracts, and non-current assets held for sale.

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Regulation masking condition of insurers

Source: FT

A great piece from Ford of the FT this morning.  Insurers don’t have to mark down the virus losses on their bond portfolios on the assumption that the spreads will narrow back down again. Analysis from Dean Buckner, a former insurance regulator at the UK watchdog, has estimated that six large UK insurers collectively ran up £28bn of mark-to-market losses on their bond holdings as of the beginning of June, etc.

But the worry is that “a large number of bonds subsequently default or get downgraded to junk. That would force the insurer to crystallise a sudden and potentially much more substantial loss. ”

Quite.  The comments as always are instructive. Buckner is accused of being a ‘mark to market fundamentalist’. Correct. If you value the balance sheet above its market price, you are defrauding prospective shareholders who might want to buy. If you value the balance sheet below its market price, you are defrauding existing shareholders who might want to sell. You should not be defrauding shareholders, who bear the brunt of the risk. Therefore value the balance sheet at best estimate of its market price.

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Liquidity vs default risk

The core assumption of Matching Adjustment is that default risk changes very slowly over time, which is why the average spread over a 30 years period is one of the inputs into the Fundamental Spread (=credit risk spread) calculation. It follows that sharp movements in bond spreads cannot be the result of changes in default risk, hence cannot correspond to any change in the credit risk spread. The change must therefore be in the Matching Adjustment (=liquidity) spread.

How could we test this assumption?

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Can UK Banks Pass the COVID-19 Stress Test, Updated

Dean and I have updated our banking report, and the new version is available here.

The new version gives figures updated to May 29th and is a little trimmed down. Its main highlight is a new Figure 1 which gives UK banks’ share prices since the start of 2007

UK Bank Share Prices Since the Beginning of 2007

and is based on Howard Mustoe’s lovely share price chart in his BBC report “Are Britain’s banks strong enough for coronavirus?”

The exam question is: Explain how this Figure shows that UK banks are well capitalised.

Answers to Sam W, c/o Bank of England, Threadneedle Street, London EC2R 8AH.

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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.

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More Market Value Nonsense from the Bank

In his opening remarks to the Treasury Committee on May 20th, Governor Bailey made an interesting observation point about market values:

 … had you done a stress test in the run-up the financial crisis on the market value, you would have been doing it on the market values that were trading well in excess of book values, so … that would of course have severely misled you. You would have concluded there was no problem and you would obviously have been badly wrong. (Our emphasis)

Mr. Bailey isn’t the first Bank spokesman to make this claim. The Bank’s head of financial stability Alex Brazier said as much in almost the same words back in January 2017:

… if you had [relied on market cap values] before the crisis, you would have been led completely astray … You would have been led to the conclusion that the British banking system was remarkably resilient, and, as forecasting errors go, that would have been quite a good one. 1

It’s an important point, but it is wrong. Flat out wrong.

It’s a shame that none of the MPs challenged it.

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Another Gem from the PRA

Capillamentum? Haudquaquam conieci esse! – A wig? I never would have guessed!  PRA meeting, believed to be not later than 79 AD

“It seems an unaccountable thing how one soothsayer can refrain from laughing when he sees another,” remarked Cicero in De Natura Deorum, I. 71. His point is that while the profession demands a certain gravitas in front of the ordinary public, its members have a jolly good laugh in private, because they all know they are frauds.

Which point takes us to this stunningly absurd speech by Charlotte Gerken (PRA director of life insurance). It is written by an impressive collection of individuals and expressed with utmost dignity, yet we imagine that they must have had a few giggles when they gathered in the halls of the PRA to write this impressive piece of tosh.

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