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From the postbag – the illiquidity premium

Two items today. A friend of Eumaeus from Ireland writes to say they are disappointed that we did not cover the Jeffery and Smith paper (Equity Release Mortgages: Irish & UK Experience) as extensively as we might have done. Another friend wrote to express a puzzle about the Matching Adjustment principle.  The principle suggests that we can construct a synthetic non-sovereign bond rate that is risk free, but which has a higher return than a (risk free) gilt, which we can use to discount the future liability. But if the gilt and the synthetic bond are certain to pay the same amount at maturity, how can their returns differ?

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LSE details

Update. Our seminar “NNEG and ERM Valuation: A Restatement of the Case for Market Consistency”, will take place from 17:00 to 18.30, Monday 10 June 2019, in the Lecture Theatre of CCLS Queen Mary University of London (67-69 Lincoln’s Inn Fields, London WC2A 3JB).

Charles Goodhart will be chairing.

External visitors can report to the reception.

Sorry for the slight change of time.

DB

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Hey Presto! The Disappearing Risk Trick

Explain why the Matching Adjustment is a fundamental principle of actuarial science

Dean wrote in his last posting that the exam question posed by Craig Turnbull’s thoughtful piece on Matching Adjustment was whether the MA, whose purpose is to provide a measure of long-term credit default risk, actually delivers a ‘good measure’ of this risk.

Turnbull sets out a deceptively simple looking problem. Suppose we hold a well-diversified portfolio of MA-eligible 10-year zero-coupon non-financial corporate bonds. All the bonds have a BBB public credit rating and a yield to maturity of 2.5%. The 10-year risk-free yield is 1.0% and so the bond credit spread is 1.5%. The problem is to work out this bond’s capital requirement.

He continues:

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LSE redux

Following our presentation (‘Is Equity Release a Second Equitable Life?’)  at the London School of Economics on Monday 1 October 2018, Kevin and I will be presenting further work on the topic of equity release at the LSE on Monday June 10 2019, 17:30-19:00.

We will be focusing on our work since October, and on external developments. Subjects will include: calibration of key variables, particularly deferment rate and volatility; market consistency; regulation.

Precise venue tbc – we will publish details when available on the website.

Dean ‘n’ Kevin

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The experience of the 1930s – more from the postbag

Source: Giseck/Longstaff/Schaefer

A friend of Eumaeus comments on my post yesterday, where I said “I have argued many times in the past that we should look at the default experience of the 1930s (or the 1880s or whenever) in assessing the true default risk of long term credit exposure.” He objects that the PRA have done exactly that, citing Supervisory Statement 8/18:

When using transition data, the PRA expects firms to … compare their modelled 1 in 200 transition matrix and matrices at other extreme percentiles against key historical transition events, notably the 1930s Great Depression (and 1932 and 1933 experience in particular). This should include considering how the matrices themselves compare as well as relevant outputs…

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An unavoidable leap of extra-statistical faith

Craig Turnbull (Investment Director at Aberdeen Standard Investments, author of A History of British Actuarial Thought) offers an intriguing critique of the Matching Adjustment here. ‘To the extent that the profession wishes to defend the MA as a matter of actuarial principle’, he says, alluding to the IFoA president’s recent defence of it, ‘we must provide a clear explanation of the apparent logical contradiction at the core of its treatment of credit risk capital: that the capital required to support the risk of adverse asset outcomes can be (partly) created by assuming those same assets perform well.’ (Our emphasis).

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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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Panic wot panic

 

Wait here for the next available cashier

A topical article in the FT today on the queues spotted at Metro Bank over the weekend, which received almost viral attention in ‘social media’.

The long queues that formed at several Metro Bank branches in west London on Sunday have been seen by some, especially on social media, as an alarming echo of the days just before Northern Rock’s collapse in 2007. The comparison is irresponsible. This lender’s problems — a few dozen customers emptying their safety deposit boxes amid unfounded rumours of imminent collapse — cannot be likened to those of a defunct bank whose woes foreshadowed the global financial crisis. Conflating them risks creating a vicious circle of customer panic.

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Just published

Just out, the Just Group financial report for 2018. The reconciliation of regulatory to statutory capital is on p.28, copied below (with added difference column).

As you see the fictive regulatory asset (TMTP) decreases by £372m over the year. This is mainly offset (1) by the increase in sub-debt, consisting of the Tier 3 subordinated debt issued in February 2018. Next year there will be a further increase of solvency II capital because of the £300m Tier 1 qualifying regulatory capital instrument issued in March this year.

There is also (2) the mysterious increase due to ‘other valuation differences’ but I have never been able to locate where this comes from.

31 December 2018 £m 31 December 2017 £m Difference
Shareholders’ net equity on IFRS basis 1,664 1,741 (77)
Goodwill (34) (33) (1)
Intangibles (137) (160) 23
Solvency II risk margin (851) (902) 51
Solvency II TMTP 1,738 2,110 (372)
Other valuation differences and impact on deferred tax (813) (1,009) 196
Ineligible items (7) (6) (1)
Subordinated debt 615 394 221
Group adjustments 1 0 1
Solvency II own funds 2,176 2,135 41
Solvency II SCR (1,597) (1,539) (58)
Solvency II excess own funds 579 596 (17)