March 14, 2016

Why do regulators insist in realizing bankers and insurers wet dreams? It costs the real economy too much!

Solvency II does to the insurance industry what Basel regulations did to banks. It introduces what is known as the “risk-based approach” to capital and regulation.

In essence it means more ex ante perceived risk more capital, less ex ante perceived risk less capital.

That translate into the lesser the ex ante risk is perceived, the more you will be able to leverage your capital.

And the more you are allowed to leverage capital, the higher are the expected risk adjusted returns on equity.

And so, just like it realized the banker's wet dreams (more elegant "nocturnal emissions") Solvency II should now realize those of the insurers… namely that of being allowed to earn the highest risk adjusted returns on equity on what is perceived as the safest.

Evidence of the existing enthusiasm we find when Oliver Ralph quotes Omar Ripon, partner at accountants Moore Stephens with “Risk-based capital is a great thing. The best firms are looking at using it to improve their returns. If you only look at it from the compliance angle, you won’t get the benefits.” “Insurance divides over shared rules” March 14.

Unfortunately allowing bankers and insurers to realize their wet dreams has a very high cost for all the rest of us.

First it obviously distort a lot in the financial markets in terms of how credit, investments and capital is allocated.

When the European Commission explains why Solvency II is needed they hold that Solvency I “does not entail an optimal allocation of capital, i.e. an allocation which is efficient in terms of risk and return for shareholders”

But that is certainly what the risk based capital approach cannot do.

That is because all risks that are considered by the capital requirements are risks that have already been perceived and cleared for in other ways, by means of risk premiums, amounts of exposure and other.

And any risk, even if perfectly perceived, if it is excessively considered, causes the wrong action.

And then of course “hiding risks” or production of Potemkin ratings, which allows for higher leverages, becomes a competitive tool.

“Any risk you hide I can hide better, I can hide better the risks than you can… No, you can't - Yes, I can - No, you can't Yes, I can! Yes, I can!”

And if the distortions in capital allocation to banks and insurance are bad, the distortion it produces among those who access bank credit or insurance investment funds from the insurance companies is much worse. It will mean the “safe” will get too much, much more than what they already get (making them risky) and that the “risky” will get too little, much less than what they already get… and as a consequence our real economy will suffer a lot.

I know too little of the insura © nce industry to estimate their capital requirements but, in the case of banks, these should be required to hold 10 percent in capital against all assets to cover for the unexpected, which, even though it can be expected, includes such events as regulators having no idea of what they are doing.

PS. I challenge you to read the European Commission’s explanations of Solvency II and count the self confessed distortions it will produce.