Lessons from Bank Recovery and Resolution

The latest issue of the Central Banking Journal includes my review of a book about the Euro Crisis in Cyprus written by Panicos Demetriades, who was Governor of the Central Bank of Cyprus at the time.   It is an fascinating book with insights about the challenge of bank recovery.   You can read the review here or below.

Book Review: A Diary of the Euro Crisis in Cyprus: Lessons for Bank Recovery and Resolution by Panicos Demetriades, Palgrave McMillan, 2017

This book is about Panicos Demetriades’ tenure as Governor of the Central Bank of Cyprus between May 2012 and April 2014. It covers the banking crisis that hit Cyprus, the banks’ resolution and the wider lessons learned from the event. Reading this book felt in some ways like a simultaneous reading of Gabriel Garcia Marquez’s novel, Chronicle of a Death Foretold, and an economics-based thriller like Murder at the Margin by Marshall Jevons.

The book begins with Demetriades’ appointment as Governor of the Central Bank of Cyprus. You know from the beginning how it ends: Demetriades resigns as Governor. This is a manifestation of the challenge that Central Bank independence represents; banking resolution is the specific context in which the Central Bank’s independence is tested. In fact, writing this sentence already reveals one of the underlying issues: the only feature of Central Banks’s independence enshrined in European treaties is the independence of the Governor of the Central Bank.

As Demetriades discovered, there are ways to limit the practical independence of the Governor such as appointing (or firing) Deputy Governor(s), creating new Executive Directors with a seat on the Board whose roles are determined by the Board rather than the Governor, and requiring Board approval for bank licensing and amendments to existing licenses. These might look like arcane corporate governance issues, but they do matter, especially when independence is most needed, i.e. in times of financial crisis. Interestingly, the European Central Bank (ECB) and the Commission witnessed these changes but had limited powers to intervene other than expressing concerns through legal opinions.

Demetriades also plays a detective role and explains how the crisis in Cyprus came about. It is interesting that the origin of the crisis is traced back to the country’s business model – an offshore financial centre for wealthy Russians and Eastern Europeans, supported by a network of lawyers and introducers to banks. Like many of you, I have seen the term business model applied to companies, but this is first time I have seen it applied to describe a country. This suggests to me that avoiding the crisis would have required a very tough regulatory stance, and that it would have happened sooner or later, regardless of the Euro crisis.

The book identifies the trigger event for the crisis.  Interestingly for me, someone who works in risk management, the trigger is the decisions of Cyprus’ two main banks to invest most of their equity capital in Greek debt in the spring 2010, when Greece was being downgraded. This resulted in losses in excess of €4 billion.  As Demetriades notes, this decision ignored the fundamental relationship between yields and risk, and diversification of investments.

There were also challenges for international institutions in the troika. There are a number of references to the IMF analysis of debt sustainability and the assumptions underpinning it. A debt to GDP ratio of 100% was assumed to be sustainable for Cyprus, compared to 120% for Greece. In Demetriades’ view, this made the bail-in for Cyprus larger than might have been necessary. 

Demetriades’ tenure as a Governor of the Central Bank spanned a right-wing and a left-wing government. You might have preconceptions about which government would find the notion of an independent Central Bank more challenging. In fact, both governments found it equally challenging because of national pride and voting considerations. These challenges weigh heavily on Demetriades who concludes the book with a stark warning about the future of the Euro, which is in fact relevant to all the members of the Eurosystem: ‘[P]opulism, if left unchecked, can shake the foundations of the monetary union beyond the point of repair’.

While the book is entitled ‘a diary’, don’t let that word put you off. It is much more than a personal diary.

Just as I did when reading Chronicle of a Death Foretold, I wondered if Demetriades could have done something to maintain the independence of the Central Bank and avoid the clash that led to his resignation. I could not identify anything.

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Securitisations and Solvency II: An opportunity? Or one to be missed?

To put it mildly, securitisations did not a get a good reputation as a result of the financial crisis.  Things are now changing.   This is illustrated well in a discussion paper from the Bank of England and the European Central Bank extolling the virtues of securitisations (here).    It is difficult to disagree with the key message; securitisations can be a win-win transactions that enhances the ability to redistribute risks more efficiently in the economy while enabling institutional investors to access a wider pool of investment.  

The Solvency II Delegated Acts (‘implementing measures’) built up a more favourable capital treatment for securitisations.  It is now recognised as a category of its own for the purposes of spread risk.  This evolution can be evidenced in the Commission’s Impact Analysis published at the time of the publication draft Delegated Acts (here).  As recognised in the Delegated Acts, this even includes recognising the name ‘securitisation’ instead of the name used in the Solvency II Directive in 2009: ‘investment in tradable securities or other financial instruments based on repackaged loans’.

As one would expect, the calibration of the standard formula spread risk for securitisation reflects the maturity of the exposure and its credit rating.  However, there is an interesting innovation.  The Delegated Acts identify two types of securitisation exposures: ‘good’ and ‘bad’, or in policy terms, type 1 and type 2.  The criteria are set out in the Delegated Acts and are quite detailed.  

Exposures of type 1 must meet 20 conditions including a rating of ‘BBB’ or above, the seniority of the exposure in the securitisation, SPV arrangements, listing in an OECD or EU exchange, and backing by residential loans, commercial loans or auto loans and leases.   The list of conditions is somewhat shorter for securitisations that were issued before the Delegated Acts came into force. Type 2 securitisations are simply those not meeting these criteria.  

Figure 1 shows the significant difference that meeting the conditions for type 1 makes to the capital charges.  It is a noticeably a more important consideration than the rating or maturity of the exposure.  

Figure 2 shows an alternative view of the spread risk capital requirements for type 1 securitisations compared against the equivalent ones for corporate bonds of equivalent ratings.   The differences aren’t that large in particular for short maturities.

All this raises a number of interesting considerations for an insurer’s capital management strategy. 

Firstly, there may be tactical adjustments where insurers find that they are holding type 2 securitisation paper as part of the Solvency II implementation work.  In this case, the insurers may seek to dispose of these investments before 1 Jan 2016 to avoid the capital increases that Figure 1 suggests.  However, given insurers’ relatively small holdings of securitisations, this may not be a material issue.

The bigger issue is the extent to which there is an appetite to consider the capital treatment of type 1 securitisation as a more strategic opportunity and readjust investment strategies.  Indeed, would it be possible to do so before 1 Jan 2016 to enhance the matching of cash flows of annuity liabilities and subject to Matching Adjustment? 

In any event, Figure 2 above suggests that there may be an interesting question about the risk and return trade-off of corporate bonds versus type 1 securitisations.  Would the returns from securitisations be sufficiently higher to justify the additional capital requirements?  Figure 2 suggests that for low maturities, e.g. up to 7 to 10 years, this could be finely balanced in particular for ‘BBB’ bonds.  If so, would insurers be willing to tilt their investment strategies to include more type 1 securitisation?  The answer to this question requires appropriate consideration, cash-flow matching including risk appetite, stress testing and governance.   

However, even if the risk and return trade-off mentioned above appears appropriate, it seems that there may be a limited supply of type 1 securitisations.  If so, there would be a limited opportunity for insurers in the short to medium term.  This would be more of an opportunity for investment banks to structure securitisation transactions.

This post is part of a series of posts on Solvency II.  To see the list, click here. 

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