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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Brexit - implications for insurers

The European Commission has issued today a note setting out the practical implications for insurers as a result for Brexit.  There are specific impacts for group internal models, branches, intermediaries and reinsurers.  For the full document, follow this link.  

I would be happy to discuss further the implications for your company.

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Risk Reviews: Not 'a Bridge Too Far'

The role of a Chief Risk Officer (CRO) and her team in the context of a three-lines-of-defence model in financial services can be best described, in my view, as ‘to protect and enable’ (click here for an earlier post on the subject).   Consistent with that, financial services supervisors in the UK and EU refer to the oversight role that the CRO's team provides. 

There are many issues and considerations in embedding effective risk management in financial services businesses.  At one level, oversight requires the CRO’s team to develop the appropriate engagement with the business to provide support, to challenge and to ensure that risk management features ultimately in decision making.  This may result in recommendations for senior management. 

On its own, this is unlikely to be adequate to evidence appropriate and effective oversight for two reasons.  Firstly, the rationale for covering certain business areas or aspects would not be evident.   Secondly, there may be overlaps with the areas reviewed by Internal Audit. 

The answer is not to restrict the engagement between businesses and the CRO’s team.  Instead, the CRO should put in place a programme of risk review which is coordinated with Internal Audit to avoid overlaps or underlaps.

A structured programme of risk reviews requires consideration of the risks to which the business is exposed and their materiality, as well as business cover.  For example, it would not be sensible to cover just one business area, even if that is the main source of risk. 

The key aspect of the development of a programme of risk reviews is identifying a number of potential reviews that map into a grid of risks, materiality and business areas.  The list of reviews is then whittled down in discussions with the CRO and the leadership team to a programme that is consistent with the scale of the business and the maturity of the CRO’s team.

The Board (or a Risk Committee) should review the proposed programme of risk reviews.  Some businesses require a combined submission from Internal Audit and the CRO to identify a complete assurance landscape.  The CRO’s team should then plan the reviews, including setting out terms of reference agreed upon with the business and delivering them throughout the year.  The CRO should also provide regular reports to the Board about the findings of the various reviews and management delivery of recommendations.

Overall, a programme of risk reviews complements Internal Audit’s activities because of the involvement of the CRO’s team on a real time basis in key business processes such as business planning and product development.  Experience suggests that overlaps with Internal Audit can be avoided and that performing these reviews enables the CRO team to get even closer to the business and embed risk management ― ‘to protect and enable’.   

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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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The European Commission’s Impact Assessment of Solvency II: Some Useful Points

The European Commission recently published a draft of the Solvency II ‘implementing measures’.  The ‘implementing measures’ expand on the requirements set out in the Solvency II directive.  Alongside the ‘implementing measures’, the European Commission also published a draft impact assessment.  This is one the many procedural requirements that apply to the policy-making process in the Commission. 

I thought it would be interesting to review the impact assessment.  As a user, I want to consider the extent to which the impact assessment can help me to understand Solvency II. 

What did I learn from this exercise?

1.    The importance of objectives in the EU policy-making process

The impact analysis is structured around a definition of problems that the policy making will address.  During the discussions about the directive, these objectives were enhancing policyholders’ protection and the integration of insurance markets in the EU. 

The Commission’s impact analysis acknowledges that there is now a third objective that has been taken into account: fostering growth and recovery in Europe by promoting long-term investment.  In the case of insurance, the main challenges that arise relate to the low interest rate environment and the volatility of asset prices. 

2.    A useful summary of how the calibration of asset risk has evolved

The third objective mentioned above has shaped the structure and calibration of capital requirements for assets risk which has evolved over a number of years.  However, it is not easy to see in a succinct way the end product where the answer is set out over a number of articles in the implementing measures.  Surprisingly, this can be summarised in a simple table (below).

3.    The scope of impact analysis remains a tricky issue

The Commission seems to have overcome the challenge of undertaking an impact analysis that seeks to cover the impact of all rules.  The Commission states,

“The options assessed have been selected to cover the most important and representative issues from each of the three pillars of Solvency II and each of the areas of the objectives and problem trees. The areas that are merely technical, have been settled in the Directive or are uncontroversial are not assessed in detail …”

This is reasonable and can result in a more productive use of scarce analytical resources but it can also have unintended consequences.  As far as I can see, the impact analysis did not cover the treatment of long-term guarantees.  I am frankly not sure if this is because it was settled in the Directive or because it turned out to be uncontroversial.

4.    The relative priorities of the Commission: the importance of reducing over-reliance on ratings

The concern about over-reliance on ratings is not new if you have been following the development of Solvency II.  However, given the breadth of Solvency II and the focused impact assessment, I found it surprising that the Commission went out of its way to include a full two-page annex summarising the requirements aimed at reducing reliance on external ratings in the risk management of insurance “such as

          ▪ external ratings shall not prevail in risk management;

          ▪ as part of their investment risk management policy, insurers and 
          reinsurers should have their own assessment of all counterparties;

          ▪ as part of their reinsurance (or other risk mitigation techniques) policy, 
          insurers and reinsurers should have their own assessment of all 
          counterparties.”

5.    And finally, a puzzle about policy making

The Commission’s impact assessment notes that one of the issues that emerged from the QIS5 was the application of a limit to the amount of Tier 2 capital (i.e. debt) that would be allowed.  This issue has remained unclear since then. 

Interestingly, if all you read is the relevant section of the impact analysis on pages 38 to 46 which also summarises EIOPA’s recommendations, you could be forgiven for thinking that the limit would not apply.  It is only the summary on pages 50 to 51 that suggested that I might need to reconsider my initial views.  Indeed, the draft implementing measures clarify that the sum of Tier 2 and Tier 3 capital must not exceed 50% of the SCR, which is an interesting development. 

This illustrates one of the key operational challenges of impact analysis: the need to keep up with the policy.

This was a selective but nonetheless in-depth reading of the impact assessment.  Have you read the impact assessment?  Did you learn any useful points from it?

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Solvency II: The Beginning of the End?

This week I spoke at a client breakfast event organised by Protiviti in London. 

The ‘beginning of the end’ is not just a rhetorical question about Solvency II but the challenging issue I had to address about Solvency II becoming effective on 1 Jan 2016.  I spoke about the ‘end point’ and focused on two issues:

• whether this is the end point we expected from a policy perspective (a measured yes, though it feels more different from the current ICA regime than expected, partly because of the financial crisis), and  

• whether insurers are engaging in contingency planning to reflect regulatory uncertainties around the end point that they are targeting.

I suggested that instead of thinking that this is the ‘beginning of the end’, we consider whether this is in fact the ‘end of the beginning’ – the implementation.  Now the real challenge begins: operating Solvency II in a BAU environment.  I offered a few suggestions to facilitate that transition; take a look at the slides. 

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Guest Post: the Objective of Risk Management – EIOPA's Perspective

One of the lessons from my post on the objective of risk management was that there are a number of perspectives on the objective of risk management.  I asked a number of leading industry experts to share their perspective.

Two weeks ago, I shared the views of James Tufts, Group CRO of Guardian Financial Services (here).  His perspective emphasised that the objective of risk management is to clarify the role of risk management of the business and of the risk function.

Today, I am delighted to share the views of Carlos Montalvo Rebuelta, Executive Director of EIOPA.  As a regulator, it is perhaps not surprising that he focuses on the extent to which Solvency II regulation changes the objective of risk management.

I will continue sharing these perspectives in the next few weeks.

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Solvency II: a revolution in risk culture?

Carlos Montalvo Rebuelta, Executive Director, EIOPA

As Executive Director of EIOPA, in charge of managing the Authority and an insurance supervisor that has faced very different approaches to risk management across national supervised entities, I would like to touch upon the topic of risk management in insurance.

If we start the topic far away from business, in Nature, we see how species try to do the best out of the environment they operate in, in order to survive, yes, but also in order to prevail and ensure a legacy. They are confronted with risks and they exploit opportunities, risk management at its best, albeit in a very primitive form.

Within the corporate world, but outside the financial sector, we may take the example of EIOPA, where different toolkits are used to anticipate and address challenges, but also to identify and grab opportunities. Risk logs, monitoring tools, clear reporting lines, allocation of ownership for action… doesn’t that sound familiar? Risk management, indeed, reinforced by the conviction from senior management on the usefulness of it; setting the tone from the top. 

A distinctive feature of insurance and reinsurance is that the business itself is all about risk. The core objective of (re)insurers is to deal with different kinds of risks making a profit out of them. So, the industry should already have a wide range of specific know-how and experience in the area of risk management, if only because this is what the business is all about i.e. risk.

However, the financial crisis has shown that financial market participants, including insurers, need to rely on stronger risk management capabilities in order to deal with the different challenges posed by the economic slowdown and the financial market volatility. In other words, their risk management frameworks were not always up to the challenge stemming from the crisis.

Self-regulation within undertakings proved insufficient. Very often, any concerns raised about long-term sustainability of the company were ignored or even ferociously denied. Wrong incentives, short term gambits, unsustainable growth… reality was far away from what undertakings claimed to be their situation, with the consequences we all have witnessed.

The upcoming supervisory and regulatory framework for insurance - Solvency II - is going to make significant changes in the current risk culture of many insurers.  It is a different way of looking at and managing risks. First of all, it presents risk management not as a point in time procedure, but as a continuous process that should be used in the implementation of the undertaking’s overall strategy.

There is a purpose, and tangible outcomes. The Solvency II framework aims at establishing high quality risk management standards that will be beneficial for insurance undertakings, shareholders and consumers. One of the main requirements of a risk-based regulatory regime is that risk and capital should not be considered separately. This approach will allow top management to ensure that the company does not take on more risks than its capital base allows. It is also an opportunity for the senior executives to anchor a risk culture in an insurer’s day-to-day operations; again, setting the tone from the top.

The Solvency II regime  requires insurers and reinsurers to have in place an effective risk management system comprising strategies, processes and reporting procedures necessary to identify, measure, monitor, manage and report, on a continuous basis the risks, both at individual and aggregated levels, they are or could be exposed, and their interdependencies. Nothing new under the sun? Unfortunately, this is not the case.

One of the most innovative changes introduced by Solvency II is the requirement that insurance companies develop their Own Risk and Solvency Assessment (ORSA) as a tool of their overall risk management system. Insurers will need to properly assess their own short- and long-term risks as well as the amount of their own funds necessary to cover them to ensure on-going compliance with capital requirements. Quoting the lyrics of a song by The Velvet Underground, “I will be your mirror, reflect what you are, in case you don’t know it”.

I believe that the Solvency II approach to risk management will allow for an enhanced understanding of the nature and significance of the risks to which a company is exposed, including its sensitivity to those risks and its ability to mitigate them. This understanding will help companies to see their real opportunities and manage their business on that basis.Strong risk management will also be beneficial also for the customers of insurance companies. It will allow insurers to better meet their claims towards clients and, thus, to promote confidence in the insurance sector.

All in all, Solvency II should lead to a win-win situation and bring a risk-based regulatory framework to a business that deals with risk.

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If you work in financial services, I would be keen to hear your thoughts about this perspective on the objective of risk management.  If you don’t, I would be keen to know if these lessons resonate with your experience. 

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The Cost and Benefits of EU Membership

A lot that has been said about the recent elections to the European Parliament.  (Full disclosure: I am an EU national living in the UK.)  For me, part of the debate in the UK represents a useful reminder of the challenge of cost-benefit analysis.  Not surprisingly, there isn’t an accepted view about the balance between costs and benefits of EU membership.  Here is an illustration of the range of estimates (as of 2013) from a research paper of the UK Parliament:

I reviewed some of what has been written and have also read with interest Hugo Dixon's recent book - 'The in / out question'.  I thought that rather than develop another cost-benefit analysis, I would set out the main considerations to take into account if you choose to read one of them to form your own views.

It seems uncontroversial – I think – that the economic benefit from EU membership is the access to supply products and services to a market of 510 million consumers and an economy the size of the US.  Hugh Dixon quotes an estimated benefit of the order of 4% to 5% of UK GDP.  If you accept this, then the key questions are whether: 

•  the costs to the UK of achieving that benefit offset it; and  
•  the benefit can be achieved through an alternative arrangement. 

To consider this, a cost-benefit analysis must set out the ‘counterfactual’, i.e. what would happen in the absence of EU membership, and identify what is incremental as a result.  However, there are a number of options.  The ‘do nothing’ option means trading with the EU based on the UK membership of the World Trade Organisation (WT0).  This does not mean free-trade; it will entail custom duties for certain products such as cars.  There are also other options as represented by the cases of Norway, Switzerland and Turkey.  The bottom line is that you cannot seriously consider the costs and benefits of EU membership without taking an explicit view on an alternative from the very beginning.

If so, here are a number of questions and answers to identify what is incremental (including the benchmark of EU membership).  A "smiley" indicates that the change (or lack of it) is a positive development from a cost-benefit perspective.

A couple of points to note about the table.

Firstly, UK manufacturers exporting to the EU will need to comply with EU product regulations.  They are likely to end up manufacturing to UK and EU product regulation standards so (at best) cost savings would be limited. 

Secondly, the distinction between goods and services in the table is the reality of “free trade”, which does not usually apply to services, such as financial, business and legal services.  They represent 78% of the UK GDP. 

The table suggests that being outside the EU could be cheaper on a ‘cash’ basis.  However, none of the options would appear to replicate the benefits of a single market.  Norway replicates many of the benefits at a reduced cost.  However, note that they are bound to follow EU legislation without having a saying on it – an interesting view about sovereignty! 

Overall, I struggle to see how the UK would be able to replicate the economic benefit of the single market in products and services outside the EU. 

However, the real value of cost-benefit analysis is the impetus to focus on increasing benefits and reducing costs.  This means considering how to reform the EU and get the best from a single market of 510 millions of consumers and a GDP that is as large as the US.  Dixon suggestions include cutting red-tape, negotiating trade deals with US, Japan and China.  For me, one of the more interesting suggestions is the potential gains from banking disintermediation and providing long-term finance to industry through capital markets.  As he puts it, the crisis was a banking crisis not a financial crisis.  Something for another post …  

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