Session II Regulatory Capital and Solvency Standards

1
Session IIRegulatory Capital and Solvency
Standards

• Dr. Peter Kandl
• April 2, 2007

2
Objectives

• To give an overview on regulatory standards in
  the banking and insurance industry
• To highlight the need for regulation
• To present the framework for calculating capital
  and solvency requirements

3
Financial Institutions Market Players

• Forms of financial institutions
• Commercial / Retail banks
• Hold customer deposits
• Extend credit to businesses, households and
  governments
• Securities houses
• Investment banks (initial sale of securities in
  primary markets)
• Broker-dealers (trading securities in secondary
  markets)
• Universal banks
• Combination of traditional banking and
  securities activities
• Insurance companies
• Property and casualty (PC) or life insurance
  coverage
• Reinsurance (Provide insurance coverage to
  primary insurer)

4
Systemic Risk

• Both commercial banks and securities houses play
  role of intermediary
• Facilitate payment flows across customers
• Maintain markets for financial instruments
• Systemic risk
• Risk of a sudden shock that would damage the
  financial system
• Involves contagious transmission of a shock
• Affects other firms
• Not limited to direct stakeholders
• Failure can be potentially harmful to the overall
  financial system
• Failure of a financial institution has
  fundamentally different effects than failure of
  an industrial corporation

5
Sources of Systemic Risk

• Panicky behaviour of depositors or investors
• Bank run
• Depositors demand immediate return of their funds
• Liquidity and credit crunch
• Sudden drop in securities prices may lead to
  margin calls
• Forces leveraged investors to liquidate positions
  at great cost
• Interruptions in payment system
• Failure of one counterparty results in chain
  reaction
• Technological breakdown

6
Regulation of Commercial Banks

• Deposit insurance (first established in 1933 in
  the US)
• Insurance fund protects investors if their bank
  fails
• Eliminates bank run
• Most countries have developed compulsory deposit
  insurance program, but great variety across
  countries concerning implementation
• Some of financial risks is passed on to the
  deposit insurance fund (I.e. government or
  taxpayer)
• Creates need for regulation of insured
  institutions
• Herstatt risk
• 1974 failure of Bankhaus Herstatt, an active
  player in FX market
• Bank shut down in noon, after having received DEM
• Counterparties never received their USD
• Serious liquidity squeeze for counterparties
• Shock for whole FX market
• Birth of Basel Committee on Banking Supervision
  (BCBS)

7
Regulations of Securities Houses

• Objectives (fundamentally different than for
  commercial banks)
• Protection of customers
• Rationale small investors are less capable of
  informed investment decisions
• Opportunistic behaviour by financial
  intermediaries, antitrust legislation
• Laws against trading on inside information
• Disclosure rules for other conflicts of interests
• Ensuring integrity of markets
• Stabilise financial markets
• Suitability standards, unsuitable recommendations
  may constitute fraud (punishable by law)

8
Regulations of Insurance Companies

• Objectives
• Protection of future benefits
• Rationale Event that triggers payment of
  benefits may occur decades later than inception
  date of contract
• Claim amount often very high
• Insurance companies have been heavily regulated
  (approval of tariffs and products)
• Insurance protection fund
• Regulation practice
• Different across world / life insurance products
  tight to social security system
• Solvency I Prudential reservation rules instead
  of strong Capital rules
• Solvency II project harmonisation of regulatory
  practice based on new solvency framework

9
Balance sheets of financial intermediaries
Type Assets Liabilities
Banks (Retail) Loans, securities Deposits, CDs, subordinated debt
Securities firms Securities (long) Securities (short)
Insurance companies Market value of assets Actuarial value of insurance obligations ()
Pension funds Market value of assets Present value of defined-benefit pensions()
() depending on pension scheme
() claim / technical reserve
10
Regulation of financial intermediaries
Type Main risk factors Purposes of regulatory capital
Banks Credit risk / Market risk / Operational risk Promote safety and soundness to financial system Protect deposit insurance fund
Securities firms Market risk / Liquidity risk / Operational risk Protect customers Protect integrity of securities market
Insurance firms (incl. pension funds) Market risk / Insurance risk / Operational risk Protect policyholder / claimants / retirees / (pension) insurance fund
11
Basel Committee on Banking Supervision (BCBS)

• BCBS consists of central bankers from G-10()
  countries, plus Luxemburg and Switzerland
• BCBS is sub-committee under Bank for
  International Settlements (BIS)
• Setting (legally not binding) standards for
  banking supervision (harmonization) in order to
• Promote safety and soundness to global financial
  system
• Set level-playing field for global institutions
• Have minimum risk-based capital standards for
  core institutions
• Instituted minimum capital levels for
  internationally active banks

() G-10 Belgium, Canada, France, Germany, Italy,
Japan, the Netherlands, Sweden, UK, USA
12
Banking Supervision

• Financial institutions ultimately regulated by
  their national supervisory authorities
• USA
• Board of Governors of the Federal Reserve System
  (FED)
• Office of the Comptroller of the Currency (OCC)
• Federal Deposit Insurance Corporation (FDIC)
• United Kingdom
• Financial Services Authority (FSA)
• Switzerland
• Federal Banking Commission (FBC/EBK)

13
Committee of European Banking Supervisors

• Established in Nov 2003, first meeting Jan 2004
• High level representatives from the banking
  supervisory authorities and central banks of EU,
  including Central European Bank
• 27 countries, 46 member organisations
• Part of legal framework (has legal power) in EU,
• Challenges and tasks
• Ensure consistency in implementation of Basel II
  in member states
• Pursue convergence of supervisory practices
  related to Basel II
• Streamlining supervisory process for cross-border
  groups (co-cooperation between home-host
  authorities)
• Effective consultations, enhance quality of
  supervisory standards

14
Insurance Supervision

• Global
• IAIS (International Association of Insurance
  Supervisors)
• Established in 1994
• Represents insurance regulators and supervisors
  of some 180 jurisdictions
• Issues global insurance principles, standards and
  guidance paper
• Promotes financial stability
• Europe
• CEIOPS (Committee of European Insurance and
  Occupational Pension Supervision)
• Same role as CEBS
• United Kingdom
• FSA
• Switzerland
• Federal Office of Private Insurance (FOPI / BPV)
• Finma (as of 2009 fusion of FBC and FOPI)

15
Basel Accords

• 1988 Accord (Basel I)
• Risk-based capital charges for credit risk
  (assets)
• 1996 Amendment
• Incorporates market risk charge for trading book
  and FX-risk CO-risk of banking book
• Allows use of internal models
• Basel II
• More risk sensitive charges for credit risk
  replaces partially 1988 accord
• New capital requirements for operational risk

16
Roadmap for the insurance industry (1/2)

• 1973 / 1979 First Non-Life / Life Directive
• Simple rule-based framework, establishment of
  solvency margin
• The solvency margin is the minimum amount of
  extra capital that an insurance provider must
  have to fall back on in unforeseen circumstances

17
Roadmap for the insurance industry (2/2)

• Mid-1990s Third generation of life and non-life
  Insurance Directives (Solvency I)
• Establishment of a single market for insurance
  (single passport system)
• System relies on mutual recognition of the
  supervision exercised by different national
  authorities according to rules harmonised to the
  extent necessary at the EU level
• Since 2002 Solvency II (EU project)
• Principles on capital adequacy and solvency
  (IAIS) (January 2002)
• Framework made public in late 2005
  implementation expected in 2011

18
Principles of Basel II / Solvency II

• Based on three pillars
• Minimum capital / solvency requirements
• Rules (and / or principles) for calculating
  capital / solvency requirements
• Supervisory review
• Supervisory process to ensure fulfilment of
  minimum capital / solvency requirements, adequate
  internal processes ( governance structures,
  soundness of internal control and risk management
  systems)
• Market discipline
• Disclosure of information to shareholders and
  other stakeholders (incl. counterparties)

19
Role of Capital

• Capital as buffer against unexpected losses
• Must be permanent
• Must allow for legal subordination (not preferred
  in case of bankruptcy)
• Goal absorb potential losses and thus avoiding
  bankruptcy / insolvency
• Broader definition than equity (recognition of
  reserves, retained earnings, revaluation
  reserves, hybrid debt, subordinated term debt)
• Classification according to quality into Tier 1,
  Tier 2 and Tier 3 capital (tiering of capital)

20
Basel II Pillar I Framework
Banking book Trading book
Credit risk Banking assets
Credit risk All derivatives All derivatives
Market risk IR (informal) IR
Market risk EQ
Market risk FX FX
Market risk CO CO
Operational risk People, systems, processes People, systems, processes
21
Basel II - Capital Requirements

• Capital adequacy measured as (simplified)
• Credit risk risk weighted assets
• Market / Operational risk risk charges x 12.5
• Well capitalized bank ratio ? 10
• Minimum regulatory standard of 8 corresponds
  approximately to BBB rating

22
Solvency II Framework / Structure
Valuation of Assets Liabilities
Required capital by risk type
Aggregation
Identification ofrisk absorbingelements
Market / ALM risk
Assets
Insurance risk
Gross Capital requirement
RequiredCapital
SCR
Liabilities
Credit risk
Risk Absorption
Diversification
Operational risk

• Recognise that certain liabilities canbe used
  to absorb risks
• Expected profits arisingfrom one year new
  business subtracted

• Market consistent valuation of assets
  liabilities
• Option factored in

• Takes into accountrisk mitigation
  andreinsurance
• Allows for diversificationwithin risk types
• Considers certaincombinatorial risks

• Correlation andconcentration effectsacross risk
  types

23
Risk Based Solvency Regime
Economic Balance Sheet
Solvency Coverage Ratio (SCR)
Insurance liabilities (fair value /
bestestimate)
Risk bearing capital
gt 100
Required capital
Assets (at market or near market value)

• SCR lt 100 does not imply insolvency
• Introduction of intervention levels / ladders

SCR
green
Required capital
100
Increasinglevel of regulatory intervention
Risk bearing capital
yellow
80
orange
MCR
Free capital
30
red
Capitalrequirements
Risk bearing capital
MCR Minimum Coverage Ratio
24
Menu of Approaches to Measure Risk (Basel II)
Risk Category Allowed Approach
Credit Standardized approach (based on the 1988 Accord) Foundation internal ratings-based approach Advanced internal ratings-based approach
Market Standardized approach Internal models approach
Operational Basic indicator approach Standardized approach Advanced measurement approach
25
Credit Risk Charge Standardised Approach

• 8 of sum of risk-weighted assets
• Risk weights according to claim type and obligor
  rating
• External credit assessments for rating according
  to
• Recognition process
• Eligibility criteria
• Implementation considerations
• Recognition of credit risk mitigation techniques
• Collateralization (for unsecured loans /
  haircuts)
• On-balance sheet netting
• Guarantees and credit derivatives

26
Credit Risk - Internal Approaches

• Internal ratings-based approach (IRB)
• Risk weight functions for corporate, sovereign,
  bank, retail, and equity asset classes
• Foundation approach
• Based on banks estimate of PD
• LGD, EAD and M (effective maturity) provided by
  supervisor
• Advanced approach
• Use of banks internal PD, LGD, EAD and M
  estimates
• Reliable process allowing to collect, store and
  utilize loss statistics over time is required

27
Market Risk - Approaches

• Two different approaches for calculation of
  capital charges
• Standardized method
• Set of rules and weights
• Internal models approach (IMA)
• Banks are allowed to use internal models to
  determine capital requirements for market risk
• Based on banks internal risk management system
• Strong system of verification
• Backtesting

28
Operational Risk

• 3 different approaches, based on either
• Basic indicator approach
• 15 of average of positive annual gross income
  over 3 previous years (aggregate measure of
  business activity)
• Does not account for controls
• Can be strongly misleading (e.g. the lower fees,
  the smaller the capital charge)
• Standardized method
• Similar to basic indicator approach, but uses
  different multipliers for each out of 8
  predefined lines of business
• Total capital charge is 3-year average of sum of
  annual business line charges (can be negative),
  subject to floor of 0

29
Operational Risk (contd)

• Advanced measurement approach (AMA)
• Banks can use their internal models, as long as
  sufficiently comprehensive and systematic
• Qualitative requirements regarding operational
  risk function, involvement of management, risk
  assessments, loss data analysis, monitoring,
  reporting, documentation, reviews
• Banks are allowed to recognise risk mitigant
  effects of insurance (limited to 20 of total OR
  charge)

30
Key Elements of Swiss Solvency Test (SST)
Standard Models or Internal Models
Mix of predefined and company specific scenarios
Scenarios
Risk Models
Valuation Models
Market Risk
Market Value Assets
Credit Risk
Best Estimate Liabilities
Life (non BVG)
Life (BVG)
RM
Output of analytical models (Distribution)
Aggregation Method
Target Capital
SST Report
31
Standard Models
PC Risk
Market Risk
Correlations btw risk factors (interest rates,
equity, FX, implied volatilities)
Small Claims (Gamma Distribution)
Premium Risk
Large Risk (Lognormal)
Insurance Risk
Catastrophes (Compound Poisson-Pareto)
Run-off Risk (Lognormal)
RiskMetrics type approach with 80 risk factors.
Sensitivities w.r.t. risk factors of both assets
and liabilities have to be determined
Life Risk
Credit Risk
Covariance approach for 8 risk factors
(mortality, morbidity,) Internal models have to
be used if substantial embedded options and
nonlinearities are in the books ? e.g.
replicating portfolios, market consistent
scenarios,
Basel II (standard, advanced or IRB)
recalibration to 99 TVaR. Spread risk treated
within the market risk model. Internal Models
(CR, KMV type,) Credit risk of default of
reinsurers is treated via a scenario
Scenarios
Historical financial market risk scenarios (Crash
of 2001/2002, Russia crisis,) Predefined
scenarios (pandemic, industrial accident, default
of reinsurers,) Company specific scenarios (at
least three, e.g. nuclear meltdown, earthquake in
Tokyo,). Scenarios have to describe impact of
events on all relevant risk factors (e.g.
Pandemic leads not only to excess mortality but
also to downturn of financial markets).
32
Objectives banking regulation
Synopsis

• Avoid Bank Run / minimise systemic risks
• Focus Stabilise financial system (including
  payment settlement)
• Method
• Strengthen risk management
• Minimum capital standards
• Regulatory authority EU CEBS (coordination) /
  Transposition into EU law (CAD capital adequacy
  directive)
• Regulatory authority UK FSA
• Regulatory authority Germany BaFin
• Regulatory authority Switzerland FBC (FINMA)

33
Objectives insurance regulation
Synopsis

• Protect future benefits
• Focus Protection of beneficiaries
• Method
• Strengthen risk management
• Minimum solvency capital standards
• Regulatory authority EU CEIOPS (coordination)
• Regulatory authority UK FSA
• Regulatory authority Germany BaFin
• Regulatory authority Switzerland FOPI (FINMA)

34
Regulatory framework - structure
Synopsis

• Basel II Solvency II
• Pillar I Capital requirements Solvency
  requirements MR, CR, OR MR, CR, Ins.R, (OR)
• Pillar II Review / Review / Quality RM Quality
  RM
• Pillar III Disclosure Disclosure
  requirements requirements
• Switzerland Swiss Finish Swiss Solvency Test

35
Regulatory systems - capital / solvency adequacy
Synopsis

• Basel II Solvency II
• Approach Balance sheet extracts Total balance
  sheet
• MR Standard / Internal Standard / Internal
• CR Standard / Standard / Internal Internal
  (Basic / Adv.)
• Ins.R - Standard / Internal
• OR Simple Standard Standard Internal (AMA)
• Aggregation Weighted Average Distribution
  (Correlation Diversification)

36
Implementation roadmap
Synopsis
2005
2006
2007
2010

• Basel II

Framework
CAD
Implementation
QIS I to IV

• Swiss Finish

Implementation

• Solvency II

Implementation
QIS I
QIS II
QIS III
FrameworkDirective

• SST

Framework
Capital needsadapted
SSTReport