Transcript Part I: - MSc UZH ETH in Quantitative Finance

Session II
Regulatory Capital and Solvency Standards
Dr. Peter Kandl
April 2, 2007
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
2
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 (P&C) or life insurance coverage
• Reinsurance (Provide insurance coverage to primary insurer)
3
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
4
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
5
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)
6
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)
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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
8
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(**)
(*) claim / technical reserve
(**) depending on pension scheme
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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
Market risk /
firms (incl.
Insurance risk /
pension funds) Operational risk
•Protect policyholder / claimants /
retirees / (pension) insurance fund
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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
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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)
12
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 (cocooperation between home-host authorities)
– Effective consultations, enhance quality of supervisory standards
13
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)
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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
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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
16
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
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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)
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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”)
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Basel II Pillar I Framework
Banking book
Credit risk
Trading book
Banking assets
All derivatives
Market risk
IR (informal)
IR
EQ
Operational risk
FX
FX
CO
CO
People, systems, processes
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Basel II - Capital Requirements
• Capital adequacy measured as (simplified)
T otalcapital
 Capitalratio 8%
Credit risk  Marketrisk  Operational risk
– 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
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Solvency II Framework / Structure
Valuation of
Assets & Liabilities
Required capital
by risk type
Aggregation
Identification of
risk absorbing
elements
Gross
Capital
requirement
Required
Capital
Market / ALM
risk
Assets
Liabilities
Insurance
risk
Credit
risk
SCR
Risk Absorption
Diversification
Operational
risk
• Market consistent
valuation of assets
& liabilities
• Option factored in
•
• Takes into account • Correlation and
risk mitigation and
concentration effects
reinsurance
across risk types
•
• Allows for diversification
within risk types
• Considers certain
combinatorial risks
Recognise that
certain liabilities can
be used to absorb risks
Expected profits arising
from one year new
business subtracted
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Risk Based Solvency Regime
Economic Balance Sheet
Solvency Coverage Ratio (SCR)
Insurance
liabilities (fair
value / best
estimate)
Assets
(at market or
near market
value)
Risk bearing capital
>= 100%
Required capital
• SCR < 100% does not imply insolvency
• Introduction of intervention levels / ladders
Risk
bearing
capital
Required
capital
SCR
green
100%
yellow
Free
capital
MCR*
orange
red
Capital
requirements
Increasing
80% level of
regulatory
30% intervention
Risk bearing
capital
* MCR = Minimum Coverage Ratio
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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
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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
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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 bank’s estimate of PD
• LGD, EAD and M (effective maturity) provided by supervisor
– Advanced approach
• Use of bank’s internal PD, LGD, EAD and M estimates
• Reliable process allowing to collect, store and utilize loss
statistics over time is required
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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 bank’s internal risk management system
– Strong system of verification
– Backtesting
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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
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Operational Risk (cont’d)
• 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)
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Key Elements of Swiss Solvency Test (SST)
Standard Models
or Internal Models
Mix of predefined
and company
specific scenarios
Valuation Models
Risk Models
Market Risk
Credit Risk
Scenarios
Market Value
Assets
Life (non BVG)
Best Estimate
Liabilities
Life (BVG)
RM
Output of analytical models (Distribution)
Aggregation Method
Target Capital
SST Report
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Standard Models
Market Risk
Correlations btw risk factors
(interest rates, equity, FX,
implied volatilities)
P&C Risk
Small Claims (Gamma
Distribution)
Premium Risk
Insurance
Risk
RiskMetrics type approach with ~80 risk
factors. Sensitivities w.r.t. risk factors of
both assets and liabilities have to be
determined
Life 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,…
Scenarios
Run-off Risk
(Lognormal)
Large Risk (Lognormal)
Catastrophes (Compound
Poisson-Pareto)
Credit Risk
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
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).
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Synopsis
Objectives banking regulation
• 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)
32
Synopsis
Objectives insurance regulation
• 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)
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Synopsis
Regulatory framework - structure
• Pillar I
• Pillar II
• Pillar III
Basel II
Capital requirements
MR, CR, OR
Review /
Quality RM
Disclosure
requirements
• Switzerland „Swiss Finish“
Solvency II
Solvency requirements
MR, CR, Ins.R, (OR)
Review /
Quality RM
Disclosure
requirements
Swiss Solvency Test
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Synopsis
Regulatory systems - capital / solvency adequacy
•
•
•
•
•
•
Basel II
Approach Balance sheet extracts
MR
Standard / Internal
CR
Standard /
Internal (Basic / Adv.)
Ins.R
OR
Simple
Standard
Internal (“AMA”)
Aggregation Weighted Average
Solvency II
Total balance sheet
Standard / Internal
Standard / Internal
Standard / Internal
Standard
Distribution (Correlation
Diversification)
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Synopsis
Implementation roadmap
2005
• Basel II
Framework
QIS I to IV
• Swiss Finish
• Solvency II
2006
CAD
2007
2010
Implementation
Implementation
QIS I
QIS II
QIS III
Implementation
Framework
Directive
• SST
Framework
“SST
Report”
Capital needs
adapted
36