## _wp11187 ## Source details **Canonical URL:** [_wp11187](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11187.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11187.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11187.pdf.json) --- ### Introduction: scope and objectives - Basel II adopted in 2004; incremental strengthening led to Basel III (BCBS 2009, 2011a, 2011b, and 2011c). - Solvency II: Directive adopted in 2009 led by the European Commission with EIOPA; work included quantitative impact studies (latest referenced as QIS5). - Paper objectives: - (i) Present similarities and differences among Pillar 1 requirements of the two accords. - (ii) Discuss possible unintended consequences of their implementation. - Analysis intentionally limited to Pillar 1 (minimum capital requirement); other arbitrage sources (Pillar 2, Pillar 3, accounting, tax) acknowledged but not analyzed in depth. ### Key contrasts between Basel III and Solvency II - Commonalities: - Both adopt a risk-based approach to minimum capital requirements and supervision. - Both promote institutional use of models for risk management and solvency assessment. - Differences in emphasis: - Basel III: increase overall quantum and quality of capital; improve quantification of inadequately covered risks under Basel II; introduce leverage and liquidity standards. - Solvency II: tailor capital quantity to insurers’ risks; strengthen capital quality for policyholder protection without necessarily increasing sector-wide capital quantity. - Structural differences: - Basel is an “accord”/agreement with potentially global applicability; Solvency II is a binding legal instrument in 30 EEA countries (27 EU states plus Iceland, Liechtenstein, Norway). - Documents differ in drafting, definitions, and treatment of similar issues. ### Banks vs insurers: business models, risks, and funding - Business model contrasts: - Banks: asset-driven; maturity transformation; higher leverage; reliance on short-term and wholesale funding. - Insurers: liability-driven; technical provisions dominate; less reliance on debt; generally longer funding duration. - Funding and balance-sheet characteristics: - Insurers’ average funding duration in sample: between 8 to 10 years. - Banks’ aggregate balance sheets: significant portion of instantaneous callable or short-term funding. - Insurer technical provisions include claims provision, provision for unearned premiums, provision for unexpired risks, life assurance provision, premium deposits, savings accumulated over with-profit policies. - Liquidity and leverage: - Insurers generally less leveraged and less exposed to liquidity risk than banks. - Banks engage in maturity transformation exposing them to liquidity risk and depositor runs. - Solvency II anticipates future profits could increase exposure to mass lapses; SCR includes a mass lapse stress component. ### Risk types and profit generation - Banks’ main risks: credit risk, liquidity risk, market risk, counterparty risk, operational risk. - Insurers’ main risks: underwriting risk, market risk, credit risk (from guarantees), liquidity risk for some life products. - Profit sources: - Banks: spread between asset income and liability cost; fee income; trading/investment income. - Insurers: premiums and investment income less costs of benefits, underwriting, reinsurance, administrative expenses. - Investment strategy: - Insurers invest premiums in assets matched to liabilities; when adequate assets unavailable, liability duration can exceed asset duration creating interest-rate duration mismatch and credit spread duration risk. ### Valuation, accounting, and prudence: core differences - Accounting frameworks: - Banks: IFRS or similar; mixture of fair-value accounting and historical cost; IFRS 9 (from January 2013) proposes financial assets measured at amortized cost or fair value. - Insurers (Solvency II): “total-balance-sheet approach” based on fair values of both assets and liabilities; Solvency II balance sheet prepared independently of general-purpose financial reporting. - Loan loss provisioning: - Banks: provisions retrospective; IAS 36 captures incurred loss; general provisions permissible only to extent measurable. - Insurers: provisions prospective under Solvency II. - Insurance liabilities (Solvency II): - Valuation methods: best estimate plus risk margin (cost-of-capital rate most recently tested was 6 percent) or as a whole via replicating assets; best estimate may be negative. - Solvency II does not permit adjustment for own credit standing; under IAS 39 banks can adjust liabilities for own credit standing; Basel III requires CET1 adjusted by cumulative gains/losses due to own credit risk on fair-valued liabilities. - Prudence implications: - If contract expected profitable: banks’ retrospective approach may be more prudent (future profit not recognized); Solvency II could recognize expected future profit upon writing the contract. - If contract expected loss-making: insurers’ prospective approach is more prudent (losses recognized upfront). - Insurers must include a margin for cost of capital in liabilities; banks do not include such a margin in retrospective valuation or loan provisioning. ### Ability to change assets/liabilities and risk-transfer tools - Banks: common securitization of loans to reduce exposure and release regulatory capital; requires sufficient deal size. - Insurers: commonly use reinsurance and, less frequently, insurance-linked securities (ILSs); reinsurance transforms underwriting risk into counterparty credit risk; ILSs limit risk exposure but do not remove liabilities from balance sheet. - Derivatives usage: - Banks: hedging trading exposures, CDSs for lending-related counterparty risk. - Insurers (life): ALM programs use derivatives to hedge market risk. ### Capital: components, tiers, and calibration differences - Pillar 1 commonalities: - Address amount of capital required and types of resources eligible. - Primary role: absorb unexpected losses and enable going-concern obligations; minimum to meet obligations if ceased business. - Two general capital types: going-concern loss-absorbing capital and subordinated gone-concern capital. - Solvency II specifics: - Recognizes Ancillary Own Funds (AOF) as off-balance-sheet items usable for SCR (going-concern) but not for MCR (gone-concern). - SCR calibrated at 99.5 percent VaR over one year. - MCR calibrated at 85 percent VaR over one year; MCR capped at 45 percent of SCR and floored at 25 percent of SCR but subject to absolute minimums (e.g., EUR 1 million captive, EUR 2.2 million to EUR 3.2 million nonlife, EUR 3.2 million life or reinsurer). - MCR must be met by eligible Basic Own Funds (BOF); SCR can be met by all eligible capital including AOF. - Basel III specifics: - CET to risk-weighted assets will rise to 4.5 percent in 2015 (from 2 percent). - Tier 1 required ratio rises from 4 percent to 6 percent by 2015. - Minimum total Tier 1 and Tier 2 remains 8 percent. - Capital Conservation Buffer: 2.5 percent, phased in between 2016 and 2019, to be met with common equity. - Countercyclical buffer: range zero percent to 2.5 percent of common equity. - Leverage ratio reporting begins 2013; required leverage ratio set at 3 percent (subject to testing and potential Pillar 1 inclusion by 2018). - Liquidity standards: LCR (30-day acute stress; must be >100 percent) and NSFR (one-year horizon; must be >100 percent). - Incremental Basel III changes include stricter regulatory adjustments and introduction of stressed VaR for market risk. ### Capital-tier rules and major divergences - Both frameworks use tiering but differ in terminology, eligibility, and treatment: - Basel III: simplified to two tiers—Tier 1 (going-concern) and Tier 2 (gone-concern); CET1 specifically identified with 14 inclusion criteria. - Solvency II: Basic Own Funds with Tier 1, Tier 2, Tier 3 plus Ancillary Own Funds; QIS5 allowed up to 20 percent of total Tier 1 to be paid-in non-common equity instruments. - Notable differences: - Basel III disallows dated instruments in Tier 1; Solvency II allows 10-year dated instruments subject to supervisory approval and automatic suspension when SCR breached. - Basel III requires write-down or conversion mechanisms for liability-accounted instruments for loss absorption; Solvency II does not require equivalent mechanisms but specifies automatic conversion triggers for certain AOFs. - Solvency II recognizes insurance-specific items (surplus funds, expected profits in future premiums) with differing classification across jurisdictions and QIS5 testing; banking recognition of expected profits requires contractual commitment. - Regulatory adjustments/deductions differ substantially; examples: - Deferred tax assets: Basel III deducts DTAs relying on future profitability from CET1 (limited recognition up to 15 percent for timing differences); Solvency II QIS5 deducts net DTA from Tier 1 but classifies them as Tier 3 BOF. - Investment in own shares: Basel III full deduction from CET; Solvency II full deduction from Tier 1. - Own credit risk: Basel III deducts unrealized gains/losses from CET; Solvency II does not consider own credit in liability valuation. ### Risk aggregation, correlations, and credit risk mitigation contrasts - Basel III: - Expresses aggregate risk as risk-weighted assets across credit, market, operational risk; results added without correlation adjustment. - IRB credit risk uses ASRF calibrated at 99.9 percent one-year VaR; operational risk AMA at 99.9 percent one-year VaR. - Recognized credit risk mitigation: collateral, guarantees, credit derivatives, claims netting; simple and comprehensive collateral approaches; maturity mismatch rules apply. - Solvency II: - SCR standard formula reflects diversification and interdependencies using correlation matrices across risk classes and business lines; correlations can substantially reduce required capital vs a linear sum. - Credit spread sub-module multiplies market value by rating-dependent stress factor and duration (with floors and caps); long-duration assets face much higher capital requirements. - Example correlations (QIS5): Market vs Counterparty default = 0.25; Nonlife underwriting vs Counterparty default = 0.50; Life underwriting vs Health underwriting = 0.25. - Diversification recognition under Solvency II can lower capital relative to Basel III’s uncorrelated aggregation. ### Internal models and supervisory issues - Both frameworks permit internal models (IRB/AMA in Basel; full/partial internal models in Solvency II) subject to supervisory approval. - Experience under Basel II IRB showed on average lower risk charges versus standardized approaches; evidence of RWA over total assets decreases suggests either methodological advantages or supervisory relaxation—cautionary lesson for Solvency II internal models. - Supervisors can impose add-ons if internal models are inadequate; strong cross-sector regulator collaboration needed to minimize model arbitrage. ### Funding patterns, asset demand, and interconnectedness - Solvency II standardized approach penalizes long-duration/lower-rated private-sector instruments via spread-duration charges, creating preference for sovereign debt and short-dated higher-rated bank debt (especially covered bonds). - Basel III LCR/NSFR prefer covered bonds and sovereign debt for liquidity purposes; senior unsecured bonds do not qualify for LCR but qualify for NSFR. - Likely market effects: - Banks’ demand for unsecured debt may decrease while demand for covered bonds and sovereign debt may increase. - Banks’ supply of covered bonds likely to increase; supply of unsecured debt may shift to longer maturities (5 to 10 years). - Potential increased sovereign exposure for both sectors, increasing interconnectedness through sovereign balance sheets. - Investor composition of bank debt (by type; example shares): - Senior Bonds: Real Money Funds 62%; Hedge Funds 10%; Insurers 10%; Banks 18%. - Covered Bonds: Real Money Funds 25%; Hedge Funds 5%; Insurers 10%; Banks 45%; Central Banks 15%. - Insurance holdings of bank debt vary by jurisdiction (example: Germany insurers hold ~35 percent of domestic bank debt). ### Product and risk migration; unintended consequences - Joint implementation could cause: - Cost-of-capital asymmetries leading to risk/product migration across sectors. - Increased use of securitization, reinsurance, and shadow-banking techniques to reduce regulatory capital costs. - Greater interconnectedness and opaque risk distribution via increased use of risk-transfer mechanisms. - Risk passing onto consumers through risk-sharing product structures (e.g., unit-linked products, re-pricing annuities). - Tax treatment differences (e.g., tax deferral on life insurance investment income vs annual taxation on bank deposits) can affect liquidity and withdrawal incentives and create arbitrage opportunities. - Solvency II’s geographic confinement and equivalence regime could enable use of non-equivalent jurisdictions for reinsurance to reduce cost of capital if credit charges are not calibrated appropriately. ### Cost-of-capital channels and ambiguous net effect - Arguments that banks’ cost of capital may increase more than insurers’ include: - Basel III deleveraging and higher-quality capital requirements, reduced TBTF subsidy, stricter capital deductions, higher hedging costs for banks. - Solvency II allows scope for reinsurance and internal models yielding potential 30–40 percent capital reductions versus standard formula (per expectations reported). - Arguments that insurers’ cost of capital may increase more include: - Solvency II’s more risk-based and informative reporting could raise capital costs for riskier insurers. - Illiquidity of many insurance liabilities limits insurers’ ability to raise capital by reducing liabilities. - Net directional conclusion: Pillar 1 differences are sufficiently varied that the net effect on relative costs of capital for banks versus insurers is ambiguous. ### Supervisory responses and remedial timelines - Banking examples: Prompt Corrective Action (PCA) frameworks with graded supervisory interventions; critically undercapitalized banks (tangible equity < 2 percent of total assets) may be placed in receivership within 90 days if no alternative. - Solvency II insurer procedures: - SCR breach: insurer notifies supervisor asap; within two months insurer must submit plan to achieve compliance within six months (extendable by three months or more in market stress). - MCR breach or likely breach within three months: notify supervisor; one month to submit plan and three months to achieve compliance. - Public disclosure required if SCR coverage falls below 100 percent; qualifying capital instruments must permit deferral of payments if SCR coverage < 100 percent. - Supervisory powers and timelines differ across jurisdictions; cross-sector supervisory collaboration recommended. ### Policy considerations and recommendations - Strengthen cross-sector supervisory communication to understand combined behavioral incentives under Basel III and Solvency II and reduce unintended consequences and arbitrage between internal models and standardized approaches. - Review adequacy and scope of group supervision, with attention to Solvency II’s geographical application and equivalence determinations by the EC. - Consider reviewing safety nets given changes in asset ring-fencing (e.g., covered bonds) and potential resolution implications. - Expand regulatory perimeter where appropriate: - Monitor non-regulated entities and market-based risk transfer mechanisms that could absorb migrated risk. - Strengthen transparency and oversight of securitization, repos, securities lending, and ILS/insurance-linked instruments. - Implement macro-prudential measures (e.g., counter-cyclical margin requirements) related to securitization, repos, and securities lending if warranted. - Improve market infrastructure for secured funding markets. - Strengthen consumer protection to mitigate excessive risk transfer to customers (notably pensions). - Empirical research needed to quantify magnitude of unintended consequences; present analysis is an initial mapping of potential effects. *Source: Excerpt from IMF working paper _wp11187 (IMF PDF chapter/section).* ### References ............................................................................................................. ### _wp11187 - References ### Introduction: Scope and objectives - Basel II was adopted in 2004 and subsequent incremental strengthening led to the Basel III framework (BCBS 2009, 2011a, 2011b, and 2011c). - Solvency II: a Directive adopted in 2009 led by the European Commission (EC) with EIOPA; work included a series of quantitative impact studies, the latest referenced as QIS5. - Regional scope differences: - Basel: an “accord”/agreement with no legal force but potentially global applicability. - Solvency II: a legal instrument binding in 30 European Economic Area (EEA) countries (27 European Union (EU) states plus Iceland, Liechtenstein, and Norway). - Paper objectives: - (i) Present similarities and differences among Pillar 1 requirements of the two accords. - (ii) Discuss possible unintended consequences of their implementation. - Scope limitation: analysis intentionally limited to Pillar 1 (minimum capital requirement). - Acknowledged sources of additional arbitrage not analyzed in depth: differences in Pillar 2 (supervisory approach), Pillar 3 (market discipline), accounting, and tax treatments. ### Key contrasts between Basel III and Solvency II - Commonalities: - Both adopt a risk-based approach to minimum capital requirements and supervision. - Both promote integrated use of models by institutions for risk management and solvency assessment. - Differences in emphasis and objectives: - Basel III: aims to increase the overall quantum of capital and its quality to protect against bank failures and to improve quantification of risks inadequately covered under Basel II. - Solvency II: focuses on strengthening capital quality and tailoring capital quantity to the risks of each insurer, without necessarily increasing the sector-wide capital quantity. - Structural and drafting differences: - Documents are long and complex, often defining similar concepts differently and treating similar issues differently. ### Banks and insurers: business models, risks, and funding - High-level summary: - Banking: asset-driven business model; maturity transformation; higher leverage; greater reliance on short-term and wholesale funding. - Insurance: liability-driven business model; technical provisions dominate; less reliance on debt and external funding; generally longer funding duration. - Funding and balance sheet characteristics: - Figure 1 (described): insurers’ average funding duration ranges between 8 to 10 years in the sample; banks’ aggregate balance sheets consist on average of a significant portion of instantaneous callable or short-term funding. - Technical provisions: amount set aside to meet liabilities from insurance contracts (claims provision, provision for unearned premiums, provision for unexpired risks, life assurance provision, premium deposits, savings accumulated over with-profit policies). - Liquidity and leverage: - Insurers are generally less leveraged and less exposed to liquidity risk than banks. - Banks engage in maturity transformation (deposit duration typically shorter than loan asset duration), exposing them to liquidity risk and potential depositor runs. - Some life insurance products generate losses during the first years of the policy under current liability valuation methods; insurers sometimes use reinsurance or own capital to absorb initial strain. - Solvency II’s anticipation of future profits could increase exposure to mass lapses; the SCR includes a mass lapse stress component to mitigate this risk. ### Risk types and profit generation - Banks: - Main risks: credit risk (loan defaults), liquidity risk (maturity mismatch), market risk, counterparty risk, operational risk. - Profits: spread between income on assets and cost of liabilities; fee-based services add fee income; loan book produces interest income; trading book produces investment income. - Insurers: - Main risks: underwriting risk, market risk, credit risk (depending on guarantees), liquidity risk for some life products. - Profits: difference between income earned (premiums, investment income) and costs of providing insurance benefits (claims payments, underwriting, reinsurance, investment, administrative expenses). - Investment strategy: insurers generally invest premiums in assets suitable to the nature of corresponding insurance liabilities; close and direct link between liability values and related assets where possible. - When adequate assets are not available, insurer liability duration can exceed asset duration, creating interest rate duration mismatch and market risk; certain assets (e.g., asset-backed securities) can introduce credit spread duration risk. ### Interactions, competition, and unintended consequences - Overlap and competition: - Consumers save with banks (deposits) and with life insurers (annuities and savings products). - Banks and insurers invest in many of the same asset types and compete in capital markets and within financial conglomerates. - Potential unintended consequences: - Differences in accords can affect cost of capital, funding patterns, interconnectedness, and promote risk/product migration across or away from the two sectors. - Other sources of arbitrage (Pillar 2, Pillar 3, accounting, tax) could reinforce or offset impacts from Pillar 1 differences. ### Structure of the paper (as provided) - Section II: differences and similarities between insurance and banking business models, valuation/accounting of assets and liabilities, and ability to change risk profiles. - Section III: overview of the two accords. - Section IV: differences and similarities in capital components under the two accords. - Section V: differences and similarities in required capital under the two accords. - Section VI: discussion of possible implications. - Section VII: conclusions and policy considerations. *Source: _wp11187 - References* ### 14. Insurance liabilities have more loss-absorption capacity than bank liabilities. ### 14. Insurance liabilities have more loss-absorption capacity than bank liabilities. ### Insurance loss-absorption capacity and capital comparisons - Insurance liabilities, particularly life insurance policies with profit participation, provide some risk-absorption capacity: adverse experience can reduce policyholder liabilities and mitigate the impact on capital. - There is a limit to the extent with which insurers can take credit for future profits as this depends on uncertain policyholder behavior. The scope for this may reduce with Solvency II if the ‘best estimate’ computation of the liability fully takes into account expected policyholder behavior in such circumstances. - Comparison of liability composition (as reported): - Banks: Debt Securities, 16%; Deposits from Financial Institutions, 23%; Government & Customers Deposits, 32%; Others (REPOs, etc), 29%. - Insurers: Subordinated Liabilities, 1%; Technical Provisions, 91%; Other (Deferred Tax, etc), 8%. - Levels and quality of capital (Figure 2, select large institutions): - Largest 50 European banks: on average 6 percent total capital over total assets, of which only 67 percent is represented by high-quality Core Tier 1 capital. - Large insurers world-wide: on average 8 percent total capital over total assets, of which 84 percent is represented by high-quality equity capital. - Large global reinsurers: on average total capital amounting to 15 percent of total assets, with high quality equity capital amounting to 73 percent of total capital. - Note: The information reported is not strictly comparable as capital levels and quality should be risk adjusted (ideally in terms of VaR at the same confidence level and time horizon). ### Key differences in accounting standards and valuation - Accounting frameworks: - Banks: financial statements often prepared under International Financial Reporting Standards (IFRS) or similar; mixture of fair-value accounting (trading, available-for-sale) and historical cost (other banking assets). - Insurers (Solvency II): use a “total-balance-sheet approach” based on the fair values of both assets and liabilities; Solvency II balance sheet must be prepared independently of general-purpose financial reporting requirements. - Assets: - Banks: assets typically valued at amortized book value or fair value under IAS 39 classifications; IFRS 9 (applying from January 2013) proposes that all financial assets will either be measured at amortized cost or fair value. - Insurers: assets are valued at fair value under Solvency II; provisions for expected losses on insurer assets are inherently reflected in valuation because provisions are prospective. - Loan loss provisioning: - Banks: loan provisions are only “retrospective.” IAS 36 requires case-by-case assessment and captures incurred loss; general provisions are permissible only to the extent they relate to a specified measurable risk. - Insurers: provisions are prospective under Solvency II. - Liabilities: - Banks: liabilities valued at amortized book value or fair value; deposits typically at book or amortized book value; IFRS 9 requires entities measuring liabilities at fair value to present changes due to own credit risk in other comprehensive income rather than profit and loss (applying from January 2013). - Insurers: Solvency II values insurance liabilities at the amount for which they could be transferred or settled between knowledgeable willing parties in an arm’s-length transaction. - Two valuation methods: best estimate plus risk margin, or as a whole via replicating assets. - Best estimate methodology involves projecting probability-weighted future cash flows and required capital; the cost-of-capital rate most recently tested was 6 percent. The best estimate liability may be negative. - The replicating assets method is appropriate when future cash flows can be reliably replicated using financial instruments with observable market values (e.g., unit-linked products). - Own credit standing: - Under IAS 39, a bank’s financial liabilities can be adjusted for changes in its own credit standing. - Solvency II does not permit any adjustment to take account of the own credit standing of the insurer. - Basel III requires CET1 to be adjusted by cumulative gains and losses due to changes in own credit risk on fair-valued financial liabilities, limiting any regulatory capital advantage for banks. ### Implications of valuation approaches and prudence - Banks have greater flexibility regarding valuation of financial liabilities: can use either amortized cost or fair value through profit and loss (subject to constraints). - Reported values of financial liabilities at amortized cost are more stable than those at fair value, which move with interest rates. - Retrospective valuation of bank balance sheet items generates greater stability in reported values: classification as loans or held to maturity enables amortized cost valuation. - Insurer assets change in value as interest rates or credit spreads move; bank assets valued at amortized cost will not automatically move with such spreads until a loss event occurs and assets are reclassified. - Prudence depends on contract profitability: - If contract expected to have positive future profitability: retrospective approach (banks) is more prudent because liability valued at book value and future profit not recognized; under Solvency II the insurer could recognize expected future profit upon writing the contract. - If contract expected to produce future losses: prospective approach (insurers) is more prudent because losses are recognized upfront. - Additional prudential difference: insurers must include a margin in liabilities for cost of capital; banks do not include such a margin in retrospective valuation or loan provisioning. ### Ongoing accounting standard developments - IASB changes affecting banks and insurers include: - IFRS 9 (applying from January 2013). - Changes regarding definition (IAS 32) and classification of financial instruments (IAS 39). - Exposure Draft on Insurance Contracts (IFRS 4). - IASB consultation on requiring balance sheet loans to bear an expected loss provision throughout their life; November 2009 exposure draft proposed adoption of an expected loss model and incorporation of an incurred loss model on top of the expected loss model (good book/bad book approach). - BCBS supports use of more forward-looking provisions. The effects of these changes are unclear. ### Differences in ability to change assets and liabilities and risk-transfer tools - Banks: - Commonly securitize loan assets and sell them into capital markets to reduce exposure and release regulatory capital; securitization must be of sufficient size to be economically viable. - Insurers: - Commonly use reinsurance and, less frequently, capital market instruments (insurance-linked securities, ILSs) to transfer risk. - Reinsurance uses include: share underwriting risk, cap absolute loss scale, stabilize experience, provide capital support, release future profits, protect against catastrophes. - Reinsurance can reduce insurance liabilities on the balance sheet but transforms underwriting risk into counterparty credit risk; counterparty risk can be mitigated via asset deposits or collateral. - ILSs limit risk exposure but do not remove liabilities from the insurer’s balance sheet. - For many insurance liabilities there is no secondary market, impacting ability to offload risk and to value liabilities. - Derivatives: - Both banks and insurers use derivatives to manage risks, but for different purposes. - Banks: mainly to hedge trading exposures and use CDSs to limit risks associated with lending. - Life insurers: use derivatives to hedge market risk as part of asset-liability management (ALM) programs. ### Different treatment of similar products - Banks and insurers compete on both investment-style and protection-style products: - Investment products written by both sectors: investment bonds, term deposits (banks) and term-certain annuities (insurers). - Protection products examples: - Investment guarantees and options written by investment banks and variable annuities with investment guarantees written by insurers. - CDSs written by both banks and insurers. - Trade finance offered by banks and surety bonds offered by nonlife insurers. *Source: _wp11187 - 14. Insurance liabilities have more loss-absorption capacity than bank liabilities.* ### 30. Different tax and capital treatments of such products can generate opportunities ### 30. Different tax and capital treatments of such products can generate opportunities ### Tax and capital arbitrage across products and sectors - Different tax treatments of economically similar savings products can create incentives that affect related assets or liabilities. - Example: savings products offered by life insurers may provide for the deferral of tax on related investment income until the policy benefits are paid, while the income on bank deposits is taxed annually. - Consequence: tax deferral may discourage withdrawals from insurance policies, subjecting an insurer to less liquidity risk than a bank offering a similar savings product (unless the tax regime changes to create an incentive for policyholders to withdraw). - Differences in capital treatment under the two accords can generate opportunities for arbitrage across sectors (see Section VI as referenced in the source). ### Implications of structural differences between banks and insurers - Banks and insurers play fundamentally different roles in the financial system: - Banks: reflect money as a means of payment in exchange; comparative advantage in screening projects and short-term finance; engage in short-term maturity transformation; require safety nets to protect depositors against liquidity shocks. - Insurers (especially life insurers): reflect money as a store of value; permit deferred consumption and smoothing; comparative advantage as investors in long-term securities and benefit from illiquidity premium. - Different intermediation suggests capital needs to protect against unexpected shocks should differ across sectors. - Risk and balance-sheet linkages: - Insurers’ assets and liabilities are more often linked (liability-driven business model; strict ALM matching requirements) than banks’ assets and liabilities, reducing insurers’ liquidity risk and need for external funding. - Banks have more short-term exposure to changing economic conditions due to liquidity risk, funding needs, and effects on loan defaults. - For banks, credit risk can be transferred via securitization, but liquidity and funding risks are harder to manage. - For insurers, reinsurance is an additional tool (unavailable to banks) that can alter balance-sheet nature and provide degrees of freedom to reduce cost of capital (as discussed in Section VI). - Systemic interconnectedness: - Greater interconnectivity among banks, especially through the interbank market, implies higher systemic risk from a single bank failure (Geneva Association, 2010). - Insurers engaged in activities closely linked to the broader financial sector (e.g., providing protection against credit exposures) could also have systemic implications if they fail. - Insurers—especially life insurers—have more long-term exposure to changing economic conditions because of liability nature; ALM can mitigate risks, but absent effective ALM, prospective liability valuation can accentuate balance-sheet effects. ### Justification and limits of differing capital accords - Many but not all differences in the respective capital accords are justified by the sectors’ differences. - Basel III reflects the view that capital was insufficient and of poor quality during the recent crisis; Solvency II is not primarily guided by that issue because insurers proved more resilient to the same shocks. - Several differences in the two accords are not supported by differences in the nature of capital needed in the two sectors, potentially generating unintended consequences. ### Overview of the two accords - Both Basel III and Solvency II aim to ensure sufficient regulatory capital is held by banks and insurers, but with different objectives: - Basel III: aims to increase the quality and level of capital and reinforce banks’ liquidity risk management. - Solvency II: aims to increase protection of policyholders by creating incentives for good risk management and calibrating capital required to insurers’ risks. - Development paths: - Basel III: developed over the last two years in reaction to the recent financial crisis. - Solvency II: first attempt to develop a fully risk-based solvency standard for the European insurance industry; had a much longer gestation. - At the time of writing, neither accord was finalized. ### Key elements of Basel III - Developed by the BCBS (membership listed in the source). - Intended to apply to internationally-active banks on a fully-consolidated basis; many jurisdictions transpose requirements into local legislation. - Strengthened elements relative to Basel II include: - Early reforms (July 2009) raising capital requirements for the trading book, complex securitization exposures, and securitizations in both banking and trading books; raised standards of Pillar 2 supervisory review; capital requirements and related disclosures to be implemented by the end of 2011. - Tier 1 capital must be of higher quality—focusing on common equity; harmonization of Tier 2 capital instruments; elimination of Tier 3 capital instruments. All elements of capital to be disclosed with detailed reconciliation to reported accounts. Introduction of a leverage ratio as an extra layer of protection. - Measures to strengthen capital requirements for counterparty credit exposures arising from derivatives, repo, and securities financing activities; designed to increase capital requirements, reduce procyclicality, and provide incentives to move derivative contracts to central counterparties. - Framework to promote conservation of capital and build-up of buffers that can be drawn down in periods of stress; the capital buffer range can be adjusted in response to signs of excessive credit growth. - Liquidity standards introduced: - Liquidity Coverage Ratio (LCR): measures whether a bank has sufficient high-quality liquid resources to survive an acute stress scenario lasting for one month. - Net Stable Funding Ratio (NSFR): time horizon of one year to help determine whether there is a sustainable maturity structure of assets and liabilities. - Transition timetable highlights (Basel III effective January 1, 2013; many items phased-in): - The Leverage Ratio must be disclosed beginning in 2015 and becomes a Pillar 1 requirement in 2018; - The Minimum Common Equity Capital Ratio reaches its ultimate level in 2015; - Various deductions from common equity are phased in between 2014 and 2018; - The Minimum Tier 1 Capital requirement reaches its maximum in 2015; - The Capital Conservation Buffer is introduced in 2016 and reaches its ultimate level in 2019; - Capital instruments that no longer qualify as noncore Tier 1 or Tier 2 capital are phased out over a 10-year horizon beginning in 2013; - Minimum standards will be introduced for the LCR in 2015 and the NSFR in 2018. - Additional reforms under consideration include promoting stronger provisioning practices via accounting changes toward an expected loss approach, updating supervisory guidance, and fundamental reviews of the trading book and securitization framework. ### Key elements of Solvency II - Originated from the European Commission (not the IAIS). - Applies to almost all insurers operating in the European Community, with exception for those with gross premium income below EUR 5 million. - Relevant to reinsurers or groups based outside the European Community operating therein; such entities can be treated more like local insurers if their home supervisory regimes are assessed as equivalent by EIOPA. - Broader in scope than Basel III: comprehensive, principles-based system consolidating 14 existing insurance directives and covering valuation of assets and liabilities, group supervision, and winding up of insurers. - Implementation timeline and legislative levels: - Several levels of legislation must be in place before effect on January 1, 2013. - Level 1 directive approved by the Council of Ministers and the European Parliament in 2009. - A proposed revision to the Level 1 directive was published by the Council of the European Union on June 7, 2011 and is not expected to be finalized until early 2012. - Level 2 implementing measures expected to be published in Quarter 1 2012. - EIOPA expected to submit draft binding technical standards to the European Commission in Quarter 2 of 2012 and to publish Level 3 guidelines in Quarter 3 of 2012. - Outstanding decisions (examples) include: - Assessment of the adequacy of the calibration of quantitative requirements; - Determination of the risk-free interest rate curve used for discounting technical provisions and the use of transitional measures; - Development of actuarial guidelines for the calculation of the best estimate; - Assessment of the consistency between IFRS valuation and Solvency II valuation approaches; - Assessment of the complexity of the Solvency Capital Requirement (SCR) standard formula and the need for simplifying the standard formula; - Calculation of the group SCR (including group-specific risks); - Based on QIS5 data, considering the grandfathering of existing capital items; - Development of guidelines to allow insurers to apply for the use of an internal model; - Transitional periods for a number of items; - Development of guidelines on own-risk and solvency assessment (ORSA); - Development of guidelines on the supervisory review process. ### Implications of the two accords and cross-sector effects - Because Solvency II does not have the same explicit objective to increase capital as Basel III, capital costs for the two sectors could rise asymmetrically, possibly promoting inappropriate risk migration from banks to insurers. - Aspects of both accords still to be finalized could result in unintended consequences; calibration of quantitative requirements could affect opportunities for cross-sectoral arbitrage. - Within the European Community, legal and regulatory frameworks should produce relatively consistent implementation of both accords across jurisdictions; among other jurisdictions, only peer pressure will limit Basel III implementation variations. - Influence of Solvency II outside the European Community is uncertain, depending on equivalence assessments, IAIS deliberations, and Solvency II implementation within the European Community. - Confined geographical application of Solvency II could generate opportunities for insurers to reduce cost of capital through reinsurance in non-equivalent jurisdictions with weaker solvency and supervisory standards, if capital charges against credit risks introduced by such reinsurance contracts are not set appropriately. ### Pillar 1: Components of capital - Pillar 1 requirements of both Basel III and Solvency II address: - The amount of capital needed to support an entity’s business (discussed in Section V of the source). - The components/types of resources considered capital available to meet those needs. - Primary role of capital in both accords: absorb unexpected losses and enable an entity to meet obligations on a going-concern basis; at minimum, sufficient capital to meet obligations if the entity ceased business. - Two general types of capital on the balance sheet: - Capital that absorbs losses on a going-concern basis. - Subordinated liabilities that absorb losses on a gone-concern basis (help ensure depositors, policyholders, and senior creditors can be repaid if wound up). - Solvency II recognizes certain off-balance sheet instruments as Ancillary Own Funds (AOF): capital that can be used to meet the going-concern Solvency Capital Requirement (SCR), but not the gone-concern Minimum Capital Requirement (MCR). - Both sectors follow a three-step process to determine capital: - Calculating the amount of required capital; - Classifying capital into various categories; - Assessing eligibility of instruments for each category. - Table 1. Quality of Capital under Basel III and Solvency II - Solvency II - Quality of Capital Basel III Basic Own Funds Ancillary Own Funds - Highest Common Equity Tier 1 (CET) - Tier 1 (BOF) Tier 1 Tier 2 (BOF) Tier 2 (AOF) - Tier 2 Tier 3 (BOF) Tier 3 (AOF) - Lowest Tier 3 *Source: IMF working paper content unit _wp11187 - 30.* ### 50. Also, both accords provide for a system of capital tiers that, however, are quite ### _wp11187 - 50. Also, both accords provide for a system of capital tiers that, however, are quite ### Capital-tiers: differences and scope - Both Basel III and Solvency II define various categories of capital, but they are inconsistent in categories, terminology, and inclusion criteria (see Table 1). - Use of explicit capital-tiering rules is more prevalent and long-standing in banking than in insurance; insurers traditionally have simpler, equity-focused capital structures and can use reinsurance to strengthen capital positions rather than issuing lower-quality capital instruments. - All capital recognized under Basel III is on the balance sheet, while the Available Own Funds (AOF) under Solvency II are not necessarily on the balance sheet. - Instruments that can be called upon to absorb losses are included in capital available to meet the Solvency Capital Requirement (SCR) but not the Minimum Capital Requirement (MCR) under Solvency II. ### Inconsistencies without business/valuation basis - Regulatory adjustments to capital differ for items such as intangibles other than goodwill, deferred tax assets, and excess assets related to employee pension benefits. - Basel III tightened requirements to avoid double-gearing from equity participation in subsidiaries but still allows exceptions that provide some scope for double-gearing, offset by more stringent risk weighting. ### Basel III structural reforms - Basel II provided for three tiers of capital; Basel III simplifies classification into two tiers: - Tier 1 = going-concern capital - Tier 2 = gone-concern capital - Basel III includes classification criteria relating to permanence, loss absorbency, and flexibility of payments. - Within Tier 1, the common equity component (CET) is specifically identified; a minimum portion of required capital must be met using common equity. - Tier 3 instruments under Basel II (used to cover market risk, large trading-book exposures, and fixed overhead requirements) are not eligible under Basel III. ### Bail-in capital proposals (Basel III) — overview and feasibility issues - Bail-in converts non-equity claims into equity upon a trigger event to facilitate resolution and create equity so a bank can continue as a going concern. - Objectives: increase loss-absorption capacity of capital, contain costs of raising it, reduce funding advantage of systemically-important banks relative to insurers, and improve resolvability. - Key feasibility issues include: - Scope: apply to only capital instruments or all non-equity liabilities. - Trigger design: tradeoffs between market discipline and cost of capital. - Effectiveness in preventing contagion given cross-border and capital mobility issues. - Investor base suitability to absorb risk ex post without fiscal/financial spillovers. - Pricing difficulty near statutory non-viability determination due to discontinuity. - Legal concerns regarding rights of claimants and hierarchy after trigger. - Accounting and tax treatment need definition. - Unclear whether bail-in instruments would meaningfully advance over subordinated debt under Basel II. - Potential impacts on regulatory arbitrage with insurers: - Successful bail-in design could strengthen market discipline, improve resolvability, and eliminate banks’ capital/funding advantage relative to insurers, increasing banks’ average cost of capital and encouraging risk migration from banks to insurers. - Alternatively, if bail-in instruments behave like subordinated debt, the cost of capital for banks could decrease relative to insurers. ### Loss-absorption capacity and tier definitions across accords - Under both accords: - Tier 1 = capital fully loss-absorbent on a going-concern basis. - Tier 2 = capital that absorbs losses on a winding-up basis. - Solvency II additionally provides Tier 3 (own funds other than Tier 1 and Tier 2). - Solvency II classification criteria include subordination, loss-absorbency, permanence, perpetuity, and absence of servicing costs. - Ancillary items that convert to Tier 1 when called are classified as Tier 2 AOF; those that convert to Tier 2 are classified as Tier 3 AOF. ### Common Equity Tier 1 (CET) and Additional Tier 1 comparisons - Both sectors allow highest-quality items to count without limit toward capital requirements. - Basel III specifically identifies CET and sets out 14 criteria for inclusion in CET; Solvency II Directive does not distinguish within Tier 1, but QIS5 technical specifications list items that can count without limit in Tier 1. - Basel III sets out another 14 criteria for additional Tier 1 instruments (hybrid equity-debt), requiring, for example, sufficient going-concern loss-absorbency, subordination, fully discretionary noncumulative dividends or coupons, no maturity date, and no incentive to redeem. - Innovative and dated hybrid instruments allowed under Basel II are not allowed under Basel III. - Under Solvency II QIS5 technical specifications, up to 20 percent of total Tier 1 capital can consist of paid-in capital instruments other than common equity (examples: preference shares, subordinated liabilities, subordinated mutual member accounts meeting specific criteria). ### Detailed differences on permanence, payment flexibility, and loss absorption - Basel III does not allow dated instruments in Tier 1; Solvency II allows 10-year dated instruments, justified by matching assets and liabilities and subject to supervisory approval and automatic suspension when SCR breached. - Basel III prohibits a bank call unless either: - the instrument is replaced with capital of same or better quality at sustainable terms; or - the bank demonstrates capital position is well above the minimum after the call. - Solvency II does not impose a similar requirement. - Alternative Coupon Settlement Mechanism (ACSM) is not allowed under Basel III but is allowed under Solvency II. - Solvency II requires coupons to be cancelled when there is a breach of the SCR; Basel III does not explicitly require such cancellation. - Basel III requires instruments accounted for as liabilities to have a loss-absorption mechanism (write-down or conversion of principal); Solvency II does not. - Solvency II is more explicit on conversion mechanics (requires automatic conversion into ordinary shares) and specifies the trigger as a significant breach of the SCR; Basel III does not specify trigger level. ### Insurance-specific inclusions under Solvency II not recognized by Basel III - Jurisdictional law or insurer by-laws may require reserves usable only for prescribed purposes; such reserves are eligible in capital only relative to the risks they cover. - Surplus funds deemed accumulated profits not available for distribution to policyholders and beneficiaries; unless law provides otherwise, surplus funds are not insurance liabilities and are classified as Tier 1 capital. - Expected profits included in future insurance premiums under in-force policies: - Solvency II values liabilities taking into account expected future insurance premiums, even if policyholder is not contractually committed, thereby including future profits inherent in those premiums as part of liabilities with some loss-absorption capacity that might be recognized as capital. - Treatment differs across jurisdictions and frameworks. EIOPA has expressed the view that expected profits included in future premiums should be classified in Tier 3; the EC decided to classify this item as Tier 1 for QIS5 purposes. The amount was tested under QIS5 and classification is expected to be revised. - In banking, expected profits in future cash flows are recognized as capital only if contractually committed. ### Bases for limits on additional Tier 1 capital - Under Basel III, limits are based on the amount of CET; if CET decreases when losses occur, eligible additional Tier 1 capital also decreases. - Under Solvency II, limits are based on the amount of the SCR. - In both frameworks, any capital in excess of the limits is not counted within regulatory capital. ### Tier 2 and Tier 3 treatment differences - Permanence-related differences: - Basel III does not allow incentives to redeem (e.g., step-ups); Solvency II allows incentives to redeem after five years, but treats a step-up associated with a call as equivalent to a maturity date. - Basel III recognition in eligible Tier 2 is “amortized” on a straight-line basis during the final five years to maturity; Solvency II does not require amortization but lock-in clauses prevent repayment if repayment would breach the SCR. - Insurance-specific Tier 2/Tier 3 items included under Solvency II but not recognized under Basel III: - Called-up but unpaid capital included in Tier 2 basic own funds (BOF). - Unpaid capital and not called-up share capital included as part of AOF. - Future claims that mutual or mutual-type associations with variable contributions may have against members by way of a call for supplementary contributions within the following 12 months are included in Tier 2 AOF. - Future claims that mutual or mutual-type associations of ship owners with variable contributions solely insuring ship risks may have against members by way of a call for supplementary contributions within the next 12 months are included in Tier 2 AOF. - Letters of credit (LOC) and guarantees provided by authorized credit institutions and held in trust for the benefit of insurance creditors by an independent trustee, currently used to meet solvency requirements under Solvency I, are included in Tier 2; other LOC that generate capital once called up can be included subject to prior supervisory approval. - The treatment of provisions included by Basel II in Tier 2 under the standardized and IRB approaches, including the cap of 1.25 percent and 0.6 percent of credit risk-weighted assets under the SA and IRB approaches, respectively, remains to be considered. ### Regulatory adjustments to capital - Substantial differences exist in regulatory adjustments to capital allowed under both accords (see Table 2). - Basel III strengthens standards for regulatory adjustments relative to Basel II. - Under Basel III, deductions and prudential filters (“regulatory adjustments” or “capital deductions”) are mainly applied at the level of CET or sometimes at the level of other tiers. - Solvency II considers regulatory adjustments to Tier 1 or Tier 2 depending on the instrument. *Source: _wp11187 - 50. Also, both accords provide for a system of capital tiers that, however, are quite (IMF PDF).* ### 68. Some of the differences arise from differences in the underlying valuation ### Some of the differences arise from differences in the underlying valuation principles rather than real differences in what is considered capital ### Valuation principles and their effects - Under Solvency II, fair-value accounting leads to zero valuation for items that are not recognized as assets (e.g., goodwill is assigned no value because it is not considered an identifiable and separable asset); an item given no value under Solvency II has the same effect as a deduction under Basel III. - Investments in own shares: - Not deducted under Solvency II because common equity is only included on a net basis. - Treated as deductions under Basel III (see Table 2). - Own credit risk: - Not considered when valuing financial liabilities under Solvency II, so changes in own credit risk do not create gains or losses. - Under Basel III, unrealized gains and losses from changes in own credit risk are fully deducted from CET (Table 2). ### Seemingly inconsistent differences in treatment of specific items - Intangible assets other than goodwill (e.g., software): - Basel III: deduction recognizes these assets are likely to have little value in stress. - Solvency II: risk is expected to be captured by a risk surcharge in the SCR, but there is no requirement that this portion be covered by a specific type of capital. - Deferred tax assets (DTA): - Basel III: DTAs resulting from tax loss carryforwards are fully deducted; DTAs from timing differences are deductible above a threshold (recognized in Tier 1 up to 15 percent of CET, full deduction above 15 percent). - Solvency II QIS5 technical specifications: net DTA are deducted from Tier 1 but classified as Tier 3 BOF. - Defined benefit pension surpluses/deficits: - Basel III: employee-defined benefit pension fund assets and liabilities are excluded when calculating capital; deficits are deducted from CET net of authorized assets to which the bank has unfettered access. - Solvency II: full recognition of surpluses; Solvency II assumes excess assets over liabilities would be available to meet other obligations, while Basel III assumes employee rights might prevent this. - Premium attached to excluded shares: - Basel III: premium attached to any shares excluded from CET must also be excluded from CET and included in the same Tier as the related shares. - Solvency II: does not indicate such treatment. - Equity investments in financial entities and regulatory adjustment methods differ between the two frameworks, potentially producing different capital outcomes. ### Group-level application of regulatory adjustments - Banking sector (Basel III): - Uses the “corresponding deduction approach”: a deduction is applied to the same component of capital that the item would qualify for if issued by the bank itself. - This approach results in a smaller transfer of resources from the participated to the participating entity — more prudent when the participated entity is in surplus, but less prudent when the participated entity is in deficit. - Insurance sector (Solvency II): - Uses the “deduction and aggregation” method: after deducting the participation from the participating entity’s own funds, capital requirements and own funds of the participated entity are added proportionally to those of the participating entity. - This method can result in a higher variance of the participating entity’s solvency position and a larger scope for double gearing (see implications below). ### Summary of regulatory adjustments (selected items from Table 2) - Goodwill and other intangibles: - Basel III: Full deduction from CET net of any deferred tax liabilities if goodwill is derecognized or impaired. Mortgage servicing rights (MRS) are excluded. Supervisors can allow banks to use IFRS instead of GAAP. - Solvency II: Goodwill not considered a capital item (not separable/identifiable). Full recognition of other intangibles if separable and identifiable; risk-weighted in the SCR formula. - Deferred tax assets: - Basel III: DTAs that rely on future profitability are fully deducted from CET net of associated deferred tax liabilities. DTAs arising from temporary differences recognized as a reserve within Tier1 up to 15 percent of CET. Full deduction above 15 percent threshold. DTAs that are claim on tax authority risk-weighted as claim on relevant government. - Solvency II: Full deduction from Tier 1, but classified as Tier 3 BOF. - Cash flow hedge reserves: - Basel III: Full deduction from CET. - Solvency II: Not applicable (banking-specific). - Changes in own credit standing: - Basel III: Full deduction from CET of all unrealized gains and losses. - Solvency II: Not applicable. - Defined benefit pensions: - Basel III: Full deduction from CET of pension liabilities and deficits net of authorized assets to which the bank has unfettered access. - Solvency II: Full recognition of surpluses. - Investment in own shares: - Basel III: Full deduction from CET of direct or indirect investment; Investment in own Tier 1 and Tier 2 capital must also be deducted following the “corresponding deduction” approach. - Solvency II: Full deduction from Tier 1. - Reciprocal cross holdings: - Basel III: Full deduction following the “corresponding deduction approach.” - Solvency II: Full deduction from the Tier in which the holding would be classified to avoid double gearing. - Equity investment thresholds: - Basel III: Non-significant participation defined as ≤10 percent of sub’s common equity; full deduction of consolidated holdings valued in aggregate in excess of 10 percent of bank’s common equity. - Solvency II: Non-significant participation defined as ≤20 percent of sub’s common equity; different treatment for holdings in insurers or credit institutions (solo basis). Detailed treatment varies for credit institutions vs insurer participations and significant participations (>10 percent vs >20 percent thresholds). - Other recognition: - Basel III: Recognition up to 10 percent of bank common equity for each of: significant holdings in shares in unconsolidated entities, MSR, and DTAs related to temporary differences; recognition up to 15 percent in aggregate after 2013; amounts recognized risk-weighted at 250 percent. - Solvency II: (Table entries reflect different approaches as summarized above.) ### Implications for cost of capital and regulatory arbitrage - Differences in capital-eligibility criteria can affect relative cost of capital and create incentives for regulatory arbitrage across banking and insurance sectors because both sectors access the same capital markets. - Treatment of claims (consumers, reinsurers, claimants under winding-up legislation) may affect availability and cost of capital. - Higher threshold for defining significant participations (20 percent under Solvency II vs 10 percent under Basel III) suggests a larger scope for double gearing under Solvency II. - The Solvency II group-level aggregation method can lead to higher variance in participating entities’ solvency positions; if this translates into higher risk-adjusted expected profitability, this could lower the cost of capital for insurers relative to banks, other things being equal. ### Basel III: required capital and methodological changes (Pillar 1 focus) - Overall methodology: - Banks express aggregate risk as risk-weighted assets across credit risk, market risk, and operational risk; required capital is a percentage of total risk-weighted assets. Results for the three risk types are added without adjustment for correlations. - Strengthened minimum capital requirements and additional buffers: - The required ratio of CET to risk-weighted assets will increase from 2 percent to 4.5 percent by January 1, 2015, and will incorporate stricter regulatory adjustments. - The required Tier 1 capital ratio will increase from 4 percent to 6 percent over the same period. - The minimum ratio of total Tier 1 and Tier 2 capital to risk-weighted assets will remain at 8 percent. - A capital conservation buffer of 2.5 percent, phased in between 2016 and 2019, is to be met with common equity. - A counter-cyclical capital buffer, within a range of zero percent to 2.5 percent of common equity or other fully-absorbing capital, will be required if national circumstances show excess credit growth and system-wide risk. - Approaches to determining risk-weighted assets: - Standardized approaches (supported by external credit assessments) or internal models (IRB) may be used for credit risk; market risk uses VaR with a 99 percent one-tailed confidence interval over a 10-day holding period (minimum one year of historical observations). - Credit risk under IRB: asymptotic single-risk factor (ASRF) model with a 99.9 percent confident interval and expected losses forecasted over a one-year horizon. - Operational risk under AMA: VaR model with a 99.9 percent confidence interval over a one-year horizon. - For operational risk, a simpler basic indicator approach is allowed where capital requirement equals 15 percent of the average of the previous 3 years of annual gross income. - Leverage and liquidity requirements: - Leverage ratio compares capital to non risk-weighted assets; set at 3 percent in July 2010 and subject to parallel-run testing starting in 2013; possible final adjustments in first half of 2017 with a view to full Pillar 1 treatment on January 1, 2018. - Net stable funding ratio (NSFR) and liquidity coverage ratio (LCR) introduced to contain funding and liquidity risk. - Market risk stress measures: - Stressed VaR based on a 10-day, one sided 99 percent confidence interval calibrated to a period of significant financial stress. - The maximum of the stressed VaR and its average of the preceding 60 days (multiplied by 3) is added to the general capital charge, alongside the specific risk charge. - Systemically important financial institutions (SIFIs): - Basel III requires additional capital charges for SIFIs; in June 2011, the BCBS, together with the G20 and the FSB, agreed that larger banks would be subject to a capital surcharge ranging from 1 percent to [text truncated at source]. *Source: Excerpt from the IMF working paper (sections 68–80).* ### 2.5 percent to be met through common equity and not through hybrid instruments. Such a ### _wp11187 - 2.5 percent to be met through common equity and not through hybrid instruments. Such a ### Solvency II: capital requirements and calibration - Minimum absolute capital requirements by insurer type: - EUR 1 million for a captive insurer. - EUR 2.2 million to EUR 3.2 million for a nonlife insurer, depending on the classes of business written. - EUR 3.2 million for a life insurer or a reinsurer. - Two risk-based capital levels: - MCR (minimum capital requirement): level below which an insurer would be considered a gone concern. - SCR (solvency capital requirement): level required for a viable going concern. - Calibration and risk measure: - Both MCR and SCR calibrated over a one-year horizon using value at risk (VaR). - MCR calibrated at 85 percent VaR over one year. - SCR calibrated at 99.5 percent VaR over one year. - Relationship and constraints between MCR and SCR: - SCR should always be higher than the MCR, but differences in calculation may prevent this. - Solvency II caps the MCR at 45 percent of the SCR and establishes a floor for the MCR of 25 percent of the SCR. - The MCR is subject to minimum absolute amounts which may override the cap (for a small insurer might be higher than 45 percent or even 100 percent of the SCR). - MCR must be met by eligible BOF of the insurer; SCR can be met by all eligible capital, including AOF. - Use of internal models and supervisory overrides: - Insurers may use the standardized approach or internal models (full or partial), subject to supervisory approval. - Supervisors can impose capital add-ons to the SCR if the insurer’s risk profile is higher than the standard formula or if internal models are inadequate. - Calculation methodologies: - MCR calculations apply linear risk factors to components of premiums and liabilities; do not account for diversification or interdependencies. - SCR calculated on a per-risk basis covering: nonlife underwriting risk, life underwriting risk, health underwriting risk, market risk, counterparty default risk, and operational risk. - Scenarios: required under the standard formula; used (but not required) under internal models; calculations include prospective new business expected within the next 12 months. - Calculations are non-linear and account for diversification and interdependencies. - Frequency and stress-testing: - MCR must be calculated quarterly. - SCR must be calculated yearly and recalculated whenever the insurer’s risk profile changes significantly. - Models should be recalibrated when Own Risk and Solvency Assessments (ORSAs) are performed. - ORSAs assess overall solvency needs, compare risk profile to that underlying the SCR standard formula, and test ability to meet the SCR; ORSA results are not used to calculate the SCR. ### Risk aggregation, dependencies, and credit risk mitigation - Basel III Pillar 1 risk weights still depend on portfolio invariance and do not reflect diversification or penalize concentrations; additional capital can be imposed by supervisors under Pillar 2. - Recognized credit risk mitigation (CRM) techniques under Basel III: - (i) collateral; - (ii) guarantees; - (iii) credit derivatives; - (iv) claims netting. - Collateral treatment: - Two approaches: the simple approach or the comprehensive approach. - Simple approach: substitute the risk weight of the collateral for the risk weight of the counterparty, subject to a 20 percent floor. - Comprehensive approach: reduce the risk weight of the counterparty by the risk weight ascribed to the collateral; adjust exposure and collateral values using haircuts and account for future fluctuations. - Guarantees and credit derivatives: - Recognized when direct, explicit, irrevocable, and unconditional. - Supervisors must be satisfied banks meet minimum operational conditions and recognize guarantors; hedged portion assigned risk weight of the guarantor or protection provider. - Maturity mismatches in CRM: - If CRM original maturity is less than one year and there is a maturity mismatch, CRM is not recognized for capital purposes. - Otherwise, partial recognition is given for regulatory capital purposes. - On-balance sheet netting: - Allowed if risk-management processes meet operational conditions and bank can determine assets and liabilities with the same counterparty at any time. - Assets treated as exposure and liabilities as collateral; haircuts zero except when a currency mismatch exists. - Solvency II treatment of diversification and correlations: - Standard formula for SCR reflects diversification and risk interdependencies using correlation matrices; adjustments applied within risk classes, across business lines, across risk classes, and at group level. - Correlations across risk classes (from QIS5 Technical Specifications): - Market risk vs Market risk: 1 - Counterparty default vs Market risk: 0.25; Counterparty default vs Counterparty default: 1 - Life underwriting vs Market risk: 0.25; vs Counterparty default: 0.25; vs Life underwriting: 1 - Health underwriting vs Market risk: 0.25; vs Counterparty default: 0.25; vs Life underwriting: 0.25; vs Health underwriting: 1 - Nonlife underwriting vs Market risk: 0.25; vs Counterparty default: 0.50; vs Life underwriting: 0; vs Health underwriting: 0; vs Nonlife underwriting: 1 - Application of correlations can reduce required capital significantly compared to a linear combination. - Concentrations and risk-mitigation contracts: - Underwriting concentrations recognized in nonlife catastrophe risk and life catastrophe risk sub-modules. - Market risk concentrations sub-module recognizes lack of diversification in asset portfolio or large exposure to a single issuer or group. - Counterparty default-risk module accounts for overall counterparty exposure irrespective of contractual form. - Reinsurance, securitizations, and derivatives recognized; counterparty default risk module accounts for related risks. ### Scope for consolidation - Basel III application: - Applied to either the solo entity or the consolidated group up to the holding company; scope unchanged from Basel II. - Includes: (i) any holding company on a fully consolidated basis within a banking, or a predominantly banking, group; (ii) all internationally-active banks at every tier within a banking group, on a fully-consolidated basis. - For bank conglomerates, the holding company bears full entrepreneurial risk of the subsidiary; supervisors assess appropriateness of recognizing the participation; when not consolidated, full deduction is required. - Same methodology to calculate capital requirements applies at solo or group level. - Solvency II group-level calculations: - Focus on group SCR; an approximation of “group MCR” is calculated by summing MCRs of separate legal entities to establish a floor for group SCR. - Two basic methods for group SCR: - Method 1 (default): accounting consolidation—apply standard formula to consolidated assets and liabilities. - Method 2 (alternative): deduction and aggregation—combine solo SCR and solo capital proportionally for insurers not wholly owned. - Groups can apply combinations of Methods 1 and 2 where exclusive application of Method 1 is inappropriate. - Internal models can be used to calculate group SCR. - Diversification across entities is reflected except under Method 2. - Non-EEA insurers: - Solvency II rules generally apply to insurers based outside the EEA. - If a non-EEA jurisdiction’s solvency regime is assessed as equivalent to Solvency II, solo SCR and solo capital determined under local rules can be used in group calculations when Method 2 is used. - Where group members are other regulated financial institutions, relevant sectoral requirements apply under Method 1 or Method 2. ### Supervisory responses to breaches of capital requirements - Role: - Capital requirements serve as triggers for supervisory action. - Banking sector examples of structured systems: - Prompt Corrective Action (PCA) in the United States; Structured Early Intervention and Resolution (SEIR) in some Asian and European countries. - PCA classifies banks into five categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. - Critically undercapitalized banks include those with tangible equity capital below 2 percent of total assets. - PCA supervisory actions summarized: - Undercapitalized banks must have supervisory permission to pay dividends or repurchase stock. - Undercapitalized banks must submit a capital restoration plan approved by the supervisor. - Significantly undercapitalized banks must limit bonuses and salary increases to management. - Critically undercapitalized banks must be placed in receivership within 90 days if no other option is available. - Supervisors can take additional actions such as changing management. - Basel III and CRD: - Emphasize timely supervisory intervention when banks fail to meet capital requirements; require review and examination of risk profiles and management systems and prompt application of prudential measures. - Supervisory powers and compliance differ by country; limited information and legal powers may hinder supervisors in some jurisdictions. - Solvency II-specific procedures for insurers: - Insurer must notify supervisor as soon as it observes SCR has been breached. - Within two months insurer must submit a plan to achieve compliance within six months; compliance period can be extended by three months—or longer in event of a significant fall in the financial markets. - Insurer must notify supervisor as soon as it observes MCR has been breached or breach likely within next three months. - Timelines: one month to submit a plan and three months to achieve compliance, either by obtaining additional capital or reducing risk profile. - During noncompliance insurers may be restricted in or prohibited from disposing of assets. - Disclosure: - Insurers required to publicly disclose SCR coverage and must announce publicly if SCR coverage falls below 100 percent, including reasons and remedial actions taken. - Capital instruments to qualify as Tier 2 or better must permit deferral of payments if SCR coverage falls below 100 percent; this creates incentive to maintain sufficient capital to minimize breach risk. ### Implications and lessons - Comparability challenges: - Very difficult to compare capital requirements under the two accords due to differing methodologies and risk categories; comparisons at transaction or business-portfolio level may not hold at entity level. - Example: Solvency II reflects correlations among main risk areas while Basel III treats main risk areas separately. - Example: A bank and an insurer holding the same loan asset may face different capital treatments because an insurer must also hold capital for insurance risk on related policies. - Different capital charges likely: - Different basic approaches, differences in credit-mitigation techniques (aggregation and dependencies), and ad hoc negotiation of capital standards are likely to result in different capital requirements for similar risks. - Caution on internal models: - Promotion of internal models under Solvency II aims to strengthen insurers’ risk-management capacity, similar to Basel II’s IRB approach. - Experience with Basel II IRB showed on average lower risk charges than the standard approach; international evidence indicated the ratio of RWA over total assets decreased for a large set of European banks (Yogarajah, 2011). - This experience suggests either banks found ways to inflate capital adequacy ratios or supervisors relaxed validation standards. - The experience with internal models under Basel II provides important lessons for insurance supervisors and suggests close collaboration between banking and insurance regulators. *Italic source attribution: Excerpt from _wp11187 (IMF PDF chapter/section).* ### 107. The joint implementation of the two accords could lead to unintended ### The joint implementation of the two accords could lead to unintended consequences ### A. Cost of Capital - Issue overview: - The largely independent development processes of the two accords and differences in their content could lead to unintended consequences focusing on (i) cost of capital; (ii) funding patterns and interconnectedness; (iii) product and/or risk migration; and (iv) other potential sources of arbitrage. - It is unclear whether, and if so, to what extent the cost of capital for banks is going to increase compared to the cost of capital for insurers. - The conceptual framework invoked is the Modigliani-Miller theorem, emphasizing market imperfections (debt interest deductibility, moral hazard, asymmetric information, safety nets, bankruptcy costs, and debt overhang) that invalidate MM in the short run and that are not equally important for banks and insurers. - Arguments supporting higher costs for banks: - Banks benefit more from debt interest deductibility because they are more leveraged; therefore, the deleveraging (debt-equity swap) Basel III aims for will raise the marginal cost of capital for banks more than for insurers. - Reduced debt weakens debt as a monitoring device, increasing moral hazard and total cost of capital for banks more than for insurers. - A reduction of the too-big-to-fail (TBTF) funding benefit enjoyed on average more by banks could lead to higher average cost of capital for banks. - Information asymmetries: Solvency II could signal insufficient capital levels (and quality) relative to recent shocks, while Basel III signals inadequate quality rather than levels; this could raise banks’ total capital costs relative to insurers. - If Basel III reduces the relative likelihood of bankruptcy for banks more than Solvency II does for insurers, the relative value of subsidized safety nets for banks is reduced more. - Specific accord- and sector-related channels tending to favor lower insurer capital costs: - Solvency II allows larger scope for risk-mitigation techniques (including reinsurance), potentially lowering insurers’ cost of capital relative to banks. - Banks’ retrospective valuation methodology could decrease (increase) cost of capital for banks in the high (low) part of the cycle relative to insurers’ more prospective methodology. - Capital deductions appear more stringent under Basel III than Solvency II (example: intangible assets other than goodwill deducted under Basel III but not under Solvency II). - Hedging costs: insurers encouraged to take long-dated swaps under Solvency II while Basel III requires banks to hold more capital (and collateral) against these positions, making hedging more expensive for banks and reducing banks’ willingness to hold long-term interest rate swaps. - Geographic scope: Solvency II’s more restricted geographical application could lead to leakage via reinsurers in jurisdictions deemed equivalent by the EC but de facto more lenient. - Bank regulators likely to adopt step-up capital surcharges for systemically-important banks by size, interconnectedness, and substitutability—conceptually difficult to apply to large insurers, given insurance size is associated with increased risk diversification. - Insurance liabilities are more loss absorbing than banks’, which could reduce insurers’ costs to raise additional capital. - Solvency II’s promotion of internal models is expected to provide 30–40 percent capital requirement reductions relative to the standardized model, giving insurers scope to reduce cost of capital relative to banks. - Great uncertainty exists regarding the treatment of the illiquidity premium in valuing liabilities under Solvency II. - Arguments supporting higher costs for insurers: - A more risk-based approach may increase capital costs for the riskier insurers as investors use additional information to seek higher-quality insurers. - Solvency II adoption could be perceived as a more fundamental informational change than Basel III (Solvency II as having greater “informational content”). - Insurers raising capital by reducing liabilities may face higher costs than banks because many insurance liabilities lack tradable markets (e.g., difficulty hedging longevity risk), making MM less applicable to insurers. - Deleveraging of banks under Basel III reduces bankruptcy costs more for banks than for insurers, potentially reducing banks’ cost of capital relative to insurers. - Debt overhang effects: deleveraging reduces returns accruing to debt holders, reducing total cost of capital. - Contingent capital and bail-in instruments under Basel III may remain a cheaper source of capital for banks if they do not eliminate TBTF advantages; such instruments are less advanced in insurance discussions. - Interaction, timing, and migration considerations: - Pillar 1 requirements across the two sectors are sufficiently different to prevent conclusive directional claims. - Joint implementation of the two accords may increase incentives for both insurers and banks to issue equity at similar times, potentially raising the cost of new equity relative to staggered implementation. - The joint implementation may generate relatively stronger incentives for risk to migrate away from both sectors simultaneously rather than from one sector to the other. - Key policy question: which part of the financial system (a priori less supervised and regulated) is likely to attract such migrating risk. ### B. Funding Patterns and Interconnectedness - Issue overview: - Basel III and Solvency II could jointly reduce demand for banks’ long-term instruments when banks most need to issue them, creating unintended consequences for banks’ funding patterns and interconnectedness. - Solvency II effects on insurers’ demand: - Insurers using the standardized approach for the SCR are charged capital requirements through the credit spread risk module proportional to rating and duration of instruments held. - This makes longer-dated and/or lower-rated private sector instruments relatively less attractive. - EEA sovereign bonds, bonds guaranteed by EEA states, and supra-national agency and development bank bonds carry a zero risk weight in the standardized approach (as it stands). - Distortions exist between banks and real sector corporates: bank-covered bonds receive preferential treatment with lower charges. - Increased issuance of covered bonds could reduce the amount of unencumbered quality assets available in bank resolution, negatively impacting banks’ ability to issue unsecured debt. - Net effect: duration multiplier penalizes long-term maturities, increasing the likelihood insurers become mismatched and bear reinvestment risk, and leads to a preference for sovereign debt and short-dated higher-rated bank debt (especially covered bonds) relative to other corporates, potentially reducing banks’ ability to issue unsecured debt. - Basel III effects on banks’ demand and supply: - Under Basel III, banks’ senior unsecured bonds do not qualify for the LCR while they qualify for the NSFR. - Covered bonds and sovereign debt qualify for both the LCR and NSFR. - Likely outcomes: - Banks’ demand for unsecured debt will decrease while demand for covered bonds and sovereign debt will increase. - Banks’ supply of covered bonds will generally increase while supply of unsecured debt will increase only at longer maturities to meet NSFR requirements. - Basel III liquidity provisions could promote a partial swap on banks’ balance sheets between senior unsecured and covered bonds and an increase in issuance of senior debt toward longer maturities (5 to 10 years). - Counterarguments and mitigating points: - It is unclear whether demand from insurers for long-term maturity instruments will decrease materially; tradeoffs between maturity mismatches, capital charges, and duration multiplier differ across insurers with different liability structures. - Preferential treatment of covered bonds under Solvency II’s standardized approach could change banks’ funding mix rather than reduce overall demand for bank funding instruments (less senior debt, more covered bonds). - “Long term” for banks differs from insurers: insurers’ potential decrease in demand likely concerns very long-term maturities (20 plus years) that banks generally do not issue, whereas banks focus on 5 to 10 year maturities. - Any decrease in insurers’ demand for banks’ instruments only matters if demand for insurance products supported by such assets decreases; insurance business is liability-driven and asset demand depends on liability structure. - Whether Solvency II represents a funding risk for banks is empirical; it depends on elasticities of demand and supply across insurance business lines and the pass-through of increased cost of capital to margins where demand is least-sensitive to prices. - Senior unsecured and covered bonds are not placed mainly with insurers: the largest purchaser of senior unsecured bank bonds is the real money funds sector while the largest purchaser of bank-covered bonds is the banking sector; insurers represent only 10 percent of total demand for the two instruments (Figure 3). - Jurisdictional variation: In Germany, insurers hold approximately 35 percent of domestic issues of bank debt. *Source: _wp11187 - 107. The joint implementation of the two accords could lead to unintended consequences* ### 117. More of a concern could be the increased interconnectedness between banks and ### More of a concern could be the increased interconnectedness between banks and insurers. ### Interconnectedness and sovereign exposure - Solvency II and Basel III could result in increased demand for sovereign debt by both sectors, implying exposure to sovereign risk could increase and the type of interconnectedness between the two sectors could change and could be strengthened through the balance sheet of the sovereign. - Insurance internal models could, in principle, diffuse this concern by capturing the heterogeneity in credit risk across EU sovereigns, but their standards are yet to be defined. - Strong collaboration between the regulators of the two sectors would be required to minimize risks of arbitrage between the use of internal models so that for both banks and insurers appropriate risk weighted capital is held and that the risk is properly recognized and accounted for. ### Banks’ debt funding sources (by type of investor) - Senior Bonds: - Real Money Funds, 62% - Hedge Funds, 10% - Insurers, 10% - Banks, 18% - Covered Bonds: - Real Money Funds, 25% - Hedge Funds, 5% - Insurers, 10% - Banks, 45% - Central Banks, 15% ### Risk/Product transfers between banks and insurers - Risk/product transfer can occur in business lines where banks and insurers compete directly (e.g., certain life insurers’ savings products like term certain annuities attracting higher capital requirements than term deposit). - The new liquidity requirements proposed under Basel III should decrease the extent of regulatory arbitrage in commercialization of similar products. - Strengthening of capital treatment of market risk under Basel III could increase incentives for conglomerates to carry equity investments in a nonlife insurer subsidiary versus a bank subsidiary. - Potential risk transfer channels include: - Credit default protection products (e.g., CDSs) issued by both banks and insurers. - Between mortgage lenders and mortgage insurance. - Trade finance. - Establishing clear patterns depends on the treatment of specific risk exposures in internal models under Solvency II; close regulator collaboration is required to minimize model arbitrage and inappropriate risk migration between sectors. ### Risk passed onto customers and product-mix effects - Risk could be passed onto customers through risk sharing products in a non-socially optimal manner. - Examples of product structures that shift risk to customers: - Unit-linked life insurers where most or all market risk is borne by the policyholder. - Pension annuity products providing for periodical re-pricing as a function of mortality experience to share longevity risk. - There is an existing strong debate whether consumers are exposed to excessive risk in pension products; Basel III and Solvency II may exacerbate the problem in Europe where many pension products are offered by insurers and because of the possibility under discussion to extend the Solvency II framework to pension funds. ### Risk migration away from banks and insurers - Joint implementation of Basel III and Solvency II could lead to increased use of securitization, reinsurance and shadow banking by both banks and insurers. - When NSFR requirements become binding, securitization can remove long-term assets (like mortgages) from banks’ balance sheets and relieve banks from related Basel III requirements. - For insurers, reinsurance and ILS can be used to offset the cost of capital under Solvency II. - Past experience under Basel II shows moving exposure off balance sheets to reduce regulatory requirements led to origination-and-transfer models, widespread use of conduits and overconcentration of exposures in less regulated areas. - Increased use of risk-transfer mechanisms could produce more interconnected systems with opaque risk distribution, migrating toward less-regulated and supervised areas. - Implications: - The two accords increase the need for regulators/supervisors to improve transparency and strengthen oversight of these contagion channels. - They call for a careful definition of equivalent jurisdictions under Solvency II. ### Other potential sources of distortion - Tax considerations: - Heterogeneous tax treatment of capital items and similar products/instruments is likely to be a more important source of arbitrage than current regulatory reforms. - Tax-minimization strategies (e.g., interest deductibility) are likely to dominate cost-of-capital minimization strategies and promote funding through debt, encouraging leverage and complexity. - Heterogeneity in supervisory approaches: - Insurance markets have traditionally been less intrusively supervised than banking. - Market discipline is likely to be less effective in insurance due to only partial transferability of insurance products. - Pillar 2 (supervisory approach) and Pillar 3 (market discipline) should be considered when assessing unintended consequences, though heterogeneity in supervisory approaches is judged less important than regulatory capital requirements, at least in Europe. - The two accords have not been finalized; many moving parts remain, so potential sources of arbitrage can only be more clearly identified once details are finalized. ### Conclusions: differences in nature of capital and potential unintended consequences - Fundamental differences between banks and insurers: - Banks: asset driven, leveraged, wide range of activities, liabilities provide little loss absorption, exposed to liquidity risk, valuation/accounting partly retrospective. - Insurers: liability driven, much less leveraged, funded mainly through policyholder premiums, liabilities provide more loss absorption, less exposed to liquidity risk, valuation/accounting more prospective under Solvency II. - Reinsurance is available to insurers but not directly to banks. - Expectations: - Composition, level, and quality of capital will differ across sectors. - Objectives of accords: - Basel III: strengthen quantity and quality of capital in banking incrementally. - Solvency II: strengthen policyholders’ protection by tailoring regulatory capital to insurer risk, without necessarily increasing quantity in the sector as a whole. - Pillar 1 differences across sectors are often too different to conclude whether cost of capital will increase more for banks or insurers. - Possible effects include increased funding costs, increased interconnectedness through sovereign balance sheets, and increased use of securitization—leading to risk migration between or away from sectors. ### Policy considerations (drawn from the analysis) - Insurance regulators should communicate with banking counterparts to understand combined behavioral incentives under Basel III and Solvency II to reduce unintended consequences and avoid arbitrage between internal models and standardized approaches. - Group supervision has been strengthened but leakages remain a concern, especially under Solvency II due to restricted geographical application and potential use of non-equivalent jurisdictions for reinsurance; a key challenge is the approach by the EC to equivalence. - The adequacy of safety nets may need reviewing; increased use of covered bonds for bank funding would ring-fence assets and make them unavailable to depositors and unsecured creditors in resolution. - Basel III and Solvency II could increase the need to expand the perimeter of regulation: - Non-regulated entities and market-based risk transfer mechanisms might fill gaps as banks and insurers move toward shorter duration and less risky business. - Likely increased use of securitization requires strengthened transparency and oversight of contagion channels including securities lending-related cash collateral reinvestment programs. - Implement macro-prudential measures (such as counter-cyclical margin requirements) related to securitization, repos and securities lending where appropriate. - Improve market infrastructure for secured funding markets. - Consumer protection may need strengthening as Basel III and Solvency II may lead to excessive risk transfer to consumers (notably in pension benefits where consumers already bear investment and longevity risk). - There is a need for empirical investigation into the magnitude of unintended consequences; this paper represents an initial attempt to generate and relate a set of unintended consequences to specifics of Basel III and Solvency II, and empirical studies on their impact are generally absent. *Source: IMF staff discussion in WP11187.* ### 1. The Basel III and Solvency II accords are coming into effect within the next few ### 1. The Basel III and Solvency II accords are coming into effect within the next few years. ### Basel III — objectives and scope - Purpose: strengthen regulation, supervision, and risk management of the banking sector by enhancing capital, leverage, and liquidity requirements. - Emphasis: improve loss-absorption capacity of banking institutions through stronger capital; enhance short- and long-term stability via funding and liquidity requirements. - Pillar 1: particularly strengthened with enhanced minimum capital and liquidity requirements. ### Basel III — capital quality and required amounts - Common equity minimum ratio to risk-weighted assets: will rise to 4.5 percent in 2015 from the current requirement of 2 percent. - Qualifying elements within Tier 1 capital: common shares, minority interests, and retained earnings. - From January 2013, instruments not meeting criteria for inclusion in common equity will be excluded and phased out over a 10-year horizon. - Grandfathering: Only instruments issued before 12 September 2010 would qualify for the proposed transition arrangements. Other existing public sector capital injections would be grandfathered until January 1, 2018. - Capital buffers: - Capital Conservation Buffer: phased in starting at 0.6 percent of RWAs in 2016 and reaching 2.5 percent of RWAs in 2019; must be met entirely with common equity. - Countercyclical Capital Buffer: can be met with both common equity and other fully-absorbing capital; could be as low as zero but could reach up to 2.5 percent of RWAs in periods of excessive growth. - Combined potential fully-absorbing capital requirement (with buffers): could reach up to 9.5 percent of RWAs. - Additional capital layers required by 2019: - Additional Tier 1 capital: 1.5 percent of RWAs. - Tier 2 capital: 2 percent of RWAs. - Total capital requirements increase to 10.5 percent by 2019. - Transition of non-common-equity instruments: capital instruments that do not meet requirements for inclusion in Tier 1 common equity will be excluded as from January 1, 2013, unless conditions met; proposed phase-out over following 10 years. ### Basel III — leverage ratio - Reporting begins in 2013, disclosure after 2015, objective to include in Pillar 1 by 2018. - Definition: ratio of Tier 1 capital to total unweighted assets, including some off-balance sheet assets. - Required leverage ratio: 3 percent or more. - Unweighted assets include: provisions, loans, off-balance sheet items with full conversion, and all derivatives. - Purpose: constrain leverage and help safeguard against model risk and measurement errors. ### Basel III — liquidity requirements - Two new measures: - Liquidity Coverage Ratio (LCR): - Definition: LCR = High quality liquidity assets / Net cash outflow over 30 days. - Objective: measure sufficiency of high-quality liquid resources to survive an acute stress scenario lasting 30 days. - Requirement: ratio must be greater than 100 percent, subject to asset quality requirements. - Asset treatment: Level 1 assets included without limits and held at market value; Level 2 assets limited to 40 percent of required pool, minimum haircut of 15 percent, and should be diversified. - Net Stable Funding Ratio (NSFR): - Definition: NSFR = Available Stable Funding / Required Stable Funding. - Time horizon: one year. - Requirement: ratio must be greater than 100 percent. - Additional monitoring ratios: LCR by Significant Currency, Contractual Maturity Mismatch, Concentration of Funding, and Available Unencumbered Assets. ### Basel III — trading book and counterparty risk - Strengthened capital required for counterparty credit risk and market risk in the trading book. - New capital requirements include: Credit Value Adjustment (CVA), Wrong Way Risk (WWR), Stress Value at Risk (stressed VaR), and Incremental Risk (IR). - Stressed VaR specification (footnote): For extreme value events banks must calculate a stressed VaR based on a 10 day, one side 99 percent confidence interval; the stressed VaR needs calibration to a period of significant and relevant financial stress; the maximum of the stressed VaR and its average of the preceding 60 days (multiplied by 3) is to be added to the general capital charge; current specific risk charge continues to be required. ### Solvency II — framework and pillars - Approach: total balance sheet approach, taking into account actual risk on the balance sheet and offsetting effects. - Implementation scheduled: January 2013 (applies to all except the very smallest insurers and reinsurers in Europe as well as non-European ones operating in that region). - Structure: three pillars - Pillar 1: quantitative requirements related to technical provisions and capital, including going-concern Solvency Capital Requirements (SCR) and gone-concern Minimum Capital Requirements (MCR). - Pillar 2: governance and risk management provisions. - Pillar 3: supervisory reporting and transparency requirements. ### Solvency II — SCR and MCR estimation (Box 2) - SCR formula: SCR = BSCR + SCR_op - Adj - BSCR: basic SCR (computed before adjustments; combines capital charges for market risk, counterparty risk, life and non-life underwriting risks, and health underwriting risk). - SCR_op: capital charge for operational risk. - Adj: adjustment for the risk absorbing effect of future profit sharing and deferred taxes. - VaR target for SCR: confidence level of 99.5 percent over a one-year time horizon. - MCR formula: MCR = Max{MCR_combined, AMCR} - AMCR: absolute floor of the MCR. - MCR_combined = {Min[Max(MCR_linear; 0.25xSCR); 0.45xSCR]} - Cap and floor applied to linear MCR: 45 percent and 25 percent of the SCR, respectively. - MCR_linear: sum of linear MCRs for each type of business before cap/floor. - Objective: SCR aims to cover against a 1 in 200 years event; MCR is the absolute minimum required capital. Breaching MCR leads to immediate supervisory action that can trigger withdrawal of supervisory authorization. - Supervisory role: difference between SCR and MCR is an intervention window to reduce the risk that MCR will be breached. ### Comparison of risk coverage under Pillar 1 - Basel III Pillar 1 risk areas: credit risk, market risk, operational risk. - Credit risk mainly from the banking book; exceptions include credit counterparty risk from Securities Financing Transactions (SFT) and OTC derivatives originating in the trading book. - Market risk: interest, equity, FX, and commodities risk, mainly in the trading book. - Operational risk: losses from inadequate or failed internal processes, people, and systems. - Solvency II Pillar 1 risk areas: nonlife underwriting risk, life underwriting risk, health underwriting risk, market risk, counterparty default risk, and operational risk. - Underwriting risk: risk of loss associated with insured perils and insurance business processes (risk selection, claims settlement). ### Credit risk — standardized approaches and weights - Basel III did not materially change Basel II credit risk treatment in the banking book; discussions include decreasing dependency on external ratings and reducing procyclicality from internal models, but no concrete amendments had been formulated at time of writing. - Treatment highlights and exact weight rules: - Claims on sovereigns and central banks: risk weighted between zero percent and 100 percent, depending on ratings. - Claims on noncentral government public sector entities (PSE): receive same risk weights as banks; supervisors may assign same rating as sovereigns when entities have revenue-raising powers. - Claims on multilateral development banks (MDB): risk weighted following option 2 for banks without preferential treatment of short-term claims. - Two options for claims on banks and securities firms: - Option 1: banks have no external ratings and claims receive a one-less-favorable rating category than the sovereign of incorporation. - Option 2: banks receive their own ratings and unrated banks receive 50 percent risk weight; supervisor can treat short-term claims preferentially by granting one-more-favorable rating category. - Claims on corporates (including insurers): similar to banks, with higher risk weights for corporate rated B+ to B-; supervisors may authorize risk weighting all corporate claims at 100 percent regardless of external ratings. - Retail loans and residential mortgages: unrated by definition; retail loans receive risk weight of 70 percent and residential mortgages 35 percent. - Claims secured by commercial real estate: 100 percent risk weight (lower weights possible for well-developed, long-established markets). - Unsecured portion of nonperforming loans (NPLs): - Provisions < 20 percent: 150 percent risk weight. - Provisions ≥ 20 percent: 100 percent risk weight. - Supervisor discretion: reduce to 50 percent risk weight when provisions are more than 50 percent. - Higher risk claims: default weight of 150 percent; other assets default to 100 percent (supervisors may increase under Pillar II). - Off-balance sheet items: risk-weighted via credit conversion factors (CCF): - Repos, reverse repos, long positions in forward markets, and securities lending: CCF of 100 percent. - Commitments original maturity > one year or contingent claims associated with performance bonds, warranties, letters of credit: CCF of 50 percent. - Commitments original maturity < one year: CCF of 20 percent, or 0 percent if commitment cancelable unilaterally by bank. ### Table A1 — Basel II/III Credit Risk Weights (Standardized Approach) — categorical weights (as presented) - Sovereigns: AAA to AA- = 0.00; A+ to A- = 0.20; BBB+ to BBB- = 0.50; BB+ to BB- = 1.00; B+ to B- = 1.00; Less than B- = 1.50; No rate = 1.00. - PSEs (1): AAA to AA- = 0.20; A+ to A- = 0.50; BBB+ to BBB- = 1.00; BB+ to BB- = 1.00; B+ to B- = 1.00; Less than B- = 1.50; No rate = 1.00. - PSEs (2): AAA to AA- = 0.20; A+ to A- = 0.50; BBB+ to BBB- = 0.50; BB+ to BB- = 1.00; B+ to B- = 1.00; Less than B- = 1.50; No rate = 0.50. - MDBs: AAA to AA- = 0.20; A+ to A- = 0.50; BBB+ to BBB- = 0.50; BB+ to BB- = 1.00; B+ to B- = 1.00; Less than B- = 1.50; No rate = 0.50. - Banks (1): AAA to AA- = 0.20; A+ to A- = 0.50; BBB+ to BBB- = 1.00; BB+ to BB- = 1.00; B+ to B- = 1.00; Less than B- = 1.50; No rate = 1.00. - Banks (2): AAA to AA- = 0.20; A+ to A- = 0.50; BBB+ to BBB- = 0.50; BB+ to BB- = 1.00; B+ to B- = 1.00; Less than B- = 1.50; No rate = 0.50. - Banks (short term claims): AAA to AA- = 0.20; A+ to A- = 0.20; BBB+ to BBB- = 0.20; BB+ to BB- = 0.50; B+ to B- = 0.50; Less than B- = 1.50; No rate = 0.20. - Corporates: AAA to AA- = 0.20; A+ to A- = 0.50; BBB+ to BBB- = 1.00; BB+ to BB- = 1.00; B+ to B- = 1.50; Less than B- = 1.50; No rate = 1.00. - Retail claims: No explicit rated weights across categories; No rate column entry = 0.75. - Residential mortgages: No rate column entry = 0.35. - Commercial mortgages: all rating categories = 1.00. - NPLs (provisions < 0.2): all rating categories = 1.50. - NPLs (provisions ≥ 0.2): all rating categories = 1.00. - Other securitized claims: all rating categories = 1.00. *Source: 1. The Basel III and Solvency II accords are coming into effect within the next few years.* ### 12. Under Solvency II, credit risk is dealt with in two risk modules. The spread risk sub- ### _wp11187 - 12. Under Solvency II, credit risk is dealt with in two risk modules. The spread risk sub- ### Credit Risk: Solvency II treatment - Credit risk is addressed in two modules: the spread risk sub-module (credit risk associated with investments in bonds) and the counterparty default risk module (credit risk associated with derivatives). - Capital under the spread risk sub-module depends on rating category and duration: - Market value of an asset is multiplied by a rating-dependent stress factor and by its duration, which is subject to floors and caps. - Long-duration assets face much higher capital requirements than short-duration assets of the same rating. - Special treatments: - No capital requirement for borrowings by or demonstrably guaranteed by the national government of an EEA state, issued in the currency of the government, or issued by a specified multilateral development bank or international organization. - Mortgage covered bonds and public sector covered bonds that meet certain requirements and are rated AAA: stress factor of 0.6 percent and duration cap of 53 years. - Table A2 (Solvency II Credit Risk Factors) — selected entries (Stress Factor / Duration Floor / Duration Cap): - AAA: 0.9 / 1 / 36 (Non-EEA Governments: 0 / - / -) - AA: 1.1 / 1 / 29 (Non-EEA Governments: 0 / - / -) - A: 1.4 / 1 / 23 (Non-EEA Governments: 1.1 / 1 / 29) - BBB: 2.5 / 1 / 13 (Non-EEA Governments: 1.4 / 1 / 23) - BB: 4.5 / 1 / 10 (Non-EEA Governments: 2.5 / 1 / 13) - B or lower: 7.5 / 1 / 8 (Non-EEA Governments: 4.5 / 1 / 10) - Unrated: 3.0 / 1 / 12 (Non-EEA Governments: 3.0 / 1 / 12) - Note: Exposures to non-EEA governments and central banks denominated and funded in the domestic currency receive the Non-EEA Government entries above. ### Market Risk — overview and Basel III changes - Market risk: risk of losses in on- and off-balance sheet positions from changes in market prices. - Basel III scope: interest rate and equity risk in trading book; foreign exchange and commodity risk throughout the bank. - Basel III modifications: - Adds concept of correlation trading portfolio (includes securitization exposure and nth-to-default credit derivatives meeting certain criteria). - Minimum capital charge of 8 percent for exposures in correlation trading portfolios; transition period until end of 2013 for capital charges for noncorrelation trading portfolios. - Options: alternative approaches depending on significance of a bank’s trading portfolio — simplified approach allowed for limited options-buying activity; intermediate approaches or internal models expected if writing and purchasing options. - Basel III does not impose a capital charge for interest rate risk in the banking book; instead addresses maturity mismatch risks via liquidity requirements (LCR) and net stable funding ratio (NSFR). ### Interest Rate Risk: Basel III vs Solvency II - Basel III: - No capital charge for interest rate risk in the banking book. - Capital required for interest rate risk in the trading book (specific and general market risk). - Specific risk rules determine capital charge for issuer risk, unrated debt, non-qualifying issuers, and positions hedged by credit derivatives. - Table A3 (Basel III Market Risk Capital Charges for Specific Risk) — selected entries (External Assessment / Capital Charges): - Government AAA to AAA-: 0 percent - A+ to BBB-: - 0.25 percent (residual term to final maturity 6 months or less) - 1.00 percent (residual term to final maturity greater than 6 months and up to (and including) 24 months) - 1.6 percent (residual term to final maturity exceeding 24 months) - BB+ to BB-: 8.00 percent - Below B-: 12.00 percent - Unrated: 8.00 percent - Qualifying (e.g., public sector, investment grade subject to supervisory approval): - 0.25 percent (residual term to final maturity 6 months or less) - 1.00 percent (residual term to final maturity greater than 6 and up to and including 24 months) - 1.6 percent (residual term to final maturity exceeding 24 months) - Other: similar to credit risk charges under the standardized approach (e.g., BB+ to BB-: 8.00 percent; Below BB-: 12.00 percent; Unrated: 8.00 percent) - Solvency II: - Capital required for interest rate risk for all assets and liabilities with net asset value sensitive to term structure or interest rate volatility (includes fixed-income investments, policy loans, interest rate derivatives, insurance liabilities). - Capital requirement determined using two pre-defined instantaneous scenarios (upward or downward shifts in term structure). - Absolute change in downward scenario must be at least one percentage point, except shocked rate cannot be negative. - Capital requirement = greater of the two absolute changes in net value of assets and liabilities due to re-valuing all interest rate sensitive items under the two scenarios. - Table A4 (Solvency II Interest Rate Risk Scenarios) — Relative Changes by Maturity: - 1 year or less: Upward 70 percent / Downward -75 percent - 5 years: Upward 55 percent / Downward -45 percent - 10 years: Upward 42 percent / Downward -31 percent - 20 years: Upward 26 percent / Downward -29 percent - 30 years or more: Upward 25 percent / Downward -30 percent ### Equity Risk - Basel III: - Two charges for equity risk: specific and general market risk. - National authorities can no longer grant lower capital specific risk charges for liquid and well-diversified equity portfolios. - Capital charge for both specific and general market risk: 8 percent. - Equity derivatives must be included and exposures converted into exposures in the relevant underlying; matched identical long/short positions can be fully offset. - Equity index exposures: additional 2 percent capital charge on net long or short position. - Solvency II: - Capital required determined by immediate shocks to equity values: - 39 percent reduction on global equities - 49 percent reduction on other equities and commodities - No shock applied to participations in financial and credit institutions - 22 percent shock applied to other strategic participations - Correlation of 0.75 assumed between global and other categories. - Intends to incorporate counter-cyclical symmetric adjustment into equity shock (example: 30 percent global equity shock applied in QIS5 instead of base 39 percent). ### Commodities Risk - Basel III: unchanged from prior standard. - Under standardized approach banks may use maturity ladder method or simplified method. - Capital charge for directional risk: 15 percent of the net position (long or short) in each commodity plus an additional 3 percent capital charge of the bank’s gross positions. - Solvency II: - Commodities risk treated as equity risk. - Capital requirement based on a 49 percent shock in the value of the commodity position. - Note: Commodities defined as physical products tradable on a secondary market such as oil, agricultural products, and precious metals (excluding gold, which is accounted for as FX). ### Foreign Exchange Risk - Basel III: - Capital for FX risk unchanged: calculate net open positions in different currencies and gold; apply uniform 8 percent capital charge to the higher of net long currency position or net short positions (across currencies and gold). - Banks with negligible FX business or not taking FX positions with own funds can be exempted. - Solvency II: - Required capital determined for each individual currency position, taking into account insurer’s investment policy (including hedging and gearing). - Contribution to capital requirement for each currency = maximum of results of a 25 percent rise or a 25 percent fall in value of the currency relative to local currency. - Most significant impact likely at group level for insurers with equity investments in foreign subsidiaries. *Source: QIS5 Technical Specifications; BCBS (2006).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11187.pdf_