ITFA’s response to the hotly debated PRA Consultation Paper highlighted two things. Firstly, insurers and banks are in fact able to fight together to defend their common interests. Secondly, given the potential ramifications of PRA Paper 6/18, it has also shown a great need for them to close ranks.
In the 180 pages long response, ITFA, coordinating with other industry bodies, explained to the UK regulator in detail how different insurance products help banks to efficiently reduce risks related to their trade finance activities. It also explained why these products - given the documentation used and prevailing market practice - are absolutely in line with the prerequisites of the Capital Requirements Regulation (CRR – the European implementation of the Basel III rules) for efficiently achieving risk weighted assed reduction.
But now the cooperation between banks and insurers is yet again being challenged. The so-called Basel IV is set to be implemented by national regulators on January 1st, 2022. The aim is clearly to harmonize the market by reducing the differences between how different banks calculate capital reserves needed to make when putting risks on their balance sheet. And with Basel IV the playing field seems indeed more levelled: Experts say the new rules could allow a bank only to get capital treatment that’s maximum 7.5% better what the a Standard Approach bank could achieve.
This year the European legislators are working on the integration of Basel IV into our legal framework, namely by adapting the CRR. But what could change and why is ITFA concerned with the matter?
There are many amendments to the existing Basel III rules – new floors have been introduced, applicable regimes have changed among many others. Here I will focus only on the two changes that have the most important impact on the cooperation between banks and insurance companies:
Advanced vs Foundation Internal Rating Based Approach
Different banks use different models to calculate the capital allocation they need to buffer the risks they take onto their balance sheet. For the Standard approach the regulator clearly defines the required capital weighting for each rating class and risk category. Conversely, when using an Internal Rating Based Approach – the so-called IRB, the bank uses its own models to determine the risk weighted assets.
Here again there are two different treatments. The Foundation IRB, where only the PD (Probability of Default) is individually modelled, and the Advanced IRB (A-IRB), which most large European banks use, whereby PD and LGD (Loss Given Default) will be determined by the banks own models.
Under the new rules, all assets related to Large Corporate (revenues > EUR 500 m) and FI risks can't be evaluated any longer under the A-IRB but have to use the pre-defined LGDs for the Foundation IRB (F-IRB) or Standard approach.
LGD floor for Financial Institutions of 45%
Basel IV will also introduce new floors for the LGD: for small corporates evaluated under A-IRB this floor will be 25%, for large Corporates which will have to be now evaluated as per the F-IRB, the floor is 40% and for Financial Institutions it is 45%.
What does this mean?
Firstly, there might be another shift in the risk mitigation behavior of banks. In the past, banks mainly used credit risk insurance to manage credit exposure. Over the last years this has shifted more towards insurance being a tool for portfolio management, reduction of risk-weighted assets and even improving of conditions for their corporate customers.
Basel IV might reduce the efficiency of insurance for capital management purposes when applying an LGD floor which is certainly meant for RWA related to lending exposure as opposed to RWA relief when mitigating risks.
Furthermore, ITFA has worked hard to create bridges between insurers and banks – mainly by educating and thus erasing doubts on efficiency of this risk mitigation tool. Basel IV will now increase complexity for using risk insurance and probably bring back some of these doubts: if the LGD of an insurance is set at 45%, while Corp only show 40% or even 25% the regulator gives the impression that one is better off with a corporate guarantee then with an insurance policy.
This will lead, on the one hand, to the fact that banks need to allocate more capital to support their corporate customers to the same extend as today. Ultimately banks will therefore probably lend less. On the other, this could lead to an unwanted anti-selection of the assets which banks will have insured: the capital relief a banks gets is function of the difference between the LGD of the insurer and the obligor as well as the difference of the PD between the insurance and obligor – if the LGD of insurance companies has such a high floor, banks will only have an interest to show insurers their lesser rated assets.
However, the business model of insurance is based on a varied book of assets – anti-selection is something insurers dread. Therefore cooperation with banks might lose attractiveness and insurers might quit this market again after having only entered it really over the last 15 to 20 years.
Why does the regulator attribute such a high LGD to Financial institution?
This could mainly be to prevent systemic risks. Indeed – as the financial crisis in 2008/09 has shown, when banks go into bankruptcy the deposits of the retail customers need to be protected in priority, therefore nothing is left in the insolvency mass to hand out to the creditors. This would be similar for insurance company: in case of an insolvency, a creditor of an insurance company has little hope of getting anything back, as the policy holders will be first reimbursed. And this is exactly the point.
When working on harmonizing capital allocation rules, the regulator did not recognize the specificity of the insurance-bank product concerning the position as a policy holder: the bank who is getting risk cover under a trade credit insurance is exactly one of these senior creditors – this is backed by law in most jurisdictions. Therefore the LGD under an insurance policy should be close to 0.
A further objective of Basel IV is to reduce unintended consequences of systemic risk to the banking system. Thus a high LGD might make sense when a bank gets unfunded cover from another bank. But insurance companies have a totally different business model than a bank does. For most global insurance companies, credit risk represents only a minor is only a minor share of their risk portfolio. Insurance companies are much more affected by large natural catastrophes. Also, insurance companies have re-insurance to further diversify their books. Id est the two markets are not closely correlated. The more the regulator standardizes, the more we need to explain to the regulator the specificities of the product. If you standardize without taking into account theses specificities, you will have unintended consequences on the viability of the product.
Also, Basel IV brings back an even greater reliance on rating agencies, as in the Standard Approach and F-IRB banks can't use their own models any longer but need to use the ones of the large rating agencies. The last financial crisis showed, that this might even increase a systemic risk, as a miss-judgement by the rating agencies might lead to an increased vulnerability of the whole banking system.
What can we do?
We need to explain the credit insurance product and the insurance business model better, so that regulators can see the specifics. Transparency is very important – we are not some obscure business to hide risk but a well-organized, structured regulated and legally fully documented market mitigating bank portfolios and therefore reducing these systemic risks.
At the moment, ITFA is working on a survey with its member banks to provide the regulator with data. This data is crucial in order to prove that our business model works and the impact it has on the real economy.
How much time do we have? Normally new laws need at least to be voted 18 months before the implementation date. As the Basel committee requested the new rules to be in force by January 2022., we have time only until June 2019!
It is therefore important to use the momentum of the PRA response now and to rally forces again – mainly to educate and explain... Because we are convinced that the credit insurance products are exactly fulfilling the aim of the regulator: it is making the bank system safer by shifting risk away from it to a highly diversified insurance market – specialized in risk management and with a risk approach which does not correlate with the one banks have.
Anyone who is interested in raising the issue further, should get in touch with Silja Calac – chair of the ITFA Insurance Committee.