A. Differences in Business Model

7. Banks’ business is asset-driven and often supported by leveraged balance sheets. Banks provide a large set of fee-based services, such as payment and settlement processing, and financial services. Commercial/retail banks provide mainly loans to borrowers, typically funded by pooling the savings of depositors; i.e., the business is based on maturity transformation and the loan books represent the largest component of their assets while deposits represent the largest components of their liabilities. However, if deposits are insufficient to support the growth of the loan book, banks leverage their balance sheet by seeking additional funding by issuing commercial paper or bonds, borrowing from other banks or the central bank, or engaging in securities repurchase transactions (repos). Investment banks provide a large set of financial services to clients and engage in securities trading activity for both their customers’ accounts and their own account. The funding needed to support trading activities and their associated risks typically comes from shareholders or wholesale sources. Finally, universal banks combine both commercial and investment banking activities. Accordingly, their assets, liabilities, and funding sources share characteristics with both commercial and investment banks.

8. Different activities subject banks to different risks. The loan book subjects a bank to credit risk, should borrowers default on the obligation to repay their loans, but such credit risk is capped by the value of the loans. The loan book (in combination with short term funding) also subjects a bank to liquidity risk. Indeed, the duration of deposit liabilities is typically shorter than the duration of loan assets. This maturity transformation usually serves to enhance the spread, but it can subject a bank to significant liquidity risk which, in turn, contributes to the need to protect depositors with safety nets. In addition, since there is no direct link between the liabilities and the assets,Footnote ⁵ if there is a run on the bank, where customers withdraw their deposits and other banks refuse to provide interbank loans, the loan assets might not be readily realizable. Investment, and universal and commercial banks are also exposed to market, counterparty, and operational risk through their trading books. Finally, fee-based services subject banks to operational risk and, in some cases, to counterparty credit risk.

9. Banks’ profits arise from the spread between the income earned on assets and the cost of liabilities. Fee-based services generate fee income. The loan book produces interest income and the trading book produces investment income. On the liability side, costs of funding are represented by the interest paid on deposits and/or the costs of alternative sources of funding.

10. Insurers typically provide a narrower range of services that are mainly liability driven (Geneva Association,2010). The core activity of nonlife insurers is limited to risk-pooling arrangements to protect policyholders from adverse future events. The life business includes products that can serve as investment vehicles for policyholders. Such products often combine the investment aspect with insurance protection—against mortality or longevity risk—and can be very long in duration.

11. Insurance activities generate mainly underwriting, credit, and market risk. The policyholder protection activity exposes both life and nonlife companies to underwriting risk, market risk, and perhaps (depending on the guarantees provided by the policy) credit risk. Life products (especially when combined with savings components) can also create liquidity risk, although many include restrictions or penalties intended to mitigate this risk. For some classes of nonlife insurance business, such as credit insurance and financial surety, the underwriting risk is similar to the credit risk borne by a bank. Finally, insurers typically seek to invest the premiums in assets that are suitable to the nature of the corresponding insurance liabilities. Mostly, there is a close and direct link between the value of the insurance liability and the value of the related assets. However, when adequate assets are not available, the duration of an insurer's liabilities is often longer than the duration of its assets. Any interest rate duration mismatch creates market risk for the insurer in the form of interest rate risk, but some investment types (i.e., asset-backed securities) can also create credit spread duration risk.

12. Insurers are less leveraged and therefore, less exposed to liquidity risk than banks. Insurers are largely funded by policyholders with technical provisionsFootnote ⁶ representing the largest component of insurers’ balance sheets and they are less reliant on debt and other external funding than are banks (Figure 1).Footnote ⁷ However, some life insurance products generate losses (under current methods of calculating liability values) during the first years of the policyFootnote ⁸ and insurers sometimes purchase reinsurance or use own capital to help meet this new business strain. Insurers are less exposed to the risk of mass lapses of policies than are banks to runs on deposits because of the locked-in nature of much of their funding. The ability of insurers to anticipate future profits under Solvency II could increase the exposure to mass lapses, because it means that some might not have sufficient readily-available capital to repay all policyholders in the event of a run. However, the mass lapse stress component in the solvency capital requirement (SCR) helps to mitigate this risk.Footnote ⁹

Figure 1

Funding Structure of European Insurers and Banks Source: Staff calculations on CEA data. Notes: As percentage of total liabilities (excluding equity).

13. Insurance profits arise from the difference between income earned and the costs of providing insurance benefits. The relative importance of the different income and expense items varies by business line, but, in general, the largest source of income is typically represented by policyholders’ premiums followed by the investment income that accumulated premiums generate prior to the payment of insurance benefits. The largest component of expenses is typically constituted by claims payments to which underwriting, reinsurance, investment, and administrative expenses need to be added.

14. Insurance liabilities have more loss-absorption capacity than bank liabilities. Insurance liabilities, particularly those in respect of life insurance policies with profit participation, provide some risk-absorption capacity. If experience is adverse and there is profit participation in place, some of the adverse impact would reduce policyholder liabilities, thereby mitigating the impact on capital. Although the same partial pass-through can also arise in banking (for example, with a derivative contract, if defined in an appropriate manner), such contract terms are much less common than in insurance.

15. These differences in business models translate into differences in both levels and quality of capital (Figure 2). The largest 50 European banks have 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 have on average 8 percent of total capital over total assets, of which 84 percent is represented by high-quality equity capital. Finally, large global reinsurersFootnote ¹⁰ have on average more capital (with total capital amounting to 15 percent of total assets) but are also more leveraged (with high quality equity capital amounting to 73 percent of total capital).Footnote ¹¹

Figure 2

Levels and Quality of Capital for Select Banks and Insurers Source: SNL and Staff estimates. Notes: For Banks: Total Capital for banks is calculated as Regulatory Capital, Core Capital is calculated as Core Tier 1 capital. For Insurers: Total Capital is calculated as Total Equity plus Subordinated Debt, Core Capital is calculated as Total Equity.

B. Key Differences in Accounting Standards

16. Banks and insurers use different accounting standards.Footnote ¹² In many jurisdictions, the financial statements of banks are prepared in accordance with International Financial Reporting Standards (IFRS) or similar accounting rules. The rules are a mixture of fair-value accounting (for trading activities and available-for-sale banking assets) and historical cost accounting (for other banking assets). The accounting standard was not designed specifically for banking regulatory purposes, so various adjustments and deductions are made in moving from the financial statements to the determination of capital adequacy. Solvency II uses instead a “total-balance-sheet approach” based on the fair values of both assets and liabilities. The Solvency II balance sheet must be prepared independently of any general-purpose financial reporting requirements. Although some assets and liabilities will be valued in the same manner as under IFRS, others will be valued differently.Footnote ¹³ Given the different underlying accounting bases, it is unsurprising that the prudential adjustments under Solvency II differ from those under Basel III (as we will see in Section IV.B).

17. Bank assets are typically valued at amortized book value or fair value. Bank loans, under IFRS, fall under financial instruments and are accounted for by using IAS 39. Under IAS 39, financial assets are categorized as either (i) loans and receivables; (ii) financial assets at fair value through profit or loss; (iii) available for sale; or (iv) held to maturity. Other financial assets are initially measured at fair value plus, if not valued at fair value through profit or loss, transaction costs that are directly attributable to the acquisition. Financial assets at fair value and assets available for sale are subsequently carried at fair value, while loans and receivables and held-to-maturity assets are carried at amortized cost. All derivatives, whether held for trading or for hedging, are carried at fair value. IFRS 9, which will apply from January 2013, proposes that all financial assets will either be measured at amortized cost or fair value.

18. In addition, loan provisions are only “retrospective.” Banks are not permitted to make provisions for expected future loan losses, no matter how likely they are to arise.Footnote ¹⁴ IAS 36 “Impairment of Assets” requires a case-by-case assessment of the facts and circumstances surrounding the recoverability and timing of future cash flows relating to a credit exposure. Should there be an expectation that all contractual cash flows would not be recovered (or recovered without full future interest payments), an exposure would be classified as impaired. The extent of impairment would be measured on a present-value basis using the effective interest rate of the exposure as the discount rate. For groups of loans that share homogenous characteristics (such as mortgage and credit card receivables), impairment can be assessed on a collective basis. The aim of an individual or collective assessment is to capture the incurred loss for a specified portfolio. General provisions are permissible only to the extent that they relate to a specified risk that can be measured reliably and for incurred losses. For investments, a similar analysis is conducted, the key difference being that the fair value of the investment is also considered as an input.

19. However, the assets of insurers are valued at fair value under Solvency II and provisions are prospective. IFRS is used as a proxy for fair value, except for some specific instances when IFRS is not equivalent to fair value. Provisions for expected losses on the assets of insurers would thus be inherently reflected in the valuation.

20. Bank liabilities are also valued at amortized book value or fair value. Bank deposits are typically valued at book value or amortized book value. A retrospective methodology is used, reflecting the amount that would be paid upon exit. Other financial liabilities of banks are initially measured at fair value plus, if not valued at fair value through profit or loss, transaction costs that are directly attributable to the acquisition. After initial recognition, financial liabilities can be carried either at amortized cost using the effective interest method or at fair value through profit or loss. A new accounting standard, IFRS 9, will apply from January 2013 and will require companies choosing to measure a liability at fair value to present the portion of the change in its fair value due to changes in the entity's own credit risk in the other comprehensive income section of the income statement, rather than within the profit and loss.

21. However, insurance liabilities under Solvency II are valued at the amount for which they could be transferred or settled between knowledgeable willing parties in an arm's-length transaction. The values can be calculated using one of two methods: best estimate plus risk margin; or as a whole. The first methodology involves projecting the probability-weighted future cash flows and required capital associated with the insurer's obligations and discounting the results back to the valuation date. The risk margin is included to ensure that the value is equivalent to the amount that another insurer would likely require in order to take over the insurance obligations. The cost-of-capital rate most recently tested was 6 percent. The best estimate liability may be negative. The second methodology uses the market value of a portfolio of replicating assets, which implicitly results in a prospective valuation. This method is appropriate if the future cash flows associated with the insurance obligations can be replicated reliably, using financial instruments for which a reliable market value is observable, such as the obligations in respect of unit-linked products.

22. Another difference relates to the effect of an entity's own credit standing in the valuation of its liabilities. Under IAS 39, a bank's financial liabilities can be adjusted for changes in its own credit standing. This allows a bank, the position of which is weakening, to book profits based on its theoretical ability to buy back debt at a reduced cost. Insurers will not have this option under Solvency II, which does not permit any adjustment to take account of the own credit standing of the insurer. However, this accounting difference does not provide an advantage to banks in the calculation of regulatory capital, because Basel III requires that common equity Tier 1 capital (CET) be adjusted by cumulative gains and losses due to changes in own credit risk on fair-valued financial liabilities.

23. These differences in accounting standards for banks and insurers suggest the following:

• • Banks have greater flexibility than insurers regarding the valuation of financial liabilities. Banks can value liabilities using either amortized cost or at fair value through the profit and loss—although a bank cannot freely switch valuation bases, while insurers will be required to value them at fair value under Solvency II. The reported values of financial liabilities that are valued at amortized cost are more stable than those valued at fair value, which will move in response to changes in interest rates.

• • The retrospective valuation of bank balance sheet items generates greater stability in the reported values. Banks have the ability to classify financial assets as loans or held to maturity, which enables them to value the assets using amortized cost. The assets of insurers change in value as interest rates move or credit spreads change, whereas bank assets that are valued using amortized cost will not. Even the new approach proposed by the International Accounting Standards Board (IASB) would still differ from a fair-value approach because, for example, movements in credit spreads will not automatically result in any change to the valuation of the asset. It is not until a loss event occurs that the bank would move the asset from the good book to the bad book and recognize the likely cost of default.

• • The relative prudence of the different valuation methods in provisioning of banks and insurers depends upon the profitability of the business written. If a contract is expected to have positive future profitability, then the retrospective approach is more prudent, because the liability will be valued at book value and will not recognize the future profit that the company expects to earn on the contract. Under Solvency II, the insurer will be able to recognize this expected future profit upon writing the contract. However, if a contract is expected to produce future losses, then the prospective approach is more prudent, because those losses would be recognized upfront rather than spread over the remaining life of the contract as with the retrospective approach.Footnote ¹⁵ Another factor that affects the level of prudence is that insurers are required to include a margin in the liabilities in respect of the cost of capital, whereas banks do not include such a margin in their retrospective valuation of liabilities or in its loan provisioning.

24. Finally, important changes are underway at the IASB, which will affect the accounting of banks and insurers. In addition to the aforementioned IFRS 9, they include changes regarding the definition (IAS 32) and classification of financial instruments (IAS 39), and the recently-issued Exposure Draft on Insurance Contracts (IFRS 4). In addition, the IASB is currently consulting on a requirement for balance sheet loans to bear an expected loss provision throughout their life. In November 2009, the Board issued an exposure draft proposing the adoption of an expected loss model for recognizing credit losses. The IASB has also agreed to incorporate an incurred loss model on top of the expected loss model, often referred to as a good book (expected loss model)/bad book (incurred loss model) approach. The BCBS supports the use of more forward-looking provisions. The effects of these changes are unclear.

C. Differences in the Ability to Change Assets and Liabilities

25. Banks and insurers manage differently the risk profile of their assets and liabilities. They typically do so to reduce overexposure to particular risks or to free up capacity to take on more business. The ways in which this is accomplished can differ significantly by sector.

26. Banks commonly securitize loan assets and sell them into the capital markets. Securitization can reduce exposure to a particular type of loan, type of borrower, or geographic area. By removing assets from the balance sheet, it may also release regulatory capital, which can then be used to support additional loans. However, a securitization must be of sufficient size to make the transaction economically viable. Sometimes, as in collateralized debt obligations (CDOs), securitizations are repackaged into another securitization.Footnote ¹⁶

27. Insurers commonly use reinsurance and, less frequently, capital market instruments to transfer risk. Reinsurance can be used to cover individual risks (i) to share the underwriting risk on a particular portfolio; (ii) to prevent the absolute scale of any loss exceeding a particular amount; (iii) to stabilize experience; (iv) to provide capital support; (v) to release future profits; and (vi) to protect against catastrophes. It offers significant flexibility to insurers to alter the nature of the risk that they hold on their balance sheet and allows them to tailor the exact form of underwriting risk that they wish to take, and it can also be structured to transfer credit risk or market risk. Many types of reinsurance enable an insurer to reduce the insurance liabilities held on its balance sheet. However, because an insurer remains liable to its policyholders in respect of the benefits that have been reinsured, reinsurance essentially transforms underwriting risk into counterparty credit risk. This counterparty risk can be protected against using methods such as depositing assets back with the insurer or providing collateral. Much less frequently, insurers limit their exposure to extreme nonfinancial underwriting risks to others through the capital markets, using insurance-linked securities (ILSs). Similarly to reinsurance, ILSs limit the risk exposure, but they do not take the liability off an insurer's balance sheet. For many insurance liabilities there is simply no secondary market, which impacts on an insurer's ability to offload risk and also on the ability to value insurance liabilities.

28. Finally, both banks and insurers use derivatives to manage risks, but generally with different purposes. Banks use derivatives mainly to hedge exposures arising from their trading activities, as well as credit default swaps (CDSs) to limit risks associated with their lending activities.Footnote ¹⁷ Life insurers use derivatives to hedge exposures to market risk as part of their asset-liability management (ALM) programs.Footnote ¹⁸

D. Different Treatment of Similar Products

29. Banks and insurers compete both on products that are predominantly investments in nature and those that predominantly provide protection. Examples of investment products that are written by both banks and insurers include investment bonds, term deposits offered by banks, and term-certain annuities offered by insurers. Examples of protection products include: (i) investment guarantees and options written by investment banks and variable annuities with investment guarantees written by insurers; (ii) CDSs written by both banks and insurers; and (iii) trade finance offered by banks and surety bonds offered by nonlife insurers.Footnote ¹⁹

30. Different tax and capital treatments of such products can generate opportunities for product and capital arbitrages. Although these products offer similar economic benefits to customers and expose financial institutions to similar economic risks, differences in the manner in which they are taxed—with respect to either the financial institution or the consumer—can affect the related assets or liabilities. For example, in some jurisdictions savings products offered by life insurers 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. This may discourage withdrawals from the insurance policies, subjecting an insurer to less liquidity risk than a bank that offers a similar savings product (unless the tax regime changes in a way that creates an incentive for the insurance policyholder to withdraw). In addition, differences in their capital treatment under the two accords can generate opportunity for arbitrage across sectors as discussed in Section VI.

E. Implications

31. The aforementioned differences between banks and insurers reflect the fundamentally different roles played by these intermediaries in the financial system. Banks are a reflection of money serving as a means of payment in exchange. Their comparative advantage is to screen projects and finance them over the short term. This short-term maturity transformation calls for the existence of safety nets to protect depositors against liquidity shocks. Insurers, instead, (especially life insurers), are a reflection of money serving as a store of value, permitting deferred consumption and smoothing. Their comparative advantage (strictly as investors) is to invest in long-term securities and benefit from their illiquidity premium. The different types of intermediation of banks and insurers already suggests capital needs to protect entities against unexpected shocks should be different across sectors.

32. The aforementioned differences can have a range of implications. For instance, the assets and liabilities of insurers are more often linked to one another (due to the liability-driven business model of insurers and strict matching requirements of ALM programs) than are those of banks (where links exist mainly through a network of financial exposures). This reduces their liquidity risk and need for external funding. Also, due to liquidity risk, the need for funding, and the effects on loan defaults, banks have more short-term exposure to changing economic conditions than insurers. For banks, the credit risk can be transferred through securitization, but the liquidity and funding risks are more difficult to deal with.Footnote ²⁰

For insurers, reinsurance represents an additional tool—unavailable to banks—that can alter the nature of their balance sheet. This, as discussed in Section VI, could provide insurers with additional degrees of freedom to reduce their cost of capital. Furthermore, there is a much greater degree of interconnectivity among banks, especially through the interbank market, than there is among insurers. Therefore, there is generally a much greater risk that the failure of a single bank could have systemic implications (Geneva Association, 2010). However, if an insurer is significantly involved in activities—such as providing protection against credit exposures—which are closely linked to the broader financial sector—then its failure could likewise have systemic implications. Finally, insurers—especially life insurers—have more long-term exposure to changing economic and other conditions than banks because of the nature of their liabilities. ALM can be used to help deal with the economic risks. However, without effective ALM, the prospective nature of liability valuation can accentuate the effects of economic changes on the balance sheet.

33. More importantly, the aforementioned differences justify many but not all the differences in the respective capital accords. In particular, Basel III reflects the general realization that capital has failed (because deemed ex post insufficient and of poor quality) during the recent crisis to protect banks and tax payers from unexpected losses. This issue does not primarily guide Solvency II, as insurers have proved to be more resilient to the same shocks. Notwithstanding this observation, several differences in the two accords (as we will see in the next sections) are not supported by differences in the nature of capital needed in the two sectors, potentially generating unintended consequences.

A. Key Elements of Basel III

36. Basel III has been developed by the BCBS in reaction to the recent financial crisis. The BCBS consists of senior representatives of bank supervisory authorities and central banks from and central banks from the major financial centers, including all G20 jurisdictions.Footnote ²¹ It is intended to apply to internationally-active banks, on a fully-consolidated basis. Basel III evolved from the Basel II framework, and now includes liquidity requirements and gives increased attention to dealing with system-wide issues, such as the interaction of prudential requirements and economic conditions.

37. In order to implement Basel III in a particular jurisdiction, its requirements generally must be transposed into local legislation. For example, in the EU this requires a directive as well as, possibly, regulations, which need in turn to be transposed into legislation in the member countries. Many jurisdictions that are not members of the BCBS also seek to implement the Basel accords because of the international character of the banking business. Furthermore, some jurisdictions apply the Basel accord, although sometimes with simplifications, even to banks that are not internationally active.

38. Although the basic framework of Basel II has been retained in Basel III, many of its elements have been strengthened, including the following:Footnote ²²

• • Early reforms to Basel II were agreed in July 2009, which will raise capital requirements for the trading book, complex securitization exposures, and securitizations in both the banking and the trading books. The reforms immediately raised the standards of the Pillar 2 supervisory review process, and the capital requirements and related disclosures are to be implemented by the end of 2011.

• • Basel III requires that Tier 1 capital must be of higher quality—focusing on common equity; harmonizes Tier 2 capital instruments; and eliminates Tier 3 capital instruments, which had been available to cover market risks. All elements of capital will be required to be disclosed, along with a detailed reconciliation to the reported accounts. A leverage ratio will also be applied to provide an extra layer of protection against model risk and measurement error.

• • It includes measures to strengthen the capital requirements for counterparty credit exposures arising from derivatives, repo, and securities financing activities. The changes were designed not only to increase capital requirements, but also to reduce procyclicality and to provide incentives to move derivative contracts to central counterparties.

• • It introduces a framework designed to promote the conservation of capital and the build-up of buffers that can be drawn down in periods of stress. The capital buffer range can be adjusted in response to signs that credit has grown to an excessive level.

39. Basel III also introduces internationally-harmonized liquidity standards.Footnote ²³ The Liquidity Coverage Ratio (LCR) is designed to measure whether a bank has sufficient high-quality liquid resources to survive an acute stress scenario lasting for one month, while the Net Stable Funding Ratio (NSFR) has a time horizon of one year and helps to determine whether there is a sustainable maturity structure of assets and liabilities.

40. A long transition period is foreseen for the implementation of Basel III. Although Basel III is effective from January 1, 2013, some items are subject to phase-in arrangements; for example:

• • 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; and

• • Minimum standards will be introduced for the LCR in 2015 and the NSFR in 2018.

41. Finally, additional reforms are also being considered. Looking to the future, the BCBS is promoting stronger provisioning practices by advocating a change in the accounting standards toward an expected loss approach, updating supervisory guidance, and providing incentives in the regulatory capital framework. It is also conducting fundamental reviews of the trading book and the securitization framework.Footnote ²⁴

B. Key Elements of Solvency II

42. By contrast, Solvency II originated from the European Commission and not from the IAIS, the insurance equivalent of the BCBS. Solvency II applies to almost all insurers operating in the European Community. This includes small, local insurers, except for those with gross premium income below EUR 5 million. Its requirements are also relevant to reinsurers or groups based outside the European Community but operating therein, which can be treated more like local insurers with respect to reinsurance, group solvency, and group supervision if their home supervisory regimes are assessed as equivalent by EIOPA.

43. Solvency II is broader in scope than Basel III. It attempts to create a comprehensive, principles-based system of regulation and supervision. In addition to establishing risk-based capital adequacy requirements, it consolidates 14 existing insurance directives and deals with such topics as the valuation of assets and liabilities, group supervision, and the winding up of insurers.Footnote ²⁵

44. Several levels of legislation must be in place for Solvency II before it takes effect on January 1, 2013. The Level 1 directive was approved by the Council of Ministers and the European Parliament in 2009. Various consultations and quantitative impact studies have since taken place, including the recent QIS5. 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 are currently expected to be published in Quarter 1 2012. EIOPA is 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.

45. Finally, there is a wide range of issues on which decisions remain to be taken in arriving at the final requirements and guidelines, including the following:

• • 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 the data gathered during QIS5, 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); and

• • Development of guidelines on the supervisory review process.

C. Implications

46. The implications of the different situations described above are somewhat uncertain. In general, since 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. However, under both accords, there are still aspects of the requirements that are yet to be finalized and which could result in additional unintended consequences. Some of these, such as the calibration of quantitative requirements, could affect the opportunities for cross-sectoral arbitrage. Within the European Community, the overall legal and regulatory framework should produce relatively consistent implementation of both Basel III and Solvency II from one jurisdiction to another. However, among other jurisdictions, only peer pressure will limit the variations in Basel III implementation. The influence of Solvency II outside the European Community will be even less certain, depending on such factors as the results of the equivalence assessments, IAIS deliberations, and the outcome of its implementation within the European Community. In particular, the confined geographical application of the Solvency II framework could generate opportunities for insurers to reduce the cost of capital through the use of reinsurance in non-equivalent jurisdictions with weaker solvency and supervisory standards, if the capital charges required against the credit risks introduced by such reinsurance contracts are not set appropriately.

A. Loss-Absorption Capacity

55. Under both accords, different tiers have different loss-absorption capacities. For both Basel III and Solvency II, Tier 1 consists of capital that is fully loss-absorbent on a going-concern basis and Tier 2 is capital that absorbs losses on a winding-up basis. However, Solvency II also provides for a Tier 3, which consists of own funds other than Tier 1 and Tier 2. The classification criteria under Solvency II include subordination, loss-absorbency, permanence, perpetuity, and absence of servicing costs. Ancillary items that would convert to Tier 1 capital, when called, are classified as Tier 2 AOF, while those that would convert to Tier 2 capital are classified as Tier 3 AOF.

B. Regulatory Adjustments to Capital

67. Substantial differences exist in the regulatory adjustments to capital allowed under both accords (Table 2). Basel III strengthens the 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 also considers regulatory adjustments to Tier 1 or Tier 2 depending on the instrument.

Table 2

Regulatory Adjustments to Capital under Basel III and Solvency II

Source: BCBS (2011b), EC (2009) and EIOPA (2010).

68. Some of the differences arise from differences in the underlying valuation principles rather than real differences in what is considered capital (Table 2). If an item is given no value under the fair-value approach required by Solvency II, it has the same effect as deducting its value under Basel III. For instance, investments in own shares are not deducted under Solvency II because common equity is only included on a net basis to begin with. Also, it is not necessary to deduct goodwill under Solvency II, because it is not considered an identifiable and separable asset, so it is assigned no value. Finally, own credit risk is not considered when valuing financial liabilities under Solvency II, so changes in own credit risk do not create gains or losses.

69. However, seemingly inconsistent differences do exist in the treatment of several items (Table 2).Footnote ³⁰ For instance, the deduction of intangible assets other than goodwill, such as software, under Basel III recognizes that in periods of stress those assets are likely to have little value. Under Solvency II, although this risk should be recognized by a risk surcharge when calculating the SCR, there is no requirement that this portion of the SCR be covered by a specific type of capital. Similarly, under Basel III, deferred tax assets resulting from tax loss carried forward are fully deducted, while DTA resulting from timing differences are deducted above a certain threshold. Under the Solvency II QIS5 technical specifications, no such differentiation is made and the net DTA are deducted from Tier 1, but classified as Tier 3 BOF. Also, employee-defined benefit pension fund assets and liabilities are excluded when calculating capital under Basel III, but not under Solvency II. Solvency II in effect assumes that an excess of assets over liabilities would be available to meet other obligations, while Basel III in effect assumes that the rights of employees might prevent this.Footnote ³¹ In addition, Basel III requires that the premium attached to any shares excluded from CET also be excluded from CET, and instead be included in the same Tier as the shares to which they relate. Solvency II does not indicate such treatment. Finally, the treatment of equity investment in financial entities and the methods used to apply regulatory adjustments are different under the two accords.Footnote ³²

70. Finally, Basel III and Solvency II use different methods to apply regulatory adjustments to capital at a group level. In the banking sector, deductions are applied following the “corresponding deduction approach.” In other words, a deduction would be applied to the same component of capital for which the capital would qualify if it was issued by the bank itself. In the insurance sector, deductions are applied following the “deduction and aggregation” method. In other words, after the participation is deducted from the participating entity's own funds, capital requirements and own funds of the participated entity are added proportionally to the ones of the participating entity. The method used in the banking results in a smaller transfer of resources from the participated to the participating entity. Hence, it is more prudent when the participated entity is in surplus, but it is less prudent when the participated entity is in deficit.

C. Implications

71. The difference in criteria used to determine capital eligibility of instruments impacts on the relative cost of capital. Both sectors have access to the same capital markets for raising funds, so differences in the criteria used to determine the eligibility of an instrument as regulatory capital might lead to differences in the cost of capital and regulatory arbitrage across sectors. In addition, the treatment of various types of claims, such as those of consumers and providers of various forms of capital—including reinsurers, under winding-up legislation—could affect the availability and cost of capital.

71. Also, the differences in regulatory adjustments to capital and their methods of application impact on the relative cost of capital. The higher threshold for defining significant participations (20 percent under Solvency II and 10 percent under Basel III) appears to suggest a larger scope for double gearing under Solvency II than Basel III.Footnote ³³ In addition, the method used under Solvency II can result in a higher variance of the solvency position of the participating entity. If this translates into a higher risk-adjusted expected profitability, then the cost of capital should be lower than for the banking sector (other things being equal).

A. Overall Methodology

B. Risk Aggregation and Dependencies

86. Despite the modifications to the Basel accord, risk weights under Pillar 1 still depend on portfolio invariance. This does not reflect the importance of diversification as an influence on portfolio risk, nor does it adequately penalize concentrations in the portfolio by requiring additional capital, which can instead be imposed by the supervisor under Pillar 2.

87. However, credit risk mitigation (CRM) techniques are recognized when determining required capital under Basel III. They include the use of (i) collateral; (ii) guarantees; (iii) credit derivatives; and (iv) claims netting.Footnote ⁴¹

88. Collateral posted by a counterparty or by a third party can hedge credit exposures, either fully or partially. Banks can choose between two approaches: the simple approach or the comprehensive approach. Under the simple approach, banks can substitute the risk weight of the collateral for the risk weight of the counterparty, subject to a 20 percent floor. Under the comprehensive approach, they can reduce the risk weight of the counterpart by the risk weight ascribed to the collateral. In doing so, they are required to adjust both the amount of the exposure to the counterparty and the value of any collateral, using haircuts, and to take account of future fluctuations in either.

89. Third-party guarantees or credit derivatives can be used to reduce credit exposure when they are direct, explicit, irrevocable, and unconditional. Supervisors must also be satisfied that banks fulfill certain minimum operational conditions relating to risk-management processes and the guarantors must be recognized by the supervisor. In such cases, the hedged portion of the exposure is assigned the risk weight of the guarantor or protection provider.

90. Credit risk mitigation (CRM) techniques can give rise to maturity mismatches. Where there is a maturity mismatch and the CRM has an original maturity of less than one year, the CRM is not recognized for capital purposes. In other cases, where there is a maturity mismatch, partial recognition is given to the CRM for regulatory capital purposes.

91. On-balance sheet netting can be allowed if risk-management processes meet certain operational conditions. In particular, a bank needs to be able at any time to determine those assets and liabilities with the same counterparty that is subject to the netting agreement. In such cases, assets (loans) are treated as exposure and liabilities (deposits) as collateral. The haircuts will be zero except when a currency mismatch exists.

92. Under Solvency II, diversification effects and risk interdependencies are reflected in the standard formula for SCR using correlation matrices. Adjustments are applied at various levels: within the same risk class and business line; within a risk class and across business lines; across risk classes; and at a group level. For example, the correlations across risk classes are based on the matrix shown in Table 3. The application of correlations can reduce the requirements significantly, compared to a linear combination.

Table 3

Solvency II Correlations among Risk Classes

Source: QIS5 Technical Specifications.

93. Concentrations affect the calculation of required capital in several risk modules or sub-modules. Underwriting risk concentrations are recognized in the nonlife catastrophe risk and life catastrophe risk sub-modules. Additional risks to an insurer stemming either from lack of diversification in the asset portfolio or from large exposure to default risk by a single issuer of securities or a group of related issuers are recognized in the market risk concentrations sub-module. The counterparty default-risk module takes account of the overall counterparty risk exposure of the insurer to that counterparty, irrespective of the legal form of its contractual obligations to the insurer.

94. All types of risk-mitigation contracts are recognized under Solvency II. They include reinsurance, securitizations, and derivatives. The counterparty default risk module takes account of the related risk that arises from such contracts.

C. Scope for Consolidation

95. Basel III is applied to either the solo entity or the consolidated group up to the holding company. The scope of application has not changed from Basel II and 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, also on a fully-consolidated basis. For bank conglomerates (i.e., groups with prevalently a banking activity but also containing other financial entities), the holding company bears the full entrepreneurial risk of the subsidiary, which is recognized at the group level and supervisors assess the appropriateness of recognizing the participation. In general, when not consolidated, full deduction is required.Footnote ⁴² Finally, the same methodology to calculate capital requirements is applied to either the solo or group level.

96. Group-level calculations of required capital under Solvency II focus on the group SCR. Although an approximation of “group MCR” is calculated by summing up the MCRs of the separate legal entities; the purpose of this calculation is just to establish a floor for the group SCR. Solvency II describes two basic methods for calculating the group SCR. Method 1, which is the default, is accounting consolidation. The standard formula for calculating the SCR is applied to the consolidated assets and liabilities of the group. Method 2, which is an alternative, is deduction and aggregation. The solo SCR and solo capital for the insurers in the group are combined, using a proportional basis for insurers that are not wholly owned. Where the exclusive application of Method 1 would not be appropriate, groups can apply a combination of Methods 1 and 2. Internal models can also be used to calculate group SCR. Diversification of risks across entities within a group is reflected in the calculations, except under Method 2.

97. Generally, Solvency II rules must be applied when making calculations in respect of insurers that are based outside the EEA. However, if the solvency regime of a non-EEA jurisdiction is assessed as equivalent to Solvency II, then the solo SCR and solo capital of insurers based in such jurisdictions, determined under local rules, can be used in the group calculations when method 2 is used.

98. Where members of a group are other types of regulated financial institutions, the relevant sectoral requirements are applied under either Method 1 or Method 2.

D. Supervisory Responses to Breaches of the Capital Requirements

99. An important role of capital requirements is to serve as a trigger for supervisory action.Footnote ⁴³ The imposition of minimum required capital and other control measures by the international standard setters and national authorities raises the need for supervisors to adopt structured systems for responding to breaches of such requirements.

100. In the banking sector, such systems take various names. They include Prompt Corrective Action (PCA, used in the United States) and Structured Early Intervention and Resolution (SEIR, used in some Asian and European countries). In general, these systems seek recovery or orderly resolution of institutions and to minimize deposit insurance losses in respect of those that do fail. For example, the PCA classifies banks under five categories and identifies appropriate supervisory responses for each. The five categories are: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. The last category includes those banks with tangible equity capital below 2 percent of total assets. Under PCA, supervisory actions can be summarized as follows:

• • Undercapitalized banks must have permission from the supervisory authority in order to pay dividends or make stock repurchases.

• • Undercapitalized banks must submit a capital restoration plan, which must be approved by the bank's supervisor.

• • Significantly undercapitalized banks must limit bonuses and salary increases to the management.

• • Critically undercapitalized banks must be placed in receivership within 90 days if no other option is available.

• • Supervisors can also take additional actions to help prevent further losses, such as changing management.

101. Basel III and the European Capital Requirements Directive (CRD) both emphasize the need for timely supervisory intervention when banks fail to meet capital requirements. Both require a review and examination of banks’ risk profiles and management systems and demand prompt application of prudential measures. However, supervisory intervention is not detailed as under the PCA of the United States. Also, supervisory powers and compliance differ from country to country. For instance, limited information and limited legal powers to intervene may hinder supervisors in some countries.

102. Under Solvency II, breaches or expected breaches of the capital requirements must be notified to supervisors. An insurer must notify its supervisor as soon as it observes that the SCR has been breached. Within the next two months, the insurer must submit a plan for achieving compliance within a period of six months. The period for achieving compliance can be extended by three months—or longer in the event of a significant fall in the financial markets. Similarly, an insurer must notify its supervisor as soon as it observes that the MCR has been breached or where a breach is likely within the next three months. In this case, however, the timeline for remediation is shorter. The insurer has one month to submit a plan and three months in which to achieve compliance, either by obtaining additional capital or reducing its risk profile. During the period of noncompliance, the insurer may be restricted in or prohibited from disposing of assets.

103. Finally, insurers are required to disclose breaches of the capital requirements. Information on SCR coverage is required to be publicly disclosed by insurers and that they announce publicly if their SCR coverage falls below 100 percent, along with the reasons why this happened and any remedial actions taken. Furthermore, for capital instruments to qualify as Tier 2 or better under Solvency II, they must permit deferral of payments if SCR coverage falls below 100 percent. It is therefore likely that insurers will seek to maintain sufficient capital to minimize the risk of breaching the SCR.

E. Implications

104. It is very difficult to compare capital requirements under the two accords. The methodologies and risk categories differ, so comparisons made at the level of a transaction or business portfolio might not be valid in the context of the entity as a whole. For example, the requirements under Solvency II reflect correlations among the main risk areas while the requirements under Basel III treat each main risk area separately. As another example, a bank and an insurer might each hold the same type of loan asset in support of their respective liabilities. Therefore, the capital required in respect of the credit risk associated with that asset can be compared. If the bank is holding the loan in its banking book, no additional capital is required in respect of the related deposit liability. However, an insurer would also be required to hold capital in respect of the insurance risk on the related policies.

105. It is very likely that some similar risks have different capital charges under the two accords. The different natures of the basic approaches to calculate capital requirements, the differences in credit-mitigation techniques (aggregation and dependencies), as well as the inherently ad hoc nature with which capital standards have been negotiated, are likelyFootnote ⁴⁴ to result in different capital requirements for similar risks.

106. Finally, the promotion of internal models under Solvency II requires careful considerations. Similarly to Basel II, the promotion of internal models under Solvency II aims at strengthening risk-management capacity among insurers. However, with Basel II, the IRB approach was calibrated to produce on average lower risk charges than those provided for by the standard approach. International experience has shown that the ratio of RWA over total assets has, on average, decreased for a large set of European banks (Yogarajah, Reference Yogarajah2011). In other words, either banks have progressively found innovative ways to inflate their capital adequacy ratios or supervisors have progressively relaxed, maybe unintentionally, validation standards. The experience with internal models under Basel II should provide important lessons for insurance supervisors and promote close collaboration in this area between regulators in both sectors.Footnote ⁴⁵

A. Cost of Capital

108. 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.Footnote ⁴⁷ The natural framework to conceptually assess the impact of the new accords on total cost of capital is the Modigliani-Miller theorem. However, not in terms of its overall validity but in terms of the market imperfections which invalidate it, especially in the short run. These are debt interest deductibility, moral hazard, asymmetric information, safety nets, bankruptcy costs, and debt overhang (Jaffee and Walden, Reference Jaffee and Walden2010). Since these imperfections are not necessarily equally important for banks as they are for insurers (as explained later), Basel III and Solvency II will have a different impact on the relative costs of capital. In addition, there are accord- and sector- specific arguments (many reviewed in the previous sections) for why the total cost of capital could increase more for one set of intermediaries than for the other more than what is required by their different risk profiles.

109. A first set of arguments in support of higher costs for banks relates to the Modigliani-Miller theorem. For instance, banks benefit more from debt interest deductibility to reduce their total cost of capital simply because they are more leveraged. Hence, the debt-equity swap (i.e., deleveraging of banks) that Basel III tries to achieve, will raise the marginal cost of capital for banks more than for insurers. Regarding moral hazard, the same difference in leverage suggests that a debt-equity swap will increase the total cost of capital for banks more than for insurers as there is now less debt that can be used as a monitoring device for bank managers.Footnote ⁴⁸ Along the same lines, a reduction of the too-big-to-fail (TBTF) funding benefit enjoyed on average more by banks than by insurers could lead to higher average cost of capital for banks. Regarding information asymmetries, Solvency II and Basel III are different information events. The former possibly signals insufficient capital levels (in addition to quality) in relation to the recent shocks, while the latter signals only inadequate quality (rather than levels, and not necessarily in relation to recent shocks). Hence, higher total capital costs could result for banks than for insurers.Footnote ⁴⁹ Finally, regarding safety nets, these are often subsidized guarantees, the value of which depends on the likelihood of bankruptcies. To the extent that Basel III reduces the relative likelihood of bankruptcy for banks (i.e., more than what Solvency II does for insurers)Footnote ⁵⁰ the relative benefit from these subsidized guarantees is also reduced more for banks.Footnote ⁵¹

110. A second set of arguments in support of higher costs for banks relates to specific differences in the two accords or sectors.

• • For instance, the larger scope for risk-mitigation techniques allowed for under Solvency II (including the use of reinsurance) could result (other things being equal) in a lower cost of capital for insurers than for banks.

• • Similarly, the retrospective valuation methodology of banks could decrease (increase) the cost of capital for banks in the high (low) part of the cycle relative to insurers, which use a more prospective (and potentially volatile) methodology.

• • In addition, capital deductions appear more stringent under Basel III than Solvency II. A case in point are intangible assets (other than goodwill), which are deducted under Basel III, but not under Solvency II. In particular, investments in software, which are meant to comply with regulations and gain efficiency.

• • Also, banks’ capital costs for hedging since insurance companies will be encouraged to take long-dated swaps contract to hedge their risks under Solvency II, but Basel III will require banks to hold more capital (and collateral) against these positions. This suggests that hedging will become more expensive for banks and they will be less willing to hold long-term interest rate swaps that insurance companies find so useful.

• • The more restricted geographical application of Solvency II could result in serious leakage problems, with insurers “lowering” their capital charges by using reinsurers in jurisdictions with solvency standards deemed equivalent by the EC but that de facto are non-equivalent (more lenient).Footnote ⁵²

• • And again, bank regulators are likely to agree on additional step-up capital surcharges for systemically-important banks, as a function of their size, interconnectedness, and substitutability, which would conceptually be difficult to apply to large insurers. Indeed, given the nature of the insurance business, size is associated with increased risk diversification and a priori not warranting higher capital charges.

• • Along similar lines, insurance liabilities are more loss absorbing than banks and this could reduce, other things being equal, insurers’ cost to raise additional capital.

• • Solvency II is explicitly promoting the use of internal models, which are expected to provide 30–40 percent capital requirement reductions relative to the standardized model.Footnote ⁵³ This provides the sector with ample scope to reduce cost of capital relative to banks in a period when regulators are instead discovering that bank RWA have been progressively eroded relative to total assets (Yogarajah, Reference Yogarajah2011).

• • Finally, there is great uncertainty on the impact of capital levels for insurers stemming from the yet-to-be-defined treatment of the illiquidity premium in valuing liabilities.Footnote ⁵⁴

111. On the other hand, there are arguments in support of a higher cost of capital for insurers.

• • In general, the move to a more risk-based approach is likely to increase the cost of capital for the riskier insurers, as investors use the additional information to seek out higher quality insurers.

• • Regarding information asymmetries, the adoption of Solvency II (relative to Solvency I) could be perceived by the markets as a more fundamental change than the adoption of the Basel III proposals (which are merely incremental, relative to the Basel II accord).Footnote ⁵⁵

• • In addition, if insurers also try to achieve higher capital levels by reducing liabilities,Footnote ⁵⁶ they are likely to do so at higher costs than for banks. Indeed, and contrary to banks, there are no markets for many insurance liabilities (think of the difficulty of hedging longevity risk, for instance) making the Modigliani-Miller theorem less applicable to insurers than to banks.

• • Along the same lines, deleveraging of banks as a consequence of Basel III would reduce bankruptcy costs more than for insurers and, therefore, reduce their cost of capital.

• • Regarding debt overhang, deleveraging will reduce the amount of investment returns that accrue to debt holders and, therefore, reduce the total cost of capital (as the sum of the remuneration of debt and equity holders).

• • Finally, contingent capital and other bail-in instruments proposed under Basel III may not succeed in eliminating the TBTF advantage enjoyed by banks. In this case, they would translate in an additional cheap source of capital for banks but not for insurers, for which discussions about such instruments are less advanced.

112. But, in general, we have seen how Pillar 1 requirements across the two sectors are too different to argue conclusively in either direction. In particular, the two accords may have the impact of increasing the incentive to issue equity by insurers and banks at similar times. The joint implementation of the two accords may thus result in higher cost of new equity for both sectors relative to a staggered implementation. It is therefore possible that the joint implementation of the two accords will generate relatively stronger incentives for risk to migrate away from the two sectorsFootnote ⁵⁷ than from one sector to the other. The key policy question then becomes which part of the financial system (a priori less supervised and regulated) is likely to attract such risk.

B. Funding Patterns and Interconnectedness

113. Basel III and Solvency II could have unintended consequences on funding patterns of banks. There is concern among policy makers and market participants alike that the two accords could jointly reduce the demand for banks’ long-term instruments when banks most need to issue them.

114. On the one hand, the demand for debt instruments is likely to change under Solvency II. In general, insurers using the standardized approach for the SCR will be charged capital requirements through the credit spread risk module proportional to the rating and duration of instruments held on balance sheet.Footnote ⁵⁸ This automatically makes longer-dated and or lower-rated private sector instruments (relatively) less attractive. In addition, EEA sovereign bonds, bonds guaranteed by EEA states and supra-national agency and development bank bonds—as it stands now—carry a zero risk weight in the standardized approach, irrespective of rating. Also, distortions exist between banks and real sector corporate, since bank-covered bonds receive preferential treatment with lower charges.Footnote ^59, Footnote ⁶⁰ Finally, the increased issuance of covered bonds could have a negative impact on banks’ ability to issue unsecured debt. This is because, with covered bonds, the amount of unencumbered quality assets available in case of bank resolution for unsecured creditors decreases. In summary, the duration multiplier penalizes long-term maturities in general, potentially increasing the likelihood that insurance companies be mismatched and bear reinvestment risk, and result in a preference for sovereign debt and short-dated and higher-rated bank debt (especially covered bonds), relative to other corporates, and could reduce the ability of banks to issue unsecured debt.

115. On the other hand, Basel III will affect the banks’ demand for and supply of certain types of debt. Under Basel III, banks’ senior unsecured bonds do not qualify for the LCR while they qualify for the NSFR.Footnote ⁶¹ Covered bonds and sovereign debt qualify for both the LCR and NSFR.Footnote ⁶² Hence, it is likely that banks’ demand for unsecured debt will decrease while the demand for covered bonds and sovereign debt will increase. For similar reasons, it is likely that banks’ supply of covered bonds will generally increase while the supply of unsecured debt will increase only at longer maturities to meet the NSFR requirements. In other words, Basel III liquidity provisions could promote a partial swap on banks’ balance sheets between senior unsecured and covered bonds for funding purposes, as well as an increase in issuance of senior debt toward longer maturities (5 to 10 years).

116. However, there are also arguments that could make unintended consequences on funding patterns less of a concern.

• • For instance, it is unclear if and to what extent the demand from insurers for long-term maturity instruments will actually decrease. The tradeoff between maturity mismatches, capital charges, and the impact of the duration multiplier will likely be different across entities with different structures of liabilities.

• • In addition, the preferential treatment of banks’ covered bonds under the standardized approach of Solvency II suggests that rather than a decrease in demand for banks’ funding instruments we might instead see only a change in the funding patterns of banks (less senior debt and more covered bonds).

• • Also, the “long term” for banks is different from the “long term” for insurers. A decrease in the demand of insurers for long-term instruments (if this takes place at all) is likely to occur in very long-term maturitiesFootnote ⁶³ that banks do not have incentives to issue (20 plus years versus the 5–10 year range needed for banks to satisfy the LCR and NSFR requirements).

• • In any case, any decrease in the demand from insurers for banks’ funding instruments is only likely if the demand for insurance products supported by such assets decreases.Footnote ⁶⁴ Again, the insurance business is liability driven and the demand for assets depends on the liability structure of the balance sheet. In the end, whether Solvency II really represents a funding risk for banks is an empirical issue: it will depend on the elasticities of demand and supply across various insurance business lines, as an increased cost of capital will be passed through to margins where the demand is least-sensitive to prices.Footnote ⁶⁵

• • Finally, 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 same banking sector. Insurers represent only 10 percent of total demand for the two instruments (Figure 3).Footnote ⁶⁶

  Figure 3

  Banks’ Debt Funding Sources by Type of Investor Source: Adapted from Bhimalingam and Burns (Reference Bhimalingam and Burns2011).

  

117. More of a concern could be the increased interconnectedness between banks and insurers. Solvency II and Basel III could indeed result in increased demand for sovereign debt by both sectors. In other words, 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. In principle, this concern could be diffused by the use of insurance internal models (which would capture the heterogeneity in credit risk across EU sovereigns), but their standards are yet to be defined.Footnote ⁶⁷ Clearly, 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.

C. Risk/Product Transfers

118. Risk/product transfer across the two sectors could take place in business lines in which banks and insurers compete directly. For instance, in some jurisdictions, the treatment of certain life insurers’ savings products, like term certain annuities, attracts higher capital requirements than (say) term deposit.Footnote ⁶⁸ The new liquidity requirements proposed under Basel III should decrease the extent of regulatory arbitrage in the commercialization of these similar products. In other jurisdictions, equity investment attracts higher capital requirements for banks than for nonlife insurers, and the strengthening of capital treatment of market risk under Basel III could further increase incentives for conglomerates to carry equity investments in a nonlife insurer subsidiary versus a bank subsidiary. Potential for risk transfer exists in products providing credit default protection, such as CDSs, which can be issued by both banks and insurers, between mortgage lenders and mortgage insurance, and in trade finance.Footnote ⁶⁹ However, establishing clear patterns is difficult, as these will depend on the treatment of specific risk exposures in the internal models under Solvency II. Close collaboration between the regulators of banks and insurers will be required in the definition of such standards so as to minimize the opportunity of model arbitrage and, consequently, the likelihood that risk migrates inappropriatelyFootnote ⁷⁰ between the two sectors.

119. Risk could also be passed onto customers through risk sharing products in a non-socially optimal manner. Increased cost of funding and capital could result in different product mixes offered by banks and insurers. For example, unit-linked life insurers offer products where most or all of the market risk is borne by the policyholder, many pension annuity products now provide for periodical re-pricing as a function of mortality experience as a way to share longevity risk between the provider and the annuitant, and other risk pass through mechanisms are in principle feasible in other insurance and banking fields. There is already a strong debate whether consumers are exposed to excessive risk in pension products. Basel III and Solvency II may exacerbate the problem in Europe as many pension products are offered by insurers and because of the possibility (being discussed) to extend the Solvency II framework to pension funds.Footnote ⁷¹

120. Risk could finally migrate away from both sectors through the use of securitization, reinsurance and shadow banking. The joint implementation of Basel III and Solvency II could lead to increased use of securitization by banks and insurers alike.Footnote ⁷²

When the NSFR requirements become binding, securitization has the benefit of removing long-term assets (like mortgages) from the bank's balance sheet and thus relieving banks from any related Basel III requirement.Footnote ⁷³ For insurers, an option for offsetting the cost of capital under Solvency II, is to use reinsurance and ILS. As witnessed under Basel II, the tendency to move exposure off balance sheets because it reduced regulatory requirements ultimately led to utilization of the origination and transfer business model, widespread use of conduits and overconcentration of exposures in less regulated areas of the financial system. An increased use of these risk-transfer mechanisms could result in more interconnected financial systems with opaque distribution of risks, possibly migrating toward less-regulated and supervised areas of the financial system. Hence, it is safe to say that the two new accords: (i) increase the need for regulators/supervisors to improve transparency and strengthen the oversight of these contagion channels; and (ii) call for a careful definition of equivalent jurisdictions under Solvency II.

D. Other Potential Sources of Distortion

121. For instance, tax considerations are likely to be a more important source of arbitrage than current regulatory reforms. Heterogeneous tax treatment of capital items and similar products/instruments might well dwarf the aforementioned Pillar 1 considerations. In other words, tax-minimization strategies are likely to dominate cost of capital minimization strategies for both banks and insurers. For instance, current regulatory reforms do nothing to reduce the tax incentive to fund financial institutions through debt and therefore, to discourage leverage. Interest deductibility is perhaps the most important tax-related distortion, which promotes the design of opaque financial products that add little economic value but creates leverage and complexity, increasing vulnerabilities in the financial system and making them more difficult to monitor.

122. Heterogeneity in supervisory approaches could also be a source, albeit less important, of arbitrage. The insurance market has traditionally (with due exceptions) been less intrusively supervised than the banking sector. Similarly, due to the only partial transferability of insurance products, market discipline is likely to be less effective in this sector than in the banking sector. In other words, Pillar 2 (supervisory approach) and Pillar 3 (market discipline) requirements should be considered when assessing potential unintended consequences of the joint implementation of the new banking and insurance capital accords. However, we do not think that heterogeneity in supervisory approaches and market discipline would represent a more important source of arbitrage than the regulatory capital requirements discussed in this paper, at least in Europe.

123. Finally, the two accords have not been finalized. There are still too many moving parts, so potential sources of arbitrage can only be more clearly identified once the details of the two accords have been finalized.