Battle of the Balance Sheets Stuart Morris FIA, Deloitte Dr. Robin Thompson, RBS Andrew Kenyon FIA, RBS 07 November 2016 Agenda Risk-based capital requirements: Banks vs. Insurers Available capital Case study: Corporate bond investment The future 07 November 2016 2 1
Overview Balance Sheet Comparison Banks Insurance Companies Assets Liabilities Assets Liabilities Equity Securities Capital Cash Capital Cash Loans Debt Issued Debt Issued Debt Securities Loans Deposits Debt Securities Equity Securities Unit-Linked Assets Insurance Technical Reserves Unit-Linked Liabilities 07 November 2016 3 Hypothesis Under an arbitrage-free financial system: Different institutions will have the same capital requirements for the same risk No reason for internal risk transfers within financial conglomerates Institutions can compete across lines of service 07 November 2016 4 2
Alternative Hypothesis Activities performed by different institutions need to be regulated differently Capital is a scarce resource: Deployment is guided by regulation but driven by business model 07 November 2016 5 Risk-Based Capital Requirements 07 November 2016 3
Insurers Capital Requirements Insurers under Solvency II The Solvency Capital Requirement, SCR shall correspond to the Value-at-Risk of the Basic Own Funds of an insurance or reinsurance undertaking subject to a confidence level of 99.5% over a one-year period. SCR Source: Directive 2009-138-EC 07 November 2016 7 Banks Basel III Implementation in Europe Basel III (2010) CRD IV (2013) CRR CRD Pillar 1 Capital Leverage Liquidity Pillar 2 ICAAP SREP Buffers ICG PRA Buffer 07 November 2016 8 4
Banks Regulatory Pillars PILLAR 1 Minimum Capital and Liquidity Requirements Risk-weighted assets: Credit Market Operational PILLAR 2 Supervisory Review Process Supervision and risks not covered by Pillar 1: Internal capital adequacy assessment process (ICAAP) Stress tests PILLAR 3 Market Discipline Transparency and comparability Enhanced disclosures 07 November 2016 9 Banks Pillar 2 Pillar 2A Individual capital guidance and risks not covered (at all, or fully) in Pillar 1. For example: Credit concentration risk Interest rate risk in the banking book (IRRBB) Pension scheme risk Under-estimation risk (e.g. operational) Pillar 2B Stress tests review a bank s ability to withstand a supervisor-defined stress event 07 November 2016 10 5
Banks Capital Requirements Banks under CRD IV Requirements added incrementally since 2004 (Basel II) Buffers Pillar 2B Pillar 2A Pillar 1 Other CRD IV also introduces a number of additional capital buffers 07 November 2016 11 Capital Requirements Comparison Overview Diversification Solvency II SCR aims to cover all material risks Risk-weighting based on expected change in risk factor Correlation between risk factors Capital Requirements Regulation Static risk weights for key risks Must withstand regulator-defined stress tests Additional non-risk-based requirements and buffers Summation of capital charges across risk modules Calibration 99.5 th %ile 1-year VaR Balance sheet Inconsistent across risk modules Assets-only 07 November 2016 12 6
Case Study Corporate Bonds 30% Required Capital 25% 20% 15% 10% 5% 0% 0 5 10 15 20 25 30 Duration (yrs) 13% RWAs SCR (Non-MA) AAA, AA & A BBB & BB B & CCC, AAA AA A BBB BB B & CCC Source: Solvency II Standard Formula 07 November 2016 13 Available Capital 07 November 2016 7
Regulation Capital Adequacy Capital = Assets Liabilities Restrictions Available Capital Required Capital Surplus Assets Liabilities 07 November 2016 15 Solvency Available Capital Banks IFRS equity Insurers IFRS equity - intangibles - intangibles - expected losses +/- valuation differences (incl. risk margin) Common equity tier 1 (CET1) + future profits + other regulatory capital + other regulatory capital Total Capital Available Own Funds - eligibility restrictions - eligibility restrictions Total Eligible Capital Eligible Own Funds 07 November 2016 16 8
Case Study: Corporate Bond Investment 07 November 2016 Case Study Corporate Bonds (Non-MA) 30% Required Capital 25% 20% 15% 10% 5% 0% 0 5 10 15 20 25 30 Duration (yrs) 13% RWAs SCR (Non-MA) AAA, AA & A BBB & BB B & CCC, AAA AA A BBB BB B & CCC Source: Solvency II Standard Formula 07 November 2016 18 9
Case Study Corporate Bonds (MA) 30% Required Capital 25% 20% 15% 10% 5% 0% 0 5 10 15 20 25 30 Duration (yrs) 13% RWAs SCR (MA) AAA, AA & A BBB & BB B & CCC, AAA AA A BBB BB B & CCC Source: Solvency II Standard Formula 07 November 2016 19 Case Study Corporate Bonds (MA) Net Impact = SCR - Decrease in BEL Decrease in BEL 12% 10% 8% 6% 4% 2% 0% 0 2 4 6 8 10 Duration (yrs) AAA AA A BBB Dur (yrs) A-rated (Non-Financials) SCR Decrease in BEL Net Impact 1 0.8% 0.4% 0.4% 2 1.7% 1.1% 0.6% 3 2.5% 2.0% 0.5% 4 3.4% 3.2% 0.2% 5 4.2% 4.7% (0.5)% 7 5.0% 6.4% (1.4)% 10 6.3% 10.1% (3.8)% Source: EIOPA, RBS, iboxx spreads as at 30-Sep-2016 07 November 2016 20 10
Case Study Corporate Bonds (MA) 20% 15% Net Impact 10% 5% 0% -5% -10% 0 5 10 15 20 Duration (yrs) -15% -20% 13% RWAs AAA, AA & A BBB & BB B & CCC Net Impact (MA), AAA AA A BBB Source: Solvency II Standard Formula, iboxx, RBS 07 November 2016 21 The Future 07 November 2016 11
Other Regulatory Considerations Banks In addition to solvency capital, banks also have formal requirements for: Leverage Liquidity Stable Funding 07 November 2016 23 Banks Net Stable Funding Ratio LCR focuses on short term, NSFR on longer term stability Compares term funding with term assets on a weighted basis Available stable funding NSFR 100% Required stable funding Driver of banks increasing term funding or reducing term assets 07 November 2016 24 12
Net Stable Funding Ratio Examples Asset Maturity RSF Factor Residential mortgages > 1 year 65% Corporate loans > 1 year 85% AAA-AA Corporate bonds All (unencumbered) 15% A-BBB Corporate bonds All (unencumbered) 50% Liability Maturity ASF Factor Retail deposits < 1 year 90-95% Regulatory capital All, excl. <1Y Tier 2 100% Funding / Other capital < 1 year 0-50% Funding / Other capital > 1 year 100% 07 November 2016 25 Banks Europe vs. US Return on equity of European banks vs US banks 20 15 10 5 0 2006 2008 2010 2012 2014 2016 Euro area banks US banks Source: Bloomberg. Weighted average values for the Dow Jones EURO STOXX bank index and KBW bank index members. RoE taken to be zero wherever negative 07 November 2016 26 13
Europe vs. US Loans Assets by Holder US EU 3% 15% 14% 5% 14% 68% 18% 63% Banks Other FIs Debt securities Other Source: BNP Paribas 07 November 2016 27 Spread (%) Banks Spread Mismatch 1.00 0.75 0.50 0.25 0.00 0.25 0.50 0.75 1.00 0 2 4 6 8 10 12 Loans Margin Deposits Short-dated issuance spread Long-dated issuance spread Time (yrs) 07 November 2016 28 14
Summary 07 November 2016 Summary Difficult to compare regulatory regimes Initial hypothesis does not appear to hold Insurers are incentivised to match asset and liability duration Bank regulations seek to promote stability in the financial system 07 November 2016 30 15
Questions Comments The views expressed in this presentation are those of the invited contributors and do not necessarily represent those of their employers nor those of the IFoA. The IFoA do not endorse any of the views stated, nor any claims or representations made in this presentation and accept no responsibility or liability to any person for loss or damage suffered as a consequence of their placing reliance upon any view, claim or representation made in this presentation. The information and expressions of opinion contained in this publication are not intended to be a comprehensive study, nor to provide actuarial advice or advice of any nature and should not be treated as a substitute for specific advice concerning individual situations. On no account may any part of this presentation be reproduced without the written permission of the IFoA. 07 November 2016 31 Appendix 07 November 2016 16
Banks Evolution of Capital Adequacy 1979 Banking Act - Licensing 1987 Banking Act - Large exposure limits Basel Accord (1988) - Credit risk risk-weighting (8% of RWAs) Basel II (2004). Broadened capital adequacy to include three Pillars Basel III Implemented via CRR/CRD IV FRTB / Basel IV 07 November 2016 33 Capital Adequacy Basel III Requirements expressed as a percentage of RWAs Requirements for quality of capital - CET1 is the most important Total Tier 1 (Min 6% of RWA) CET1 AT1 4.5% 1.5% Called-up share capital plus P&L reserves, less adjustments for excluded items Perpetual instruments that can only be called, redeemed or repurchased by the issuer 5 years after the issuance date Tier 2 2% Subordinated instruments with a minimum initial maturity of 5 years Total Minimum Eligible Capital 8% of RWA 2% 07 November 2016 34 17
Capital Adequacy Basel III Minimum capital requirements are bolstered by buffers: Total Tier 1 CET1 4.5% 2.5% 0% - 2.5% 1% - 2.5% AT1 1.5% Tier 2 2% Total Minimum Eligible Capital 8% 2.5% - 5.0% 1% - 2.5% 11.5% - 15.5% 07 November 2016 35 Capital Adequacy Solvency II Requirements expressed as a percentage of SCR Total Tier 1 Unrestricted Tier 1 Restricted Tier 1 50% 20% of Tier 1 Called-up share capital plus P&L reserves, less adjustments for excluded items Perpetual instruments that can only be called, redeemed or repurchased by the issuer 5 years after the issuance date* Max 50% of SCR Tier 2 50% Tier 3 15% Subordinated instruments with a minimum 10-year maturity Subordinated instruments with a minimum 5-year maturity Total Minimum Eligible Capital 100% of SCR *other conditions also apply based on SCR/MCR trigger events 07 November 2016 36 18