Category: Regulation

I posted a brief note on Basel 3 when it was announced on the weekend … here are some more thoughts.

The press release states:

. In addition, banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirements to 7%.
…
The Group of Governors and Heads of Supervision also agreed that the capital conservation buffer above the regulatory minimum requirement be calibrated at 2.5% and be met with common equity, after the application of deductions. The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions. This framework will reinforce the objective of sound supervision and bank governance and address the collective action problem that has prevented some banks from curtailing distributions such as discretionary bonuses and high dividends, even in the face of deteriorating capital positions.
…

• The capital conservation buffer will be phased in between 1 January 2016 and year end 2018 becoming fully effective on 1 January 2019. It will begin at 0.625% of RWAs on 1 January 2016 and increase each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of RWAs on 1 January 2019. Countries that experience excessive credit growth should consider accelerating the build up of the capital conservation buffer and the countercyclical buffer. National authorities have the discretion to impose shorter transition periods and should do so where appropriate.
• Banks that already meet the minimum ratio requirement during the transition period but remain below the 7% common equity target (minimum plus conservation buffer) should maintain prudent earnings retention policies with a view to meeting the conservation buffer as soon as reasonably possible.

The American Enterprise Institute, quite rightly, considers this rather vague:

Third, the SFRC believes that both the capital conservation buffer and countercyclical buffer are insufficient to protect against sudden shocks. The proposal also suggests that enforcement of the capital conservation buffer may be unduly lenient. Rather than prohibiting distributions of earnings as the buffer is approached, the GGHS announcement indicates that there will only be some restriction on the size of such payouts. Permitting a payout of capital when a firm’s capital cushion is declining toward a critical threshold makes little economic sense.

I’ve seen a lot of lot of generalities about the constraints to be placed on banks when they are in the buffer zone, but no informed opinions, which makes me feel a little better about not having been able to find a schedule of restrictions on the BIS web-site.

However, it does appear – on the basis of what unfounded, uninformed and entirely speculative inferences I can make from the available documents – that banks will still be paying common dividends while in the buffer zone, although the amount of these dividends may be restricted. Who knows, there might be forced reductions but I think paying a penny will be OK. And if they pay common dividends, they have to pay the preferred dividends. So that’s a good thing, and from the perspective of safety the additional buffer will simply be that much more common equity between preferreds and a harsh environment.

The Globe story on the issue mentioned Eric Helleiner:

Nevertheless, the banker’s argument about the economic impact of new regulations got the authorities’ attention. Financial institutions won’t face higher capital standards until Jan. 1, 2013, a delay that seems “kind of long” and is probably “where some of the political compromises are coming in,” said Eric Helleiner, the Waterloo, Ont.-based Centre for International Governance and Innovation’s chair in political economy, who has written several articles about Basel III.

So I looked him up. Those interested in international bureaucracy may wish to review his publications.

There is euphoria over Basel 3:

Canadian banks said Monday they expect to be able to adopt new Basel III rules for maintaining reserve capital with little trouble, meaning dividend hikes and share buybacks could be on the way once Canada’s banking regulator gives the go-ahead.
…
“Based on our first read, we’re encouraged by the announcement and feel very comfortable in meeting these standards within the established timelines, given where our capital ratios stand today,” Janice Fukakusa, chief financial officer of Royal Bank of Canada, (RY-T54.601.102.06%) said at the Barclays Financial Services Conference in New York.

Her comments were echoed by other Canadian banks presenting at the conference.
…
Rod Giles, a spokesman for OSFI, told Reuters in an e-mail that the regulator will soon issue an advisory to the nation’s big banks providing more clarity on its expectations for future capital outlays.

Bank officials with the clout to hire ex-regulators will be in a far better position to judge the effect of the accord on Canadian regulation than any investor scum, so I won’t speculate too much about the final rules. I suspect, however, that OSFI’s ‘more capital is always better’ mind-set will result in a certain extra capital requirement over and above the global minimum. After all, if it tacks another 20bp on the price of Canadian mortgages, who cares?

Update: Within minutes of the “Publish” button being clicked, OSFI issued Interim Capital Expectations for Banks, Bank Holding Companies, Trust and Loan Companies (collectively, Deposit taking institutions or “DTIs”):

In light of the recent international developments providing greater certainty as to the reform of capital rules, until this Advisory is withdrawn or amended, OSFI expects sound capital management by DTIs, as set out in its guidance, but will no longer require the increased conservatism in capital management announced late in 2008.

As part of sound capital management, and in response to the continuing uncertainty caused by regulatory reform, DTIs must be able to demonstrate on request, both continually and prior to any transaction that may negatively impact their capital levels:

• that they have prudent internal capital targets that incorporate:
  • the impact of the most recent regulatory reform information from the BCBS, GHOS and OSFI;
  • expected market requirements arising from such reforms; and
  • the impact of any such proposed transaction;
• via an up-to-date capital plan, prepared in accordance with OSFI’s guidance on Internal Capital Adequacy Assessment Program (ICAAP)7, that they would have sufficient capital to meet their internal capital targets at all times while taking into account:
  • current regulatory requirements and the most recent regulatory reform information from the BCBS, GHOS and OSFI;
  • the full transition period required to implement such reforms;
  • due consideration of possible alternatives related to finalizing such reforms; and
  • due consideration of remote but plausible business scenarios that may adversely affect their ability to comply with current and reformed regulatory rules.

Please note that this Advisory repeals the October 2008 Advisory titled Normal Course Issuer Bids in the Current Environment.

The Bank for International Settlements has announced:

a substantial strengthening of existing capital requirements and fully endorsed the agreements it reached on 26 July 2010.
…
The Committee’s package of reforms will increase the minimum common equity requirement from 2% to 4.5%. In addition, banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirements to 7%.
…
Under the agreements reached today, the minimum requirement for common equity, the highest form of loss absorbing capital, will be raised from the current 2% level, before the application of regulatory adjustments, to 4.5% after the application of stricter adjustments. This will be phased in by 1 January 2015. The Tier 1 capital requirement, which includes common equity and other qualifying financial instruments based on stricter criteria, will increase from 4% to 6% over the same period. (Annex 1 summarises the new capital requirements.)

The Group of Governors and Heads of Supervision also agreed that the capital conservation buffer above the regulatory minimum requirement be calibrated at 2.5% and be met with common equity, after the application of deductions. The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions.
…
A countercyclical buffer within a range of 0% – 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances. The purpose of the countercyclical buffer is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any given country, this buffer will only be in effect when there is excess credit growth that is resulting in a system wide build up of risk. The countercyclical buffer, when in effect, would be introduced as an extension of the conservation buffer range.

These capital requirements are supplemented by a non-risk-based leverage ratio that will serve as a backstop to the risk-based measures described above. In July, Governors and Heads of Supervision agreed to test a minimum Tier 1 leverage ratio of 3% during the parallel run period.
…
Systemically important banks should have loss absorbing capacity beyond the standards announced today and work continues on this issue in the Financial Stability Board and relevant Basel Committee work streams. The Basel Committee and the FSB are developing a well integrated approach to systemically important financial institutions which could include combinations of capital surcharges, contingent capital and bail-in debt. In addition, work is continuing to strengthen resolution regimes.

By “strengthen resolution regimes”, they mean “let regulators pretend they’re bankruptcy judges and eviscerate creditor rights”, but never mind.

The Basel Committee also recently issued a consultative document Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability. Governors and Heads of Supervision endorse the aim to strengthen the loss absorbency of non-common Tier 1 and Tier 2 capital instruments.

The numbers are summarized in the Annex.

US agencies have expressed support:

The U.S. federal banking agencies support the agreement reached at the September 12, 2010, meeting of the G-10 Governors and Heads of Supervision (GHOS).1 This action, in combination with the agreement reached at the July 26, 2010, meeting of GHOS, sets the stage for key regulatory changes to strengthen the capital and liquidity of internationally active banking organizations in the United States and around the world.

No comments from OSFI so far. Maybe they haven’t been told.

Yalman Onaran of Bloomberg reports:

Of the 24 U.S. banks represented on the KBW Bank Index, seven would fall under the new ratios based on calculations using the revised definitions of capital, Keefe, Bruyette & Woods analyst Frederick Cannon said in a Sept. 10 report. Bank of America Corp. and Citigroup Inc., the nation’s No. 1 and No. 3 lenders, would be among those, Cannon estimates. Bank of America would have to hold off paying dividends or buying back shares until the end of 2013, he said.

European banks are less capitalized than U.S. counterparts and may be required to raise more funds under the new Basel rules. Deutsche Bank AG, Germany’s biggest lender, said today it plans to sell at least 9.8 billion euros ($12.5 billion) of stock. Germany’s 10 biggest banks, including Frankfurt-based Deutsche Bank and Commerzbank AG, may need about 105 billion euros in fresh capital because of new regulations, the Association of German Banks estimated on Sept. 6.
…
The committee has yet to agree on revised calculations of risk-weighted assets, which form the denominator of the capital ratios to be determined this weekend. The implementation details of a short-term liquidity ratio will also be decided by the time G-20 leaders meet, members say. A separate long-term liquidity rule will likely be left to next year.

The two liquidity rules would require banks to hold enough cash and easily cashable assets to meet short-term and long-term liabilities. The long-term requirement has been criticized the most by the banking industry, which claims it would force banks to sell $4 trillion of new debt.

The Basel committee has another meeting scheduled for Sept. 21-22 and said it may gather in October to finish its work.

I can’t help feeling that the emphasis on capital misses the point. Banks did not fail due to insufficient capital, although more is always helpful, obviously. The banks failed, or came close to failing, or were crippled in the panic because:

• They held concentrated portfolios, particularly of CDOs that, while having a face value of X, had exposure to mortgages of many times that amount since they were comprised of subordinated tranches of structured mortgages
• Interbank (and inter-near-bank in the case of AIG) exposures were not collateralized and the uncollateralized risk was weighted according to the credit rating of the sovereign of the counterparty’s regulator (i.e., when BMO buys RBC paper, that is risk-weighted as if it has bought Canada paper). Interbank exposures should be penalized by the rules, not encouraged!

I don’t have much time for commentary because this is PrefLetter weekend … but discussion of this will form a big part of future posts, never fear!

The Investment Industry Regulatory Organization of Canada has announced its release of the Review of the Market Events of May 6, 2010:

The factors that contributed to the trading patterns are:

• The existence of large sell imbalances: A number of the securities showed more sell interest beginning at the opening of trading on May 6 and in some cases the ratio of sell volume to buy volume was upwards of 3:1.…
• Electronic trading activity in the securities: High Frequency Traders (“HFT”) and Electronic Liquidity Providers (“ELP”) were trading in a number of the securities reviewed. Although the definitions of the above terms are open to discussion, we are using these terms to identify fast and relatively dominant electronic traders. The review shows that after the sudden sharp decline in the US indices, a number of HFTs and ELPs quickly withdrew from the Canadian market causing a dramatic and rapid decline in available liquidity. This withdrawal was particularly apparent on the buy side putting further pressure on prices. Some HFT entities remained in the market but predominately on the sell side and we noted markedly reduced liquidity. The withdrawal of HFTs and ELPs was particularly apparent in the heavily traded ETFs that were reviewed. IIROC is aware that some of the ELP and HFTs withdrew from the US market due to their concern about significant latencies in their data feeds from the US markets.
• “Traditional” market makers were not active in the review securities with the exception of the four highly liquid ETFs. IIROC found that market makers were present and fulfilling their obligations on the other securities reviewed including their oddlot and spread goals.…
• The triggering of Stop Loss Orders: In many cases the triggering of Stop Loss Orders was a major contributor to the deeper price declines experienced by a number of the securities reviewed. The analysis suggests that many of the egregious price declines were due to Stop Loss Order activity from Stop Loss “market” Orders as opposed to Stop Loss “limit” Orders.

No data is presented in the report that support any of the conclusions. Trust your regulators! They’re very smart, and beholden to nobody.

Recommendations are:

• The CSA and IIROC should review the current market wide circuit breaker to determine if the current trigger levels are appropriate and whether an independent Canadian-based circuit breaker level is required.
• IIROC along with the CSA should investigate whether single stock circuit breakers in the form of temporary trading halts should be implemented in Canada.
• All marketplaces should adopt volatility controls and the form and the level of these controls should be reviewed to assess to what degree they ought to be harmonized.
• All IIROC dealers should consider how to effectively manage Stop Loss Orders in the current high-speed, multi-market environment. IIROC firms should also provide their RRs and clients, including those who enter their orders directly on to the marketplace without personalized advice, with guidance on the use of Stop Loss Orders effectively in a high speed, multimarket environment.
• IIROC should review the current erroneous and unreasonable price policies and procedures, taking into account the experience of May 6.

Circuit breakers? While my natural inclination is that nothing should get in the way of two parties agreeing to a trade, I can’t really get excited over circuit breakers one way or another anyway. When the market gets as wild as it did during the flash crash, the only sensible thing to do is to go out and get a cup of coffee.

It appears that there will be more regulatory paperwork surrounding Stop Loss orders, but we’ll see how that works out. Anybody stupid enough to use a stop-loss order in the first place isn’t going to be impressed by another piece of paper.

Update: The SEC has approved new circuit breaker and trade-busting rules:

The Securities and Exchange Commission today approved new rules submitted by the national securities exchanges and FINRA to expand a recently-adopted circuit breaker program to include all stocks in the Russell 1000 Index and certain exchange-traded funds. The SEC also approved new exchange and FINRA rules that clarify the process for breaking erroneous trades.
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A list of the securities included in the Russell 1000 Index, which was rebalanced on June 25, is available on the Russell website. The list of exchange-traded products included in the pilot is available on the SEC’s website. The SEC anticipates that the exchanges and FINRA will begin implementing the expanded circuit breaker program early next week.
…
For stocks that are subject to the circuit breaker program, trades will be broken at specified levels depending on the stock price:

• For stocks priced $25 or less, trades will be broken if the trades are at least 10 percent away from the circuit breaker trigger price.
• For stocks priced more than $25 to $50, trades will be broken if they are 5 percent away from the circuit breaker trigger price.
• For stocks priced more than $50, the trades will be broken if they are 3 percent away from the circuit breaker trigger price.

Where circuit breakers are not applicable, the exchanges and FINRA will break trades at specified levels for events involving multiple stocks depending on how many stocks are involved:

For events involving between five and 20 stocks, trades will be broken that are at least 10 percent away from the “reference price,” typically the last sale before pricing was disrupted.

For events involving more than 20 stocks, trades will be broken that are at least 30 percent away from the reference price.

This paper was referenced in the recent BoC analysis of capital ratio cost/benefits as the “LEI Report”.

The Bank for International Settlements has released a report titled An assessment of the long-term economic
impact of stronger capital and liquidity requirements:

This simple mapping yields two key results, with the central tendency across countries measured by the median estimate. First, each 1 percentage point increase in the capital ratio raises loan spreads by 13 basis points. Second, the additional cost of meeting the liquidity standard amounts to around 25 basis points in lending spreads when risk-weighted assets (RWA) are left unchanged; however, it drops to 14 basis points or less after taking account of the fall in RWA and the corresponding lower regulatory capital needs associated with the higher holdings of low-risk assets.

Their approach relies heavily on the theory that output losses due to bank crises may be ascribed entirely to the crisis (although they do acknowledge that “that factors unrelated to banking crises, and not well controlled for in these studies, may also influence the output losses observed in the data.”):

Why should the effects of banking crises be so long-lasting, and possibly even permanent? One reason is that banking crises intensify the depth of recessions, leaving deeper scars than typical recessions. Possible reasons for why banking related crises are deeper include: a collapse in confidence; an increase in risk aversion; disruptions in financial intermediation (credit crunch, misallocation of credit); indirect effects associated with the impact on fiscal policy (increase in public sector debt and taxation); or a permanent loss of human capital during the slump (traditional hysteresis effects).

One of the papers they quote in support of their approach is Carlos D. Ramirez, Bank Fragility, ‘Money Under the Mattress,’ and Long-Run Growth: U.S. Evidence from the ‘Perfect’ Panic of 1893:

This paper examines how the U.S. financial crisis of 1893 affected state output growth between 1900 and 1930. The results indicate that a 1% increase in bank instability reduces output growth by about 5%. A comparison of the cases of Nebraska, with one of the highest bank failure rates, and West Virginia, which did not experience a single bank failure reveals that disintermediation affected growth through a portfolio change among savers – people simply stop trusting banks. Time series evidence from newspapers indicate that articles with the words “money hidden” significantly increase after banking crises, and die off slowly over time.

Ramirez continues:

The intuition behind the explanation of why financial disintermediation affects
growth is straightforward. In the absence of deposit insurance or any other institutional arrangement that restores confidence on the banking system, depositors who experience losses or whose money becomes illiquid, even temporarily, may become reluctant to keep their money in the banking system. They simply stop “trusting” banks. This lack of trust may affect all depositors, including those that did not experience losses. With a high enough degree of risk aversion and a high enough probability of a bank run or failure depositors may be induced to reshuffle their liquid asset portfolio away from the banking system. To the extent that the panic induces a portfolio change in asset holdings away from the banking system and into more rudimentary forms of savings, such as keeping the money “under the mattress,” financial intermediation, and thus, growth are adversely affected.

According to me, this raises a red flag about the use of these data to determine the the severity of bank crises in the current environment, even without considering the difficulty of disentangling the degree of recession actually caused by the Panic versus the degree of economic stupidity that was merely brought to light. The Nebraskans kept their money “under the mattress” due to a lack of deposit insurance – just how relevant are the mechanics to what is going on now?

Additionally, the underlying rationale behind the desire to avoid banking crises points to an alternative solution to the problem: rather than reducing the chance of a systemic banking crisis, why not increase the range of alternative intermediation pathways?

Currently, regulators are doing everything they can – by way of Sarbox, completely random regulatory punishment for having been involved in the underwriting and distribution of investments that went bad, TRACE, costs of prospectus preparation, etc. – to deprecate the direct capital markets. A concious effort should be made in the other direction; the option of issuing public debt should be made more attractive to companies, not less.

Additionally, I have previously proposed that Investment Banks be treated differently from Vanilla Banks, not by a strick separation such as Glass-Steagall, but by imposing differing schedules for different types of banks, so that the latter would be penalized for holding assets while the former would be penalized for trading them (where “penalized” refers to higher capital requirements). The idea can be extended: bring back the Trust Company, which would get a preferential capital rate for first mortgages with loan-to-value of less than 75% and a penalty rate of everything else.

In the financial system as in the financial investments, bad investments (bad banks) can hurt you: it is concentration that kills you. And the point is related to my other big complaint about the regulatory response to the crisis: right in the age of networking, regulators are emphasizing systems which are vulnerable to single point failure.

Just as an example, the BIS paper notes:

The final approach used in this exercise relies on the Bank of Canada’s stress testing framework. This methodology is based on the idea that the failure of a bank arises from either a macroeconomic shock or spillover effects from other distressed banks. Spillover effects arise either because of counterparty exposures in the interbank market or because of asset fire sales that affect the mark to market value of banks’ portfolios. In this context, a greater buffer of liquid assets can only be beneficial insofar as it helps the bank to avoid asset fire sales, which would otherwise lead to losses.

You could get the same benefit by reducing the degree of interbank holdings, but such a solution is not even considered. BIS, it appears, will continue to risk-weight bank paper according to the credit rating of the sovereign – if you want an example of moral hazard, that’s a good one right there.

Anyway, BIS comes up with a figure of 13bp per point of capital ratio:

Column A of Table 6 reports the results of this exercise. In order to keep ROE from changing, each percentage point increase in the ratio of TCE to RWA results in a median increase in lending spreads across countries of 13 basis points.

… but this is subject to four major problems acknowledged by BIS:

• The existing literature, which is the basis for this report’s estimates of the costs of banking crises, may overestimate the costs of banking crises. Possible reasons include: overestimation of the underlying growth path prior to the crises; failure to account for the temporarily higher growth during that phase; and failure to fully control for factors other than a banking crises per se that may contribute to output declines during the crisis and beyond, including a failure to accurately reflect causal relationships.
• Capital and liquidity requirements may be less effective in reducing the probability of banking crises than suggested by the approaches used in the study. This would reduce the overall net benefits for a given level of the requirements. However, to the extent that net benefits remain positive, it would also imply that the requirements would need to be raised by more in order to achieve a given net benefit.
• Shifting of risk into the non-regulated sector could reduce the financial stability benefits.
• The results of the impact of regulatory requirements on lending spreads are based on aggregate balance sheets within individual countries, so that they do not consider the incidence of the requirements across institutions. They implicitly assume that theinstitutions that fall short of the requirements (ie, that are constrained) do not react more than those with excess capital or liquidity (ie, that are unconstrained). These effects may not be purely distributional.

I consider the third point most important. To the extent that higher capital ratios imply higher spreads implies a greater role for the shadow banking industry, then the real effect of higher capital levels will be to shift important economic activity from the somewhat flawed regulated sector to a sector with no regulation at all.

I certainly support the idea that we should have layers of regulation – a strong banking system surrounded by a less regulated / less systemically important investment banking sector, surrounded in turn by a wild-n-wooly hedge fund/shadow bank sector … but regulators are, as usual fixing yesterday’s problem with little thought for the implications.

As highlighted in MFC’s 2Q10 Report to Shareholders, OSFI has released a letter to the Canadian Life and Health Insurance Association regarding Seg Fund Capital Requirements [footnote changed to link – JH]:

As mentioned publicly by the Superintendent in the fall of 2009, OSFI has been, as part of this [MCCSR Advisory Committee review] process, conducting a fundamental review of segregated fund capital requirements. We are proceeding to act on the results of this review. In particular, two work streams are underway with respect to internal modeling for the capitalization of segregated fund guarantee exposures.

The first area of work is the implementation of changes to underlying calibration standards for modeling segregated fund guarantee exposures. While we are currently continuing to consult through the MAC process, we expect to issue a draft advisory in the fall of 2010 for public comment. We expect that this will change the existing capital requirements in respect of new (rather than in-force) segregated fund business (e.g. post 2010 contracts).

It is not clear whether or not this draft advisory will include leverage caps on assets including seg funds.

The letter does not make any predictions about the effects on capital expected in the draft advisory:

It is premature to draw conclusions about the cumulative impact this process will have. For example, considered as a whole, there could be increases in some lines of business and decreases in others – and increases may be offset by other changes, such as hedge recognition. In addition, the impact is likely to vary from company to company. As usual, OSFI will be consulting with the CLHIA and your members on proposed changes and will provide ample notice prior to the implementation of new guidance.

… but I suggest that an increase in required capital is something of a slam-dunk.

Sun Life Financial stated in its 2Q10 Earnings Release:

The regulatory environment is evolving as governments and regulators develop enhanced requirements for capital, liquidity and risk management practices. In Canada, the Office of the Superintendent of Financial Institutions Canada (OSFI) is considering a number of changes to the insurance company capital rules, including new guidelines that would establish stand-alone capital adequacy requirements for operating life insurance companies, such as Sun Life Assurance Company of Canada (Sun Life Assurance), and that would update OSFI’s regulatory guidance for non-operating insurance companies acting as holding companies, such as Sun Life Financial Inc. In addition, it is expected that OSFI will change the definition of available regulatory capital for determining regulatory capital to align insurance definitions with any changed definitions that emerge for banks under the proposed new Basel Capital Accord.

OSFI is considering more sophisticated risk-based modeling approaches to Minimum Continuing Capital and Surplus Requirements (MCCSR), which could apply to segregated funds and other life insurance products. In particular, OSFI is considering how advanced modeling techniques can produce more robust and risk-sensitive capital requirements for Canadian life insurers, including internal models for segregated fund guarantee exposures. OSFI expects to issue a draft advisory in the fall of 2010 for public comment which will change the existing capital requirements in respect of new, rather than in-force, segregated fund business (e.g. post 2010 contracts). OSFI is also reviewing internal models for in-force segregated fund guarantee exposures, a review process that is ongoing. OSFI is considering a range of alternatives for in-force business, including a more market-consistent approach and potentially credit for hedging. Although it is difficult to predict how long the process for reviewing in-force segregated fund guarantee exposures will take, OSFI expects the review to continue for several years, likely into 2013. It is premature to draw conclusions about the cumulative impact this process will have on capital requirements for Canadian life insurance companies.

The outcome of these initiatives is uncertain and could have a material adverse impact on the Company or on its position relative to that of other Canadian and international financial institutions with which it competes for business and capital. In particular, the draft advisory on changes to existing capital requirements in respect of new segregated fund business to be issued by OSFI in the fall of 2010 may result in an increase in the capital requirements for variable annuity and segregated fund policies currently sold by the Company in the United States and Canada on and after the date the new rules come into effect. The Company competes with providers of variable annuity and segregated fund products that operate under different accounting and regulatory reporting bases in different countries, which may create differences in capital requirements, profitability and reported earnings on these products that may cause the Company to be at a disadvantage compared to some of its competitors in certain of its businesses. In addition, the final changes implemented as a result of OSFI’s review of internal models for in-force segregated fund guarantee exposures may materially change the capital required to support the Company’s in-force variable annuity and segregated fund guarantee business. Please see the Market Risk Sensitivity and Capital Management and Liquidity sections of this document.

They also provided more information regarding the effect of a market crash on their earnings. Whereas a 10% drop in equity prices from 2010-6-30 levels would cost $175-225-million, a 25% crash would cost $550-650-million. I was most impressed to see disclosure of the effect of their hedging programmes, which reduced the impact of these market moves by more than 50%. Now all we have to worry about is whether their hedges will, in fact, prove effective if needed!

They are not updating their guidance regarding underlying earnings:

Based on the assumptions and factors described below, in the third quarter of 2009, the Company estimated that its adjusted earnings from operations for the year ending December 31, 2010 would be in the range of $1.4 billion to $1.7 billion. The Company cautioned that its earnings in 2010 would reflect the lower asset levels and account values that were expected in 2010, as well as higher risk management costs, potential volatility and uncertainty in capital markets, the expected higher levels of capital required by regulators, lower leverage, currency fluctuations and the potential for higher tax costs as governments around the world look to address higher deficits.

Updates to the Company’s best estimate assumptions as well as changes in key internal and external indicators during the first half of 2010 did not impact the range of its estimated 2010 adjusted earnings from operations that was previously disclosed in the third quarter of 2009.

They’re also warning of a goodwill impairment charge under IFRS:

The Company anticipates that it will record a net goodwill impairment charge of approximately $1.7 billion, to be recognized in opening retained earnings upon transition to IFRS. This impairment relates to a portion of the goodwill recorded on the acquisitions of Keyport Life Insurance Company in the United States in 2001 and Clarica Life Insurance Company in Canada in 2002. This impairment charge reflects the application of IFRS standards as well as the continuing impact of the economic environment.

The impairment of goodwill is a non-cash item and will not impact the level of regulatory capital for the Company as existing goodwill is already deducted from available capital for regulatory purposes in the calculation of the MCCSR for Sun Life Assurance.

And there will be a small dilution adjustment:

Under IFRS, all financial instruments that contain a conversion feature to common shares must be included in the calculation of diluted earnings per share, irrespective of the likelihood of conversion. Certain innovative Tier 1 instruments issued by the Company (SLEECS Series A and SLEECS Series B) contain features which enable the holder to convert their securities into common shares under certain circumstances. The impact of including these financial instruments in the calculation of the Company’s diluted EPS will be a reduction in EPS of approximately $0.03 per quarter. If the SLEECs Series A are redeemed at their par call date in 2011, the ongoing reduction on diluted EPS is expected to be reduced to $0.01 per quarter.

And, of more potential interest, they note that they are highly interested in the IFRS exposure draft on Insurance Contracts, which has been previously discussed:

On July 30, 2010 the International Accounting Standards Board issued an exposure draft for comment, which sets out measurement changes on insurance contracts. The Company is in the process of reviewing the exposure draft, however it is expected that measurement changes on insurance contracts, if implemented as drafted, will result in fundamental differences from current provisions in Canadian GAAP, which will in turn have a significant impact on the Company’s business activities and volatility of its reported results. Changes from this exposure draft are expected to be finalized and applicable no earlier than 2013.

The Globe & Mail published an article today, Insurers cry foul over pending rule changes, highlighting a problem that I’m not sure exists:

A key sticking point is the “discount rate,” or interest rate, that insurers use to calculate the current value of payments that they will have to make to customers in the future.

The rate that Canadian insurers are using basically allows them to take credit now for investment performance that they hope to achieve in the future, the IASB argues. Instead, it says, they should be using a current risk-free rate (essentially measured by the return on government bonds). Since that rate is lower, the Canadian insurers’ liabilities will rise when the change kicks in, and it will be especially painful in areas such as life annuities or whole life non-participating insurance, when the insurers value payments that they owe customers decades from now.

That hasn’t been lost on the IASB. Both Julie Dickson, the head of Canada’s banking and insurance regulator, and Jim Flaherty, the Finance Minister, wrote to the international accounting body earlier this year asking it to consider the impact on the Canadian sector.

To my total lack of surprise, I was unable to find the letters from Dickson or Flaherty published anywhere. So much nicer to do things in private, doncha know.

However, the issue has been bubbling for a while. A presentation by Rubenovitch in April 2008 (about six months before they nearly blew up), Manulife decried:

Asymmetrical accounting for asset and liability and earnings volatility that is not relevant and that will not ultimately be realized

which would result if long-term obligations were to be discounted at the risk-free rate, stating, quite rightly that this:

Assumes liquidity required and overstates liability

The problem is, of course, that government bonds do not simply reflect the “risk free rate”. They also represent the liquidity premium. You cannot get a risk-free rate without also losing the liquidity premium and attempts to disentangle the two aspects of corporate bond pricing came to grief during the Panic of 2007 (see chart 3.16 of the BoE FSR of June 2010 and note the amusing little gap in the x-axis).

But I can’t see that the rules actually require insurers to use government rates as their discounting rate. The relevant portion of the IFRS exposure draft states (emphasis added):

30 An insurer shall adjust the future cash flows for the time value of money, using discount rates that:
(a) are consistent with observable current market prices for instruments with cash flows whose characteristics reflect those of the insurance contract liability, in terms of, for example, timing, currency and liquidity.
(b) exclude any factors that influence the observed rates but are not relevant to the insurance contract liability (eg risks not present in the liability but present in the instrument for which the market prices are observed).

31 As a result of the principle in paragraph 30, if the cash flows of an insurance contract do not depend on the performance of specific assets, the discount rate shall reflect the yield curve in the appropriate currency for instruments that expose the holder to no or negligible credit risk, with an adjustment for illiquidity (see paragraph 34).
…
34 Many insurance liabilities do not have the same liquidity characteristics as assets traded in financial markets. For example, some government bonds are traded in deep and liquid markets and the holder can typically sell them readily at any time without incurring significant costs. In contrast, policyholders cannot liquidate their investment in some insurance contract liabilities without incurring significant costs, and in some cases they have no contractual right to liquidate their holding at all. Thus, in estimating discount rates for an insurance contract, an insurer shall take account of any differences between the liquidity characteristics of the instruments underlying the rates observed in the market and the liquidity characteristics of the insurance contract.

I don’t see anything unreasonable about this.

The Globe & Mail had reported earlier:

Despite their disappointment in the rules, at least some Canadian insurance executives say they are still optimistic that they will succeed in making their case as it appears that the draft is very preliminary and that the IASB is open to feedback. The insurers intend to present the accounting board with figures that demonstrate the impact the rules will have on their results.

I will be most interested in seeing those figures, particularly their derivation of the discount rate. Detail please!

KPMG comments:

Aspects of the proposed insurance model which are likely to attract debate include determining a discount rate for obligations based on their characteristics as opposed to the return on invested assets, and the treatment of changes in assumptions driving the measurement of the insurance obligation. The effects of changes in assumptions, whether financial such as interest rates or non-financial such as mortality and morbidity rates, would be required to be recognised in the statement of financial position and the statement of comprehensive income each reporting period.
…
Neil Parkinson, KPMG’s Insurance Sector Leader for Canada, emphasized the implications for Canadian insurers: “The IASB’s proposals would affect how all insurers measure their profitability and their financial position, and would likely result in greater volatility in many of the key measures they report. This volatility would be magnified for longer term insurance products, and is of particular concern for Canadian life insurers.”

I don’t see anything on the insurance companies’ websites themselves.

One way or another, this is an issue well worth following. Volatility in key measures? Great! Lets have a little more volatility in key measures and a little less “Whoopsee, we need $6-billion and a rule-change TODAY, came out of nowhere, honest!”

Update: Reaction in the UK is soporific:

Peter Vipond, director of financial regulation and taxation at the Association of British Insurers, said current insurance accounting methods have been inconsistent and haven’t adequately captured “the economics of the industry.”

“We are pleased that the IASB aims to offer a modern approach based on current measures that may offer investors a clearer view of insurers’ obligations and performance,” Vipond said in an e-mailed statement.

I believe – but am not sure! – that UK insurers use gilts to hedge annuities much more than corporates, in which case this change won’t make too much difference to them.

Update, 2010-8-4: Price-Waterhouse highlights the volatility issue:

Gail Tucker, partner, PricewaterhouseCoopers LLP, added:

“Industry reaction will be divided on these proposals. They will create increased volatility in insurer’s reported results going forward, as market movements will now affect reported profit. There will also be significant changes to the presentation of the income statement which stakeholders will need to take the time to understand. Today’s developments will also cast their net wider than the insurance industry, affecting all companies that issue contracts with insurance risk, such as financial guarantee contracts.

“Given the profound impact of these proposed changes, it is vital insurers work closely with industry analysts to make sure they fully understand the changes and what insurers’ accounting will look like going forward. As there is only a small window during which the industry has an opportunity to influence the final outcome of these proposals, insurers need to act now in assessing the implications of the new model on both their existing contracts and business practices.”

Update 2010-8-9: The MFC Earnings Release 2Q10 sheds some light (a little, anyway) on their objections:

We determine interest rates used in the valuation of policy liabilities based on a number of factors, as follows:
(a) we make assumptions as to the type, term and credit quality of the future fixed income investments;
(b) to reflect our expected investable universe, we adjust the publicly available benchmarks to remove the issues trading extremely tight or wide (i.e., the outliers);
(c) we assume reinvestment rates are graded down to average long-term fixed risk free rates at 20 years; and
(d) consistent with emerging best practices we limit the impact of spreads that are in excess of the long-term historical averages.

In other words. they are making an implicit assumption that they are always perfectly hedged.