PrefBlog

Moody’s discussion of original rules:

Canadian guaranteed seg funds, like guaranteed variable annuities in the U.S., expose their issuers to catastrophe risk – namely, the low frequency, but potentially high severity risk of a prolonged downturn in the equity markets, resulting in reduced seg fund asset values and potential losses on guaranteed benefit payments. In Canada, this risk is magnified by the prevalence of maturity guarantees, which, unlike death benefits, pay out with certainty at a specified contract maturity date (assuming no previous lapsation). We believe that significant individual guaranteed seg fund exposures exist, given the recent retreatof reinsurers from this market, and in the absence of effective hedging techniques.
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In 1999, OSFI, with the collaboration of the Canadian Institute of Actuaries (CIA), began to seek a solution to the industry’s growing exposure to guaranteed seg fund risk from a capital and reserving standpoint. In August 2000, a special CIA task force produced a report9 with a recommended framework for establishing total minimum balance sheet requirements (i.e., capital plus reserves, rather than just capital or reserves). Following a review and modification by OSFI, the recommendations culminated in the introduction of a new Mandatory Minimum Continuing Capital and Surplus (MCCSR)10 guideline in December 2000. The new requirements are being phased into the MCCSR capital of Canadian seg fund providers with 50% of the new standards required at year-end 2000, and the full standards required by year-end 2001.

At that time, MFC had seg-fund AUM of $6,767-million. According to MFC’s 3Q08 Earnings Release, segregated funds at 2008-9-30 were $165,488-million, comprised largely of $101,301-million in the US and $29,851 in Canada.

OSFI’s Revisions to Segregated Fund Guarantee MCCSR Rules:

Minimum Capital Dependent on Expected Payment Date: Currently SFG capital is established based on a confidence level of CTE(95) over the term of a contract, regardless of whether the payments are expected to be due next quarter or in 30 years. OSFI believes that the confidence level and the capital requirement should reflect the proximity of the expected cash flows. Therefore, cash flows would be grouped into 3 categories according to expected dates and the following minimum confidence levels would apply: i) due in 1 year or less, CTE(98); ii) due between 1 and 5 years, CTE(95); and iii) due after 5 years, CTE(90).

2. >5 Yr Capital Increases Towards Capital Based On CTE(95): To help ensure sufficient capital is methodically accumulated for cash flows beyond 5 years and to allow such capital to grow towards a CTE(95) capital requirement, a calculation will be performed to measure the amount (the “Adjustment Amount”) that would, if accumulated over the next 20 quarters (and no other changes occur – i.e. all parts of the equation remain the same), be required to adjust the actual >5 year capital at the end of the prior quarter (the “>5Yr Previous Q Required Capital”) to equal the capital required at the end of the current quarter measured at a CTE(95) confidence level (the “Current Q >5Yr CTE(95) Capital). The Adjustment Amount would equal 5% of the amount obtained when the >5Yr Previous Q Required Capital is subtracted from the Current Q >5Yr CTE(95) Capital.

Globe & Mail story Shaken Manulife goes to banks for loan:

During a conference call with analysts, Mr. D’Alessandro acknowledged he had asked the Office of the Superintendent of Financial Institutions, which regulates banks and insurers in Canada, to change certain capital rules as the firm faced the prospect of having to tap equity markets for an infusion

Conference call transcript:

As you can see on this slide in the box in the middle, we are expecting to close the third quarter in our target MCCSR range of 180% to 200% albeit at the lower end of that range.

As you can see, the required capital has increased and the primary driver of the increase in required capital is the impact of the equity markets on the segregated fund guarantees. Available capital has also increased through the notches by expected earnings but also by some capital re-positioning whereby we’ve moved excess capital from other components of the organization into Manulife.

I would just caution at this stage that the Q3 numbers are still estimated as we’re still preparing our final close of the books so all the Q3 numbers that you see in this report are preliminary.
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Our segregated fund guarantee offerings are primarily in three jurisdictions: our US business, our Canadian business, and our Japanese business, and we have approximately $72 billion of net in force of guarantees.

MFC Slideshow, Impact of Equity Markets on Capital Position.

Update, 2008-11-12: Comparison of US & Canadian practice.

Discussion of Internal Models

Update, 2008-11-13: OSFI’s Framework for a New Standard Approach to Setting Capital Requirements.

Update, 2008-11-13:OSFI’s 2001-12-20 Letter to the OSC re Financial Reporting in Canada’s Capital Markets

subsection 22(6) of the OSFI Act requires that the Superintendent report annually “respecting the disclosure of information by financial institutions and describing the state of progress made in enhancing the disclosure of information in the financial services industry.” Prudential regulators, such as OSFI, take an interest in improving disclosure by financial institutions, not only to better serve the interests of their depositors and policyholders but also to promote the application of market discipline as a governance tool. As you are aware, this concept underlies Pillar 3 of the revised Basel Accord and also features in the international supervisory framework for insurance enterprises.

Update, 2018-10-30: I just realized I didn’t have a link here to the Globe story Manulife’s choice: Safety first, by Tara Perkins:

On Sept. 30, the head of Canada’s regulator, the Office of the Superintendent of Financial Institutions, wrote an e-mail to various OSFI officials. “D’Alessandro just called and asked that we try to meet next week with the company to discuss capital,” Julie Dickson wrote, noting that the meeting would replace one that had been arranged for November. Mr. D’Alessandro wanted to discuss the capital requirements for the variable-annuity, or segregated funds, business, other e-mails show.

Discussions took place in October in which he laid out why he felt the rules were too onerous, and OSFI officials had a flurry of internal discussions. On Oct. 28, the rules were changed.

OSFI consulted with more than one insurer that month, but the changes were most important to Manulife.

Federal lobbyist records show that Mr. D’Alessandro also met with Prime Minister Stephen Harper on Nov. 6 to discuss “financial institutions.” It is not known what was discussed at the meeting with Mr. D’Alessandro.

OSFI has released a proposed Framework for a New Standard Approach to Setting Capital Requirements

This paper proposes a new standard approach to determine how much capital a Canadian life insurance company should be required to have on hand in order to be able to meet its obligations. The proposed framework is consistent with the “Canadian Vision for Life Insurer Solvency Assessment,” endorsed by the Office of the Superintendent of Financial Institutions (OSFI) and Autorité des marchés financiers (AMF). It uses a target asset requirement approach1, meaning that insurance companies would be required to hold assets equal to the sum of the best estimate of their insurance obligations and a solvency buffer.

They note that:

The current MCCSR does not adequately account for risk concentration and risk diversification. Nor does it provide explicitly for operational risk. These areas will also need to be considered in the updated standard approach. However, implementation may be later than for credit, market, and insurance requirements.

In yet another example of OSFI’s contempt for investors – who are the ones supposed to be supplying the market discipline. Remember? – they restrict participation in the discussions to industry:

We will now be preparing more detailed papers on market, credit, insurance and operational risk. We will ask the industry for comments on each paper and for participation in quantitative impact studies.

Further:

The framework will consider in the future the possible recognition of concentration or diversification of risk.

We can only hope that this is the NEAR future! It is not clear to me how a rational determination of the credit risk of a portfolio can be made without considering concentration risk, but maybe that’s just me.

OSFI has released an Advisory re Securitization – Expected Practices.

It’s mostly motherhood, but there are some interesting highlights:

Effective immediately, GMD liquidity facilities provided by Canadian FREs will no longer result in zero capital usage (e.g. a 0% credit conversion factor will cease to apply under the standardized approach) and will, regardless of the approach (e.g. standardized approach; internal ratings based approach) used to measure risk arising from securitization exposures, receive the same credit conversion factors and capital treatment as global style liquidity facilities. In particular, when using an internal ratings-based approach, no reduction in risk exposure for a liquidity facility will apply if it is structured as a GMD liquidity facility and such facility shall be treated in a manner consistent with global style liquidity facilities. This guidance reflects that, while GMD liquidity facilities may not exhibit material credit risk, recent events have shown that other risks do exist (such as reputational risk) [Footnote] and that, consequently, a capital charge is appropriate.
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Footnote: GMD facilities have been converted to global style facilities in support of sponsored conduits.

OSFI misses the point here. It was not the GMD facility that created reputational risk – it was the sponsorship. There has been no effect on the foreign banks that provided GMD facilities for the Canadian ABCP, because they weren’t sponsoring the conduits.

There is no need to increase the capital charge for GMD – this move simply represents OSFI caving to a few uninformed headline writers. I’d prefer to have an independent regulator, frankly.

In a related example:

Effective October 31, 2008, new securities issued by securitization SPEs, other than securities issued as a result of the “Montreal Accord”, must be rated by at least two recognized ECAIs to permit, in the case of any securitization exposure related to such securities, the use of a standardized or internal ratings-based approach, or an Internal Assessment Approach13, by a FRE14. In all cases where a securitization exposure arises from a re-securitization and the exposure is acquired after October 31, 2008, the securities issued by the re-securitization SPE (or such securitization exposure), other than securities issued as a result of the “Montreal Accord”, must be rated by two recognized ECAIs to permit a FRE to use a ratings-based or Internal Assessment Approach for such exposure. further, in the case of a re-securitization exposure acquired after October 31, 2008, the Supervisory Formula under CAR can only be applied based on the ultimate underlying assets (e.g. the third party loans or receivables giving rise to cash flows) and not based upon securities issued by any underlying securitization.

Now, me, I’d rather have one good credit analysis than two bad ones, but maybe that’s just me.

I do support their efforts on resecuritization:

While re-securitizations share many of the same issues and features as securitizations of unsecuritized assets, because additional risks exist, it may not be appropriate to apply the same risk assessment and capital adequacy measures to re-securitizations as are applied to other securitizations. For example, reliance on the credit ratings ascribed to the securitization exposures held by the re-securitization may be misleading unless a detailed analysis of the underlying assets in the underlying securitizations is performed (e.g. to ensure that those assets will perform as expected under stress test scenarios and that those underlying assets do not pose any concentration risks and provide sufficient diversity).

This is attempting to get at the correlation of default behaviour – copulas, in technical parlance – without actually using the word! But it’s a start.

Maximizing deposit insurance coverage is a favourite topic with my friends at Financial Webring Forum – see, for example, the thread Multiple RRSP accounts advisable when reach $100k?, and that’s only the first one I found. People go into endless loving detail about how to maximize coverage through use of separate accounts for spouses, joint accounts, trust accounts, multiple institutions … in the States, there’s an outfit called Promontory that handles all that for a fee.

I mentioned Promontory briefly yesterday:

There has been some criticism of a diversification service which allows large deposits to be distributed amongst many banks and be entirely insured:

“When I first saw Promontory, I was amazed that the regulators would let it fly,” says Sherrill Shaffer, a former chief economist at the New York Federal Reserve Bank. “It undermines a lot of the safeguards around the FDIC deposit fund. I’m astounded that the FDIC has not picked up on that and tried to shut down that loophole.”

The loophole Promontory exploits is the FDIC rule that allows an individual to open up federally insured accounts of up to $100,000 at an unlimited number of banks.
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Edward Kane, senior fellow of the FDIC’s Center for Financial Research, says CDARS intercepts FDIC premiums.

“It’s portrayed as a public-spirited way to help customers as opposed to a way to game the system,” he says. “They’ve decided there’s a loophole that they’re in charge of.”

… which I confess I don’t understand. The only legitimate criticism I have been able to come up with is that it exploits the minimum and therefore deprives the financial system as a whole of the due diligence that would arise from a large depositor being worried about the soundness of the bank he uses. But this concern is not consistent with the criticism in the article, or with the level of disdain for the process expressed.

However, I have had some discussion with specialists in the field; the concern is that the FDIC is insuring all deposits anyway – the Wachovia deal – and should get paid for it. Infinite deposit insurance! Now there’s a moral hazard issue if ever there was one. Problems at IndyMac & WaMu and the subsequent wipe-out of common shareholders were brought to a head by a run on deposits … it seems to me that infinite deposit insurance will allow banks to ignore the hazards of losing confidence.

So, when you don’t understand something, you ask a question, right? It saves a lot of time. I sent an eMail to Prof. Sherrill Shaffer:

You are quoted in the captioned story at [Bloomberg] as saying ““When I first saw Promontory, I was amazed that the regulators would let it fly. It undermines a lot of the safeguards around the FDIC deposit fund. I’m astounded that the FDIC has not picked up on that and tried to shut down that loophole.”

I regret that I do not understand your criticism. If we can accept that FDIC premia are computed rationally and based on insured deposits, then Promontory is simply engaged in an exchange of value.

The only criticism I have been able to come up with is that when a large depositor’s assets are diversified amongst banks in this manner, the system as a whole is deprived of the due diligence that he might otherwise do if the bulk of the deposit was uninsured. But the Bloomberg story does not bring up this critique.

I would be very grateful if you could help me understand your concern.

Dr. Shaffer was kind enough to respond at length and to grant permission to be quoted.

You are correct that extended deposit insurance coverage (whether statutory or synthesized) does tend to reduce the degree of market discipline exerted by large depositors.

The more market discipline that’s in place, the better it is for everybody … although it should be noted that I am referring to market discipline that is rational. The excesses of irrational (or uninformed) market discipline is what causes perfectly good banks to suffer runs in the first place, which is why the discount window was invented. The Panic of 1907 is the classic example, but there is also the Panic of 1825 and the events following the collapse of Overend and Gurney.

It should be noted, however, that evidence of rational market discipline of banks is a little hard to come by. In the post Banks and Subordinated Debt, I highlighted the Cleveland Fed’s mostly vain attempt to extract useful information from credit spreads. Given that it is institutional investors who will determine these spreads – and FIXED INCOME institutional investors at that, who are well known to be both much smarter and better looking than the equity guys – I suggest that hopes for market discipline exerted by large retail depositors is more of an expression of piety than the foundation of successful regulation.

You are also correct that Promontory would be engaged in a simple exchange of value if the FDIC premia were computed on the basis of insured deposits. However, FDIC premia are instead computed as a fraction of (essentially) total domestic deposits, not merely insured deposits. (The exact assessment base is total deposits, less foreign deposits, less cash & due from depository institutions, less pass-through reserve balances, less a few smaller exclusions – please see pages 2-3 of the attached file.) Under this current system, any means of extending deposit insurance coverage to a larger fraction of total domestic deposits does not directly result in larger premium payments to the FDIC.

I have uploaded the file regarding FDIC assessments.

I hadn’t been aware of that. I am open to correction, but it seems to me that establishing deposit insurance premia based on total deposits rather than insured deposits rather undermines the policy objective of market discipline:

• The FDIC will be on the moral defensive should it wish to enforce the limit at the expense of uninsured depositors
• There is no advantage to the insured institution, in terms of premia, to establish a reputation for soundness that will attract uninsured deposits.
• There is less room than there might otherwise be for institutions to offer higher rates for uninsured deposits, rewarding depositors for the (perceived) additional risk

Rather, the banking industry as a whole is assessed higher premium rates in years when the FDIC’s fund drops below the Designated Reserve Ratio spelled out in federal law. To the extent that Promontory member banks impose larger losses on the FDIC when they fail, non-Promontory banks help pay the tab to the same extent as Promontory banks, and thus cross-subsidize the extra coverage provided to Promontory banks.

So the first problem caused by CDARS is that the FDIC is not compensated for the additional risk ex ante, and any ex post compensation involves an element of cross-subsidization from non-CDARS banks. This is the “unpriced risk” concern.

I agree, all this follows from the fact that premia are charged on uninsured deposits at the same rate as insured ones.

A second problem is that, if our policy makers desired to extend deposit insurance coverage to larger accounts, doing so by statute would avoid the overhead costs (data base costs, marketing costs, administrative and executive costs, etc.) associated with a synthesized coverage such as CDARS. Those overhead costs therefore represent a deadweight loss, paid directly by CDARS banks but ultimately passed on to society. This is the “efficiency concern.”

This is a familiar argument that is seen in virtually everything that can be construed as a “public good” – medicare, toll-roads, transit, you-name-it – not just deposit insurance. One’s views on this question will be heavily influenced by idealogy; there’s no need to go into it in detail here.

There’s not enough information, either! If there was, in fact, a two-tiered deposit system in which the market clearly differentiated between insured and uninsured deposits, then we could start dissecting the data to determine where the line between the two should be drawn. But there ain’t, so we won’t.

A third problem, more philosophical in nature, is that Congress has periodically re-visited the question of whether $100,000 is an appropriate ceiling on FDIC coverage, and thus far has rejected the alternative of raising that cap (although that may change soon). By achieving a much larger cap of $50 million for participating banks, CDARS legally circumvents the expressed intent of Congress. Equivalently, we can view CDARS as extending to all depositors the same protection accorded to depositors in “too-big-to-fail” banks – a protection that Congress has explicitly sought to limit, as in some provisions of the 1991 FDIC Improvement Act. Thus, the effect of CDARS runs contrary to the spirit, though not the letter, of federal law.

On the other hand, one might consider CDARS as being a simple diversification mechanism … like a mutual fund in many ways, although the big difference is that the “diversification” is simply a mechanism to achieve concentration in FDIC’s credit strength. I will suggest that a great deal of this problem would be solved if Congress applied the same limit to premium calculation as it does to insurance coverage.

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There are other cross-currents in the mix. I have briefly mentioned (most recently on May 16) the Fed’s decade-long drive to pay interest on reserves; the idea being that increasing the attractiveness to banks of reservable deposits will assist the Fed to transmit its monetary policy to the broader economy. And we have recently witnessed the bizarre occurance of Treasury writing Credit Default Swaps on MMFs (see September 19) … it’s totally unclear to me what long-term influence that might have, and whether policy will change to require banks to hold capital against branded MMFs.

As far as I know, the CDIC charges premia based on insured deposits only:

Premiums are based on the total amount of insured deposits held by members as of April 30th each year, calculated in accordance with the CDIC Act and its Differential Premiums By-law, which classifies member institutions into one of four premium categories.

Classification is based on a mix of quantitative and qualitative factors. Premium rates in effect for the 2006 premium year, unchanged from 2005, were as follows:
• Category 1—1/72nd of 1% of insured deposits
• Category 2—1/36th of 1% of insured deposits
• Category 3—1/18th of 1% of insured deposits
• Category 4—1/9th of 1% of insured deposits

Note that 2007 “saw 98 percent of its members ranked in the best rated premium categories”. So much for this great-sounding differential premia song-and-dance!

These are strange times and the public demands the right never to lose money on short term investments, particularly the ones that pay higher interest than stinky old T-Bills. But I want to thank Dr. Shaffer again for taking the time to respond in such detail to my eMail.

Update 2008-10-3 Dr. Shaffer has read this post and comments:

Although I haven’t yet begun to dwell on such possibilities, much of the problem would be solved if the FDIC’s premium rate structure could be revised to charge banks in proportion to their insured deposits rather than their total domestic deposits.

A further option could be considered under such a revision: Banks could perhaps be given their choice of what level of coverage to receive (and pay for), whether $100,000 or some larger amount. As long as the pricing was actuarially fair, any such choices would be revenue-neutral to the FDIC on average.

Of course, choosing a larger level of coverage would tend to undermine market discipline, as you corrected noted. But recent events have indicated that the existing market discipline was already inadequate to constrain risk-taking at many institutions, even with the post-1980
$100,000 limit.

The idea of letting the banks themselves decide where to the draw the line is an attractive free-market solution, but I’m not convinced (yet!) that such a move would be in the public interest.

I perceive deposit insurance to serve the purpose of:

• To aid the economy by letting Mom and Pop know that they are perfectly safe in keeping a cash float at the bank
• To reduce the risk of self-feeding runs on the banks that might otherwise occur if Mom & Pop decide that their emergency stash is not safe
• As a public service, so that Mom & Pop don’t have to read and understand a bank’s annual report prior to depositing the weekly paycheque

If everybody was a professional fixed income analyst, there would be no need for deposit insurance at all. And therefore, I say, a variable cut-off (however attractive theoretically) is simply too complicated. Let Mom & Pop know that if they invest their tuppence wisely in the bank it will be safe and sound; and any bank has the same magic number to remember. Simply because of the policy objective to simplify the process.

Incidentally, I think the $100,000 limit is far too high to begin with. Given my views on the proper policy objective, I think that something along the lines of “median household annual income, rounded up to next $10,000, reviewed every five years” is much better. If you have more than that (in cash!) … well, sorry guys, either diversify your banks or buy a money market fund.

Update #2, 2008-10-3: In accordance with legislation passed today, the limit is now $250,000 until Dec. 31, 2009, according to the FDIC.

DBRS has published its response to a European Union commssion with a mandate described by some in terms that make it sound as more of a lynching than an inquiry:

It is generally accepted that CRAs underestimated the credit risk of structured credit products and failed to reflect early enough in their ratings the worsening of market conditions thereby sharing a large responsibility for the current market turmoil.

The current crisis has shown that the existing framework for the operation of CRAs in the EU (mostly based on the IOSCO Code of Conduct for CRAs) needs to be significantly reinforced. The move to legislate in this area was initially welcomed by the Ecofin Council at its meeting in July.

However, even the official press release shows an intense desire to scapegoat the credit rating agencies, rather than those who actually made the investment decisions:

The main objective of the Commission proposal is to ensure that ratings are reliable and accurate pieces of information for investors.

“reliable and accurate”? This is just another way of saying that investments should only be recommended if they go up.

DBRS stated in its response:

A key lesson for DBRS from the crisis was the need for additional transparency of its practices, policies and procedures and for additional education and dialogue with investors, regulators and other market participants regarding the role of a CRA and the meaning of a credit rating.

Very nice, very desirable, very useless.

There is already much more information available about everything than can be used, and there is far more information that can be used that there is that is used.

Any regulator that wants to get serious about discouraging herd behavior and bad analysis in the future will start by enforcing publication of returns. If you have a license, that license will – at least in North America – be verifiable on a regulatory website. If that license is being used in any way in an advisory capacity with respect to real live money … your composite should be published.

Proficiency is the ability to generate superior returns. All too often, it is measured by regulatory authorities as the ability to parrot introductory textbooks that may – or may not – have relevence to how the advisor actually formulates his recommendations.

Update, 2008-9-15: I found a response to this, a piece in the Guardian by David Gow:

The plans will force agencies to register, subject themselves to pan-European regulators and improve their corporate governance to avoid conflicts of interest with their client customers, including plans to rotate analysts every four years.

Bell, S&P head of structured finance for Europe, Africa and Middle East, said the proposals seemed to treat the ratings process as scientific, whereas mistakes were inevitable. “The provisions of the draft regulation are for regulators to have a direct influence on a variety of aspects of our work … They can take powers to make us desist.”

… rotate analysts every four years? rotate analysts every four years???? I’ve never heard a more moronic idea in my life. Take a guy off his desk, just as soon as he’s accumulated some valuable experience, for no reason other than rotation? That’s a thoroughly bankerly approach, an approach guaranteen not just mediocrity, but bland mediocrity. Which is an excellent way to run a bank, but rather less well suited for excellence.