(I) Calculation of the solvency margin for banks under the Basle Accord 2:
Solvency margin can be regarded as similar to capital adequacy requirement for banks. The capital adequacy requirements are the rules that help bank supervisors determine whether banks hold sufficient capital at all times to meet unexpected losses. The new capital adequacy under Basle 2 which was issued in June 2004 is fast being adopted by bank regulators as an international standard for the capital that banks need to put aside to deal with current and potential financial and operational risks. Its main aim is to promote international financial stability by ensuring that banks can effectively access and manage their risks. Basle 2 presents four distinct improvements over the Basle 1 framework. Firstly: a set of more risk-sensitive capital requirements. Secondly: stronger incentives for better risk management. Thirdly: sounder supervisory framework. Finally: the use of market incentives as additional discipline on bank behaviour by requiring greater transparency in their operations (Caruana and Narain, 2008).
Explaining how to calculate the minimum capital requirement
Saunders and Cornett (2008) found that under the Basle 2 risk-based capital plan, each bank assigns its assets to one of the following five categories of credit risk exposure:
0% as no risk- Like Cash or its equivalents
20% as low risk - Like Short-term claims maturing in a year or less
50% as moderate risk- Like mortgages
100% as standard risk- Like commercial loans
150% as high risk- Like loans to sovereigns, banks and securities firms with an S&P credit rating below B-.
Bank capital according to the Basle Accord is made up of two types, the core capital which is the Tier1 and supplement capital which is the Tier2.
According to Dr Mohamed Nurullah in the module Guidebook on financial service regulation week 7-12 of 2008/2009 semester B page 8, the basic capital requirement for banks under Basle 2 was expressed as:
Credit risk + Market risk + Operational risk
Under Basle 2, the minimum capital requirement of 8% of risk weighted assets does not change, but risk weights are assigned based either on ratings provided by qualified external agencies or on banks own models and internal rating systems. Basle 1 did not cover operational risk but under Basle 2, the capital charge for this can be calculated based either on gross annual income or on banks own models of loss estimates. For market risk, the methods of computing the capital charge do not change and can be based either on supervisory formulas or on banks own models. In all cases in which internal models are accepted, the bar is kept significantly high in terms of data, processes and systems (Caruana and Narain, 2008).
In addition to the above explanation, the credit risk exposure is measured either using the standardised manner, internal rating-based (IRB) approach or an advance IRB approach. For market risk, capital charges for the trading book would be based upon a crude value-at-risk (VaR) measure loosely consistent with a 10-day 95% VaR metric. The operational risk capital charge is calculated using the basic Indicator Approach (BIA), the standardised approach or the advanced measurement approach (AMA). The method of measuring the operational risk depends on the sophistication and risk sensitivity of the bank (Nurrulah, 2008).
(ii) Calculation of solvency margin for life and non-life insurance companies under the EU solvency 1.
The aim of a solvency rule is to ensure the financial soundness of insurance undertakings, and in particular to ensure that they can survive difficult period. All this also aims at protecting policyholders (consumer, businesses) and the stability of the financial system as a whole. The solvency rules stipulate the minimum amounts of financial resources that insurers and reinsurers must have in order to cover the risks to which they are exposed (Europa, 2007).
The solvency margin requirement corresponds to the minimum amount of capital deemed necessary to deal with unforeseen risks. Insurance directives define the term very precisely, as a proportion of at risk capital, reserves or premiums, net of reinsurance (Trainar, 2006).
Explaining the calculation of solvency margin under the EU solvency 1
According to the study carried out by Swiss Re (2006), it was found that the required solvency margin for life business is calculated based on the following method:
4% × gross mathematical reserves × retention rate mathematical reserves + 3% × capital at risk × retention rate capital at risk.
Furthermore, They explained that the retention rate mathematical and retention rate capital at risk are the net reserves divided by the gross reserves but not less than 50% and the net capital at risk divided by gross capital at risk but not less than 50% respectively.
To calculate EU solvency margin for Non-life, SwissRe (2006), found that the required solvency margin is calculated based on two methods, which is the premium method and the claim method.
Under the premium method, it is calculated as (18% × the first €50m gross premiums and 16% × remaining gross premium) × retention rate.
Under the claims method, the calculation is (26% × the first €35m gross claims and 23% × the remaining gross claims) × retention rate. The retention rate is derived from net claims divided by gross claims, 3 years average but not less than 50%.
In addition, they suggested that A factor of 1.5 is applied to these methods in liability, marine and aviation insurance.
Basle accord 2 for banks.
In 1988, the Basle committee on banking supervision introduced the Basle 1 Accord that dictates regulation for banks minimal capital requirements with the purpose of promoting safety and soundness in the banking industry. Over time there has been a growing concern that the effectiveness of the accord has eroded as banks have devised ways to engage in regulatory capital arbitrage introducing mismatching of risk taken on and buffer capital held. In response to these concerns, the new Basle 2 Accord was introduced (Carling et at, 2002).
The Bank for International settlement (BIS) 2004 found that the Basle 2 framework sets out the details for adopting more risk sensitive minimum capital requirements for banking organisations. The framework reinforces these risk sensitive requirements by stipulating principles for banks to assess the adequacy of their capital and for supervisors to review such assessments to ensure banks have adequate capital to support their risks. Additionally, they show that the framework seeks to strengthen market discipline by enhancing transparency in banks financial reporting. The chairman of the G10 group of central bank governors Mr Jean-Claude Trichet cited in BIS (2004) suggested that the new Basle Accord will enhance banks safety and soundness, strengthen the stability of the financial system as a whole and improve the financial sectors ability to serve as a source for sustainable growth for the broader economy. The Basle 2 framework was centred on three pillars of:
Pillar 1 = Minimum capital requirement:
The pillar of capital requirement is more robust than the previous Basel accord rule as risk weights introduced are now aligned to the borrower's credit rating. The pillar made it compulsory for banks to maintain a minimum of 8% of their assets as capital. The recognition of operational risk as an important risk that banks should try and actively minimize is one of the features of this pillar. The pillar also made the calculating of credit risk in relation to capital requirement a matter of choice for banks as two options were provided. The first being the standardized approach which based on credit report provided by external credit rating agency on different types of entities like banks and corporate organizations, assigned risk weights to their credit risk exposure. The second being the Internal Ratings-based (IRB) approach which under strict guideline and disclosure requirement allows banks to make use of credit risk assessment internally generated ((Dierick et al,2005).
Pillar 2 = the supervisory review process:
The supervisory review pillar is meant to harmonize banks risk profiles with its minimum capital requirement and to do that; a more efficient and effective supervisory review process was required from the banks. Regulatory banks were expected under this arrangement to take a proactive approach to supervision by imposing higher capital level on banks than the minimum stipulated in Pillar 1 in order to match their individual risk profiles (BIS, 2004).
Pillar 3 = Market discipline:
“Pillar 3 enhances the degree of transparency in banks public reporting with the expectation that this will provide a basis for more informed analysis by markets and customers on banks financial condition and risk management. Such information will encourage market discipline which in turn will support the efforts of bank supervisors to encourage prudent management by banks” (IMF, 2005).
Effectiveness of Basle 2:
The Basle 2 plays a vital role in addressing a key incentive distortion that came up from the treatment of securitisation exposures in Basle 1. This new framework provided strong incentives for moving even low-risk assets off the balance sheet and inadequate capital treatment for securitisation of high-risk assets (Caruana and Narain, 2008).
Incentives to develop credit rating agencies:
Basle 2 helps to facilitate the development of credit rating agencies and foster an improved credit culture. For example, for rating to qualify for use under Basle 2, supervisors are expected to assess the quality of the rating agencies, based on criteria of objectivity, independence, availability to foreign and domestic institutions, disclosure of methodologies, adequacy of resources and credibility (IMF, 2005).
It strengthens the link between regulatory capital and risk management:
Under the advanced approaches, banks will be required to adopt more formal, quantitative risk measurement and risk management procedures and processes. By way of illustration, Basle 2 establishes standards for data collection and the systematic use of the information collected. These standards are consistent with broader supervisory expectations that high quality risk management at large complex firms will depend upon credible data (Bies, 2005).
Credit risk mitigation:
Basle 2 contains a wider range of credit risk mitigation techniques that may receive recognition in the form of lower capital requirements, subject to prudential eligibility standards. For credit risk mitigation in the form of guarantees and credit derivatives, the borrowers risk weight is replaced by that of the protection provider (Dierick et al, 2005).
Assessment of the consolidating supervisor:
the new framework ensure that the consolidating supervisors has a comprehensive group wide view, while the host subsidiary supervisors will have easier access to group information that might be relevant for the entities they supervise. Also the risk of different, inconsistent or even conflicting, supervisory approaches is therefore significantly reduced. Since large cross-border groups typically organise some of their key functions on a group-wide basis, it also lead to a better match between the way they are supervised and managed (Dierick et al, 2005).
The integration of operational risk which is the risk of losses as a result of failures of internal processes, people and systems or from losses as a result of failed systems instigated by external events is seen as a significant benefit in the Basel II framework. Operational risk has been the main cause of major financial disasters like Daiwa Bank, Allied Irish Bank and NatWest Bank and its inclusion has been hailed as a major step in minimizing bank insolvency. In addition to this, calculation of capital ratio with operational risk as one of the variables would result in banks being more operationally efficient and in turn lead to effective allocation of capital and human resources relative to risk taking (Alexander, 2003).
On the contrary, a lot of issues have been raised on the implementation of Basel II such as:
Pressure to implement Basle 2:
There are some countries that reported pressure from their market and major banks to adopt Basle 2 promptly. As Basle 2 is viewed by many as the new global capital standard, some countries may find it difficult to explain to market analyst why they are not immediately moving to implement it. In addition, hurried implementation may lead to weaker rather than stronger supervision (IMF, 2005).
Higher capital requirements likely for loans to emerging markets:
In a study carried out by IMF (2005), they are of the belief that, for many developing and emerging countries, the increase risk sensitivity in Basle 2 may lead to higher bank capital requirements for loans to these countries. Furthermore, they found that the third quantitative impact study of the BCBS showed that banks lending to emerging and developing markets will face higher capital charges for credit risk and operational risk which could result in higher borrowing costs as well as reduced capital flows to higher risk countries.
The issue of cost:
Sandra Fan (2003) point out that cost of implementing Basle 2 would be too much for many emerging economies. In addition, she found that additional resources need to be devoted to attain a significant upgrading of expertise and skills among staff of supervisory authorities in many emerging economies.
Current market event:
Basle 2 does not address all the regulatory issues that figure in the lessons learned from current market events. Most especially, it is not a liquidity standard, though it has been agreed that more work needs to be done on developing guidance for liquidity provision (Caruana and Narain, 2008).
EU Solvency 2
Committee of European insurance and occupational pensions supervisors (CEIOPS), (2009) found that solvency 2 is a project that aims at introducing and developing a risk oriented supervisory framework for the insurance sector, in the sense that undertakings will have to hold capital on the basis of the risks they are facing and the way such risks are managed by the undertaking. In such a framework, the appropriate treatment of risks becomes a core issue for the soundness and effectiveness of the whole system. Furthermore, the committee show that the risk profile of a given undertaking should take into account both the internal and external risks that it faces, quantifiable and non quantifiable ones. They also suggested that in doing so, there needs to be in place an appropriate interaction between the pillar 1 and pillar 2, to incorporate those that, in principle, are deemed as non quantifiable.
Effectiveness of EU solvency 2
Reinforcement for outsourcing and off shoring trends:
The cost transparency resulting from solvency 2 will encourage insurers to review their overall cost structures with a view to improving overall efficiency. As a result of this, some insurers may decided to outsource or offshore their back office, capital and asset management and possibly claims settlement to specialists. Solvency 2 would thus reinforce the outsourcing and off shoring trends observed in recent years (Swiss Re, 2006).
Break-up into product designer and distributor:
As a result of the data, information technology and risk management expertise required in a solvency 2 framework, insurers now have the options to decide whether to focus more on their core competencies or pursue an integrated business model. That is, whether to be a product provider or to focus on distribution. It could make sense for an insurer with strong risk management skills but a weak distribution network to focus on product design and risk transfer and to withdraw from distributing policies (Swiss Re, 2006).
Reinforcement of risk and return consideration:
Insurers which in the past have done business without adequately putting in consideration the underlying characteristic of their risk will find solvency 2 challenging. This may be the case in life insurance where traditional actuarial practices have often not extended to assessing and putting value on product guarantee and option features. Solvency 2 will effectively reinforce insurers focus on risk and return fundamentals, which mean achieving high underwriting profit margins, posting premium growth and optimal scales of operation (Swiss Re, 2006).
Raise efficiency and improve competitiveness of the EU insurance sector:
Solvency 2 frameworks will help to raise efficiency and improve competitiveness of the EU insurance sector through the recognition of risk diversification and mitigation benefits in terms of capital relief, stricter requirements for risk and capital management and enlarged public financial disclosure requirement (European central bank, 2007).
Optimisation of Capital structure, Greater Transparency and Market based discipline:
Solvency 2 will provide EU insurers with a strong incentive to optimise their capital structure by enlarging the elements of eligible capital innovative tools such as hybrid capital, subordinated debt and securitisation (European central bank, 2007).
Encourage small insurer:
Since certain costs associated with solvency 2 are not fully scalable, small insurers will have to cope. However, a less complex investment portfolio, a relatively simple product structure and regional concentration with a branch structure may reduce the cost of solvency calculation (Swiss Re, 2006).
However, some issues have been raised on the implementation of solvency 2 such as:
The new standard formula failed to take into account the principal risks:
Trainer(2006) show that the current formula for calculating the solvency margin is overly simplistic because it only considers one risk that is the underwriting risk. He also admitted that some other aspects of risk may be taken into account by temporary mechanisms, other risk categories are totally ignored and others are counted twice rather than once. Furthermore, he found that diversification and pooling which are two of the central pillars of insurance business have no place whatsoever in the prudential construction of insurance. As a consequence of this oversight, the current solvency requirement makes no real distinction between insurance companies based on their actual exposure to risk.
The risk of financial market disruption:
The execution of solvency 2 might have potentially negative outcomes for financial markets. That is, in the short run the risk of market disruption will be closely connected to the size of possible portfolio reallocations, while in the long run, negative financial market feedback effect and herding behaviour by financial institutions might worsen any financial turmoil amid a less diversified financial system (European central bank, 2007).
According to the European Central Bank (2007), they are of the belief that the solvency 2 framework is likely to induce a redistribution of risks between insurers and banks that might increase counterparty risk for banks in the short term and also, may well increase cross holding of equities and subordinated debt between EU banks and insurers.
Higher credit risk for banks from riskier household balance sheets:
The solvency 2 regime will provide EU insurers with a significant incentive to sell unit-linked products rather than traditional life policies with guaranteed returns, as this shift will result in low regulatory capital requirements. Through this shift in products, more risk will be transferred to policyholders. The spreading of risk from the insurance companies' balance sheets and its dissemination to a large number of policyholders could possibly increase the overall level of risk in the economy (European central bank, 2007).
Conclusively, Both the Basle 2 and Solvency 2 aims at fostering consistency of prudential supervisory and regulatory requirements across financial sectors. However, the analysis contained in this report also identifies a number of area where there is potential for risks to the financial system stability.