The debate on whether insurers can be systemically important has taken a strange turn. After focusing on non-traditional and non-insurance activities at large international insurance groups, the scrutiny is now on whether or not to include reinsurance groups into the set of systemically important insurers. Lobbyists are rumored to have found the weakest link at the FSB (this time the USA) to stop reinsurers from being considered as systemically important. The arguments for this remain unclear. The main reinsurers are big, their clients depend on them, and if they have to liquidate their assets to afford a timely payout this would impact on the financial markets.

In the past, arguments appeared to focus on the expectation that the problems would be dampened by the structure of the insurance market. A regular insurer stands between them and policyholders, which would continue to be liable even if the reinsurer on which it relied fails. A traditional argument is also that reinsurance is more like traditional direct insurance instead of like non-traditional insurance activities such as derivatives investing. If such reasoning would be considered valid still, that would be shortsighted, but not unexpected. Reinsurers, insurers and the IAIS have a track record of downplaying potential contagion arising in the insurance sector, including in the reinsurance sector.

Reinsurers are not client-facing, that is true. And the policies they close are not structured as formal derivatives, but as insurance policies of a direct insurer against the materialization of a risk (in their case, that policyholders make claims at the direct insurer). If a reinsurer fails, the direct insurer is indeed left holding the bag. However, that direct insurer would have a huge gap in its capital and technical provisions. A reinsurance contract counts as risk mitigation for prudential supervision purposes at the direct insurer. If the reinsurer can pay out, it does indeed mitigate that risk by offering to pay all or part of the claim that arises from a policy written by a direct insurer (in exactly the way derivatives do if the triggering event occurs). The direct insurer subsequently does not need to hold financial buffers for potential claims that are no longer expected to land on its balance sheet as it is expected to be reimbursed in full by the reinsurer. For large reinsurers this (large) gap at the direct insurer it contracts with is multiplied across all the direct insurers it accepted premiums from. If one of them makes a disproportionally large claim, the reinsurer may no longer be able to honor its commitments to other direct insurers, making reinsurers the main potential channel for contagion in the insurance sector. As e.g. mortgage loans are built on required fire insurance and long-term pension payments from life insurance policies, this would impact on the banking sector too, providing another channel for systemic risks. Even if reinsurers can delay the pay-out by denying the validity of claims, that would just speed up the problems at the direct insurers and their clients, and would not dampen market expectations of asset sales by the reinsurer for an eventual pay-out.

The limited set of large reinsurers are thus a crucial underpinning of this sector of the financial market, similar to the role of central clearing parties (CCP) in securities trading, and ECB systems in Eurozone payment systems. The argument a non-client-facing entity is not systemic has been (and should be) eradicated from public policy thinking since the AIG London branch, LTCM and the Fannie Mae/Freddy Mac bail-outs. Even shareholders of large reinsurance companies like the subsidiaries of Berkshire Hathaway should actually see the benefit of better focus on and the acknowledgement of the importance of such key service providers. For one, it makes their investment in a reinsurance company less likely to suffer catastrophic damage. And if reinsurance would get a more explicit systemic role as a stimulated safety buffer for the wider insurance sector (like CCP’s and depositaries are for the securities markets), it would actually be a business opportunity. It would strengthen their hand against competitors from the hedge fund industry or (other) derivative writers. Even so, it would be more likely that shareholders and boards of reinsurance companies would actually admit that reinsurance is systemic, if the consequences of being deemed systemic were more focused on the business at hand. This is now not the case. The FSB and the committees that work for it (such as the IAIS) appear focused on just slapping an extra percentage on a yet to be developed solvency ratio for large worldwide operating insurers, in a move copied from the banking sector. The fact that it is not yet tested there as an effective tool to avoid or even mitigate a banking crisis does not seem to dampen regulatory ardor to roll it out to non-banks, but it may dampen the ardor of shareholders and boards to subject their reinsurance companies to it.

They have a point. To me it appears strange that the systemic surcharge on top of a debatable ratio calculation is now copied in other financial sectors as if it is a wonder formula. Especially if there is little or no experience with a solvency ratio in the insurance sector in the first place (where a first solvency ratio under the EU Solvency II directive is being rolled out only now). It is not guaranteed that a higher percentage for systemic insurers based on a totally new formula for calculating a ratio would withstand (fear of) the potential waves of destruction of a next crisis, nor that it would avoid the pitfall of being calibrated to the last crisis instead of to the next.

It may be better for the FSB and the (re)insurance industry instead to come up with a more measured response, focused on what is known to work in the specific financial sector at hand. For instance, CCP’s have a similar role in the securities sector both as a core service provider, risk mitigator for client facing securities firms, and – because they are trusted to handle this – risk aggregator as reinsurers have in the insurance sector. CCP’s developed homegrown techniques to be able to bear that risk, mainly by a system of collateral (margin), guarantee funds and novation and netting through which risk is minimized and spread. If reinsurers de facto are relied on in the insurance sector to play a risk-mitigating role and want to be trusted to be a risk aggregator, they should equally develop or expand risk-mitigating techniques. If reinsurers ask legislators to rely on the insurance they provide to direct insurers – which does appear to be part of their business model – they could embrace this role in a proactive manner by mitigating such aggregation/concentration risks. It should not be necessary to assume that each can withstand a multiple of risks arising at the same time, it should be certain. In other words: if reinsurers would like policyholders, direct insurers and supervisors to embrace a core role of reinsurers, it becomes more important that they are bankruptcy remote.

Learning from the CCP example and from what has worked well in the insurance sector, it might be good to take a second look at the benefits of solo supervision and the assets reserved for the calculated technical provisions (i.e. the calculated maximum potential pay-out under open policies). Instead of relying on untested new solvency ratios – even if they are calibrated to be higher for systemic entities – a better response to a systemic reality would be to rely on a combination of:

• more conservatively calculated technical provisions for the maximum potential pay-outs under the reinsurance contracts they have written;
• segregated assets for those;
• collateral rights held by the collective of (policy holding) direct insurers on those segregated assets;
• with a clear pay-out schedule that guarantees equal treatment of various current and future claims;
• and perhaps a mutual guarantee system if overwhelming claims arrive at a reinsurer.

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Also see:

• Buffett clout brought to bear in rules fight, FT 14 October 2015 (published under different title on ft.com on 13 October 2015).
• EU Banking Supervision, chapter 6.2, 6.5, 19.4 and 22.
• Are EU Banks Safe?, chapter 4.5.
• FSB, 2014 update of list of global systemically important insurers (G-SIIs), 6 November 2014.
• IAIS, Reinsurance and Financial Stability, 19 July 2012.

A new component of the recovery and resolution framework for banks is the mandatory bail-in of shareholders and unsecured creditors that will become mandatory across the EU at the latest in 2016. The bail-in of creditors has been introduced to avoid having member states (ultimately at the expense of its taxpayers) chipping in to bail out a bank that is too important for its economy to let fail. As a policy choice this is understandable, even if much of the initial investment in bailing out a failing bank is normally recouped when the bank or its assets are sold at a later point in time (unless the public sector owner manages the bank for other public policy reasons than recouping its investment).

For subsets of depositors/investors at banks the new mandatory bail-in at the behest of resolution authorities requires a new mind-set in risk management. Specifically this applies to those depositors holding funds at the bank that are not protected under the applicable depositor guarantee system, such as companies or individuals keeping more than 100.000 euro at the bank, or (from 2019) those that bought bonds issued by the bank.

The new rules aim to the public budget, while continuing to protect small depositors, and anyone with a secured claim on the bank (such as central banks). Really new in this line-up is the protection of the public budget, or as politicians/legislators name it: ‘the taxpayer’. Increasing the protection for the public budget does mean that the losses will have to be suffered by someone else, in this case the ‘senior unsecured creditors’ that used to rely on (1) implicit government support for large banks, (2) good banking supervision that would fail and liquidate the bank when it was still solvent enough to pay back each senior unsecured creditor after the liquidation process, or (3) for bondholders that qualify as consumers or small companies on the explicit deposit guarantee system for bond portfolios up to 100.000 euro. These are all in the process of being removed, as senior unsecured creditors will no longer be protected under any of them but instead will be forcibly bailed in when there are signs that the bank might be in trouble. The thinking is probably that very wealthy individuals will ultimately bear these costs, but in practice the impact is more likely to be suffered by pension funds, insurers, banks, investment funds that hold cash at the bank in their current accounts, have bonds or own shares issued by the bank, or have to replenish deposit guarantee systems that have to cough up the cash under a bail-in. And by the consumers and companies dependent on them of course.

Though the commitments to the pension fund of the employees of the failing bank are protected, any debts to other pension funds or insurance companies are fair game. Regulators can still opt – in an optional and thus non-dependable manner – to exclude bail-inable creditors at the moment of the bail-in if they for instance fear unrest. This might benefit certain senior creditors, but will only increase the burden on the remaining senior creditors that do not get this benefit from the resolution authorities (for instance because they are based in another member state, or are too small to start a crisis if they in turn fail due to writing down the money they had entrusted to the bank).

For bonds, the exclusion from deposit guarantee protection and accompanying bail-in-ability may be somewhat defendable (in spite of the potential financial instability risks of writing down bank bond values), as long as the right risk premium is paid by the bank for this risk. I understand that after downgrades of bank bonds by rating agencies in anticipation of the bail-in instrument, the (ultra low) interest rates on unsecured senior debt have shown an increase in the risk premium paid to investors in such bonds. It is doubtful whether that risk premium is enough to compensate for the de facto highly increased risk that bank supervisors will deem a bank to be potentially in trouble and potentially to cause financial instability, and ‘rescuing’ the bank by increasing its capital by writing down or converting these bonds. This can and perhaps should be judged part of normal risk management at the institutions investing in such bonds. It could be a conscious assessment by a well-trained lender that the likelihood of such an event is sufficiently low per bank in a diversified portfolio of bank bonds that even at the current low interest rates the small add-on constitutes an acceptable risk premium. Perhaps. For non-deposit protected consumers and non-financial companies that invest spare cash in bank bonds after the deposit insurance expires for bank bonds in 2019 it is unlikely to be as well prepared for.

A risk perhaps less well understood is that any cash held at any bank on a savings/payment/current account (to the extent it exceeds the coverage by the deposit guarantee system or collateral, and thus also constitutes a so-called senior unsecured credit) is subject to the same write down or conversion as unsecured bonds are. For instance, if a pension funds uses one single bank to collect the liquidity needed to make out the monthly payments to its pensioners, it is in fact making a high risk investment in the bank. This high risk materialises if the banks’ supervisor and resolution authority decide that the time for failing the bank has come before the order for the transfer to pensioners has been given. The bank will in that case re-open the next Monday as usual, but the cash needed by the pension fund to make the payment to pensioners will no longer be available as such cash was bailed-in. The supervisor/resolution authority may or may not give an exemption to the bail-in, but this would increase the burden for others (and is certainly not a right of the pension fund).

The main dependable exception is if the bank gives collateral to the owner of the cash, in the example to the pension fund. Senior unsecured debt is bail-inable, but secured debt is excluded. This is for instance the case with central bank loans that will be collateralized by sovereign bonds or other acceptable collateral. Other examples are for funds owed in the clearing and settlement process, or in the case of bonds so-called pfandbriefe and other covered bonds (that are secured by specific assets of the bank). Small pension funds and small insurers will normally not have the market power or political power to ensure such security is given to them for payment accounts. If they do not get it, they may be wise to spread their cash holdings over a wide range of banks in order to avoid potentially losing all their cash in one go. They could also seek insurance e.g. via derivatives on the potential that a bank will fail, but that may be costly, and it would need to be certain that the writer of that derivative/insurance is not itself linked to or exposed to the bank that is failing.

Should the shares in a bank, bonds issued by a bank, and savings held at a bank by an institutional investor be bailed in, this may have an impact on its own obligations to pay out. An investment fund will be worth less (and so will the pro rata investments by its investors, and the investors in such investors), which may or may not have been understood by those investing via such a fund. At an insurance company or pension fund it may mean that premiums will need to be increased, or payouts reduced. Though their clients may not always be taxpayers in the country where the bank was based, they will definitely be taxpayers somewhere. Taxpayers will thus still bear the costs directly or indirectly via their pension funds, investment funds and insurance firms. The main change is that this burden will only to a lesser extent arrive via state budgets (which will still contract due to lower tax receipt as a result of the losses suffered by banks, insurers, and individual taxpayers, as well as via bailed-in cash held by municipalities, provinces and other state bodies at the bank). The main advantage is the public relations benefit that the burden will not go via the state budget immediately, and that the costs – if pension funds, insurers etcetera have limited their risks via risk management – will be spread out over time and many consumers. Small increases in premiums or limits to payments are less noticeable than a big headline number of initial investment by the state in a traditional bailout. Saving the taxpayer by bailing taxpayers in (directly or indirectly) does, however, appear to be logically impossible.

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– Recital 1, 5, 8, 31, 67 and art 44, 47, 48, 108, 109 and 130 BRRD directive 2014/59/EU

– Recital 5 and 6 Recast Banking Directive 2006/48/EC (part of the previous version of the CRD)

– Art 27 SRB regulation 806/2014

– Art 1.1 and 1.4 of the currently applicable Deposit guarantee directive 1994/19/EC, and Recital 47 and art 5, 20 and 21 Deposit guarantee directive 2014/49/EU (of which 5.1 sub k on excluding bonds will be applicable from July 2019)

– Italy/Romanelli, EU Court of Justice 11 February 1999, Case C-366/97, §13-15.

– EU Banking Supervision, chapter 4.4, 18 and 19

– Are EU Banks Safe?, chapter 3

The VW manipulation of its emissions testing results provides lessons for banks, insurers and their supervisors. Testlab results bear no similarity to real life survival or failure is a simple one. Bad governance structures can lead to bad decisions (as highlighted by John Plender in the FT and supported by a wide range of examples such as the DSB Bank failure in the Netherlands). Another lesson is that the testlab/models that are the basis for calculating capital requirements are prone to pressure and manipulation.

There appear to have been two stages that shifted the results in response to high-level orders to pass environmental tests and improve sales. The first is the – as I understand – industry standard in the EU that emissions are only tested in laboratory conditions on vehicles that are specially selected and prepared for this testing by stripping off all inconvenient aspects (rear view mirrors, wipers, and anything that weighs anything in the car that is not needed to make it run, such as the standard airconditioning or audio equipment). For some this is the minor league of evasion or fraud as it ‘only’ changes the hardware, and anyone actually looking would notice. Even for this type of lab-adaptation there is little relation between the car in the lab and on the road, but some people would say it remains in the nudge and wink category of how smart it is to evade the vague requirements and the light touch oversight, and the general contours of the car tested remain the same. The second stage is now provoking more outrage, as the manipulation is not in the visible hardware, but in lines of code in the software. Any instrument that supposedly cleans up the emissions but was a drag on ease of handling on the road was automatically switched off by the design of the software, except when the exact conditions of the laboratory test were found.

Though it is unlikely that executives removed the hardware from the testlab-models or wrote the software that changed the car from fake circumstances to real life riding and back, it is likely that they created the incentives to do so by demanding relative growth as compared to competitors, in the cars case by simultaneously demanding low emissions during tests so that the cars could legally be sold, and high performance so that customers would actually want to buy them, and did not bother to sufficiently check whether the product sold fit the description on issues that customers did not bother to verify or sue on, and regulators did not bother to/were not able to check.

The calculation of capital requirements is open to similar pressures. It is abstract, only important if thousands of products fail to perform at the same time, only important in the long term, and customers do not like it while the bank or insurer is alive because it heightens their costs if the bank or insurer would take it seriously. The old standardised approach for capital requirements calculation was abandoned for complex institutions because the choices made in investments were optimized by these institutions to take the highest risk/reward road within each wide basket of types of assets, such as corporate bonds. This maximized returns while minimizing costly capital requirements. The newly invented ‘internal’ models that have been introduced for banks in the 2004 Basel II accord (in the EU implemented via the 2006 version of the CRD) and will be introduced for insurers in 2016 under Solvency II allow more leeway to reward the bank or insurer if they choose a less risky product to invest in, but does expect them to take better regard of the more risky products too. Some banks are indeed relatively conservative or are being forced to be relative conservative by their supervisors, and estimate the riskiness of the assets they hold higher than the models used by their competitors estimate the same or the same type of assets. Some banks, however, are removing the airconditioning and audio systems by abandoning newly capital-costly areas such as trade finance or investment banking, while plunging collectively into low capital-costly areas, or professing high confidence in their clients or risk management systems. The result is that banks’ internal models show wildly different results, which is an indicator that some may be too lightly capitalised for the risks they run in their entire business. An additional result is that worthy areas of services are no longer provided by banks, but are either not provided, or are now provided by less regulated service providers. It is likely that more conservatively calculating banks are under pressure to become more ‘capital efficient’ in order to retain profitability and competitiveness.

The temptation to adapt the outcomes of test-results is easy to understand. Lower capital requirements (emissions) lead to the potential for acquiring more assets (making more sales) that generate higher profits and higher status for the CEO. And a slight tweak in one area that makes the boss happy does not really impact a lot on the overall capital; except of course if this happens in all areas the bank or insurer is active in. These tweaks stimulate the financial company, their shareholders and the economy as long as the bank or insurer makes no losses yet. And the internal models used by complex banks do not show with a big blinking warning whether there is internal pressure to always lean in the same direction. Fundamental attitudes towards the need for buffers or the need for speed and profits are neither measured nor checked easily, especially if the number of experts is vastly larger on the bank’s side than on the supervisors’ side. But if the general attitude at a financial company is that it is acceptable to have slight manipulations, or just slightly reducing the riskiness of the asset just by removing the dragging mirrors from the test-lab model, this risks the continued survival of the firm once it comes out. Removing trade finance already does not make the bank safer. It just makes it less well capitalised, and diminishes the value of the bank to society similar to cars with high Nox emissions in real life. Especially harmful would be if it turns out that the models used by banks are deliberately built to optimise testlab results that bear no relation to known market and firm behaviour when risks materialise. Bankers/Insurers would, however, not be unique in such manipulation. The regulated bits of internal models and the standardised models are riddled with such deliberate misdesign by lawmakers, e.g. to underestimate the riskiness of SME-loans, or to hugely underestimate the riskiness of sovereign bonds. In the end, if banks add to this, and do not compensate for design-faults in the laws that rule the design of models to calculate capital by adding voluntary layers of safety themselves, it remains deceit towards clients, investors, and society as a whole.

Though supervisors are aware of the discrepancies, they have been kicking the can down the road for a while, and there are no signs yet of an official line. The amount of capital needed for the most derelict banks – and the financial stability consequences of exposing them – may pressure them into regulatory forbearance. Though this is both understandable and damnable at the same time, such regulatory forbearance does not impact on the own responsibility of bank and insurance boards on whose watch such collective leaning or manipulation takes place by underlings who aim to please their bosses by improved headline numbers.

Safety should not be tampered with, and will not be tampered with in the long run, as the sheltered executives of VW already found out.

Also see:

• Plender, John, Poor governance at VW should have been a warning to investors, FT 30 September 2015
• Noonan, Laura, ECB doubles the time needed to review banks’ risk models, FT 16 August 2015
• EBA reports of 22 July 2015 on eba.europa.eu
• BCBS, Regulatory Consistency Assessment Programme (RCAP) Analysis of Risk-Weighted Assets for Market Risk, January 2013 (rev February 2013)
• BCBS, Regulatory Consistency Assessment Programme (RCAP) Analysis of Risk-Weighted Assets for Credit Risk in the Banking Book, July 2013
• UK FSA, A Regulatory Response to the Global Banking Crisis; Discussion Paper 09/2, March 2009, page 71-73

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• EU Banking Supervision, chapter 6.3
• Are EU Banks Safe?, chapter 4.5

Increasing mortgage loan risk weights in a depressed property market is likely to be procyclical, as would reducing risk weights in booming property market. Strangely, this procyclicality appears to be acceptable under the contemplated EBA standards on adjusting risk weights due to financial stability considerations that are currently out for consultation. The draft binding rules do not specify when they should best be adjusted up, and when down, nor how to take into account such potential procyclical effects. Nothing in the proposed binding rules clarifies at which part of the cycle this lever should be used, which is a bit odd for nominally technical rules that have as their key ingredient that a specific lever can be used for financial stability considerations.

The EBA proposals do give a clue as to what information is relevant, but mainly leave the type of response to the supervisor itself. A supervisor eager to apply the law in a conservative manner is left scratching his head as to the optimum course and timing. A supervisor eager or under political or monetary policy pressure to boost a growing economy, or to stop a sliding property market, is free to do whatever it wants even if the longer term effects might be a less safe banking system. For example, the economies of many of the member states currently need a stimulus. Increasing house prices and office prices based on cheaper lending – if banks do not need to hold so much capital – could help provide such a stimulus. Even though bad lending practices and too low risk premiums and risk buffers for mortgage loans in the USA subprime sector actually kicked off the latest worldwide crisis, the solution to help growth in the short term could be to keep risk weights low, and to keep all options open for national legislators and supervisors. As a result of such pressures it is difficult to blame EBA and its voting members for building in this leeway. However, it does mean that the new binding rules are not very useful if a supervisor or financial stability regulator would like to be able to take measures to ensure the stability of the banking sector and/or the property market. The standards instead excel in less than clear guidance such as ‘Take into account housing market developments’, which kicks in a wide-open door, and says nothing on whether rising values or buyers interest should lead to an increase in risk weighting (and thus higher capital requirements), or to a decrease in risk weighting (and thus lower capital requirements).

This leaves aside that a discussion could be had on whether a higher risk weight would be best from a technical point of view in the upslope of a boom (to stop irrational exuberance, and build up capital buffers for the eventual decline in property values a few years hence and thus in an anticyclical manner), or on the downslope towards a trough (to increase the potential for bank capital being sufficient to deal with future losses in a value-declining property market, thus limiting the scope for banks to lend to potential new purchasers and forcing them to double down capital for existing and new downward developing mortgage loans, even though for the wider economy this would be procyclical). In this light, an analysis performed by supervisors on the basis of the lengthy data sets available over the boom period and the bust in immovable property markets in almost every member state could have been used to base these standards on an analysis of the costs and benefits of heightening and reducing risk weights in each national or regional property market in the period from e.g. 2000 until now. Indicating when Dutch, Spanish, Irish or any other national supervisor in hindsight would have wished that they used the existing risk weight-adjustment instrument either in a pro- or anticyclical manner during that period might lead to useful indicators as to when it should be used in the future with the best impact on wider financial stability as well as on the resilience provided by larger bank financial buffers.

A compromise solution could be to try to aim for the upper slopes of the boom for an increase, and reduce it when property prices have gone below reasonable long term values. At the bottom of the trough this would stimulate the housing market, especially if the expected losses on the housing portfolio have already been written down in full under a possibly wider definition of default and/or lower valuation of the collateral. Higher risk weights on the remaining fully covered mortgage loans would then no longer be necessary, if – and only if – the risk weight setter is able to correctly call when a boom is under way, or when a property market recession is entering irrationally depressed territory.

It would thus be helpful if the standards clarify whether their primary target is to stabilise the immovable property market in a certain market segment, or to stabilise the banks that lend in that area even if that means restricting loans to a already plummeting property market, or both. That would also help indicate whether there is a need to coordinate across financial sectors and across banks on the standardised and IRB approach (to ensure that banks, insurers, pension funds and other non-bank mortgage loan providers increase or decrease their exposure to the market segment involved in the same manner) which I would favour, or not (to ensure that the banks are safe by being able – to put it bluntly – to offload the risky and more costly exposure to the overheated property segment, even if that is to unsuspecting insurers or securitisation-investors such as pension funds).

This overall lack of clear indicators and purposes means that I am a bit reluctant to criticise the only clear benchmark that EBA does provide, which has been referenced in the draft standards and made more concrete in the impact assessment. According to it, loss expectations should be a key factor to determine how high the risk weights should be. It is a welcome clarification of intent, and something supervisors might be benchmarked to. However, though I applaud its inclusion, this specific benchmark does clarify two things that in view of pro and anti-cyclical thinking are a bit unwelcome. The first is that higher loss expectations are expected to be the trigger for an increase in risk weighting. As soon as market based loss expectations are made the determining factor, any irrationality in the market suddenly becomes less easy to deal with. This irrationality is part of the accepted market wisdom at that time, so if for ten years prices have gone up, no one ‘expects’ losses any more. Only once the bust period actually arrives, loss expectations suddenly swing up (sometimes to irrational heights in a panic). Increasing risk weights at that point in time will only strengthen the slide into the abyss. If risk weights instead are already up when loss expectations are still close to nil, then the lever could helpfully be used to lighten the load on the way down, helping to dampen the cycle. That does, however, require supervisors actually to take a stand against ‘the sky is the limit’ politicians and realtors, which as indicated above may not be their favoured role.

Second, the table appears to indicate that the lowest risk weights are appropriate in ‘normal’ times. If so, the lever of risk weights is unavailable during the entire trough of the cycle, meaning it has no dampening effect to get the market (and the banks’ capital requirements) into a mood that indicates light at the end of the tunnel. From a macroprudential point of view, that seems unhelpful. The lowest risk weights should be only in force at the ‘apex’ of the bust, so that the lever can be used both in the downswing and the upswing. No doubt this is more the role of the ESRB to point out, but strangely their role as providers of warnings and advisors on the cyclicality of draft-rules is not visibly reflected in the EBA draft standards.

In conclusion, it may be good to re-assess and clarify some of the key concepts, main goals and direction of adjustments in the draft binding rules before they enter into force. Building upon the experience in the past crisis with a ‘in hindsight’ analysis as to when and how this tool would have been most effective and efficient would be helpful. Both changes would help shelter banking supervisors from being put under pressure to sacrifice long term bank stability against short term political pressure for economic growth.

Also see:

• The separate comment on adjusting the mortgage risk weights
• EU Banking Supervision, chapter 6.2, 6.5, 8, 18.3, 21.2-21.4, and 22.5
• 124-126 CRR
• 128.2 sub d CRR
• 164-166 CRR
• EBA consultation paper EBA/CP/2015/12 of 6 July 2015 on determining higher risk-weights

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Banks that provide mortgage loans can be subject to more or less risk depending on for instance developments in house prices and house shortages in countries or cities. This means they need to hold more financial buffers or less financial buffers depending on the risk that the loan will not be repaid in full, which shift in prudential buffer demands in turn affects housing affordability for most buyers (and thus stimulates or dampens the housing market). EBA is now consulting on the ‘regulatory standards’ on varying the risk weighting for mortgage loans for both homes (residential property) and commercial properties such as shops and offices due to such financial stability considerations. The consultation paper is fostering this discussion very helpfully, but still has some severe shortcomings if it were to become law in this way, one of them is that it only deals with the increase of the risk weight, not with the decrease thereof, the effect of this information on the market, nor the changes in prices and risk over time. Another concern is the lack of clear rules on the timing these supervisory interventions in the financial cycle, which is the subject of a separate comment.

The headline risk rate for immovable property backed loans in the standardised approach to credit risk is that they should be risk weighted at 100%. This headline risk rate is, however, only used if some rather lenient criteria set by the CRR are not fulfilled. If sufficiently backed by qualifying homes, shops or offices the risk weight is sharply reduced (to 35 or 50 %). For the internal model based approach, there is an equivalent possibility to reduce or increase the LGD factor. The result is that banks normally only have to hold a reduced amount of financial buffers on residential and commercial types of mortgage loans. The only exception is if these criteria on the relative value of the collateral to the loan are found not to be fulfilled, and – and this is the subject of the consultation – when supervisors indicate that the reduction in perceived risk is not opportune at that moment in time, or even demand an additional slice of capital by increasing the risk weighting for commercial and residential mortgage loans to up to 150%.

Lets leave aside that the definitions of the terms used are as clear as tar (of the type of definition that residential property means a property that is a residence) and thus highly likely to be moulded not only to local practices but also to the lowest risk requirements. Lets also leave aside that if the supervisors set a high risk weight of 150%, it might be miraculously decided by the bank that the collateral is no longer sufficient, in which case the back-up risk weight of 100% will start to apply in accordance with the badly worded CRR provisions. Lets focus instead on the good intention that sometimes it would be good to require more capital, and sometimes less, for the good of the immovable property market and of the individual mortgage providers active in it.

The 150% risk weight is actually not new. It existed also in previous versions of the capital requirements directives, but was one of those territories that sounded good in theory but in practice were not used. In the depths of the subprime crisis, these levers gained new attention, and even a modicum of followers. For the standardised approach, some member states have now introduced stricter requirements on the lowest risk weighting, and some member states increased the risk weighting to 100% (none yet to the maximum of 150%). For the internal model based approach, only Norway (which is outside of the EU but covered by the CRR provisions under the EEA treaty) has used the possibility to increase the LGD factor in the internal model approach to credit risk (though other supervisors, however, may have done this too in an ad hoc manner as part of the model approval process). This is one of the macro/micro prudential levers that directly impact on the banks’ capital requirements for mortgage loans, and thus on the property market in specified regions (either in a whole country like Greece, or just in overheating segments such as London or Amsterdam). The weird thing is that the proposed regulation only addresses the ‘when should the requirement go up’ question, and ignores the equally important ‘when and how should the requirement go down’.

Even though this tool formally addresses only the capital position of individual banks, it applies to each domestic and foreign bank that is active in a specific property market, and thus will impact – intentionally it appears – on market prices in that area, by increasing or decreasing mortgage availability and interest rate levels. Hopefully, a similar restriction will apply to non-bank mortgage providers, though how this is ensured for specialised institutions or e.g. insurers is equally not addressed in the CRR or consultation paper. If the risk weight change might even potentially be a market-moving event, it is as important to give clarity on when the risk weight percentage or LGD should go down as on when it should go up. If this is not immediately clear from the new contemplated laws, the supervisor will join monetary authorities in their catch 22 of never being able to increase the interest rates if the only thing holding up market prices and holding back a recession is the fact that the market does not expect such an increase in interest rates. That the monetary interest rate dilemma relates also to bond and other financial instrument prices instead of – like this specific instance of mortgage loan risk weighting – only impacts on house prices and affordability does not really matter. If the risk weight is stuck at either a high or low value due to unclear criteria and potential market moving impact, it becomes useless as a macro economic and micro prudential lever.

In addition, the proposed rules should be clear on how supervisors should determine when the risk requirement goes up, but also how they clarify to the market when it certainly will go down again, and how gradual that decline will be. As market prices in the defined segment will be impacted – at least if they are intended to be useful – both by the decision to go up and by the decision to climb down (by reducing or increasing the exposure of the banks to that segment, and making new mortgage loans more expensive or cheaper) in a parallel to the insider information rules the obligatory decision-path and the communication plan of the supervisor involved should be very clear indeed. The consultation paper is silent on the communication plan that should have accompanied it, which is a serious defect on any issue that will and should impact overheating or collapsing housing markets.

To be fair, EBA’s drafting problems derive in part from unclear or one sided drafting of the CRR itself, which focuses solely on the going up variety, and ignores cross-sector and insider-information type concerns. Perhaps the attention of prudential supervisors and housing market organisations could have been better asked for and used at the time of drafting of the related CRR provision, which now contains pitfalls (what is the impact on the bank’s profitability, on their market share compared to other providers, why is there only a level playing field between banks on a specific approach, and not between banks on different approaches, and would a gradual build up and decrease not be better than the sharp cliffs now envisaged, and why do the increases not impact immediately on new mortgage loans, alongside a gradual build up for the existing mortgage loan portfolio?). And what should be the impact on the interest rates agreed in the existing loan portfolio, and is this a public policy concern (which it might well be if it impacts on the financial health of house owners), or is it an issue that can be left to banks (by introducing an additional component into their contractual interest rate calculation and adaptation).

In short, even within the boundaries of the sketchy provisions in the CRR, the consultation paper could be helpfully improved by filling in some of the blanks on adjusting these risk weight provisions both down and up, and on cross-sector cooperation as well as good communication. In an area as important as housing markets, leaving this to national discretion or to market participants may not be the best course. In addition, the related CRR provisions might be adjusted to improve their effectiveness.

Also see:

• The separate comment on timing these supervisory interventions
• Art. 124-126 CRR
• Art. 128.2 sub d CRR
• Art. 164-166 CRR
• EBA consultation paper EBA/CP/2015/12 of 6 July 2015 on determining higher risk-weights,
• EBA overview of notifications on 124 and on 164 CRR
• EBA Q&A 2014-1214
• EU Banking Supervision, chapter 6.2, 8, and 16.6.

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