A primary focus for Taiwan’s Financial Supervisory Commission (FSC) over the past five years has been to curb the excessive foreign currency risks that the nation’s financial institutions and companies were increasingly taking on.
The regulator has reined in the excessive use of hedging tools such as target redemption forwards (Tarfs) and, over the past year, restricted the significant foreign currency exposure that the country’s life insurance sector had built up. It has now turned its attention to exchange-traded funds (ETFs) that have caught the fancy of insurers. The regulator is working on determining the risk calculation and capital provisions for bond ETFs.
While controlling such irrational exuberance in the financial system, the FSC has also embraced digital banking to increase competition and drive innovation in the market.
The rule change imposed in November last year to close a loophole, which allowed Taiwanese insurers to pile up on foreign currency debt over the past five years, is an example of the proactive approach the regulator takes to risk management. Spooked by the currency risks, the FSC imposed a new ceiling of 65.25% on the amount of overseas assets insurers can hold on their books, and included Formosa bonds (Taipei-listed bonds denominated in US dollars) in the category.
That effectively reversed the rule relaxation in 2014 that allowed Formosa bonds to be treated as domestic investment. Issuance has surged after the rule relaxation and firms including Apple tapped the market.
The 2018 move came as insurers’ foreign exchange losses surged, raising doubts about their ability to meet long-term obligations to policyholders.
“The entire insurance industry has increased their allocation to overseas markets, so we have to limit the impact with better pre-emptive measures,” says Chuang-Chang Chang, vice-chairman of the FSC.
The rate of overseas investment has slowed. Figures from the FSC show that in the seven months following the November change the rate of overseas investment by insurance companies fell 27 basis points, to 6.79%. As of June 2019, total insurance assets invested overseas amounted to $557.32 billion.
“It is important to note that the investible assets managed by Taiwan’s insurance industry stands very high so, from a regulator perspective, given this sizable amount, we have to remain prudent on managing foreign exchange risk,” says Chang.
The FSC is also stepping up scrutiny of how insurance companies are performing, to make sure they have a better understanding of the risks in the market they are facing.
From April 1 next year, insurance companies will have to issue a formal report every six months on their capital adequacy, demonstrating their ability to deal with potential market volatility, especially during downturns.
If the ratio of an insurer’s net assets to total assets – in other words, the amount of equity being used to service the company’s liabilities – falls below 2% for more than two consecutive reporting periods, the firm will be deemed “capital significantly inadequate”.
“With these new measures, the FSC can request a plan for improving the financial and organisational structure [of the insurer] within a certain period and, for very severe cases, stop the insurer from trading,” Chang says.
The head of Taiwan for a global bank says the FSC’s efforts to rein in risky insurance products has made the country’s financial markets much safer.
“The regulator has spent a lot of time and effort strengthening the risk management of insurance businesses, and that is very positive,” he says. “They have done a number of things over the past few years: making sure that firms are properly taking care of their forex exposure; forcing mark-to-market reserves; so they have some flexibility for managing risk and encouraging insurers to better manage their duration mismatch.”
The FSC didn’t just stop with risk reduction measures, it did a deep dive to understand the reasons for insurers’ attraction to offshore assets and tried to address it.
One of the things that has driven insurers’ appetite for riskier assets and greater overseas exposure is a tendency for insurance products to be used as wealth management vehicles rather than purely for protection. Official government figures show that 54% of all insurance products in the country were sold for investment purposes, as investors sought to take advantage of the higher guaranteed rates those policies promise.
This is something that the FSC wants to end, returning insurance companies to their roots, as guardians of the future rather than a way of topping up returns.
“Life insurance products are commonly used as a wealth management tool in Taiwan,” says Chang. “Financial education is the key to addressing the misconception that purchasing insurance products are for the purpose of gaining returns rather than protection. The FSC are also continuing to encourage insurance companies to provide protection-oriented insurance products so as to meet consumers’ demand for protection.”
The FSC also has some sympathy of the need for insurers to continue to achieve adequate returns, which is what drove them overseas in the first place. Having successfully mitigated some of the riskier practices of insurance firms, the FSC is now in a good position to work out what insurers need.
“Looking ahead, it remains important for the FSC to align the demand for yields among insurers with sound risk management practices, and open up multiple investment vehicles,” says Chang.
One example is exchange-traded notes, which since June 21, insurance schemes have been allowed to invest in. Insurers have also displayed a keen interest in exchange-traded funds since they first made appearance on the Taiwanese stock exchange last year. By the end of 2018, there were 43 bond ETFs trading in Taiwan, with combined assets-under-management of $25.82 billion.
Although these bond ETFs are denominated in Taiwanese dollars, most of them trade in foreign currencies, which potentially leads to heightened exchange rate risk. However, they do not count towards an insurers’ overseas investment limit, which has made them popular with insurers as a source of stable return that satisfies yield targets, especially following the clampdown on Formosa bonds. But the FSC remains mindful of the risk they could present.
“We will put our heads together to review and find the most representative risk calculations that is able to reflect the amount of capital provision the firms should set aside,” says Chang.
The changes build on previous measures put forth by the FSC to reign in foreign currency risk for domestic investors.
For instance, the regulator targeted Tarf, a potentially risky hedging tool typically used by exporters to guard against exchange rate fluctuations. Tarfs allow foreign currency to be purchased at a favourable rate until a set target is reached. It only worked if the spot is moved in the right direction. As soon as the currency moved in the opposite direction, investors lost money.
And that was exactly what happened in 2014 when the renminbi unexpectedly started to weaken. Losses totalled “many hundreds of millions, possibly even billions, of dollars” across the industry, according to estimates by Morgan Stanley.
Back then, too, the FSC imposed rules on how Tarfs can be traded, limiting who can sell the products and capping the loss that can be incurred. The market slowly died away.
The FSC’s achievements this year go beyond enforcing sound risk management practices for the financial sector. It has also embraced one of the biggest trends that is sweeping the financial world at the moment: digital banking.
At the end of July, the FSC issued its first three virtual banking licences to consortiums led by Taiwan and Japanese investors: LINE Financial, Next Commercial and Rakuten International.
“The idea to issue virtual banking licence did not come out of the blue. It follows one of the biggest trends in the financial world,” says Chang. ”As Bill Gates [the founder of Microsoft] put it, ‘banking is necessary, but banks are not’. In our mind, there certainly will be a need for financial services in the future, but this will not necessarily happen in a bank in its current form.”
For now the FSC is happy to test the water and check that certain things work before embracing virtual banking further. Three potential risks in particular are on the regulator’s horizon: liquidity risk; credit risk; and information security (including data privacy).
On the first point, the FSC has compelled all licensed virtual banks to submit an emergency plan about what they would do if market liquidity suddenly started to deteriorate. For credit risk, the FSC plans to conduct regular model reviews of the virtual banks, with particular focus on making sure they are using credible data. Information security is all about making sure the virtual banks have robust systems in place – which formed a core part of the review process of the banks’ licence applications.
“We hope these financial institutions will make the best use of digital development to provide faster, more inclusive, more transparent and more cost-effective services,” says Chang.