The elixir of finance

Donizetti's 19th century comic opera L'Elisir d'amore, currently playing at London's Royal Opera House, features an itinerant quack doctor who peddles worthless love potions. But the audience has sympathy for the doctor - his ignorant customers are convinced the potions work, so he makes them happy by responding to market demand.

Like patent medicine, the evolving US sub-prime mortgage crisis has highlighted financial products that also promise far more than they actually deliver, both from the perspective of mortgage borrowers and investors. But this crisis would be far less serious had it not been for another magic potion essential to the banking system: liquidity.

As in Donizetti's opera, so long as everyone believes the potion is working, the industry can carry on bottling it and selling it. But somehow, when combined with sub-prime, the elixir of liquidity grew toxic.

Today, the seriousness of the crisis can be gauged from two measures. The ABX index, which tracks the market prices of US sub-prime mortgage-backed securities, prices AAA-rated debt (which normally trades at par) at 70 cents on the dollar and AA-rated debt at 40 cents on the dollar. Meanwhile, the one-month London inter-bank offer rate (Libor) for sterling and euro stands at about 100 basis points above central bank base rates - a gap that highlights the extreme lack of liquidity in the market.

Aside from the odd municipal pension fund or multinational reinsurance company taking a sub-prime bath, the insurance and pensions industry has largely escaped the effect of this crisis. But at a time when multinational banks are firing their CEOs and hedge funds shutting their doors in droves, there is something faintly surreal about the stately progress of the Solvency II quantitative impact studies (QIS).

Insurers - currently so bullish about their capital position that they are engaging in takeover battles - are being asked to estimate their capital under a hypothetical one-in-200 worst case scenario. Regulators fresh from chairing late night crisis meetings with troubled banks are trying to negotiate a capital framework that protects policyholders against an imagined insurance sector meltdown.

The latest study, QIS3, has elicited a couple of double takes from participants with an interest in today's markets. For example, there is the jarring absence of a liquidity module and the generosity of AAA and AA-rated credit spread stress tests that would make a rating agency blush. And the less said about groups in QIS3 the better.

Overall, the approach of Solvency II, which seeks to improve on bank regulation by looking at the total insurance balance sheet in an economic way, is a positive step. But at the end of the day, the belief of policyholders in protection and long-term savings products is the equivalent of liquidity in banking. Both insurance company shareholders and supervisors have to defend the credibility of this belief.

If this credibility is damaged, look to the UK's Northern Rock for an example of what can quickly happen. In QIS3, the widely-criticised 'lapse cat' module, which proposes a capital charge for a sudden mass surrender of policies, may be a clumsy supervisory analogue. But any attempt to model insurance capital without seriously addressing the magic potion of policyholder belief deserves to be treated as comic opera.