Risk transfer to insurers could threaten Basle II, warns UK central banker

LONDON -- Financial stability and financial efficiency could be undermined if the new Basle II capital adequacy rules proposed for banks are simply "arbitraged away" by the transferral of banking risks to insurers, according to a senior UK central banker.

In May, Bank of England deputy governor David Clementi called for a critical look at the rationale for the difference in the way banks and insurance companies are regulated.

Clementi said he would welcome being put on the international agenda the question of whether the trend towards risk-based regulation of banks exemplified by Basle II needed mirroring in non-life insurance regulation in Europe.

Basle II is the new set of rules due to come into force in 2004 that stipulate how much capital large international banks have to set aside to guard against the hazards of the banking business.

The European Union intends applying rules modelled closely on Basle II to all banks and investment firms in the 15-nation EU from the same date.

Nullifying Basle II

Banks might nullify the Basle II rules by transferring credit risk, for example, to insurance subsidiaries, Clementi told a London conference on banks and systemic risk organised by the Bank of England.

The rules might also be nullified by asset securitisation sales to third-party insurers, or by credit insurance and derivatives sold by insurers.

Banking industry analysts noted that the architects of Basle II, the global banking regulators of the Basle Committee on Banking Supervision, are considering the role insurance might play in mitigating the operational risk capital charge that the new accord will impose for the first time.

Clementi said financial stability could be endangered if any risk transfers from the banking sector were not robust or resulted in potentially systemic strains in the insurance sector. Financial efficiency could be undermined through the extra costs of the arbitrage process.

Common risks

He said there was a body of common risks faced by banks and insurers on both their assets and liabilities, namely credit, market and operational risks. There were also distinct risks, such as mortality risk for life insurance companies and liquidity risk on the banking side.

"To my mind, this means that any very fundamental divergences in the basic [regulatory] frameworks do need careful consideration," Clementi said.

"We may find that some differences are justified," he added. He said, for instance, regulators might tolerate different minimum solvency levels for the two industries if they found that insurance company failures imposed fewer risks on the financial system as a whole than did bank failures.

And much of the detail of risk measurement and regulation must necessarily differ, he added, because of the different time horizons involved in life insurance, for example, compared with either banking or investment firms or non-life insurance.

No small task

Looking at the problem would not be a small task, Clementi said. But the setting up of regulatory agencies such as the UK’s Financial Services Authority, the country’s chief financial watchdog, with responsibility for both banking and insurance supervision, will help to achieve progress.

Meanwhile, Clementi reiterated a previous warning that the risk-sensitive Basle II rules should be used carefully to avoid accentuating the peaks and troughs of the economic cycle (see Operational Risk, May 2001).

Economic downturns would be accentuated if bank credit dried up because the increased risk of loan default required banks to hold more regulatory capital.

"We need to ensure that, so far as we can, we avoid sudden perceptions of changed risk," said Clementi. "To achieve this, risk-sensitive capital requirements need to be both sufficiently backward-looking and sufficiently forward-looking".

Backwards and forwards

Clementi said they should be backward-looking in the sense that they are based on long runs of data that incorporate experience of both peaks and troughs.

And he said they should be forward-looking in the sense that risk measures hold good through the business cycle, taking account of possible future downturns, even as banks are extending credit in benign conditions.

He also said there is evidence that banking crises have become more frequent over the past 20 years. Four out of the Group of 10 leading economies, from which the regulators of the Basle Committee are mainly drawn, have suffered banking crises in the past 10 years, he noted.

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