24 May 2013

Risk.net: Shadow bank reforms 'should prompt review' of Solvency II money market fund charge

The European Commission (EC) is expected to publish in June a proposal to regulate the money market sector, as part of a broader strategy to clamp down on shadow banks. According to a leaked draft, money market funds (MMFs) will be required to hold a net asset value buffer of at least 3 per cent and face severe constraints on counterparty exposure and asset maturity, limiting the portfolio's average maturity to no more than 60 days.

The increased liquidity requirements and security imposed on MMFs by the draft proposals would justify reducing the capital charges for these investments under Solvency II, according to legal experts. "Given the enhanced security implied by these proposals, EIOPA should reconsider how MMFs are treated under Solvency II", says Victoria Sander, head of the insurance practice at international law firm Linklaters, based in London.

The current version of Solvency II treats MMFs as collective investment funds. If there is insufficient detail about the underlying assets, the investment is treated as equity and attracts a capital charge of up to 49 per cent. Sander suggests that a new category of market risk in Solvency II could be introduced, if MMFs are to be subject to specific liquidity requirements and restrictions on counterparty exposures.

Insurers' allocation to MMFs has increased significantly during the past five years, as insurance companies have reduced the volume of cash deposits and exposure to banks. "The majority of insurers realised through the financial crisis that [cash] deposits were unsecured and added on to pre-existing exposure to banks, which can go up to 60 per cent because of their significant corporate bond portfolios. Cash is great for liquidity, but they need to invest it in a way that is mindful of concentration risk and industry exposure", says Etienne Comon, managing director of Goldman Sachs Insurance Asset Management.

Traditionally, MMF investments are better suited to non-life insurers and reinsurers, as they write short-dated liabilities and have uncertain cash payments to make. The level of investments in MMFs is on average higher in the UK than in the rest of Europe.

A spokesperson for EIOPA says any legislative changes that fundamentally affected Solvency II would be discussed with the EC, but it was important to finalise the rules as soon as possible and avoid re-opening more issues. "Solvency II, as with any supervisory regime, will not be perfect and will need to be updated over time. Indeed, for example, there are explicit provisions in the Directive for the periodic review and update of the correlation parameters relating to the standard formula capital requirements", the spokesperson says.

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