02 September 2014

Risk.net: BoE group kicks off procyclicality debate

The negotiations over the Omnibus II Directive are still fresh in the memory, yet already the UK’s Bank of England (BoE) is launching a debate about possible next steps in insurance regulation.

At the end of July, the Procyclicality Working Group, led by the central bank’s chief economist Andrew Haldane and including academics, consultants and notable industry figures such as Jim O’Neill, former chairman of Goldman Sachs Asset Management, published a discussion paper entitled 'Procyclicality and structural trends in investment allocation by insurance companies and pension funds.'

The paper stops short of policy recommendations, but nevertheless presents some contentious ideas about the need to balance policyholder protection with financial stability and economic growth.

The question it sets out to address is whether insurers and pension funds invest in ways that exacerbate asset volatility, thereby contributing to financial instability. The paper also asks whether the economy is missing an opportunity if firms fail to invest for the long term, even though with long-term liabilities they are well suited to doing so. An implied question is whether regulation could be inadvertently responsible for some procyclical behaviour.

The conclusions reached about procyclical investing are vague, mainly due to a lack of data (part of the objective of the paper is to encourage further research). There is some evidence, the authors say, that insurance companies have invested in a procyclical way at various times, such as selling equities during the dotcom crash of the early 2000s. But data for the financial crisis paints a less conclusive picture.

As for what might cause such behaviour: “In most cases, it is not possible to draw a direct causal link between procyclical investment behaviour or structural shifts in asset allocation and a singular driving force because of the difficulty of disentangling the multiple factors at work,” states the paper.

Nevertheless, the authors devote much attention to the role of regulation in investor behaviour. One section of the paper uses a hypothetical market-consistent capital regime to illustrate how fixed capital charges might contribute to procyclicality.

The paper also shows BoE thinking about the potential of insurers and pension funds to fill the funding hole in the real economy as banks deleverage. “Because many of their liabilities are long term, insurance companies and pension funds have the potential to be significant providers of long-term investment. Long-term investment is crucial not only to long-term economic growth, but also has the potential to improve the resilience of the financial system,” the paper states.

The opportunity has passed for any of the suggestions to influence the details of Solvency II, but the paper might start a debate that affects the first review of the European directive, which is scheduled to take place three years after its 2016 adoption.

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BoE report

 

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