Solvency Regulation of Banks and Insurers: A Two-Pronged Critique

Abstract

This paper puts forth two models, one of a bank and one of an insurer. Their divisions responsible for investment (and risk underwriting, respectively) seek to maximize the expected risk-adjusted rate of return on capital (RAROC). For the bank, higher solvency lowers the cost of refinancing; for the insurer, it attracts more premium income. In both cases, however, higher solvency ties costly capital. Sequential decision making is tracked over three periods. In period 1, exogenous changes in expected returns and in volatility occur, each suggesting optimal adjustments in solvency. However, there can be only one adjustment, which in period 3 creates an endogenous trade-off between expected returns and volatility. This tradeoff is shown to involve parameters that differ between banks and insurers, calling for bank-specific and insurance-specific solvency regulation. In addition, Basel I and II (Solvency I and II, respectively) are shown to modify this tradeoff, inducing senior management of both banks and insurers to opt for higher volatility and lower solvency than otherwise. Therefore, existing solvency regulation can run counter their stated objective in both cases, which quite likely is also true of Basel III and Solvency III.

Solvency Regulation—An Assessment of Basel III for Banks and of Planned Solvency III for Insurers

“…This question is motivated by the finding of Zweifel et al (2015) that Basel I (and to a lesser extent Basel II) might well induce banks to adopt a more rather than less risky position, resulting in a lower level of solvency. The same effect was predicted by Zweifel (2015) regarding insurers, for Solvency I and II. The methodology adopted was to determine banks' and insurers' optimal adjustments to exogenous changes in expected returns dµ and volatility dσ on the capital market.…”

“…The first question reflects the finding of Zweifel et al (2015) that Basel I and II may well induce banks to take on more rather than less risk, resulting in a lowering of their solvency level. This was found to also hold for insurers in response to Solvency I and II by Zweifel (2015). The second question is motivated by the fact that the parameters determining the solvency of banks differ from those of importance to insurers.…”

“…Through their neglect of this variability Basel I and II as well as Solvency I and II had the unexpected consequence of increasing the slope of the bank's (insurer's, respectively) EPEF. This, consequently induced senior management to opt for higher expected returns ( μ) but higher volatility ( σ) and hence a lower level of solvency (Zweifel et al 2015;Zweifel 2015). This deficiency is corrected by Basel III which explicitly requires banks to take account of developments in the capital markets (dubbed "interest rate risk") in the formulation of their business strategies designed to ensure solvency (Basel Committee on Banking Supervision 2016, Principle 5).…”

“…12 For more detail on the difference between Solvency I and II, see Zweifel (2015). According to Ng and Cheung (2015), the authorities of Singapore anticipate Solvency III to closely copy Basel III.…”