ESRB Working Paper: “Cyclical investment behaviour across financial institutions”
On 2 July, the European Systemic Risk Board (ESRB) published a working paper on the cyclical investment behaviour across financial institutions, authored by Yannick Timmer (Trinity College Dublin). The paper analyses the cyclical investment behaviour of investment funds, banks, insurers and pension funds.
http://www.esrb.europa.eu/pub/pdf/wp/esrb.wp77.en.pdf?65da78f3d23df6963ad7947c4b16d316
The conclusions of the paper are:
- Banks and investment funds are pro-cyclical investors with respect to past returns, whereas insurance companies and pension funds are counter-cyclical investors with regard to past returns.
- One channel that could generate the heterogeneity in the cyclical investment behaviour is based on the investors’ balance sheet dynamics. Since insurance companies’ and pension funds’ balance sheets are more resilient to short-term losses, they can act in a counter-cyclical manner.
- The pro-cyclical investment behaviour of investment funds and banks resulted in relatively mild losses during the European sovereign debt crisis. Although insurance companies and pension funds suffered severe losses during the crisis, they outperformed banks and investment funds in the medium run.
- The investment behaviour of insurers and pension funds can be a stabilising force on capital markets. In contrast, the investment behaviour of banks and investment funds can exacerbate price dynamics and lead to excessive volatility in capital markets. Therefore, it can be hazardous for countries to rely on investment funds and banks as their main investors.
BIS Report: “Financial stability implications of a prolonged period of low interest rates”
On 5 July, the Bank for International Settlements (BIS) published a report on the financial stability implications of a prolonged period of low interest rates, that was submitted by a Working Group established by the Committee on the Global Financial System. The report identifies and provides evidence for the channels through which a “low-for-long” scenario might affect financial stability, focusing on the impact of low rates on banks and on insurance companies and private pension funds.
https://www.bis.org/publ/cgfs61.pdf
The conclusions of the report are:
- While banks should generally be able to cope with solvency challenges in a low-for-long scenario, insurance companies and pension funds would do less well.
- Even in the absence of greater risk-taking by financial institutions, a future snapback in interest rates could prove challenging. Banks without sufficient capital buffers could face solvency issues, driven by
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- both valuation and credit losses. Insurance companies and pension funds, instead, could face liquidity problems, driven either by additional collateral demands linked to losses on derivative positions or by spikes in early liquidations.
- In addition, the scope for claimholders to terminate life insurance contracts early can become a source of liquidity vulnerability for insurance companies if a period of low interest rates ends with a sudden snapback in rates.
The policy recommendations made in the report are:
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- Enhanced monitoring of financial institutions’ exposure to low-for-long and snapback risks, especially through stress tests. For insurers, longer time horizons should be used and, in designing stress tests intended to assess the vulnerability to interest rate risk, authorities should adopt a consistent valuation approach across assets and liabilities. A mark-to-market approach may best capture challenges to economic solvency and liquidity from changes in interest rates.
- Collection and analysis of appropriate firm-level data to monitor exposures and risks.
- Adoption of appropriate resolution strategies, in particular, considering whether insurers’ resolution regimes can allow insolvent insurers to be resolved without systemic disruption).
The Working Group also discussed two potential measures for insurance companies, without endorsing them:
- Providing firms facing financial shortfalls with adequate time for them to rebuild their balance sheets to required norms, thereby not encouraging procyclical or disruptive actions by the affected firms.
- Reducing early termination incentives (eg by imposing larger surrender penalties), or suspending surrenders altogether.