One of the consequences of the Greek tragedy that has played out over the last few months is a growing realisation that Europe can no longer paper over the design faults at the heart of the Euro project. As Ben Bernanke points out in a recent blog, the “promise of the euro was both to increase prosperity and to foster closer European integration” and suggests what is needed now to fulfil that dream is an official European mechanism to ensure “that creditor as well as debtor countries have an obligation to adjust over time (through fiscal and structural measures, for example)”. The reality of the European positions played out over Greece, particularly from Germany, is that the prospect of any agreement on such a fiscal mechanism is pure fantasy. A striking graph from Bernanke’s post illustrates how beneficial the Euro has been to Germany compared to the rest of the Eurozone.
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The Euro has been exposed as a fixed exchange rate system, only marginally stronger than those that came before it, which has inflated Germany’s large trade surplus and placed the burden of real wage adjustment on countries with trade deficits. Mario Draghi’s QE programme is inflating Germany’s trade account surplus further, now estimated at 7%, through the competitive devaluation of the Euro. With the negative impacts of the Euro’s fall being countered by falling commodity prices, you would think that Germany would appreciate the economic benefits of the Euro it bestows on them even more now than ever. The graph below shows the fall of the Euro against the dollar and sterling compared to the QE daddy of them all Japan (which has failed miserably to raise workers real earnings).
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The extraordinary (and rather crude) acts of the Chinese in recent months to counter the latest bubble, this time in the stock market, illustrates too well the dangers of over-leverage to China’s developing experiment with capitalism. State sponsored championing of stock market rises, particularly through additional leverage, smacks of folly. Colin Powell’s quote “if you break it, you own it” comes to mind. The McKinsey deleveraging report (see previous post) from last year detailed the rise in Chinese debt, as per the graph below.
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Some analysts speculate that China may join the currency wars and turn to the competitive devaluation game later this year to inflate business profits, although any such move will likely not be considered until after the IMF decides on whether to include the Chinese currency in the special drawing rights basket used for holding their reserves. A rise in US interest rates later this year will likely further strengthen the dollar and may prove too much for the Chinese. By widening the fixed trading bands at which the yuan is allowed to trade against the dollar, Chinese authorities may try to counter the competitive impacts of the yen and Euro depreciation. The historical exchange rate of the dollar:yuan is depicted below.
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Were China to join the currency wars to boost their economy, the beggar thy neighbour strategy may get increasing dicey for the developed economics currently embracing competitive devaluation as a means of curing their ills. Germany may have to rethink its dependence on export led growth after all and may come to regret their recent actions in exasperating the underlying fault lines in the Euro.
Posted in Economics
Tagged Beggar thy neighbour, Ben Bernanke, Chinese debt, Chinese stock market bubble, commodity prices, competitive devaluation, creditor countries, currency wars, debtor countries, design faults, euro dollar, euro sterling, Euro weakness, European mechanism, European unemployment, eurozone, exchange rates, fixed exchange rate system, Germany, Greece crisis, Greek tragedy, IMF special drawing rights basket, Mario Draghi, McKinsey deleveraging report, over-leverage China, QE programme, real wage adjustment, strengthen dollar, trade account surplus, trade surplus, workers real earnings, yen dollar, yen sterling
In an opinion piece in the FT in 2008, Alan Greenspan stated that any risk model is “an abstraction from the full detail of the real world”. He talked about never being able to anticipate discontinuities in financial markets, unknown unknowns if you like. It is therefore depressing to see articles talk about the “VaR shock” that resulted in the Swissie from the decision of the Swiss National Bank (SNB) to lift the cap on its FX rate on the 15th of January (examples here from the Economist and here in the FTAlphaVille). If traders and banks are parameterising their models from periods of unrepresentative low volatility or from periods when artificial central bank caps are in place, then I worry that they are not even adequately considering known unknowns, let alone unknown unknowns. Have we learned nothing?
Of course, anybody with a brain knows (that excludes traders and bankers then!) of the weaknesses in the value-at-risk measure so beloved in modern risk management (see Nassim Taleb and Barry Schachter quotes from the mid 1990s on Quotes page). I tend to agree with David Einhorn when, in 2008, he compared the metric as being like “an airbag that works all the time, except when you have a car accident“. A piece in the New York Times by Joe Nocera from 2009 is worth a read to remind oneself of the sad topic.
This brings me to the insurance sector. European insurance regulation is moving rapidly towards risk based capital with VaR and T-VaR at its heart. Solvency II calibrates capital at 99.5% VaR whilst the Swiss Solvency Test is at 99% T-VaR (which is approximately equal to 99.5%VaR). The specialty insurance and reinsurance sector is currently going through a frenzy of deals due to pricing and over-capitalisation pressures. The recently announced Partner/AXIS deal follows hot on the heels of XL/Catlin and RenRe/Platinum merger announcements. Indeed, it’s beginning to look like the closing hours of a swinger’s party with a grab for the bowl of keys! Despite the trend being unattractive to investors, it highlights the need to take out capacity and overhead expenses for the sector.
I have posted previously on the impact of reduced pricing on risk profiles, shifting and fattening distributions. The graphic below is the result of an exercise in trying to reflect where I think the market is going for some businesses in the market today. Taking previously published distributions (as per this post), I estimated a “base” profile (I prefer them with profits and losses left to right) of a phantom specialty re/insurer. To illustrate the impact of the current market conditions, I then fattened the tail to account for the dilution of terms and conditions (effectively reducing risk adjusted premia further without having a visible impact on profits in a low loss environment). I also added risks outside of the 99.5%VaR/99%T-VaR regulatory levels whilst increasing the profit profile to reflect an increase in risk appetite to reflect pressures to maintain target profits. This resulted in a decrease in expected profit of approx. 20% and an increase in the 99.5%VaR and 99.5%T-VaR of 45% and 50% respectively. The impact on ROEs (being expected profit divided by capital at 99.5%VaR or T-VaR) shows that a headline 15% can quickly deteriorate to a 7-8% due to loosening of T&Cs and the addition of some tail risk.
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For what it is worth, T-VaR (despite its shortfalls) is my preferred metric over VaR given its relative superior measurement of tail risk and the 99.5%T-VaR is where I would prefer to analyse firms to take account of accumulating downside risks.
The above exercise reflects where I suspect the market is headed through 2015 and into 2016 (more risky profiles, lower operating ROEs). As Solvency II will come in from 2016, introducing the deeply flawed VaR metric at this stage in the market may prove to be inappropriate timing, especially if too much reliance is placed upon VaR models by investors and regulators. The “full detail of the real world” today and in the future is where the focus of such stakeholders should be, with much less emphasis on what the models, calibrated on what came before, say.
Posted in Insurance Market, Insurance Models
Tagged 1 in 10000 return period, 99% T-VaR, 99.5% VaR, adverse selection, Alan Greenspan, Barry Schachter, climate models, David Einhorn, deeply flawed VaR metric, dilution of terms and conditions, discontinuities in financial markets, economic capital models, economic modelling, European insurance regulation, exchange rates, fat tails, financial engineering, financial innovation, financial models, FTAlphaVille, game theory, imperfect art of modelling, insurance capital models, insurance pricing pressure, internal capital models, internal models, Joe Nocera, loss exceedance probability distribution, modern risk management, Nassim Taleb, New York Times, probability models, probability of default, probability of occurrence, reducing risk adjusted premiums, Return on equity, return period, risk based capital, risk model, solvency ii, Solvency II calibration, Solvency II standard formula, specialty insurance sector, Swiss National Bank, Swiss Solvency Test, Swissie, tail value at risk, Tails of VaR, the Economist, unknown unknowns, unrepresentative low volatility, value at risk, VaR and T-VaR, VaR shock