After the holidays, it’s time to pack the bucket and spades away and get back into the routine. It has been a volatile August. A bear call in a post in early May is looking pertinent (as is the post on a suggested tie-up between Paddy Power and Betfair!) given the 7% drop in the S&P500 since then, although it is more likely dumb luck.
The market concern is centred on the prospects for China’s economy. Growth is widely believed to be a lot lower than the official 7% with exports down, concerns about zombie loans and the political ramifications of managing a lower growth economy. The Economist, in an article this week, highlighted the potential impact of a slow-down in China and other emerging markets on global growth, as per the graph below.
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Amongst the usual holiday reading, I brought two books on economics for the beach. The first was the FT’s Martin Wolf’s “The shifts and the shocks” from late in 2014 and the second is the recently published “Postcapitalism” by Paul Mason. Although often a laboured read, I did manage to finish the former whilst I only got to start the latter (which is a much easier read).
Reading Wolf’s book as the China led volatility was unfolding only led to an enhanced feeling of negativity from the themes of the book, namely the lessons as yet unlearned from the crisis. Wolf competently covers much of the causes of the crisis and its aftermath – a global savings glut and associated global imbalances, an expansionary monetary policy that ignored asset prices and credit, an unstable liberalized financial system supervised by naïve regulation. The following graph from the IMF reminds of the global imbalances that proved so toxic when combined with a rampant financial sector.
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Wolf questions the “belief that government borrowing is the illness for which private borrowing is the cure has survived all that has happened”. Some of the solutions that Wolf proposes include much higher capital requirements for banks than is currently being implemented under Basel III, deleveraging initiatives such as tax incentives towards equity and away from debt, corporate tax changes to encourage corporate investment, changes in debt contracts to convert to equity on macro-economic metrics, policies to address income inequality and to promote research and education.
A more radical reform of the financial system, along the lines of the Chicago Plan for 100% reserve banking whereby the ability to create money is taken away from profit seeking banks and given solely to central banks, is a step that Wolf favours but believes is unrealistic given the realpolitik of the developed world system. On the globalised financial system, Wolf believes that the “obvious truth that unless regulation and the supply of fiscal backstops is to be much more global, finance should be far less so” and suggests a greater segmentation of the world’s financial system.
There are many themes in Wolf’s book that got me thinking and I am hoping that Mason’s book will do the same, albeit from a totally different perspective. I think the market volatility has more time to play out and hopefully my summer reading, although yet to be completed, will assist in understanding what may come next.
Posted in Economics
Tagged 100% reserve banking, a global savings glut, Basel III, BetFair, Chicago Plan, China, China economy, corporate tax changes, deleveraging initiatives, emerging markets, expansionary monetary policy, global imbalances, higher capital requirements, income inequality, lessons as yet unlearned, lower growth economy, Martin Wolf, my summer reading, Paddy Power, Paul Mason, political ramifications, Postcapitalism, rampant financial sector, slow-down in China, tax incentives on equity, the Economist, The shifts and the shocks, unstable liberalized financial system, volatile August, zombie loans
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