Reinventing the risk free asset concept

Reinventing the risk free asset concept

The International Monetary Fund’s latest Global Financial Stability Report includes a chapter that will make interesting reading for the bosses of big insurers and reinsurers. It is to do with the demise of risk-free investing, a worrying trend for an industry that relies on safe assets.

The IMF’s analysis notes that the price of assets regarded as safe is on the rise, with supply dwindling and demand rising amid uncertainty in financial markets, regulatory reforms, and increased demand from central banks in advanced economies.

It adds that the growing demand and shrinking supply of safe assets, predominantly government bonds, could have negative effects on global financial stability.

The global economic crisis and rising government debt concerns in some advanced economies have shown that no asset can be viewed as truly safe, the IMF said.

Absolute safety implicit in credit rating agencies’ highest ratings, and embedded in financial regulations and investor mandates, created a false sense of security prior to the crisis. Before the crisis, the excess demand for assets categorized as safe was driven by booming emerging economies that had accumulated reserves and used these to buy large amounts of safe assets.

Now, the demand for safe assets creates pressures due to new financial regulations that require banks to hold more safe assets; higher collateral needs for over-the-counter derivatives transactions or their transfer to centralized counterparties; and the increasing use of safe assets in monetary policy operations, such as purchases of government securities by central banks, according to the IMF.

On the supply side, concerns about high government debts and deficits in some advanced economies have reduced the perceived safety of government debt, however. Recent rating downgrades of sovereigns, previously considered to be virtually riskless, show that even highly-rated assets are subject to risks.

The number of sovereigns whose debt is considered safe has fallen. The IMF estimates that safe asset supply could decline by some $9 trillion, or roughly 16 per cent of the projected sovereign debt, by 2016. Private sector issuance of safe assets has also contracted sharply on poor securitization practices in the US.

Safe asset scarcity will increase their price, with assets perceived as the safest affected first. Investors unable to pay the higher prices would have to settle for assets that have higher levels of risk.

Shortages of safe assets could also lead to more short-term spikes in asset volatility, and shortages of liquid, stable collateral. If collateral became too expensive, funding markets would be compelled to accept lower-quality collateral, raising funding costs.

The IMF report references the implications for banks, but they apply to insurers and reinsurers too. Both Basel 2 and Solvency have zero credit risk factors for soverign debt.

Risk weights are adjustments, based on the riskiness of assets, for the purpose of determining how much capital banks – and insurers - should hold. When these are set at zero, banks and insurers can hold government debt without any required capital to cover potential losses associated with such holdings.

The IMF thinks that might have to change.

It pointed out that to mitigate pressures on the demand side, regulations and policy responses should differentiate better across assets based on underlying risks. The categorizations of assets based on risk should be reviewed at regular intervals to ensure that they reflect adequately such risks. Specifically:

* Concerning capital adequacy requirements, risk weights on government debt should eventually reflect more accurately the relative credit risk of sovereigns;

* Concerning liquidity requirements, the IMF suggested future regular revisions in the calibration of discounts, known as haircuts, of liquid assets in the estimation of the yet-to-be implemented liquidity coverage ratio.

* In the derivatives markets, the IMF advocated that regulators of central counterparties ensure a sufficiently broad range of acceptable collateral with appropriate risk-based valuations in default funds, funds meant to cover losses in the event of default of a clearing member.

The IMF said policy responses to the pressures in the markets for safe assets should be implemented gradually to avoid unnecessary volatility in the prices of some assets.

The IMF stressed that credible plans to reduce government debt levels and strengthen debt management over the medium term would help increase the supply of safe assets. However, where financing conditions allow, the near-term pace of reducing government debts and deficits needs to be mindful of the dampening effects on economic growth, it said.

The private sector could once again become a key supplier of safe assets. Sound reforms and effective regulations would be needed to govern the pooling of various types of lower-rated contractual debt into higher-rated financial instruments, for example through securitization.

The build-up of the capacity of emerging economies to issue their own safe assets with the improvement of domestic financial infrastructure would also alleviate the imbalances in the global markets for safe assets.

While the price of safety will inevitably rise, a smooth adjustment process can be ensured if policymakers are aware of their actions and their potential consequences, the IMF concludes somewhat hopefully.

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October 2018


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