The consequences of risk-based regulation

A new international regulatory framework is imminent, and the management of a mid-sized financial institution is worried. Although the institution is respected in its home market, experts say that the only way it can compete and grow is by becoming internationally diversified and by embracing sophisticated financial engineering techniques.

A few years later, the institution has become a favourite customer of the big investment banks, and seems to be making money. According to the institution's internal risk model, it had a one-in-three-thousand chance of becoming insolvent in a given year. Yet, in the space of a few weeks, exposure to an unfamiliar, troubled foreign market has brought the institution to its knees.

No, not a hypothetical cautionary tale about Solvency II, but the story of IKB and Sachsen LB, two mid-sized German banks tripped up by US sub-prime mortgages they didn't seem aware they owned. It can hardly have been a comfort to banking regulators that this summer's credit crunch came on the eve of the final implementation of Basel II. This long-awaited international capital framework was supposed to make the system safer, and was supposed to capture the off-balance sheet credit risks that sunk IKB and Sachsen LB. So far, insurance companies and pension funds appear to have escaped the effects of the crisis. Luckily, their liabilities have durations far longer than the 90 days typical in the commercial paper market. But surely there are some lessons for insurance and pensions regulators, in particular the architects of Solvency II.

One wonders if insurance and pension regulators are prepared for the tensions between mid-sized regional entities and multinational institutions that arise from the imposition of a new risk-based framework. Multinational banks were prepared years in advance of Basel II in the same way that CRO Forum members have already had a significant impact on the shape of Solvency II.

But it will be the mid-sized regional players who will feel the most pressure, and they will not have to wait until the implementation of the new directive to feel it. Lacking the readymade advantages of group diversification, and unwilling or unable to merge or be taken over, these players will seek other ways to keep up, and regulators will be urged to help them do so - or to look the other way.

How might this happen? The regulators have high hopes for internal models, which give considerable scope to combine risks. The multinationals have already built their own models, or are in the process of doing so. But with a skills shortage of modern risk professionals in the industry, mid-sized players might lack the internal resources to follow suit.

However, external experts will appear offering to build the internal models these mid-sized firms need. These models will be designed to help regional players to survive and compete internationally. The trick will be to 'buy in' diversification, either on the asset side using alternative investments or structured products, or on the capital side using reinsurance or securitisation. Some of these experts might be employed by the same firms offering these solutions.

This isn't to suggest that such arrangements can't be mutually beneficial if used wisely. But the lesson of IKB and Sachsen LB is that regulators should be prepared for the disruptive impact of risk-based regulation on smaller players, and the potential for the capital markets industry to feed on this impact, long before Solvency II is signed into existence. When it comes to risk, ignorance is no excuse.