Thursday, 3 March 2011

Insurance and Banking: Risk, Resiliency and Harmonisation

I attended an interesting discussion of risk management in the City this week, bringing together insurers with bankers. The two sectors manage risk quite differently, which is why there are rarely insurance crises and frequently banking crises. Insurance crises tend to occur when insurers act like banks (AIG Financial Products, MBIA and other monolines). Bank crises tend to occur when banks act like investment banks.

Insurers must not underwrite risks that they will not be able to cover in the event, and must therefore have reserves sufficient to perform at all times. This makes the insurers much more cautious about taking on risk, about pricing risk accurately at the time of contracting, and about managing reserves to be liquid when claims require payment. Regulation is fundamentally about solvency and selling.

Banks undertake risks on their books that they can only cover so long as they continue to have access to liquidity (funding, deposits, repos or central bank support). Bank capital is never enough to ensure performance without market liquidity for reserve assets. Banks are generally much less cautious about taking on risk, rely overmuch on incomplete models to price risk, and manage capital to optimise returns rather than ensure survival. Regulation focuses on capital (never enough on its own) rather than conduct, common sense and functional suitability.

One risk manager observed that in insurance the risks are exogenous, generally independent in occurrence, and finite. In banking the risks are too often endogenous, correlated in unpredictable ways, and of unknowable magnitude. As a result, a single bank failing has systemic consequences for the banking system, where a single insurance company failure has no systemic consequences for the insurance sector.

An interesting observation both insurers and bankers agreed on was that international harmonisation of regulation had driven formerly diverse business models and management preferences toward uniformity by enforcing preferred models for capital and solvency. As a result, the risks of total systemic failure are much, much higher than before Basel II and Solvency II, because when the models are wrong, the whole financial system is compromised.

Models are always wrong because they are partial, approximate, and use historic data and correlations. In internationally harmonised regulation, the failure of models is even more assured as many domestic factors which have great implications for financial risk are ignored or discounted. Quite simply, models are illuminating, not correct.

What this means is that the 25 year drive to harmonise regulation using financial models is almost certainly counterproductive if the aim was to ensure wider financial integrity and stability. Instead of a global financial system constructed as a spider's web, such that the breaking of one strand does not compromise the whole web, we have a system that has bound all the threads into a single cable. And if that cable frays under stress . . .

There was controversy around the idea of functionally segregating the pedestrian but systemically important functions like payments and mortgage intermediation from the riskier eccentricities of modern of investment banking. About half the room thought it perfectly sensible, and half thought it couldn't be done. I'm of the view that "narrow banking" for some functions might be a very reasonable way to secure the taxpayer from future losses by reducing the scope for contagion in the banking system. And if we could do that, we could allow bad banks to fail, restoring some morals and some hazard to the management of banking.


SB said...

the old Lloyds, of course, was run in a way that meant risks were endogenous, systemic, correlated and potentially limitless... the failure of one syndicate did threaten the survival of the others...

and look what happened to them,

London Banker said...

@ SB
You are very right about the Lloyds of London crisis, and that was raised at the meeting as a counter-example. What I esteem about the Lloyds crisis though, is how it was addressed through collective resolution and reforms. The creation of Equitas and the loss-sharing resolution regime have reinforced professionalism and accountability.

It is precisely these sorts of successful collective reforms we should be looking to implement/impose in the banking sector to address the current systemic failures.

Simon, Denmark said...

Interesting stuff and definitely worth thinking about when trying to set up a regulatory regime, however it often seems to me that bankers have lots of escuses for not putting up the capital requirements and live up to other regulations.
There should be some room for individuality, but it's clear to me that the banks have abused it in the last decade.

Richard said...

One of the interesting aspects of managing risk is that insurance firms focus on managing tail risk, while banks focus on managing non-tail risk. This leads to very different outcomes.

There is only one banking regulation that should be harmonized globally. That is the disclosure of all current asset-level positions.

This disclosure would allow every firm to analyze the riskiness of its competitors and to properly price their exposure to these firms.

Finally, the UK is going to face increasing difficulty in reducing the risk of its financial system as the US continues to do nothing and claim that their financial system is now stronger than before the credit crisis. Any changes contemplated by the UK regulator will now come up against the "you cannot do that, because we need a level playing field with banks in the US to compete" argument.

Nath said...

Thank you for your interesting posts.
I was wondering what would be your comment on this letter from FT:
Sir, I read with interest the news that the UK government is freezing billions of dollars in assets belonging to Muammer Gaddafi and his family. I would also be intrigued to know whether the banks and other financial institutions handling these assets have applied the same anti-money laundering (AML) procedures to these assets as are applied to every other “normal” banking client in the UK.

I am less interested in whether Col Gaddafi and his family were able to supply passport copies and utility bills but more interested in what evidence they were able to present as to the source of the funds.

It seems to me entirely implausible that Col Gaddafi could have earned billions of dollars through legal means. And yet if the AML procedures, to which we are all subjected, have not been applied rigorously to the likes of Col Gaddafi and his family, one is forced to ask what purpose they really serve.

Charles L.M. Horner

London Banker said...

@ Richard

Spot on about tail risk. Insurers have to reserve as if the tail risk is almost certain to occur; whereas bankers reserve as if the tail risk has no chance of occurring, knowing they can socialise the loss to the central bank/state if it does.

@ Nath

AML and its cousin CTF (counter terrorism finance) operate as a non-tarriff barrier to smaller banks, foreign banks and anyone the extra-judicial authorities take a dislike to. Enforcement is very, very selective and ill-transparent, being mostly an extra-judicial process with no consistent mechanisms for evaluation, review or repeal.

The complexity and large fines on banks tend to concentrate global cash in the top tier of poltiically powerful payments banks through making it too complex, expensive difficult, and risky to move money through smaller, less influential institutions. Rather like airport security, AML/CTF inconveniences the massive majority of the innocent, while hardly impairing at all the risk of malfeasance by those who choose to ignore the law.

It is an interesting fact that both the terms "war on drugs" and "war on terror" were coined by former Director of Central Intelligence George H. W. Bush. The Financial Action Task Force (FATF) for AML/CTF propagation was formed in 1989 when he was President of the USA.

I have always thought it odd that banks acquiesced so readily to be unpaid policemen in the opaque and extra-judicial processes of AML/CTF reporting. Perhaps it was in their self-interest as the quid pro quo is that their franchise in payments intermediation has been protected from encroachment by more efficient transaction processors.

Nath said...

War on drugs...Hm that what exactly I think when I hear our PM talking about "No-flight zone above Lybia".
Are they on drugs?
If I've understood you right there is very minore chance of somebody asking me any questions if I go transfer ...let say couple billons of GBP on my account in Barclay? Because enforcement is very, very selective and ill-transparent?

Anonymous said...

Segregating the 2 would surely lead to collapse. (IMHO) The MTG (pedestrian) and the equity/risk (investment) are supposed to see-saw. ...and support the banks in a balanced way.

I don't know if you remember this one... but in my first RGE artile (Friends Romans Countrymen...) I sight a blog post I had written in article form called "The Broken See-Saw"

I'd say this broken harmony is what allowed the market to spin out of it manipulated control.

I believe both sides of these crimes need each other to survive. ...and neither survive to serve a good for too long as greed always wins.

I just read the prior piece about the healthcare... Good stuff. Interesting! I've always read horror stories about fgn healthcare and wondered how much of what I read was US propoganda?

Have a nice weekend.


Detlef Guertler said...

@Rich: "Segregating the 2 would surely lead to collapse..."
I respectfully disagree. Especially because I don't care about the collapse of banks - but I do care about the collapse of societies. Every system that is essential for the functioning and short-term survival of a society is INFRASTRUCTURE - and infrastructure should be owned or tightly regulated by the government. At the moment the banksters can take the whole society as hostage: If we, the banks, fall, then you, the society, will fall, too. That's what they did in september 2008, and that's what they will do next time soon - and that is the main source of moral hazard. And utterly disgusting.
IMHO the best cure indeed is to separate the infrastructure part (that LB and you call "pedestrian") from the rest of the banking universe. After that the only one too big to fail would be the government - and that's what governments (not banks) are made for.

Knute Rife said...

I believe the Lloyds crisis/Equitas are a perfect compare and contrast with the current banking mess: a solution to resolve the problem, rather than a pseudo-solution to preserve the problem.

You're quite right about insurance crises coming when insurers act like banks. Credit default swaps are insurance instruments but were traded upstream and downstream like securities. Insurers learned over two centuries ago about insurable risk. Banks have never learned, and insurers like AIG and MBIA chose to forget.

Disclosure alone isn't enough; someone needs to be watching over what is disclosed. Here in the US, both the asset valuations and the audits supporting them were about as well-grounded as Birnam Wood, but the regulators did nothing until the house had already burned to the ground.

Hate to go all X-Files (although "The Good Shepherd" may be more apropos), but the folks who pull the strings in the financial institutions and the folks who pull the AML/CTF strings all went to the same schools and belong to the same clubs. Extraordinary procedures allow for arrangements and resolutions within those circles and outside public observation.

London Banker said...

@ Knute
Circles within circles, make a myth of all we believe to be true.

PeterJB said...

@ LB
The blatantly obvious difference between banks and Insurance orgs is that Insurance orgs hedge with the Re's - (In fact, AIG was a Re, started in Shanghai.) Re's hedge with each other, and Re's also syndicate to create larger pools of Re's for risk mitigation. They also tend to specialize.

No Insurance Company insures anything without a pre-approved hedge option with a Re which explicitly infers that the Re's must and do approve every Insurance Policy written.

Re's get to Government's and attempt to reduce their Risk though Law, Policy and the nod of the regulator; the bigger and more influential the Re, the lower the risk. But there is never NO Risk.

Banks in order to reduce risk infiltrate government like fleas, tape worms and ticks on/in dogs until they create a sycophantic relationship where they are Senior Partner; just like a parasite, they have no shell or skin and lodge themselves into the control organs of the Host. The Rulers become totally dependent upon the Bankers and Policy and Law, and regulations become Banker Law, in their quest to zero put Risk; the bankers merely carry the chalice like the living dead, jerking along as their strings are pulled.

Insurance companies, that is, the Re's act normally in commercial markets compared relatively to the Banks that enjoy total Risk Free privileges - while at the same time, enjoying free market status.

The source of the problem is the "risk free" desired optimization, as free markets will not function efficiently nor effectively in Zero Risk environment, a priori. Zero Risk is unnatural and not in concordance with natural Law.

Banks operate and function in closed system or endogenous systems where in physics, endogenous systems, or closed systems cannot exist and survive for long. The analogy from biology and physics is the breakdown in life forms due to incest.

Bottom Line is that Insurance companies take risk even if "leadership" assists through Law.

Bankers are now taking NO Risk - and have any losses covered by the taxpayers, as well as taking deposits and charging fees for these deposits despite fractional reserve banking privileges, Central Banking Authority, political protection, government deposit guarantees, government insurances, covered bands access in full, Securitization purchases of RMBS, etc, all by Government making the banking systems of the World today, parasitical and predatory as well as the fraudulent Ponzi schema that it is. This will not end well.

Personally I think what is happening is great and serendipitous, as the World is looking and Tweeting and SMS'ing etc., and will / are learn 'ing their lessons and when the whole mess collapses in the 2011 /2012 period, the world will demand the return of risk for all sectors and abolish risk free banking theft.

I have started to post the socio-economic solutions to this Global Leadership Failure of 2011/2012 on my Blog and am optimistic, but it didn't have to be like this.

A new post is up and it starts in 1383BCE or thereabouts and end in todays biological sciences and physics. Just click on my handle above.

Ho hum

PeterJB said...

Is Iceland a rouge and heretical Nation that is defying the Banker's Guild and chalice bearing "Leadership"?

Sigurdur Einarsson, former chairman of Kaupthing Bank, and Robert Tchenguiz, who was the now-defunct bank’s biggest customer, were both arrested this morning in London in a joint operation by the Serious Fraud Office and Iceland’s Special Prosecutor into the banking crash.
Searches were carried out at two business premises in the British capital this morning and at the homes of eight people. Seven people were arrested in the operation carried out by the SFO in conjunction with the Metropolitan and Essex police forces."

Oh Dear, Another hit job for Karl Rove on behalf of the Global Elite's - now threatened with their feeding frenzy on the "unwashed masses".

Is this the same "spark" that "The former head of Britain's Secret Intelligence Service has credited WikiLeaks and other secret-spilling sites with sparking the revolutions sweeping the Middle East."

Oh Dear... Open season on Bankers?

Sounds like a good start methinks, what say you London Banker?

London Banker said...

@ PeterJB
The easiest way to rob a bank is to own one. As I understand it, Tchenguiz owned 1.5 percent of Kraupthing equity personally, was a director of the largest shareholder, served on the board of Kraupthing, and received about $2 billion in loans secured by a pledge of his stock in the bank back to the bank as collateral. How good would that collateral be if it were known T was defaulting on the $2 billion? That sort of self-dealing by an insider should be criminal. We'll have to see what else comes out.

PeterJB said...

@ LB

"That sort of self-dealing by an insider should be criminal. ***We'll have to see what else comes out.***

Doesn't this sound like JPMorgan Chase, etc., manipulating and shorting the Silver Markets; same MO methinks even if acting on behalf of the FedRes.

Keywords: criminal | what else |

Indeed; but my point was why is Iceland the only Nation acting in Law against 'probable cause' as there is no shortage anyway of allegations of extreme banker fraud, without any doubt at all.

As a professional in my former life, our Institution had as its highest committee, the Review and Oversight in self-regulation and would bring charges against any member thought to be in the slightness violation of the Institutions Articles and indeed, even minor transgressions of civil Law.

So, is Iceland to be the only Nation in this World today to implements the Laws of the Land?

Do all the other Nations prefer to wait to see what else comes out?

If so, why? IS this refusal to apply the Law because those alleged to be breaking the Laws, are Bankers and thusly, connected at the rectum to "leadership" in a daisy chain?

Today, the sexual charges against Julian Assange of Wikileaks, the nobody from Australia which government wants to sell him to the US, have been fully exposed as naught but fraudulent manipulations of bent and twisted sexual repressent saddists in a web of sick and bent political opportunists having their strings pulled by monkey George W Bush's organ grinder - Karl Rove. And this is where the "Leadership" focus is while the Banker/ruler cartel screws the arsehole out of the global population for ten of Trillions of their hard earned wealth?

And you propose that we have no choice but to wait "and see what else come out".

Sophistry is premeditated intent to defraud. The intent of Law is to protect those that cannot defend themselves and not to protect those that feed and hunt like hyaena's.

So to my original question: Is Iceland rouge and heretical - in these contexts?

tks for the prompt response and I truly hope that you are not just lining up as another apologist of fascism.

London Banker said...

@ PeterJB

Allow me to point out that the arrests did not take place in Iceland, they took place in London. Therefore Iceland cannot be the only country that continues to respect the rule of law. These British citizens were arrested by British police on British soil under a British warrant. My country is beginning to clean up - maybe not enough, but some.

There are plenty of apologists for the bankers, and they can buy protection from law in many countries, but I would assert that the UK makes it less and less easy for them.

As I have pointed out before, when policy makers act out of deliberation and not out of fear and blackmail, they come to better decisions. The British government and Bank of England are not acting out of fear just now.

Maybe that means that bankers need to give them a reminder of what fear feels like?

I might relate events at Heathrow today to the fear agenda - or even events in the market today. It is because there are still events being orchestrated in the background that I reserve judgement.

PeterJB said...

@ LB

Thanks but you fail to mention that the joint warrant initiating appears to have been initiated by Iceland and not the UK.

Now, then we have:

It isn't the British government covering up for bankers would it?

Don't concern yourself, for the Australian government just gave the nation to the US Military for total regional occupation so that China may be confronted and to bring stability to the region????

Yes, Australia lost the War and not a shot was fired. You can verify this by following M's Gillard's current Partying in the US with Madam Clinton.

There is a massive movement going on between "us and them" where "us" are the elite minority and the "them" is the rest of us.

Bankers like everybody else, as individuals need to choose sides,

Ho hum

PeterJB said...

@ LB

An interesting outlook:
The Global Economic Crisis: Central Banking at the Centre of Power
Excerpt from, "The Global Economic Crisis: The Great Depression of the XXI Century"

by Andrew Gavin Marshall

My position is that the Banking system that we are using globally - and blindly - is fatally flawed in terms of fractional reserve banking - the usury system and - the debt system.

All in all it compounds the Power of the banker / ruler and corrupts these people absolutely.

Mind you so to be clear, what I am saying is that there are few men, if any, that can resist the corruptions of the system that we have in place and when I say few, I really mean around x3

At the time that this corruption arises at the top level of "leadership" the power's power goes with the money (naturally), that is to say the Bankers. The corruption then spreads - top down, again naturally, until it reaches saturation where, the whole system destructs. I acknowledge the frailty of men; I really do, but I also see the necessity for a priori Law.

Added to this, there is no shortage of books expounding the destructive powers of corruption and human weakness. So why is it, that we do not acknowledge such things - and just go ahead and dump on the whole of societies and allow the poor to pay?

Hayek, Mises, Adams, Bastiat et al have expounded this issues - are there no economists, bureaucrats, bankers or financiers that can read?

If a banker has 1 Billion dollars, pounds or RMB - how is he to spend it - how to enjoy it - how to protect it? It is mindless.

Ho hum

PeterJB said...

@ LB

Further your context article - Here is some more flesh about the 'No Risk' industry of Banks Inc.

"Research by the Guardian shows that clients of the Icelandic bank have handed more than £900,000 to the Conservative party in recent years. Those who donate more than £50,000 in a single year can join the "Leader's Club" and get access to dinners, lunches and other meetings with the Tory party leader. In relation to those caught up in the SFO inquiry, the Conservative party admitted last night that it might need to reconsider some of the donations. "There is a due process to be followed and once it is completed we will, if necessary, review the donations," a spokesman said."

Strikes me that "... it might need to reconsider some... " and
"We'll have to see what else comes out." has been plagiarized from the same script?

It seems that my written posit as to the , a priori, corrupt sycophantic relationship between banker and ruler is not far off the mark but I wonder what makes this "A Team" such cannibalistic predators?

Any ideas?

PS Its no wonder that I can't get a loan!

PeterJB said...


Could be THE career decision of a life time for you to look for another job in another industry and quick!

FYI You can take it from me that an asymmetric system cannot be defeated by an institutional system and that goes for warfare, corporate manipulations, imposition, governance, critique, etc.

Anarchy is the preferred type of government where the intellect is not only lifted, but so integrity and sentience.

Anarchy, or asymmetric governance and true democracy, brings freedom and protection from those elite groups that feed on the human trusting and gullible which the pretend to represent.

Anarchy reduces fear and ignorance, sophistry and hypocritical arrogance and instills responsibility and compassion as well as many other things. A great start for the 21st. Century.

What we are experiencing is a major trend to delouse or restructure the global socio-economic orders with reason and concordance. I see it as a very strong and a good thing, and well overdue.


alex said...

"Idea of functionally segregating the pedestrian but systemically important functions like payments and mortgage intermediation from the riskier eccentricities of modern of investment banking. " Sounds a good idea.

Property Investments