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Non Bank Financial Institutions: Measuring risks to financial stability

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Samer Saab

on 13 January 2014

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Transcript of Non Bank Financial Institutions: Measuring risks to financial stability

Insurance undertakings and pension funds play similar roles in financial intermediation, acting as large institutional investors and purchasers of fixed income securities.
International Association of Insurance Supervisors (IAIS)" there is little evidence of traditional insurance either generating or amplifying systemic risk within the financial system or the real economy".
However, the nature of the role in financial intermediation has changed over time. Over the years activities with potentially increasing systemic features have emerged.
Risk management and monitoring tools
Global and regional context and trends
Image by Tom Mooring
Contributors to financial (in)stability? Evolving lines of business for NBFIs
Non-Bank Financial Institutions: Measuring risks to financial stability
Analytical framework to assessing risk to financial stability of NBFIs
The EC framework for analysing risks to financial stability of NBFIs is intended to categorise a wide range of underlying and proximate causes and set out how these relate to a common set of risks to financial stability and impacts on the financial system.
Underlying causes relate to the characteristics of individual non-bank financial sectors or connections between a non-bank financial sector and banks/other non-bank financial sectors that bring about the build up of risks to financial instability.
Proximate causes relate to factors that trigger the materialisation of these risks.
Risk Assessment
Arguably, the main effects on financial stability of this sub-sector of NBFIs relate to its size. That is, as a consequence of asset devaluations, insurance undertakings and pension funds have curtailed their purchasing activities on securities markets, which exacerbated already difficult conditions in these markets.
In the context of the crisis, the main focus on insurance undertakings and pension funds has been their entry into non-traditional business lines. In the case of insurance undertakings the notable case is AIG writing CDS contracts and, in the case of pension funds, their participation in securities lending markets.
Relatively weak macro outlook and near historical lows for interest rates: frantic search for return via riskier investments. In the pension sector, the shift from defined benefit schemes towards defined contribution or hybrid schemes continues.
Increase in relative size and interconnectedness of NBFI sector over the last decade: a notable increase in
to affect financial stability
In Caribbean, insurance companies have recorded lower premiums and experienced a reduction in investment income in recent years, reflecting weaker demand for insurance and the difficulties experienced by policy holders in making payments under low economic growth. In particular, the insurance sector was affected by the collapse of the CL Financial Group.
Concluding thought:
Don't get caught off guard!
Yellen Says Fed to Tailor Oversight of Non-Bank Financial Firms
Federal Reserve Vice Chairman Janet Yellen said the central bank should tailor regulations for non-bank financial companies such as insurers that may fall under Fed oversight, because their businesses are different than banks.
Apr 2013 IMF GFSR
"U.S. public pension funds and life-insurance companies are building up potentially dangerous levels of risky investments that could threaten their solvency. It is a gamble that could harm not only on pensioners and insurance customers, but also on the financial system."

Returns from traditional investments and contributions have dwindled during the recession. And as the Federal Reserve lowered interest rates to try to revive growth, some pension funds and insurance companies have been unable to match their funding levels with future liabilities. That funding shortfall has encouraged pension funds and insurance companies to bet on higher risk, and potentially higher-return, investments to meet those needs. At the weakest pension funds, money managers have boosted their holdings of alternative (riskier) investments such as hedge funds and financial derivatives.

“An undesired buildup of excesses in broader asset markets is a potential risk over the medium term.
Asset reallocations of institutional investors to alternative asset managers
, excess cash holdings by those asset managers, the decline in underwriting standards, and the sharp rise in bond valuations are all intertwined.
Constraining those potential excesses is a financial stability imperative.

Financial Stability Oversight Council Makes First Nonbank Financial Company Designations
The Financial Stability Oversight Council (Council) has voted to designate three nonbank financial companies to address potential threats to financial stability. This is the Council’s first use of its authority under the Dodd-Frank Act.
"The Council has taken a decisive step to address threats to U.S. financial stability and create a safer and more resilient financial system,” said Treasury Secretary Jacob J. Lew, Chairperson of the Council.
The three NBFIs are
Prudential Financial Inc., American International Group Inc. and General Electric Co.’s finance unit
, the largest U.S. life insurer, is under consideration for the label.
Three noteworthy recent news items...
A growing awareness about potential risk from NBFIs to financial stability, and a need for tailored policy response
Going forward
Banking sector at the center of financial crisis, but NBFIs played important role in risk buildup and transmission
First, some NBFIs produce product risk through securitisation
Second, some NBFIs are highly interconnected with banks and other NBFIs: distress transmittal
Third, some NBFIs are very large: leads to uncertainty and lack of trust, which leads to counterparty risk
Fourth, strict investment rules could lead to automatic fire sales of assets in times of distress, further depressing prices and loss of assets value
NBFIs vs. Banks
Both are financial intermediaries
Main role of banks is to intermediate financial funds
Main role of insurance is to spread financial loss

Within NBFIs, we'll focus on Insurance Companies and Pension Funds
NOVEMBER 25-26, 2013

Samer Y. Saab - Consultant
Looking forward, regulatory requirements are a key source of risk to financial stability insofar as they may force institutions into correlated responses to events, which may exacerbate stressed market conditions (or, generate feedback loops).
Absence of widely accepted model for measuring systemic risk: use of multiple indicators, some borrowed from banking sector.
Types of risk:
the risk factors in the insurance/pension industry can be divided into three groups:
underwriting risk, investment risk and nontechnical risk.
Main tools used:
Indicators of financial distress based on balance sheet variables
Early warning indicators
Macro/Micro stress tests
Methods for calculating the systemic importance of individual institutions
Analyses of interconnectedness.
Review of the literature shows that the work on such indicators is still very much work in progress with no conclusive and
robust findings as to the best approach.
Insurance stress tests
Pensions stress tests

Financial Interconnectedness and Financial Sector Reforms in the Caribbean,
Ogawa et. al, IMF Working paper WP/13/175

Non-bank financial institutions: Assessment of their impact on the stability of the financial system
, Economic Papers 472 | November 2012, European Commission

Insurance and Financial Stability
, International Association of Insurance Supervisors, November 2011
What we monitor could very well be just the tip of the iceberg...
Lurking hazards
Data Gaps
 Early warning indicators
: There is a lack of information on the basic relationships between non-bank financial intermediary sector and financial stability.
 Macro stress tests:
Without an understanding of basic relationships between NBFIs and financial stability, more in depth empirical studies using macro stress tests, for instance, cannot be undertaken effectively.
 Calculating the systemic importance of individual institutions:
The approaches for calculating the systemic importance of individual institutions relate to banks for which there is market data available. Analogous market data is not available for many NBFIs and therefore alternative measures for calculating the systemic importance of individual NBFIs is required.
Monitor these indicators!
The key risk contributing factors that should be regularly monitored as part of a broader risk monitoring system include at the level of the various NBFI segments and individual NBFI:
An indicator of the appetite for risk-taking
(e.g. growth in balance sheet size)
An indicator of leverage
(balance sheet info, debt/equity)
An indicator of liquidity risk
(ST debt/Assets)
An indicator of maturity mismatch
(interest rate movements sensitivity)
Risk-based or rules based? one size fits all? consolidated supervision?

Looking forward, regulatory requirements are a key source of risk to financial stability insofar as they may force institutions into correlated responses to events, which may exacerbate stressed market conditions (or, generate feedback loops).
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