IMF paper highlights regulation’s unintended consequences

An International Monetary Fund (IMF) working paper first published in August last year is circulating among asset managers beginning to despair at the waves of legislation building up across the European industry.

The paper notes that efforts to strengthen the quality of capital for banks and insurers through Basel III and Solvency II are well advanced. On the one hand, the Basel Committee on Banking Supervision (BCBS), the organization responsible for developing international standards for banking supervision, adopted the Basel II framework in 2004 and, in response to the financial crisis, has taken steps to strengthen it in an incremental fashion to form whatis now known the Basel III framework (BCBS 2009, 2011a, 2011b, and 2011c).

On the other hand, the European Commission (EC) is leading the Solvency II project, in close cooperation with the European Insurance and Occupational Pensions Authority (EIOPA), to develop harmonized standards for insurance supervision within the European Union. A directive was adopted in 2009, and work – which included a series of quantitative impact studies – has been underway to develop supporting rules.

But the regional scope of application of the two accords varies. Basel is an “accord” or agreement with no legal force but potentially global applicability, whereas Solvency II is a legal instrument that will be binding in 30 European Economic Area (EEA) Countries(27 European Union states plus Iceland, Liechtenstein, and Norway).

However, Solvency II has also implications beyond Europe through, for example, its influence on the international standards being developed by the International Association of Insurance Supervisors, and because external insurance groups will be more easily able to operate in the EU if their home supervisory regimes are considered equivalent.

Although these standards have much in common, differences do exist. Both take a risk-based approach to minimum capital requirements and supervision and promote the integrated use of models by institutions in managing risks and assessing solvency.

However, their objectives overlap only partially. In particular, Basel III attempts to increase the overall quantum of capital and its quality as a means of protecting against bank failures, including improved quantification of risks that were poorly catered for under Basel II.

Solvency II attempts to strengthen the quality of capital and tailor the quantity of capital required more closely to the risks of each insurer, without necessarily increasing the quantity within the sector as a whole.

Finally, the two accords have been tailored to the business characteristics of the respective sectors, often as a result of bilateral negotiations, and shaped by the views of those involved in their development in a piecemeal manner. Accordingly, they have generated long and complex documents which define the same concepts in different ways and often deal differently with the same or similar issues.

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