Speech by Peter Praet, Member of the Executive Board of the ECB,
at the 2011 European Pension Funds Congress during the 14th Euro Finance Week,
Frankfurt am Main, 15 November 2011
Ladies and Gentlemen,
It is a pleasure to speak here at the European Pension Funds Congress in Frankfurt, which forms an important part of the 14th Euro Finance Week.
Earlier this year I was asked to chair a global Working Group with participating central banks from North America, Europe and Asia for the so-called Committee on the Global Financial System, CGFS, which works under the Bank for International Settlement. Our aim was to assess how the regulatory initiatives together with the low-yield environment have affected the fixed income strategies of institutional investors, such as pension funds and insurance companies, and to draw implications for the financial system. In doing so, we relied on bilateral interviews and regional roundtables, involving 70 private sector institutions. Even after discounting industry complaints, there are grounds for expecting certain adjustments to the assets, liabilities and derivatives books run by insurance companies and pension funds.
I would like to share the main findings of the CGFS work with you and express some of my views on the topic.
Our exercise is published in the form of a CGFS Report, which can be found at the web-site of the Bank of International Settlements. 
I will first provide some background on the role of insurance companies and pension funds, then elaborate on the main changes concerning international accounting standards and the regulatory front, before presenting some views on potential financial system implications.
1. Background on the role of insurance companies and pension funds
Insurance companies and pension funds (ICPFs) indeed currently find themselves at the intersection of major developments. Having weathered the financial crisis on the whole comparatively well, they are now exposed to problems confronting some euro area sovereigns and banks, the low-interest rate environment, and they face upcoming changes in international regulation and accounting standards.
With combined assets of some $40 trillion, insurance companies and pension funds constitute a large segment of the institutional investor space and they are therefore important for financial system stability. In particular, they play a major role in fixed income markets, also as providers of long-term funding to banks and the public sector.
If we look at the situation within the euro area, the role of insurers and pension funds has been increasingly important as the size of the euro area sectors has grown rapidly over the last decade. It should however be noted that the prominence and asset allocation strategies of these institutional investors is very different in different euro area countries.
The investments of insurers and pension funds have created strong and important interlinkages with sovereigns as well as banks and other financial institutions.
Insurers and pension funds, with €1.1 trillion invested, hold almost 20% of the debt securities issued by euro area governments, which make them an important provider of governments’ funding.
Euro area ICPFs are also providing funding to other sectors. After governments, the euro area ICPF sector has the second biggest debt securities exposure to euro area monetary financial institutions (MFIs), a sector that consists, in particular, of credit institutions. Euro area insurance corporations and pension funds hold about €600 billion of debt securities issued by euro area MFIs, which represents around 12% of the total MFI debt securities.
Most of the time, given the typically long-term investment horizons of insurers and pension funds, they are a source of stability in financial markets. In current discussions in different fora about systemically important financial institutions, I believe that it is therefore important to distinguish between “systemically important” and “systemically risky” financial institutions. A financial institution can in my view be important for the financial system even if it does not pose direct threats to it. I believe most insurers and pension funds fall into this category. They are unlikely to trigger financial instability but it is crucial that they maintain their important role in financial markets, an in particular as a source of long term funding in fixed income markets.
2. Changes in international accounting standards and in regulatory front
It is important to know that current regulatory standards and requirements differ between EU countries. Also, the timetable for the implementation of future regulatory changes remains in a state of flux.
It is therefore legitimate to ask whether we can draw any conclusions from such a mixed pie. Indeed, our first direct finding was that the uncertainty about the scope, timing and extent of accounting and regulatory changes increases uncertainty which makes it more difficult for insurance companies and pension funds to plan their investment strategies over the long-term. So let me briefly recall the main upcoming accounting and regulatory changes relevant for these investors.
I start with the changes in international accounting standards. They should be implemented from 2013 or 2014 onward, though much remains to be decided. Alongside the gains in transparency and comparability, one can expect them to produce greater volatility in financial statements:
– For pension commitments: modifications to IAS 19 (concerning the measurement and recognition of “employee benefits”) by 2013 will create more valuation changes in defined benefit (DB) pension plans which will be reflected in their funding status and the profit and loss statement of the sponsoring company. This is mainly attributable to the fact that the revised IAS 19 – among other things – eliminates the existing option to defer the recognition of gains and losses, known as the ‘corridor method’.
– For insurance contracts: IFRS 4 Phase 2 proposes a single accounting model for insurance contracts by 2014 and requires that liability valuation changes are recognised in the P&L. This would also lead to greater accounting volatility, for the following reasons:
- Going forward all life insurance liabilities and non-life (property and casualty) claims liabilities would have to be discounted either via a bottom up approach (risk free + liquidity premium…) or a top down approach (starting from assets return). The discount rate would have to be adjusted regularly, namely at the end of each reporting period. In the IASB’s tentative approach, the effect of changes in the discount rate must to be posted in P&L at each reporting date. As a result, the volatility in interest rates – as currently experienced with sovereign risk rates – will impact the annual results without consideration for the fact that the discounted insurance liability may span over very long term.
- On the other side, in response to mounting volatility of their liabilities, insurers may be tempted to – contrary to their current treatment – measure larger portions of their investments in fixed-income securities at fair value, reflecting all fair value changes in profit or loss (“net income”). With this new approach to classification and measurement of their investment portfolios, insurers would aim to reduce the “mismatch” between the valuation of assets and insurance liabilities (which is often referred to as “accounting mismatch”).  Reducing any existing “accounting mismatch”, however beneficial this may be, would on the other hand not alleviate another serious concern of insurers, namely the “maturity mismatch”. As a general rule, insurance contracts tend to have a longer maturity than insurers’ investments.
Such accounting measurement volatility will have an impact on the position of own funds and likely also on the ease with which insurers can secure capital through financial markets
In both cases, there may be increased pressure from markets or sponsoring companies to de-risk asset holdings to limit volatility in financial statements.
On the international regulatory front, the main development is the introduction of Solvency II in Europe for insurance companies, requiring that:
- assets should be marked to market, and liabilities be discounted at risk-free rates, possibly augmented by a liquidity premium, or a counter cyclical premium in case of stressed financial market situations
- insurers must hold loss-absorbing capital against the full range of risks on both their asset and liability side to withstand unexpected losses with a probability of 99.5% over a one-year horizon.
The fifth Quantitative Impact Study QIS5 by the European Insurance and Occupational Pensions Authority (EIOPA) on the impact of Solvency II shows that most insurers face no imminent need to raise new equity. But they may rebalance their asset portfolios in line with the new risk charges, as they tend to make it more expensive to hold equity, structured products, and long-term or low-rated corporate bonds, whereas government bonds and covered bonds get more favourable capital treatment. Sovereign exposures are exempted from capital charges under the latest Solvency II proposals.
It is important to prevent risks of heightened pro-cyclicality arising from these planned regulatory changes.
As Solvency II requires both assets and liabilities to be marked-to-market, one key question concerns the discount rate curve to be used for valuation. As already mentioned, IFRS 4 Phase 2 requires that future cash commitments be discounted using risk-free rate adjusted for a liquidity premium or a yield curve that reflects current asset returns. This contrasts with the experience during the crisis, when the liability cash flows often continued to be discounted at the risk-free rate. The application of a liquidity premium on the liability side could in principle reduce the valuation mismatch and thereby avoid situations where insurers are unduly forced to dispose of illiquid assets. Such a counter-cyclical mechanism might even mean that insurers would be willing to take on additional illiquid assets in a period of market distress. However, there are also some conceptual issues associated with this idea, mainly because insurance liabilities are different in nature from insurance assets and often do not have an accessible market. Nevertheless, it is important to find a method defining a discount rate that would be consistent from a financial stability perspective.
Overall, accounting and regulatory changes bring important benefits in terms of financial soundness and disclosure. But they could also cause portfolio shifts affecting financial markets. For instance, firms may want to divest equity and shorten the duration of their corporate bond holdings. But to limit the resulting duration gap, they may have to use more long-term swaps or buy more long-term low-risk bonds, as defined by regulation. This would tend to flatten the risk-free term structure, but steepens the term structure for lower-rated credit.
However, the financial market implications from asset allocation perspective may be transitory rather than permanent: other investors come in, and the phase-in period of Solvency II is very long and gradual. It remains to be seen to what extend the risk weight of the internal models will significantly differ from the standard regulatory risk weight.
3. Financial system implications:
Let me now move to my final part and elaborate on the potential main financial system implications:
First, insurers and pension funds are likely to continue to move away from products offering a guaranteed return or defined benefits. This trend is being reinforced by the low-interest rate environment and the consequences of the financial crisis. As was the case in Japan in the 1990s, low interest rates make it difficult for these institutions to meet future obligations out of meagre fixed income yields. Moreover, a negative duration gap means that falling interest rates raise the value of liabilities more than that of assets. This risk-shifting to households could eventually lead to greater sensitivity of household spending to changes in asset prices and interest rates, and more conservative asset allocation in aggregate (if households seek to reduce their direct risk exposure). This, in turn, may result in inefficient risk sharing.
Experience in the US has shown that when fully exposed to market risk, individuals may on average opt for pension plans or insurance policies with lower risk allocations. Such products may however not offer sufficient return to ensure adequate retirement income without additional saving.
Second, firms may engage in more risk transfer, not just on liabilities (securitisation, reinsurance) but also on assets and duration gaps, leading to greater use of derivatives such as interest rate swaps. Our interviews confirmed that insurance companies and sponsors of pension plans have already been placing more emphasis on ALM practices in recent years. This will involve still greater use of fixed income assets and long-maturity interest rate swaps to match more closely their liabilities’ cash flows. Such a trend is relevant also for the current regulatory developments concerning the clearing of derivative contracts with a central counterparty.
Third, portfolio shifts may alter sectoral funding patterns. Up to recently, many observers expected a shift from corporate bonds to government bonds due to differential capital charges, LDI strategies, and the need to limit duration gaps. However, current unease about sovereign risk could mitigate this trend. Within corporates, the industry has been clearly reducing exposure to financial institutions, except for covered bonds.
The fourth issue concerns the role of insurers and pension funds as global providers of long-term risk capital. These institutions found it difficult to play this role during the crisis, due to extreme market pressure and volatility. But steeper risk charges will also make it costlier to hold long-term risky/illiquid assets in the future. Moreover, the investment horizon is being reduced by the one-year-horizon of Solvency II, shorter grace periods for pension funds to address funding shortfalls, and heightened accounting volatility. This limits the scope for taking long-term or illiquid positions without too much concern for short-term fluctuations in their value.
These factors tend to encourage a shift away from long-term investing in risky assets. A partial retreat of institutional investors from the long-term and/or illiquid segment of the credit market could reduce private and social benefits of long-term investing, and reduce the extent to which the industry mitigates the procyclicality of the financial system. These possible evolutions will have to be closely monitored.
Thank you for your attention.
I would like to thank Jürgen Kirchoff, Torsti Silvonen and Stefan Wredenborg for their contributions to the preparation of this keynote speech as well as Michel Colinet and Kajal Vandenput for their helpful comments and all members of the CGFS working group on Fixed income strategies of insurance companies and pension funds for the preparation of its report.
There is another potential problem for insurers’ investment strategies related to the new IFRS 9 Financial Instruments. In contrast to the existing IAS 39, going forward insurers may no longer be allowed to recognise realised gains or losses (e.g. gains on sale) on their longer-term equity investments (e.g. in banks) in profit or loss (net income), but only in a separate reserve within equity (“other comprehensive income”).
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Can Thematic Investing provide investors with growth opportunities in uncertain times?
New whitepaper from CAMRADATA explores
CAMRADATA’s latest whitepaper on Thematic Investing, considers the role this type of investing can play in asset management and explores trends that can permeate society and traverse sectors. The whitepaper includes insights from guests who attended a virtual roundtable on Thematic Investing hosted by CAMRADATA in November, including representatives from CPR Asset Management, Sarasin & Partners, Impact Investing Institute, PwC, Quilter Cheviot, Scottish Widows and Stonehage Fleming.
Sean Thompson, Managing Director, CAMRADATA said, “In these seminal times, thematic investing has the potential to shape how the future unfolds. Yet running a successful thematic fund is no easy feat – it is a bit like navigating unchartered waters trying to identify the trends and the long-term opportunities.
“Trends such as AI and biotechnology are still in their relative early days, for example, and global economies are undergoing dramatic changes. But mapping out certain trends, identifying potential sustainable returns through a unifying thread that spans multiple sectors, could help future-proof investments. “Our roundtable guests considered current key themes, which themes worked well, and which have not and how thematic investors could identify trends with the potential to offer future growth.”
The guests named themes they currently like which included artificial intelligence, China, climate change, clean energy, automation, evolving consumption, ageing, digitalisation, water, waste management, biodiversity, and board diversity.
After discussing themes that have worked or not, the guests looked at total allocation to themed funds, and whether clients might be blinded by themes to the overall risk exposure in their portfolios.
Key takeaway points were:
- Themes have a habit of coming and going. One guest recognised that automation and robotics, for example, were cyclical, which means that investors will have to think carefully about entry-points.
- It was agreed that the commodities ‘super cycle’ of the 2000s came about with the economic development of China. Many commodities-based products found their way into mainstream investing, but this is unlikely to happen again.
- One guest was surprised by some of the themes that interested their customers; with their research showing that Board Diversity was almost the lowest-ranking concern among the ESG choices they listed.
- There was correlation between environmental impact and social benefits to investing. The theme that concerns the Impact Investing Institute, which is less than two years old, is improved measurement of such relationships.
- In terms of successful themes, one clear winner due to COVID had been digitalisation.
- One theme that has not done so well is the Ageing theme focused on older people travelling and enjoying experiences abroad later in life.
- One guest said their firm used themes for ideas generation, not as a shortcut for portfolio construction. They said themes lead to good ideas, but they then spend at least three months researching a stock, so that the best themes are represented by the best investments.
- The final point was that there are sensitivities for any global investor in allocating to themes, even the biggest one of all, Climate Change.
- But on a positive note, one guest added if all stakeholders can resolve their differences on definitions such as impact and ethical investing, then more capital will be readily transferred into opportunities.
The whitepaper also features two articles from the sponsors offering valuable additional insight. These are:
- CPR Asset Management: ‘Central Banks: leading the path towards Impact Investing’
- Sarasin & Partners: ‘Theme or fad? How to invest for the long term’
To download the Thematic Investing whitepaper, click here
For more information on CAMRADATA visit www.camradata.com
Promises, Promises: Navigating the Reputational Risks of ESG Investment Pledges
By Nir Kossovsky and Denise Williamee, Steel City Re
As the trend towards ESG investment and a low-carbon economy continues, banks are being backed into a reputational corner. Law firms specializing in representing the expanding pool of litigious shareholders are salivating.
On one hand, banks understand the inherent financial risks and challenges involved with making a wholesale move towards a low-carbon economy. The transition to a greener corporate world can’t happen overnight; as long as “brown” assets continue to be profitable, those in bank leadership positions have to balance their green aspirations with their responsibility to shareholders.
On the other hand, while not renewing loans on existing coal mines or fracking sites may improve a bank’s carbon disclosures, it could have social and financial ramifications that disappoint other stakeholders—i.e., causing people to lose their jobs. Still, financial institutions are experiencing pressure from all sides—from ESG investors to social license holders – to divest the fossil fuel industry and adopt drastic “green financing” practices now.
To alleviate these pressures, banks are pledging greener financing initiatives. Almost every large global bank has made some sort of commitment. Goldman Sachs, for example, announced they would spend $750 billion on sustainable finance over the next decade. Bank of America pledged $300 billion.
Bank boards and executives likely don’t fully appreciate the reputational risks posed by the aspirational statements they’re making. They are making promises and raising expectations without the operational or governance systems in place to ensure those expectations will actually be met. Overpromising and increasing the risk of angering and disappointing stakeholders is the very definition of reputational risk.
Banks are in a unique position: integral to every aspect of our economy, well-known brands that work hard to build and retain the trust of their customers and the general public while operating in an environment of intense scrutiny by politicians and regulators at every level of government. Satisfying all the stakeholders calling for greener policies while fulfilling their responsibility to their shareholders is a demanding balancing act fraught with risk. The Business Roundtable pledge, led by JP Morgan Chase CEO Jamie Dimon, and elevating employees, communities, and the environment as stakeholders, was an attempt to strike that balance. Already, though, that pledge is being dismissed by politicians like Senator Elizabeth Warren, who characterized it as an “empty publicity stunt.”
The price of missing expectations is costly, and bank executives and board members could find themselves in a legal hot seat. Federal securities lawsuit filings alleging reputation harm from missed expectations are up 60% over last year, the third year of a rising trend.
This trend stems from SEC regulation S-K that calls for more human capital disclosures, and the Caremark decision that sets the bar for most securities litigation and makes board oversight of mission-critical corporate operations a test of the duty of loyalty. Other cases, like In Re Signet, have made ESG-like pronouncements—historically “immaterial corporate puffery”—now potentially material in the securities arena.
For example, directors’ duty of loyalty were successfully questioned in alleged failures of innovation (In Re Clovis Oncology, Inc., board failure to protect the firm’s reputation for pharmacologic innovation); safety (Marchand v. Blue Bell Creameries, board failure to protect the company’s reputation for food safety); and environmental sustainability (Inter-Marketing Group USA, Inc. v. Armstrong, board failure to protect the firm’s reputation for oil pipeline-related environmental protection).
In other words, aspirational pledges are now being considered by courts with the full weight of a material public disclosure. As wealth managers chase ESG-informed investing and capital markets chase ‘green underwriting’, the plaintiff’s bar chases boards and executives making pledges that appear to be no more than aspirational marketing.
The only way to strike a balance and mitigate these risks is through a robust Enterprise Risk Management (ERM) strategy that’s centered around understanding who your key stakeholders are, what their interests are, and ultimately, what their expectations are. Coincidentally, it is also one of the three key behaviors the world’s largest asset management firm, Blackrock, is demanding of all investee companies in 2021 thus communicating the type of authenticity to its slogan “beyond investing,” that BP failed to accomplish with similar sloganeering a decade ago.
Banks need to create a central intelligence unit with board level oversight to comb through every aspect of the organization to identify stakeholder interests, potential risks and/or exposures. Pledges and communications should be informed by a rigorous and honest self-assessment of the institution’s public filings and operational capacity. Overpromising is costly. ESG pledges must be rooted in achievable goals that a bank’s leadership are confident their institutions can reasonably execute on an operational level. Banks also need to consider transferring or financing risks using the broad range of conventional and parametric insurance products currently available.
Enterprise risk management, when executed properly, will fulfill ESG commitments, reassure stakeholder groups and give marketers, counsel, and investment as well as government relations professionals an authentic story to tell about strong corporate governance. ERM focused on reputational intelligence will provide confidence to ESG funds, institutional investors, bond raters, and government officials alike.
The popularity of ESG investment and chasing ESG ratings is not going to go away, and stakeholder pressures will continue to mount. Investors doubled the size of the ESG sector this year, putting $27.4 billion into ETFs traded in U.S. markets. According to a recent survey conducted by Bank of America relating to ‘Gen Z’—which is just entering the workforce—80% take ESG into account when making their investment decisions.
Bank leadership that is striving to attain the correct balance between stakeholders and shareholders need to lean more into the “governance” portion of the ESG equation; pledges backed by enterprise risk management are the strongest pledges you can make.
ESG – Bubble or Bandwagon?
By Josh Gregory, Founder of Sugi
Isaac Newton was a successful investor, but he lost a fortune (£15m in today’s money) in the South Sea Bubble of 1720. When asked about his misadventure, he supposedly replied that he ‘could calculate the motions of the heavenly stars, but not the madness of people’ (presumably, himself included).
The rise and fall of South Sea stock was one of the earliest and largest instances of a market bubble and crash. Three hundred years later, we’re facing another massive investing trend: sustainable investing. In the last year or so, almost every investment institution has jumped on the sustainability bandwagon.
It’s now arguably more notable to find an asset manager who hasn’t committed to sustainable, ethical, responsible, impact and/or ESG (environmental, social and governance) investing than one who has. The numbers are telling: in August 2020, assets in global ESG exchange traded funds and products topped $100 billion (£73 billion) globally.
Demand for sustainable investments has been bolstered by two main factors. Firstly, with climate change firmly on the global agenda and all eyes watching the Biden administration’s transition to power (and the subsequent climate change policy that will follow), ‘greening up’ has never been more of a priority for businesses and individuals. This includes the investment industry, with both retail and institutional investors increasingly demanding that their money has a positive impact on our planet.
Secondly, since the start of the COVID-19 pandemic reports have continually claimed that ESG funds are outperforming ‘traditional’ investments. No longer is going green cited as a ‘nice to have’; rather, these reports demonstrate the value and resilience of ESG funds to the investor community, increasing demand. Surely, this can only be a good thing? Yes, but only if investors know what they’re buying.
It’s no secret that ESG investing suffers from complexity, lack of transparency and a lack of any universal standard. Fundamentally, this is why we created Sugi – a new platform enabling retail investors to track the environmental impact of their investment portfolios using clear and objective carbon impact data.
Today, ESG terms can lawfully be used to label pretty much anything. Ultimately, this means that the ESG label is not a guarantee of good practice. In fact, an ESG rating is a financial risk metric – the scores calculate the extent to which ESG issues affect a company’s economic value. Many investors, even institutional investors, don’t know how to decipher this. The scores themselves are designed to be used in tandem with portfolio dashboards and other data to make financial decisions. This effectively means that the scores on their own without any context are not of much use to anyone.
This has led to a glut of greenwashing in the sector, where investment products are described as green, ethical or sustainable, but the description is unsubstantiated. And while the top financial performance of ESG funds seems uncontroversial, those digging a little deeper may be surprised at what they find. Many ESG funds are heavily weighted in favour of technology companies, which typically have low carbon emissions. These stocks skyrocketed in 2020 but it’s important to note the context. It was largely due to the COVID-19 lockdowns and had nothing to do with the stocks’ ESG credentials.
The EU, the UK and the US are all working on their own strict definitions of ESG. This should, in theory, go some way to clarify what investors are getting when they choose an ESG or sustainable investment product. However, this will take a while to implement and there will still not be a globally recognised definition or standard.
It would seem many people are pouring money into investments when they don’t know what they’re buying. That’s nothing new. But underneath the ESG label lies something meaningful, worthwhile and, above all, valuable for the world in which we live – environmental, social and governance best practice.
The question remains though, is it a bubble? A bubble exists if ESG investments are over-valued (i.e. over-bought). Right now, ESG funds may be in bubble territory because many of the underlying stocks that make up the funds are themselves in a bubble. But does that make ESG a bubble? If it is, when do we call it?
Historically, all bubbles –whether they be tulips, canals, railways or the internet – no-one knows. And if I knew now, I’d be sunning in the South Seas rather than writing this blog!
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