A note on the impact of regulatory and accounting influences on the ability to
invest effectively for the long-term
Accounting and prudential regulation within the financial sector have in recent years moved
away from judgment-based matching of future returns on assets, including of dividend flows
from equity investment, to the pattern of expected liabilities. The focus is now firmly on
market or ‘fair’ values of liabilities and the risks arising from changes in the values of these
liabilities and of the assets held to match them. This has accentuated trends towards
greater holdings of fixed interest investments designed to match the duration of projected
liabilities.
Recent developments in regulation, and notably the development of the EU’s Solvency II
regime for insurers, have intensified the focus on short-term movements in market prices.
There is a complicated interplay of different technical elements and the rules remain under
discussion but essentially the problems are in two areas:
Level of capital to be held by insurers
Specifically the intention under Solvency II is to achieve 99.5% confidence that, over a 12
month period, the value of assets will exceed the value of liabilities (a.k.a. technical
provisions). Where liabilities will crystallise only after many years, it is sensible, other things
being equal, to invest in assets of similar duration. However, over a one year period there
could be volatility in asset prices, even though it could reasonably be expected that these
price changes will later reverse. This would create artificial volatility for regulatory solvency
purposes and an increase in required capital, a consequent bias against long-term
investment, and an increase in the cost of provision of the long-term savings products.
Efforts are currently underway to reduce this adverse impact on long-dated insurance
business through application of a ‘matching adjustment’ where credit will be given for having
fixed interest type assets with cash flows that replicate the projected liability cash-flows but it
is by no means yet certain that these efforts will be successful.
Discount rate used to discount the value of projected liabilities
Other adjustments are also needed to the regulatory discount rate to reflect the ability of
insurers to invest in assets that provide effective matches over the full life of liabilities, viz. a
‘countercyclical premium’ and an extrapolation of the yield curve. These would be designed
to include the risk that liabilities are not discounted at an unduly low rate but more accurately
reflect the rates of the return that may expected to be earned on long-term assets. However,
the design of these has also not yet been finally resolved.
In the absence of an appropriately designed long-term package, life insurance products will
cease to make economic sense for insurers and customers. In the UK, it has been estimated
that the benefit to policyholders could decrease by circa 20%.
The expectation that, over the long-term, equity returns will exceed debt returns remains an
embedded expectation within a functioning capitalist system even if (as has been the case in
recent years) equities may show considerable periods of underperformance. A focus on
returns and volatility on a 12 month view is clearly unhelpful to any assessment of equity
investment.
Other financial sectors
The appetite of pension funds and banks to invest over the long-term is similarly impaired.
The establishment of the Pensions Regulator (tPR) with substantial powers to require
pension schemes to make good funding deficits, and of the Pension Protection Fund which
has been seeking to apply levies that are calibrated to investment risk viewed through the
same type of regulatory lens have had a major impact on the pension schemes’ investment
strategies and have led, in many cases, to a requirement to make high contributions to
reduce deficits, calculated on a snapshot pro-cyclical basis. This added to existing
pressures resulting from accounting changes (first under the UK ASB’s FRS17 and then
under the equivalent standards under IFRS).
In the case of banks, under the Basel system of regulation the risk weighting of long-term
lending activity has increased and this has made them less prepared to commit to lend over
terms that reflect the underlying need of businesses to fund the purchase of plant,
equipment and other assets. These changes may be appropriate for prudential reasons but
they have not been evidently effective; indeed the business model of a bank is predicated on
the ability to undertake maturity transformation (i.e. to lend ‘long’ when deposit-taking and
funding activities remain much shorter). It has clearly contributed to a material reduction in
lending capacity over the long-term.