POSITION PAPER
FOR STAKEHOLDERS AND INSTITUTIONS

The financial crisis is far from over, even if the worst is most likely behind us. Two key factors have been identified as root causes of the downturn, and these failures need to be addressed rapidly: (i) serious shortcomings in terms of micro-supervision, a lack of macro-supervision and, more generally, inadequate regulations that have exacerbated the second factor: (ii) considerable international macro-economic imbalances in a context of fierce global competition.

The crisis also revealed failures in the financial markets. The excessive search for short-term profit was acknowledged as a key factor, and the post-crisis era needs to put more emphasis on the long term. We have to ensure that the reforms to prudential and accounting regulations currently being introduced no longer encourage practices that unsustainably push up profits in the short-term.
It is therefore critical to conduct an in-depth analysis to:
• define the most favourable conditions for a resilient and sustainable recovery;
• design an appropriate regulatory framework conducive to both financial stability and growth financing

 1. WHAT CONDITIONS FOR A RESILIENT AND SUSTAINABLE RECOVERY?

• a) To make the best use of capital resources

There are ample liquid assets around, but part of the capital that could have been invested sustainably was deleted during the crisis. In the post-crisis era, these costly resources should satisfy conflicting needs: public deficits, investments and recapitalisation of financial institutions. Besides, in the face of global competition and despite its demographic challenges, Europe has the advantage of high savings ratios. These need to be consolidated and not undermined.

The need to improve financial stability is more than justified. We might even say that we cannot have a healthy and sustainable economy unless the financial system is stable, well capitalised and able to take measured risks. However, there is a real risk today of introducing poorly conceived “regulatory zeal” that could well stifle the recovery. The focus should therefore be on designing a well-adapted framework that would allow the financial system to successfully perform its economic role while at the same time limiting global volatility.

In order to draft the new regulatory and supervisory measures and to grasp their potential impact on growth properly, we need to understand the specific features and roles of each sector (banking, insurance, financial markets) to appreciate their diversity and, above all, their individual temporal horizons. Financial stability essentially requires an adequate market structure and the downturn has underscored the risks linked to the economy’s over-dependence on credit. Measures designed to preserve or develop other sectors, such as insurance companies and investment funds, are needed for better global stability. It is this diversity, among other things, that will lead to eventual stability.

The main role of financial institutions is to finance the economy. In designing the new system, the decision-makers need to ensure that they are not putting forward inadequate incentives and sowing the seeds for future financial instability. In particular, they need to guard against introducing a potentially harmful combination of profoundly inadequate prudential and accounting regulations for the insurance sector. In effect, such regulations would lead insurers to considerably shorten their investment horizon and reduce their appetite for risk. In concrete terms, the time that insurers hold onto their shares is 3 times less than 10 years ago. In attempting to harmonise regulations between the different actors, insurers have gradually moved away from their traditional role as long-term investors.

• b) A new regulatory and supervision framework for the insurance sector

The Solvency II directive aims at conducting a full financial assessment of European (re) insurers’ risk profiles. A balanced and fair adaptation of level 1 principles to the technical processes involved in operation measures at level 2 is needed to develop a well-adapted supervisory framework for the European insurance sector. An over-cautious position would lead to serious problems. The precautionary margins would overlap on all fronts and their combined effects could have a dramatic impact on the sector. As a result, the aim to develop financial stability could undermine the aim to grow and finance the economy. The financial system needs greater stability but everything depends on where the bar is placed. Ultimate stability would in fact mean immobility created by zero risk, and immobility means absence of growth. The real challenge is to accurately assess the risks needed to promote growth, based on new collective choices (such as “green industries,” etc.).

Certainly, the costs linked to protection and financing would be higher if capital requirements increased without adequate targeting of the objectives. This would ultimately lead to higher costs for consumers. However, since the fallout from the crisis, there has never been a greater need for protection against the risks of speculation and the capacity to provide financial protection.

In its role as risk-taker, the insurance sector protects people and businesses from uncertainty by adopting a long-term perspective. Consequently, insurance is one of the main contributors to economic prosperity, growth and a return to stability. Without insurance, no one (no individual, family, business or investor) could take the risks needed for the development of a healthy economy. Any measures that tried to reduce the insurance sector’s potential to cautiously and sustainably cover risks would put the whole economy in danger.

The regulators are responsible for ensuring that this fundamental role is not jeopardised, and that, at the end of the day, consumers are reliably and effectively protected.

 2. NEED FOR AN EXHAUSTIVE AND WELL-ARTICULATED EUROPEAN REGULATORY FRAMEWORK

• a) Regulations must be based on sound and realistic principles

A new system is now being developed, and the decision-makers need to clearly define the principles and underlying regulatory objectives. Otherwise we risk finding ourselves with ineffective tools and empty measures.
The underlying principles must be a priority. The first is that of integration. In the same way as harmonisation is the byword for the free circulation of goods, European integration for sustainable growth must be the byword for the single financial services market. In collaboration with the social-economic stakeholders, European institutions must try to develop a single financial services market that works in the interest of our citizens - consumers, users, workers – and businesses in order to develop cohesion and growth.

This means fulfilling a second principle, namely establishing good governance at European level. A new European supervisory architecture for enhanced integration is currently in the throes of development.

The crisis highlighted the need for reliable and effective supervision. A key requirement for effective regulation is its legitimacy. Just as important as the decision itself is the process by which (a) the supervisor arrives at a conclusion and (b) his/her decision may be queried or challenged.

A more integrated and powerful control authority creates high expectations. A fully legitimate European supervisor would ultimately be answerable to the stakeholders concerned.

In addition, the regulations and supervision must go hand in glove. No coherent supervisory framework can be built if the regulations are not stabilised first. And yet, in the insurance sector, the powers, the work, the structures, and the way the future supervision authority will operate are now being negotiated, even though the Solvency II regulation framework is far from complete. In fact, with regard to the drafting of operational measures, CEIOPS is tempted to fill the regulatory void by stepping outside its supervisory role.
Given the attitude of CEIOPS and its activities throughout the consultation process on the Solvency II revisions, it is fair to say that there should be an in-depth analysis and real improvements to its governance, as well as a clear delimitation between the authority and the role of regulator and that of supervisor.

• b) Need for effective and well-articulated macro and micro supervision

Effective supervision must be European and integrated.
In this respect, the Larosière report is a major step forward. Following its recommendations, the Commission has adopted a two-tier approach to the new supervisory framework:
- European Systemic Risk Committee (ESRC): responsible for the macro-prudential supervision of the financial system in the EU, designed to warn against or limit systemic risk;
- European System of Financial Supervision (ESFS): this financial supervisory authorities’ network would work in cooperation with the new European supervisory authorities, created after the European Insurance and Occupational Pensions Authority (EIOPA) succeeded CEIOPS. These European supervision authorities will be responsible for micro-prudential supervision.
However, there are not enough details on the operational development and the articulation of both organisations in the regulatory measures. In addition, the measures do not provide enough guarantees regarding the dissemination of information between the ESRC and the ESFS.
Firstly, the European supervisory authorities’ effectiveness should not be hampered by the determination of national supervisory authorities to retain their sovereignty to the detriment of cooperation.
Secondly, confusion between the levels of supervisory roles (micro/macro) must be avoided at all costs. The ESRC should concentrate on its basic role, in other words, monitoring the global macro-economic risks that could threaten financial stability. In no case should the ESRC become a new micro-regulatory body. Monetary policy should cover the risks linked to excessive borrowing and the volatility of assets. For really effective supervision, the supervisory organisations must have enough knowledge about the sector. Each of the financial services sectors should therefore be represented in the ESRC.

CONCLUSION

The economic crisis has weakened the level of trust between the financial services sector as a whole, the regulators and the supervisory organisations. It is therefore vital to support and implement the positive initiatives already available so as to manage the risks better and promote the integration of financial services in the EU.

Solvency II has been designed with this in mind. Previous experience has shown that political clarification on the role of the supervisor is indispensable. It is unacceptable that experts, whose role is to submit various alternatives to politicians, impose their own choices. If we don’t act soon, European institutions and the main stakeholders in the sector will find themselves in an unsustainable situation to the detriment of a project whose founding principles remain more relevant and vital than ever.

There is still time to act and to contribute to meeting the main challenge of the post-crisis era, namely, to finance growth, invest in the long term, create jobs and maintain low costs for consumers.

Confrontations Europe
On 23 March 2010

En français

Position paper - Solvancy 2