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Can Davos Weave More Sense in Web of Post-Crisis Rules?

Post-crisis rules designed to protect the financial system have vexed investors. Will policymakers in Davos offer any new ideas to shape their regulatory approach?

As policymakers prepare to gather in Davos, Switzerland, for the 2018 World Economic Forum, investment experts are considering the cost of sweeping regulations created after the global financial crisis.

Over the past decade, institutional investors have moved away from certain asset classes and strategies to comply with the post-crisis rules meant to keep them from taking on too much risk, but it’s not clear their portfolios are any safer. In Europe, for example, insurers have turned away from asset-backed securities and hedge funds but have taken new risks in areas such as nonbank lending.

While policymakers are seeking to protect investors from the broad and deep financial losses seen during the 2008 crisis, some investors complain of overly prescriptive rules that have merely pushed risk into different parts of financial markets. It’s a difficult dance. Finding the right balance between free markets and regulation is an evolving process that has made “Shaping the Future of Financial and Monetary Systems” one of the 14 initiatives of the World Economic Forum, scheduled to convene in late January.

One area that has vexed investors is the Solvency II Directive, rules adopted in 2009 for insurers in the European Union.

“Solvency II has led to the creation of risks by unwittingly encouraging illiquidity and opacity,” says Alexander Batchvarov, head of international structured finance research at Bank of America Merrill Lynch. “Investors are buying illiquid things as opposed to liquid, tradable instruments. It is so outrageous. Solvency II is so incorrectly calibrated it is unbelievable.”

To prepare for Solvency II, which was fully implemented in 2016, insurance companies based in Europe spent years changing their investment exposure to hedge funds, according to Preqin’s 2017 Global Hedge Fund Report. A 49 percent capital charge on hedge funds, for example, led insurers such as Norway’s Storebrand to mainly focus on traditional assets as they became more conservative investors, Preqin said.

Storebrand didn’t immediately return phone calls seeking comment.

Patrick Liedtke, head of the EMEA financial institutions group at BlackRock, says Solvency II has made insurers filter out hedge funds that behave similarly to other assets in their portfolios.

“Companies are rethinking their strategies when it comes to hedge fund exposures,” Liedtke says. “You have seen a shift away from hedge funds that behave similarly to long-only strategies.”

There’s another matter relating to Solvency II that insurers find troubling: Under the rules, all sovereign bonds in the EU may be treated similarly from a risk perspective.

“There is no recognition of the differences between sovereign bonds,” says Heneg Parthenay, head of insurance at Insight Investment. “A German government bond is treated the same as a Greek government bond because both are issued in Europe.”

As a safeguard, and to provide a cushion in times of market turmoil, regulators have made investing in risky loans more expensive. Creating cash cushions after the housing market collapsed and prices of mortgage-backed securities plummeted seemed reasonable in the aftermath of the financial crisis: Regulators had to act swiftly in 2008 to bail out Wall Street and insurance giant American International Group.

And yet under Solvency II, the rules around government bonds defy logic, according to Parthenay. “From an economic perspective, it doesn’t make sense,” he says. “It is very difficult to argue that the risk in Germany is the same as the risk in Greece.”

Greece recently reached an agreement with its international creditors on reforms needed to secure its third bailout, according to a December 3 Financial Times report. The country received its first bailout, from the International Monetary Fund and the EU, in 2010 to avoid defaulting on its debt.

Solvency II has also pushed European insurers to abandon ABS because of the large amounts of cash they were required to set aside in case such assets became bad, according to Rob Ford, a founding partner at TwentyFour Asset Management.

“Numerous insurance clients who invested in ABS through us prior to the introduction of Solvency II have now either completely or substantially left the market,” Ford says.

And with that, investors have missed out on ABS gains. In the three years through November, JPMorgan Chase & Co.’s asset management business saw its MBS strategy gain 6.4 percent, while Man GLG’s ABS strategy returned 11.1 percent over the same period and TwentyFour’s asset-backed income strategy gained 17.8 percent, according to data from FE Analytics.

Two European ABS indexes show a similar performance over that period: The Citi Euro BIG Corporate Finance/Asset Backed Index returned 6.8 percent in the three years through November and the ICE BofAML Euro Asset Backed and Mortgage Backed Securities Index gained 7.7 percent.

While regulations including Solvency II, Europe’s Basel III rules, and the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act were designed to make the financial system safer, the risk policymakers are trying to keep from harming the economy is moving to darker corners of the market.

The Alternative Credit Council, the private credit arm of the Alternative Investment Management Association, said in an October report that nonbank lending has been gaining momentum since 2008 and is on track to surpass $1 trillion in assets under management by 2020. The report, called Financing the Economy 2017, said the loans were being offered at lower interest rates and with less stringent covenants. Still, with their relatively high yields, direct-lending funds, which originate loans to midmarket companies, have attracted investors.

Meanwhile, the Alternative Investment Fund Managers Directive, or AIFMD, has changed the hedge fund landscape in Europe. The European rules, which began taking effect in 2013, were put together to help regulators more closely monitor hedge funds, private equity firms, and venture capital funds. But there was an unintended consequence: less choice for investors.

AIFMD limited selection of managers because some U.S.-based firms decided they would rather not spend the time or money needed to develop a strategy to comply with the regulation, according to Patrick Ghali, managing partner and co-founder of hedge fund consulting firm Sussex Partners.

“European investors are missing out,” says Ghali. “Ultimately, our universe has been restricted because some clients can only invest in a UCITS fund of funds.”

UCITS funds are essentially mutual funds sold across the EU, with the abbreviation standing for Undertakings for Collective Investment in Transferable Securities. Ghali says regulators need to be “less simplistic” in how they label risks as AIFMD could lead banks to invest in less suitable funds.

Many of the world’s regulatory approaches prior to the Great Recession were more principles-based than rules-based. Since the crisis, new approaches have been more specific. This is seen with Solvency II, which has drawn up a risk tariff for every type of asset. Similarly, under Basel III and U.S. liquidity coverage ratio rules, riskier assets held by banks require more capital to be set aside to ensure they can withstand a severe downturn, as seen when Lehman Brothers Holdings failed in September 2008.

Kate Miller, head of institutions at London & Capital, says it isn’t unusual for regulators to witness “teething problems” when implementing new rules, and says “we are in a better place” than before the crisis.

Miller’s comments are echoed by Insight Investment’s Parthenay, who acknowledges that many of the risks from the financial crisis “have been mitigated.” Still, he asks that policymakers spend some time considering the outcome of their previous rules before introducing new ones.

“The intention was to make the financial markets less risky,” he says. “But was that really the outcome? Other risks have emerged.”

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