Solvency II and the Corporate Treasurer

COMMENT

The effects of  Solvency II on corporate treasury are often overshadowed by a preoccupation with Basel III. However, Kevin Lester, contributing editor for gtnews, argues that Solvency II could further damage an already deteriorating corporate funding market. The issue of financial regulation and its impact on funding costs is an important concern for most corporate treasurers, and it is not hard to understand why. A recent study by Standard & Poor’s (S&P) estimated that the impact of Basel III and Solvency II would result in a rise in bank borrowing costs for European corporates of up to €50bn, by the time the regulations are fully implemented in 2018, representing an increase in interest costs of between 10%-20% on average. Unlike Basel III, whose potential impact is quite widely discussed within the corporate treasury community (probably because it directly impacts banking counterparties), Solvency II appears to attract a little less attention. A recently published report by the Economist Intelligence Unit (EIU) indicated that less than half of all corporates surveyed were aware that the Solvency II regulations would make the tenor and rating of corporate bonds a more significant factor in the investment decisions of insurance companies. However, the potential consequences of these regulations for corporate treasurers should not be underestimated. Solvency II, scheduled to come into force next year, is often likened to a Basel III equivalent for the insurance industry. Similar to Basel III, the key focus of the pending regulation is to ensure that insurance companies maintain sufficient capital to minimise the risk of insolvency. However, it could be argued that the impact of Solvency II represents an even more radical shift for insurers than Basel III does for banks (perhaps not surprising, given that Solvency I is more than 30 years old). Currently, insurers do not face any capital requirements for risk assets. However, under Solvency II, such requirements will come into force for a number of specific investment types. As such, the new regulations will likely lead to a significant shift in insurers’ relative preference for financial assets. In particular, long duration corporate bonds (particularly non-investment grade instruments) and equity (public and private) will become less attractive, while sovereign debt (which, incredibly, will be considered risk-free) will increase in appeal. As the European insurance industry manages over €7 trillion in investments, 40% of which is in bonds, the impact on the supply of corporate credit in Europe is likely to be significant. The result of these impending changes for corporates, and the corporate funding market in Europe, will be threefold: 1. Higher funding costs (and a higher spread between high grade and high yield issues). 2. Lower availability of long-term credit (e.g. insurers may be required to hold up to three times more capital to invest in a 10-year bond compared to a three-year bond). 3. Reduced equity investor base (and a higher cost of equity). There is a danger that these regulations will incentivise companies to potentially compromise their capital structures by switching into a higher proportion of short-term debt, even when funding long-term assets. And the timing could not really be worse, as this is occurring just as Basel III is forcing banks to replace their short-term debt with longer-term funding under the new net stable funding ratio. This could lead to banks and corporates competing with each other for a shrinking pool of long-term funding providers. The law of unintended consequences often applies when dealing with a system as complex as the financial markets. The actions of regulators, however well-meaning in intention, often lead to repercussions which can often outweigh the positive benefits that the regulations were originally intended to bring. With Solvency II, one unintended consequence may be to further damage an already deteriorating corporate funding market, forcing the adoption of sub-optimal debt profiles for many non-financial companies. — The author is a contributing editor for gtnews. He is director of risk management and treasury services at Validus Risk Management. The views expressed are the author’s own. The article was originally published on the gtnews Risk blog.]]>