In this context, it is important to recognise that balance sheet valuations and capital requirements play different roles in Solvency II and they are not substitutes for each other: The balance sheet valuation assesses whether the firm has sufficient assets to be able to meet the potential costs of transferring its business to a third party should the need arise. The Solvency Capital Requirement (SCR) is intended to cover the impact of a 1 in 200 year stress on the balance sheet over the next year. The ability to transfer the business after a stress event provides a critical ‘bridge’ between the one-year Value at Risk methodology that underpins the SCR and the long-term risk profile of insurance business. Therefore, if Solvency II is truly to be a ‘going concern’ capital regime then it is essential that the calibration of the Fundamental Spread (FS) – the allowance for risks retained by firms in respect of their investments - be aligned with this. In particular the FS should sufficiently capture the retained risk for which a third party would seek compensation in any transfer price. Without this – the resilience of the Solvency II balance sheet is undermined and firms may struggle to de-risk in times of stress. The PRA is supportive of the MA as a concept that reflects the nature of the risks arising from a portfolio of well-matched, long-term illiquid assets and liabilities. However, it does not imply a departure from Solvency II’s near-term transfer value discipline.
More attention has been paid to the “time-series” dimension where there is now a clear international consensus among the members of the Financial Stability Forum and the Basel Committee that some form of counter-cyclical prudential supervision is required. The principle has been established. To correct these types of market failure will require a system of regulation that effectively marries the “top down” assessment of the risks to the system as a whole to the “bottom up” supervision of individual institutions. The present system has not delivered that. A lot of detailed work needs to be done to convert these general principles into concrete implementation. How would the interaction between the “cross-section” and “time-series” risks be taken into account? Would the framework take the form of an addition to capital requirements as a function of the degree of maturity mismatch, leverage or the rate at which the balance sheet was expanding? Or would there be a limit on leverage ratios? How would leverage and maturity mismatch embedded in the assets side of the balance sheet be taken into account? And how would the framework be implemented for banks whose assets and liabilities span jurisdictions? Can we define a group of institutions that are systemically significant? In the present crisis most institutions are deemed to be potentially systemic because of the impact of the failure of any of them on creditor confidence. If most banks appear systemic in a crisis won’t countries want to require foreign banks to be subsidiaries not branches?