Zero interest rates and regulation create new risks

New risk models required

RiskNET [Editor-in-chief]12.01.2016, 18:38

The combination of zero interest rates and more stringent regulatory requirements is creating additional risks for investors and the financial system as a whole. Asset managers must react to these new challenges with new investment strategies and risk models, according to the results of an investigation by Martin Hellmich, Professor at the Frankfurt School of Finance & Management as part of the risk management study conducted end of last year by Union Investment.

Banks and insurance companies confronted with new regulatory requirements from Basel III and Solvency II face particularly significant challenges. The average performance of proprietary account portfolios at German banks fell from 5.2 per cent in 2005 to approximately 1.8 per cent in 2014 due to a decline in interest income.

The regulatory requirement for banks to hold more liquid and, in the present circumstances, not particularly profitable assets also increases their risk of falling short of performance targets. "These minimum capital requirements mean banks have little latitude to modify the strategic asset allocation in their proprietary account portfolios," explains Martin Hellmich.

In the case of insurance companies, the combination of zero interest rates and Solvency II has created a situation that can only be tackled by companies with high equity ratios. Insurance companies must have investment expertise in asset classes generating higher returns while adapting to greater risk and lower liquidity. "If life insurance companies reinvest without making any changes to their strategic asset allocation, the average return on the reinvestments in the current environment will only be marginally more than 2.1 per cent and therefore fall significantly short of the average level of guarantees of approximately 3.3 per cent," adds Hellmich. In addition, an increase in interest rates would pose considerable risks for insurance companies. A sudden increase in interest rates of approximately 200 basis points could pose a serious threat for around 60 major German life insurance companies.

Investors looking ahead with scepticism

In light of these challenges, investors are sceptical about prospects for the future. Banks surveyed as part of the risk management study believed that almost 55 per cent of German banks would fail to achieve their investment objectives over the next three years as a result of new regulatory requirements, while 69 per cent believed that companies in their sector would fail to achieve their investment objectives because of low interest rates. The insurance companies surveyed showed less concern, expecting only 29 per cent of the sector to miss their targets due to regulatory requirements and 49 per cent of German insurers to fail to achieve their objectives due to low interest rates.

Setting a new course

Investors and asset managers must respond to this changing environment by systematically scanning the investment universe for profitable opportunities that meet regulatory requirements. "Greater flexibility and risk within the regulatory framework are the order of the day," says Alexander Schindler, a member of Union Investment's Board of Managing Directors with responsibility for the Company's institutional clients. Schindler believes that it is particularly advisable to internationalise investments in order to profit from global variations in interest rates and growth. He also advocates the use of risk-controlled equity strategies and real estate investments, and cites structured credit as a viable option for portfolio diversification. "However, there are currently no indications that many investors are making material changes to their portfolios," warns Schindler, adding that the majority of investment volumes are still made up of fixed income and money market instruments while the investment ratios for equities and real estate are generally less than five per cent.

New risk models required

The current investment environment not only affects the risk position of individual investors but also presents additional risks for the financial system as a whole.

Extensive levels of intervention by central banks are leading to significant correlations between different asset classes. At the same time, the demand behaviour of major classes of investors is being influenced by regulatory parameters in a way that reinforces the correlation between investors, impacts asset prices and heightens the risk of price bubbles. "We are observing an increasing risk of contagion within the financial system," says Hellmich.

A new generation of risk models is required to tackle these challenges, as traditional risk and portfolio optimisation models are largely only able to model linear phenomena. "The weaknesses in the traditional models do not mean that quantitative methods will be less significant in the future. Mathematical methods in risk management need to be continually developed in order to be able to describe and simulate complex economic systems as a whole," explains Schindler.

"The foundations for the ongoing development of risk models have already been laid," says Prof. Hellmich, adding that there has been huge growth in data processing opportunities. "At the same time, further increases in the reporting obligations for financial institutions imposed under new regulatory requirements and the onward march of digitisation mean that we will have in the future a substantially greater volume of data, which can be used to calibrate new types of risk model," says Hellmich.

[ Source of images: © Cherries - ]

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