Abstract
This paper puts forth two models, one of a bank and one of an insurer. Their divisions responsible for investment (and risk underwriting, respectively) seek to maximize the expected risk-adjusted rate of return on capital (RAROC). For the bank, higher solvency lowers the cost of refinancing; for the insurer, it attracts more premium income. In both cases, however, higher solvency ties costly capital. Sequential decision making is tracked over three periods. In period 1, exogenous changes in expected returns and in volatility occur, each suggesting optimal adjustments in solvency. However, there can be only one adjustment, which in period 3 creates an endogenous trade-off between expected returns and volatility. This tradeoff is shown to involve parameters that differ between banks and insurers, calling for bank-specific and insurance-specific solvency regulation. In addition, Basel I and II (Solvency I and II, respectively) are shown to modify this tradeoff, inducing senior management of both banks and insurers to opt for higher volatility and lower solvency than otherwise. Therefore, existing solvency regulation can run counter their stated objective in both cases, which quite likely is also true of Basel III and Solvency III.
Highlights
Risk-adjusted return on risk-adjusted capital (RAROC) has increasingly become the benchmark for assessing the performance and governance of banks’ investment as well as insurers’ underwriting and investment divisions
This paper deals with the conflict between the optimization of solvency by banks and insurers themselves and solvency levels imposed by Basel I and II (Solvency I and II, respectively)
Regulations imposed by Basel/Solvency I, II, and III are introduced as parameter restrictions in Section 6 to show how the slopes of these efficiency frontiers are modified, likely inducing senior management of regulated banks and insurers to opt for a higher volatility and lower solvency than absent this regulation
Summary
Risk-adjusted return on risk-adjusted capital (RAROC) has increasingly become the benchmark for assessing the performance and governance of banks’ investment as well as insurers’ underwriting and investment divisions. Regulations imposed by Basel/Solvency I, II, and III are introduced as parameter restrictions in Section 6 to show how the slopes of these efficiency frontiers are modified, likely inducing senior management of regulated banks and insurers to opt for a higher volatility and lower solvency than absent this regulation. This effect is again conditioned on parameters that differ between the two types of financial firms.
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