IMPLICATIONS OF REDUCED LIQUIDITY: AN INSURERS’ PERSPECTIVE
The ABI appreciates the opportunity to contribute to the Bank of England Open Forum discussion.
Both pillars of the debate – efficiency and social license – are vital to us. Insurers play an important economic
and societal role by allocating and managing risk, allowing individuals and businesses to focus on what they
value the most. In turn, insurers benefit, and need access to, well-functioning and effective financial markets.
At the same time, we are very aware of the importance of gaining and maintaining public trust in the insurance
market, and the financial services more broadly.
This paper explores the issue of market liquidity1, and the implications illiquidity could potentially have on
insurers. We believe that liquidity2 under both ‘normal’ and stress conditions is important, and outline the
key ways in which insurers can be affected. This includes insurers’ ability to raise funding, the cost of
asset/liability matching, and the impact on derivative use collaterisation. This leads us to conclude that it is
well worth exploring means of preserving and improving liquidity in key markets.
In considering a potential policy response, we find that, even if the central bank is prepared to act as a market
maker of last resort, this would not address the underlying problems created by illiquidity. Instead, further
thought should be given to market structure solutions.
Above all, we would encourage policymakers to devote further thought to the means of restoring adequate
levels of market liquidity in a way that is also compatible with the goals of financial stability, and to continue
engaging with market participants on these critical issues.
We hope this paper helps to stimulate the debate.
Why market liquidity matters
Liquidity is increasingly on the agenda, but while some claim the market is awash with liquidity, others worry
about its decline. Indeed, on the one hand, there is (perhaps over) abundant supply of money in the economy,
thanks to extraordinary monetary policy.3 On the other, trading liquidity has shrunk across almost all market
sectors, as documented in the recent PwC Global Financial Markets Liquidity Study.4 And it is feared that, in
times of stress, liquidity may evaporate entirely.
This matters because liquidity has far-reaching repercussions for financial markets, including, as discussed
below, insurers. Juncker’s Capital Markets Union initiative recognises the benefits of well-developed capital
markets as an alternative source of funding for the real economy, and studies have shown the statistically
significant link between liquidity, and economic growth and productivity.5
1
The article focuses on market liquidity, rather than monetary, funding or asset liquidity. Please refer to Cunliffe J. (2015). Market
liquidity and market-based financing Accessible at http://www.bankofengland.co.uk/publications/Pages/speeches/2015/853.aspx
2
Market liquidity is described in the PwC Global financial markets liquidity study as “a multi-dimensional concept, generally
referring to the ability to execute large transactions with limited price impacts, and tends to be associated with low transaction
costs and immediacy of execution.” However, the report also notes that different capital markets may be more suitable to the
various measures of liquidity, and a uniform approach may not be appropriate.
3
For how this could mask the underlying market liquidity issues, please refer to Cunliffe J. (2015), as above.
4 PwC (2015), Global Financial Markets Liquidity Study. Accessible at http://www.pwc.com/gx/en/industries/financialservices/publications/financial-markets-liquidity-study.html
5 Beck and Levin (2003) and Corporale, Howells and Soliman, cited in Global financial markets liquidity study (August 2015)
ABI.ORG.UK
Association of British Insurers | 51 Gresham Street | London EC2V 7HQ | Telephone 020 7600 3333
But this is not merely an academic issue, nor one whose impact is constrained to the realm of the financial
services. As the global financial crisis illustrated all too well, the drying up of liquidity can have a devastating
impact on the availability of credit for businesses, and, ultimately, on individuals’ jobs, and future prospects.
It is therefore critical for policymakers and market participants alike to grapple with the drivers behind the
post-crisis structural changes in liquidity, and what this implies. The question is made more pressing by the
prospect of an interest rate rise and the unwinding of quantitative easing. Even a suggestion of the latter was
enough to trigger a “taper tantrum” – and this is in the world’s deepest and most liquid market.
Unfortunately, such volatility is characteristic of markets with impaired liquidity, where market makers have
been forced to either withdraw or limit the capacity offered to the market due to a mixture of heightened risk
aversion and regulatory changes.6
Policymakers may find it easier to suggest that market participants should just get used to, and adjust, to the
‘new normal’. However, we argue below that the implications of impaired liquidity are such as to make it
worthwhile for policymakers and market participants alike to work together in aid of liquidity. The liquidity of
asset classes varies naturally7, but the costs of illiquidity are high - exploring means of preserving and
improving liquidity in key markets is well worth it.
Impact of reduced market liquidity on insurers
Reduced market liquidity could have a variety of direct and second-order implications for insurers.
Direct impact of reduced liquidity on insurers
A number of these are well-documented, and apply more broadly. For example, lower market liquidity
translates into higher liquidity premia, which in turn impacts the cost and availability of funding, and
investment returns. The interlinkages between primary and secondary markets affect insurers as issuers.8
We therefore see the key direct implications of reduced liquidity on insurers as including:



a lack of bond market liquidity can impact an insurer’s ability to raise debt funding and/or inflate
pricing unexpectedly. The volatility associated with reduced liquidity makes it much more difficult to
predict appropriate funding windows cost;
decreased liquidity impacts the cost of purchasing and selling bonds needed to match liabilities and
pay policyholder claims, having a direct impact on profitability and, in turn, customers;
volatility of spreads has an impact on the value of bonds already held on balance sheet. Whilst these
are generally long-term investments, an insurer’s capital position is still impacted by changes in value.
In addition, increased volatility offers greater opportunity for arbitrage at the expense of long-term investors.
Above all, it lays them open to huge book losses in stressed market conditions, which may force fire sales and
6
On impact on market makers, please refer to Carney, M. (2013). The UK at the heart of a renewed globalisation. Accessible at
http://www.bankofengland.co.uk/publications/Documents/speeches/2013/speech690.pdf
7
Andeson, N. et al. The resilience of financial market liquidity Bank of England Financial Stability Paper No. 34 Accessible from
http://www.bankofengland.co.uk/financialstability/Pages/fpc/fspapers/fs_paper34.aspx
8 For the impact of reduced dealer inventory on capital bonds, please refer to Baranova Y., Chen L. and Vause N. (2015). Has
corporate bond market liquidity fallen? Accessible at Bank Underground at http://bankunderground.co.uk/2015/08/27/hascorporate-bond-market-liquidity-fallen/
ABI.ORG.UK
Association of British Insurers | 51 Gresham Street | London EC2V 7HQ | Telephone 020 7600 3333
a rush for safety which subsequently prove to be poor decisions when the market recovers.910 Fortunately,
insurers are largely insulated from market volatility by the long-term nature of their liabilities, although the
impact of the high level of change in the pensions market may need to be considered in the future. We also
note that insurers, as long-term investors, are not naturally pro-cyclical in their behaviour, although this can
be encouraged by poorly calibrated regulation.11
Liquidity under normal and stressed conditions
Those who argue that liquidity will evaporate just when you need it the most – under stress - may be tempted
to give up on the concept altogether.12 However, it would be misguided to assume liquidity is important in a
crisis but irrelevant under normal conditions. Both matter. Even in the case of buy-to-hold investors, as life
insurers can often be, ‘normal’ liquidity shapes the elements underpinning investment decisions, including
pricing, the ease and cost of transacting, and the riskiness and appetite for investing in the first place. Insurers
have traditionally been a force for stability and resilience in the markets, and this role should not be
abandoned lightly.
Ability to collaterise the use of derivatives
Derivatives are an important part of insurers’ risk management strategies, used to hedge against risks such as
interest rate movements, foreign exchange and longevity.
With the advent of EMIR there will be a move from OTC to exchange-traded derivatives, and the associated
requirements for initial and variation margins. These have to be collaterised with highly liquid assets (mainly
gilts or cash). Large buffers of cash or liquid short-term instruments would inevitably reduce the return to
savers and pensioners. In addition, these assets may not always comprise a large proportion of some insurers’
overall portfolios, as holders of longer-term assets.
In these cases, insurers can use repo markets to convert existing assets into cash. In times of stress, or when
rates rise, firms are likely to face increased collateral demands to cover CCP variation margins.13 The concern
is that this may coincide with repo markets drying up, limiting the ability for funds to engage in collateral
transformation. In this stressed scenario, insurers may be forced to sell some of their existing, and possibly
increasingly less liquid, assets just when their prices may also be falling.
Interaction of liquidity with regulatory assumptions
The valuation of insurers’ regulatory balance sheets is founded on the assumption the markets are deep and
liquid. This relates to both the asset side, valued at a mark-to-market basis, and the liability side, valued using
9
Ellul A., Jotikasthira C. and Lundblad CT (2001). Spillover Effects from Risk Regulation on the Asset Side to Asset Markets. Journal
of Finance Economics, Volume 101, Issue 3
10 For a further discussion of spillovers of market illiquidity across asset classes, please refer to International Monetary Fund (2015).
Market Liquidity – Resilient or fleeting? Chapter 2. Accessible at
http://www.imf.org/External/Pubs/FT/GFSR/2015/02/pdf/c2_v2.pdf
11 Bank of England and the Procyclicality Working Group (2014). Procyclicality and structural trends in investment allocation by
insurance companies and pension funds. Accessible from
http://www.bankofengland.co.uk/publications/Documents/news/2014/dp310714.pdf
12 Wolf, M. (2015). Beware the liquidity delusion. Accessible at http://www.ft.com/cms/s/0/c8c2cc44-68fa-11e5-a57f21b88f7d973f.html#axzz3pEEEqhav
13 For a further discussion of collateral linkages to the broader financial system, please refer to Anderson, N. et al. The resilience of
financial market liquidity Bank of England Financial Stability Paper No. 34 – October 2015
ABI.ORG.UK
Association of British Insurers | 51 Gresham Street | London EC2V 7HQ | Telephone 020 7600 3333
a risk-free discount rate based on swaps and an additional risk margin representing the cost of transferring
the liabilities to a third party. If the assumption stops holding true in the future, there may be some difficult
questions to ask about how this should be reflected in regulatory frameworks. On the asset side, the adoption
of amortised cost would be a step backwards to the market distortions seen in the 1980s. Further use of
mark-to-model also has risks associated with it, as was demonstrated by the behaviour of markets for
structured investment in the financial crisis.
This is not to argue against any re-thinking about valuation. For example, the Matching Adjustment in
Solvency II effectively uses cash flows. However, mark-to-market is hard wired into many regulatory systems.
The use of alternatives would take time, and require careful thought about the secondary consequences.
Central banks as a market maker of last resort
So where to from here?
One suggestion that has been put forward is for central banks to step in at times of liquidity crises as market
makers of last resort to prevent further contagion.14
This could take one of the following forms:
-
The central bank acts as a market maker, simultaneously quoting buy and sell prices. In practice, in a
panic/crisis situation, this would effectively mean being a buyer of last resort for assets that others
no longer want to hold;
-
The central bank addresses the collateral/repo issue identified above by taking the place of the repo
markets.
Both versions have their own appeal, but also raise further questions.
If the central bank decides to directly intervene in secondary capital markets, as per the first scenario, at
which point should intervention be triggered, and when should it stop? Would the intervention be carried
out covertly or signalled to the market in advance? Either way, a central bank commitment to buy would
expose it to a rather large fiscal risk, without mentioning the potential for gaming or a run.
The question is further complicated by the incentives for risk-taking that the buying of impaired assets might
send to the market.15 And, politically, there is a risk this would this be perceived as bail-outs by another name.
In the second, repo scenario, the central bank would effectively replace collateral whose value has
deteriorated with its own ‘safe assets’. This could act as a safety net, and limit contagion. However, the
process would need to be carefully designed to ensure it does not merely become a subsidy for collateral
posters, nor incentivise the collateral-acceptors to weaken due diligence or erode the quality standards for
the collateral they accept.
14
Shafik, M. (2005). Dealing with change: Liquidity in evolving market structures. Accessible from
http://www.bankofengland.co.uk/publications/Pages/speeches/2015/855.aspx
15 Bank of International Settlements (2014). Market-making and proprietary trading: industry trends, drivers and policy implications
CGFS paper No 52, accessible from http://www.bis.org/publ/cgfs52.htm
ABI.ORG.UK
Association of British Insurers | 51 Gresham Street | London EC2V 7HQ | Telephone 020 7600 3333
Policy response
A role for central banks as market makers of last resort has significant practical drawbacks and unforeseen
consequences. Policymakers should think very carefully before going down this road. In addition, this
solution takes effect only in the highly stressed conditions associated with a last resort, and offers no answer
to the day-to-day issues created by illiquidity in the markets.
From insurers’ perspective, and from the perspective of their policyholders, the consequences of abandoning
the convention of deep and liquid markets are severe. We therefore urge policymakers to give further
thought to market structure which preserve the functions of deep and liquid markets, and on ways to work
with market participants to re-build market making capacity and restore liquidity.
Current regulatory practice might suggest the imposition of further capital and liquidity buffers on users of
the markets. However, this is very expensive and adds cost to the users of the markets instead of those who
operate the markets. Capital buffers will be even more expensive after rates rise and capital once again
becomes a scarce commodity. As such, this is not a future-proof solution. Worse still, it is not a solution that
would address the underlying causes of illiquidity.
The problem is one of market structure, and the solution should therefore be found in market structures. We
understand banking regulators’ reluctance to return to the market structures that were operational in the
run-up to the financial crisis, with market making activities wrapped up in much larger proprietary trading
activities. The question is how to incentivise parties to dedicate capital to market making activities without
risking recent improvements in financial stability.
The pre-crisis model is not the only model that can be drawn on. Perhaps one possibility that policymakers
might explore is a prudential regime where a limited number of entities are licensed to perform defined roles
in the market, with special privileges but also special responsibilities. This might also draw on recent thinking
on the use of ring fencing to secure critical services.
Hugh Savill
Director of Regulation
[email protected]
ABI.ORG.UK
Alisa Dolgova
Senior Policy Adviser
[email protected]
Association of British Insurers | 51 Gresham Street | London EC2V 7HQ | Telephone 020 7600 3333