Part two: counter-cyclical measures and no risk-free rate Turmoil in the European government debt markets is calling into question the zero percent capital charge on European government bonds under Solvency II. This two part article explores how firms and regulators are handling the discrepancy between the charge and real default risk, and what life without a risk-free rate might look like. Part one examined the implication of a zero percent capital charge on risk-free assets that are anything but. Part two looks at counter-cyclical measures and explores the implications of operating in an environment where nothing is risk-free.
The pitfalls of market consistency
The problem with regulation that reflects market prices is that it reflects market prices. When markets becomes very volatile, market consistent valuation can contribute to the volatility.

Introducing short-term volatility
But pro-cyclicality bites both ways. In the current economic climate it is easy to be caught up in doomsday-frenzy, yet the rule makers of Solvency II must consider market booms as well as busts. As discussed in part one, while there are major concerns about the way the regulation treats European sovereign debt the likelihood of default is still very low. The treatment of counter-cyclical measures must not be clouded by what is happening now.
Separating volatility from fundamentals
The solution will have to tackle the key obstacle of separating market volatility from economic fundamentals in the asset prices. Mr Bäte said it was vital that the regulatory solution reflects real economics and does not propel market panic. “That does not mean that we ignore the risks, but we differentiate between the real risks and those that we are importing both through accounting volatility that is nonsensical and market volatility,” he said. Looking at the ratings of individual countries rather than market prices is a possible step in this direction. According to Dan Morris, Market Strategist at J.P. Morgan Asset Management, “Because ratings agencies rely more on the underlying fundamentals and look at a longer term horizon, they can provide a view that is not as volatile as that reflected in credit default swaps spreads. It should then be possible to calculate a meaningful measure of how much of the price can be attributed to each factor.” However, relying on rating agencies alone is problematic and unlikely to provide a sufficiently meaningful separation between real market price and short term volatility.Solvency II counter-cyclical premium
Solvency II has a range of counter-cyclical tools at its disposal, including the Pillar I equity dampener, Pillar II extension of recovery period and the supervisory ladder of intervention. The current EIOPA proposal to manage short-term volatility between asset and liability values is through the use of a counter-cyclical premium. This replaces the illiquidity premium used in QIS5 and will also include exposure to sovereign debt – something the illiquidity premium did not. The current proposal will give companies the ability to apply the premium when market conditions are stressed – while EIOPA will retain the power to decide when these conditions occurs for individual markets. The industry has been opposed to this switch-on / switch-off mechanism for two main reasons. First, market data has shown that while factors such as illiquidity increase during times of market stress, they are still present during more relaxed conditions (albeit at much reduced levels), and as such tend to tail in and out over time. Activating the counter-cyclical premium only at points of high market stress ignores these tail effects.

The risk free rate
Whatever solution is found to address extreme market volatility, regulators must consider the treatment of sovereign bonds as a special case. Because sovereign bonds are used to determine the risk-free rate, any change to the zero percent capital charge on them would be akin to an admission that the system no longer has a risk-free rate. Already insurance firms and other investors are seeing the traditional risk and return equation (i.e. higher risk = higher return) being eroded. Peter Praet, Member of the Executive Board of the European Central Bank, said that the reappearance of credit risk in the sovereign debt markets was making it difficult for insurance companies who were already struggling with persistent low yields on risk-free assets. Speaking at the 6th European Pension Funds Congress, Mr Praet said, “Now they discovered that low yield is also attached to credit risk and market price risk. So here the response of course is that public finance has to be in order. It is very important in any society that sovereigns remain of very good quality in the whole financial system.” Mr Praet highlighted the importance of the risk-free rate to the economy. “Any course on money and banking will start with the risk-free rate, the yield curve and government debt. And that is the sort of benchmark in our economies to fix the prices.” “If there are doubts about the credit quality of this benchmark, all your pricing system gets jammed and this is the situation we get here in a number of countries especially in the Euro zone. So it is very important not only for the good sake of public finances … but also for the good functioning of our financial system because other things are fixed around them.” “Maybe later we will get other benchmarks but for the time being it is quite difficult to replace the government yield curve as reference pricing system,” he added.What if nothing is risk-free?
The economic effects of operating without a risk-free rate are explored in the somewhat dramatically titled paper, Into the Abyss: What If Nothing is Risk Free?, by Professor Aswath Damodaran at the Stern School of Business, NY.