Barrie & Hibbert Blog
Confessions of an investment banker
Posted on 06-07-2010 by Andrew Barrie | 0 comments
I was an investment banker.
There we have it. Outed. Confessed. General applause please – it’s all part of my rehabilitation.
I will always be an ex-investment banker. I may choose to omit it from my CV, but it will be there: part of me, hidden, shameful.
Of course, I didn’t think of myself as one. I’ve never ever called myself one. Nobody who really knows me would recognise the label. My wife never knew....“Oh Andrew, he does sales or something”. Now she understands. Conversations with new acquaintances are gently steered away from Andrew’s career history.
I wasn’t a particularly successful investment banker. Not where it really counts for a capitalist – moolah, readies, spondoolies. I know that’s not an excuse, but it plays to my Scottish Presbyterian guilt. Perhaps I wasn’t clever enough or too lazy. My ego blames luck.
Back in 1986 when the job cards were being dealt out I picked the wrong one. I could have chosen proprietary trading or Japanese warrant sales or synthetic CDO structuring or securitisation analysis or a dozen others that have been spectacularly, if briefly, successful at some time over the past 24 years.
But no. For me it was ten years of institutional risk management. Sounded good – basically developing risk management solutions for the pensions and insurance industries. At my fingertips were a whole new array of instruments and techniques with which to revolutionise the market. Armed with some wizzy analysis by Mr H, my Global Megabank business card and a knowledge that only comes with the ignorance of youth, how could I fail? But I did.
The main problem was that the actuarial profession (let’s call it Actuaryland) and investment banking (Global Megabank) had entirely different philosophies about the nature of risk, how to manage it and, ultimately, its price. In Actuaryland equities returned 12% pa, every annum, interest rates were always going to be 8%. Even if this went a bit awry in the short term, the joys of mean reversion would eventually sort it out. The crash in 1987 followed by the unseemly rebound six months later only served to reinforce this thinking. Why would any actuary in their right mind pay the price of hedging demanded by Global Megabank and their Black & Scholes models and risk neutral pricing and no risk premium? If lunch wasn’t quite free in Actuaryland, it was pretty well subsidised. It’ll be OK: equities will deliver over 20 years.
Don’t get me wrong, there were some high points. Insurers were always up for a bit of regulatory arbitrage fun. For a few halcyon months the spectre of Minimum Funding Requirement (MFR) beat a few nervous pension managers to my door – before compromise put paid to the concept. But ultimately the gap between Actuaryland and Global Megabank was too great, so Mr B and Mr H left the big City for an Edinburgh bunker.
However, all was not well in Actuaryland. By the end of the 90’s the insurance sector was starting to uncover some unwanted consequences of their risk philosophy. A decade of falling interest rates begged serious questions about core products in the sector. Guaranteed annuity options and then with-profits failures led many to challenge their approach to pricing and managing risk. Could Global Megabank be right after all?
A new order
Then something bizarre happened. The UK’s insurance regulator took control, ordered their oversights to adopt a financial economic approach to risk and forced them to implement new processes over an incredibly short period. Solvency II extended these principles in scope and geography. Now Actuaryland has some of the smartest, most sophisticated risk managers in the financial services sector. Even more surprising is the accord amongst the different stakeholders and the convergence of approaches and philosophies deployed by regulators, rating agencies and accountants. However, is it not interesting that such a diverse group of professionals with different perspectives and objectives should embrace remarkably common valuation and risk measurement techniques?
Under strong regulatory pressure and deadlines even the more difficult issues such as liquidity premium (an important component of liability discount rate), where practice for the past 20 years has been diverse, have been debated and a common, pragmatic approach agreed by the industry.
But what about pensions?
Contrast this with the pensions sector. The approach here has been to develop a different lens through which each stakeholder views the world. Each lens has varying levels of clarity, going from a buy-out basis which shows the pension scheme in all its glory or pain through to accounting and technical provisions basis typically hazes the lens a bit.
Further, the standards applied to each of these approaches can vary significantly from scheme to scheme, actuary to actuary and accountant to accountant. Add this to the fact that we now have different advisers to sponsors and trustees and it is no wonder that many schemes struggle to get common agreement on management strategy . Unlike the insurance sector, there has been no regulatory driver for change and hence little incentive towards adopting a common approach to valuation and risk management.
However, we are now seeing clear signs that there are a number of influences coming to bear which will bring sharper focus and greater consistency in pensions-related modelling and risk management:
- Technical Actuarial Standards (TAS). The Board for Actuarial Standards are currently in consultation and delivering a series of standards with the aim of independently setting these for actuarial work. This will ensure appropriate transparency that I believe will improve consistency and generally raise the standards and debate within the actuarial profession.
- Solvency II. Many insurers, who are obliged to measure their core business risks are now turning their attention to other risks such as their DB pension fund and active investment risk. With a need for consistency, insurers are now starting to adopt Solvency II valuation and projection standards for these other risks.
- EC regulations. By the time you read this, the EC may have published a much anticipated green paper on Occupational Pension Schemes. This paper is expected to have a Solvency II spin on it, but until it is published we can only speculate as to its content.
- The questions being asked of pension funds are quite different now than a few years ago. Many relate to short-term balance sheet risk and cash flow requirements rather than long- term funding. Answering these questions creates new challenges for modellers — the calibration, time horizon, granularity of analysis, capturing existing market conditions, pricing banking and insurance solutions, etc.
- Run-off. With an increasing number of DB schemes now closed to new business, they find themselves in a maturing and run-off position. This is similar to insurance products such as with-profits (which are also essentially closed to new premiums), in that the challenges are different from growing funds where significant future contributions or premiums can afford management a more liberal investment approach.
- Technology. A significant barrier to more funds getting better, timelier analysis at a price they can afford is the labour-intensive administrative, valuation and modelling environment. This has meant that only the largest of schemes can afford anything more than an infrequent valuation. However, we are now seeing a growing number of platforms and techniques that will change this. Real time valuations will allow stakeholders see the impact of market risk drivers on their assets and liabilities.
The consequence of the developments outlined above will be a growing convergence between the valuation and risk management philosophies of insurers, pension funds and banks. Of course, these are all very different industries, with their own specific risks and needs. Adopted practice will be tempered and shaped by these differences. But we can expect that there will be large areas of commonality in approach and standards.
A brave new world
The pensions industry is already rising to these challenges and opportunities. Consultants are now building teams with some of their smartest resources, learning from their insurance and banking cousins and re-using much of the architecture already developed there.
I am looking forward to welcoming a new era in pension scheme risk management. This time assuming that the world is always changing and won’t always look great over the long term. Hopefully this will ensure we are prepared to deal with the issues that may be thrown our way.
At Barrie & Hibbert we are playing our own part in these developments, sharing the knowledge we have gained in life insurance risk management to promote the same high standards in the pensions industry. Together with our pensions clients – consultants, sponsors, trustees and asset managers – who are already sophisticated and demanding users of our pensions risk management solutions, we will work to support the sector to meet the challenges ahead.
If you are interested in finding out more about our services then please contact us at .
Understanding and measuring liquidity premia in asset markets
Posted on 17-12-2009 by Axel Kirchner | 0 comments
Earlier this month, leading academics and practitioners convened in London to discuss the latest thinking on liquidity premia: both its very existence and whether it can be reliably measured formed the focus for eager debate, with Yakov Amihud of the Stern Business School, NYU expressing amazement that its existence continues to be doubted. He has been studying liquidity premia since 1986 and is an absolute follower of the LP faith. For the most part, however, the main thrust of the day’s proceedings turned on issues of measurability and the concerns raised by regulators as to whether liquidity premia should be allowed for in discounting future cash flows. Axel Kirchner recounts the event.
Measurability
The body of theoretical work, strongly supported by empirical studies, shows that illiquid securities are priced at discounts to identical liquid securities irrespective of the time period studied or the methodology used. In other words, hard-to-trade assets sell at a different price to more liquid assets with otherwise equivalent characteristics indicating strong evidence for the existence of a liquidity premium.
Questions were raised throughout the day pertaining to whether there are reliable, objective and practical methods for estimating it at specific points in time. The methods currently in use for this purpose – the CDS negative basis, structural models and covered bond based approaches - all share a similar conceptual foundation and measure liquidity premium by comparing a relatively more liquid to a less liquid asset with otherwise identical characteristics. However, as liquidity premia are likely to exhibit strong pro-cyclical effects, questions remain as to how well estimation methods hold under stressed conditions. Is there a single superior method or should we instead combine estimates from multiple methods to arrive at a “consensus” estimate?
According to John Hibbert, founding director of Barrie & Hibbert, the main concerns of the insurance industry and regulatory bodies are squarely focused on how companies can “prudently, credibly, simply and reliably” measure liquidity premia. This view was echoed by Richard Olswang from Prudential: he also advocates simple and reliable LP estimates, but favours an estimation method which addresses a multi currency/economy environment, and provides reliable answers in periods of market stress.
Practical issues
As reliable liquidity premium estimates need to be available shortly after the reporting dates, and because liquidity premium models need to be calibrated and monitored on a regular basis, several practitioners cited timeliness as a key concern. Furthermore, it was felt that the choice of method of calculation itself should not lead to changes or disruptions in supply and demand in financial markets (for example where regulations favour one particular asset class with specific characteristics over another). The point was also made that insurance companies should be validate estimates themselves.
Uncertainty
An interesting behavioural finance take on how liquidity should be interpreted was offered by Mark Salmon of the Warwick Business School. He suggested interpreting it as aversion to uncertainty, with uncertainty being defined as the absence of knowledge about the appropriate probability distribution and by assuming a range of possible distributions. In other words, just because things have not happened before, doesn’t mean that they won’t happen in the future.
In this context, the explanatory power of VIX, used on its own, is probably too limited to be an effective proxy for LP. Salmon proposed that we should instead obtain a measure based on the “joint” distribution of all factors likely to affect the price of liquidity, not just volatility. He also highlighted that using “investor sentiment” as a variable removes that need for different regimes. Its measurability, however, remained subject to discussion.
On the regulators…
In response to a question regarding what we should be expecting from regulators’ proposals, Richard Olswang from Prudential pointed out that regulators should look for something simple in order to avoid a situation where the regulatory answer is, “there are too many different options – so we decide the consensus is to have zero LP”. Such a situation would be the least desirable option for the industry; not least because business with long-term illiquid liabilities and a long-term investment horizon, such as the annuity business, rely on realisation of liquidity premia as a source of yield and will be significantly affected should there be no regulatory allowance for a liquidity premium. Both regulatory and industry bodies should therefore strive instead to achieve a consistent view.
Sticking with the theme of regulators, the question regarding the ways in which insurance companies could present an easily auditable LP estimation method was explored. In the context of decomposing credit spreads, John Hibbert suggested combining different approaches such as CDS negative basis; structural model; covered bond approach and a regression based method in a scorecard. The regression based approach, which also combines different measures of liquidity, was initially proposed by David Lando from Copenhagen Business School. Richard Olswang was also positive about using that approach to come up with an estimate, while Yakov Amihud of the Stern Business School, NYU, pointed out that unobservable liquidity effects could be imputed from observable measures, for example the trading frequency of a fund. Funds which hold relatively liquid assets are more likely to trade compared to funds which hold relatively illiquid assets.
Conclusion: how should we discount liabilities or value assets?
Liquidity premia permeate the asset markets in different ways but, in general, delegates felt that it is hard to argue for one unique estimation method. A common industry view is that relatively illiquid assets should trade at a lower value compared to relatively liquid assets. Illiquid long-term liabilities should be discounted at higher rate when backed by illiquid assets as the long-term investor could earn the liquidity premium. Practitioners and academics alike share a view of vigilance towards absolute estimates of liquidity premia and highlight the requirement to benchmark LP measures against multiple models.
It was a lively discussion which arrived at a wide agreement that liquidity premia do exist and can be substantial. The academic panellists, however, did question how reliable different methods of estimating liquidity premia would be in providing a good assessment of the current level of liquidity premia.
About the conference
The one-day conference Understanding and Measuring Liquidity Premia in Asset Markets took place on 12 November 2009. Its aim was to review both the established consensus and the latest thinking of leading researchers on liquidity premia bringing together academics, practitioners and policy makers to discuss the complex matters of liquidity premium estimation. The conference was sponsored by Barrie & Hibbert, the European Insurance CFO Forum, MMF and Warwick University.
Presentation slides from the conference can be found here: http://www.barrhibb.com/documents/knowledge/Liquidity_Premium_Conference_Slides.zip