23 Sep 2021
Many young francophones once had to face a peculiar rite of passage: standing in front of a (usually very bored) classroom, they had to declaim - in verse - one of La Fontaine’s fables. Among the most famous of these moral allegories was “La Cigale et la Fourmi”, a short story describing the differences in approaches between a diligent and cautious ant and a frivolous cicada. The one spending the winter with enough to spare, the other starving after “singing all summer” – a cautious tale for children and adults alike.
The Solvency II Directive and the Capital Requirements Regulation are much more recent, much longer and much more technical texts - and they are thankfully (!) not in verse. But they share with the story a principle that can be best summarised as such: you better stock up as things will not always be as rosy as they currently are.
One year into the biggest pandemic we faced over a century, one understands better than ever the virtues of that rule and the reasons why Basel officials (in the CRR case) and the European Commission continue to expand these prudential frameworks. After all, capital requirements imposed on banks and insurers helped ensure stability at a time where stability was everyone’s top priority.
At the same time, the parable may in its genuine simplicity ignore that only acting like an ant may not do you much good. While singing like a cicada will obviously not help you weather the next crisis (although it may remind you of sunny times near the Mediterranean), not taking any risk (or not sufficiently diversifying your portfolio) may be riskier for you over the long-term.
Solvency II and CRR delivered their objective, but they also had an impact on the ability of banks and insurers to commit long-term equity capital to businesses. This in turn made it harder for EU companies – including more innovative ones - to get the funding they need to grow...but also ultimately more difficult for institutional investors to build diversified portfolios.
The launch of the Solvency II review today – and of the CRR framework in a few weeks – present a unique opportunity to ensure that institutional investors become key actors of the EU recovery (and a cornerstone of the EU Capital Markets Union) by giving their long-term equity exposures the risk charge they deserve. In other words: they offer the chance to keep the ant safe without muting the cicada.
And there is more good news: no fundamental overhaul and no deviation from international standards – only careful recrafting - is required to do so. In the Solvency II case, it is about making the criteria to use long-term equities portfolios more workable and suitable for insurers, for example by extending the geographic scope and improving ring-fencing requirements. In the CRR case, it is simply about not treating investments in long-term, diversified funds as speculative.
As often, this is a question of balance – as was noted by the European Commission itself when it called for these very changes as part of the EU Capital Markets Union Action Plan less than two years ago. When legislators - francophones or not - start debating the content of both legislation, they should therefore give some considerations to a successful and effective prudential framework, not only based on the stock-up efficiency, but also on the quality of the singing.
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