Did asset allocation models lead to the Greek financial crisis?

As Greece continues to negotiate with the European Union, a significant question is whether asset allocation models contribute to financial instability?

An excellent case study is the German insurance market. As at the end of 2012, German life insurers held investments to the value of EURO 768.9 billion. Of this, 90% of total assets were held in fixed-income securities.

The current low-yield environment has led Germany’s Reserve Bank, Deutsche Bundesbank to raise questions about the potential for German insurers to become insolvent if low yields persist.

In a discussion paper issued in October 2014, Deutsche Bundesbank researchers Anke Kablau and Matthias Weiß analysed the impact of protracted low yields on solvency. According to Kablau and Weiß one option was for insurers to take on additional risk. “They could try to increase the net return in order to enlarge the allocations to the bonus and rebate provisions, part of which is recognised as own funds. Increased risk-taking would have to be viewed critically in terms of financial stability. Insurers’ risk management systems would certainly need to be progressively adapted.”

The German insurance dilemma raises the broader question of the macro-economic impacts of asset allocation. At a micro-economic level it makes complete sense for an insurer to adopt an asset allocation model where 90% of assets are invested in fixed-income securities. But when a whole system, which in this case is not just German insurers but pension funds globally, adopts the same asset allocation model we create problems.

What we need to see is differentiation, not herding, in investment strategy. Regulators have a role to play in supporting this. Rather than frowning upon risk, which the language of the Deutsche Bundesbank discussion paper implicitly does, regulators need to understand that by encouraging herding behaviour of investors we actually increase systemic risk.

The German insurance model, and others like it, created a platform where government bonds would be purchased, even where risks were deteriorating. We may be facing a Greek crisis today, but the makings of future crises exist in the sustainability of US debt.

The core message for investors is that whether we like it or not we have to step up and recognise that what we do contributes to the health of the global economy. Adopting investment strategies that look cost effective from a micro perspective, does not mean we don’t have responsibility at a macro level for their outcomes.

LINKS

Anke Kablau and Matthias Weiß, Deutsche Bundesbank, How is the low-interest-rate environment affecting the solvency of German life insurers?
https://www.bundesbank.de/Redaktion/EN/Downloads/Publications/Discussion_Paper_1/2014/2014_10_27_dkp_27.pdf?__blob=publicationFile

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Vale Phil Spathis

I first met Phil Spathis when we were at the Finance Sector Union of Australia. For a number of years I worked for Unite in the UK. I remember making a call from a phone box in Spain to talk to the FSU about my return to Australia. I got the time zones wrong and ended up calling at some un-godly hour in the morning. The phone was answered by Phil, the only one in the office. This was typical of Phil. His studying for his law degree whilst working full time and looking after a family were the stuff of legend.

Years later when we both found ourselves working in the industry fund movement, Phil’s commitment to the trade union movement had not wavered. He continued for many years to serve on the state executive of the FSU, and continued to be passionate about working issues.

When I began consulting in the responsible investment space it was Phil that gave me my first assignment, which was to establish a Sustainability Reporting framework that benchmarked the progress that the ASX was marking improving reporting around sustainability. Phil was the quiet force for investors on the ASX Corporate Governance Council, working in a collaborative, yet determined manner to incrementally improve governance stances of the Australian market.

Phil’s best known contribution to corporate governance is the battle that he led with Michael O’Sullivan against News Corp’s transfer of listing from Australia to US that would have undermined minority shareholders rights and entrench the power of the Murdoch family.

When ACSI stood up on behalf of Australian investors, Murdoch initially thought that he could brush them aside. But ACSI started organising – skills learned in the trade union movement – and established a global coalition that in the end forced Murdoch to the negotiating table.

Eleven years later the importance of corporate governance is universally recognised. But it wasn’t always like this. ACSI’s News Corp campaign was not just important for Australian investors. It gave legitimacy for others to stand up. That in the end describes Phil.

My deepest sympathy to Phil’s family.

Links

ACSI’s News Corp story:
http://www.theage.com.au/articles/2004/10/08/1097089571715.html?from=storylhs
http://www.acsi.org.au/sustainability-reporting.html

How to manage house price increases caused by foreign investment

This week I had a good chat with a London cabbie who besides bemoaning England’s cricket team, said that one of the results of the property boom in London is that he rarely gets fares to Chelsea, which has emptied out as properties are bought by foreigners who do not reside in them. The story of foreign investors driving up property prices is the same in other global cities including New York, Toronto and Paris.

Returning to Australia, the subject of rising house prices is reaching fever pitch. With the real economy declining as a result of the fading of the resources boom, and with banks curtailing their investment lending, the finger is being squarely pointed at foreign investors.

The demand by foreign investors for property is a global phenomenon. And much of the investment is from emerging markets where individuals are seeking to transfer wealth to countries where the rule of law means provides long term security.

The desire to transfer assets from the developing world to the developed world is likely to be a permanent feature of the new global economy. But what are the implications?

In the short term governments may be happy to see housing markets buoyant and local construction stimulated, but in the long term are we creating economic imbalances?

The danger is that rising property prices in global cities will ultimately make these cities uncompetitive as higher wages and higher rents makes the cost of running a business unaffordable. The increasing cost of operating in the world’s global cities, may in turn cement the divide between the developing and developed world where business costs will be lower. The cycle of property investing is therefore likely to continue as wealth will continue to be built in developing countries and transferred to property investments in global cities.

What should governments and investors do?

The first thing is that there is a need to establish sensible constraints on the flow of capital.

Singapore took an early lead in this direction in 2011, introducing a foreign buyers’ sales tax, which is now 18%, after property prices boomed by 20-30% in 2008-09. Singapore provides exemptions from the sales tax for certain countries, the result of which has been to stabilise property prices.

We may also need legislation to prevent hoarding of housing. Requiring investors who do not rent out a property to pay a special levy may be one option that could ensure that increased housing supply actually results in an increase in availability of rental properties.

By structuring foreign sales taxes at a rate that allows for sensible investment there is the potential to raise revenue that could be used in ways that are in the long term interest of cities. Taxes on empty households and foreign buyer sales taxes are a good way of financing infrastructure, urban development and affordable housing.

The final area of focus needs to be on governance of emerging markets. We need to create a global environment where private wealth feels secure investing for long term in the economies where they create wealth. With growth in emerging markets likely to be higher than growth in developed countries it is also in the interest of institutional investors to focus on improving governance, which would allow greater flows of pension capital to be allocated to growth regions. This means that institutional investors should actively support measures to crack down on corruption wherever it may occur.

Foreign capital has the potential to be a source of development that can stimulate local economies, but like fire it is a good friend, but bad master, and must be managed.