Solvency requirements ‘encourage investment in risky equities’

The new Dutch financial assessment framework (nFTK) and Solvency II rules encourage pension funds and insurers to invest in the most risky equities, according to quant investors at Robeco.

In an article published on Me Judice, a website for economists, they advocated the introduction of financial “buffer” requirements based on the volatility of equity portfolios.

Their comments contrasted with common criticism of the Netherlands’ framework, which investors often claim unnecessarily forces pension funds to avoid investment risk – for example, because the supervisor wants trustees to understand all of their scheme’s investments.

Sometimes, the consequence is that pension funds refrain from complex or more risk-bearing investments.

According to the Robeco quant managers – David Blitz, Winfried Hallerbach, Laurens Swinkels and Pim van Vliet – the cause of the problem was that the nFTK and Solvency II rules only distinguish between equities listed in developed markets and equities from emerging markets, without further details.

“As a consequence, investors don’t have to balance risk and return, but can aim for the highest return without taking the financial and economic risks into account,” the quartet argued.

In their opinion, it was strange that buffer requirements for equity exposures were unrefined, whereas the conditions for fixed income investments – including corporate bonds – were much more detailed and, for example, subject to credit and interest risk criteria.

The authors concluded that current “simplistic” regulations had unintended and damaging effects, with the damage caused by the impact of the buffer requirements on markets.

They contended that “if investors manage sufficient assets under this kind of regulation, the price of risky equity will be forced upwards, whereas the price of low-risk equity will be suppressed”.

The researchers said that this distortion of the link between return and risk was visible in the financial markets.

“As a result, stable companies incur too high capital costs, which destroys value and is damaging to the economy,” they said.

In their opinion, the solution should be sought in linking buffer requirements with the volatility of equity categories by, for example, demanding a higher buffer for a small-cap portfolio and a lower one for low-risk equity.