Using Insurance as an Alternative to the Bad Bank

The Current Situation

In spite of the German Special Fund Financial Market Stabilization (SoFFin) guarantees extended to German banks to refinance them (not to mention the measures taken to increase tier 1 capital), German banks are becoming increasingly reluctant to lend money, and this reluctance, together with the downturn in the economy, is putting a great strain on the German economy.

One of the main reasons for this is that there are types of assets in banks’ nontrading portfolios (less so in their trading portfolios) that are increasingly tying up capital as ratings are lowered. “Rating migration” will continue to have a negative impact on banks’ risk-weighted assets (RWAs) and will make banks even more reluctant to lend money. This is why the German government has been discussing, for some time now, whether to establish one or several “bad banks” to which banks could shift their “problem assets.” Apart from it being difficult to manage such a solution, it would also involve cash flow and rating problems. The German government has thus decided (and to my mind, rightly so) not to “sponsor” such a solution.

The Insurance Alternative

The government could establish a government-owned insurance company (with guarantor liability) to solve the problem. This company would charge premia to insure banks’ problem assets against actual failure when they reach final maturity (!). That is, the problem assets would stay with the banks and continue to be managed by the banks. The actual value of an asset would be calculated not before it reaches maturity (for example, when a structured, mortgage-based asset reaches maturity) using the cash flow generated by the asset.. Depending on the type of insurance a bank has chosen (asset types could be differentiated), the bank would have to absorb a deductible and pay a proportion (e.g., 10%) of the loss covered by the insurance company.

The advantage to this is that it would provide capital relief equaling the amount insured without federal funds having to be used from the outset. The banks would continue to manage their financial products, which are usually quite complex, and would be motivated by deductibles and coinsurance fees to minimize their final losses (and of course would be required to submit to audits and to account for their assets (“ring-fencing”)).

The Rating Problem

One of the main problems in selling problem assets is the current volatility and liquidity-engendered distortion of market prices. Since the insurance alternative would not per se involve selling assets, an across-the-board solution could be used which would take into account the amount insured and which could possibly be differentiated according to asset types or ratings.

Determining the Premia

Here it would be possible to be creative. The base case would be a premium amounting to x% of the insured assets, payable in advance in cash. Depending on the size of the portfolio involved and the bank’s liquidity situation, payment of premia could of course be deferred (even until final maturity). The British government, which intends to insure huge amounts of money, is going so far as to accept newly issued tier 1 capital as premia. This will also strengthen the capital position of the banks. In order to prevent cherry picking, insurance could be offered only for complete categories of assets (e.g., leveraged buy out (LBO) loans, residential mortgage-backed securities (RMBSs)).

Other Considerations

• Of course, there are a number of issues that would need to be dealt with before the insurance alternative could be implemented. Here are some of these issues:
• A solution of this type could also help to put an end to one of the worn-out arguments against consolidating the Landesbanks.
• Since an insurer is generally viewed according to its capital (which is relatively small because of guarantor liability) or premium volumes, it could also be possible to get away from nominal, or guaranteed, amounts that are hardly understandable for the normal person anymore (this issue would have to be discussed with budgetary law experts in order to find a solution conforming to the law).
• It is still an open question where it would be best to locate such an insurance company (at SoFFin, KfW, a new institution, etc.) and what would be the best name (failure insurance, surety insurance, capital protection insurance, relief insurance, or something-else insurance).
• While running the risk of talking the concept to death, one would like to point out that an insurer that ensures financial products against losses at maturity could of course also insure industrial companies’ assets (or loans?).

Illustration

Bank x has problem assets on its balance sheet amounting nominally to 100. These assets are insured against a premium of 5%, with a 15% deductible and a 10% coinsurance fee. This means that the first 15% of a loss is assumed by the bank itself, beyond that it assumes 10%.

Amount of Loss Assumed (including premia) at the Bank and the Insurance Company

Dr. Paul Achleitner

Member, Board of Management

Allianz SE