Policy Options in Monitoring Solvency - Coursework Example

Table of Contents 1.0.Introduction 1 2.0.Historical development of solvency 3 3.0.Policy options in monitoring Solvency 5 3.1.End or continue bailout 6 3.2.Limiting the scope of the firms providing financial services 6 3.3.Minimizing Spillover effect 7 3.4.Resolving a large, Interconnected Failing Firm 9 3.5.Harmonization of Solvency rule 10 4.0.Conclusion 12 5.0.Bibliography 12 1.0. Introduction Advancement in technology has improved even in developing countries hence there is need to change, adopt technology and make optimum use of the same. Simplification for payment of goods and services has taken place through the introduction of technological changes and innovations. The statistics from world payment report 2013 indicates that there is a worldwide raise in the volume of non-cash payments by a total of 7% in 2009 to over 260 billion in the year 2013. A study by Abor (2010) pointed out that before the introduction of electronic payments in most countries, customers had their banks to perform all transaction and with long queues payments through the banks became a problem in as much as it has been realized that the liquidity and capital solvency problems was monitored through central banks. Heek (2011) in his study described information development in countries like Kenya and Ghana as questionable and coupled with different challenges when it comes to electronic payments. The environment of payments normally consists of institutional infrastructure and processes that exist in a particular society for initiating and transferring monetary claims in the form of commercial and central banks liability (EU Commission, 2006). The setting includes payments instrument, the network arrangement, institutional players, and market convention, legal and regulatory framework. In rapidly developing countries like Ghana, the central bank plays a regulatory role in the payment business. At the same time, there are firms that develop, rollout and provide the needed infrastructure for electronic payment system (SST, 2014). The organizations that adopt the payment systems are the consuming firms in the transaction business while serving as intermediaries between the service providers and the public as a whole who uses the payment system like mobile phones. The recent introduction of mobile money payment in fast growing economies like Kenya, Ghana and India has ease the trouble of sending money domestically (SST, 2014). The main problem or an answered question is how firms harness and established this innovation into a rapid growing economy while maintaining Solvency/capital and reporting requirements for all mobile phone network providers to caution the customers for the insolvency problems, which might occur. For the moment, the legislative regulation of third-party compensation platform relics a real risk of misappropriation with several amount of sedimentary money persevered by the platform. Furthermore, the impact of virtual currency on the realistic currency should be taken into account by central bank (EU Commission 2006). 2.0. Historical development of solvency The term solvency margin refers to a buffer in corporation’s assets that covers a conjectural capital requisite by the regulator while solvency means the capability of a firm to settle future claims as they fall due. This involves that the firm must have sufficient asset to meet the liabilities and to satisfy statutory financial requirements. This is important for the firm that the consumer is protected and important for supervisor to ensure the stability of the financial market. The availability of solvency margin is the difference between asset and the liability in a company. Pentikainen (1952) was the first person to give the definition of solvency margin. It is also imperative to note the dissimilarity between the definite, available solvency margins and theoretical by the regulator required solvency margin. The actual solvency margin is the difference between asset and liability set by the company itself. The theoretical capital requirement (TCR) can be defined as the quantity necessary by the controller so that insurers can carry on their business in some structure. It is the target or early warning signal. It is also a model whereby if the company is having actual solvency margin above theoretical capital requirement, then it is good to continue operating as a going concern entity. Meanwhile, the Company has to dialogue between itself and the regulatory body on what major steps to be taken in order to ensure that the ASM is always above the TCR (Giamouridis, 2006). There are some institutions, which have an intervention ladder between the upper target level and the absolute minimum level. If we take for example, two regulatory capital requirements, the target in this case called the Solvency Capital Requirement, SCR and the absolute minimum requirement called the Minimum Capital Requirement MCR, therefore, will have; MCR SCR. Some scholars to refer to going concern approach and static solvency for the break-up situation have used the term dynamic solvency (Giamouridis 2006). By the use of risk theory techniques, the ability and strength of solvency can be easily evaluated. The ruin probability is that the insurer, in this case mobile phone service provider having an initial available solvency margin ASM > SCR will become insolvent with regard to a chosen time horizon called (0, T). Normally, T must be at least one year and chosen according to the company accounting period. The solvency regulation of the financial institutions currently is undergoing significant changes in most rapidly growing economies. The globalization and integration of financial services coupled with technological changes are ever increasing. The need to regulate and level playing ground for players is necessary. So is the need for increased protection to customers and significant advances in the conjecture and practice of current risk management which are among the reasons for the changes in the solvency regulation approach. Basel II is the recent attempts to solve solvency crisis by using three pillars; quantitative capital necessities, supervisory assessment and public disclosure and market discipline among players (EU Commission 2006). Using the context of the rapidly growing and evolving era of electronic commerce, there is need for a common regulatory framework that allows electronic money to deliver its full potential benefits. Such will contribute to the use of innovative means of payment, increasing the confidence of the bearer to facilitate transaction is necessary (EU Commission 2006). Electronic money can be considered an electronic surrogate for coins and banks notes that are stored on electronic platforms, and it normally intended for making electronic payments (EU Commission 2006). 3.0. Policy options in monitoring Solvency In order to control financial failures of the financial institutions, there are two set of policy that can be implemented; preventive policy measures and reactive policy response. A comprehensive policy is likely to incorporate both the two set of policies because different approaches are aimed at different parts of the problem to be solved. Some of the policies are as follows: 3.1. End or continue bailout Bailouts are government assistance to a single firm to prevent it from collapsing. Governments can fund small mobile phone operators to meet their immediate financial needs and ongoing obligations in full (Abor 2010). Abor also adds that this is one of the available government emergency programs which should be implemented to rapid growing economy as it will help consumers have more confidence in the financial institutions. The governments can deliver bailouts unique to a specific firm on a preferential or subsidized basis. There are three main policy approaches to government bailouts for the financial institutions which can be adapted to small mobile phone operators (Wright 2006). First, institutionalize the availability of assistance in standing programs with standard and procedures for access enumerated beforehand. Secondly, offer assistance on an ad hoc basis using broad discretional authority, adding authority as necessary and required. Lastly, eliminate any other source of broad authority that could potentially make assistance available normally referred as market discipline (Wright 2006). 3.2. Limiting the scope of the firms providing financial services One of the approaches of eliminating the idea that some firms are too big to fall is actually to distort the characteristics of firms that makes them feel that they are too big to fail (Abor 2010). The policy makers should ensure that a stable and big financial institutions spread their risk and break into small business units that operate independently hence breaking the notion that they are too big to fall. Firms sizes can be measured in different ways and the regulators would likely need to use more discretion to weigh a number of measures before deciding the methods to be used in measuring the firm size (Wright 2006). It should be noted that the size of the firm is it small or big does not determines or act as a source of systematic risk (Benjamin, 1977). A firm can be considered too big to fail due to its overall size, its importance in a particular segment of the financial markets, indicating that overall size alone cannot determine systematic importance of a firm. It should be also possible that in case all the financial institutions were small due to size cap, the largest institutions would be systematically important, even though their size would not be large enough as per today’s standards (Wright 2006). The benefit of reducing the firm is that if successful, it could eliminate the moral perils and the need for future bailout. Therefore small mobile phone operating in good position will eliminate insolvency that has hit most of the mobile phone business operators (Wright 2006). Though reducing the size may raise the cost or reduce the quality of financial services provided by big firms in the market and reduce their attractiveness to investors, it is a good approach to control solvency issues in the raising electronic payment services. 3.3. Minimizing Spillover effect This is one of the areas where policymakers have ignored for long in as much it was well-experienced after the financial crisis of the year 2008. Spillover effects refer to the situations of how failure in one firm affects other related firms. If a bigger or smaller financial firm has failed, it will affect the entire financial system since the customers will start losing confidence in the financial firms even mobile operators. Instead of altering the size of the firm, the regulators should find a means of neutralizing spillover effect to the point where failure of one firm would not hinder the broad financial or mobile operators system. From this point of understanding, if a firm has been believed that it could be allowed to safely fail regardless of its size, or what is called interconnectedness, the moral hazards related to the small firm syndrome would fade away and spillover effect would be minimized. One of the common means through which spillover effects occur is through counterpart risk. Counterparty risk is the risk that arises as a result of losses due to counterparty transactions where parties are unable to fulfill their obligatory duties. The policy makers can reduce counterparty risk through moving transactions, requiring risk exposure to be hedged and putting limits on the exposure of the specific counterparties that is debt, transaction and equity holdings. If these measures are adopted, they might have an impact of increasing the cost of the financial system. Like counterparty, limits have the potential of reducing liquidity and raise costs for transactions that may not be standardized adequately to be traded on the exchange. In the contrary, the market cost may be too low for the big firms from the societal perspective due to lack of proper incentives to monitor or price in the counterparty risk. One of the limitations of the solvency approach is that spillover effect cannot always be identified before it happens. In situations where counterparty are transparent during exposure, in theory, all market participants could have a chance to hedge themselves against any failure a head of time and the failure would not have contagion effect or at least the government could have rescue the exposure to prevent contagion. In practice, linkages have proven more complex and opaque, and sources of contagion have proven to predict over a long period. This effect is well depicted in the financial crisis of 2008 where policy makers reasoned that market participants and policy makers had had several months after the management of Bear Stearns to prepare for the failure of the so-called Lehman Brothers an indicators such as credit default swaps that have signaled an elevated risk of default for several months. Policy makers have indicated that identifying spillover effect is more difficult if a firm is not already regulated for soundness safety stay (SST 2014). Without clear and prudential regulator closely monitoring the firm’s activities and evaluating its counterparties, it is less likely that policy makers could quickly and more accurately identify who would be exposed to a firm’s failure. 3.4. Resolving a large, Interconnected Failing Firm From the experience of the financial crisis, failing banks were resolved through FDIC’s resolution regime while at the same time additional monetary institutions such as brokerage dealers were resolved through corporate bankruptcy system (SST, 2014). Bankruptcy can be described as a judicial process, which is initiated by the creditors in order to recover debts and other liabilities (SST 2014). FDIC’s, on the other hand, is a resolution regime where administration initiates a process by FDIC. These include transferring of assets, freezing of assets, obligation payment, and contract repudiation and obtaining judicial stay (SST 2014). Usually, FDIC resolved failed banks through the purchase assumption method under which the banks is closed down and some of its assets or its entire asset and deposits of the failed banks are sold out to other healthy banks. In situations where losses are too large, to be absorbed by creditors, they are absorbed by the FDICs deposit insurance fund, which in turn is pre-funded through assessment on deposit. This process can properly work with small institutions like small phone operators who most often collapse as a consequence of meager supervision or lack of adequate capital bases. The purchase as assumption method normally avoids open –ended government assistance and keeps the FDIC out of the business of running banks; one of the unintended consequences is that it encourages greater concentration, since the only entity capable of absorbing a large failed bank is likely to be an even larger institutions. However, with small mobile phone operators, this is possible and can help the problem of solvency. One rationale behind a resolution regime for banks is that the need to safeguard federally insured deposits and requires a swift resolution and gives the FDIC, which insures the deposits, priority over other creditors. Therefore, small and medium financial operating some are forced to insure themselves with regulatory commission so that in situations of problems or insolvency, the commission can come to their rescue. Prompt corrective measures and lowest cost resolutions requirements are intended to minimize losses to the FDIC and other creditors whereas any creditor cannot initiate the bankruptcy process until default has occurred (Groupe, 2005). 3.5. Harmonization of Solvency rule One of the most important goals of the solvency regime is to ensure the financial soundness not only to insurance companies but also to another financial undertaking like mobile banking and electronic payments. Particularly, to ensure that they can survive difficult periods and times, it aims at protecting policyholders, including consumers and business community and ensures stability of the financial system as a whole. Solvency policy stipulates that the minimum amount of financial resources that an insurers and reinsurers must have in order to cover the risk to which they are exposed (Groupe, 2005). With similar magnitude, the rule also lays down the principles that should guide overall risk management approach so that they can be much better anticipated; therefore, the situations can be better handles. EU for their part have enacted legislation to make easy the expansion of a solitary market in the insurance services, at the same time, they have secured an adequate level of consumer protection (Groupe, 2005). Though the current minimum EU regulations are not enough, tougher rules ought to be developed to ensure market discipline among market players. Similarly, countries need to develop harmonized rules regarding mobile phone operators within any country, so has to instill financial discipline among market players and protecting consumer interest (Groupe, 2005). It is sound known that a monetary institution is insolvent when its going concern value does not exist anymore, in normal times, when the financial markets are strong; it is easy to identify insolvent financial firms. Nevertheless, in times of crisis, it is not easy since solvency become so co-mingled with liquidity issues (Willemse & Wolthuis 2005).. In such circumstances, prices of assets becomes disconnected with the estimated cash flow and instead reflects prices that could be obtained if the asset had to be sold in the future to the few investors prepared to buy such assets at that time. Therefore, minimum cash float for any financial institutions needs to be well stipulated to avoid insolvency problems (Willemse & Wolthuis 2005). 4.0. Conclusion The new reserving, solvency/capital and reporting requirements So the failures and subsequent concerns can be considered to be the trigger for this request from the government. Their intention would be that these new requirements would influence the future chance of failure. The government should put the failure of financial sector as first priority to its rapid economic growth. Without stable financial sector, the economy is headed to collapse. New regulations and rules should be fully implemented to caution further collapse. Therefore, the government should adopt above policies to rescue its economy. 5.0. Bibliography Abor N. 2010 Lecture Notes on Market-Consistent Actuarial Valuation, Ver 1.4, ETH, Z¨urich. Benjamin, B. 1977. General Insurance. Heinemann, London (published for the Institute of Actuaries and the Faculty of Actuaries). EU Commission 2006. Amended Framework for Consultation on Solvency II, MARKT/2515/06, April 2006. European Commission, Internal Market and Services DG, Financial Institutions, Insurance and Pensions. financial instruments. Report presented at the 28th International Congress of Actuaries in Giamouridis, D 2006. Estimation risk in financial risk management: a correction, Journal of Risk, Vol. 8, pp. 121–125 Groupe Consultatif (2005): Diversification, Technical paper, Version 3.1, 17 October 2005 Heek N, 2011. Market value of liability mortality risk: a practical model, North American Actuarial Journal, 6, pp. 95–106. Paris, 2006. Pentik¨ainen, Teivo, Heikki Bonsdorff, Martti Pesonen, Jukka Rantala and Matti Ruohonen 1952 . Insurance Solvency and Financial Strength. Finnish Insurance Training and Publishing Company Ltd, Helsinki. ISBN 951-9174-75-3. SST, K 2014. The Risk Margin for the Swiss Solvency Test. Swiss Federal Office for Private Insurance, September 17. Willemse, W. & Wolthuis. H, (2005): Risk based solvency norms and their validity. Report (1 September 2005), Presented at the 28th International Congress of Actuaries in Paris 2006. Wright, Peter (2006): A view of the IASB’s work on accounting for insurance contracts. Read More