Sam Woods, Deputy Governor of the Bank of England and Chief Executive of the Prudential Regulation Authority, recently made a major speech with radical ideas for how banks’ capital requirements could be regulated. In it, he praised actuaries for their skill in designing capital regimes in other contexts, especially in Solvency II, and he referred to them – tongue-in-cheek - as ‘druids’.
This response from IFoA President Louise Pryor offers insights into both the regulatory issues and the value actuaries can bring:
Dear Mr Woods,
I am writing in my capacity as President of the Institute and Faculty of Actuaries (IFoA) to respond to your absorbing ‘Bufferati’ speech at City Week in April. I should also mention my role as the chair of the Ecology Building Society, which adds another dimension to my comments.
In your speech you referred strikingly to the actuarial profession as ‘druids’. According to one online definition, a druid is “A member of a literate and influential class in Celtic society that included priests, soothsayers, judges, poets, etc”. While leadership, imagination, judgement and creativity are all vital in the actuarial profession, we also need the solid mathematical and statistical grounding needed to qualify as an actuary. Indeed, we are often described as ‘financial engineers’ so we are pleased that your comparison with druids was carefully phrased, saying actuaries were ‘engineers dressed as druids’. I would suggest that the modern financial professional needs both soft skills such as curiosity as well as the more traditional modelling skills in order to provide the judgements needed to navigate through an uncertain world.
I hope the following thoughts on your remarks will be helpful, bearing in mind the particular blend of skills and knowledge that actuaries can contribute. Your reference to actuaries was in respect of our contribution to the development of Solvency II, and so these comments include references to that. Central to this must be the need for professional judgement and expertise to act as a countervailing force to the flavour of the day in policymaking – the point of the public interest made well by the Governor in his speech to the IFoA back in December 2021.
We welcome the imaginative approach to banking capital requirements in your speech, and the simplicity of your proposal for a single capital buffer. As you mention, this approach (like the Basel 3.1 parked beside the Bufferati) can be complementary to existing regulatory frameworks and need not be in competition with them. It can act as a helpful reminder that despite the everyday focus on incremental changes, the future could – and probably will – look radically different from the past. Indeed, we may well be moving away from an era of economic cycles to one of recurrent ‘shocks’ (Covid, climate, Ukraine, and more to come) which may call for a completely different approach. Recently, similar reflections have spurred the IFoA to expand our thought leadership programme significantly to ensure the profession is better equipped to think outside its own tramlines.
We also welcome your emphasis on avoiding rigid rules using thresholds and triggers. This would enable regulators to take account of firms’ specific circumstances, whereas an overly rigid structure would tend to be gamed. In your speech you mentioned a ‘ladder of intervention’ to govern how regulators would use judgement to apply the tools at their disposal. While we agree that this is a desirable outcome, there is always the challenge of developing principles for the exercise of judgement, so that regulators can avoid either acting in a rigid manner at one end of the spectrum, or acting irrationally or capriciously at the other.
We support your emphasis on ‘buffer usability’, and the importance of enabling firms to support the real economy in downturns. There is no point always having to have at least one cab on the taxi rank, if you can’t then use the cab when you need it.
It would be vital to ensure that your proposed framework was effective for the full range of banks, from complex systemically important investment banks through to smaller retail banks and building societies. In the section of your speech entitled ‘Unmoored from reality’ you raise questions that could be levelled against the Bufferati approach, including whether it fails to acknowledge the need for a special buffer for larger banks, given their greater potential to damage the economy. As you suggest, Solvency II provides an example of a regulatory framework with a degree of proportionality, with a larger buffer and a smaller minimum capital requirement.
You rightly emphasise the importance of achieving a common international framework, noting this would depend on having common aims plus a degree of trust. Our experience of Solvency II shows that this is far from straightforward, and that challenges can arise not just from disagreements about the regulatory architecture but also from broader political issues.
Even the significant changes to Solvency II being consulted on in the UK will not lead to divergent conceptual foundations between the UK and Europe. The 1 in 200 risk approach will still operate on both sides of the Channel. We are not clear, however, if the Bufferati proposal is built on a similar underlying concept. We think the vehicle’s contours look intriguing but they remain hidden under a cloth. To become more useful as an alternative to current models we believe a little more definition is needed. This could come in various shapes or sizes. For example, it could be an indication of how large the minimum capital requirement might be; or a target limitation on the probability of banks going bust; or again, a goal to limit the circumstances under which they go bust.
These are just examples, but we think something of this kind would bring your proposals to life. In a recent (non-UK) consultation response we commented that the consultation paper focused largely on the impact of the external environment on banks but was silent about the impact of banks on the external environment. However, the banking sector has a crucial role in society, and capital requirements should reflect this by demonstrating a clear sense of purpose beneath the technical details.
Thank you for sharing your insights on this challenging subject, and I hope you have found something of value in these responses. I would be delighted to continue the discussion in whatever form (druidic or otherwise!) was most convenient.
Yours sincerely,
Louise Pryor
President, Institute and Faculty of Actuaries