This article focuses on capital requirements for institutional investors who invest in government-related private loans and who are subject to FTK, Solvency II or Basel III. We discuss the stand-alone capital requirements for government-related private loans, but also the impact of these requirements on the overall balance sheet and solvency position. This provides more insight into the attractiveness of these investments, compared with other asset classes, for institutional investors.
We can conclude that this asset class has potentially a very low capital requirement under the different regulatory frameworks. Under FTK, the capital requirement is limited due to the underlying government guarantees, which leads to low expected losses. Under Solvency II and Basel III, almost all government-guaranteed loans are exempted from capital charges. This makes this asset class attractive from a capital point of view. In addition, the more illiquid nature of these loans is also translated into additional returns compared to liquid sovereign or credit bonds with a similar credit quality.
Some stylized results are shown below for FTK – applicable for Dutch pension funds – and Solvency II – applicable for European insurance companies.
Figure 1: Impact of government-related private loans on required capital and expected return under FTK and Solvency II. Source: Aegon Asset Management
These results show that the required capital can be reduced by substituting credits (or riskier assets) with government-related private loans. A capital-constrained institutional investor can thus free up much capital by funding government-related private loans with equities. At the same time, the expected return improves significantly in our base scenario when government-related private loans are funded by sovereigns or credits, making this asset class a good alternative to sovereign or credit bonds in the current low yield environment. A capital rich investor can thus also increase expected return by substituting sovereigns or credits with government-related private loans.
- Additional return in base economic scenario compared to sovereigns or credits due to lower liquidity
- Low risk profile and low (or zero) capital charge under FTK, Solvency II and Basel III
- Attractive alternative for sovereigns or credits
This article is written by David van Bragt of Aegon Asset Management and Rémi Lamaud of La Banque Postale Asset Management (LBPAM). Aegon Asset Management and LBPAM have a strategic, long-term partnership to jointly develop and sell investment products. LBPAM is France's fifth largest asset manager.
David van Bragt is a senior consultant in the Investment Solutions team at Aegon Asset Management. Rémi Lamaud is Head of Regulation and ALM at LBPAM. The authors advise institutional investors about ALM, LDI, risk management and regulatory developments.