The theory is that the insurer isn’t then exposed to changes in the term structure on interest rates, only exposed to illiqudity/reinvestment risk to the extent of mortality fluctuations, isn’t exposed to currency risk and certainly isn’t exposed to credit risk. Without complex margining requirements like some swaps and without the need to roll cash investments over, government bonds should allow ALM teams to sleep well.

Now, Solvency II is likely to adopt a swap yield curve rather than bond yield curve. There are some good reasons here, including arguably fewer distortions from temporary supply and demand imbalances, improved liquidity and so on. The same yield curve is used for liquid liabilities so the allowance for an illiquidity premium over and above the swap curve at some times, in some ways and for some products is still under debate.

But what should Greek insurers do in the meantime?

Frankly, Greek government bonds don’t remove credit risk and the huge credit spreads on these instruments will create huge funding gaps and variability in earnings unless a Greek govi yield curve is used to value liabilities as well. It’s not clear at all that Greece will stay part of the Euro, so German government bonds don’t remove currency risk. German government bonds in any case are show signs of nervousness as yields creep up.

The swap market is exposed to the same Euro break-up risks as bonds. Which banks will survive, what happens to currencies in the meantime and what does that do to long-term Euro swaps? What about Euro-Sterling swaps issued by Greek banks (I’m not sure if these even exist though).

All in all, it’s good to be involved in ALM in South Africa, and even the Middle East just at the moment.

Europe is in serious trouble and very few South Africans have yet woken up to exactly how serious this trouble is.

[update: intrade betting has it more likely than not that at least one country will leave the Euro by December 2014. If one goes, it's likely more than one will.]

I wouldn’t want anything to do with any bank that has much at all to do with European banks or European sovereign debt. The old South African Rand is seeming like a safer relative bet than at pretty much any other time in the last decade.

Part of the deal is a “50% loss for private investors”. Which is part true and part nonsense but will be an effective Greek default when enacted / agreed. (I don’t care how “voluntary” it may be, it’s a default and almost all definitions of default include restructuring of debt in any way that isn’t what was originally promised.)

Why is it only partly true? Well it’s not necessarily a “loss” for private investors. The probability of default on Greek bonds has been just about 100% for a while now. This probability of default is derived from market prices for Greek bonds and market spreads on Greek Credit Default Swaps (CDS) and an assumed Loss Given Default or Recovery Rate for investors when the bonds do default. Actual Recovery Rates vary widely, but often analysts plug in the average Recovery Rate over most of this century on unsecured debt which is around 40%.

So if market prices for Greek bonds assumed 100% default probability and a 40% recovery, then a 50% recovery doesn’t sound so bad. The potential downside is that Greece may still (need to) default on these written-down bonds at some point in the next two decades.

So the real question is what will the new probability of default be? Then we will know whether investors “took a loss” and perhaps gain the market’s view on how successful the deal really will be.

Hearing that the conditions are sufficiently onerous that the borrower may not want it is great news. At the very least this reflects a balanced package rather than one heavily in favour of the undemocratic absolute monarchy of our neighbour.

I wonder how many of these conditions were added or modified after the initial public announcement. Cosatu, amongst other powerful groups, has also been very outspoken against the loan.

This is not a new idea, and has historically been resisted by the major banks since they feel, generally rightly, that they are less likely to have a problem of confidence and therefore less likely to benefit from deposit insurance. Smaller banks, on the other hand, are certainly more at risk of a run on the bank arising due to perceptions thus causing a liquidity problem when a solvency problem doesn’t exist.

Determining the appropriate mechanism to charge for deposit insurance is not straightforward. Clearly the charge can’t be the same fixed amount for all banks as the exposure will be very different between banks. The large banks would lobby hard to pay a lower rate (even if a higher overall amount) for the insurance given that they should be less subject to those confidence issues.

But how to determine that difference? One could take cue from the market by looking at credit ratings and, even more market-oriented, the spreads on debt issued by the banks. Three immediate problems come to mind:

1. Credit quality of long-term debt isn’t the same as protection for depositors
2. Probability of default is an input into confidence issues but certainly isn’t the entire story
3. Does anybody seriously still believe in the Efficient Market Hypothesis and trust that we can believe what the market offers as an impartial, objective and balanced view of reality?

So there are some fascinating technical problems to solve when implementing deposit insurance, not least of which is deciding how much gets protected.

What caught my eye was Moneyweb columnist, Phakamisa Ndzamela, demonstrating his disbelief at how deposit insurance could create a moral hazard and ultimately increase risk within the banking system.

some senior bank executives have cautioned that this could push the cost of banking higher and somehow encourage risky lending. [emphasis added]

Obviously Ndzamela hasn’t heard of the Savings and Loan crisis in the US in the 1980s, or, I don’t know, the Global Financial Crisis that we are still in, which was massively exacerbated (if perhaps not quite caused) through risk being accepted without due care because it was being passed off immediately to someone else.