Regulation Risk: The Case of Solvency II

Abstract

This paper is a piece for contributing to the sustainable European stake in order to interlock financial systems with the objectives of the 2030 Agenda (the UN’s SDGs). It is intended to be used as a platform for discussion between risk management practitioners in the financial industry and the regulator, to mitigate regulation risk. In its 2018 report, the High-Level Expert Group of the European Commission (2018, p. 48) introduces the idea that the short-term behaviours could result from the regulation itself. There would be a risk created by the regulation, a regulation risk.

In this paper, it is argued that a part of the observed short-termism on financial markets is indeed due to a regulation risk based on a falsehood way to understand the randomness in the case of long-term horizons and uncertain risks. The argument makes a detour via philosophy of science, exhibiting the Leibniz “principle of continuity”: change is continuous. It is argued that short-termism created by regulation risk is the visible result of the choice of continuous randomness, the Brownian representation, itself the outcome of the principle of continuity. The principle of continuity trickled down into all of neoclassical economic thought, which was the source of contemporary finance. The “Absence of Opportunity of Arbitrage” (AOA) which represents the intellectual cornerstone of the dominant contemporary financial approaches derives from the principle of continuity. The introduction of fair value valuation, AOA and the “market consistency” valuation in the Solvency II directive are results of the principle of continuity. The principle of continuity carried by Solvency II has overseen a general disqualification of traditional risk assessment methods. Hence Solvency II illustrates a specific case of regulation risk by creating an unexpected effect of short-termism.

In its 2018 report, the High-Level Expert Group of the European Commission asked that consideration be given to “how Solvency II could be adapted to further facilitate long-term investments”. In the present paper it is argued: by removing the principle of continuity from the epistemological background of risk models used in the technical contents of the Solvency II framework. Financial regulation will be sustainable for long horizons and uncertain risks if it removes the principle of continuity from its probabilistic background.

Keywords: Solvency II, Regulation risk, Financial Risk modelling, Short-termism, Mental model, Brownian motion, Quantification convention, Risk neutral valuation

JEL Classification: A1,B2,C6,G1,G2,K2,M48,N2,N4