As a consequence of reforms aimed at reducing systemic risk in banking and insurance, many of the largest global financial institutions will need to adjust their capital structures and portfolios of assets in the next few years. New standards for risk-weighted assets in the Basel III requirements—and additional national requirements such as the US Dodd-Frank legislation—will prompt banks to reduce the sizes of their balance sheets and shed risky assets, including some types of corporate bonds and equities. This may have a potentially large impact on capital markets, since banks in the United States and Europe today hold $15.9 trillion of sovereign bonds, corporate bonds, and equities. These are securities used for trading books, assets held to meet liquidity requirements, cross-holdings in other banks and corporations, and debt securities issued by corporate clients. As banks deleverage and shrink balance sheets, they may reduce lending and the need for all such securities, including equities.
Similarly, new capital adequacy standards for insurers in Europe—known as Solvency II—assess capital charges for risky assets.39 The capital charges are highest for equities and some types of corporate bonds (those with low credit ratings and/or long maturities). In response to these pending rules, which have been developed over recent years and will take effect in 2014, insurance companies in Europe have already reduced holdings of such assets. How much more they will sell is a matter of diverging opinion among the experts we have interviewed. Insurers have already reduced their allocation to equities from 39 percent of assets in 2000 to 27 percent in 2010, and the majority of their remaining equity holdings are held for clients in unit-linked accounts and are not covered by the new rules.
We calculate that insurers could sell as much as $150 billion of equities over the next five years, if they shed all equities not associated with unit-linked accounts. Alternatively, they may continue to hold some equities outside of unit-linked accounts over the next few years. In any case, it is clear that Solvency II already has reduced the amount of long-term risk capital that insurers will provide to the economy. At a time when European banks need to raise more capital, Solvency II significantly constrains the insurance sector as a potential source of equity for banks.