APPENDIX 11
First supplementary memorandum by ECGD
RESPONSE TO THE DOCUMENT PROVIDED BY MARK
AND PAUL INGRAM (BASIC)
The Ingrams propose a methodology for calculating
ECGD's subsidy on what the market charges for "identical
risk", which is different to the Value at Risk (VAR) approach
that has been adopted by ECGD to determine its capital needs as
a capitalised Trading Fund.
In section 3 of their paper, the Ingrams identify
what they consider to be a number of weaknesses in the VAR approach.
Against their arguments, EGGD would cite the following:
(i) the VAR Model is used widely in the banking
and insurance industry for risk management and measuring capital
adequacy;
(ii) the Bank for International Settlements
(Basle II) capital adequacy arrangements explicitly recommend
the use of VAR type models for assessing commercial banks' capital
requirements;
(iii) ECGD has adopted best commercial practice
in the determination of the appropriate VAR period and the calculation
of confidence intervals;
(iv) ECGD's approach is consistent with the
recommendations in KPMG's Risk Management Review (1999) (see p15-17
and p48-50) which recommended a VAR type approach to measuring
ECGD's risk capital requirements;
(v) an integral feature of ECGD's country
and corporate (overseas (buyer) risk assessment is a comparison
of our own risk ratings with those of the private sector rating
agencies such as Moody's and Standard and Poors. EGGD's probabilities
of loss are therefore cross-checked with private sector comparators;
and
(vi) ECGD's auditors also validate on an
annual basis a selected sample of our loss probabilities as part
of the auditing of ECGD's Trading Accounts.
CRITIQUE OF
THE INGRAM'S
METHODOLOGY (IM)
The Ingram's approach looks at a hypothetical
"stand-alone" piece of risk and compares the cost (and
therefore subsidy) based on what the market would charge with
that implied by a VAR approach.
Their hypothetical example[69]
and choice of figures suggest that the VAR approach understates
the cost to government and therefore the "true subsidy".
The major shortcoming of IM is that it does
not take account of the portfolio impact of underwriting a piece
of risk. The VAR approach allows ECGD to assess the impact of
an individual risk on its portfolio to determine whether it improves
or worsens the Department's loss distribution. Against this background
a piece of risk that improves ECGD's risk profile implies that
it could charge a premium rate lower than the rate demanded by
the capital markets.
The IM is in effect a simplified short cut
to arriving at the subsidy in ECGD's pricing. In fact, the IM
does not make any explicit assumptions about the capital needed
to support the risk nor the cost of capital used. The VAR approach
is, on the other hand, a more precise measure as it takes account
of the specific capital needed to support the risk and a more
robust estimate of the capital cost (and any subsidy) can be determined.
ECGD'S IMPACT
ON THE
COST OF
GOVERNMENT BORROWING
The paper suggests that the Government's borrowing
costs are increased because it guarantees ECGD's risk book. It
would be helpful to see any empirical evidence underpinning this
statement. It is important to bear in mind here that ECGD does
not make loans or issue debt; its guarantees represent
only contingent liabilities for HMG. It is only in the event of
a default by a buyer that claims arise and the exchequer may be
required to increase its borrowings. Consequently the statement
in the paper that the "incremental increase for each pound
of debt is very small. However, the total cost of the exchequer
equates to the subsidy" is not substantiated.
CONCLUSION
The capitalised Trading Fund arrangements envisage
that ECGD's risk management should take account of the cost of
capital. Ministers have yet to determine what the cost of capital
should be. Several approaches are currently being explored; in
particular, ECGD is examining what it might have to pay for its
capital if it were a freestanding private sector entity not supported
by Government guarantee. In this context, we have looked at: a
hypothetical securitisation of ECGD's portfolio—in short
how much return would private sector investors demand for assuming
ECGD's risk book; the cost of equity capital for comparator companies
in the private sector—an approach used by NERA in their
study of "Estimating the Economic Costs and Benefits of ECGD"
(2002); and the target rates of return of other government owned
trading fund entities. The so-called commercial rate of return
produced by this analysis will help to inform Ministers' decision
on the appropriate cost of capital for the ECGD Trading Fund.
We believe that the approach of looking at commercial rates of
return is very much in sympathy with the Ingram methodology. Allied
to the precise measurement of the Department's capital needs through
a VAR model, this should yield a more robust and rigorously based
estimate of ECGD's cost to government.
ECGD
May 2004
69 The hypothetical example seems flawed. The cost
implied by the market (based on the quoted figures of 3.5% and
3.2% is in fact £0.9 million (and not the £9 million
quoted). The cost over five years is therefore £4.5 million
(and not £45 million) implying no subsidy. Back
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