The macro-financial environment
The macro-financial environment
This domain tests the two-way link between the real economy and the financial system, and what that implies for insurers, pension funds and regulators.
Core rules
- The financial cycle amplifies the business cycle. Credit booms raise collateral values, which support further credit; the reversal produces debt deflation, as Fisher described.
- Quantitative easing works through asset purchases financed by created reserves, lowering yields, prompting portfolio rebalancing into riskier assets, and signalling future policy. Exit carries reversal risk.
- Systemic risk arises from common exposures, interconnectedness and the mismatch between funding liquidity and market liquidity.
- Macroprudential tools include the countercyclical capital buffer, loan-to-value and debt-to-income caps, leverage ratios and stress testing.
- Mark-to-market accounting and collateral haircuts are procyclical, reinforcing upswings and downswings.
- For long-dated institutions, falling interest rates raise bond values but cut reinvestment yields and raise the value of long-dated liabilities - a duration gap between assets and liabilities.
- Sovereign and currency risk, capital-flow reversals and foreign-currency borrowing amplify domestic shocks.
Worked example
An insurer holds assets with duration 8 and liabilities with duration 12. A 1 percentage point fall in yields raises asset values by about 8% and liability values by about 12%, worsening the surplus by roughly 4% of balance-sheet values. The firm can lengthen asset duration, use interest-rate swaps, or reprice liabilities to close the gap.
Traps
- Assuming QE works purely through the money multiplier.
- Treating duration as synonymous with maturity.
- Discussing interest-rate risk only on the asset side.
- Assuming regulation removes systemic risk rather than redistributing it.