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Understanding Liquidity Risk Management: A Scrubber Analogy

Discover the complexities of liquidity risk management explained through a scrubber analogy. Learn about regulatory approaches, cost uncertainties, and the implications for the Liquidity Coverage Ratio (LCR). Unveil the similarities between BIS regulations and scrubbers, unlocking new insights into financial risk mitigation.

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Understanding Liquidity Risk Management: A Scrubber Analogy

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  1. P age |1 BaseliiiComplianceProfessionalsAssociation(BiiiCPA)1200GStreetNWSuite800Washington,DC20005-6705USATel:202-449-9750Web:www.basel-iii-association.com DearMember, Ihadadifficulttimeinthepasttoexplainliquidityriskmanagementandratios. NowIknowwhattodo.Problemsolved! Iwilluseapollution-mitigatingtechnology,likescrubberstoexplainliquidityrisk. Mr.JeremyCStein,MemberoftheBoardofGovernorsoftheFederalReserveSystemexplainedhow: “Supposewehaveapowerplantthatproducesenergyand,asabyproduct,somepollution. Supposefurtherthatregulatorswanttoreducethepollutionandhavetwotoolsattheirdisposal: Theycanmandatetheuseofapollution-mitigatingtechnology,likescrubbers,ortheycanlevyataxontheamountofpollutiongeneratedbytheplant. Inanidealworld,regulationwouldaccomplishtwoobjectives. First,itwouldleadtoanoptimallevelofmitigation–thatis,itwouldinducetheplanttoinstallscrubbersuptothepointwherethecostofan BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  2. P age |2 additionalscrubberisequaltothemarginalsocialbenefit,intermsof reducedpollution. And,second,itwouldalsopromoteconservation: Giventhatthescrubbersdon’tgetridofpollutionentirely,onealsowantstoreduceoverallenergyconsumptionbymakingitmoreexpensive. Asimplecaseisoneinwhichthecostsofinstallingscrubbers,aswellasthesocialbenefitsofreducedpollution,areknowninadvancebytheregulatorandthemanagerofthepowerplant. Inthiscase,theregulatorcanfigureoutwhattherightnumberofscrubbersisandrequirethattheplantinstallthesescrubbers. Themandatecanthereforepreciselytargettheoptimalamountofmitigationperunitofenergyproduced. And,totheextentthatthescrubbersarecostly,themandatewillalsoleadtohigherenergyprices,whichwillencouragesomeconservation,though perhapsnotthesociallyoptimallevel. Thislattereffectistheimplicittaxaspectofthemandate. Amorecomplicatedcaseiswhentheregulatordoesnotknowaheadoftimewhatthecostsofbuildingandinstallingscrubberswillbe. Here,mandatingtheuseofafixednumberofscrubbersispotentiallyproblematic: Ifthescrubbersturnouttobeveryexpensive,theregulationwillendup beingmoreaggressivethansociallydesirable,leadingtooverinvestment inscrubbersandlargecostincreasesforconsumers;however,ifthe scrubbersturnouttobecheaperthanexpected,theregulationwillhavebeentoosoft. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  3. P age |3 Inotherwords,whenthecostofthemitigationtechnologyissignificantlyuncertain,aregulatoryapproachthatfixesthequantityofmitigationisequivalenttoonewheretheimplicittaxratebouncesaroundalot. Bycontrast,aregulatoryapproachthatfixesthepriceofpollutioninsteadofthequantity–say,byimposingapredeterminedproportionaltaxratedirectlyontheamountofpollutionemittedbytheplant–ismoreforgivinginthefaceofthiskindofuncertainty. Thisapproachleavesthescrubber-installationdecisiontothemanageroftheplant,whocanfigureoutwhatthescrubberscostbeforedecidinghowtoproceed. Forexample,ifthescrubbersturnouttobeunexpectedlyexpensive,theplantmanagercaninstallfewerofthem. Thisflexibilitytranslatesintolessvariabilityintheeffectiveregulatoryburdenandhencelessvariabilityinthepriceofenergytoconsumers. Scrubbersandhigh-qualityliquidassets WhatdoesallthisimplyforthedesignoftheLCR?Let’sworkthroughtheanalogyindetail. Theanalogtothepowerplant’senergyoutputisthegrossamountofliquidityservicescreatedbyabank–viaitsdeposits,thecreditlinesitprovidestoitscustomers,theprimebrokerageservicesitoffers,andsoforth. Theanalogtothemitigationtechnology–thescrubbers–isthestockofHQLAthatthebankholds. Andtheanalogtopollutionisthenetliquidityriskassociatedwiththedifferencebetweenthesetwoquantities,somethingakintotheLCRshortfall. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  4. P age |4 Thatis,whenthebankoffersalotofliquidityondemandtoitscustomersbutfailstoholdanadequatebufferofHQLA,thisiswhenitimposesspillovercostsontherestofthefinancialsystem. Inthecaseofthepowerplant,Iarguedthataregulationthatcallsforafixedquantityofmitigation–thatis,forafixednumberofscrubbers–ismoreattractivewhenthereislittleuncertaintyaboutthecostofthesescrubbers.” ThankyouJeremy! Ihavejustopenedmymasterplan.Ihavetolearnmoreaboutscrubbers.InowseeothersimilaritiesbetweentheBISandscrubbers.OnlynowIcanunderstandtheshapeoftheBISbuilding! IthinkIhavejustfoundanotherregulatoryarbitrageopportunity.Arealnationaldiscretion,justified. Scrubbersarecapableofreductionefficienciesintherangeof50%to 98%.WhyshouldtheLiquidityCoverageRatiobe100%? BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  5. P age |5 ALCRfrom50%to98%(meaning50,001%)isgoodenough! ThecalculationsinBaselandscrubbersarealsoalmostthesame! BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  6. P age |6 Liquidityregulationandcentralbanking SpeechbyMrJeremyCStein,MemberoftheBoardofGovernorsoftheFederalReserveSystem,atthe“Findingtherightbalance”2013CreditMarketsSymposium,sponsoredbytheFederalReserveBankofRichmond,Charlotte,NorthCarolina I’dliketotalktodayaboutoneimportantelementoftheinternationalregulatoryreformagenda–namely,liquidityregulation. Liquidityregulationisarelativelynew,post-crisisadditiontothefinancialstabilitytoolkit. KeyelementsincludetheLiquidityCoverageRatio(LCR),whichwasrecentlyfinalizedbytheBaselCommitteeonBankingSupervision,andtheNetStableFundingRatio,whichisstillaworkinprogress. Inwhatfollows,IwillfocusontheLCR. ThestatedgoaloftheLCRisstraightforward,evenifsomeaspectsofitsdesignarelessso. InthewordsoftheBaselCommittee,“TheobjectiveoftheLCRistopromotetheshort-termresilienceoftheliquidityriskprofileofbanks. Itdoesthisbyensuringthatbankshaveanadequatestockofunencumberedhigh-qualityliquidassets(HQLA)thatcanbeconvertedeasilyandimmediatelyinprivatemarketsintocashtomeettheirliquidityneedsfora30calendardayliquiditystressscenario.” Inotherwords,eachbankisrequiredtomodelitstotaloutflowsover30daysinaliquiditystresseventandthentoholdHQLAsufficienttoaccommodatethoseoutflows. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  7. P age |7 Thisrequirementisimplementedwitharatiotest,wheremodeledoutflowsgointhedenominatorandthestockofHQLAgoesinthenumerator;whentheratioequalsorexceeds100percent,therequirementissatisfied. TheBaselCommitteeissuedthefirstversionoftheLCRinDecember2010. InJanuaryofthisyear,thecommitteeissuedarevisedfinalversionoftheLCR,followinganendorsementbyitsgoverningbody,theGroupofGovernorsandHeadsofSupervision(GHOS). TherevisionexpandstherangeofassetsthatcancountasHQLAandalsoadjustssomeoftheassumptionsthatgovernthemodelingofnetoutflowsinastressscenario. Inaddition,thecommitteeagreedinJanuarytoagradualphase-inoftheLCR,sothatitonlybecomesfullyeffectiveonaninternationalbasisinJanuary2019. Onthedomesticfront,theFederalReserveexpectsthattheU.S.bankingagencieswillissueaproposallaterthisyeartoimplementtheLCRforlargeU.S.bankingfirms. Whilethisprogressiswelcome,anumberofquestionsremain. First,towhatextentshouldaccesstoliquidityfromacentralbankbeallowedtocounttowardsatisfyingtheLCR? InJanuary,theGHOSnotedthattheinteractionbetweentheLCRandtheprovisionofcentralbankfacilitiesiscriticallyimportant. AndthegroupinstructedtheBaselCommitteetocontinueworkingonthisissuein2013. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  8. P age |8 Second,whatstepsshouldbetakentoenhancetheusabilityoftheLCRbuffer–thatis,toencouragebankstoactuallydrawdowntheirHQLAbuffers,asopposedtofire-sellingotherlessliquidassets? TheGHOShasalsomadeclearitsviewthat,duringperiodsofstress,itwouldbeappropriateforbankstousetheirHQLA,therebyfallingbelowtheminimum. However,creatingaregimeinwhichbanksvoluntarilychoosetodosoisnotaneasytask. AnumberofobservershaveexpressedtheconcernthatifabankisheldtoanLCRstandardof100percentinnormaltimes,itmaybereluctanttoallowitsratiotodropbelow100percentwhenfacinglargeoutflows,evenifregulatorsweretopermitthistemporarydeviation,forfearthatadeclineintheratiocouldbeinterpretedasasignofweakness. Myaimhereistosketchaframeworkforthinkingabouttheseandrelatedissues. Amongthem,theinterplaybetweentheLCRandcentralbankliquidityprovisionisperhapsthemostfundamentalandanaturalstartingpointfordiscussion. Bywayofmotivation,notethatbeforethefinancialcrisis,wehadahighlydevelopedregimeofcapitalregulationforbanks–albeitonethatlooksinadequateinretrospect–butwedidnothaveformalregulatorystandardsfortheirliquidity. Theintroductionofliquidityregulationafterthecrisiscanbethoughtofasreflectingadesiretoreducedependenceonthecentralbankasalenderoflastresort(LOLR),basedonthelessonslearnedoverthepreviousseveralyears. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  9. P age |9 However,totheextentthatsomerolefortheLOLRstillremains,onenowfacesthequestionofhowitshouldcoexistwitharegimeofliquidityregulation. Toaddressthisquestion,itisusefultotakeastepbackandaskanotherone: Whatunderlyingmarketfailureisliquidityregulationintendedtoaddress,andwhycan’tthismarketfailurebehandledentirelybyanLOLR? Iwillturntothisquestionfirst. Next,Iwillconsiderdifferentmechanismsthatcouldpotentiallyachievethegoalsofliquidityregulation,andhowthesemechanismsrelatetovariousfeaturesoftheLCR. Insodoing,Ihopetoillustratewhy,eventhoughliquidityregulationisaclosecousinofcapitalregulation,itneverthelesspresentsanumberofnovelchallengesforpolicymakersandwhy,asaresult,wearegoingtohavetobeopentolearningandadaptingaswego. Thecaseforliquidityregulation Oneoftheprimaryeconomicfunctionsofbanksandotherfinancialintermediaries,suchasbroker-dealers,istoprovideliquidity–thatis,cashondemand–invariousformstotheircustomers. Someofthisliquidityprovisionhappensontheliabilitysideofthebalancesheet,withbankdemanddepositsbeingaleadingexample. But,importantly,banksalsoprovideliquidityviacommittedlinesof credit. Indeed,itisprobablynotacoincidencethatthesetwoproducts–demand depositsandcreditlines–areofferedundertheroofofthesame BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  10. P age |10 institution;theunderlyingcommonalityisthatbothrequireanabilitytoaccommodateunpredictablerequestsforcashonshortnotice. Anumberofotherfinancialintermediaryservices,suchasprimebrokerage,alsoembodyasignificantelementofliquidityprovision.Withoutquestion,theseliquidity-provisionservicesaresociallyvaluable. Ontheliabilityside,demanddepositsandothershort-termbankliabilitiesaresafe,easy-to-valueclaimsthatarewellsuitedfortransaction purposesandhencecreateaflowofmoney-likebenefitsfortheirholders. Andloancommitmentsaremoreefficientthananarrangementinwhicheachoperatingfirmhedgesitsfutureuncertainneedsby“pre-borrowing”andhoardingtheproceedsonitsownbalancesheet;thislatterapproach doesapoorjobofeconomizingonthescarceaggregatesupplyofliquidassets. Atthesametime,asthefinancialcrisismadepainfullyclear,thebusinessofliquidityprovisioninevitablyexposesfinancialintermediariestovariousformsofrunrisk. Thatis,inresponsetoadverseevents,theirfragilefundingstructures,togetherwiththebindingliquiditycommitmentstheyhavemade,canresultinrapidoutflowsthat,absentcentralbankintervention,leadbankstofire-sellilliquidassetsor,inamoreseverecase,tofailaltogether. Andfiresalesandbankfailures–andtheaccompanyingcontractionsincreditavailability–canhavespillovereffectstootherfinancialinstitutionsandtotheeconomyasawhole. Thus,whilebankswillnaturallyholdbufferstocksofliquidassetstohandleunanticipatedoutflows,theymaynotholdenoughbecause,althoughtheybearallthecostsofthisbufferstocking,theydonotcaptureallofthesocialbenefits,intermsofenhancedfinancialstabilityandlowercoststotaxpayersintheeventoffailure. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  11. P age |11 Itisthisexternalitythatcreatesaroleforpolicy. Therearetwobroadtypesofpolicytoolsavailabletodealwiththissortofliquidity-basedmarketfailure. Thefirstisafter-the-factintervention,eitherbyadepositinsurerguaranteeingsomeofthebank’sliabilitiesorbyacentralbankactingasanLOLR. Thesecondtypeisliquidityregulation. Asanexampleoftheformer,whentheeconomyisinabadstate,assumingthataparticularbankisnotinsolvent,thecentralbankcanlendagainstilliquidassetsthatwouldotherwisebefire-sold,therebydampingoreliminatingtherundynamicsandhelpingreducetheincidenceofbankfailure. Inmuchoftheliteratureonbanking,suchinterventionsareseenasthe primarymethodfordealingwithrun-likeliquidityproblems. Aclassicstatementofthecentralbank’sroleasanLOLRisWalterBagehot’s1873bookLombardStreet. Morerecently,theseminaltheoreticaltreatmentofthisissueisbyDouglasDiamondandPhilipDybvig,whoshowthatundercertaincircumstances,theuseofdepositinsuranceoranLOLRcaneliminaterunriskaltogether,therebyincreasingsocialwelfareatzerocost. Tobeclear,thisworkassumesthatthebankinquestionisfundamentallysolvent,meaningthatwhileitsassetsmaynotbeliquidonshortnotice,thelong-runvalueoftheseassetsisknownwithcertaintytoexceedthevalueofthebank’sliabilities. Onewaytointerpretthemessageofthisresearchisthatcapitalregulationisimportanttoensuresolvency,butonceareliableregimeof BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  12. P age |12 capitalregulationisinplace,liquidityproblemscanbedealtwithafterthefact,viasomecombinationofdepositinsuranceanduseoftheLOLR. ItfollowsthatifoneisgoingtomakeanargumentinfavorofaddingpreventativeliquidityregulationsuchastheLCRontopofcapitalregulation,acentralpremisemustbethattheuseofLOLRcapacityinacrisisscenarioissociallycostly,sothatitisanexplicitobjectiveofpolicytoeconomizeonitsuseinsuchcircumstances. Ithinkthispremiseisasensibleone. Akeypointinthisregard–andonethathasbeenreinforcedbytheexperienceofthepastseveralyears–isthatthelinebetweenilliquidityandinsolvencyisfarblurrierinreallifethanitissometimesassumedtobeintheory. Indeed,onemightarguethatabankorbrokerdealerthatexperiencesaliquiditycrunchmusthavesomeprobabilityofhavingsolvencyproblemsaswell;otherwise,itishardtoseewhyitcouldnotattractshort-termfundingfromtheprivatemarket. ThisreasoningimpliesthatwhenthecentralbankactsasanLOLRinacrisis,itnecessarilytakesonsomeamountofcreditrisk. Andifitexperienceslosses,theselossesultimatelyfallontheshouldersoftaxpayers. Moreover,theuseofanLOLRtosupportbankswhentheygetintotroublecanleadtomoralhazardproblems,inthesensethatbanksmaybelessprudentexante. IfitwerenotforthesecostsofusingLOLRcapacity,theproblemwouldbetrivial,andtherewouldbenoneedforliquidityregulation: BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  13. P age |13 Assumingawell-functioningcapital-regulationregime,thecentralbankcouldalwaysavertallfiresalesandbankfailuresexpost,simplybyactingasanLOLR. Thisobservationcarriesanimmediateimplication: Itmakesnosensetoallowunpricedaccesstothecentralbank’sLOLRcapacitytocounttowardanLCRrequirement. Again,thewholepointofliquidityregulationmustbeeithertoconserveontheuseoftheLOLRorinthelimit,toaddresssituationswheretheLOLRisnotavailableatall–as,forexample,inthecaseof broker-dealersintheUnitedStates. Atthesametime,itisimportanttodrawadistinctionbetweenpricedand unpricedaccesstotheLOLR. Forexample,takethecaseofAustralia,whereprudentfiscalpolicyhasledtoarelativelysmallstockofgovernmentdebtoutstandingandhencetoapotentialshortageofHQLA. TheBaselCommitteehasagreedtotheusebyAustraliaofaCommittedLiquidityFacility(CLF),wherebyanAustralianbankcanpaytheReserveBankofAustraliaanupfrontfeeforwhatiseffectivelyaloancommitment,andthisloancommitmentcanthenbecountedtowarditsHQLA. IncontrasttofreeaccesstotheLOLR,thisapproachisnotatoddswiththegoalsofliquidityregulationbecausetheup-frontfeeiseffectivelyataxthatservestodeterrelianceontheLOLR–which,again,ispreciselytheultimategoal. IwillreturntotheideaofaCLFshortly. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  14. P age |14 Thedesignofregulation Onceithasbeendecidedthatliquidityregulationisdesirable,thenextquestionishowbesttoimplementit. Inthiscontext,notethattheLCRhastwologicallydistinctaspectsasaregulatorytool: Itisamitigator,inthesensethatholdingliquidassetsleadstoabetteroutcomeifthereisabadshock;itisalsoanimplicittaxonliquidityprovisionbybanks,totheextentthatholdingliquidassetsiscostly. Ofcourse,onecansaysomethingbroadlysimilaraboutcapitalrequirements. ButtheimplicittaxassociatedwiththeLCRissubtlerandlesswell understood,soIwillgointosomedetailhere. Ananalogymayhelptoexplain. Supposewehaveapowerplantthatproducesenergyand,asabyproduct,somepollution. Supposefurtherthatregulatorswanttoreducethepollutionandhavetwotoolsattheirdisposal: Theycanmandatetheuseofapollution-mitigatingtechnology,likescrubbers,ortheycanlevyataxontheamountofpollutiongeneratedbytheplant. Inanidealworld,regulationwouldaccomplishtwoobjectives. First,itwouldleadtoanoptimallevelofmitigation–thatis,itwouldinducetheplanttoinstallscrubbersuptothepointwherethecostofanadditionalscrubberisequaltothemarginalsocialbenefit,intermsof reducedpollution. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  15. P age |15 And,second,itwouldalsopromoteconservation: Giventhatthescrubbersdon’tgetridofpollutionentirely,onealsowantstoreduceoverallenergyconsumptionbymakingitmoreexpensive. Asimplecaseisoneinwhichthecostsofinstallingscrubbers,aswellasthesocialbenefitsofreducedpollution,areknowninadvancebytheregulatorandthemanagerofthepowerplant. Inthiscase,theregulatorcanfigureoutwhattherightnumberofscrubbersisandrequirethattheplantinstallthesescrubbers. Themandatecanthereforepreciselytargettheoptimalamountofmitigationperunitofenergyproduced. And,totheextentthatthescrubbersarecostly,themandatewillalsoleadtohigherenergyprices,whichwillencouragesomeconservation,though perhapsnotthesociallyoptimallevel. Thislattereffectistheimplicittaxaspectofthemandate. Amorecomplicatedcaseiswhentheregulatordoesnotknowaheadoftimewhatthecostsofbuildingandinstallingscrubberswillbe. Here,mandatingtheuseofafixednumberofscrubbersispotentiallyproblematic: Ifthescrubbersturnouttobeveryexpensive,theregulationwillendup beingmoreaggressivethansociallydesirable,leadingtooverinvestment inscrubbersandlargecostincreasesforconsumers;however,ifthe scrubbersturnouttobecheaperthanexpected,theregulationwillhavebeentoosoft. Inotherwords,whenthecostofthemitigationtechnologyissignificantlyuncertain,aregulatoryapproachthatfixesthequantityofmitigationis equivalenttoonewheretheimplicittaxratebouncesaroundalot. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  16. P age |16 Bycontrast,aregulatoryapproachthatfixesthepriceofpollutioninsteadofthequantity–say,byimposingapredeterminedproportionaltaxratedirectlyontheamountofpollutionemittedbytheplant–ismoreforgivinginthefaceofthiskindofuncertainty. Thisapproachleavesthescrubber-installationdecisiontothemanageroftheplant,whocanfigureoutwhatthescrubberscostbeforedecidinghowtoproceed. Forexample,ifthescrubbersturnouttobeunexpectedlyexpensive,theplantmanagercaninstallfewerofthem. Thisflexibilitytranslatesintolessvariabilityintheeffectiveregulatoryburdenandhencelessvariabilityinthepriceofenergytoconsumers. Scrubbersandhigh-qualityliquidassets WhatdoesallthisimplyforthedesignoftheLCR?Let’sworkthroughtheanalogyindetail. Theanalogtothepowerplant’senergyoutputisthegrossamountofliquidityservicescreatedbyabank–viaitsdeposits,thecreditlinesitprovidestoitscustomers,theprimebrokerageservicesitoffers,andsoforth. Theanalogtothemitigationtechnology–thescrubbers–isthestockofHQLAthatthebankholds. Andtheanalogtopollutionisthenetliquidityriskassociatedwiththedifferencebetweenthesetwoquantities,somethingakintotheLCRshortfall. Thatis,whenthebankoffersalotofliquidityondemandtoitscustomersbutfailstoholdanadequatebufferofHQLA,thisiswhenitimposesspillovercostsontherestofthefinancialsystem. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  17. P age |17 Inthecaseofthepowerplant,Iarguedthataregulationthatcallsforafixedquantityofmitigation–thatis,forafixednumberofscrubbers–ismoreattractivewhenthereislittleuncertaintyaboutthecostofthese scrubbers. InthecontextoftheLCR,thecostofmitigationisthepremiumthatthebankmustpay–intheformofreducedinterestincome–foritsstockofHQLA. And,crucially,thisHQLApremiumisdeterminedinmarketequilibriumanddependsonthetotalsupplyofsafeassetsinthesystem,relativetothedemandforthoseassets. Ontheonehand,ifsafeHQLA-eligibleassetsareinamplesupply,thepremiumislikelytobelowandstable. Ontheotherhand,ifHQLA-eligibleassetsarescarce,thepremiumwillbebothhigherandmorevolatileovertime. ThislattersituationistheonefacingcountrieslikeAustralia,where,asInotedearlier,thestockofoutstandinggovernmentsecuritiesisrelativelysmall. Anditexplainswhy,forsuchcountries,havingaprice-basedmechanismaspartoftheirimplementationoftheLCRcanbemoreappealingthan purerelianceonaquantitymandate. Whenonesetsanup-frontfeeforaCLF,oneeffectivelycapstheimplicit taxassociatedwithliquidityregulationatthelevelofthecommitmentfeeandtampsdowntheundesirablevolatilitythatwouldotherwisearisefromanentirelyquantity-basedregime. Moreover,itbearsreemphasizingthathavingaCLFwithanup-frontfeeisverydifferentfromsimplyallowingbankstocountcentral-bank-eligiblecollateralasHQLAatnocharge. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  18. P age |18 Rather,theCLFislikethepollutiontax. Foreverydollarofpre-CLFshortfall–thatis,foreverydollarofrequiredliquiditythatabankcan’tobtainontheprivatemarket–thebankhastopaythecommitmentfee. Soevenifthereisnotasmuchmitigation,thereisstillanincentivefor conservation,inthesensethatbanksareencouragedtodolessliquidityprovision,allelsebeingequal. ThiswouldnotbethecaseiftheCLFwereavailableatazeroprice.Whataboutthesituationincountrieswheresafeassetsaremore plentiful? TheanalysisherehasanumberofmovingpartsbecauseinadditiontotheimplementationoftheLCR,substantialincreasesindemandforsafeassetswillarisefromnewmarginrequirementsforbothclearedand nonclearedderivatives. Nevertheless,giventhelargeandgrowingglobalsupplyofsovereigndebtsecurities,aswellasotherHQLA-eligibleassets,mostestimatessuggest thatthescarcityproblemshouldbemanageable,atleastfortheforeseeablefuture. Inparticular,quantitativeimpactstudiesreleasedbytheBaselCommitteeestimatethattheworldwideincrementaldemandforHQLAcomingfromboththeimplementationoftheLCRandswapmarginrequirementsmightbeontheorderof$3trillion. Thisisalargenumber,butitcompareswithaglobalsupplyofHQLA-eligibleassetsofmorethan$40trillion. Moreover,theeligiblecollateralforswapmarginisproposedtobebroaderthantheLCR’sdefinitionofHQLA–including,forexample, certainequitiesandcorporatebondswithoutanycap. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  19. P age |19 IfonefocusesjustonU.S.institutions,theincrementaldemandnumberisontheorderof$1trillion,whilethesumofTreasury,agency,andagencymortgage-backedsecuritiesismorethan$19trillion. Whilethissortofanalysisissuperficiallyreassuring,thefactremainsthat theHQLApremiumwilldependonmarket-equilibriumconsiderationsthatarehardtofullyfathominadvance,andthatarelikelytovaryovertime. Thisuncertaintyneedstobeunderstood,andrespected. Indeed,themarket-equilibriumaspectoftheproblemrepresentsacrucialdistinctionbetweencapitalregulationandliquidityregulation,anditisonereasonwhythelatterisparticularlychallengingtoimplement. Althoughcapitalregulationalsoimposesataxonbanks–totheextent thatequityisamoreexpensiveformoffinancethandebt–thistaxwedgeis,toafirstapproximation,afixedconstantforagivenbank,independentofthescaleofoverallfinancialintermediationactivity. IfBankAdecidestoissuemoreequitysoitcanexpanditslendingbusiness,thisneednotmakeitmoreexpensiveforBankBtosatisfyitscapitalrequirement. Inotherwords,thereisnoscarcityproblemwithrespecttobankequity–bothAandBcanalwaysmakemore. Bycontrast,thetotalsupplyofHQLAisclosertobeingfixedatanypoint intime. Policyimplications Whatdoesallofthisimplyforpolicydesign? First,atabroadphilosophicallevel,therecognitionthatliquidityregulationinvolvesmoreuncertaintyaboutcoststhancapitalregulationsuggeststhatevenapolicymakerwithaverystrictattitudetowardcapital BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  20. P age |20 mightfinditsensibletobesomewhatmoremoderateandflexiblewithrespecttoliquidity. Thispointisreinforcedbytheobservationthatwhenaninstitutionisshortofcapitalandcan’tgetmoreontheprivatemarket,thereisreallynobackupplan,shortofresolution. Bycontrast,asImentionedearlier,whenaninstitutionisshortofliquidity,policymakersdohaveabackupplanintheformoftheLOLRfacility. Onedoesnotwanttorelytoomuchonthatbackupplan,butitspresenceshouldneverthelessfactorintothedesignofliquidityregulation. Second,inthespiritofflexibility,whileaprice-basedmechanismsuchastheCLFmaynotbeimmediatelynecessaryincountriesoutsideofAustraliaandafewothers,itisworthkeepinganopenmindaboutthemorewidespreaduseofCLF-likemechanisms. IfascarcityofHQLA-eligibleassetsturnsouttobemoreofaproblemthanweexpect,somethingalongthoselineshasthepotentialtobeausefulsafetyvalve,asitputsacaponthecostofliquidityregulation. Suchasafetyvalvewouldhaveadirecteconomicbenefit,inthesenseofpreventingtheburdenofregulationfromgettingundulyheavyinanyonecountry. Perhapsjustasimportant,asafetyvalvemightalsohelptoprotecttheintegrityoftheregulationitself,byharmonizingcostsacrosscountriesandtherebyreducingthetemptationofthosemosthard-hitbytherulestotrytochipawayatthem. Withoutsuchasafetyvalve,itispossiblethatsomecountries–thosewithrelativelysmallsuppliesofdomesticHQLA–willfindtheregulationconsiderablymorecostlythanothers. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  21. P age |21 Ifso,itwouldbenaturalforthemtolobbytodilutetherules–for example,byarguingforanexpansioninthetypeofassetsthatcancountasHQLA. Takentoofar,thissortofdilutionwouldunderminetheefficacyoftheregulationasbothamitigatorandatax. Inthisscenario,holdingthelinewithwhatamountstoaproportionaltaxonliquidityprovisionwouldbeabetteroutcome. Onesituationwhereliquidassetscanbecomeunusuallyscarceisduringafinancialcrisis. Consequently,evenifCLFswerenotcountedtowardtheLCRinnormaltimes,itmightbeappropriatetocountthemduringacrisis. Indeed,whiletheLCRrequiresbankstoholdsufficientliquidassetsingoodtimestomeettheiroutflowsinagivenstressscenario,itimplicitlyrecognizesthatifthingsturnoutevenworsethanthatscenario,centralbankliquiditysupportwillbeneeded. AllowingCLFstocounttowardtheLCRinsuchcircumstanceswouldacknowledgetheimportanceofaccesstothecentralbank,andthisaccesscouldbepricedaccordingly. Finally,aprice-basedmechanismmightalsohelppromoteawillingnessofbankstodrawdowntheirsupplyofHQLAinastressscenario. AsInotedattheoutset,oneimportantconcernaboutapurequantity-basedsystemofregulationisthatifabankisheldtoanLCRstandardof100percentinnormaltimes,itmaybereluctanttoallowitsratiotofallbelow100percentwhenfacinglargeoutflowsforfearthatdoingsomightbeseenbymarketparticipantsasasignofweakness. Bycontrast,inasystemwithsomethinglikeaCLF,abankmightin normaltimesmeet95percentofitsrequirementbyholding BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  22. P age |22 private-marketHQLAandtheremaining5percentwithcommittedcreditlinesfromthecentralbank,soitwouldhaveanLCRofexactly100percent. Then,whenhitwithlargeoutflows,itcouldmaintainitsLCRat100percent,butdosobyincreasingitsuseofcentralbankcreditlinesto25percentandselling20percentofitsotherliquidassets. Thisscenariowouldbethesortofliquid-assetdrawdownthatonewouldideallyliketoseeinastresssituation. Moreover,thecentralbankcouldencouragethisdrawdownbyvaryingthepricingofitscreditlines–specifically,byreducingthepriceofthelinesinthemidstofaliquiditycrisis. Suchanapproachwouldamounttotaxingliquidityprovisionmoreingoodtimesthaninbad,whichhasastabilizingmacroprudentialeffect. ThisexamplealsosuggestsadesignthatmayhaveappealinjurisdictionswherethereisarelativelyabundantsupplyofHQLA-eligibleassets. OnecanimaginecalibratingthepricingoftheCLFsoastoensurethatlinesprovidedbycentralbanksmakeuponlyaminimalfractionofbanks’requiredHQLAinnormaltimes–apart,perhaps,fromtheoccasional adjustmentperiodafteranindividualbankishitwithanidiosyncraticliquidityshortfall. Atthesametime,inastressscenario,whenliquidityisscarceandthereisupwardpressureontheHQLApremium,thepricingoftheCLFcouldbeadjustedsoastorelievethispressureandpromoteusabilityoftheHQLAbuffer. SuchanapproachwouldrespectthepolicyobjectiveofreducingexpectedrelianceontheLOLRwhileatthesametimeallowingforasafetyvalveinaperiodofstress. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  23. P age |23 ThelimitcaseofthisapproachisonewheretheCLFcountstowardtheLCRonlyinacrisis. Conclusion Bywayofconclusion,letmejustrestatethatliquidityregulationhasakey roletoplayinimprovingfinancialstability. However,weshouldavoidthinkingaboutitinisolation;rather,wecanbestunderstanditaspartofalargertoolkitthatalsoincludescapitalregulationand,importantly,thecentralbank’sLOLRfunction. Therefore,properdesignandimplementationofliquidityregulationssuchastheLCRshouldtakeaccountoftheseinterdependencies. Inparticular,policymakersshouldaimtostrikeabalancebetweenreducingrelianceontheLOLRontheonehandandmoderatingthecostscreatedbyliquidityshortagesontheotherhand–especiallythoseshortagesthatcropupintimesofseveremarketstrain. And,asalways,weshouldbepreparedtolearnfromexperienceaswego. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  24. P age |24 BaselIIICapital:AWell-IntendedIllusionThomasM.Hoenig ViceChairman,FederalDepositInsuranceCorporation InternationalAssociationofDepositInsurers2013ResearchConference,Basel,Switzerland Introduction Aristotleiscreditedwithbeingthefirstphilosophertosystematicallystudylogicalfallacies,whichhedefinedasargumentsthatappearvalidbut,infact,arenot. Icallthemwell-intendedillusions. OnesuchillusionofprecisionistheBaselcapitalstandardsinwhichworldsupervisoryauthoritiesrelyprincipallyonaTier1capitalratiotojudgetheadequacyofbankcapitalandbalancesheetstrength. Forthelargestofthesefirms,eachdollarofrisk-weightedassetsisfundedwith12to15centsinequitycapital,projectingtheillusionthatthesefirmsarewellcapitalized. Therealityisthateachdollaroftheirtotalassetsisfundedwithfarlessequitycapital,leavingopenthematterofhowwellcapitalizedtheymightbe. Here’showtheillusioniscreated. Basel'sTier1capitalmeasureisabank'sratioofTier1capitalto risk-weightedassets. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  25. P age |25 Eachcategoryofbankassetsisweighedbythesupervisoryauthorityonacomplicatedscaleofprobabilitiesandmodelsthatassignarelativeriskoflosstoeachgroup,includingoffbalancesheetitems. Assetsdeemedlowriskarereportedatloweramountsonthebalancesheet. Thelowertherisk,thelowertheamountreportedonthebalancesheetfor capitalpurposesandthehigherthecalculatedTier1ratio. WeknowfromyearsofexperienceusingtheBaselcapitalstandardsthatoncetheregulatoryauthoritiesfinishtheirweightingscheme,bankmanagersbegintheprocessofallocatingcapitalandassetstomaximizefinancialreturnsaroundtheseconstructedweights. Theobjectiveistomaximizeafirm'sreturnonequity(ROE)bymanagingthebalancesheetinsuchamannerthatforanylevelofequity,therisk-weightedassetsarereportedatlevelsfarlessthanactualtotalassetsundermanagement. Thiscreatestheillusionthatbankingorganizationshaveadequatecapitaltoabsorbunexpectedlosses. Forthelargestglobalfinancialcompanies,risk-weightedassetsareapproximatelyone-halfoftotalassets. This"leveragingup"hasservedworldeconomiespoorly. Incontrast,supervisorsandfinancialfirmscanchoosetorelyonthetangibleleverageratiotojudgetheoveralladequacyofcapitalfortheenterprise. Thisratiocomparesequitycapitaltototalassets,deductinggoodwill,otherintangibles,anddeferredtaxassetsfrombothequityandtotalassets. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  26. P age |26 Inadditiontoincludingonlyloss-absorbingcapital,italsomakesnoattempttopredictorassignrelativeriskweightsamongassetclasses.Usingthisleverageratioasourguide,wefindforthelargestbankingorganizationsthateachdollarofassetshasonly4to6centsfundedwithtangibleequitycapital,afarsmallerbufferthanassertedundertheBasel standards. ComparingMeasures Table1reportstheBaselTier1risk-weightedcapitalratioandthe leverageratiofordifferentclassesofbankingfirms. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  27. P age |27 Column4showsTier1capitalratiosrangingbetween12and15percentforthelargestglobalfirms,givingtheimpressionthatthesebanksarehighlycapitalized. However,itishardtobecertainofthatbylookingatthisratiosince risk-weightedassetsaresomuchlessthantotalassets. Incontrast,Column6showsU.S.firms'averageleverageratiotobe6percentusinggenerallyacceptedaccountingstandards(GAAP),andColumn8showstheiraverageratiotobe3.9percentusinginternationalaccountingstandards(IFRS),whichplacesmoreofthesefirms'derivativesontothebalancesheetthandoesGAAP. ThebottomportionofTable1showsthedegreeofleverageamongdifferentsizegroupsofbankingfirms,whichisstrikingaswell. TheTier1capitalmeasuresuggeststhatallsizegroupsofbanksholdcomparablecapitallevels,whiletheleverageratioreportsadifferentoutcome. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  28. P age |28 Forexample,theleverageratioformostbankinggroupsnotconsideredsystemicallyimportantaveragesnear8percentorhigher. UnderGAAPaccountingstandards,thedifferenceinthisratiobetweenthelargestbankingorganizationsandthesmallerfirmsis175-250basispoints. UnderIFRSstandards,thedifferenceisasmuchas400-475basispoints. Thelargestfirms,whichmostaffecttheeconomy,holdtheleastamountofcapitalintheindustry. Whilethisshowsthemtobemorefragile,italsoidentifiesjusthowsignificantacompetitiveadvantagetheselowercapitallevelsprovidethelargestfirms. ThesecomparisonsillustratehoweasilytheBaselcapitalstandardcanconfuseandmisinformthepublicratherthanmeaningfullyreportabankingcompany’srelativefinancialstrength. Recenthistoryshowsalsojusthowdamagingthiscanbetotheindustryandtheeconomy. In2007,forexample,the10largestandmostcomplexU.S.bankingfirmsreportedTier1capitalratiosthat,onaverage,exceeded7percentof risk-weightedassets. Regulatorsdeemedtheselargesttobewellcapitalized. Thisrisk-weightedcapitalmeasure,however,mappedintoanaverageleverageratioofjust2.8percent. Welearnedalltoolatethathavinglessthan3centsoftangiblecapitalforeverydollarofassetsonthebalancesheetisnotenoughtoabsorbeventhesmallestoffinanciallosses,andcertainlynotamajorshock. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  29. P age |29 Withthecrisis,theillusionofadequatecapitalwasdiscovered,afterhavingmisledshareholders,regulators,andtaxpayers. Thereareother,morerecent,examplesofhowthisarcanemeasurecan bemanipulatedtogivetheillusionofstrengthevenwhenafirmincurslosses. Forexample,inthefourthquarterof2012,DeutscheBankreportedalossof2.5billionEUR. Thatsamequarter,itsTier1risk-basedcapitalratioincreasedfrom14.2percentto15.1percentdue,inpart,to“modelandprocessenhancements”thatresultedinadeclineinrisk-weightedassets,which nowamounttojust16.6percentoftotalassets. OnFeb.1,SNSReaal,thefourthlargestDutchbankwith$5billioninassets,wasnationalizedbytheDutchgovernment. Justsevenmonthsearlier,onJune30,2012,SNSreportedaTier1risk-basedcapitalratioof12.2percent. However,thefirmreportedaTier1leverageratiobaseduponinternationalaccountingstandardsofonly1.47percent. ThisleverageratiowasmuchmoreindicativeoftheSNS’spoorfinancialposition. TheBaselIIIproposalbelatedlyintroducestheconceptofaleverageratiobutcallsforittobeonly3percent,anamountalreadyshowntobeinsufficienttoabsorbsizablefinanciallossesinacrisis. Itiswrongtosuggesttothepublicthat,withsolittlecapital,theselargestfirmscouldsurvivewithoutpublicsupportshouldtheyencounteranysignificanteconomicreversals. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  30. P age |30 MisallocatingResourcesandCreatingAssetImbalances Aninherentproblemwitharisk-weightedcapitalstandardisthattheweightsreflectpastevents,arestatic,andmostlyignorethemarket'scollectivedailyjudgmentabouttherelativeriskofassets. Italsointroducestheelementofpoliticalandspecialinterestsintotheprocess,whichaffectstheassignmentofriskweightstothedifferentassetclasses. Theresultisoftentoartificiallyfavoronegroupofassetsoveranother,therebyredirectinginvestmentsandencouragingover-investmentinthefavoredassets. Theeffectofthismanagedprocessistoincreaseleverage,raisethe overallriskprofileoftheseinstitutions,andincreasethevulnerabilityofindividualcompanies,theindustry,andtheeconomy. Itisnocoincidence,forexample,thatafteraBaselstandardassignedonlya7percentriskweightontripleA,collateralizeddebtobligationsandsimilarlowriskweightsonassetswithinafirm'stradingbook,resourcesshiftedtotheseactivities. Overtime,financialgroupsdramaticallyleveragedtheseassetsontotheirbalancesheetsevenastheriskstothatassetclassincreasedexponentially. Similarly,assigningzeroweightstosovereigndebtencouragedbankingfirmstoinvestmoreheavilyintheseassets,simultaneouslydiscountingtherealrisktheypresentedandplayinganimportantroleinincreasingit. Inplacingalowerriskweightonselectassets,lesscapitalwasallocatedtofundthemandtoabsorbunexpectedlossforthesebanks,underminingtheirsolvency. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  31. P age |31 • AMoreRealisticCapitalStandardIsRequired • Taxpayersaretheultimatebackstoptothesafetynetandhaverealmoneyatstake. • Inchoosingwhichcapitalmeasureismostuseful,itisfairtoaskthefollowingquestions: • DoestheBaselTier1ratioorthetangibleleverageratiobestindicatethecapitalstrengthofthefirm? • Whichoneismostclearlyunderstood? • Whichonebestenablescomparisonofcapitalacrossinstitutions? • Whichoneoffersthemostconfidencethatitcannotbeeasilygamed?Charts1through4comparetherelationshipofthetangibleleverageand • BaselTier1capitalratiostovariousmarketmeasuresforthelargestfirms. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  32. P age |32 BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  33. P age |33 BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  34. P age |34 BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  35. P age |35 BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  36. P age |36 Thesemeasuresinclude:theprice-to-bookratio,estimateddefault frequency,creditdefaultswapspreads,andmarketvalueofequity. Ineachinstance,thecorrelationofthetangibleleverageratiotothesevariablesishigherthanfortherisk-weightedcapitalratio. Whilesuchfindingsarenotconclusive,theysuggeststronglythat investors,whendecidingwheretoplacetheirmoney,relyupontheinformationprovidedbytheleverageratio. Wewoulddowelltodothesame. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  37. P age |37 Despitealloftheadvancementsmadeovertheyearsinriskmeasurementandmodeling,itisimpossibletopredictthefutureortoreliablyanticipatehowandtowhatdegreeriskswillchange. Capitalstandardsshouldservetocushionagainsttheunexpected,nottodivineeventualities. AlloftheBaselcapitalaccords,includingtheproposedBaselIII,lookbackwardandthenattempttoassignriskweightsintothefuture. Itdoesn'twork. Incontrast,thetangibleleverageratioprovidesasimpler,moredirect insightintotheamountofloss-absorbingcapitalthatisavailabletoafirm. AleverageratioasI’vedefineditexplicitlyexcludesintangibleitemsthatcannotabsorblossesinacrisis. Also,usingIFRSaccountingrules,off-balancesheetderivativesarebroughtontothebalancesheet,providingfurtherinsightintoafirm'sleverage. Thus,thetangibleleverageratioissimplertocomputeandmoreeasilyunderstoodbybankmanagers,directors,andthepublic. Importantlyalso,itismorelikelytobeconsistentlyenforcedbybanksupervisors. Amoredifficultchallengemaybetodetermineanappropriateminimumleverageratio. Chart5providesahistoryofbankleverageoverthepast150yearsforthe U.S.bankingsystemandgivesinitialinsightintothisquestion. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  38. P age |38 ItshowsthattheequitycapitaltoassetsratiofortheindustrypriortothefoundingoftheFederalReserveSystemin1913andtheFederalDepositInsuranceCorporationin1933rangedbetween13and16percent,regardlessofbanksize. Withoutanyinternationallydictatedstandardoranyarcaneweightingprocess,marketsrequiredwhattodayseemslikerelativelyhighcapitallevels. Inaddition,thereisanincreasingbodyofresearch(AdmatiandHellwig;Haldane;Miles,Yang,andMarcheggiano)thatsuggeststhatleverageratiosshouldbemuchhigherthantheycurrentlyareandthatBaselIII’sproposed3percentfigureaddslittlesecuritytothesystem. Finally,andimportantly,someformofrisk-weightedcapitalmeasure couldbeusefulasabackstop,orcheck,againstwhichtojudgetheadequacyoftheleverageratioforindividualbanks. Ifabankmeetstheminimumleverageratiobuthasconcentratedassetsinareasthatriskmodelssuggestincreasetheoverallvulnerabilityofthebalancesheet,thebankcouldberequiredtoincreaseitstangiblecapitallevels. Suchasystemprovidesthemostcomprehensivemeasureofcapital adequacybothinabroadcontextofallassetsandaccordingtoabank's allocationofassetsalongadefinedriskprofile. TangibleLeverageRatioandtheMythofUnintendedConsequences Concernsareoftenraisedwithinthefinancialindustryandelsewherethatrequiringthelargestandmostcomplexfirmstoholdhigherlevelsof capitalasdefinedusingatangibleleverageratiowouldhaveseriousadverseeffectsontheindustryandbroadereconomy. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  39. P age |39 Ithasbeensuggested,forexample,thatrequiringmorecapitalfortheselargestbankswouldraisetheirrelativecostofcapitalandmakethemlesscompetitive. Similarly,thereisconcernthatfailingtoassignriskweightstothedifferentcategoriesofassetswouldencouragefirmstoallocatefundstothehighestriskassetstoachievetargetedreturnstoequity. TheseissueshavebeenwelladdressedbyAnatAdmatiandMartinHellwigintheirrecentlypublishedbook,TheBankers’NewClothes. TherequiredROEandtheabilitytoattractcapitalaredeterminedbyahostoffactorsbeyondthelevelofequitycapital. Theseincludeafirm’sbusinessmodel,itsrisk-adjustedreturns,thebenefitsofservicesandinvestments,andtheundistorted,or non-subsidized,costsofcapital. Alevelofcapitalthatlowersriskmayverywellattractinvestorsdrawntothemorereliablereturns. Table1showsmanyofthebankswithstrongerleverageratiosalsohavestockpricestradingatahigherpremiumtobookvaluethanthelargestfirmsthatarelesswell-capitalized. Therealsoisaconcernthatrequiringastronger,simplerleverageratiowouldcausemanagerstoplacemoreriskontheirbalancesheet. Whilepossible,theargumentisunconvincing. Withmorecapitalatriskandwithoutregulatoryweightingschemesaffectingchoice,managerswillallocatecapitalinlinewithmarketriskandreturns. Furthermore,risk-weightedmeasuresandstrongbanksupervisioncanbe availableasaback-upsystemtomonitorsuchactivity. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  40. P age |40 Moreover,giventheexperienceoftherecentcrisisandtheon-going effortstomanagereportedriskassetsdown,nomattertherisk,itringshollowtosuggestthathavingahigherequitybufferforthesameamountoftotalassetsmakesthefinancialsystemlesssafe. Inaddition,thereisaconcernthatdemandingmoreequitycapitaland reducingleverageamongthelargestfirmswouldinhibitthegrowthof creditandtheeconomy. ThisstatementhasanimpliedpresumptionthattheBaselweightingschemeismoregrowthfriendlythanasimpler,strongerleverageratio. However,havingasufficientcapitalbufferallowsbankstoabsorb unexpectedlosses. Thisservestomoderatethebusinesscycleandthedeclineinlendingthatotherwiseoccursduringcontractions. IftheBaselrisk-weightschemesareincorrect,whichtheyoftenhavebeen,thistoocouldinhibitloangrowth,asitencouragesinvestmentsinothermorefavorably,butincorrectly,weightedassets. Baselsystematicallyencouragesinvestmentsinsectorspre-assignedlowerweights--forexample,mortgages,sovereigndebt,andderivatives --anddiscouragesloanstoassetsassignedhigherweights--commercialandindustrialloans. Wemayhaveinadvertentlycreatedasystemthatdiscouragestheveryloangrowthweseek,andinsteadturnedourfinancialsystemintoonethatrewardsitselfmorethanitsupportseconomicactivity. Ifriskweightscouldbeassignedthatanticipateandcalibrateriskswith perfectforesight,adjustedonadailybasis,thenperhapsrisk-weightedcapitalstandardswouldbethepreferredmethodfordetermininghowtodeploycapital. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  41. P age |41 However,theycannot. Tobelievetheycanisafallacythatputstheentireeconomicsystemat risk. ChangingtheDebate Thetangibleleverageratioisasuperioralternativetorisk-weightingschemesthathaveproventobeanillusionofprecisionandinsufficientindefiningadequatecapital. Theeffectofrelyingonsuchmeasureshasbeentoweakenthefinancialsystemandmisallocateresources. Theleverageratiodeservesseriousconsiderationastheprincipaltoolinjudgingthecapitalstrengthoffinancialfirms. TheBaseldiscussionwouldbewellservedtofocusontheappropriatelevelsoftangiblecapitalforbankingfirmstoholdandtherighttransitionperiodtoachievetheselevels. Finally,weshouldnotacceptevencomfortingerrorsoflogicwhichsuggestthatBaselIIIrequirementswillcreatestrongercapitalthanthoseofBaselII,whichfailed. Instead,pastindustryperformanceandmountingacademicandotherevidencesuggestthatwewouldbebestservedtofocusonastrongleverageratiostandardinjudgingafirmandtheindustry'sfinancialstrength. Nobankcapitalprogramisperfect. Ourresponsibilityasregulatorsanddepositinsurersistochoosethebestavailablemeasurethatwillcontributetofinancialstability. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  42. P age |42 Note: ThomasM.HoenigwasconfirmedbytheSenateasViceChairmanoftheFederalDepositInsuranceCorporationonNov.15,2012. HejoinedtheFDIConApril16,2012,asamemberoftheFDICBoardofDirectorsforasix-yearterm. HeisamemberoftheexecutiveboardoftheInternationalAssociationofDepositInsurers. PriortoservingontheFDICboard,Mr.HoenigwasthePresidentoftheFederalReserveBankofKansasCityandamemberoftheFederalReserveSystem'sFederalOpenMarketCommitteefrom1991to2011.Mr.HoenigwaswiththeFederalReservefor38years,beginningasaneconomistandthenasaseniorofficerinbankingsupervisionduringthe U.S.bankingcrisisofthe1980s. In1986,heledtheKansasCityFederalReserveBank'sDivisionofBankSupervisionandStructure,directingtheoversightofmorethan1,000banksandbankholdingcompanieswithassetsrangingfromlessthan $100millionto$20billion. HebecamePresidentoftheKansasCityFederalReserveBankonOctober1,1991. Mr.HoenigisanativeofFortMadison,Iowa.HereceivedadoctorateineconomicsfromIowaStateUniversity. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  43. P age |43 “AcomfortablepositionforGermanbanks” TheBundesbankcurrentlyseesnosignswhatsoeverofacreditshortageoratighteningoflendingstandardsinGermany. “Germanbanksareinaprettycomfortablepositionatthemoment. Byandlarge,neithertheirliquiditynortheircapitalsituationarecausingthemanyproblems,”DeputyPresidentSabineLautenschlägersaidearlierthisweekattheInternationalerClubFrankfurterWirtschaftjournalisten(InternationalclubofFrankfurt-basedbusinessjournalists). Whatismore,bankswerebenefitingfromtheirstrongindustrialandSMEcustomerbase. “Germanbanksfurtherimprovedtheirresiliencein2012,”MsLautenschlägerexplained,referringtotheresultsoftheBaselIIIimpactstudypublishedsometimeago. ThisstudylookedathowthesampleofbankswouldhavefaredifBaselIIIhadalreadybeenfullyphasedinasatthecut-offdate. TheimpactstudyrevealsthatthecapitalshortfalloftheeightlargeGermanbankshasdecreasedby€15billion,or30%,ascomparedwiththelastcut-offdate. Anothergratifyingoutcomeofthestudyisthat,onaverage,the33participatingGermaninstitutionsalreadymeetthefutureminimumratioof4.5%forcoretier1capital. SabineLautenschlägercommentedthatthistrendhadcontinued“withthesameintensity”inthesecondhalfof2012,withbanksraisingcapitalinthetensofbillions. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  44. P age |44 Challengesfacingbanksinthefuture Theabilityofbankstocarryongeneratingsufficientincomeonahighercostbasewasakeyfactorindecidingwhethertheirbusinessmodelsweresustainableoverthelongrun,MsLautenschlägerexplained. Persistentlylowinterestratesandthefiercecompetitionamongbanksweredraggingonearnings. “Theweakearningstrendwillpresentamajorchallengeforbanksandsupervisorsalike,”theDeputyPresidentadded. MsLautenschlägerstruckapositivetoneoverthescheduledglobalimplementationofBaselIIIandsaidsheexpectedtheothermajor financialcentrestofollowsuit. “OnlythenwillBaselIIIbeabletofulfilitsprotectivefunctionandprovideasuitableresponsetothe2008financialcrisis.” Appropriatesupervisionandresolutionmechanismsforbankswithaninternationalfocusnecessitatedgreatercoordinationandimprovedcooperation. Specialarrangementsatthenationallevelwouldbeabreedinggroundforriskstofinancialstability,MsLautenschlägerremarked. Bankingunion–questionsstillunanswered SabineLautenschlägersaidthatmanyquestionsstillremainedunansweredovertheestablishmentofthesingleEuropeansupervisorymechanism. Mostnotably,aclearsetofrulesgoverningthecooperationbetweennationalsupervisorsandtheECBwouldhavetobedrawnup. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  45. P age |45 Developingacommonapproachtosupervision,buildingupappropriatereportingproceduresandrecruitingstaffweretasksthatwouldcertainlykeepsupervisorsbusyoverthenextfewmonths. But,MsLautenschlägeradded,therewasonethingthatsupervisorscouldnotchange,thatbeingthelegalbasis. AlegalframeworkforbanksupervisorsthatallowedmonetarypolicytobestrictlysegregatedfromsupervisorydutieswassomethingthatonlyEUgovernmentsandparliamentscouldcreate. “Thisisaprocessthatwillprobablytakeyears.ButIbelievetheeffortwillbeworthwhile,”shetoldjournalists. MsLautenschlägeralsospokeoutinfavourofasingleEuropeanresolutionmechanism. ItdidnotmakesensetooverseebanksattheEuropeanlevelwhileleavingtheirresolutiontonationalauthorities. Asingleresolutionmechanismshouldallowalargebanktobe restructuredandresolvedwithoutseriouslyjeopardisingfinancialstability,sheadded. Atthesametime,ithadtobeguaranteedthatanyresultinglosseswould befairlydistributedaccordingtosourceandresponsibility. “Ifinvestorsreceiveapremiumforrisk,theyshouldalsobepreparedtobeartheriskitself. Taxpayersshouldbeleftoutoftheequationaltogether,wherepossible.” Legacyrisksshouldnotberedistributed Legacyrisks–thatis,financialrisksthataroseatnationalbanksonthewatchofnationalsupervisors–should,however,bebornebythose BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  46. P age |46 responsibleforthemandnotbemutualised,MsLautenschlägerpointedout. AndtherewasalsothequestionofwhetherthelossesresultingfromfuturerisksshouldbeshoulderedsolelyattheEuropeanlevel.Afterall,banks’balancesheetsalsoreflectedalargenumberofnationalfactorssuchastaxesoreconomicpolicymeasures. “Aslongaseconomicandfiscalpoliciesarenotcoordinated,itmightmakesenseforliabilityriskstobedividedbetweenthenationalandEuropeanlevels,”sheconcluded. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  47. P age |47 RemarksbytheSuperintendentJulieDickson, OfficeoftheSuperintendentofFinancialInstitutionsCanada(OSFI) tothe2013FinancialServicesInvitationalForum,Cambridge,Ontario Introduction OSFIrecentlyreleaseditsPlanandPrioritiesfor2013-2016,andtonightIamgoingtohighlightanddiscussafewofourkeyprioritiesandwhywechosethem:specificallyourfocusontheincreasedthreatofcyberattacks;lowinterestrates(includingrealestatelending);andgovernanceandriskappetite. Cybersecurity AtOSFI,cyberriskhasbecomeoneofourtopconcerns. AgrowingnumberofNorthAmericanbankshavebeenhitwithdenialofserviceattacks,insomecasescausingwebsitestogodown,therebycreatingproblemsforcustomerstryingtodoeverydaytransactions. Denialofserviceattacksarecostlytodefendagainstandaformofharassmentandinconvenience. Butmoreimportantly,theycanbeapreludetomoreserioustypesofcyberattacks. Ourconcernisgrowingduetotherapidevolutionofcyberattacksintermsoffrequency,firepowerandtargets. Thisdriveshometheneedforallfinancialinstitutionstofocusonthisthreat. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  48. P age |48 AtOSFI,wehavesignificantlyincreasedoursupervisoryresourcesintheOp-riskarea,andhavelaunchedanumberofinitiatives,suchasconductingin-depthreviewsofinstitutions’currentcyberprotectionpractices. Therearemanystakeholdersinvolvedinthiseffortandaclearfocusonthisissuebyallwillserveuswell. Lowinterestrates Whenlowinterestratesfirstappeared,theimpactwasmostnoticeableon pensionplansandinsurancecompanies. Butasustainedlowinterestrateenvironment(especiallycombinedwithaflatyieldcurve)affectsthebankingsectoraswell. Banksloseflexibilitytoadjustthecustomerdepositratedown,henceintroducingadepositratefloor. Netinterestmarginsaresqueezed,negativelyaffectingrevenues. Combinedwithtepideconomicgrowth,reduceddemandforloansisfurtheraffectingbanks. Thisenvironmentcanprovideincentivesforbankstogrowtheirearningsassetbasebytryingtogainmarketshare(azerosumgame),increasefeeincomeactivities,reduceexpenses,enternewmarkets,andincreasetheproportionofhigher-yieldingassets(bothinthelendingandinvestmentportfolios). Productsandbusinessesthatareover-reliantonlowfinancingcoststendtogrow. Andborrowersarestronglyincentedtoincreaseleverage. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  49. P age |49 Forallthesereasonsweareveryfocusedonhowbanksarereactingtocurrentconditions. Wearealsocognizantthatthelongerthelowinterestrateenvironmentpersists,themoreinterestrateriskcanbebuiltup. Noonecanpredictwhen,orhowfast,rateswillstarttoclimb(orindeed,whethertheywillfallfurther). Yetdependenceonlowinterestratescanbecomesignificant,meaningthattransitiontohigherratescouldbeverypainful. TherealestatelendingmarkethasbeenabigareaoffocusforOSFI,becauseofthesignificantincentivesforconsumerstoborrowandforbankstomaintainrevenues,thesizeofmortgagelendingportfolios,theconcernsaboutsomemarketsbeingovervalued,andthepossibilitythatcustomers’debtserviceabilitycouldbemaskedbylowinterestrates. Ourworkhasinvolvedmajorreviewsofbanklendingportfolios,whichwasonefactorleadingtotheissuanceofGuidelineB-20. GuidelineB-20includesasetofbestpracticesforprudentresidentialmortgagelending,inalleconomicconditions. Ourguideline,aswellasthestepstakenbytheMinisterofFinancetoplacerestrictionsonmortgageinsurance,haveledtosomewelcomechangesinthemarket:slowergrowthinhouseholdcredit,andamorebalancedpictureoverall. Wearewatchingthisveryclosely,anditistooearlytosaywhetherthejobinthisareaisdone. Oneotherareawhereriskscanhideisinthemodelsthatareusedbysomebankstodeterminetheamountofcapitaltheyhavetoholdformortgageloans. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  50. P age |50 Accordingly,OSFIhasbeenincreasingscrutinyinthisarea. Investorsarealsofocusedonthis,andanumberofthemhaveaskedquestionsaboutthecalculationofriskweights,giventhelimitedamountofinformationthatthebankspubliclydiscloseinthisregard. InCanada,theaveragemodelriskweightscalculatedbybanksforuninsuredmortgagesareinthemid-teens. Thelackofinformationavailableonriskweightsissomethingwearehopingtoaddress. Therewillbeenhanceddisclosurebydomesticsystemicallyimportantbanksinthecomingyear,pursuanttorecommendationsfromtheEnhancedDisclosureTaskForce,whichwascreatedattherequestoftheFinancialStabilityBoard. Someothercountriesareexperiencingfrothyrealestatemarketsandhaveintroducedfloorsonriskweights—sometimesaround15percent. GiventhatinCanadatheuninsuredmortgageswouldtendtobeofhigherqualitythantheaverageloanportfolioinothercountries(becauseuninsuredloansinCanadahavemaximumloan-to-valueratiosof80percent),wearegenerallycomfortablewiththecapitalbeingheldbybanksusingmodels. OSFIisalsoawarethatfloorscanbecomesafeharboursandleadbanksandsupervisorstopaylessattentiontothe―appropriate‖riskweight,especiallywhenitshouldbewellabovethefloorforaparticularbank. Thus,ourfocuswillcontinuetobeonscrutinizingmodelscurrentlyin use. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

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