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Insights on Liquidity Risk Management: A New Approach with Scrubber Analogy

This week's discussion highlights key developments in risk and compliance management, focusing on liquidity risk. Drawing on insights from Mr. Jeremy C. Stein of the Federal Reserve, we explore how pollution-mitigating technologies like scrubbers can serve as a metaphor for managing liquidity risks within banks. The piece emphasizes the importance of understanding the regulation of liquidity through effective asset management strategies and invites members to engage with new perspectives in regulatory frameworks.

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Insights on Liquidity Risk Management: A New Approach with Scrubber Analogy

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  1. P age |1 InternationalAssociationofRiskandComplianceProfessionals(IARCP) 1200GStreet NWSuite800Washington,DC20005-6705USATel:202-449-9750www.risk-compliance-association.com Top10riskandcompliancemanagementrelatednewsstoriesandworldeventsthat(forbetterorforworse)shapedthe week'sagenda,andwhatisnext DearMember, Ihadadifficulttime inthepasttoexplainliquidityriskmanagementandratios. NowIknowwhattodo.Problem solved! Iwilluseapollution-mitigatingtechnology,likescrubberstoexplainliquidityrisk. Mr.JeremyCStein,MemberoftheBoardofGovernorsoftheFederalReserveSystemexplainedhow: “Supposewehaveapowerplantthatproducesenergyand,asabyproduct,somepollution. Supposefurtherthatregulatorswanttoreducethepollutionandhavetwo toolsattheirdisposal: They canmandatetheuseofapollution-mitigatingtechnology,likescrubbers,ortheycanlevyataxontheamountofpollutiongeneratedbytheplant. In anidealworld,regulationwouldaccomplishtwo objectives. First,itwouldlead toanoptimallevelofmitigation– thatis,itwouldinduce theplanttoinstallscrubbersuptothepointwherethecostofan InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  2. P age |2 additionalscrubberisequalto themarginalsocialbenefit,intermsof reducedpollution. And,second,itwouldalsopromoteconservation: Giventhatthescrubbersdon’tgetridofpollutionentirely,onealsowantstoreduceoverallenergyconsumptionbymakingitmoreexpensive. Asimplecaseisonein whichthecostsofinstallingscrubbers,aswellasthesocialbenefitsofreducedpollution,areknownin advancebytheregulatorandthemanagerofthepowerplant. In thiscase,theregulatorcanfigureoutwhattherightnumberofscrubbersisandrequirethattheplantinstallthesescrubbers. Themandate canthereforepreciselytargettheoptimalamountofmitigationperunitofenergyproduced. And,totheextentthatthescrubbersarecostly,themandatewillalsoleadtohigherenergyprices,whichwillencouragesomeconservation,though perhapsnotthesocially optimallevel. Thislattereffectistheimplicittaxaspectofthemandate. Amorecomplicatedcaseiswhentheregulatordoesnotknow aheadoftimewhatthecostsofbuildingandinstallingscrubberswillbe. Here,mandatingtheuseofafixednumberofscrubbersispotentiallyproblematic: Ifthescrubbersturnouttobeveryexpensive,theregulationwillendup beingmoreaggressivethansociallydesirable,leadingtooverinvestmentinscrubbersandlargecostincreasesforconsumers;however,ifthescrubbersturnouttobecheaperthanexpected,theregulationwillhavebeentoosoft. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  3. P age |3 Inotherwords,whenthecostofthemitigationtechnologyissignificantlyuncertain,aregulatoryapproachthatfixes thequantityofmitigationisequivalenttoonewheretheimplicittaxratebouncesaroundalot. Bycontrast,aregulatoryapproachthatfixesthepriceofpollutioninstead ofthequantity– say,byimposingapredeterminedproportionaltaxratedirectlyontheamountofpollutionemittedby theplant– ismoreforgivinginthefaceofthiskindofuncertainty. Thisapproachleavesthescrubber-installationdecisiontothemanageroftheplant,whocanfigureoutwhatthescrubberscostbeforedecidinghowtoproceed. Forexample,ifthescrubbersturnout to beunexpectedlyexpensive,theplantmanagercan installfewerofthem. Thisflexibilitytranslatesintolessvariabilityintheeffectiveregulatoryburdenandhencelessvariabilityin thepriceofenergytoconsumers. Scrubbersandhigh-qualityliquidassets WhatdoesallthisimplyforthedesignoftheLCR?Let’sworkthroughtheanalogy indetail. The analogtothepowerplant’senergyoutputisthegrossamount ofliquidityservicescreatedbyabank– viaitsdeposits,thecreditlinesitprovides to itscustomers,theprimebrokerageservicesitoffers,andsoforth. The analogtothemitigationtechnology– thescrubbers– isthestockofHQLAthatthebankholds. Andtheanalogto pollutionisthenetliquidityrisk associatedwiththedifferencebetweenthesetwoquantities,somethingakin to theLCRshortfall. Thatis,whenthebankoffersalotofliquidityondemandtoitscustomers InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  4. P age |4 butfailstoholdanadequatebufferofHQLA,thisiswhenitimposesspillovercostsontherestofthefinancialsystem. In thecaseofthepowerplant,Iarguedthataregulationthatcallsforafixedquantityofmitigation–thatis,forafixednumberofscrubbers– is moreattractivewhenthereislittleuncertaintyaboutthecostofthesescrubbers.” ThankyouJeremy! Ihavejustopenedmymasterplan.Ihave to learnmoreaboutscrubbers.Inow seeothersimilaritiesbetweentheBISandscrubbers.OnlynowIcanunderstandtheshapeoftheBISbuilding! IthinkIhavejustfoundanotherregulatoryarbitrageopportunity.Arealnationaldiscretion,justified. Scrubbersare capableofreductionefficienciesintherangeof50%to98%.WhyshouldtheLiquidityCoverageRatiobe100%? ALCRfrom50%to98%(meaning50,001%)isgoodenough! InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  5. P age |5 ThecalculationsinBaselandscrubbersarealsoalmostthesame! ReadmoreatNumber1below. Welcome totheTop10list. BestRegards, GeorgeLekatisPresidentoftheIARCP GeneralManager,ComplianceLLC 1200GStreetNWSuite800,WashingtonDC20005,USATel:(202)449-9750 Email:lekatis@risk-compliance-association.com Web:www.risk-compliance-association.comHQ:1220N.MarketStreetSuite804,WilmingtonDE19801,USA Tel:(302)342-8828 InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  6. P age |6 Liquidityregulationandcentralbanking SpeechbyMrJeremyCStein,MemberoftheBoard ofGovernorsoftheFederalReserveSystem,atthe“Findingtherightbalance”2013CreditMarketsSymposium,sponsoredbytheFederalReserveBankofRichmond,Charlotte,NorthCarolina BaselIIICapital:AWell-IntendedIllusion ThomasM.Hoenig,ViceChairman,FederalDepositInsuranceCorporation,InternationalAssociationofDepositInsurers,2013ResearchConference,Basel, Switzerland “Aristotleiscreditedwithbeingthefirstphilosophertosystematicallystudylogicalfallacies,whichhedefinedasargumentsthatappearvalidbut,infact,arenot. Icallthemwell-intendedillusions. OnesuchillusionofprecisionistheBaselcapitalstandardsinwhichworldsupervisoryauthoritiesrelyprincipallyonaTier1capitalratio tojudgetheadequacyofbankcapitalandbalancesheetstrength.” PCAOBIssuesPolicyStatementonExtraordinaryCooperationinConnectionwithBoardInvestigationsWashington,DC InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  7. P age |7 The PublicCompanyAccountingOversightBoardtodaypublishedaformalstatementconcerningthebenefitsthatmaybeavailable toregisteredpublic accountingfirmsandindividualswhoprovideextraordinarycooperationinPCAOBinvestigations. SolvencyII:whereare wenow? AlthoughthereisnocertaintyontheSolvencyIIimplementationdate,EUpolicymakersarecontinuingtofinalisekeyaspectsoftheframework. PolicyStatementConductingstatutoryinvestigations ThePrudentialRegulationAuthority(PRA)isrequired,undertheFinancialServicesAct2012(theAct),to investigateandreport to HMTreasuryonpossibleregulatoryfailureandmattersofpublicinterest. Commissionreportunderlinesimportanceandurgencyoffinancialsectorreformsasabasistorestorelong-termgrowth TheEuropeanCommissionispublishingtodaytheEuropean FinancialStabilityandIntegration Report(EFSIR),whichisbeingpresentedatajointconferencewiththeEuropean CentralBank(ECB)inBrussels. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  8. P age |8 Statementonthe2013PCAOBAcademicConference JeanetteM.Franzel,BoardMember2013PCAOBAcademicConferenceWashington,D.C. TheimportanceofcultureindrivingbehavioursoffirmsandhowtheFCAwillassessthis SpeechbyCliveAdamson,DirectorofSupervisionattheCFASociety-UKProfessionalismConference19April2013,London. LessonsforSouthAfricafromGermanyinachallengingglobalenvironment AddressbyMsGillMarcus,GovernoroftheSouthAfricanReserveBank,attheSouthern African-GermanChamberofCommerceandIndustryluncheon,Johannesburg Thejourneyoffinancialreform AddressbyMrPhilipLowe,DeputyGovernoroftheReserveBankofAustralia,tothe AustralianChamberofCommerceinShanghai. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  9. P age |9 Liquidityregulationandcentralbanking SpeechbyMrJeremyCStein,MemberoftheBoardofGovernorsoftheFederalReserveSystem,atthe“Findingtherightbalance”2013CreditMarketsSymposium,sponsoredbytheFederalReserveBankofRichmond,Charlotte,NorthCarolina I’dlike to talktodayaboutoneimportantelementoftheinternationalregulatoryreformagenda–namely,liquidityregulation. Liquidityregulationisarelativelynew,post-crisisadditiontothefinancialstability toolkit. KeyelementsincludetheLiquidityCoverageRatio(LCR),whichwasrecentlyfinalizedbytheBaselCommitteeonBankingSupervision,andtheNetStableFundingRatio,whichisstillawork inprogress. In whatfollows,IwillfocusontheLCR. ThestatedgoaloftheLCRisstraightforward,evenifsomeaspectsofitsdesignarelessso. In thewordsoftheBaselCommittee,“The objectiveoftheLCRistopromotetheshort-termresilienceoftheliquidityriskprofileofbanks. Itdoes thisbyensuringthatbankshaveanadequatestock of unencumberedhigh-qualityliquidassets(HQLA)that canbeconverted easilyandimmediatelyinprivatemarketsintocashtomeettheirliquidityneedsfora30 calendardayliquiditystressscenario.” In otherwords,eachbankisrequired tomodelitstotaloutflowsover30daysinaliquiditystresseventandthentohold HQLAsufficientto InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  10. P age |10 accommodatethoseoutflows. Thisrequirementisimplementedwitharatiotest,wheremodeled outflowsgoin thedenominatorandthestockofHQLAgoes in thenumerator;whentheratioequalsorexceeds100percent,therequirementissatisfied. TheBaselCommitteeissuedthefirstversionoftheLCRinDecember 2010. InJanuaryofthisyear,thecommitteeissuedarevisedfinalversionoftheLCR,followinganendorsementbyitsgoverningbody,theGroupofGovernorsandHeadsofSupervision(GHOS). Therevisionexpandstherangeofassetsthat cancountasHQLAandalsoadjustssomeoftheassumptionsthatgovernthemodelingofnetoutflowsin astressscenario. In addition,thecommitteeagreedinJanuarytoagradualphase-in oftheLCR,sothatitonlybecomesfullyeffectiveonaninternational basisinJanuary2019. Onthedomesticfront,theFederalReserveexpectsthattheU.S.bankingagencieswillissueaproposallaterthisyeartoimplementtheLCRforlargeU.S.bankingfirms. Whilethisprogressiswelcome,anumberofquestionsremain. First,towhatextentshouldaccesstoliquidityfromacentralbankbeallowedtocounttowardsatisfyingtheLCR? In January,theGHOSnotedthattheinteractionbetweentheLCRandtheprovisionofcentralbankfacilitiesiscriticallyimportant. AndthegroupinstructedtheBaselCommitteetocontinueworkingonthisissuein2013. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  11. P age |11 Second,whatstepsshouldbetaken toenhancetheusabilityoftheLCRbuffer–thatis,toencouragebanks toactuallydrawdowntheirHQLAbuffers,asopposedtofire-sellingotherlessliquidassets? TheGHOShasalsomadeclearitsviewthat,duringperiodsofstress,itwouldbeappropriateforbankstousetheirHQLA,therebyfalling belowtheminimum. However,creatingaregimeinwhichbanksvoluntarilychoose todosoisnotaneasytask. AnumberofobservershaveexpressedtheconcernthatifabankisheldtoanLCRstandardof100percentinnormaltimes,itmaybereluctanttoallow itsratio todropbelow100percentwhenfacinglarge outflows,evenifregulatorswere topermitthistemporarydeviation,forfearthatadeclineintheratiocouldbeinterpretedasasignofweakness. Myaimhereistosketchaframeworkforthinkingabouttheseandrelatedissues. Amongthem,theinterplaybetweentheLCRandcentralbankliquidityprovisionisperhapsthemostfundamentalandanaturalstartingpointfordiscussion. Bywayofmotivation,notethatbeforethefinancialcrisis,wehadahighlydevelopedregimeofcapitalregulationforbanks– albeitonethatlooksinadequateinretrospect–butwedidnothaveformalregulatorystandardsfortheirliquidity. Theintroductionofliquidityregulationafterthecrisis canbethoughtofasreflectingadesiretoreducedependenceonthecentralbankasalenderoflastresort(LOLR),basedonthelessonslearnedoverthepreviousseveralyears. However,to theextentthatsomerolefortheLOLRstillremains,onenow facesthequestionofhowitshouldcoexistwitharegimeofliquidityregulation. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  12. P age |12 Toaddressthisquestion,itisusefulto take astepbackandask anotherone: Whatunderlyingmarketfailureisliquidityregulationintendedtoaddress,andwhy can’tthismarketfailurebehandledentirelybyanLOLR? Iwillturn tothisquestionfirst. Next,Iwillconsiderdifferentmechanismsthatcouldpotentially achievethegoalsofliquidityregulation,andhow thesemechanismsrelatetovariousfeaturesoftheLCR. In sodoing,Ihopetoillustratewhy,eventhoughliquidityregulationisaclosecousinofcapitalregulation,itneverthelesspresentsanumberof novelchallengesforpolicymakersandwhy,asaresult,wearegoingtohave tobeopentolearningandadaptingaswego. Thecaseforliquidityregulation Oneoftheprimaryeconomicfunctionsofbanks andotherfinancialintermediaries,suchasbroker-dealers,isto provideliquidity– thatis,cashondemand–invariousformstotheircustomers. Someofthisliquidityprovisionhappensontheliabilitysideofthebalancesheet,withbankdemanddepositsbeingaleadingexample. But,importantly,banks alsoprovideliquidityviacommittedlinesofcredit. Indeed,itisprobablynotacoincidencethatthesetwoproducts–demand depositsandcreditlines– areofferedundertheroofofthesameinstitution;theunderlyingcommonalityisthatbothrequireanabilitytoaccommodateunpredictablerequestsforcashonshortnotice. Anumberofotherfinancialintermediaryservices,suchasprimebrokerage,alsoembodyasignificantelementofliquidityprovision.Withoutquestion,theseliquidity-provisionservicesaresociallyvaluable. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  13. P age |13 Ontheliabilityside,demanddepositsand othershort-termbankliabilitiesaresafe,easy-to-valueclaimsthatarewellsuitedfortransaction purposesandhencecreateaflow ofmoney-likebenefitsfortheirholders. Andloan commitmentsaremoreefficient thananarrangementinwhicheachoperatingfirmhedgesitsfutureuncertainneedsby“pre-borrowing”andhoardingtheproceedsonits ownbalancesheet;thislatterapproach doesapoorjobofeconomizingonthescarceaggregatesupplyofliquidassets. Atthesametime,asthefinancialcrisismadepainfullyclear,thebusinessofliquidityprovisioninevitablyexposesfinancialintermediariestovariousformsofrunrisk. Thatis,inresponsetoadverseevents,theirfragilefundingstructures,togetherwiththebindingliquiditycommitmentstheyhavemade,canresultinrapidoutflowsthat,absentcentralbankintervention,lead bankstofire-sellilliquidassetsor,inamoresevere case,to failaltogether. Andfiresalesandbankfailures– andtheaccompanyingcontractionsincreditavailability– canhavespillovereffectsto otherfinancialinstitutionsand totheeconomyasawhole. Thus,whilebankswillnaturallyholdbufferstocksofliquidassets tohandleunanticipatedoutflows,theymaynotholdenoughbecause,althoughtheybearallthecostsofthisbufferstocking,theydonotcaptureallofthesocialbenefits,intermsofenhancedfinancialstabilityandlowercoststotaxpayersintheeventoffailure. Itisthisexternalitythatcreatesaroleforpolicy. Therearetwobroadtypesofpolicytoolsavailabletodealwiththissortofliquidity-basedmarketfailure. Thefirstisafter-the-factintervention,eitherbyadepositinsurerguaranteeingsomeofthebank’sliabilitiesorbyacentralbankactingasanLOLR. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  14. P age |14 Thesecondtypeisliquidityregulation. Asanexampleoftheformer, whentheeconomyisin abadstate,assumingthataparticularbankisnotinsolvent,thecentralbankcanlendagainstilliquidassetsthatwouldotherwisebefire-sold,therebydampingoreliminatingtherundynamicsandhelpingreducetheincidenceof bankfailure. In muchoftheliteratureonbanking,suchinterventionsareseenastheprimarymethodfordealingwithrun-likeliquidityproblems. Aclassicstatementofthecentralbank’sroleasanLOLRisWalterBagehot’s1873bookLombardStreet. Morerecently,theseminaltheoreticaltreatmentofthisissueisbyDouglasDiamondandPhilipDybvig,whoshowthatundercertaincircumstances,theuseofdepositinsuranceoranLOLR caneliminaterunrisk altogether,therebyincreasingsocialwelfareatzerocost. Tobeclear,thisworkassumesthatthebankinquestionisfundamentallysolvent,meaningthatwhileitsassetsmaynotbeliquidonshortnotice,thelong-runvalueoftheseassetsisknownwithcertainty toexceedthevalueofthebank’sliabilities. Onewaytointerpretthemessageofthisresearchisthatcapitalregulationisimportanttoensure solvency,butonceareliableregimeofcapitalregulationisinplace,liquidityproblems canbedealtwithafterthefact,viasomecombinationofdepositinsuranceanduseoftheLOLR. ItfollowsthatifoneisgoingtomakeanargumentinfavorofaddingpreventativeliquidityregulationsuchastheLCRontopofcapitalregulation,acentralpremisemustbethattheuseofLOLRcapacityinacrisisscenarioissociallycostly,sothatitisanexplicitobjectiveofpolicy toeconomizeonitsuseinsuchcircumstances. Ithinkthispremiseisasensibleone. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  15. P age |15 Akeypointinthisregard– andonethathas beenreinforcedbytheexperienceofthepastseveralyears– isthatthelinebetweenilliquidityandinsolvencyisfarblurrierin reallife thanitissometimesassumed tobeintheory. Indeed,onemightarguethatabankorbrokerdealerthatexperiencesaliquiditycrunchmusthavesomeprobabilityofhavingsolvencyproblemsaswell;otherwise,itishardtoseewhyitcouldnotattractshort-termfundingfromtheprivatemarket. ThisreasoningimpliesthatwhenthecentralbankactsasanLOLRin acrisis,itnecessarilytakes onsome amountofcreditrisk. Andifitexperienceslosses,theselossesultimatelyfallontheshouldersoftaxpayers. Moreover,theuseofanLOLRtosupportbanks whentheygetintotrouble canlead tomoralhazardproblems, in thesensethatbanksmaybelessprudentexante. IfitwerenotforthesecostsofusingLOLRcapacity,theproblemwouldbetrivial,andtherewouldbenoneedforliquidityregulation: Assumingawell-functioningcapital-regulationregime,thecentralbankcouldalwaysavertallfiresalesandbankfailuresexpost,simplybyactingasanLOLR. Thisobservationcarriesanimmediateimplication: It makesnosense toallow unpricedaccesstothecentralbank’sLOLRcapacitytocount towardanLCRrequirement. Again,thewholepointofliquidityregulation mustbeeithertoconserveontheuseoftheLOLRor in thelimit,toaddresssituationswheretheLOLRisnotavailableatall– as,forexample,inthecaseof broker-dealersintheUnitedStates. Atthesametime,itisimportanttodrawadistinctionbetweenpricedand unpriced access totheLOLR. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  16. P age |16 Forexample,takethecaseofAustralia,whereprudentfiscalpolicyhasledto arelativelysmallstock ofgovernmentdebtoutstandingandhencetoapotentialshortageof HQLA. TheBaselCommitteehasagreedtotheusebyAustraliaofaCommittedLiquidityFacility(CLF),wherebyanAustralianbankcanpaytheReserveBankofAustraliaanupfrontfeeforwhatiseffectivelyaloancommitment,andthisloancommitmentcan thenbecountedtowarditsHQLA. In contrast to free accesstotheLOLR,thisapproachisnotatoddswiththegoalsofliquidityregulationbecausetheup-frontfeeiseffectivelyataxthatservestodeterrelianceontheLOLR– which,again,ispreciselytheultimategoal. Iwillreturntotheidea ofaCLF shortly. Thedesignofregulation Onceithasbeendecidedthatliquidityregulationisdesirable,thenextquestionishowbesttoimplementit. In thiscontext, notethattheLCRhastwologicallydistinctaspectsasaregulatorytool: Itisamitigator,inthesensethatholdingliquidassetsleadstoabetteroutcomeifthereisabadshock;itisalsoanimplicittaxonliquidityprovisionbybanks,totheextentthatholdingliquidassetsiscostly. Ofcourse,onecansaysomethingbroadlysimilarabout capital requirements. ButtheimplicittaxassociatedwiththeLCRissubtlerandlesswellunderstood,soIwillgointosomedetailhere. Ananalogymayhelp to explain. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  17. P age |17 Supposewehaveapowerplantthatproducesenergyand,asabyproduct,somepollution. Supposefurtherthatregulatorswanttoreducethepollutionandhavetwotoolsattheirdisposal: They canmandatetheuseofapollution-mitigatingtechnology,likescrubbers,orthey canlevyataxontheamount ofpollutiongeneratedbytheplant. In anidealworld,regulationwouldaccomplishtwo objectives. First,itwouldlead toanoptimallevelofmitigation– thatis,itwouldinduce theplanttoinstallscrubbersuptothepointwherethecostofanadditionalscrubberisequalto themarginalsocialbenefit,intermsof reducedpollution. And,second,itwouldalsopromoteconservation: Giventhatthescrubbersdon’tgetridofpollutionentirely,onealsowantstoreduceoverallenergyconsumptionbymakingitmoreexpensive. Asimplecaseisonein whichthecostsofinstallingscrubbers,aswellasthesocialbenefitsofreducedpollution,areknownin advancebytheregulatorandthemanagerofthepowerplant. In thiscase,theregulatorcanfigureoutwhattherightnumberofscrubbersisandrequirethattheplantinstallthesescrubbers. Themandate canthereforepreciselytargettheoptimalamountofmitigationperunitofenergyproduced. And,totheextentthatthescrubbersarecostly,themandatewillalsoleadtohigherenergyprices,whichwillencouragesomeconservation,though perhapsnotthesocially optimallevel. Thislattereffectistheimplicittaxaspectofthemandate. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  18. P age |18 Amorecomplicatedcaseiswhentheregulatordoesnotknow aheadoftimewhatthecostsofbuildingandinstallingscrubberswillbe. Here,mandatingtheuseofafixednumberofscrubbersispotentiallyproblematic: Ifthescrubbersturnouttobeveryexpensive,theregulationwillendup beingmoreaggressivethansociallydesirable,leadingtooverinvestmentinscrubbersandlargecostincreasesforconsumers;however,ifthescrubbersturnouttobecheaperthanexpected,theregulationwillhavebeentoosoft. Inotherwords,whenthecostofthemitigationtechnologyissignificantlyuncertain,aregulatoryapproachthatfixes thequantityofmitigationisequivalenttoonewheretheimplicittaxratebouncesaroundalot. Bycontrast,aregulatoryapproachthatfixesthepriceofpollutioninstead ofthequantity– say,byimposingapredeterminedproportionaltaxratedirectlyontheamountofpollutionemittedby theplant– ismoreforgivinginthefaceofthiskindofuncertainty. Thisapproachleavesthescrubber-installationdecisiontothemanageroftheplant,whocanfigureoutwhatthescrubberscostbeforedecidinghowtoproceed. Forexample,ifthescrubbersturnout to beunexpectedlyexpensive,theplantmanagercan installfewerofthem. Thisflexibilitytranslatesintolessvariabilityintheeffectiveregulatoryburdenandhencelessvariabilityin thepriceofenergytoconsumers. Scrubbersandhigh-qualityliquidassets WhatdoesallthisimplyforthedesignoftheLCR?Let’sworkthroughtheanalogy indetail. The analogtothepowerplant’senergyoutputisthegrossamount ofliquidityservicescreatedbyabank– viaitsdeposits,thecreditlinesit InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  19. P age |19 provides to itscustomers,theprimebrokerageservicesitoffers,andsoforth. The analogtothemitigationtechnology– thescrubbers– isthestockofHQLAthatthebankholds. Andtheanalogto pollutionisthenetliquidityrisk associatedwiththedifferencebetweenthesetwoquantities,somethingakin to theLCRshortfall. Thatis,whenthebankoffersalotofliquidityondemandtoitscustomersbutfailstoholdanadequatebufferofHQLA,thisiswhenitimposesspillovercostsontherestofthefinancialsystem. In thecaseofthepowerplant,Iarguedthataregulationthatcallsforafixedquantityofmitigation– thatis,forafixednumberofscrubbers– is moreattractivewhenthereislittleuncertaintyaboutthecostofthesescrubbers. In thecontextoftheLCR,thecostofmitigationisthepremiumthatthebankmustpay–intheformofreducedinterestincome– foritsstockofHQLA. And,crucially,thisHQLApremiumisdeterminedinmarketequilibriumanddependsonthetotalsupplyofsafeassetsinthesystem,relativetothedemandforthoseassets. Ontheonehand,ifsafeHQLA-eligibleassetsareinamplesupply,thepremiumislikelytobelowandstable. Ontheotherhand,ifHQLA-eligibleassetsarescarce,thepremiumwillbebothhigherandmorevolatileovertime. Thislattersituationistheonefacingcountrieslike Australia,where,asInotedearlier,thestock ofoutstandinggovernmentsecuritiesisrelativelysmall. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  20. P age |20 Anditexplainswhy,forsuchcountries,havingaprice-basedmechanismaspartoftheirimplementationoftheLCR can bemoreappealingthan purerelianceonaquantitymandate. Whenonesetsanup-frontfeeforaCLF,oneeffectivelycapstheimplicit taxassociatedwithliquidityregulationatthelevelofthecommitmentfeeandtampsdowntheundesirablevolatilitythatwouldotherwisearisefromanentirelyquantity-basedregime. Moreover,itbearsreemphasizingthathavingaCLF withanup-frontfeeisverydifferentfromsimplyallowingbanks tocountcentral-bank-eligiblecollateralasHQLAatnocharge. Rather,theCLF islike thepollutiontax. Foreverydollarofpre-CLF shortfall– thatis,foreverydollarofrequiredliquiditythatabankcan’tobtainontheprivatemarket– thebankhastopaythecommitmentfee. Soevenifthereisnotasmuchmitigation,thereisstillanincentiveforconservation, in thesensethatbanks areencouragedtodolessliquidityprovision,allelsebeingequal. ThiswouldnotbethecaseiftheCLF wereavailableatazeroprice. What aboutthesituationin countrieswheresafeassetsaremoreplentiful? Theanalysisherehasanumberofmovingpartsbecauseinaddition totheimplementationoftheLCR,substantialincreasesindemandforsafeassetswillarisefromnewmarginrequirementsforbothclearedand nonclearedderivatives. Nevertheless,giventhelargeandgrowingglobalsupplyofsovereigndebtsecurities,aswellasotherHQLA-eligibleassets,mostestimatessuggest thatthescarcityproblemshouldbemanageable,atleastfortheforeseeablefuture. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  21. P age |21 In particular,quantitativeimpactstudiesreleasedbytheBaselCommitteeestimatethattheworldwideincrementaldemandforHQLAcomingfromboththeimplementationoftheLCRandswapmarginrequirementsmightbeontheorderof$3trillion. Thisisalargenumber,butitcompareswithaglobalsupplyofHQLA-eligibleassetsofmorethan$40trillion. Moreover,theeligiblecollateralforswapmarginisproposedtobebroaderthantheLCR’sdefinitionofHQLA– including,forexample,certainequitiesandcorporatebondswithoutanycap. IfonefocusesjustonU.S.institutions,theincrementaldemandnumberisontheorderof$1trillion,whilethesumofTreasury,agency,andagencymortgage-backedsecuritiesismorethan$19trillion. Whilethissortofanalysisissuperficiallyreassuring,thefactremainsthat theHQLApremiumwilldependonmarket-equilibriumconsiderationsthatarehard to fullyfathominadvance,andthatarelikelytovaryovertime. Thisuncertaintyneeds tobeunderstood,andrespected. Indeed,themarket-equilibriumaspectoftheproblemrepresentsacrucial distinctionbetweencapitalregulationandliquidityregulation,anditisonereasonwhythelatterisparticularlychallengingtoimplement. Althoughcapitalregulationalsoimposesataxonbanks– totheextent thatequityisamoreexpensiveformoffinancethandebt–thistaxwedgeis,toafirstapproximation,afixedconstantforagivenbank,independentofthescaleofoverallfinancialintermediationactivity. IfBankAdecidestoissuemoreequitysoit canexpanditslendingbusiness,thisneednotmakeitmoreexpensiveforBankBtosatisfyitscapitalrequirement. In otherwords,thereisnoscarcityproblemwithrespect tobankequity– bothAandBcanalwaysmakemore. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  22. P age |22 Bycontrast,thetotalsupplyofHQLAisclosertobeingfixedatanypointintime. Policyimplications Whatdoesallofthisimplyforpolicydesign? First,atabroadphilosophicallevel,therecognitionthatliquidityregulationinvolvesmoreuncertaintyaboutcoststhancapitalregulationsuggeststhatevenapolicymakerwithaverystrictattitudetowardcapitalmightfinditsensible to besomewhatmoremoderateandflexiblewithrespecttoliquidity. Thispointisreinforcedbytheobservationthatwhenaninstitutionisshortofcapitalandcan’tgetmoreontheprivatemarket,thereisreallynobackupplan,shortofresolution. Bycontrast,asImentionedearlier,whenaninstitutionisshortofliquidity,policymakersdohaveabackupplanintheformoftheLOLRfacility. Onedoesnotwanttorelytoomuchonthatbackupplan,butitspresenceshouldneverthelessfactor intothedesignofliquidityregulation. Second,inthespiritofflexibility,whileaprice-basedmechanismsuchastheCLFmaynotbeimmediatelynecessary incountriesoutsideofAustraliaandafewothers,itisworthkeepinganopenmindaboutthemorewidespreaduseofCLF-like mechanisms. IfascarcityofHQLA-eligibleassetsturnsouttobemoreofaproblemthanweexpect,somethingalongthoselineshasthepotentialto beausefulsafetyvalve,asitputsa caponthecostofliquidityregulation. Suchasafetyvalvewouldhaveadirecteconomicbenefit, inthesenseof preventingtheburdenofregulationfromgettingundulyheavyinanyonecountry. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  23. P age |23 Perhapsjustasimportant,asafetyvalvemightalsohelp toprotecttheintegrityoftheregulationitself,byharmonizingcostsacrosscountriesandtherebyreducingthetemptationofthosemosthard-hitbytherulestotrytochipawayatthem. Withoutsuchasafetyvalve,itispossiblethatsomecountries–thosewithrelativelysmallsuppliesofdomesticHQLA– willfindtheregulationconsiderablymorecostlythan others. Ifso,itwouldbenaturalforthemtolobby to dilutetherules– for example,byarguingforanexpansioninthetypeofassetsthatcancountas HQLA. Taken toofar,thissortofdilutionwouldunderminetheefficacyoftheregulationasbothamitigatorandatax. In thisscenario,holdingthelinewithwhatamountstoaproportionaltaxonliquidityprovisionwouldbeabetteroutcome. Onesituationwhereliquidassetscanbecomeunusuallyscarceisduringafinancialcrisis. Consequently,evenifCLFswerenotcountedtowardtheLCRinnormaltimes,itmightbeappropriatetocountthemduringacrisis. Indeed,whiletheLCRrequiresbanks toholdsufficientliquidassetsingoodtimestomeettheiroutflowsinagivenstressscenario,itimplicitlyrecognizesthatifthingsturnoutevenworsethanthatscenario,centralbankliquiditysupportwillbeneeded. AllowingCLFstocount towardtheLCRinsuchcircumstanceswould acknowledgetheimportanceofaccesstothecentralbank,andthisaccesscouldbepricedaccordingly. Finally,aprice-basedmechanismmightalsohelppromoteawillingnessofbanks to drawdowntheirsupplyofHQLAinastressscenario. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  24. P age |24 AsInotedattheoutset,oneimportantconcernaboutapurequantity-basedsystemofregulationisthatifabankisheldtoanLCRstandardof100percentinnormaltimes,itmaybereluctanttoallow itsratiotofallbelow100percentwhenfacinglargeoutflowsforfearthatdoingsomightbeseenbymarketparticipantsasasignofweakness. Bycontrast, in asystemwithsomethinglike aCLF,abankmightin normaltimesmeet95percentofitsrequirementbyholding private-marketHQLAandtheremaining5percentwithcommittedcreditlinesfromthecentralbank,soitwouldhaveanLCRofexactly100 percent. Then,whenhitwithlargeoutflows,itcouldmaintainitsLCRat100percent,butdosobyincreasingitsuseofcentralbankcreditlinesto25percentandselling20percentofitsotherliquidassets. Thisscenariowouldbethesortofliquid-assetdrawdownthatonewouldideallylike toseeinastresssituation. Moreover,thecentralbankcouldencouragethisdrawdownbyvaryingthepricingofitscreditlines– specifically,byreducingthepriceofthelinesinthemidstofaliquiditycrisis. Suchanapproachwouldamounttotaxingliquidityprovisionmoreingoodtimesthaninbad,whichhasastabilizingmacroprudentialeffect. ThisexamplealsosuggestsadesignthatmayhaveappealinjurisdictionswherethereisarelativelyabundantsupplyofHQLA-eligibleassets. Onecan imaginecalibratingthepricingoftheCLF soas to ensurethatlinesprovidedbycentralbanksmakeuponlyaminimalfractionofbanks’requiredHQLAinnormaltimes– apart,perhaps,fromtheoccasionaladjustmentperiodafteranindividualbankishitwithanidiosyncraticliquidityshortfall. Atthesametime,inastressscenario,whenliquidityisscarceandthereisupwardpressureontheHQLApremium,thepricingoftheCLFcouldbe InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  25. P age |25 adjustedsoastorelievethispressureandpromoteusabilityoftheHQLAbuffer. SuchanapproachwouldrespectthepolicyobjectiveofreducingexpectedrelianceontheLOLRwhileatthesametimeallowingforasafetyvalveinaperiodofstress. ThelimitcaseofthisapproachisonewheretheCLF countstowardtheLCRonlyinacrisis. Conclusion Bywayofconclusion,letmejustrestatethatliquidityregulationhasakeyrole to playinimprovingfinancialstability. However,weshouldavoidthinkingaboutitinisolation;rather,we canbestunderstanditaspartofalargertoolkitthatalsoincludescapitalregulationand,importantly,thecentralbank’sLOLRfunction. Therefore,properdesignandimplementationofliquidityregulationssuchastheLCRshouldtakeaccountoftheseinterdependencies. In particular,policymakersshouldaimtostrikeabalancebetweenreducingrelianceontheLOLRontheonehandandmoderatingthecostscreatedbyliquidityshortagesonthe otherhand– especiallythoseshortagesthatcropupintimesofseveremarketstrain. And,asalways,weshouldbepreparedtolearnfromexperienceaswego. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  26. P age |26 BaselIIICapital:AWell-IntendedIllusionThomasM.Hoenig ViceChairman,FederalDepositInsuranceCorporation InternationalAssociationofDepositInsurers2013 ResearchConference,Basel,Switzerland Introduction Aristotleiscreditedwithbeingthefirstphilosophertosystematicallystudylogical fallacies,whichhedefinedasargumentsthatappearvalidbut,infact,are not. Icallthemwell-intendedillusions. OnesuchillusionofprecisionistheBaselcapitalstandardsinwhichworldsupervisoryauthoritiesrelyprincipallyonaTier1capitalratio tojudgetheadequacyofbankcapitalandbalancesheetstrength. Forthelargestofthesefirms,eachdollarofrisk-weightedassetsisfundedwith12to15centsinequitycapital,projectingtheillusionthatthesefirmsarewellcapitalized. Therealityisthat eachdollaroftheir totalassetsisfundedwithfarlessequitycapital,leavingopenthematterofhowwellcapitalizedtheymightbe. Here’showtheillusioniscreated. Basel'sTier1capitalmeasureisabank'sratioofTier1capitaltorisk-weightedassets. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  27. P age |27 Eachcategoryofbankassetsisweighedbythesupervisoryauthorityonacomplicatedscaleofprobabilitiesandmodelsthatassignarelativeriskoflossto eachgroup,includingoffbalancesheetitems. Assetsdeemedlow riskarereportedatlower amountsonthebalancesheet. Thelowertherisk,thelowertheamountreportedonthebalancesheetforcapitalpurposesandthehigherthecalculatedTier1ratio. WeknowfromyearsofexperienceusingtheBaselcapitalstandardsthatoncetheregulatoryauthoritiesfinishtheirweightingscheme,bankmanagersbegintheprocessofallocatingcapitalandassetstomaximizefinancialreturnsaroundtheseconstructedweights. The objectiveistomaximizeafirm'sreturnonequity(ROE)bymanagingthebalancesheetinsuchamannerthatforanylevelofequity,therisk-weightedassetsarereportedatlevelsfarlessthan actualtotalassetsundermanagement. Thiscreatestheillusionthatbankingorganizationshaveadequatecapitaltoabsorbunexpectedlosses. Forthelargestglobalfinancialcompanies,risk-weightedassetsareapproximatelyone-halfoftotalassets. This"leveragingup"hasservedworldeconomiespoorly. In contrast,supervisorsandfinancialfirmscanchoosetorelyonthetangibleleverageratiotojudgetheoveralladequacyof capitalfortheenterprise. Thisratiocomparesequitycapitaltototalassets,deductinggoodwill,other intangibles,anddeferredtaxassetsfrombothequityand totalassets. In additiontoincludingonlyloss-absorbingcapital,italsomakes noattempt topredictorassignrelativeriskweightsamongassetclasses. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  28. P age |28 Usingthisleverageratioasourguide,wefindforthelargestbankingorganizationsthateach dollarofassetshasonly4 to6centsfundedwithtangibleequity capital,afarsmallerbufferthanassertedundertheBaselstandards. ComparingMeasures Table1reportstheBaselTier1risk-weighted capitalratioandtheleverageratiofordifferentclassesofbankingfirms. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  29. P age |29 Column4showsTier1capitalratiosrangingbetween12and15percentforthelargestglobalfirms,givingtheimpressionthatthesebanks arehighlycapitalized. However,itishardtobecertainofthatbylookingatthisratiosincerisk-weightedassetsareso muchlessthan totalassets. In contrast,Column6showsU.S.firms'averageleverageratiotobe6percentusinggenerallyacceptedaccountingstandards(GAAP),andColumn8showstheiraverageratio tobe3.9percentusing internationalaccountingstandards(IFRS),whichplacesmoreofthesefirms'derivativesontothebalancesheetthandoesGAAP. ThebottomportionofTable1shows thedegreeofleverageamongdifferentsizegroupsofbankingfirms,whichisstrikingaswell. TheTier1capitalmeasuresuggeststhatallsizegroupsofbanks holdcomparablecapitallevels,whiletheleverageratioreportsadifferentoutcome. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  30. P age |30 Forexample,theleverageratioformostbankinggroupsnotconsideredsystemicallyimportantaveragesnear8percentorhigher. UnderGAAP accountingstandards,thedifferenceinthisratiobetweenthelargestbankingorganizationsandthesmallerfirmsis175-250basispoints. UnderIFRSstandards,thedifferenceisas muchas400-475basispoints. Thelargestfirms,whichmostaffecttheeconomy,holdtheleastamountofcapital in theindustry. Whilethisshowsthemtobemorefragile,italsoidentifiesjusthowsignificantacompetitiveadvantagetheselower capitallevelsprovidethelargestfirms. ThesecomparisonsillustratehoweasilytheBaselcapitalstandard canconfuseandmisinformthepublicratherthanmeaningfullyreportabankingcompany’srelativefinancialstrength. Recenthistoryshowsalsojusthowdamagingthis canbetotheindustryandtheeconomy. In 2007,forexample,the10largestandmostcomplexU.S.bankingfirmsreportedTier1capitalratiosthat,onaverage,exceeded7percentof risk-weightedassets. Regulatorsdeemedtheselargesttobewellcapitalized. Thisrisk-weightedcapitalmeasure,however,mappedintoanaverageleverageratioofjust2.8percent. Welearnedalltoolatethathavinglessthan3centsoftangible capitalforeverydollarofassetsonthebalancesheetisnotenough toabsorbeventhesmallestoffinanciallosses,andcertainlynotamajorshock. Withthecrisis,theillusionofadequatecapitalwasdiscovered,afterhavingmisledshareholders,regulators,andtaxpayers. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  31. P age |31 Thereare other,morerecent,examplesofhow thisarcanemeasurecan bemanipulatedtogivetheillusionofstrengthevenwhenafirmincurslosses. Forexample,inthefourthquarterof2012,DeutscheBankreportedalossof2.5billionEUR. Thatsamequarter,itsTier1risk-basedcapitalratioincreasedfrom14.2percentto15.1percentdue,inpart,to “modelandprocessenhancements”thatresultedinadeclinein risk-weightedassets,which now amount to just16.6percentoftotalassets. OnFeb.1,SNSReaal,thefourthlargestDutchbankwith$5billioninassets,wasnationalizedbytheDutchgovernment. Justsevenmonthsearlier,onJune30,2012,SNSreportedaTier1risk-based capitalratioof12.2percent. However,thefirmreportedaTier1leverageratiobaseduponinternationalaccountingstandardsofonly1.47percent. ThisleverageratiowasmuchmoreindicativeoftheSNS’spoorfinancial position. TheBaselIIIproposalbelatedlyintroducestheconceptofaleverageratiobutcallsforittobeonly3percent,an amountalreadyshown tobeinsufficienttoabsorbsizablefinanciallossesinacrisis. Itiswrongtosuggesttothepublicthat,withsolittlecapital,theselargestfirmscouldsurvivewithoutpublicsupportshouldtheyencounteranysignificanteconomicreversals. MisallocatingResourcesandCreatingAssetImbalances Aninherentproblemwitharisk-weightedcapitalstandardisthattheweightsreflectpastevents,arestatic,andmostlyignorethemarket'scollectivedailyjudgmentabouttherelativerisk ofassets. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  32. P age |32 Italsointroducestheelementofpoliticalandspecialinterestsintotheprocess,whichaffectstheassignmentofriskweightstothedifferentasset classes. Theresultisoftentoartificiallyfavoronegroupofassetsoveranother, therebyredirectinginvestmentsandencouragingover-investmentinthefavoredassets. Theeffectofthismanagedprocessis to increaseleverage,raisetheoverallrisk profileoftheseinstitutions,andincreasethevulnerabilityofindividualcompanies,theindustry,andtheeconomy. Itisnocoincidence,forexample,thatafteraBaselstandardassignedonlya7percentriskweightontripleA,collateralizeddebtobligationsandsimilarlow riskweightsonassetswithinafirm'stradingbook,resourcesshiftedtothese activities. Overtime,financialgroupsdramaticallyleveragedtheseassetsontotheirbalancesheetsevenas theriskstothatassetclassincreasedexponentially. Similarly,assigningzeroweightstosovereigndebtencouragedbankingfirmsto investmoreheavily intheseassets,simultaneouslydiscountingtherealrisktheypresentedandplayinganimportantroleinincreasingit. In placingalowerrisk weightonselectassets,lesscapitalwasallocatedtofundthemandtoabsorbunexpectedlossforthesebanks,underminingtheirsolvency. AMoreRealisticCapitalStandardIsRequired Taxpayersaretheultimatebackstoptothesafetynetandhaverealmoneyatstake. In choosingwhichcapitalmeasureismostuseful,itisfairtoaskthefollowingquestions: InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  33. P age |33 • DoestheBaselTier1ratioorthetangibleleverageratiobestindicatethecapitalstrengthofthefirm? • Whichoneismostclearlyunderstood? • Whichonebest enablescomparisonofcapitalacrossinstitutions? • Whichoneoffersthemostconfidencethatitcannotbe easilygamed? • Charts1through4comparetherelationshipofthetangibleleverageandBaselTier1capitalratiostovariousmarketmeasuresforthelargestfirms. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  34. P age |34 InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  35. P age |35 InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  36. P age |36 InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  37. P age |37 Thesemeasuresinclude:theprice-to-bookratio,estimateddefaultfrequency,creditdefaultswapspreads,andmarketvalueofequity. In eachinstance,thecorrelationofthetangibleleverageratio to thesevariablesishigherthanfortherisk-weighted capitalratio. Whilesuchfindingsarenotconclusive,theysuggeststronglythatinvestors,whendecidingwheretoplacetheirmoney,relyupontheinformationprovidedbytheleverageratio. Wewoulddowelltodothesame. Despitealloftheadvancementsmadeovertheyearsinriskmeasurementandmodeling,itisimpossible topredictthefutureortoreliablyanticipatehow andtowhatdegreeriskswillchange. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  38. P age |38 Capitalstandardsshouldservetocushionagainsttheunexpected,not todivineeventualities. AlloftheBaselcapitalaccords,includingtheproposedBaselIII,lookbackwardandthenattempt to assignriskweightsintothefuture. Itdoesn'twork. In contrast,thetangibleleverageratioprovidesasimpler,moredirectinsightintothe amountofloss-absorbingcapitalthatisavailable to afirm. AleverageratioasI’vedefineditexplicitlyexcludesintangibleitemsthatcannotabsorblossesin acrisis. Also,usingIFRS accountingrules,off-balancesheetderivativesarebroughtontothebalancesheet,providingfurtherinsightintoafirm'sleverage. Thus,thetangibleleverageratioissimplertocomputeandmoreeasilyunderstoodbybankmanagers,directors,andthepublic. Importantlyalso,itismorelikelytobeconsistentlyenforcedbybanksupervisors. Amoredifficultchallengemaybetodetermineanappropriateminimumleverageratio. Chart5providesahistoryofbankleverage overthepast150yearsforthe U.S.bankingsystemandgivesinitialinsightintothisquestion. Itshowsthattheequity capitalto assetsratiofortheindustryprior tothefoundingoftheFederalReserveSystemin1913andtheFederalDepositInsuranceCorporationin 1933rangedbetween13and16percent,regardlessofbanksize. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  39. P age |39 Withoutanyinternationallydictatedstandardoranyarcaneweightingprocess,marketsrequiredwhat todayseemslike relativelyhigh capitallevels. Inaddition,thereisanincreasingbodyofresearch(AdmatiandHellwig;Haldane;Miles,Yang,andMarcheggiano)thatsuggeststhatleverageratiosshouldbemuchhigherthantheycurrentlyareandthatBaselIII’sproposed3percentfigureaddslittlesecurity tothesystem. Finally,andimportantly,someformofrisk-weightedcapitalmeasurecouldbeusefulasabackstop,orcheck,againstwhich to judgetheadequacyoftheleverageratiofor individualbanks. Ifabankmeetstheminimumleverageratiobuthasconcentratedassetsinareasthatriskmodelssuggestincreasetheoverallvulnerabilityofthebalancesheet,thebankcouldberequired to increaseitstangible capitallevels. Suchasystemprovidesthemostcomprehensivemeasureofcapitaladequacybothin abroadcontextofallassetsand accordingto abank'sallocationofassetsalongadefinedrisk profile. TangibleLeverageRatio andtheMythofUnintendedConsequences Concernsareoftenraisedwithinthefinancialindustryandelsewherethatrequiringthelargestandmostcomplexfirmstoholdhigherlevelsofcapitalasdefinedusingatangibleleverageratiowouldhaveseriousadverseeffectsontheindustryandbroadereconomy. Ithasbeensuggested,forexample,thatrequiringmore capitalfortheselargestbankswouldraisetheirrelativecostofcapitalandmakethemlesscompetitive. Similarly,thereisconcernthatfailingtoassignrisk weightstothedifferent categoriesofassetswouldencouragefirmstoallocatefundstothehighestrisk assets to achievetargetedreturnstoequity. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  40. P age |40 TheseissueshavebeenwelladdressedbyAnatAdmatiandMartinHellwig intheirrecentlypublishedbook,TheBankers’NewClothes. TherequiredROEandtheability to attractcapitalaredeterminedbyahostoffactorsbeyondthelevelofequity capital. Theseincludeafirm’sbusinessmodel,itsrisk-adjustedreturns,thebenefitsofservicesandinvestments,andtheundistorted,or non-subsidized,costsofcapital. Alevelofcapitalthatlowersriskmayverywellattractinvestorsdrawn tothemorereliablereturns. Table1showsmanyofthebankswithstrongerleverageratiosalsohavestockpricestradingatahigherpremiumto bookvaluethanthelargestfirmsthatarelesswell-capitalized. Therealsoisaconcernthatrequiringastronger,simplerleverageratiowouldcausemanagers to placemoreriskontheirbalancesheet. Whilepossible,theargumentisunconvincing. Withmorecapitalatrisk andwithoutregulatoryweightingschemesaffectingchoice,managerswillallocatecapital in linewithmarketriskandreturns. Furthermore,risk-weightedmeasuresandstrongbanksupervisioncanbeavailableasaback-upsystemtomonitorsuch activity. Moreover,giventheexperienceoftherecentcrisisandtheon-goingeffortstomanagereportedrisk assetsdown,nomattertherisk,itringshollow to suggestthathavingahigherequitybufferforthesameamountoftotalassetsmakesthefinancialsystemlesssafe. In addition,thereisaconcernthatdemandingmoreequitycapitaland reducingleverageamongthelargestfirmswouldinhibitthegrowthofcreditandtheeconomy. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  41. P age |41 ThisstatementhasanimpliedpresumptionthattheBaselweightingschemeismoregrowthfriendlythanasimpler,strongerleverageratio. However,havingasufficient capitalbufferallowsbanks to absorb unexpectedlosses. Thisservestomoderatethebusinesscycleandthedeclineinlendingthatotherwiseoccursduringcontractions. IftheBaselrisk-weightschemesareincorrect,whichtheyoftenhavebeen,thistoocouldinhibitloan growth,asitencouragesinvestmentsinothermorefavorably,butincorrectly,weightedassets. Baselsystematicallyencouragesinvestmentsinsectorspre-assignedlowerweights--forexample,mortgages,sovereigndebt,andderivatives --anddiscouragesloanstoassetsassignedhigherweights--commercial andindustrialloans. Wemayhaveinadvertentlycreatedasystemthatdiscouragestheveryloan growthweseek,andinsteadturnedourfinancialsystemintoonethatrewardsitselfmorethanitsupportseconomicactivity. Ifrisk weightscouldbeassignedthatanticipateandcalibraterisks with perfectforesight,adjustedonadailybasis,thenperhapsrisk-weightedcapitalstandardswouldbe thepreferredmethodfordetermininghow todeploy capital. However,they cannot. Tobelievethey canisafallacythatputstheentireeconomicsystemat risk. ChangingtheDebate Thetangibleleverageratioisasuperioralternative to risk-weightingschemesthathaveproventobeanillusionofprecisionandinsufficientindefiningadequatecapital. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  42. P age |42 Theeffectofrelyingonsuchmeasureshasbeentoweakenthefinancialsystemandmisallocateresources. Theleverageratiodeservesseriousconsiderationastheprincipaltool injudgingthecapitalstrengthoffinancialfirms. TheBasel discussionwouldbewellservedto focusontheappropriatelevelsoftangiblecapitalforbankingfirmstoholdandtherighttransitionperiod to achievetheselevels. Finally,weshouldnotacceptevencomfortingerrorsoflogicwhichsuggestthatBaselIIIrequirementswillcreatestrongercapitalthanthoseofBaselII,whichfailed. Instead,pastindustryperformanceandmountingacademicandotherevidencesuggestthatwewouldbebestserved to focusonastrongleverageratiostandardinjudgingafirmandtheindustry'sfinancialstrength. Nobankcapitalprogramisperfect. Ourresponsibilityasregulatorsanddepositinsurersistochoosethebest availablemeasurethatwillcontribute tofinancialstability. Note: ThomasM.HoenigwasconfirmedbytheSenateasViceChairmanoftheFederalDepositInsuranceCorporationonNov.15,2012. HejoinedtheFDIConApril16,2012,asamemberoftheFDICBoardofDirectorsforasix-yearterm. HeisamemberoftheexecutiveboardoftheInternationalAssociationofDepositInsurers. PriortoservingontheFDICboard,Mr.HoenigwasthePresidentoftheFederalReserveBankofKansasCityandamemberoftheFederalReserveSystem'sFederalOpenMarketCommitteefrom1991to2011. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  43. P age |43 Mr.HoenigwaswiththeFederalReservefor38years,beginningasaneconomistandthenasaseniorofficerinbankingsupervisionduringthe U.S.bankingcrisisofthe1980s. In 1986,heledtheKansasCityFederalReserveBank'sDivisionofBankSupervisionandStructure,directingtheoversightofmorethan1,000banksandbankholdingcompanieswithassetsrangingfromlessthan $100million to $20billion. HebecamePresidentoftheKansasCityFederalReserveBankonOctober1,1991. Mr.HoenigisanativeofFortMadison,Iowa.HereceivedadoctorateineconomicsfromIowaStateUniversity. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  44. P age |44 PCAOBIssuesPolicyStatementonExtraordinaryCooperationinConnectionwithBoardInvestigationsWashington,DC The PublicCompanyAccountingOversightBoardtodaypublishedaformalstatementconcerningthebenefitsthatmaybeavailable toregisteredpublic accountingfirmsandindividualswhoprovideextraordinarycooperationinPCAOBinvestigations. ThepolicystatementdescribeswhatthePCAOBmayconsidertobeextraordinarycooperationandhowcreditmightbereflectedforsuchcooperation. ThepolicyisgenerallyconsistentwiththeBoard'sexistingpractices. "Thispolicyprovidesbenefitstoinvestorsandreal,tangibleincentivestocooperatetofirmsandpersonsassociatedwithfirms,"saidJamesR.Doty,PCAOBChairman." ExtraordinarycooperationpermitstheBoard tomorequicklyandefficientlyaddresswrongdoingfortheprotectionofinvestors,andmayearnpartiescreditinconnectionwiththeBoard'sdisciplinaryprocesses." Accordingto thepolicy statement,extraordinarycooperationisvoluntaryandtimelyactionbeyondcompliancewithlegalorregulatoryobligations. Cooperationthatcouldresultincreditincludesself-reportingviolationsbeforetheconductcomestotheattentionoftheBoardoranotherregulator. Self-reportingismorevaluabletheearlieritisprovided. The othertypesofextraordinarycooperationthatcouldresultin creditaretakingremedialorcorrective actiontoreducetherisk ofsimilar InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  45. P age |45 violationsrecurring,andprovidingsubstantialassistanceinthePCAOB'sinvestigativeprocesses. Creditforcooperationmayresultin reducedchargesorsanctionsinadisciplinaryproceeding. In somecases,extraordinarycooperationmayleadtolanguageinsettlementdocumentsnotingthecooperationanditseffect. In exceptionalcases,extraordinarycooperationcouldleadtonodisciplinaryactionatall. "Extraordinarycooperation canhelpstreamline andexpeditePCAOBinvestigations,whichallowstheBoardtoturnitsattentionandresourcesto otherpotentialauditormisconduct,"saidClaudiusB.Modesti,DirectorofthePCAOBDivisionofEnforcementandInvestigations. "Thispolicystatementisanimportantstepinencouragingauditorstogoaboveandbeyondwhatisrequiredbylaw,"hesaid. Membersofthepublicwhowish to reportpotentialviolationsoflaworPCAOBrulesmaycontacttheBoardthroughtheTipandReferralCenteronthePCAOBwebsite. Summary The PublicCompanyAccountingOversightBoard("PCAOB" or"Board")isissuingthispolicystatement to provideguidance toregisteredpublicaccountingfirms("firms")andpersonsassociatedwithfirms("associatedpersons")concerning howextraordinarycooperationmaybeconsideredindeterminingtheoutcomeofaPCAOBinvestigation. Thispolicy statementdoesnotbindandisnotintendedtoinfluenceanyPCAOBhearingofficerortheBoardintheadjudicationoflitigatedmatters. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  46. P age |46 Further,pleasenotethattheBoardisnotadoptinganyruleormakinganycommitmentorpromiseaboutanyspecific case,orconferringanyrightsonanypersonorentity. Further,theBoardisnotinanywaylimitingitsdiscretion toevaluateevery caseindividually,onitsownparticularfactsandcircumstances. Thetypesofcooperationthatcouldresultin creditare:voluntaryandtimelyself-reporting;voluntaryandtimelyremedialorcorrective action;andvoluntaryandtimelysubstantialassistancetotheBoard’sinvestigativeprocessesortootherlawenforcementauthorities. Theseactions,aloneortakentogether,canbeviewedasextraordinarycooperationforpurposesofthispolicystatementand,dependingonthefactsandcircumstances,mayinfluencethePCAOB’senforcementdecisions. Bypublishingthispolicy statementoncooperation,theBoardseeks: to encouragefirmsandassociatedpersonstovoluntarilyandtimelyself-report,correctandremediateviolativebehavior,andprovidesubstantialassistance to theBoard’sinvestigativeprocesses;and to increasetransparencyintohowtheBoardmaycreditcooperation. Moreover,theBoardwill, in appropriatecasesandin itsdiscretion,notein settlementdocumentsorotherpublicstatementsthatithascreditedtheextraordinarycooperationofafirmorassociatedperson. DoingsowillenhancetheBoard’senforcementprogrambypublicizingthebenefitsofcooperationandinformingfirmsandassociatedpersonsofthetypesofcooperationthatmaymeritcredit. I.Introduction TheSarbanes-OxleyAct(the"Act")andBoardRulesrequirefirmsandassociatedpersonstocooperateinconnectionwithPCAOBinspectionsandinvestigations. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  47. P age |47 Section102(b)(3)oftheActrequireseveryfirmapplyingforPCAOBregistrationtosupply aconsenttocooperateinandcomplywithanyrequestfortestimonyortheproductionofdocumentsmadebythePCAOBinthefurtheranceofitsauthorityandresponsibilitiesundertheAct, anagreementtosecureandenforcesimilarconsentsfromeachassociatedpersonofthefirm,and astatementthatthefirmunderstandsandagrees,amongotherthings,thatitscooperationandcomplianceshallbeaconditiontothecontinuingeffectivenessofthefirm’sregistrationwiththeBoard. Evenifafirmfailstoprovidethoseitemswithitsapplication,itisnotrelievedoftheobligations tocooperateinandcomplywithBoardrequestsmadeinfurtheranceoftheBoard’sauthorityandresponsibilitiesundertheAct. Moreover,two BoardRulesaddresscooperationbyregisteredfirmsandassociatedpersons. BoardRule4006,Duty to CooperatewithInspectors,appliestoinspections,andrequiresaregisteredfirmandanyassociatedpersonofthatfirm tocooperatewithanyBoardinspectionbyprovidinginformationrequestedinBoardinspectionsandprovidingaccess to thefirm’srecords. Rule4006alsorequiresthatinformationprovidedtotheBoardbetruthfulandnotmisleading. Sections105(c)(4)and(5)oftheActandBoardRule5300(a)governsanctionsfornoncooperationwithaninspection. Section105(b)(3)oftheActandBoardRule5110,NoncooperationwithanInvestigation,applytoinvestigations,andprovidethattheBoardmaysanctionafirmorassociatedpersonforfailingtocooperatewithaBoardinvestigation. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  48. P age |48 TheformsofcooperationcoveredbyRule5110areenumeratedinparagraphs(1)-(3),withparagraph(4)providinga catch-allprovisionforfailuretocooperategenerally.Section105(b)(3)oftheActandBoardRule5300(b)governsanctionsforfailuretocooperatewithaninvestigation. In certainsituations,afirmorassociatedpersonmightcooperatewithPCAOBinvestigationsbeyondcompliancewiththoseobligations. Cooperationbeyondwhatisrequired tocomplywithlegalandregulatoryobligationscan contributesignificantlytothesuccessoftheBoard’smissionofprotectinginvestorsandfurtheringthepublicinterestinthepreparationofinformative,accurateandindependentauditreports. SuchextraordinarycooperationmighthelptheBoard’sstafftodiscoverpotentialviolationsearlierandallowtheBoardtoconcludeinvestigationsinamoreefficientandtimelymanner,thusreducingtheriskthatsuchviolativeconductwillberepeatedandresultinmoresignificantharmtoinvestors,andassistingtheBoardinidentifyingauditreportsthatmaybeinaccurate. Forthatreason,extraordinarycooperationin connectionwithBoardinvestigationsmaybeconsideredbytheBoard’sDivisionofEnforcementandInvestigations(the"Division") initsdisciplinaryrecommendationstotheBoard,andbytheBoardindetermining whetherto acceptsettlementoffers. II.Whatisextraordinarycooperation? Extraordinarycooperationisvoluntaryandtimelyaction– beyondcompliancewithlegalorregulatoryobligations–thatcontributestothemissionoftheBoard. Therearethreebroadtypesofcooperationthat (aloneortakentogether)mightmeritcooperationcredit:self-reporting;remedialorcorrectiveaction;andsubstantialassistancetotheBoard’sinvestigativeprocessesorto otherlawenforcementauthorities. Self-Reportingrelates to conductuponlearningofviolations. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  49. P age |49 Afirmorassociatedpersonmayearncreditforself-reportingbymakingvoluntary,timelyandfulldisclosureofthefactsrelatingto violationsbeforetheconductcomestotheattentionoftheBoardoranotherregulator. Ifself-reportingisrequiredbylegalorregulatoryobligations,itisnotvoluntaryandisnoteligibleforcooperationcredit. Thus,forexample,self-reportingisnotvoluntaryifmadeafterreceiptofaregulatoryinquiry(e.g.,anyrequest,demandorsubpoenaforthesameinformationordocumentsfromtheBoard,theU.S. SecuritiesandExchangeCommission,Congress,anyotherfederal,state,localorforeignauthority,orany self-regulatoryorganization). Likewise,self-reportingisnotvoluntaryifrequiredbySection10A(b)oftheSecuritiesExchangeActof1934[15U.S.C.§78j-1(b)],Auditrequirements-Requiredresponsetoauditdiscoveries(whichaddressesanauditor’sobligationto reporttheillegalactsoftheauditclient)andRule10A-1thereunder. Asaresult,iftheauditordiscoversordetectsanillegalactduringeitheraquarterlyrevieworannualaudit,andisrequiredtoreportitpursuant toSection10A,theauditor wouldnotbeeligible to earncreditfor self-reporting. Self-reportingismorevaluabletheearlieritisprovided. Whenfirmsorassociatedpersonsself-reporttothePCAOB,theBoardencouragesthemto self-reportbydirectlycontactingtheDivisionofEnforcementandInvestigations,orbyprovidinginformationanddocumentsviatheBoard’stipshotline:http://pcaobus.org/Enforcement/Tips/Pages/default.aspx RemedialorCorrectiveActionsarevoluntary,timelyandmeaningfulactionsdesigned toreducethelikelihoodandrisk thatsimilarviolationswillrecur,aswellasactionstocorrectviolativeconduct. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  50. P age |50 Forexample,afirmmightearncreditbypromptlyandvoluntarilymodifyingandimprovingitsqualitycontrolsorother internalpoliciesandprocedurestopreventrecurrenceoftheviolativeconduct. Afirmmighttakeremedialorcorrectiveactionbyre-assigningorlimitingtheactivitiesofthoseindividualsresponsibleforviolations(whichmightincludemembersoftheauditteam,aswellaspersonsoutsidetheauditteam,includingpersonsinfirmmanagement),andinappropriatecasesby terminatingorimposing disciplineupontheresponsibleindividuals. Afirm’sremedialorcorrectiveactionmightalsoincludepromptlynotifyingitsauditclientoritsauditcommittee(asappropriate)oftheviolativeconductandcooperatingwiththeclient,sothattheclientcan(ifnecessary)takesteps to complywiththefederalsecuritieslawsandregulations(e.g.,byengaginganauditorto re-auditthefinancialstatementsaffectedbyanauditor’s independenceviolations). Afirm’sremedialorcorrectiveactionalsomightincludeappropriatelycompensatingthoseadverselyaffectedbythefirm’sviolations. SubstantialAssistancetotheBoard’sinvestigativeprocessesorto otherlawenforcementauthoritiesincludestimelyandvoluntarilyprovidinginformationordocumentsthatmightnothavebeendiscoveredabsent thatcooperation,orbeyondthatsoughtbytheBoard’sstaffviaaccountingboarddemandsandrequests,andbeyondwhatisrequiredpursuanttolegalandregulatoryreportingrequirements. Forexample,afirmmightsubstantiallyassisttheBoardbyconductingatimely,thorough,objectiveandcompetentinternal investigationintotheviolativeconductwhenitwasdiscovered,andinformingtheDivision’sstaffofthepertinentfactsdiscoveredintheinternalinvestigation. Afirmorassociatedpersonmightsubstantiallyassist anotherlawenforcementauthority’sinvestigativeprocessesby self-reportingto thatauthority,orprovidingitwiththefactsdiscoveredin aninternalinvestigation. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

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