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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