Basel iii News December 2012


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Basel iii News December 2012

  1. 1. 1 Basel iii Compliance Professionals Association (BiiiCPA) 1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 202-449-9750 Web: www.basel-iii-association.comDear Member,Today we will start with an interestingassessment:Basel III Experts vs. RiskManagement ExpertsIt is interesting to feel the market.Do you make more money as a riskmanager, or a risk manager with Basel iiiknowledge? What do you believe?Source: IT Jobs Watch, that provides aunique perspective on todays information technology job market. This is not an advertisement. We have no affiliation or any other relationshipwith IT Jobs Watch. Basel iii Compliance Professionals Association (BiiiCPA)
  2. 2. 2Basel III Top 30 Related IT Skills in UKBasel III Jobs, Salary Trend in UK Basel iii Compliance Professionals Association (BiiiCPA)
  3. 3. 3Risk Management Jobs, Salary Trend in UKBasel III Salary Histogram in UK Basel iii Compliance Professionals Association (BiiiCPA)
  4. 4. 4Risk Management Salary Histogram in UKBasel III, Top 9 Job Locations in UK Basel iii Compliance Professionals Association (BiiiCPA)
  5. 5. 5Risk Management, Top Job Locations in UK Basel iii Compliance Professionals Association (BiiiCPA)
  6. 6. 6Basel 3 –The Timing DilemmaLast month the United States (US) regulatory authorities announced thatthey did not expect their rules implementing Basel 3 would becomeeffective on 1 January 2013, although they are working as “expeditiouslyas possible” to complete their rulemaking process.Similarly in the European Union (EU), the trilogue between theEuropean Commission, the European Parliament and the Council ofMinisters to agree the text of Capital Requirements Directive IV (CRDIV, the EU version of Basel 3 is still ongoing and, even if a politicalagreement can be reached by year-end (which still appears to be theintention), it is recognised in the EU that there will not be sufficient timefor CRD IV to be codified as legislation and put into effect on 1 January2013.So, does it necessarily follow that we should delay Basel 3 implementationin Hong Kong because the US and the EU cannot meet theinternationally agreed timeline?Or should we follow the timeline set by the Basel Committee on BankingSupervision and begin the first phase of Basel 3 implementation from 1January 2013?Our Basel 3 rules (the Banking (Capital) (Amendment) Rules 2012) arecurrently tabled at LegCo and notwithstanding the expected delays in theUS and the EU, the Basel Committee’s timeline remains unchanged.Its gradual phase-in of the new capital standards over six years beginsfrom January 2013 and extends until 2019.In resolving the timing dilemma, it might first be instructive to remindourselves that Basel 3 is being introduced to rectify weaknesses made alltoo starkly apparent in the recent global financial crisis. Basel iii Compliance Professionals Association (BiiiCPA)
  7. 7. 7Or, put another way, Basel 3 is considered good for financial stability.The Basel 3 capital standards are designed to strengthen banks’ resilienceby requiring more and better quality capital and by addressing andcapturing risks not adequately recognised previously.The aim is to ensure that banks can weather future financial stormswithout disruption to their lending.This should in turn make them less likely to create or amplify problems inother areas of the economy and facilitate their contribution to long-termsustainable economic growth.The roller-coaster of excessive leverage pre-crisis and excessivedeleveraging post-crisis is not conducive to sustainable growth.Regulation is all about balance.If regulation is too lax, excessive risk-taking may result with devastatingeffects.If regulation is too tight, it may suppress beneficial financial activity andreduce growth.In our view, Basel 3 represents an appropriate balance in bolsteringresilience whilst at the same time (with its extended phase-in) not undulyhampering lending to business and households today and ensuring bankscan continue to lend in any downturn tomorrow.For this reason we propose to begin implementing Basel 3 from 1 January2013.We are not alone in this.Our regional peers, Mainland China, Japan, Singapore and Australia haveall published their final rules for Basel 3 implementation next year. Basel iii Compliance Professionals Association (BiiiCPA)
  8. 8. 8As has Switzerland, another important financial centre.But notwithstanding the intrinsic benefits of Basel 3, should wenevertheless be swayed by the argument put to us that Asia is taking the“medicine” designed for the countries worst affected by the crisis, whilstthe intended “patients” defer and thereby give their banks significant“competitive advantages” over our own?This competitive advantage argument would seem to be based on twoassumptions.First that US and EU global banks (i.e. those banks that could realisticallycompete with our own) are currently holding much lower levels of capitalthan required by Basel 3 (and hence will have a genuine cost advantage);and second that our banks will, come 1 January 2013, have to hold morecapital than they currently hold (and hence will incur additional cost).Are these assumptions correct?Well even though adoption of Basel 3 is delayed in the US and the EU,this certainly does not mean that banks in these regions remain at theirpre-crisis capital levels.There has been significant re-capitalisation.The Dodd Frank Wall Street Reform and Consumer Protection Act in theUS already requires the regulatory agencies to conduct stress-testingprogrammes to ensure banks and other systemically important financialinstitutions have enough capital to weather severe financial conditionsand, even before the passage of the Dodd Frank Act, the US FederalReserve Board put some of the largest US bank holding companiesthrough stress-tests, the results of which have led to significant increasesin capital. Basel iii Compliance Professionals Association (BiiiCPA)
  9. 9. 9By 2012, the 19 bank holding companies subject to the Fed’sComprehensive Capital Analysis and Review had increased theiraggregate tier 1 common capital to US$803 billion in the second quarter ofthe year from US$420 billion in the first quarter of 2009, with their tier 1common capital ratio (which compares high quality capital to assetsweighted according to their riskiness) doubling to a weighted average of10.9% from 5.4%.In the EU, under a recapitalisation exercise in 2011 that covered 71 of theEU’s major banks, the European Banking Authority (EBA) required mostto attain a “core tier 1 ratio” of not less than 9% by the end of June 2012.In October 2012, the EBA indicated that it will focus on capitalconservation to “support a smooth convergence to the CRD IV…..regulatory requirements” and require the banks to maintain an absoluteamount of core tier 1 capital corresponding to the level of the 9% core tier1 ratio.So even absent formal adoption of Basel 3, the capital levels of the largestbanks in the US and the EU have increased significantly post-crisis tolevels comparable with, or even in excess of, those required under Basel 3and so the prospect of such banks “competing” by being allowed tomaintain much lower capital levels than Basel 3 banks would seem moreapparent than real.Turning to the second “competitive” assumption, will the first phase ofBasel 3, which starts next year, require local banks to hold significantlymore capital than they do at present, to the extent that they may becomeconstrained in their ability to lend and compelled to pass on the costs ofthe extra capital to borrowers?Well, the results of the HKMA’s quantitative impact studies tell us thatour local banks are already very well-placed to meet the new Basel 3capital ratios. Basel iii Compliance Professionals Association (BiiiCPA)
  10. 10. 10Their capital levels are already in excess of the standard taking effect on 1January 2013 and the issuance of ordinary shares (common equity)already accounts for a very significant proportion of their capital base,positioning them well for Basel 3’s new focus on common equity as thehighest quality capital for the purpose of loss absorption.In summary then, irrespective of any delay in formal implementation ofBasel 3, major banks in the US and EU are inexorably moving to higherlevels of capital.This, together with the benefits offered by Basel 3 and the relative easewith which local banks can comply, serves to underpin our view that weshould proceed to implement the first phase of Basel 3 in line with theBasel Committee’s timeline.Generally speaking, jurisdictions in Asia have in the past tended to adoptregulations that are in some respects higher than the Basel Committee’sminimum standards.This may have helped Asia weather the global financial crisis relativelyunscathed when compared with the jurisdictions worst affected.There would, therefore, seem little to be gained from seeking to engagein, or indeed prompt, a “race-to-the-bottom” in regulatory terms bydeliberately delaying the introduction of Basel 3 at this point in time.In implementing on 1 January 2013, we will be fulfilling our commitmentboth as an international financial centre which customarily adopts bestinternational standards and as a member of the Basel Committee onBanking Supervision.Karen KempExecutive Director (Banking Policy) Basel iii Compliance Professionals Association (BiiiCPA)
  11. 11. 11Governor Daniel K. TarulloAt the Yale School of Management Leaders Forum,New Haven, ConnecticutRegulation of Foreign Banking OrganizationsIn the aftermath of the financial crisis, regulatorsaround the world continue to implement reforms designed to limit theincidence and severity of future crises.My subject today pertains to an area in which reforms have yet to bemade--the regulation of the U.S. operations of large foreign banks.Applicable regulation has changed relatively little in the last decade,despite a significant and rapid transformation of those operations, asforeign banks moved beyond their traditional lending activities to engagein substantial, and often complex, capital market activities.The crisis revealed the resulting risks to U.S. financial stability.In taking a fresh look at regulation of foreign banks in the United States, Iby no means want to imply that the United States should revoke itswelcome to foreign banks.On the contrary, this reconsideration reflects the important role foreignbanks have played.The presence of foreign banks can bring particular competitive andcountercyclical benefits because foreign banks often expand lending inthe United States when U.S. banking firms labor under commondomestic strains.But just as we are adapting our regulatory approach to U.S. banks, so weneed to incorporate important lessons learned from the crisis into ouroversight program for foreign banks.The question of how best to regulate foreign banks is hardly a new one,either here or in other countries. Basel iii Compliance Professionals Association (BiiiCPA)
  12. 12. 12Debates over the relative merits of territorial versus global or mutualrecognition approaches, the difficulties in achieving strictly equal termsof competition between banks with different home regulatory systems,and the degree to which harmonization of international standards andsupervisory consultations can mitigate the resulting inconsistencies andfrictions are all familiar topics to academics, banking lawyers, andsupervisory authorities.While I do not aim to resolve this afternoon the complicated interactionamong these perspectives and considerations, I will try to outline apractical and reasonable way forward.To be effective, a new approach must address the vulnerabilities that havebeen created by the shift in foreign bank activities, in keeping with soundprudential policy and congressional mandates in the Dodd-Frank WallStreet Reform and Consumer Protection Act.At the same time, a modified regulatory system should maintain theprinciple of national treatment and allow foreign banks to continue tooperate here on an equal competitive footing, to the benefit of the U.S.banking system and the U.S. economy generally.Foreign Bank Regulation in the United StatesRegulating the U.S. operations of foreign banks presents uniquechallenges.Although U.S. supervisors have full authority over the local operations offoreign banks, we see only a portion of a foreign banks worldwideactivities, and regular access to information on its global activities can belimited.Foreign banks operate under a wide variety of business models andstructures that reflect the legal, regulatory, and business climates in thehome and host jurisdictions in which they operate.Despite these difficulties, the United States has traditionally accordedforeign banks the same national treatment as domestic banks, and U.S.regulators generally have allowed foreign banks to choose among Basel iii Compliance Professionals Association (BiiiCPA)
  13. 13. 13structures that they believe promote maximum efficiency at theconsolidated level.Under the statutory scheme established by Congress, permissible U.S.structures include cross-border branching and direct and indirectsubsidiaries, provided that they operate in a safe and sound manner.U.S. law also allows well-managed and well-capitalized foreign banks toconduct a wide range of bank and nonbank activities in the United Statesunder conditions comparable to those applied to U.S. bankingorganizations.Still, it is worth noting that even as there has been continuity in this basicpolicy, U.S. regulation of foreign banks has evolved over the years inresponse to changes in the extent and nature of foreign bank activities.Let me mention two examples.Before 1978, foreign bank branches in the United States were licensed andregulated by individual states, with little in the way of federal regulationor restrictions.They were not subject to the full panoply of limitations on interstatebanking, equity investments, or affiliations with securities firms that wereapplicable to domestic banks.The rapid growth of foreign banking in the 1970s, particularly branching,prompted an end to this lighter regulatory regime.The International Banking Act of 1978 gave the Federal Reserve Boardregulatory authority over the domestic operations of foreign banks andsignificantly equalized regulatory treatment of foreign and domesticfirms.Congress maintained this approach of basic competitive equality in the1999 Gramm-Leach-Bliley Act.That law substantially removed restrictions on affiliations betweencommercial banks and other kinds of financial firms for both domesticand foreign institutions operating in the United States. Basel iii Compliance Professionals Association (BiiiCPA)
  14. 14. 14Moreover, in light of provisions in Gramm-Leach-Bliley that permitted aforeign bank to be a financial holding company (FHC), the FederalReserve announced in 2001 that a bank holding company (BHC) in theUnited States that was owned and controlled by a well -capitalized andwell-managed foreign bank generally would not be required to meet theBoards capital requirements normally applicable to BHCs.My second example relates to the massive fraud uncovered at the Bank ofCredit and Commerce International (BCCI) and its subsequent collapsein 1991, which highlighted the need for more effective supervision ofbanks operating in multiple countries.The Foreign Bank Supervision Enhancement Act of 1991 (FBSEA)required foreign banks to receive approval from the Board beforeestablishing a branch or agency in the United States.The law required the Federal Reserve, in turn, to determine that theforeign bank is subject to "comprehensive supervision or regulation on aconsolidated basis" in its home country before approving an applicationeither to open a branch or to acquire a U.S. subsidiary bank.It is further worth noting that changes in U.S. law and regulatory practiceaffecting foreign banking organizations have often corresponded tochanges in international regulatory agreements.For example, FBSEA was enacted at the same time as the BaselCommittee on Banking Supervision was working to address the problemsrevealed by BCCI--an effort that bore fruit the next year in changes to theso-called Basel Concordat, which established minimum standards for thesupervision of international banking groups.Another instance was the substantial reduction or removal of remainingasset-pledge and asset-maintenance requirements for most U.S. branchesof foreign banks, prompted in part by implementation of the newinternational capital standards included in the 1988 Basel Accord. Basel iii Compliance Professionals Association (BiiiCPA)
  15. 15. 15The Shift in Foreign Bank ActivitiesAlthough foreign banks expanded steadily in the United States during the1970s, 1980s, and 1990s, their activities here posed limited risks to overallU.S. financial stability.Throughout this period, the U.S. operations of foreign banks were largelynet recipients of funding from their parents and generally engaged intraditional lending to home-country and U.S. clients.U.S. branches and agencies of foreign banks held large amounts of cashduring the 1980s and 90s, in part to meet asset-maintenance andasset-pledge requirements put in place by regulators.Their cash-to-third-party liability ratio from the mid-1980s through thelate 1990s generally ranged between 25 percent and 30 percent.The U.S. branches and agencies of foreign banks that borrowed fromtheir parents and lent those funds in the United States ("lendingbranches") held roughly 60 percent of all foreign bank branch and agencyassets in the United States during the 1980s and 90s.Commercial and industrial lending continued to account for a large partof foreign bank branch and agency balance sheets through the 1990s.This profile of foreign bank operations in the United States changed inthe run-up to the financial crisis.Reliance on less stable, short-term wholesale funding increasedsignificantly.Many foreign banks shifted from the "lending branch" model to a"funding branch" model, in which U.S. branches of foreign banks wereborrowing large amounts of U.S. dollars to upstream to their parents.These "funding branches" went from holding 40 percent of foreign bankbranch assets in the mid-1990s to holding 75 percent of foreign bankbranch assets by 2009. Basel iii Compliance Professionals Association (BiiiCPA)
  16. 16. 16Foreign banks as a group moved from a position of receiving fundingfrom their parents on a net basis in 1999 to providing significant fundingto non-U.S. affiliates by the mid-2000s--more than $700 billion on a netbasis by 2008.A good bit of this short-term funding was used to finance long-term, U.S.dollar-denominated project and trade finance around the world.There is also evidence that a significant portion of the dollars raised byEuropean banks in the pre-crisis period ultimately returned to the UnitedStates in the form of investments in U.S. securities.Indeed, the amount of U.S. dollar-denominated asset-backed securitiesand other securities held by Europeans increased significantly between2003 and 2007, much of it financed by the short-term, dollar-denominatedliabilities of European banks.Meanwhile, commercial and industrial lending originated by U.S.branches and agencies as a share of their third-party liabilities fellsignificantly after 2003.In contrast, U.S. broker-dealer assets of the top-10 foreign banksincreased rapidly during the past 15 years, rising from 13 percent of allforeign bank third-party assets in 1995 to 50 percent in 2011.Lessons from the Recent Financial CrisisThe 2007–2008 financial crisis and the continuing financial stress inEurope have revealed financial stability risks associated with the foreignbanking model as it has evolved in the United States.To some extent the concerns associated with foreign banking operationstrack the more general shortcomings of pre-crisis financial regulation.Internationally agreed minimum capital levels were too low, the qualitystandards for required capital were too weak, the risk weights assigned tocertain asset classes did not reflect their actual risk, and the potential forliquidity strains was seriously underappreciated. Basel iii Compliance Professionals Association (BiiiCPA)
  17. 17. 17But some risks are more closely tied to the specifically internationalcharacter of certain global banks, both here and in some other parts of theworld.The location of capital and liquidity proved critical in the resolution ofsome firms that failed during the financial crisis.Capital and liquidity were in some cases trapped at the home entity, as inthe case of the Icelandic banks and, in our own country, LehmanBrothers.Actions by home-country authorities during this period showed that whilea foreign bank regulatory regime designed to accommodate centralizedmanagement of capital and liquidity can promote efficiency during goodtimes, it also increases the chances of ring-fencing by home and hostjurisdictions at the moment of a crisis, as local operations come undersevere strain and repayment of local creditors is called into question.Resolution regimes and powers remain nationally based, complicatingthe resolution of firms with large cross-border operations.The large intra-firm, cross-border flows that grew rapidly in the yearsleading up to the crisis also created vulnerabilities.To be fair, the ability to move liquidity freely throughout a banking groupmay have provided some financial stability benefits during the crisis byenabling banks to respond to localized balance-sheet shocks anddysfunctional markets in some areas (such as the interbank and foreignexchange swap markets) and by transferring resources from healthierparts of the group.Nevertheless, this model also created a degree of cross-currency fundingrisk and heavy reliance on swap markets that proved destabilizing.Moreover, foreign banks that relied heavily on short-term, U.S. dollarliabilities were forced to sell U.S. dollar assets and reduce lending rapidlywhen that funding source evaporated, thereby compounding risks to stability. Basel iii Compliance Professionals Association (BiiiCPA)
  18. 18. 18Although the United States did not suffer a destabilizing failure of foreignbanks, many rode out the crisis only with the help of extraordinarysupport from home- and host-country regulators.Following national treatment practice, the Federal Reserve itself providedsubstantial discount window access to U.S. branches and the opportunityto participate in the Primary Dealer Credit Facility to U.S. primary-dealersubsidiaries of foreign banks.Moreover, the potential for funding disruptions did not disappear with thewaning of the global financial crisis.In 2011, for example, as concerns about the euro zone rose, U.S. moneymarket funds suddenly pulled back their lending to large euro area banks,reducing lending to these firms by roughly $200 billion over just fourmonths.While there has been some reduction in operations and some change infunding patterns by foreign banking organizations in the United Statessince the crisis, particularly by European firms reacting to euro zonefinancial stress, the basic circumstances have not changed.The proportion of foreign banking assets to total U.S. banking assets hasremained at about one-fifth since the end of the 1990s.But the concentration and complexity of those assets have changednoticeably from earlier decades, and have not reversed in recent yearsdespite the global financial crisis and subsequent events.Ten foreign banks now account for more than two-thirds of foreign bankthird-party assets held in the United States, up from 40 percent in 1995.And while the largest U.S. operations of foreign banks do not approachthe size of our largest domestic financial institutions, it is striking thatthere are 23 foreign banks with at least $50 billion in assets in the UnitedStates--the threshold established by the Dodd-Frank Act for specialprudential measures for domestic firms--compared with 25 U.S. firms. Basel iii Compliance Professionals Association (BiiiCPA)
  19. 19. 19Most notably, perhaps, five of the top-10 U.S. broker-dealers are owned byforeign banks.Like their U.S.-owned counterparts, large foreign-owned were highly leveraged in the years leading up to the crisis.Their reliance on short-term funding also increased, with much of theexpansion of both U.S.-owned and foreign-owned U.S. broker-dealeractivities attributable to the growth in secured funding markets duringthe past 15 years.Finally, we should note that one of the fundamental elements of thecurrent approach--our ability, as host supervisors, to rely on the foreignbank to act as a source of strength to its U.S. operations--has come intoquestion in the wake of the crisis.The likelihood that some home-country governments of significantinternational firms will backstop their banks foreign operations in a crisisappears to have diminished.It also appears that constraints have been placed on the ability of thehome offices of some large international banks to provide support to theirforeign operations.The motivations behind these actions are not hard to understand andappreciate, but they do affect the supervisory terrain for host countriessuch as the United States.International and Domestic Regulatory ResponseSince the crisis, important changes have been made to strengtheninternational regulatory standards.The Basel III capital and liquidity frameworks are big improvements, andthe proposed capital surcharges for systemically important firms will beanother important step forward. Basel iii Compliance Professionals Association (BiiiCPA)
  20. 20. 20But these reforms are primarily directed at the consolidated level, withlittle attention to vulnerabilities posed by internationally active banks inhost markets.The risks associated with large intra-group funding flows have remainedlargely unaddressed.Managing international regulatory initiatives also has become moredifficult, as the number of complex items on the agenda has increased.And despite continued work by the Financial Stability Board, challengesto cross-border resolution are likely to remain significant.For the foreseeable future, then, our regulatory system must recognizethat while internationally active banks live globally, they may well dielocally.Quite apart from the need to act pragmatically under the circumstances,it is not clear that we should aim toward extensive harmonization ofnational regulatory practices related to foreign banking organizations.The nature and extent of foreign banking activities vary substantiallyacross national markets, suggesting that regulatory responses might bestvary as well.For instance, the importance of the U.S. dollar in many internationaltransactions can motivate foreign banks to use their U.S. operations toraise dollar funding for their international operations, potentially creatingvulnerabilities.Such a model is unlikely to prevail in most other host financial marketsaround the world.Indeed, in response to financial stability risks highlighted during thecrisis, ongoing challenges associated with the resolution of largecross-border firms, and the limitations of the international reform agenda,several national authorities have already introduced their own policies tofortify the resources of internationally active banks within theirgeographic boundaries. Basel iii Compliance Professionals Association (BiiiCPA)
  21. 21. 21Regulators in the United Kingdom, for example, have recently increasedrequirements for liquidity to cover local operations of domestic andforeign banks, set stricter rules around intra-group exposures of U.K.banks to foreign subsidiaries, and moved to ring-fence home-countryretail operations.Meanwhile, Swiss authorities have explicitly prioritized the domesticsystemically important operations of their large, internationally activefirms in resolution.Here in the United States, Congress included in the Dodd-Frank Act anumber of changes directed at the financial stability risk posed by foreignbanks.Sections 165 and 166 instruct the Federal Reserve to implement enhancedprudential standards for large foreign banks as well as for large domesticBHCs and nonbank systemically important financial institutions.Dodd-Frank also bolstered capital requirements for FHCs, includingforeign FHCs, by extending the well-capitalized and well-managedrequirements beyond U.S. bank subsidiaries to the top-tier holdingcompany.In addition, the so-called Collins Amendment in Dodd-Frank removedthe exemption from BHC capital requirements granted by the FederalReserves Supervision and Regulation Letter 01-01.The required phase-out of SR 01-01 was clearly intended to strengthen thecapital regime applied to the U.S. operations of foreign banks; however,the organizational flexibility that the amendment gave to foreign banks inthe United States has allowed some large foreign banks to restructuretheir U.S. operations to minimize the impact of this regulatory change.As a result, in the absence of additional structural requirements forforeign banks in the United States, the effectiveness of our capital regimefor large foreign banks with both bank and nonbank operations in theUnited States depends on the foreign banks own organizational choices. Basel iii Compliance Professionals Association (BiiiCPA)
  22. 22. 22A Rebalanced Approach to Foreign Bank RegulationAs has been the case in the past, we need to adjust the regulatoryrequirements for foreign banks in response to changes in the nature oftheir activities in the United States, the risks attendant to those changes,and instructions from Congress in new statutory provisions.The modified regime should counteract the risks posed to U.S. financialstability by the activities of foreign banking organizations, as manifestedin the years leading up to, and through, the financial crisis.Special attention must be paid to the risk of runs associated withsignificant reliance on short-term funding.In addition, the regime should reduce the difficulties in resolution ofcross-border firms.Finally, it should take steps to diminish the potential need for ex-postring-fencing when losses mount or runs develop during a crisis, sincesuch actions may well be unhelpfully procyclical.At the same time, in modifying our regulatory regime for foreign bankingorganizations, we must remain mindful of the benefits that foreign bankscan bring to our economy and of the important policies of nationaltreatment and comparable competitive opportunity.Thus, we should chart a middle course, not moving to a fully territorialmodel of foreign bank regulation, but instead making targetedadjustments to address the risks I have identified.In basic terms, three such adjustments are desirable.First, a more uniform structure should be required for the largest U.S.operations of foreign banks--specifically, that these firms establish atop-tier U.S. intermediate holding company (IHC) over all U.S. bank andnonbank subsidiaries. Basel iii Compliance Professionals Association (BiiiCPA)
  23. 23. 23An IHC would make application of enhanced prudential supervisionmore consistent across foreign banks and reduce the ability of foreignbanks to avoid U.S. consolidated-capital regulations.Because U.S. branches and agencies are part of the foreign parent bank,they would not be included in the IHC.However, they would be subject to the activity restrictions applicable tobranches and agencies today as well as to certain additional measuresdiscussed below.Second, the same capital rules applicable to U.S. BHCs should also appl yto U.S. IHCs.These rules have been reshaped to counteract the risks to the system revealed by the crisis and should be implementedconsistently across all firms that engage in similar activities.Similarly, other enhanced prudential standards required by theDodd-Frank Act--including stress testing requirements, riskmanagement requirements, single counterparty credit limits, and earlyremediation requirements--should be applied to the U.S. operations oflarge foreign banks in a manner consistent with the Boards domesticproposal.Third, there should be liquidity standards for large U.S. operations offoreign banks.Standards are needed to increase the liquidity resiliency of theseoperations during times of stress and to reduce the threat of destabilizingruns as dollar funding channels dry up and short-term debt cannot berolled over.For IHCs, the standards should be broadly consistent with the standardsthe Federal Reserve has proposed for large domestic BHCs, pending finaladoption and phase-in of quantitative liquidity requirements by the BaselCommittee. Basel iii Compliance Professionals Association (BiiiCPA)
  24. 24. 24That is, they should be designed to ensure that, in stressedcircumstances, the U.S. operations have enough high-quality liquidassets to meet expected net outflows in the short term.There should also be liquidity standards for foreign bank branch andagency networks in the United States, although they may be lessstringent, in recognition of the integration of branches and agencies intothe global bank as a whole.By imposing a more standardized regulatory structure on the U.S.operations of foreign banks, we can ensure that enhanced prudentialstandards are applied consistently across foreign banks and incomparable ways between U.S. banking organizations and foreignbanking organizations.As with domestic firms subject to enhanced prudential standards, theFederal Reserve would work to ensure that the new regime is minimallydisruptive, through transition periods and other means.An IHC structure would also provide the Federal Reserve, as umbrellasupervisor of the U.S. operations of foreign banks, with a uniformplatform to implement a consistent supervisory program across largeforeign banks.In the case of foreign banks with the largest U.S. operations, the IHCwould also help mitigate resolution difficulties by providing U.S.regulators with one consolidated U.S. legal entity to place intoreceivership under title II of the Dodd-Frank Act if the failure of theforeign bank would threaten U.S. financial stability.Branches and agencies would remain separate, but all other entitieswould be included.Further, an IHC structure would facilitate a consistent U.S. capitalregime for bank and nonbank activities of foreign banks under the IHC,similar to the approach taken in other jurisdictions, such as the UnitedKingdom and some continental European countries. Basel iii Compliance Professionals Association (BiiiCPA)
  25. 25. 25Some observers will, I am sure, ask if it is necessary to depart from theprevailing firm-by-firm approach to foreign banking regulation and toadopt generally applicable requirements in implementing theDodd-Frank enhanced prudential standards for foreign banks.It is difficult to see how reliance on this approach can be effective inaddressing risks to U.S. financial stability, at least in the absence ofextraterritorial application of our own standards and supervision, andperhaps not even then.We would, at a minimum, need to make regular and detailed assessmentsof each firms home-country regulatory and resolution regimes, thefinancial stability risk posed by each firm in the United States, and thefinancial condition of the consolidated banking organization.In fact, such an approach might result in the worst of both worlds--anongoing intrusiveness into the consolidated supervision of foreign banksby their home-country regulators without the ultimate ability to evaluatethose banks comprehensively or to direct changes in a parent bankspractices necessary to mitigate risks in the United States.Although the Federal Reserve will continue to cooperate with its foreigncounterparts in overseeing large, multinational banking operations, thatsupervisory tool cannot provide complete protection against risksengendered by U.S operations as extensive as those of many large U.S.institutions.It is also important to note that while the reforms I have described todaycontain some elements that are more territorial than our currentapproach, including requiring some additional capital and liquiditybuffers to be held in the United States, they do not represent a completedeparture from prior practice.This enhanced approach would allow foreign banks to continue tooperate branches in the United States and would generally allow branchesto meet comparable capital requirements at the consolidated level. Basel iii Compliance Professionals Association (BiiiCPA)
  26. 26. 26Similarly, this approach would not impose a cap on intra-group flows,thereby allowing foreign banks in sound financial condition to continueto obtain U.S. dollar funding for their global operations through their U.S.entities.It would instead provide an incentive to term out at least some of thisfunding in a way that reduces the risk of runs.Requiring additional local capital and liquidity buffers, like anyprudential regulation, may incrementally increase cost and reduceflexibility of internationally active banks that manage their capital andliquidity on a centralized basis.However, managing liquidity and capital on a local basis can havebenefits not just for financial stability generally, but also for firmsthemselves.During the crisis, the more decentralized global banks relied somewhatless on cross-currency funding and were less exposed to disruptions ininternational wholesale funding and foreign exchange swap markets thanthe more centralized banks.Indeed, as noted earlier, in the wake of the crisis and of subsequentstresses, many foreign banks have modified their funding practices andbusiness models.In revamping our approach, we will both be guarding against a return topre-crisis practices and, more generally, ensuring that foreign bankingoperations in the United States that pose potential risks to U.S. financialstability are regulated similarly to domestic banking operations posingsimilar risks.ConclusionThe imperative for change in our foreign bank regulation is clear and,indeed, mandated by Dodd-Frank.Of course, I have provided only an outline of the three key measures thatwill best navigate the middle course I have suggested. Basel iii Compliance Professionals Association (BiiiCPA)
  27. 27. 27The all-important details are under discussion at the Board.I anticipate that in the coming weeks we will complete our work and issuea notice of proposed rulemaking that will elaborate the basic approach Ihave foreshadowed.I look forward to hearing your general reactions today and more specificfeedback after the Board has adopted a proposed rule. Basel iii Compliance Professionals Association (BiiiCPA)
  28. 28. 28Opportunities facing Islamic finance andchallenges in managing capital flows in AsiaOutline of special address by Mr TharmanShanmugaratnam, Chairman of the MonetaryAuthority of Singapore, at the 8th World IslamicEconomic Forum, Johor Bahru, MalaysiaThe Prime Minister of Malaysia, His ExcellencyDato’ Sri Najib Tun Razak, The President ofComoros, His Excellency Ikililou Dhoinine, ThePresident of the Islamic Development Bank, HisExcellency Ahmad Mohamed Ali, Chairman of the World IslamicEconomic Forum Foundation Tun Musa HitamMinisters and distinguished guests, Ladies and gentlemenIntroductionIt is my pleasure to be here today and have the opportunity to share somethoughts.Let me first congratulate the WIEF on the progress it has made inestablishing itself as a leading international forum for economic leadersand opinion shapers from a broad range of countries to discuss issues ofinterest in Islamic Finance and related themes in global finance.The theme of the Forum, “Changing Trends, New Opportunities” isparticularly relevant.Allow me to first offer a brief perspective on opportunities facing Islamicfinance.I will then go on to talk about the challenges we face in Asia in managingcapital flows in the aftermath of the Global Financial Crisis. Basel iii Compliance Professionals Association (BiiiCPA)
  29. 29. 29Islamic finance: opportunities for growthThe Islamic finance industry is estimated to have grown by some 19% peryear since 2006 – to record nearly US$1.3 trillion of total shariah compliantassets in 2012.But there is still considerable scope for its development:• Islamic finance presently forms less than 1% the global financialindustry.• For a large number of countries, even in jurisdictions with substantialMuslim populations, Islamic finance currently constitutes less than 5% oftheir financial sector.• And despite a record level of sukuk issuance in 2012, the industry as awhole is still largely concentrated on the banking sector.There is much ahead in the journey to develop Islamic capital marketsand the takaful (Islamic insurance) industry.I believe the next 10–15 years offer significant opportunities for the growthand diversification of Islamic finance.Let me highlight the reasons to be optimistic about its prospects:• First, Islamic financial institutions have in the main escaped significantdamage in the global financial crisis.They are well-placed to grow, at a time when many of the global banks,especially the European banks, are deleveraging or focusing onconsolidating their balance sheets.• Second, Islamic finance has much potential to diversify into new growthareas such as trade and infrastructure financing in Asia and the emergingmarkets. Basel iii Compliance Professionals Association (BiiiCPA)
  30. 30. 30These new areas will allow Islamic banks to reduce their exposure to thereal estate sector, and to take advantage of the stronger growth potentialof the emerging market economies.There are gaps to be filled in structured trade finance and in funding forinfrastructural projects as the emerging markets grow, and as globalfinance consolidates.• Third, Islamic finance can also seek to meet the increased demand forsimpler and more transparent products and ‘back-to-basics’ finance.Investors are now much more circumspect about complex products andtheir risks.The crisis taught investors worldwide not only about the damage they canface from the risks that are known and unsurprising, but of the risks of‘what we do not know’.Islamic finance, with its focus on transparency, price certainty andrisk-sharing, can ride this wave of demand for simpler and more basicinvestments.However, Islamic finance will have to overcome a few importantchallenges in order to grow its share in global finance and contribute tocross-border finance.These include the need to reduce fragmentation in Islamic financemarkets due to differences in accepted standards of Shariah compliancebetween regions, jurisdictions, and in some cases even domesticallywithin jurisdictions.This has hampered the flow of liquidity between jurisdictions, and is inpart why there is yet no Islamic equivalents to the international moneyand bond markets.There is considerable progress being made to address these challenges. Basel iii Compliance Professionals Association (BiiiCPA)
  31. 31. 31Bodies such as AAOIFI, IDB’s Islamic Research & Training Institute,and Malaysia’s International Shariah Research Academy (ISRA) havemade significant efforts to narrow the differences in acceptability ofShariah compliance.The Islamic Financial Services Board (IFSB), in conjunction withinternational standards setting bodies such as the Bank of InternationalSettlements (BIS), IOSCO and IAIS and various regulators from Islamicand conventional jurisdictions, are also formulating internationalstandards and best practices for the industry.Islamic finance is also seeing increasing interest in Asia.We are seeing financial institutions leveraging on the strengths andexpertise that have been developed in both Islamic and conventionalfinancial markets.This is expanding the range of Shariah-compliant products and allowingthe Islamic finance industry to tap on broad and deep investor poolsglobally and in Asia.• Malaysia is widely recognised as a leader in Islamic finance, inparticular for the issuance of sukuks.• Islamic finance is also seeing growing interest in other Asian financialcentres such as Singapore, Hong Kong and Tokyo.• Just recently in mid-November 2012, institutional and private investorsin Singapore and HK were the largest investors in the US$15.5 billionglobal sukuk issued by the Abu Dhabi Islamic Bank (ADIB).• Between our two countries, we are seeing Malaysian bankscollaborating with Singapore corporates and financial players to structureS$ denominated corporate sukuk programmes. Basel iii Compliance Professionals Association (BiiiCPA)
  32. 32. 32And Singapore-listed companies are venturing out to tap the Ringgitsukuk market in Malaysia.These are trends that we are keen to encourage.To repeat therefore, I am optimistic that we can realise the significantgrowth potential for Islamic finance in the next 10–15 years.Managing the challenge of capital flows in the post-crisis eraLet me move on now to say a few things about the challenges that manyin the emerging world face in managing capital flows, particularly in theface of the extremely low interest rates being set in the advancedeconomies (AEs).We are in an unprecedented situation.Interest rates are expected to stay extremely low in the US and much ofthe advanced world for a few years, reflecting decisions by their centralbanks to keep monetary conditions highly accommodative until theireconomies resume normal growth.There is debate among economists on how effective these activistmonetary policies, such as the US Fed’s QE3 strategy, will be in revivingentrepreneurial spirits and rivate investments.If the strategy succeeds and the US economy recovers, it will be a plusfor Asia as well.In the meantime, however, there are significant implications for emergingmarket economies, as global investors search for better returns – betterthan the near-zero rates they get on cash and treasury bills.With large amounts of liquidity now moving between markets, short-termshifts in investor sentiment leads to volatility in capital flows. Basel iii Compliance Professionals Association (BiiiCPA)
  33. 33. 33We have seen how a shock in the European periphery can send moneythat was invested in emerging markets rushing back to the US or othersafe havens.To be clear about it, there is a lot that is good about capital flows,including even short term flows.They add liquidity to markets, by bringing more buyers and sellerstogether.However, we know too that capital inflows can also be too much of a goodthing.They can lead to asset prices, or exchange rates, becoming disconnectedfrom fundamentals.And the sudden withdrawal of capital from emerging economies wheninvestors switch from ‘risk on’ to ‘risk off’ in their portfolios can bedestabilising.As I mentioned, the current global condition is unprecedented.The policy responses in the advanced countries too are withoutprecedent.Globally therefore, we need some humility in understanding the benefitsand costs of QE3 and easy monetary policies in the advanced countries.But it will be wise to strengthen our policy toolkits in Asia, so that we candeal with unpredictable and often excessive capital flows.There are some lessons that come out of our experiences in Asia andelsewhere, and policy responses that we can learn from each other.I will mention three sets of policy responses that will inevitably have tofigure in our toolkits. Basel iii Compliance Professionals Association (BiiiCPA)
  34. 34. 34First, there is much sense in curtailing volatility in the exchange rate overthe short-term.The costs of volatile and uncertain exchange rates are high in small openeconomies especially – which is what most of our ASEAN economies are.Accordingly, Malaysia, Singapore and several other Asian countries havenot felt comfortable leaving their exchange rates entirely to market forces.Their central banks, within each of their monetary policy frameworks,have sought to instil a focus on longer term fundamentals.There is merit in allowing exchange rates in Asia’s emerging economiesto appreciate gradually over the long term, reflecting their more rapidgrowth.If we resist these long term trends, we are likely to see more inflation inour economies.But some stability in the short term is wise.Second, macro-prudential policies are now an important part of the policytool kit.Many Asian countries have introduced new macro-prudential measuresto try and avoid bubbles in their property markets over the last two years.Malaysia brought in stricter limits on loan-to-value ratios on housingloans.Singapore and Hong Kong have done similarly, and have introducedadditional stamp duties or transaction taxes to discourage speculativedemand for residential properties.These targeted administrative and prudential measures are notconventional macro-economic tools. Basel iii Compliance Professionals Association (BiiiCPA)
  35. 35. 35But they are likely to remain part of our policy toolkit, at least forthe foreseeable future, given the real risks to macro-economic stabilitythat an environment of very low global interest rates poses.A third and more fundamental strategy has to focus on building greaterdepth in Asia’s capital markets, while ensuring that our banking systemsremain sound.A good example of this strategy is in fact in Malaysia.Bank Negara’s Financial Sector Blueprint II (2012–2020), released as partof the government’s Economic Transformation Programme (ETP), willbuild on the solid foundations of Malaysia’s financial system, includingdeveloping a deep and vibrant bond market.The banks in several leading Asian countries, including Malaysia andSingapore, are generally well-managed and well-capitalised.They were a source of strength for us during the global financial crisis.However, Asia’s capital markets, and especially the corporatebond markets, need much more depth.Broader and deeper capital markets will allow investors to invest for thelong term while hedging against risks.They will help us meet the growing infrastructural and other long terminvestment needs of the region.This is therefore a very important priority in the region, and there is in factsignificant scope for future development of Asian capital markets.Regulators are working to harmonise rules and market practices acrossthe region, such as issuance procedures and settlement standards. Basel iii Compliance Professionals Association (BiiiCPA)
  36. 36. 36We also need to develop the securitisation markets, with appropriatesafeguards, so that banks can recycle their capital.More too is being done to boost linkages between our markets andeconomies.We have to pool liquidity across our markets, so as to add depth to theAsian capital market.An example is how the Malaysian stock exchange, Bursa Malaysia, theSingapore Exchange and the Stock Exchange of Thailand recentlylaunched an ASEAN Trading Link.We are also cooperating to encourage financing for infrastructure projectsin the region.The ASEAN Infrastructure Fund (AIF), an initiative that was led byMalaysia, is a good example.It will pool resources, knowledge and experience among ASEANgovernments and the Asian Development Bank (ADB) for loans tosovereign or sovereign-guaranteed infrastructure projects.The Fund will also issue bonds, so as to bring in private sector andinstitutional investors.Another example of such cooperation in the region is the CreditGuarantee and Investment Facility (CGIF) amongst the ASEAN+3countries, which aims to help companies in ASEAN+3 countries raiselong term financing for infrastructure investment by providing thegovernments’ guarantees on their corporate bonds, thereby reducing riskfor bond-holders.Projects such as Iskandar Malaysia are also a prime example of howintra-regional investments can be encouraged, and how countries in ourregion can develop competitive strengths jointly. Basel iii Compliance Professionals Association (BiiiCPA)
  37. 37. 37• Iskandar Malaysia’s performance has been impressive – poised toexceed its targeted RM100 billion investment mark by the end of this year.• I am glad there is good progress on the joint venture by TemasekHoldings and Khazanah Nasional, Pulau Indah Ventures Sdn Bhd toco-develop two separate sites in Medini.• Other significant projects include a S$1.5 billion integrated eco-friendlytech-park by Ascendas and Malaysia’s UEM Land Berhad in Nusajaya(one of the five flagship zones in Iskandar).Once completed, the park will accommodate a range ofindustries including electronics and precision engineering.• Just in the last month, we have seen other significant investmentcommitments in Iskandar reported by Singapore companies.Iskandar Malaysia will enhance the complementary space between ourtwo economies.It is a win-win.To ensure continued progress in Iskandar, Singapore and Malaysia willcontinue to take steps to improve connectivity, cross-border tradefacilitation, and immigration processes.ConclusionI would like to conclude by emphasising once again that I am basicallyoptimistic about the prospects in our bilateral and regional cooperation.We face many challenges in this post-Global Financial Crisis era.But the opportunities for us in Asia are intact, and our ability to cooperatewith each other to achieve our full potential as a region is an asset for allour countries. Basel iii Compliance Professionals Association (BiiiCPA)
  38. 38. 38Resolving GloballyActive, SystemicallyImportant, FinancialInstitutionsA joint paper by the Federal Deposit Insurance Corporation and the Bankof EnglandResolving Globally Active, Systemically Important, Financial InstitutionsFederal Deposit Insurance Corporation and the Bank of EnglandExecutive summaryThe financial crisis that began in 2007 has driven home the importance ofan orderly resolution process for globally active, systemically important,financial institutions (G-SIFIs).Given that challenge, the authorities in the United States (U.S.) and theUnited Kingdom (U.K.) have been working together to develop resolutionstrategies that could be applied to their largest financial institutions.These strategies have been designed to enable large and complexcross-border firms to be resolved without threatening financial stabilityand without putting public funds at risk.This work has taken place in connection with the implementation of theG20 Financial Stability Board’s Key Attributes of Effective ResolutionRegimes for Financial Institutions.The joint planning has been productive and effective.It has enhanced the resolution planning process in both jurisdictions,tackled key issues in relation to cross-border coordination, and identifiedpotential challenges that will be addressed through further work. Basel iii Compliance Professionals Association (BiiiCPA)
  39. 39. 39This paper focuses on the application of “top-down” resolution strategiesthat involve a single resolution authority applying its powers to the top ofa financial group, that is, at the parent company level.The paper discusses how such a top-down strategy could be implementedfor a U.S. or a U.K. financial group in a cross-border context.In the U.S., the strategy has been developed in the context of the powersprovided by the Dodd-Frank Wall Street Reform and ConsumerProtection Act of 2010.Such a strategy would apply a single receivership at the top-tier holdingcompany, assign losses to shareholders and unsecured creditors of theholding company, and transfer sound operating subsidiaries to a newsolvent entity or entities.In the U.K., the strategy has been developed on the basis of the powersprovided by the U.K. Banking Act 2009 and in anticipation of the furtherpowers that will be provided by the European Union Recovery andResolution Directive and the domestic reforms that implement therecommendations of the U.K.Independent Commission on Banking. Such a strategy would involve thebail-in (write-down or conversion) of creditors at the top of the group inorder to restore the whole group to solvency.Both the U.S. and U.K. approaches ensure continuity of all criticalservices performed by the operating firm(s), thereby reducing risks tofinancial stability.Both approaches ensure activities of the firm in the foreign jurisdictionsin which it operates are unaffected, thereby minimizing risks tocross-border implementation.The unsecured debt holders can expect that their claims would be writtendown to reflect any losses that shareholders cannot cover, with some Basel iii Compliance Professionals Association (BiiiCPA)
  40. 40. 40converted partly into equity in order to provide sufficient capital to returnthe sound businesses of the G-SIFI to private sector operation.Sound subsidiaries (domestic and foreign) would be kept open andoperating, thereby limiting contagion effects and cross-bordercomplications.In both countries, whether during execution of the resolution orthereafter, restructuring measures may be taken, especially in the parts ofthe business causing the distress, including shrinking those businesses,breaking them into smaller entities, and/or liquidating or closing certainoperations.Both approaches would be accompanied by the replacement of culpablesenior management.This paper outlines several common considerations that affect theseparticular approaches to resolution in the U.S. and the U.K., including theneed to ensure sufficient loss absorbency at the top of the group.The Federal Deposit Insurance Corporation and the Bank of England willcontinue to work together on these resolution strategies.Resolving Globally Active, Systemically Important, FinancialInstitutions, Federal Deposit Insurance Corporation and theBank of EnglandIntroduction1 The Federal Deposit Insurance Corporation (FDIC) and the Bank ofEngland—together with the Board of Governors of the Federal ReserveSystem, the Federal Reserve Bank of New York, and the FinancialServices Authority—have been working to develop resolution strategiesfor the failure of globally active, systemically important, financialinstitutions (SIFIs or G-SIFIs) with significant operations on both sidesof the Atlantic. Basel iii Compliance Professionals Association (BiiiCPA)
  41. 41. 41This work has taken place in connection with the implementation of theFinancial Stability Board’s (FSB) Key Attributes of Effective ResolutionRegimes for Financial Institutions (Key Attributes), as well as inconnection with the reforms to the legal arrangements for handling thefailure of financial institutions that were instituted in the United States(U.S.) and the United Kingdom (U.K.) in response to the recent financialcrisis.2 The goal is to produce resolution strategies that could be implementedfor the failure of one or more of the largest financial institutions withextensive activities in our respective jurisdictions.These resolution strategies should maintain systemically importantoperations and contain threats to financial stability.They should also assign losses to shareholders and unsecured creditors inthe group, thereby avoiding the need for a bailout by taxpayers.These strategies should be sufficiently robust to manage the challenges ofcross-border implementation and to the operational challenges ofexecution.3 As highlighted in the FSB’s recently published draft Guidance onRecovery and Resolution Planning, strategies for resolution may broadlybe categorized as either applying resolution powers to the top of a groupby a single national resolution authority (single point of entry), orapplying resolution tools to different parts of the group by two or moreresolution authorities acting in a coordinated way (multiple points ofentry).Which strategy is most suitable to resolving the group will depend upon arange of factors.For example, a single point of entry strategy may offer the simplest andmost effective choice if the debt issued at the top of the group is sufficientto absorb the group’s losses. Basel iii Compliance Professionals Association (BiiiCPA)
  42. 42. 42Where this is not the case, a multiple points of entry strategy will be moresuitable, particularly if different parts of the group can continue on astandalone basis.4 The focus of this paper is on a single point of entry resolution approach.It is hoped that the detail it provides on the single point of entryapproach, when combined with the published FSB Guidance onRecovery and Resolution Planning, will give greater predictability formarket participants about how resolution authorities may approach aresolution.This predictability cannot, however, be absolute, as the resolutionauthorities must not be constrained in exercising discretion in pursuit oftheir statutory objectives in how best to resolve a firm.Post-crisis resolution strategy5 The financial crisis that began in late 2007 highlighted the shortcomingsof the arrangements for handling the failure of large financial institutionsthat were in place on either side of the Atlantic.Large banking organizations in both the U.S. and the U.K. had becomehighly leveraged and complex, with numerous and dispersed financialoperations, extensive off-balance-sheet activities, and opaque financialstatements.These institutions were managed as single entities, despite theirsubsidiaries being structured as separate and distinct legal entities.They were highly interconnected through their capital markets activities,interbank lending, payments, and off-balance-sheet arrangements.6 The legislative frameworks and resolution regimes at the time wereill-suited to dealing with financial institution failures of this scale andinterconnectedness. Basel iii Compliance Professionals Association (BiiiCPA)
  43. 43. 43In the U.S., the FDIC only had the power to place an insured depositoryinstitution into receivership; it could not resolve failed or failing bankholding companies or other nonbank financial companies that posed asystemic risk.In the U.K., until 2009 there was no special resolution regime available forbanks or other financial companies, whatever their size or complexity,and as a result the U.K. was reliant on standard insolvency proceduressuch as administration.7 As demonstrated by the Title I requirement of the Dodd-Frank WallStreet Reform and Consumer Protection Act of 2010 (Dodd-Frank Act),the U.S. would prefer that large financial organizations be resolvablethrough ordinary bankruptcy.However, the U.S. bankruptcy process may not be able to handle thefailure of a systemic financial institution without significant disruption tothe financial system.8 Similarly, the U.K. administration process often takes time and involvessignificant uncertainty regarding the outcome.Forcing large financial organizations through administration can createsignificant and systemic risks for the real economy by interrupting criticalservices, disrupting key financial relationships, and freezing financialmarkets. In addition, it can destroy value, harming the real economy.9 Given these problems with the bankruptcy process, the U.S. and theU.K. authorities resorted to providing large scale public support to failingfinancial companies during the 2007-09 crisis to prevent further systemicdisruption.This public support has exposed taxpayers to loss and resulted in thebailout of multiple financial institutions and their creditors. Basel iii Compliance Professionals Association (BiiiCPA)
  44. 44. 4410 Following the crisis, an overhaul of the framework for dealing withlarge and complex financial institution failures was required.While it may be useful to strengthen the current bankruptcy code oradministration rules to improve the handling of financial failures,systemic considerations warrant having an alternative resolution strategy.11 A resolution strategy for a failed or failing G-SIFI should assign lossesto shareholders and unsecured creditors, and hold managementresponsible for the failure of the firm.The strategy should provide continuity of the critical services that theinstitution provides within the financial system and to the real economy,thereby minimizing systemic risk.The strategy should also enable a prompt transition of the firm’s ongoingoperations to full private ownership and control without taxpayer support.Given the cross-border nature of G-SIFIs, the resolution strategy shouldensure financial stability concerns are addressed across all jurisdictions inwhich the firm operates.To be successful, such an approach will require close cooperationbetween home and foreign authorities.12 Under the strategies currently being developed by the U.S. and theU.K., the resolution authority could intervene at the top of the group.Culpable senior management of the parent and operating businesseswould be removed, and losses would be apportioned to shareholders andunsecured creditors.In all likelihood, shareholders would lose all value and unsecuredcreditors should thus expect that their claims would be written down toreflect any losses that shareholders did not cover. Basel iii Compliance Professionals Association (BiiiCPA)
  45. 45. 45Under both the U.S. and U.K. approaches, legal safeguards ensure thatcreditors recover no less than they would under insolvency.13 An efficient path for returning the sound operations of the G-SIFI tothe private sector would be provided by exchanging or converting asufficient amount of the unsecured debt from the original creditors of thefailed company into equity.In the U.S., the new equity would become capital in one or more newlyformed operating entities.In the U.K., the same approach could be used, or the equity could be usedto recapitalize the failing financial company itself—thus, the highest layerof surviving bailed-in creditors would become the owners of the resolvedfirm.In either country, the new equity holders would take on thecorresponding risk of being shareholders in a financial institution.Throughout, subsidiaries (domestic and foreign) carrying out criticalactivities would be kept open and operating, thereby limiting contagioneffects.Such a resolution strategy would ensure market discipline and maintainfinancial stability without cost to taxpayers.Legislative frameworks for implementing the strategy14 It should be stressed that the application of such a strategy can beachieved only within a legislative framework that provides authoritieswith key resolution powers.The FSB Key Attributes have established a crucial framework for theimplementation of an effective set of resolution powers and practices intonational regimes. Basel iii Compliance Professionals Association (BiiiCPA)
  46. 46. 46In the U.S., these powers had already become available under theDodd-Frank Act.In the U.K., the additional powers needed to enhance the existingresolution framework established under the Banking Act 2009 (theBanking Act) are expected to be fully provided by the EuropeanCommission’s proposals for a European Union Recovery and ResolutionDirective (RRD) and through the domestic reforms that implement therecommendations of the U.K. Independent Commission on Banking(ICB), enhancing the existing resolution framework established underthe Banking Act.The development of effective resolution strategies is being carried out inanticipation of such legislation.U.S. regime15 The framework provided by the Dodd-Frank Act in the U.S. greatlyenhances the ability of regulators to address the problems of large,complex financial institutions in any future crisis.Title I of the Dodd-Frank Act requires each G-SIFI to periodically submitto the FDIC and the Federal Reserve a resolution plan that must addressthe company’s plans for its rapid and orderly resolution under the U.S.Bankruptcy Code.The FDIC and the Federal Reserve are required to review the plans todetermine jointly whether a company’s plan is credible.If a plan is found to be deficient and adequate revisions are not made, theFDIC and the Federal Reserve may jointly impose more stringent capital,leverage, or liquidity requirements, or restrictions on growth, activities, oroperations of the company, including its subsidiaries.Ultimately, the company could be ordered to divest assets or operationsto facilitate an orderly resolution under bankruptcy in the event of failure. Basel iii Compliance Professionals Association (BiiiCPA)
  47. 47. 47Once submitted and accepted, the SIFIs’ plans for resolution underbankruptcy will support the FDIC’s planning for the exercise of itsresolution powers by providing the FDIC with an understanding of eachSIFI’s structure, complexity, and processes.16 Title II of the Dodd-Frank Act provides the FDIC with new powers toresolve SIFIs by establishing the orderly liquidation authority (OLA).Under the OLA, the FDIC may be appointed receiver for any company that meets specified criteria, including being in defaultor in danger of default, and whose resolution under the U.S. BankruptcyCode (or other relevant insolvency process) would likely create systemicinstability.Title II requires that the losses of any financial company placed intoreceivership will not be borne by taxpayers, but by common and preferredstockholders, debt holders, and other unsecured creditors, and thatmanagement responsible for the condition of the financial company willbe replaced.Once appointed receiver for a failed financial company, the FDIC wouldbe required to carry out a resolution of the company in a manner thatmitigates risk to financial stability and minimizes moral hazard.Any costs borne by the U.S. authorities in resolving the institution notpaid from proceeds of the resolution will be recovered from the industry.U.K. regime17 In the U.K., the Banking Act provides the Bank of England with toolsfor resolving failing deposit-taking banks and building societies.Powers similar to those of the FDIC are available, including powers totransfer all or part of a failed bank’s business to a private sector purchaseror to a bridge bank until a private purchaser can be found. Basel iii Compliance Professionals Association (BiiiCPA)
  48. 48. 48The Banking Act also provides the U.K. authorities with a bespoke bankinsolvency procedure that fully protects insured depositors whileliquidating a failed bank’s assets.These powers have proved valuable; for example, during the crisis theyallowed the authorities to transfer the retail and wholesale deposits,branches, and a significant proportion of the residential mortgageportfolio of a failed building society to another building society.18 The Banking Act powers do not, however, provide a wholly effectivesolution to the failure of a large, complex, and international financial firm.The critical economic functions of a G-SIFI are currently intertwinedlegally, operationally, and financially across jurisdictions and legalentities.For U.K. firms, these functions frequently reside in the same entities asthe firms’ core unsecured liabilities.Using the existing statutory transfer powers would involve separating andtransferring large and complex businesses from within operating entitiesto a purchaser or bridge bank, while leaving behind the remainingliabilities and bad assets in the failed firm to be wound up throughinsolvency.These operating companies may have several thousand counterparties,customers, and contracts.Such a transfer would be almost impossible to achieve over a resolutionweekend without destroying value and causing financial stabilityconcerns in multiple jurisdictions.19 The introduction of a statutory bail-in resolution tool (the power towrite down or convert into equity the liabilities of a failing firm) under theRRD is critical to implementing a whole group resolution of U.K. firms ina way that reduces the risks to financial stability. Basel iii Compliance Professionals Association (BiiiCPA)
  49. 49. 49A bail-in tool would enable the U.K. authorities to recapitalize aninstitution by allocating losses to its shareholders and unsecuredcreditors, thereby avoiding the need to split or transfer operating entities.The provisions in the RRD that enable the resolution authority to imposea temporary stay on the exercise of termination rights by counterparties inthe event of a firm’s entry into resolution (in other words, preventingcounterparties from terminating their contractual arrangements with afirm solely as a result of the firm’s entry into resolution) will be needed toensure the bail-in is executed in an orderly manner.20 The existing Banking Act does not cover nondeposit-taking financialfirms, notably investment banks and financial market infrastructures(clearing houses in particular), the failure of which, in many cases, wouldalso have significant financial stability consequences.The Banking Act also has limitations with regard to the application ofresolution tools to financial holding companies.The U.K. is in the process of expanding the scope of the Banking Act toinclude these firms.This is expected to be achieved through the introduction of the U.K.Financial Services Bill, which is due to complete its passage throughParliament by the end of this year.21 In addition to expanding the U.K. resolution regime, the FinancialServices Bill will significantly enhance the U.K.’s approach to bankingsupervision.Going forward, the framework for prudential supervision in the U.K. willemphasize supervisory judgment, rather than supervision based solely onrules.Under this framework, considerations of resolvability or ease of resolutionwould become a core part of the supervisory process. Basel iii Compliance Professionals Association (BiiiCPA)
  50. 50. 5022 In conjunction with the Financial Services Bill, the adoption of therecommendations of the ICB will also significantly improve theresolvability of the U.K. domestic retail bank by ringfencing it from therest of the group.This will help to preserve core domestic intermediation services if agroup-wide resolution is not feasible for some reason.23 To ensure that banks are resolvable, the Financial Services Authority(and in the future, the Prudential Regulation Authority (PRA)) willrequire firms under the Financial Services Act 2010 to produce Recoveryand Resolution Plans (RRPs).Firms will submit the information that the authorities will need to prepareresolution plans and to assess resolvability.Where barriers to resolution are identified, firms will be required toremove them through changes to their structure and operations.The proposed RRD provides authorities with the necessary powers toachieve this, including the ability to require changes to the legal oroperational structures of institutions, and to require firms to ceasespecific activities.Description of the resolution strategiesU.S. approach to single point of entry resolution strategy24 Under the U.S. approach, the FDIC will be appointed receiver of thetop-tier parent holding company of the financial group following thecompany’s failure and the completion of the appointment process setforth under the Dodd-Frank Act.Immediately after the parent holding company is placed intoreceivership, the FDIC will transfer assets (primarily the equity and Basel iii Compliance Professionals Association (BiiiCPA)
  51. 51. 51investments in subsidiaries) from the receivership estate to a bridgefinancial holding company.By taking control of the SIFI at the top of the group, subsidiaries(domestic and foreign) carrying out critical services can remain open andoperating, limiting the need for destabilizing insolvency proceedings atthe subsidiary level.Equity claims of the shareholders and the claims of the subordinated andunsecured debt holders will likely remain in the receivership.25 Initially, the bridge holding company will be controlled by the FDIC asreceiver.The next stage in the resolution is to transfer ownership and control of thesurviving operations to private hands.Before this happens, the FDIC must ensure that the bridge has a strongcapital base and must address whatever liquidity concerns remain.The FDIC would also likely require the restructuring of thefirm—potentially into one or more smaller, non-systemic firms that couldbe resolved under bankruptcy.26 By leaving behind substantial unsecured liabilities and stockholderequity in the receivership, assets transferred to the bridge holdingcompany will significantly exceed its liabilities, resulting in awell-capitalized holding company.After the creation of the bridge financial company, but before anytransition to the private sector, a valuation process would be undertakento estimate the extent of losses in the receivership and apportion theselosses to the equity holders and subordinated and unsecured creditorsaccording to their order of priority. Basel iii Compliance Professionals Association (BiiiCPA)
  52. 52. 52In all likelihood, the equity holders would be wiped out and their claimswould have little or no value.27 To capitalize the new operations—one or more new privateentities—the FDIC expects that it will have to look to subordinated debtor even senior unsecured debt claims as the immediate source of capital.The original debt holders can thus expect that their claims will be writtendown to reflect any losses in the receivership of the parent that theshareholders cannot cover and that, like those of the shareholders, theseclaims will be left in the receivership.28 At this point, the remaining claims of the debt holders will beconverted, in part, into equity claims that will serve to capitalize the newoperations.The debt holders may also receive convertible subordinated debt in thenew operations.This debt would provide a cushion against further losses in the firm, as itcan be converted into equity if needed.Any remaining claims of the debt holders could be transferred to the newoperations in the form of new unsecured debt.29 The transfer of equity and investments in operating subsidiaries to thebridge holding company should do much to alleviate liquidity pressures.Ongoing operations and their attendant liabilities also will be supportedby assurances from the FDIC, as receiver.As demonstrated by past bridge-bank operations, the assurance ofperformance should encourage market funding and stabilize the bridgefinancial company. Basel iii Compliance Professionals Association (BiiiCPA)
  53. 53. 53However, in the case where credit markets are impaired and marketfunding is not available in the short term, the Dodd-Frank Act providesfor FDIC access to the Orderly Liquidation Fund (OLF), a fund withinthe U.S. Treasury.In addition to providing a back-up source of funding, the OLF may alsobe used to provide guarantees, within limits, on the debt of the newoperations.An expected goal of the strategy is to minimize or avoid use of the OLF.To the extent that the OLF is used, it must either be repaid fromrecoveries on the assets of the failed financial company or fromassessments against the largest, most complex financial companies.The Dodd-Frank Act prohibits the loss of any taxpayer money in theorderly liquidation process.U.K. approach to single point of entry resolution strategy30 The U.K.’s planned approach to single point of entry also involves atop-down resolution.On the basis that the RRD will introduce a broad bail-in power, the U.K.authorities would seek to recapitalize the financial group through theimposition of losses on shareholders and, as appropriate, creditors of thefirm via the exercise of a statutory bail-in power.This U.K. group resolution approach need not employ a bridge bank andadministration, although such powers are available in the U.K. and maybe appropriate under certain circumstances.31 Current proposals for implementing such a strategy incorporate aperiod in which equity and debt securities would be transferred from theshareholders and debt holders to an appointed trustee. Basel iii Compliance Professionals Association (BiiiCPA)
  54. 54. 54The trustee would hold the securities during a valuation period in whichthe extent of the losses expected to be incurred by the firm would beestablished and, in turn, the recapitalization requirement determined.During this period, listing of the company’s equity securities (andpotentially debt securities) would be suspended.Once the recapitalization requirement has been determined, anannouncement of the final terms of the bail-in would be made to theprevious security holders.This announcement would include full details of the write-down and/orconversion.32 Debt securities would be cancelled or written down in order to returnthe firm to solvency by reducing the level of outstanding liabilities.The losses would be applied up the firm’s capital structure in a processthat respects the existing creditor hierarchy under insolvency law.The value of any loans from the parent to its operating subsidiaries wouldbe written down in a manner that ensures that the subsidiaries remainsolvent and viable.33 Completion of the exchange would see the trustee transfer the equity(and potentially some of the existing debt securities written downaccordingly) back to the original creditors of the firm.Those creditors unable to hold equity securities (for example, for reasonsof investment mandate restrictions) would be able to request that thetrustee sell the equity securities on their behalf.The trust would then be dissolved and the equity securities (andpotentially debt securities) of the firm would resume trading. Basel iii Compliance Professionals Association (BiiiCPA)
  55. 55. 55The firm would now be recapitalized and primarily owned by the(appropriate layer of) original creditors of the institution.As described later, the process would be accompanied by restructuringmeasures to address the causes of the firm’s failure and to restore thebusiness to viability.34 The U.K. has also given consideration to the recapitalization process ina scenario in which a G-SIFI’s liabilities do not include much debtissuance at the holding company or parent bank level but insteadcomprise insured retail deposits held in the operating subsidiaries.Under such a scenario, deposit guarantee schemes may be required tocontribute to the recapitalization of the firm, as they may do under theBanking Act in the use of other resolution tools.The proposed RRD also permits such an approach because it allowsdeposit guarantee scheme funds to be used to support the use ofresolution tools, including bail-in, provided that the amount contributeddoes not exceed what the deposit guarantee scheme would have as aclaimant in liquidation if it had made a payout to the insured depositors.That is consistent with the contribution requirement that is alreadyimposed on the Financial Services Compensation Scheme in the U.K. inthe exercise of resolution powers and simulates the losses that would havebeen incurred by those deposit guarantee schemes during bankinsolvency.But insofar as a bail-in provides for continuity in operations and preservesvalue, losses to a deposit guarantee scheme in a bail -in should be muchlower than in liquidation.Insured depositors themselves would remain unaffected.Uninsured deposits would be treated in line with other similarly rankedliabilities in the resolution process, with the expectation that they mightbe written down. Basel iii Compliance Professionals Association (BiiiCPA)
  56. 56. 5635 Following the recapitalization process, the firm would be restructuredto address the causes of its failure.It should then be solvent and viable, and as a result in a position to accessmarket funding.In recognition of the fact that it will take time for losses to be assessed forpurposes of recapitalization, and that it will take time to execute therestructuring plan that will underpin the firm’s viability, immediateaccess may prove difficult.In certain circumstances, to reduce the immediate funding need and sofacilitate market access, illiquid assets might be removed from thebalance sheet of the firm and transferred into an asset managementcompany to be worked out over a longer period.36 If market funding were not immediately available, temporary fundingmay need to be provided by the authorities to meet the firms’ liquidityneeds.The funding would only be provided on a fully collateralized basis withappropriate haircuts applied to the collateral to reduce further the risk ofloss.In the unlikely event that losses were associated with the provision oftemporary public sector support, such losses would be recovered from thefinancial sector.37 It is important to note that the strategy described above would notnecessarily be appropriate for all U.K. G-SIFIs in all circumstances.Other strategies may be more appropriate depending on the structure of agroup, the nature of its business, and the size and location of the group’slosses. Basel iii Compliance Professionals Association (BiiiCPA)
  57. 57. 57For example, in cases where the losses on assets in a particular operatingsubsidiary were potentially so great that they could not be absorbed bybailing in at group level or where the business had incurred suchsignificant losses and was so weighed down by toxic assets that thecapital needs in resolution were too difficult to estimate credibly,resolution at the level of one or more operating subsidiaries may be moreappropriate.In this situation, the application of resolution tools to operatingsubsidiaries would be easier if the subsidiaries providing criticaleconomic services were operationally and financially ringfenced from therest of the group.38 This is one of the advantages of the ringfence which is beingintroduced in the U.K. It will provide flexibility in the event of fatalproblems elsewhere in the group to transfer the ringfenced entity to abridge bank or purchaser in its entirety.If losses were concentrated in the ringfenced entity and capital in theringfenced entity was insufficient to absorb them, then losses could beborne by creditors of the ringfenced bank (including debt holders wherethe ringfenced bank had issued debt into the market).This could be achieved either by bail-in or by transferring the operationsof the ringfenced bank to a bridge bank, leaving uninsured creditorsbehind in administration.Draft legislation to establish this ringfence of the largest retaildeposit-takers is due to be introduced into Parliament early in 2013 and ifpassed will provide valuable additional flexibility in implementingresolution strategies to preserve the provision of core services in the of U.K. G-SIFIs. Basel iii Compliance Professionals Association (BiiiCPA)
  58. 58. 58Key common considerations for U.S. and U.K. approaches39 As outlined above, high-level transaction structures have beendeveloped for each jurisdiction.As discussed in the FSB Guidance on Recovery and Resolution Planning,for any resolution to be effective, consideration needs to be given inadvance to various preconditions and operational requirements.Several of these considerations in relation to a top-down resolutionstrategy are discussed in more detail below.Resolution and restructuring measures40 A top-down resolution by definition focuses on assigning losses andestablishing new capital structures at the top of the group.This approach keeps the rest of the group, potentially comprised ofhundreds or thousands of legal entities, intact.However, a top-down resolution would need to be accompanied, orshortly followed, by significant restructuring measures to address thecauses of the firm’s failure and to underpin the firm’s viability.Such a restructuring may include shrinking the G-SIFI’s balance sheet,breaking the company up into smaller entities, and/or selling or closingcertain operations.The newly restructured companies will all need to have strong corporategovernance and management oversight, which would likely necessitatesignificant changes to management and board personnel and processes.In both countries, it is likely that supervisory actions will continue afterthe return to private ownership to ensure that the firm is on a stable and Basel iii Compliance Professionals Association (BiiiCPA)