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The State of the Banking Industry

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    The State of the Banking Industry The State of the Banking Industry Document Transcript

    • BANKING & FINANCE The State of the Banking Industry Banking and Investment Banking & Securities Winter 2005
    • SOBI Winter 2005 BANKING & FINANCE The State of the Banking Industry Banking and Investment Banking & Securities Winter 2005 The State of the Banking Industry is published by KPMG LLP’s Banking & Finance Industry Sector for members of the Banking and Investment Banking & Securities Industries. Information and statistics contained in this document were obtained from materials available to the public. The information provided here is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without the appropriate professional advice after a thorough examination of the facts of the particular situation. For additional information on KPMG LLP, please go to our Web site at www.us.kpmg.com. © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • SOBI Winter 2005 Contents Page Changes & Trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 General Highlights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Regulatory and Legislative Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Accounting Standards and Developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Market Forces . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Broker/Dealers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 Consolidation and Convergence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 International Focus and Globalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 e-Business and Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 KPMG Banking Insider . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Analysis and Commentary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 KPMG Contacts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 © 2004 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. 23680NYGR © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • SOBI Winter 2005 1 Changes & Trends General Highlights – The net purchases of U.S. securities • Commercial banks and savings by foreigners has brought the total institutions insured by the Federal • According to the Securities Industry value of their U.S. portfolios to $5.8 Deposit Insurance Corporation (FDIC) Association’s “Key Trends in the trillion in mid-2004 — a new high. reported net income of $32.5 billion for Securities Industry,” the U.S. securities the third quarter of 2004, surpassing industry continued to raise trillions of – Seventy-three percent of Americans’ the first quarter high of $31.8 billion. dollars for new and expanding liquid financial assets are invested in According to the FDIC, the profits were businesses as individuals, both U.S.- securities-related products, such as fueled in part by increased lending to and foreign-based investors, increased stocks, bonds, and mutual funds. consumers and businesses and higher their ownership of equities. Other key This represents a large shift in gains on sales of securities and other trends, based on nine-months’ investments over the past 30 years assets. Profits for the third quarter annualized data, include: — in 1975, 55 percent of the surpassed the total for the same period American public’s assets were in in 2003 by 6.9 percent. The numbers – The securities industry raised an bank deposits. are from the FDIC’s “Quarterly Banking estimated $2.9 trillion of capital for – Pre-tax profits for all broker-dealers Profile,” released on November 23, U.S. business in 2004 through doing a public business in the United 2004. Major findings in the third quarter corporate underwriting activity in the States are forecast to reach report include: net interest income grew United States, the second straight $18.9 billion in 2004, representing the strongly while noninterest income year at this level. fourth most profitable year ever for declined; the $198 billion increase in – IPOs are projected to raise $42 billion the industry. Total revenues are loans and leases was the second in 2004, a strong rebound from the forecast to reach $216.3 billion (up largest quarterly increase ever reported $16 billion achieved in 2003. 1.7 percent from 2003). by the industry; growth in consumer loans remained robust, while – Average daily share volume on the – The M&A market remains stagnant, commercial and industrial loan demand NYSE and NASDAQ remains strong. but will show a modest improvement showed signs of picking up Average daily volume on the NYSE over 2003. The value of announced momentum. Also according to the was 1.44 billion shares. NASDAQ’s deals is expected to reach FDIC, should interest rates increase, the average daily volume was 1.78 billion $757 billion in 2004, still far from the industry’s ability to realize gains on shares. These figures are roughly $1.741 trillion in 2000. securities sales would be limited. (FDIC twice the daily average traded five Press Release, November 23, 2004) – The securities industry’s employment years ago. levels apparently bottomed-out in • The Federal Open Market Committee, – International trading and investments May 2003. Since then the industry on December 14, 2004, raised its target in foreign securities are booming. The has gained 35,800 jobs through for the federal funds rate by 25 basis September 2004. (Securities Industry total value of U.S. holdings of foreign points to 24 percent. Despite this Association Press Release, securities was $1.9 trillion in mid- increase, the Committee believes that November 4, 2004) 2003, and by mid-2004 the value had the stance of monetary policy remains grown to $2.5 trillion (peak value was accommodative and, coupled with $2.5 trillion in 1999). robust underlying growth in productivity, © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • 2 SOBI Winter 2005 is providing ongoing support to Almost half of the respondents said that refinance mortgages will account for economic activity. The Committee said credit availability from their current only 32 percent of the mortgage market the upside and downside risks to the lender has increased during the year, in 2005 and 26 percent in 2006. (Press attainment of both sustainable growth and the majority of the companies Releases: OFHEO, December 1; and price stability for the next few surveyed purchased at least one Mortgage Bankers Association, quarters are roughly equal. With financial product in addition to the credit October 27, 2004) underlying inflation expected to be facility. (Press Releases: Business • The Bank Administration Institute’s relatively low, the Committee believes Roundtable, December 1; Bank of Check 21 readiness survey revealed that policy accommodation can be America, December 6, 2004) that many bankers believe their financial removed at a pace that is likely to be • Average U.S. home prices increased institutions have a long way to go measured. In a related action, the Board 12.97 percent from the third quarter of before they will be able to maximize the of Governors unanimously approved a 2003 through the third quarter of 2004. potential of Check 21, but a majority are 25 basis point increase in the discount Appreciation was 4.62 percent, or an expected to be able to meet the rate to 3-1/4 percent. (Federal Reserve annualized rate of 18.48 percent. The minimum requirements by October 28, Press Release, December 14, 2004) figures were released on December 1 2004. Sixty-four percent of those • Business Roundtable’s December 2004 by the Office of Federal Housing responding place their institutions in CEO Economic Outlook Survey shows Enterprise Oversight (OFHEO), as part one of the top two overall readiness that America’s leading CEOs expect the of OFHEO’s House Price Index (HPI). categories, but fewer than one in 20 U.S. economy to continue to grow at a Several factors could be playing a role in expressed doubt that their companies healthy pace in the first half of 2005, the large house price increases in the would be able to receive and process with a slight easing from the strong third quarter, OFHEO notes. With the substitute checks, make consumers growth of 2004. The responses led to a slight decrease in long-term interest aware of the law and their rights under CEO Economic Outlook Index of 98.9, rates, purchasing a house has been less it, and provide expedited recredit as the second-highest index level for the expensive. Also, refinancing volume fell required by the Check Clearing for the survey. A majority of the respondents last quarter substantially below levels in 21st Century Act. In a separate report, expect sales to continue to increase, recent quarters. During the previous Celent estimates that paper check and half of the CEOs expect to increase period of intense refinancing, HPI processing should nearly disappear by capital expenditures. In the annual increases may have been held down as the end of the decade. According to its question about challenges to growth, appraised values used for refinancing report, “The Future of Check CEOs cited health care costs as the mortgages with low loan-to-value ratios Processing in the US,” image exchange greatest cost pressure to corporate may not have kept up with recent of transit checks will grow from more America, followed by litigation costs and market price increase. According to the than 14 percent in 2005 to 61 percent energy prices. The percentage of CEOs Mortgage Bankers Association’s (MBA) by 2007. By 2010, more than 93 per- who cited energy cost pressures is long-term forecasts for the housing cent of transit items will be image- nearly three times higher than a year finance market for 2005 and 2006, exchanged. (Press Releases: Bank ago. A separate manufacturing sector purchase mortgage originations should Administration Institute, October 2004; “CFO Outlook” survey, released on remain near the record levels of 2004. Celent, October 27, 2004) December 6, 2004 by Bank of America, MBA predicts that purchase originations saw almost the same results. CFOs will decline from an expected Regulatory and surveyed also were bullish about the $1.48 trillion in 2004 to $1.45 trillion in Legislative Issues economy in 2005 and expect to 2005 and $1.44 trillion in 2006. The Important actions during recent months increase their capital expenditures. Also, refinance market is expected to decline by federal agencies, including the almost a quarter of CFOs expect to from $1.19 trillion in 2004 to Securities and Exchange Commission participate in a merger or acquisition in $0.68 trillion in 2005 and $0.46 trillion in (SEC) and other regulatory bodies and 2005, up substantially from last year. 2006. As a result, according to MBA, industry groups such as NASD (formerly © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • SOBI Winter 2005 3 known as the National Association of and expectations under related inter- • The SEC voted to propose amendments Securities Dealers, Inc.), the New York pretive material in Notice to Members to Regulation M under the Securities Stock Exchange, Inc. (NYSE), and the 04-71 and Notice to Members 04-79. Exchange Act of 1934, the anti- Municipal Securities Rulemaking Board The NYSE has communicated the manipulation rule concerning securities (MSRB) are referenced below. All dates same information to its members via offerings, which applies to broker- refer to the year 2004, unless otherwise Information Memo 04-38. (CRF, October dealers and their activities relative to noted. For more information on select and December; WR, November 8, the promotion of sales of initial public topics, please see the publications 2004; and RPL 04-06) offerings. The changes would curtail referenced including KPMG’s The certain market activities that undermine • The SEC adopted rule amendments Washington Report (WR) and KPMG’s the integrity and fairness of this under Regulation S-P to require financial Compliance & Regulatory Focus (CRF) process, as well as enhance the institutions to adopt policies and available at www.us.kpmg.com. transparency of underwriters’ procedures regarding the safeguarding aftermarket activities. (CRF, November; Rulemaking Initiatives and disposal of certain customer WR, October 11 and 18, 2004) • In a series of related rulemaking information as per section 216 of the initiatives, the SEC approved Fair and Accurate Credit Transactions • The SEC approved an order to delay the complementary NASD and NYSE rules Act of 2003. The rules apply to most Regulation SHO (Short Sales) pilot and amendments that form a broker-dealers, investment companies, period to suspend the operation of short comprehensive regulatory scheme and investment advisers, among others. sale price provisions. (CRF, January designed to strengthen the supervisory (CRF, January 2005; WR, December 6, 2005; WR, December 6, 2004) procedures and internal controls of 2004) broker-dealers. New NASD Rule 3013 Enforcement Actions • The SEC voted to propose new rules • The NYSE announced that it reached an and related interpretive material require and rule and form amendments that agreement in principle with a broker- the designation of a chief compliance would impact the current structure dealer to settle an action that resulted in officer by December 1, and annual and function of the self-regulatory a censure and $19 million fine, among certifications by the chief executive organization (SRO) paradigm. The other things, for allegedly failing to officer relative to the state of a firm’s proposals address the areas of deliver prospectuses to customers in internal compliance systems, among governance, transparency, SRO registered offerings. (CRF, October; WR, other things. Effective January 31, reporting, SRO ownership, and SRO October 4, 2004) 2005, amendments to NASD Rule 3010 self-listing activities. In a related action, and new NASD Rule 3012 will require the SEC issued a concept release to • NASD censured and fined 29 broker- firms to establish procedures to test explore issues relating to the efficacy dealers over $9.2 million in connection their supervisory internal controls, of the self-regulatory system. (CRF, with widespread late disclosures of among other things. The NYSE has December; WR, November 15, 2004) reportable information about firm promulgated requirements under Rule registered representatives, including 342, effective December 17, 2004, that • The SEC voted to propose new and customer complaints, regulatory actions are substantially similar to the NASD amended rules and form changes to and criminal charges and convictions. regulations. Further, there are certain modify the registration, communi- Two of the firms were also prohibited additional new requirements relating to cations, and offering processes under from registering new brokers for a the transmission of customer funds and the Securities Act of 1933 that would period of time, due to the number of securities, customer changes in facilitate the ability of a company that violations and their previous disciplinary addresses, changes in customer plans to issue shares of its stock in an histories. (CRF, December; WR, investment objectives, time and price initial public offering to communicate December 6, 2004) discretionary limits, and recordkeeping accurate information to investors and under NASD Rule 3110 and NYSE Rules potential investors in the weeks before • The SEC announced a $2 million 401, 408(d), 410. NASD has set forth the sale. (CRF, November; WR, settlement with a broker-dealer that elements of its new rules, amendments November 1, 2004) allegedly made undisclosed cash © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • 4 SOBI Winter 2005 payments to three investment advisers inappropriate sales literature that discussed its reception by the public. in return for encouraging the advisers to included unsubstantiated claims and (CRF, November; WR, October 11, direct their clients’ brokerage business inadequate risk disclosure. (CRF, 2004) to the firm. The SEC initiated and December 2004) • Before the Investment Company subsequently settled related fraud • NASD announced that it exercised, for Institute’s 2004 Equity Markets actions against the advisers. (CRF, the first time, its temporary cease and Conference, Annette L. Nazareth, October; WR, October 4, 2004) desist authority. (CRF, October; WR, Director of the SEC’s Division of Market • NASD censured and fined 18 broker- September 13, 2004) Regulation, spoke primarily about dealers over $1.2 million in connection proposed Regulation NMS and the with findings of widespread trade SEC Agenda substance of comments received reporting violations to NASD’s Order • At the Securities Industry Association’s relative to this rulemaking initiative. Audit Trail System. Multiple firms annual meeting, SEC Chairman William (CRF, October; WR, September 27, were also cited for related supervisory H. Donaldson discussed well-publicized 2004) deficiencies. (CRF, November; WR, industry events of the last year, initiatives undertaken by his agency and • Stephen M. Cutler, Director of the October 11, 2004) the industry to meet the related SEC’s Division of Enforcement, • In a NASD action, a broker-dealer was challenges of the current business delivered a speech entitled “The fined $156,000, ordered to disburse climate, and the corresponding progress Themes of Sarbanes-Oxley as Reflected over $1 million in restitution to made in many areas to date. (CRF, in the Commission’s Enforcement customers, and required to retain an December; WR, November 29, 2004) Program” at the UCLA School of Law. independent consultant and pre-file (CRF, October; WR, September 27, advertising material with NASD for • SEC Chairman Donaldson delivered 2004) one year. The allegations related to remarks before the Annual Conference advertising, markup/down, and of Independent Sector regarding the Regulatory Issues supervisory and other deficiencies. issue of the erosion of investor • NASD’s Mutual Fund Task Force (CRF, November 2004) confidence in the non-profit sector of submitted a report to the SEC con- U.S. business and the corresponding taining its first set of recommendations • NASD fined a broker-dealer $1 million opportunity for independent sector regarding soft dollars and portfolio for allegedly providing misleading institutions to work to restore the trust transaction costs. (CRF, December; WR, information as to the nature of the of donors, the public, and Congress. November 22, 2004) variable life insurance products at (CRF, December; WR, November 29, sales seminars for its agents. (CRF, • The SEC recently published interpretive 2004) December 2004) guidance relative to issues regarding • Remarks by Lori A. Richards, Director of Addendum A of the Global Research • NASD censured and fined a broker- the SEC’s Office of Compliance Analyst Settlement. (CRF, December; dealer $700,000 in connection with Inspections and Examinations, at the WR, November 15, 2004) allegations that it failed to prevent Financial Services Institute’s First market timing in three mutual funds • NASD issued Notice to Members 04-66 Annual Public Policy Day, centered on a offered by an affiliate. The firm was to remind member firms of their discussion of developments in the also cited for related supervisory obligations under NASD supervisory SEC’s examination program. (CRF, failures. (CRF, November; WR, regulations to ensure that their November; WR, October 25, 2004) October 18, 2004) supervisory systems and written • SEC Commissioner Cynthia A. supervisory procedures are adequate to • In the largest enforcement action to Glassman spoke before the Council of ensure the proper entry of orders into date involving hedge fund sales by Institutional Investors on proposed new trading systems. (CRF, October; WR, broker-dealers, NASD fined a firm Regulation National Market System September 20, 2004) $250,000 for allegedly disseminating (NMS) governing market structure, and © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • SOBI Winter 2005 5 (Sources: The Federal Register and Web sites of the issuing Statement 123 allowed companies a Issues Relevant to the agencies including: www.sec.gov, www.nasd.com, www.nyse.com, www.msrb.org, www.federalreserve.gov, choice between the fair value method Financial Services Industry www.occ.treas.gov, www.fdic.gov, www.gao.gov, www.financialservices.house.gov, and www.ots.treas.gov.) and the intrinsic value method. The • The SEC adopted new rules that require revised statement does not specify certain hedge funds to register as To receive KPMG’s regulatory and legislative reports electronically, please send an e-mail what type of valuation model should investment advisers under the message to fsregpubs@kpmg.com for any of be used to determine fair value. The Investment Advisers Act of 1940. The the following: classification of a share-based award new rules will also subject these – The Washington Report entities to inspection and examination will affect compensation cost – Regulatory Practice Letters by the SEC, require that registered recognized. Liability-classified awards – Legislative Practice Letters hedge funds adopt basic compliance are remeasured to fair value at each – Compliance & Regulatory Focus controls, and mandate certain balance-sheet date until the award is These reports can also be accessed through disclosures, among other things. KPMG’s Web site at www.us.kpmg.com settled. Equity-classified awards are (Financial Services industry). Compliance with the new regulations measured at grant-date fair value and KPMG hosts Regulatory Perspectives, a is expected by February 1, 2006. (CRF, are not subsequently remeasured. The quarterly teleconference briefing for clients October and November; WR, on important legislative and regulatory statement is effective for most public activities specific to the financial services December 12, November 11, and companies’ interim or annual periods industry. For more information about October 25) Regulatory Perspectives, or to register for beginning after June 15, 2005 and is future teleconferences, please send an e-mail effective for nonpublic companies for message to dwoodard@kpmg.com, and • The Government Accountability Office annual periods beginning after include your name, title, company name, and issued a report recommending that e-mail address. You will be notified via e-mail December 15, 2005. regarding future teleconferences. Congress consider improvements to the current U.S. financial services regulatory • Following the issuance of Statement structure, particularly with respect to 123(R), Share-Based Payment, as the oversight of complex, internationally Accounting Standards noted above, the FASB approved the active firms. (CRF, December; WR, and Developments resulting revisions to Statement 133 November 15, 2004) • FASB Statement No. 123(R), Share- (Accounting for Derivative Instruments Based Payment, issued in December and Hedging Activities) Implementation • The SEC extended, until March 31, 2004, sets accounting requirements Issues. The FASB amended Statement 2005, the compliance dates for banks for “share-based” compensation to 133 Implementation Issue No. C3 relative to the temporary exemption employees, including employee stock (Exception Related to Stock-Based from the definition of “broker” under purchase plans. It does not affect the Compensation Arrangements) to clarify the Gramm-Leach-Bliley Act of 1999. accounting for awards to non- that equity-based compensation (CRF, December; WR, November 8, employees nor does it affect the instruments issued to non-employees 2004) accounting for employee stock only receive the scope exception • On December 17, President Bush ownership plan transactions, which provided in paragraph 11(b) of signed the “National Intelligence will still follow SOP 93-6, Employers’ Statement 133 while the instrument Reform Act of 2004” into law. The new Accounting for Employee Stock is subject to the requirements of law is intended to: disrupt the financing Ownership Plans. Awards to non- Statement 123(R). The FASB also of terrorism; strengthen the country’s employee directors, however, do fall noted that Statement 133 anti-money laundering laws; and under the scope of the newly revised Implementation Issue No. G1 (Hedging improve the tools with which the statement. The statement requires an SAR Obligation) was updated to government can stop the flow of companies to recognize as income the reflect the changes in the underlying terrorist funds. (WR, December 20, grant-date fair value of stock options accounting for non-vested stock 2004) and other equity-based compensation appreciation rights (SARs) under issued to employees. Previously, Statement 123(R), and noted that they © 2004 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. 23680NYGR © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • 6 SOBI Winter 2005 are still considering the need for consensus in EITF 04-8 would have for the Foreign Earnings Repatriation specific transition guidance or whether coincided with the effective date of a Provision within the American Jobs the current guidance in Statement 133, proposed amendment to FASB Creation Act of 2004,” allows paragraph 31 is sufficient. Additionally, Statement No. 128, Earnings per companies additional time to evaluate the FASB noted that there were no Share. However, at the November whether foreign earnings will be substantive changes to Statement 133 2004 meeting, due to an anticipated repatriated under the repatriation Implementation Issue No. E19, delay in the issuance of that provisions of the new tax law and Methods of Assessing Hedge amendment, the Task Force de-linked requires specified disclosures for Effectiveness When Options Are the effective date of EITF 04-8 from companies needing the additional time Designated as the Hedging the effective date of the proposed to complete the evaluation. Instruments. amendment to Statement 128 and (Source: KPMG’s Defining Issues; FASB Web site) specified that the consensus in EITF • The FASB is reconsidering in its KPMG's Audit Committee Institute 04-8 should be applied for reporting Recognizing the challenge that audit entirety Emerging Issues Task Force periods ending after December 15, committees face in meeting their demanding (EITF) and all other guidance on responsibilities, KPMG created the Audit 2004. Committee Institute (ACI) in 1999 to serve as a disclosing, measuring, and recognizing resource for audit committee members and other-than-temporary impairments of • Corporate accounting for income taxes senior management. Our primary mission is to debt and equity securities. Until new communicate with audit committee members will be affected by the American Jobs and enhance their awareness, commitment, and guidance is issued, companies must Creation Act of 2004, signed into law ability to implement effective audit committee continue to comply with the disclosure during October 2004. The new law processes. ACI's initiatives include semiannual roundtables, publication of Audit Committee requirements of EITF Issue No. 03-1, allows domestic entities to repatriate Quarterly, conference and board presentations, “The Meaning of Other-Than- foreign earnings at a reduced rate, a toll-free hotline, periodic distribution of time- sensitive information, and our Web site. During Temporary Impairment and Its subject to certain limitations. The law’s the past five years, ACI has conducted active Application to Certain Investments,” outreach among thousands of audit committee incentive to repatriate foreign earnings members and we have sponsored hundreds of and all relevant measurement and will affect evaluations of whether workshops, presentations, and issue-oriented recognition requirements in other meetings. some or all of those earnings qualify accounting literature. In September, ACI's Web site address is for Statement 109’s exception from http://www.kpmg.com/aci/. ACI can be reached the FASB delayed the guidance on recognizing deferred tax liabilities. In toll-free at 877-576-4224 or via e-mail at impairment losses under EITF 03-1, but auditcommittee@kpmg.com. December 2004, the FASB issued two the delay did not include the disclosure Staff Positions on the accounting provisions, which will remain in effect until the full reconsideration of the treatment of the tax change. FSP FAS Taxation 109-1, “Application of FASB Statement EITF 03-1 guidance is completed. • Withholding Taxes Under Internal No. 109, Accounting for Income Taxes, New measurement and recognition Revenue Code Section 1441 to the Tax Deduction on Qualified guidance had been expected to be in Production Activities Provided by the In September of 2004, the IRS place by the end of 2004. However, American Jobs Creation Act of 2004,” announced a new Section 1441 the FASB is expected to present requires companies that qualify for Voluntary Compliance Program (VCP) recommendations on its full the recent tax law’s deduction for under which eligible withholding reconsideration of EITF 03-1 and the domestic production activities to agents may essentially be able to related literature in early 2005. account for the deduction as a special perform a self-evaluation of their • The effective date has been adjusted deduction under Statement 109 and documentation, withholding and for EITF Issue No. 04-8, “The Effect of reduce their tax expense in the period reporting obligations, identify areas of Contingently Convertible Instruments or periods the amounts are deductible noncompliance, and pay any on Diluted Earnings per Share.” on the tax return. FSP FAS 109-2, underwithholding. This VCP is not an Originally, the effective date of the “Accounting and Disclosure Guidance amnesty, but a temporary opportunity © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • SOBI Winter 2005 7 for withholding agents to avail which the World Trade Organization domestic reinvestment plan themselves of an attractive alternative had found to be an “illegal trade (“Plan”) approved by company to an IRS audit. Taxpayers have until subsidy.” The key provisions of the management before the funds are December 31, 2005 to file their VCP legislation are highlighted below. repatriated. application with the IRS. – International Tax Reform On January 13, 2005, the Treasury To encourage withholding agents to Department and IRS released an The Act contains significant changes come in under VCP, the IRS has advance copy of Notice 2005-10 to the international tax law regime. announced that it intends to achieve and a Fact Sheet providing 100 percent coverage, whether by o Repatriation of Foreign Earnings guidance on repatriation of foreign traditional IRS audit or voluntary earnings under the Act. According disclosures under VCP, for the top 500 Under section 965 of the Act, to a related Treasury Department Form 1042 filers. The IRS has further certain actual and deemed release, Notice 2005-10 and the indicated that it does not intend to dividends received by a U.S. Fact Sheet are the first in a series impose penalties on those withholding corporation from controlled foreign of notices that will provide agents that come in voluntarily. More- corporations in which it is a U.S. guidance for U.S. companies over, it has also agreed to entertain shareholder, are eligible for an planning to repatriate earnings individual proposals for the allowance 85 percent dividends-received from overseas subsidiaries subject of lower documentation standards deduction (DRD). At the taxpayer’s to the temporary reduced tax rate (i.e., faxed forms, and forms with election, this deduction is available available under the Act. inconsequential errors permissible to for dividends received either: Notice 2005-10 provides detailed support reduced rates of withholding) » During the taxpayer’s last tax guidance regarding the para- as long as the withholding agent year beginning before meters for a Plan and the types of proposes and implements a remedial October 22, 2004 (the date of investments in the United States plan to correct the problem(s) in the enactment); or for which repatriated funds may future. The IRS has indicated that it will be used under this provision. The not afford either benefit to withholding » During the taxpayer’s first tax notice also provides guidance on agents that opt for the traditional IRS year, which begins during the the requirement that the repatri- audit. (IRS Web site, September and one-year period beginning on ation be in the form of a cash October 2004) the date of enactment. dividend. In addition, Notice 2005- The DRD applies only to certain 10 provides guidance on electing • The American Jobs Creation Act of extraordinary repatriations in application of the provision and on 2004 required information reporting excess of the taxpayer’s “average The American Jobs Creation Act of regarding repatriated dividends repatriation level” in recent tax 2004 (Pub. L. No. 108-357, hereinafter and associated U.S. investments, years. Special rules apply for the the Act) that was signed into law by and provides a safe harbor computation of the repatriated the president on October 22, 2004, is mechanism for taxpayers to use amount eligible for the DRD. the culmination of a multiyear effort to in establishing that the Plan resolve a number of controversial tax Section 965 contains several requirement is satisfied. (KPMG’s and international trade issues. Its limitations on the repatriated TaxNewsFlash-United States Nos. primary objective, which has been dividends that are eligible for the 2005-12 and 2005-13) accomplished, was the repeal of the reduced tax rate. One key require- foreign sales corporation regime and ment is that the repatriated funds the repeal of its replacement, the must be invested by the company exclusion for extraterritorial income, in the United States pursuant to a © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • 8 SOBI Winter 2005 o Foreign Tax Credits U.S. corporation hold 80 percent o Financial “triggers” based on the or more of the stock of the health of the company are not The Act makes a number of foreign-incorporated entity, the allowed. (Under the Act, plan changes to the foreign tax credit foreign entity is deemed to be triggers are treated as property regime, including: a domestic U.S. corporation for transfers.) » Reducing from nine to two tax purposes. If the entity is Elections of “initial deferral” must be the number of categories 60 percent owned, the top-tier made in the preceding tax year (with (“baskets”) by which income corporation is respected as a a performance-based compensation must be classified foreign corporation, but a number deferral election possible later). of corporate-level “toll charges” » Extending the period of time “Subsequent deferral” elections are imposed upon the over which foreign tax credits cannot be made less than 12 months establishment of the structure. may be carried forward (from 5 prior to the first scheduled payment, years to 10 years), but reducing – Deferred Compensation Rules cannot take effect for 12 months, the carryback period (from 2 Effective in 2005 and must result in a deferral of at years to 1 year) least five additional years. As a result of changes to the tax » Modifying the calculation of the characterization of unfunded These rules also may apply to stock foreign tax credit by permitting deferred compensation under the appreciation rights or discounted deductible interest to be Act, virtually all such plans will need stock options. determined on a worldwide to be examined — and most will In addition, deferred compensation basis and providing a rule that need to be changed — to conform assets in foreign trusts (rabbi trusts) redresses an inequity with to the new rules. When these rules are taxed upon vesting, with the regard to how domestic income become effective in 2005, any exception of assets in foreign following a domestic loss may attempt to defer compensation will jurisdictions where “substantially all” be allocated to enhance the be deemed “ineffective” — and services were performed. Many U.S. foreign tax credit. the deferred element of the taxpayers working overseas and compensation will be immediately o Deferral of Taxation of Foreign- covered under foreign deferred taxable and subject to significant Sourced Income compensation arrangements (even if additional penalties — unless the unfunded) may not be in compliance The Act makes a number of following conditions are met: with these rules. specific, but relatively limited, o Distributions are payable only changes to the regime governing In a taxpayer-friendly provision, the upon an employee’s separation the extent to which the foreign Act specifies that the “spread” upon from service, death, or disability; a earnings of a controlled foreign the exercise of rights under an change in control of the company; corporation are taxed currently in incentive stock option or employee an “unforeseeable emergency”; the United States. stock ownership plan will not or a specific date in the future. constitute wages for employment o Inversions o The timing and schedule of tax purposes. The Act imposes a new tax payments cannot be accelerated – New Disclosure and Penalty regime on companies that (unless in accordance with certain Regimes for Reportable “invert” — i.e., become the sub- regulatory exceptions). Thus, Transactions (Tax Shelters) sidiary of a foreign-incorporated “haircut” provisions and “board entity — after March 4, 2003. If discretion” distributions are Taxpayers should take particular note the former shareholders of the prohibited. of new disclosure and penalty © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • SOBI Winter 2005 9 regimes that the Act establishes Commissioner can rescind the – Conclusion with respect to reportable penalty for failing to disclose a The American Jobs Creation Act transactions. These provisions — nonlisted reportable transaction of 2004 provides significant which are generally applicable to all but must submit an annual report opportunities for U.S. businesses companies — include the following: to Congress describing each to improve their tax positions. At penalty and explaining why it was o Disclosure of Reportable the same time, however, it presents rescinded. Transactions a host of new hurdles and risks, SEC reporting companies must including stricter reporting require- The Act imposes a strict liability inform shareholders, via their SEC ments, increased penalties, and, penalty for the failure to disclose filing, in the event that this penalty potentially, new tax costs. In addition “listed transactions.” It also is imposed on the company for to the provisions highlighted in this imposes a penalty on nonlisted failure to disclose a listed executive brief, the Act affects a reportable transactions. Nonlisted transaction. broad spectrum of business reportable transactions include activities, transactions, and entities. those that: o Understatements Businesses, tax professionals, regu- » Result in certain large losses or lators, lawmakers, and third parties The Act created a new accuracy- book/tax differences in excess will have to devote significant time related penalty for listed trans- of $10 million per year; and resources to analyzing this new actions, and other reportable law to gain a better understanding » Are offered under conditions of transactions if a significant of the implications of the Act and confidentiality; purpose of the other reportable provisions that are pertinent to their transaction is the avoidance or interests. (The American Jobs » Are subject to contingent fee evasion of federal income tax Creation Act of 2004 unless arrangements or refunds if the (reportable avoidance transaction). otherwise stated above) intended tax results are not This penalty affects returns for tax achieved; years ending after October 22, • IRS Administrative Procedures for 2004. Automatic Consent to Change » Result in tax credits (including Method of Accounting Under foreign tax credits) in excess of The understatement penalty is "INDOPCO Regulations" for Second $250,000 when the taxpayer 20 percent in the case of Tax Year Ending After 2003 has held the underlying asset disclosed listed or reportable for less than 45 days. On December 13, 2004, the IRS avoidance transactions and 30 per- cent if the transaction was not released an advance copy of Rev. Proc. The penalty is $50,000 ($10,000 disclosed. The 20 percent penalty 2005-9, that sets forth the exclusive for a natural person) with respect may be mitigated in the case of administrative procedures that a to nonlisted reportable trans- taxpayer must use to obtain automatic actions, and $200,000 ($100,000 disclosed transactions by consent to change its method of for a natural person) with respect “reasonable cause” (although an accounting for the second tax year to listed transactions. This penalty opinion from a disqualified tax ending on or after 2003, under the regime, which affects tax returns adviser cannot be used to final section 263(a) regulations on and statements due after establish reasonable cause). capitalizing costs incurred in acquiring October 22, 2004, applies solely Companies that are penalized at or creating intangible assets. (KPMG’s to the issue of nondisclosure; it is the 30 percent rate under this TaxNewsFlash-United States, No. not in lieu of other penalties and is provision must disclose the action 2004-303) applicable even if the taxpayer in their SEC filing. An additional prevails on the underlying merits $200,000 penalty may be imposed of the position. However, the for failure to do so. © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • 10 SOBI Winter 2005 • Final Instructions for New Schedule additional guidance to those corpo- American Jobs Creation Act of 2004 M-3 Are Released rations required to file the schedule, (P.L. 108-357).” (IRS Issues Long- including detailed instructions for Awaited Circular 230 Regs, Proposes On December 2, 2004, the Treasury almost every line and many illustrative Bond Opinion Regs, 2004 TNT 244-1, Department and IRS released the final examples. The additional guidance and December 20, 2004) instructions for Schedule M-3, Net examples are expected to assist Income (Loss) Reconciliation for taxpayers in completing the schedule. Corporations With Total Assets of (KPMG’s TaxNewsFlash No. 2004-298) $10 Million or More. • Rev. Proc. 2004-73 – IRS Provides Schedule M-3 generally expands Accuracy-Related Penalty Guidance certain reporting made on Schedule M-1, and is intended to make On December 20, 2004, the IRS differences between financial released Rev. Proc. 2004-73, 2004-51 accounting net income (book income) IRB 999, which updates Rev. Proc. and taxable income more transparent. 2003-77, 2003-44 IRB 964. Rev. Proc. 2004-73 identifies circumstances under Schedule M-3 is to be used by certain which the disclosure on a taxpayer’s corporate taxpayers filing Form 1120, return with respect to an item or a U.S. Corporation Income Tax Return. position is adequate for purposes of The final draft version of Schedule M-3 reducing the understatement of was issued in October 2004, in income tax under IRC section 6662(d), advance of the final Schedule M-3 instructions to provide affected relating to the substantial understate- taxpayers, tax software vendors, and ment aspect of the accuracy-related other stakeholders immediate access penalty, and for purposes of avoiding to the form as they prepare to imple- the preparer penalty under IRC section ment and comply with Schedule M-3. 6694(a), relating to understatements due to unrealistic positions. (Rev. Proc. Schedule M-3 is effective for any tax 2004-73, 2004-51 IRB 999) year ending on or after December 31, 2004. In general, Schedule M-3 must • Final Circular 230 Regulations be filed by a corporation required to file On December 17, 2004, the IRS issued Form 1120 and that reports on Form final Circular 230 regulations on tax 1120 at the end of the corporation’s opinion standards. “The [regulations] tax year total assets that equal or set best practice standards only for exceed $10 million. However, a those practicing before the IRS and corporation is only required to com- provide mandatory rules for plete certain sections of Schedule M-3 practitioners who provide covered in the first tax year for which the opinions. The [regulations] define corporation is required to file the covered opinions and explain the schedule. requirements for covered opinions, According to a related Treasury disclosures, and other written advice. Department release, the final They do not, however, reflect changes instructions to Schedule M-3 provide made to the practice standards by the © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • SOBI Winter 2005 11 Market Forces and specialty finance deals up but Broker/Dealers prefer Eurozone and Global Emerging Market assets and dislike U.S. assets. insurance and specialty finance deal • Global prime broker revenues for the By global sector, fund managers see volume on the decline. The total five years ending 2004 reached the most value in pharmaceuticals and number of banking M&A deals $5 billion, but this number is expected the least value in technology. For announced during the quarter totaled to more than double over the next five those who need to maintain a bond 71, about the same as the year ago years to $11.5 billion, according to allocation, managers expect govern- quarter’s 68, but well above the Celent’s report “The Burgeoning ment bonds to outperform corporate second quarter’s 59. Volume by total Business of Prime Brokerage.” The bonds in 2005 and inflation-linked deal value declined 74 percent to report indicates that although currently bonds to perform better than $9.6 billion from $36.5 billion in the top three leading prime brokers conventional bonds, according to the previous quarter, but more than represent 55 to 65 percent of the survey. (Merrill Lynch Press Release, doubled the year ago period’s market, this will change with the December 14, 2004) $4.2 billion. Securities and investments explosive growth of the hedge fund M&A deals slowed during the third industry. Celent predicts that global • Client satisfaction with the quarter with 27 deals announced, hedge fund assets will grow at an performance of their brokers was the compared to second quarter’s 38 average annual rate of 16.5 percent topic the annual Securities Industry deals, but up slightly from the year ago over the next five years, reaching Association Investor Survey released quarter’s 23 deals. Securities and $2.1 trillion by 2009. This growth, on November 4, 2004. The results Investments deal value fell more than according to the company, will indicate that the majority of perpetuate demand for prime broker- 60 percent to $984.5 million from last respondents felt that they are satisfied age services at all points of the hedge quarter’s $2.6 billion and decreased with the quality of service they receive fund life cycle. Other changes in the 76 percent from the year ago quarter’s from their broker. Respondents believe industry, including new technology, $4.1 billion. (SNL Financial Press that recent reforms of securities market structure changes, growth in a Release, October 8, 2004) regulations are working and that these derivatives market that is increasingly recently adopted regulations will curb • On December 2, ING Group complex, and bank consolidations, will abuses in the securities industry. announced that it finalized an modernize firms, enable cross-asset Additionally, the study found that the agreement to sell most of its German class servicing, and spur innovation in vast majority of respondents continue banking unit, ING BHF-Bank, to Sal. prime brokerage, according to the to look to the securities industry to do Oppenheim for EUR 600 million. The report. (Celent Press Release, more to educate them about how to deal included ING BHF-Bank’s asset October 20, 2004) make good investments. (Securities management, private banking, financial • According to Merrill Lynch’s “Survey of Industry Association, November 4, markets, and core corporate banking Global Fund Managers” for December, 2004) businesses, with a total of EUR global asset allocators expect 2005 to 6 billion in risk-weighted assets and be another year in which equities EUR 600 million in capital at the time outperform bonds. The survey shows Consolidation and of the announcement. ING Group also that a net 49 percent of asset Convergence announced that it had reached allocators expect equities to be the • According to SNL Financial, M&A deal agreements in principle to sell the best performing asset class while a net value decreased in the financial London branch of ING BHF-Bank to 38 percent believe bonds will be the services sector in the third quarter Deutsche Postbank and to sell part of worst. Regionally, asset allocators while volume was mixed, with bank the bank’s corporate lending portfolio © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • 12 SOBI Winter 2005 to HVB Group. All three transactions international insurance businesses, to mitigating some risks. The attraction were expected to close by the end MetLife for $11.5 billion, subject to toward more speculative products is of 2004. (ING Press Release, closing adjustments. As a result of this occurring at a time when regulators in December 2, 2004). combination, MetLife will become the several countries are stepping-up largest individual life insurer in North oversight of these strategies. There is • Bank of America announced on America based on sales, and MetLife’s some uncertainty surrounding the role October 20, the merger of the Retirement and Savings general the regulatory environment will play, broker/dealers of Banc of America account assets will increase by almost and for now, concerns about regulatory Investment Services, Inc. and Quick & 60 percent, according to MetLife. ambiguity appear to be taking a back Reilly. The newly formed brokerage (MetLife, Inc. Press Release, seat to the pressure for higher invest- organization will operate under the January 31, 2005) ment returns. Greenwich Associates name Banc of America Investment notes that in the past year European Services, Inc. (BAI) and will represent institutional investors doubled their the nation’s third-largest bank-owned International Focus and investment in below-investment grade brokerage firm and ninth-largest Globalization credit bonds and credit derivatives. The brokerage organization, according to • The Eastern European markets have ambiguity caused by the potential for Bank of America. BAI is part of the performed strongly over the past two regulatory agency actions has also company’s Wealth & Investment years and are expected to continue slowed the expansion of electronic Management division, which has over to do well over the coming 6 to 12 trading of fixed income vehicles $690 billion in client assets under months, according to Credit Suisse throughout Europe. A recently released administration and generates more European Frontiers Fund co-managers’ Celent analysis demonstrates how than $6 billion in annual revenue, analysis. Many of the positive factors widespread electronic trading is also according to Bank of America. (Bank of that have driven markets historically hampered by the lack of uniformity America Press Release, October 20, should remain in place and thus spur among national markets and the lack 2004) investment in the region going of European settlement and payment • Northern Trust Corporation and ING forward. Economic growth was strong institutions apart from banks. (Press Group N.V. announced on in the region when compared to the Releases, Greenwich Associates, November 22 that they reached an global economy. The fund co-managers December 1; Celent, October 6, 2004) agreement for Northern Trust to continue to prefer Hungary to Poland • Standard & Poor’s announced on acquire Baring Asset Management’s in Central Europe as Hungarian stocks December 2 that it has signed a Financial Services Group (FSG) for continue to trade at lower multiples Memorandum of Understanding approximately GBP 260 million and generally have excellent manage- (MOU) with RTS Stock Exchange (approximately USD 480 million), ment track records, while even though (RTS), the Moscow-based stock subject to adjustments. FSG is the the Polish economy seems to be in a exchange, to create a new generation institutional fund administration, slow recovery, it is difficult to find of Russian equity indices. Under the custody, and trust services arm of compelling ideas at a stock level. MOU, Standard & Poor’s and RTS will Baring Asset Management, a unit in (Credit Suisse Press Release, develop, calculate, license, and ING Group. (Press Releases: Northern September 27, 2004) promote Russian equity indices Trust Corporation and ING Group, • European fixed income trading is facing worldwide, and will revamp the indices November 22, 2004) a challenging environment. According by applying to them internationally • MetLife, Inc. and Citigroup Inc. to a new report from Greenwich recognized Standard & Poor’s indexing announced on January 31, 2005 an Associates, with interest rates at principals. Launch of the new RTS/S&P agreement for the sale of Citigroup’s historic lows, institutional investors are indices is expected in the first half of Travelers Life & Annuity, and turning to more complex instruments 2005. (Standard & Poor’s Press substantially all of Citigroup’s that may boost returns while hopefully Release, December 2, 2005) © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • SOBI Winter 2005 13 • Merrill Lynch announced on October Survey Report,” released on although the industry remains in 14 that a number of changes in the November 22, 2004. Although check excellent health, there is danger of selection criteria used to construct the fraud continued to grow (increasing complacency. Focusing on emerging Merrill Lynch global bond indices 3 percent to 616,469 cases in 2003), risks, including a net slippage in credit would take effect on December 31, actual dollar losses remained stable underwriting standards, rising interest 2004. Some of the more significant at $677 million, down from the rate risk, expansion in home equity changes include: (1) the algorithm $698 million that banks lost in 2001. lending, and certain credit card account underlying the composite rating, Regardless of bank size, the most management and disclosure practices, currently based on Moody’s and S&P, common type of check fraud in 2003 Ms. Williams said that when the OCC will add Fitch ratings as well (except in was forgery. Survey participants sees risk issues emerging, it will work Canada, which will use DBRS), and (2) credited check fraud prevention with banks to prevent those issues minimum size filters for the EMU systems with keeping actual losses from developing into damaging Broad Market Index will be increased, significantly lower, citing the use of problems. (Office of the Comptroller eliminating 1,992 securities currently account screening software during of the Currency Press Release, in the Index. (Merrill Lynch Press account opening as the most effective December 3, 2004) Release, October 14, 2004) prevention method. (American Bankers Association Press Release, • PeopleSoft on December 8, announced • Household debt in Canada has been a software alliance with Algorithmics November 22, 2004) rising twice as fast as disposable that will deliver an enterprise risk and income over the past 15 years, and • According to TowerGroup projections profitability management solution for faster than growth in household assets released in December 2004, fraud the banking and capital markets since the beginning of the decade, losses due to “phishing” scams on industry. The combination of according to CIBC World Markets’ consumers will reach $137 million PeopleSoft’s profitability management January Consumer Watch. A CIBC globally in 2004. “Phishing” scams, or applications and Algorithmic’s spokesperson indicates that with low using e-mail to convince individuals to enterprise risk management products and declining interest rates, borrowers reveal confidential information, could will deliver a comprehensive solution have a false sense of confidence that become one of the most urgent that will enable financial institutions to they are able to control their debt. threats to the growth of online financial better analyze risk, allocate investment However, should interest rates services. TowerGroup expected the capital, and comply with Basel II increase substantially or in the event incidence of phishing to rise to 86,000 regulatory requirements, according to of an economic slowdown, borrowers incidents globally in 2005, from 31,000 PeopleSoft. (PeopleSoft Press Release, may find themselves unable to keep incidents in 2004, as the phenomena December 8, 2004) pace. According to the release, spread to smaller institutions and grow Canadians are now 7 percent more more sophisticated. The greatest indebted than they were a year ago. threat is the negative impact that the e-Business and CIBC points to the lack of income growth, with wages remaining virtually scams could have on consumer Technology confidence in the Internet as a viable flat since the beginning of the decade, • According to a survey conducted by commerce channel. According to as the key cause for the excess Federal Reserve, electronic payment TowerGroup the cost of managing the borrowing. (CIBC Press Release, transactions (credit cards, debit cards, risk could be greater than the cost of January 20, 2005) and automated clearinghouse trans- the direct fraud itself. (TowerGroup actions) in the United States have Press Release, December 1, 2004) Risk Management exceeded check payments for the • Attempted check fraud at U.S. banks • In a recent presentation to the Bank first time. The number of electronic rose to $5.5 billion in 2003, according Administration Institute’s “Roundtable payment transactions totaled to the American Bankers Association’s for CFOs,” Acting Comptroller of the 44.5 billion in 2003, while the number (ABA) biennial “Deposit Account Fraud Currency Julie L. Williams said that of checks paid totaled 36.7 billion. © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • 14 SOBI Winter 2005 According to the survey, this trend is low-volume check deposits, the forecasts this to rise to 35 percent by expected to continue. Another product has future application for 2009. In its new research, “Mobilizing indication that checks are losing higher-volume depositors as banks the Financial Services Enterprise: ground are the findings of a Visa study ultimately implement electronic Business Mobility Gets Unwired,” that indicate about half of financial check presentment. TowerGroup indicates that financial executives responding plan to reduce institutions are exploring mobile – Banks will need to address several their organization’s reliance on checks opportunities with enterprise issues related to remote deposit applications tailored to a number of as a form of commercial payment. Instead, 40 percent plan to increase capture before widespread roll-out of vertical sectors. Executive alerts, use of commercial payment cards. the technology can occur (including insurance claims and quotes, mortgage (Press Releases: Federal Reserve, the defining of legal liability between information, and institutional mutual December 6; Visa Press, November 8, the bank and corporate depositor, fund sales are examples of applications 2004) quality of the check images, and being prepared for wireless new controls to detect fraudulent deployment. (TowerGroup Press • Since the Check 21 Act became check deposits). (TowerGroup Press Release, September 27, 2004) effective, several banks in the U.S. Release, November 16, 2004) have begun to offer business customers remote deposit capture, • Use of online banking surged in creating a “virtual” bank branch that Canada’s largest cities, according to can provide significant convenience BMO Financial’s survey released on and flexibility to those corporate November 29, which found that almost customers, according to the half of the respondents who are TowerGroup research report “Check 21 residents of five of Canada’s six largest and Remote Deposit Capture: Creating cities are using online banking. These the Virtual Branch,” released usage numbers represent a significant November 16. Key findings of the change in how customers are TowerGroup report include: conducting their banking business from previous years. A study looking at – In addition to offering remote deposit similar measures conducted in 2000 capture, banks see an opportunity of found that 75 percent of customers helping consolidate the banking were visiting a bank branch and only business of clients that maintain 18 percent were using online services accounts at multiple banks. to conduct their transactions. (BMO – Business environments that are well Press Release, November 30, 2004) suited for remote deposit products • TowerGroup believes that enterprise include corporations using deposit mobility in financial services is at the concentration services, businesses beginning of a significant, long-term receiving high-value checks, upswing as deployment costs continue companies receiving checks at to fall and the available device, nonpayment locations, and network, application, and other tech- businesses using Internet banks. nology options improve considerably. – Banks will succeed in their efforts to Adoption of mobile data devices by sell remote deposit products. financial services executives stands at Although the initial focus of these approximately 10 percent of total initiatives should be on clients with industry employment. TowerGroup © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • SOBI Winter 2005 15 KPMG Banking Insider www.kpmginsiders.com Analysis and Exchange has reported that the amount of On the whole, banks’ nascent entrance in contracts on its most liquid market, open the wholesale energy market is positive, Commentary natural gas, has risen 11 percent since the according to Denise Furey, an analyst with In this section we offer KPMG’s analysis beginning of 2004. Fitch Ratings Service in New York. She and commentary reprinted from KPMG says that banks’ high credit ratings will A couple of trends are driving the Banking Insider. allow the wholesale energy market to increased trading. The first has been the grow: “The average utility has about a Banks Power Up Energy Trading large swings in power prices. Banks will November 11, 2004 Triple-B rating, while most banks are By Christopher Westfall, Managing Editor, trade against the market on a proprietary Banking Insider graded above ‘A.’” As the increased credit basis, in the same manner that banks The unprecedented spike in oil and gas stability helps attract investors, “the entire trade against swings in currency, equity, price volatility has motivated several market’s credit profile is being enhanced,” and bond prices. banks to create or expand energy-trading Furey says. operations. The other element is that many bank Also, she explains, banks’ expertise in customers — namely hedge funds — But industry watchers caution that banks financial structures will help expand want banks to act as counterparties to will need to juggle their expertise with the power trading beyond the current bilateral their own trading activity. As many as 200 unique risks that power trading entails. trades to more complex derivative hedge funds have begun energy trading structures, such as swaps. “There are many different risks involved in activity over the past year, according to physical energy trading that banks are just energy consultants Global Change But as banks and hedge funds ramp up Associates. energy trading, they also need to ramp up now beginning to understand,” says Julie Luecht, a principal in KPMG’s Financial their risk management. That’s because as Working with hedge funds is perhaps the Risk Management practice in Chicago. first-time market participants, they have key reason that banks are interested in little experience in the perils of the power energy, says KPMG’s Luecht. She Several banks have built their energy market, especially the concept of physical explains that after the collapse of energy trading business over the past year. delivery risk, says Peter Fusaro, CEO of trading giant Enron, many power Barclays, UBS, Wachovia Corp., and Global Change. companies that had been acting as a JPMorgan Chase have created new counterparty and source of liquidity for “There is a lack of knowledge in the energy trading desks, according to traders in the energy market pulled out. physical energy space,” Fusaro says, as published reports. Established players, many new participants are simply applying including Goldman Sachs and Morgan “Power generators [utility companies] are their previous trading models without Stanley, have expanded their energy still trading, but only around their own taking into account the unique risks of the trading capabilities, including ownership of assets rather than acting as market power market. power generation facilities. makers,” Luecht says. She adds that utilities are making mostly trades that “This is not the foreign exchange market, Trading of energy is conducted primarily hedge their own risk, rather than acting as and black box traders are going to have through two-party, or bilateral, contracts, a major force in the markets. Luecht says their heads handed to them,” Fusaro as well as on over the counter (OTC) that banks have the opportunity to provide says. stock markets. There are few statistics on the market large amounts of liquidity, bilateral energy trading. However, several By physical delivery risk, energy traders adding to their credibility as traders. energy OTC markets have seen increased take into account the possibility that the trading; the New York Mercantile underlying commodity — oil, gas or © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • 16 SOBI Winter 2005 electricity — is not delivered on time or at educated with technical expertise — the Many of the costliest debacles against all. For instance, a pipeline blowing up, issue for [financial services] has become banks or securities firms have come from foreign unrest, or a truckers’ strike [the quality of] background checks,” Collie employees who were able to manipulate represent physical delivery risk. said. IT systems, according to a study conducted by Carnegie Mellon As a result, banks have been on a hiring Collie, who is also chairman of the University’s Computer Emergency binge for experienced energy traders, Financial Services Information Sharing and Readiness Team (CERT) Coordination says Adam Josephson, an analyst with Analysis Center Threat and Intelligence Center. The study reveals 23 “illicit cyber Celent Communications. Committee, said that while the common activity” incidents carried out by 26 perception of cyberttacks — hackers “A few banks have wanted to get into this insiders in the banking and finance sectors using their home computers to assault IT and bought a trading desk on the quick,” between 1996 and 2002. systems from the outside — is true, the Josephson says. Although banks can threat is often exaggerated. Some of the activity resulted in major quantify a financial risk for most losses, including a foreign currency trader industries, they need the expertise in “Usually, [remote] attacks against who hacked a bank’s systems to cover quantifying and modeling physical risk in systems or networks are transient and over $600 million in losses; and two energy market trades. don’t have a long-term impact,” Collie employees that cost a credit union said. Remote cyberattacks usually lack the “[Banks] were obvious candidates [to $215,000 by altering credit reports for widespread network access rights needed enter energy trading] given their large kickbacks. to cause serious damage. “Without balance sheets, trading expertise, and risk access, no amount of technology will management expertise and the only piece One attack had nothing to do with help,” Collie added. that was missing was experienced energy personal gain: a disgruntled employee let professionals.” In the past, terrorists have used external loose a “logic bomb” (illicit code that computers as their method of attack in a launches an attack after a triggering event) The Enemy Within on an international bank system that December 6, 2004 few less-than-successful campaigns. By Christopher Westfall, Managing Editor, deleted over 10 billion files on 1,300 Banking Insider Collie pointed to “cyberwar” between With reports that terrorist groups are Israelis and Palestinians between October servers in the United States. The cost to targeting the American financial system, of 2000 through January of 2001. During repair the damage from that attack was many argue the industry needs to actively that period, attackers from 23 countries more than $3 million. prepare for attacks that would target or hit eight governments, mostly with denial- None of the events listed in the study affect their information technology of-service attacks and Web site deface- were thought to have a political impetus, systems through cyberterrorism. ments touting pro-Israeli or pro-Palestinian but they point to the vulnerability of causes. But security professionals caution that the financial institutions to insiders, says greatest threat could come not from an Al “There was a lot of hype in the media, so Dawn Cappelli, a senior member of the Qaida operative with a laptop, but rather a lot of things that followed came under technology staff of CERT. from a terrorist sitting quietly in a nearby the definition of cyberterrorism,” he said. “A majority of the cases we looked at cubicle. Last summer, several banks and other were done for financial gain, or by “Access is the key, and the insider is the financial industry firms were put on higher disgruntled workers looking to inflict harm most likely threat vector,” said Byron alert after detailed information identified on the employer,” Cappelli says. “There Collie, a Goldman Sachs vice president, several buildings as terrorism targets. was also sabotage to extort payment. But, at the Securities Industry Association it does point to the vulnerability of the But an employee with even the lowest Business Continuity Conference. security systems.” security clearance into a financial services “With the fourth generation of Al Qaida firm’s network can do enormous damage. In the context of a terrorist strike, Cappelli being fielded — and many being highly says one major danger is that financial © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • SOBI Winter 2005 17 system networks may be targeted in transmitted and stored among banks and But with an increasing amount of tandem with a physical attack. For their third-party service providers is customer data being managed by third example, after a car bomb is used against expected to receive considerable attention parties, regulators are expected to pay a bank’s critical infrastructure, the from regulators and examiners in the closer attention in 2005 to how that terrorists may seek to cause additional coming months, according to speakers at information is being protected. confusion by cyberattacking the equity the BITS/American Banker Financial “Privacy will not only be a [regulatory] market’s computer systems. “[Cyber- Services Outsourcing Conference. imperative, but it is something we see terrorism] could be used to enable or And as government officials point out, any Congress getting involved in,” said magnify the impact of a physical attack,” consequences for privacy failures are not Stephen Malphrus, staff director for she says. expected to end with the third-party management at the Federal Reserve Part of a good defensive measure is a provider. “If your outsourcer screws up, Board of Governors. background check system that reviews it’s the bank that is going to pay,” said Many agencies involved in bank oversight anyone who has access to systems, Mark O’Dell, deputy comptroller in the argue they want to ensure that including employees and contractors, operational risk office of the Office of the compliance keeps up with industry says Scott Moritz, director of corporate Comptroller of Currency (OCC). practice. “We, as regulators, are not intelligence in KPMG Forensics. The outsourcing of bank functions such as against outsourcing,” said OCC’s O'Dell. “The image of the corporate hacker for call centers, data management and direct “But we expect a bank to adopt appropri- many is sort of a ‘War Games’ mentality,” marketing programs has become a ate policies and procedures to deal with Moritz says, referring to the 1983 film common practice in recent years. the risks.” that depicted a teenager unwittingly According to research firm TowerGroup, O’Dell said several agencies have issued breaking into U.S. defense systems and one-third of financial institutions’ regulations that deal with privacy. These nearly causing World War III. “But it's information technology spending is rules typically revolve around four main really people in a position of trust who are currently dedicated to third-party issues: compliance, information security, in the best position to hurt you.” providers. And total spending on business recovery, and personnel outsourcing by financial institutions is controls. A bank’s vendor-management Many banks don’t know just how deep expected to move from $30.9 billion this process, including due diligence, contract into a potential employee’s background year to $38.2 billion by 2006, a rise of management and performance of third they should delve. They are building 11.2 percent. party providers, will also be part of the programs that have different “tiers” of For many banks, the appeal of outsourcing regulators’ common exam process. background checks corresponding to a stems in part from the merger and job’s level of access and responsibility. “There are also reputational and strategic acquisition craze of the 1990s. As banks risks that banks need to follow,” O’Dell “You need to look at everyone, not solely gobbled up smaller competitors, they took added. based on their salary and title,” Moritz on disparate systems and technologies says, adding that checking credit and that were often unwieldy and expensive O’Dell cited three OCC Bulletins — 2001- criminal records are not enough for to manage in-house, said Lawrence 47 (Risk Management Principals of Third some employees. “They need to ask Baxter, executive vice president and chief Party Relationships), 2002-16 (Bank Use themselves, ‘If this is a malicious person, eCommerce Officer for Wachovia of Foreign-Based Third Party Service how could they hurt us?’” Corporation. Providers) and 2004-20 (Risk Management Privacy to Dominate Bank Outsourcing of New, Expanded or Modified Bank “Wachovia did 150 merger and acquisition Plans Services) — that deal with regulators’ December 15, 2004 deals in the last three years, and there By Christopher Westfall, Managing Editor, supervisory guidance when it comes to Banking Insider were a number of different platforms from outsourcing arrangements. Privacy considerations related to the ways the mergers for bill payment and online customer information is managed, banking,” Baxter said. © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • 18 SOBI Winter 2005 Bankers were also told to follow an single, reliable trading platform may turn The first electronic platforms for credit examination handbook called Outsourcing credit derivatives trading from a fast- derivatives trading will focus on trading Technology, which was published last year growing market into an explosive one. index-based products, such as iTraxx, by the Federal Financial Institutions which are baskets of individual CDS Examination Council. “A lot of people who want to use [credit issues. derivatives] find it difficult to do so, but Bank controls can become more getting [derivatives] on a trading screen The brass ring for the exchanges? The complicated if the bank has outsourced will make [trading] them essential,” said platform that gets out of the gate first operations to a third party located outside Michael Bagguley, managing director of with the most users is likely to be the one the United States. Banks’ “offshoring” Barclays Capital in London. that sticks; a successful platform will also practices, or using third-party providers in help increase use outside of traditional popular domiciles like India, Vietnam or Credit derivatives use has skyrocketed markets in Europe and into the U.S. the Philippines, is becoming more over the past several years. Banks, The only question for many is when CDS common as the financial services industry insurers, and hedge funds use the trading will become widespread, and looks to take advantage of a less instruments to mitigate risk in the face which firms will succeed after spending expensive international labor force. of declining credit quality. According to the time and money on a successful the International Swaps and Deals “U.S. companies need to have an platform. “For many, it is ‘if you build it, Association, credit derivative use grew understanding of local laws and customs, they will come’ issue,” said Michael 67 percent in 2003 to $3.6 trillion in especially if [problems] lead to a delay in Lustig, managing director of BlackRock notional outstanding. The most basic form certain projects,” said Michael L. Jackson, Investment Management. of credit derivatives is a credit default associate director of e-banking for the swap (CDS), in which one party sells And although the U.S. is developing into a Federal Deposit Insurance Corporation. protection to the holder of a bond in case major CDS market, not everyone is Jackson cited the example of a U.S. firm that did not take local bank holidays into of default. excited by the prospect of an electronic account and wound up having several trading platform. Large investment banks The credit derivative market has grown projects delayed. may not benefit from the price despite the product’s opaque structure. transparency that electronic trading Offshoring will likely also be a focus of Like most other derivatives, credit platform may bring, Lustig said. regulators as it becomes a common derivatives are contractual agreements practice throughout the financial services between two firms, making it difficult to “The buy-side likes it, but the dealers in industry, O’Dell added. “We do see an convert them into units that can be valued the U.S. have a good thing going,” Lustig increase in foreign bank service providers, and traded over an electronic system, said. American dealers would rather see and that’s moving down to mid-sized according to speakers at the recent Fixed CDS traded at a higher price on their institutions,” O’Dell said. Income Summit & Expo on Technology individual desks than more cheaply on a single electronic platform. “They have Credit Derivatives Platform: Build it and and Electronic Trading sponsored by the They Will Trade their spreads and they don’t want to see January 4, 2005 Bond Market Association. By Christopher Westfall, Managing Editor, profits hit again.” Banking Insider Realizing the potential market, several The race is on to develop a successful But European firms are already latching companies have built trading platforms electronic credit derivatives trading onto the idea of trading CDS electronically, they hope will make credit trading quick platform, which could introduce new making it likely that the rest of the world and transparent. Creditex has launched a players and transform the market. will follow. system for trading credit derivatives, and Industry observers say that eventually UK-based firms Markit and Icap plan to “Companies in Europe are much bigger only one credit derivatives platform will be offer platforms, as well as New York- users, and the investment space [for CDS] used universally. And the emergence of a based Axiom Global Partners. is much more diversified,” said Lisa © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • SOBI Winter 2005 19 Watkinson, product manager for flow CDS and credit indexation with Morgan Stanley. “[An electronic trading platform’s] ability to capitalize quickly and gain market share is much more certain in Europe.” There’s a huge incentive for banks to push electronic trading: quantifying risk, according to Jim Toffey, CEO of Thomson TradeWeb. Currently most CDSs are settled in cash, lending to the uncertainty whether the counterparty will make good on the trade. However, an electronic trading platform backed by highly liquid dealers that guarantee banks would make banks more apt to participate. “It’s clear to me that the market is ripe and everyone is looking for a workflow solution,” Toffey said. “Operational risk is a big driver to have the market go electronic.” In addition, much of the settlement process is already automated, which will help foster CDS trading, said Chip Carver, CEO of SwapsWire. “We have been in a market where the volume [of traders] was doubling every six months,“ said Carver. “The back office aspect is already there, so the next step is the execution side.” The information provided in the preceding articles is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. The views and opinions are those of the authors and do not necessarily represent the views and opinions of KPMG LLP. To receive a complimentary subscription to KPMG Banking Insider, go to www.kpmginsiders.com. © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR
    • 20 SOBI Winter 2005 Contacts Christopher S. Lynch For additional information on KPMG, National Sector Leader please visit our Web site at Financial Services and Banking www.kpmg.com. San Francisco, CA To submit changes to our mailing list, clynch@kpmg.com please contact Erika Arroyo at Robert T. McCahill earroyo@kpmg.com. Tax Sector Leader – Banking New York, NY mccahill@kpmg.com Editorial Production Mary Ann Bramer Special Projects, Industries Marketing & Communication Montvale, NJ (201) 505-3570 mabramer@kpmg.com Contributing Authors: Legislation and Regulation Laura H. Leigh Financial Risk Management Washington, D.C. lhleigh@kpmg.com Karen Staines National Regulatory Advisory Services Group Washington, D.C. kstaines@kpmg.com Accounting T. J. Scallon Audit & Risk Advisory Services New York, NY tscallon@kpmg.com Taxation Denise Schwieger Tax New York, NY dschwieger@kpmg.com © 2005 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. A13954NYGR