Basel 3 May 2013

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Basel iii Compliance Professionals Association (BiiiCPA)
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Basel 3 May 2013

  1. 1. P a g e | 1Basel iii Compliance ProfessionalsAssociation (BiiiCPA)1200G Street NW Suite800Washington, DC 20005-6705USA Tel:202-449-9750Web: www.basel-iii-association.comDear Member,I had a difficult timein thepast to explainliquidityrisk management and ratios.Now I know what todo. Problem solved!I will use a pollution-mitigatingtechnology, likescrubbersto explain liquidityrisk.Mr. JeremyC Stein, Memberof the Board of Governorsof the Federal Reserve System explainedhow:―Supposewehave a powerplant that producesenergyand, asa byproduct, somepollution.Supposefurther that regulatorswant toreducethepollutionand have twotoolsat their disposal:Theycan mandatethe useof a pollution-mitigatingtechnology, like scrubbers, or theycanlevyatax ontheamount of pollution generatedby theplant.In an ideal world, regulation wouldaccomplishtwoobjectives.First, it wouldlead toan optimal level of mitigation– that is, it wouldinducethe plant toinstall scrubbers up tothe point wherethecostof anBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  2. 2. P a g e | 2additional scrubber isequal to themarginal socialbenefit, in termsofreducedpollution.And, second, it wouldalsopromote conservation:Giventhat thescrubbersdon‘t get rid of pollutionentirely, onealsowantstoreduceoverall energyconsumption bymaking it more expensive.Asimplecaseis onein whichthe costsof installingscrubbers,aswell asthesocial benefits of reducedpollution, are knownin advanceby theregulator and themanager of the powerplant.In this case, the regulatorcan figure out what theright number ofscrubbersis and require that theplant install thesescrubbers.Themandate can thereforepreciselytarget the optimal amount ofmitigation per unit of energy produced.And, to the extent that the scrubbers are costly, the mandate will alsoleadto higher energy prices, which will encourage some conservation, thoughperhapsnot the sociallyoptimal level.This latter effect isthe implicit tax aspect of themandate.Amore complicatedcaseis when the regulator doesnot know ahead oftimewhat the costsof building and installingscrubberswill be.Here, mandatingtheuse of a fixednumber of scrubbers ispotentiallyproblematic:If the scrubbersturn out tobe very expensive, the regulation will end upbeingmore aggressivethansociallydesirable,leadingto overinvestmentin scrubbersand largecost increasesfor consumers;however, if thescrubbersturn out tobe cheaper than expected, theregulation will havebeen too soft.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  3. 3. P a g e | 3In otherwords, whenthecostofthemitigationtechnologyissignificantlyuncertain, a regulatory approachthat fixesthequantityof mitigationisequivalent toone wherethe implicit tax rate bouncesaround a lot.Bycontrast, aregulatoryapproachthat fixesthepriceof pollutioninsteadof the quantity– say, by imposing a predeterminedproportional tax ratedirectlyon the amount of pollution emittedby the plant – is moreforgivingin the faceof this kind of uncertainty.This approach leaves the scrubber-installation decision to the manager ofthe plant, who can figure out what the scrubbers cost before deciding howtoproceed.For example, if thescrubbers turn out to be unexpectedlyexpensive, theplant manager can install fewer of them.This flexibilitytranslatesintolessvariabilityin theeffectiveregulatoryburden and hence lessvariabilityin the price of energy toconsumers.Scrubbers and high-quality liquid assetsWhat doesall thisimplyfor the designof the LCR?Let‘s workthrough theanalogyin detail.Theanalog to the powerplant‘senergyoutput is thegrossamount ofliquidityservicescreatedby a bank – via its deposits,thecredit linesitprovidesto itscustomers, the prime brokerage servicesit offers,and soforth.Theanalog to themitigationtechnology– the scrubbers– is the stock ofHQLA that the bank holds.And the analogto pollution is thenet liquidityriskassociated withthedifferencebetweenthesetwoquantities, somethingakin to the LCRshortfall.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  4. 4. P a g e | 4That is,whenthebank offersalot of liquidityondemandtoitscustomersbut fails tohold an adequatebuffer of HQLA, this is whenit imposesspillover costson the rest of thefinancial system.In the caseof thepowerplant, I argued that a regulation that callsfor afixed quantityof mitigation– that is, for a fixednumber of scrubbers– ismore attractivewhenthere is littleuncertainty about thecost of thesescrubbers.‖Thank you Jeremy!I have justopenedmy master plan. I have to learn more about scrubbers.I now see other similaritiesbetweentheBISand scrubbers. Onlynow Ican understand theshapeof the BISbuilding!I think I have just found another regulatoryarbitrageopportunity. Arealnational discretion, justified.Scrubbersarecapableof reduction efficienciesin the rangeof 50% to98%. Why should theLiquidityCoverage Ratiobe 100%?Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  5. 5. P a g e | 5ALCR from 50% to98% (meaning50,001%) is good enough!Thecalculationsin Basel and scrubbersare alsoalmost the same!Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  6. 6. P a g e | 6Liquidity regulation and central bankingSpeechby Mr Jeremy C Stein, Member of the Boardof Governorsof theFederal Reserve System, at the―Finding theright balance‖ 2013Credit MarketsSymposium, sponsored bythe Federal ReserveBankof Richmond, Charlotte, North CarolinaI‘d like to talk todayabout one important element of the internationalregulatoryreform agenda– namely, liquidityregulation.Liquidityregulation is a relativelynew, post-crisisaddition tothefinancial stabilitytoolkit.Key elementsincludethe LiquidityCoverage Ratio (LCR), whichwasrecentlyfinalizedbythe Basel Committeeon Banking Supervision, andthe Net StableFundingRatio, whichis still a workin progress.In what follows, I will focuson the LCR.Thestated goal of the LCR is straightforward,even if some aspectsof itsdesignare lessso.In the wordsof theBasel Committee, ―Theobjectiveof theLCR is topromotetheshort-term resilienceof the liquidityrisk profile of banks.It doesthis by ensuringthat bankshavean adequatestock ofunencumberedhigh-qualityliquid assets(HQLA) that can be convertedeasilyandimmediatelyin privatemarketsintocashtomeettheir liquidityneedsfor a 30 calendar day liquiditystressscenario.‖In other words,each bank isrequired to model its total outflowsover 30days in a liquiditystressevent and then tohold HQLA sufficient toaccommodatethoseoutflows.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  7. 7. P a g e | 7This requirement isimplemented witha ratiotest, wheremodeledoutflowsgo in thedenominator and thestock of HQLA goesin thenumerator;whentheratio equalsor exceeds100percent, therequirementis satisfied.TheBasel Committeeissued the first versionof the LCR in December2010.In January of thisyear, thecommitteeissueda revisedfinal version of theLCR, followingan endorsement byitsgoverningbody, theGroup ofGovernorsand Headsof Supervision (GHOS).Therevision expandsthe rangeof assetsthat can count asHQLA andalsoadjustssome of the assumptionsthat govern the modeling of netoutflowsin a stressscenario.In addition, thecommitteeagreed in January toa gradual phase-in of theLCR, sothat it only becomesfullyeffectiveon an international basisinJanuary 2019.On thedomesticfront, theFederal Reserve expectsthat theU.S. bankingagencieswill issuea proposal later this year toimplement theLCR forlargeU.S.bankingfirms.While thisprogressiswelcome, a number of questionsremain.First, towhat extent should accesstoliquidityfrom a central bank beallowedto count towardsatisfying theLCR?In January, the GHOS noted that theinteraction betweentheLCR andtheprovision of central bank facilitiesiscriticallyimportant.And the group instructedthe Basel Committeeto continueworkingonthisissuein 2013.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  8. 8. P a g e | 8Second, what stepsshould be taken to enhancethe usability of the LCRbuffer – that is, toencouragebanksto actuallydraw down their HQLAbuffers,asopposed tofire-sellingother lessliquid assets?TheGHOShasalsomade clearitsview that, during periodsof stress,itwouldbe appropriatefor banksto usetheir HQLA, therebyfallingbelowtheminimum.However,creatinga regimein whichbanks voluntarilychooseto dosoisnot an easytask.Anumberofobservershaveexpressedtheconcernthat if abank isheldtoan LCR standard of 100percent in normal times,it may be reluctant toallowitsratioto drop below 100percent whenfacing largeoutflows, evenif regulatorswereto permit this temporarydeviation, for fear that adeclinein the ratiocould be interpretedasa sign of weakness.My aim hereistosketchaframeworkforthinkingabout theseandrelatedissues.Among them, theinterplay betweentheLCR and central bank liquidityprovisionisperhapsthemostfundamentalandanatural startingpoint fordiscussion.Bywayofmotivation, notethat beforethefinancialcrisis, wehadahighlydeveloped regime of capital regulationfor banks– albeit onethat looksinadequatein retrospect – but wedid not have formal regulatorystandardsfor their liquidity.Theintroduction of liquidityregulation after the crisiscan be thought ofasreflectinga desire to reducedependenceon the central bank asalender of last resort(LOLR), based on thelessonslearnedover thepreviousseveral years.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  9. 9. P a g e | 9However,to the extent that some role for the LOLR still remains,onenow facesthe questionof how it should coexistwith a regime of liquidityregulation.Toaddressthis question, it is useful to take a step back and ask anotherone:What underlying market failure is liquidityregulation intendedtoaddress, and whycan‘t this market failurebe handledentirelyby anLOLR?I will turn to this questionfirst.Next, I will considerdifferent mechanismsthat could potentiallyachievethegoalsof liquidityregulation, and how thesemechanismsrelate tovariousfeaturesof theLCR.In sodoing, I hope toillustratewhy, even though liquidityregulation is aclosecousin of capital regulation, it neverthelesspresentsa number ofnovel challengesfor policymakers and why, asa result, weare going tohaveto be opentolearningand adaptingaswego.The case for liquidity regulationOneof theprimary economic functionsof banksand other financialintermediaries,suchasbroker-dealers,is to provide liquidity– that is,cashon demand – in variousforms totheir customers.Someof thisliquidityprovisionhappenson the liability sideof thebalancesheet, withbank demand depositsbeinga leadingexample.But, importantly, banks alsoprovide liquidityvia committed linesofcredit.Indeed, it isprobablynot acoincidencethatthesetwoproducts– demanddepositsand credit lines– are offered under the roof of the sameBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  10. 10. P a g e | 10institution;theunderlying commonalityis that both require an abilitytoaccommodateunpredictablerequestsfor cash on short notice.Anumber of other financial intermediaryservices,such asprimebrokerage, alsoembodya significant element of liquidityprovision.Without question, theseliquidity-provisionservicesare sociallyvaluable.On the liabilityside, demand depositsand other short-term bankliabilitiesaresafe,easy-to-valueclaimsthat arewellsuitedfor transactionpurposesand hencecreatea flowof money-like benefitsfor their holders.And loancommitmentsare more efficient than an arrangement in whicheachoperatingfirm hedgesitsfutureuncertainneedsby―pre-borrowing‖andhoarding theproceedson itsown balancesheet;this latterapproachdoesa poor job of economizingon thescarce aggregate supplyof liquidassets.At thesametime, asthefinancial crisismadepainfullyclear, thebusinessof liquidityprovision inevitablyexposesfinancial intermediariestovariousforms of run risk.That is, in responsetoadverse events, their fragile funding structures,together withthe binding liquiditycommitmentstheyhavemade, canresult in rapid outflowsthat, absent central bank intervention, lead bankstofire-sellilliquid assetsor, in a more severe case,to fail altogether.And fire salesand bank failures– and theaccompanying contractionsincredit availability– can have spillover effectstoother financialinstitutionsand to the economy asa whole.Thus, while bankswill naturallyhold buffer stocksof liquid assetstohandleunanticipatedoutflows, theymay not hold enough because,although theybear all thecostsof this buffer stocking, theydonotcapture all of thesocial benefits, in termsof enhancedfinancial stabilityand lowercoststotaxpayers in the event of failure.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  11. 11. P a g e | 11It is this externalitythat createsa role for policy.Therearetwobroadtypesof policytoolsavailabletodeal withthissortofliquidity-basedmarket failure.Thefirst isafter-the-fact intervention, either by a deposit insurerguaranteeingsome of thebank‘sliabilitiesor by a central bank actingasan LOLR.Thesecond type isliquidityregulation.As an exampleof theformer, whenthe economy isin a bad state,assumingthat aparticularbank isnot insolvent, thecentralbank canlendagainst illiquidassetsthat wouldotherwisebefire-sold,therebydampingor eliminatingthe run dynamics and helpingreducetheincidenceof bankfailure.In much of theliteratureon banking, such interventionsare seen astheprimarymethod for dealing withrun-likeliquidityproblems.Aclassicstatement of the central bank‘srole asan LOLR is WalterBagehot‘s1873book Lombard Street.Morerecently, the seminal theoretical treatment of this issueis byDouglasDiamond and Philip Dybvig, whoshowthat under certaincircumstances, the useof deposit insuranceor an LOLR can eliminaterun risk altogether, therebyincreasingsocial welfareat zero cost.Tobeclear, thisworkassumesthat thebank in questionisfundamentallysolvent, meaning that whileitsassetsmay not be liquid on short notice,thelong-run valueof these assetsisknownwithcertaintyto exceed thevalueof thebank‘sliabilities.Onewaytointerpret themessageof this research is that capitalregulation is important toensuresolvency, but oncea reliableregime ofBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  12. 12. P a g e | 12capital regulation is in place, liquidityproblemscan bedealt withafter thefact, via somecombinationofdepositinsuranceanduseof theLOLR.It followsthat if one is goingto make an argument in favor of addingpreventativeliquidityregulationsuch asthe LCR on top of capitalregulation, a central premisemust be that the use of LOLR capacityin acrisisscenario is sociallycostly, sothat it is an explicit objectiveof policytoeconomize on itsusein such circumstances.I think this premiseis a sensibleone.Akey point in this regard – and one that hasbeen reinforcedby theexperienceof thepast several years – is that the linebetweenilliquidityand insolvencyisfar blurrier in real life than it is sometimesassumed tobein theory.Indeed, one might argue that a bank or broker dealer that experiencesaliquiditycrunch must havesomeprobability of havingsolvencyproblemsaswell;otherwise,it is hard tosee whyit could not attract short-termfundingfrom the private market.This reasoningimplies that when thecentral bank actsasan LOLR in acrisis, it necessarilytakesonsome amount of credit risk.And if it experienceslosses,theselossesultimatelyfall ontheshouldersoftaxpayers.Moreover,theuseof an LOLR to support banks whentheyget intotroublecan lead tomoral hazard problems, in thesensethat banksmaybelessprudent ex ante.If it werenot for thesecostsof usingLOLR capacity, the problem wouldbe trivial, and there wouldbenoneed for liquidityregulation:Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  13. 13. P a g e | 13Assuming a well-functioningcapital-regulationregime, the central bankcouldalwaysavert all firesalesand bank failuresexpost, simplybyactingasan LOLR.This observation carries an immediate implication:It makes no senseto allowunpriced accessto thecentral bank‘sLOLRcapacityto count toward an LCR requirement.Again, the wholepoint of liquidityregulation must be either toconserveon theuseof the LOLR or in the limit, to addresssituationswheretheLOLR is not availableat all – as, for example, in the caseofbroker-dealersin theUnitedStates.At thesametime, it isimportant todraw adistinctionbetweenpriced andunpriced accessto the LOLR.For example, takethecaseofAustralia, whereprudent fiscal policyhasledto a relatively small stock of government debt outstandingand hencetoa potential shortageof HQLA.TheBasel Committeehasagreed totheusebyAustralia of a CommittedLiquidityFacility (CLF), wherebyanAustralianbank canpaytheReserveBank ofAustralia an upfront fee for what is effectivelya loancommitment, and this loan commitment can then be countedtowarditsHQLA.In contrast to free accesstotheLOLR, this approachisnot at oddswiththegoalsof liquidityregulationbecausetheup-front feeis effectively atax that servestodeter relianceon the LOLR – which, again, is preciselytheultimategoal.I will return tothe ideaof a CLF shortly.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  14. 14. P a g e | 14Thedesign of regulationOnceit hasbeen decided that liquidityregulationis desirable, thenextquestion ishow best toimplement it.In this context, notethat the LCR hastwologicallydistinct aspectsasaregulatorytool:It is a mitigator, in thesense that holding liquid assetsleadstoa betteroutcome if there is a bad shock; it is alsoan implicit tax on liquidityprovision by banks, tothe extent that holdingliquidassetsiscostly.Of course,one can say somethingbroadlysimilar about capitalrequirements.But the implicit tax associated withtheLCR is subtler and lesswellunderstood, soI will go intosome detail here.An analogymay help to explain.Supposewehaveapowerplant that producesenergyand, asabyproduct,somepollution.Supposefurtherthat regulatorswant toreducethepollutionandhavetwotoolsat their disposal:Theycan mandatethe useof a pollution-mitigatingtechnology, likescrubbers,or theycan levya tax on theamount of pollution generatedbythe plant.In an ideal world, regulation wouldaccomplish twoobjectives.First, it wouldlead toan optimal level of mitigation– that is, it wouldinducethe plant toinstall scrubbers up tothe point wherethecostof anadditional scrubber isequal to themarginal socialbenefit, in termsofreducedpollution.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  15. 15. P a g e | 15And, second, it wouldalsopromote conservation:Giventhat thescrubbersdon‘t get rid of pollutionentirely, onealsowantstoreduceoverall energyconsumption bymaking it more expensive.Asimplecaseis onein whichthe costsof installingscrubbers,aswellasthesocial benefits of reducedpollution, are knownin advanceby theregulator and themanager of the powerplant.In this case, the regulatorcan figure out what theright number ofscrubbersis and require that theplant install thesescrubbers.Themandate can thereforepreciselytarget the optimal amount ofmitigation per unit of energy produced.And, to the extent that the scrubbers are costly, the mandate will alsoleadto higher energy prices, which will encourage some conservation, thoughperhapsnot the sociallyoptimal level.This latter effect isthe implicit tax aspect of themandate.Amore complicatedcaseis when the regulator doesnot know ahead oftimewhat the costsof buildingand installingscrubberswill be.Here, mandatingtheuse of a fixednumber of scrubbers ispotentiallyproblematic:If the scrubbersturn out tobe very expensive, the regulation will end upbeingmore aggressivethansociallydesirable,leadingto overinvestmentin scrubbersand largecostincreasesfor consumers;however, if thescrubbersturn out tobe cheaper than expected, the regulationwill havebeen too soft.In otherwords, whenthecostofthemitigationtechnologyissignificantlyuncertain, a regulatory approachthat fixesthe quantityof mitigationisequivalent toone wherethe implicit tax rate bouncesaround a lot.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  16. 16. P a g e | 16Bycontrast, aregulatoryapproachthat fixesthepriceof pollutioninsteadof the quantity– say, by imposing a predeterminedproportional tax ratedirectlyon the amount of pollution emittedby the plant – is moreforgivingin the faceof this kind of uncertainty.This approach leaves the scrubber-installation decision to the manager ofthe plant, who can figure out what the scrubbers cost before deciding howtoproceed.For example, if thescrubbers turn out to be unexpectedlyexpensive, theplant manager can install fewer of them.This flexibilitytranslatesintolessvariabilityin theeffectiveregulatoryburden and hence lessvariabilityin the price of energy toconsumers.Scrubbers and high-quality liquid assetsWhat doesall thisimplyfor the designof the LCR?Let‘s workthrough theanalogyin detail.Theanalogto the powerplant‘s energyoutput is the grossamount ofliquidityservicescreatedby a bank – via its deposits,thecredit linesitprovidesto itscustomers, the prime brokerage servicesit offers,and soforth.Theanalog to themitigationtechnology– the scrubbers– is the stock ofHQLA that the bank holds.And the analogto pollution is thenet liquidityriskassociated withthedifferencebetweenthesetwoquantities, somethingakin to the LCRshortfall.That is,whenthebank offersalot of liquidityondemand toitscustomersbut fails tohold an adequatebuffer of HQLA, this is whenit imposesspillover costson the rest of thefinancial system.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  17. 17. P a g e | 17In the caseof thepowerplant, I argued that a regulation that callsfor afixed quantity of mitigation– that is, for a fixednumber of scrubbers– ismore attractivewhenthere is littleuncertainty about the costof thesescrubbers.In the context of the LCR, the cost of mitigation is the premium that thebank must pay – in the form of reduced interest income – for itsstock ofHQLA.And, crucially, this HQLA premium is determined in market equilibriumand dependson the total supplyof safe assetsin the system, relative tothedemand for thoseassets.On the onehand, if safeHQLA-eligibleassetsare in ample supply, thepremium is likelytobe low and stable.On the other hand, if HQLA-eligible assetsare scarce, thepremium willbeboth higher and more volatile over time.This latter situation is the one facing countrieslike Australia, where, as Inoted earlier, the stock of outstanding government securities is relativelysmall.And it explainswhy, for such countries,havinga price-basedmechanismaspart of their implementationof the LCR can be more appealingthanpure relianceon a quantitymandate.When one sets an up-front fee for a CLF, one effectively caps the implicittax associated with liquidity regulation at the level of the commitment feeand tamps down the undesirable volatility that would otherwise arise froman entirelyquantity-based regime.Moreover,it bearsreemphasizingthat havinga CLF withanup-front feeis very different from simplyallowingbankstocount central - bank -eligiblecollateral asHQLA at no charge.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  18. 18. P a g e | 18Rather, the CLF is like the pollution tax.For every dollar of pre-CLF shortfall – that is, for every dollar of requiredliquidity that a bank can‘t obtain on the private market – the bank has topaythe commitment fee.Soeven if there isnot asmuch mitigation, thereis still an incentiveforconservation, in thesensethat banks areencouragedto dolessliquidityprovision, all elsebeing equal.This wouldnot be thecaseif the CLF wereavailableat a zeroprice.What about the situation in countrieswheresafeassetsaremoreplentiful?Theanalysis here hasa number of moving parts becausein addition totheimplementationof the LCR, substantial increasesin demand for safeassetswill arise from new margin requirementsfor both clearedandnonclearedderivatives.Nevertheless,giventhelargeandgrowingglobalsupplyofsovereigndebtsecurities,aswellasother HQLA-eligibleassets,most estimatessuggestthat the scarcityproblem should be manageable, at least for theforeseeablefuture.In particular, quantitativeimpact studiesreleasedby the BaselCommitteeestimatethat the worldwide incremental demand for HQLAcomingfrom both the implementationof the LCR and swapmarginrequirementsmight be on the order of $3 trillion.This is a largenumber, but it compareswith a global supplyofHQLA-eligibleassetsof more than $40trillion.Moreover,the eligiblecollateral for swapmargin is proposedtobebroader than theLCR‘s definition of HQLA – including, for example,certain equitiesand corporatebondswithout any cap.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  19. 19. P a g e | 19If one focusesjust on U.S.institutions,theincremental demand numberis on the order of $1trillion, while the sum of Treasury, agency, andagencymortgage-backedsecuritiesis more than $19trillion.While this sort of analysisissuperficiallyreassuring, thefact remainsthattheHQLA premium will depend on market-equilibrium considerationsthat are hard to fullyfathom in advance, and that are likely tovary overtime.This uncertaintyneedsto beunderstood, and respected.Indeed, themarket-equilibriumaspect of theproblemrepresentsacrucialdistinctionbetweencapital regulationand liquidityregulation, and it isonereasonwhythelatter isparticularly challengingtoimplement.Although capital regulationalsoimposesa tax on banks – tothe extentthat equityisamore expensiveform of financethandebt – thistax wedgeis,toafirstapproximation, afixed constant foragivenbank, independentof the scaleof overall financial intermediation activity.If Bank Adecidestoissuemore equitysoit can expand itslendingbusiness,this need not make it more expensivefor Bank B tosatisfyitscapital requirement.In other words,thereis noscarcityproblem withrespect to bank equity –bothAand B can alwaysmake more.Bycontrast, thetotal supplyof HQLA isclosertobeingfixedat anypointin time.Policy implicationsWhat doesall of this implyfor policydesign?First, at a broadphilosophical level, the recognitionthat liquidityregulation involvesmore uncertaintyabout coststhancapital regulationsuggeststhat even apolicymaker witha very strict attitudetowardcapitalBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  20. 20. P a g e | 20might find it sensibleto besomewhat more moderate and flexiblewithrespect toliquidity.This point is reinforced by the observationthat whenan institutionisshort of capitalandcan‘t get moreontheprivatemarket, thereisreallynobackup plan, short of resolution.By contrast, asI mentioned earlier, whenan institution isshort ofliquidity, policymakers do have a backup plan in the form of theLOLRfacility.Onedoesnot want torelytoomuch on that backup plan, but itspresenceshould neverthelessfactor intothedesign of liquidityregulation.Second, in thespirit of flexibility, while aprice-basedmechanism such astheCLF may not beimmediatelynecessaryin countriesoutsideofAustralia and a few others,it is worthkeepingan open mind about themore widespreaduse of CLF-like mechanisms.If a scarcityof HQLA-eligible assetsturnsout tobe more of a problemthan weexpect, somethingalong thoselineshasthepotential to be auseful safetyvalve, asit putsa cap on thecostof liquidityregulation.Such a safety valvewouldhave a direct economicbenefit, in thesenseofpreventingtheburdenof regulationfrom gettingundulyheavyin anyonecountry.Perhapsjust asimportant, a safetyvalvemight alsohelp to protect theintegrityof the regulation itself, by harmonizingcostsacrosscountriesandtherebyreducingthetemptationofthosemosthard-hit bytherulestotry tochip awayat them.Without suchasafetyvalve, it ispossiblethat somecountries– thosewithrelativelysmall suppliesof domestic HQLA – will find the regulationconsiderably more costlythan others.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  21. 21. P a g e | 21If so, it wouldbenatural for them to lobbyto dilutetherules– forexample, by arguingfor an expansion in thetype of assetsthat can countasHQLA.Taken toofar, this sort of dilution wouldunderminethe efficacyof theregulation asboth amitigatorand a tax.In this scenario, holdingthe linewithwhat amountstoa proportional taxon liquidityprovision wouldbe a better outcome.Onesituation whereliquid assetscan becomeunusuallyscarceis duringa financial crisis.Consequently, evenif CLFs werenot counted towardtheLCR in normaltimes,it might be appropriatetocount them during a crisis.Indeed, while theLCR requires banks tohold sufficient liquid assetsingood timestomeet their outflowsin a givenstressscenario, it implicitlyrecognizesthat if thingsturn out even worsethanthat scenario, centralbank liquiditysupport will be needed.AllowingCLFs tocount toward theLCR in such circumstanceswouldacknowledgethe importanceof accesstothecentral bank, and thisaccesscould be priced accordingly.Finally, a price-based mechanism might alsohelp promote a willingnessof banksto draw down their supplyof HQLA in a stressscenario.As I noted at the outset, one important concern about a pure quantity-based system of regulation isthat if a bank is held toan LCR standardof100percent in normal times,it may be reluctant toallowitsratio tofallbelow 100percent whenfacinglargeoutflowsfor fear that doing somightbeseenby market participantsasa sign of weakness.By contrast, in a system withsomethinglike a CLF, a bank might innormal timesmeet 95 percent of itsrequirement by holdingBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  22. 22. P a g e | 22private-market HQLAandtheremaining5percent withcommittedcreditlinesfrom thecentral bank, soit wouldhavean LCR of exactly100percent.Then, when hit withlargeoutflows, it could maintain its LCR at 100percent, but dosoby increasingits useof central bank credit linesto25percent and selling20 percent of itsother liquid assets.This scenariowouldbe the sort of liquid-asset drawdownthat one wouldideallylike to seein a stresssituation.Moreover, the central bank could encourage this drawdown by varyingthe pricing of its credit lines – specifically, by reducing the price of thelinesin the midst of a liquiditycrisis.Such an approach wouldamount totaxingliquidityprovision more ingood timesthan in bad, whichhasa stabilizing macroprudential effect.Thisexamplealsosuggestsadesignthat mayhaveappealinjurisdictionswherethere is a relatively abundant supplyof HQLA-eligible assets.Onecan imagine calibratingthe pricingof the CLF soasto ensure thatlinesprovidedbycentralbanksmakeuponlyaminimal fractionofbanks‘requiredHQLA in normal times– apart, perhaps,from the occasionaladjustment periodafter an individual bank is hit withan idiosyncraticliquidityshortfall.At the same time, in a stressscenario, when liquidityisscarce and there isupward pressure on the HQLA premium, the pricing of the CLF could beadjusted so as to relieve this pressure and promote usability of the HQLAbuffer.Such an approach would respect the policyobjective of reducing expectedreliance on the LOLR while at the same time allowing for a safety valve ina period of stress.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  23. 23. P a g e | 23Thelimit caseof thisapproach is one wheretheCLF countstowardtheLCR onlyin a crisis.ConclusionBywayofconclusion, letmejustrestatethat liquidityregulationhasakeyroleto playin improving financial stability.However,weshould avoid thinkingabout it in isolation;rather, wecanbest understand it aspart of a larger toolkit that alsoincludescapitalregulation and, importantly, thecentral bank‘sLOLR function.Therefore, proper design and implementation of liquidityregulationssuch asthe LCR should takeaccount of theseinterdependencies.In particular, policymakers should aim tostrike a balancebetweenreducingrelianceontheLOLR ontheonehandandmoderatingthecostscreated by liquidityshortageson the other hand – especiallythoseshortagesthat crop up in timesof severe market strain.And, asalways, weshould bepreparedtolearnfrom experienceaswego.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  24. 24. P a g e | 24Basel III Capital: AWell-Intended IllusionThomasM. HoenigVice Chairman, Federal Deposit InsuranceCorporationInternationalAssociation of Deposit Insurers2013Research Conference, Basel, SwitzerlandIntroductionAristotle is creditedwith being thefirst philosophertosystematicallystudylogical fallacies,whichhe definedasargumentsthat appear validbut, in fact, arenot.I call them well-intendedillusions.Onesuch illusion of precision is the Basel capital standardsin whichworldsupervisory authoritiesrely principallyon a Tier 1capital ratiotojudgethe adequacyof bank capital and balance sheet strength.For the largest of thesefirms, each dollar of risk-weighted assetsis fundedwith 12to15cents in equitycapital, projecting the illusion that thesefirmsare wellcapitalized.Thereality isthat each dollar of their total assetsis funded withfar lessequitycapital, leavingopenthematter of how wellcapitalizedtheymightbe.Here‘show theillusionis created.BaselsTier 1capital measure is a banks ratio of Tier 1capital torisk-weightedassets.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  25. 25. P a g e | 25Each category of bank assets is weighed by the supervisory authority on acomplicated scale of probabilitiesand models that assign a relative risk oflossto each group, includingoff balancesheet items.Assetsdeemed lowrisk are reported at loweramountson thebalancesheet.Thelowertherisk,thelowertheamount reported onthebalancesheet forcapital purposesand thehigher the calculatedTier 1ratio.We know from years of experience using the Baselcapital standardsthatoncethe regulatory authorities finish their weightingscheme, bankmanagersbegin theprocessof allocatingcapital and assetstomaximizefinancial returns around these constructedweights.Theobjectiveis tomaximize a firmsreturn on equity(ROE) bymanagingthe balancesheet in such a manner that for anylevel of equity,therisk-weightedassetsare reported at levelsfar lessthan actual totalassetsunder management.Thiscreatestheillusionthatbankingorganizationshaveadequatecapitaltoabsorbunexpected losses.For thelargest global financial companies,risk-weightedassetsareapproximatelyone-half of total assets.This "leveragingup" hasserved worldeconomiespoorly.In contrast, supervisorsand financial firmscan choosetorely on thetangibleleverageratio tojudgethe overall adequacyof capital for theenterprise.This ratiocomparesequitycapital to total assets,deductinggoodwill,other intangibles,and deferred tax assetsfrom both equity and totalassets.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  26. 26. P a g e | 26In additiontoincludingonly loss-absorbingcapital, it alsomakesnoattempt to predict or assign relativerisk weightsamong asset classes.Usingthisleverageratioasour guide, wefind for thelargest bankingorganizationsthat each dollar of assetshasonly4 to 6centsfundedwithtangibleequitycapital, a far smallerbuffer than asserted under the Baselstandards.Comparing MeasuresTable1reportstheBasel Tier 1risk-weightedcapital ratio and theleverageratiofor different classesof banking firms.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  27. 27. P a g e | 27Column 4 showsTier 1capital ratiosrangingbetween12 and 15percentfor the largest global firms, giving theimpression that thesebanksarehighly capitalized.However,it is hard tobe certain of that by lookingat thisratiosincerisk-weightedassetsaresomuch lessthan total assets.In contrast, Column 6 showsU.S.firms averageleverageratiotobe 6percent using generallyacceptedaccountingstandards(GAAP), andColumn 8 showstheir averageratioto be3.9percent using internationalaccountingstandards(IFRS), whichplacesmore of thesefirmsderivativesonto thebalancesheet than doesGAAP.Thebottom portionof Table1showsthe degreeof leverageamongdifferent size groupsof banking firms, whichis striking aswell.TheTier 1capital measuresuggeststhat all size groupsof banks holdcomparable capital levels,while the leverageratioreports a differentoutcome.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  28. 28. P a g e | 28For example, the leverageratiofor most bankinggroupsnot consideredsystemicallyimportant averagesnear 8 percent or higher.Under GAAP accounting standards, the difference in this ratio betweenthe largest banking organizations and the smaller firms is 175-250 basispoints.Under IFRSstandards, thedifferenceisasmuch as400-475basispoints.Thelargest firms, whichmost affect theeconomy, hold the least amountof capital in the industry.While thisshowsthem tobe more fragile, it alsoidentifies just howsignificant a competitiveadvantagethese lowercapital levelsprovidethelargestfirms.Thesecomparisonsillustratehow easily the Baselcapital standard canconfuseand misinform the public rather than meaningfullyreport abankingcompany‘srelativefinancial strength.Recent history showsalsojusthow damagingthiscan be totheindustryandtheeconomy.In 2007, for example, the10 largest and most complex U.S.bankingfirmsreported Tier 1capital ratiosthat, on average, exceeded 7 percent ofrisk-weightedassets.Regulatorsdeemed theselargest to be well capitalized.This risk-weightedcapital measure, however,mapped intoan averageleverageratioof just 2.8percent.We learned all toolatethat having lessthan 3 centsof tangiblecapital forevery dollar of assetson thebalancesheet is not enough to absorbeventhesmallest of financial losses,and certainlynot a major shock.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  29. 29. P a g e | 29With the crisis, the illusion of adequate capital wasdiscovered, afterhavingmisled shareholders,regulators,and taxpayers.There are other, more recent, examples of how this arcane measure canbe manipulated to give the illusion of strength even when a firm incurslosses.For example, in thefourthquarter of 2012, DeutscheBank reported a lossof 2.5 billion EUR.That same quarter, its Tier 1risk-basedcapital ratioincreasedfrom 14.2percent to15.1percent due, in part, to ―model and processenhancements‖ that resultedin a declinein risk-weightedassets, whichnowamount to just16.6 percent of total assets.On Feb. 1, SNSReaal, the fourth largest Dutch bank with$5billion inassets,wasnationalized by the Dutch government.Just seven monthsearlier, on June 30, 2012,SNSreported a Tier 1risk-basedcapital ratio of 12.2 percent.However,the firm reported a Tier 1leverageratiobased uponinternational accountingstandardsof only1.47percent.This leverageratiowasmuch more indicativeof the SNS‘spoor financialposition.TheBasel III proposal belatedlyintroducestheconcept of a leverageratio but callsfor it tobe only 3 percent, an amount alreadyshown to beinsufficient toabsorb sizablefinancial lossesin a crisis.It iswrongtosuggest tothepublic that, withsolittlecapital, theselargestfirmscould survive without public support should theyencounter anysignificant economicreversals.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  30. 30. P a g e | 30Misallocating Resourcesand CreatingAsset ImbalancesAn inherent problem with a risk-weighted capital standard is that theweights reflect past events, are static, and mostly ignore the marketscollectivedaily judgment about the relativerisk of assets.It alsointroducestheelement of political and special interestsintotheprocess, whichaffectstheassignment ofriskweightstothedifferent assetclasses.Theresult is oftentoartificiallyfavor onegroup of assetsover another,therebyredirectinginvestmentsand encouragingover-investment in thefavoredassets.Theeffect of thismanagedprocessisto increaseleverage, raisetheoverall risk profile of theseinstitutions,and increasethevulnerabilityofindividual companies, the industry, and the economy.It is no coincidence,for example, that after a Basel standard assignedonlya 7 percent risk weight ontripleA, collateralizeddebt obligationsand similar lowrisk weightson assetswithina firmstradingbook,resourcesshiftedtotheseactivities.Overtime, financial groupsdramaticallyleveragedtheseassetsontotheirbalancesheetsevenasthe risksto that asset classincreasedexponentially.Similarly, assigningzero weightstosovereign debt encouragedbankingfirmsto invest more heavily in theseassets, simultaneouslydiscountingtherealrisk theypresentedand playing animportant rolein increasingit.In placing a lowerrisk weight on select assets,lesscapital wasallocatedtofundthemandtoabsorbunexpectedlossforthesebanks,underminingtheir solvency.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  31. 31. P a g e | 31AMore Realistic Capital Standard Is RequiredTaxpayersaretheultimatebackstoptothesafetynetandhaverealmoneyat stake.In choosingwhichcapital measure is most useful, it is fair toaskthefollowingquestions:- Doesthe BaselTier 1ratio or the tangibleleverageratiobest indicatethecapital strengthof the firm?- Whichone is most clearlyunderstood?- Whichone best enablescomparison of capital acrossinstitutions?-Whichone offersthemost confidencethat it cannot be easily gamed?Charts 1through 4compare the relationship of the tangibleleverageandBaselTier1capitalratiostovariousmarketmeasuresforthelargestfirms.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  32. 32. P a g e | 32Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  33. 33. P a g e | 33Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  34. 34. P a g e | 34Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  35. 35. P a g e | 35Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  36. 36. P a g e | 36Thesemeasuresinclude:theprice-to-book ratio, estimated defaultfrequency, credit default swapspreads, and market value of equity.In each instance, thecorrelationof thetangibleleverageratioto thesevariablesis higher than for the risk-weightedcapital ratio.While such findingsare not conclusive, theysuggest stronglythatinvestors,whendecidingwhereto placetheir money, rely upon theinformation provided by the leverageratio.We woulddowellto do thesame.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  37. 37. P a g e | 37Despiteall of theadvancementsmadeover theyearsin riskmeasurementandmodeling, it isimpossibleto predict thefuture or to reliablyanticipatehow and towhat degreeriskswill change.Capital standardsshould serve to cushion against theunexpected, not todivineeventualities.All of the Baselcapital accords, includingtheproposedBasel III, lookbackwardand then attempt to assign risk weightsintothe future.It doesnt work.In contrast, the tangible leverage ratio provides a simpler, more directinsight into the amount of loss-absorbing capital that is available to afirm.Aleverageratio asI‘ve definedit explicitlyexcludesintangibleitemsthatcannot absorb lossesin a crisis.Also, using IFRSaccounting rules, off-balancesheet derivativesarebrought ontothe balancesheet, providingfurtherinsight intoa firmsleverage.Thus, thetangibleleverageratiois simpler tocomputeand more easilyunderstood by bank managers,directors, and thepublic.Importantlyalso,it ismore likely tobe consistentlyenforcedby banksupervisors.Amore difficult challengemay be todetermine an appropriateminimumleverageratio.Chart 5providesa historyof bank leverageover thepast 150years for theU.S. banking system and givesinitial insight intothisquestion.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  38. 38. P a g e | 38It showsthat the equitycapital to assetsratiofor the industryprior to thefounding of the Federal Reserve System in 1913and the Federal DepositInsuranceCorporation in 1933ranged between13 and 16 percent,regardless of bank size.Without any internationally dictated standard or any arcane weightingprocess, markets required what today seems like relatively high capitallevels.In addition, thereis an increasingbodyof research(Admati and Hellwig;Haldane;Miles,Yang, and Marcheggiano) that suggeststhat leverageratios should be much higher than theycurrentlyare and that BaselIII‘sproposed 3percent figure addslittlesecurity to thesystem.Finally, and importantly, some form of risk-weightedcapital measurecouldbe useful asabackstop, or check, against whichto judgetheadequacyof theleverageratiofor individual banks.If a bank meets the minimum leverage ratio but has concentrated assetsin areas that risk models suggest increase the overall vulnerability of thebalance sheet, the bank could be required to increase its tangible capitallevels.Such a system providesthemost comprehensivemeasure of capitaladequacyboth in a broad context of all assetsand accordingto a banksallocationof assetsalonga definedrisk profile.Tangible Leverage Ratio and the Myth of UnintendedConsequencesConcernsareoften raisedwithinthefinancialindustryandelsewherethatrequiringthelargest and most complex firms tohold higher levelsofcapital asdefined usinga tangibleleverageratiowouldhaveseriousadverseeffectson theindustry and broader economy.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  39. 39. P a g e | 39It hasbeen suggested, for example, that requiring more capital for theselargestbankswouldraisetheir relativecost of capital and make them lesscompetitive.Similarly, there is concern that failingto assign riskweightstothedifferent categoriesof assetswouldencourage firms toallocatefundstothehighest riskassetsto achievetargeted returnstoequity.Theseissueshave been well addressed byAnat Admati and MartinHellwig in their recentlypublishedbook, The Bankers‘New Clothes.Therequired ROE and the abilityto attract capital are determinedby ahost of factorsbeyond the level of equitycapital.Theseinclude a firm‘sbusinessmodel, itsrisk-adjustedreturns, thebenefitsof servicesand investments, and theundistorted, ornon-subsidized, costsof capital.Alevel of capital that lowersrisk may very well attract investorsdrawn tothemore reliablereturns.Table1showsmany of the bankswithstrongerleverageratiosalsohavestockpricestradingat a higher premium tobook valuethan the largestfirmsthat are lesswell-capitalized.There alsois a concern that requiringa stronger, simpler leverageratiowouldcausemanagers to placemore risk on their balancesheet.While possible, the argument isunconvincing.With more capital at risk and without regulatory weightingschemesaffectingchoice, managers will allocatecapital in linewithmarket riskand returns.Furthermore,risk-weightedmeasuresandstrongbank supervisioncanbeavailableasa back-up system tomonitor such activity.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  40. 40. P a g e | 40Moreover,given theexperienceof therecent crisisand the on-goingeffortsto manage reported risk assetsdown, no matter the risk, it ringshollowto suggest that having a higher equitybuffer for the same amountof total assetsmakesthe financial system lesssafe.In addition, there isa concern that demanding more equitycapital andreducingleverageamong thelargest firms wouldinhibit thegrowthofcredit and the economy.This statement hasan implied presumptionthat the Basel weightingschemeismore growthfriendlythan a simpler, stronger leverageratio.However,having a sufficient capital buffer allowsbanks to absorbunexpected losses.Thisservestomoderate thebusinesscycleandthedeclineinlendingthatotherwiseoccursduring contractions.If the Basel risk-weight schemesare incorrect, whichthey oftenhavebeen, this toocould inhibit loangrowth, asit encouragesinvestmentsinother more favorably, but incorrectly, weightedassets.Basel systematically encouragesinvestmentsin sectorspre-assignedlowerweights-- for example, mortgages, sovereign debt, and derivatives-- and discouragesloanstoassetsassignedhigher weights-- commercialand industrial loans.We may have inadvertently created a system that discourages the veryloan growth we seek, and instead turned our financial system into onethat rewardsitselfmore than it supportseconomicactivity.If risk weightscould be assigned that anticipateand calibraterisks withperfect foresight, adjusted on a daily basis,then perhapsrisk-weightedcapital standardswouldbe the preferred method for determininghow todeploycapital.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  41. 41. P a g e | 41However,they cannot.Tobelieve theycan isa fallacythat putsthe entire economic system atrisk.Changing the DebateThetangibleleverageratiois a superior alternativeto risk-weightingschemesthat haveproven tobean illusionof precisionand insufficient indefiningadequatecapital.Theeffect of relying on suchmeasureshasbeen toweakenthe financialsystem and misallocate resources.Theleverageratio deservesseriousconsiderationasthe principal tool injudgingthe capital strength of financial firms.TheBasel discussion wouldbe well served to focuson the appropriatelevelsof tangiblecapitalfor bankingfirmstohold and theright transitionperiod to achievetheselevels.Finally, weshould not accept even comfortingerrorsof logic whichsuggest that BaselIII requirementswill createstronger capital than thoseof Basel II, whichfailed.Instead, past industryperformanceand mountingacademicand otherevidencesuggest that wewouldbebest served to focuson a strongleverageratiostandard in judginga firm and theindustrys financialstrength.No bank capital program is perfect.Our responsibility asregulatorsand deposit insurersis tochoosethebestavailablemeasure that will contributeto financial stability.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  42. 42. P a g e | 42Note:ThomasM. Hoenig wasconfirmedbytheSenateasViceChairman oftheFederal Deposit InsuranceCorporation on Nov. 15, 2012.He joinedtheFDIC onApril 16, 2012,asa member of the FDIC Board ofDirectorsfor a six-year term.He isamember of theexecutiveboard of theInternationalAssociationofDeposit Insurers.Prior toservingon the FDIC board, Mr. Hoenig wasthe President of theFederal Reserve Bank of KansasCity and a member of the FederalReserveSystems Federal Open MarketCommittee from 1991to2011. Mr.Hoenig waswiththe Federal Reserve for 38years, beginningasaneconomistand then asa senior officer in banking supervision during theU.S. banking crisisof the 1980s.In 1986, he led theKansasCity Federal Reserve BanksDivision of BankSupervisionand Structure, directingtheoversight of more than 1,000banksand bank holdingcompanies withassetsranging from lessthan$100million to $20billion.He became President of theKansasCityFederal Reserve Bank onOctober 1,1991.Mr. Hoenig is a nativeof Fort Madison, Iowa. He receiveda doctorateineconomicsfrom IowaStateUniversity.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  43. 43. P a g e | 43―A comfortable position for German banks‖TheBundesbank currentlyseesno signswhatsoeverof a credit shortage or a tighteningoflendingstandardsin Germany.―Germanbanksare in a pretty comfortableposition at themoment.By and large, neither their liquiditynor their capital situation are causingthem any problems,‖DeputyPresident Sabine Lautenschlägersaidearlierthisweek at the InternationalerClub Frankfurter Wirtschaftjournalisten(International club of Frankfurt-basedbusinessjournalists).What is more, bankswerebenefiting from their strongindustrial andSME customer base.―Germanbanksfurther improved their resiliencein 2012,‖ MsLautenschlägerexplained, referring to theresultsof the Basel III impactstudypublished sometimeago.This study looked at how the sampleof bankswouldhave faredif BaselIII had already been fullyphased in asat thecut-off date.Theimpact studyrevealsthat the capitalshortfall of the eight largeGermanbankshasdecreasedby€15billion, or30%, ascomparedwiththelast cut-off date.Another gratifying outcome of thestudyis that, on average, the 33participatingGerman institutionsalreadymeet the future minimum ratioof 4.5% for core tier 1capital.SabineLautenschlägercommented that this trend had continued ―withthesameintensity‖ in the second half of 2012,withbanks raisingcapitalin thetensof billions.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  44. 44. P a g e | 44Challengesfacing banksin the futureThe ability of banks to carry on generating sufficient income on a highercost basewasa key factor in deciding whether their businessmodelsweresustainableover thelongrun, MsLautenschlägerexplained.Persistentlylow interestratesand the fierce competition among banksweredragging on earnings.―Theweakearningstrend will presenta major challengefor banksandsupervisorsalike,‖ the DeputyPresident added.Ms Lautenschlägerstruck a positivetone over the scheduledglobalimplementationof BaselIII and said sheexpectedtheother majorfinancial centresto followsuit.―Onlythen will Basel III be able to fulfil its protectivefunction andprovidea suitableresponsetothe 2008financial crisis.‖Appropriate supervisionand resolutionmechanismsfor bankswithaninternational focusnecessitatedgreater coordination and improvedcooperation.Specialarrangementsat thenationallevel wouldbeabreedinggroundforrisksto financial stability, MsLautenschlägerremarked.Banking union – questions still unansweredSabineLautenschlägersaid that many questionsstill remainedunanswered over theestablishment of thesingleEuropean supervisorymechanism.Most notably, a clear set of rulesgoverning the cooperation betweennational supervisorsand theECB wouldhave to be drawnup.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  45. 45. P a g e | 45Developing a common approach to supervision, building up appropriatereporting procedures and recruiting staff were tasks that would certainlykeepsupervisorsbusyover thenext few months.But, MsLautenschläger added, there wasonethingthat supervisorscould not change, that beingthe legal basis.Alegal framework for bank supervisorsthat allowedmonetary policy tobestrictlysegregated from supervisory dutieswassomethingthat onlyEU governmentsand parliamentscould create.―This is a processthat will probablytake years. But I believe the effortwill be worthwhile,‖ shetold journalists.Ms Lautenschlägeralsospokeout in favour of a singleEuropeanresolutionmechanism.It did not make senseto overseebanksat the European level whileleavingtheir resolution to national authorities.Asingleresolution mechanism should allowa largebank toberestructuredand resolved without seriously jeopardisingfinancialstability, she added.At the same time, it had tobe guaranteed that anyresultinglosseswouldbefairlydistributedaccordingto sourceand responsibility.―If investorsreceivea premium for risk, theyshould alsobe prepared tobear the risk itself.Taxpayers should be left out of the equation altogether, wherepossible.‖Legacyrisks should not be redistributedLegacyrisks– that is, financial risksthat aroseat national banks on thewatchof national supervisors– should, however, be borneby thoseBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  46. 46. P a g e | 46responsiblefor them and not be mutualised, MsLautenschläger pointedout.And there wasalsothe question of whetherthe lossesresultingfromfuturerisks should beshouldered solely at the European level. Afterall, banks‘balancesheetsalsoreflecteda largenumber of nationalfactorssuch astaxesor economic policymeasures.―As long aseconomicand fiscalpoliciesare not coordinated, it mightmake sensefor liabilityrisksto be divided betweenthe national andEuropean levels,‖ sheconcluded.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  47. 47. P a g e | 47Remarks by the SuperintendentJulie Dickson,Office of the Superintendent ofFinancial Institutions Canada (OSFI)tothe 2013Financial ServicesInvitational Forum, Cambridge, OntarioIntroductionOSFI recentlyreleaseditsPlan and Prioritiesfor 2013-2016,and tonight Iam goingtohighlight and discussa few of our key prioritiesand whywechosethem: specificallyour focuson theincreasedthreat of cyber attacks;lowinterestrates (includingreal estatelending);and governanceand riskappetite.Cyber securityAt OSFI, cyber risk hasbecome one of our top concerns.Agrowingnumber of NorthAmerican bankshavebeen hit withdenial ofserviceattacks,in some casescausing websitesto godown, therebycreatingproblemsfor customerstrying todo everyday transactions.Denial of service attacksare costlyto defend against and a form ofharassment and inconvenience.But more importantly, theycan be a prelude tomore serioustypes ofcyber attacks.Our concern is growingdue to therapidevolution of cyber attacksintermsof frequency, firepowerand targets.This driveshome theneed for all financial institutionsto focuson thisthreat.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  48. 48. P a g e | 48At OSFI, wehavesignificantlyincreased our supervisoryresourcesin theOp-riskarea, and have launcheda number of initiatives,suchasconducting in-depthreviewsof institutions‘current cyber protectionpractices.There aremany stakeholdersinvolved in thiseffort and a clear focus onthisissueby all will serveuswell.Low interest ratesWhenlowinterest ratesfirstappeared, theimpactwasmostnoticeableonpension plansand insurancecompanies.But asustainedlowinterestrateenvironment (especiallycombinedwithaflat yield curve) affectsthebankingsector aswell.Banks loseflexibilityto adjustthe customer deposit rate down, henceintroducinga deposit rate floor.Net interest marginsare squeezed, negativelyaffectingrevenues.Combined withtepid economicgrowth, reduced demand for loansisfurther affectingbanks.Thisenvironment can provideincentivesfor bankstogrowtheir earningsasset baseby trying to gain market share(a zero sum game), increasefeeincome activities, reduce expenses,enter new markets, and increasetheproportion of higher-yielding assets(both in the lendingand investmentportfolios).Productsand businessesthat are over-reliant on lowfinancing coststendtogrow.And borrowersare strongly incentedto increaseleverage.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  49. 49. P a g e | 49For all thesereasonswearevery focusedon how banks are reactingtocurrent conditions.We are alsocognizant that the longer thelowinterest rate environmentpersists,themore interest rate risk can be built up.No one can predict when, or how fast, rateswill start to climb (or indeed,whethertheywill fall further).Yet dependenceon low interestratescan become significant, meaningthat transition to higher ratescould be very painful.Thereal estatelendingmarket hasbeen a big area of focusfor OSFI,becauseof thesignificant incentivesfor consumers to borrowand forbanksto maintain revenues, thesize of mortgage lendingportfolios, theconcernsabout some marketsbeingovervalued, and thepossibilitythatcustomers‘debt serviceability could be masked bylow interest rates.Our workhasinvolved major reviewsof bank lendingportfolios, whichwasone factor leadingto the issuanceof GuidelineB-20.GuidelineB-20includesa set of best practicesfor prudent residentialmortgagelending, in all economic conditions.Our guideline, aswell asthestepstakenby the Ministerof Financetoplacerestrictionson mortgage insurance, have ledtosome welcomechangesin the market: slowergrowthin household credit, and a morebalancedpicture overall.Wearewatchingthisveryclosely,and it istooearlytosaywhetherthejobin this area is done.One other area where risks can hide isin the modelsthat are used bysome banks to determine the amount of capital they have to hold formortgageloans.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  50. 50. P a g e | 50Accordingly, OSFI hasbeen increasingscrutinyin this area.Investorsarealsofocusedon this, and a number of them haveaskedquestionsabout thecalculationof risk weights,given the limitedamountof information that the bankspublicly disclosein this regard.In Canada, the averagemodel risk weightscalculated by banksforuninsured mortgagesare in themid-teens.Thelack of information availableon risk weightsis somethingwearehopingtoaddress.There will be enhanced disclosurebydomestic systemicallyimportantbanksin thecoming year, pursuant torecommendationsfrom theEnhanced DisclosureTaskForce, whichwascreatedat therequestof theFinancial Stability Board.Someothercountriesareexperiencingfrothyrealestatemarketsandhaveintroduced floorson risk weights— sometimesaround 15per cent.Giventhat inCanadatheuninsuredmortgageswouldtendtobeofhigherqualitythan the averageloanportfolio in other countries (becauseuninsured loansin Canada have maximum loan-to-valueratiosof 80percent), weare generallycomfortable withthe capital being held by banksusingmodels.OSFI isalsoawarethat floorscan become safeharboursand lead banksand supervisorstopaylessattention tothe ―appropriate‖ risk weight,especiallywhenit should be well abovethefloor for a particular bank.Thus, our focus will continuetobe on scrutinizingmodels currentlyinuse.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  51. 51. P a g e | 51Risk appetiteOSFI introduced a new corporate governanceguideline in 2012,and in2013wewill be lookingat how well it isbeingimplemented, withaparticular focuson risk appetite.It is at timeslike thesewhena regulator getsa good feel for whetherabank reallyhasa solid risk appetiteframework.What I mean is that institutionsare being incented to move further alongtheriskcurvedue tomore gradual economic growth, and coolingin themortgagemarket.Now iswhenproductscan be developed to appeal toyield-consciousinvestors.Now iswhenconditionsmight alsomaketheenvironment look saferthanit is — volatilityindicatorshave generallybeen at very lowlevels, similartothosejust beforethe 2008financial crisis.Now iswhenlowinterestratesandthepsychologyaroundthem– i.e. thatthereislittlerisk,alongwiththemisconception that ratescannot gobackup in rapid fashion – can lead both borrowersand lenderstooverlookcertainrisks.And the relativecurrent calm in Europe — despite the flare-upin Cyprusin March— can causesome to become complacent about therisks andthechallengesthat lieahead.Indeed, prudent global bank supervisors are testing the impact of a rapidincreasein rates(while rates could go down even further, there is not a lotmore room tomove in that direction).Bank supervisorsare testingtheimpact of a rapid risein rates,notbecausepeople think thiswill happen; rather, it is becauseof the need tobeprepared for all contingencies.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  52. 52. P a g e | 52Such testing alsoforcessupervisorsto think about the reasonsfor anysuch scenarios:If rates rise as growth resumes, the outcome is usually better than if ratesrise due to a sudden aversion to risk or serious concern about the future –whichcould be manifestedasan increasein global risk premiums.An institution‘srisk appetiteframeworkshould enableitsboard andmanagement todetermine just howmuch risk an institutioniswillingtotolerate— not only in termsof thebusinesstheyput on their books, butalsoin termsof their tolerancefor gettingcloseto any regulatoryrequirementsor limits,and even their tolerance for behavioursthat canlead to big losses,such asill-equippedriskmanagement groupsandfailure to imposean effective―three linesof defense‖ model.In the ―three linesof defensemodel management is the first lineofdefense,the variouscontrolsand oversight functions(such asriskmanagement) are thesecond lineof defense,and internal audit isthethird lineof defense.Thenatural geneticsof a bank are sometimestogive the businesslinesconsiderable leewayand tosee risk management and internal audit asstandingin the wayof progress.This ―wiringreflectsthe fact that the businessiswherethemoney ismade– at least in theshort term.Abank cannot consistentlymake money without regard for sound riskmanagement.So, structuresand processesneed to be built asa counterbalance,and toreinforcea broader and longer perspective.Riskappetitestatementsare part of the new suite of toolstoaid inensuring that the bank management and theboardhave a 100per centBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  53. 53. P a g e | 53agreement on the balanceof power in the institutionand theoverall riskstance.Riskappetitestatementswill be particularlypowerful in the future asbanksexperienceunexpectedlossesand surprises.Thetool should help ensure that management isheld accountableandthat boardshaveplayed their rolein havingset out clear expectationsandaccountabilities.ConclusionOSFI‘splanandprioritiesattempt toconveythemostimportant issuesasweseethem, and indicatewheresignificant time will be spent by banksupervisors.Theeffectsof low interest rateshave set in motion sector-shapingforcestowhichwemust pay attention.Cyber risk isanotherissue: Left unchecked, it could seriouslyimpactbankingoperations.Effectivegovernanceand risk appetitestatementswill help banksdetermineacceptableand unacceptablerisk exposuresand to buildsystemsand processestokeep them on track, sothat Canadianscancontinueto enjoy a safeand sound financial system.Thank you.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  54. 54. P a g e | 54Dear Member,Lifeis becoming more complex for risk managers.We must have a―forward-lookingperspective‖, remember?We have all thesenew lawsand regulations…… but wealsohave rules, proposalsand reportstoconsider.Have you everdiscoveredthecommon elementsof thevariousinitiatives,includingthe Volcker rule in the United States,the proposalsof theVickers Commission for the United Kingdom, the LiikanenReport totheEuropean Commission?LeonardoGambacorta andAdrian van Rixtel from the MonetaryandEconomicDepartment of the BISwill help ustoday to seethecommonelementsand the differences!This is a great analysis! We read:TheVolcker rule isnarrow in scope but otherwisequitestrict.It is narrow in that it seekstocarve out onlyproprietarytrading whileallowingmarket-makingactivitieson behalf of customers.Moreover,it hasseveralexemptions, includingfortransactionsinspecificinstruments,such asUS Treasuryand agencysecurities.It is strict in that it forbids the coexistenceof such tradingactivitiesandother banking activitiesin different subsidiarieswithin thesame group.It similarlypreventsinvestmentsin, and sponsorship of, entitiesthatcould expose institutionsto equivalent risks,such ashedge fundsandprivateequityfunds.That said, it imposesvery few additionalrestrictionson thetransactionsof banking organisationswith other financial firmsmore generally(egsuch asthrough constraintson lendingor funding among them).Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  55. 55. P a g e | 55BiiiCPA)However,it is worthrememberingthat the current US legislationdoesconstrain theactivitiesof depositoryinstitutions.TheLiikanenReport proposalsaresomewhat broader in scope but lessstrict.Theyare broader becausetheyseek to carve out both proprietarytradingand market-making, without drawinga distinctionbetweenthe two.Theyare lessstrict becausetheyallowtheseactivitiestocoexist withotherbankingbusinesswithinthesamegroup aslongasthesearecarriedout in separate subsidiaries.Theproposalslimit contagion withinthegroup by requiring, inparticular, that the subsidiaries be self-sufficient in termsof capital andliquidityand that transactionsbetweenthe legal entitiestakeplace onmarket terms.Just like theVolcker rule, theproposalsdonot envisagesignificantrestrictionsbetweentheprotected bankingunit and other financialfirms, except that theyrequire the separation of exposuresto entitiessuchashedge fundsand special investment vehicles(SIVs) in the tradingentity.TheVickersCommission proposalsare evenbroader in scope but have amore articulatedapproachtostrictness.BIS Working Papers, No 412Structural bank regulation initiatives:approachesand implicationsLeonardoGambacorta andAdrian vanRixtel, Monetaryand Economic DepartmentBasel iii ComplianceProfessionalsAssociation (www.basel-iii-association.com
  56. 56. P a g e | 56IntroductionIn responseto the global financial crisis, several advanced economieshaveeither adopted or are consideringstructural bank regulationmeasures.Thecommon element of the variousinitiatives,includingthe ―Volckerrule‖ in theUnitedStates, the proposalsof the VickersCommission fortheUnited Kingdom, the Liikanen Report totheEuropean Commissionanddraft legislationin Franceand Germany, isamandatoryseparationofcommercial bankingfrom certain securitiesmarketsactivities.Theproposalsmark a paradigm shift.Sincethe 1970s,in parallelwiththe deregulationof financial markets,restrictionson banks‘businesslineshave been relaxed.There wasa broad consensusthat bankswhichoffer a full rangeoffinancial servicescan providethe largest economicbenefitsin a rapidlygrowingglobal economy.Diversificationof businesslines,innovationsinriskmanagement, marketbased pricing of risksand market disciplinewereseen aseffectivesafeguardsagainst financial risksassociatedwith therapid expansion oflargeuniversal banks.The financial crisis has triggered a reassessment of the economic costsand benefits of universal banks‘ involvement in proprietary trading andother securitiesmarketsactivities.With hindsight, manylargeuniversal banksshiftedtoomanyresourcestotradingbooks, supportedby cheap funding.Thecomplexityof many banks weakenedmarket discipline, whiletheirinterconnectednessincreasedsystemic risk, contributingto contagionwithinand acrossfirms.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  57. 57. P a g e | 57While thecrisishasshowntheneed to strengthenmarket-basedpricing ofriskandmarketdiscipline,theheavyburdenofbank lossesimposedontaxpayers hasraised questionsabout theseparationof certain bankingactivities.Theproposedchangesdonot goasfar asthepreviousstrict separationofcommercial from investment banking that existed in some jurisdictions,such asthe United States.But for many countries, notablya number of continental European ones,restrictionson universalbanking wouldbe new.Anumber of questionsarise.How effectivecan thesemeasuresbe in improving financial systemsoundness?What can their impact be on banks‘profitabilityand businessmodels,both nationallyand internationally?This paper explorestheseissues.Section 2considersin more detail the rationalebehind themeasuresaswell astheir similaritiesand differences.Section 3 providesa basisfor evaluatingtheir effectivenessin promotingfinancial stability.Section 4 discussestheir implicationsfor banks‘businessmodels andprofitability.Thelast sectionconcludes.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  58. 58. P a g e | 582. The initiatives: basic rationale and featuresThebasic rationalefor thestructural measuresis toinsulate certain typesof financial activitiesregarded asespeciallyimportant for therealeconomy,or significant on consumer/depositorprotectiongrounds,fromtherisksthat emanate from potentiallyriskier but lessimportantactivities.The line is generally drawn somewhere between ―commercial‖ and―investment‖ banking businesses, restricting the universal bankingmodel.Such a separation can, in principle, help in several ways.First, and mostdirectly, it can shield the institutionscarrying out theprotected activitiesfrom lossesincurredelsewhere.Second, it can prevent any subsidiesthat support the protectedactivities(egcentral bank lendingfacilitiesand deposit guarantee schemes) fromloweringthecost of risk-takingand encouraging moral hazard in otherbusinesslines.Third, it can reducethe complexityand possiblysize of bankingorganisations,making them easier tomanage, more transparent tooutsidestakeholdersand easier toresolve; this in turn could improve riskmanagement, contain moral hazard and strengthenmarket discipline.Fourth, it can prevent the aggressive risk culture of the riskier activitiesfrom infecting that of more traditional banking business, thus reducingthescope for conflictsof interest.In addition, some observershave noted that smallerinstitutionswouldreducethe risk of regulatory capture.All thesemechanismswouldalsohelp tolimit taxpayers‘exposure tofinancial sector losses.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  59. 59. P a g e | 59Beyond this basic similarity, structural reform initiatives differ in scope(where they draw the separation line) and strictness (how thick that lineis);TheVolcker rule isnarrow in scope but otherwisequitestrict.It is narrow in that it seekstocarve out onlyproprietarytrading whileallowingmarket-makingactivitieson behalf of customers.Moreover,it hasseveralexemptions, includingfortransactionsinspecificinstruments,such asUS Treasuryand agencysecurities.It is strict in that it forbids the coexistenceof such trading activitiesandother banking activitiesin different subsidiarieswithin thesame group.It similarlypreventsinvestmentsin, and sponsorship of, entitiesthatcould expose institutionsto equivalent risks,such ashedgefundsandprivateequityfunds.That said, it imposesvery few additionalrestrictionson thetransactionsof banking organisationswith other financial firmsmore generally(egsuch asthrough constraintson lendingor funding among them).However,it is worthrememberingthat the current US legislationdoesconstrain theactivitiesof depositoryinstitutions.TheLiikanenReport proposalsaresomewhat broader in scope but lessstrict.Theyare broader becausetheyseek to carve out both proprietarytradingand market-making, without drawinga distinctionbetweenthe two.Theyare lessstrict becausetheyallowtheseactivitiestocoexist withotherbankingbusinesswithinthesamegroup aslongasthesearecarriedout in separate subsidiaries.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  60. 60. P a g e | 60Theproposalslimit contagion withinthegroup by requiring, inparticular, that the subsidiaries be self-sufficient in termsof capital andliquidityand that transactionsbetweenthe legal entitiestakeplace onmarket terms.Just like theVolcker rule, theproposalsdo not envisagesignificantrestrictionsbetweentheprotected bankingunit and other financial firms,except that theyrequire the separation of exposuresto entitiessuchashedgefundsand special investment vehicles(SIVs) in thetradingentity.TheVickersCommission proposalsare evenbroader in scope but have amore articulatedapproachtostrictness.Theyare broader in that theyexcludea larger set of banking businessfrom theprotectedentity, includingalsosecuritiesunderwritingandsecondarymarket purchasesof loansand other financial instruments.Avery narrow set of retail banking businessmust be withintheprotectedentity(retail deposit-taking, overdraftstoindividualsand loanstosmalland medium-sizedenterprises(SMEs));and another set may beconductedwithin it (egsomeother formsof retail andcorporate banking,includingancillaryoperationsto hedgerisks tosupport them).Theapproach to strictnessismore articulatedbecauseit involvesbothintragroup and inter-firm restrictions(the―ring fence‖).As in the LiikanenReport, protected activitiescan coexistwithothersinseparatesubsidiarieswithinthe same group but subject tointragroupconstraintsthat aresomewhat tighter, includingon the size of thelinkages.Moreover,a seriesof restrictionslimit the extent to whichthe bankingunit within the ring fencecan interact with other financial sector firms.An in-depthexploration of theeconomicunderpinningsof thereforms is provided in Vickers(2012).Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  61. 61. P a g e | 61Recent French and German reform proposalscan be seen asadaptationsof the Liikanenproposal.Thenew Frenchbankinglaw proposal adoptsthesubsidiarisationmodel, but allowsthedeposit-takinginstitutionto carry out moreactivities, includingmarket-makingwithin limits.Anew draft law on the separation of retail and some investment bankingactivitiessubmittedtothe German Parliament considersseparationofretail banking if assetsdevoted to proprietary or high frequencytradingand hedgefund financingoperationsare relatively largein relationtothebanks‘balancesheet.3. Implications for financial stability and systemic riskDothevariousstructural regulatoryinitiativesstrengthen financialstability?Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  62. 62. P a g e | 62Themechanismslistedabove have intuitiveappeal.The question, though, is how far the various measures would be effectivein realising the hoped-for benefitsand whether theymay have unintendedsideeffects.While it is difficult toprovidean answer,it is possibletolayout therelevant considerations.From a financial stability perspective, a preconditionfor theinitiativestobe helpful is that banks whichcombinecommercial and securitiesbusinessarelesssafeorthat their failureismorecostlytothecommunity.Theevidencesuggeststhat the costsof failure of universal bankscan belarger, sinceuniversal banking encouragessizeand complexity.Theevidenceon theprobabilityof failureis much more indirect andmixedbut, on balance, pointsin a similar direction.For instance, a general conclusion is that growingrelianceonnon-interestincome – a very rough proxy for more investmentbanking-like activities– hasnot resulted in lowerearningsvolatilityor adeclinein bank systematic risk, asderived from stock market returns.Similarly, Box 1providestentativeevidencethatprofitsofsomewhatmorediversified banksarehigher, but alsomore volatile.Moreover, risk diversification benefits appear to be mostly restricted tocertain ranges of income sources or to geographical and loan portfoliodiversification.Against thisbackdrop, a number of questions about thedesign ofstructural regulationarise.Afirst question concernswheretheseparation lineisdrawn.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  63. 63. P a g e | 63Here, the philosophybehind theproposalsis quitedifferent.TheLiikanenReport optsfor combining proprietarytradingandmarket-making activities on the grounds that the line between the two istoo fuzzy and hard to enforce – a controversial issue with the Volcker rulein theUnited States.And the VickersReport takesa verynarrow view of the typesof activitythat needtobeprotectedonthegroundsthat disruptionstherecanhavealargeimpact on economic activity.Moreover,while theVickers Report arguesfor more stringent capitalrequirementsfor theprotected activities,on importancegrounds, theLiikanenReport arguesfor potentiallymorestringent onesforthetradingbusiness(and possiblyfor real-estaterelated lending), on risk grounds.It is not unequivocallyclearthat the concentrationof tradingactivities inseparateentitieswill enhancefinancial stability.Thesefirmsmay have lessstable, wholesalemarket-basedfundingstructures,while still beinghighly interconnectedwithother parts of theglobal financial system.This could give rise toconsiderablecontagion risk, asdemonstrated bytherepercussionsof the failure of Lehman Brothers on global bankfundingmarkets.Asecond question concernsthethicknessof the line.How effectiveisit in insulatingthe protected partsof the bankingbusiness?Onetypical criticism of allowingthe activitiesto coexist within the samegroup is that, especiallyat timesof stress,the linewill provenotsufficientlystrong asreputational considerationsloom large.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  64. 64. P a g e | 64In turn, any expectation that the linewill turn out tobe ineffectivewouldweakenmarket discipline.Moreover,onlythe Vickers Report proposesmajor additional restrictionson theinteractionsbetweenthe protectedbanking unitsand the rest ofthefinancial system.Their effectivenessisyet tobe tested.Athird questionconcernsthe possibilityof sidesteppingthelinealtogether.Theworryis that risky activitiescould migrate outsidethe regulatoryperimeter.In fact, one reason whythe LiikanenReport optsfor subsidiarisationrather than full separationis tolimit thisrisk.Migrationwouldbe a worryif thoseactivitiesproved to be systemic innature.All thisputsa premium on effectiveresolutionmechanisms.Whilestructural separation may help resolvability, the benefitsof theproposalsdohingeon the adequacyof the resolutionschemesin place.TheLiikanenReport, for instance, suggestsseveral complementarystepsin this area.Effectiveresolution schemesare especiallyimportant if, contrary toexpectations,the businesslinesleft outsidethe protectiveumbrellaresultin systemic disruptions.In this case, the pressure to ―bail out‖ the legal entities involved could bevery strong: this would put taxpayers‘money on the line ex post and raisemoral hazard concernsex ante.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  65. 65. P a g e | 65Yet anotherquestionconcernstheinteractionbetweennationalstructuralbank regulation and international bankingregulation, such asBasel III.Thetwotypes of regulation differ in approach and scope.Thelattertakesbanks‘businessmodelsasgivenand imposescapital andliquidityrequirementsthat depend on theriskiness of a bankinggroup‘sbusiness.Theformer imposesconstraintson specific activities and typesofbusiness.From this angle, the two approachescan be seen ascomplementary.Indeed, certain aspectsof structural regulation– restrictionson leveragefor ring-fenced institutions– may reinforceelementsof Basel III.At the same time, there may be challenges.Onerisk, already alluded to, is that banksmay shift activitiesoutsidetheperimeter of consolidated regulation in responseto structural regulation.Another riskisthatstructuralregulation, especiallyif nationalapproachesdiffer, will createbusinessmodels that are difficult to supervise.For example, resolution strategiesmay berather complextodesign forgloballyoperatingbanksthat have tofaceincreasingheterogeneity inpermittedbusinessmodelsat thenational level.Finally, structural regulation may lead to different capital and liquidityrequirementsfor thecore banking and tradingentitieswithin a singlebankinggroup.Although thismay be intended, in practiceit hasimplicationsforregulatorystandardsapplied at the consolidatedlevel.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  66. 66. P a g e | 66Somenew evidence on risk diversification and economies ofscopeThis box presentssome new preliminaryevidenceon the impact ofcombining different businesslineson therisk return profile of bankingorganisations.Anovel aspect is that the analysis allowsfor thepossibilityof non-lineareffects,sothat the benefitsmay exist only withincertain ranges.Theevidenceis basedon a sample of 108 international diversifiedbanks.Product differentiationis proxied by theratio of non-interest income(traderevenues, feesand commissionsfor services) to total income.On balance, theevidenceindicatesthat benefitsdoaccrueup to a certaindegreeof diversificationin termsof return on equity(ROE).However,bank profitabilitytendstobe more volatile for more diversifiedbanks(for details of the econometric analysis, seeAnnex B).The twolinesin the upper part of the graph below represent the result of apanel regression of bank ROE on the ratio of non-interest to total income(diversificationratio) and itssquare.Theregressionincludesfixed effectsfor each bank, aswell asa countryyear interactionterm tocontrol for idiosyncratic and macro factors.Thecurvesare drawnon thebasis of thetwoestimatedparameters.Bluereferstothepre-crisisperiod (2000–07),whileredindicatesthecrisisperiod (2008–11).Thesymbolsindicateaveragevaluesobtainedby grouping banksbyjurisdictionin the twosub-periods.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  67. 67. P a g e | 67Theresultsindicatethat revenue diversificationdoesincreaseROE, butonlyup toa point, after whichROE declines.While the optimal mix may have shiftedsomewhat towardsa smallershareof non-interest income in the post-crisisperiod, the resultsof thisexercisesuggest that economies of scope do exist onlyup toa certaindegreeof product diversification.Thegreenlinein thelowerpanel representstheresult of across-sectionalregressionof banks‘coefficientsof variation of ROE – a proxy for risk –on thediversificationratio, itssquare and country fixed effects.Thegreen symbolsindicateaveragevaluesobtained by groupingbanksbyjurisdictionover the period2000–11.Theeconometric analysisfindsthat ROE volatilityalsoincreases,up toapoint, with revenue diversification, after whichit declinesagainBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  68. 68. P a g e | 68Toread this excellent paper:http:/ / www.bis.org/ publ/ work412.pdfBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  69. 69. P a g e | 69Challengesfor bankingregulation and supervision inthe monetary unionSpeechby Dr JensWeidmann,President of the DeutscheBundesbank, at theDeutscherSparkassentag2013,Dresden.1. IntroductionMr Fahrenschon, Mr Genscher, Mr Steinbrück, Ladies and GentlemenIt givesme great pleasuretospeak toyou today at the Sparkassentag2013.For more than three years now,the financial, economic and sovereigndebt crisishasbeen thedominant topic in the European monetary unionand, at thesame time, itsbiggest test.Dated from the outbreak of the crisison the US real estatemarket in thesummer of 2007, this is already thefifth year in whichwehave been incrisismode.That said, Germanyis still in relatively good shape – despiteundergoingbyfar itsworstpostwarslump in 2009and despitebeing one of thefirstcountriestobe affectedby the spillover from thecrisis on theUS realestatemarket.Germanyhashad to useconsiderable financial resourcestostabilisethefinancial system.Savingsbanks,too, felt the effectsof thecrisis– although theydid sodirectlyonly in a few cases;mostly it wasthrough their investments.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  70. 70. P a g e | 70Even so, savingsbanks had a stabilisingeffect during the crisis.Theywerea robust and reliablesource of lending.And theystrengthenedtheir capital base.That is a major preconditionfor overcoming the challengesthat areonthehorizon – such assustained pressure on marginsand increased riskprovisioningfor thenext economicdownturn, whichis bound to come atsometime.Thevariousaspectsof the crisis– first, onlya financial crisis, then aneconomiccrisisand, finally, the sovereign debt crisis– whichis still withus– have prompted a largenumber of discussions,changesandupheavals.This appliesto the role of central banksand tothe expectationof whatcentral bankscan and should– or cannot and should not – doto helpresolve the crisis.It alsoapplies tothefinancial system and thewayit is perceivedby thepublic at large.Mr Steinbrück will undoubtedlyexplainin more detail soon how hewishesto―tamethefinancial markets‖.Overcomingthe crisisrequires considerableeffortsin many areas.But, asimportant asthe issuesof government debt, monetary policy andcompetitivenessare, I wouldnow like toturn my attention tobankingregulation and supervision.2. Reform of financial market regulation – objectives andmeasuresBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  71. 71. P a g e | 71Roughlyten yearsago, theprincipal issuein banking regulationwasBasel II and the regulatorychangesit brought about.At thetime, onlyveryfewofthoseinvolvedcouldhaveguessedthat,justashort while later, thepolitical agendawouldbe dominated byprobablythemost all-encompassingchangesever tothe regulatoryframework of thefinancial marketsin theshape of Basel III and further regulatoryinitiatives– and all starting off with an awe-inspiringzeal for reform.BaselII took five years from thefirst consultation paper up to apolicyagreement on thenewprinciples.Basel III onlyneeded oneyear for that.Thenew regulatorymeasures,whicharedesigned to havea longer-termimpact, are focused lesson the acutemanagement of the crisis and aregeared more to preventingnew crisesfrom emerging in the future in thefirst place.The changesinitiated since the G20 meeting in Washington in November2008, have the key objective of making financial systems more stable andthereforemore resistant toshocks.Furthermore, the aim is that the taxpayer nolonger hasto step in tocorrectdifficultiesin the financial system.And it wasalsoimperativeto ensure that the financial system hasa clearvalueadded for theeconomy asa whole.There is good empirical evidencethat growthin the financial sectoralsostrengthensa country‘soverall economicgrowth.On the other hand, studiesby the IMF indicatethat, along withincreasingfinancial sector growth, thiseffect becomesweaker and mighteven gointoreverse.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  72. 72. P a g e | 72It is not necessary to agree with Paul Volcker‘s deliberately provocativelyworded opinion that there hasn‘t been a useful innovation in the financialindustry since the invention of the ATM, and derivativesdo not have to beregarded asfinancial weaponsof massdestruction.Nevertheless, if the financial sector is too large, there is evidently anincrease in the risks to stability and the percentage of less beneficialtransactions.Cyprus is undoubtedly a telling example and provides an urgent warningthat the supervisory and regulatory requirements have to keep pace withthesize of thefinancial system relativetoeconomicpower.Astableand efficient financial system that enhancesgrowthandprosperitycan be achieved onlywitha wholepackageof measures.With this in mind, theG20, at their meetingin Washington at the end of2008,defined variousfields in whichtherewasa particular need foraction.Let me outlinea few major points.•Risksand mutual interdependencies in the financial system have tobemore transparent.•Banksshouldhold more and higher-qualitycapital soasto bettershoulder lossesthemselves.•Systemicallyimportant financial institutions– the hubsof thefinancialsystem – must meet special, stricter requirements,for example, withregard to capital adequacyand risk management.•In the event of difficulties,it must alsobe possibleto resolve orrestructure large, international and particularlyinterconnectedbanks.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  73. 73. P a g e | 73•Areasof thefinancialsystem whichhavehithertobeensubjecttono– orvery little– regulation, but which perform taskssimilar tothoseof banksand are linked directlyor indirectlytothebanking system, should bebetter regulated – theshadow banking system and derivativestradingarekey issueshere.At this point, I wouldlike to refer toa fundamental point that isparticularlyimportant tome.Theconnectinglink betweenthestated aims and the meansof achievingthem is a strengtheningof the principleof liability.In hisPrinciplesof EconomicPolicy, Walter Eucken declaredtheprincipleof liability tobe a constituent principleof the market economy,referringto theestablishedlegal principlethat ―thosewhobenefit shouldalsobear thecosts‖.Ensuring that playersin the financial system have to, and areable to,better bear lossesand risksthemselves in future will make thefinancialsystem more stableand more focused on transactionsthat are beneficialtothe economy asa wholeand make thetaxpayer the last rather thanthefirst lineof defenceagain in the event of crises.Liabilityis thereforea steptowardsovercoming thecrisis and not anegative concept – quitethe opposite!It isthecounterpart ofthefreedomtotakedecisionsasanentrepreneurorinvestorin a self-determined manner.Freedom of choiceand liabilitythereforebelong together asa conceptualpair or twosidesof the same coin.That appliesincidentallyto the financial system just like it doestothemember stateswithinthe monetary union.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  74. 74. P a g e | 74Someof the measurestaken during the crisisunderminetheprincipleofliability rather than strengtheningit.It is against that background that weshould alsoassessthenewlyresurfaced debatein Europeon theright coursein fiscal policy.Of course,a major roleis played by thepoliticalacceptabilityof thereform coursethat hasbeen embarked on.At least withregardtotheprogrammecountries,however,moretime alsomeansgreater recourseto European solidarity: more fundsare neededfrom therescuepackageor maybe eventransfersthat havetobeacceptedpoliticallyby the ―donor countries‖.The non-programme countries, in turn, should not repeat the mistakes of2004 and not interpret the strengthened Stability Pact too flexibly when itis first put to thetest.France, in particular, has an important role in setting an example in termsof the credibility of the rules and confidence in the sustainability of publicfinances.But back to regulation.At times, concernsare raisedor thecriticism is made that theimplementationof thesenoble intentionsis not making much headwayandthat enthusiasm for reform haswanedsignificantly.I can quiteunderstand a certain amount of impatience.For example, withregard to the shadowbankingsystem, an totalintegratedpackagewithrecommendationsonregulationwillnotbereadyuntil September and it will be even longer beforeconcretedecisionshavebeen made and enshrined in law.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  75. 75. P a g e | 75Thereform objectiveof clearingall standardised OTC derivativesthroughcentral counterpartiesand recordingthem by theend of 2012hasnot beenachieved.There arestill several stickingpoints– startingwitha lack of standardsand ranging asfar asdata protectionproblems, and, in particular, theimpassein negotiationsoncross-bordercoordinationbetweentheUnitedStatesand Europe.Progresshasalsobeen mixed on the―toobig to fail‖ issue– morespecificallytheimplementation of internationallyagreed standardsforresolution regimes.Here wehavetocontend with acertain tendencytowardnationalprotection and the fragmentation of the financial markets.Otherwisethere isthe threat of competitive distortionsand new riskstostability.Just recently, Börsenzeitunggavea categoricaland lucid warningagainsta new nationalismon thepart of the supervisors.TheUS proposalson regulatingthecapital and liquidityof foreigninstitutionsare a prime negative exampleof this.Agreat deal thereforestill needstobe done and wehave to maintainpoliticalinterest in a stablefinancial system.Regulation is not an end in itself, however.Thecostsand benefitsof theplannedmeasures,includingtheirside-effectsand interactions,have tobe weighedup against one another.This type of analysis is time-consuming and input-intensive, especiallysince the particular given country-specific aspects also have to be takenintoconsideration whenthemeasuresare actuallyimplemented.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com

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