Monday April 30 2012 - Top 10 risk and compliance management related news stories and world events


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Monday April 30 2012 - Top 10 risk and compliance management related news stories and world events

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Monday April 30 2012 - Top 10 risk and compliance management related news stories and world events

  1. 1. Page |1 International Association of Risk and Compliance Professionals (IARCP) 1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 202-449-9750 Top 10 risk and compliance management related news storiesand world events that (for better or for worse) shaped the weeks agenda, and what is next George Lekatis President of the IARCPDear Member,Do you know that investor in London are betting on when a particular setof US citizens will die and, if these people live longer than anticipated, theinvestment may not function as expected …… and that the UK Financial Services Authority (FSA) has confirmedguidance that this is a high risk product that should not be promoted tothe vast majority of retail investors in the UK?We live in (mad) financial times. These “high risk products” are calledTraded Life Policy Investments (TLPIs). Yes, risk management is veryimportant. The risk is that policyholders will not die the day we wantthem to die.Investors hope to benefit by buying the right to the insurance payoutsupon the death of the original policyholder.Well, we speak about London, let’s see the interesting definition of theshadow banking sector from Mr Paul Tucker, Deputy Governor forFinancial Stability at the Bank of England, (speaking at the EuropeanCommission High Level Conference, Brussels, 27 April 2012).He said that “shadow banking” is not the same as the non-bank financialsector._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  2. 2. Page |2For example, the vast majority of hedge funds are not shadow banks, anddon’t trade in the credit markets or especially illiquid markets.Also, non-bank intermediation of credit is not a bad thing in itself. Indeed,it can be a very good thing, helping to make financial services moreefficient and effective and the system as a whole more resilient.But, as we know from this crisis and from previous ones, true shadowbanking can weaken the system. Regulatory arbitrage, which is alwayswith us, can distort and disguise channels of intermediation.Shadow banking comes in lots of shapes and colours. There are degreesto which any particular instance of shadow banking replicates banking.The liquidity offered by some shadow banks relies pretty well entirely,and more or less openly, on committed lines of credit from commercialbanks.In these cases, the liquidity insurance offered by the shadow bank is“derivative”; there is a real bank in the shadows.But for other shadow banks, liquidity services are offered without suchback-up lines. In those cases, claims on the shadow bank have, in effect,become a monetary asset. Examples probably include money marketmutual funds and an element of the prime brokerage services offered bysecurities dealers to levered funds.Interesting!Welcome to the Top 10 list._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  3. 3. Page |3Developing a Single Rulebook in bankingAndrea Enria, Chairperson European BankingAuthority, Central Bank of Ireland –Stakeholder Conference ‘Financial Regulation, Thinking about thefuture, 27 April 2012FSA confirms traded life policy investments should notgenerally be promoted to UK investors25 Apr 2012The Financial Services Authority (FSA) has confirmedguidance that traded life policy investments (TLPIs) are high riskproducts that should not be promoted to the vast majority of retailinvestors in the UKFederal Deposit Insurance CorporationU. S. Small Business AdministrationApril 24, 2012FDIC and SBA Team Up to Offer Financial Education Support for Newand Aspiring EntrepreneursFSA JapanPress Conference by Shozaburo Jimi,Minister for Financial Services (Excerpt)_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  4. 4. Page |4Securities Lending and Repos:Market Overview and Financial StabilityIssuesInterim Report of the FSB Workstream on Securities Lending and Repos,27 April 2012Shareholder value and stability in banking: Is there aconflict?Speech by Jaime Caruana, General Manager, Bank forInternational SettlementsJens Weidmann:Global economic outlook – whatis the best policy mix?Speech by Dr Jens Weidmann,President of the Deutsche Bundesbank,Economic Club of New York, New York,23 April 2012_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  5. 5. Page |5Energy ≠ Heat:DARPA seeks non-thermal approaches tothin-film depositionFederal Open Market CommitteeInformation received since the Federal OpenMarket Committee met in March suggeststhat the economy has been expandingmoderately.FSB Principles for Sound ResidentialMortgage Underwriting PracticesApril 2012_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  6. 6. Page |6Developing a Single Rulebook in bankingAndrea Enria, Chairperson European Banking Authority, Central Bank ofIreland – Stakeholder Conference ‘FINANCIAL REGULATION -THINKING ABOUT THE FUTURE’ 27 April 2012Ladies and Gentlemen,My main topic today will be the Single Rulebook, the main path ahead ofus to achieve the objectives of the new European institutional frameworkestablished with the endorsement of the recommendations of the deLarosière report.I will primarily focus on owns funds, as this is a key issue forre-establishing the regulatory framework on a sound footing and the EBAis currently running a public consultation on this.I will also briefly touch on another important component of the SingleRulebook: the liquidity requirements.However, before tackling these issues, I would like to give you anoverview of the first year of existence of the EBA and especially of thework done to face the challenges posed by the current crisis.1. The efforts of the EBA in tackling the financial crisisIn the first year of its life, the priorities of the EBA had to be focused onthe challenges raised by the deterioration of the financial market _____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  7. 7. Page |7environment.The stress test exercise we conducted in the first part of 2011 focused oncredit and market risks but also, in recognition of the risks thatsubsequently crystallised, incorporated sensitivity to movements infunding costs.Banks were also required to assess the credit risk in their sovereignportfolios.In many respects, I believe the exercise was successful: in order toachieve the tougher capital threshold, anticipating many aspects of thenew Basel standards, banks raised € 50 bn in fresh capital in the first fourmonths of the year; we set up a comprehensive peer review exercise,which ensured consistency of the exercise across the Single Market,notwithstanding the many differences in national regulatory frameworks;the exercise included an unprecedented disclosure of data (more than3200 data points for each bank), including amongst other things detailedinformation on sovereign holdings.However, the progress of the stress test was tracked by a significantfurther deterioration in the external environment.The main objective of restoring confidence in the European bankingsector was not achieved, as the sovereign debt crisis extended to morecountries, thus reinforcing the pernicious linkage between sovereigns andbanks.Most EU banks, especially in countries under stress, experiencedsignificant funding challenges.In this context, the IMF and the European Systemic Risk Board (ESRB)called for coordinated supervisory actions to strengthen the banks’ capitalpositions.The EBA assessment was that without policy responses, the freeze inbank funding would have led to an abrupt deleveraging process, which_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  8. 8. Page |8would have hurt growth prospects and fuelled further concerns on thefiscal position of some sovereigns, in a negative feedback loop.We then called for coordinated action on both the funding and thecapitalisation side.While advising the establishment of an EU-wide funding guaranteescheme, the EBA focused its own efforts on those areas where it hadcontrol, primarily bank capitalisation.To this end, the Board of Supervisors, comprising the heads of all 27national supervisory authorities, discussed and agreed that a furtherrecapitalisation effort was required as part of a suite of coordinated EUpolicy measures.Our Recommendation identified a temporary buffer to address potentialconcerns over EU sovereign debt holdings and required banks to reach9% CT1.The total shortfall identified was € 115 bn.The measure was agreed in October and enacted in December 2012.It was swiftly followed by the ECB’s long term refinancing operations(LTROs), arguably the key “game changer” in this context.But the recapitalisation was a necessary complementary measure: whilebanks needed unlimited liquidity support, to avoid a credit crunch, theyhad to be asked to accelerate their action to repair balance sheets andstrengthen capital positions.These measures have bought time but should not bring complacency.The recapitalisation plan has seen banks make significant efforts tostrengthen their capital position without disrupting lending into the realeconomy._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  9. 9. Page |9The EBA’s intensive monitoring of the process shows that 96% of theshortfall identified was met by direct capital actions.Moreover, there has been a strong spirit of cooperation between homeand host supervisors in discussing and taking forward these plansthrough colleges of supervisors, which has acted as a meaningfulcounterweight to the trend for national concerns to come to the fore in thecurrent environment.Going forward, heightened attention to addressing residual credit risk,making efforts to meet the new CRD IV requirements, setting in placeplans to gradually restore access to private funding and exit theextraordinary support of the ECB will be key.2. The Single Rulebook in bankingAs the finalisation of the new legislative framework for capital andliquidity requirements was coming closer, the focus of the EBA work hasbeen increasingly moving to our tasks in the rule-making process.The key task that the reform proposed by the de Larosière report assignsto the EBA is the establishment of a Single Rulebook, ensuring a morerobust and uniform regulatory framework in the Single Market andpreventing a downward spiral of competitive relaxation of prudentialrules.The EBA is asked to draft technical standards that, once endorsed by theCommission, will be adopted as EU Regulations.The standards will therefore be directly applicable to all financialinstitutions operating in the Single Market, without any need for nationalimplementation or possibility for additional layers of local rules.I see that at the moment, while the negotiations on the capitalrequirement directive and regulation (CRD4-CRR) are entering the finalstages, there is a call for more national flexibility.It is often argued that minimum harmonisation is all that is needed, as the_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  10. 10. P a g e | 10decision of a national authority to apply stricter requirements would onlypenalise financial institutions chartered in that jurisdiction.This argument neglects the fact that we have lived in a world of minimumharmonisation until now, and this has delivered an extremely diverseregulatory environment, prone to regulatory competition.It is a fact that the flexibility left by EU Directives has been a keyingredient in the run-up to the crisis.The Directives left significant flexibility to national authorities in thedefinition of key prudential elements (e.g., definition of capital,prudential filters for unrealised gains and losses), the determination ofrisk weights (e.g., for real estate exposures), the approaches to ensure thatall the risks are captured by the requirements (e.g., effectiveness of risktransfers).All these elements of flexibility have been used by banks to put pressureon their supervisors, triggering a process that led to excessive leverageand fuelled credit and real estate bubbles.The heterogeneity of the regulatory environment also complicatedsignificantly the effective supervision of cross-border groups, which wereat the epicentre of the crisis: supervisors had serious difficulties bothbuilding up a firm-wide view of risks and acting in a timely andcoordinated fashion.Furthermore, regulatory arbitrage drove business decision. This problemhas not been fixed yet.In its first year of activity, the EBA identified a number of differences inregulatory treatment that lead to very material discrepancies in keyrequirements.For instance, the EBA staff conducted a simple exercise on the datacollected for the recapitalisation exercise.The capital requirement for the same bank were calculated using the less_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  11. 11. P a g e | 11stringent and the most restrictive approaches in four areas where nationalrules present important differences – the calculation of the Basel I floors,the application of the prudential filters, the treatment (deduction fromcapital or inclusion in assets with a 1250% weight) of IRB shortfalls and ofsecuritisations.As a result, the ratio was 300 bps lower when the stricter methodologieswere applied, showing that differences can be very material and difficultto spot.In integrated financial markets, these differences can have very disruptiveeffects.Once risks generated under the curtain of minimum harmonisationmaterialise, the impact is surely not contained within the jurisdictionsthat adopted less conservative approaches.Without using exactly the same definition of regulatory aggregates andthe same methodologies for the calculation of key requirements, theproblem will not be fixed.At the same time, it is absolutely true that the new regulatory frameworkhas to be shaped in such a way to leave a certain degree of nationalflexibility in the activation of macroprudential tools, as credit andeconomic cycles are not synchronised across the EU.Also, there could be structural features of financial sectors, orcomponents thereof, which might require tweaking prudentialrequirements to prevent systemic risk.But the same source of systemic risk should be treated in a broadlyconsistent manner in different jurisdictions across the Single Market, toavoid an unlevel playing field and less stringent approaches that mightsubsequently generate spillovers in other countries.The ideal long-term solution for avoiding conflicts between the flexibilityneeded for macroprudential supervision and the degree of regulatoryharmonisation called for by the Single Rulebook is constructing a suite of_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  12. 12. P a g e | 12macroprudential instruments along the blueprint of the countercyclicalbuffer.This provides a significant leeway for tightening standards while theEuropean Systemic Risk Board (ESRB) is entrusted with the task ofdrafting guidance on the activation of the tool and of conducting ex postreviews.At the same time, reciprocity in the application of the tool allows forcross-border consistency and reduces the room for regulatory arbitrage.So, we may well have a single rule, adopted through an EU Regulation,while this rule provides for flexibility in its application, with a frameworkthat the Basel Committee has labelled as “constrained discretion”.3. Giving life to the Single Rulebook: the new regulatoryframework of bank capital and liquidityIn giving life to the Single Rulebook in banking, the EBA is facing amajor challenge.The CRD4-CRR proposal envisages around 200 tasks, more than 100technical standards - 40 of which will have to be finalised by the end ofthis year.We will have to ensure standards of high legal quality as they will beimmediately binding in all 27 Member States when endorsed by theEuropean Commission.We will have to respect due process, with wide and open consultationsand adequate impact assessments.As to the substance of the new regulatory framework, I will focus today onthe definition of capital and the quality of own funds, which I consider asone of the cornerstones of the Single Rulebook in banking._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  13. 13. P a g e | 133.1. Own fundsThe definition of capital has been a major loophole in the run-up to thecrisis.As financial innovation brought about increasingly complex hybridinstruments, national authorities have been played against each other bythe industry, with the result that the standards for the quality of capitalwere continuously relaxed.As a consequence, once the crisis hit, a significant amount of capitalinstruments proved to be of inadequate quality to absorb losses.In several cases, taxpayers’ money was injected while the holders ofcapital instruments continue to receive regular payments.The Basel Committee has done an outstanding job in significantlystrengthening the definition of capital and we must make sure that this isnot lost in the implementation of the standards.The EBA already achieved some progress in the use of stringent uniformstandards when imposing the use of a common definition of capital forthe purpose of the stress test and the recapitalisation exercise.This proves that collective enhancements can be reached when necessary.But what can be done in periods of stress must be perpetuated in normaltimes.For this purpose, on 4 April, the EBA published a consultation on a firstset of regulatory technical standards on own funds.These cover most areas of own funds, fleshing out the features ofinstruments of different quality (from CET1 to Tier 2 instruments).The consultation will provide appropriate input from interested partiesand regular contacts with banks and market participants are alreadyunder way._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  14. 14. P a g e | 14The standards elaborate on the characteristics of the instrumentsthemselves, as well as on deductions to be operated from own funds.It is indeed crucial to ensure that there is a uniform approach regardingthe deduction from own funds of certain items like losses for the currentfinancial year, deferred tax assets that rely on future profitability, definedbenefit pension fund assets.It is also necessary to ensure that, where exemptions from andalternatives to deductions are provided, sufficiently prudent requirementsare applied.The standards cover also several areas affecting more directly cooperativebanks and mutuals, whose particular features have to be taken intoadequate account.At the same time, it is necessary to define appropriate limitations to theredemption of the capital instruments by these institutions.The standards will also contribute to increase the permanence of capitalinstruments more generally by strengthening the features of the latter andby specifying the need for supervisory consent when reducing own funds.Finally, the standards will also increase the loss absorbency features ofeligible hybrid instruments, in line with the objective to bring investorscloser to shareholders and share losses on a pari passu basis.In order to complete its current work on own funds, the EBA will soonpublish a technical standard on disclosure by institutions.The work of the EBA on own funds will not be concluded with theendorsement of the new technical standards.Indeed, although technical standards, like EU Regulations, should notleave room for interpretation, it cannot be excluded that some provisionswill not work as they are meant to._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  15. 15. P a g e | 15This is the reason why a close review of the application of the standards isnecessary to detect potential loopholes and propose changes whenneeded.A framework should be developed, probably in the form of a Q&Aplatform, in order to address technical issues that may well emerge in thepractical application of the standards.Furthermore, an important task that has been attributed to the EBA is thepublication of a list of instruments included in Common Equity Tier 1(CET1) as well as the monitoring of the quality of capital instruments.I believe the current text of the CRD4-CRR does not go far enough inensuring a strong control on the instruments that will be included in thecapital of higher quality.I understand the decision of the EU institutions to follow an approachthat privileges substance over form: the definition of Common EquityTier 1 will not be restricted to ordinary shares, as there is no harmonisedEU-wide definition that could be relied upon.Instead, the legislation will require that only instruments that are in linewith all the principles defined by the Basel Committee will qualify.In order for this to ensure a strict control on the quality of theseinstruments, strong mechanisms should be put in place to make sure thatthere is no room for watering down the requirements.The “substance” needs to be checked and has to be the same across theSingle Market.From my perspective, the list that the EBA will keep should be legallybinding.There should be an in-depth scrutiny of the instruments conducted at theEU level by the EBA, in cooperation with national supervisors, to confirmthe inclusion in the list._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  16. 16. P a g e | 16If an instrument is included in the list, it should be accepted throughoutthe Single Market.If it is not included in the list, no authority should have the possibility toconsider it eligible as CET1.The present text limits the role of the EBA to the publication of anaggregated list only based on the assessment done at national level.This would not bring any added value compared to a situation whereMember States would be required to publish by themselves a list ofinstruments recognised in their jurisdictions.On the contrary, this could be misleading, as it could convey theimpression that the instruments have received an EU-wide recognition.In any case, even if the legislative framework does not provide the EBAwith the necessary legal tools, we are committed to fully exploiting thedraft Regulation’s provisions that require the EBA to monitor the qualityof own funds across the Single Market and to notify the Commission incase of evidence of material deterioration in the quality of thoseinstruments.If we consider that some instruments that are not of sufficient qualityhave been accepted, we also have the possibility to open formalprocedures for breach of European law.Having strong enforcement tools is essential: supervisors have lostcontrol of the definition of capital once and we should not allow this tohappen again.We are acutely aware that the new rules will trigger a new wave offinancial innovation, aimed at limiting the restrictive impact of the reform.Indeed, this is already under way.We already hear that new ways are being devised to smooth the impact ofpermanent write-downs or to circumvent the prohibition of dividendstoppers for hybrid instruments._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  17. 17. P a g e | 17Our monitoring of capital issuances is ongoing.The EBA recently decided to develop a set of benchmarks for hybridinstruments to give more clarity on what are the terms and conditions – interms of permanence, flexibility of payments, loss absorbency – that makean instrument compliant with applicable rules.The work in this area will begin when the final legislation is in place and asufficient number of new issuances are available, in order to have ameaningful sample of instruments to assess.In the future, hopefully, this work could move a step further, towardsproviding common templates, which could lead to the harmonisation ofthe main contractual provisions of hybrid capital instruments, in line withthe objectives of a Single Rulebook.A concrete illustration of these common templates has already been givenby the EBA when publishing a common term sheet for the convertibleinstruments accepted for the purpose of the recapitalisation exercise.3.2. LiquidityThe new liquidity standards represent a second important area of work forthe EBA.The first deliverable is due at the end of 2012, when we will have toprovide for uniform reporting formats.The framework is currently under development and is expected to bereleased for public consultation over the summer.However, we can already foresee that the reporting is likely to be fairlysimilar to that used by the Basel Committee for the quantitative impactstudy, which many European banks are already familiar with.But the most important and delicate area of work is the definition ofliquid assets and, more generally, the calibration of the new requirements._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  18. 18. P a g e | 18We are aware that the banking industry has raised serious concerns on thetwo liquidity standards defined by the Basel Committee, the liquiditycoverage ratio (LCR) and the net stable funding ratio (NSFR).The Basel Committee itself is reviewing the calibration of the ratios,recognising that some underlying assumptions are excessivelyconservative, even if confronted with the toughest moments of thefinancial crisis.The key principles underlying the LCR and the NSFR are sound andcannot be given up by regulators: banks need to have sufficient buffers ofliquid assets to withstand a shock for some time without the need forpublic support; maturity transformation needs to be constrained to someextent, so as to prevent banks from adopting fragile business modelsrelying excessively on volatile, short term wholesale funding to supportlonger term lending.But it is essential to get the calibration right, as funding is and willincreasingly be the main driver of the deleveraging process at EU banks.Time is needed to do a proper job: we have to ensure that data ofadequate quality is available – hence the need for a uniform reportingprovided at the end of 2012 – and to allow for in-depth analyses.The first impact assessments on LCR and the NSFR are due in 2013 and2015 respectively.The EU has taken the decision to use the monitoring period until 2015 forthe LCR and 2018 for the NSFR, before proposing legislation for a finalcalibration of the liquidity ratios.This monitoring phase exactly mirrors the Basel Committee’s timeline.It is in my view the right choice to allow for this extensive observationperiod. I would strongly argue that we should avoid making any policychoice before proper evidence on the potential impact of the two ratios._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  19. 19. P a g e | 19ConclusionsLadies and gentlemen,Today I tried to convey to you a bird’s eye picture on the difficultchallenges the EBA is facing.In the first year of activity we have already done a huge effort tostrengthen the capital position of EU banks and to restore confidence intheir resilience. The work is not over in this area.The liquidity support provided by the ECB avoided an abruptdeleveraging process, but banks are still in the process of repairing anddownsizing their balance sheets and of refocusing their core business.We, as supervisors, need to accompany this process and do our utmost toensure that it occurs in an ordered fashion, without adverse consequenceson the financing of the real economy.One way to support the process is the introduction of the reforms oncapital and liquidity standards endorsed by the G20.I strongly believe that we need to exploit this opportunity to move to atruly harmonised regulatory framework, a Single Rulebook that ensuresthat high quality standards are enforced throughout the Single Market.We have to be particularly rigorous on the definition of capital, as this isthe basis for most prudential requirements.We cannot afford anymore financial innovation that allows instruments tobe accepted as capital, while not respecting the key principles ofpermanence, flexibility of payments and loss absorbency.The control on eligible capital instruments needs to be very strict andshould be performed at the EU level. Ideally, the co-legislators shouldgive the EBA the legal basis to perform this difficult task._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  20. 20. P a g e | 20But in any case we will conduct a close monitoring of capital issuances, aswe consider our duty to ensure that only the instruments of the bestquality are accepted as regulatory capital.As to liquidity standards, I believe that while the principles embodied inthe Basel text are absolutely shared, we need to do more work on thecalibration of the requirements.We understand the concerns expressed by the industry, but it is importantthat we collect solid empirical evidence before taking any decision in thisdelicate area, which will provide a major driver for the needed changes inbanks’ business models.Thank you for your attention._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  21. 21. P a g e | 21FSA confirms traded life policy investments should not generallybe promoted to UK investors25 Apr 2012The Financial Services Authority (FSA) has confirmed guidance thattraded life policy investments (TLPIs) are high risk products that shouldnot be promoted to the vast majority of retail investors in the UK.The guidance is an interim measure – the FSA will shortly be consultingon new rules imposing significant restrictions on the promotion ofnon-mainstream investments, including TLPIs, to retail investors.TLPIs invest in life insurance policies, typically of US citizens.Investors hope to benefit by buying the right to the insurance payoutsupon the death of the original policyholder.Basically, a TLPI investor is betting on when a particular set of UScitizens will die and, if these people live longer than anticipated, theinvestment may not function as expected.The FSA has found evidence of significant problems with the way inwhich TLPIs are designed, marketed and sold to UK retail investors.Many of these products have failed, causing loss for UK retail investors.Many TLPIs take the form of unregulated collective investment schemes,which cannot lawfully be promoted to retail investors in most cases, buthave often been marketed inappropriately to retail customers.Peter Smith, the FSA’s head of investment policy said:_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  22. 22. P a g e | 22“The TLPI retail market is worth £1 billion in the UK and we were veryconcerned that it was likely to grow even more.At the time that we published our guidance over half of existing retailinvestments were in financial difficulty – even so, we were hearing aboutthe development of new products intended to be sold to UK retailcustomers.“The threat to new customers was significant and growing: the potentialfor substantial future detriment was clear.There was a concern that we were witnessing a repeating cycle ofunsuitable sales followed by significant customer detriment in the TLPImarket.Following publication of the guidance for consultation, this threat hasreceded.“This is an interim measure – we believe that TLPIs and all unregulatedcollective investment schemes should not generally be marketed to retailinvestors in the UK and will be publishing proposals soon to prevent thembeing promoted except in rare circumstances.”Traded Life Policy Investments (TLPIs), Key risks associatedwith TLPIsLongevity riskAn accurate estimation of life expectancy is the most important factor inassessing the price of each underlying life insurance policy in a TLPI.Based on this, the primary risk is that the underlying policies’ livesassured live longer than expected (for example, because of medicaladvances and the incompatibility of life assurance actuarial models as thebasis for investment purposes) so the TLPI needs to continue to fundpremiums on the policies for longer than expected._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  23. 23. P a g e | 23This could negatively affect the return on investment and liquidity on anongoing basis.Liquidity riskThe underlying investments are illiquid due to their specialised natureand there is only a limited secondary market for them.This may mean they are sold at a significantly reduced value if the TLPIneeds to raise funds at short notice, which has an impact on the value ofthe portfolio.Investors may therefore suffer financial loss at the point of redemption.Parties involved in the TLPI may become insolventThis risk factor, though not unique to TLPIs, is often overlooked.For example, if an insurance company becomes insolvent and is unable tomeet claims upon the deaths of the original policyholders the TLPI couldfind itself in difficulties given the often large value of the policies it holds.Governance issuesTLPI product governance has often proven problematic and led toproduct difficulties.Some common issues are as follows:Conflicts of interestConflicts exist among different participants in the product value chainthat lead to high fees being charged and may lead to detriment forinvestors.TLPI models/structure_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  24. 24. P a g e | 24In some models, yields are promised to previous investors, which canonly be sustained by using new investors’ money, so the model in effect‘borrows’ from itself.The underlying assets are located offshoreThis means there is an exchange rate risk, both in terms of the costs ofmeeting ongoing premiums and the final payout for the underlyinginsurance contracts.Currency hedging instruments may be used by TLPI providers, but thesemay pose additional risks and involve extra costs.Many TLPIs sold in the UK are operated by firms basedoffshoreThis means investors may have limited or no recourse to the FinancialServices Compensation Scheme (FSCS) if things go wrong and theproduct fails.They may also not be covered by the Financial Ombudsman Service(FOS) if they have a complaint about the operation of the TLPI.Customers would be able to complain to the FOS if, for example, theadvice they have received from UK distributors was unsuitable or if apromotion from a UK provider or distributor was unfair, unclear ormisleading.Awareness of authorisation/compensation arrangementsMany TLPIs are operated by firms based abroad and outside of the FSA’sjurisdiction.There is evidence that providers and advisers have not fully understood orconveyed to investors the risks involved in how or whether the client’sproduct will be authorised and what compensation arrangements apply._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  25. 25. P a g e | 25These factors could result in a significant risk of loss of capital (and anyincome provided) for customers._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  26. 26. P a g e | 26Federal Deposit Insurance CorporationU. S. Small Business AdministrationApril 24, 2012FDIC and SBA Team Up to Offer Financial Education Supportfor New and Aspiring EntrepreneursThe Federal Deposit Insurance Corporation (FDIC) and U.S. SmallBusiness Administration (SBA) announced new resources to supportsmall businesses.FDIC Director for Depositor and Consumer Protection Mark Pearce andSBA’s Deputy Associate Administrator for Entrepreneurial DevelopmentMichael Chodos released Money Smart for Small Business, a trainingcurriculum for new and aspiring business owners.Developed in partnership between both agencies, this curriculum is thelatest offering in the FDIC’s 10 year old award-winning MoneySmart program.Money Smart for Small Business provides an introduction to day-to-daybusiness organization and planning and is written for entrepreneurs withlimited or no prior formal business training.It offers practical information that can be applied immediately, while alsopreparing participants for more advanced training.The curriculum is designed to be delivered to new and aspiring businessowners by financial institutions, small business development centers(SBDCs), among others.Director Pearce and SBA Associate Administrator Chodos were joined byTraining Alliance partners at the launch of Money Smart for Small_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  27. 27. P a g e | 27Business, hosted by the District of Columbia’s Affinity Lab, a smallbusiness incubator.“We are proud to launch Money Smart for Small Business,” said ActingChairman Gruenberg.“Since 2001, Money Smart has helped individuals build a secure financialfuture for themselves.I am very pleased that small businesses, which play a vital role insupporting our national economy, will now have access to this resource.The FDIC looks forward to working with the SBA and the MoneySmart Alliance, to promote financial literacy among small businessowners.”“We are excited to join the FDIC in its expansion of the MoneySmart curriculum for small business,” said SBA Administrator KarenMills.“The FDIC is a vital ally in our efforts to help small business owners start,grow and create jobs.Money Smart for Small Business will help to put more information on thebusiness basics of financial management at entrepreneurs’ fingertips andmake it easier for them to build their knowledge and skill set.”Each of the ten instructor-led modules in Money Smart for SmallBusiness provides financial and business management for businessowners and includes a scripted instructor guide, participant guide andoverhead slides.Organizations that use the curriculum to support small businessesthrough training, technical assistance or mentoring are invited to join theFDIC and SBA’s Training Alliance.The FDIC will host an online “town hall” for potential Training Alliancepartners in the months ahead.More than ten years after the original release of the award -winning Money Smart adult curriculum, Money Smart for Small_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  28. 28. P a g e | 28Business builds on the proven results in financial management for thosewho complete the curriculum._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  29. 29. P a g e | 29FSA Japan - Press Conference by Shozaburo Jimi, Minister forFinancial Services (Excerpt)[Opening Remarks by Minister Jimi]This morning, the Minister of Economic and Fiscal Policy, the Ministerof Economy, Trade and Industry and the Minister for Financial Servicesheld a meeting, and I will make a statement regarding the policy packagefor management support for small and medium-size enterprises (SMEs)based on the final extension of the SME Financing Facilitation Act.Recently, the Diet passed and enacted an amendment bill to extend theperiod of the SME Financing Facilitation Act for one year for the last timeand an amendment bill to extend the deadline for the determination ofsupport by the Enterprise Turnaround Initiative Corporation of Japan,over which Minister of Economic and Fiscal Policy Furukawa hasjurisdiction, for one year, and the new laws were promulgated and putinto force._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  30. 30. P a g e | 30I believe that this year will be very important for creating an environmentfor vigorously implementing support that truly improves the managementof SMEs, namely an exit strategy.From this perspective, the ministers who represent the Cabinet Office,the Financial Services Agency (FSA) and the Small and MediumEnterprise Agency held a meeting and adopted the policy formanagement support for SMEs.The FSA will seek to facilitate financing for SMEs through measuresrelated to the final extension of the period of the SME FinancingFacilitation Act, including this policy package, and will also create anenvironment favorable for management support for SMEs whilemaintaining cooperation with relevant ministries and agencies.For details, the FSA staff will later hold a press briefing, so please ask yourquestions then.[Questions & Answers]Q. The G-20 meeting started on April 19.I hear that the expansion of the International Monetary Funds lendingfacility, which has been the focus of attention, may be put off, and themarket could fall into turmoil again, with the yield on Spanishgovernment bonds rising in Europe.Could you tell me how you view the recent financial marketdevelopments?A. As for the current situation surrounding the European debt problemthat you mentioned now, individual countries financial and capitalmarkets have generally been recovering for the past several months as aresult of efforts made by euro-zone countries and the European CentralBank, as you know._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  31. 31. P a g e | 31On the other hand, concern over the European fiscal problem has notbeen dispelled, as indicated by unstable market movements caused byconcern over Spains fiscal condition.The euro zone has set forth the path to fiscal consolidation and PresidentDraghi of the European Central Bank (ECB) has taken bold measures, asyou know well.Such measures as the ECBs long-term refinancing operation and thestrengthening of the firewall have been taken.To ensure that the market will be stabilized and the European debtproblem will come to an end, it is important not only that the series ofmeasures adopted by the euro zone is carried out but also that the IMFsfinancial base is strengthened.From this perspective, Minister of Finance Azumi recently expressed anintention to announce Japanese financial support worth 60 billion dollarsfor the IMF at the G-20 meeting.I hope that this Japanese action, combined with Europes own efforts, willhelp to resolve the European debt problem.As you know, it is unusual for Japan to exercise initiative and announcesupport for the IMF.Although Japan has various domestic problems, it is the worldsthird-largest country in terms of GDP.In addition, as I have sometimes mentioned, Japan is the only Asiancountry that has maintained a liberal economy and a free market since thelatter half of the 19th century.Even though Japan lost 65% of its wealth because of World War II, it wenton to recover from the loss._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  32. 32. P a g e | 32In that sense, it is very important for Japan to exercise initiative, on whichthe United States eventually showed an understanding from what I haveheard informally.Q. It has been decided that Kazuhiko Shimokobe of the Nuclear DamageLiability Facility Fund will be appointed as Tokyo Electric PowerCompanys new chairman.Tokyo Electric Powers management problem has had some effects onthe corporate bond market and also has affecteds SMEs through a hike inelectricity rates. What do you think of this appointment?A. I am aware that Mr. Shimokobe, who is chairman of the NuclearDamage Liability Facility Funds management committee, has acceptedthe request to serve as Tokyo Electric Powers chairman, but the FSAwould like to refrain from commenting on personnel affairs.Formerly, I, together with Mr. Yosano, joined the cabinet task force,which was responsible for determining the scheme for rehabilitatingTokyo Electric Power, in response to the economic damage caused by thenuclear station accident, as additional members, and our efforts led to theenactment of the Act on the Nuclear Damage Liability Facility Fund.I understand that Tokyo Electric Power and the Nuclear DamageLiability Facility Fund are drawing up a comprehensive special businessplan.What kind of support Tokyo Electric Power will ask stakeholders toprovide and how stakeholders including financial institutions willrespond are matters to be discussed at the private-sector level, as I havebeen saying, so the FSA would like to refrain from making comments forthe moment.In any case, regarding Tokyo Electric Powers damage compensation,making damage compensation payments quickly and appropriately andensuring stable electricity supply are important duties that electric powercompanies must fulfill._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  33. 33. P a g e | 33Therefore, with the fulfillment of those duties as the underlying premise,it is important to prevent unnecessary, unpredictable adverse effects - youmentioned the effects on the corporate bond market earlier - so I willcontinue to carefully monitor market developments.Q. On April 19, the Democratic Party of Japans working team on theexamination of the future status of pension asset management and theAIJ problem adopted an interim report.Could you tell me about the status of the FSAs deliberation on measuresto prevent the recurrence of the problem, including when the measureswill be worked out?A. I read about that in a newspaper article.Regarding problems identified in this case, it is necessary to ensure theeffectiveness of countermeasures while taking account of practicalfinancial practices.That report is an interim one, so it stated that various measures will beworked out in the future. I have my own thoughts as the person in chargeof the FSA.However, I think that the FSA needs to conduct a study on measures suchas strengthening punishment against false reporting and fraudulentsolicitation - as you know, false reports were made in this case -establishing a mechanism that ensures effective checks by third-partieslike companies entrusted with funds, auditing firms and trust banks - thechecking function did not work at all in this case - and including ininvestment reports additional information useful for pension fundassociations to judge the reliability of companies managing customersassets under discretionary investment contracts and the investmentperformance.In any case, regarding measures to prevent the recurrence of this case, wewill quickly conduct deliberation while taking into consideration theresults of the Securities and Exchange Surveillance Commissions_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  34. 34. P a g e | 34additional investigation and the survey on all companies managingcustomers assets under discretionary investment contracts - thesecond-round survey is underway - as well as the various opinionsexpressed in the Diet, including the arguments made in the interim report,which was written under Ms. Renhos leadership.We will implement measures one by one after each has been finalized.Q. Regarding the policy package announced today, several people said inthe Diet that more efforts should be devoted to measures to supportSMEs in relation to the extension of the period of support by theEnterprise Turnaround Initiative Corporation of Japan.In relation to the policy package, do you see any problems with thecollaboration that has so far been made with regard to managementsupport for SMEs?A. Twenty-two years ago, in 1990, I became parliamentary secretary forinternational trade and industry, and served in the No. 2 post of theformer Ministry of International Trade and Industry for one year andthree months under then Minister of International Trade and IndustryEiichi Nakao.At that time, I was in charge of financing for SMEs, such as financingprovided by Shoko Chukin Bank, the Japan Finance Corporation forSmall and Medium Enterprise, the National Life Finance Corporationand the Small Business Corporation, for one year and three months.Many departments and divisions are involved in the affairs of SMEs.While diversity and nimbleness are important for SMEs, I know from myexperiences that they lack human resources and that unlike largecompanies, it is difficult for them to change business policies quickly inresponse to tax system changes.The FSA will continue to cooperate with relevant ministries and agenciesand relevant organizations, such as the Enterprise Turnaround Initiative_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  35. 35. P a g e | 35Corporation of Japan, liaison councils on support for the rehabilitation ofSMEs, financial institutions and related organizations, including theJapanese Bankers Association, and commerce and industry groups - thereare four traditional associations of SMEs - as well as prefectural creditguarantee associations, which play an important role for thegovernments policy for SMEs.In addition, the FSA will cooperate with government-affiliated financialinstitutions and take concrete actions, and I hope that recovery andrevitalization of local economies based on the rehabilitation of regionalSMEs will lead to the development of the Japanese economy.However, between the three ministers who held a meeting today, thepolicy toward SMEs tends to lack coordination.In Tokyo, Minister of Economy, Trade and Industry Edano and Ministerof Economic and Fiscal Policy Furukawa and I worked together to adoptthe policy package. In Japans 47 prefectures, there are liaison councils onsupport for rehabilitation of SMEs and there are commerce and industrydepartments in prefectural and municipal governments, and theseorganizations will also be involved, so the policy for SMEs iswide-ranging and involves various organizations.Therefore, while we provide management support, these variousorganizations tend to act without coordination.Today, the three of us held a meeting to exercise central governmentcontrol, and we will keep close watch on minute details so as to ensurecoordination.As I have often mentioned, there are 4.3 million SMEs, which account for99.7% of all Japanese corporations in Japan, and 28 million people, whichtranslates into one in four Japanese people, are employed by SMEs, soSMEs have large influence on employment.We will maintain close cooperation with relevant organizations._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  36. 36. P a g e | 36Q. In relation to the previous question, I understand that the EnterpriseTurnaround Initiative Corporation of Japan has mostly handled casesinvolving SMEs.At a board meeting yesterday, it was decided that a former official of aregional bank will be appointed to head the corporation. How do you feelabout that?A. I read a newspaper article about the decision to appoint a formerpresident of Toho Bank.Toho Bank is the largest regional bank in Fukushima Prefecture, andpersonally, I am pleased that a very suitable person will be appointed as anew president.Fukushima Prefecture has been stressing that the revival of Japan wouldbe impossible without the revival of Fukushima in relation to the nuclearstation accident.In that sense, the selection of the former president of Toho Bank, a fairlylarge regional bank, who also served as chairman of the Regional BanksAssociation of Japan, is appropriate.This morning, Minister of Economic and Fiscal Policy Furukawareported on the selection.I think that a very suitable person has been selected._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  37. 37. P a g e | 37_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  38. 38. P a g e | 38Securities Lending and Repos: Market Overview and FinancialStability Issues, Interim Report of the FSB Workstream onSecurities Lending and Repos, 27 April 2012IntroductionAt the Cannes Summit in November 2011, the G20 Leaders agreed tostrengthen the regulation and oversight of the shadow banking system,and endorsed the Financial Stability Board (FSB)’s initialrecommendations with a work plan to further develop them in the courseof 2012.Five workstreams have been launched under the FSB to develop policyrecommendations to strengthen regulation of the shadow banking system,including securities lending and repos (repurchase agreements).The FSB Workstream on Securities Lending and Repos (WS5) under theFSB Shadow Banking Task Force is developing policy recommendations,where necessary, by the end of 2012 to strengthen regulation of securitieslending and repos.In order to inform its decision on proposed policy recommendations, theWorkstream has reviewed current market practices through discussionswith market participants, and existing regulatory frameworks through asurvey of regulatory authorities.The Workstream has identified a number of issues that might pose risksto financial stability.These financial stability issues will form the basis for the next stage of itswork in developing appropriate policy measures to address risks wherenecessary.This report documents the Workstream’s progress so far._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  39. 39. P a g e | 39Sections 1 and 2 provide an overview of securities lending and reposmarkets globally, including the main drivers of the markets.Section 3 places securities lending and repo markets in the wider contextof the shadow banking system.Section 4 provides an overview of existing regulatory frameworks forsecurities lending and repos, and section 5 lists a number of financialstability issues posed by these markets.Additional detailed information on the market segments and a survey ofrelevant literature survey can be found in the annexes.1. Market Overview: Four market segmentsThe securities financing markets can be divided into four main,inter-linked segments:(i) a securities lending segment;(ii) a leveraged investment fund financing and securities borrowingsegment;(iii) an inter-dealer repo segment; and(iv) a repo financing segment, as described below.The securities lending segment (Exhibit 1) comprises lending ofsecurities by institutional investors (e.g. insurance companies, pensionfunds, investment funds) to banks and broker-dealers against thecollateral of cash (typical in the US and Japanese markets, andcomprising a minority share of the European market) or securities.According to one industry estimate, the total securities on loan globally,as of April 2012, are estimated to be about US$1.8 trillion.In general, borrowers may borrow specific securities for covering shortpositions in their own activities – for example arising from market -making activities – or those of their customers; or for use as collateral inrepo financing and other transactions._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  40. 40. P a g e | 40Lenders (or beneficial owners) may reinvest cash collateral throughseparate accounts or commingled funds managed by their agent lender ora third party investment manager.Cash collateral is also reinvested through the repo financing segmentdescribed laterThe leveraged investment fund financing and securities borrowingsegment (Exhibit 2) comprises financing of leveraged investment funds’long positions by banks and broker-dealers using both reverse repo andmargin lending secured against assets held with prime brokers, as well assecurities lending to hedge funds by prime brokers to cover shortpositions.This segment is closely linked to the securities lending segment, which isused by prime brokers to borrow securities to on-lend to hedge funds.The cash proceeds of short sales by hedge funds, in turn, may be used byprime brokers as cash collateral for securities borrowing.Hedge funds may give prime brokers permission to re-hypothecate assets,usually up to a proportion of their current net indebtedness to the primebroker (e.g. 140% in the US)._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  41. 41. P a g e | 41Re-hypothecated assets may then be given as collateral to borrow cash orsecurities by prime brokers in the repo financing or securities borrowingsegments.The inter-dealer repo segment (Exhibit 3) comprises primarilygovernment bond repo transactions amongst banks and broker-dealers.These may be used to finance long positions via general collateral (GC)repos (primarily against government securities), or to borrow specificsecurities via special repos.In the US, Europe and Japan, the inter-dealer repo segment is typicallycleared by central counterparties (CCPs). Transactions are predominantlyat an overnight maturity.Total repos and reverse repos outstanding (including both theinter-dealer repo segment and the repo financing segment) are estimatedaround US$2.1-2.6 trillion in the US, US$8 trillion in Europe, and US$2.4trillion in Japan_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  42. 42. P a g e | 42The repo financing segment (Exhibit 4) comprises repo transactionsprimarily by banks and broker-dealers to borrow cash from “cash-rich”entities, including central banks, retail banks, money market funds(MMFs), securities lenders and increasingly non-financial corporations.As described in the next section, the drivers of this market segment areprimarily the short-term financing needs of banks and broker-dealers, aswell as the desire of institutional cash managers to hold collateralised,“money-like” investments.Increasingly in the US and Europe, collateral movements and valuationare outsourced to tri-party agents (the so-called “tri-party repo”).Collateral includes government bonds, corporate bonds, structuredproducts, money market instruments and equities.The share of asset-backed securities (ABSs) used as repo collateral hasdeclined sharply since the crisis.Transactions are predominantly short-term but the European market alsoincludes a growing, longer-term element._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  43. 43. P a g e | 43The above 4 market segments can be combined to form a complexnetwork of securities lending and repos as shown in Exhibit 5._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  44. 44. P a g e | 442. Five key drivers of the securities lending and repo marketsThe Workstream has identified the following five key drivers of thesecurities lending and repo markets that contribute to betterunderstanding of the characteristics and developments of the four marketsegments described in section 1.These drivers are not ranked in order of importance and may overlap.2.1 Demand for repo as a near-substitute for central bank andinsured bank deposit moneyThe first key driver, particularly for the repo financing segment, isdemand by certain risk-averse institutions for “money-like” instrumentsto support their primary investment objectives of preserving principal andliquidity.Such institutions may not have access to central bank reserves; may beineligible for deposit insurance or have cash holdings that exceed depositinsurance limits; and/or find that Treasury bill markets do not have anadequate supply or depth, or do not match their maturity requirements.These repo investors include:(i) MMFs;(ii) entities seeking to reinvest cash collateral from securities lendingactivities;(iii) official reserves managers;(iv) commercial banks that are required to hold a regulatory liquiditybuffer;(v) pension funds, investment funds and insurance companies;(vi) non-financial corporations;_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  45. 45. P a g e | 45(vii) other specialist entities, e.g. CCPs and the US Federal Home LoansBanks;(viii) structured finance (e.g. securitisation) vehicles.A key attribute of repo is that it allows banks, broker-dealers and otherintermediaries to create “collateralised” short-term liabilities providedthey can access underlying collateral securities meeting the credit andregulatory requirements of the cash lenders.The institutional demand for money-like assets has grown significantlyover the last twenty years.Pozsar (2011) estimates that the total size of MMFs, cash collateralreinvestment programmes and corporate cash holdings in the US rosefrom $100 billion in 1990 to a peak of over $2.2 trillion in 2007 and stood at$1.9 trillion in Q4 2010.2.2 Securities-based financing needsThe second key driver is the financing needs of leveraged intermediaries.Regulated banks and broker-dealers dominate, using these markets bothas part of their wider wholesale funding and more particularly forsecurities dealing.But some unregulated non-bank intermediaries, such as ABCP conduitsand CDOs, did make use of repo financing alongside other sources ofmoney market funding such as ABCP issuance before the crisis as part ofthe shadow banking system.For most large global banks, the inter-dealer repo market has almostreplaced unsecured money markets as the marginal source and use ofovernight funds.In particular, repo financing markets have become an increasinglyimportant source of borrowing at maturities from overnight to twelvemonths or even longer._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  46. 46. P a g e | 46With access to liquid repo and securities lending markets, broker-dealerscan:(i) quote continuous two-way prices in the cash market ( in a reasonable size without carrying inventory in everysecurity;(ii) prevent a chain of settlement delivery failures from developing;(iii) finance long positions and cover short positions more effectively; and(iv) hedge against their credit or market risk exposures arising from otheractivities, e.g. government auctions, corporate bond underwriting, andtrading in cash instruments and derivatives.Liquid securities financing markets are therefore critical to thefunctioning of underlying cash, bond, securitisation and derivativesmarkets.For instance, before the crisis, the acceptability of senior tranches ofABSs as repo collateral contributed significantly to the growth of thesecuritisation leg of the shadow banking system.2.3 Leveraged investment fund financing and short-coveringneedsThe third key driver, primarily of the leveraged investment fund financingand securities borrowing market segment, is facilitation of hedge fundand other investment strategies involving leverage and short selling.Some hedge funds are insufficiently creditworthy to borrow cashunsecured or to borrow securities directly from institutional investors.They therefore rely on prime brokers for financing as well as to locate andborrow the securities they want to sell short.By pooling the supply of lendable securities in the market, prime brokerscan also provide hedge funds with stable securities loans allowing them tomaintain short positions while providing securities lenders with the_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  47. 47. P a g e | 47liquidity to recall securities loans if they wish: for example, in order to sellthe underlying holdings (securities on loan) or exercise shareholdervoting rights.Short-sale proceeds may be used by hedge funds as cash collateral againstborrowed securities.That cash is in turn used by prime brokers to collateralise securitiesborrowing from securities lenders that reinvest the cash in the separateaccounts or commingled funds (e.g., registered MMFs or unregisteredcash reinvestment funds), which vehicles may invest in repo.In this way, short selling may have the effect of temporarily re-directingcash intended for investment in equity or bond markets into the moneymarkets, creating additional demand for wholesale “money-like” assets(the first driver described above).In addition, market participants told the Workstream that some pensionfunds use repos to finance part of their bond holdings.This is notably the case of funds running liability-driven investment(LDI) strategies, with one such strategy consisting of repo-ing outholdings of high-quality long-term assets, usually for term, to raise cashfor liquidity management or return enhancement purposes, and by doingso to achieve some degree of leverage.2.4 Demand for associated “collateral mining” from banks andbroker-dealersThe fourth driver of the markets is the increasing need for banks andbroker-dealers to gain access to securities for the purpose of optimisingthe collateralisation of repos, securities loans and derivatives.As mentioned earlier, the creation of money-like repo liabilities requirescollateral, and therefore the borrowing capacity of banks andbroker-dealers depends on the total amount of non-cash collateralavailable to them.“Collateral mining” refers to the practice whereby banks andbroker-dealers obtain and exchange securities in order to collateralisetheir other activities. _____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  48. 48. P a g e | 48Increasingly, banks and broker-dealers are seeking to centralise collateralmanagement in order to use collateral in the most efficient andcost-effective way across the firm’s activities.That may include:(i) Ensuring that repo, securities lending and derivatives counterpartiesare delivered the cheapest collateral acceptable to them, for example, byusing tri-party services;(ii) Using the securities lending and collateral swap markets to upgradelower quality collateral into higher quality collateral that is moreacceptable to other counterparties, for example, in the repo financingmarkets or at CCPs, or which is eligible for regulatory liquidityrequirements;(iii) Re-using collateral delivered by other counterparties in repo,securities lending or OTC derivatives transactions;(iv) Taking advantage of opportunities to re-hypothecate client assetsfrom prime brokerage activities; and(v) Taking advantage of the option to deliver from a range of eligiblecollateral in bilateral agreements (e.g. credit support annexes supportingISDA derivatives agreements) in order to deliver collateral securities atthe lowest cost to the firm, which is typically the securities with the lowestcredit quality or highest yielding.2.5 Demand for return enhancement by securities lenders andagent lendersThe fifth driver, particularly of the securities lending market segment, isseeking of additional returns by institutional investors, such as pensionfunds, insurance companies, and investment funds._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  49. 49. P a g e | 49Most lend out securities in order to generate additional income on theirportfolio holdings at minimal risk, to help offset the cost of maintainingthe portfolio, or to generate incremental returns.Agent lenders may take a share of their clients’ lending income (net ofborrower rebates paid out) arising from lending fees or cash collateralreinvestment.In general, the loan fees paid by borrowers to the lenders represent whatborrowers are prepared to pay for “renting” ownership/use of particularsecurities, for example, in order to create a short position.Some securities lenders, however, also treat lending against cashcollateral as a source of financing for leveraged investment in search ofadditional returns, making market activity “supply-led”.For example, government bonds can usually be lent to raise cashcollateral, which can be reinvested with proceeds split between thesecurities lender and its agent, net of the fixed "rebate" percentage paidto the party borrowing the securities and posting cash.Securities lenders may thereby run a cash reinvestment business throughwhich they seek higher returns by taking credit and liquidity risk.One major asset manager also told the Workstream that it intended to usesecurities lending as a means of raising cash collateral for treasurypurposes, in particular, to collateralise OTC derivative positions wherebank counterparties are no longer willing to take uncollateralisedcounterparty risk following regulatory changes.3. Location within the shadow banking systemIt is important to note that banks play important roles in these marketsand many of the policy issues concern their use of collateral.Arguably, our main focus from a shadow banking perspective should beon four areas:(i) Borrowing through repo financing markets, including againstsecuritised collateral, which creates leverage and facilitates maturity andliquidity transformation._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  50. 50. P a g e | 50Repo allows banks as well as non-banks – such as securitiesbroker-dealers, pension funds, and (to a greater extent before the crisis)conduits and investment vehicles – to create short-term, collateralisedliabilities.Because repo financing is typically short-term but collateralised withlonger-maturity assets, it often has embedded risks associated withmaturity transformation.It can also involve liquidity transformation depending on the type ofsecurities used as repo collateral.(ii) The extent to which leveraged investment fund financing leads tomaturity transformation and leverage;(iii) The chain of transactions through which the cash proceeds fromshort sales are used to collateralise securities borrowing and thenreinvested by securities lenders, into longer-term assets, including repofinancing.This activity can mutate from conservative reinvestment of cash in “safe”collateral into more risky reinvestment of cash collateral in search ofgreater investment returns (prior to the crisis, AIG was an extremeexample of such behaviour).(iv) Collateral swaps (also known as collateral downgrades/upgrades)involving lending of high-quality securities (e.g. government bonds)against the collateral of lower- quality securities (e.g. equities, ABSs),often at longer maturities and with wide collateral haircuts.Banks then use the borrowed securities to obtain repo financing, whichcan further lengthen transaction chains, or hold them to meet regulatoryliquidity requirements.4. Overview of regulations for securities lending and repos_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  51. 51. P a g e | 51The major participants in securities lending and repo markets aregenerally regulated institutions.By comparison with “financial market intermediaries” such as banks andbroker-dealers (securities firms), regulations and activity restrictions onlenders such as investment firms, pension funds and insurancecompanies vary considerably by jurisdiction and type of entity.In general, these regulations are focused more on investor/policyholderprotection than financial stability considerations.As for the channels for disclosure (transparency) related to securitieslending and repo activities, they are not significantly different from thegeneral requirements for public disclosures through financial reportingand regulatory reporting.The FSB Workstream on Securities Lending and Repos (WS5), incooperation with the IOSCO Standing Committee on Risk and Research(SCRR), conducted a survey exercise in autumn 2011 to map the currentregulatory frameworks in member jurisdictions.This section provides a high-level summary of the results of theregulatory mapping exercise based on the survey responses from 12jurisdictions (Australia, Brazil, Canada, France, Germany, Japan, Mexico,the Netherlands, Switzerland, Turkey, UK and US), the EuropeanCommission, and the European Central Bank (ECB).4.1 Requirements for financial intermediaries: banks andbroker-dealersRisk exposures (including counterparty credit risk) arising fromsecurities lending and repo transactions are typically taken into accountin the regulatory capital regimes for banks and broker-dealers.Under the Basel capital regime, for example, banks are required to holdcapital against any counterparty exposures net of the collateral receivedon the repo or securities loan, together with an add-on for potential futureexposure._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  52. 52. P a g e | 52But netting of the collateral is only permitted if the legal agreement isenforceable under applicable laws. Capital requirements must alsocontinue to be held against lent or repo-ed securities.In addition, banks and securities broker-dealers are subject to otherrequirements that are designed to enhance investor protection andimprove risk management.Unlike regulatory capital requirements that apply consistently acrossjurisdictions (e.g. Basel III for banks), there is diversity in the tools andthe details each jurisdiction has adopted for risks that need to beaddressed.For example, a number of jurisdictions have established regulations forthe use (re-hypothecation) of customer assets by banks andbroker-dealers but the details differ:In Australia and the UK, a bank or broker-dealer is permitted tore-hypothecate (i.e. use for its own account) customer assets transferredfor the purpose of securing the client’s obligations where permitted underthe terms of the relevant legal agreement (e.g. a prime brokerageagreement with a hedge fund).Once the assets have been re-hypothecated, title transfers to the bank orbroker-dealer, and the client’s proprietary interest in the securities isreplaced with a contractual claim to redelivery of equivalent securities.In France, re-hypothecation is subject to several caps.The use of re-hypothecation is authorised in a specific framework for amaximum amount of 100% of the contracted loan (from the prime brokerto the hedge fund) for ARIA funds and 140% for ARIA EL funds.There is no regulatory cap for contractual funds.In the US, re-hypothecation by a broker-dealer is subject to a 140% cap asproportion of client indebtedness.In the UK, no similar regulatory cap exists but re-hypothecation is onlypermitted where securities are transferred for the purpose of securing or_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  53. 53. P a g e | 53otherwise covering present or future, actual or contingent or prospectiveobligations.Under UK regulations, prime brokers are required to set out for the clienta summary of the key provisions permitting re-hypothecation in theagreement, including the contractual limit (if any) and key risks to theclient’s assets, and report to the client daily on the amount ofre-hypothecated assets.4.2 Requirements for investors: investment funds and insurancecompaniesFor institutional investors (e.g. MMFs, other mutual funds, ETFs,pension funds, college endowments, and insurance companies) that actas “investors” in the securities lending and repo markets, risk exposuresarising from their involvement in the markets tend to be regulated by therelevant regulatory requirements and/or activity restrictions designed toprotect investors.4.2.1 Counterparty credit riskCounterparty credit risk arising from securities lending and repotransactions can be mitigated by restrictions on eligible counterparties(e.g. based on credit ratings or domicile) and counterparty concentrationlimits (e.g. percentage of total capital or net asset value).Some jurisdictions measure counterparty risk on a gross (no collateralbenefit) basis; while others measure on a net basis (adjusted bycollateral). Restrictions on eligible counterpartiesThere is a divergence across jurisdictions in the entities that are eligibleas counterparties for securities lending and repo transactions.In France, for MMF and UCITS, the eligible counterparties for securitieslending transactions are limited to UCITS depositaries; credit institutionsheadquartered in an OECD country; and investment companiesheadquartered in an EU member state or in another state in the European_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  54. 54. P a g e | 54Economic Area (EEA) Agreement, with minimum capital funds of 3.8million euros.In Mexico, for mutual funds and pension funds, their counterparties canonly be banks and brokerage firms.In the UK, counterparties of regulated funds are generally restricted toEuropean banks, investment firms and insurers, US banks and USbroker-dealers.In the US, registered investment company (RIC) lenders are generallyrequired to approve counterparties, and may not lend securities toaffiliated counterparties except with express approval of the SEC. Counterparty concentration limitsIn addition to restriction on eligible counterparties, some jurisdictions setcounterparty concentration limits to mitigate the impact of a largecounterparty’s default.A number of jurisdictions measure counterparty risk on a gross (nocollateral benefit) basis while others measure it on a net basis (adjustedfor the value of the collateral).For example:In the EU, the UCITS Directive allows securities lending (securitiesborrowing is not allowed) by UCITS funds but limits net counterpartyexposure of a fund (i.e. adjusted for collateral received) to 10% of NAV.The directive also includes a reference to repo and securities lendingtransactions in the context of calculating global exposure, requiring theseto be taken into account when they are used to generate additionalleverage or exposure to market risk.Future changes to the UCITS Directive are likely to include a range ofissues relating to securities lending such as rules on collateralisation andgross limits._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  55. 55. P a g e | 55In the US, for MMFs, no counterparty can be greater than 5% of thefund’s total assets unless the repo is fully collateralised by cash or USgovernment securities, in which case the MMF may look to the issuer ofthe collateral for the purposes of the 5% limit on exposure to a singleissuer.4.2.2 Liquidity riskRestrictions on the term or maturity of securities loans and repos are usedin a few jurisdictions to mitigate liquidity risk arising from securitieslending and repo transactions for insurance companies (Australia, Brazil,Mexico, US) and MMFs (Brazil, Canada, Germany, Japan, Mexico, US).The maturity limits range from 30 days to around one year.The requirement to allow securities lending transactions to be terminableat will is relatively common.4.2.3 Collateral guidelinesSome jurisdictions have introduced collateral guidelines that apply eithergenerally or specifically to securities lending and repos.Such guidelines may include various regulatory tools such as: minimummargins and haircuts; eligibility criteria for collateral; restrictions onre-use of collateral and re-hypothecation; and restrictions on cashcollateral reinvestment. Minimum levels of margins and haircutsA few jurisdictions have imposed minimum levels of haircuts/margins.For example:In Canada, haircut requirements for repos are applied to mutual fundsand require collateral with a market value of at least 102% of cashdelivered.In the UK, exposures of regulated funds arising from securities financingtransactions must be 100% collateralised at all times._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  56. 56. P a g e | 56In the US, RICs must maintain at least 100% collateral at all times,regardless of the type of collateral received (but RICs may only accept ascollateral cash, securities issued or guaranteed by the US government andits agencies, and eligible bank letters of credit). Eligibility criteria on acceptable collateral (eligiblecollateral)Some jurisdictions set criteria for eligible collateral for certain financialinstitutions to restrict assets acceptable as collateral so as to ensure thequality of collateral.Such criteria are usually based on credit ratings, currency-denomination,market liquidity, instrument types and correlation risk. Restrictions on the re-use of collateral / re-hypothecationRestrictions on re-use of collateral/re-hypothecation by investment fundsand insurance companies have been imposed in a few jurisdictions.These usually take the form of simple ban on such activities, aquantitative cap (based on client indebtedness), or are based onconsiderations of ownership.For example, in France, pursuant to Article 411-82-1 of the AMF GeneralRegulation28 non-cash collateral cannot be sold, re-invested or pledged. Cash collateral reinvestmentCanada, Germany, the UK and the US have restrictions on cash collateralreinvestment for UCITS and RICs (including MMFs).These restrictions usually take the form of limits on the maturity orcurrency-denomination of the investments, or are based on asset liquidityconsiderations._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  57. 57. P a g e | 57In Canada, mutual funds can use cash received in a securities lendingtransaction to purchase qualified securities with a maturity no longer than90 days, or purchase securities under a reverse repurchase agreement.During the term of a securities lending transaction, a mutual fund musthold all non-cash collateral delivered under the transaction, withoutreinvesting or disposing of it.For cash received under a repo transaction, the maximum term tomaturity of securities in which the cash can be reinvested is 30 days.In Germany, for MMFs and UCITS, deposits may be (re)invested inmoney market instruments denominated in the respective currency of thedeposits; or (re)invested in money market instruments by way ofrepurchase agreements.In the UK, regulations on UCITS restrict the types of cash collateralreinvestment to a certain set of financial instruments, and require thatcash collateral reinvestment be consistent with the fund’s investmentobjectives and risk profile.In the US, for RICs (including MMFs), cash collateral reinvestment isgenerally limited to short-term investments which give maximumliquidity to pay back the borrower when the securities are returned.4.2.4 Transparency (Disclosures)Disclosure requirements for securities lending and repo activities are notsignificantly different from the general requirements for publicdisclosures and regulatory reporting, e.g. disclosure as appropriate inregistration statements, financial statements, and other periodic SECfilings for US RICs, and reporting of outstanding positions for banks.One exception is in the case of US regulated insurers involved insecurities lending program.They are required to file added disclosure regarding reinvested collateralby specific asset categories and stress testing._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  58. 58. P a g e | 58Such disclosures will highlight the duration mismatch and require astatement from the company on how they would deal with an unexpectedliquidity demands.5. Financial stability issuesBased on the results from the market practices survey and regulatorymapping exercise, the Workstream has preliminarily identified thefollowing seven issues that could be considered from a financial stabilityperspective.These issues are not equally relevant to all market segments.For example, securities financing markets for high-quality governmentbonds tend to have higher levels of transparency and contribute less toprocyclicality of system leverage.5.1 Lack of transparencySecurities financing markets are complex, rapidly evolving and can beopaque for some market participants and policymakers.Market transparency may also be lacking due to the usually bilateralnature of securities financing transactions.It may be appropriate to consider, from a financial stability perspective,whether transparency could be improved at the following levels:(i) Macro-level market data - Prior to the crisis, some jurisdictions faceddifficulties in assessing and monitoring the risks in certain aspects ofthose markets. Some data is available based on surveys carried out by theauthorities or trade associations and from data vendors that collectinformation from intermediaries for commercial purposes.The lack of transparency is serious especially for bilateral transactions (i.e.not involving tri-party agents, who may publish aggregated data on thetransactions they process, or agent lenders, who may report transactionsto commercial data vendors) and synthetic transactions, where currentlyno market data is readily available and authorities have to rely on marketintelligence._____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  59. 59. P a g e | 59(ii) Micro-level market data (transaction data) – Since securities lendingand repo are structured in a variety of ways, it can be difficult tounderstand the real risks individual market participants entail or pose tothe system without detailed transaction-level information/data.This is especially so for bilateral transactions.(iii) Corporate disclosure by market participants – In most jurisdictions,cash-versus-securities transactions (e.g. repo, reverse repo,cash-collateralised securities loans) are usually reported on-balancesheet.However,(i) in some limited cases (e.g. repo to maturity or over-collateralisedrepos), repos can be off-balance sheet depending on the accountingstandards used; and(ii) limited disclosure is provided in financial accounts ofsecurities-versus-securities transactions (e.g. securities loanscollateralised by other securities), that are typically “looked through” forthe purposes of financial reporting.The ability of financial institutions to engage in off-balance sheettransactions without adequate disclosure may contribute to theirrisk-taking incentives and hence the fragility of the financial system.(iv) Risk reporting by intermediaries to their clients – Prior to the crisis,many prime brokers did not provide sufficient disclosure onre-hypothecation activities to their hedge fund clients.For example, following the collapse of Lehman Brothers International,many hedge funds unexpectedly became unsecured general creditorsbecause they had not realised the extent to which it had beenre-hypothecating client securities.In addition, some securities lenders, in particular some less sophisticatedones, have alleged that they were not adequately informed of thecounterparty risk and cash collateral reinvestment risk of their securitieslending programmes by the agent lenders.5.2 Procyclicality of system leverage/interconnectedness_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)