Risk management presentation May 13 2013

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Risk management presentation May 13 2013

  1. 1. P a g e | 1International Association of Risk and ComplianceProfessionals (IARCP)1200 G Street NW Suite 800 Washington, DC 20005-6705 USATel: 202-449-9750 www.risk-compliance-association.comTop 10 risk and compliance management related news storiesand world events that (for better or for worse) shaped theweeks agenda, and what is nextDear Member,Lifeisbecoming morecomplex for riskmanagers.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 proposalsoftheVickers 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 seekstocarveout onlyproprietarytradingwhileallowingmarket-makingactivitieson behalf of customers.Moreover,it hasseveralexemptions, includingfortransactionsinspecificinstruments,such asUS Treasuryand agencysecurities.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  2. 2. P a g e | 2It 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 withotherbankingbusinesswithinthesamegroupaslongasthesearecarriedout 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, 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.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  3. 3. P a g e | 3Read moreat Number 3below.Welcometo the Top 10list.BestRegards,GeorgeLekatisPresident of the IARCPGeneral Manager, ComplianceLLC1200G Street NW Suite800,Washington DC 20005,USATel: (202) 449-9750Email: lekatis@risk-compliance-association.comWeb: www.risk-compliance-association.comHQ:1220N. Market Street Suite804, Wilmington DE19801,USATel: (302) 342-8828International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  4. 4. P a g e | 4GovernorDaniel K. TarulloAt the Peterson Institutefor InternationalEconomics,Washington, D.C.Evaluating Progress in Regulatory Reformsto Promote Financial StabilityMorethanfive yearsafterthefailureof BearStearnsmarkedanescalationof the financial crisis, and nearlythreeyears sincethepassageof theDodd-FrankAct, debate continuesover the appropriateset of policyresponsestoprotect against financial instability.Letters…… betweenAndrew TyrieMP, and theExecutiveDirectorof the PrudentialRegulationAuthority, AndrewBailey, discussingSolvency II.BIS Working Papers, No 412Structural bank regulation initiatives:approachesand implicationsLeonardoGambacorta andAdrian vanRixtel, Monetaryand Economic DepartmentInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  5. 5. P a g e | 5CIMA Statement onAIFMDApril 12, 2013TheCayman IslandsGovernmentpassedan amendment on 15March, 2013, whichwill allowtheCayman IslandsMonetaryAuthority (CIMA) to enter intomemorandaof understanding withitsEU counterparts, usinga modelMoU developedby the European Securities MarketsAuthority (ESMA).Theamendment wasa responseto theEuropean Union‘sAlternativeInvestment Fund ManagersDirective(AIFMD), which will requirecertainconditionstobe met beforenon-EU countries can marketalternativeinvestment funds– such ashedgefunds– in theEU.―Acomfortable position for German banks‖TheBundesbank currentlyseesno signswhatsoeverof a credit shortageor a tighteningof lendingstandardsin Germany.―Germanbanksare in a pretty comfortableposition at themoment.Remarks by the SuperintendentJulie Dickson, Office of theSuperintendent of Financial Institutions Canada (OSFI)tothe 2013Financial ServicesInvitational Forum, Cambridge, OntarioInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  6. 6. P a g e | 6Switzerland – developments andchallengesin 2012from a monetarypolicy perspectiveSpeechby Mr ThomasJordan, Chairman oftheGoverning Board of the SwissNational Bank, at theAnnual GeneralMeetingof Shareholdersof theSwissNationalBank, BerneChallengesfor banking regulation andsupervision in the monetary unionSpeechby Dr JensWeidmann, President oftheDeutsche Bundesbank, at the DeutscherSparkassentag2013,Dresden.Testimonyon theImplementation of TitleII ofthe JOBS ActCommissionerElisseB. WalterU.S. Securitiesand ExchangeCommissionBeforetheSubcommitteeonOversight andInvestigations,CommitteeonFinancial Services, U.S. Houseof Representatives―I appreciate theopportunitytotestifytodayregarding theimplementationof TitleII of the Jumpstart Our BusinessStartupsAct(JOBSAct or theAct) by theCommission and itsstaff.‖International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  7. 7. P a g e | 7MONETARY ANDFINANCIALDEVELOPMENTSBankingSystem: Capitalisationremained strongunder the new Basel IIICapitalAdequacyFrameworkwithcommon equitytier1capitalratio,tier1capital ratio and total capital ratioof 12.2%, 13.1% and 14.5%respectively.Thelevel of net impaired loansimproved to 1.3% of net loans,while theloanlosscoverageremainedwell above 90%.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  8. 8. P a g e | 8GovernorDaniel K. TarulloAt the Peterson Institutefor InternationalEconomics,Washington, D.C.Evaluating Progress in RegulatoryReforms to Promote FinancialStabilityMorethan five years after thefailure ofBear Stearnsmarked an escalation of thefinancial crisis,and nearlythree yearssincethe passageof the Dodd-FrankAct,debate continuesover the appropriateset of policy responsesto protectagainst financial instability.In recent months, there hasbeen, in particular,a renewal of interest inadditional measurestoaddressthetoo-big-to-fail problem.In some respects,the persistenceof debate is unsurprising.After all, theseverityof thecrisisand ensuingrecession, and thefrustratinglyslowpaceof economic recovery, have properlyoccasionedmuch thought about the structure of thefinancial system and thefundamentalsof financial regulation.Continuingdiscussionof theseissuesispart of a protractedpolicydebate over financial regulatory reform.Somearguethat littlehaschanged and that theneeded reform is asingle,dramatic policy change(though that singlepolicy differsconsiderablyamongthosetakingthisview).Others argue that reformsalreadyenacted aresufficient toensurefinancial stability.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  9. 9. P a g e | 9Still otherscontend that there has alreadybeen too much of a regulatoryresponse, whichis suppressingcredit extension and faster economicrecovery.I think most of uswouldacknowledge, upon reflection, that a good bithasbeen done, or at least put in motion, tocounteract theproblemsoftoo-big-to-fail and systemic riskmore generally.At thesametime, I believethat moreisneeded, particularlyinaddressingtherisksposed by short-term wholesalefundingmarkets.This afternoon I wouldlike both to highlight the importanceof what hasalready been accomplishedand, at somewhat greater length, toidentifywhat I believeto bethe keystepsthat remain.Beforeturningtothesesubjects,though, I beginwithabrief repriseoftheoriginsof thefinancial crisis,toremind ourselvesof thevulnerabilitiesthat ledtothe crisis and that remain of concern today.It should, but doesnot always, gowithout saying that proposed solutionsshould actuallyhelp solvetheproblems at hand, and do soin a mannerthat minimizesthe coststootherwiseproductive activities.Vulnerabilities Exposed by the CrisisBeginningin the 1970s, the separation of traditional lendingand capitalmarketsactivitiesestablishedby New Deal financial regulationbegantobreak down under the weight of macroeconomicturbulence, technologicaland businessinnovation, and competition.During the succeedingthreedecadestheseactivitiesbecameprogressivelymore integrated, fueling theexpansion of what hasbecomeknownastheshadow banking system, includingtheexplosivegrowthofsecuritizationand derivativeinstrumentsin the first decade of thiscentury.This trend entailedtwomajor changes.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  10. 10. P a g e | 10First, it diminishedtheimportance of depositsasa sourceof fundingforcredit intermediation, in favor of capital market instrumentssoldtoinstitutional investors.Over time, thesemarketsbeganto servesome of thesamematuritytransformation functionsasthe traditional banking systems, whichin turnledtobothanexpansionandalterationoftraditionalmoneymarkets.Ultimately, there was a vast increase in the creation of so-called cashequivalent instruments, which were supposedly safe, short-term, andliquid.Second, thistrend alteredthestructure of theindustry, both transformingtheactivitiesof broker-dealersand fosteringthe emergenceof largefinancial conglomerates.There was,in fact, a symbiotic relationship betweenthe growthof largefinancial conglomeratesand the shadow bankingsystem.Largebankssponsored shadow banking entitiessuch asStructuredInvestment Vehicles(SIVs), moneymarket funds, asset-backedcommercial paper conduits,and auctionrate securities.Thesefirmsalsodominated the underwritingof assetspurchased byentitieswithin theshadow banking system.Though motivated in part by regulatory arbitrage, thesedevelopmentsweredriven by more than regulatory evasion.The growth and deepening of capital markets lowered financing costs formany companies and, through innovations such as securitization, helpedexpand the availabilityof capital for mortgage lending.Similarly, the rise of institutional investorsasguardiansof householdsavingsmade a widearray of investment and savingsproductsavailabletoa much greater portion of theAmerican public.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  11. 11. P a g e | 11But thesechangesalsohelped acceleratethefracturingof thesystemestablished in the 1930s.While the increasinglyoutmoded regulation of earlier decadeswaseroded, no new regulatory mechanismswereput in placeto control newrisks.When, in 2007, questionsaroseabout the qualityof some of theassetsonwhichthe shadowbankingsystem wasbased--notably, thosetied topoorlyunderwrittensubprime mortgages--aclassic adversefeedbackloopensued.Investorsformerlywillingto lend against almost any asset on ashort-term, secured basisweresuddenlyunwillingtolend against a widerangeof assets, notablyincludingthe structured productsthat hadbecome central to theshadowbankingsystem.Liquidity-strained institutionsfound themselvesforced to sellpositions,whichplaced additional downwardpressure on assetprices,therebyacceleratingmargin callson leveraged actorsandamplifyingmark-to-market lossesfor all holders of the assets.Themargin callsand booked losseswouldstart another round in theadversefeedbackloop.Severerepercussionswerefelt throughout the financial system, asshort-termwholesalelendingagainstall but theverysafest collateralfrozeup, regardlessof theidentityof theborrower.Moreover,asdemonstratedby the intervention of the government whenBear StearnsandAIG werefailing, and by the aftermath of LehmanBrothers failure, theuniverse of financial firms that appearedtoo-big-to-fail during periodsof stressextendedbeyond theperimeter oftraditional safetyand soundnessregulation.In short, the financial industryin theyears preceding the crisishad beentransformedintoonethat washighlyvulnerabletorunsontheshort-term,International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  12. 12. P a g e | 12uninsured cash equivalentsthat fed thenew systems relianceonwholesalefunding.Therelationshipbetweenlargefirms and shadow banking meant thatstrainson wholesalefundingmarketscould both reflect and magnify thetoo-big-to-fail problem.Thesewerenot the relatively slow-developingproblemsof theLatinAmerican debt crisis, or even the savingsand loan crisis,but fast-movingepisodesthat risked turningliquidityproblemsintoinsolvencyproblemsalmost literallyovernight.However, notethat while thepresenceof too-big-to-fail institutionssubstantiallyexacerbatesthe vulnerabilitycreatedbythenewsystem, they do not define itslimits.Even in theabsenceof anyfirm that mayindividuallyseem toobig or toointerconnectedtobe allowedto fail, the financial system can bevulnerable tocontagion.An external shock toimportant asset classescan lead to substantialuncertaintyastounderlying values,a consequent reluctanceby investorstoprovideshort-term fundingtofirmsholdingthoseassets,a subsequentspateof fire salesand mark-to-market losses,and thepotential for anadversefeedback loop.An effectiveset of financial reforms must addressboth theserelatedproblemsof too-big-to-fail and systemic vulnerability.Regulatory Responseto DateAs is obviousfrom the scope of the Dodd-Frank Wall Street Reform andConsumer ProtectionAct and theamount of activityat the regulatoryagencies,reform effortsto datehave been extensive.Theyhave alsobeen significant.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  13. 13. P a g e | 13Without trying to givea full review, let me draw your attention tosome ofthemore notableaccomplishments,whichcan be categorizedin threegroups.First, the basic prudential frameworkfor banking organizationsis beingconsiderably strengthened, both internationallyand domestically.Central tothis effortare theBasel III changestocapital standards, whichcreatea new requirement for a minimum common equitycapital ratio.This new standard requires substantial increasesin both the qualityandquantityof theloss-absorbingcapital that allowsafirm toremain aviablefinancial intermediary.Basel III also established for the first time an international minimumleverage ratio which, unlike the traditional U.S. leveragerequirement, takesaccount of off-balance-sheet items.Second, a seriesof reformshavebeen targeted at the larger financialfirmsthat are more likely tobe of systemic importance.When fullyimplemented, thesemeasureswill have formed a distinctregulatoryand supervisorystructure on top of generallyapplicableprudential regulationsand supervisoryrequirements.Thegoverning principlefor this new set of rules is that larger institutionsshould be subject to more exactingregulatoryand supervisoryrequirements,whichshouldbecomeprogressivelystricterasthesystemicimportanceof a firm increases.This principlehasbeen codified in Section 165of the Dodd-FrankAct, which requiresspecial regulationsapplicablewithincreasingstringencytolargebanking organizations.Under this authority, theFederal Reserve will imposecapital surchargeson theeight largeU.S.bankingorganizationsidentified in theBaselCommitteeagreement for additional capital requirementson bankingorganizationsof global systemic importance.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  14. 14. P a g e | 14Thesizeof a surchargewill vary depending on the relativesystemicimportanceof thebank.OtherrulestobeappliedunderSection165--includingcounterpartycreditrisk limits,stresstesting, and the quantitativeshort-term liquidityrequirementsincludedin the internationally-negotiatedLiquidityCoverageRatio (LCR)--willapplyonlytolargeinstitutions,insomecaseswith stricter standardsfor firmsof greatest systemic importance.An important, related reform in Dodd-Frank wasthecreation of orderlyliquidationauthority, under whichthe Federal Deposit InsuranceCorporation can imposelosseson a failedsystemic institutionsshareholdersand creditorsand replaceitsmanagement, whileavoidingrunsand preservingthe operationsof thesound, functioningparts of thefirm.This authoritygivesthegovernment a real alternativeto theHobsonschoiceof bailout or disorderlybankruptcythat authorities faced in 2008.Similarresolutionmechanismsareunderdevelopment in othercountries,and international consultationsare underwayto plan forcooperativeeffortsto resolvemultinational financial firms.Athird set of reforms hasbeen aimed at strengtheningfinancial marketsgenerally, without regard to the statusof relevant market actorsasregulated or systemically important.Thegreatest focus, asmandated under TitlesVII and VIII ofDodd-Frank, hasbeenon making derivativesmarketssaferthroughrequiringcentral clearing for derivativesthat can be standardized andcreatingmargin requirementsfor derivativesthat continuetobe writtenandtraded outsideof central clearingfacilities.Therelevant U.S.agenciesare working with their internationalcounterpartstoproduceaninternationalarrangement that willharmonizetheserequirementssoasto promote both global financial stability andcompetitiveparity.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  15. 15. P a g e | 15In addition, eight financial market utilitiesengaged in importantpayment, clearing, and settlement activitieshavebeen designatedby theFinancialStabilityOversight Council assystemicallyimportantand, thus, will now be subject toenhanced supervision.Asyou can tell from my description, manyof thesereformsarestill beingrefined or are still in the processof implementation.Therather deliberatepace--occasionedasit is by the rather complicateddomesticand international decisionmaking processes--maybeobscuringthe significanceof what will be far-reachingchangein theregulation of financial firms and markets.Indeed, even without full implementationof all the new regulations, theFederal Reserve hasalready used its stress-testand capital-planningexercisestoprompt a doublingin the last four years of thecommonequitycapital of thenations18 largest bank holdingcompanies, whichhold more than 70percent of the total assetsof all U.S.bank holdingcompanies.The weighted tier 1 common equity ratio, which compares high-qualitycapital to risk-weighted assets, of these 18 firms rose from 5.6 percent atthe end of 2008 to 11.3 percent in the fourth quarter of 2012, reflecting anincrease in tier 1common equity from $393 billion to $792 billion duringthesameperiod.Gaps in Regulatory ReformDespitethisconsiderableprogress,wehavenot yet adequatelyaddressedall the vulnerabilitiesthat developed in our financial system in thedecadesprecedingthe crisis.Mostimportantly, relativelylittlehasbeendonetochangethestructureofwholesalefunding marketssoastomake them lesssusceptibletodamagingruns.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  16. 16. P a g e | 16It is true that some of the clearlyriskyforms of wholesalefundingthatexistedbeforethe crisis,such astheinfamousSIVs, havedisappearedorsubstantiallycontracted.But significant continuing vulnerability remains, particularly in thosefunding channels that can be grouped under the heading of securitiesfinancingtransactions(SFTs).Repo, reverserepo, securitieslendingand borrowing, and securitiesmargin lendingarepart of thehealthyfunctioningof the securitiesmarket.But, in theabsenceof sensibleregulation, theyare alsopotentiallyassociated withthedynamic I describedearlier of exogenousshockstoasset valuesleadingtoan adversefeedback loop of mark-to-marketlosses,margin calls,and fire sales.Indeed, some haveargued that this dynamic is exacerbatedby a"maturityrat race," in whicheach creditoractstoshortenthematurityofitslendingsoastofacilitate quick and easyflight, and in which creditorspayrelativelylittleattentiontotherecoveryvalueoftheunderlyingassets.With respect to thetoo-big-to-fail problem, asI noted earlier, actualcapital levelsare substantiallyhigher than before thecrisis,andrequirementsto extend and maintain higher levelsof capital are on theway.Theregularization and refinement of rigorousstresstestingmay be thesinglemost important supervisoryimprovement to strengthen theresilienceof largeinstitutions.Thecreation of orderlyliquidationauthority and theprocessof resolutionplanningadvance prospectsfor increasingmarket discipline.But questionsremain asto whetherall this isenough to contain theproblem.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  17. 17. P a g e | 17Theenduring potential fragility of a financial system substantiallydependent on short-term wholesalefundingis especiallyrelevant inconsideringthe impact of severe stressor failure at thevery largeinstitutionswithvery largeamountsof such funding.Concernabout theadequacyof policyresponsestodateis supportedbysome recent research that attempts to quantify the implicit fundingsubsidyenjoyedbycertaininstitutionsbylookingtosuchfactorsascreditratingsuplifts,differentialsin interest ratespaid on depositsor in riskcompensation for bank debt and equity, andpremia paid for mergersthatwouldarguablyplacethemerged firm in thetoo-big-to-fail category.Thecalculationof a precisesubsidyis difficult, and each such effort willlikely occasion substantial disagreement.But several measuresprovideat least directionallyconsistent results.KeyAdditional Reform MeasuresIn sketchingout thekindsof stepsneededtoaddresstheseremainingvulnerabilities,let me begin with wholesalefunding generally, and thencircle back totoo-big-to-fail.Short-Term Wholesale Funding.At a conceptual level, the policygoal is fairlyeasytostate: a regulatorychargeor other measure that appliesmore or lesscomprehensivelytoallusesof short-term wholesalefunding, without regard to the form of thetransactionsor whetherthe borrowerwasa prudentiallyregulatedinstitution.Theaspirationtocomprehensivenessis important for tworeasons.First, the risksassociated withshort-term fundingare asmuch or moremacroprudential astheyare firm-specific.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  18. 18. P a g e | 18From a microprudential perspective, SFTsare low risk, becausetheborrowingisshort-dated, overcollateralized, marked-to-market daily, andsubjecttoremarginingrequirements.Thedangersariseinthetail andapplytotheentirefinancialmarket whenthenormallysafe,short-term lendingcontractsdramaticallyin thefaceofsudden and significant uncertaintyabout asset valuesand the condition ofcounterparties.Aregulatory measureshould force some internalization by market actorsof the systemic costsof this intermediation.Second, to the degreethat regulatory measuresapply onlytosometypesof wholesalefunding, or only to that used by prudentiallyregulatedentities,there will be a growingrisk of regulatory arbitrage.Ideally, the regulatorycharge should apply whethertheborroweris acommercial bank, broker-dealer, agencyReal EstateInvestment Trust(REIT), or hedgefund.Statingthegoal is easy, but executingit is not, preciselybecauseshort-term wholesalefunding isused in a variety of forms by a variety ofmarket actors.Determiningappropriately equivalent controlsisa challengingtaskand, withrespect toinstitutionsnot subjecttoprudential regulation, theremaybe questionsasto where--if at all--current regulatory authorityresides.And, of course, thereis the overarching problem of calibratingtheregulation soastomitigatethe systemic risks associated withthesefundingmarkets, while not suppressingthe mechanismsthat havebecome important parts of themodern financial system in providingliquidityand loweringborrowing costsfor both financial andnon-financial firms.For all thesereasons, it may well be that the abstract desirabilityof asingle,comprehensive regulatorymeasure may not be achievablein thenear term.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  19. 19. P a g e | 19Still, at least asa startingpoint, wewoulddo well to consider measuresthat applybroadly.Oneoption is tochangeminimum requirementsfor capital, liquidity, orboth at all regulatedfirmssoasto realize a macroprudential, aswell asmicroprudential, purpose.In their current form, existing and plannedliquidityrequirementsproduced by the Basel Committeeaim mostlytoencouragematurity-matched books.While maturitymismatch by core intermediariesisa keyfinancialstability riskin wholesalefunding markets,it is not the only one.Even if an intermediarys book of securities financingtransactionsisperfectlymatched, a reduction in its accessto fundingcan force the firmtoengagein asset fire salesor toabruptlywithdrawcredit fromcustomers.Theintermediarys customersare likelytobe highly leveragedandmaturitytransformingfinancial firmsaswell, and, therefore,may thenhaveto engagein fire salesthemselves.Thedirect and indirect contagion risksare high.Thus, thelong-term and short-term liquidityratiosmight berefashionedsoasto addressdirectlytherisksof largeSFT books.Similarly, existingbank and broker-dealer risk-basedcapital rules donotreflect fullythe financial stabilityrisksassociatedwithSFTs.Accordingly, higher, generallyapplicablecapital chargeappliedto SFTsmight be a useful pieceof a complementaryset of macroprudentialmeasures,though an indirect measurelike a capital chargemight havetobequitelargetocreateadequateincentivetotempertheuseofshort-termwholesalefunding.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  20. 20. P a g e | 20Bydefinition, bothliquidityandcapitalrequirementswouldbelimitedtobankingentitiesalready within the perimeterof prudential regulation.Theobviousquestionsare whether thesefirms at present occupyenoughof the wholesalefundingmarketsthat standardsapplicableonlyto themwouldbereasonablyeffectivein addressingsystemicriskand, evenif thatquestion isansweredaffirmatively, whetherthe imposition of suchstandardswouldsoon lead tosignificant arbitragethrough increasedparticipationby thoseoutsidetheregulatory circle.In part for these reasons,a second possibility that hasreceivedconsiderable attentionis a universal minimum margining requirementapplicabledirectlytoSFTs.TheFinancialStabilityBoardhasalreadyissuedaconsultativepaper,andreceivedpublic comment, on the idea.Under such a regime, all repolenders, for example, could be required totake a minimum amount of over-collateralizationasdeterminedbyregulators(the amount varying withthenature of the securitiescollateral), regardlessof whethertherepolender or repoborrowerwereotherwiseprudentiallyregulated.This kind of requirement could be an effectivetool tolimit procyclicalityin securitiesfinancingand, thereby, tocontain the risksof runsandcontagion.Of course,it alsoraisesmany of theissuesthat make settlingon a singlepolicy instrument sohard toachieve, and thedecision on calibrationwouldbe particularlyconsequential.Still, theconcept hasmuchtobesaidforit and seemsthemost promisingavenuetowardsatisfying the principleof comprehensiveness.It is definitelyworthpursuing.As you can tell, thereis not yet a blueprint for addressingthebasicvulnerabilitiesin short-term wholesalefundingmarkets.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  21. 21. P a g e | 21Accordingly, the risksof runsand contagion remain.For thepresent, wecan continuetowork on discreteaspectsof thesemarkets,such asthrough thediminution of reliance on intradaycredit intripartyrepomarketsthat isbeing achievedby Federal Reservesupervision of clearingbanks and through the moneymarket fundreforms that I expect will be pursued by theSecurities and ExchangeCommission.We might alsothink about lesscomprehensivemeasuresaffectingSFTs,such aslimitson rehypothecation, whenan institutionusesassetsthat havebeen posted ascollateral by itsclientsfor itsownpurposes.But I donotthink that thepost-crisisprogram ofregulatoryreform canbejudgedcomplete until a more comprehensiveset of measurestoaddressthisproblem isin place.Too-Big-to-Fail.Before discussingpoliciesspecificallydirected at too-big-to-fail, let mesayawordabout thecapitalregimethat shouldbeapplicabletoallbanks,on top of whichany additional requirementsfor systemicallyimportant institutionswouldbe built.ThefirstorderofbusinessistocompletetheBaselIII rulemakingassoonaspossible.Therequired increasesin thequalityand quantity of minimumcapital, and theintroductionof an international leverageratio, representimportant stepsforwardfor bankingregulationaround theworld.U.S. bankshave increased their capital substantiallysincethefinancialcrisisbegan, andthevastmajorityalreadyhaveTier1common risk-basedratios greater thanthe Basel III 7percent requirements.Thenew requirements, while big improvements, are not ashigh asIwouldhave liked, and the agreement containssome provisionsI wouldhaveomitted or simplified.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  22. 22. P a g e | 22In comingyearswemay well seek changes.Indeed, I continuetobe a strong advocateof establishingsimpler,standardized risk-basedcapital requirementsand amencouraged at theinitial workbeingdone on the topic of simplificationin the BaselCommittee.And wewill certainlysimplify the final capital ruleshere in the UnitedStatessoasto respondtothe concernsexpressed by smallerbanks.But opposing, or seeking delay in, Basel III would simply give an excusetobanksthat donot meet Basel III standards toseek delayfrom their owngovernments.It wouldbe ironic indeed if thosewhofavor higher or simpler capitalrequirementswereunintentionallytolend assistanceto banksthat wanttoavoid strengtheningtheir capital positions.Turningto specificpoliciesto addresstoo-big-to-fail, the first task is toimplement fullythecapital surcharge for systemically importantinstitutions,theLCR, resolution plans,and other relevant proposedregulations.But, completion of this agenda, significant asit is, wouldleavemoretoo-big-to-fail risk than I think is prudent.What more, then, should be done?As I have said before, proposalsto imposeacross-the-boardsize capsorstructural limitationson banks--whatever their meritsanddemerits--embodybasicpolicydecisionsthat areproperlytheprovinceofCongress.However, that doesnot mean there is norole for regulators.On the contrary, Section 165of theDodd-FrankAct givestheFederalReservethe authority, and theobligation, to apply regulationsofInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  23. 23. P a g e | 23increasingstringencyto large bankingorganizationsin order tomitigaterisksto financial stability.In any event, it isunlikely that the problemsassociated withtoo-big-to-fail institutionscan be efficientlyamelioratedusing a singleregulatorytool.Theexplicit expectationin Section 165that therewill be a variety ofenhancedstandardsseemswell-advised.We should be consideringwaysto usethis authorityin pursuit of threecomplementaryends:(1)ensuring the lossabsorbencyneeded for a credibleand effectiveresolutionprocess,(2) augmentingthe going-concern capital of thelargest firms, and(3)addressingthesystemic risksassociatedwiththe use of wholesalefunding.Thereisclearneedforarequirement that largefinancialinstitutionshaveminimum amountsof long-term unsecured debt that could be convertedtoequityand therebybe availabletoabsorb lossesin theevent ofinsolvency.Although the details will, as always, be important, there appears to be anemerging consensus among regulators, both here and abroad, in supportof the general idea.Debt subjecttothis kind of bail-in wouldsupplement the increasedregulatorycapital in order to provide greater assurancethat, should thefirm become insolvent, all lossescould beborne usingresourceswithinthefirm.This requirement for additional "goneconcern" capital wouldincreasetheprospectsfor orderlyresolution and, thereby, counteract themoralhazard associatedwithexpectationsof taxpayer bailouts.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  24. 24. P a g e | 24Switzerland hasalreadyadopted a requirement of this sort, and similarproposalsare beingactively debated in the European Union.AU.S. requirement, enacted under theFederal Reserves Section 165authority, wouldboth strengthenour domestic resolution mechanismsandbe consistent with emerging international practice.With respect to "goingconcern" capital requirements, there is a goodcasefor additional measurestoincreasethechancesthat large financialinstitutionsremain viablefinancial intermediarieseven under stress.Tome, at least, the important question isnot whethercapitalrequirementsfor largebanking firms need to be stronger than thoseincludedinBasel III andtheagreement oncapitalsurcharges,but howtomake them soand withwhat specificrisksin mind.In this regard, I wouldobservethat our stresstestsand capital-planningrequirementshave already strengthenedcapital standardsbymakingthem more forward-lookingand more responsive to economicdevelopments.As wegain experience, and asthe annual processbecomessmoother forboth thebanksand the Federal Reserve, wehave the opportunitytoenhancethestresstestsby, for example,varying thescenarioforstressingthetrading booksof the largest firms, soasto reflect changesin thecomposition of thosebooks.As to regulatorymeasuresof capital outsidethecustomizedcontext ofstresstesting, one approachisto revisit the calibrationof twoexistingcapital measuresapplicabletothe largest firms.Thefirst isthe leverageratio. U.S.regulatorypracticehastraditionallymaintaineda complementary relationshipbetweenthe greater sensitivityofrisk-basedcapitalrequirementsandthecheckprovidedbytheleverageratio on too much leveragearising from low-risk-weightedassets.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  25. 25. P a g e | 25This relationship has obviously been changed by the substantial increasein the risk-based ratio resulting from the new minimum and conservationbuffer requirementsof Basel III.Theexisting U.S. leverageratiodoesnot take account ofoff-balance-sheet assets,whichare significant for manyof the largestfirms.Thenew Basel III leverageratiodoesincludeoff-balance-sheetassets,but it may havebeen set too low.Thus, thetraditional complementarityof the capital ratiosmight bemaintainedby usingSection 165toset a higher leverageratiofor thelargest firms.Theother capital measurethat might berevisited is the risk-basedcapital surchargemechanism.Theamountsof thesurchargeseventuallyagreedtoin Basel wereat thelowerend of the rangeneeded to achievethe aim of reducingtheprobabilityof thesefirms failuresenough to offset fullythe greaterimpact their failure wouldhave on thefinancial system.At thetimethesesurchargeswerebeingnegotiated, I favoredasomewhatgreater requirement for thelargest, most interconnected firms.Here, after all, is where the potential for negative externalitiesis thegreatest, while the marginal benefits accruing from scale and scopeeconomiesare hardest to discern.While it is clearlypreferable at thispoint to implement what wehaveagreed, rather thantoseekchangesthat could delayany additional capitalrequirement, it maybedesirablefortheBaselCommitteetoreturn tothiscalibration issuesooner rather than later.The area in which the most work is needed is in addressing the risksarising from the use of short-term wholesale funding by systemicallyimportant firms.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  26. 26. P a g e | 26Thesystemic risksassociatedwithrunson wholesalefundingwould, almost by definition, be exacerbated if a very largeuser of thatfundingwereto comeunder seriousstress.There could alsobegreater negativeexternalitiesfrom a disruption oflarge, matched SFT positionson the booksof a major financial firm thanif the same total activitywerespread among a greater number of dealers.Thus, in keepingwiththe principleof differential and increasinglystringent regulationfor largefirms, there is a strong casetobemade fortakingstepsbeyond anygenerallyapplicablemeasuresthat areeventuallyappliedtoSFTs or short-term wholesalefundingmore generally.Onepossibilitywouldbe tohave progressively greaterminimumliquidityrequirementsfor larger institutionsunder theLCR and thestill-under-construction Net StableFunding Ratio (NSFR).Thereiscertainlysomeappealtofollowingthisroute,sinceit wouldbuildon all thework done in fashioningtheseliquidityrequirements.Theonlysignificant additionaltaskwouldbecalibratingtheprogressivitystructure.However,there are at least twodisadvantagestothisapproach.First, the LCR and, at leastat this stageof itsdevelopment, theNSFR, both restontheimplicit presumptionthat afirm withaperfectlymatchedbook is in a fundamentallystableposition.As a microprudential matter, this isprobablya reasonableassumption.But under some conditions,thedisorderlyunwindof a single, largeSFTbook, even onethat wasquitewell maturitymatched, could set off thekind of unfavorabledynamic describedearlier.Second, creatingliquiditylevelssubstantiallyhigherthan thosecontemplatedin theLCR and eventual NSFR may not be themostefficient wayfor some firms tobecome better insulated from therun riskInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  27. 27. P a g e | 27that can lead totheadversefeedback loop and contagionpossibilitiesdiscussed earlier.Amore interesting approachwouldbe totie liquidityand capitalstandardstogether byrequiringhigher levelsof capital for largefirmsunlesstheir liquidityposition is substantiallystronger than minimumrequirements.Thisapproachwouldreflectthefact that themarket perceptionof agivenfirmspositionascounterparty dependsupon the combinationof itsfundingposition and capital levels.It wouldalsosupplement the Basel capital surchargesystem, whichdoesnot includeuseof short-term wholesalefunding among the factorsusedtocalculatethe systemic "footprint" of each firm, and thusdetermineitsrelativesurcharge.While thereisdecidedlyaneed for solidminimum requirementsfor bothcapital and liquidity, the relationship betweenthe twoalsomatters.Whereafirm haslittleneedof short-term fundingtomaintainitsongoingbusiness,it is lesssusceptibleto runs.Where, on the other hand, a firm is significantlydependent on suchfunding, it may need considerablecommon equitycapital to convincemarket actorsthat it is indeed solvent.Similarly, the greater or lesser useof short-term funding helpsdefine afirmsrelativecontribution to thesystemic risk latent in thesemarkets.If realized, thisapproach wouldallowa firm of systemic importancetochoosebetweenholdingcapital in greater amountsthan wouldotherwiseberequired, or changingthe amount and composition of itsliabilitiesinorder to reducethecontribution it could make to systemic risk in theevent of a shock toshort-term fundingchannels.Theadditional capital requirementsmight be tied, for example, tospecifiedscoresunder an NSFR that had been reworked significantlysoInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  28. 28. P a g e | 28asto takeaccount of themacroprudential implicationsof wholesalefundingdiscussed earlier.If one wishedto maintain thepractice of groundingcapital requirementsin measuresof assets,another possibilitywouldbe toadd asa capitalsurchargea specifiedpercentageof assetsmeasuredsoastoweight mostheavily thoseassociatedwith short-term funding.Toprovidea meaningful counterweight to the risksassociatedwithwholesalefunding runs, the additional capital requirement wouldhavetobematerial.Thehighest requirement wouldbe at just the point wherea firm had theminimum required level of liquidity.Therequirement then woulddiminish asthe liquidityscore of the firmrosesufficientlyabove minimum required levels.If therequirement weresignificant enoughandlikelytoapplytoanylargeinstitution with substantial capital market activities,it might alsobe asubstitutefor increasingthecapital surchargeschedulealreadyagreed toin Basel.I readilyacknowledgethat calibratingtherelationshipwouldnot beeasy,and that the stakesfor both financial stability and financial efficiencyin gettingit right wouldbe significant.But I think this approach isworth exploring, preciselybecauseit restsupon the link betweentoo-big-to-fail concernsand the runsandcontagion that weexperiencedfive yearsago, and towhichweremainvulnerable today.Whether it provesfeasible, or whetherwewouldhave to fall back on themore straightforwardapproach of strengtheningliquidityrequirementsfor systemicallyimportant firms, the keypoint is that the principleofincreasingstringencybe applied.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  29. 29. P a g e | 29ConclusionOf late I find myself of two mindson thequestionof bringingto a closethemajor elementsof regulatory changefollowingthe financial crisis.On theonehand, I stronglybelievethat all theregulatoryagenciesshouldcompleteassoon aspossiblethe remainingrulemakingsgenerated byDodd-Frank and BaselIII.It is important that banks and other financial market actors know therules that will govern capital standards, proprietary trading, mortgagelending, and other activities.In fact, weshould monitor whethertheserulesend up havingsignificantunintended effectson credit availability and, if so, modify them in amannerconsistent withbasicaimsofsafetyandsoundnessandconsumerprotection.On theother hand, I equallystronglybelievethat wewoulddotheAmerican public a fundamental disservicewereweto declarevictorywithout tacklingthestructural weaknessesof short-term wholesalefundingmarkets, both in general and astheyaffect thetoo-big-to-failproblem.This is themajor problem that remains,and I wouldsuggest thatadditional reform measuresbeevaluated by referencetohow effectivetheycould be in solving it.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  30. 30. P a g e | 30Letters…… betweenAndrew Tyrie MP, and the ExecutiveDirector of thePrudential RegulationAuthority, Andrew Bailey, discussingSolvency II.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  31. 31. P a g e | 31International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  32. 32. P a g e | 32International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  33. 33. P a g e | 33International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  34. 34. P a g e | 34International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  35. 35. P a g e | 35BIS Working Papers, No 412Structural bank regulation initiatives:approachesand implicationsLeonardoGambacorta andAdrian vanRixtel, Monetaryand Economic DepartmentIntroductionIn responseto the global financial crisis, severaladvancedeconomieshave either adopted or are consideringstructuralbank regulation measures.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 financialmarkets,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 risks and market disciplinewereseen aseffectivesafeguardsagainst financial risksassociatedwith therapid expansion oflargeuniversal banks.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  36. 36. P a g e | 36The 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.While thecrisishasshowntheneed to strengthenmarket-basedpricing ofriskandmarketdiscipline,theheavyburdenofbank lossesimposedontaxpayers hasraised questionsabout theseparationof certain bankingactivities.Theproposedchangesdonot goasfar asthepreviousstrict separationofcommercial from investment banking that existed in somejurisdictions,such asthe United States.But for many countries, notablya number of continental Europeanones,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.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  37. 37. P a g e | 37Section 4 discussestheir implicationsfor banks‘businessmodels andprofitability.Thelast sectionconcludes.2. 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 guaranteeschemes) 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 to resolve;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.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  38. 38. P a g e | 38All thesemechanismswouldalsohelp tolimit taxpayers‘exposure tofinancial sector losses.Beyond 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 seekstocarveout onlyproprietarytradingwhileallowingmarket-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.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  39. 39. P a g e | 39Theproposalslimit 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 financialfirms, except that theyrequire theseparation of exposuresto entitiessuchashedge fundsand special investment vehicles(SIVs) in the tradingentity.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 andcorporatebanking, includingancillaryoperationsto hedge risks to support 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).International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  40. 40. P a g e | 40Recent 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?Themechanismslistedabove have intuitiveappeal.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  41. 41. P a g e | 41The 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 whichcombine commercial and securitiesbusinessarelesssafeorthat their failureismorecostlytothecommunity.Theevidencesuggeststhat the costsof failure of universal banks can 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 banks arehigher, 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 the design ofstructural regulationarise.Afirst question concernswheretheseparation lineisdrawn.Here, the philosophybehind theproposalsis quitedifferent.TheLiikanenReport optsfor combining proprietarytradingandmarket-makingactivitieson thegroundsthat the linebetweenthe twoisInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  42. 42. P a g e | 42toofuzzy and hard toenforce– a controversial issuewith theVolcker rulein theUnited States.And theVickersReport takesa very narrow view of thetypesof 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 tradingactivitiesinseparateentitieswill 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 provenotsufficientlystrongasreputational considerationsloom large.In 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.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  43. 43. P a g e | 43Their 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.While structural separation may help resolvability, thebenefitsof 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.Yet another questionconcernstheinteractionbetweennationalstructuralbank 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.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  44. 44. P a g e | 44Theformer 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 tofaceincreasingheterogeneityinpermittedbusinessmodelsat 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.Some new 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.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  45. 45. P a g e | 45Product differentiationis proxied by theratio of non-interest income(traderevenues, feesand commissionsfor services) to total income.On balance, theevidenceindicatesthat benefitsdoaccrueup toa 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.Theresultsindicatethat 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.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  46. 46. P a g e | 46Theeconometric analysisfindsthat ROE volatilityalsoincreases,up toapoint, with revenue diversification, after whichit declinesagainToread this excellent paper:http:/ / www.bis.org/ publ/ work412.pdfInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  47. 47. P a g e | 47CIMA Statement onAIFMDApril 12, 2013TheCayman IslandsGovernment passedan amendment on 15March, 2013,whichwill allowthe CaymanIslandsMonetaryAuthority (CIMA) to enterintomemoranda of understanding withitsEUcounterparts,usinga model MoU developed by theEuropean SecuritiesMarketsAuthority (ESMA).Theamendment wasa responseto theEuropean Union‘sAlternativeInvestment Fund ManagersDirective(AIFMD), which will requirecertainconditionstobe met beforenon-EU countries can marketalternativeinvestment funds– such ashedgefunds– in theEU.Minister,theHon. RolstonAnglin, whohasresponsibilityfortheCaymanIslandsfinancial servicessector, stated in the LegislativeAssembly thattheamendment wasnecessaryto enablethe continued marketingofCayman Islandsfundsin the European market.TheAIFMD is tobe implemented acrossEuropefrom 22July, 2013.With the amendment, Cayman is now compliant withthethreeAIFMDconditionsthat are of particular relevanceto this jurisdiction.Sinceearly2012,CIMA hasbeen in discussion with ESMAon the modelrequirements.TheAuthority hasnowtaken all necessary stepstoenablethesigning oftheagreement withESMA and hasindicateditsabilityand willingnesstoenter intocooperationagreementswiththeEU securitiesregulatorsbasedon the ESMAmodel MOU.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  48. 48. P a g e | 48CIMA to Host Meeting of theFinancial Stability BoardRegionalConsultative Group for theAmericas(GRAND CAYMAN - Friday, 3 May2013)TheCayman IslandsMonetaryAuthority (CIMA) will host the fourth meetingof the RegionalConsultativeGroup for theAmericasof the Financial StabilityBoard(FSB) on 27May, 2013.TheFSB wasestablished in 2009tocoordinatetheworkof nationalfinancial authoritiesand international standard setting bodiesat theinternational level, and todevelop and promote the implementation ofeffectiveregulatory, supervisoryand other financial sectorpoliciesin theinterest of financialstability.It brings togethernational authoritiesresponsiblefor financial stabilityin24countries and jurisdictions,international financial institutions,sector-specificinternational groupingsof regulatorsand supervisors, andcommitteesof central bank experts.TheFSB Secretariat is located in Basel,Switzerland, and hosted by theBank for International Settlements.Six regional consultativegroupsof theFSBwereestablishedin 2011, inresponseto a call from the G20Leaders at their TorontoSummit thepreviousyear, tobringtogetherfinancial authoritiesfrom89FSB memberandnon-member countries toexchangeviewsonvulnerabilitiesaffectingfinancial systems and on initiativesto promote financial stability.Theregional groupingsare theAmericas, Asia, Commonwealth ofIndependent States, Europe, MiddleEast and NorthAfrica, andSub-SaharanAfrica.Throughthesesix regional groups, the FSBis able todevelop globalfinancial policyinitiativesthrough a more inclusiveprocess.In additiontothe Cayman Islands,theRegional ConsultativeGroup fortheAmericas consistsofArgentina, Bahamas, Barbados, Bermuda, Bolivia, Brazil, BritishVirginIslands,Canada, Chile, Colombia, CostaInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  49. 49. P a g e | 49Rica,Guatemala, Jamaica,Mexico, Panama, Paraguay, Peru, UruguayandtheUnited StatesofAmerica.Approximately 40 representativesfrom these member countries areexpectedto come tothe Cayman Islandstoparticipatein themeeting tobehostedby CIMA.Themeeting will focuson vulnerabilitiesand regional financial stabilityissues,keyregulatoryissuesin financial stability includingtheover-the-counterderivativesmarket reformsand theKeyAttributesofEffectiveResolution Regimes.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  50. 50. P a g e | 50A. Introduction1.Section 34(1)(a) of the MonetaryAuthority Law (2008Revision) (asamended) (―MAL‖) states that –After privatesector consultationand consultationwiththe FinancialSecretary, theAuthority may –(a) issue or amend rulesor statementsof principleor guidanceconcerningtheconduct oflicenseesandtheirofficersand employees,andanyother personstowhom and totheextent that theregulatorylawsmayapply;2. Requirementsspecific totheprivatesector consultation areoutlinedinsection 4(1) of theMAL asfollows:When this Law requires private sector consultationin relationto aproposed measure-(a) theAuthorityshall givetoeach privatesectorassociationadraft of theproposed measure, together with –(i) an explanationof thepurpose of the proposedmeasure;International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  51. 51. P a g e | 51(ii)an explanationof theAuthority‘s reasonsfor believingthat theproposedmeasureiscompatiblewiththeAuthority‘sfunctionsanddutiesundersection6;(iii)an explanationof the extent to whicha corresponding measurehasbeen adoptedin a country or territoryoutsidethe Islands;(iv)anestimateof anysignificant costsoftheproposedmeasure,togetherwith an analysisof thebenefitsthat will arise if theproposed measure isadopted;and(v)noticethat representationsabout theproposed measure may be madetotheAuthority within a period specified in thenotice (not being lessthanthirty daysorsuchshorterperiod asmay bepermittedbysubsection(3));and(b) before proceedingwiththeproposed measure, theAuthority shallhaveregard to anyrepresentationsmade by the privatesectorassociations,and shall give a writtenresponse,whichshall be copiedtoall the privatesector associations.3.This paper outlinescorporategovernanceproposalsthat are intendedtoenhanceand clarify corporategovernancestandardsand providegreater transparencyin the financial servicesmarkets.As is the norm, thepaper proposeschangestocurrentguidance,regulationsor laws.However,ascorporategovernanceconsiderationsimpact on all financialservicessectorsand regulatory functionssuch aslicensing; fit and properassessment/ approval;regulatoryandsupervisorypowersoftheAuthority;regulatoryfilingsand many regulatory lawsand regulations;thisconsultation not onlymakes some proposalsbut alsoprovidesindustrywith an opportunitytofeedbackon certain issuestheAuthority iscurrentlyreviewing.4.CIMA has commissioneda corporate governanceindustrysurveytorun concurrentlywiththis consultation.The feedback received from this consultation will be consolidated withthe feedback received from the industry survey, providing CIMA with acomprehensiveassessment of industryviewson corporategovernance.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  52. 52. P a g e | 525. TheAuthority wantsfeedback from all interestedpartiesand requeststhat regulatedentitiessubmit their commentsvia their private sectorassociations.Due to the significance of this consultation, the Authority will allow otherinterested stakeholders in the Cayman Islands financial services sector torespond to thispaper.However,theAuthority requeststhat wherea submission ismade by anon-regulatedentity/ personthat the responseexplicitlystateswhatrole/interestthestakeholderhasin the industry; for examplean investorin Cayman Islandsstructures, funds, or Cayman Islandscaptives,etc.B. Background6.Analysisby international organisations,includingthe Financial StabilityBoard (‗FSB‘) and the Basel Committeeon BankingSupervision(‗BCBS‘), intothecausesof the 2007/2008financial crisisrevealeddeficienciesin corporate governancepracticesof regulatedfinancialservicesentitiesasa fundamental reasonfor the crisis.This resulted in a renewedfocusand review of corporate governancestandardsin thefinancial servicesindustry.As a consequence, the FSB, BSBSand the International Association ofInsurance Supervisors (‗IAIS‘) amongst others, revised their corporategovernanceexpectationsof regulated entities(seeappendix A).Thenew expectationsadvisedregulatorsthat enhanced corporategovernancestandards wereneeded toreinforced financial stabilityandprotect the financialmarkets.7.Regulatorsaround the worldarerespondingtotheseexpectationsbyenhancingthecorporate governancerequirementsin their respectivejurisdictions.Theseenhanced requirementsdemand improved corporate governancestandardsfrom regulatedentities,withgreater probity, transparencyandaccountabilityexpectedfrom regulated entitiesand their boards.8.Theglobal enhancement of corporategovernancestandards,inconjunction withtheAuthority‘s legal objectivesand the CaymanInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  53. 53. P a g e | 53Islands‘standing asan international financial centre, necessitatesareview of the jurisdiction‘scorporategovernance regulatory standards.9.This consultationpaper focuseson clarifying corporate governanceexpectations;rationalisingand modernisingtheregulatory framework;andpresentingcorporategovernancefactorstobeconsideredsubsequenttothis consultation.10.Thepaper reviewscorporate governance acrossall industry sectors.Unlessthe paper statesotherwise, all proposalswouldapplyacrossallsectors.C. Purposeof the Corporate Governance Review11.Thetransition of corporategovernance intoa fundamentalconsiderationin theoperation of a businessoccurred in the last 25-30years.The2007/2008financial crisis(‗theFinancial Crisis‘) resultedinCorporateGovernancebecoming a focal point in theglobal regulatoryreform agenda.12.One consequenceof the Financial Crisisisthe extensivecall, byinternational organisationsresponsiblefor promotingeffectivesupervision of the financial servicesindustry, for enhancedCorporateGovernancestandards. In the2-3years followingtheFinancial Crisis:a.The Basel Committee for Banking Supervision, in December2011, consulted on the review and modernisation of its CorePrinciplesfor Banking Supervision.Theupdated Core Principlesnow incorporate a new corporategovernancestandard (seeAppendix A).b.The Technical Committee of the International Organization ofSecurities Commissions‘ (‗IOSCO‘) recently published MitigatingSystemic Risk –ARole for SecuritiesRegulators.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  54. 54. P a g e | 54This paper focuseson the rolesecuritiesregulatorsplayin addressingsystemic risk and assessescorporategovernanceconsiderationssuch asappropriatelymanagingconflict of interestsand theincreased prevalenceof non-riskfocused incentivestructures.c.TheIAIS published, in October 2011, its updatedCore Principlesintroducingnew corporategovernanceexpectationsof regulators(seeappendixA).d.TheOrganisationfor EconomicCo-operation and Developmentreiteratedsome key messagesin itslatest report on CorporateGovernanceand theFinancial Crisis issuedin February2010.e.TheFSB issuedCorporate Governancepapersin 2011oncompensation, improved supervisorypowersand monitoring, andbolsteringfinancial stability through corporategovernance.13.Theseinternational developmentsrecommend or require greaterprobity, transparencyand accountability at a national level.14.Section6(2) of theMonetaryAuthority Law (‗MAL‘) requirestheAuthorityto:(a) act in the best economicinterestsof the Islands;(b) promoteand maintain a sound financial system in theIslands;…15.In section6(3) theMAL stipulatesfurther that ―In performing itsregulatoryfunctionsand itsco-operativefunctions,theAuthority shall, inadditiontocomplying withthe requirementsof subsection(2)‖:(a)endeavour topromote and enhancemarket confidence, consumerprotectionand the reputationof the Islandsasa financial centre;(b)endeavour toreducethepossibilityof financial servicesbusinessorrelevant financial businessbeingused for the purposeof moneylaunderingor other crime;International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  55. 55. P a g e | 55(c)recognisetheinternationalcharacterof financial servicesand marketsandthenecessityof maintainingthe competitiveposition of theIslands,from thepoint of view of both consumersand suppliersoffinancial services, while conforming to internationallyapplied standardsinsofarastheyare relevant and appropriate to thecircumstancesof theIslands;(d)recognise the principle that a burden or restriction which is imposedon a person, or on the carrying on of an activity, should be proportionateto the benefits, considered in general terms, which are expected to resultfrom theimpositionof that burden or restriction;(e)recognisethe desirabilityof facilitatinginnovation in financialservicesbusiness;and …16.Bearingin mind theselegislativeobligationsresting on theAuthorityandthe Cayman Islands‘position asa leadinginternational financialcentre, theAuthority considersregulatingand supervisingtheCaymanIslandsfinancial servicesindustrytoobserved international standards-insofarastheyarerelevant and appropriatetotheCayman Islands- a keyobjectiveto meetingits obligationsin section 6(2)(a) and (b) and section6(3)(a).However,in seekingto meet these legislativeobligationstheAuthoritycontinuouslystrivestopropose and implement standardsthat areproportionateto theanticipatedbenefits.17.Thus,consideringthe developmentsemanatingfrom internationalorganisationsandtheresultant nationaldevelopmentsoccurringglobally, theAuthority considersthe modernising of the corporategovernancestandardsin theCayman Islandsfinancial servicessectornecessaryand beneficial tothe continued international standingof thejurisdiction.TheAuthority further considersthepurposeof theseproposalsbeingcompatiblewithitslegislativeobligationsand strategic objectives.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  56. 56. P a g e | 56D. Implementation in other jurisdictions18.In the 24 monthssubsequent to theonset of the Financial Crisis, theBVI Financial ServicesCommission, the Central Bank of Ireland, theJerseyFinancial ServicesCommission, theBermuda MonetaryAuthority,theGuernseyFinancial ServicesCommission, the BahamasFinancialServicesBoard and the Isleof Man SupervisionCommissionall updatedtheir CorporateGovernancecodes, lawsand/ or regulationstoaccommodatethe international developments.19.Theseamendmentsoccurred in variousforms,includinglaws,regulations,Codesof Conduct and guidance.Many of thesejurisdictionshave thekey directors‘duties in theirCompaniesLaw or theequivalent thereof.Generallythesejurisdictionssupplement theselawswithguidance fortheir industry.E. The ProposalsE1 Statement of Guidance: Corporate Governance17.TheStatement of Guidance on Corporate Governance (‗SOG‘)currentlyappliesto licenseesonly.However,theheightenedexpectationof investorsandprovidersofcapitalis demanding more prudent corporategovernancestandardsfrom allfinancial servicesentities.Having reviewedthefinancial servicessectors, theAuthority recognisedtheimportanceof registeredand administeredentitiesapplyingappropriatecorporategovernancestandards.18.Therefore,the proposal isto extend the current SOG to registrants.Simultaneously, theAuthorityproposestoamend the current SOG.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  57. 57. P a g e | 57Theobjectivesfor theamendmentsare:a.to make theSOG more generic and suitablefor cross-sectoralapplication, i.e. tomake the SOG relevant to thefunds,insurance,bankingand fiduciarysectorsalike; andb.to reinforcefundamental corporate governancestandardsexpectedfrom entitiesregulatedand supervised by theAuthority.Thisistobeachievedbyexplicitlyoutliningin theSOG keymanagementoversight and corporate governanceprinciplesand the primary duties oftheboard directors.19.Theproposed amended SOG is attached in appendix B. Yourcommentsare sought on thedraft SOG.In particular, theAuthority would like toknow whetherthe addition of keycorporate governanceprinciplesenunciated in sections3-6areuseful inclarifying what theminimum expectationsof theboard and its directorsare.20.TheAuthority hasrefrainedfrom proposingthe implementation of arule or code settingout compulsory standardsfor the industry.TheAuthority considersthisto predominantlybe a sophisticatedfinancial servicesjurisdictionwith suitablyqualified participantsandserviceproviders.Our researchindicatesanappropriateawarenessof corporategovernanceexpectationsand a suitableapplication of these standards in day-to-dayoperations.21.EachsectorlawallowstheAuthoritytotakespecifiedactionwheretheAuthority considersthedirection and management of a licensee‘sbusinessnot tohavebeen conductedin a fit and proper manner.TheAuthoritywillberecommendinglegislativeamendmentswithineachof theselaws(in footnote 2) confirmingthat theAuthority will assessandInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  58. 58. P a g e | 58consider adherencewith the SOG whendeciding whethera licensee‘sbusinesshasbeen conducted in a fit and proper manner.In addition toviewson issuesraisedabovetheAuthority asksforindustryviews on the following questions:Question 1: Tofacilitatethe cross-sectoral application of theSOG, theAuthorityhasrestrictedthecorporategovernanceguidancein theSOG tofundamental principlesand requirements.Doesthe industryfind thisuseful and appropriateor wouldtheindustry prefer more detailedguidance?Question2:Doesindustryapproveof thecross-sectoralapplicationof theSOG or wouldyou prefer sector-specific guidance?If you wouldprefersector-specificguidanceexplain the reasonsfor your preference.E2 Public Database22.TheAuthority hasbeen consideringthedevelopment of a publicdatabase,operated and controlled by theAuthority, for accessbyinterestedstakeholders.With theinternational call for heightened disclosureand transparencywebelievethat a public databasewill not onlycomplement current duediligenceprocessesbut alsoenhancethereputationof itsfinancialservicesindustry.Thedatabasewouldbe accessibleonline.23.Toaccommodatethe cost of settingup the database,it is proposed togrant accesstothe databaseupon thepayment of a fee.TheAuthorityhasnot yet decidedwhetherthefeewouldbean annual feeor a fee charged per searchor whetherboth optionswouldbe provided.Thedatabasewouldincorporateall sectorsand wouldcontaininformation relatingto licenseesand registrantsalike.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  59. 59. P a g e | 59It is currentlyenvisagedthat thedatabasebe searchableusingtheregulated entity‘s name.Onceasearchisconducted, thedatabasewill provide, asaminimum, thename/sof theentity‘s directorsand itsregisteredoffice.The Authority is considering what further information could be providedon the database and is interested in your viewson how you could benefitfrom thedatabase.24.TheAuthorityiscautiousindefiningthecriteriaandinformationtobeprovided in thedatabasetoensure that the information providedisrelevant, appropriate and useful for thoseusing the database.25.The independent information provided by the database will facilitatethe due diligence process involved during investment or capital injectiondecisions.Theproposeddatabasewill make theduediligenceprocessmoreefficient and cost effectivefor industry.It is anticipatedthis positivedevelopment wouldresult in investorsseekingtoinvesttheir assetsand capital tolookfavourablyuponCaymanIslands‘incorporatedentities.26.TheAuthority alsoanticipatesthedisclosuresin the databasetocontributeto market disciplineobjectives;thusadding a constructivesupplement to thesupervisory actionsof theAuthority.27.We will recommend legislativeamendmentsto theMAL toexplicitlyincorporateregulatorypowersto providethepublic database.In addition toviewson issuesraisedabovetheAuthority asksforindustryviews on the following questions:Question 3: Doyou consider theinformation proposed tobe availableonthepublic databaseto be relevant and appropriateor wouldit beInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  60. 60. P a g e | 60beneficial toincludefurtherinformation such as(whereapplicable)custodian, fund administrator,insurancemanager, or auditor?E3 Application of the Companies Management Law28.Section3(3) of theCompaniesManagement Law (‗CML‘) statesthat anatural person shall not be deemedtobe in the businessof companymanagement ‗merelyby virtue of beinga director of oneof morecompanies.‘.Theintentionof this provision wastoensure that only individualswhowereprovidingdirectorship servicesinthecourseof their businessorasaprofessional director and for profit or reward wouldbe classifiedasconducting company management business.Theintentionof this provision wasnot the blanket exemption ofindividualsactingasdirectors.TheAuthority will recommend amendmentsto the CML that clarifythisposition.29.TheAuthority considersclarifying thescope of applicationof theCML beneficial totheindustry and thesupervision thereof.The intention at all timeswas for the CML to apply to all personsorentities who offer, provide or arrange others to act as directors, or topersonswhothemselvesact asdirectors.30.TheCML and Mutual FundsLaw both includetheprovision ofdirectorsin their respectivedefinitions.Theselawsrefer tothe ‗provision‘, ‗offering‘, ‗arranging‘ of ‗directors‘or‗operators‘.Having this service regulated by two separate laws, and - by extension –two divisions in the Authority potentially obscures the understanding ofthelaw and the supervisionof this service.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  61. 61. P a g e | 61In addition, thevarioustermsused todescribetheservicemaycontributetouncertaintyin theindustry. Thus,in addition to clarifying theapplication of the CML, theAuthority will alsorecommend legislativechangesthat simplifyand clarify the provision of this service and thedefinitionthereof.31. In clarifying the supervisory structure, the Authority proposes toimplement greater consistency in the regulation and supervision ofdirectorship services.Complementing theremoval of section3(3), theAuthority willrecommend legislativeamendmentsconfirmingwhothe CML appliesto(withregard totheprovisionof directorship services). Theobjectiveisto:a.continueapplying theCML toentitiesor personswhoprovide, offer orarrangedirectorshipservices;andb. require personsor entitieswho:i. act asa director;andii. dosofor six or more entities;andiii. do sofor profit or reward;torequire permissionto act or be offered or provided asa director.We will recommend a legislativeamendment prohibitingpersonsfallingwithinthe definitionof paragraph 31(b) above from being offered orprovided or actingasdirectorswithout first beingregisteredwith theAuthority.Toensure consistent application, thiswill apply to all personsmeetingthedefinition in paragraph 31(b) irrespectiveof their geographicallocation.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  62. 62. P a g e | 6232.The intention isto better define and regulate directorship services byallowing the Authority to assess and approve persons acting as directorsasa profession.This approval processis toreceiveassurancethat thepersonsbeingofferedand actingin thiscapacityhaveasoundfinancial backgroundandare sufficientlycompetent and experiencedtoact asdirectors.It is anticipatedthat this approval processwill contributeto the soundandproficient provision of this service.E4 Directors‘ registration33.Tosupporttherealignment ofthesupervisionof directorshipservices, theAuthority wantstoenhancethesupervisionof this serviceand theprovision thereof.Althoughcorporategovernanceexpectationsaredependent onthetypeofbusinessan entity conductsand thenature, scaleand complexityof thebusiness,corporategovernancestandardsare a keyfactorin all regulatedactivities.34.TheAuthority proposesimplementinga requirement for all directorsof regulatedentities,whoare not beingapproved asdirectorsof licenseesor via the‗professional‘director route (i.e. the CompaniesManagementLaw amendment) to registerwiththeAuthority.This registration will entail a proposeddirectorproviding personal andcontact details;informationregarding therole;the director‘sexperienceand knowledgeof thesector s/he will be overseeing;and informationregardingany previousor on-goingregulatory, legal or judicialenforcement action against the director.This information wouldbe submitted together withan entity‘sregistrationdocumentsor, if the appointment occursafterregistration, upon appointment.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  63. 63. P a g e | 6335.TheAuthoritywill alsorecommendalegislativeamendment requiringthedirectorstoinform theAuthority, within a certaintimeframe, of anychangesto the informationsubmitted.This processis expectedto improvetheAuthority‘s industrydata andshould improve efficiencieswhen supervisingcorporategovernancestandards.This information should enabletheAuthority to more readily contactdirectorswhenseekingresponsestoqueries it may have.E5 Corporate Governance Survey36.Concurrent withthisconsultationprocess, theAuthoritycommissionedan industry survey on corporategovernancestandards,includingcanvassingviewson implementing limitson thenumber of directorshipsheld.Thein-depth reviewstheAuthority hasconducted on thisissueshowsome advantagestoimplementing a limit;howeverthereviewsalsoconfirm shortcomingsin imposinga limit.Tocomplement the policy development process, theAuthoritycommissionedthesurvey to collect comprehensiveindustryviewson thetopic.37.Imposinga limit wouldbe beneficial in pronouncing what theAuthority considersan acceptablelevel of responsibilitybut it ischallengingto designa limit that takesaccountthe nature, size andcomplexityof theregulatedentity.For example; a ‗low‘ limit would not take account of the feasibility of adirector being able to sit on the boards of connected entities where themajorityof thedecisionsmay applytoall theinterconnectedentities.Thus, such a director adheringto a limit may bedisadvantagedbecause,having a largeportion of his/ her entitiesinterlinked, wouldallow him toInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  64. 64. P a g e | 64take on more directorshipsand yet remain able toapplyadequatelyhis/ hermind toall entities.Thecorollaryof thisisthat thesamelimit maybeinappropriateforafunddirectorwhoalsositson theboard of an international conglomerateassucharolemay notallowthedirectortoprovideadequateattentiontothefund directorshipss/ hemay hold.38.Another concernis that a limit wouldonlytakeaccount of thedirectorshipsheld in regulated entities.It wouldnot be feasibleto design a limit that takesintoaccount adirector‘scommitmentsoutsidethe regulated arena.Thus, twoindividualscould each have thesamenumber of directorshipson regulatedentitiessimilarin nature, size and complexity, but onecould,in additiontohisdirectorshipduties,bethemanagingdirectorofa largecorporation or professional servicesfirm.Alimit may be suitablefor theperson holdingonly the directorshippositionsbut not suitablefor the directorholdingthe directorshippositionsin additionto beingthe MD of an organisation.39.Whether a person is ableto adequatelyapplyhis/ her mind to all thedirectorshipss/ heholdsis the fundamental question tobe considered.40.For thereasonsoutlinedabove, theAuthority hasdecided that itwouldask industryfor itsviewson a limit through an industry survey.41.This surveywill alsoask questionsregardingthe regulatory corporategovernanceframework, includingwhether it wouldbe advantageoustorecommend a legislativeamendment requiringthenumber ofdirectorshipsheld by a director tobe stipulatedin an entity‘sfoundingdocuments(suchasthe offeringmemorandum of a regulated fund).International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  65. 65. P a g e | 65E6 Corporate directorships42.Corporatedirectorshipis not beingconsulted on in thispaper;howevertheAuthority intendsto consult on this in the near future and wouldwelcomeanyinitial thoughtson allowingcorporatedirectorstosit on theboardsof certain regulated entities.43.Internationally, the acceptanceof corporatedirectorsof regulatedentitiesis fragmented with some jurisdictionsallowingit, someprohibitingit, and some accepting it but withstringent conditions.44.TheAuthority is particularlyinterestedin receivingviewsonapportioningaccountabilityasit relatestoa corporate director;how toapplya limit on thenumber of directorshipsto a corporatedirector;andassessingthe fitnessand propriety of a corporate director.This will be consultedon but initial thoughtson this wouldcontributetoour review of the topic.F. Estimation of significant costsand benefitsa. Costs18.There should not be any direct costsassociated withtheamendedSOGasmostofthestandardsarein thecurrent versionoftheSOGandallnew standardsincorporatedin theSOG are current common lawprinciplesthat applyto Cayman Islands-registeredcompanies.19.TheAuthority hason-going IT initiativesthat seek to enhancetheeffectivenessand efficiencyof regulatoryfilings and reports.Theseinitiativeswillserveasaplatform fortheproposedpublic database.Thus, themajority of the costsare incorporatedintoapproved ITprojects.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  66. 66. P a g e | 66Theadditional costof settingup thedatabasewill be subsidisedby anadministrativefeefor accesstothedatabase.This fee will be borne by usersof thedatabase.There should be no tangibleeffect on due diligencecostsasthe databasewill improveduediligenceprocessesfor many stakeholdersin thefinancial servicesindustry.20.TheCML provisionsare intended to capture individualsactingasdirectors,thustheclarificationof thisrequirement doesnot impactonthecostsof providingthis service.Those entities currently providing operators (directors) under a MutualFund Administrators Licence will have reduced registration and licencefeesunder theCML.21.Thesurvey costswill be taken from theAuthority‘s operationalbudget. Therewill nocostimplication on the industryemanatingfromthecommissioningof the survey.b. Benefits22.As outlinedin Section B, inadequatecorporategovernance standardswerea key factor in theFinancial Crisis.Financialfailuresarecostlytotheshareholders,customers,suppliersandcreditorsof the failed entity.Researchshowsthat better corporategovernancereducesthepossibilityof financial failures.Modernisingthe corporategovernancestandardsin the Cayman Islandswill result in better managed entities;better board oversight of an entity;more focused risk management practicesand enhanced controlstomitigaterisks.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  67. 67. P a g e | 6723.This should contribute not onlyto minimising corporatefailuresbutalsotoprotectingthereputationof theCayman Islands‘financialservicessector.24.Thepublic databasewill provideindustrywithan independent andreadilyavailablesource of informationthat shouldexpeditethe duediligenceprocessfor manyinvestors.ThecentralCIMAdatabaseshouldenableamoreefficientandtimelyduediligenceprocessthat can contributeto reducingthe cost of theprocess.25.Regulatingtheprovision of directorsand operatorsunder the CMLwill streamlinethesupervision of thisbusiness.It will reduceany potential for duplication of supervisorywork betweentheAuthority‘sInvestment ServicesDivision and the Fiduciary Division.This alsopromotesmore consistent treatment of regulated entities.26.As corporategovernance standardshavea significant effect on thestrength and stabilityof the financial servicessector, it isimportant thatanyproposalsamendingthe corporategovernancestandardsareconsideredand appropriatefor this jurisdiction.To contribute to this objective, the Authority has commissioned a surveyto receive direct feedback on certain issues from as wide a representationof the industry aspossible.Not onlywill this feedback contributetoour current corporategovernanceresearchand analysis, but it will providetheAuthority withacomprehensiveand informed view from industry on theseissues.27.TheAuthority considersthesecorporate governance amendmentsasbeneficial tothe Cayman Islands,itsstandingin the internationalfinancial servicessector and itsreputation.TheAuthority alsoconsiderstheseamendmentsessential tothecontinued soundnessand stabilityof theindustry.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  68. 68. P a g e | 6828. TheAuthority considersthebenefitsof theseproposedmeasurestosignificantlyoutweightheir costs.G. Commentsand Consultation29.TheAuthority seeksconsultationthrough writtencommentsandrepresentationsfromtheprivatesectorassociationsconcerningtheissuesdetailed above.30.TheAuthority must receiverepresentationsby 17H00, Monday, 18thMarch2012.32.TheAuthorityshall havedueregardtoanyrepresentationmadebytheprivatesector associationsand industrystakeholders.TheAuthority shallprovidea writtenresponsecollatingthe feedbackreceived and theAuthority‘s positionon thisfeedback. Thisresponseshall be copiedtoallrelevant privatesector associationsonly.Appendix AEnhancements of International Standards1. Basel Committee for Banking SupervisionPrincipleproposedin current BCBSconsultationupdating theitsCorePrinciples:Principle 14– Corporate governance:Thesupervisor determinesthat banks and banking groupshave robustcorporategovernance policiesand processescovering, for example,strategic direction, group and organisational structure, controlenvironment, responsibilitiesof thebanks‘Boards and seniormanagement, and compensation.Thesepoliciesand processesare commensurate with the risk profile andsystemic importanceof the bank.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  69. 69. P a g e | 692. International Association of Insurance SupervisorsUpdated Core Principles(October 2011)ICP 7 Corporate GovernanceThesupervisor requiresinsurerstoestablish and implement a corporategovernanceframework whichprovidesfor sound and prudentmanagement and oversight of the insurer‘sbusinessand adequatelyrecognisesand protectsthe interestsof policyholders.Structure and governance of the Board3.Thesupervisorrequiresthe insurer‘sBoard to have, on an on-goingbasis:- an appropriate number and mix of individualsto ensure that there isan overall adequatelevel of knowledge,skillsand expertiseat theBoard level commensuratewiththe governance structure and thenature, scaleand complexityof the insurer‘sbusiness;- appropriateinternal governance practicesand procedures tosupporttheworkof theBoard in a manner that promotestheefficient, objectiveand independent judgment and decision makingbytheBoard; and- adequatepowersand resources tobe able to discharge itsduties fullyand effectively.Duties of individual Board members4. Thesupervisor requiresthe individual membersof the Board to:- act in good faith, honestlyand reasonably;- exercisedue care and diligence;International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com

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