Risk management presentation May 6 2013

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Risk management presentation May 6 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,I had a difficult time in thepast to explainliquidityrisk management and ratios.Now I know what todo. Problem solved!I will use a pollution-mitigatingtechnology, likescrubberstoexplain liquidityrisk.Mr. JeremyC Stein, Memberof the Board of Governorsof the Federal Reserve System explainedhow:―Supposewehave a powerplant that producesenergyand, asa byproduct, somepollution.Supposefurther that regulatorswant toreducethepollutionand have twotoolsat their disposal:Theycan mandatethe useof a pollution-mitigatingtechnology, like scrubbers, or theycanlevyatax ontheamount of pollution generatedby theplant.In an ideal world, regulation wouldaccomplishtwoobjectives.First, it wouldlead toan optimal level of mitigation– that is, it wouldinducethe plant toinstall scrubbers up tothe point wherethecostof anInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  2. 2. P a g e | 2additional scrubber isequal to themarginal socialbenefit, in terms ofreducedpollution.And, second, it wouldalsopromote conservation:Giventhat thescrubbersdon‘t get rid of pollutionentirely, onealsowantstoreduceoverall energyconsumption bymaking it more expensive.Asimplecaseis onein whichthe costsof installingscrubbers,aswellasthesocial benefits of reducedpollution, are knownin advanceby theregulator and themanager of the powerplant.In this case, the regulatorcan figure out what theright number ofscrubbersis and require that theplant install thesescrubbers.Themandate can thereforepreciselytarget the optimal amount ofmitigation per unit of energy produced.And, to the extent that the scrubbers are costly, the mandate will alsoleadto higher energy prices, which will encourage some conservation, thoughperhapsnot the sociallyoptimal level.This latter effect isthe implicit tax aspect of themandate.Amore complicatedcaseis when the regulator doesnot know ahead oftimewhat the costsof building and installingscrubberswill be.Here, mandatingtheuse of a fixednumber of scrubbersispotentiallyproblematic:If the scrubbersturn out tobe very expensive, the regulation will end upbeingmore aggressivethansociallydesirable,leadingto overinvestmentin scrubbersand largecostincreasesfor consumers;however, if thescrubbersturn out tobe cheaper than expected, theregulation will havebeen too soft.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  3. 3. P a g e | 3In otherwords, whenthecostofthemitigationtechnologyissignificantlyuncertain, a regulatory approachthat fixesthe quantityof mitigationisequivalent toone wherethe implicit tax rate bouncesaround a lot.Bycontrast, aregulatoryapproachthat fixesthepriceof pollutioninsteadof the quantity– say, by imposing a predeterminedproportional tax ratedirectlyon the amount of pollution emittedby the plant – is moreforgivingin the faceof this kind of uncertainty.This approach leaves the scrubber-installation decision to the manager ofthe plant, who can figure out what the scrubbers cost before deciding howtoproceed.For example, if thescrubbers turn out to be unexpectedlyexpensive, theplant manager can install fewer of them.This flexibilitytranslatesintolessvariabilityin theeffectiveregulatoryburden and hence lessvariabilityin the price of energy toconsumers.Scrubbers and high-quality liquid assetsWhat doesall thisimplyfor the designof the LCR?Let‘s workthrough theanalogyin detail.Theanalog to the powerplant‘s energyoutput is the grossamount ofliquidityservicescreatedby a bank – via its deposits,thecredit linesitprovidesto itscustomers, the prime brokerage servicesit offers,and soforth.Theanalog to themitigationtechnology– the scrubbers– is the stock ofHQLA that the bank holds.And the analogto pollution is thenet liquidityriskassociated with thedifferencebetweenthesetwoquantities, somethingakin to the LCRshortfall.That is,whenthebank offersalot of liquidityondemand toitscustomersInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  4. 4. P a g e | 4but fails tohold an adequatebuffer of HQLA, this is whenit imposesspillover costson the rest of thefinancial system.In the caseof thepowerplant, I argued that a regulation that callsfor afixed quantityof mitigation– that is, for a fixednumber of scrubbers– ismore attractivewhenthere is littleuncertainty about thecost of thesescrubbers.‖Thank you Jeremy!I have justopenedmy master plan. I have to learn more about scrubbers.I now see other similaritiesbetweentheBISand scrubbers. Onlynow Ican understand theshapeof the BISbuilding!I think I have just found another regulatoryarbitrageopportunity. Arealnational discretion, justified.Scrubbersarecapableof reduction efficienciesin the rangeof 50% to98%. Why should theLiquidityCoverageRatiobe 100%?ALCR from 50% to98% (meaning50,001%) is good enough!International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  5. 5. P a g e | 5Thecalculationsin Basel and scrubbersare alsoalmost thesame!Read moreat Number 1below.Welcometo the Top 10list.BestRegards,GeorgeLekatisPresident of the IARCPGeneral Manager, ComplianceLLC1200G Street NW Suite800,Washington DC20005,USATel: (202) 449-9750Email: lekatis@risk-compliance-association.comWeb: www.risk-compliance-association.comHQ: 1220N. Market Street Suite804,Wilmington DE 19801,USATel: (302) 342-8828International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  6. 6. P a g e | 6Liquidity regulation and central bankingSpeechby Mr Jeremy C Stein, Member of the Boardof Governorsof theFederal Reserve System, at the―Finding theright balance‖ 2013Credit MarketsSymposium, sponsored by theFederal Reserve Bankof Richmond, Charlotte, North CarolinaBasel III Capital: AWell-Intended IllusionThomasM. Hoenig, Vice Chairman, Federal DepositInsuranceCorporation, InternationalAssociation ofDeposit Insurers, 2013ResearchConference, Basel,Switzerland―Aristotleis creditedwithbeingthe first philosophertosystematicallystudylogical fallacies, whichhedefinedasargumentsthat appearvalid but, in fact, arenot.I call them well-intendedillusions.Onesuch illusion of precision is the Basel capital standardsin whichworldsupervisory authoritiesrely principallyon a Tier 1capital ratiotojudgethe adequacyof bank capital and balance sheet strength.‖PCAOB IssuesPolicy Statement onExtraordinary Cooperation in Connectionwith Board InvestigationsWashington, DCInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  7. 7. P a g e | 7ThePublic CompanyAccounting Oversight Boardtoday publishedaformal statement concerningthebenefitsthat may be availabletoregisteredpublic accounting firms and individualswhoprovideextraordinarycooperation in PCAOB investigations.Solvency II: whereare we now?Although there is nocertaintyon theSolvencyII implementationdate, EU policymakers are continuingtofinalisekey aspectsof theframework.Policy StatementConducting statutoryinvestigationsThePrudential RegulationAuthority (PRA) is required, under theFinancial ServicesAct 2012(theAct), to investigateand report to HMTreasuryon possibleregulatory failureand mattersof public interest.Commission report underlines importanceand urgency of financial sector reforms asabasis to restore long-term growthThe European Commission is publishing today the European FinancialStability and Integration Report (EFSIR), which is being presented at ajoint conferencewith the European Central Bank (ECB) in Brussels.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  8. 8. P a g e | 8Statement on the 2013PCAOB AcademicConferenceJeanette M. Franzel, Board Member2013 PCAOB Academic ConferenceWashington, D.C.The importance of culture in drivingbehavioursof firms and how the FCA willassessthisSpeechby CliveAdamson, Director of Supervisionat theCFA Society -UK ProfessionalismConference19April 2013,London.Lessons for South Africa from Germany in achallenging global environmentAddress by MsGill Marcus,Governor of theSouthAfrican Reserve Bank, at theSouthernAfrican-German Chamber of Commerceand Industryluncheon, JohannesburgThe journey of financial reformAddress by Mr Philip Lowe,DeputyGovernor of theReserveBank ofAustralia, totheAustralian Chamber of Commercein Shanghai.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  9. 9. P a g e | 9Liquidity regulation and centralbankingSpeechby Mr Jeremy C Stein, Member oftheBoard of Governorsof theFederalReserveSystem, at the ―Finding the rightbalance‖ 2013Credit MarketsSymposium, sponsored by theFederalReserve Bank ofRichmond, Charlotte, North CarolinaI‘d like to talk todayabout one important element of the internationalregulatoryreform agenda– namely, liquidityregulation.Liquidityregulation is a relativelynew, post-crisisaddition tothefinancial stabilitytoolkit.Key elementsincludethe LiquidityCoverage Ratio (LCR), whichwasrecentlyfinalizedbythe Basel Committeeon Banking Supervision, andthe Net StableFundingRatio, whichis still a workin progress.In what follows, I will focuson the LCR.Thestated goal of the LCR is straightforward, even if some aspectsof itsdesignare lessso.In the wordsof theBasel Committee, ―Theobjectiveof theLCR is topromotetheshort-term resilienceof theliquidityrisk profile of banks.It doesthis by ensuringthat bankshavean adequatestock ofunencumberedhigh-qualityliquid assets(HQLA) that can be convertedeasilyandimmediatelyin privatemarketsintocashtomeettheir liquidityneedsfor a 30 calendar day liquiditystressscenario.‖In other words,each bank isrequired to model its total outflowsover 30days in a liquiditystressevent and then tohold HQLA sufficient toInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  10. 10. P a g e | 10accommodatethoseoutflows.This requirement isimplemented witha ratio test, wheremodeledoutflowsgo in thedenominator and the stock of HQLA goesin thenumerator;whentheratio equalsor exceeds100percent, therequirementis satisfied.TheBasel Committeeissued the first versionof the LCR in December2010.In January of thisyear, thecommitteeissueda revisedfinal version of theLCR, followingan endorsement byitsgoverningbody, theGroup ofGovernorsand Headsof Supervision (GHOS).Therevision expandsthe rangeof assetsthat can count asHQLA andalsoadjustssomeof the assumptionsthat govern themodeling of netoutflowsin a stressscenario.In addition, thecommitteeagreed in January toa gradual phase-in of theLCR, sothat it only becomesfullyeffectiveon an international basisinJanuary 2019.On thedomesticfront, theFederal Reserve expectsthat theU.S. bankingagencieswill issuea proposal later this year to implement theLCR forlargeU.S.bankingfirms.While thisprogressiswelcome, a number of questionsremain.First, towhat extent should accesstoliquidityfrom a central bank beallowedto count towardsatisfying theLCR?In January, the GHOS noted that theinteraction betweentheLCR andtheprovision of central bank facilitiesiscriticallyimportant.And the group instructedthe Basel Committeeto continueworkingonthisissuein 2013.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  11. 11. P a g e | 11Second, what stepsshould be taken to enhancethe usability of the LCRbuffer – that is, toencouragebanksto actuallydraw down their HQLAbuffers,asopposed tofire-sellingother lessliquid assets?TheGHOShasalsomadeclear itsview that, during periodsof stress,itwouldbe appropriatefor banksto usetheir HQLA, therebyfallingbelowtheminimum.However,creatinga regimein whichbanks voluntarilychooseto dosoisnot an easytask.Anumberofobservershaveexpressedtheconcernthat if abank isheldtoan LCR standard of 100percent in normal times,it may be reluctant toallowitsratioto drop below 100percent whenfacing largeoutflows, evenif regulatorswereto permit this temporary deviation, for fear that adeclinein the ratiocould be interpretedasa sign of weakness.My aim hereistosketchaframeworkforthinkingabout theseandrelatedissues.Among them, theinterplay betweentheLCR and central bank liquidityprovisionisperhapsthemostfundamentalandanatural startingpoint fordiscussion.Bywayofmotivation, notethat beforethefinancialcrisis, wehadahighlydeveloped regime of capital regulationfor banks– albeit onethat looksinadequatein retrospect – but wedid not have formal regulatorystandardsfor their liquidity.Theintroduction of liquidityregulation after the crisiscan be thought ofasreflectinga desire to reducedependenceon the central bank asalender of last resort (LOLR), basedon thelessonslearned over thepreviousseveral years.However,to the extent that some role for the LOLR still remains,onenow facesthe questionof how it should coexistwith a regime of liquidityregulation.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  12. 12. P a g e | 12Toaddressthis question, it is useful to take a step back and ask anotherone:What underlying market failure is liquidityregulation intendedtoaddress, and whycan‘t this market failurebe handledentirelyby anLOLR?I will turn to this questionfirst.Next, I will considerdifferent mechanismsthat could potentiallyachievethegoalsof liquidityregulation, and how thesemechanismsrelate tovariousfeaturesof theLCR.In sodoing, I hope toillustratewhy, even though liquidityregulation is aclosecousin of capital regulation, it neverthelesspresentsa number ofnovel challengesfor policymakers and why, asa result, weare going tohaveto be opentolearningand adaptingaswego.The case for liquidity regulationOneof theprimary economic functionsof banksand other financialintermediaries,suchasbroker-dealers,is to provideliquidity– thatis,cash on demand – in variousforms totheir customers.Someof thisliquidityprovisionhappenson the liability sideof thebalancesheet, withbank demand depositsbeinga leadingexample.But, importantly, banks alsoprovide liquidityvia committed linesofcredit.Indeed, it isprobablynot acoincidencethatthesetwoproducts– demanddepositsand credit lines– are offered under the roof of the sameinstitution;theunderlying commonalityis that both require an abilitytoaccommodateunpredictablerequestsfor cash on short notice.Anumber of other financial intermediaryservices,such asprimebrokerage, alsoembodya significant element of liquidityprovision.Without question, theseliquidity-provisionservicesare sociallyvaluable.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  13. 13. P a g e | 13On the liabilityside, demand depositsand other short-term bankliabilitiesaresafe,easy-to-valueclaimsthat arewellsuitedfor transactionpurposesand hencecreatea flowof money-like benefitsfor their holders.And loancommitmentsare more efficient than an arrangement in whicheachoperatingfirm hedgesitsfutureuncertainneedsby―pre-borrowing‖andhoarding theproceedson itsown balancesheet;this latterapproachdoesa poor job of economizingon the scarceaggregate supplyof liquidassets.At thesametime, asthefinancial crisismadepainfullyclear, thebusinessof liquidityprovision inevitablyexposesfinancial intermediariestovariousforms of run risk.That is, in responsetoadverse events,their fragile fundingstructures, together withthe binding liquiditycommitmentstheyhavemade, can result in rapid outflowsthat, absent central bankintervention, lead bankstofire-sellilliquid assetsor, in a more severecase,to fail altogether.And fire salesand bank failures– and theaccompanying contractionsincredit availability– can have spillover effectstoother financialinstitutionsand to the economy asa whole.Thus, while bankswill naturallyhold buffer stocksof liquid assetstohandleunanticipatedoutflows, theymay not hold enoughbecause,although theybear all the costsof this buffer stocking, they donot capture all of thesocial benefits, in termsof enhancedfinancialstabilityand lowercoststotaxpayers in theevent of failure.It is this externalitythat createsa role for policy.Therearetwobroadtypesof policytoolsavailabletodeal withthissortofliquidity-basedmarket failure.Thefirst isafter-the-fact intervention, either by a deposit insurerguaranteeingsome of thebank‘sliabilitiesor by a central bank actingasan LOLR.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  14. 14. P a g e | 14Thesecond type isliquidityregulation.As an exampleof theformer, whenthe economy isin a badstate, assumingthat aparticularbank isnot insolvent, thecentralbank canlendagainst illiquidassetsthat wouldotherwisebefire-sold,therebydampingor eliminatingthe run dynamics and helpingreducetheincidenceof bank failure.In much of theliteratureon banking, such interventionsare seen astheprimarymethod for dealing withrun-likeliquidityproblems.Aclassicstatement of the central bank‘srole asan LOLR is WalterBagehot‘s1873book Lombard Street.Morerecently, the seminal theoretical treatment of this issueis byDouglasDiamond and Philip Dybvig, whoshow that under certaincircumstances, the useof deposit insuranceor an LOLR can eliminaterun risk altogether, therebyincreasingsocial welfareat zero cost.Tobeclear, thisworkassumesthat thebank in questionisfundamentallysolvent, meaning that whileitsassetsmay not be liquid on shortnotice,the long-run valueof these assetsisknownwith certaintytoexceed thevalue of thebank‘sliabilities.Onewaytointerpret themessageof this research is that capital regulationis important toensuresolvency, but oncea reliableregime ofcapitalregulation is in place, liquidityproblemscan bedealt with after thefact, via somecombinationofdepositinsuranceanduseof theLOLR.It followsthat if one is goingtomake an argument in favor of addingpreventativeliquidityregulation such asthe LCR on top of capitalregulation, a central premisemust be that the use of LOLR capacityin acrisisscenario is sociallycostly, sothat it is an explicit objectiveof policytoeconomize on itsusein such circumstances.I think this premiseis a sensibleone.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  15. 15. P a g e | 15Akey point in this regard – and one that hasbeen reinforcedby theexperienceof thepast several years – is that the linebetweenilliquidityand insolvencyisfar blurrier in real life than it is sometimesassumed tobein theory.Indeed, one might argue that a bank or broker dealer that experiencesaliquiditycrunch must havesomeprobability of havingsolvencyproblemsaswell;otherwise,it is hard toseewhyit could not attract short-termfundingfrom the private market.This reasoningimplies that when thecentral bank actsasan LOLR in acrisis, it necessarilytakeson some amount of credit risk.And if it experienceslosses,theselossesultimatelyfall ontheshouldersoftaxpayers.Moreover,theuseof an LOLR to support banks whenthey get intotroublecan lead tomoral hazard problems, in thesensethat banksmaybelessprudent ex ante.If it werenot for thesecostsof usingLOLR capacity, the problem wouldbe trivial, and there wouldbenoneed for liquidityregulation:Assuming a well-functioningcapital-regulationregime, the central bankcouldalwaysavert all firesalesand bank failuresexpost, simplybyactingasan LOLR.This observationcarries an immediate implication:It makes no senseto allowunpriced accessto thecentral bank‘sLOLRcapacityto count toward an LCR requirement.Again, the wholepoint of liquidityregulation must be either toconserveon theuseof theLOLR or in the limit, to addresssituationswheretheLOLR is not availableat all – as, for example, in the caseofbroker-dealersin theUnitedStates.At thesametime, it isimportant todraw adistinctionbetweenpriced andunpriced accessto the LOLR.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  16. 16. P a g e | 16For example, takethecaseofAustralia, whereprudent fiscal policy hasledto a relatively small stock of government debt outstandingand hencetoa potential shortageof HQLA.TheBasel Committeehasagreed totheusebyAustralia of a CommittedLiquidityFacility (CLF), wherebyanAustralianbank canpaytheReserveBank ofAustralia an upfront fee for what is effectivelya loancommitment, and this loan commitment can then be countedtowarditsHQLA.In contrast to free accesstotheLOLR, this approachisnot at oddswiththegoalsof liquidityregulationbecausetheup-front feeis effectively atax that servestodeter relianceon the LOLR – which, again, is preciselytheultimategoal.I will return tothe ideaof a CLF shortly.The design of regulationOnceit hasbeen decided that liquidityregulationis desirable, thenextquestion ishow best toimplement it.In this context, notethat the LCR hastwologicallydistinct aspectsasaregulatorytool:It is a mitigator, in thesense that holdingliquid assetsleadstoa betteroutcome if there is a bad shock; it is alsoan implicit tax on liquidityprovision by banks, tothe extent that holdingliquidassetsiscostly.Of course,one can say somethingbroadlysimilar about capitalrequirements.But the implicit tax associated withtheLCR is subtler and lesswellunderstood, soI will go intosome detail here.An analogymay help to explain.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  17. 17. P a g e | 17Supposewehaveapowerplant that producesenergyand, asabyproduct, some pollution.Supposefurtherthat regulatorswant toreducethepollutionandhavetwotoolsat their disposal:Theycan mandatethe useof a pollution-mitigatingtechnology, likescrubbers,or theycan levya tax on theamount of pollution generatedbythe plant.In an ideal world, regulation wouldaccomplishtwoobjectives.First, it wouldlead toan optimal level of mitigation– that is, it wouldinducethe plant toinstall scrubbers up tothe point wherethecostof anadditional scrubber isequal to themarginal socialbenefit, in terms ofreducedpollution.And, second, it wouldalsopromote conservation:Giventhat thescrubbersdon‘t get rid of pollutionentirely, onealsowantstoreduceoverall energyconsumption bymaking it more expensive.Asimplecaseis onein whichthe costsof installingscrubbers,aswellasthesocial benefits of reducedpollution, are knownin advanceby theregulator and themanager of the powerplant.In this case, the regulatorcan figure out what theright number ofscrubbersis and require that theplant install thesescrubbers.Themandate can thereforepreciselytarget the optimal amount ofmitigation per unit of energy produced.And, to the extent that the scrubbers are costly, the mandate will alsoleadto higher energy prices, which will encourage some conservation, thoughperhapsnot the sociallyoptimal level.This latter effect isthe implicit tax aspect of themandate.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  18. 18. P a g e | 18Amore complicatedcaseis when the regulator doesnot know ahead oftimewhat the costsof building and installingscrubberswill be.Here, mandatingtheuse of a fixednumber of scrubbers ispotentiallyproblematic:If the scrubbersturn out tobe very expensive, the regulation will end upbeingmore aggressivethansociallydesirable,leadingto overinvestmentin scrubbersand largecostincreasesfor consumers;however, if thescrubbersturn out tobe cheaper than expected, the regulationwill havebeen too soft.In otherwords, whenthecostofthemitigationtechnologyissignificantlyuncertain, a regulatory approachthat fixesthe quantityof mitigationisequivalent toone wherethe implicit tax rate bouncesaround a lot.Bycontrast, aregulatoryapproachthat fixesthepriceof pollutioninsteadof the quantity– say, by imposing a predeterminedproportional tax ratedirectlyon the amount of pollution emittedby the plant – is moreforgivingin the faceof this kind of uncertainty.This approach leaves the scrubber-installation decision to the manager ofthe plant, who can figure out what the scrubbers cost before deciding howtoproceed.For example, if thescrubbers turn out to be unexpectedlyexpensive, theplant manager can install fewer of them.This flexibilitytranslatesintolessvariabilityin theeffectiveregulatoryburden and hence lessvariabilityin the price of energy toconsumers.Scrubbers and high-quality liquid assetsWhat doesall thisimplyfor the designof the LCR?Let‘s workthrough theanalogyin detail.Theanalog to the powerplant‘s energyoutput is the grossamount ofliquidityservicescreatedby a bank – via its deposits,thecredit linesitInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  19. 19. P a g e | 19providesto itscustomers, the prime brokerage servicesit offers,and soforth.Theanalog to themitigationtechnology– the scrubbers– is the stock ofHQLA that the bank holds.And the analogto pollution is thenet liquidityriskassociated with thedifferencebetweenthesetwoquantities, somethingakin to the LCRshortfall.That is,whenthebank offersalot of liquidityondemand toitscustomersbut fails tohold an adequatebuffer of HQLA, this is whenit imposesspillover costson the rest of thefinancial system.In the caseof thepowerplant, I argued that a regulation that callsfor afixed quantity of mitigation– that is, for a fixednumber of scrubbers– ismore attractivewhenthere is littleuncertainty about the costof thesescrubbers.In the context of the LCR, the cost of mitigation is the premium that thebank must pay – in the form of reduced interest income – for itsstock ofHQLA.And, crucially, this HQLA premium is determined in market equilibriumand dependson the total supplyof safe assetsin the system, relative tothedemand for thoseassets.On the onehand, if safeHQLA-eligibleassetsare in ample supply, thepremium is likelytobe low and stable.On the other hand, if HQLA-eligible assetsare scarce, thepremium willbeboth higher and more volatile over time.This latter situation is the one facing countrieslike Australia, where, as Inoted earlier, the stock of outstanding government securities is relativelysmall.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  20. 20. P a g e | 20And it explainswhy, for such countries,havinga price-basedmechanismaspart of their implementationof the LCR can be more appealingthanpure relianceon a quantitymandate.When one sets an up-front fee for a CLF, one effectively caps the implicittax associated with liquidity regulation at the level of the commitment feeand tamps down the undesirable volatility that would otherwise arise froman entirelyquantity-based regime.Moreover,it bearsreemphasizingthat havinga CLF withanup-front feeis very different from simplyallowingbankstocount central - bank -eligiblecollateral asHQLA at no charge.Rather, the CLF is like the pollution tax.For every dollar of pre-CLF shortfall – that is, for every dollar of requiredliquidity that a bank can‘t obtain on the private market – the bank has topaythe commitment fee.Soeven if there isnot asmuch mitigation, thereis still an incentiveforconservation, in thesensethat banks areencouragedto dolessliquidityprovision, all elsebeingequal.This wouldnot be thecaseif the CLF wereavailableat a zeroprice.What about the situation in countrieswheresafeassetsaremoreplentiful?Theanalysis here hasa number of moving parts becausein addition totheimplementationof the LCR, substantial increasesin demand for safeassetswill arise from new margin requirementsfor both clearedandnonclearedderivatives.Nevertheless,giventhelargeandgrowingglobalsupplyofsovereigndebtsecurities,aswellasother HQLA-eligibleassets,most estimatessuggestthat the scarcityproblem should be manageable, at least for theforeseeablefuture.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  21. 21. P a g e | 21In particular, quantitativeimpact studiesreleasedby the BaselCommitteeestimatethat the worldwide incremental demand for HQLAcomingfrom both the implementationof the LCR and swapmarginrequirementsmight be on the order of $3 trillion.This is a largenumber, but it compareswith a global supplyofHQLA-eligibleassetsof more than $40trillion.Moreover,the eligiblecollateral for swapmargin is proposedtobebroader than theLCR‘s definition of HQLA – including, forexample,certain equitiesand corporatebondswithout any cap.If one focusesjust on U.S.institutions,theincremental demand numberis on the order of $1trillion, while the sum of Treasury, agency, andagencymortgage-backedsecuritiesis more than $19trillion.While this sort of analysisissuperficiallyreassuring, thefact remainsthattheHQLA premium will depend on market-equilibrium considerationsthat are hard to fullyfathom in advance, and that are likely tovary overtime.This uncertaintyneedsto beunderstood, and respected.Indeed, themarket-equilibriumaspect of theproblemrepresentsacrucialdistinctionbetweencapital regulationand liquidityregulation, and it isonereasonwhythelatter isparticularly challengingtoimplement.Although capital regulationalsoimposesa tax on banks – tothe extentthat equityisamore expensiveform of financethandebt – thistax wedgeis,toafirstapproximation, afixed constant foragivenbank, independentof the scaleof overall financial intermediation activity.If Bank Adecidestoissuemore equitysoit can expand itslendingbusiness,this need not make it more expensivefor Bank B tosatisfyitscapital requirement.In other words,thereis noscarcityproblem withrespect to bank equity –bothAand B can always make more.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  22. 22. P a g e | 22Bycontrast, thetotal supplyof HQLA isclosertobeingfixedat anypointin time.Policy implicationsWhat doesall of this implyfor policydesign?First, at a broadphilosophical level, the recognitionthat liquidityregulation involvesmore uncertaintyabout coststhancapital regulationsuggeststhat even apolicymaker witha very strict attitudetowardcapitalmight find it sensibleto besomewhat more moderate and flexiblewithrespect toliquidity.This point is reinforced by the observationthat whenan institutionisshort of capitalandcan‘t get moreontheprivatemarket, thereisreallynobackup plan, short of resolution.By contrast, asI mentioned earlier, whenan institution isshort ofliquidity, policymakers do have a backup plan in the form of theLOLRfacility.Onedoesnot want torelytoomuch on that backup plan, but itspresenceshould neverthelessfactor intothedesign of liquidityregulation.Second, in thespirit of flexibility, while aprice-basedmechanism such astheCLF may not beimmediatelynecessaryin countriesoutsideofAustralia and a few others,it is worthkeepingan open mind about themore widespreaduse of CLF-like mechanisms.If a scarcityof HQLA-eligible assetsturnsout tobe more of a problemthan weexpect, somethingalong thoselineshasthepotential to be auseful safetyvalve, asit putsa cap on thecostof liquidityregulation.Such a safety valvewouldhave a direct economicbenefit, in thesenseofpreventingtheburdenof regulationfrom gettingundulyheavyin anyonecountry.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  23. 23. P a g e | 23Perhapsjust asimportant, a safetyvalvemight alsohelp to protect theintegrityof the regulation itself, by harmonizingcostsacrosscountriesandtherebyreducingthetemptationofthosemosthard-hit bytherulestotry tochip awayat them.Without suchasafetyvalve, it ispossiblethat somecountries– thosewithrelativelysmall suppliesof domestic HQLA – will find the regulationconsiderably more costlythan others.If so, it wouldbenatural for them to lobbyto dilutetherules– forexample, by arguingfor an expansion in thetype of assetsthat can countasHQLA.Taken toofar, this sort of dilution wouldunderminethe efficacyof theregulation asboth amitigatorand a tax.In this scenario, holdingthe linewithwhat amountstoa proportional taxon liquidityprovision wouldbe a better outcome.Onesituation whereliquid assetscan becomeunusuallyscarceis duringa financial crisis.Consequently, evenif CLFs werenot counted towardtheLCR in normaltimes,it might be appropriatetocount them during a crisis.Indeed, while theLCR requires banks tohold sufficient liquid assetsingood timestomeet their outflowsin a givenstressscenario, it implicitlyrecognizesthat if thingsturn out even worsethanthat scenario, centralbank liquiditysupport will be needed.AllowingCLFs tocount toward theLCR in such circumstanceswouldacknowledgethe importanceof accesstothecentral bank, and thisaccesscould be priced accordingly.Finally, a price-based mechanism might alsohelp promote a willingnessof banksto draw down their supplyof HQLA in a stressscenario.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  24. 24. P a g e | 24As I noted at the outset, one important concern about a pure quantity-based system of regulation isthat if a bank is held toan LCR standard of100percent in normal times,it may be reluctant toallowitsratio tofallbelow 100percent whenfacinglargeoutflowsfor fear that doing somightbeseenby market participantsasa sign of weakness.By contrast, in a system withsomethinglike a CLF, a bank might innormal timesmeet 95 percent of itsrequirement by holdingprivate-market HQLAandtheremaining5percent withcommittedcreditlinesfrom thecentral bank, soit wouldhavean LCR of exactly100percent.Then, when hit withlargeoutflows, it could maintain its LCR at 100percent, but dosoby increasingits useof central bank credit linesto25percent and selling20 percent of itsother liquid assets.This scenariowouldbe the sort of liquid-asset drawdownthat one wouldideallylike to seein a stresssituation.Moreover, the central bank could encourage this drawdown by varyingthe pricing of its credit lines – specifically, by reducing the price of thelinesin the midst of a liquiditycrisis.Such an approach wouldamount totaxingliquidityprovision more ingood timesthan in bad, whichhasa stabilizing macroprudential effect.Thisexamplealsosuggestsadesignthat mayhaveappealinjurisdictionswherethere is a relatively abundant supplyof HQLA-eligible assets.Onecan imagine calibratingthe pricingof the CLF soasto ensure thatlinesprovidedbycentralbanksmakeuponlyaminimal fractionofbanks‘requiredHQLA in normal times– apart, perhaps,from the occasionaladjustment periodafter an individual bank is hit withan idiosyncraticliquidityshortfall.At thesametime,in astressscenario,whenliquidityisscarceandthereisupwardpressure ontheHQLA premium, thepricingof theCLF couldbeInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  25. 25. P a g e | 25adjustedsoastorelievethispressureand promoteusabilityof theHQLAbuffer.Such an approach would respect the policyobjective of reducing expectedreliance on the LOLR while at the same time allowing for a safety valve ina period of stress.Thelimit caseof thisapproach is one wheretheCLF countstowardtheLCR onlyin a crisis.ConclusionBywayofconclusion, letmejustrestatethat liquidityregulationhasakeyroleto playin improving financial stability.However,weshould avoid thinkingabout it in isolation;rather, wecanbest understand it aspart of a larger toolkit that alsoincludescapitalregulation and, importantly, thecentral bank‘sLOLR function.Therefore, proper design and implementation of liquidityregulationssuch asthe LCR should takeaccount of theseinterdependencies.In particular, policymakers should aim tostrike a balancebetweenreducingrelianceontheLOLR ontheonehandandmoderatingthecostscreated by liquidityshortageson the other hand – especiallythoseshortagesthat crop up in timesof severe market strain.And, asalways, weshould bepreparedtolearnfrom experienceaswego.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  26. 26. P a g e | 26Basel III Capital:AWell-Intended IllusionThomasM. HoenigVice Chairman, Federal Deposit InsuranceCorporationInternationalAssociation of Deposit Insurers2013Research Conference, Basel, SwitzerlandIntroductionAristotle is creditedwith being the firstphilosophertosystematically study logicalfallacies, whichhedefinedasargumentsthat appearvalid but, in fact, arenot.I call them well-intendedillusions.Onesuch illusion of precision is the Basel capital standardsin whichworldsupervisory authoritiesrely principallyon a Tier 1capital ratiotojudgethe adequacyof bank capital and balance sheet strength.For the largest of thesefirms, each dollar of risk-weighted assetsis fundedwith 12to15cents in equitycapital, projecting the illusion that thesefirmsare wellcapitalized.Thereality isthat each dollar of their total assetsis funded withfar lessequitycapital, leavingopenthematter of howwell capitalizedtheymightbe.Here‘show theillusionis created.BaselsTier 1capital measure is a banks ratio of Tier 1capital torisk-weightedassets.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  27. 27. P a g e | 27Each category of bank assets is weighed by the supervisory authority on acomplicated scale of probabilitiesand models that assign a relative risk oflossto each group, includingoff balancesheet items.Assetsdeemed lowrisk are reported at loweramountson thebalancesheet.Thelowertherisk,thelowertheamount reportedonthebalancesheet forcapital purposesand thehigher the calculatedTier 1ratio.We know from years of experience using the Baselcapital standardsthatoncethe regulatory authorities finish their weightingscheme, bankmanagersbegin theprocessof allocatingcapital and assetstomaximizefinancial returns around these constructedweights.Theobjectiveis tomaximize a firmsreturn on equity(ROE) bymanagingthe balancesheet in such a manner that for anylevel ofequity, the risk-weightedassetsare reported at levelsfar lessthan actualtotal assetsunder management.Thiscreatestheillusionthatbankingorganizationshaveadequatecapitaltoabsorbunexpected losses.For thelargest global financial companies,risk-weightedassetsareapproximatelyone-half of total assets.This "leveragingup" hasserved worldeconomiespoorly.In contrast, supervisorsand financial firmscan choosetorely on thetangibleleverageratio tojudgethe overall adequacyof capital for theenterprise.This ratiocomparesequitycapital to total assets,deductinggoodwill, other intangibles,and deferred tax assetsfrom both equityand total assets.In additiontoincludingonly loss-absorbingcapital, it alsomakesnoattempt to predict or assign relativerisk weightsamong asset classes.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  28. 28. P a g e | 28Usingthisleverageratioasour guide, wefind for thelargest bankingorganizationsthat each dollar of assetshasonly4 to 6centsfundedwithtangibleequitycapital, a far smaller buffer than asserted under the Baselstandards.Comparing MeasuresTable1reportstheBasel Tier 1risk-weightedcapital ratio and theleverageratiofor different classesof banking firms.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  29. 29. P a g e | 29Column 4 showsTier 1capital ratiosrangingbetween12 and 15percentfor the largest global firms, giving theimpression that thesebanksarehighly capitalized.However,it is hard tobe certain of that by lookingat thisratiosincerisk-weightedassetsaresomuch lessthan total assets.In contrast, Column 6 showsU.S.firms averageleverageratiotobe 6percent using generallyacceptedaccountingstandards(GAAP), andColumn 8 showstheir averageratioto be3.9percent using internationalaccountingstandards(IFRS), whichplacesmore of thesefirmsderivativesonto thebalancesheet than doesGAAP.Thebottom portionof Table1showsthe degreeof leverageamongdifferent size groupsof banking firms, whichis striking aswell.TheTier 1capital measuresuggeststhat all size groupsof banks holdcomparable capital levels,while the leverageratioreports a differentoutcome.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  30. 30. P a g e | 30For example, the leverageratiofor most bankinggroupsnot consideredsystemicallyimportant averagesnear 8 percent or higher.Under GAAP accounting standards, the difference in this ratio betweenthe largest banking organizations and the smaller firms is 175-250 basispoints.Under IFRSstandards, thedifferenceisasmuch as400-475basispoints.Thelargest firms, whichmost affect theeconomy, hold the least amountof capital in the industry.While thisshowsthem tobe more fragile, it alsoidentifies just howsignificant a competitiveadvantagethese lowercapital levelsprovidethelargestfirms.Thesecomparisonsillustratehow easily the Baselcapital standard canconfuseand misinform the public rather than meaningfullyreport abankingcompany‘srelativefinancial strength.Recent history showsalsojusthow damagingthiscan be totheindustryandtheeconomy.In 2007, for example, the10 largest and most complex U.S.bankingfirmsreported Tier 1capital ratiosthat, on average, exceeded 7percent ofrisk-weightedassets.Regulatorsdeemed theselargest to be well capitalized.This risk-weightedcapital measure, however,mapped intoan averageleverageratioof just 2.8percent.We learned all too latethat having lessthan 3centsof tangiblecapital forevery dollar of assetson thebalancesheet is not enough to absorbeventhesmallest of financial losses,and certainlynot a major shock.With the crisis, the illusion of adequate capital wasdiscovered, afterhavingmisled shareholders,regulators,and taxpayers.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  31. 31. P a g e | 31There are other, more recent, examples of how this arcane measure canbe manipulated to give the illusion of strength even when a firm incurslosses.For example,in thefourthquarter of 2012, Deutsche Bank reported a lossof 2.5 billion EUR.That same quarter, its Tier 1risk-basedcapital ratioincreasedfrom 14.2percent to15.1percent due, in part, to ―model and processenhancements‖ that resultedin a declinein risk-weightedassets, whichnowamount to just16.6 percent of total assets.On Feb. 1, SNSReaal, the fourth largest Dutch bank with$5billion inassets,wasnationalized by the Dutch government.Just seven monthsearlier, on June 30, 2012,SNS reported a Tier 1risk-basedcapital ratio of 12.2 percent.However,the firm reported a Tier 1leverageratiobased uponinternational accountingstandardsof only1.47percent.This leverageratiowasmuch more indicativeof the SNS‘spoor financialposition.TheBasel III proposal belatedlyintroducestheconcept of a leverageratio but callsfor it tobe only 3 percent, an amount alreadyshown to beinsufficient toabsorb sizablefinancial lossesin a crisis.It iswrongtosuggest tothepublic that, withsolittlecapital, theselargestfirmscould survive without public support should theyencounter anysignificant economicreversals.Misallocating Resourcesand CreatingAsset ImbalancesAn inherent problem with a risk-weighted capital standard is that theweights reflect past events, are static, and mostly ignore the marketscollectivedaily judgment about the relativerisk of assets.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  32. 32. P a g e | 32It alsointroducestheelement of political and special interestsintotheprocess, whichaffectstheassignment ofriskweightstothedifferent assetclasses.Theresult is oftentoartificiallyfavor onegroup of assetsoveranother,therebyredirectinginvestmentsand encouragingover-investment in thefavored assets.Theeffect of thismanagedprocessisto increaseleverage, raisetheoverall risk profile of theseinstitutions,and increasethevulnerabilityofindividual companies, the industry, and the economy.It is no coincidence,for example, that after a Basel standard assignedonlya 7 percent risk weight ontripleA, collateralizeddebt obligationsand similar lowrisk weightson assetswithina firmstradingbook, resourcesshiftedtotheseactivities.Overtime, financial groupsdramaticallyleveragedtheseassetsontotheirbalancesheetsevenasthe risksto that asset classincreasedexponentially.Similarly, assigningzero weightstosovereign debt encouragedbankingfirmsto invest more heavily in theseassets, simultaneouslydiscountingtherealrisk theypresentedand playing animportant rolein increasingit.In placing a lowerrisk weight on select assets,lesscapital wasallocatedtofundthemandtoabsorbunexpectedlossforthesebanks,underminingtheir solvency.AMore Realistic Capital Standard Is RequiredTaxpayersaretheultimatebackstoptothesafetynetandhaverealmoneyat stake.In choosingwhichcapital measure is most useful, it is fair toaskthefollowingquestions:International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  33. 33. P a g e | 33- Doesthe BaselTier 1ratio or the tangibleleverageratiobest indicatethecapital strengthof the firm?- Whichone is most clearlyunderstood?- Whichone best enablescomparison of capital acrossinstitutions?-Whichone offersthemost confidencethat it cannot be easily gamed?Charts 1through 4compare the relationship of the tangibleleverageandBaselTier1capitalratiostovariousmarketmeasuresforthelargestfirms.International 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 | 35International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  36. 36. P a g e | 36International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  37. 37. P a g e | 37Thesemeasuresinclude:theprice-to-book ratio, estimated defaultfrequency, credit default swapspreads, and market value of equity.In each instance, thecorrelationof thetangibleleverageratioto thesevariablesis higher than for the risk-weightedcapital ratio.While such findingsare not conclusive, theysuggest stronglythatinvestors,whendecidingwhereto placetheir money, rely upon theinformation provided by the leverageratio.We woulddowellto do thesame.Despiteall of theadvancementsmadeover theyearsin riskmeasurementandmodeling, it isimpossibleto predict thefuture or to reliablyanticipatehow and towhat degreeriskswill change.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  38. 38. P a g e | 38Capital standardsshould serve to cushion against theunexpected, not todivineeventualities.All of the Baselcapital accords, includingtheproposedBasel III, lookbackwardand then attempt to assign risk weightsintothe future.It doesnt work.In contrast, the tangible leverage ratio provides a simpler, more directinsight into the amount of loss-absorbing capital that is available to afirm.Aleverageratio asI‘ve definedit explicitlyexcludesintangibleitemsthatcannot absorb lossesin a crisis.Also, using IFRSaccounting rules, off-balancesheet derivativesarebrought ontothe balancesheet, providingfurtherinsight intoa firmsleverage.Thus, thetangibleleverageratiois simpler tocompute and more easilyunderstood by bank managers,directors, and thepublic.Importantlyalso,it ismore likely tobe consistentlyenforcedby banksupervisors.Amore difficult challengemay be todetermine an appropriateminimumleverageratio.Chart 5providesa historyof bank leverageover thepast 150years for theU.S. banking system and givesinitial insight intothisquestion.It showsthat the equitycapital to assetsratiofor the industryprior to thefounding of the Federal Reserve System in 1913and theFederal DepositInsuranceCorporation in 1933ranged between13 and 16percent, regardless of bank size.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  39. 39. P a g e | 39Without any internationally dictated standard or any arcane weightingprocess, markets required what today seems like relatively high capitallevels.In addition, thereis an increasingbodyof research(Admati and Hellwig;Haldane;Miles,Yang, and Marcheggiano) that suggeststhat leverageratios should be much higher than theycurrentlyare and that Basel III‘sproposed 3 percent figure addslittlesecurity to thesystem.Finally, and importantly, some form of risk-weightedcapital measurecouldbe useful asabackstop, or check, against whichto judgetheadequacyof theleverageratiofor individual banks.If a bank meets the minimum leverage ratio but has concentrated assetsin areas that risk models suggest increase the overall vulnerability of thebalance sheet, the bank could be required to increase its tangible capitallevels.Such a system providesthemost comprehensivemeasure of capitaladequacyboth in a broad context of all assetsand accordingto a banksallocationof assetsalonga definedrisk profile.Tangible Leverage Ratio and the Myth of UnintendedConsequencesConcernsareoften raisedwithinthefinancialindustryandelsewherethatrequiringthelargest and most complex firms tohold higher levelsofcapital asdefined usinga tangibleleverageratiowouldhaveseriousadverseeffectson theindustry and broader economy.It hasbeen suggested, for example, that requiringmore capital for theselargestbankswouldraisetheir relativecost of capital and make them lesscompetitive.Similarly, there is concern that failingto assign riskweightstothedifferent categoriesof assetswouldencourage firms toallocatefundstothehighest riskassetsto achievetargeted returnstoequity.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  40. 40. P a g e | 40Theseissueshave been well addressed byAnat Admati and MartinHellwig in their recentlypublishedbook, The Bankers‘New Clothes.Therequired ROE and the abilityto attract capital are determinedby ahost of factorsbeyond the level of equitycapital.Theseinclude a firm‘sbusinessmodel, itsrisk-adjustedreturns, thebenefitsof servicesand investments, and theundistorted, ornon-subsidized, costsof capital.Alevel of capital that lowersrisk may very well attract investorsdrawn tothemore reliablereturns.Table1showsmany of the bankswithstronger leverageratiosalsohavestockpricestradingat a higher premium to book valuethan thelargestfirmsthat are lesswell-capitalized.There alsois a concern that requiringa stronger, simpler leverageratiowouldcausemanagers to placemore risk on their balancesheet.While possible, the argument isunconvincing.With more capital at risk and without regulatory weightingschemesaffectingchoice, managers will allocatecapital in linewithmarket riskand returns.Furthermore,risk-weightedmeasuresandstrongbank supervisioncanbeavailableasa back-up system tomonitor such activity.Moreover,given theexperienceof therecent crisisand the on-goingeffortsto manage reported risk assetsdown, no matter the risk, it ringshollowto suggest that having a higher equitybuffer for the same amountof total assetsmakesthe financial system lesssafe.In addition, there isa concern that demanding more equitycapital andreducingleverageamong thelargest firms wouldinhibit thegrowthofcredit and the economy.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  41. 41. P a g e | 41This statement hasan implied presumption that the Basel weightingschemeismore growthfriendlythan a simpler, stronger leverageratio.However,having a sufficient capital buffer allowsbanks to absorbunexpected losses.Thisservestomoderate thebusinesscycleandthedeclineinlendingthatotherwiseoccursduring contractions.If the Basel risk-weight schemesare incorrect, whichthey oftenhavebeen, this toocould inhibit loangrowth, asit encouragesinvestmentsinother more favorably, but incorrectly, weightedassets.Basel systematically encouragesinvestmentsin sectorspre-assignedlowerweights-- for example, mortgages, sovereign debt, and derivatives-- and discouragesloanstoassetsassignedhigher weights-- commercialand industrial loans.We may have inadvertently created a system that discourages the veryloan growth we seek, and instead turned our financial system into onethat rewardsitselfmore than it supportseconomicactivity.If risk weightscould be assigned that anticipateand calibraterisks withperfect foresight, adjusted on a daily basis,then perhapsrisk-weightedcapital standardswouldbe the preferred method for determininghow todeploycapital.However,they cannot.Tobelieve theycan isa fallacythat putsthe entire economic system atrisk.Changing the DebateThetangibleleverageratiois a superior alternativeto risk-weightingschemesthat haveproven tobean illusionof precisionand insufficient indefiningadequatecapital.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  42. 42. P a g e | 42Theeffect of relying on suchmeasureshasbeen toweakenthe financialsystem and misallocate resources.Theleverageratio deservesseriousconsiderationasthe principal tool injudgingthe capital strength of financial firms.TheBasel discussion wouldbe well served to focuson the appropriatelevelsof tangiblecapitalfor bankingfirmstohold and theright transitionperiod to achievetheselevels.Finally, weshould not accept even comfortingerrorsof logic whichsuggest that BaselIII requirementswill createstronger capital than thoseof Basel II, whichfailed.Instead, past industryperformanceand mountingacademicand otherevidencesuggest that wewouldbebest served to focuson a strongleverageratiostandard in judginga firm and theindustrys financialstrength.No bank capital program is perfect.Our responsibility asregulatorsand deposit insurersis tochoosethebestavailablemeasure that will contributeto financial stability.Note:ThomasM. Hoenig wasconfirmedbytheSenateasViceChairman oftheFederal Deposit InsuranceCorporation on Nov. 15, 2012.He joinedtheFDIC onApril 16, 2012,asa member of the FDIC Board ofDirectorsfor a six-year term.He isamember of theexecutiveboard of theInternationalAssociationofDeposit Insurers.Prior toservingon the FDIC board, Mr. Hoenig wasthe President of theFederal Reserve Bank of KansasCity and a member of the FederalReserveSystems Federal Open MarketCommittee from 1991to2011.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  43. 43. P a g e | 43Mr. Hoenig waswiththe Federal Reserve for 38years, beginningasaneconomistand then asa senior officer in banking supervision during theU.S. banking crisisof the 1980s.In 1986, he led theKansasCity Federal Reserve BanksDivision of BankSupervisionand Structure, directingtheoversight of more than 1,000banksand bank holdingcompanies withassetsranging from lessthan$100million to $20billion.He became President of theKansasCityFederal Reserve Bank onOctober 1,1991.Mr. Hoenig is a nativeof Fort Madison, Iowa. He receiveda doctorateineconomicsfrom IowaStateUniversity.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  44. 44. P a g e | 44PCAOB IssuesPolicy Statement onExtraordinary Cooperation in Connectionwith Board InvestigationsWashington, DCThePublic CompanyAccounting Oversight Boardtoday publishedaformal statement concerningthebenefitsthat may be availabletoregisteredpublic accounting firms and individualswhoprovideextraordinarycooperation in PCAOB investigations.The policy statement describes what the PCAOB may consider to beextraordinary cooperation and how credit might be reflected for suchcooperation.Thepolicyis generallyconsistent with theBoards existingpractices."Thispolicyprovidesbenefitstoinvestorsand real, tangibleincentivestocooperatetofirms and personsassociatedwith firms," said JamesR.Doty, PCAOB Chairman. "Extraordinarycooperationpermitsthe Board to more quicklyandefficientlyaddresswrongdoing for the protection of investors, and mayearnpartiescredit inconnectionwiththeBoards disciplinaryprocesses."According to the policy statement, extraordinarycooperationis voluntaryandtimelyactionbeyond compliancewithlegalorregulatoryobligations.Cooperation that could result in credit includesself-reportingviolationsbeforetheconduct comestothe attentionof the Board or anotherregulator.Self-reportingismore valuabletheearlier it is provided.Theother typesof extraordinarycooperation that could result in creditare taking remedial or corrective action toreducethe risk of similarInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  45. 45. P a g e | 45violationsrecurring, andprovidingsubstantialassistanceinthePCAOBsinvestigativeprocesses.Credit for cooperationmay result in reduced chargesor sanctionsin adisciplinaryproceeding.In some cases,extraordinarycooperationmay lead tolanguageinsettlement documentsnoting the cooperation and itseffect.In exceptional cases, extraordinarycooperation could lead tonodisciplinaryaction at all."Extraordinarycooperationcan help streamline and expeditePCAOBinvestigations,whichallowstheBoard toturn its attention and resourcestoother potential auditor misconduct," said ClaudiusB.Modesti, Director of the PCAOB Division of Enforcement andInvestigations."Thispolicystatement isanimportant stepinencouragingauditorstogoaboveand beyond what isrequired by law," he said.Membersof the public whowishto report potential violationsof law orPCAOB rulesmay contact theBoard through theTip and Referral Centeron thePCAOB website.SummaryThePublic CompanyAccounting Oversight Board ("PCAOB" or"Board") is issuingthispolicy statement to provideguidancetoregisteredpublic accounting firms("firms") and personsassociated withfirms("associatedpersons") concerninghow extraordinarycooperationmay be consideredin determining the outcome of a PCAOBinvestigation.This policy statement doesnot bind and is not intended toinfluenceanyPCAOB hearingofficer or theBoard in the adjudication of litigatedmatters.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  46. 46. P a g e | 46Further, please note that the Board is not adopting anyrule or making anycommitment or promise about any specific case, or conferring any rightson anypersonor entity.Further, the Board isnot in any waylimitingitsdiscretionto evaluateevery caseindividually, on its own particularfactsand circumstances.Thetypes of cooperation that could result in credit are: voluntary andtimely self-reporting;voluntary and timelyremedial or correctiveaction;andvoluntary and timelysubstantial assistancetothe Board‘sinvestigativeprocessesor toother law enforcement authorities.Theseactions,aloneor taken together, can be viewedasextraordinarycooperation for purposesof this policy statement and, dependingon thefactsand circumstances,may influencethe PCAOB‘s enforcementdecisions.By publishingthispolicy statement on cooperation, the Board seeks:(a)to encourage firms and associatedpersonstovoluntarilyand timelyself-report, correct and remediateviolativebehavior, and providesubstantial assistanceto the Board‘s investigativeprocesses;and(b)to increasetransparency intohowthe Board may credit cooperation.Moreover,the Board will, in appropriatecasesand in itsdiscretion, notein settlement documentsor other public statementsthat it hascreditedtheextraordinary cooperation of a firm or associated person.Doingsowill enhancethe Board‘senforcement program bypublicizingthebenefitsof cooperationandinformingfirmsandassociatedpersonsofthetypes of cooperation that may merit credit.I. IntroductionThe Sarbanes-Oxley Act (the "Act") and Board Rules require firms andassociated persons to cooperate in connection with PCAOB inspectionsand investigations.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  47. 47. P a g e | 47Section 102(b)(3) of theAct requireseveryfirm applying for PCAOBregistrationtosupply(1)aconsenttocooperateinandcomplywithanyrequest fortestimonyortheproduction of documentsmadeby thePCAOB in thefurtheranceofitsauthorityand responsibilitiesunder theAct,(2)an agreement tosecure and enforce similar consentsfrom eachassociated person of thefirm, and(3)a statement that the firm understands and agrees, among otherthings, that its cooperation and compliance shall be a condition to thecontinuingeffectivenessof the firm‘s registration withthe Board.Even if a firm fails toprovidethoseitemswithitsapplication, it is notrelieved of theobligationsto cooperatein and complywithBoard requestsmadeinfurtheranceof theBoard‘sauthority andresponsibilitiesunder theAct.Moreover,twoBoard Rulesaddresscooperation by registered firms andassociated persons.Board Rule 4006, Duty to Cooperate withInspectors,appliestoinspections,and requires a registered firm and any associatedpersonofthat firm to cooperatewithany Board inspection by providinginformation requestedin Board inspectionsand providing accessto thefirm‘s records.Rule4006alsorequiresthat informationprovidedtotheBoard betruthfulandnot misleading.Sections105(c)(4) and (5) of theAct and Board Rule 5300(a) governsanctionsfor noncooperationwith an inspection.Section105(b)(3) oftheAct and BoardRule5110,NoncooperationwithanInvestigation, applytoinvestigations,and provide that the Board maysanctiona firm or associatedperson for failing tocooperate with a Boardinvestigation.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  48. 48. P a g e | 48Theforms of cooperation covered by Rule5110are enumerated inparagraphs(1)-(3), with paragraph (4) providing a catch-all provision forfailuretocooperategenerally. Section 105(b)(3) oftheAct andBoardRule5300(b) govern sanctionsfor failure tocooperatewithan investigation.In certain situations,a firm or associatedperson might cooperate withPCAOB investigationsbeyond compliancewith thoseobligations.Cooperation beyond what isrequired to comply with legal and regulatoryobligationscan contribute significantlytothesuccessof theBoard‘smission of protectinginvestorsand furtheringthepublic interestin thepreparation of informative,accurateand independent audit reports.Such extraordinarycooperation might help the Board‘s staff todiscoverpotential violationsearlier andallowtheBoard toconcludeinvestigationsin a more efficient and timely manner, thusreducingthe risk that suchviolativeconduct will be repeated and result in more significant harm toinvestors,andassistingtheBoard in identifyingaudit reportsthat may beinaccurate.For that reason, extraordinary cooperation in connection withBoardinvestigationsmaybeconsideredbytheBoard‘sDivisionofEnforcementand Investigations(the "Division") in itsdisciplinary recommendationstothe Board, and bythe Board in determiningwhether toacceptsettlement offers.II. What is extraordinary cooperation?Extraordinarycooperationis voluntary and timely action – beyondcompliancewithlegal or regulatory obligations– that contributestothemission of the Board.There are three broad types of cooperationthat (aloneor takentogether)might merit cooperation credit:self-reporting;remedial or correctiveaction;and substantial assistancetothe Board‘sinvestigativeprocessesortoother law enforcement authorities.Self-Reportingrelatesto conduct upon learningof violations.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  49. 49. P a g e | 49Afirm or associatedperson may earn credit for self-reportingby makingvoluntary, timely and full disclosureof the factsrelatingto violationsbeforetheconduct comestothe attention of theBoard or anotherregulator.If self-reportingis required by legal or regulatory obligations,it is notvoluntary and is not eligiblefor cooperationcredit.Thus,forexample,self-reportingisnot voluntaryif madeafterreceipt ofaregulatoryinquiry (e.g., any request, demand or subpoena for the sameinformation or documentsfrom the Board, theU.S. SecuritiesandExchangeCommission, Congress, anyother federal, state, localor foreignauthority, or anyself-regulatoryorganization).Likewise,self-reportingis not voluntary if required by Section 10A(b) ofthe Securities ExchangeAct of 1934 [15 U.S.C. 78j-1(b)], Auditrequirements- Required responsetoaudit discoveries(whichaddressesanauditor‘sobligationto report theillegalacts of the audit client) andRule10A-1thereunder.As a result, if theauditordiscoversor detectsan illegalact during either aquarterlyreview or annual audit, and isrequired toreport it pursuant toSection 10A, the auditor wouldnot be eligibleto earn credit forself-reporting.Self-reportingismore valuabletheearlier it is provided.When firms or associated personsself-report tothePCAOB, the Boardencouragesthem toself-report by directlycontacting theDivision ofEnforcement and Investigations,or by providing information anddocumentsvia the Board‘s tipshotline:http:/ / pcaobus.org/ Enforcement/ Tips/ Pages/ default.aspxRemedial or CorrectiveActionsare voluntary, timely and meaningfulactionsdesigned to reducethe likelihood and risk that similar violationswill recur, aswell asactionstocorrect violative conduct.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  50. 50. P a g e | 50For example, a firm might earn credit by promptly and voluntarilymodifying and improvingits qualitycontrolsor other internal policiesandprocedurestoprevent recurrenceof theviolativeconduct.Afirm might takeremedial orcorrectiveactionbyre-assigningorlimitingtheactivitiesof those individualsresponsiblefor violations(whichmightincludemembersof the audit team, aswell aspersonsoutsidetheauditteam, includingpersonsin firm management), and in appropriate casesbyterminatingor imposingdisciplineupon the responsible individuals.Afirm‘s remedial or correctiveaction might alsoincludepromptlynotifying itsaudit client or itsaudit committee(asappropriate) of theviolativeconduct andcooperatingwiththeclient, sothat theclient can(ifnecessary) take stepsto comply withthefederal securities lawsandregulations(e.g., by engagingan auditorto re-audit the financialstatementsaffectedby an auditor‘sindependenceviolations).Afirm‘s remedial or correctiveaction alsomight includeappropriatelycompensatingthoseadverselyaffectedby thefirm‘s violations.Substantial Assistance tothe Board‘sinvestigativeprocessesor tootherlawenforcement authorities includestimely and voluntarily providinginformation or documentsthat might not have been discoveredabsentthat cooperation, or beyond that sought by the Board‘sstaff viaaccountingboard demandsand requests,and beyond what is requiredpursuant to legal and regulatory reportingrequirements.For example, a firm might substantiallyassist the Board by conductingatimely, thorough, objectiveand competent internal investigation intotheviolativeconduct whenit wasdiscovered, and informing theDivision‘sstaff of thepertinent factsdiscovered in the internal investigation.Afirm or associatedperson might substantiallyassist another lawenforcement authority‘s investigativeprocessesby self-reportingto thatauthority, or providingit withthe factsdiscoveredin an internalinvestigation.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  51. 51. P a g e | 51III. How might extraordinary cooperation be credited?Credit for extraordinarycooperationin PCAOB mattersmaybe reflectedin a varietyof ways.Credit may be reflectedby reducingchargesand sanctionsimposed insettlement against the cooperatingfirm or associated person.Extraordinarycooperationcould, in somecases, lead to languageinsettlement documentsnoting the cooperation and itspositive effect onthefinal settlement by the firm or associatedperson.In exceptional cases, depending on the facts and circumstancesinvolved, the level of extraordinary cooperation could lead to nodisciplinaryaction at all againsta firm or associated person.IV. Other FactorsThere existssome tension betweenthe Board‘s interest in encouraging(andcrediting) extraordinarycooperationanditsinterestin holdingfirmsand associatedpersonsfullyaccountablefor their violativeconduct.TheBoard‘scooperation policyis intendedto balancethattension, encouraging cooperation withthe Board and itsstaff whilemaintainingaccountabilityfor violativeconduct.Thus, whethera firm or associatedperson provided extraordinarycooperation is onlyone factor that will be consideredin determining theappropriatedisciplinaryresponsetoviolative conduct.Other factorsalsomay impact the appropriate regulatory responsetoanyparticular violativeconduct, includingthenature of the misconduct anditsroot causes(includingwhetherit wasdeliberate,the result ofrecklessness,negligence, or honest mistake), whetherthere wererepeatedviolationsor a pattern of misconduct, the duration of themisconduct, andtheexistenceof prior disciplinaryhistory.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  52. 52. P a g e | 52For firms, whethersupervisorsor firm management directed, toleratedorremainedwillfullyblindtotheviolative conduct may impact theappropriateregulatory response.Also for firms, self-policingand the implementation of qualitycontrolsprior tothediscoveryof theviolativeconduct, includingtheestablishment of effectivecomplianceprocedures, an effectiveinternalwhistleblowerand complaint system, and an appropriatetoneat thetop, may impact the appropriate regulatoryresponse.For associatedpersons, their role in the violative conduct and theirknowledge, education, training, experiencein auditing, and positionofresponsibilityat the timethe violationsoccurred may impact theappropriateregulatory response.Thespecific factsand circumstancesof each casewill be consideredtodeterminewhether(and how) thefirm or associatedperson shouldreceivecredit for extraordinarycooperation.V. ConclusionThePCAOB wasestablishedby Congressto oversee the auditsof publiccompanies (and broker-dealers)in order toprotect the interestsofinvestorsand further thepublic interest in the preparation ofinformative, accurateand independent audit reports.Extraordinary cooperation can contribute significantly to those interestsby, among other things, allowing the Board to address possible audit orother violations sooner, reducing the risk that such violative conduct willbe repeated and result in more significant harm to investors, and assistingtheBoard in identifying audit reportsthat may be inaccurate.Also, creditingextraordinarycooperation may shorten investigationsandreducetheburdenson theBoard‘s resources, thusallowingthe Board tofocus on other potential auditor misconduct for theprotection ofinvestors.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  53. 53. P a g e | 53Providingthisguidanceand publicly acknowledgingextraordinarycooperation may encouragefirmsand associatedpersonsto provideextraordinarycooperation, and may provide insightsintohowextraordinarycooperationis credited.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  54. 54. P a g e | 54Solvency II: whereare we now?Although there is nocertaintyon theSolvencyII implementationdate, EU policymakers are continuingtofinalisekey aspectsof theframework.Recent developmentsincludeEIOPA‘s consultationon interimmeasures,theimpact assessment ofthelong-termguaranteepackageanda debateon whethernew legislation is needed formally to delaySolvencyII‘sapplication.Solvency II implementation dateThelegal positionis that Member Statesmust transposetheSolvencyII Directiveintonational lawsby30 June2013and applyit to firmsfrom 1January 2014.It is clear, however,that this Solvency IItimetableis not feasible.EU Member Statescannot implement theSolvencyII framework bytheset dates,for thesimplereasonthat it isnotfinalised.AMember State‘sfailure to meet the legal implementation deadlinesforSolvencyII wouldmeanthat it wasnot complying withEU lawand couldhavelegal implications.As a result, MemberStatesare keentoensure that further legislationamendstheSolvencyII Directiveto postpone deadlinesfor SolvencyIIimplementationon a formal basis.This can be done bymeansof another ―quick-fix Directive‖, similar totheone adopted last summer, whichestablishedcurrent transpositionand implementationdates.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  55. 55. P a g e | 55Many peopleexpect implementation to beput back to January2016.TheEuropean Commission, however, is resistingpressure tointroduceanother quick-fix, soasto encourage othersin theEU‘s legislativeprocessto agree theOmnibusII Directiveasa priority.Instead, the Commission proposestoproducea letter of comfort toMemberStatesconfirmingthat it will not commenceproceedingsagainstthem for failure to implement SolvencyII.Thediscussionisongoingand wearemonitoring it.EIOPA‘s consultation on Solvency II interim measuresAlthough the SolvencyII legislativeprocessis delayed, EIOPAbelievesthat the insuranceindustryshould build on preparatory work alreadyundertaken.In additionthe IMF‘sFinancial SectorAssessment Programme (FSAP)review of the EU concluded that earlyharmonised implementationofSolvencyII wouldreduce risksarisingfrom thecurrent regime.EIOPA hasthereforepublisheda set of consultation documentsproposingtointroducesomecoreSolvencyII provisionsinadvanceoftheformal deadline(still to be confirmed).EIOPA‘sguidelinesare addressed tonational supervisorsand cover thefollowingareas:- System of governance- Aforward lookingassessment of theundertaking‘sown risks(basedon theORSA)- Submissionof informationto national supervisors(reportingrequirements)- Pre-applicationfor internal modelsInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  56. 56. P a g e | 56Lloyd‘sis reviewingthe guidelinesand contributingto thedebate at UKandEU levels.Many insurersare most concerned about EIOPA‘sproposed reportingrequirements,whichlook very onerous.In arelated development, theEuropeanCentral Bank (ECB) plans topassaRegulation enablingit tocollect information from insurersforfinancial stabilityand statistical purposes.TheECB is workingwithEIOPAand, sofar aspossible,will relyon datacollectedthrough theSolvencyII reportingtemplates.In the interim period, before Solvency II is implemented, it probablywillnot require insurerstoreport any additional data.Longer-term, however, its requirementsmay become more extensive.Legally, this Regulation will applyto EurozoneMember Statesonly,although central banks in other MemberStatesmay decidetoimposesimilar reporting requirements.It is unclear what position the Bank of England will take.Impact assessment of the long-termguarantee packageLast year‘s debateson thelong-termguaranteepackageproved inconclusiveandtheCommissiondecidedtoconduct animpact assessment toinform OmnibusII‘sdevelopment.EIOPA launched theassessment inJanuary 2013:insurershad until the end ofMarch2013tosubmit information.Lloyd‘s did not participatedueto the issue‘slimited relevanceto most ofLloyd‘s business.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  57. 57. P a g e | 57EIOPA is expectedtopublish a report withitsfindingsin June thisyear, followedby a communication from theCommission.Parliament hasscheduled a vote on theOmnibusII Directive for 22October 2013.This is indicativeonly, but suggeststhedeadlineby whichagreement onthelong-term guarantee packageshould be reached.Compromisesover the long-term guaranteepackageand subsequentadoption of the OmnibusII Directive areimportant totheSolvency IIimplementationtimeline.If agreement is not reachedand the Directiveis not finalisedin 2013,thisis likelyto delaySolvencyII implementationbeyond theexpecteddeadlineof January2016.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  58. 58. P a g e | 58PolicyStatementConducting statutoryinvestigationsIntroduction1.ThePrudential RegulationAuthority (PRA) is required, under theFinancial ServicesAct 2012(theAct), to investigateand report to HMTreasuryon possibleregulatory failureand mattersof public interest.2.This statement fulfilstherequirement, under section 80of theAct, forthePRA to describehow it will dischargeits functionsin carrying outinvestigationsand for identifying whereregulatory failure hasoccurred.It hasbeen approved for publication by the PRA and HM Treasury.Statutory provisionsThe PRA‘sobjectives3.ThePRA hastwostatutoryobjectives:•topromotethesafety andsoundnessof PRA-authorised firms, primarilybyseekingtominimise the adverseeffect their failurecould have on thestability of theUK financial system, and by seekingtoensurethat theycarryon their businessin a waythat avoidsany adverse effect on thestability of theUK financial system; and•for insurers,tocontributetothe securingof an appropriate degreeofprotectionfor thosewhoare or may become policyholders.4. Consistent with those objectives, it is not the PRA‘s role to ensure thatno PRA-authorised firm fails, as made clear in section 2G of the FinancialServicesand MarketsAct 2000(FSMA).International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  59. 59. P a g e | 595.As describedin thePRA‘spolicydocumentson itsapproach toprudential supervision, the PRA‘s supervisionwill be driven by itsstatutoryobjectives.The objectiveswill alsoact asguidingprinciplesforthePRA in identifying regulatory failure.The PRA‘sduty to undertake statutory investigations6.There arethree broadcircumstancesin whichthe PRAis requiredunder theAct toconduct a statutoryinvestigation:(i)whereit appearstothe PRAthat a seriousregulatory failurehasoccurred; or(ii)whereit appearstoHM Treasurythat a seriousregulatoryfailure hasoccurred; or(iii)whereHM Treasuryconsidersan investigationtobe in the publicinterest.7.As required by theAct, this paper setsout howthe PRAwill identifywhethertheconditionsforaninvestigationintoregulatoryfailurearemet, and how it will carry out investigationsboth intoregulatory failureand mattersof public interest.Identifying regulatory failure8.Reflecting the PRA‘s statutory objectives, the Act sets out threeconditions which trigger the requirement for an investigation intoregulatoryfailure bythe PRA:(a)Public expenditure— whererelevant public expenditure hasbeenincurredin respect of a PRA-authorised firm and might not have beenincurredbut for a serious failurein thescope or design of thesystem ofregulationor the operationof that system; or(b)Safetyor soundness— whereeventshave occurredwhichhad, orcouldhave had, a significant adverseeffect on the safety or soundnessofInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  60. 60. P a g e | 60oneormorePRA-authorised firms,whichmight nothaveoccurred, ortheeffect of whichmight have been reduced, but for a seriousfailure in thescopeor design of the system of regulationor the operation of thatsystem; or(c) Policyholder protection— whereeventshaveoccurred, relatingtotheeffectingand carrying out of contractsof insurancebya PRA-authorisedfirm, which indicatea significant failure tosecure an appropriate degreeof protection for policyholders, whichmight not haveoccurred, or theeffect of whichmight have been reduced, but for a seriousfailure in thescopeor design of the system of regulationor the operation of thatsystem.9.Should it appeartothe PRAthat any of these three conditionshavebeen met, the PRAwill be required to investigatethe eventsin questionandthecircumstancessurroundingthem.ThePRAmust report to HM Treasury on its findingsand, subject tosome restrictionsasdescribedbelow, thisreport must be published.10.An investigationinto regulatory failuremay alsobe required inconnectionwiththe Lloyd‘s insurancemarket, in whichcasetherequirementswill be thesame asthe above savethat theywill referrespectivelyto:(a)relevant public expenditure that hasbeen incurred in respect of amember of theSociety of Lloyd‘s;(b)eventswhichhad, or could have had, a significant adverse effect onthesafetyor soundnessof theSociety of Lloyd‘s and itsmembers, takentogether;and(c)eventsrelatingto theeffectingand carrying out of contractsofinsuranceby the Societyof Lloyd‘s or any other person whocarriesonPRA-regulated activitiesin relation toanything done at Lloyd‘s, whichindicateasignificant failure tosecure anappropriatedegreeof protectiontopolicyholders.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  61. 61. P a g e | 61How the PRAwill identify regulatory failure11. In order todeterminewhetherthe conditionsfor an investigationintoregulatoryfailure have been met, the PRA must:(i)assesswhetherrelevant public expenditure, significant adverseeffectson safetyor soundness, or significant failure tosecure an appropriatedegreeof policyholder protectionhave occurred;and(ii)assesswhetherthoseeventsweretheresult of a seriousfailure of theregulatorysystem or its operation.If the PRAdeterminesthat both (i) and (ii) are satisfied, an investigationintoregulatory failurewill be required.12.Thefact that investigationswill not be triggered automaticallybyrelevant eventsreflectsthe important principle, rooted in thePRA‘sobjectives,that it is not the PRA‘s roletoprevent all firm failures, nor toprotect all policyholders in full in all circumstances.13.ThematterswhichthePRAwill take intoaccount in itsassessment ofwhetheran investigationintoregulatoryfailure is required areoutlinedbelow.Relevant public expenditure14.‗Relevant public expenditure‘isdefinedby theAct, asbeing in broadterms:•financial assistanceprovided, or expenditure incurred, by HM Treasuryin respect of a PRA-authorised firm, for the purposeof resolving orreducing a threat to thestabilityof the UK financial system.This may include,for example, an injectionof capital or fundinginto, ortheprovision of a guarantee to, a major insurer to prevent its failure;International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  62. 62. P a g e | 62•expenditureincurred by HM Treasuryin the exerciseof resolution andvariousother powersunder the BankingAct 2009.This may include, for example, a lossincurredby HM Treasuryin takinga bank intotemporarypublic ownershipand onward saletoa privatesectorpurchaser;•financial assistanceprovided, or expenditure incurred, by HM Treasuryin respect of the Financial ServicesCompensation Scheme(FSCS) inrelationtoa PRA-authorised firm.This may include,for example, a temporary loanto the FSCSallowingitswiftly tocompensatethedepositorsof afailing bank.15.‗Financialassistance‘toaPRA-authorised firm includesguaranteesorindemnitiesand anyother kind of financial assistance(actual orcontingent), but not indemnitiesor guaranteesgivenby HM Treasuryinrespect of theprovision of financial assistanceby theBank of England.Safety or soundnessand policyholder protection16.ThePRA must assesswhether there hasbeen a significant adverseeffect on thesafety or soundnessof one or more PRA-authorised firmsora significant failure tosecure an appropriate degreeof policyholderprotection.‗Safetyand soundness‘is assessedin thecontext of thePRA‘sgeneralobjective,whichisadvanced primarilyby:(a)seekingtoensurethat thebusinessof PRA-authorised firmsis carriedon in a waywhichavoidsany adverse effect on the stabilityof the UKfinancial system; and(b) seeking to minimisethe adverseeffect that the failure of aPRA-authorised firm could be expectedto haveon the stabilityof theUKfinancial system.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  63. 63. P a g e | 63Thefailure of a PRA-authorisedfirm wouldnot necessarilysatisfytheconditionsfor an investigationif there hasnot been a significant adverseeffect on safetyand soundnessin thissense.17.Subject to this, thePRA may judgethat sucheventshave occurred if:(a)a firm is in resolution or actively beingwoundup; or(b)solvencyconstraintshavepreventedaninsurancefirm from deliveringon contractual obligationsto policyholders, or from providinga level ofpayout topolicyholdersthat the Financial ConductAuthority(FCA)consideredfair; or(c)there wasan imminent risk totheviabilityof the firm such that eventsasdescribed in (a) or (b) wouldhaveoccurredbut for theinterventionsorforbearanceof a third party(for example, an acquisition or capitalinjectionby a third-party institution).18.In addition, even wherea firm doesnot itselffail, if its behaviourhashada significant adverseeffect on thestability of theUK financial systemthen this wouldsatisfy the ‗seriousadverseeffect on safetyor soundness‘requirement.Seriousfailure in the scope or design of the system of regulationor its operation19.If eventsasdescribed abovehave been identified, an initialassessment will examinewhetherthoseeventsmight have beenavoided, or their severitybeen lower,but for a seriousfailure in theregulatorysystem or itsoperation.Where this is thecase, an investigationwill be required.20.Seriousfailuresof theregulatorysystem or itsoperationcould fall intothreebroad categories:International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  64. 64. P a g e | 64•a failure in the designof the PRA‘ssupervisoryapproach — in otherwords,that its approach doesnot deliver on itsobjectives;or•a failure by thePRAtoimplement itssupervisory approacheffectively;or•a failure in the scope or design of the frameworkof regulation, at aglobal, EU or domestic level, wherethesehaveprevented thePRAeffectivelyfrom advancingits objectives.21.As describedin the PRA‘s policy documentson itsapproach tosupervision, eventsthat causelittledisruption tothe stabilityof thefinancial system or topolicyholders arenot necessarilyinconsistent withthePRA‘sobjectives.ThePRA‘sapproachhasbeendesignedonthebasisthatsucheventsmayoccur, and if theydo, theywill not automaticallyimply regulatoryfailure.22.Seriousfailuresin the design of the PRA‘s supervisoryapproach mustthereforebe considered in the context of the PRA‘sstatutoryobjectives.If eventshave occurredwhichare not inconsistent withthePRA‘sobjectives— forexample,thefailureof asmall credit unionwithnowiderimpact on financial stability, or a public loanto the FSCSin the courseoforderly liquidation— then thiswouldnot automaticallyindicatearegulatoryfailure, sincethePRA hasdesigned itsapproach withatolerancefor such eventsin mind.23.Other eventsthat are inconsistent withthe PRA‘s objectives, however— for examplethedisorderlyfailure of a systemically important firm withsevereimpact on financial stability — wouldbe more likelytoindicateafailure in the approach.24. SeriousfailuresbythePRAto implement itssupervisory approacheffectivelywill be identified and assessedin their own right.Such failureswill be evidenced by, for example, the PRA failingto reviewbasicregulatoryreturnswhichit hascommitted toanalyseasa minimumInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  65. 65. P a g e | 65baselinelevel of supervision, or more generallyfailing toundertakesupervision asoutlinedin its published documents.25.Seriousfailuresin the scope or design of the framework of regulationwill alsobe identifiedand assessed in their own right.EU legislation, for example, introducesbinding rulesto theUnitedKingdom, includingsomethat implement standards agreed at a globallevel.Further powersand responsibilities are allocatedtodomesticsupervisorybodies, includingthe PRA, by UK legislation.Potential defectsin anyelement of this regulatory framework couldrestrict the PRA‘s ability toadvanceitsobjectiveseffectively, or lead toambiguousareasof responsibility.While thePRAiscommittedtoworkingwith EU and global counterpartsin establishinga robust prudential policy framework, in some casesitsabilityto offset any defectswill be limited.In caseswhere the PRA believes that its ability to advance its objectiveshas been materially restricted by defects in the framework, the PRAwillconsider this tobe a seriousfailure of theregulatory system.Conducting investigations into regulatory failure and mattersofpublic interest26.An initial assessment examiningwhetherrelevant eventsweretheresult of a seriousregulatoryfailure will be conducted by a part of thePRAnot involved in supervision, and will be overseen by thePRABoard.ThePRABoard will make the determination asto whethertherequirement for an investigationis triggered.27.Once a seriousregulatory failureis judged to have occurred, aninvestigationwill be initiatedassoon aspossible.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  66. 66. P a g e | 66Since investigations will be triggered only once the initial assessment iscomplete, however, they will inevitably not follow immediately from theeventsin question.28.An investigationintomattersof publicinterest will be triggered, andinitiatedassoon aspossible, when the PRA receivesa directionto thateffect from HM Treasury.29.ThePRAwill normallyengageindependent, external specialistsinconnection withitsinvestigations.Thesespecialistswill report directlytothePRA Board.Arange of measurestailoredtothecircumstancesof thematter will beemployedin investigations,including:desk-basedanalysisof documents;interviewsof PRA staff;interviewswith therelevant firm or other externalparties;and theuseof expert analysisor opinion.ThePRAwillalsoco-ordinatewithotherpartiesasappropriate,includingtheFCA.ThePRAwillinform theFCAof aspectsoftheinvestigationrelevant toit, and will seek itsinput wherenecessary.30.ThePRAexpectsfirms todeal withanyinvestigationin an open andco-operativemanner.This includesfirmsproviding the investigator with theinformationnecessaryfor it to carryout thorough investigationsand producecomprehensivereports, enablingit properlyto identify and addressanyfailures that may have occurred.WhilethePRAwilllookforfirms‘co-operationin thefirstinstance,it mayalsouseformal powers— in particular itsinformation gatheringpowers— whereit considersthem tobe an appropriate meansof obtainingthenecessaryinformation.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  67. 67. P a g e | 67This may includecircumstanceswherea firm is reluctant or unabletohand over informationfor reasonsof confidentiality.31.Theinvestigatingparty will report directlyto the PRABoard, whichwill have oversight of the processand be engagedthroughout asnecessary.32.Should it be necessary, thosesubject topotential criticism in thereport will be given an opportunityto make representationsin responsebeforeit is finalised.Postponing or suspending investigations33.Under theAct, thePRA must have regard to the desirabilityofminimisingany adverseeffectthat investigationsmay have on its otherfunctions.This will includeinstanceswherethe outcome of an investigationcouldprejudice an enforcement action being carried out by the PRA.In caseswherethePRA considersthat an investigationwould prejudiceitsother functions,it may postponethestart of, or suspend, thatinvestigation.HM Treasuryinvolvement34.While it will be theresponsibilityof thePRA todeterminehowinvestigationsare carried out, HM Treasury may give the PRAdirectionstocontrol how an investigationisundertaken.In particular, HM Treasury may give the PRA directions controlling thescope of the investigation, the period of time in which it is to be carriedout and how it is tobe conducted.It may alsogive directionsabout how reportsare tobe made, includingwhetheranyinterim reportsare required.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  68. 68. P a g e | 6835.ThePRAwill report to HM Treasury on the resultsof anyinvestigation,settingout thelessonsthat it considersshouldbelearnt andanyrecommendationsit thinksappropriate.This includes identifying necessary improvements to the design orimplementation of the PRA‘s supervisory approach, or the scope ordesignof theframeworkof regulation.36.HM Treasurymust publish the report, but will withholdmaterialwhereit is required todo soby law or whereit considersthat thiswouldbein the public interest.For example, HM Treasurymay withholdmaterial where confidentialityrestrictionsprecludepublication, or wherethe report concernsongoingeventsposing a risk tofinancial stability that could be aggravatedby itsrelease.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  69. 69. P a g e | 69Commission report underlinesimportance and urgency of financialsector reforms asa basis to restorelong-term growthThe European Commission is publishing today the European FinancialStability and Integration Report (EFSIR), which is being presented at ajoint conferencewith the European Central Bank (ECB) in Brussels.This event brings together policymakers, financial market leaders andacademicsfor discussionon financial stabilityand integrationin Europe.Internal Market and Services Commissioner Michel Barnier said "Thepoliciesanalysed in thisreport areour best instrumentstoexit thecrisis.Our reform agenda addresses the "too big to fail" question and iscreating a more resilient and integrated European market in financialservices. It is imperative that our financial sector is in a position tosupport thereal economyand establishthebasisforlong-term growth‖.Overall, the report shows that despite improvements, the financial crisiscontinued to exert a significant impact in holding back economic growthin 2012.Morespecifically, this years report:Showsthat European proposalsfor the establishment of abankingunion stem from theneed todeepeneconomic andfinancial integrationin Europe.Coversthemainpolicyinitiativesthat havebeenorarebeingimplemented, adopted, presented, or developed in 2012.Takesstock of the important debateinitiatedbygovernments,international organizations,and, ultimately, thegeneral public toanalyse the businessmodels of thefinancialInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  70. 70. P a g e | 70institutions;in particular, thedesirabilityof adoptingstructuralreforms in the banking sector.Describesand takesstock of progressin regulatingtheover-the-counter(OTC) derivativesmarkets.Underscoresthepivotal role the financial sector hasinsupportingthereal economy and in providingjobsand growthforsociety, by examiningthe difficultiessmall and medium-sizedenterprises(SMEs) experiencein their accessto funding.BackgroundIn 1999, a singlefinancial market in whichfundscould flowand marketparticipantscould tradefreelyacrossEU borderswasa distant dream.Sincethen significant developmentshavebeen achieved.European financial institutionsand marketshave become moreinterdependent. Market dynamicshave forcedfurther adjustmentsfromregulatorsand supervisors.Old waysof organisingfinancial regulationand supervision werecalledintoquestion, and cross-borderrisk transmission channelsintensified.In this regard, theCommissionrecognisedtheneed to regularlymonitordevelopmentsin theEU financial sector.For thispurpose, until 2009it publishedtheEuropean FinancialIntegration Report.It reported on market and policydevelopmentspresentingindicatorsonfinancial integration, efficiency, stability and competitiveness.Thefinancial crisishasdemonstratedthe need for an additional focusonfinancial stabilityissues.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com

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