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Understanding Liquidity Risk Management Through Regulatory Analogies

This week’s highlight from the International Association of Risk and Compliance Professionals (IARCP) focuses on innovative ways to explain liquidity risk management utilizing pollution-mitigating technology analogies. By comparing liquidity services to energy output and high-quality liquid assets to scrubbers, we can better understand regulatory impacts on financial systems. The discussion includes insights from Federal Reserve Board member Jeremy C. Stein on optimal regulatory strategies to handle uncertainties in cost mitigation, enhancing our comprehension of liquidity coverage ratios.

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Understanding Liquidity Risk Management Through Regulatory Analogies

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  1. P age |1 InternationalAssociationofRiskandCompliance Professionals(IARCP) 1200GStreetNWSuite800Washington, DC20005-6705USATel:202-449-9750www.risk-compliance-association.com Top10riskandcompliancemanagementrelatednewsstoriesandworldeventsthat(forbetterorforworse)shapedthe week'sagenda,andwhatisnext DearMember, Ihadadifficulttimeinthepasttoexplainliquidityriskmanagementandratios. NowIknowwhattodo.Problemsolved! Iwilluseapollution-mitigatingtechnology,likescrubberstoexplainliquidityrisk. Mr.JeremyCStein,MemberoftheBoardofGovernorsoftheFederalReserveSystemexplainedhow: “Supposewehaveapowerplantthatproducesenergyand,asabyproduct,somepollution. Supposefurtherthatregulatorswanttoreducethepollutionandhavetwotoolsattheirdisposal: Theycanmandatetheuseofapollution-mitigatingtechnology,likescrubbers,ortheycanlevyataxontheamountofpollutiongeneratedbytheplant. Inanidealworld,regulationwouldaccomplishtwoobjectives. First,itwouldleadtoanoptimallevelofmitigation–thatis,itwouldinducetheplanttoinstallscrubbersuptothepointwherethecostofan InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  2. P age |2 additionalscrubberisequaltothemarginalsocialbenefit,intermsof reducedpollution. And,second,itwouldalsopromoteconservation: Giventhatthescrubbersdon’tgetridofpollutionentirely,onealsowantstoreduceoverallenergyconsumptionbymakingitmoreexpensive. Asimplecaseisoneinwhichthecostsofinstallingscrubbers,aswellasthesocialbenefitsofreducedpollution,areknowninadvancebytheregulatorandthemanagerofthepowerplant. Inthiscase,theregulatorcanfigureoutwhattherightnumberofscrubbersisandrequirethattheplantinstallthesescrubbers. Themandatecanthereforepreciselytargettheoptimalamountofmitigationperunitofenergyproduced. And,totheextentthatthescrubbersarecostly,themandatewillalsoleadtohigherenergyprices,whichwillencouragesomeconservation,though perhapsnotthesociallyoptimallevel. Thislattereffectistheimplicittaxaspectofthemandate. Amorecomplicatedcaseiswhentheregulatordoesnotknowaheadoftimewhatthecostsofbuildingandinstallingscrubberswillbe. Here,mandatingtheuseofafixednumberofscrubbersispotentiallyproblematic: Ifthescrubbersturnouttobeveryexpensive,theregulationwillendup beingmoreaggressivethansociallydesirable,leadingtooverinvestment inscrubbersandlargecostincreasesforconsumers;however,ifthe scrubbersturnouttobecheaperthanexpected,theregulationwillhavebeentoosoft. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  3. P age |3 Inotherwords,whenthecostofthemitigationtechnologyissignificantlyuncertain,aregulatoryapproachthatfixesthequantityofmitigationisequivalenttoonewheretheimplicittaxratebouncesaroundalot. Bycontrast,aregulatoryapproachthatfixesthepriceofpollutioninsteadofthequantity–say,byimposingapredeterminedproportionaltaxratedirectlyontheamountofpollutionemittedbytheplant–ismoreforgivinginthefaceofthiskindofuncertainty. Thisapproachleavesthescrubber-installationdecisiontothemanageroftheplant,whocanfigureoutwhatthescrubberscostbeforedecidinghowtoproceed. Forexample,ifthescrubbersturnouttobeunexpectedlyexpensive,theplantmanagercaninstallfewerofthem. Thisflexibilitytranslatesintolessvariabilityintheeffectiveregulatoryburdenandhencelessvariabilityinthepriceofenergytoconsumers. Scrubbersandhigh-qualityliquidassets WhatdoesallthisimplyforthedesignoftheLCR?Let’sworkthroughtheanalogyindetail. Theanalogtothepowerplant’senergyoutputisthegrossamountofliquidityservicescreatedbyabank–viaitsdeposits,thecreditlinesitprovidestoitscustomers,theprimebrokerageservicesitoffers,andsoforth. Theanalogtothemitigationtechnology–thescrubbers–isthestockofHQLAthatthebankholds. Andtheanalogtopollutionisthenetliquidityriskassociatedwiththedifferencebetweenthesetwoquantities,somethingakintotheLCRshortfall. Thatis,whenthebankoffersalotofliquidityondemandtoitscustomers InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  4. P age |4 butfailstoholdanadequatebufferofHQLA,thisiswhenitimposesspillovercostsontherestofthefinancialsystem. Inthecaseofthepowerplant,Iarguedthataregulationthatcallsforafixedquantityofmitigation–thatis,forafixednumberofscrubbers–ismoreattractivewhenthereislittleuncertaintyaboutthecostofthese scrubbers.” ThankyouJeremy! Ihavejustopenedmymasterplan.Ihavetolearnmoreaboutscrubbers.InowseeothersimilaritiesbetweentheBISandscrubbers.OnlynowIcanunderstandtheshapeoftheBISbuilding! IthinkIhavejustfoundanotherregulatoryarbitrageopportunity.Arealnationaldiscretion,justified. Scrubbersarecapableofreductionefficienciesintherangeof50%to98%.WhyshouldtheLiquidityCoverageRatiobe100%? ALCRfrom50%to98%(meaning50,001%)isgoodenough! InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  5. P age |5 ThecalculationsinBaselandscrubbersarealsoalmostthesame! ReadmoreatNumber1below. WelcometotheTop10list. BestRegards, GeorgeLekatisPresidentoftheIARCP GeneralManager,ComplianceLLC 1200GStreetNWSuite800, WashingtonDC20005,USA Tel:(202)449-9750 Email:lekatis@risk-compliance-association.com Web:www.risk-compliance-association.com HQ:1220N.MarketStreetSuite804,WilmingtonDE19801,USA Tel:(302)342-8828 InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  6. P age |6 Liquidityregulationandcentralbanking SpeechbyMrJeremyCStein,MemberoftheBoardofGovernorsoftheFederalReserveSystem,atthe“Findingtherightbalance”2013CreditMarketsSymposium,sponsoredbytheFederalReserveBankofRichmond,Charlotte,NorthCarolina BaselIIICapital:AWell-IntendedIllusion ThomasM.Hoenig,ViceChairman,FederalDepositInsuranceCorporation,InternationalAssociationofDepositInsurers,2013ResearchConference,Basel, Switzerland “Aristotleiscreditedwithbeingthefirstphilosophertosystematicallystudylogicalfallacies,whichhedefinedasargumentsthatappearvalidbut,infact,arenot. Icallthemwell-intendedillusions. OnesuchillusionofprecisionistheBaselcapitalstandardsinwhichworldsupervisoryauthoritiesrelyprincipallyonaTier1capitalratiotojudgetheadequacyofbankcapitalandbalancesheetstrength.” PCAOBIssuesPolicyStatementonExtraordinaryCooperationinConnectionwithBoardInvestigationsWashington,DC InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  7. P age |7 ThePublicCompanyAccountingOversightBoardtodaypublishedaformalstatementconcerningthebenefitsthatmaybeavailabletoregisteredpublicaccountingfirmsandindividualswhoprovideextraordinarycooperationinPCAOBinvestigations. SolvencyII:wherearewenow? AlthoughthereisnocertaintyontheSolvencyIIimplementationdate,EUpolicymakersarecontinuingtofinalisekeyaspectsoftheframework. PolicyStatementConductingstatutoryinvestigations ThePrudentialRegulationAuthority(PRA)isrequired,undertheFinancialServicesAct2012(theAct),toinvestigateandreporttoHMTreasuryonpossibleregulatoryfailureandmattersofpublicinterest. Commissionreportunderlinesimportanceandurgencyoffinancialsectorreformsasabasistorestorelong-termgrowth TheEuropeanCommissionispublishingtodaytheEuropeanFinancialStabilityandIntegrationReport(EFSIR),whichisbeingpresentedatajointconferencewiththeEuropeanCentralBank(ECB)inBrussels. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  8. P age |8 Statementonthe2013PCAOBAcademicConference JeanetteM.Franzel,BoardMember2013PCAOBAcademicConferenceWashington,D.C. TheimportanceofcultureindrivingbehavioursoffirmsandhowtheFCAwillassessthis SpeechbyCliveAdamson,DirectorofSupervisionattheCFASociety-UKProfessionalismConference19April2013,London. LessonsforSouthAfricafromGermanyinachallengingglobalenvironment AddressbyMsGillMarcus,GovernoroftheSouthAfricanReserveBank,attheSouthern African-GermanChamberofCommerceandIndustryluncheon,Johannesburg Thejourneyoffinancialreform AddressbyMrPhilipLowe,DeputyGovernoroftheReserveBankofAustralia,tothe AustralianChamberofCommerceinShanghai. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  9. P age |9 Liquidityregulationandcentralbanking SpeechbyMrJeremyCStein,MemberoftheBoardofGovernorsoftheFederalReserveSystem,atthe“Findingtherightbalance”2013CreditMarketsSymposium,sponsoredbytheFederalReserveBankofRichmond,Charlotte,NorthCarolina I’dliketotalktodayaboutoneimportantelementoftheinternationalregulatoryreformagenda–namely,liquidityregulation. Liquidityregulationisarelativelynew,post-crisisadditiontothefinancialstabilitytoolkit. KeyelementsincludetheLiquidityCoverageRatio(LCR),whichwasrecentlyfinalizedbytheBaselCommitteeonBankingSupervision,andtheNetStableFundingRatio,whichisstillaworkinprogress. Inwhatfollows,IwillfocusontheLCR. ThestatedgoaloftheLCRisstraightforward,evenifsomeaspectsofitsdesignarelessso. InthewordsoftheBaselCommittee,“TheobjectiveoftheLCRistopromotetheshort-termresilienceoftheliquidityriskprofileofbanks. Itdoesthisbyensuringthatbankshaveanadequatestockofunencumberedhigh-qualityliquidassets(HQLA)thatcanbeconvertedeasilyandimmediatelyinprivatemarketsintocashtomeettheirliquidityneedsfora30calendardayliquiditystressscenario.” Inotherwords,eachbankisrequiredtomodelitstotaloutflowsover30daysinaliquiditystresseventandthentoholdHQLAsufficientto InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  10. P age |10 accommodatethoseoutflows. Thisrequirementisimplementedwitharatiotest,wheremodeledoutflowsgointhedenominatorandthestockofHQLAgoesinthenumerator;whentheratioequalsorexceeds100percent,therequirementissatisfied. TheBaselCommitteeissuedthefirstversionoftheLCRinDecember2010. InJanuaryofthisyear,thecommitteeissuedarevisedfinalversionoftheLCR,followinganendorsementbyitsgoverningbody,theGroupofGovernorsandHeadsofSupervision(GHOS). TherevisionexpandstherangeofassetsthatcancountasHQLAandalsoadjustssomeoftheassumptionsthatgovernthemodelingofnetoutflowsinastressscenario. Inaddition,thecommitteeagreedinJanuarytoagradualphase-inoftheLCR,sothatitonlybecomesfullyeffectiveonaninternationalbasisinJanuary2019. Onthedomesticfront,theFederalReserveexpectsthattheU.S.bankingagencieswillissueaproposallaterthisyeartoimplementtheLCRforlargeU.S.bankingfirms. Whilethisprogressiswelcome,anumberofquestionsremain. First,towhatextentshouldaccesstoliquidityfromacentralbankbeallowedtocounttowardsatisfyingtheLCR? InJanuary,theGHOSnotedthattheinteractionbetweentheLCRandtheprovisionofcentralbankfacilitiesiscriticallyimportant. AndthegroupinstructedtheBaselCommitteetocontinueworkingonthisissuein2013. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  11. P age |11 Second,whatstepsshouldbetakentoenhancetheusabilityoftheLCRbuffer–thatis,toencouragebankstoactuallydrawdowntheirHQLAbuffers,asopposedtofire-sellingotherlessliquidassets? TheGHOShasalsomadeclearitsviewthat,duringperiodsofstress,itwouldbeappropriateforbankstousetheirHQLA,therebyfallingbelowtheminimum. However,creatingaregimeinwhichbanksvoluntarilychoosetodosoisnotaneasytask. AnumberofobservershaveexpressedtheconcernthatifabankisheldtoanLCRstandardof100percentinnormaltimes,itmaybereluctanttoallowitsratiotodropbelow100percentwhenfacinglargeoutflows,evenifregulatorsweretopermitthistemporarydeviation,forfearthatadeclineintheratiocouldbeinterpretedasasignofweakness. Myaimhereistosketchaframeworkforthinkingabouttheseandrelatedissues. Amongthem,theinterplaybetweentheLCRandcentralbankliquidityprovisionisperhapsthemostfundamentalandanaturalstartingpointfordiscussion. Bywayofmotivation,notethatbeforethefinancialcrisis,wehadahighlydevelopedregimeofcapitalregulationforbanks–albeitonethatlooksinadequateinretrospect–butwedidnothaveformalregulatorystandardsfortheirliquidity. Theintroductionofliquidityregulationafterthecrisiscanbethoughtofasreflectingadesiretoreducedependenceonthecentralbankasalenderoflastresort(LOLR),basedonthelessonslearnedoverthepreviousseveralyears. However,totheextentthatsomerolefortheLOLRstillremains,onenowfacesthequestionofhowitshouldcoexistwitharegimeofliquidityregulation. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  12. P age |12 Toaddressthisquestion,itisusefultotakeastepbackandaskanotherone: Whatunderlyingmarketfailureisliquidityregulationintendedtoaddress,andwhycan’tthismarketfailurebehandledentirelybyanLOLR? Iwillturntothisquestionfirst. Next,Iwillconsiderdifferentmechanismsthatcouldpotentiallyachievethegoalsofliquidityregulation,andhowthesemechanismsrelatetovariousfeaturesoftheLCR. Insodoing,Ihopetoillustratewhy,eventhoughliquidityregulationisaclosecousinofcapitalregulation,itneverthelesspresentsanumberofnovelchallengesforpolicymakersandwhy,asaresult,wearegoingtohavetobeopentolearningandadaptingaswego. Thecaseforliquidityregulation Oneoftheprimaryeconomicfunctionsofbanksandotherfinancialintermediaries,suchasbroker-dealers,istoprovideliquidity–thatis,cashondemand–invariousformstotheircustomers. Someofthisliquidityprovisionhappensontheliabilitysideofthebalancesheet,withbankdemanddepositsbeingaleadingexample. But,importantly,banksalsoprovideliquidityviacommittedlinesof credit. Indeed,itisprobablynotacoincidencethatthesetwoproducts–demand depositsandcreditlines–areofferedundertheroofofthesameinstitution;theunderlyingcommonalityisthatbothrequireanabilitytoaccommodateunpredictablerequestsforcashonshortnotice. Anumberofotherfinancialintermediaryservices,suchasprimebrokerage,alsoembodyasignificantelementofliquidityprovision.Withoutquestion,theseliquidity-provisionservicesaresociallyvaluable. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  13. P age |13 Ontheliabilityside,demanddepositsandothershort-termbankliabilitiesaresafe,easy-to-valueclaimsthatarewellsuitedfortransaction purposesandhencecreateaflowofmoney-likebenefitsfortheirholders. Andloancommitmentsaremoreefficientthananarrangementinwhicheachoperatingfirmhedgesitsfutureuncertainneedsby“pre-borrowing”andhoardingtheproceedsonitsownbalancesheet;thislatterapproach doesapoorjobofeconomizingonthescarceaggregatesupplyofliquidassets. Atthesametime,asthefinancialcrisismadepainfullyclear,thebusinessofliquidityprovisioninevitablyexposesfinancialintermediariestovariousformsofrunrisk. Thatis,inresponsetoadverseevents,theirfragilefundingstructures,togetherwiththebindingliquiditycommitmentstheyhavemade,canresultinrapidoutflowsthat,absentcentralbankintervention,leadbankstofire-sellilliquidassetsor,inamoreseverecase,tofailaltogether. Andfiresalesandbankfailures–andtheaccompanyingcontractionsincreditavailability–canhavespillovereffectstootherfinancialinstitutionsandtotheeconomyasawhole. Thus,whilebankswillnaturallyholdbufferstocksofliquidassetstohandleunanticipatedoutflows,theymaynotholdenoughbecause,althoughtheybearallthecostsofthisbufferstocking,theydonotcaptureallofthesocialbenefits,intermsofenhancedfinancialstabilityandlowercoststotaxpayersintheeventoffailure. Itisthisexternalitythatcreatesaroleforpolicy. Therearetwobroadtypesofpolicytoolsavailabletodealwiththissortofliquidity-basedmarketfailure. Thefirstisafter-the-factintervention,eitherbyadepositinsurerguaranteeingsomeofthebank’sliabilitiesorbyacentralbankactingasanLOLR. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  14. P age |14 Thesecondtypeisliquidityregulation. Asanexampleoftheformer,whentheeconomyisinabadstate,assumingthataparticularbankisnotinsolvent,thecentralbankcanlendagainstilliquidassetsthatwouldotherwisebefire-sold,therebydampingoreliminatingtherundynamicsandhelpingreducetheincidenceofbankfailure. Inmuchoftheliteratureonbanking,suchinterventionsareseenasthe primarymethodfordealingwithrun-likeliquidityproblems. Aclassicstatementofthecentralbank’sroleasanLOLRisWalterBagehot’s1873bookLombardStreet. Morerecently,theseminaltheoreticaltreatmentofthisissueisbyDouglasDiamondandPhilipDybvig,whoshowthatundercertaincircumstances,theuseofdepositinsuranceoranLOLRcaneliminaterunriskaltogether,therebyincreasingsocialwelfareatzerocost. Tobeclear,thisworkassumesthatthebankinquestionisfundamentallysolvent,meaningthatwhileitsassetsmaynotbeliquidonshortnotice,thelong-runvalueoftheseassetsisknownwithcertaintytoexceedthevalueofthebank’sliabilities. Onewaytointerpretthemessageofthisresearchisthatcapitalregulationisimportanttoensuresolvency,butonceareliableregimeof capitalregulationisinplace,liquidityproblemscanbedealtwithafterthefact,viasomecombinationofdepositinsuranceanduseoftheLOLR. ItfollowsthatifoneisgoingtomakeanargumentinfavorofaddingpreventativeliquidityregulationsuchastheLCRontopofcapitalregulation,acentralpremisemustbethattheuseofLOLRcapacityinacrisisscenarioissociallycostly,sothatitisanexplicitobjectiveofpolicytoeconomizeonitsuseinsuchcircumstances. Ithinkthispremiseisasensibleone. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  15. P age |15 Akeypointinthisregard–andonethathasbeenreinforcedbytheexperienceofthepastseveralyears–isthatthelinebetweenilliquidityandinsolvencyisfarblurrierinreallifethanitissometimesassumedtobeintheory. Indeed,onemightarguethatabankorbrokerdealerthatexperiencesaliquiditycrunchmusthavesomeprobabilityofhavingsolvencyproblemsaswell;otherwise,itishardtoseewhyitcouldnotattractshort-termfundingfromtheprivatemarket. ThisreasoningimpliesthatwhenthecentralbankactsasanLOLRinacrisis,itnecessarilytakesonsomeamountofcreditrisk. Andifitexperienceslosses,theselossesultimatelyfallontheshouldersoftaxpayers. Moreover,theuseofanLOLRtosupportbankswhentheygetintotroublecanleadtomoralhazardproblems,inthesensethatbanksmaybelessprudentexante. IfitwerenotforthesecostsofusingLOLRcapacity,theproblemwouldbetrivial,andtherewouldbenoneedforliquidityregulation: Assumingawell-functioningcapital-regulationregime,thecentralbankcouldalwaysavertallfiresalesandbankfailuresexpost,simplybyactingasanLOLR. Thisobservationcarriesanimmediateimplication: Itmakesnosensetoallowunpricedaccesstothecentralbank’sLOLRcapacitytocounttowardanLCRrequirement. Again,thewholepointofliquidityregulationmustbeeithertoconserveontheuseoftheLOLRorinthelimit,toaddresssituationswheretheLOLRisnotavailableatall–as,forexample,inthecaseof broker-dealersintheUnitedStates. Atthesametime,itisimportanttodrawadistinctionbetweenpricedand unpricedaccesstotheLOLR. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  16. P age |16 Forexample,takethecaseofAustralia,whereprudentfiscalpolicyhasledtoarelativelysmallstockofgovernmentdebtoutstandingandhencetoapotentialshortageofHQLA. TheBaselCommitteehasagreedtotheusebyAustraliaofaCommittedLiquidityFacility(CLF),wherebyanAustralianbankcanpaytheReserveBankofAustraliaanupfrontfeeforwhatiseffectivelyaloancommitment,andthisloancommitmentcanthenbecountedtowarditsHQLA. IncontrasttofreeaccesstotheLOLR,thisapproachisnotatoddswiththegoalsofliquidityregulationbecausetheup-frontfeeiseffectivelyataxthatservestodeterrelianceontheLOLR–which,again,ispreciselytheultimategoal. IwillreturntotheideaofaCLFshortly. Thedesignofregulation Onceithasbeendecidedthatliquidityregulationisdesirable,thenextquestionishowbesttoimplementit. Inthiscontext,notethattheLCRhastwologicallydistinctaspectsasaregulatorytool: Itisamitigator,inthesensethatholdingliquidassetsleadstoabetteroutcomeifthereisabadshock;itisalsoanimplicittaxonliquidityprovisionbybanks,totheextentthatholdingliquidassetsiscostly. Ofcourse,onecansaysomethingbroadlysimilaraboutcapitalrequirements. ButtheimplicittaxassociatedwiththeLCRissubtlerandlesswell understood,soIwillgointosomedetailhere. Ananalogymayhelptoexplain. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  17. P age |17 Supposewehaveapowerplantthatproducesenergyand,asabyproduct,somepollution. Supposefurtherthatregulatorswanttoreducethepollutionandhavetwotoolsattheirdisposal: Theycanmandatetheuseofapollution-mitigatingtechnology,likescrubbers,ortheycanlevyataxontheamountofpollutiongeneratedbytheplant. Inanidealworld,regulationwouldaccomplishtwoobjectives. First,itwouldleadtoanoptimallevelofmitigation–thatis,itwouldinducetheplanttoinstallscrubbersuptothepointwherethecostofanadditionalscrubberisequaltothemarginalsocialbenefit,intermsof reducedpollution. And,second,itwouldalsopromoteconservation: Giventhatthescrubbersdon’tgetridofpollutionentirely,onealsowantstoreduceoverallenergyconsumptionbymakingitmoreexpensive. Asimplecaseisoneinwhichthecostsofinstallingscrubbers,aswellasthesocialbenefitsofreducedpollution,areknowninadvancebytheregulatorandthemanagerofthepowerplant. Inthiscase,theregulatorcanfigureoutwhattherightnumberofscrubbersisandrequirethattheplantinstallthesescrubbers. Themandatecanthereforepreciselytargettheoptimalamountofmitigationperunitofenergyproduced. And,totheextentthatthescrubbersarecostly,themandatewillalsoleadtohigherenergyprices,whichwillencouragesomeconservation,though perhapsnotthesociallyoptimallevel. Thislattereffectistheimplicittaxaspectofthemandate. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  18. P age |18 Amorecomplicatedcaseiswhentheregulatordoesnotknowaheadoftimewhatthecostsofbuildingandinstallingscrubberswillbe. Here,mandatingtheuseofafixednumberofscrubbersispotentiallyproblematic: Ifthescrubbersturnouttobeveryexpensive,theregulationwillendup beingmoreaggressivethansociallydesirable,leadingtooverinvestment inscrubbersandlargecostincreasesforconsumers;however,ifthe scrubbersturnouttobecheaperthanexpected,theregulationwillhavebeentoosoft. Inotherwords,whenthecostofthemitigationtechnologyissignificantlyuncertain,aregulatoryapproachthatfixesthequantityofmitigationisequivalenttoonewheretheimplicittaxratebouncesaroundalot. Bycontrast,aregulatoryapproachthatfixesthepriceofpollutioninsteadofthequantity–say,byimposingapredeterminedproportionaltaxratedirectlyontheamountofpollutionemittedbytheplant–ismoreforgivinginthefaceofthiskindofuncertainty. Thisapproachleavesthescrubber-installationdecisiontothemanageroftheplant,whocanfigureoutwhatthescrubberscostbeforedecidinghowtoproceed. Forexample,ifthescrubbersturnouttobeunexpectedlyexpensive,theplantmanagercaninstallfewerofthem. Thisflexibilitytranslatesintolessvariabilityintheeffectiveregulatoryburdenandhencelessvariabilityinthepriceofenergytoconsumers. Scrubbersandhigh-qualityliquidassets WhatdoesallthisimplyforthedesignoftheLCR?Let’sworkthroughtheanalogyindetail. Theanalogtothepowerplant’senergyoutputisthegrossamountofliquidityservicescreatedbyabank–viaitsdeposits,thecreditlinesit InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  19. P age |19 providestoitscustomers,theprimebrokerageservicesitoffers,andsoforth. Theanalogtothemitigationtechnology–thescrubbers–isthestockofHQLAthatthebankholds. Andtheanalogtopollutionisthenetliquidityriskassociatedwiththedifferencebetweenthesetwoquantities,somethingakintotheLCRshortfall. Thatis,whenthebankoffersalotofliquidityondemandtoitscustomersbutfailstoholdanadequatebufferofHQLA,thisiswhenitimposesspillovercostsontherestofthefinancialsystem. Inthecaseofthepowerplant,Iarguedthataregulationthatcallsforafixedquantityofmitigation–thatis,forafixednumberofscrubbers–ismoreattractivewhenthereislittleuncertaintyaboutthecostofthese scrubbers. InthecontextoftheLCR,thecostofmitigationisthepremiumthatthebankmustpay–intheformofreducedinterestincome–foritsstockofHQLA. And,crucially,thisHQLApremiumisdeterminedinmarketequilibriumanddependsonthetotalsupplyofsafeassetsinthesystem,relativetothedemandforthoseassets. Ontheonehand,ifsafeHQLA-eligibleassetsareinamplesupply,thepremiumislikelytobelowandstable. Ontheotherhand,ifHQLA-eligibleassetsarescarce,thepremiumwillbebothhigherandmorevolatileovertime. ThislattersituationistheonefacingcountrieslikeAustralia,where,asInotedearlier,thestockofoutstandinggovernmentsecuritiesisrelativelysmall. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  20. P age |20 Anditexplainswhy,forsuchcountries,havingaprice-basedmechanismaspartoftheirimplementationoftheLCRcanbemoreappealingthan purerelianceonaquantitymandate. Whenonesetsanup-frontfeeforaCLF,oneeffectivelycapstheimplicit taxassociatedwithliquidityregulationatthelevelofthecommitmentfeeandtampsdowntheundesirablevolatilitythatwouldotherwisearisefromanentirelyquantity-basedregime. Moreover,itbearsreemphasizingthathavingaCLFwithanup-frontfeeisverydifferentfromsimplyallowingbankstocountcentral-bank-eligiblecollateralasHQLAatnocharge. Rather,theCLFislikethepollutiontax. Foreverydollarofpre-CLFshortfall–thatis,foreverydollarofrequiredliquiditythatabankcan’tobtainontheprivatemarket–thebankhastopaythecommitmentfee. Soevenifthereisnotasmuchmitigation,thereisstillanincentivefor conservation,inthesensethatbanksareencouragedtodolessliquidityprovision,allelsebeingequal. ThiswouldnotbethecaseiftheCLFwereavailableatazeroprice.Whataboutthesituationincountrieswheresafeassetsaremore plentiful? TheanalysisherehasanumberofmovingpartsbecauseinadditiontotheimplementationoftheLCR,substantialincreasesindemandforsafeassetswillarisefromnewmarginrequirementsforbothclearedand nonclearedderivatives. Nevertheless,giventhelargeandgrowingglobalsupplyofsovereigndebtsecurities,aswellasotherHQLA-eligibleassets,mostestimatessuggest thatthescarcityproblemshouldbemanageable,atleastfortheforeseeablefuture. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  21. P age |21 Inparticular,quantitativeimpactstudiesreleasedbytheBaselCommitteeestimatethattheworldwideincrementaldemandforHQLAcomingfromboththeimplementationoftheLCRandswapmarginrequirementsmightbeontheorderof$3trillion. Thisisalargenumber,butitcompareswithaglobalsupplyofHQLA-eligibleassetsofmorethan$40trillion. Moreover,theeligiblecollateralforswapmarginisproposedtobebroaderthantheLCR’sdefinitionofHQLA–including,forexample, certainequitiesandcorporatebondswithoutanycap. IfonefocusesjustonU.S.institutions,theincrementaldemandnumberisontheorderof$1trillion,whilethesumofTreasury,agency,andagencymortgage-backedsecuritiesismorethan$19trillion. Whilethissortofanalysisissuperficiallyreassuring,thefactremainsthat theHQLApremiumwilldependonmarket-equilibriumconsiderationsthatarehardtofullyfathominadvance,andthatarelikelytovaryovertime. Thisuncertaintyneedstobeunderstood,andrespected. Indeed,themarket-equilibriumaspectoftheproblemrepresentsacrucialdistinctionbetweencapitalregulationandliquidityregulation,anditisonereasonwhythelatterisparticularlychallengingtoimplement. Althoughcapitalregulationalsoimposesataxonbanks–totheextent thatequityisamoreexpensiveformoffinancethandebt–thistaxwedgeis,toafirstapproximation,afixedconstantforagivenbank,independentofthescaleofoverallfinancialintermediationactivity. IfBankAdecidestoissuemoreequitysoitcanexpanditslendingbusiness,thisneednotmakeitmoreexpensiveforBankBtosatisfyitscapitalrequirement. Inotherwords,thereisnoscarcityproblemwithrespecttobankequity–bothAandBcanalwaysmakemore. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  22. P age |22 Bycontrast,thetotalsupplyofHQLAisclosertobeingfixedatanypoint intime. Policyimplications Whatdoesallofthisimplyforpolicydesign? First,atabroadphilosophicallevel,therecognitionthatliquidityregulationinvolvesmoreuncertaintyaboutcoststhancapitalregulationsuggeststhatevenapolicymakerwithaverystrictattitudetowardcapitalmightfinditsensibletobesomewhatmoremoderateandflexiblewithrespecttoliquidity. Thispointisreinforcedbytheobservationthatwhenaninstitutionisshortofcapitalandcan’tgetmoreontheprivatemarket,thereisreallynobackupplan,shortofresolution. Bycontrast,asImentionedearlier,whenaninstitutionisshortofliquidity,policymakersdohaveabackupplanintheformoftheLOLRfacility. Onedoesnotwanttorelytoomuchonthatbackupplan,butitspresenceshouldneverthelessfactorintothedesignofliquidityregulation. Second,inthespiritofflexibility,whileaprice-basedmechanismsuchastheCLFmaynotbeimmediatelynecessaryincountriesoutsideofAustraliaandafewothers,itisworthkeepinganopenmindaboutthemorewidespreaduseofCLF-likemechanisms. IfascarcityofHQLA-eligibleassetsturnsouttobemoreofaproblemthanweexpect,somethingalongthoselineshasthepotentialtobeausefulsafetyvalve,asitputsacaponthecostofliquidityregulation. Suchasafetyvalvewouldhaveadirecteconomicbenefit,inthesenseofpreventingtheburdenofregulationfromgettingundulyheavyinanyonecountry. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  23. P age |23 Perhapsjustasimportant,asafetyvalvemightalsohelptoprotecttheintegrityoftheregulationitself,byharmonizingcostsacrosscountriesandtherebyreducingthetemptationofthosemosthard-hitbytherulestotrytochipawayatthem. Withoutsuchasafetyvalve,itispossiblethatsomecountries–thosewithrelativelysmallsuppliesofdomesticHQLA–willfindtheregulationconsiderablymorecostlythanothers. Ifso,itwouldbenaturalforthemtolobbytodilutetherules–for example,byarguingforanexpansioninthetypeofassetsthatcancountasHQLA. Takentoofar,thissortofdilutionwouldunderminetheefficacyoftheregulationasbothamitigatorandatax. Inthisscenario,holdingthelinewithwhatamountstoaproportionaltaxonliquidityprovisionwouldbeabetteroutcome. Onesituationwhereliquidassetscanbecomeunusuallyscarceisduringafinancialcrisis. Consequently,evenifCLFswerenotcountedtowardtheLCRinnormaltimes,itmightbeappropriatetocountthemduringacrisis. Indeed,whiletheLCRrequiresbankstoholdsufficientliquidassetsingoodtimestomeettheiroutflowsinagivenstressscenario,itimplicitlyrecognizesthatifthingsturnoutevenworsethanthatscenario,centralbankliquiditysupportwillbeneeded. AllowingCLFstocounttowardtheLCRinsuchcircumstanceswouldacknowledgetheimportanceofaccesstothecentralbank,andthisaccesscouldbepricedaccordingly. Finally,aprice-basedmechanismmightalsohelppromoteawillingnessofbankstodrawdowntheirsupplyofHQLAinastressscenario. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  24. P age |24 AsInotedattheoutset,oneimportantconcernaboutapurequantity-basedsystemofregulationisthatifabankisheldtoanLCRstandardof100percentinnormaltimes,itmaybereluctanttoallowitsratiotofallbelow100percentwhenfacinglargeoutflowsforfearthatdoingsomightbeseenbymarketparticipantsasasignofweakness. Bycontrast,inasystemwithsomethinglikeaCLF,abankmightin normaltimesmeet95percentofitsrequirementbyholding private-marketHQLAandtheremaining5percentwithcommittedcreditlinesfromthecentralbank,soitwouldhaveanLCRofexactly100 percent. Then,whenhitwithlargeoutflows,itcouldmaintainitsLCRat100percent,butdosobyincreasingitsuseofcentralbankcreditlinesto25percentandselling20percentofitsotherliquidassets. Thisscenariowouldbethesortofliquid-assetdrawdownthatonewouldideallyliketoseeinastresssituation. Moreover,thecentralbankcouldencouragethisdrawdownbyvaryingthepricingofitscreditlines–specifically,byreducingthepriceofthelinesinthemidstofaliquiditycrisis. Suchanapproachwouldamounttotaxingliquidityprovisionmoreingoodtimesthaninbad,whichhasastabilizingmacroprudentialeffect. ThisexamplealsosuggestsadesignthatmayhaveappealinjurisdictionswherethereisarelativelyabundantsupplyofHQLA-eligibleassets. OnecanimaginecalibratingthepricingoftheCLFsoastoensurethatlinesprovidedbycentralbanksmakeuponlyaminimalfractionofbanks’requiredHQLAinnormaltimes–apart,perhaps,fromtheoccasional adjustmentperiodafteranindividualbankishitwithanidiosyncraticliquidityshortfall. Atthesametime,inastressscenario,whenliquidityisscarceandthereisupwardpressureontheHQLApremium,thepricingoftheCLFcouldbe InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  25. P age |25 adjustedsoastorelievethispressureandpromoteusabilityoftheHQLAbuffer. SuchanapproachwouldrespectthepolicyobjectiveofreducingexpectedrelianceontheLOLRwhileatthesametimeallowingforasafetyvalveinaperiodofstress. ThelimitcaseofthisapproachisonewheretheCLFcountstowardtheLCRonlyinacrisis. Conclusion Bywayofconclusion,letmejustrestatethatliquidityregulationhasakey roletoplayinimprovingfinancialstability. However,weshouldavoidthinkingaboutitinisolation;rather,wecanbestunderstanditaspartofalargertoolkitthatalsoincludescapitalregulationand,importantly,thecentralbank’sLOLRfunction. Therefore,properdesignandimplementationofliquidityregulationssuchastheLCRshouldtakeaccountoftheseinterdependencies. Inparticular,policymakersshouldaimtostrikeabalancebetweenreducingrelianceontheLOLRontheonehandandmoderatingthecostscreatedbyliquidityshortagesontheotherhand–especiallythoseshortagesthatcropupintimesofseveremarketstrain. And,asalways,weshouldbepreparedtolearnfromexperienceaswego. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  26. P age |26 BaselIIICapital:AWell-IntendedIllusionThomasM.Hoenig ViceChairman,FederalDepositInsuranceCorporation InternationalAssociationofDepositInsurers2013ResearchConference,Basel,Switzerland Introduction Aristotleiscreditedwithbeingthefirstphilosophertosystematicallystudylogical fallacies,whichhedefinedasargumentsthatappearvalidbut,infact,are not. Icallthemwell-intendedillusions. OnesuchillusionofprecisionistheBaselcapitalstandardsinwhichworldsupervisoryauthoritiesrelyprincipallyonaTier1capitalratiotojudgetheadequacyofbankcapitalandbalancesheetstrength. Forthelargestofthesefirms,eachdollarofrisk-weightedassetsisfundedwith12to15centsinequitycapital,projectingtheillusionthatthesefirmsarewellcapitalized. Therealityisthateachdollaroftheirtotalassetsisfundedwithfarlessequitycapital,leavingopenthematterofhowwellcapitalizedtheymightbe. Here’showtheillusioniscreated. Basel'sTier1capitalmeasureisabank'sratioofTier1capitalto risk-weightedassets. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  27. P age |27 Eachcategoryofbankassetsisweighedbythesupervisoryauthorityonacomplicatedscaleofprobabilitiesandmodelsthatassignarelativeriskoflosstoeachgroup,includingoffbalancesheetitems. Assetsdeemedlowriskarereportedatloweramountsonthebalancesheet. Thelowertherisk,thelowertheamountreportedonthebalancesheetfor capitalpurposesandthehigherthecalculatedTier1ratio. WeknowfromyearsofexperienceusingtheBaselcapitalstandardsthatoncetheregulatoryauthoritiesfinishtheirweightingscheme,bank managersbegintheprocessofallocatingcapitalandassetstomaximizefinancialreturnsaroundtheseconstructedweights. Theobjectiveistomaximizeafirm'sreturnonequity(ROE)bymanagingthebalancesheetinsuchamannerthatforanylevelofequity,therisk-weightedassetsarereportedatlevelsfarlessthanactualtotalassetsundermanagement. Thiscreatestheillusionthatbankingorganizationshaveadequatecapitaltoabsorbunexpectedlosses. Forthelargestglobalfinancialcompanies,risk-weightedassetsareapproximatelyone-halfoftotalassets. This"leveragingup"hasservedworldeconomiespoorly. Incontrast,supervisorsandfinancialfirmscanchoosetorelyonthetangibleleverageratiotojudgetheoveralladequacyofcapitalfortheenterprise. Thisratiocomparesequitycapitaltototalassets,deductinggoodwill,otherintangibles,anddeferredtaxassetsfrombothequityandtotalassets. Inadditiontoincludingonlyloss-absorbingcapital,italsomakesnoattempttopredictorassignrelativeriskweightsamongassetclasses. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  28. P age |28 Usingthisleverageratioasourguide,wefindforthelargestbankingorganizationsthateachdollarofassetshasonly4to6centsfundedwithtangibleequitycapital,afarsmallerbufferthanassertedundertheBasel standards. ComparingMeasures Table1reportstheBaselTier1risk-weightedcapitalratioandthe leverageratiofordifferentclassesofbankingfirms. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  29. P age |29 Column4showsTier1capitalratiosrangingbetween12and15percentforthelargestglobalfirms,givingtheimpressionthatthesebanksarehighlycapitalized. However,itishardtobecertainofthatbylookingatthisratiosince risk-weightedassetsaresomuchlessthantotalassets. Incontrast,Column6showsU.S.firms'averageleverageratiotobe6percentusinggenerallyacceptedaccountingstandards(GAAP),andColumn8showstheiraverageratiotobe3.9percentusinginternationalaccountingstandards(IFRS),whichplacesmoreofthesefirms'derivativesontothebalancesheetthandoesGAAP. ThebottomportionofTable1showsthedegreeofleverageamongdifferentsizegroupsofbankingfirms,whichisstrikingaswell. TheTier1capitalmeasuresuggeststhatallsizegroupsofbanksholdcomparablecapitallevels,whiletheleverageratioreportsadifferentoutcome. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  30. P age |30 Forexample,theleverageratioformostbankinggroupsnotconsideredsystemicallyimportantaveragesnear8percentorhigher. UnderGAAPaccountingstandards,thedifferenceinthisratiobetweenthelargestbankingorganizationsandthesmallerfirmsis175-250basispoints. UnderIFRSstandards,thedifferenceisasmuchas400-475basispoints. Thelargestfirms,whichmostaffecttheeconomy,holdtheleastamountofcapitalintheindustry. Whilethisshowsthemtobemorefragile,italsoidentifiesjusthowsignificantacompetitiveadvantagetheselowercapitallevelsprovidethelargestfirms. ThesecomparisonsillustratehoweasilytheBaselcapitalstandardcanconfuseandmisinformthepublicratherthanmeaningfullyreportabankingcompany’srelativefinancialstrength. Recenthistoryshowsalsojusthowdamagingthiscanbetotheindustryandtheeconomy. In2007,forexample,the10largestandmostcomplexU.S.bankingfirmsreportedTier1capitalratiosthat,onaverage,exceeded7percentof risk-weightedassets. Regulatorsdeemedtheselargesttobewellcapitalized. Thisrisk-weightedcapitalmeasure,however,mappedintoanaverageleverageratioofjust2.8percent. Welearnedalltoolatethathavinglessthan3centsoftangiblecapitalforeverydollarofassetsonthebalancesheetisnotenoughtoabsorbeventhesmallestoffinanciallosses,andcertainlynotamajorshock. Withthecrisis,theillusionofadequatecapitalwasdiscovered,afterhavingmisledshareholders,regulators,andtaxpayers. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  31. P age |31 Thereareother,morerecent,examplesofhowthisarcanemeasurecan bemanipulatedtogivetheillusionofstrengthevenwhenafirmincurslosses. Forexample,inthefourthquarterof2012,DeutscheBankreportedalossof2.5billionEUR. Thatsamequarter,itsTier1risk-basedcapitalratioincreasedfrom14.2percentto15.1percentdue,inpart,to“modelandprocessenhancements”thatresultedinadeclineinrisk-weightedassets,which nowamounttojust16.6percentoftotalassets. OnFeb.1,SNSReaal,thefourthlargestDutchbankwith$5billioninassets,wasnationalizedbytheDutchgovernment. Justsevenmonthsearlier,onJune30,2012,SNSreportedaTier1risk-basedcapitalratioof12.2percent. However,thefirmreportedaTier1leverageratiobaseduponinternationalaccountingstandardsofonly1.47percent. ThisleverageratiowasmuchmoreindicativeoftheSNS’spoorfinancialposition. TheBaselIIIproposalbelatedlyintroducestheconceptofaleverageratiobutcallsforittobeonly3percent,anamountalreadyshowntobeinsufficienttoabsorbsizablefinanciallossesinacrisis. Itiswrongtosuggesttothepublicthat,withsolittlecapital,theselargestfirmscouldsurvivewithoutpublicsupportshouldtheyencounteranysignificanteconomicreversals. MisallocatingResourcesandCreatingAssetImbalances Aninherentproblemwitharisk-weightedcapitalstandardisthattheweightsreflectpastevents,arestatic,andmostlyignorethemarket'scollectivedailyjudgmentabouttherelativeriskofassets. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  32. P age |32 Italsointroducestheelementofpoliticalandspecialinterestsintotheprocess,whichaffectstheassignmentofriskweightstothedifferentassetclasses. Theresultisoftentoartificiallyfavoronegroupofassetsoveranother,therebyredirectinginvestmentsandencouragingover-investmentinthefavoredassets. Theeffectofthismanagedprocessistoincreaseleverage,raisethe overallriskprofileoftheseinstitutions,andincreasethevulnerabilityofindividualcompanies,theindustry,andtheeconomy. Itisnocoincidence,forexample,thatafteraBaselstandardassignedonlya7percentriskweightontripleA,collateralizeddebtobligationsandsimilarlowriskweightsonassetswithinafirm'stradingbook,resourcesshiftedtotheseactivities. Overtime,financialgroupsdramaticallyleveragedtheseassetsontotheirbalancesheetsevenastheriskstothatassetclassincreasedexponentially. Similarly,assigningzeroweightstosovereigndebtencouragedbankingfirmstoinvestmoreheavilyintheseassets,simultaneouslydiscountingtherealrisktheypresentedandplayinganimportantroleinincreasingit. Inplacingalowerriskweightonselectassets,lesscapitalwasallocatedtofundthemandtoabsorbunexpectedlossforthesebanks,underminingtheirsolvency. AMoreRealisticCapitalStandardIsRequired Taxpayersaretheultimatebackstoptothesafetynetandhaverealmoneyatstake. Inchoosingwhichcapitalmeasureismostuseful,itisfairtoaskthefollowingquestions: InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  33. P age |33 • DoestheBaselTier1ratioorthetangibleleverageratiobestindicatethecapitalstrengthofthefirm? • Whichoneismostclearlyunderstood? • Whichonebestenablescomparisonofcapitalacrossinstitutions? • Whichoneoffersthemostconfidencethatitcannotbeeasilygamed?Charts1through4comparetherelationshipofthetangibleleverageand • BaselTier1capitalratiostovariousmarketmeasuresforthelargestfirms. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  34. P age |34 InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  35. P age |35 InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  36. P age |36 InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  37. P age |37 Thesemeasuresinclude:theprice-to-bookratio,estimateddefault frequency,creditdefaultswapspreads,andmarketvalueofequity. Ineachinstance,thecorrelationofthetangibleleverageratiotothesevariablesishigherthanfortherisk-weightedcapitalratio. Whilesuchfindingsarenotconclusive,theysuggeststronglythat investors,whendecidingwheretoplacetheirmoney,relyupontheinformationprovidedbytheleverageratio. Wewoulddowelltodothesame. Despitealloftheadvancementsmadeovertheyearsinriskmeasurementandmodeling,itisimpossibletopredictthefutureortoreliablyanticipatehowandtowhatdegreeriskswillchange. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  38. P age |38 Capitalstandardsshouldservetocushionagainsttheunexpected,nottodivineeventualities. AlloftheBaselcapitalaccords,includingtheproposedBaselIII,lookbackwardandthenattempttoassignriskweightsintothefuture. Itdoesn'twork. Incontrast,thetangibleleverageratioprovidesasimpler,moredirect insightintotheamountofloss-absorbingcapitalthatisavailabletoafirm. AleverageratioasI’vedefineditexplicitlyexcludesintangibleitemsthatcannotabsorblossesinacrisis. Also,usingIFRSaccountingrules,off-balancesheetderivativesarebroughtontothebalancesheet,providingfurtherinsightintoafirm'sleverage. Thus,thetangibleleverageratioissimplertocomputeandmoreeasilyunderstoodbybankmanagers,directors,andthepublic. Importantlyalso,itismorelikelytobeconsistentlyenforcedbybanksupervisors. Amoredifficultchallengemaybetodetermineanappropriateminimumleverageratio. Chart5providesahistoryofbankleverageoverthepast150yearsforthe U.S.bankingsystemandgivesinitialinsightintothisquestion. ItshowsthattheequitycapitaltoassetsratiofortheindustrypriortothefoundingoftheFederalReserveSystemin1913andtheFederalDepositInsuranceCorporationin1933rangedbetween13and16percent,regardlessofbanksize. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  39. P age |39 Withoutanyinternationallydictatedstandardoranyarcaneweightingprocess,marketsrequiredwhattodayseemslikerelativelyhighcapitallevels. Inaddition,thereisanincreasingbodyofresearch(AdmatiandHellwig;Haldane;Miles,Yang,andMarcheggiano)thatsuggeststhatleverageratiosshouldbemuchhigherthantheycurrentlyareandthatBaselIII’sproposed3percentfigureaddslittlesecuritytothesystem. Finally,andimportantly,someformofrisk-weightedcapitalmeasure couldbeusefulasabackstop,orcheck,againstwhichtojudgetheadequacyoftheleverageratioforindividualbanks. Ifabankmeetstheminimumleverageratiobuthasconcentratedassetsinareasthatriskmodelssuggestincreasetheoverallvulnerabilityofthebalancesheet,thebankcouldberequiredtoincreaseitstangiblecapitallevels. Suchasystemprovidesthemostcomprehensivemeasureofcapital adequacybothinabroadcontextofallassetsandaccordingtoabank's allocationofassetsalongadefinedriskprofile. TangibleLeverageRatioandtheMythofUnintendedConsequences Concernsareoftenraisedwithinthefinancialindustryandelsewherethatrequiringthelargestandmostcomplexfirmstoholdhigherlevelsof capitalasdefinedusingatangibleleverageratiowouldhaveseriousadverseeffectsontheindustryandbroadereconomy. Ithasbeensuggested,forexample,thatrequiringmorecapitalfortheselargestbankswouldraisetheirrelativecostofcapitalandmakethemlesscompetitive. Similarly,thereisconcernthatfailingtoassignriskweightstothedifferentcategoriesofassetswouldencouragefirmstoallocatefundstothehighestriskassetstoachievetargetedreturnstoequity. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  40. P age |40 TheseissueshavebeenwelladdressedbyAnatAdmatiandMartinHellwigintheirrecentlypublishedbook,TheBankers’NewClothes. TherequiredROEandtheabilitytoattractcapitalaredeterminedbyahostoffactorsbeyondthelevelofequitycapital. Theseincludeafirm’sbusinessmodel,itsrisk-adjustedreturns,thebenefitsofservicesandinvestments,andtheundistorted,or non-subsidized,costsofcapital. Alevelofcapitalthatlowersriskmayverywellattractinvestorsdrawntothemorereliablereturns. Table1showsmanyofthebankswithstrongerleverageratiosalsohavestockpricestradingatahigherpremiumtobookvaluethanthelargestfirmsthatarelesswell-capitalized. Therealsoisaconcernthatrequiringastronger,simplerleverageratiowouldcausemanagerstoplacemoreriskontheirbalancesheet. Whilepossible,theargumentisunconvincing. Withmorecapitalatriskandwithoutregulatoryweightingschemesaffectingchoice,managerswillallocatecapitalinlinewithmarketriskandreturns. Furthermore,risk-weightedmeasuresandstrongbanksupervisioncanbe availableasaback-upsystemtomonitorsuchactivity. Moreover,giventheexperienceoftherecentcrisisandtheon-going effortstomanagereportedriskassetsdown,nomattertherisk,itringshollowtosuggestthathavingahigherequitybufferforthesameamountoftotalassetsmakesthefinancialsystemlesssafe. Inaddition,thereisaconcernthatdemandingmoreequitycapitaland reducingleverageamongthelargestfirmswouldinhibitthegrowthof creditandtheeconomy. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  41. P age |41 ThisstatementhasanimpliedpresumptionthattheBaselweightingschemeismoregrowthfriendlythanasimpler,strongerleverageratio. However,havingasufficientcapitalbufferallowsbankstoabsorb unexpectedlosses. Thisservestomoderatethebusinesscycleandthedeclineinlendingthatotherwiseoccursduringcontractions. IftheBaselrisk-weightschemesareincorrect,whichtheyoftenhavebeen,thistoocouldinhibitloangrowth,asitencouragesinvestmentsinothermorefavorably,butincorrectly,weightedassets. Baselsystematicallyencouragesinvestmentsinsectorspre-assignedlowerweights--forexample,mortgages,sovereigndebt,andderivatives --anddiscouragesloanstoassetsassignedhigherweights--commercial andindustrialloans. Wemayhaveinadvertentlycreatedasystemthatdiscouragestheveryloangrowthweseek,andinsteadturnedourfinancialsystemintoonethatrewardsitselfmorethanitsupportseconomicactivity. Ifriskweightscouldbeassignedthatanticipateandcalibrateriskswith perfectforesight,adjustedonadailybasis,thenperhapsrisk-weightedcapitalstandardswouldbethepreferredmethodfordetermininghowtodeploycapital. However,theycannot. Tobelievetheycanisafallacythatputstheentireeconomicsystemat risk. ChangingtheDebate Thetangibleleverageratioisasuperioralternativetorisk-weightingschemesthathaveproventobeanillusionofprecisionandinsufficientindefiningadequatecapital. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  42. P age |42 Theeffectofrelyingonsuchmeasureshasbeentoweakenthefinancialsystemandmisallocateresources. Theleverageratiodeservesseriousconsiderationastheprincipaltoolinjudgingthecapitalstrengthoffinancialfirms. TheBaseldiscussionwouldbewellservedtofocusontheappropriatelevelsoftangiblecapitalforbankingfirmstoholdandtherighttransitionperiodtoachievetheselevels. Finally,weshouldnotacceptevencomfortingerrorsoflogicwhichsuggestthatBaselIIIrequirementswillcreatestrongercapitalthanthoseofBaselII,whichfailed. Instead,pastindustryperformanceandmountingacademicandotherevidencesuggestthatwewouldbebestservedtofocusonastrongleverageratiostandardinjudgingafirmandtheindustry'sfinancialstrength. Nobankcapitalprogramisperfect. Ourresponsibilityasregulatorsanddepositinsurersistochoosethebestavailablemeasurethatwillcontributetofinancialstability. Note: ThomasM.HoenigwasconfirmedbytheSenateasViceChairmanoftheFederalDepositInsuranceCorporationonNov.15,2012. HejoinedtheFDIConApril16,2012,asamemberoftheFDICBoardofDirectorsforasix-yearterm. HeisamemberoftheexecutiveboardoftheInternationalAssociationofDepositInsurers. PriortoservingontheFDICboard,Mr.HoenigwasthePresidentoftheFederalReserveBankofKansasCityandamemberoftheFederalReserveSystem'sFederalOpenMarketCommitteefrom1991to2011. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  43. P age |43 Mr.HoenigwaswiththeFederalReservefor38years,beginningasaneconomistandthenasaseniorofficerinbankingsupervisionduringthe U.S.bankingcrisisofthe1980s. In1986,heledtheKansasCityFederalReserveBank'sDivisionofBankSupervisionandStructure,directingtheoversightofmorethan1,000banksandbankholdingcompanieswithassetsrangingfromlessthan $100millionto$20billion. HebecamePresidentoftheKansasCityFederalReserveBankonOctober1,1991. Mr.HoenigisanativeofFortMadison,Iowa.HereceivedadoctorateineconomicsfromIowaStateUniversity. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  44. P age |44 PCAOBIssuesPolicyStatementonExtraordinaryCooperationinConnectionwithBoardInvestigationsWashington,DC ThePublicCompanyAccountingOversightBoardtodaypublishedaformalstatementconcerningthebenefitsthatmaybeavailabletoregisteredpublicaccountingfirmsandindividualswhoprovideextraordinarycooperationinPCAOBinvestigations. ThepolicystatementdescribeswhatthePCAOBmayconsidertobe extraordinarycooperationandhowcreditmightbereflectedforsuchcooperation. ThepolicyisgenerallyconsistentwiththeBoard'sexistingpractices. "Thispolicyprovidesbenefitstoinvestorsandreal,tangibleincentivestocooperatetofirmsandpersonsassociatedwithfirms,"saidJamesR.Doty,PCAOBChairman." ExtraordinarycooperationpermitstheBoardtomorequicklyandefficientlyaddresswrongdoingfortheprotectionofinvestors,andmayearnpartiescreditinconnectionwiththeBoard'sdisciplinaryprocesses." Accordingtothepolicystatement,extraordinarycooperationisvoluntaryandtimelyactionbeyondcompliancewithlegalorregulatoryobligations. Cooperationthatcouldresultincreditincludesself-reportingviolationsbeforetheconductcomestotheattentionoftheBoardoranotherregulator. Self-reportingismorevaluabletheearlieritisprovided. Theothertypesofextraordinarycooperationthatcouldresultincreditaretakingremedialorcorrectiveactiontoreducetheriskofsimilar InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  45. P age |45 violationsrecurring,andprovidingsubstantialassistanceinthePCAOB'sinvestigativeprocesses. Creditforcooperationmayresultinreducedchargesorsanctionsinadisciplinaryproceeding. Insomecases,extraordinarycooperationmayleadtolanguageinsettlementdocumentsnotingthecooperationanditseffect. Inexceptionalcases,extraordinarycooperationcouldleadtonodisciplinaryactionatall. "ExtraordinarycooperationcanhelpstreamlineandexpeditePCAOB investigations,whichallowstheBoardtoturnitsattentionandresourcestootherpotentialauditormisconduct,"saidClaudiusB.Modesti,DirectorofthePCAOBDivisionofEnforcementandInvestigations. "Thispolicystatementisanimportantstepinencouragingauditorstogoaboveandbeyondwhatisrequiredbylaw,"hesaid. MembersofthepublicwhowishtoreportpotentialviolationsoflaworPCAOBrulesmaycontacttheBoardthroughtheTipandReferralCenteronthePCAOBwebsite. Summary ThePublicCompanyAccountingOversightBoard("PCAOB"or"Board")isissuingthispolicystatementtoprovideguidancetoregisteredpublicaccountingfirms("firms")andpersonsassociatedwithfirms("associatedpersons")concerninghowextraordinarycooperationmaybeconsideredindeterminingtheoutcomeofaPCAOB investigation. ThispolicystatementdoesnotbindandisnotintendedtoinfluenceanyPCAOBhearingofficerortheBoardintheadjudicationoflitigatedmatters. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  46. P age |46 Further,pleasenotethattheBoardisnotadoptinganyruleormakinganycommitmentorpromiseaboutanyspecificcase,orconferringanyrightsonanypersonorentity. Further,theBoardisnotinanywaylimitingitsdiscretiontoevaluateeverycaseindividually,onitsownparticularfactsandcircumstances. Thetypesofcooperationthatcouldresultincreditare:voluntaryandtimelyself-reporting;voluntaryandtimelyremedialorcorrectiveaction;andvoluntaryandtimelysubstantialassistancetotheBoard’sinvestigativeprocessesortootherlawenforcementauthorities. Theseactions,aloneortakentogether,canbeviewedasextraordinary cooperationforpurposesofthispolicystatementand,dependingonthefactsandcircumstances,mayinfluencethePCAOB’senforcementdecisions. Bypublishingthispolicystatementoncooperation,theBoardseeks: toencouragefirmsandassociatedpersonstovoluntarilyandtimelyself-report,correctandremediateviolativebehavior,andprovidesubstantialassistancetotheBoard’sinvestigativeprocesses;and toincreasetransparencyintohowtheBoardmaycreditcooperation.Moreover,theBoardwill,inappropriatecasesandinitsdiscretion,note insettlementdocumentsorotherpublicstatementsthatithascredited theextraordinarycooperationofafirmorassociatedperson. DoingsowillenhancetheBoard’senforcementprogrambypublicizingthebenefitsofcooperationandinformingfirmsandassociatedpersonsofthetypesofcooperationthatmaymeritcredit. I.Introduction TheSarbanes-OxleyAct(the"Act")andBoardRulesrequirefirmsandassociatedpersonstocooperateinconnectionwithPCAOBinspectionsandinvestigations. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  47. P age |47 Section102(b)(3)oftheActrequireseveryfirmapplyingforPCAOBregistrationtosupply aconsenttocooperateinandcomplywithanyrequestfortestimonyortheproductionofdocumentsmadebythePCAOBinthefurtheranceofitsauthorityandresponsibilitiesundertheAct, anagreementtosecureandenforcesimilarconsentsfromeachassociatedpersonofthefirm,and astatementthatthefirmunderstandsandagrees,amongotherthings,thatitscooperationandcomplianceshallbeaconditiontothecontinuingeffectivenessofthefirm’sregistrationwiththeBoard. Evenifafirmfailstoprovidethoseitemswithitsapplication,itisnotrelievedoftheobligationstocooperateinandcomplywithBoardrequestsmadeinfurtheranceoftheBoard’sauthorityandresponsibilitiesundertheAct. Moreover,twoBoardRulesaddresscooperationbyregisteredfirmsandassociatedpersons. BoardRule4006,DutytoCooperatewithInspectors,appliestoinspections,andrequiresaregisteredfirmandanyassociatedpersonofthatfirmtocooperatewithanyBoardinspectionbyprovidinginformationrequestedinBoardinspectionsandprovidingaccesstothefirm’srecords. Rule4006alsorequiresthatinformationprovidedtotheBoardbetruthfulandnotmisleading. Sections105(c)(4)and(5)oftheActandBoardRule5300(a)governsanctionsfornoncooperationwithaninspection. Section105(b)(3)oftheActandBoardRule5110,NoncooperationwithanInvestigation,applytoinvestigations,andprovidethattheBoardmay sanctionafirmorassociatedpersonforfailingtocooperatewithaBoardinvestigation. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  48. P age |48 TheformsofcooperationcoveredbyRule5110areenumeratedinparagraphs(1)-(3),withparagraph(4)providingacatch-allprovisionforfailuretocooperategenerally.Section105(b)(3)oftheActandBoardRule 5300(b)governsanctionsforfailuretocooperatewithaninvestigation. Incertainsituations,afirmorassociatedpersonmightcooperatewithPCAOBinvestigationsbeyondcompliancewiththoseobligations. CooperationbeyondwhatisrequiredtocomplywithlegalandregulatoryobligationscancontributesignificantlytothesuccessoftheBoard’smissionofprotectinginvestorsandfurtheringthepublicinterestinthepreparationofinformative,accurateandindependentauditreports. SuchextraordinarycooperationmighthelptheBoard’sstafftodiscoverpotentialviolationsearlierandallowtheBoardtoconcludeinvestigationsinamoreefficientandtimelymanner,thusreducingtheriskthatsuchviolativeconductwillberepeatedandresultinmoresignificantharmtoinvestors,andassistingtheBoardinidentifyingauditreportsthatmaybeinaccurate. Forthatreason,extraordinarycooperationinconnectionwithBoardinvestigationsmaybeconsideredbytheBoard’sDivisionofEnforcementandInvestigations(the"Division")initsdisciplinaryrecommendationstotheBoard,andbytheBoardindeterminingwhethertoacceptsettlementoffers. II.Whatisextraordinarycooperation? Extraordinarycooperationisvoluntaryandtimelyaction–beyondcompliancewithlegalorregulatoryobligations–thatcontributestothemissionoftheBoard. Therearethreebroadtypesofcooperationthat(aloneortakentogether)mightmeritcooperationcredit:self-reporting;remedialorcorrectiveaction;andsubstantialassistancetotheBoard’sinvestigativeprocessesortootherlawenforcementauthorities. Self-Reportingrelatestoconductuponlearningofviolations. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  49. P age |49 Afirmorassociatedpersonmayearncreditforself-reportingbymakingvoluntary,timelyandfulldisclosureofthefactsrelatingtoviolationsbeforetheconductcomestotheattentionoftheBoardoranotherregulator. Ifself-reportingisrequiredbylegalorregulatoryobligations,itisnotvoluntaryandisnoteligibleforcooperationcredit. Thus,forexample,self-reportingisnotvoluntaryifmadeafterreceiptofaregulatoryinquiry(e.g.,anyrequest,demandorsubpoenaforthesameinformationordocumentsfromtheBoard,theU.S.SecuritiesandExchangeCommission,Congress,anyotherfederal,state,localorforeignauthority,oranyself-regulatoryorganization). Likewise,self-reportingisnotvoluntaryifrequiredbySection10A(b)oftheSecuritiesExchangeActof1934[15U.S.C.§78j-1(b)],Auditrequirements-Requiredresponsetoauditdiscoveries(whichaddressesanauditor’sobligationtoreporttheillegalactsoftheauditclient)andRule10A-1thereunder. Asaresult,iftheauditordiscoversordetectsanillegalactduringeitheraquarterlyrevieworannualaudit,andisrequiredtoreportitpursuanttoSection10A,theauditorwouldnotbeeligibletoearncreditfor self-reporting. Self-reportingismorevaluabletheearlieritisprovided. Whenfirmsorassociatedpersonsself-reporttothePCAOB,theBoardencouragesthemtoself-reportbydirectlycontactingtheDivisionofEnforcementandInvestigations,orbyprovidinginformationanddocumentsviatheBoard’stipshotline:http://pcaobus.org/Enforcement/Tips/Pages/default.aspx RemedialorCorrectiveActionsarevoluntary,timelyandmeaningfulactionsdesignedtoreducethelikelihoodandriskthatsimilarviolationswillrecur,aswellasactionstocorrectviolativeconduct. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  50. P age |50 Forexample,afirmmightearncreditbypromptlyandvoluntarilymodifyingandimprovingitsqualitycontrolsorotherinternalpoliciesandprocedurestopreventrecurrenceoftheviolativeconduct. Afirmmighttakeremedialorcorrectiveactionbyre-assigningorlimitingtheactivitiesofthoseindividualsresponsibleforviolations(whichmightincludemembersoftheauditteam,aswellaspersonsoutsidetheauditteam,includingpersonsinfirmmanagement),andinappropriatecasesbyterminatingorimposingdisciplineupontheresponsibleindividuals. Afirm’sremedialorcorrectiveactionmightalsoincludepromptlynotifyingitsauditclientoritsauditcommittee(asappropriate)oftheviolativeconductandcooperatingwiththeclient,sothattheclientcan(ifnecessary)takestepstocomplywiththefederalsecuritieslawsandregulations(e.g.,byengaginganauditortore-auditthefinancialstatementsaffectedbyanauditor’sindependenceviolations). Afirm’sremedialorcorrectiveactionalsomightincludeappropriatelycompensatingthoseadverselyaffectedbythefirm’sviolations. SubstantialAssistancetotheBoard’sinvestigativeprocessesortootherlawenforcementauthoritiesincludestimelyandvoluntarilyprovidinginformationordocumentsthatmightnothavebeendiscoveredabsent thatcooperation,orbeyondthatsoughtbytheBoard’sstaffviaaccountingboarddemandsandrequests,andbeyondwhatisrequiredpursuanttolegalandregulatoryreportingrequirements. Forexample,afirmmightsubstantiallyassisttheBoardbyconductingatimely,thorough,objectiveandcompetentinternalinvestigationintotheviolativeconductwhenitwasdiscovered,andinformingtheDivision’sstaffofthepertinentfactsdiscoveredintheinternalinvestigation. Afirmorassociatedpersonmightsubstantiallyassistanotherlawenforcementauthority’sinvestigativeprocessesbyself-reportingtothatauthority,orprovidingitwiththefactsdiscoveredinaninternalinvestigation. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

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