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P a g e | 1 Inter n a tio n a l A s s oci a t ion of R isk a nd Compl i a n c e Pro f e s s io n a ls ( I A RCP) 1200 G St re e t NW Su i te 800 W a s h i ng t o n, D C 200 0 5 - 67 0 5 U SA T e l : 202 - 449 - 9750 w w w .ri s k - co m pl i a nce - a s s o c i a tion . co m.

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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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