Journal of Regulation & Risk, North Asia_ Feb 2015

Articles, Papers & Speeches

US Federal Reserve’s financial services stability agenda Lael Brainard

CCP risk management, recovery and resolution arrangements David Bailey

Looking ahead as the Renminbi internationalises Alexa Lam

If Europe wants growth, reform its financial services system Nicolas Véron

Is the concept of “moral hazard” a myth or reality? Philip Pilkington and Macdara Dwyer

Why “bail-in” securities should be considered fool’s gold Avinash D. Persaud

After AQR & stress tests, where next for EU-banking? Thorsten Beck

City of London determined to plumb new depths William K. Black

Compliance with risk targets: efficacy of the Volcker Rule Josef Korte and Jussi Keppo

Higher capital requirements: the jury is out Stephen Cecchetti

Will Basel III operate to plan as its proponents desire? Xavier Vives

Helicopter money can reverse the present economic cycle Biagio Bossone

US regulatory feeding frenzy on HFT is wholly misguided Steve Wunsch

Derivatives markets in China to be built upon G20 reforms Sol Steinberg

China’s securities industry to undergo metamorphosis Andy Chen

Accounting hurdles for CVA in the region Yin Toa Lee

CVA “pricing”issues across Asia Pacific Ben Watson

Volume VI, Issue 4 – Winter 2015

JOURNAL OF REGULATION & RISK NORTH ASIA

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Journal of Regulation & Risk North Asia 1

Editor EmeritusProf. Stephen (Steve) Keen

Editor-in-ChiefChristopher D. Rogers

EditorRachel Banner

Sub EditorMacdara Dwyer

Editorial ContributorsAmit Agrawal, David Bailey, Thorsten Beck, William K. Black, Biagio Bossone, Lael Brainard, Stephen Cecchetti, Rowan Bosworth-Davies, Andy Chen, Jose-

phine Chung, Macdara Dwyer, Stuart Holland, Sara Hsu, Steve Keen, Jussi Kep-po, Josef Korte, Alexa Lam, Yin Toa Lee, Paul McPhater, Bart Naylor, Avinash P. Persaud, Philip Pilkington, Alex J. Pollock, Stephen S. Roach, Sol Steinberg, Joseph Stiglitz, Mayra Rodríguez Valladares, Yanis Varoufakis, Nicolas Véron,

Xavier Vives, Ben Watson, Steve Wunsch, Erinç Yelden Design & Layout

Lamma Studio Design Printing

DG3Distribution

Deltec International Express LtdISSN No: 2071-5455

Journal of Regulation and Risk – North Asia23/F, Suite 2302, New World Tower One, 16-18 Queen’s Road,

Central, Hong Kong SAR, ChinaTel (852) 8121 0112

Email: [email protected]: www.irrna.org

JRRNA is published quarterly and registered in Hong Kong as a Journal. It is distributed free to governance, risk and compliance professionals in China,

Hong Kong, Japan, South Korea, Philippines, Singapore and Taiwan.

© Copyright 2015 Journal of Regulation & Risk - North AsiaMaterial in this publication may not be reproduced in any form or in any way

without the express permission of the Editor or Publisher.

Disclaimer: While every effort is taken to ensure the accuracy of the information herein, the editor cannot accept responsibility for any errors, omissions or those opinions expressed by contributors.


Volume VI, Issue 4 – Winter 2015

ContentsForeword – Prof. Stephen (Steve) Keen 7Acknowledgements – 9Q&A – Yanis Varoufakis 11Opinion – Stephen Roach 15Opinion – Alex J. Pollock 19Opinion – Rowan Bosworth-Davies 23Opinion – Stuart Holland 29Book review – Bart Naylor 31Book précis – Steve Wunsch 33Letter from an economist – Steve Keen 37Comment – Sara Hsu 41Comment – Mayra Rodríguez Valladares 43Comment – Erinç Yelden 45Comment – Joseph Stiglitz 47Advisory – Amit Agrawal 49Advisory – Paul McPhater 53Regulatory update – Josephine Chung 57

Articles, Papers & SpeechesUS Federal Reserve’s financial services stability agenda 65Lael BrainardCCP risk management, recovery and resolution arrangements 73David BaileyLooking ahead as the Renminbi internationalises 79Alexa LamIf Europe wants growth, reform its financial services system 87Nicolas VéronIs the concept of “moral hazard” a myth or reality? 95Philip Pilkington and Macdara Dwyer


regulationasia.comTo join the conversation, learn more and stay ahead visit


Why “bail-in” securities should be considered fool’s gold 101Avinash D. PersaudAfter AQR & stress tests, where next for EU-banking? 111Thorsten BeckCity of London determined to plumb new depths 115William K. BlackCompliance with risk targets: efficacy of the Volcker Rule 121Josef Korte and Jussi KeppoHigher capital requirements: the jury is out 125Stephen CecchettiWill Basel III operate to plan as its proponents desire? 129Xavier VivesHelicopter money can reverse the present economic cycle 133Biagio BossoneUS regulatory feeding frenzy on HFT is wholly misguided 137Steve WunschDerivatives markets in China to be built upon G20 reforms 143Sol SteinbergChina’s securities industry to undergo metamorphosis 147Andy ChenAccounting hurdles for CVA in the region 151Yin Toa LeeCVA “pricing” issues across Asia Pacific 157Ben Watson

Articles (continued)

11597 LN Full Pg Ad A4.indd 1 8/21/14 10:39 AM


ForewordTHOUGH numerous opinions on how to deal with the European economic crisis have been expressed in social media, only the consensus view in favour of austerity has been aired within the European Union’s formal bodies.

That will now change after the Greek elections that brought Syriza (and its coalition partner Independent Greeks) to power. Austerity will be opposed, not merely on political grounds, but on the basis of its appropriateness as an economic policy as well.

Given the history of Greece’s entry into the Eurozone, there is a danger that this debate will be sidelined by historical issues, by arguments over the morality of Greece seeking debt forgiveness given this history, and by assertions that Greece’s problems reflect its administra-tion and corruption, rather than austerity.

This would be a mistake. The election of Syriza should instead be an opportunity to turn the debate towards the two key economic issues: what caused the economic crisis of 2008; and what is the best way to end the economic depressions afflicting both Greece and Spain, and the stagnation affecting the rest of the Eurozone?

This is also the time to abandon rigid adherence to previously agreed policies, simply because they were agreed to in the past. We now have half a decade of experience with which to assess the effectiveness of those policies, and with the election of Syriza we now have a test of how politically sustainable those policies are as well. Neither augur well for business as usual. The depth and duration of the downturn caused by austerity were far greater than predicted. The election of an anti-austerity party in Greece – and the likelihood that this will be followed by other victories in other countries this year – shows that sustained economic austerity is not politically sustainable.

Since austerity has proven neither effective nor sustainable, then Europe has to work out policies that are. To do so, empirical knowledge, sound logic, and the dispassionate consid-eration of alternative ideas must rule the debate. This journal is a contribution to that end.

Prof. Stephen (Steve) KeenEditor Emeritus

Day 1OIS Discounting• Introduction to OIS• OIS Curve Construction• OIS and CSA Pricing• Decomposing OIS and CSA Risk• Managing OIS/CSA Risk• OIS Migration Steps

Day 2Counterparty Credit Risk & CVA• Introduction to Counterparty Credit• Quantifying Counterparty Exposures• Probability of Default• Credit Value Adjustment (CVA)• Wrong-Way Risk (WWR)• Managing CVA Risk

Who Should Attend?Anyone that needs to know how the introduction of OIS and CVA will impact them and their organisation. � is includes Traders, Trading Management, Sales, Operations, Middle O� ce, Finance, Risk Management, Technologists, Technology Management, Business Management, Credit and Collateral Management, Quantitative Analysts, Consultants and Brokers.

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Both OIS Discounting and the Credit Value Adjustment create complexity for banks for di� erent reasons. OIS discounting is an organisational challenge whereas CVA is a technical challenge. � is 2 day workshops will provide you with the tools to be able to understand the challenges and opportunities OIS and CVA present.

� is workshop is led by Ben Watson. Ben has worked for more than 20 years as a quantitative analyst in investment banking. Until 2012 he was the APAC head of Quantitative Analytics a global Investment Bank. Today Ben is the CEO of Maroon Analytics Australia, a consultancy that specialises in providing quantitative solutions to banks, � nancial institutions and corporates. From 2011 to 2013, Ben was heavily involved with a successful OIS migration at a Global Investment Bank.

OIS Discounting and Counterparty Credit Risk Workshop

Hong Kong27th & 28th of May 2015


AcknowledgementsTHE editorial management team of the Journal of Regulation and Risk – North Asia could not have published this edition of the Journal without a great deal of as-sistance and advice from professional associations, international monetary and financial bodies, regulatory institutions, consultants, vendors and, indeed, from the industry itself.

A full list of those who kindly assisted with the publication of this issue of theJournal is not possible, but the Editor-in-Chief and Editor would like to extend a special thank you to Prof. Stephen (Steve) Keen, Head of Economics, History and Politics, Kingston University London, for his generous assistance in generating copy for this edition of the Journal; specifically, arranging the Q&A with Prof. Yanis Varoufakis and opinion piece from Stuart Holland. Further thanks must also be extended to the following organisations and institutions for their generous assistance, support and permission in allowing the Journal to reproduce articles and papers from their respective publications and online websites: the Board of Governors of the US Fed-eral Reserve System; the Bank of England; the Hong Kong Securities and Futures Com-mission; New Economic Perspectives; Dealbook, The New York Times; Triple Crisis; Project Syndicate; VoxEU; the Peterson Institute for International Economics; MRV As-sociates; and TabbForum.

Detailed comments and advice on the text and scope of content from Amit Agrawal; Assoc., Prof. William K. Black; Macdara Dwyer; Sara Hsu; Prof. Thor-sten Beck; Fanny Fung; Ben Watson; Les Kovach; Dominic Wu; Steve Wunsch; Erinç Yelden, together with Michael C.S. Wong and Phillip Dalhaise of CTRisks.

Further thanks must also go to the China Banking Regulatory Commission, Hong Kong Institute of Bankers, the Beijing & Shanghai Chapters of the Profes-sional Risk Managers International Association and the Hong Kong Chapters of the Global Association of Risk Professionals and Institute of Operational Risk Management, Asia Financial Risk Think Tank, together with SWIFT and Wolters Kluwer Financial Services, for their kind assistance in helping to distribute the Journal to their respective memberships and client-base in Greater China, Japan, South Korea, Philippines and Singapore.

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www.hunt�inancialtraining.com CPD Af�iliate Member NO: 7025

It is critical for you and your business, in the current regulated financial market to have up to date knowledge of Collateral Management, Counterparty Risk and CVA.

This seminar, led by Chris Hunt, along with other leading industry experts, will help you understand the key concepts, values, risks and processes undertaken by leading players in the marketplace today.

Chris Hunt has extensive experience in the Collateral, Counterparty Risk and CVA space, having worked in that field at UBS as well as at Fortis, Barclays Capital and Standard Chartered Bank. Chris holds an MBA from the London Business School. For further details on Chris please visit www.huntfinancialtraining.com

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Q. What am I going to learn from this course and how will I be able to apply it? A. A good understanding of the areas of collateral, risk management and CVA and the interconnectivity between them. In addition, the participant will gain an understanding of the questions firms should be asking and how they need to develop their processes and infrastructure to capture and price risk accurately. The cost implications in this space are huge, and substantial savings are available to those that plan well and ask the right questions. Q. Who should attend this course? A. Collateral Managers or Risk or Treasury professionals; IT professionals involved in building systems in this space; those wanting to get a broad understanding of these areas and their interconnectivity. Full FAQ available on website

Q&A

End of the Euro is nigh without radical EU-wide reforms

A bruised and battle-weary Chris Rogers raises a flag of truce, following an encounter with

University of Athens economist, Yanis Varoufakis.

IT’S not often one gets to interact per-sonally with their heroes, so it was with great relish and delight that I grasped an opportunity to engage in intellectual swordplay with one of Europe’s lead-ing heterodox economists and political activist in his homeland, Professor Yanis Varoufakis of the University of Athens - courtesy of the Journal’s new honourary “Editor Emeritus”, Professor Steve Keen of Kingston University.

Before moving to the Question and Answer section of this article, it’s necessary to give a brief introduction to Prof. Varoufakis for those unfamiliar with his work and personal background; a career greatly impacted by the 2008 financial crisis and subsequent woes of his country of residency, Greece, where pres-ently he’s running for election to the Greek Parliament as a standard-bearer of the the Greek political reform movement, SYRIZA.

A duel-citizen of Australia and Greece, Prof. Yanis attended university at Essex and Birmingham in the UK and was awarded his PhD in economics also from the University of Essex. He began his professional career as

a university lecturer, influencing undergrad-uates and postgraduates on three continents.

Leading critic of economic orthodoxyA prolific author and committed blogger, Prof. Varoufakis has published numerous academic papers and two seminal books on the 2008 financial crisis and its aftermath, these being The Global Minotaur: The True Origins of the Financial Crisis and the Future of the World Economy, London and New York: Zed Books; and Modern Political Economics: Making sense of the post-2008 world, London and New York: Routledge, (with J. Halevi and N. Theocarakis) 2010.

A leading figure in the heterodox eco-nomics movement and vociferous critic of economic and monetary policy conducted after the GFC on both sides of the Atlantic Ocean, Prof. Varoufakis is much in demand by journalists and on the international speakers’ circuit. As such, the staff of the Journal and I thank Prof. Varoufakis for taking valuable time out from the Greek Election campaign to share his valuable insights with our readers. The full text of the Q&A appears overleaf:

Journal of Regulation & Risk North Asia12

Chris Rogers: Prof. Varoufakis, since the demise of Lehman Brothers in September 2008 and the ensuing great financial crisis (GFC), it would seem rather obscene that central bankers and monetary policy have been obsessed with “deflation”, rather than remedying the actual causes of the crisis itself. Is this a fair analysis?

Transferring lossesProf. Varoufakis: Central bankers and pol-icy makers were obsessed not so much with deflation but with transferring the losses of financial institutions onto the shoulders of citizens. When this transfer produced deflationary forces, only then did they enter into Quantitative Easing (QE) territory in an attempt to stem them. Since then, they have been trying to contain deflation with-out doing anything that might restore a modicum of bargaining power to labour or income to the dispossessed.

Chris Rogers: Given collapsing global oil prices, an emerging car loan subprime cri-sis brewing in the United States, slowdown in China and continued economic woes in Japan, together with fears over Greece ignit-ing another round of sovereign debt crisis within the European Union, is it fair to say we may be entering a perfect storm again and a repeat of events similar to those wit-nessed in 2008?

Major discontinuityProf. Varoufakis: Whether the next phase of the global crisis will take the form of a major discontinuity or a slow burning, ever increasing loss of socio-economic poten-tial is not something that we can predict.

What is clear is that, under the current policy mix, the world is facing either what [Larry]Summers described as secular stagnation or another Lehman moment. Not a great set of options.....

Chris Rogers: Turning to the EU and the Eurozone itself, would it be prudent for the EU Commission and European Central Bank to countenance the rapid introduc-tion of a two-tier Euro, specifically a “hard” Eurozone with Federal Germany at its helm, and a “soft” Eurozone headed by France?

1930s comparisons Prof. Varoufakis: If Europe continues the way it is now going, there will be no soft and hard euro. The euro will disintegrate, the result being a Deutsch mark zone east of the Rhine and north of the Alps and an assort-ment of national currencies everywhere else. The former zone will be gripped by deflation and the latter by stagflation. Chris Rogers: With reference to the second question and your response, is it correct, as many now argue, that the economic and social ramifications of the 2008 great finan-cial crisis are greater in many G20 nations today than those suffered during the Great Depression of the 1930s?

Prof. Varoufakis: It is not useful to make such comparisons. While it is true that the crisis transmission mechanisms are more poignant now than then, let us not forget that 1929 set in train the process leading to the carnage of the the Second World War: hardly a minor repercussion.Chris Rogers: Back to European matters


and the development of a nascent bank-ing union within the EU. Do you believe it wise of political and economic policymakers to concentrate on a “banking union” when centrifugal forces within the EU are growing, rather than dissipating, presently?

Death embrace continuesProf. Varoufakis: A banking union would be a godsend. It would break up the death embrace between insolvent banks and insolvent states. Alas, we created a bank-ing union in name so as to ensure it never happens in practice. And so the said death embrace continues.

Chris Rogers: Is it not the case that recent US unemployment figures (December 2014) and the third quarter 2014 GDP growth fig-ure of 5 per cent seem a little unbelievable, particularly given that most statistical analy-sis demonstrates all gains and that, since the “supposed” US recovery, more within the top 5 per cent have accumulated, at the expense of the average Joe on Main Street?

Macro data prosper.....people sufferProf. Varoufakis: If you look at the US labour market closely, you find that the number of Americans wanting a full time job and not having one has remained more or less constant over the last few years.

Employment growth has not kept up with labour supply which, in the United States, rises faster than in Europe. As for income growth, it is no great wonder that, courtesy of low investment and QE, asset price increases and share buybacks boost the income of the top one per cent further, while wages are languishing on a filthy floor. And

so macro data prosper while most people suffer.

Chris Rogers: Since late 2014, and continu-ing during the first weeks of 2015, we have heard many Cassandra-like voices warning of a Greek exit from the Eurozone, should left of centre political parties gain power in late January’s parliamentary election. Is this view overstated and fearmongering, no less?

Prof. Varoufakis: It is pure fearmongering for the purposes of dissuading Greek voters from voting for SYRIZA. It is that cynical. The powers-that-be know that Grexit (Greek exit) would unleash destructive powers that they cannot control. So they are bluffing, hoping that Greeks will fall for this piece of terror a second time – after 2012. It looks as if they cannot fool the Greek voters twice.

EU, democracy-free zoneChris Rogers: An economically prosperous EU would seem essential for the wellbeing of the global economy, given this assump-tion. What exactly are EU policymakers and the constituent member national govern-ments thinking about in hailing austerity as a panacea, rather than implementing a mas-sive fiscal expansion similar in impact to that of Marshall Aid nearly 70 years ago?

Prof. Varoufakis: You are making the wrong assumption that EU officials are in the busi-ness of promoting shared prosperity. I wish that were true. No, they are in business of perpetuating their bureaucratic author-ity within an institution that was designed as a democracy-free zone and as a media-tor between various powerful, oligopolistic


vested interests for whom austerity is a golden opportunity to maximise their social power over the rest of society. And if gigantic unemployment and a humanitarian crisis is the result, so be it.....

Chris Rogers: A new Bretton Woods agree-ment and re-imposition of capital controls would seem more beneficial, rather than all the supposed “free trade” orthodoxy we keep hearing about from both sides of the Atlantic. Would you agree?

Prof. Varoufakis: Capital controls have even been adopted by the IMF, recently, as essen-tial shock absorbers and stabilisers. A new Bretton Woods agreement would need to configure what I call a global surplus recy-cling mechanism that prevents bubble-creat-ing financial flows during the “good” times and

limits the extent to which the burden of adjust-ment falls on the shoulders of weaker nations and citizens during the “bad” times.

Politically, the trouble is that, unlike in 1944, today there exists no equivalent to the then United States to convene such a confer-ence and underpin the resulting agreement. Only the G20 can do this collectively. But with Europe in a state of comic idiocy and with the United States ungovernable, the prospects are dim.

Chris Rogers: May we thank you for sharing your engaging and somewhat controversial answers with the Journal of Regulation & Risk - North Asia and bid you luck in your effort to seek elected office in Greece on 25th of January. I – and the staff at the Journal – look forward to following your career, regardless of the outcome of the election.•

Call for papers

Contact:Christopher [email protected]

Journal of Regulation & Risk North Asia

33

Opinion

Deregulation, non-regulation and ‘desupervision’

Professor William Black examines the causes of the mortgage fraud epidemic that has swept the United States.THE author of this paper is a leading academic, lawyer and former banking regulator specialising in ‘white collar’ crime. As one of the unsung heroes of the Savings & Loans debacle of the 1980s, Professor Black nowadays spends much of his time researching why financial markets have a tendency to become dys-functional. Renowned for his theory on ‘control fraud’, Prof. Black lectures at the University of Missouri and Kansas City. He is the author of ‘The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry.’ A prominent commenta-tor on the causes of the current financial crisis, Prof. Black is a vocal critic of the way the US government has handled the banking crisis and rewarded institutions that have clearly failed in their fiduciary duties to investors.

The following commentary does not nec-essarily represent the view of the Journal of Regulation and Risk – North Asia. “The new numbers on criminal refer-rals for mortgage fraud in the US are just in

and they implicitly demonstrate three criti-cal failures of regulation and a wholesale failure of private market discipline of fraud and other forms of credit risk. The Financial Crimes Enforcement Network (FinCEN) released a study this week on Suspicious Activity Reports (SARs) that federally regu-lated financial institutions (sometimes) file with the Federal Bureau of Investigation (FBI) when they find evidence of mortgage fraud.

Epidemic warningThe FBI began warning of an “epidemic” of mortgage fraud in their congressional testi-mony in September 2004 – over five years ago. It also warned that if the epidemic were not dealt with it would cause a financial cri-sis. Nothing remotely adequate was done to respond to the epidemic by regulators, law enforcement, or private sector “market dis-cipline.” Instead, the epidemic produced and hyper-inflated a bubble in US housing prices that produced a crisis so severe that it nearly caused the collapse of the global financial system and led to unprecedented bailouts of many of the world’s largest banks.


147

Legal & Compliance

Who exactly is subject to the

Foreign Corrupt Practices Act?

In this paper, Tham Yuet-Ming, DLA

Piper Hong Kong consultant, examines the

pernicious effects of the FCPA in Asia.

The US Foreign Corrupt Practices

Act (FCPA), has its beginnings in the

Watergate era, when the Watergate Special

Prosecutor called for voluntary disclo-

sures from companies that had made

questionable contributions to Richard

Nixon’s 1972 presidential campaign.

However, these disclosures revealed

not just questionable domestic payments

but illicit funds that had been channelled

to foreign governments to obtain business.

The information led to subsequent investi-

gations by the US Securities and Exchange

Commission (SEC) which revealed that

many US issuers kept “slush funds” to

pay bribes to foreign officials and political

parties. The SEC later came up with a voluntary

disclosure programme under which any cor-

poration which self-reported illicit payments

and co-operated with the SEC was given

an informal assurance that it would likely

be safe from enforcement action. The result

was the disclosure that more than USD$300

million in questionable payments (a mas-

sive amount in the 1970s) had been made

by hundreds of companies – many of which

were Fortune 500 companies. The US legis-

lature responded to these scandals by even-

tually enacting the FCPA in 1977.

There are two main provisions to the

FCPA – the anti-bribery provisions, and the

accounting provisions. Both the SEC and the

US Department of Justice (DOJ) have juris-

diction over the FCPA. Generally, the SEC

prosecutes the accounting provisions and

the anti-bribery provisions as against issuers

through civil and administrative proceedings

whereas the DOJ prosecutes companies and

individuals for the anti-bribery provisions

through criminal proceedings.

The anti-bribery provision

The FCPA’s anti-bribery provision makes it

illegal to offer or provide money or anything

of value to foreign officials (“foreign” mean-

ing “non-US”) with the intent to obtain or

retain business, or for directing business to

any person.

Anything of value can include sponsor-

ship for travel and education, use of a holi-

day home, promise of future employment,

discounts, drinks and meals. There is no


163

Risk management

Of ‘Black Swans’, stress tests & optimised risk management Standard & Poor’s David Samuels outlines the positive benefits of bank stress testing on the bottom line.It is a big challenge for banks to build

a robust approach to managing the risk of worst-case stress scenarios that, almost by definition, are triggered by apparently unlikely or unprecedented events.

However, solving the problem of identi-fying the risk concentrations and dependen-cies that give rise to worst-case outcomes is vital if the industry is to thrive – and if indi-vidual banks are to turn the lessons of the past two years to competitive advantage. Banks that tackle the issue head-on will

be lauded by investors and regulators in the coming years of industry recuperation and, most importantly, will be able to deliver sus-tained profitability gains. Meanwhile, banks that are well placed to take advantage of the consolidation process need to be sure they can understand the risks embedded in the portfolios of potential acquisitions. To improve enterprise risk management

and strengthen investor confidence, we think banks can take the lead in three related areas:

Better board and senior executive over-sight and control of enterprise risk man-agement; re-invigorated stress testing and

downturn capital adequacy programs to uncover risk concentrations and risk depend-encies, and; applying these improvements to drive business selection – for example, through performance analysis and risk-adjusted pricing that takes stress test results into account.

Top-level oversightBuilding a more robust and comprehensive process for uncovering threats to the enter-prise is clearly, in part, a corporate govern-ance challenge. The board and top executives must have the motivation and the clout to scrutinise and call a halt to apparently profit-able activities if these are not in the longer-term interests of the enterprise or do not fit the intended risk profile of the organisation.

But contrary to popular opinion, improv-ing corporate governance is not just a ques-tion of putting the ‘right’ executives and board members in place and giving them appropriate incentives. For the bank to make the right deci-

sions when they are difficult, e.g. when business growth looks good in the upturn, or when risk management looks expensive



135

Compliance

Global financial change impacts

compliance and risk

EastNet’s head of products management –

compliance, David Dekker, details a potent

chemical reaction in financial markets.

About a year ago we saw the first signs

of a transformation in the financial world

and in the last months the credit crisis

has transformed the financial world at

an explosive pace. the change that is

occurring is much broader in scope than

originally expected. banks that were

considered to be too big to fail or fall

are either failing or being taken over by

financial institutions that are more finan-

cially sound, resulting in a huge para-

digm shift in how banks are regarded by

the public and other banks.

Since banking largely revolves around

trust and the ability to service customers, los-

ing a customer and determining the impact

of it, should be part of the ongoing risk

management of the organisation, as well as

monitoring the riskiness of existing and new

products and the customers using/buying

these products. But there are more changes

and challenges in the banking world that are

threatening banking as we have known it.

The banks will, in the future, not be the

default vehicles by which to move our funds,

maintain our balances and portfolios; they

will just be one of companies amongst oth-

ers that will be able to offer these services.

These days we should rather speak about

financial institutions than banks, or moni-

tored financial service providers, a name that

covers their current and future activities.

Look at how rapidly we have moved

from physical interaction on the banks

terms (location and hours of operation) to

electronic payments then Internet banking.

Again the banks were still in charge, but

as mentioned the paradigm is shifting to a

world where we (physical persons and cor-

porations) pay each other without the banks

involvement with new technologies such as

mobile payments.

Network providers

In the future the banks and organisations

such as SWIFT, NACHA and other pay-

ment networks become network providers

that allow you to send money from A to B

and will charge you for the network traf-

fic that you generate. This brings similari-

ties with industries such as telecom, energy

suppliers and cable companies. The financial

world is clearly undergoing an important

Opinion

The four lemmings of quantitative easing

Yale economist Stephen Roach urges the ECB to take a long hard look at its quantitative easing

road-to-nowhere before it’s far too late.

PREDICTABLY, the European Central Bank has joined the world’s other major monetary authorities in the great-est experiment in the history of central banking. By now, the pattern is all too familiar. First, central banks take the conventional policy rate down to the dreaded “zero bound”. Facing continued economic weakness, but having run out of conventional tools, they then embrace the unconventional approach of quanti-tative easing.

The theory behind this strategy is simple: unable to cut the price of credit further, cen-tral banks shift their focus to expanding its quantity. The implicit argument is that this move from price to quantity adjustments is the functional equivalent of additional monetary-policy easing. Thus, even at the zero bound of nominal interest rates, it is argued, central banks still have weapons in their arsenal.

But are those weapons up to the task? For the European Central Bank and the Bank of Japan, both of which are facing for-midable downside risks to their economies

and aggregate price levels, this is hardly an idle question. For the United States, where the ultimate consequences of quantitative easing remain to be seen, the answer is just as consequential.

The “three Ts”Quantitative easing’s impact hinges on the “three Ts” of monetary policy: transmis-sion (the channels by which monetary policy affects the real economy); traction (the responsiveness of economies to policy actions); and time consistency (the unwa-vering credibility of the authorities’ promise to reach specified targets like full employ-ment and price stability).

Notwithstanding financial markets’ celebration of quantitative easing, not to mention the US Federal Reserve’s hearty self-congratulation, an analysis based on the three Ts should give the European Central Bank cause for pause.

In terms of transmission, the US Federal Reserve has focused on the so-called wealth effect. First, the balance-sheet expansion of some US$3.6 trillion since late 2008 – which far exceeded the US$2.5 trillion in nominal


gross domestic product growth over the quantitative easing period – boosted asset markets.

ECB constrainedIt was assumed that the improvement in investors’ portfolio performance – reflected in a more than threefold rise in the S&P 500 from its crisis-induced low in March 2009 – would spur a burst of spending by increas-ingly wealthy consumers. The Bank of Japan has used a similar justification for its own policy of quantitative and qualitative easing.

The European Central Bank, however, will have a harder time making the case for wealth effects, largely because equity owner-ship by individuals (either direct or through their pension accounts) is far lower in Europe than in the United States or Japan.

For the European Union, specifically those members of the Eurozone, monetary policy seems more likely to be transmit-ted through banks, as well as through the currency channel, as a weaker euro – it has fallen some 15 per cent against the dollar over the last year – boosts exports.

Traction problemsThe real sticking point for quantitative easing relates to traction. The United States, where consumption accounts for the bulk of the shortfall in the post-crisis recovery, is a case in point. In an environment of excess debt and inadequate savings, wealth effects have done very little to ameliorate the balance-sheet recession that clobbered US house-holds when the property and credit bubbles burst.

Indeed, actualised annualised real con-sumption growth has averaged just 1.3

per cent since early 2008. With the current recovery in real gross domestic product on a trajectory of 2.3 per cent annual growth – two percentage points below the norm of past cycles – it is tough to justify the wide-spread praise of quantitative easing.

Japan’s massive quantitative and qualita-tive easing campaign has faced similar trac-tion problems. After expanding its balance sheet to nearly 60 per cent of gross domes-tic product – double the size of the the US Federal Reserve’s – the Bank of Japan is finding that its campaign to end deflation is increasingly ineffective. Japan has lapsed back into recession, and the Bank of Japan has just cut the inflation target for this year from 1.7 per cent to 1 per cent.

Denial of risksFinally, quantitative easing also disappoints in terms of time consistency. The US Federal Reserve has long qualified its post-quanti-tative easing normalisation strategy with a host of data-dependent conditions pertain-ing to the state of the economy and/or infla-tion risks.

Moreover, it is now relying on ambigu-ous adjectives to provide guidance to finan-cial markets, having recently shifted from stating that it would maintain low rates for a “considerable” time to pledging to be “patient” in determining when to raise rates.

But it is the Swiss National Bank, which printed money to prevent excessive appreci-ation after pegging its currency to the euro in 2011, that has thrust the sharpest dagger into quantitative easing’s heart. By unexpectedly abandoning the euro peg on January 15 – just a month after reiterating a commitment to it – the once-disciplined Swiss National


Bank has run roughshod over the credibility requirements of time consistency.

With the Swiss National Bank’s assets amounting to nearly 90 per cent of Switzerland’s gross domestic product, the reversal raises serious questions about both the limits and repercussions of open-ended quantitative easing.

And it serves as a chilling reminder of the fundamental fragility of promises like that of the European Central Bank’s President Mario Draghi to do “whatever it takes” to save the euro.

In the quantitative easing era, monetary policy has lost any semblance of discipline and coherence. As Mr. Draghi attempts to deliver on his nearly two-and-a-half-year-old commitment, the limits of his prom-ise – like comparable assurances by the US Federal Reserve and the Bank of Japan

– could become glaringly apparent. Like lemmings at the cliff’s edge, central banks seem steeped in denial of the risks they face.•

Editor’s note: The publisher and edi-tors of the Journal of Regulation & Risk - North Asia would like to extend their thanks to Stephen S. Roach, senior fel-low at Yale University’s Jackson Institute of Global Affairs and a senior lecturer at the Yale School of Management, together with Project Syndicate for allowing the Journal to re-print an amended version of this article, which first appeared on Project Syndicate’s website on 26 January, 2015. Readers are kindly reminded that copyright belongs to Mr. Roach and Project Syndicate. The original source material can be found at the follow-ing website link: http://www.project-syndi-cate.org/columnist/stephen-s--roach.

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Contact:Christopher RogersEditor-in-Chief [email protected]

Articles & PapersIssues in resolving systemically important financial institutions Dr Eric S. RosengrenResecuritisation in banking: major challenges ahead

Dr Fang DuA framework for funding liquidity in times of financial crisis

Dr Ulrich BindseilHousing, monetary and fiscal policies: from bad to worst

Stephan Schoess,Derivatives: from disaster to re-regulation

Professor Lynn A. Stout Black swans, market crises and risk: the human perspective

Joseph RizziMeasuring & managing risk for innovative financial instruments Dr Stuart M. Turnbull Red star spangled banner: root causes of the financial crisis Andreas Kern & Christian FahrholzThe ‘family’ risk: a cause for concern among Asian investors

David SmithGlobal financial change impacts compliance and risk

David DekkerThe scramble is on to tackle bribery and corruption

Penelope Tham & Gerald LiWho exactly is subject to the Foreign Corrupt Practices Act?

Tham Yuet-MingFinancial markets remuneration reform: one step forward Umesh Kumar & Kevin MarrOf ‘Black Swans’, stress tests & optimised risk management

David SamuelsChallenging the value of enterprise risk management

Tim Pagett & Ranjit JaswalRocky road ahead for global accountancy convergence

Dr Philip GoethThe Asian regulatory Rubik’s Cube

Alan Ewins and Angus Ross

Journal of regulation & risk north asia

Volume I, Issue III, Autumn Winter 2009-2010


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Can a central bureau prevent systemic risk? Not likely!

Alex J. Pollock of the AEI pours cold water on the belief that the Financial Stability Oversight

Council can control against systemic risk.

Opinion

IN a typical political over-reaction to a financial crisis, as happens each cycle, the US Congress created the notorious Dodd-Frank Act of 2010. Ironically, this act is named after two of the biggest political promoters of Fannie Mae and Freddie Mac, the government-sponsored insti-tutions which greatly helped inflate the housing bubble and then failed in 2008. The act did nothing to reform Fannie and Freddie, but it did cultivate a vast efflorescence of regulatory bureaucracy, which has by now been multiplying for four years and continues its inexorable spread.

Among the creations of the Dodd-Frank Act is the Financial Stability Oversight Council, often referred too as the FSOC (called “eff-sock”). The Financial Stability Oversight Council is a committee of regulators assigned with the responsibility of identifying and preventing the ill-defined threat of systemic risk. It is not clear that this is even possible. The utter failure of central banks, regulators and economists in general to understand the great 21st century bubbles or to foresee their

disastrous consequences certainly suggests it is not.

This unlikelihood of success is accen-tuated by the nature of the committee as a congress of turf-protecting regulatory fief-doms. But of course politicians in the wake of a financial crisis have to be seen to be doing something! Setting up a committee is something which can always be done. An analogous international committee of central bank and regulatory bureaucracies, the Financial Stability Board, was similarly established.

The “Faith in Bureaucracy” ActThe FSOC has unprecedented power to expand its own jurisdiction, escaping demo-cratic checks and balances, by meeting in secret to designate financial companies as “systemically important financial institu-tions” or SIFIs. This subjects such compa-nies to additional regulatory controls. You would not think that Congress would give an unelected bureaucratic committee the ability to expand its own jurisdiction, but the Dodd-Frank Act displays throughout a naïve assumption of the virtue, as well as the


knowledge, of government bureaucracies. It should have been entitled, “The Faith in Bureaucracy Act”.

What good the committee?Systemic risk is a readily available rationale for the expansion of regulatory bureaucracy, but no one has offered a clear definition of “systemic risk”. Justice Potter Stewart of the US Supreme Court famously said of por-nography that he could not define it, but he knew it when he saw it. With systemic risk, we cannot define it, and we do not know it when we see it, or we do not see it at all, because we are looking somewhere else.

How good can a committee composed of jealous regulatory fiefdoms be at knowing systemic risk when it sees it? The problem is exacerbated because systemic risk is created by what we do not know, and therefore can-not “see” intellectually.

Even more to the point, systemic risk is caused by what we think we know, when really we don’t. For example, the following passages detail instances where financial actors as a group, including regulators and central bankers, thought they knew.

Classic “group think” failureThe classic “group think” failure prior to the great financial crisis (GFC) of 2007-2008 was the view that US house prices could not go down on a national average basis. This was plausible, given how large the United States is and how diversified its economy. That this idea was widely believed and acted upon was a key factor in falsifying it, with disas-trous consequences, needless to say.

Then we have this marvellous conten-tion doing the rounds prior to the GFC that

central banks globally had achieved the “Great Moderation”. Of course, the “Great Moderation” for which central banks, includ-ing the US Federal Reserve, warmly congrat-ulated themselves, turned out to be the great series of bubbles.

Our delusions of grandeur are not just confined to central bankers though. Again, prior to the GFC, global regulators under the guise of the Bank for International Settlements were all of the opinion that bank capital requirements should be based on risk weightings. It was another quite plausible idea, believed in and worked on by thou-sands of intelligent and diligent regulators and bankers. It led to thoroughly unsound heights of leverage.

Can it get worse? You bet!Of course, this would all have not been possible without the fact that new finan-cial techniques in risk management justify higher leverage, allegedly. Techniques such as tranched mortgage-backed securities, structured investment vehicles (SIVs), and credit default swaps (CDSs) were all clever structures created by clever people, but could not survive what turned out to be their hyper-leverage to house prices falling (see first item in this list).

Such group think and delusions are not confined to one specific group or agency. All regulators and central bankers are gov-ernment employees, which leads us to this blinder that government debt is “risk free”.

Of course it is understandable that they want to promote the debt of their employers: the governments and the politicians who control them.

Still, this idea was particularly silly, given


the large number of government defaults that litter financial history.

“Countries don’t go bankrupt”Last, but not least in our list, is the view held by many that “Countries cannot go bankrupt”. This memorable line of Walter Wriston, the Chairman of what was then Citicorp, helped lead the parade of banks into the tar pit of the sovereign debt crisis of the 1980s. This parade had been cheered on by official voices as the success of “petro-dollar recycling”. Of course, it is true that countries don’t enter bankruptcy proceedings – quite the reverse, they just default.

Did the bureaucracies, which are now members of Financial Stability Oversight Council, in previous crises see in advance that all this “knowledge” was false, any better than anybody else? Nope. Are they exempt from cognitive herding? Nope. Will they have superior insight into the false beliefs and fads of the next crisis? That is most improbable.

Government is much to blameA deep and fundamental problem of a government committee like the Financial Stability Oversight Council is that govern-ments themselves are major creators of systemic risk, including of course the US government. This is especially true of cen-tral bank money-printing blunders, like that which set off the hugely destructive Great Inflation of the 1970s, or that which stoked the US housing boom as it turned into a bubble in the early 2000s.

Indeed, the US Federal Reserve, the cen-tral bank to the world as long as the dollar is the dominant global currency, is itself the

single greatest creator of systemic risk and the biggest SIFI of them all. The Federal Reserve and the US Treasury, whose low-rate bonds the Federal Reserve has so gen-erously been buying, are the most senior members of the Financial Stability Oversight Council. Is the Financial Stability Oversight Council going to indict the actions of the Fed, however culpable, for creating systemic risk? Nope.

Likewise, is the Financial Stability Oversight Council going to criticise other parts of the government, let’s say a Congress or a Department of Housing which pro-motes poor quality mortgage loans as a bub-ble expands? A Department of Education which pushes extreme levels of student debt with no credit underwriting? A government pension guarantor which is hopelessly insol-vent? No, it won’t.

Fannie and FreddieThe former “government-sponsored enter-prises”, Fannie Mae and Freddie Mac, were principal inflators of the US housing bubble. They made boodles of bad loans and bought billions in subprime mortgage-backed secu-rities, growing in mortgage credit risk to over US$5 trillion. Their collapse escalated the cri-sis of 2008.

They are now government-owned and controlled entities, which still have over US$5 trillion in assets and more than half of the entire mortgage credit risk of the country, combined with zero capital. They demonstrably represent systemic risk, if any-body does. But does the Financial Stability Oversight Council designate them as sys-temically important financial institutions? In a nutshell, no. And, why not? Because


a committee chaired by the Secretary of the Treasury in partnership with the Federal Reserve, and filled with government offic-ers, is constitutionally incapable of dealing with the systemic risks created by the gov-ernment. The egregious failure to address Fannie and Freddie, in itself, deflates the FSOC’s intellectual credibility.

In general, systemic risk reflects exagger-ated asset prices which have become highly leveraged. I like to ask audiences of mort-gage lenders, “What is the collateral for a mortgage loan?” “The house” , which seems the obvious answer, is incorrect. The correct answer is “the price of the house”. The price is the only way the lender can recover value from the collateral. The price of the asset is what supports the debt.

The essential question about risk and systemic risk is therefore: how much can a price change? The answer is: a lot more than

you think. It can go up more than you think, and it can go down a lot more than you think. That is why your worst-case scenario is nowhere near as bad as what actually hap-pens in a crisis, and why risk, to paraphrase an old banker, is the price you never believed you would really have to pay.

How do we know how much a price can change? How indeed? Our ignorance of future prices has just been demonstrated yet once again by the unforecasted more than 50 per cent drop in the price of global oil supplies.

Will the Financial Stability Oversight Council, staffed as it is, be better than any-body else at knowing how much prices will change? Did it identify the coming collapse in the price of oil as a looming risk factor? It did not. Given past and recent experience, there is no reason to think it will do any better in the future. •


Editorial deadline for Vol VII Issue I Summer 2015

May 15th 2015

Opinion

“The secret of great wealth is… a crime never found out…” Balzac

Former Fraud Squad investigator, Rowan Bosworth-Davies, lambasts the failure of the

political class to tackle City of London criminality.

MY good friend, Ian Fraser, author of Shredded: Inside RBS, The Bank That Broke Britain, argues that Thomas Piketty’s Capital in the Twenty-First Century was perhaps the most impor-tant book published in 2014. Similarly, Paul Krugman, in the New York Review, praises this tour de force by the Paris School of Economics professor as a “magnificent, sweeping meditation on inequality”.

The book’s big idea is that we haven’t just gone back to 19th century levels of income inequality – we’re also on a path back to “patrimonial capitalism”, in which the com-manding heights of the economy are con-trolled not by talented individuals but by family dynasties. Here, I would argue, the word “family” should be interpreted in its widest context, to include corporate bodies and, increasingly, criminal organisations.

Piketty’s influence runs deep. It has become commonplace to say that we are liv-ing in a second Gilded Age – or, as Piketty likes to put it, a second Belle Époque – defined by the incredible rise of the “one

per cent”. But it has only become a com-monplace thanks to Piketty’s work. He and his colleagues (notably Anthony Atkinson at Oxford and Emmanuel Saez at Berkeley), have pioneered statistical techniques that make it possible to track the concentration of income and wealth deep into the past – back to the early twentieth century for America and Britain, and all the way to the late eight-eenth century for France.

The result has been a revolution in our understanding of long-term trends in inequality. Before this, most discussions of economic disparity more or less ignored the very rich. But even those willing to dis-cuss inequality generally focused on the gap between the poor or the working class and the merely well-off, not the truly rich; on col-lege graduates whose wage gains outpaced those of less-educated workers, or on the comparative good fortune of the top fifth of the population compared with the bottom four fifths – not on the rapidly rising incomes of executives and bankers.

It therefore came as a revelation when Piketty and his colleagues showed that the incomes of the now famous “one per cent”,


and of even narrower groups, are actually the big story in rising inequality. And this discovery came with a second revelation: talk of a second Gilded Age was nothing of the kind. In America, in particular, the share of national income going to the top one per cent has followed a great U-shaped arc.

Risible idea of meritBefore World War I, the one per cent received around a fifth of total income in both Britain and the USA. By 1950, that share had been cut by more than half. But since 1980 the one per cent has seen its income share surge again – and in the US it’s back to what it was a century ago.

Back then, great wealth tended to be inherited; and the idea that today’s eco-nomic elite are people who have legitimately “earned” their position, is frankly risible.

I posit that it simply isn’t possible to “earn” your way to significant wealth. No one working lawfully for someone else in an employed position, and paying full tax contributions on that salary, as well as pur-chasing a commensurate home property, together with educating children in a private manner will ever save enough money to be considered to be sufficiently wealthy as to enter the top one per cent.

Robber baronsFrankly, my friends, we have returned to the days of the “robber barons”, the organised criminal groups and dynastic families who largely owned and controlled the wealth in America at the turn of the nineteenth century, and whose spiritual and criminogenic coun-terparts are alive and well today in Russia and parts of the old former Communist Bloc,

Pakistan, India, Malaysia, Indonesia, China, parts of Sub Saharan Africa and the Middle East, as well as in parts of the UK, the EU and America

We, in the West, notably London and New York, have become the facilitators of the movement of that criminal capital. We have become economic prostitutes, selling our services and our abilities to the high-est bidder, in return for vast amounts of the dirty criminal money that flows out of these countries into the City of London or New York, to be washed, cosseted, protected and moved on into the subterranean world of the offshore banking industry, free from over-sight and interdiction.

New dynastic elitesMy own belief is that the changes being predicated in the UK and the USA for the better facilitation and distribution of such capital are leading to the emergence of a new series of dynastic elites. These are all closely aligned to the deliberate and sys-tematic destruction of a socio-political sta-tus that had deliberately sought to achieve a far greater equality of the distribution of wealth to a much wider subset of citizens by engineering a deliberately “liberal”model of economic dissemination, maintained by elevating the power of the rule of law to a pre-eminent position in Western Capitalist Societies. The aim of enforcing this new regulatory legal regime had been to protect the new ideas underpinning the policies of “Consensus” in the UK and of “The New Deal”and its aftermath in the USA.

The end of World War II left the United Kingdom with an appetite for a broader distribution of wealth and a strengthening


of social security, while more conservative instincts held fast to a belief in individual ini-tiative and private property.

Post-war intervention The practical resolution of this tension in politics by the two Chancellors was a Keynesian-style mixed economy with mod-erate state intervention (regulatory control underpinned by statute) to promote social goals, particularly in education and health.

The Bank of England enjoyed a centrist, prudent controlling role and oversaw various levels of financial borrowing policy, as well as Exchange Controls. As with other laws introduced during the war-time crisis, the overriding aim was to ensure as fair a dis-tribution of capital as possible, and to main-tain rigid controls on speculation in capital holdings, an unnecessary practice which it was believed could undermine and thereby damage both the war-time and early peace-time economy.

These policies were continued by succes-sive consensualist Governments even after the War, despite their apparent unfairness towards the interests of the uber-rich.

Until the pips squeakDennis Healey, speaking at the Labour conference on 1 October 1973, said, “I warn you that there are going to be howls of anguish from those rich enough to pay over 75 per cent on their last slice of earnings”. In a speech on 18 February 1974, Healey went further, promising he would “squeeze property speculators until the pips squeak” and confronted Lord Carrington, the Conservative Secretary of State for Energy, who had made £10m profit from selling

agricultural land at prices 30 to 60 times as high as it would command as farming land.

The consensus on wealth redistribution dominated British politics until the economic crisis of the late 1970s which led to the end of the “Golden Age of Capitalism” and the rise of monetarist economics. The Conservative administration of Margaret Thatcher insti-tutionalised a far greater emphasis on a free market approach to government, while at the same time dedicating itself to what was called “the rolling back of the nanny State” and “the dismantling of Socialism”.

Relief, Recovery, ReformIn the USA, the era of the New Deal was underpinned by the realisation that the seeds of the economic austerity and the era of severe hardships caused by the collapse of the US economy in the aftermath of the Wall Street Crash, had been predicated, to a great extent, by unregulated speculative trading on margin, during which criminals and dishonest speculators had manipulated the US securities market so as to destroy its very foundations.

Unregulated speculation coupled with the highly dangerous practice of ‘naked shorting’ or selling stock the seller did not own, with a view to driving down the price of the underlying security, undermined the legitimacy of the US stock market, thus deterring natural users from wishing to engage with its services.

The period of economic reconstruc-tion witnessed a huge Keynsian economic re-engineering project. The programmes focused on what historians call the “3 Rs”: Relief, Recovery, and Reform. That is, Relief for the unemployed and poor; Recovery of


the economy to normal levels; and Reform of the financial system to prevent a repeat depression.

Honest bankingThe “Truth in Banking” legislation, coupled with the work of the SEC, and the power of its lawyers and investigators, working with Justice Department Prosecutors to maintain strict controls over the conduct of business on American exchanges, protecting them from predators and encouraging ordinary men and women to invest in them, was fun-damental to the post-depression American Dream.

It was only the emergence of Chicago-school monetarist economic theorists in both the US and the UK, that spelt the end of the era of consensual politics, and the deliberate de-regulation of financial markets.

These policies were very largely driven by theoretical economic analyses: both Thatcher in the UK and Reagan in the USA had their gurus who whispered economic radicalism in their ears.

Crooks, wiseguys and thievesThe policy, on both sides of the Atlantic, to engage in a policy of financial de-regulation, led to a concerted attack on the effective-ness of the law enforcement components which underpinned the protection of mar-ket integrity; they were now described as “protectionist” and “contra-preneurial”, anti-thetical to the efficient running of a free mar-ket. Certainly by the mid 1980s, the powers of criminal investigatory action were being effectively curtailed.

What the proponents of unfettered free-dom of markets failed to realise, whether

deliberately or by mistake, was that, by allowing greater freedoms for markets to develop entrepreneurial skills and increas-ing efficiency in the management or risk, they opened the door to every crook, wise-guy and thief, whose very existence had hitherto been made much more difficult by the existence of strong laws and powerful prosecutors.

Once those powers were revoked, there was nothing left to prevent the markets from being turned into a criminal free-for-all, which is what they rapidly became.

ProsecutionsNevertheless, there was a clear agenda on the part of successive Governments on both sides of the Atlantic to play down the pro-tectionist powers of the criminal law, leaving the regulation of the markets in the hands of enthusiastic amateurs, academics, and bankers, who had every incentive to see a continuation of the status quo.

In the UK, despite the real successes of the prosecutions of the first Guinness trial in 1987, which stemmed originally from the successful investigations of Ivan Boesky and others in the USA, quickly followed by the even greater success of the criminal convic-tions sustained in the Blue Arrow case, these two major city fraud cases were to be the last prosecutions of anyone even remotely associated with positions of power and social significance within the City of London Establishment.

The City and its powerful friends were frightened rigid by the Guinness prosecu-tion and had decided that they did not want the conduct of their affairs being investigated by Police Fraud Squad detectives – men and


women who really were capable of quickly grasping the innate criminality of the con-duct alleged, and doing something swiftly and effectively about it.

Political lobbyingTreating socially elevated financiers in the same way as they treated East End villains running dodgy “break-out” companies, knocking them up in the early hours of the morning, locking them up at Holborn police station and treating them generally like the criminals they undoubtedly were, was a most unpleasant experience, and some of the weaker blue-bloods had a tendency to talk too much to the cops, too quickly, in the hope of more lenient treatment.

Such was the social damage being caused by these cases, that a concerted period of lobbying of selected politicians, civil servants and law officers was begun, to amplify the perception of damage to the reputation of UK plc being caused by such trials.

Closing of ranksThe dropping of the other Guinness cases, coupled with the indecently swift reversal of the convictions of the defendants in the Blue Arrow case by the Court of Appeal, demonstrated just how scared the politi-cal and financial controllers of the British Establishment had become of allowing City fraud scandals to be dealt with by the cops and tried by ordinary juries, who had also demonstrated, only too well, that they clearly understood the issues at trial and were perfectly capable of potting the blue-bloods and convicting them of major crimes. After the Court of Appeal reversals in the Blue Arrow case, a friend of mine who was

a senior lawyer at the Serious Fraud Office told me that the message being sent down from “the top, was that there would never again be a prosecution along the lines of the Blue Arrow trial.”

The salient point underpinning this entire farrago is that, ever since those days in 1989, no important City criminal scandal has ended in the dock of the Central Criminal Court, and the concomitant regime of lais-sez-faire and “light touch regulation” which has been perpetrated ever since has allowed the banking and financial establishment to commit crimes on a wholesale basis, secure in the knowledge that they will never be dealt with by the police.

Culture of impunityIf you wonder why so many bankers have been paid so much money in the interven-ing years, well you can make a great deal of criminal profit in 25 years if you are secure in the knowledge that the police will not be looking at you! Imagine what Al Capone or Lucky Luciano could have siphoned off if they had known that they were free from law-enforcement oversight, and that is exactly the situation with regard to the British Banking Sector in the last quarter of a century!

In the UK, the emergence of the civil regulatory regime that was spawned by the passing of the Financial Services Act 1986, began an era which gave all the appearances of being a regulatory-positive agenda, but which, in practice, began and continued a concerted policy of unpicking the influence of law enforcement.

Successive administrations, the Securities and Investments Board, the Financial


Services Authority, now the Financial Conduct Authority, have rigidly steered clear of prosecuting anyone of stature in the bank-ing industry.

Naming and shamingIt took many years of “naming and sham-ing” to get the FSA to begin prosecutions of practitioners for even the most egregious cases of “insider dealing”, and even then, the defendants were always relatively minor employees, the majority of whom pleaded guilty.

Despite this development, the FCA has even now consistently refused to prosecute any senior banker for any of the concerted criminal activities which have marked out the banking leitmotif.

You only have to look at the activities of all the major banks in the perpetration of the institutionalised level of PPI fraud, which has lasted for many years, to understand the truth of this allegation. The monies made in the pursuit of profits and the ‘grabbing of the biggest share of the customer’s wallet’, which so identified the PPI fraud era, has enriched many bankers a hundredfold.

Drug cartels, Libor & FXAdd into this the other levels of criminal fraud perpetrated against clients, the delib-erate lying about the valuations of debt-secured securities followed by the fraudulent foreclosure on loans, the false enrichment of bankers at the expense of clients criminally forced out of their contractual obligations, and you begin to see a positive policy of criminal activity being widely perpetrated.

Then you start to look at the level of for-eign money laundering, sanctions busting

and other breaches of anti-terror controls being imposed by governments, many if not most of which were routinely ignored by the banks. HSBC led the way with billions of dollars recovered from their money wash-ing activities on behalf of the Mexican Drug Cartels. Libor and Forex manipulations are among the more recent exposés.

For these, and for other reasons, I assert that the level of criminality is so widespread in the banking galère that it is impossi-ble to calculate the amount of money they have created for themselves, and which has been paid to them in the form of bonuses. While their basic salaries may remain rela-tively modest, they have more than made up for the wealth they have absorbed through other payment abuses and tax avoidance.

I lived through the era of change as a detective at the New Scotland Yard Fraud Squad, and I watched with mounting irrita-tion and bemusement while perfectly proper cases we should have been investigating were undermined by Government lawyers.

Later, as a regulator, I observed the spine-less kowtowing of the regulatory regime towards those who were facilitating the movement of the growing levels of criminal money being slushed through the UK finan-cial sector. I believe that it is now too late to put the genie back into the bottle; we must live with the fact that the City of London is run by a gang of organised criminals who make Al Capone look positively benign.

Without their intervention, as an inte-gral component in the onward transmission of the billions of foreign dirty money which comes to London, I seriously wonder how UK plc would survive if we had to run our affairs lawfully and properly. •

Leader opinion

A simple answer to the Euro crisis exists, why not use it?

Former Labour Party stalwart and confidant of Jaques Delors and Yanis Varoufakis, Stuart Hol-

land, offers Europe a way out of present crisis.

THE electoral success of Syriza in the recent Greek parliamentary elections raises serious questions as to whether the new Greek Prime Minister, Alexis Tsipras, and his Finance Minister, former academic and accidental political activist, Yanis Varoufakis can fulfill the political mandate of Syriza to renegotiate Greek debt with the “Troika” of the European Commission, ECB and IMF – never mind overcome entrenched German intransi-gence personified by Germany’s present Chancellor, Angela Merkel.

But this is only part of the wider question of whether the European Union can resolve the present crisis afflicting much of the Eurozone. As many are aware, the best way to reduce debt and deficits is by growth, as witnessed by US President Bill Clinton’s sec-ond administration in the late 90s.

An answer to our present predicament exists and was addressed by myself and Minister Varoufakis in our Modest Proposal announced in November 2013 in Austin, Texas. A proposal that now provides the framework for the negotiating position the

Syriza government of Tsipras will undertake with Greece’s creditors in the weeks and months ahead.

There have been three revisions to the Modest Proposal originally outlined by Yanis Varoufakis and myself, prior to the noted US Economic Historian Prof. James K. Galbraith joining our cause in 2013. The main thrust of our proposal is based on the argument I made to Jacques Delors (the then President of the European Commission) in 1993 that the deflationary debt and deficit conditions of the Maastricht Treaty needed to be offset by a bond financed investment recovery on the lines of that undertaken in America by President Roosevelt via the New Deal in the 1930s.

At that time, I recommended that these should be issued by a European Investment Fund, which consequently was established in 1994 and is today a sister institution of the European Investment Bank (EIB).

In response to the proposal of a European Fund for Strategic Investment (EFSI) by Polish Finance Minister Mateusz Szczurek, Wolfgang Schäuble, the pre-sent German Finance Minister under Frau


Merkel, has stressed that there should not be any increase in debt.

EIB bonds are not national debtBut EIB bonds and lending for project finance do not count towards national debt. Nor is an EFSI needed to fulfil the EIB bond funded European recovery that the present European Commission President Jean-Claude Juncker made his top prior-ity in his adoption address to the European Parliament in July 2014.

The European Investment Fund can issue bonds to co-finance the EIB and does so by recycling global surpluses. Thus the South African Minister of Finance, Nhlanhla Nene, declared at a meeting of the BRICS (Brazil, Russia, India and China) in Washington on September 25th last year that they would buy eurobonds if these were to finance a European recovery.

Neither should governments fear mar-kets or rating agencies. When Standard & Poor’s downgraded Eurozone member states’ debt in January 2012, it stressed that key reasons for this decision were simulta-neous debt and spending reduction by gov-ernments and households, the weakening thereby of economic growth, and inability of European policymakers to assure any eco-nomic recovery within their ranks.

No new criteria neededLast year Bill Gross, when still head of the Pimco fund, also called for European recov-ery, stressing that pension funds needed growth to secure retirement income, whereas low to near zero interest rates in Europe would not underpin said recovery, much as is the case in the USA. Similarly,

Norway’s sovereign wealth fund has cut its investments in private equity in Europe because of low growth.

The Chinese CIC sovereign wealth fund also made losses on its private sector invest-ments after the onset of the financial crisis, and declared that it wanted public invest-ment projects with a maturity of at least 10 years. The Gulf States have assets of some US$1.1 trillion presently, much of which is under-invested or making poor returns.

Nor are any new criteria needed for an investment led recovery. Apart from the TENS of the Trans-European Transport and Telecommunications Networks, the Amsterdam Special Action Programme of 1997 gained the agreement of the EIB that it would invest in health, education, urban regeneration, green technologies and finance for small and medium-sized firms – all areas that ECB President Draghi’s more than US$1 trillion quantitative easing pro-gramme will fail to reach. Eurogroup chair Joerem Dijsselbloem recently recognised in the Financial Times that a new institution such as the EFSI is not needed.

So what is blocking ‘action this day’? Little other than the Merkel-Schäuble presumption that Germany would have to pay. Yet this is not the case. EIB bonds are project financed, not serviced by German or any other taxpayers. They have no formal guarantees by govern-ments, and have not needed them since 1958. Besides which, those member states that want a joint EIB-EIF funded European recovery, such as France, Italy – and Greece – need not be blocked by Germany. They, or Jean-Claude Juncker, could move an “enhanced coop-eration procedure” on the European Council which does not need unanimity. •

Book review

Policy failures at the heart of the US 2008 financial crisis

Bartlett Naylor of the Public Citizen pro-vides a heartfelt review of Jennifer Taub’s

book charting the US mortgage debacle.

WHAT’S most compelling about Jennifer Taub’s new book, “Other People’s Houses: How Decades of Bailouts, Captive Regulators, and Toxic Bankers Made Home Mortgages a Thrilling Business”, is her authoritative argument that the recent financial crisis did not result from isolated policy decisions and fraudu-lent business practices of the few years leading to 2008. Instead, our recent Wall Street crash played out already proven policy failures from the savings-and-loan (S&L) crisis of the 1980s onwards.

Even moral hazard, the surrender of disci-pline for banks “too-big-to-fail” that epito-mised the bailouts of 2008, Taub reminds us, originated in 1984 with the bailouts of Continental Illinois National Bank and suc-cessive taxpayer rescues of American Savings and Loan, the largest S&L in the nation.

Professor Taub, a colleague and friend, teaches at Vermont Law School and previ-ously served as associate general counsel at Fidelity Investments. With unique cre-dentials, she can explain the intentional complexity of Wall Street products and

Washington regulation without glossing over contradiction and nuance.

Unlike the majority of crash pathologies that focus on Washington players such as Timothy Geithner’s “Stress Test” , Sheila Bair’s “Bull by the Horns”, or Andrew Ross Sorkin’s “Too Big to Fail”, Taub’s book spends quality time outside the Washington DC beltway.

Nobelman familyHer narrative follows real individuals, from rogues who pillage the banks along with their lieutenants, to regulatory chiefs often aligned with industry interests, a few heroes who actually understand and fulfill their responsibility to protect taxpayers, and finally, victims of this morass. And we meet the Nobelman family.

The Nobelmans and their mortgage help connect this three decade story of dysfunction. In 1984, Harriet and Leonard Nobelman borrowed US$68,250 for a one-bedroom condominium. American Savings and Loan Association held the loan.

Over the years, American Savings would be bailed out several times in several reincar-nations. In one sale, it went to Washington


Mutual. When that firm failed, it went to JP Morgan during the height of the 2008 finan-cial crisis, completing the more than 20 year arc from the S&L crisis.

The Nobelmans also ran into financial trouble when, in 1990, they lost their jobs and encountered health problems. They sought not a bailout, but bankruptcy relief.

The Supreme Court eventually ruled against the Nobelmans.

Because lenders understood a mortgage didn’t come with the same consumer pro-tection as other loans, Taub contends that Nobelman v. American Savings Bank gave lenders” added incentive to place people in homes they could not afford”.

The London WhaleTaub doesn’t pin the 2008 financial crisis on this decision alone. For example, she runs through a devastating critique of deregula-tion of the last 15 years in the chapter “Legal Enablers of the Toxic Chain”. After the banks made reckless loans, the pools of mortgages won lax accounting oversight with risk dis-guised by unsupervised bets at institutions with far too much debt.

JP Morgan, the inheritor of American Savings, figured near the centre of that toxic chain right through to the notorious London Whale bets of 2012 that dramatised banking too big to manage and regulate.

Responding to the 2008 crash, reformers brought many ideas to Congress, including reversal of the Nobelman decision. The real impact, Taub recounts, would be in loan-making itself. With the potential for bank-ruptcy, economists of the Cleveland Federal Reserve Bank speculated that it “worked without working”, as loan makers would be

less likely to make unaffordable loans in the first place, and seek an out-of-court settle-ment in the case of problems.

Following passage in the House of Representatives of a “principal reduction” measure, Sen. Richard Durbin (D-Ill.) pro-posed a parallel reform in the Senate. But he ran into a buzz saw of 60 financial service, insurance and real estate firms that unloaded US$40 million in lobbying in the first quarter of 2009 to fight this and other reforms.

President Barack Obama, who originally endorsed the idea as a presidential candidate in the Primaries, reversed course under the advice of his new Treasury Secretary Timothy Geithner. Durbin’s measure drew 45 votes, all Democrats. Without White House sup-port, it fell short. “Obama gave it away on the way to the White House,” concluded Barney Frank, the Massachusetts Democrat who chaired the House Financial Services Committee.

Taub frequently notes the pernicious role of money in financial policy, both in large dollar flows and in micro-deals. For exam-ple, Lewis Ranieri, the originator of mort-gage-backed securities, sought a favourable tax ruling on a proposed structure, but ran into opposition from a Treasury Department analyst. So Ranieri “hired the analyst away from the Treasury”. Such mischief forms the tapestry of policy.

“Other People’s Houses” achieves numer-ous goals – history, deconstruction of finan-cial products, policy critique. Throughout her book, Taub returns to the real people who suffer at the hands of financial rogues and their legal enablers. Too often, these victims appear as statistics; Taub reminds us they have real names. •

Book précis

Life, Liberty and the pursuit of Inequality

New York-based trader Steve Wunsch makes an impassioned plea that the USA return to past meth-

ods that underscored its “Liberty” and prosperity.

IS the stock market rigged? Are inter-est rates, currencies and commodities manipulated and rigged, too? Yes, say regulators. But not to worry, they say. We’re onto it. We’re writing new rules and fining the perpetrators billions. Soon we’ll put a few behind bars, so this never happens again. Should we breathe a sigh of relief? Or should we worry anew? Unfortunately, we should worry.

In my new book, Life, Liberty and the pursuit of Inequality, I show how the freedoms of the English-speaking peoples led to pros-perity precisely through the ability of stock exchange founders to design and run their markets as they saw fit, without input or oversight from regulators. Did this result in rigging? Yes, it did. But their rigging created the paradigm that enabled London and New York to lead their countries and, ulti-mately, the world, toward the first glimmers of self-sufficiency and wealth for all.

That paradigm, which I call the “do-it-yourself monopoly”, first appeared tenta-tively around 1690 in London as forerunners of the London Stock Exchange, and then

moved around 1790 to New York as fore-runners of the New York Stock Exchange, but this time explicitly, as evidenced by such documents as the Buttonwood Agreement. As the “do-it-yourself monopoly” reached full flower with the robber barons in the latter part of nineteenth century America, it underwrote a succession of the world’s wealthiest men and the world’s biggest businesses, as the United States became the world’s greatest economic power.

Principles of liberty abandonedToday, the evident economic malaise of the wealthy western countries is traceable to their having abandoned the principles of freedom that made them wealthy, in par-ticular with regard to how they design and run their capital markets. The collapse of the US initial public offer (IPO) market’s abil-ity to fund new technology companies and industries is examined in detail and seen as the clear consequence of this abandonment. And the rest of the west is following the US’s lead in this and many other instances incompatable with notions of “liberty”.

Scores of global regulators, including


over a dozen in the United States alone, are now pushing principles pioneered over the last four decades by the US Securities and Exchange Commission (SEC). Following the SEC’s guidance, they are reshaping capital markets so as to eliminate manipulation, rigging, spoofing and other vestiges of old-fashioned human intermediation as they force markets to be transparent, fair, com-petitive and, above all, electronic.

Over-regulation dooms economiesThe regulators are confident they are on the right track, and have thousands of pages of laws and regulations to back them up, such as Dodd-Frank and the National Market System in the US, the Markets in Financial Instruments Directive (MiFID) in Europe, and similar rules in Canada, Australia and other countries. But the problem is that these well-meaning regulators are actually eliminating the whole value that markets once had to society, which was to create new companies and jobs.

Thus, regardless of whether govern-ments succeed with their extraordinary fiscal and monetary interventions, such as auster-ity and quantitative easing, the big surprise will be that the intervention they are most certain of – bringing transparency, fairness, efficiency, etc. to capital market structure – will in fact be what dooms their economies.

Imaginary harmsAnd the confidence they are trying to revive will not do so, because lack of confidence is now a permanent accompaniment of regu-lators’ political ambitions, a self-perpetuating narrative that constantly renews itself on their alleged ability to address what I show

to be imaginary harms. Investors never did complain about regular continuous equity market trading costs, which always had seemed low and reasonable to them.

Now, under high frequency trading (HFT), costs are down 90 per cent from where they were – and the public is furious. They hear HFT is a rigged game, so they know they’re getting ripped off somehow, even if they’re not, and even though they have no way of assessing the practical value to them of the SEC’s complex and confusing creation.

And why would anyone complain about fixings, when everyone got the same price whether they were buyers or sellers? The answer is, they didn’t. There was safety in numbers in those fixings: lots of people both buying and selling at the same time and price. So they naturally trusted the bankers who got them the fixing price. But regula-tors saw that intermediaries must have been making something somewhere, so they busted the bankers for rigging.

Loss of safety in numbersCustomers now see in the news that bank-ers are abandoning fixings and skittish about participating lest they get fined again. And since everyone now knows fixings are rigged, courtesy of the reformers’ self-justi-fying narrative, customers are less interested anyway. The net effect is that fixings are los-ing the safety-in-numbers characteristic that was their chief attraction.

In short, in order to restore confidence, regulators created HFT in stock markets, which all investors hate, and they turned fix-ings into fraught affairs that customers are scared of. But never mind confidence. The


regulators’ accidental assault on confidence is the least of our worries, as I show in some detail by looking both back a few centuries to see how markets should be run, and then ahead to the future to show what we will be missing by having them run by regulators on opposite principles.

Historical drivers of prosperityIf markets had been run on the principles of modern regulators when they were form-ing, they would not have formed in the first place. And since, as I also show, the exchanges were the essential triggers of the Industrial Revolution, blocking them would have prevented the Industrial Revolution from emerging, which would have meant that this extraordinary historical event that began lifting the world’s people out of seem-ingly permanent and universal poverty, would not have happened, either.

As demonstrated by my re-examination of some authoritative but overlooked his-torical works, the principles that pertained when the New York Stock Exchange and London Stock Exchange were forming are the key to understanding such mysteries as what triggered the Industrial Revolution in the first place, why it was originally only a British phenomenon, and why it eventually left Britain and settled in America.

Killing, actual killingThis chain of logic also shows that modern regulation would have prevented the emer-gence of the British Empire and the United States as dominant economic powers. But these are not just retrospective curiosities. As I also show, the same regulatory princi-ples are killing the prospects for prosperity

today across the world, with the United States leading the downturn. And it’s not just money.

The same forces that are killing jobs are also behind the killing, actual killing, of many people. The tolerance of inequality that America’s founders and the British before them invented with their freedoms was not only the foundation of prosperity, but it was also the foundation of peace.

Its absence today is the cause of the national and global conflicts over inequality that underlie the “haves versus have-nots” disputes that are erupting in violence from Ferguson, Missouri to Paris, France, to Iraq and Syria. The English-speaking peoples once led the world’s peoples to tolerance for inequality. The question now is, can they lead them back?

We can turn back the tideThe signs are not positive. On current trajec-tory, the more likely evolution of the global disputes over inequality, of which the War on Terrorism is both a cause and a consequence, is toward atrocities that will result in millions of deaths. While these trajectories cannot be altered by “democratic debate”, as advo-cated by the likes of France’s Thomas Piketty – Capital in the Twenty-First Century – and other inequality gurus, I suggest there is a way to rescue the nations and peoples of the world from these impending tragedies. And that is by eliminating the cause of our current problems: the SEC.

By removing this scourge, we can break up the logjam blocking both the free flow of capital and the human interaction of indi-viduals working to improve themselves that is the real source of peace. •


Letter from an economist

Is a government surplus sustainable, never mind desirable?

Heterodox economist Prof. Steve Keen shows how government obsession with surplus

budgets is antithetical to financial stability.

THE preventive arm of the European Union’s Stability and Growth Pact speci-fies the requirement of a “close to balance or in surplus” position for member states’ government budgets. In this “opinion brief”, I want to consider whether a sus-tained government surplus is possible, by considering its monetary impact on the private sector.

In order to simplify this analysis I will ini-tially ignore the external sector (exports and imports plus net foreign payments), and divide the economy into two sectors, these being the private sector and the government sector. If the government runs a surplus, then government taxes on the private sector exceed the subsidies paid to it by the gov-ernment. This necessitates the running of a deficit by the private sector with the govern-ment. Let’s call the difference between taxes and government subsidies “NetGov”. The flow of funds to the government of NetGov has to be matched by a private sector defi-cit of exactly the same amount, as shown in Figure 1 (where a surplus is shown in black and a deficit in red).

The question now arises as to how exactly the private sector generates the flow of money needed to finance the government surplus. It could run down its existing stock of money; but that means a shrinking private sector, when the objective of the govern-ment surplus is to enable economic growth to occur.

So for the government to run a surplus, and for the economy to grow at the same

Government:surplus = NetGov

Private:de�cit = NetGov

Figure 1: A two-sector picture of the economy.


time, the private sector has to produce not only enough money to finance the govern-ment surplus, but also enough money for the economy to grow as well.

How can it do this?There is only one method to achieve this, namely the non-bank subsector has to bor-row money from the bank subsector. As the Bank of England recently emphasised, bank lending creates money (see Money Creation in the Modern Economy, Michael McLeay; Amar Radia and Ryland Thomas, Bank of England Quarterly Bulletin, 2014 Q1, pp.14-27). Bank creation of money by lending must therefore exceed NetGov.

To represent this we need a three-sector model, with the non-bank sector borrowing from the banks. Let’s call the flow of funds from the banking sector to the non-bank sector “NetLend”. Then for the government

to run a surplus, and for the private non-bank sector to grow at the same time, the banking sector has to run a deficit: new lending (money going out of the banking sector) has to exceed loan repayments and interest (money coming into the banking sector). This situation is shown in Figure 2.

Indebtedness to banksThe private sector’s money stock is grow-ing at the rate of NetGov + NetLend, but its indebtedness to the banks is growing at the faster rate of NetLend (since NetGov is negative). This combination of a growing economy, and a government sector surplus, means that the rate of growth of private sec-tor debt has to exceed the rate of growth of the private non-bank’s money stock. The private sector’s net indebtedness must there-fore grow faster than the economy.

Clearly this cannot go on forever, for at some point the non-bank sector will stop

Government:surplus =NetGov

Private:surplus =

NetGov + NetLend

Banks:de�cit =NetLend

Figure 2: A three-sector model to explain how the private sector can finance a government sector surplus and still grow.


Private:de�cit =

NetGov + NetLend

Banks:surplus =NetLend

Figure 3: A shrinking private sector whereby the private sector desists from borrowing and repays debt.


borrowing, or attempt to “de-lever”. Then the banking sector ceases running a deficit and instead runs a surplus, as does the gov-ernment. This necessitates a private sector deficit: outflows of money from the private sector exceed inflows and its money stock shrinks. That situation, which is incompat-ible with a growing economy, is shown in Figure 3.

Tipping pointTherefore, we can see that the medium-term consequence of a government running a sustained surplus is an economic crisis when the private sector is unable or unwilling to continue going into debt – a tipping point.

The only way to avoid this situation is if the external sector – which we’ve ignored till thus far – is in deficit with the nation: pay-ments by the country to the rest of the world amount to less than its receipts from the rest of

the world. Let’s call the balance of payments “NetExt”.

The banks, the government and the private sector can all run surpluses if NetExt is bigger than the government surplus and the scale of private sector deleveraging.

This situation, shown in Figure 4, is sus-tainable for some countries in isolation, but not for all, since the sum of all external sector deficits must be zero. Therefore, in general, a sustained government surplus is not sus-tainable, since it will lead to a private sector debt crisis. By the process of elimination, the only long term sustainable situation is that shown in Figure 5: both the government and the banking sector must run deficits, while the private non-bank sector runs a surplus.

In a monetary economy, it follows that the only sustainable policy is that the gov-ernment runs a deficit, where the size of the deficit is related to the desired rate of economic growth. •


Private: surplus =NetExt + NetGov +

NetLend

Banks:surplus =NetLend

External:de�cit =NetExt

Figure 4: A shrinking private sector when the private sector desists from borrowing and repays debt.

Government:de�cit =NetGov

Private: surplus =NetExt + NetGov +

NetLend

Banks:de�cit =NetLend

External:balance =

NetExt

Figure 5: The sustainable long-term situation – deficits by banks and the government.

Comment

Stock-listing in China post-Alibaba hurrah

State University of New York’s Sara Hsu, gives a brief analysis of what 2015 may offer in terms

of stock market growth and pitfalls in China.

CHINA’S stock exchange rallied at the outset of 2014, marking the largest start of the year rally since 1993. This has been attributed in part to the govern-ment’s announcement on December 31 that it will allow first-time small home buyers to be eligible for housing fund loans. Relaxation of price controls on railway bulk cargo, packages and pri-vately invested cargo were also behind the stock surge. However, the rally belies the existence of underlying deterrents to listing on the Shenzhen and Shanghai stock exchanges.

Alibaba’s case illustrates this problem. Alibaba officially listed on the New York Stock Exchange in the United States in September of 2014, and not on the Shenzhen or Shanghai stock exchanges in mainland China, to the chagrin of many yield-seeking Chinese citizens. As Alibaba’s listing under-scores, China’s domestic stock exchanges remain unappealing IPO destinations for many a business. Excessive listing rules and procedures coupled with inadequate super-vision and presence of fraud and insider

trading, have rendered the Chinese stock markets a second-best choice for competi-tive and innovative companies. But there’s potential.

China’s stock market is the third largest in the world by market capitalisation, weighing in at some US$3.7 trillion in 2013. However, despite recent reform proposals that have attempted to improve the listing process by proposing a registration-based listing sys-tem that would allow companies that meet criteria for making a public offering (instead of the current system in which the China Securities Regulatory Commission approves IPOs), China’s stock market remains one of the poorest performing stock markets in the world. This fact can be easily discerned from a quick glance at the MSCI Index, cal-culated by Morgan Stanley, and even in the Shanghai Composite Index itself.

The stock market has often been criti-cised for channelling funds to state-owned companies and their subsidiaries, via other state-owned companies that purchase shares. This does not reflect a market-based environment, but rather is reminiscent of earlier practices of earmarking bank loans


for state enterprises. Insider trading is also a problem, as is accounting fraud. A recent crackdown on “rat trading” has sought to eradicate fund managers’ practice of pur-chasing shares using personal accounts and selling them for a profit once they gain in value. Accounting fraud presents investors with incorrect information, including incor-rect revenue recognition and fraudulent asset information, among other abuses.

Potential for improvementChina’s stock market does have potential to improve. Despite being branded early on as a ‘casino’ by Wu Jinglian, a Chinese economist, and others, in which speculation, accounting fraud, and stock price manipu-lation play a large role, Carpenter, Lu, and Whitelaw (2014) show that stock prices are now informed by real indicators of risks and returns.

In addition, Ya, Ma and He (2014) find that herding behaviour, in which investors mimic the behaviour of others by making the same stock purchasing choices, is not an issue in Shanghai’s and Shenzhen’s A-share stock markets. These are positive findings that show the market is developing in some fundamental ways. These findings dem-onstrate that while the companies that list on China’s stock market may be inefficient or distorted, and the process that lists the companies may be slow and cumbersome, the market itself prices risks and returns efficiently.

Important implicationsPoor performance can likely be chalked up to the underlying companies them-selves. Although subject to further rigorous

analysis, this conclusion has important impli-cations. This means that if stock market reform improved the quality of companies that list, performance may improve. This resonates with research that shows that listed non-state owned firms perform better on China’s stock markets than do state-owned firms.

Enhancing accounting and auditing standards of listed companies and encour-aging the listing of innovative companies over static state-owned companies would increase the quality of China’s stock markets and prevent the financial “brain drain” that China has recently experienced as the most innovative companies have listed outside of the country. As China restructures, it is criti-cal that innovative companies have sufficient access to funding. Further reform of mainland stock exchanges will benefit both the listing companies themselves and China’s financial economy.

Stock market alluring optionIf indeed, as research shows, the stock mar-ket is now efficient, then deepening capital markets through the stock market should not be an impossible task. There is an increasing possibility that the stock market will grow up to be quite an alluring option.

Indeed, some analysts have predicted a bull market for Chinese stocks in 2015 as economic conditions in China, the US, and Europe generally improve, notwithstanding the recent oil-induced panic. Looser domestic monetary policy and a larger reform agenda can play a role in enhancing China’s economic outlook. Capital markets are also expected to become more international. Coupled with reform of the stock market itself, these policies may lead to additional stock growth in 2015. •

Comment

Living wills are very much a live issue for regulators

Mayra Rodriguez Valladares of MRV Associ-ates stresses that “living wills” have not gone away and remain on the regulatory agenda.

AT a Washington conference on finan-cial reform last November, Jeremiah O. Norton, a member of the board of the Federal Deposit Insurance Corporation, was asked what the US midterm elec-tions meant for ending “too big to fail”. He demurred that he was not in a posi-tion to comment on what elected officials may or may not do. What he said next, however, really tells me that irrespective of election results, bank regulators like him are determined to carry on with their ambitious bank reform agenda. “I intend to do my job today and tomorrow like I did yesterday, trying to make the bank-ing sector safer for Americans,” he said.

When attending panellists were asked if they have ended the problem of “too big to fail” banks, they all agreed with Mr. Norton on the view that “we are not where we should be” in terms of financial reforms.

In the eyes of an array of academics and regulators at the conference, globally systemically important banks remain too large, significantly leveraged, interconnected globally and reliant on wholesale lending.

Moreover, the 11 largest banks in the United States have not been able to write credible bank resolution plans, commonly known as living wills, that would explain to regulators how they could be resolved across multiple jurisdictions around the world in an orderly manner and without taxpayers supporting them.

Jeffrey Lacker, the president of the Federal Reserve Bank of Richmond, made it clear in his keynote address that to end the problem of “too big to fail”, we need to stop thinking that bankruptcy is not a viable option for banks.

Noting that the Dodd-Frank Act lays out a path to make bank resolution possible, he said that the process had already proven valuable, because some banks have been reorganising and getting rid of unnecessary subsidiaries.

In a revealing comment, he said that liv-ing wills should not assume that the current banking structure was a given. That seemed to be a hint that if banks do not make their wills credible, regulators could force banks to have simpler structures that could be resolved more easily if in a stressed situation.


When I asked Mr. Lacker what would happen if by next year big banks’ living wills are still not credible, he emphasised that both the Federal Reserve and the FDIC had tools under Dodd-Frank that they could use to compel banks to make necessary changes. He added that it “may take more guidance from the bank regulators.”

“We are both still learning in the process,” he said. For banks to rely less on short-term funding or to make changes in their subsidi-aries will not be popular, said Mr. Lacker, but “the changes are feasible.”

Other speakers at the conference were not as optimistic about banks making the necessary changes needed to protect taxpay-ers. A Stanford professor, Anat R. Admati, expressed her concern about whether “banks even know themselves well enough to write credible wills.” She also emphasised that banks have been “travelling at an explo-sive speed for no reason.”

“We keep talking about hospitals and backstops if banks implode, but we do not talk enough about speed limits,” that is, the needed regulations “to curb their reckless behaviour for the sake of society,” she said.

From a regulatory perspective, a num-ber of challenges exist to credible living wills. Regulators do not have an answer as to whether they and governments would cooperate effectively in the event that a large global bank had to be resolved in multiple jurisdictions.

When there is market stress, the fear is that regulators might “ring fence” good assets, irrespective of what that might do to the liquidity and normal functioning of a bank’s subsidiary in another country.

Although the International Securities

Dealers Association has made significant strides to work with the industry on how derivatives contracts would be managed during a resolution, to avoid the kind of chaos that ensued during the bankruptcy of Lehman Brothers, what will really happen is still a big unknown to many, including both bankers and regulators.

Moreover, where liquidity would come from during a bank resolution is also a big question. If banks could access the Federal Reserve discount window, that would imme-diately turn out to be like a bailout. Yet, if there is a market perception that the govern-ment or regulators will provide any liquidity, that might exacerbate market stress at a time that we want to calm markets down.

According to Mr. Thomas Hoenig, the vice chairman of the FDIC, a bank resolu-tion “will mean making difficult choices”. During his keynote speech, he said that his agency was compelled to declare that the living wills of the banks were not credible, because of the erroneous assumptions that banks made.

Some banks “lack understanding about relying on government support” during a res-olution, he explained. He was asked whether he still stood by his comments of last March at Boston University, that the contents of banks’ living wills should be made available to the public. Without hesitation, he said yes, adding that, if banks felt that there was infor-mation that was truly proprietary, “then they need to make a convincing case as to why that information should not be disclosed.”

At least that way the market could then possibly have a chance of exerting market discipline if it were not satisfied with the opacity of banks’ living wills. •

Comment

The end of (monetary) history: Bretton Woods 70 years on

Prof. Erinç Yeldan of Bilkent University laments the demise of the “Bretton Woods” agreement and

subsequent ascent of global financialisation.

AS we bid farewell to 2014, it may prove worthwhile to celebrate the 70th anniver-sary of one of the most innovative and exciting episodes of homo economicus: the Bretton Woods Monetary Conference. Hosted in 1944 at the Mount Washington Hotel in New Hampshire, USA, the con-ference established the World Bank and the IMF (later referred to as the “Bretton Woods Institutions”) and set the gold standard at US$35.00 an ounce with fixed rates of exchange to the US dollar.

Based on John Maynard Keynes’s famous dictum, “let finance be a national matter”, and on the productivity advances of Fordist technology and institutional structures, the global economy expanded at a fast rate over the postwar era, from 1950 to the mid-1970s. Per capita global output increased by 2.9 per cent per year over this period, which later came to be referred to as the “Golden Age of Capitalism” .

The conditions that created the Golden Age were exhausted by the late 1960s, however, as industrial profit rates started to decline in the USA and Western Europe due

to increased competition, particularly from the Asian “tigers” or “dragons”– South Korea, Taiwan, Hong Kong, and Singapore. In the meantime, Western banks were severely constrained in their ability to recycle the massive petro-dollar funds and the domestic savings of the newly emerging baby-boom generation.

Trumpets of doomTrumpets for the “end of financial repression” intensified with the so-called McKinnon-Shaw-Fama hypotheses of financial deregu-lation and efficient markets. A global process of financialisation was commenced, lifting its logic of short-termism, liquidity, flexibility, and immense capital mobility over objec-tives of long-term industrialization, sustain-able development, and poverty alleviation with social-welfare driven states.

A number of leading economists, among them Joseph Stiglitz, Daron Acemoglu and Gerald Epstein, had long cautioned against the dangers of excessive financialisation and deregulation. Under the new finan-cialised capitalism regime, loanable funds are increasingly diverted away from the real


sphere of the economic activity and towards speculative finance.

Casino capitalismThe global economy has grown too slowly and allocated too small a portion of its scarce savings into physical fixed investments that would enhance employment and gener-ate incomes for the working poor. An ever-increasing portion of global profits are now generated from speculative finance, rather than productive activities.

According to the International Labour Organisation’s estimates in the World of Labour Reports, financial profits currently constitute almost 50 per cent of aggregate profits. This ratio was only a quarter in the early 1980s.

As accumulation patterns diverged away from industry towards speculative finance, employment faltered and the global econ-omy entered a phase of “casino capitalism” with international productivity gaps being maintained due to structurally persistent differences in physical infrastructure and human capital.

Great RecessionWe know where this story led. As the specu-lative bubbles of finance erupted in 2008, a real-sector crisis developed that would lead to what has been labelled by many as the “Great Recession”. Output declined in 2009, for the world as a whole, for the first time since the 1930 crash. Some 20 million people were added to the reserve army of the unemployed, bringing the total to above 200 million, or 7 per cent of the global labour force.

The main policy intervention in response

to the crisis – monetary expansion – was again based on the conventional recipes of the Bretton Woods system. Under a policy referred to for public relations reasons by the esoteric name of “quantitative easing”, the US Federal Reserve amassed a total of US$3 trillion worth of assets from the finance markets. This equalled roughly 20 per cent of US GDP. In turn, interest rates fell all around the globe to virtually zero; yet unemployment barely fell to the pre-reces-sion levels, despite the fact that the labour-force participation rate was reduced sharply to its 1970s level.

The “end of history”These large monetary interventions barely made a dent in the real sector, with GDP in the USA and elsewhere remaining stagnant throughout the Great Recession. Figures from the US Bureau of Economic Analysis detailing the US monetary base, its GDP and the Fed Effective Interest rate for the years from 2006 through to 2014 make for uncomfortable reading. They illustrate viv-idly, the most decisive example of the “end of history”– monetary history, that is.

The dramatic expansion of the monetary base and the equally dramatic collapse of interest rates are clear. Everything works in textbook fashion up to that point. But the effect in terms of real output is overwhelmed by the conditions of the Great Recession.

In the absence of an effective real rise of investment demand, the expansion of mon-etary base and the collapse of the interest rates have had a negligible effect on GDP.

That means that the instruments of monetary policy are virtually powerless. What a nightmare for a central banker! •

Comment

European Union’s economic folly threatens continental chaos

Columbia University’s Prof. Joseph Stiglitz believes urgent reform of the Eurozone is nec-

essary if it is to avoid certain catastrophe.

AT long last, the United States is show-ing signs of recovery from the crisis that erupted at the end of President George W. Bush’s administration, when the near-implosion of its financial system sent shock waves around the world. But it is not a strong recovery; at best, the gap between where the economy would have been and where it is today is not wid-ening. If it is closing, it is doing so very slowly; the damage wrought by the crisis appears to be long term.

Then again, it could be worse. Across the Atlantic, there are few signs of even a modest US-style recovery: the gap between where Europe is and where it would have been in the absence of the crisis continues to grow. In most European Union countries, per cap-ita GDP is less than it was before the crisis. A lost half-decade is quickly turning into a whole one. Behind the cold statistics, lives are being ruined, dreams are being dashed, and families are falling apart (or not being formed) as stagnation – depression in some places – runs on year after year.

The EU has highly talented, highly

educated people. Its member countries have strong legal frameworks and well-function-ing societies. Before the crisis, most even had well-functioning economies. In some places, productivity per hour – or the rate of its growth – was among the highest in the world.

Self-inflicted malaiseBut Europe is not a victim. Yes, America mismanaged its economy; but, no, the US did not somehow manage to impose the brunt of the global fallout on Europe. The EU’s malaise is self-inflicted, owing to an unprecedented succession of bad economic decisions, beginning with the creation of the euro. Though intended to unite Europe, in the end the euro has divided it; and, in the absence of the political will to create the institutions that would enable a single currency to work, the damage is not being undone.

The current mess stems partly from adherence to a long-discredited belief in well-functioning markets without imperfec-tions of information and competition. Hubris has also played a role. How else to explain


the fact that, year after year, European offi-cials’ forecasts of their policies’ consequences have been consistently wrong?

Badly flawed modelsThese forecasts have been wrong not because EU countries failed to implement the prescribed policies, but because the models upon which those policies relied were so badly flawed. In Greece, for example, measures intended to lower the debt burden have in fact left the country more burdened than it was in 2010: the debt-to-GDP ratio has increased, owing to the bruising impact of fiscal austerity on output. At least the International Monetary Fund has owned up to these intellectual and policy failures.

Europe’s leaders remain convinced that structural reform must be their top prior-ity. But the problems they point to were apparent in the years before the crisis, and they were not stopping growth then. What Europe needs more than structural reform within member countries is reform of the structure of the eurozone itself, and a rever-sal of austerity policies, which have failed time and again to reignite economic growth.

Those who thought that the euro could not survive have been repeatedly proven wrong. But the critics have been right about one thing: unless the structure of the euro-zone is reformed, and austerity reversed, Europe will not recover.

Democracy deniedThe drama in Europe is far from over. One of the EU’s strengths is the vitality of its democ-racies. But the euro took away from citizens – especially in the crisis countries – any say over their economic destiny. Repeatedly,

voters have thrown out incumbents – dis-satisfied with the direction of the economy – only to have the new government continue on the same course dictated from Brussels, Frankfurt, and Berlin.

But for how long can this continue? And how will voters react? Throughout Europe, we have seen the alarming growth of extreme nationalist parties, running counter to the Enlightenment values that have made Europe so successful. In some places, large separatist movements are rising.

Now Greece is posing yet another test for Europe. The decline in Greek GDP since 2010 is far worse than that which confronted America during the Great Depression of the 1930s. Youth unemployment is over 50 per cent. Prime Minister Antonis Samaras’s gov-ernment has failed, and now, owing to the parliament’s inability to choose a new Greek president, an early general election will be held on January 25.

The left opposition Syriza party, which is committed to renegotiating the terms of Greece’s EU bailout, is ahead in opinion polls. If Syriza wins but does not take power, a principal reason will be fear of how the EU will respond. Fear is not the noblest of emotions, and it will not give rise to the kind of national consensus that Greece needs in order to move forward.

The issue is not Greece. It is Europe. If Europe does not change its ways – if it does not reform the eurozone and repeal austerity – a popular backlash will become inevitable. Greece may stay the course this time. But this economic madness cannot continue for-ever. Democracy will not permit it. But how much more pain will Europe have to endure before reason is restored? •

Advisory - Asia IT focus

Regulatory change is a business opportunity, not a burden

Singapore-based Amit Agrawal highlights some of the pressing regulatory and compli-

ance issues banks must face during 2015.

NAVIGATING the compliance, regu-latory and operational risk landscape has, without doubt, poised the biggest headache for senior management and front-line staff within financial institu-tions since the plethora of reforms imple-mented after the 2008 financial crisis. And the pressures aren’t likely to ease any time soon, given the ongoing wide-spread compliance failures over the past 12 months.

Gazing back through 2014, one can only be but amazed at the amount of regulatory reform and gains made, despite widespread scepticism and intense industry blow-back.

Among the key achievements of 2014 has been the successful deployment of Basel III across the European Union and other reforms emanating out of the European Commission. These have paved the way for a reduction of systemic risk through meas-ures relating to the safety and soundness of both banks and market infrastructure and to the effective resolution of failing banks; advancing the wholesale and retail conduct regimes; and setting out the supervisory stall

for assessing risk governance, risk culture and risk data.

Looking forward to 2015 and beyond, it’s apparent that reforms to date constitute only the beginning of a long journey ahead, rather than the end of the road. Both the USA and the European Union continue to issue forth with further reforms, compounded by new initiatives emerging from the G20 gatherings and the Basel Committee in Switzerland. All of this fuels further uncertainty, thus making it difficult for institutions to plan ahead and allocate resources.

Avoid over-complexityAs the Basel II compliance process dem-onstrated prior to the onset of the 2008 financial crisis, large whole scale regulatory change programmes must take a firm-wide, business-focused view if they are to be suc-cessful. Any operational and technology change should run in tandem with business model reviews to enable a more structured, effective and cohesive outcome that helps avoid over-complexity.

Glancing back to 2014 once more, there is little doubt what proved the greatest


headache to senior management, compli-ance and operational heads and risk manag-ers in financial institutions. And there will be no let-off this year, as illustrated by the fol-lowing analysis.

Exponential IT investmentOne of the most pressing issues during 2014, and which remains true during 2015 is IT expenditure and exponential costs associ-ated with it, as risk and regulation continue to demand large-scale technological invest-ment to comply with the new regulatory environment we find ourselves in. Chartis forecasts that global risk IT expenditure in financial services will rise by 14 per cent and exceed a spending level of US$30 billion, by the close of 2015.

Much of this growth will be accounted for by businesses in North America, with financial institutions picking up most of the pace in an effort to mitigate against stiff fines and penalties imposed by various regulatory agencies and the US Department of Justice, together with State supervisors and enforce-ment agencies. Thomson Reuters estimates that US authorities imposed penalties and settlements fees that cost financial services firms more than US$40 billion.

Highest growth in Tier 1 banksThe highest growth in spending is expected to be amongst the Tier 1 firms who have been among the greatest offenders, many of which remain firmly in the crosshairs of regulators and enforcement agencies. It’s expected that these firms alone will increase expenditures by some 24 percent compared with 2014 outlays, whilst Tier 2 and Tier 3 firms are expected to increase expenditures

by 9 per cent and 10 per cent respectively, according to the Chartis research.

In total, it was estimated that financial institutions in the United States invested more than US$28 billion on automated risk management and regulatory IT systems dur-ing 2014, and that this figure is expected to rise to nearly US$32 billion through 2015.

Next of our pressing issues is costs asso-ciated with “capital” and “liquidity”. Liquidity monitoring for financial institutions is a key to profitability for many firms. It can reduce credit/settlement risks during large value payments and managing bank’s cash inflow/outflow. The implementation of liquidity requirements will start from the beginning of this year and is expected to be finalised by 2019.

LCR, NSFR & leverage ratioThe following is just a back-of-an-enve-lope exercise in liquidity ratios that banks and financial institutions need to begin implementing as of now: first, we have the Liquidity Coverage Ratio (LCR). This is a mandate whereby banks are expected to maintain a minimum 60 per cent LCR, which will increase by 10 per cent each year through to 2019, at which time the LCR will constitute 100 per cent.

Next, we have the Net Stable Funding Ration (NSFR). 2015 will kick-start this initiative, with this year and 2016 being an observation period, after which banks and financial institutions will be required to report their NSFR positions. From January 2018 banks will be expected to hold suffi-cient stable deposits to fund all their long-term lending.

Finally, we have the “leverage ratio”;


as of January this year onwards, banks are required to report their leverage ratios in any and all financial statements. This will become a binding requirement by 2018. Presently, the Basel Committee has proposed it to be 3 per cent of a banks tier 1 capital. However, heightened financial concerns mean this minimum requirement may be revised upwards and is thus likely to change.

CentralisationAnother pressing concern for banks and financial institutions is their “centralised risk/compliance operation model”. Outsourcing and shared services is a more than two dec-ades old strategy to improve back-office efficiency. Financial institutions use different operational models and approaches for this method to work consistently.

Each model has its own set of merits/demerits and thus it is vitally important that operational models be aligned with the organisational strategy.

It’s expected that outsourcing will reduce in relevance as more and more businesses move to more centralised operational mod-els, aligning them with the rest of their business to better manage risk and make efficiency savings, thus driving down overall costs.

Reports, reports, reportsNext on our pain index is regulation and supervision. Moving through 2015, it’s anticipated that regulators will require banks to provide more and more reports of their activities, in line with new regulatory require-ments, which obviously translates to more supervision. This will place another burden on the banks in terms of people, systems and

quality assurance to support such reporting. This will also have a direct impact on bank-ing procedure for data capture, data recon-ciliation (across system/regulators), control process and review/governance procedures. A pressing question that needs to be answered during this process is about the ability of banks and financial institutions to aggregate risk quality accurately and across risk types, activities and geographies and to use this information to manage emerging risks. One should not think of it as a busi-ness burden and cost centre; rather, it should be viewed as a business opportunity to add to the bottom line.

Overlap and underlapMoving on, our next topic of concern is gov-ernance. As a result of the 2008 financial crisis, banks have been pressurised by regu-lators to introduce enhanced risk manage-ment structures and reporting procedures, many of which are “new”, shall we say, with clear roles and responsibilities. This has led to increased overlap and underlap in many institutions as they struggle to cope with the plethora of imposed changes.

The silver lining in all of this is that, given the huge amount of work undertaken thus far, best procedures and practices are emerg-ing, thereby allowing for benchmarking and for banks to raise the bar in terms of risk management and risk governance.

As such, our maxim should read:” A well- governed bank takes the amount of risk that gives maximum value to shareholders, subject to constraints imposed by laws and regulations. “

Nearing the end of our pain thresh-old, our next pressing concern focuses on


“culture and conduct”. It is to be hoped that during the course of 2015, banks will spend more time building “business-focus change capabilities” so that they can address the regulation challenge more effectively and in a timely manner during a period of extreme flux.

People of the right calibreBanks need to ensure they hire the right people for the job. Although time lines for the implementation of new requirements are strict and aggressive, properly addressing this challenge requires assembling the right team of experts with a sound understand-ing of compliance, firm-wide risk require-ments, process excellence and technology capabilities.

This is of particular importance as focus shifts from defining the regulatory response to implementation and execution. While there remains a vital role for compliance in interpreting new regulatory requirements, this should not be to the detriment of build-ing a true change capability

Nearing the finish line, our final area of concern is that all-encompassing one of infrastructure and infrastructure redesign.

Silo effectIt’s a well known fact within the industry that different divisions within banks have histori-cally been re-creating rather than sharing systems.

This problem is further compounded by mergers that result in banks inheriting numerous IT systems and processes, thus adding to complexity, system architecture and army of staff required to service them – which equates to a lot of inefficiencies. It‘s

to be hoped centralisation and cost-sharing will eliminate much of this inefficiency and reduce costs in the long run.

The new regulatory paradigm is meant to achieve a safer, more stable banking envi-ronment, protecting the banks, shareholders and taxpayers alike from the horrors of 2008. In this new era, banks need to change their approach to executing regulatory change, and recognise it as opportunity which enhances the underlying business model.

To do this successfully, banks must rec-ognise the symbiotic relationship between process efficiency and compliance, and build into the foundations of every change pro-gramme a clear view not only of the regu-latory imperative, but where it aligns with a client or business improvement goal.

A clear strategyThis is not an immediately obvious relation-ship, but there is a clear link between achiev-ing successful regulatory change and driving process improvements.

Furthermore, this illustrates how process improvement is an essential component of any solution, helping banks to achieve long-term compliance and true business benefit. Investment banks dealing with the current high volume of regulatory reform must turn their current challenges into opportunities to drive strategic change.

By moving away from a short-term, fragmented approach to implementing reg-ulatory change programmes, and building a clear strategy that uses process improve-ment as a means to achieve compliance, banks can begin to reduce the complex-ity, and cost of their response to the new regulatory environment. •

Advisory - BCBS 239

BCBS 239: How to simplify your data architecture

Markit’s COO, Paul McPhater, details four key areas banks must focus on if they are to achieve

BCBS 239 compliance by January, 2016.

THE crux of BCBS 239, set forth by the Basel Committee on Banking Supervision (BCBS), is the laying down of standards for risk data aggregation and reporting. Data is at the heart of it, and it’s an opportunity to look at the cost and synergies of data and improve the deci-sion-making process enterprise-wide.

Regulatory fatigue aside, the January 2016 deadline for compliance with BCBS 239 is tight. While not currently mandatory for all banks, there are indications that the stand-ards are considered to be best practice for all. There are four key areas: risk data aggre-gation (RDA), risk reporting, supervisory review, and governance; and in this article, we review each in turn.

BCBS 239 dictates that data should be aggregated on a largely automated basis. With so many data sources, legal entities and geographies, this means simplifying current architectures into a single hub. The aim is to enable banks to make much better use of all the data they gather. A central platform will also provide a comprehensive assessment of risk exposures at a global consolidated level.

The quality of data is also under the spotlight, as controls around data accuracy are being tightened. Managing the qual-ity of data is made harder as it is a shared resource. Empowering data creators and users enables them to take ownership of the data. The same standards and rules need to be applied across the enterprise so that data doesn’t need to be cleaned multiple times. Risk should have the same data as the back office, finance, operations or legal.

The system needs to be both flexible and scalable. This is the only way accurate risk data can be produced on an ad hoc basis or during times of stress/crisis for all critical risks, a key requirement of BCBS 239.

There also needs to be sufficient depth and breadth of data for the reporting needs of different parts of the business to be sat-isfied. Different parts of the business need information presented to them in different ways, and the system needs to be able to handle such diversity.

While all of these capabilities may already exist in pockets throughout the bank, best practice now needs to be exe-cuted on an enterprise-wide basis. Sounds


like a challenge? Perhaps. But an enterprise-wide risk data management platform is achievable.

BIS stocktaking reportNext up on our list is the fact that without data that is accurate, reconciled and vali-dated, risk reporting may be useless. In its stocktaking report on BCBS 239 progress at the end of 2013, the Bank for International Settlements (BIS) highlighted how banks had assigned themselves higher ratings on the risk reporting than they did on the cor-responding data aggregation principles.

This raised the question as to how reli-able and useful risk reports can be when the data within these reports and the pro-cesses to produce them are not in place. The reports being produced need to be accurate, clear, complete, useful and frequent. The end game is simple: to enable informed decisions based on accurate information.

When you consider what a risk report usually looks like – a bunch of spreadsheets – and how long it has taken to produce – typically not a quick process, but rather a complex and time-consuming one that hap-pens across silos – the ongoing challenge becomes clearer.

All roads lead back to dataExact reporting requires data that is accu-rate, reconciled and validated. Outside the data architecture issues, an historic reliance on manual processes and inconsistencies in reconciliation procedures also hamper progress. BCBS 239 also requires firms to fully incorporate risk appetite into their risk reporting, which adds an additional layer to the challenge.

Risk management executives must be empowered to make informed decisions, and all roads lead back to the data. As a result, it’s vital that banks have a system in place that can cope with the vast volumes of data across the institution. BCBS 239 is big on interdependencies across all three areas of the principles: governance and infra-structure, RDA, and risk reporting. Without adherence to principles governing data, reporting adherence simply cannot happen.

The third key area on our list, and prob-ably the most contentious as far as senior management and boards of directors are concerned, is the issue of data ownership. Dealing with data is an issue of which senior management has long been aware.

Elephant in the roomAs Moody’s so aptly put it in a report issued towards the tail-end of 2013: “It is often the elephant in the room – a big something to be dealt with, but one that is almost always too big to tackle, or one that is postponed as tomorrow’s problem”.

With BCBS 239, a bank’s board and sen-ior management are now very much cen-tre stage as the owners of the dreaded data problem. And it’s not just the Tier 1 banks that need to take notice; there is an increas-ing belief that this regulation is merely a footnote – that it isn’t the end game.

Under BCBS 239, there are some key questions to which senior managers must know the answer. Among these are: What are the limitations that prevent full risk data aggregation? Do I understand what those limitations are and their impact in terms of coverage? How are the reports I’m read-ing and on which I’m making decisions


impacted by these limitations? Do we have adequate resources deployed to meet the standards required? Have we agreed to ser-vice level standards with our outsourcers? Who has responsibility for what? Is there a stratification of control from executives to management and business leads to day-to-day users?

Not just another regulationAs mentioned, if BCBS 239 is not the end game, then it makes sense for all banks to take notice. The financial crisis exposed risk, data and IT failures throughout the entire community, so looking to BCBS 239 as a starting point for minimum standards of best practice makes sense.

Why would the regulators stop at the global systemically important banks (G-SIBs) or the domestic systemically important banks (D-SIBs)? Surely the ulti-mate goal has to be better risk management for all.

Our fourth and final key area in this paper is the fact that RDA isn’t about mov-ing data; it’s about access – to the source and for the end user. To think of BCBS 239 as just another regulation is to misunderstand its end game. Solving the challenges it lays down requires a strategic approach. RDA needs executive sponsorship, for a start; after all, executives will now be responsible for approving the RDA and risk reporting framework.

Holistic approachA strategic approach will require a holistic mapping of the risk data universe, and this will be no small challenge. Given the dead-line of January 2016 for BCBS 239, the focus

needs to be on accessing data, not moving it.There remains a lot of uncertainty around

how best to tackle BCBS 239. Other regula-tions somehow seem more pressing, and cost is an ever-present issue. A key mind shift that needs to happen is at the executive level.

Given that the boards of banks now have ultimate responsibility for RDA and risk reporting, they will require a greater under-standing of the risk data challenges within their institutions. To achieve that will require an overhaul of data governance which, if applied correctly, should result in significant cost savings in operations and IT.

Mapping out the risk data universe means challenging the data and your people. Where is your data? What data do you have? What data don’t you have? Can you access the data? Do you know its provenance? What are you going to include, and what are you not going to include? What is the data dictionary for the firm? Who owns what? Once all this is determined, the rules and logic must be created, then cleansed, aggre-gated and golden copies created.

Risk data aggregation isn’t about mov-ing data, either; a warehouse isn’t the answer. Risk data aggregation is about access: to the source and for the end user. It all needs to be mapped out and traceable. Data quality is paramount.

During the financial crisis, lack of data quality and data itself was a fundamental issue. Being able to access the right data at the right time and get it to the right people means banks can make more money and lose less money. BCBS 239 is part of risk data aggregation – it’s a great start and all agree it needs to be done. Risk data is in the spotlight and needs attention.•

Regulatory round-up

Hong Kong regulatory year in review and outlook for 2015

Josephine Chung Of Compliance Plus surveys capital market reforms in Hong Kong during 2014 and advises on what to expect in 2015.

SINCE the global financial crisis in 2008, Hong Kong regulators have been consulting to adopt reforms in the Over-the-Counter (“OTC”) Derivatives market and to tighten the reporting and record-keeping obligations of financial institutions. The Hong Kong Monetary Authority (“HKMA”) and the Securities and Futures Commission (“SFC”) jointly set up the new OTC derivatives regime which aims to enhance the stability of the financial market by increasing trans-parency of the OTC derivatives market.

The SFC also proposed amendments to the Professional Investor (“PI”) Regime and further consulted on the Client Agreement Requirements in order to protect PIs ade-quately. Financial institutions are therefore required to review and update their compli-ance policy and procedures in order to reflect the new changes of the SFC regulation.

In January 2014, the electronic trading regulations came into effect, which included the sufficient and adequate management and supervision of the electronic trading systems and the internet trading behaviours;

risk management had to be put in place with adequate monitoring on trade orders includ-ing pre-trade control and post-trade moni-toring; records on the designs, development and operation of the trading system must be kept properly.

The SFC reminded all the licensed cor-porations (“LCs”) to maintain effective poli-cies, procedures and control to monitor the adequate compliance with cross-border business activity and prudent risk manage-ment measures including complying with the “Know your client” and Anti-money Laundering (“AML”) guidelines.

Cybersecurity concernsIn June 2014, all LCs should have an effective business continuity plan implemented in order to ensure that key business functions can be recovered in a timely fashion in case of operation disruptions.

In November 2014, the SFC had height-ened concerns on Cybersecurity issues, and two circulars were delivered to the LCs regarding internet trading security. The SFC demanded the LCs to have formal Information Technology (“IT”) governance


and management policies in place. Adequate information management control, monitor-ing and contingency plan must be put in place to ensure network security and prevent material system failures.

Amendments to “PIs” regimeIn September 2014, the SFC published consultation conclusions on the proposed amendments to the PIs regime. These amendments will come into effect on 25 March 2016. Paragraph 15 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (“the Code”) will be replaced by the new paragraph 15 written in the con-clusion. The new paragraph 15 sets out the terms of exemptions from the Code require-ment on the different categories of investors.

There are two key amendments:1. When dealing with individual PIs, inter-

mediaries will no longer be capable to waive the investor protection provisions of the Code. Thus, intermediaries will be required to treat the PIs in the same manner as the retail investors in order to ensure the suitability of a recommenda-tion or solicitation.

2. The SFC introduced a principles-based Corporate Professional Investor assess-ment (“CPI Assessment”) for the invest-ment vehicles, family trusts and corporate PIs that are not institutional investors.

Further suitability changesApart from the amendment to paragraph 15, the SFC also proposed further suitability requirements to be incorporated in the Code by referencing the client agreements as a

contractual term. A new clause on suitabil-ity and non-derogation will also be inserted into client agreements, and a new paragraph 6.5 will be added to prohibit the inclusion of clauses which are inconsistent with the Code or anything inaccurate or misleading in the description of services.

The effective date and the confirma-tion of the details will be published in the upcoming consultation conclusion on this client agreement requirement.

With regard to preparation for the amendments to the PIs regime, it’s recom-mended that “intermediaries” should now develop and discuss policies and procedures in detail to reflect the change, including the new CPI Assessment, and introduce training for relevant personnel so as to be ready for compliance.

On the other hand, with the pending details and effective date of the client agree-ment requirement, intermediaries should prudently begin reviewing their current agreements for compliance with the new paragraph 6.5 of the Code in advance.

OTC derivatives regulatory regimeIn November 2014, the HKMA and the SFC announced the consultation conclusion on the OTC derivatives reporting and record keeping rules. This consultation conclu-sion set out the mandatory record keeping requirements and reporting obligations for the registered intermediaries/LCs.

The SFC intended to introduce the OTC Derivative Transactions – Reporting and Record Keeping Rules (“Rules”) to the Hong Kong Legislative Council (“LegCo”) for negative vetting in the first quarter of 2015, and expected to commence the relevant


mandatory reporting and record keeping obligations for regulated entities in the first quarter of 2015.

New and expanded licencesFurther public consultation will be con-ducted on the detailed rules for mandatory clearing and related record keeping obliga-tions, as well as the oversight of systemically important participants (“SIP”) and reporting and related record-keeping obligations for Hong Kong persons.

The HKMA and the SFC introduced two new regulated activities (“RAs”): one is dealing in OTC derivative products or advising on OTC derivative products (Type 11) and the other is providing client clear-ing services for OTC derivative transactions (Type 12). They also widen the scope of Type 9 (asset management) and Type 7 (provision of automated trading services).

An application period of 3 months and a transition period of 6 months, starting from the commencement date of the OTC deriva-tives regime, were proposed for the licensed persons to continue their OTC derivative activities for a limited period of time. This allows the SFC and the HKMA to set a time frame for receiving applications and, there-after, to process licensing or registration applications with minimal disruption to the market.

Mandatory reporting productsIn addition, the Rules specified the man-datory reporting obligations in phases by different types of products. The first phase of mandatory reporting covered interest rate swaps (“IRS”), non-deliverable for-wards (“NDF”) and overnight index swaps

(“OIS”). Forward rate agreements (“FRA”) and foreign exchange (“FX”) derivatives other than NDF will be covered in the future phases.

The three pillars of reporting obligations are:1. Persons other than authorised institu-

tions (“AIs”), approved money brokers (“AMBs”) and LCs - the persons based in, or operating from Hong Kong (“Hong Kong persons”) such as dealers.

2. AIs, AMBs and LCs - these are a coun-terparty, or they have conducted business in Hong Kong on behalf of an affiliate, or they have entered in on behalf of a counterparty in their capacity as a person licensed or registered to carry out a Type 9 RA for that counterparty.

3. Central counterparties (“CCPs”) - the recognised clearing houses (“RCHs”) and those authorised to provide auto-mated trading services (“ATS-CCP”)The reportable transactions must be

reported to the HKMA via the Hong Kong Trade Repository (”HKTR”), which is the electronic reporting system developed by the HKMA. However, the SFC also allows the use of reporting agents which could be an overseas TR for the purpose of complying with overseas regulations under this regime.

Hong Kong persons and Type 9 LCs are exempted from the reporting and record-keeping obligation in the first phase.

With regards to record-keeping obliga-tions, the following applies for all reporting entities, other than Type 9 LCs and Hong Kong persons:- Sufficient records to demonstrate compli-

ance with reporting obligations;- Where relying on exempt person relief,


records sufficient to demonstrate that they were entitled to such exemption;

- Where relying on the relief in respect of transactions reported by an affiliate, the confirmation received from the affiliate;

- Records as specified when relying on exemptions or relief related to transac-tions that have matured or been termi-nated during the grace period; and

- Where the reporting was done through an agent, records relating to the agent’s appointment and to demonstrate moni-toring of the agent’s compliance.The records of a reportable transaction

must be kept for as long as the transaction exists and for a further 5 years after the trans-action has matured or been terminated.

Advice for regulatory changesReaders with businesses and operations in Hong Kong overseen by the SFC are advised to plan now (January/February 2015) for the new regulatory environment and heav-ily revised OTC transaction regime. This can be best implemented via the following considerations:1. Consider the licensing requirements

under the new/extended licensing regime- The current Type 9 LCs should consider

whether they need to apply to the SFC for approval to engage in the expanded Type 9 RA. If the current licence is subject to a condition prohibiting the management of futures contracts for investment pur-poses, it is necessary to consider whether to lift the condition or one will still be pro-hibited from investing in listed futures, despite being able to invest in OTC deriv-atives.

- If you currently provide a discrete service

of advice on OTC derivative products, you will also be required to apply the Type 11 RA license.

2. Consider the qualification for deemed licensing

- Be reminded that the corporate applicants that apply to be deemed licensed for Type 11 RA, must have at least two persons who are approved as responsible officers in relation to Type 11 RA, each of whom must have been carrying out the activity of dealing, trading or advising on OTC derivative products in Hong Kong for at least two years immediately before the commencement date of the new regime.

- The Type 9 RA LCs does not require one to show that he/she has been carrying out the activity of managing OTC derivative products in the past, but it does require one to have a responsible officer who has at least 2 years’ relevant experience of managing OTC derivative products in Hong Kong or overseas over the past 6 years immediately before the commence-ment date of the new regime.

3. Business Plan and compliance policies - Business plan should be updated to reflect the addition of expanded Type 9 RA and/or Type 11 RA with details below:

• Description of the types of OTC deriva-tive products that you propose or currently manage and/or advise on• Updated organisation structure showing the licensed persons engaging in the RA of OTC derivative products• Operation procedures for managing and/or advising on OTC derivative products• Brief summary of your history, managing and/or advising on OTC derivative products.• Internal control and contingency plans


in relation to managing and/or advising on OTC derivative products. 4. Mandatory reporting and record-keep-

ing plan:- Review and upgrade the internal infra-

structure to ensure you can identify OTC derivative transactions that need to be reported; collate information that needs to be submitted to the HKTR for each reportable transaction and subse-quent event.

- Consider appointing a suitable agent to report on your behalf. Please bear in mind that you will remain responsible for any failure to report by the agent.

- Revise your record-keeping arrange-ment to ensure that you have kept the

required records in the required form and manner.

- Update your compliance and proce-dures to reflect the mandatory reporting and related record-keeping obligation for the OTC derivative transaction.

To conclude, Hong Kong regulators have been revising and developing regulations to regulate the manners of the financial insti-tutions. Licensed corporations must catch up rapidly with the amended regulations so as to safeguard their current business activ-ity, revising their compliance policy and procedures in accordance with the develop-ment and reformation of the SFC rules and regulations. •

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Editorial deadline for

Vol VII Issue I Spring 2015

May 15th 2015

A t its zenith, the Royal Bank of Scotland was the world’s biggest bank.

It had assets of $3 trillion, employed over 200,000 people, had branches on every high street and was admired and trusted by millions of savers and investors. Now the mere mention of its name causes anger and resentment, and its former CEO Fred Goodwin is reviled as one of the architects of the worst financial crisis since 1929. In Shredded, award-winning financial journalist Ian Fraser lifts the lid on the catastrophic mistakes that led the bank

to the brink of collapse, and those who were responsible for them – the colleagues who were overawed by Goodwin’s despotic style of leadership, the investors who egged him on, the politicians who created the ‘light touch, limited touch’ regulatory framework, and the RBS directors who, in failing to check his hubris, allowed him to lead the bank to destruction. As more and more toxic details emerge about the bank’s pre- and post-bailout misconduct, including its deliberate ruination of numerous small businesses in the UK and Ireland, its alleged manipulation of global foreign-exchange markets, its fiddling of Libor and other benchmark interest rates, and its pivotal role in the ‘mis-selling’ of US mortgage bonds, Ian Fraser examines what the future holds for RBS and weighs up its chances of ever regaining the public’s trust.

IAN FRASER is an award-winning journalist, commentator and broadcaster whose work has been published by among others The Economist, Financial Times, The Sunday Times, Independent on Sunday, Guardian, Observer, Mail on Sunday, Herald, Sunday Herald, Thomson Reuters, Huffington Post, economia and qfinance. He has taught at the University of Stirling and his BBC documentary, RBS: The Bank That Ran Out of Money, was short-listed for a Bafta.

www.ianfraser.org

www.birlinn.co.uk

£259 7 8 1 7 8 0 2 7 1 3 8 5

ISBN 978-1-78027-138-5

IAN

FR

AS

ER

Cover design by James HutchesonPhotographs by Victor Albrow and James Hutcheson

‘The definitive account of the Royal Bank of Scotland fiasco. It’s an engaging, if in some ways infuriating, tale of how self-serving bank

executives systematically broke the rules, lent with astonishing recklessness, abused customers and got suckered by Wall Street – before ultimately

dumping their mess on taxpayers. Fraser doesn’t just point the finger at Royal’s clueless bankers. He also expertly chronicles the role of misguided

regulations, captured supervisors, and deluded politicians in fuelling this catastrophe.’

Yves Smith, founder of Naked Capitalism and author of econned: How Unenlightened Self Interest Undermined Democracy

and Corrupted Capitalism

‘This book should be posted through the letterbox of every taxpayer in Britain.’

David Mellor, former chief secretary to the Treasury and secretary of state for National Heritage

‘Ian Fraser has spotted stories, uncovered scandals and written about them in a detailed and accessible way that leaves many other financial

journalists in the dust.’

Eamonn O’Neill, director of the MSc course in investigative journalism at the University of Strathclyde INSIDE RBS

SHREDDEDIAN FRASER

THE BANK THAT BROKE BRITAIN

INSIDE RBSTHE BANK

THAT BROKE BRITAIN

US Federal Reserve’s financial services stability agenda 65Lael Brainard

CCP risk management, recovery and resolution arrangements 73David Bailey

Looking ahead as the Renminbi internationalises 79Alexa Lam

If Europe wants growth, reform its financial services system 87Nicolas Véron

Is the concept of “moral hazard” a myth or reality? 95Philip Pilkington and Macdara Dwyer

Why “bail-in” securities should be considered fool’s gold 101Avinash D. Persaud

After AQR & stress tests, where next for EU-banking? 111Thorsten Beck

City of London determined to plumb new depths 115William K. Black

Compliance with risk targets: efficacy of the Volcker Rule 121Josef Korte and Jussi Keppo

Higher capital requirements: the jury is out 125Stephen Cecchetti

Will Basel III operate to plan as its proponents desire? 129Xavier Vives

Helicopter money can reverse the present economic cycle 133Biagio Bossone

US regulatory feeding frenzy on HFT is wholly misguided 137Steve Wunsch

Derivatives markets in China to be built upon G20 reforms 143Sol Steinberg

China’s securities industry to undergo metamorphosis 147Andy Chen

Accounting hurdles for CVA in the region 151Yin Toa Lee

CVA “pricing” issues across Asia Pacific 157Ben Watson


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Financial stability

US Federal Reserve’s financial services stability agenda

Governor Lael Brainard of the US Federal Reserve outlines the tools available to the Fed

in pursuit of its commitment to stability.

ALTHOUGH its founding statute makes no explicit mention of financial stabil-ity, the Federal Reserve was created in response to a severe financial panic more than 100 years ago, and safeguarding financial stability is deeply ingrained in the mission and culture of the Federal Reserve Board. Today, financial stability is more important than ever to the work undertaken by the Board of Governors and regional Federal Reserve Banks spread across the breadth of the US Federal Reserve Board. With the lessons from the crisis still fresh, we are in the process of strengthening our financial stability capabilities.

In carrying out the work of financial stabil-ity, the Federal Reserve is seen as the agency with the broadest sight lines across the econ-omy and one that has some important sta-bility tools, as well as a critical first responder when a crisis hits. But it also faces limitations as a financial stability authority.

The Federal Reserve is predominantly a supervisor of banks and bank holding companies in a system with large capital

markets, several independent agencies have responsibilities for regulation of non-bank financial intermediaries and markets, and no US agency yet has access to complete data regarding bank and non-bank financial activities.

Financial stability Recognising these limitations, the Federal Reserve is likely to actively use the tools under its authority, which means placing a strong emphasis on structural resilience in the largest and most complex institutions, while strengthening less tested time-varying tools to lean against the build-up of risks and, in some circumstances, looking to the unique capacity of monetary policy to act across the financial system.

It will also need to cooperate closely with other regulators to develop well-rehearsed working protocols and a joint sense of responsibility for financial stability, while respecting that each independent agency has its own specific statutory mandate and governing body.

In the wake of the financial crisis, the Congress and the Federal Reserve itself


became more deliberate and explicit about the responsibility for safeguarding the sta-bility of the financial system. The Wall Street Reform and Consumer Protection Act - usu-ally referred too as the Dodd-Frank Act, enacted in July 2010, charged the Federal Reserve with specific authorities for the pur-poses of safeguarding financial stability.

The “four pillars”At the Federal Reserve, we created the Office of Financial Stability Policy and Research to strengthen our cross-disciplinary approach to the identification and analysis of potential risks to the financial system and the broader economy, and to support macro-prudential supervision of large financial institutions; then, following its creation, participation on the Financial Stability Oversight Council (FSOC).

This work is carried out by staff in that office as well as in many areas across the Board and is overseen by the Board’s newly created Committee on Financial Stability. This work comprises four pillars, which are in varying stages of advancement. The pil-lars are: surveillance of the possible risks that could threaten financial stability; macro-prudential policy; working across the regula-tory perimeter; and monetary policy.

SurveillenceStarting with surveillence first, research and historical case studies suggest that increasing valuation pressures accompanied by rising leverage, widening maturity mismatches, and the erosion of underwriting standards often provide important warning signals.

The research that informs this work, by helping to identify financial patterns likely

to be associated with rising risks of finan-cial crisis, continues to grow. But its predic-tive power is still limited; it remains difficult to identify, ahead of time, credit booms that are likely to cause severe damage, such as the subprime housing crisis, from those that do not, such as the high-tech boom, in part because risk-taking by financial market par-ticipants cannot always be well-observed.

Over time, our surveillance and that of others will benefit, as the Office of Financial Research, established by the Dodd-Frank Act, makes progress in facilitating the shar-ing of previously siloed data sets among the independent regulators and as international impediments are overcome, allowing more comprehensive analysis of financial transac-tion flows across different types of financial intermediaries and activities.

Buttresses This regular, systematic surveillance of finan-cial vulnerabilities is buttressed by three other valuable types of analysis. First, we use the detailed information gathered through bank examinations and loan reviews that are the regular work of our supervisors to assess emerging risky practices; these reviews helped identify deteriorating underwriting standards in the leveraged loan market.

Second, we undertake periodic analyses of potential systemwide consequences of possible, particularly salient shocks, such as a sharp rise in the level or volatility of inter-est rates, including possible bottlenecks that could impede orderly adjustments.

Finally, when there is a close brush with specific risk events, we closely study the behaviour of markets and institu-tions for insights into possible structural


vulnerabilities that might be revealed and assess possible policy actions.

Macroprudential policyThe ultimate objective of our surveillance is to build resilience of firms and markets and to counter risks early enough to prevent disruptions to financial stability that could damage the real economy. While the macro-prudential toolkit is larger than it was pre-crisis, there is a substantial amount of work remaining to implement some of these tools.

In particular, as I will discuss in more detail, the ability of the available tools to counteract time-varying risks has yet to be tested in the United States

First, the Federal Reserve is well along in promulgating an important system of new, through-the-cycle safeguards that together should deliver much greater structural resil-ience and make excessive risk-taking costly for the large, complex institutions that pose the greatest risks to the financial system.

Second, the Federal Reserve is assessing the kinds of broad time-varying regulatory tools that might further buttress resilience during periods in which risks associated with rapid credit expansion are building.

ToolkitThird, the Federal Reserve is exploring tools that can be varied over the cycle to target specific activities, recognising that we will have limited authorities relative to some for-eign financial regulators in operating on the borrowing side and outside the regulatory perimeter of the banking system. Let’s take each in turn, beginning with our first tool, that being “structural resilience”.

We are relatively far advanced, and

compare favourably to other jurisdictions, in implementing a framework of rules and supervision that compels large, complex financial institutions to build substantial loss-absorbing buffers and to internalise the costs of undertaking activities that pose risks to the system.

This framework represents a substantial improvement on structural resilience relative to the pre-crisis framework across a num-ber of dimensions: it is forward looking in assessing risks under severely stressed con-ditions, and it is explicitly macroprudential in design, so that bank management internal-ises risks not only to the safety and sound-ness of their own institution, but also to the system as a whole.

“Belts and suspenders”Reforms undertaken in recent years help ensure that institutions that are large, inter-nationally active, and interconnected face significantly higher capital and liquidity charges when undertaking risky activities. The core of the framework is the require-ment of a very substantial stack of com-mon equity to absorb shocks and to provide incentives against excessive risk-taking.

The new framework imposes “belts and suspenders” on the capital cushion by requiring a simple, non-risk-adjusted ceil-ing on leverage as well as requiring the largest banking firms to satisfy two sets of risk-based capital requirements: one derived from internal models and a second based on standardised supervisory risk weights.

Beyond that, the largest, most complex firms will face an additional common equity requirement that reflects the risk they pose to the system and an additional layer of loss


absorbency on top of that to provide ade-quate support to operating subsidiaries in resolution.

Stress testsLarge financial institutions are also required to maintain substantial buffers of high-qual-ity liquid assets calibrated to their funding needs and to their likely run risk in stressed conditions. Similar to the equity cushions, the liquidity buffers are calibrated to affect disproportionately those financial institu-tions that pose the greatest risks.

Regular stress tests of both capital and liquidity at our largest banking firms pro-vide a key bulwark in the new supervisory architecture.

Minimum capital requirements must be met under severely adverse macroeconomic conditions and, for the very largest firms, in the face of severe market shocks, including the failure of a firm’s largest counterparty.

By providing a forward-looking assess-ment that takes into account correlations among risks under stressed conditions, these stress tests on capital and liquidity are pow-erful tools for building resilience in our larg-est banking firms.

LimitationsBut they also have some limitations. For instance, while the severity of the stresses can be varied from year to year, it is difficult to introduce entirely new scenarios each year to target specific sectoral risks without intro-ducing excessive complexity.

And while the new US framework requires that capital buffers are calibrated for the riskiness of their assets and exposures, the proportion of capital required does not

vary systematically to counter the cyclicality that arises through elevated asset valuations and other channels.

Next in our toolkit is “time-var-ying broad macroprudential tools”. While our efforts are far advanced in build-ing structural resilience, progress is less advanced in developing time-varying tools that counter the build-up of excesses across the system broadly or in a particular finan-cial sector. These efforts are in earlier stages of elaboration and more of a departure from recent practice. Here we can learn from financial authorities in other countries that have recent experience deploying a broader array of macroprudential tools.

Countercyclical capitalThe classic case for time-varying broad macroprudential tools is to lean against a dangerous acceleration of credit growth at a time when the degree of monetary tighten-ing that would be needed to slow it down would be highly inconsistent with condi-tions in the real economy.

The Basel Committee agreed on a com-mon countercyclical capital buffer frame-work for addressing such circumstances, and the Federal Reserve and the other US bank-ing agencies issued a final rule to implement the Basel III countercyclical capital buffer for US banking firms in 2013.

Under the rule, starting in 2016 and phasing in through 2019, the US bank-ing agencies could require the largest, most complex US banking firms to hold addi-tional capital in amounts up to 2.5 per cent of their risk-weighted assets if the agencies determine it is warranted by rising risks.

We are currently considering how best to


implement the countercyclical capital buffer. The existing research would suggest that indicators related to debt growth, leverage, and other signs of growing financial imbal-ances would provide guidance on when to implement the buffer and when to deacti-vate it.

Time-varying toolsThe countercyclical capital buffer may enhance financial stability by building addi-tional resilience at systemic banking institu-tions near the height of the credit cycle.

However, it may prove to be less effec-tive in leaning against credit growth, since, as credit booms progress, there is greater potential for capital to be relatively cheap, asset valuations to be inflated, and risk weights to be incorrect.

Moreover, the countercyclical capi-tal buffer has some practical limitations: it applies to a subset of the US banking sys-tem and is designed to act with a one-year lag. It also cannot be used efficiently to tar-get specific asset classes that appear frothy, a challenge I turn to next, namely our focus on “time-varying sector-specific tools’. A blunt instrumentThe countercyclical buffer may be a relatively blunt tool for circumstances where the build-up of risk is highly concentrated in a particu-lar sector. This was, of course, the challenge US policymakers faced early in the recent housing bubble, with home prices rising and capital markets developing the complicated, opaque securities built on subprime mort-gages that would ultimately cause damage throughout the financial system.

Indeed, property booms are perhaps the most common macroprudential challenge

that have confronted financial authori-ties in advanced economies over the years, although macroprudential challenges have also surfaced in other sectors, such as the corporate lending boom that confronted Korea in the mid-to-late 1990s.

In addition to time-varying broad macroprudential tools, such as countercycli-cal capital buffers and dynamic provisioning, many financial authorities have the authority to promulgate rules that target activity in a specific sector.

For instance, Swiss authorities activated, in early 2013, a countercyclical capital buffer that added 1 percentage point of capital requirement for direct and indirect mort-gage-backed positions secured by Swiss residential property, and then increased this amount in 2014 to 2 percentage points.

Lending-side toolsIn the United States, there is a more limited set of authorities the Federal Reserve could exercise, either on its own or jointly with the other banking agencies to address sector-specific risks.

Most commonly, as we have seen with leveraged lending, the banking regulators acting together can use the tools of supervi-sory guidance and intensive supervision to discourage banks from taking on additional risk on safety and soundness grounds.

Moreover, the annual supervisory stress tests can be tailored to increase the severity of losses in specific portfolios of loans or the market shock. However, these authorities fall short of direct restrictions on activities in a particular sector.

Such supervisory actions usually flow from microprudential concerns about the


safety and soundness of individual institu-tions rather than macroprudential concerns about the stability of the entire system.

Section 165 Dodd-FrankBy contrast, section 165 of the Dodd-Frank Act provides that the Federal Reserve could restrict the activities of banks with assets greater than $50 billion or non-bank sys-temically important financial institutions (SIFIs) designated by the FSOC “to prevent or mitigate risks to the financial stability of the United States”, thus providing potential macroprudential authority.

In addition, the Federal Reserve has authority under the Securities and Exchange Act of 1934 to set initial and variation mar-gin requirements for repurchase agreements and securities financing transactions, which applies across the financial system.

This authority was used to curb perceived excesses in the equity markets through the mid-1970s with what was seen as limited success, and it has not been used in such a manner since.

Minimum margin requirementsThere is some interest in exploring whether imposing minimum margin requirements on additional forms of securities credit could prevent margins from compressing during booms and likewise help mitigate destabilis-ing procyclical margin increases at times of stress, reducing the associated “fire sales” in short-term wholesale funding markets.

Consideration of the usefulness of these authorities is in preliminary phases. It is being undertaken as part of a broad review of macroprudential authorities and not with regard to developments in any particular

sector. For purposes of comparison, it is instructive to focus on how central banks in several advanced economies have dealt with housing booms in recent years.

Financial authorities in the United Kingdom, Sweden, Switzerland, and New Zealand have recently confronted rapidly rising residential housing prices in macro-economic environments where there were compelling reasons not to use the policy rate as the first line of defence.

They responded by imposing strictures on borrowers, through loan-to-value or debt-to-income limits, in some cases in concert with disincentives to lenders, and in many cases in an escalating pattern.

Restrictions on borrowingIndeed, restrictions on borrowing are among the most commonly employed macro-prudential tools and, according to some research, among the most effective in stem-ming the build-up of borrowing.

This is not a problem we face today. If anything, the most pressing problem cur-rently facing housing authorities in the United States is to restore vitality to the sin-gle-family housing market, where construc-tion activity remains puzzlingly weak.

However, if, in the future, a mortgage-credit-fuelled house price bubble were to re-emerge, the banking regulators could perhaps impose higher risk weights on mortgage loans with certain characteris-tics either directly or through expectations around stress testing.

This approach would be slow, perhaps requiring upwards of a year to adjust, and narrow in its scope of application, and it may prove ineffective at times when bank


regulatory capital comfortably exceeds the required thresholds.

Third pillarThe third pillar of our financial stability agenda is “working across the regulatory perimeter”. In some cases, foreign central banks acted in concert with other financial authorities to address the buildup of risk in their housing sectors.

In the American context, the Federal Reserve’s work is embedded in a larger web of efforts by other financial authorities. In parallel to the Federal Reserve’s own efforts to formalise its financial stability surveil-lance and policy making, the network of independent financial agencies is enhancing cooperation through the formal structure and responsibilities of the FSOC, as well as through joint rulemakings and joint super-visory efforts.

It is vitally important that the bank and market regulators actively work to share assessments of risks across the financial sys-tem and to develop joint macroprudential efforts to address risks that stretch across regulatory perimeters.

Realistically, however, those efforts are in early stages and must respect differences of mission and mandate, authority, and gov-ernance structures.

The CFPB by way of exampleAs an example, the Consumer Financial Protection Bureau (CFPB) has authority to adjust the definition of qualifying mortgages (QM), which affects mortgage credit at all lenders, whether inside or outside the bank-ing regulatory perimeter. It is worth not-ing, however, that the Consumer Financial

Protection Bureau operates primarily under a consumer protection mandate.

While the ultimate consequences of a mortgage credit boom have, in the past, proved very costly for families, the danger to consumers in the initial stages of such a boom may be too unclear to warrant timely action.

Recognition of the limits to the macro-prudential framework brings us to a consid-eration of monetary policy – a powerful tool with broad reach, but also relatively blunt.

Fourth pillar: monetary policyThis brings us to our fourth and final pillar, that of monetary policy. Monetary policy is the only tool available to the Federal Reserve that has far-reaching effects on private credit creation across the entire financial system and one of the few tools that can be changed rapidly (although its effects have famously long and variable lags).

While recognising the far-reaching effects of monetary policy on financial con-ditions, there are good reasons to view mon-etary policy as the second line of defence. It is better viewed as a complement, rather than an alternative, to macroprudential tools. In many circumstances, standard monetary policy and financial stability considerations will reinforce one another.

Nevertheless, there may be times when standard monetary policy and financial stability considerations conflict. In several recent instances, foreign economies have faced some tension between high unem-ployment and shortfalls in inflation rela-tive to the central bank’s target, on the one hand, and financial stability concerns asso-ciated with rapidly rising real estate prices


on the other. In the United Kingdom, poli-cymakers put in place a range of measures to limit the build-up of risks in the housing market, and, partly as a result, the housing market appears to be cooling somewhat. Nonetheless, policymakers in the United Kingdom have acknowledged the potential for monetary policy adjustments to play a role in the pursuit of financial stability.

UK “knockout” punchThe Bank of England’s 2013 forward guid-ance had a specific financial stability “knock-out” for monetary policy accommodation if the Financial Policy Committee judges that the stance of monetary policy poses a sig-nificant threat to financial stability that can-not be contained by the substantial range of mitigating policy actions available to the Financial Policy Committee.

If, in the future, the United States did face a similar dilemma, where financial imbalances are growing rapidly against a backdrop of subpar economic conditions, the Federal Reserve may consider monetary policy for financial stability purposes more readily than some foreign peers because our regulatory perimeter is narrower, the capital markets are more important, and the macro-prudential toolkit is not as extensive.

A second line defenceEven in these circumstances, however, it is important to be prudent about the role of monetary policy, recognising that the necessary adjustments in monetary pol-icy could have broader economic conse-quences within the economy. For example, a tightening in monetary policy sufficient to limit strong credit growth could depress

employment and potentially trigger a sharp correction in financial markets.

These limitations should lead us to be circumspect regarding the use of monetary policy as a tool to address financial stability risks; it should perhaps be viewed as a sec-ond line of defence.

But it is equally important to acknowl-edge the potential usefulness of monetary policy for addressing risks to financial sta-bility and to the broader economy, and to continue expanding our work on the appro-priate role of financial stability in our mon-etary policy framework.

ConclusionIn short, while the United States Federal Reserve System has an inherent responsibil-ity for financial stability, it has an incomplete set of authorities and a limited regulatory perimeter in a financial system that has large capital markets and a fragmented regulatory structure – much of this due to the “federal”, hence fractured, structure of our political governance.

It is therefore important that we actively use the tools under our author-ity which place particular emphasis on building structural resilience at the largest, most complicated institutions via tougher through-the-cycle standards, along with broad countercyclical measures to limit the build-up, and potential consequences, of risks to financial stability.

This should be done while exploring the design of time-varying sector-specific tools, and, at times, looking to monetary policy as a powerful tool that unlike any other operates across the entire financial system. •

CCP Exchanges

CCP risk management, recovery and resolution arrangements

David Bailey of the Bank of England en-quires if centralised counterparty exchanges

have become “super-systemic” institutions.

THIS conference [the Deutsche Boerse Group and Eurex Exchange of Ideas] comes at a very timely point, just over five years on from the G20 summit in Pittsburgh that placed such a significant focus on central clearing. In the EU we also have a new Commission settling in and so it seems an appropriate juncture at which to reflect on the progress of the last five years and the challenges that lie ahead.

I think we can all agree that the G20 man-date to centralise the clearing of standardised OTC derivatives has increased the systemic importance of CCPs; I will even borrow a phrase I have heard one of my fellow speak-ers use previously to note that CCPs are emerging as “super-systemic” institutions, with increasing importance across multiple jurisdictions.

It is also clear that, recognising this, the international community has made very sig-nificant and tangible progress to ensure that CCPs are being held to higher risk standards and regulatory expectations.

As the supervisor of some of the largest

CCPs, which clear securities and derivatives denominated in over seventeen currencies across the globe, the Bank of England has been heavily engaged in the international efforts to promote the right standards and expectations of CCPs, and also to ensure that they are implemented in practice.

Robust risk standardsBut it is important to recognise that we have not reached the end of our journey – more can, and must, be done. I will therefore outline my views on the progress made to date, internationally and within the UK, to develop and strengthen risk management standards at CCPs, CCP recovery arrange-ments and resolution tools for CCPs.

It is critical that we maintain our momen-tum in these areas and I will highlight the key points of focus from my perspective. In particular, further progress is needed to ensure that recovery and resolution regimes are robust, credible and well understood so that they can be used to successfully mini-mise the impact of a failing CCP on financial stability.

Let me start with the first area: CCP risk


standards. Robust risk standards, imple-mented consistently across jurisdictions are clearly essential to ensure that CCPs deliver the outcome that we, and the G20, expect of them; that is, to safeguard the financial sys-tem through the effective management of counterparty credit risk.

International principlesInternationally, the 2012 CPMI-IOSCO Principles for Financial Market Infrastructure PFMI), as implemented within the EU by EMIR (European Market Infrastructure Regulation), have represented a signifi-cant step forward, resulting in more rig-orous expectations of CCPs across their business and including important areas such as counterparty, liquidity and operational risk management.

Within the UK, the PFMIs form a key foundation stone of the Bank of England’s supervisory approach and our regulatory framework is consistent with these stand-ards. As part of our approach, we require CCPs to complete annual self-assessments against the PFMIs which provide an effec-tive test of the CCPs’ implementation of, and commitment to, the standards the interna-tional regulatory community has set.

Centre of approachFurthermore, and recognising the impor-tance of UK-based CCPs across multiple jurisdictions, we [the Bank of England] have placed the PFMI “Responsibilities”on inter-national co-operation at the heart of our supervisory approach. Making regulatory cooperation effective between the relevant regulators of CCPs is a priority for the Bank as our CCPs perform important activities for

firms and markets in the European Union, United States and globally. For that reason, we operate regulatory colleges for UK CCPs at both the EU level, as mandated by EMIR, and globally.

These arrangements are important in allowing us to inform our international counterparts of developments at UK CCPs, and to benefit from their valuable input, expertise and experience in supervising CCPs and firms in many other jurisdictions. Our experience is that the supervisory exper-tise brought together through these arrange-ments means that colleges can be greater than the sum of their parts.

We see this collegiate model as an effec-tive template for all CCPs that operate on a multi-jurisdictional basis and we advocate the use of such arrangements more widely.

Not an end-pointWhilst the PFMIs have taken us a long way, we do not believe that they represent an end-point to our regulatory journey; rather they must be viewed as a very useful baseline that must continue to evolve and develop to continue to provide for effective CCP risk management.

Indeed, we have already identified areas in which the international standards could benefit from additional guidance, which will be important to ensure robust and consistent interpretation and implementation across the G20, particularly with regard to counter-party credit risk standards.

For example, one clear area of the current international standards that could be further developed to strengthen CCPs’ counterparty credit risk management relates to stress test-ing requirements. Whilst the PFMIs and


EMIR do require an appropriately and pru-dently sized default fund, there is no require-ment for CCPs to disclose the details of the stress tests which they use, which ultimately determines the size of these default funds. Therefore, it may be difficult for participants to fully compare the level of stress that CCPs can withstand.

Viewed as minimumFurthermore, we would welcome the development of standardised approaches to designing stress scenarios, which could include standardised regulatory stress tests for CCPs as we have seen in the banking sector. However, it is crucial for these to be set in context. Standardised stress tests must be well-designed to incorporate the diversity of business models of CCPs globally.

And more importantly, they could only be viewed as “minimum” stress tests, which would complement more tailored and potentially much more rigorous internal stress testing, developed and implemented by individual CCPs.

The last thing I will say on CCP risk standards is, however, that a consistent reg-ulatory framework is not enough. Ensuring CCPs are robust and resilient relies on a joint effort from regulators, the CCPs and their users alike. We, and I stress we, must hold the CCPs to the highest risk standards.

CCP recovery arrangementsIn this regard, we welcome the forthcom-ing guidance from CPMI-IOSCO on pub-lic quantitative disclosure standards for CCPs, which will represent a step in the right direction to put clearing members and participants in a better position to use only

those CCPs that are sufficiently well risk-managed, not simply those that are the most cost-effective. Clearing members must stand ready to justify their choices to regulators and other stakeholders on request.

Now I will turn to recovery: what hap-pens in the event that a CCP’s pre-funded resources are not sufficient? No matter how strict the regulations are, or how good a CCP’s risk management is, the possibility of an extreme event, one that we might even consider implausible, that causes financial distress or failure is something that we can-not and indeed must not ignore.

Supervisors need to carefully consider what actions a CCP could take to maintain its economic viability whilst also continuing to provide its critical clearing services.

Potential toolsThe Bank of England therefore welcomes the recently published CPMI-IOSCO report on recovery of FMIs which provides clear guidance to CCPs on how to answer this very important question and develop their own recovery arrangements.

Potential tools identified in the report include “assessment rights”, that is, the right to call for additional resources from mem-bers, variation margin haircutting and, ulti-mately, contract termination, or “tear-up”.

Within the UK we have already required CCPs to prepare recovery plans and intro-duce arrangements to allocate extreme losses. This means that they have put in place loss-allocation arrangements to meet uncovered losses arising from a clear-ing member default, and for non-clearing member default losses that could threaten solvency.


From our domestic experience, we know that there is no “one-size-fits-all” recov-ery plan. Plans must take into account the specific CCP, the nature of its products and the markets in which it operates. This is reflected in the approaches the UK CCPs have taken in developing their own recovery arrangements.

Possibility of failureThese arrangements will continue to be developed and fine-tuned in response to the rigorous periodic tests that the CCPs will undertake and arrangements may need to be updated as clearing services, CCP partici-pants and central clearing mandates evolve. We will also consider whether UK CCPs need to make any more changes to bring them in line with the recently published CPMI-IOSCO guidance.

One point that I will emphasise is that there is the potential for CCPs to suffer losses, or even fail, for reasons other than member default. For instance, a CCP could incur losses on its investment policy or through operational issues.

Despite the strict requirements in EMIR and the PFMIs that reduce the probability of this failure, there is still a tail risk that these could create uncovered losses that would exceed the CCP’s capital. Therefore, CCPs, together with their clearing members and regulators, must consider the recovery tools that they would employ if a non-default loss depletes the CCP’s capital.

CCP resolution toolsIt is, however, important that recovery arrangements do not disincentivise effective management by CCPs of their non-default

risks. CCPs should bear at least the first tranche of the loss with an amount of their own capital, providing a clear incentive to prudently manage these risks.

Finally, however, if a CCP decides to implement its recovery plan, it must prop-erly disclose information on the risks and liabilities that its clearing members will face in extremis so that its participants can truly understand and manage the risks and prop-erly scrutinise the CCP’s management of these risks. This is in line with CPMI-IOSCO guidance, and reinforced via our supervisory approach.

The final question I will touch upon in this paper is: “what would happen if it appears likely that a CCP’s recovery plan will not work in practice; or if a CCP can only remain viable by taking actions that could undermine wider financial stability?”

Prudent and robustA CCPs’ risk management should be pru-dent and robust, and its recovery plans should be designed to be fully comprehen-sive and effective.

However, it is incumbent on us, as authorities, to consider what happens if they are not. In this case, resolution authorities will need to step in with effective and com-prehensive stabilisation powers to act as a final backstop; and to provide continuity to the CCP’s critical economic functions, whilst providing an orderly wind-down for any non-systemic operations.

The UK has been at the forefront of developing thinking around the appropriate resolution tools for CCPs. Earlier this year we put in place a domestic resolution regime for our UK CCPs. This is a significant step


forward which provides the BoE, as resolu-tion authority, with some of the tools nec-essary to facilitate the resolution of a failing CCP. We welcome the recently published annex to the Financial Stability Board’s (FSB)Key Attributes on resolution and we aim to further develop our domestic resolution regime to bring it in line with these interna-tional standards.

Protect financial stabilityWe anticipate achieving this via the forth-coming European legislative proposal on CCP resolution which we expect to be pro-posed in 2015. Ensuring that we, and other resolution authorities, have a comprehensive set of tools to effectively resolve a CCP will be a clear priority for that legislation.

In my view, an effective resolution regime must offer national resolution authorities flexibility to assess the specific circumstances of a CCP’s failure and to react in the most appropriate manner to protect financial stability.

To do this, resolution authorities must be able to act in a timely and forward-looking way, even potentially before recovery actions have been exhausted, and with a variety of tools, to respond to the specific nature and cause of the CCP’s business failure. However, there is, of course, a trade-off between reso-lution flexibility and ex-ante transparency for CCP participants.

“No Creditor Worse Off” To alleviate this concern, participants should be given reassurance that any resolution actions would be accompanied by relevant safeguards, including a “No Creditor Worse Off” safeguard, which would limit the

individual losses to the losses they would experience in insolvency. This should pro-vide some degree of ex-ante transparency about the size, but perhaps not the exact form, of the loss. The next obvious question is: what tools should this legislation provide?

Here we can be informed by the expe-rience of developing the European Bank Recovery and Resolution Directive (BRRD). In my view there should be a flexible resolu-tion toolkit for CCPs. In particular, resolution authorities need the power to recapitalise a failing CCP in a timely manner, including through writing down liabilities and con-verting them to equity.

Existing shareholders should be the first to bear the losses if this approach is to be taken.

“Total loss absorbing capacity”There is also an important question as to whether CCPs are resolvable in their current forms, and within that, whether changes to the liability structure of CCPs are neces-sary to make this approach credible, with-out recourse to taxpayer funds. The FSB has recently proposed that there must be a minimum level of “Total Loss Absorbing Capacity” for banks and we will need to con-sider carefully whether and how this concept could be effectively translated to CCPs.

In a similar vein, writing down operating liabilities through some form of initial mar-gin haircutting should also be considered. There may, of course, be other solutions, and the legislative proposal should consider a full suite of tools to ensure that the CCP resolution regime can be timely, credible, well-understood and effective. Finally, one important point that an effective resolution


regime must address relates to informa-tion sharing.

To ensure that resolution plans are practicable and timely, resolu-tion authorities must communicate and cooperate with other resolution authorities and relevant regulators, through Crisis Management Groups or other similar arrangements, to explain what specific plans and tools would be adopted for each CCP in a non-exhaus-tive range of crisis scenarios, as has already been done by banks.

Given the increasing importance of CCPs across jurisdictions, this active international cooperation and engage-ment is essential and we are actively considering how to embed this along-side the college arrangements for UK CCPs that I referred to earlier.

So to conclude – we have made real progress since 2009 to increase CCP risk standards and to ensure these have been implemented effectively.

However, we must regularly take stock of the standards to ensure that they keep pace with market practices as they evolve, and to ensure that the standards are being implemented con-sistently internationally.

Furthermore, CCPs, their users and their regulators must not ignore the possibility that, despite these risk standards, a CCP could get into finan-cial distress. CCPs must therefore put in place well-considered and appropri-ate recovery arrangements, while reso-lution authorities should be provided with a full suite of tools that will deal with the unique risks posed by CCPs. These are necessary steps in promot-ing the G20s objectives, with respect to central clearing, in a manner consistent with an objective to promote financial stability.

Good progress is being made and, recognising the importance of the CCPs that we supervise within the UK, we are committed to playing a leading role in taking these steps. •

Editor’s note: The publisher of the Journal would like to thank David Bailey, Director, Financial Market Infrastructure, the Bank of England and the BoE itself for allowing the Journal to re-publish this article in full, the original of which can be accessed via the following link: http://www.bankofengland.co.uk/publications/Pages/speeches/2014/781.aspx

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Foreign exchange

Looking ahead as the Renminbi internationalises

Alexa Lam, the deputy head of the HKSFC, charts the global rise of the RMB and issues some sage advice to Hong Kong and China

THE internationalisation of a currency refers to the process where its use has expanded beyond the borders of the jurisdiction where it is issued, and mar-kets around the world have come to accept the currency as a unit of account, a medium of exchange and a store of value.

This paper will examine important prerequi-sites for the Renminbi (RMB) to succeed as an international currency, a likely roadmap from here on and the role of offshore RMB centres. The last section of this paper offers some suggestions on how Hong Kong could compete in the new paradigm of multiple offshore RMB centres around the globe.

After more than 30 years of rapid growth, China is now the world’s second largest economy. A persistent and enormous trade surplus and foreign capital inflows have led to a sharp increase in China’s foreign reserves, causing uncomfortable pressure due to a substantial international payment imbalance.

The risk of “hot money” has become a difficult subject, one invariably linked to the need for a market mechanism to set RMB

exchange and interest rates, and expand two-way flows of capital. In 2009, China started to promote the cross-border use of RMB in a calculated manner, starting with foreign trade.

This is very much a broad-fronted initia-tive designed to improve the terms of trade and the balance of international payments, to lower exchange rate risk in international trades and official reserves, and to maintain control over macroeconomic measures and monetary policy.

Currency reviewAfter the 2008 global financial crisis, the stability and credibility of major interna-tional currencies such as the USD and euro came under pressure. There were calls to commence a review of the de facto single global reserve currency system. In hindsight, China’s initiative to promote the cross-bor-der use of RMB could not have come at a better time.

While the paths to internationalisation taken by other currencies – the US dollar, GB pound, euro and the Japanese Yen – dif-fered, each having been uniquely shaped


by a confluence of world events, deliberate policy and historical opportunities, there are discernible commonalities among them.

CommonalitiesFirst among these commonalities is the fact that a currency’s strength and dominance are directly co-related with the strength of the underlying economy. Second, appropri-ate government support (including domes-tic and international policies) is vital. Third, the formation and development of offshore markets determines the breadth and depth of the internationalisation of a currency. And, fourth, as a currency assumes greater influence, it also has greater international responsibilities.

For the RMB to become an international currency, certain prerequisites must be in place, chief among these being that China must have an open economic system and a relatively free flow of cross-border capital, thus driving a greater market demand for RMB to be the payment and settlement cur-rency for trades, services and investments.

Further, China’s domestic financial sys-tem, financial market and relevant rules and regulations are relatively well developed to enable price discovery, and offshore RMB markets have gained sufficient depth and liquidity to support a healthy velocity and provide a global network to complement the functioning of the onshore market.

PrerequisitesOther prerequisites necessary for the RMB to become a truly global currency are that the value of RMB is relatively stable, and that the exchange rate and interest rate formation mechanism is sufficiently market-oriented

and transparent. Added to this is a require-ment that the political situation is stable and that the country has good international relations, together with a high level of inter-national credibility underscored by reliable legal institutions.

Having detailed certain prerequisites necessary for a currency to gain internati-ional credence, it’s now possible to gauge how China has navigated the internationali-sation journey thus far.

After China ushered in modernisation and reforms in 1978, trade between China and her neighbours quickly blossomed. Traders in the region started to accept pay-ment in RMB. Although the currency was not freely convertible, these traders were happy to take the currency which they could use to settle future trades with their Chinese customers.

2010 sea changeAs we all know, some 30 years later (in 2009), China officially allowed cross-border trade settlement in RMB in a pilot scheme cover-ing five Chinese cities. The market initially responded very slowly. The one-way trend of appreciation of the RMB, the higher fund-ing cost, and the lack of banking and finan-cial products to hedge and manage currency risks gave foreign traders little incentive to settle their trades in RMB.

This situation started to change in 2010, when RMB became easily transferrable within Hong Kong. By 2013, close to 12 per cent of all China’s foreign trades were set-tled in RMB. As this percentage is still much lower than the percentage in other countries or trading blocs1 , we could expect this per-centage to increase. Meanwhile, the RMB


has already become the second most-used currency in global trade finance, after the USD, and the 7th most-traded currency in the world as of November 20142.

Creating inroadsTrade alone cannot sustain a long-term international demand for a currency. A broad and deep offering of financial, investment and derivative products and services in RMB, and the accompanying freedom to hold, use and transfer RMB assets, must be readily available. The RMB falls short in these areas. While RMB is freely convertible under cur-rent accounts (e.g. payments for trades and services), this is not so for capital accounts (e.g. investments).

China started creating inroads into its otherwise closed capital account as early as 2004, when Hong Kong was encouraged to develop an infrastructure allowing individu-als to open RMB bank accounts in Hong Kong.

While initially there were severe restric-tions on transfers between accounts, Hong Kong nevertheless quickly built a decent liquidity pool which supported the first off-shore RMB investment products – RMB bonds and treasuries of 2-3 year duration issued by Chinese financial institutions and the Chinese Ministry of Finance.

First “big bang”While restrictions abound, these bonds, and the RMB bank accounts underpinning them, served the historic function of developing and testing the infrastructure for the circu-lation of the RMB outside mainland China, and the linkage between the offshore and the onshore markets.

The year 2010 saw what was arguably the first ‘Big Bang’ when funds in RMB bank accounts in Hong Kong became freely trans-ferrable. Hong Kong quickly experienced a flourishing of first-in-the-world offshore RMB investment products – RMB mutual funds, and listed RMB securities. The follow-ing year, Hong Kong worked closely with mainland China to create a new innovation – the RMB Qualified Foreign Institutional Investors (RQFII) scheme.

The concept of the RQFII is quite simple. It is a QFII quota denominated in RMB. The ingenuity behind the RQFII is that it used the Hong Kong asset management platform to connect the offshore RMB liquidity with the onshore securities market. Riding on the back of the RQFII, Hong Kong rapidly developed a wide range of RMB investment products.

Premier offshore marketThe Mainland continued to roll out meas-ures to support the development of Hong Kong’s offshore market: foreign direct invest-ments and overseas direct investments could be made directly in RMB, and the Chinese Ministry of finance commenced a regular programme of treasury issuance in different tenors in the Hong Kong market. Over time this will anchor Hong Kong’s position as the premier offshore RMB bond market.

Just as it was supporting the develop-ment of the Hong Kong offshore market, China also commenced a calculated pro-gramme of pushing the RMB footprint to other parts of the world. It entered into swap agreements with a total of 29 central banks3, with an aggregate agreed value of RMB 3,000 billion. Meanwhile, replicating


the experiments conducted in Hong Kong, China gradually expanded the RMB Clearing Bank arrangement and the RQFII scheme to other markets. Today, the UK, Singapore, South Korea, France, Germany, Qatar, Canada and Australia each has in its jurisdiction a China-designated RMB clear-ing bank and a modest RQFII quota.

Outlook for internationalisationLooking to the future, the Chinese Government’s Communique of the Third Plenary Session of the 18th CPC Central Committee (November 2013) concluded that it must “promote reforms through opening-up”. The determination is very clear. The country will, through a wider opening of its economy, push through inter-nal structural reforms which until now have proven extremely difficult.

China has just launched the Shanghai-Hong Kong Stock Connect programme. The Mainland-Hong Kong Mutual Recognition of Funds scheme is expected to follow soon. Each of these is a bold move and a seminal event in the history of China’s financial mar-kets; these two programmes will support a wider and deeper use of the RMB globally as an investment currency and a store of value, and quicken the pace of the opening of the country’s capital account.

Offshore RMB businessThese two bold steps have significant impli-cations for the country’s financial market reforms. So far, offshore RMB business has been developed first on the Greater China platform, then in Asian countries with a close political and economic relationship with China, and subsequently across to the

European and North American Continents. Apart from the inherent strengths of a poten-tial offshore market, international geopolitics is a key factor in determining where offshore RMB business will be developed next.

Today, for foreign governments who desire new business opportunities from China, the prospect of developing RMB off-shore business with a toolkit consisting of an offshore RMB clearing bank, a swap line with the Chinese central bank, The People’s Bank of China (PBOC), and a modest RQFII quota has replaced the giant panda as the most coveted gift from China.

In the next five to 10 years, as RMB inter-nationalisation deepens with the opening of the capital account and the liberalisation of China’s capital markets, the RMB will likely join other international currencies including the USD, euro, GBP and Yen to form a more plural international financial and monetary system, while the USD continues to occupy a dominant role.

RMB appreciationRegions with stable bilateral or relationships with China such as those other countries in “BRICS” (Brazil, Russia, India and China), the “Silk Road Economic Belt” and the “21st Century Maritime Silk Road” 4, the Middle East, Africa and South America are likely to be offered the opportunity of developing off-shore RMB business.

China has so far deftly combined calcu-lated policy initiatives with sheer economic strength to launch the debut of the RMB. Aided by the 2008 global financial crisis, and the currency’s steady one-way appreciation trajectory, investor interest in offshore RMB assets, particularly bonds, continued almost


unabated, until the one-way appreciation of the currency began to pause, and even reverse, in the last 12 months.

Key to successIn the longer term, as the RMB exchange rate becomes more market driven, the global marketplace will ultimately decide if the RMB has an integral place in financial markets. This will be determined largely by whether there is genuine long-term demand for the currency, not just for trade and investment but also for long-term needs and liabilities, and the relative cost and ease with which RMB can be acquired and put to use.

For offshore centres, long-term growth momentum must come from the inherent strengths of their market – liquidity, talent, innovation and infrastructure.

As interest rates and exchange rates in China become more market oriented, there will be freer cross-border capital flows and transactions. The connection and transac-tions between offshore markets and onshore markets will deepen.

More RMB investment, financing, deriv-atives, trading products and tools will also emerge from the offshore markets. This will both feed and stimulate velocity and the degree of international utility of the currency – the key to whether RMB will succeed as a global currency.

What for Hong Kong?Hong Kong enjoys a significant lead over other offshore RMB centres. It has the largest offshore RMB liquidity pool (over RMB1 tril-lion), a critical mass of talent and the neces-sary infrastructure. Currently, it processes 90 per cent of China’s RMB-settled cross-border

trade. It has the lion’s share (RMB270 billion) of the aggregate worldwide RQFII quota (RMB870 billion), which it has fully invested in the onshore equity and debt markets.

Hong Kong also offers a broad spectrum of RMB banking and financial services, and the widest choice of offshore RMB invest-ment products. RMB businesses in other offshore centres often need to access Hong Kong’s liquidity pool. A growing number of RMB products offered in other centres are also packaged or managed out of Hong Kong. Competition, however, is heating up.

Replicating Hong Kong’s successLondon recently completed the offering of RMB denominated treasuries (RMB3 billion) issued by the UK government. While these bonds were not issued under the RQFII scheme, it is the world’s first RMB bond issue by a foreign government, a move that imme-diately jumpstarted the creation of offshore RMB assets in the London market.

At present, markets such as London and Singapore, being the trading hub respec-tively of the EU and ASEAN blocs, have a relative advantage over Hong Kong in the areas of foreign exchange, fixed income and derivatives trading.

As the pioneer, there is a cost in the development of innovative products and solutions but these could be easily replicated by others.

While the “one country, two systems framework” has dealt Hong Kong a strong hand as it plays the role of the international market on Chinese soil, under this frame-work any policy change in China is likely to impact the Hong Kong market more than other offshore centres.


While Hong Kong was previously China’s only partner in experiments involv-ing the cross-border use of RMB, China has today demonstrated a readiness to replicate the Hong Kong experience in other markets, giving Hong Kong little time to consolidate its position. Moreover, the recently estab-lished Shanghai Trade Zone indicates that some of the market liberalisation experi-ments could be first tested there rather than in Hong Kong.

Maintaining its positionThere is no longer any implicit guarantee of exclusivity. The question for Hong Kong, therefore, is how it can maintain its position as the lead offshore centre in the new para-digm of multiple offshore RMB markets?

The pace and progress of RMB interna-tionalisation are of necessity dictated by the degree in which difficult domestic reforms are implemented. In the process, China will need to test ideas and find solutions. Hong Kong should continuously assess the pro-gress of these reforms, proactively identify China’s needs, provide expertise, advocate solutions and offer to trial run them.

There are several pressing issues on China’s reform agenda. Interest rate and exchange rate liberalisation are no doubt two difficult tasks.

Two-pronged approachAnother key policy objective is to develop orderly fund flows between the onshore and offshore markets. To fully open its capi-tal account and converge with international markets, China will need to put in place transparent systems and regulation. There is also the all-important financial security

concern – that massive inflows and outflows of international liquidity under an open cap-ital account could exacerbate volatility and destabilise the onshore market.

Before China’s capital account becomes fully convertible, Hong Kong should adopt a two-pronged approach. One prong is to compete by offering a comprehensive range of RMB products and cost-effective solu-tions, a robust and efficient infrastructure and a worldwide network of coverage.

One of the functions of an offshore mar-ket is to help the onshore market in price discovery and operational risk management.

Hong Kong, in particular, should quickly develop a deeper offshore RMB bonds mar-ket with vibrant secondary trading to assist in price setting, and a vibrant RMB forex trading platform with multi-tiered products and derivatives.

Cementing the leadHong Kong should also actively participate in the PBOC-led development of the RMB Cross-border inter-bank Payment System to solidify Hong Kong’s position as the leading offshore RMB settlement centre. Additionally, Hong Kong must continue to cement its lead as the offshore centre for RMB wealth and asset management through renewed efforts in product innovation.

The other prong is to focus on areas where other offshore centres may not enjoy the same degree of access. These areas include: helping China in setting market-oriented policies for orderly cross-border flows between the onshore and offshore markets; designing and jointly administer-ing appropriate industry-wide systems and regimes to support and regulate product and


business development and innovation to enable and monitor such cross-border flows; and helping in developing seamless connec-tivity of the clearing and settlement systems between the Mainland and Hong Kong so that, through Hong Kong, the Mainland could seamlessly connect with the global network. The Shanghai-Hong Kong Stock Connect programme is a case in point.

A crucial roleMonetary co-operation and maintaining financial stability is another area where the trust between the Hong Kong and Mainland regulators could help cement for Hong Kong a crucial role. Hong Kong has withstood the onslaught of the 1997 Asian Financial Crisis and the 2008 Global Financial Crisis. Severely tested on both occasions, Hong Kong’s financial system and infrastructure weathered both crises very well.

As the onshore market becomes exposed to the contagion of global market disloca-tions, Hong Kong could share its experience and establish a cross-border platform with the Mainland to jointly monitor and manage volatile cross-border flows of international liquidity.

This is a crucial function, one which quite naturally Hong Kong is best suited to perform.

Seizing the opportunityAs the RMB capital account becomes fully convertible, Hong Kong should quickly seize the opportunity to develop a comprehensive range of multi-currency transactions, ser-vices and products to encourage the expand-ing use of RMB in Hong Kong.

In a free and open market environment,

the offshore market that outperforms others is the one that succeeds in devel-oping a broad, sustainable and genuine demand for Renminbi for commercial and investment needs. •

Endnotes1. Approximately, the percentage in 2013 of EU

trades that were settled in euro was about 65 per cent,

the percentage in 2012 of Japan trades settled in Yen

was about 40 per cent, and the percentage in 2013 of

US trades settled in USD was about 90 per cent.

2. Source: RMB Tracker published by SWIFT in

November 2014.

3. Those monetary authorities include Korea, Hong

Kong, Malaysia, Belarus, Indonesia, Argentina, Ice-

land, Singapore, New Zealand, Uzbekistan, Mongolia,

Kazakhstan, Thailand, Pakistan, United Arab Emirates,

Turkey, Australia, Ukraine, Brazil, the United Kingdom,

Hungary, Albania and the European Central Bank.

4. The “Silk Road” is a general term used to geo-

graphically describe the ancient trade and culture

routes between China and Central Asia, South Asia,

Europe and the Middle East that originally took form

during the Han Dynasty, about AD 200 BC. In 2013,

China proposed two new themes based on the tradi-

tional concept of “Silk Road”. One is “Silk Road Eco-

nomic Belt”, proposed by Chinese President Xi Jinping

during his official visit to Kazakhstan in September

2013, which covers 9 provinces of west China and all

the West Asian countries. The other is “21st Century

Maritime Silk Road”, also proposed by President Xi

during his official visit to Indonesia in October 2013,

which aims at strengthening China’s economic partner-

ship with countries in South and Southeast Asia. Both

proposals were emphasised by China’s Prime Minister

Li Keqiang in his government work report in March

2014, and adopted as China’s latest national strategy of

developing diplomatic and co-operation engagements

with countries along both routes.

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Capital markets

If Europe wants growth, reform its financial services system

Nicolas Véron of the Peterson Institute issues advice to EU policymakers for developing a pan-Europe capital markets infrastructure.

EUROPE’S crisis has been a banking and financial system crisis at least as much as a crisis of unsustainable public finances and sclerotic economies. Banking system dysfunction has crippled the European economy from the start of the crisis in 2007 to mid-2012, when the survival of the euro itself was threatened. Since mid-2012, more energetic policy efforts have been devoted to bank crisis resolution and the creation of a more sustainable architecture for banking policy, known as banking union.

A healthy banking union can only be a part of the solution to securing a prosperous future, however. Europe’s entire financial system needs to be reformed to strengthen financing, particularly for high-growth busi-nesses, and jumpstart growth. The goal of this ambition is what is currently referred to in Brussels as capital markets union (CMU).

Banking union and capital markets union are at different stages of design and execution, necessitating different approaches for each. Part of the reason why the euro area economy has not bounced back yet is that

banks have been constrained in their lend-ing by the sorry state of their balance sheets. The banking union has belatedly triggered a process of balance sheet repair, but this pro-cess is still far from complete.

Banking union refers to the centralisa-tion of supervisory and resolution authority in two European-level bodies: a newly cre-ated supervisory arm within the European Central Bank (ECB) and a new Brussels-based agency, the Single Resolution Board (SRB).

SRB fully functional by 2016The ECB’s supervisory arm is fully opera-tional and has been the licensing authority for all banks in the euro area since November 4, 2014, just after a year-long comprehensive assessment of the area’s 130 largest banking groups was completed.

The SRB will gradually start operations in 2015 and become fully operational in early 2016, when it acquires the authority to “bail in” failing banks by imposing losses on their creditors as well as to use its own resources for bank resolution (the Single Resolution Fund or SRF).1


By contrast, Europe’s capital markets union is not even on the drawing board yet. A senior European financial policymaker describes the CMU as “a concept under construction.”2

CMU, major structural impactOn July 15, 2014, Jean-Claude Juncker, on his way to becoming president of the European Commission, announced the establish-ment of a European CMU to develop the weak and fragmented non-bank segment of Europe’s financial system.

While the banking union will have the biggest economic benefit in the short run, a well-designed capital markets union would have major long-term structural impact by making the European financial system more resilient, efficient, and competitive.

Jonathan Hill, who holds the unwieldy title of European commissioner for finan-cial stability, financial services, and capital markets union, has announced his inten-tion to “develop an action plan by the sum-mer of next year [2015] (...) [as a] roadmap to developing an ambitious Capital Markets Union”.3

The CMU agenda is widely seen as being primarily about new EU legislation. Since the European legislative cycle from initial proposal to entry into force typically takes at least 18 months to two years, the CMU is not likely to have much economic impact before 2017, unless the behaviour of market participants changes in anticipation of its creation.

Four main economic factorsPresently, there are four main factors that could contribute to the economic impact of banking union. The first of which was the

unanimous decision of euro area member states in late June 2012 to initiate this union by pooling their sovereignty over bank-ing policy at the supranational level, and to entrust the corresponding supervisory authority to the ECB, signalled their political solidarity and commitment to the integrity of the euro area.

This development enabled the ECB to proceed with its outright monetary transac-tions (OMT) programme, announced less than three months later. This step succeeded in calming the euro area’s shaky sovereign debt markets.

Greater market disciplineSecond, the announcement of a banking union has already led to greater market dis-cipline in the European banking system. Before mid-2012, most situations of bank-weakness in Europe were met by public bailouts and/or nationalisations, at least in countries not under formal assistance pro-grammes by the International Monetary Fund and the European Union.

Since then, a belated backlash against overly generous bank bailouts during 2007–12 has imposed the principle that share-holders and subordinated creditors should lose their money before any public assis-tance is provided, and even stricter discipline is expected to apply from 2016, when new anti-bailout legislation enters into force.

Third, EU policymakers hope that the results of the comprehensive assessment will restore trust in the European banking system, even though the demand for credit is likely to remain anaemic in several mem-ber states for a long time. A firmer judg-ment on the success of the comprehensive


assessment should be possible in early spring 2015, assuming that no nasty sur-prises ruin the credibility of the process, as had sadly been the case in earlier stress test-ing exercises in 2010 and 2011. A successful assessment will likely ease the credit supply problem, which has constricted European growth since 2007.

Less fragmentationFourth, the ECB’s actions as a banking supervisor in the next 12 to 18 months couldreverse the euro area financial system’s harmful fragmentation along national lines since 2010–11. The ECB should prevent national supervisors from forcing banks to ring-fence their internal capital and liquid-ity along national lines and should work at reducing the high home bias in their portfo-lios of euro area sovereign debt.

The ECB can also favour the emergence of more integrated pan-European banking groups through more cross-border acquisi-tions. Despite these steps, the onset of bank-ing union also coincides with a phase of bank deleveraging, resulting in more scarce credit in parts of Europe and highlighting the insufficient diversity of Europe’s financial system, in which banks are the dominant actors.

Expect no miraclesThe ECB is trying to stimulate the devel-opment of market-based alternatives to bank financing through its consideration of purchases of asset-based securities (ABS) in the next few months. But no miracles should be expected on this front: Many obstacles to cross-border capital market integration in the European Union are

deeply embedded in legislative frameworks and entrenched in financial industry struc-tures. Complementing the current bank-dominated system with a “spare tyre”4 of non-bank finance requires legislative and structural changes, which is what the CMU agenda is about.

It’s essential for the purpose of clarity to define “capital markets”, which in this paper is shorthand for a variety of equity and credit market segments that are small compared with banks, and thus play a smaller role in the process of channelling savings into investments in Europe. The list includes venture capital, private equity investment, public equity issuance and initial public offerings, corporate bond issuance, corpo-rate debt securitisation, direct purchase of loans by insurers and investment funds from banks, and credit intermediation by special-ised non-bank financial firms such as leasing companies or consumer finance companies.

Full EU-wide CMU coverageBy developing these and other financial market segments, the CMU agenda aims to make Europe’s financial system more efficient and competitive, more resilient thanks to greater diversity, more responsive to monetary policy signals, and more able to respond to the financing needs of a vibrant innovation-driven economy.

The European Commission has also made clear that, unlike the banking union, the CMU would cover all EU member states, including the United Kingdom because of its status as host to Europe’s largest financial centre in London. CMU policy should not freeze market structures in their currently underdeveloped form. On the contrary,


policy should improve the environment for the development of new forms of interme-diation – i.e. channelling savings toward productive investment – and new financing contracts, with effective but not excessive controls against systemic risk.

Setting the right CMU frameworkIn this respect, it is odd that some early blue-prints for CMU read like a catalogue of mar-ket segments, as if each of these needed spe-cific legislation to fulfill its potential.5 Rather than this curiously top-down government driven impulse, a more growth-friendly CMU approach should embody the prin-ciple of setting the right general framework that is conducive to the development of efficient financial services and contractual arrangements.6

An ambitious CMU agenda will face challenges from powerful interests threat-ened with displacement. Many banks will resist competition from alternative financ-ing channels. Banking advocates will warn against the perils of “shadow banking” and regulatory arbitrage, while ignoring that their own core features of deposit collection and high leverage call for targeted and oner-ous regulation.

Scepticism & national interestsA capital market development agenda will run into deep ideological scepticism from those who view markets with suspicion, a view that is influential among politicians and the general public in large parts of continen-tal Europe. This view is abetted by the fail-ure of economists to produce a convincing model for the financial sector around which a market-friendly consensus could coalesce.

Finally, as previously mentioned, the agenda may centralise regulatory policy at EU level to encourage market development, even though this would not be the primary end of the CMU project, unlike banking union. Such a move is sure to encounter stiff resistance from interests invoking national sovereignty in the United Kingdom and elsewhere.

The UK situation is unique because of the high concentration in London of whole-sale market activity, private equity, hedge funds, and other segments. Representatives of the City of London often highlight the benefits to the European Union of having a globally leading financial centre on its terri-tory. But they typically fail to acknowledge that the regulatory framework for the City should support the broader European public interest and not only the local interest of the UK.7

Six areas for inclusion in CMUAs Simon Gleeson, a prominent British legal expert on financial services regulation, put it, “We still do not have sufficient European control of the City of London to leave other European governments happy with the fact that increasingly Europe has only one finan-cial centre, and that is it.”8 This issue must also be considered within the current UK domestic political context, which is marked by uncertainty about government attitudes towards the European Union and even about continuation of EU membership.

Policymakers should concentrate on six specific areas for inclusion in the European Union’s nascent CMU agenda these are covered by increasing potential economic impact and political difficulty. Our first area


of inclusion should focus on the “regulation of specific market segments”. This area com-mands the broadest discussion and consen-sus so far. Possible items include defining simple and transparent securitisation prod-ucts; amending the Transparency Directive to facilitate market access for medium-sized companies; and harmonising frameworks for private placements. Onerous national rules that require non-bank lenders that do not take deposits to have a banking licence could also be dismantled.

Prudential frameworksThe second area should focus on a “review of prudential frameworks”. Regulators should reconsider capital and liquidity require-ments for financial firms that unnecessarily discourage investment in unrated corporate credit and other market segments.

In particular, prudential require-ments on insurers and pension funds have tended to mimic banking requirements, partly ignoring the fact that these players can legitimately take different risks from those taken by banks because of the longer maturity of their liabilities. The Solvency II Directive (for insurers) and the Occupational Pension Funds Directive should be reviewed accordingly.

EU-wide auditing regulatorThe third area should cover “financial trans-parency, accounting, and auditing”. While banks can use their relationships with bor-rowers to assess their credit worthiness, capital market investors need reliable public financial data. But public financial informa-tion in the European Union at present is of variable and often poor quality and not easily

comparable across the 28 member nation states.

A reform agenda could (1) harmonise EU regulation of auditors and create an EU regulator for the largest audit firms (some-thing that recently adopted EU audit legisla-tion signally failed to achieve); (2) establish a European chief accountant with author-ity over the enforcement of International Financial Reporting Standards (IFRS), either within the European Securities and Markets Authority (ESMA) or as a new EU agency; and (3) require the use of IFRS by all unlisted banks to enable consistent banking supervision.9

The fourth area should focus on “supervision of financial infrastructure”. Financial mar-ket infrastructure firms that carry potential systemic risk, primarily central counterpar-ties (CCPs, known as clearing houses in the United States), remain subject to a national framework for their supervision, contingent liquidity support, recovery, and resolution.

Existing major barriersThis existing framework creates major bar-riers to cross-border capital market integra-tion. The European Union should support the establishment of a global (treaty-based) supervisor and resolution authority for CCPs, with the establishment of an EU-wide supervisory and resolution agency for CCPs as a second-best alternative.

The fifth area of focus should be “insol-vency and debt restructuring frameworks”. Present European insolvency frameworks work too slowly. They result too often in liquidation, and they fail to protect employ-ment and private creditor rights.

Furthermore, differences across national


insolvency frameworks hamper the emer-gence of pan-European credit markets, not least for securitisations. Out-of-court restructuring is also underdeveloped in Europe. While full harmonisation would be unrealistic, EU framework legislation could help overcome national obstacles. Even par-tial harmonisation might foster cross-border market integration.10

TaxationThe sixth and most contentious area of focus should be “taxation”. Differences between national tax regimes for savings products pose a major obstacle to cross-border capital market integration.

Member states should seek more con-vergence in this area, either by unanimity or through enhanced cooperation, as well as simplification and stabilisation of national tax regimes.

In addition, the European Union should build on existing studies and national experi-ences to rebalance the differential tax treat-ment, which generally favours debt over equity.

The third and fourth areas could transfer some regulatory and supervisory functions from the national to the EU level. It would be a mistake to bar such a transfer a priori. EU-level supervision already exists within the ESMA for derivatives trade repositories and credit rating agencies.

London-based ESMA?Other categories of supervised financial firms may be subjected to either ESMA’s authority or one or several specialised agen-cies that are to be created. Simultaneously, ESMA’s governance and funding should

be reformed to better fit its supervisory role, as suggested in President Juncker’s mission letter to Commissioner Hill. A location in London for such new supervisory functions, inside or outside ESMA, could mitigate UK concerns.

The EU debate on CMU over the next few months should determine whether a realistic legislative reform agenda for the next half-decade could include all six of these items, or only some of them.

The debate should also shape which reforms are of highest priority, and in what sequence they should be adopted.

The European Commission will need to consult widely and will face challeng-ing tradeoffs. But capital markets union can become a major component of the European agenda of structural reform, and the cur-rent moment of opportunity should not be missed. •

Endnotes1. The SRF will reach its steady-state dimension in 2024.

2. Speech by Steven Maijoor, chairman of the European

Securities and Markets Authority (ESMA), at the Finance

for Growth Conference in Brussels, November 6, 2014,

www.esma.europa.eu/content/Capital-Markets-Union-

building-competitive-efficient-capital-markets-trusted-

investors.

3. “Capital markets union—Finance serving the economy,

speech in Brussels, November 6, 2014, http://europa.eu/

rapid/press-release_SPEECH-14-1460_en.htm

4. This expression was popularized by the then-chairman

of the Federal Reserve Board when he advocated a simi-

lar policy of capital market development in Asia following

that region’s crisis in 1997–98. See Alan Greenspan, speech

at the 1999 Financial Markets Conference of the Federal

Reserve Bank of Atlanta, www.federalreserve.gov/board-

docs/speeches/1999/19991019.htm.


5. See, for example, Hugo Dixon, “Unlocking Europe’s

capital markets union,” Centre for European Reform (Lon-

don), October 2014.

6. The phrase Ordnungspolitik, “Policy of order” in Ger-

man, is a familiar reference in European economic debates

to government action that focuses on setting the right

framework conditions for economic development, as

opposed to the dirigiste approach of directly promoting

or protecting individual economic actors, sectors, or in this

case, market segments.

7. See International Regulatory Strategy Group, “Briefing

on the principles that should underpin the development

of a Capital Markets Union in Europe,” City of London /

TheCityUK, 2014.

8. UK House of Lords, transcript of evidence taken

before the Select Committee on the European Union, Sub-

Committee A on Economic and Financial Affairs, Septem-

ber 9, 2014.

9. On a related theme, it is worth noting that the ECB

has taken steps towards the gradual formation of a credit

register that would cover the entire banking union area.

See the “Decision of the ECB of 24 February 2014 on

the organisation of preparatory measures for the collec-

tion of granular credit data by the European System of

Central Banks,” https://www.ecb.europa.eu/ecb/legal/pdf/

oj_jol_2014_104_r_0008_en_txt.pdf.

10. Separately, in order to move towards a more com-

plete banking union, a specifi c European insolvency regime

should be created for banks, at least the largest ones.

Editor’s note: The publisher and editor of the Journal would like to thank Nicolas Veron, visiting fellow at the Peterson Institute for International Economics, for allowing the Journal to re-print an amended version of this paper, which was first published in December, 2014. The original document can be downloaded from the following link: http://www.piie.com/publications/briefings/piieb14-5.pdf


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Opinion

Deregulation, non-regulation and ‘desupervision’ Professor William Black examines the causes of the mortgage fraud epidemic that has swept the United States.THE author of this paper is a leading

academic, lawyer and former banking regulator specialising in ‘white collar’ crime. As one of the unsung heroes of the Savings & Loans debacle of the 1980s, Professor Black nowadays spends much of his time researching why financial markets have a tendency to become dys-functional. Renowned for his theory on ‘control fraud’, Prof. Black lectures at the University of Missouri and Kansas City. He is the author of ‘The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry.’ A prominent commenta-tor on the causes of the current financial crisis, Prof. Black is a vocal critic of the way the US government has handled the banking crisis and rewarded institutions that have clearly failed in their fiduciary duties to investors.

The following commentary does not nec-essarily represent the view of the Journal of Regulation and Risk – North Asia. “The new numbers on criminal refer-

rals for mortgage fraud in the US are just in



Moral hazard

Is the concept of “moral hazard” a myth or economic reality?

Philip Pilkington and Macdara Dwyer ques-tion the validity of utilising moral hazard to

inform central banking and regulatory policy.

THE concept of moral hazard first began to appear in the economics literature in the 1960s and 1970s. It arose out of the growing body of literature called “contract theory” that was emerging in economics, especially that surrounding the work of Kenneth Arrow. A Google Ngram search reveals that the term took off in its modern form in 1975. By the year 2000, the term was appearing in published work nearly 15 times more frequently than it was in 1975.

The problem in contract theory falls under the heading of what has become known in economics as “information asymmetry.”A leading textbook lays out the problem in light of the following example: “After an owner of a firm hires a manager, the owner may be unable to observe how much effort the manager puts into the job… The hidden action case, also known as moral hazard, is illustrated by the owner’s inability to observe how hard his manager is working“. (Green et al 1995, p477)

What follows is typically a landslide of complex mathematics, which tries to show

how the various agents will maximise their utility and so forth, given certain presupposi-tions. Such mathematisation does not, how-ever, hide the fact that we are talking about problems basically of human trust (in this regard it is highly unlikely that mathemati-cal models can actually tell us anything novel or of interest about the phenomenon being studied). The basic problem runs as follows: if I enter into a contract with you, how do I know that you will follow through with your side of the deal?

Insurance heritageThe term “moral hazard” has an older, but more archaic sense, meaning outright fraud or immorality bordering on criminality (Dembe & Roden, 2000). Moral hazard – as a concept rather than a term – began life in the insurance industry in the middle of the nineteenth century. It described behav-iour arising from the unique relationship between the insurer and the insured.

First described in The Practise of Fire Underwriting (1865) as ‘‘the danger pro-ceeding from motives to destroy property by fire, or permit its destruction’’, moral hazard


indicated the risky or negligent behaviour engendered by individuals aware that another party will pay the ultimate price for recklessness. This origin/etymology had a lasting influence on the concept and it was used almost exclusively by this industry until the twenty-first century.

Unwarranted useThat is not to say that moral hazard has an actual definition in popular discourse – it would be more accurate to say that it is understood as any behaviour by organisa-tions or individuals in which future (invari-ably negative) consequences are borne by other entities. This flexibility and broadness has resulted in it being applied to a variety of situations where empirical observation indi-cates it is unwarranted.

These are usually situations in which a vested interest or an ideological mental-ity has used the term to argue for solutions detrimental to their perceived goals.This is apparent in the number of situations and problems that the term has been applied to. From the beginning it was freighted with subjective moral connotations and was ‘‘used by stakeholders to influence public attitudes to insurance’’ (Rowell & Connelly 2012).

Larry opinesMore recently, it has been used by the health insurance industry in the United States to argue against radical alterations in US health-care coverage or government intervention in the market for private health insurance (Gladwell 2005). Since the financial crisis of 2007-8, however, popular and media uses of the term have massively increased

When the financial crisis of 2008 was just

emerging on the scene talk began to emerge about moral hazard. Once of the first to weigh in on the debate was Larry Summers who argued against the importance of moral hazard at that point (Summers 2007).

Summers was trying to justify the fact that it was looking increasingly likely that the US government and the Federal Reserve would have to step in to pour money into insolvent financial institutions. He said that the risk of moral hazard was at least as bad, if not worse, than the risk of not acting at all.

Summers never made the case, however, that moral hazard had not been the main precipitant of the crisis. Granted this would have been a rather controversial position to take at that particular moment in time but it was also one that was in all likelihood true.

Savings & Loan scandalThe present crisis has quite famously not provoked extensive legal investigation so potential examples of cases that we might scrutinise as falling under the category of “moral hazard” are hard to come by. But we do have extensive legal accounts of the sav-ings and loan (S&L) crisis of the 1980s. In his seminal work on the crisis, prosecutor and economist William K. Black does not find any strong evidence that any of the typical channels of “moral hazard” played a large role in the crisis.

Indeed, Black suggests it was Federal deposit insurance that contributed to the unpalatable events of the 1980s, which is summed up in the following extract: “S&L control frauds generally relied on deposit insurance to fund their Ponzi growth. Federal deposit insurance was a key attraction to opportunistic control frauds and the primary


reason they clustered in the S&L industry. But that does not mean it was essential. S&L control frauds were consistently able to defraud uninsured private market actors. ACC/Lincoln Savings was able to sell over US$250 million in worthless junk bonds – the worst security in America – primarily from three branches in one state”.

Import of “control fraud”Following on, Black contends that: “It is true that Keating targeted widows because they generally lacked financial sophistication, but Keating also sold ACC stock to sophisticated investors. He beat the “shorts”, and (worth-less) ACC stock sold at a substantial share price after five years of continuous fraud. [Michael] Milken sold US$125 million of (worthless) ACC junk bonds to (purportedly ultrasophisticated) investors in 1984” (Black 2005, pp254-255 – My emphasis).

Rather, what Black and other investiga-tors found over and over again was that the main culprit for allowing financial institu-tions to over-extend themselves was simple accounting fraud. Large companies were able to use their clout in both regulatory circles and among the accounting agencies to effectively cook the books. The CEOs of these companies did not care a great deal whether the companies would go insol-vent or not because they were able to make massive personal gains while running the companies.

Key culpritsWhile deposit insurance certainly made it easier for many companies to cook the books during the savings and loan crisis, it was not key to understanding the crisis. The key

culprits were regulatory capture and simple accounting fraud while the motivations were typically simple greed and an overarching sense that even if the whole thing collapsed one’s personal wealth would remain intact.

In the recent crisis we saw a re-emer-gence of this dynamic in the acronym that emerged out of the financial industry “IBGYBG” which stood for “I’ll be gone, you’ll be gone”. No such similar acronym has yet surfaced that indicated that actors were thinking in terms of: “If trouble occurs, the authorities will bail us out”.

In the US in the 19th century we see banking crises every decade or so. Indeed, we can count in this era at least seven major “panics”: 1819, 1837, 1857, 1873, 1884, 1893 and 1896. As the careful reader will note, these crises increased in frequency in the later part of the 19th century as the financial system became more developed.

Homo speculatisA further two crises took place in the early 19th century in 1901 and 1907, the latter of which led to the founding of the Federal Reserve in 1913. Now, during the 19th cen-tury there was not much risk of what would today be called “moral hazard”. If a bank failed it was allowed to go under. Those that held a stake in the bank – and also often those that held savings deposits at the failed bank – would be allowed to go bankrupt. Yet despite this fact these crises occurred with increasing intensity every few years.

The fact is that the “moral hazard” argu-ment has it all wrong. It implicitly rests on a view of man as a homo economicus, a rational agent who learns from his mis-takes, rather than the homo speculatis that


he actually is. People are extremely prone to herd behaviour, especially in the finan-cial markets, as the great economic his-torian Charles Kindleberger noted well (Kindleberger 2005). Allowing institutions to go under does not result in some sort of evolutionary process in which the bad ele-ments are weeded out and the good allowed to prosper.

Bad banker memeThe sad fact of the matter is that the com-petitive market does not self-regulate; rather it simply has a tendency to go haywire every now and then. The moral hazard argument is one only put forward by people who, at some level, believe that in the “long-run” financial markets are somewhat efficient.

During the financial crisis a commenta-tor or interested observer was either against the banks or they were likely in some way tied to the banks. The hostility to the industry transcended political divisions and was basi-cally a consensus opinion.

The same was the case with the moral hazard argument. Because it became basically synonymous with the “bad banker”narrative adopted by all sides few questioned it. But when examined in any detail it becomes clear that it was always a thoroughly free market and anti-regulatory argument.

Sovereign debt crisisThose that had deployed it on the left, and those who believed that the government has a role to play in regulating the economy more generally, quickly found their chickens coming home to roost when the argument began to be used to justify austerity. As the

sovereign debt crisis in the Eurozone started to boil over the moral hazard was adopted by those that opposed bailouts. They claimed that backstopping a country’s sovereign debt would incentivise them to engage in reckless borrowing practices.

The irony is, of course, that countries like Ireland and Spain had been running fis-cal surpluses before the crisis and it was the banks that led to the deficits and public debt build-ups. It was precisely because there was no central bank standing behind their private banks that huge amounts of pub-lic debt had to be issued to backstop these banks. Some pointed to Greece which had been running fiscal deficits prior to the crisis (Gerson 2012).

More conspiracy than factFew enquired whether these deficits were structural and largely caused by the actual setup of the Eurozone system and instead many commentators and politicians leapt on the moral hazard argument. A sort of conspiracy theory was generated that said that the Greeks had basically concocted a scheme to game the system and if they were bailed out they would only repeat the grift.

Looked at from any reasonable point of view, however, the moral hazard argu-ment is either an abstraction that does not adequately explain real world motivation – again, there are no documented cases of those in charge of large institutions actually acting in this manner – or it is something bordering on conspiracy theory where it is imagined that government officials and bankers conspire to defraud whomever is above them without any evidence of this conspiracy ever being discovered.


In terms of public finance, good macro-economic theory tells us that government deficits – especially large government defi-cits – are mostly endogenous; that is, they are generated by large-scale macroeconomic shocks that cause tax revenue to decline and unemployment compensation to rise. Indeed, there is good reason to think that this stabilises the economy and prevents it from falling into an almost bottomless depression (Godley & Lavoie 2006).

Popular lexiconGovernment deficits are rarely opened up by the choice of irresponsible politicians outside of war or social upheaval. Again, the onus should be on those making the moral haz-ard argument with respect to public finances to give examples to the contrary. Otherwise we must assume that this is not a serious explanation and is likely just a cover for an underlying politically motivated argument.

The way that “moral hazard” has entered the common lexicon is a perfect good case study in the transference of pseudo-techni-cal, morally-loaded terminology to common consciousness. It is also a good case study of the way such terms, imbued with moralistic meaning can be utilised to justify or prevent a variety of strategies that threaten particular interests.

Linguistic gymnasticsThe representational gymnastics of the term “moral hazard” is equally apparent within a very narrow timeframe, namely, from the period 2004-2014. It began it from a warning against universal health-care coverage (vis-ible in post-Katrina handwringing over pur-portedly excessive relief funds). Since then,

the phrase has shifted and was absorbed by left-liberal opinion during the financial crisis as a way of traducing the alleged immorality (and implied illegality) of the banking indus-try and its members. It gained its greatest exposure through this channel.

These commentators, at loss for an expla-nation, but desirous of scapegoats, trans-formed the insurance and health lobbies’ dismal belief in reckless individual behaviour and applied it to an industry held to blame for the series of complex economic and finan-cial decisions of an aggregate of millions of individual policy-makers, lenders, borrow-ers, agents and auxiliary service workers. The degree to which this simplistic – and easily assimilated – narrative has saturated popular understanding of the ongoing financial crisis should not be underestimated.

Popularised on the silver screenTake this exchange from a popular sequel to an earlier movie about Wall Street’s excesses called “Wall Street: Money Never Sleeps” – both of which are what would have been called in times past ‘morality plays’; that is a genre of Tudor plays that served to instruct the public about the evils of society and how to overcome them. The principal bankers of New York – in a dramatised (but thinly-veiled) depiction of the Lehman Brothers collapse – gather to discuss the potential ramifications and possible strategies for the insolvency of a fictional investment bank, Keller Zabel Investments. A federal bail-out is proposed. The dialogue runs as follows:

Bretton James (interjecting): What about moral hazard, Jack? We bail out Keller Zabel, who’s to say it’s not going to happen again and again?


Louis Zabel: You vindictive bastard! Who are you to talk about moral hazard?

Bretton James: Sorry Lou, the Street needs to make a statement here to the world….

Totemic expressionIn the film, it is made clear that “Keller Zabel” reached such dire circumstances through incompetence, herd mentality and confu-sion rather than through self-assurance that government agencies or other financial insti-tutions would automatically assist in case of difficulty or default. But such complex and morally ambiguous realities did not accord with public and journalistic appetites during and after 2008.

So, the media turned a moralistic and loaded concept – previously utilised by spe-cific vested interests in order to appeal to a public desirous of simplistic moral tales – and applied it to the financial institutions.

However, this usage, once out of the bag, became a totemic expression that might be used to banish any innovative or undesir-able policy alteration by appealing to the ingrained moral determinism created by its initial use. The short-sightedness of those who began its use must be clear in this regard.

Further risksToday it is used ad nauseam to make the case that any country or institution which requires funding in order to prevent eco-nomic collapse or depression will only end up taking advantage of such well-meaning intervention.

And it is thus that the term becomes the key argument in favour of the policies

of economic depression and stagnation that we see across the world today.

The widespread use of the term also raises another important risk: if the major econo-mies were to experience another banking crisis in the next few years would the term be used to ensure that governments and central banks did not intervene? In such a situation we would likely see a wave of bank failures as we did in the US in the period 1929-1933 as the economy plunged into the depths of depression.

In their justified moral outrage there is every chance that the public might demand policy action that would ultimately serve to do ruinous damage to the economy and to their own employment prospects.

Politically motivatedThe fact is that the moral hazard argument is a politically motivated one. Not only does it cloud our judgement when trying to under-stand the real dynamics of what happened in the run-up to the 2008 financial crisis, but it also furnishes ready-made artillery for those who want to engage in ‘Scorched Earth’ economic policies that will only lead to ruin for the countries that implement them. People engaged in such debates should think long and hard about using such terms opportunistically lest they give rise to forces that they would otherwise want to keep under control. •

.Editor’s note: The publisher and editor of the Journal of Regulation & Risk - North Asia would like to thank Macdara Dwyer, the Journal’s associate UK editor, for his coopera-tion with Philip Pilkington in assisting with the research and writing of this paper.

Policy brief – bank bail-ins

Why “bail-in” securities should be considered fool’s gold

Avinash D. Persaud of the Peterson Institute cautions against investors and regulators treating “bail-in” securities as a panacea.

BAILOUTS and bail-ins of failing financial institutions have been hotly disputed in the global financial crisis of the last five years. At the height of the crisis, several failing banks were bailed out with taxpayer money so they could service their debts, but as public outrage mounts, policymakers are increasingly looking at bailing in these institutions before using taxpayer funds.

Bail-ins, also called haircuts, require the troubled institution’s creditors to write off some of the debt or agree to a restructuring of the debt, which reduces their holdings. The public has demanded the imposition of these costs on creditors and bondhold-ers, arguing that if bad lending as well as bad borrowing went unpunished it would be encouraged. Additionally, the yawning fiscal deficits that have followed bailouts have led to unpopular fiscal retrenchment.

Consequently, eliminating bailouts has become a political imperative on both sides of the Atlantic. The clear intention of the Dodd-Frank Act (2010) in the US was to end taxpayer bailouts through more bail-ins.

The European Union’s Bank Recovery and Resolution Directive (BRRD), which came in to force in January this year, requires creditor bail-in before public funds can be accessed.

Bail-ins and creditor haircuts have long been a feature of resolutions and recapi-talisations when banks have become, or are on the verge of becoming, “gone” con-cerns. This time the public outcry against bailouts has also led to the development of something new – the automatic bail-in of creditors of institutions that are still going concerns. This mechanism and its attendant instruments are the focus of the remainder of this paper.

The Financial Stability Board and national regulators – among them the US Federal Reserve Board and the European Central Bank (ECB) – are formalising rules requir-ing the 30 globally systemically important banks (GSIBs) to hold an additional layer of capital. Estimates range from 4 to 7 per cent of risk-weighted capital or approximately US$1.2 trillion globally or US$250 billion in the US and more in Europe. A bank’s losses would be met by this additional buffer first before the minimum capital adequacy level


is touched. To put the size of this new buffer into context, between 2009 and 2012, the 16 largest US banks raised just US$24 billion of new equity capital and the 35 largest banks in Europe raised only US$23 billion. But the proposal is that this additional layer of capital need not be in the form of equity or retained earnings.

A political trade-offWe may be witnessing a political trade-off where bankers give in to the substan-tially higher overall capital requirements demanded by politicians if part of this addi-tional capital is in instruments that, com-pared with issuing more equity, are cheaper and do not dilute the bankers’ control and pay in the good times. These bail-in securi-ties, commonly known as cocos, convert into equity once a bank’s capital falls below a pre-announced level.

Even before the ink is dry on these pro-posals, banks have started to issue cocos and the market has quickly grown to a capitalisa-tion of US$150 billion. The case for bail-in securities is that bailouts create “moral haz-ard”, i.e., they encourage reckless lending by banks in the secure knowledge of a rescue if desperate times ensued. Bailouts also allow depositors, creditors, and investors to relax their monitoring of banks knowing that taxpayers will foot the bill if things fall apart. Many see both behaviours as critical in per-petuating boom-bust cycles.

Idiosyncratic bank failuresIn fixed exchange rate regimes, such as the eurozone, there is the added potential of a “doom-loop”, where increased public debts and sovereign credit downgrades undermine

the remaining healthy banks that hold many of their assets in government securities. Higher public debts in Europe and else-where, as a result of bailouts, have also led to cuts in safety nets to the most vulnerable and in public investment.

The case of moral hazard may be over-stated. An important element of financial crisis is commonly considered safe assets, like housing, becoming risky, not starting off as risky, but the focus of this paper is on how these new bail-in instruments fare when clouds first appear on the horizon.

Bail-in securities may make sense for an idiosyncratic bank failure – like the 1995 collapse of Baring Brothers, which was the result of a single rogue trader. But they do not make sense in the more common and intractable case where many banks get into trouble at roughly the same time as the assets they own go bad.

Fool’s gold is no alternativeOn such occasions these securities, which may also have encouraged excessive lending, either will inappropriately shift the burden of bank resolution on to ordinary pensioners or, if held by others, will bring forward and spread a crisis. Either way they will probably end up costing taxpayers no less and maybe more. In this regard, fool’s gold is an apt description. Fool’s gold has a metallic lus-tre that gives it a superficial resemblance to gold. However, it is an iron sulphide, one of the ancient uses of which was to spark fires.

Either we need real gold – more equity capital – or not. Fool’s gold is no alternative!

Banks are required to hold a minimum amount of capital – assets able to absorb a loss. They generally can’t meet permanent


losses by borrowing, for instance, because it would need to have the resources to repay those loans with interest. Bank capital is pri-marily made up of retained earnings and the sale of equity held in near-cash instruments.

What is safe, what is riskyThe minimum amount of capital held by internationally important banks is set under the Basel Accord and is a ratio of the bank’s risk-weighted assets. The idea is that the riskier the assets the more capital banks need to hold. The 30 GSIBs hold approxi-mately US$47 trillion of assets, US$18 trillion of risk-weighted assets, and US$2.5 trillion of capital. Many issues surround this frame-work, such as the assessment of what is safe and risky and what requires social insurance, but further discussion of these is outside the scope of this paper.

When a going concern’s capital falls below a preannounced ratio of its risk-weighted assets, bail-in securities automati-cally convert into more equity to absorb the concern’s losses. Cocos are bonds that pay a coupon in good times and convert into equity that could be lost completely with-out any recourse in bad times. This new equity injection automatically dilutes exist-ing shareholders. The range of instruments that have a similar effect goes beyond cocos and includes other hybrids (financial instru-ments bearing characteristics of both debt and equity) or wipeout bonds.

Trigger levelOne of the critical issues for cocos and similar instruments is the point at which they auto-matically convert from debt-like to equity (i.e., the trigger level). Too low a trigger and

in effect the instrument converts directly into a loss. Too high a number and it may give the false impression that the bank is about to topple over. Banks fear the latter more than the former.

In periods of financial stress, financial markets quickly become febrile rumour mills where expectations – right or wrong – become self-fulfilling. If a bank’s coun-terparties are reluctant to extend short-term advances it is quickly done for. Most of the early cocos had low trigger levels. To offset the tendency to set trigger levels too low, some newer instruments have dual triggers, with the first trigger leading not to conver-sion but suspension of the coupon payment.

Exponential growthAlthough the picture is still emerging, it appears that regulators at the Financial Stability Board are progressing towards an international agreement that by 2019 the 30 GSIBs should carry total loss absorbing capital (TLAC) of around 16 to 20 per cent of risk-weighted assets, but when factoring in other buffers this will effectively be 21 to 25 per cent.

Critically, only part of that will need to be in the form of equity or retained earnings. The rest will be in the form of bail-in secu-rities, because for a banker issuing equity is more expensive than debt. The 30 GSIBs would require over US$1 trillion of new bail-in securities.

The market for bail-in securities has already grown from virtually nothing in 2010 to a cumulative issuance of approximately US$150 billion towards the end of 2014, despite the fundamental uncertainty about regulations regarding the amount of capital


required and the features of eligible bail-in securities.

Dash for cocosThis growth is perhaps a testament to the hunger for assets and yield in the market-place today. Credit Agricole’s coco issued in February 2014, which offered a 7.8 per cent coupon, generated US$25 billion of orders chasing a US$1.75 billion issue. Since then the Credit Suisse index of coco yields has fallen to 6 per cent.

The trend line is straight, where each year more cocos are being issued than in the previous, suggesting that a target of US$1.2 trillion may be possible if raised over sev-eral years, though the proposed 2019 target is tight. By the end of 2014, still ahead of formal agreement on what constitutes an eligible bail-in security, an estimated US$85 billion worth of cocos will have been issued.

Recent issuers include Banco Bilbao Vizcaya Argentaria, Barclays, UBS, Crédit Agricole, SNS Reaal, Société Générale, and KBC Bank. Deutsche Bank and HSBC are reportedly debating issues on the order of US$6 billion. Approximately 80 per cent of the issuance has been from European banks (including those headquartered in the UK and Switzerland).

Regulators’ ireIn the absence of the scrutiny that will come when one of these instruments is “converted”, there is little information on who is buying. Early indications suggest it is investors focused on short-term gains, namely retail investors, private banks, and hedge funds, not the buyers regulators want.Regulators are particularly keen that banks

not hold cocos. The banking system is more “systemic” than almost any other because of its unusual degree of interconnectivity: One bank’s loan is another’s deposit.

If banks held the bail-in securities of other banks, trouble at one bank would instantly spread to other banks. Interconnectivity would be reinforced, not dispersed. This interconnectivity would also exist if the holders received a significant amount of their funding from banks, such as leveraged special investment vehicles, hedge funds, or private equity firms.

Regulators say that they want long-term holders of these instruments. It is likely that they will propose that in order to count towards TLAC, a bail-in security must have a maturity of at least 12 months, possibly longer, with a view to attracting long-term investors to own these assets. Banks have followed suit and many of the issued bonds have maturities of 5 to 10 years.

Asset concentrationLong-term holders are primarily pension funds and life insurance companies as they have the long-term liabilities. Many throw sovereign wealth funds into the mix; they did step up to the table in 2007 and 2008 in a few high-profile bank capital raisings.

However, once defined as funds that are not backed with short-term liabilities like foreign exchange reserves, they are not as large in aggregate as many think. Cumulative assets are not much more than US$6 tril-lion. Pension fund assets in advanced coun-tries are close to US$22 trillion. While this appears to dwarf the potential size of the bail-in security market, most of these assets are concentrated in the three countries that


rely on private rather than public pension provision (US, UK, and the Netherlands) and where a fair portion of the assets are in annuity programmes with little capacity for investment risk.

UK’s FCA interventionIn countries such as Germany, France, Italy, Spain, Belgium, and Portugal, there is a severe mismatch between the proportion of risk-weighted assets of banks and the pro-portion of pension assets held there.

There are other, major problems with pushing these instruments on to pension funds and life insurance firms. A key danger is that taxpayers would be saved by pushing pensioners under the bus. If a crisis has not been prevented, it is unlikely that the direct and indirect consequences of delivering a loss to pensioners are lower, and more fairly distributed, than giving taxpayers a future liability. The opposite is far more likely to be the case.

Indeed, it is interesting that in 2014 the UK’s new Financial Conduct Authority (FCA) used its consumer protection pow-ers for the first time in suspending the sale of cocos to retail investors on the grounds that the instruments were “highly complex” and “unlikely to be appropriate for the mass retail market”. The authority also stated that “there is growing concern that even profes-sional investors may struggle to evaluate and price cocos properly” .

Taxpayers on the hook again!If pension funds suffered losses on cocos, taxpayers would very likely be pressurised into bailing them out. Given the greater fragmentation of the savings markets such

a bailout will probably be even more com-plicated, messy, and politically sensitive than bailing out a handful of banking institutions.

Another problem is that from an invest-ment and economic perspective these are the wrong type of instruments for pension-ers and life insurers to own. Financial instru-ments offer returns above the risk-free rate as compensation for different risks.

The principal investment risks are credit, liquidity, and market risks. They are identi-fiably separate types of risks because each must be hedged differently. Distinct inves-tors, courtesy of their unique liabilities, have innate abilities to hedge certain risks and natural inabilities to hedge others.

Market reluctance to “buy”The right economic and investment strategy for an investor is to hold those risks for which they have a natural ability to hedge and to rid themselves of risks that they cannot hedge.

That strategy will lead pension funds and life insurance companies away from bail-in securities, unless the authorities attract them in some other way. It also suggests that their current reluctance to buy them is deliberate and not a result of unfamiliarity.

Liquidity risk is the risk that if one has to sell an asset tomorrow it will fetch a far lower price than if one could afford the time to wait to find the particular buyer. To hedge liquidity risks one must have time to wait – perhaps through long-term funding or the long-term liabilities that pension funds and life insurance companies have.

But having time does not help to hedge credit risks. The longer a credit risk is held the more time there is for it to blow up. Being required to hold a General Motors


bond for one day carries little risk. Being required to hold it for 25 years carries signifi-cantly greater risk.

Choosing the right instrumentCredit risk is best hedged by diversify-ing across a wide range of credit risks and actively managing the spread of risk – in the way that a bank or a credit hedge fund can do far more easily than a traditional pension fund.

The right instruments for institutions with long-term liabilities, like pension funds and life insurance, are instruments offering a higher return because they are illiquid rather than because they carry substantial credit risk.

Examples of these instruments include infrastructure bonds (especially where there are guarantees or hedges on the construc-tion risk and market risk), asset-backed securities, and real estate development – the exact type of assets they have historically purchased.

From a private investment perspective, bail-in securities are best held by investors able to diversify and monitor a wide range of liquid credit risks, such as hedge funds. It should be no surprise that they appear to be the ones currently buying them.

Encouraging pension funds and life insurance companies to follow would not be in their best interests.

Regulatory interferenceIf, in a liquidity crisis, the price of a credit instrument falls sharply – not because it is no longer performing but because the market is so spooked by a background of turmoil that there is no liquidity in the asset class – then

it makes sense for institutions who can comfortably own liquidity risk, like pension funds and life insurance companies, to buy them at that point. They should then keep them until their price has recovered and the greater part of their future return no longer reflects a liquidity risk but a credit risk.

Allowing pension funds and insurance companies to do that not only makes good sense for them – they are earning a return for taking a risk they have a natural ability to hedge – but it also makes for a more resil-ient financial system. Life insurance com-panies complain that regulators of savings institutions make it hard for them to do that through regulatory requirements to hold certain assets, mark their assets to market prices, and adhere to short-term measures of solvency.

Passing the regulatory buckIt would also be hard – usually for internal reasons – for them to buy bail-in securities when they are cheap if they had previously owned them at a time when they were expensive. If they had bought bail-in secu-rities during the good times and suffered an unanticipated loss later, regulatory and internal pressures (investment losses tend to trigger regret rather than a desire to find bar-gains) would conspire to reduce their appe-tite to purchase the better valued of these instruments just when the market most needs buyers and differentiation.

The regulation of long-term savings institutions is a subject for another paper, though I will make the observation here that bank regulators appear to be putting the safety of banks into the hands of a dif-ferent part of the financial sector – long-term


savings institutions – not regulated by them and without much coordination with that sector’s regulator.

Heterogeneous resilienceBut there is an important point here on sys-temic resilience that will further inform this discussion on what kind of instruments and behaviour would reduce the scale of finan-cial crises and the attendant need for tax-payer support.

Financial sector liquidity is about diver-sity not size. A market with only two players, where one player wants to buy whenever the other wants to sell, perhaps because one has short-term liabilities and focus and the other long-term liabilities and focus, is more liquid than one with a thousand players who, because they all use the same model of value and risk, want to buy or sell assets at the same time.

Homogeneity of behaviour is the route to liquidity crises. Heterogeneity creates resilience. To limit the economic disruption and costs of a financial crisis the forces of homogenous behaviour must be tempered and the sources of heterogeneity encour-aged. Observers of economic or financial cycles would recognise this as the need for instruments or investment behaviour that counters the procyclicality of finance.

Liquidity test failureA simple test of whether a new policy or instrument will help deal with a liquidity cri-sis is whether it will moderate the collective enthusiasm to buy assets during a boom or the crowd mania to sell them during a crisis.

The dynamics of financial markets sug-gest that bail-in securities will fail this test.

Short-term investors, such as hedge funds, who buy these instruments do so today and will do so in the future because they see no near-term risk of a bail-in. Their investment philosophy will be that in the long run you need to be out or you are dead.

The longer their belief that short-term risks are low is validated, the more confident they will get and the more they will want to own these instruments, sending their yields lower. The more these yields fall, the more the banks will be encouraged to issue more of these securities, enabling them to lend more.

Temper bank behaviourIncidentally, because they are short-term in focus they will not, as it was hoped of hold-ers of these instruments, invest in monitor-ing long-term developments and emerging concentrations of risk. They will assume that they are not holding these instruments long enough for it to matter to them and anyway someone else is doing that. It is therefore unlikely that these instruments would tem-per bank lending prior to a crash.

If prior to the global financial crisis we had a “going concern, total loss absorbing capital limit” of 25 per cent of risk weighted assets, and half of that capital was in bail-in securities, banks may have had even more assets on their books – not less.

Confidence in financial markets gener-ally comes in only two flavours: high or low. In the US, over the past 15 years, the Federal Deposit Insurance Corporation (FDIC) has closed 532 banks – an average of 35 each year. Yet, in 2003, only three banks were closed and in 2004 four. None were closed in 2005 and 2006.


During the four years before the global financial crisis, when confidence was rid-ing high, the yields on subprime mortgages were low, falling within 1.0 per cent of AAA corporate bonds in 2004. It wasn’t just short-term financial participants who were overconfident.

Historic lessonsPrior to 2007, Financial Stability Reviews at central banks regularly supported the notion that the new risk management techniques and bumper estimates of bank capital sug-gested banks had never been so safe and the search for systemic risk was concentrated elsewhere.

It is contrary to the lessons of history to suppose that if bail-in securities were around then, their yields would have constrained banks from issuing more and lending more. Even today, when the economy is far from free of the clutches of the global financial cri-sis, bail-in yields at close to 6.0 per cent are below long-run average equity returns.

When an event changes perceptions of risk, short-term investors in these bail-in securities will trample over each other to reach the exit before bail-in. These inves-tors are not interested in hanging on, not just for reasons of potential losses but because a bail-in is not an eventuality they have the institutional capacity to manage.

Contagious mechanismsFunds that trade in liquid debt securi-ties cannot easily become owners of illiq-uid bank equity. As they form a disorderly queue at the exit, the price of these securities will collapse, triggering a series of contagious mechanisms.

We have seen these before, notably in the Asian financial crisis between 1997 and 1999, during the first, credit derivative phase of the global financial crisis between 2007 and 2008, and to some extent dur-ing the October 1998 Long-Term Capital Management (LTCM) crisis.

Faced with collapsing prices, and declin-ing confidence, the rating agencies will downgrade bail-in securities. More stoical holders of bail-in securities who had resisted the urge to sell in the first wave will now be forced to sell as a result of investment man-dates limiting the holdings of low-rated instruments. If the size of the market were US$1.2 trillion then it would be significant enough.

However, there will be wider knock-on effects where these instruments are being used as collateral for other instruments or where their prices are used to price other, less liquid, assets. Hedge fund clients will bolt for the exit, forcing hedge funds to raise liquidity by selling otherwise unconnected assets.

Bail-ins may exacerbate crisisThese indirect effects will give an impres-sion that strong, hidden undercurrents are driving financial markets, which will cause aggregate uncertainty to rise, triggering a general risk aversion and further liquidation of assets. There are many avenues through which the correlation of asset prices tends towards 1 during a period of stress.

Collapsing asset prices will undermine the position of banks. Bail-in securities will bring forward and spread a crisis, not snuff it out. As recently as February 2013, long after policymakers had insisted that the time for bailouts was over, the Dutch government


decided to nationalise SNS Reaal and spend US$5 billion paying off senior creditors, pro-tecting depositors in full, and cleaning up the bank. The Dutch finance minister said that this was necessary because not doing so would have posed a “serious and imme-diate threat…to the stability of the financial system.”

Loss expectationsA similar approach was taken in August 2014 in the rescue of the Portuguese Banco Espirito Santo, even though there was a good case to let it fail due to the unusual and precarious situation the bank was put in by its controlling shareholders.

Supporters of cocos argue that Europe required only another €150 billion of capital to offset bank losses, and bail-ins of this large but manageable sum would not be destabi-lising. This is how it might look long after the embers of a financial crisis have cooled. But in the middle of a crisis, when bail-ins would be triggered, speculation of potential losses is many times greater than the realised losses once the system has been stabilised.

At the time of Lehman’s default it was widely reported in the press that losses could range from US$270 billion to US$360 billion, as it was feared that many counterparties would not honour their side of derivative contracts. When the dust settles, counter-parties survive, and the administrator and lawyers have done their chasing, the net payout will be just US$6 billion.

Difficult to adjust market dynamicsIt would be wrong to conclude that all would have been fine if only there were another US$6 billion of capital. Bailouts risk

encouraging reckless bankers and credi-tors and depositors who take their eyes off the ball. The global financial crisis has also powerfully illustrated how the socialisation of risks can hobble policymakers from fully responding to the economic consequences of a financial crisis and can have seriously adverse distributional consequences.

But the market dynamics that deliver financial crises cannot easily be adjusted to deliver bank resolutions that are free from recourse to taxpayers or severely adverse economic consequences.

Credit economies are founded on confi-dence and there are no easy market mecha-nisms to recover from the disruption of that confidence. Bail-in securities will help to address idiosyncratic bank failures where the circumstances are unique to one institution, confidence in the system is not at risk, and the scope for contagion is limited.

Bank resolutionBut authorities are already quite good at resolving these individual gone concerns, often with the help of some creditor bail-in or haircut. In the US, the FDIC has been doing so routinely and quite effectively for decades. In the UK, the oft-quoted example is the tidy wind up by the Bank of England of Barings Bank in 1995 after Nick Leeson’s trading bets on the Nikkei 225 futures rid the bank of all its capital.

The circumstances that the authorities are much less good at resolving are those where many banks run into trouble around the same time. It is in these situations that bail-in securities are likely to make matters worse not better.

Regulators envisage bail-in securities will


be bought and held by long-term investors like pension funds or life insurance com-panies. But these are the wrong kinds of assets for investors with long-term liabilities. Regulators should know better.

Import of credit riskPension funds and insurance companies need assets that provide higher yields as compensation for liquidity risk not credit risk. Credit risk, like that embedded in bail-in securities, is a risk that rises with time and is best held by investors with access to a wide range of credit risks that they actively diver-sify and manage over the short term and not by investors who buy and hold for a long time.

If regulators prohibit banks and retail investors from holding these instruments they will be held by short-term, leveraged investors like hedge funds. This appears to be what is already happening with insti-tutional investors staying away and hedge funds chasing the extra basis points.

But if hedge funds own a US$1 trillion plus bank bail-in securities market, it will likely lead to a crisis being brought forward and spreading. A test of whether a new policy or instrument will help deal with a liquidity crisis is whether it will moderate the collective enthusiasm to buy assets dur-ing the prior boom or to sell them during the subsequent crisis. Bail-in securities held by hedge funds or other short-term, leveraged institutions would fail this test.

Bail-in securities no panaceaDuring the boom years when short-term risks appear low and this assessment is repeatedly validated over short periods of

time, these investors will demand more bail-in securities, driving down their yield, encouraging their issuance, and enabling banks to expand their balance sheets and loan portfolios.

Short-term investors, aware that they are not in a position to be converted into a long-term equity investor, will try to preempt any change in the environment that suggests what was previously safe is no longer so.

When a few read signs of trouble ahead and start to exit, others will quickly follow.

There will be a herding and self-feeding effect across the asset class, putting scru-tiny on good and bad banks alike as yields on cocos rocket across the board and rating agencies follow, with widespread down-grades of the securities.

The full gamut of the alternatives to bail-in securities to mend the banks, revive the economy, and limit the cost to taxpayers, is outside the scope of this paper.

My remit here is to show that bail-in securities are not the silver bullet. In prac-tice, they will likely make matters worse. If more gold plating of bank capital is what is required, then this fool’s gold will not do. •

Editor’s note: The publisher of the Journal would like to thank Avinash D. Persaud, non-resident senior fellow at the Peterson Institute for International Economics and emeritus professor at Gresham College, UK and the Peterson Institute itself for allowing the Journal to re-print an abridged version of this Policy Brief, which was first published in November, 2014. The original full docu-ment can be accessed at the following link: http://www.iie.com/publications/interstitial.cfm?ResearchID=2706

Banking union

After AQR & stress tests, where next for EU-banking?

Much more needs to be done if the nascent EU banking union is to escape the notion it’s

“half-baked” argues Cass’s Thorsten Beck.

THE ECB published the results of its asset quality review and stress tests of Eurozone banks on the 26 October, 2014. This paper argues that, while this process had clear shortcomings, it still constitutes a huge improvement over the three pre-vious exercises in the European Union. Nevertheless, the banking union is far from complete, and the biggest risk now is complacency by all parties involved in this process. A long-term reform agenda awaits Europe.

The European Central Bank (ECB) in the final quarter of 2014 published the results of a year-long painstaking process to go through the books of the 130 largest and most important banks of the Eurozone, adjusting balance sheets and testing the sen-sitivity of their capital position to two differ-ent scenarios, one of which includes a severe economic downturn.

This exercise constitutes the entry point to the Single Supervisory Mechanism, where the European Central Bank has direct super-visory responsibility for most of these 130 banks and indirect responsibility for the rest

of the banks in countries that are members of the Single Supervisory Mechanism.

There is a lot to be said and criticised about the asset quality review (AQR) and stress tests, but it certainly constitutes a huge improvement over the three previ-ous exercises in the EU, particularly the fact that this assessment was a top-down approach – driven and monitored by the ECB – that focused on creating a level play-ing field in asset valuation and stress testing across banks in the Eurozone. And, that by combining the asset quality review with the stress tests it increased the transparency and reliability of the stress tests.

ShortcomingsHowever, there are also clear shortcomings, the most important of these being that the stress test still does not include the scenario of a sovereign default; it does not include the adverse scenario of deflation, an issue that was less of a concern when the stress test scenario was developed earlier this year;.

And, finally, It focuses exclusively on the risk-weighted capital–asset ratio and not on the leverage ratio. For instance, 14 of the 130


banks before the asset quality review, and 17 banks after, are below the 3 per cent leverage ratio, and that does not take into account yet the effect of the stress tests themselves.

Glaring discrepanciesThe results provide interesting insights into the shortcomings of national supervision, as the asset quality review has revealed glaring discrepancies in asset classification. For example, more than 20 per cent of the reviewed debtors were reclassified as non-performing in Greece, Malta, and Estonia, and even 32 per cent in Slovenia. In the case of one bank, that share even amounted to 43 per cent.

This suggests a high degree of regulatory forbearance. These discrepancies between published balance sheets and adjusted numbers presented in the ECB clearly point to the consistency advantages of suprana-tional supervision.

Overall, the comprehensive assessment identified a capital shortfall of €24.6 billion across 25 participating banks after com-paring the projected solvency ratios under the adverse stress test scenario against the threshold of 5.5 per cent tier 1 capital relative to risk-weighted assets.

Capital raisingTaking into account capital raisings during 2014, only 13 banks still face a net capital shortfall of a total of €9.5billion, a rather small number. Among these 13 banks, four are in Italy, three in Greece, two in Slovenia, one in Portugal, one in Austria, one in Ireland, and one in Belgium – thus a certain concentra-tion in crisis countries.

The number of banks with (net) capital

shortfalls seems exactly what the doctor pre-scribed – not too low, so that the test would be considered rigorous enough, not too high, in order to not shake the market.

As recognised by the ECB itself, this is just a starting point into the Single Supervisory Mechanism; as capital requirements become tighter, additional capital shortfalls might appear.

The initial reaction seems to indicate that the ECB has achieved two of the objec-tives of the exercise: transparency and con-fidence building. The third objective – repair of banks’ balance sheets where necessary – is still a work in progress.

Where next?While this seems a good starting point for the first pillar of the banking union, it again lays open the limitations of the second and third pillars. The 13 banks that have net capi-tal shortfalls have a nine month window to come up with recapitalisation/restructuring plans.

While the ECB is involved as supervi-sor, it is not in itself a resolution authority – a responsibility still at the national level. The Single Resolution Mechanism only comes into force in 2016, and even then it is not an effective supranational mechanism like the Single Supervisory Mechanism, but rather the result of a compromise, a mix of national and supranational frameworks.

A third pillar, a joint deposit insurance funding scheme has been quietly dropped.

The evolution of the Eurozone crisis over the past five years, on the other hand, pro-vides sufficient arguments for a fully fledged banking union. This is best summed up by the two glaring examples of Cyprus and


Portugal. Cyprus demonstrates clearly that a deposit insurance scheme is only as good as the sovereign backing it. The banking union in its current form does not address this.

“Half-baked” banking unionMeanwhile, the recent failure of the Portuguese Banco Espirito Santo in the final quarter of 2014 demonstrates the limita-tions of effective resolution in fiscally weak countries.

Ultimately, the Portuguese government had to rely on Troika funding to resolve the bank, in light of the precarious fiscal position of the Portuguese government.

So, where does all this leave us? There are two ways to look at the current situation, corresponding to the glass-half full and glass half-empty attitudes. On the one hand, the fact that some basic elements of a European financial safety net have been put in place is a great success.

On the other hand, this compromise is far from the financial safety net that an inte-grated European banking market would need – and a “half-baked” banking union might actually backfire, as some observers have pointed out (Schoenmaker 2012).

A lot has been accomplished though, such as, a single supervisor that can inter-nalise cross-border externalities. Matching the perimeter of banks with the regula-tory perimeter can reduce distortions in the supervisory process.

Big step for EuropeAnd given the risk of political capture of reg-ulators that we could observe across Europe (both in the core and periphery), this is also progress. Given how politically sensitive

banking has been across the European Union, this is indeed a big step for the Eurozone.

Further, bank resolution frameworks across Europe are being strengthened, on the national level, but also – with the bail-in clause – on the European level. The Single Resolution Mechanism – with all the cave-ats explained a little further in this paper – is an important first step in the right direction towards resolving failing banks in a more effective way than done during the recent crises.

There are still several issues open, among these: What are the relative roles of the European Banking Authority and the ECB in supervising banks in Europe? How will fragilities be addressed during the 14-month transition period between now and the date the Single Resolution Mechanism takes effect on 1 January 2016? How effective can the ECB be as supervisor, having to deal with 19 different banking laws?

What has been missed?A European bank resolution mechanism that deserves the name. The current arrange-ment is too complicated and still relies too much on the subsidiarity principle, where first national authorities are in charge and only then the European mechanism comes in place.

A single banking market requires a sin-gle financial safety net. A proper funding mechanism is missing.

While there is some money available, funded by the banking industry itself, it seems too small to serve for the purpose of having to restructure a relatively large bank somewhere in Europe. A public backstop is


missing. Even if the resolution fund under the Single Resolution Mechanism were less limited than it is under current plans, such a fund will never be enough for a sys-temic banking crisis. A public backstop is necessary.

Irrational sentimentZero risk weights for government bonds further increase incentives to hold govern-ment debt and facilitate the “Sarkozy carry trade”. Most importantly, the banking union just agreed on is a forward-looking structure, designed for the next crisis, but not supposed to address the current crisis.

So, are we there yet? There is an increas-ing sentiment that the Eurozone is about to exit the crisis. With both Ireland and Portugal having exited Troika programs, Greece showing signs of economic recovery, and the crisis in Cyprus being less deep than feared, there are understandable hopes that the worst might be behind us.

And there seems to be an important positive trend across Europe, which is the return to market discipline. The fact that many banks have accessed markets to raise additional equity in 2014, supposedly before being forced to do so by the ECB, can very well be interpreted as the return of market discipline.

Jumping the gunIn the absence of a European banking union and a Eurozone mechanism to recapitalise banks, this may be premature. In addition, recent bank failures have seen junior credi-tors being bailed in rather than bailed out (SNS Reaal in the Netherlands and Cyprus), even though the bail-in rule supposedly only

kicks in after 2016 once the Single Resolution Mechanism supposedly goes live. The dis-cussion on the banking union is related to a broader question about the role of the banking system in European finance.

As pointed out by many observers, European financial systems are heavily bank-based, with a limited role for non-bank finan-cial providers and capital markets (European Systemic Risk Board 2014). This exacerbates the link between governments and banks, as there are a limited number of non-bank buyers of government bonds. It makes financial sys-tems more concentrated and results not only in larger banks, but also a stronger reliance on large banks.

Post the asset quality review and stress tests and post-banking union agreement, the largest risk is not necessarily the “half-baked” nature of the banking union, but rather the complacency that might follow from the feeling “we have done it”. A long-term reform agenda awaits Europe. We are certainly not there yet! •

References European Systemic Risk Board (2014), “Is Europe Overbanked?”, Advisory Scientific Committee Report 4, June.Schoenmaker, D (2012), “Banking union: Where we’re going wrong”, VoxEU.org, 16 October.

Editor’s note: The publisher of the Journal would like thank Thorsten Beck, Professor of Banking and Finance, Cass Business School, together with VoxEU for allowing the Journal to publish an amended version of this article, which first appeared on the VoxEU website on 10 November, 2014. A transcript of the original article can be accessed via the VoxEU website: www.voxeu.org.

Regulation

City of London determined to plumb new depths

William K. Black, former US regulator, despairs of the Britain’s desire to win gold

in global race to regulatory bottom.

ON June 20, 2012 the UK Commercial Secretary to the Treasury, Lord Sassoon of Ashley Park gave a speech to the British Bankers Association (BBA) – the group the US government under the guise of the Federal Deposit Insurance Corporation found to have helped organ-ise the world’s largest price rigging cartel and fraud in the form of the rigging of the London Interbank Offered Rate (Libor).

The financial crisis occurred under the “new” neo-liberal Labour administration when its championing of the three “de’s”– financial deregulation, desupervision, and de facto decriminalisation – combined with modern executive and professional compensation, together with the effective elimination of “joint and several liability” to make the City of London the most criminogenic environ-ment in the world for financial “control frauds.”

Naturally, the UK Conservative Party (the Tories), the senior partners in the pre-sent UK coalition government, have decided that the answer to this disaster is to double-down on the former Labour administration’s

embrace of the three “de’s.” Indeed, the first words in Lord Sassoon’s prepared speech were: “Thank you, Philip [Hampton]”; Sir Hampton of course being the person who prepared the notorious report for Tony Blair – the former British Prime Minister – in his neoliberal heyday, that called for dramati-cally increasing the three “de’s” – in every regulatory context.

Incongruous remarksSir Hampton, after holding a senior position with one serial criminal enterprise Lloyds TSB, was, at the time of Lord Sassoon’s talk, the Chairman of the Board of an even larger serial criminal enterprise, the Royal Bank of Scotland (RBS). In a cruel twist of irony, the UK government, which owns 80 per cent of RBS after bailing it out under the Premiership of the Labour Party’s Gordon Brown – the former UK Treasury Minister under Tony Blair’s ten-year helm, turned to Sir Hampton to help run one of the many banks he did so much to destroy.

On February 3, 2012, a few months before Lord Sassoon’s BBA speech to the bankers, Sir Hampton made the front pages


of the British newspapers for his somewhat incongruous comments that “top bank-ers had ‘creamed it’ by hauling in high pay, while shareholders had received ‘diddly squat’ for ten years”.

Regulatory aversionThat too was a consequence of Sir Hampton’s anti-regulatory architecture. His open hostil-ity to vital regulation (of bank compensation) meant that “top bankers” had made tens of millions of dollars for looting “their” banks while the fraud epidemics they led caused the Great Recession that resulted in share-holders receiving “diddly squat” and borrow-ers being left with huge losses and debts.

As late as February 3, 2012, he contin-ued to oppose any regulation of execu-tive compensation as being proposed by the European Commission. Sir Hampton claimed that it was necessary for RBS to pay huge bonuses to its CEO in order to get the “best people”, even though he had just wit-nessed a full decade in which such bonuses led to the worst people being made wealthy whilst they looted the UK’s largest banks and tanked the country’s economy.

Win the race to the bottomLord Sassoon, following in Sir Hampton’s illustrious footsteps, continued to push the mantra that the City of London needed to win the global financial regulatory race to the bottom in his June 2012 BBA speech. He stated: “Now I would like to focus this evening on some of the work that has been done – and the work that still needs to be done – to secure the future of the UK as the world’s number one financial hub. And what we need to do truly to bring about a

new Golden age for British banking – one that is some improvement on the pre-2008 model.”

Lord Sassoon said that the UK should learn some (unstated) regulatory “lessons” from the financial crisis brought on by the three “de”s. That crisis devastated the UK, but Lord Sassoon claimed that the UK’s critical need was to aggravate the three “de’s” to ensure that the City of London contin-ued to “win” the regulatory race to the bot-tom emphasised in the following passage: “[I]t is also important that we do not allow regulation to worsen the existing problems that Europe faces. I carefully read the BBA’s own Banking Industry report, published last month [May 2012], which rightly drew attention to the negative effect that global regulation and the uncertainty around it was having on the industry.”

Bankers’ gleeThe senior UK bankers, of course, are delighted that the City of London wishes to continue to create the criminogenic environ-ment under which they were guaranteed to “cream it” while shareholders got “diddly squat” and borrowers and customers were bankrupted or suffered huge losses. The bankers championed the three “de”s before the financial crisis and after the financial crisis.

Lord Sassoon then emphasised how total the Tories’ commitment to the big UK banks was – no matter how many frauds the senior bankers committed while loot-ing “their” banks, no matter how many unsophisticated customers they ripped off through the sale of unsuitable investment products, and no matter how many small


businesses were denied credit or ripped off through exotic derivatives (swaps) – the Tories would “of course, plough on” in sup-port of the bankers.

Exasperated complicitySurprisingly, Lord Sassoon did express exas-peration that the bankers failed to make it easier for the Tories to help them by ending the practice of having a huge new scandal disclosed every month: “However it may feel at times to you in the industry, this is a gov-ernment that wants to see a thriving bank-ing industry. Not just to support the rest of the economy but to be a world leading, suc-cessful industry in its own right. Now, you still don’t always make it easy for us – or for yourselves. Every board pay dispute, every new mis-selling scandal, every deserving SME refused credit, complicates our shared agenda – but we will, of course, plough on.”

On every regulatory issue that could impair the City of London’s determination to retain the weakest financial regulation, Lord Sassoon made it clear that the Tories were firmly in the bankers’ corner. Indeed, such was his entrenchment in the bankers’ corner that Lord Sassoon made it irrevocably clear that if it were a choice between “inno-vation” and avoiding a financial crisis (“sta-bility”) the Tories would pick financial crisis any day of the week.

Hostility to EUSuch madness is well illustrated in the fol-lowing paragraphs from his speech: “We must not allow innovation to be stifled in the name of stability. So, we are strongly resisting the Commission’s proposals for a Financial Transaction Tax. A proposal that

would harm growth, increase market vola-tility and drive business away from Europe is insane. Similarly, we are challenging the ECB’s location policy in the European Courts because it is not acceptable for a body that is meant to promote single market principles to force clearing houses dealing with large Euro based transactions to locate within the Eurozone.”

With steam seemingly venting from his nostrils, Lord Sassoon continued to lambast European meddling by claiming that:”The recent proposals from the European Parliament that variable remuneration [bonuses] should be limited to no more than fixed pay are also of concern. Capping vari-able remuneration in this way will inevitably lead to an increase in fixed costs as banks increase fixed pay.”

Dire warningsNow fully into his anti-European Union stride, Lord Sassoon claimed that “much of the progress made in recent years to align risk with reward, through deferral and claw backs, will be lost.” He continued: “The pro-posal, if enacted, would also make it more difficult for banks to retain capital in a stress scenario, and would also make it harder for financial institutions to claw back pay in cases of poor performance – reducing the alignment of employee incentives and risk.”

The only issue with the above sentiment is the fact that the UK has not “align[ed]” “risk with reward” in its compensation and bonus plans. Indeed, it has chosen to make it very difficult to claw back even massive bonuses that prove to have been based entirely on inflated reported income. Lord Sassoon admitted that effective financial


regulation is actually critical to maintaining bank safety: “A well regulated sector is key to competitiveness, reassuring customers that they can have confidence in the markets they are using. A strong and proportionate regulatory system is an essential platform for the success of the City; not a hindrance to it.”

Vigorous regulation unwantedThe reality, however, is that he knew his audience was composed of bankers – not banks. Bankers know that vigorous banking regulation is good for honest banks, which is why they strive so mightily to prevent vigor-ous banking regulation.

Lord Sassoon followed those remarks with this ode to the three “de”s: “And on the PRA [the then newly proposed Prudential Regulator division of the Bank of England] side, I want to read an extract from what Sir Mervyn King said in his Mansion House speech a year ago because I found it hugely encouraging. This is what the Governor said: “The style of regulation will also change with the PRA. Process – more reporting, more regulators, more committees – does not lead to a safer banking system.”

“Hugely encouraged”More financial reporting and regulators are essential in the UK because they would lead “to a safer banking system” if they were used competently and vigorously. The UK had far too few regulators and needed much better information systems that would draw on “more reporting.”

The now former Governor King (replaced by the UK Chancellor George Osborne’s Canadian choice pick and for-mer employee of Goldman Sachs, one Mark

Carney) was a failed regulator, yet the Tories were “hugely encouraged” that at the time he had abandoned none of his anti-regulatory dogmas despite the financial crisis.

The Tories picked the Bank of England to be the new regulator to ensure the con-tinuation of weak regulation and supervision and the de facto decriminalisation of finan-cial fraud by elite bankers, while creating the political illusion of change by moving finan-cial regulation from the equally neo-liberal Financial Services Authority.

Love of the three “de’s”Unsurprisingly, the Tories also substan-tially reduced the Serious Fraud Office’s already grossly inadequate budget and staff to ensure that it remained a paper tiger. The ensuing Libor scandal, and the Serious Fraud Office’s unwillingness and inability to take on even the fraud “mice” eventually became such a political embarrassment that the Serious Fraud Office was forced to start an investigation of the mice and the Tories found it politically expedient to provide a budgetary supplement to the Serious Fraud Office to fund a modest investigation.

Lord Sassoon was so enamoured of the three “de’s” that he emphasised that the Tories’ answer to the financial crisis was a reduction in the number of regulators and the information they received from the banks. He said: “I believe that we can oper-ate prudential supervision at lower cost than hitherto by reducing the burden of routine data collection and focusing on the major risks to the system. It is vital that we collect and process data only where the supervisors have a need to know. Targeted and focused regulation, allowing senior supervisors to


exercise their judgement, does not require ever-increasing resources.”

Kumbaya regulationThis point is subtle and I will expand on the point in many future articles, but the most abused and dangerous word in destroying effective regulation is “risk”. It has become the weapon of choice to try to justify that which has proven catastrophically harmful to the public – and a goldmine to corrupt CEOs.

The word “risk” is used in a financially illiterate and anti-scientific manner to ena-ble the imposition of the three “de”s for the purpose of deliberately crippling what crimi-nologists refer to as our “system capacity” to detect, investigation, and sanction the most damaging white-collar crimes. Proponents of “risk-based regulation” have consist-ently created Kumbaya regulation systems in which the most severe risks are ignored under the disingenuous rubric of “risk-focused regulation”.

Intellectual gymnasticsIn a bizzare twist of the imagination via intellectual gymnastics worthy of a gold medal, the con is underpinned by the fol-lowing contentions. They, the Kumbaya proponents, assume (contrary to reality) that industry members rarely engage in serious misconduct and therefore, a paltry number of regulators can, if they “risk-focus” on the rare “bad apple” regulate an entire industry successfully.

Conversely, the same Kumbaya pro-ponents claim that there are innumerable lesser violations and that those lesser viola-tions are unimportant, even cumulatively, so

the failure to sanction white-collar criminals for minor violations of the law is no big deal –no “broken windows” white-collar spheres where we’d have to arrest CEOs – or even desirable. Further, the regulators will never have enough resources (staff and finances) to sanction all of these lesser violations because they are so numerous – and it would be a waste of societal resources to sanction large numbers of lesser violations.

The proverbial bottom line is that regula-tory resources might as well be slashed and we should regard the fact that violations of the laws by elite white-collar perpetra-tors will rarely be sanctioned as a great leap forward.

Competitive objectiveThis bottom line is a superb means of max-imising the risk of producing a criminogenic environment and multiple examples of Gresham’s dynamic. That means that the Kumbaya proponent’s faux “risk-focused” rubric has, recurrently, dramatically increased the risk to the public purse and the gain to elite criminals operating openly within the City.

Lord Sassoon noted to the bankers that winning the regulatory race to the bot-tom was an explicit or implicit mandate of the UK’s financial anti-regulators. In his 12 June British Bankers Association presenta-tion, he said: “We agreed with the Vickers Commission and introduced an amendment to give the Financial Conduct Authority a competition objective. We don’t, though, see the need for an explicit international com-petitiveness objective” .

He continued in this vein by stating: “We believe that it is getting the substance


right – proportional, fair, transparent regula-tion – which will lead to a more competitive London and UK sector – not the introduc-tion of a further competitive markets objec-tive of an ill-defined kind”.

It is absolutely insane for financial regu-lators to have “a competition objective.” It is, however, nirvana for corrupt senior bankers. The City of London, ultimately, caused the UK enormous harm both in the run-up to the 2007/2008 global financial crisis and its austerity riddled aftermath. Its culture is cor-rupt and it functions as a parasite that saps the real economy rather than as an “engine of growth” as some would have us believe.

All the UK’s major legacy parties – Labour, the Conservatives and the Liberal Democrats, together with the UKIP lead by Nigel Farage – agree with Lord Sassoon that this sentence from his speech is

sensible – which reveals how widespread that insanity has spread among UK elites. Indeed, Sassoon et al revel in the fact that:“While other Western financial centres have lost their competitive edge, London has strengthened its position as number one in the global index. Key players across the sector are locating here.”

That final riposte is very bad news. The City of London was already the financial cesspool of the world, the most criminogenic environment for financial fraud, and the cause of immense losses of jobs and wealth by tens of millions of peo-ple of the UK. The City of London is actively working to race even further to the bottom, and the politicians from all the major par-ties remain eager to help make the City of London ever more corrupt at the expense of the public. •

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Volcker rule

Compliance with risk targets: Efficacy of the Volcker Rule

Far from reducing risk-taking by covered institutions, the Volcker Rule has the opposite

effect, argue Josef Korte and Jussi Keppo.

MORE than four years after the Volcker Rule was codified as part of the Dodd–Frank Act in an attempt to separate allegedly risky trading activities from commercial banking, we present evi-dence finding that those banks most affected by the Volcker Rule have indeed reduced their trading books more sub-stantially than those less impacted by the legislation. However, there are no corresponding effects on risk-taking – if anything, affected banks take more risks and use their trading accounts less for hedging.

The Volcker Rule, passed as part of the Dodd–Frank Act in July 2010, has been appraised as one of the most important changes to banking regulation since the global financial crisis. By restricting banks’ business models and prohibiting allegedly risky activities, the rule ultimately aims at increasing resolvabil-ity and reducing imprudent risk-taking by banks, and therefore at increasing financial stability.

This is done by banning banks from proprietary trading and limiting their

investments in hedge funds and private equity. Four years after the enactment of Dodd–Frank and with the final rulemaking by regulatory agencies recently presented, it is time to evaluate whether the Volcker Rule has already had any major impact on the affected banks’ business models and risk-taking.

Although full compliance is not required until July this year, major affected bank holdings in the US have already repeatedly announced reconfigurations of their busi-ness models. Apparently in an effort to com-ply with the Volcker Rule, these banks have declared that they have shut down propri-etary trading desks and sold their shares in hedge funds.1

Despite those public compliance pro-nouncements, the effect of the Volcker Rule could be dubious. First, the final rules stipu-late a long list of exemptions – for example, activities that might be seen as similar to proprietary trading or hedge fund invest-ments, but are explicitly exempted from the ban. Second, as banks can take risks in many different ways (e.g. increasing leverage or risks in the trading or the banking book,


or decreasing the hedging of the banking book), there is no reason to assume that a decrease in the size of the trading book or its particular activities decreases banks’ overall risk.

Grey areasFurther, regulators may find it difficult to dif-ferentiate between prohibited and permitted activities such as trading on behalf of cus-tomers, market-making, or hedging. Hence, affected banks might be able to keep their risk targets without raising the leverage or the riskiness of their banking books.

Consequently, several authors have argued that the effect of the Volcker Rule on bank business models, overall bank risk, and financial stability might be rather limited.

This might be a consequence of grey areas, creative compliance, reduced trans-parency, or simply other levers banks pull to keep their risk targets (see, e.g., Kroszner and Strahan 2011, Richardson et al. 2010, Chung and Keppo 2014).

So, what exactly are the effects of the Volcker Rule to date?

Existing theoretical and empirical research cannot ultimately clarify the pre-dicted effects of the Volcker Rule. Firstly, papers evaluating the impact of the Volcker Rule are still relatively scarce (presumably because it is not yet fully implemented).

Conflicting evidenceAnd secondly, although numerous stud-ies evaluate the historical precedents of the Volcker Rule – e.g. the Glass–Steagall Act – there is no clear consensus in the litera-ture regarding the impact of a separation of commercial and investment banking on

banks’ risk (Barth et al. 2000, Barth et al. 2004, Benston 1994, Saunders and Walter 1994, Stiroh 2006, Stiroh and Rumble 2006).

Motivated by the conflicting evidence, the work-in-progress implementation, and banks’ early compliance announcements, we analyse in a new working paper (Keppo and Korte 2014) whether and how banks are already complying with the rule and what the effects are of this compliance.

For this, we construct a comprehensive dataset of all Bank Holding Companies (BHCs) in the US covering a timespan of ten years on a quarterly basis.

We rely on the assumption that those BHCs that traditionally had their busi-ness models geared towards activities now banned or limited by the Volcker Rule (i.e. institutions with comparably large trading books and large non-bank investments) are affected most and should hence show the strongest reactions.

Trading booksTo begin with, we find that banks – on aver-age – reduce the size of their trading books relative to total assets after the passing of the Volcker Rule. This, of course, can only be traced back to the Volcker Rule by compar-ing the development over time and across groups of differently affected institutions. Indeed, we find that those BHCs that are presumably most affected by the Volcker Rule had even stronger reductions in their trading books, above and beyond the aver-age effect.

Moreover, when comparing affected banks and hedge funds, we do not find a similar trend – in fact, hedge fund assets have even been rising. The reduction of


banks’ trading books is quite an intuitive reaction, and also corresponds with the pub-lic announcements by most of the banks that see themselves affected by the Volcker Rule.

Risk-takingExtending our model towards actual risk-taking by BHCs, however, we find less obvious results. While overall bank risk (expressed, for instance, in the composite measure of a bank’s distance to default) has decreased after the enactment of the Volcker Rule, we do not find a pronounced effect on the BHCs that are particularly affected. If anything, the risk reduction effect is smaller for the affected banks.

Turning to the volatility of trading returns, we find those to be largely unchanged after the Volcker Rule; again, if anything, affected banks get more volatile trading books. The same applies to liquidity risk; if anything, affected banks hold less liquid assets. If the reduction of bank risk is an objective of the rule, our findings suggest that the Volcker Rule has so far not led to its intended consequences.

Nevertheless, there might be trading that is wanted and hence permitted as an exemption from the Volcker Rule. In fact, the Volcker Rule explicitly stipulates that trad-ing accounts held for hedging purposes are permitted.

Increase in correlationIf affected banks were increasingly using their trading accounts for hedging of bank-ing book returns, we would expect the corre-lation between trading and banking returns to strongly decrease – or to be negative after the introduction of the Volcker Rule.

We test for this and find neither to be the case. Rather, while the correlation between trading and banking returns has indeed decreased after the Volcker Rule became effective, the opposite is true for the most affected banks, which even experienced a significant increase in the correlation.

Taken together, our findings can be interpreted as evidence for successful risk targeting – although banks shifted portfolios to become at least more compliant with the Volcker Rule, they keep their risk targets (e.g. by hedging their banking businesses less).

This explains why we find a significant decrease in the trading asset ratio, but no sig-nificant shift in overall risk. Further, possibly because of the continuing trading activities, the banking book risks have not, or at least not yet, risen significantly.

Serious risks and concernsTo be fair, the final regulatory rulebook for the Volcker Rule was only published just over a year ago and as of the time of writing it is not yet fully binding for banks. However, our results (together with several banks’ self-declared compliance) identify serious risks in the Volcker Rule.

Since banks’ risk-taking incentives have not changed, the remaining assets in the trading book have been used less in the hedging of banking book returns. Thus, American regulators might want to analyse further possible implementation risks and unintended consequences to ensure increas-ing bank, and thereby, financial stability.

Our findings also have important impli-cations for other global regulatory bodies and supervisors – those in the European Union, for example – who are currently


debating the introduction of similar sepa-rations between commercial banking and investment/trading business. •

ReferencesBarth, J R, R D Brumbaugh, and J A Wilcox (2000), “The

Repeal of Glass–Steagall and the Advent of Broad Banking”,

Journal of Economic Perspectives, 14(2): 191–204.

Barth, J R, G J Caprio, and R Levine (2004), “Bank Regulation

and Supervision: What Works Best?”, Journal of Financial

Intermediation, 13(2): 205–248.

Benston, G J (1994), “Universal Banking”, Journal of Eco-

nomic Perspectives, 8(3): 121–143.

Chung, S and J Keppo (2014), “The Impact of Volcker Rule

on Bank Profits and Default Probabilities”, Working paper.

Keppo, J and J Korte (2014), “Risk Targeting and Policy Illu-

sions – Evidence from the Volcker Rule”, Working paper.

Kroszner, R S and P E Strahan (2011), “Financial regulatory

reform: Challenges ahead”, American Economic Review,

101(3): 242–246.

Richardson, M, R C Smith, and I Walter (2010), “Large

Banks and the Volcker Rule”, in V V Acharya, T F Cooley, M

P Richardson, and I Walter (eds.), Regulating Wall Street:

The Dodd–Frank Act and the New Architecture of Global

Finance, John Wiley & Sons: 181–212.

Saunders, A and I Walter (1994), Universal Banking in the

United States: What Could We Gain? What Could We

Lose?, Oxford University Press.Stiroh, K J (2006), “A portfo-

lio view of banking with interest and noninterest activities”,

Journal of Money, Credit and Banking, 38(5): 1351–1361.

Stiroh, K J and A Rumble (2006), “The dark side of diversifi-

cation: The case of US Financial Holding Companies”, Jour-

nal of Banking & Finance, 30(8): 2131–2161.

Endnote1. See, e.g., Susanne Craig, “Goldman Moves to Comply

With Volcker Rule”, New York Times, 10 May 2012; Lloyd

Blankfein, “Goldman Sachs CEO Views the World From

Wall Street”, Remarks at the Economic Club, 18 July 2012;

Dakin Campbell and Jody Shenn, “Citigroup’s Raytcheva

Survives Volcker Rule as Prop Trader”, Bloomberg, 25 June

2014.


Editorial deadline for Vol VII Issue 1 Summer 2015

May 15th 2015

Basel III

Higher capital requirements: the jury is out

Stephen Cecchetti of Brandeis International Business School calls for higher bank capital

standards in lieu of all available evidence.

REGULATORS forced up capital requirements after the Global Financial Crisis – triggering fears in the bank-ing industry of dire effects. This paper argues that the capital increases had little impact on anything but bank profitabil-ity. Lending spreads and interest mar-gins are nearly unchanged, while credit growth remains robust everywhere but in Europe. Perhaps the requirements should be raised further.

During the Basel III debate, a key concern was that higher capital requirements might damage economic growth. By forcing banks to increase their capitalisation, long-run growth would be permanently lower and the adjustment itself would put a drag on the recovery from the Great Recession.

Unsurprisingly, the private sector saw catastrophe, while the official sec-tor was more sanguine. The Institute of International Finance (2010) is the most sensationalist example of the former, and the Macroeconomic Assessment Group (2010a and 2010b) one of the most staid cases of the latter.1

With four years of evidence behind us, my reading is that the optimists were not optimistic enough. Since the crisis, capital requirements and capital levels have both gone up substantially. Yet, outside the still fragile Eurozone, lending spreads have barely moved, bank interest margins have fallen, and loan volumes are up.

To the extent that more demanding capital regulations had any macroeconomic impact at all, it would appear to have been offset by accommodative monetary policy. In what follows, I summarise the evidence for this conclusion and its policy implications. For more details, see CEPR Policy Insight 76, Cecchetti (2014).

Higher capital requirements To begin, it is important to appreciate how much higher the new international capital standards are. Basel III is more rigorous than its predecessor in three fundamental ways: the definition of what constitutes capital is tighter, the coverage of what counts as an asset is broader, and the required ratio of the two is higher.

Overall, I estimate that risk-weighted


capital requirements increased by factor of 10 to 20 (albeit from a level that was abys-mally close to zero).

Not only have requirements gone up, but capital levels have, too. According to the Basel Committee on Banking Supervision’s (various years) quantitative impact assess-ments, from the end of 2009 to the end of 2013, capital for the 102 largest global banks (based on the new stringent definitions) rose from 5.7 per cent to 10.2 per cent of risk-weighted capital.

Margins and costs squeezedThe recent study by Cohen and Scatigna (2014) shows that two-thirds of this increase has been from retained earnings, with the remaining third coming from capital issuance.

Contrary to the predictions of the private-sector doomsayers, as banks were increasing their capital levels, they were shrinking their return on assets, cutting their net interest margins and reducing their operating costs. BIS (2014) provides data on banks in 15 large advanced and emergingmarket countries.

Comparing 2013 results with the 2000–2007 average, we see that return on assets fell roughly 40 basis points, interest rate spreads fell by an average of more than 30 basis points, and operating costs by closer to 75 basis points. At the same time, bank credit to the non-financial private sector was rising.

… except in the EurozoneI should note that Europe is something of an exception. There, lending spreads are gen-erally up and loans down. The explanation for this is likely to be two-fold. First, there is the way in which supervisors conducted

European stress tests and capital exercises. Instead of requiring banks to raise additional capital to offset a shortfall – as the 2009 US stress test did – authorities allowed them to meet capital ratios by shedding assets.

In fact, Eurozone banks did not raise capital. Instead, they reduced both their total assets and their risk-weighted assets. Second, a number of continental European banks remain under pressure to further raise their levels of capitalisation.

The Eurozone’s problems are consistent with the commonly held belief that banks with debt overhangs do not lend – a belief that is substantiated by data of the sort that I describe in Cecchetti (2014). Europe’s banks still need capital to reduce the overhang.

Countercycle capital bufferIn fact, fears about higher capital require-ments have not been borne out. I draw two principal conclusions from this accumulated evidence.

First, the predictions that higher capital requirements would drive up interest mar-gins and reduce credit volumes are very clearly at odds with the evidence of smaller spreads and increased lending. Insofar as there was any macroeconomic impact at all, it appears to have been inconsequential. Instead, it is high levels of capital that lead to healthy lending.

Second, the evidence is bad news for the Basel III’s countercyclical capital buffer. The idea of the buffer is that, when they are confronted with a credit boom, authorities should raise capital requirements to limit the expansion.

By using prudential tools to lean against credit booms, regulators can help to stabilise


the financial system and the real economy.But, as Aiyar et al. (2014) note, for the coun-tercyclical buffer to work, there are three pre-conditions: first, capital requirements have to bind before they are raised; second, equity has to be costly and difficult to raise in the short term; and third, alternatives to bank credit have to be relatively unavailable and costly.

SummaryOn all three counts, the experience I have summarised is not very encouraging. Lending spreads do not appear to be the first-order response to higher capital require-ments; loan volumes do not look sensitive to changes in capital so long as banks are rea-sonably well capitalised; and at the stage in the business cycle when the countercyclical buffer would be needed, banks’ business is likely to be booming and profitable, making it cheaper and easier to raise equity.

We need to continue to study this epi-sode, doing a proper statistical analysis that controls for macroeconomic conditions and policy responses.

At this stage, however, it seems reason-ably safe to conclude that supervisors and bank regulators should seriously consider requiring further additions to bank capital, given that the social costs of post-crisis capi-tal increases appear to have been small; and the efficacy of time-varying capital require-ments in moderating credit fluctuations is questionable to say the least. •

Endnote1. Full disclosure, Please note I was Chair of the Macroeconomic Assessment Group.

ReferencesAiyar, S, C W Calomiris, and R Wieladak (2014), “Identifying channels of credits substitution when bank capital requirements are varied”, Bank of Eng-land Working Paper 485, January.Bank for International Settlements (2014), 84th Annual Report, June. Results of Basel III Monitoring Exercise.Cecchetti, S G (2014), “The Jury is In”, CEPR Policy Insight 76, December.Cohen, B H and M Scatigna (2014), “Banks and capi-tal requirements: channels of adjustment”, BIS Work-ing Paper 443, March.Institute of International Finance (2010), Interim Report on the Cumulative Impact on the Global Economy of Proposed Changes in the Banking Reg-ulatory Framework, June.Macroeconomic Assessment Group (2010a), Assessing the macroeconomic impact of the transi-tion to stronger capital and liquidity requirements: Interim Report, August. Macroeconomic Assess-ment Group (2010b), Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements: Final Report, December.

Editor’s note: The publisher and editor of the Journalof Regulation & Risk - North Asia would like to extend thanks to Stephen Cicchetti, Professor of International Economics at the Brandeis International Business School, together with VoxEU for allowing the Journal to publish a slightly amended version of this article, which first appeared on the VoxEU website on 17 December, 2014. Readers are reminded that copyright remains the sole preserve of the author and VoxEU. A transcript of the original article can be accessed via the VoxEU portal via this link: http://www.voxeu.org/article/verdict-higher-capital-requirements.

Basel III

Will Basel III operate to plan as its proponents desire?

Prof. Xavier Vives of the IESE Business School queries ability of Basel III and regula-

tors to prevent another financial crisis.

BANKING has recently proven much more fragile than expected. This col-umn argues that the Basel III regula-tory response overlooks the interactions between different kinds of prudential policies, and the link between pru-dential policy and competition policy. Capital and liquidity requirements are partially substitutable, so an increase in one requirement should generally be accompanied by a decrease in the other. Increased competitive pressure calls for tighter solvency requirements, whereas increased disclosure requirements or the introduction of public signals may require tighter liquidity requirements.

The recent financial crisis has exposed the failures of regulation. We have witnessed how the three pillars of the Basel II approach – namely capital requirements, supervision, and disclosure and market discipline – have been insufficient to prevent or contain the crisis. Banking has proved much more fragile than expected.

Among the problems that have sur-faced is the danger of an overexposure to

wholesale financing, as demonstrated by the demises of Northern Rock and Bear Stearns.

Another startling development has been the large impact of public news, such as the decline of the ABX index of credit derivatives on subprime mortgages in 2007, credited with inducing the run on structured invest-ment vehicles (SIVs) in the summer of that year (see, e.g., Gorton 2008) and consequen-tially contributing greatly to the 2008 finan-cial crisis.

FAS rule 157The effects of disclosure requirements have also been dramatic, such as the imple-mentation in 2007 of Financial Accounting Standards (FAS) rule 157 – a piece of mark-to-market accounting legislation – which was credited with aggravating the conse-quences of the bursting of the real-estate bubble by forcing banks to disclose large losses on their portfolios of mortgage-backed securities.1

The regulatory response has been, in the so-called Basel III process, to increase capital requirements, introduce liquidity requirements and strengthen transparency


requirements.2 Apart from this, structural reform has been proposed in the US, the UK, and in the EU in order to separate traditional banking from market-oriented activities to a certain degree. Some of these measures have already been implemented.

Problems with the Basel approachFurthermore, in the immediate response to the crisis, antitrust concerns were set aside and large banks were allowed to merge in the United States, the United Kingdom, and Spain among other countries – not to men-tion the amount of state aid granted to the banking sector with the effect of distorting competition.

The approach in the Basel III process has been to calibrate capital and liquidity requirements independently, with the latter still not quite settled, and to think about dis-closure requirements separately. With regard to competition policy, the standard idea has been to enforce it independently of the level of prudential regulation.

I argue in Vives (2014) that this approach may prove problematic: “Capital and liquid-ity requirements are both necessary but partially substitutable in the regulatory aims of keeping the probabilities of insol-vency and illiquidity in check. This means that an increase in one requirement should be accompanied by a reduction in another requirement to accomplish regulatory objec-tives in an efficient way.....”.

Optimum prudential policyContinuing with this theme:“.....The opti-mal levels of capital and liquidity require-ments are not independent of the level of disclosure in the market. For example, more

disclosure may need to be accompanied by a higher liquidity requirement in order to keep the probability of illiquidity in check. Optimal prudential policy is not independ-ent of the level of competitive pressure that banks face”.

I obtain these results in a model of cri-ses that distinguishes solvency from liquidity problems, and which is based on a simple game of strategic complementarities with incomplete information (e.g. Morris and Shin 2004, Rochet and Vives 2004).

The financial intermediary obtains unse-cured wholesale financing that may not be renewed depending on the information received by fund managers. If this happens, the intermediary typically will need to liqui-date some assets at fire sale prices in order to meet its debt obligations. Those sales can be moderated by holding more liquidity.

Solvent but illiquidThe result is that there is a range of funda-mentals of the investment portfolio of the bank for which the entity is solvent but illiquid. The intermediary faces a coordina-tion failure that leads to fragility in the sense that a small change in the environment may move the equilibrium of the investors’ game from safe to unsafe.

This fragility is linked positively to the co-movement of investors’ actions or, in more technical terms, to the degree of strategic complementarity of their actions.

I find then that strategic complementa-rity and fragility are increasing in the weak-ness of the balance sheet of the intermediary (high level of wholesale short-term financ-ing and low level of liquid reserves), market stress parameters (such as the extent of fire


sales penalties of early asset sales or of the cost of funding), and the precision of public signals about the fundamentals.

Substitutability of capital and liquidityThe probabilities of insolvency and illiquidity can be controlled with capital and liquidity requirements. If the regulator aims to cap the probabilities of insolvency (to mitigate moral hazard) and illiquidity (to mitigate contagion risk), it can accomplish this by setting mini-mum capital and liquidity requirements.

Those requirements are partially substi-tutable, and typically a change in the envi-ronment that calls for an increase in one will imply a decrease (at least weakly) in the other.

For example, higher fire sales penalties to liquidate assets will call for an increased liquidity requirement and a relaxed solvency one, whereas increased competition raising funding costs will call for an increased sol-vency ratio and a stationary liquidity ratio.

The latter prescription is important when the regulator faces a liberalisation episode such as that of Savings and Loans in the US in the 1980s. In this case the failure to tighten solvency requirements led to disaster.

Implications of public signalsA more subtle change in the environment is in disclosure requirements or the introduc-tion of strong public signals. In an environ-ment with weak balance sheets and market stress, bad news provided by a strong public signal may coordinate expectations on a run equilibrium.

This is what seems to have happened with the SIVs crisis in 2007. The SIVs were mostly funded short term in the wholesale

market, and investors had poor information when deciding whether to roll over their loans given the opaque nature of residential-based subprime securities.

The introduction of the ABX index in 2006 provided a potent public signal about the state of subprime mortgages, and when this index started to decline in early 2007 it eventually triggered a run on the SIVs.

All the conditions that make investors’ actions co-move strongly were present: a high level of unsecured short-term financing in particular, coupled when the crisis started with high fire sales penalties, and a strong public signal in relation to the accuracy of private signals.

Concluding remarksWith hindsight, and according to my analy-sis, the regulator should have tightened liquidity requirements when the ABX index was established.

If properly calibrated, the liquidity requirement would have decreased the prof-itability of special investment vehicles, but avoided the run.

Similarly, the regulator should have established a liquidity ratio when introduc-ing the mark-to-market accounting FAS rule 157 in 2007 in order to avoid increasing the risk of illiquidity.

In conclusion, independently of the debate on the right amount of capital (see e.g. Admati et al. 2013 and Corsetti et al. 2011), regulators should look at the interac-tion between capital, liquidity, and disclosure requirements.

Regulators should take into account also the level of competitive pressure when set-ting prudential requirements. This implies


that competition policy and prudential policy are not independent either. Taking these interactions into account in a holistic approach will lower the likelihood of regu-latory blunders and improve the chances of the Basel III process delivering the expected results. •

Footnotes1. See the testimony of former FDIC chairman William Isaac at the US House of Representatives Committee on Financial Services on 12 March 2009.2. In regard to disclosure (Pilar 3 of the Basel approach) in BIS (2014) it is stated that “in the wake of the 2007–2009 financial crisis, it became appar-ent that the existing Pillar 3 framework failed to promote the early identification of a bank’s material risks and did not provide sufficient information to enable market participants to assess a bank’s overall capital adequacy”.

ReferencesAdmati, A, P de Marzo, M Hellwig, and P Pfleiderer (2013), “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive”, Stanford University GSB Research Paper 13-7.BIS (2014), “Review of the Pillar 3 Disclosure Requirements”, Basel Committee on Banking Supervision, Consultative Document.Corsetti, G, M Devereux, J Hassler, G Saint-Paul,

H-W Sinn, J-E Sturm, and X Vives (2011), “A New Crisis Mechanism for the Euro Area”, in The EEAG Report on the European Economy 2011, CesIFO: 71–96.Morris, S and H S Shin (2004), “Coordination Risk and the Price of Debt”, European Economic Review 48: 133–153.Gorton, G (2008), “The Panic of 2007”, in Maintain-ing stability in a changing financial system, Proceed-ings of the 2008 Jackson Hole Conference, Federal Reserve Bank of Kansas City.Rochet, J C and X Vives (2004), “Coordination Fail-ures and the Lender of Last Resort: Was Bagehot Right After All?”, Journal of the European Economic Association 2(6): 1116–1147.Vives, X (2014), “Strategic Complementarity, Fragility, and Regulation”, Review of Financial Studies 27(12): 3547–3592.

Editor’s note: The publisher of the Journal would like thank Xavier Vives, Professor of Economics and Finance and academic direc-tor of the Public-Private Sector Research Center at IESE Business School; CEPR Research Fellow, together with VoxEU for allowing the Journal to publish an amended version of this article, which first appeared on the VoxEU website on 22 December, 2014. A transcript of the original article can be accessed via the VoxEU website: www.voxeu.org.

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Monetary policy

Helicopter money can reverse the present economic cycle

Chairman of the Group of Lecce, Biagio Bossone, urges fiscal and monetary policy makers to abandon

supply-side prescriptions and to “drop” money.

HIGH debt and deflation have afflicted Japan, the Eurozone, and the US. However, the monetary and fiscal poli-cies implemented so far have been dis-appointing. This paper discusses the importance of helicopter money in the form of overt monetary financing in addressing these problems. Overt money financing is the policy with the highest impact in raising demand and output without increasing public debt and inter-est rates.

The G20 leaders may well have committed themselves to endorse a higher “growth tar-get” – 2.1 per cent by 2018, or US$2 trillion – at their November meeting in Australia – the Brisbane Action Plan – but as predicted seem incapable of agreeing to a combined and coordinated meaningful monetary and fiscal policy mix that would substantially lift aggregate consumer demand and economic growth globally.

Fiscal and monetary policy cordination is urgently required to facilitate any meaningful global economic recovery. The International Monetary Fund (IMF), if reports are to

believed, are examining more than 900 structural/infrastructure policies, and more will be needed to reach growth targets. However, the required locomotive power to substantially lift consumer demand is far and away beyond that which can be harnessed from supply-side policies. However, a mere handful of well-chosen, coordinated macro-economic policies could ensure success.

Seeds of new crisisAs we have witnessed at the beginning of 2015, present economic policies are failing to provide for growth and stability. In the Eurozone, Germany is now running both a budget surplus and a large current account surplus, thus providing none of the power-ful locomotive potential it could provide to revive the Eurozone block of nations.

There are also growing concerns – includ-ing at the Bank of International Settlements and the Financial Stability Board – that the ultra-low interest rate policies adopted by Japan, the US and the Eurozone are creat-ing large risks in the form of the mispric-ing of risk, asset overvaluation, downward price dynamics, and a new financial crisis.


Quantitative easing has raised asset prices, but the new money allegedly created has failed to stimulate spending and inflationary expectations to the extent that was originally anticipated.

Helicopter moneyAs provocatively discussed by Friedman (1969), helicopter money is a policy whereby new money is created by the central bank and provided directly to households and private businesses. Grenville (2013) notices that central banks have no mandate to give money away (they can only exchange one asset for another), and that such decisions need to be backed by the budget-approval process.

In most countries, therefore, central banks cannot conduct helicopter money operations on their own – helicopter money must involve fiscal policymaking.1 Buiter (2014) focuses on the application of helicop-ter drops through overt monetary financ-ing, whereby the central bank creates new money to finance a fiscal stimulus.

He identifies the conditions under which such a helicopter drop increases aggregate demand. One of these conditions is the irreversibility of the new money base stock creation, which constitutes a permanent addition to the total net wealth of the econ-omy, which is made possible by the (“fiat”) money base being an asset for the holder but not a liability for the issuer (Buiter 2004).

IrreversibilitySuch irreversibility can be attained if overt monetary financing operations are executed by one of two routes. The first is by having the government issue interest bearing debt,

which the central bank would buy and hold in perpetuity, rolling over into new govern-ment debt when the existing debt on its bal-ance sheet reaches maturity.

In this case, the government would face a debt interest servicing cost, but the central bank would make an exactly matching profit from the difference between the interest rate it receives on its debt and the zero cost of its money liabilities, and would return this profit to the government.

A second route is having the central bank buy government securities which are explic-itly non-interest bearing and never redeem-able. In terms of the fundamentals of money creation and government finance, the choice between these two routes would make no difference (Turner 2013).

Composition shiftNote that the irreversibility condition has nothing to do with the fact that, at any future date, the central bank might decide to with-draw part or all of the liquidity injected in the system by selling its own bonds. In this case, the holders of liquidity would exchange it for the bonds sold by the central bank, but the total net worth of the economy would not change – only its composition would (shift-ing from more to fewer liquid assets).

The addition to the economy’s net worth originally operated through the overt mon-etary financing would not be undone by any new open market operation. Note that where overt money financing operations are run by the Treasury, without involving the central bank (see opposite page), neither of the two routes above is necessary, since the Treasury directly finances the budget by issu-ing money or a money-like instrument.


In relation to overt money financing, we claim the following: First, it is the combina-tion of monetary and fiscal policy that has the greatest impact in raising demand and output (McCully and Pozsar 2013, Turner 2013).

No increase in public debtSecond, overt money financing is most likely to turn deflation into inflation in the shortest time. Unlike quantitative easing, it flows to households with a relatively high marginal propensity to consume ordinary goods and services. Hence, demand and consumer goods prices both rise relatively early under overt money financing.

Third, overt money financing does not trigger Ricardian Equivalence effects (in contrast with conventional bond financing) since the intertemporal budget constraint of the state is permanently relaxed by the cor-responding new money stock.

Fourth, it creates no rise in interest rates and hence there is no crowding-out. Fifth, it always increases demand (Buiter 2014).

And, finally, most importantly, overt money financing involves no increase in public debt, whereas conventional bond financing does.

Central banks and public debtGovernment bonds held by the central bank are usually counted as part of general government debt (public debt). Indeed, this might be considered an anachronism since the central bank, as well as the Treasury, are both organs of the state.

Conceptually, in a consolidated public-sector balance sheet there would be no new debt creation if the government received

new money from the central bank to finance the state budget.

However, this is not quite the case in reality, for a number of possible reasons. Where central banks are partly privately owned by commercial banks, there is a justi-fiable separation. Another justification may be that many central banks are ‘independent’ agencies, and separable from government influence. A third reason is that financial markets ‘see through’ the consolidated pub-lic sector balance sheet and recognise that a central bank may sell government bonds to the private sector at any time.

Except for the case where the central bank creates money to finance the budget in exchange for new government bonds, heli-copter drops do not cause the public debt to increase.

High level of coordinationThis equally holds when: (1.)New helicopter money flows from the central bank directly into the private bank accounts of individu-als and businesses (see, for instance, Kimball 2012). (2.)Overt money financing opera-tions are implemented under the two routes above (Bossone and Wood 2013). (3.) The Treasury (not the central bank) issues new money and uses it to finance its own budget (Wood 2012). (4.)The Treasury (not the cen-tral bank) issues a pseudo-money instru-ment to finance tax cuts (Bossone et al. 2014).

The first two cases require a great deal of coordination between a (possibly) inde-pendent central bank and the Treasury, implying that they have to come to an agree-ment in order to engineer an overt money financing operation. On the other hand, the third and fourth cases do not involve the


central bank, thus simplifying overt money financing execution; yet, the government needs to exert a great sense of fiscal disci-pline in order to avert the risk of abusing the money financing.

The issues touched upon in this arti-cle are important for a number of reasons.First, if the above taxonomy is not clearly understood, then the policy of overt money financing could be misinterpreted, and its significance not appreciated, including by key policymakers who have, to date, seem-ingly turned a blind eye to it.

Second, quantitative easing has failed to deliver what was promised and is likely to be disruptive as ‘normal’ interest rates are restored. A new approach to monetary policy needs to be developed to impact con-sumer demand much more rapidly. Third, as the case of Japan – where the public debt level is very large – shows, successive rounds of quantitative easing and bond-financed budget deficits do not prove effective.

Fourth, the afflicted countries just sur-vived the global financial crisis. However, with public debt already at danger levels, they are currently incapable of responding to any new crisis that may emerge by using large-scale conventional bond financed def-icit spending. Fifth, Eurozone countries are again sliding into depression and deflation.

Current policies need to be radically altered to create the requirements for widespread and strong economic recovery. Finally, there has been much conjecture about whether or not some advanced countries have entered an era of “secular stagnation” (Teulings and Baldwin 2014). Overt money financing offers the most effective monetary and fiscal policy response to secular stagnation. •

Endnotes1. Buiter (2014) considers the ECB as one possible

exception in particular circumstances.

ReferencesBossone B (2013), “Unconventional Monetary Policies

Revisited (Part I)”, VoxEU.org, 4 October.

Bossone B (2013), “Unconventional Monetary Policies

Revisited (Part II)”, VoxEU.org, 5 October.

Bossone B, M Cattaneo and G Zibordi (2014), “Which

Options for Mr. Renzi to Revive Italy and Save the Euro?”

Economonitor, 3 July.

Bossone B and R Wood (2013), “Overt Money Financing:

Navigating Article 223 of the Lisbon Treaty”, EconoMoni-

tor, 22 July.

Buiter W H (2004) ‘Helicopter Money: Irredeemable

Fiat Money and the Liquidity Trap’, NBER, Working Paper

10163.

Buiter W H (2014), “The Simple Analytics of Helicopter

Money: Why it Works – Always”, Economics,Vol. 8, 2014-28.

Friedman M (1969), “Optimum Quantity of Money”, Aldine

Publishing Company. 1969. p. 4.

Grenville S (2013), “Helicopter Money”, VoxEU.org, 24

February.

Kimball M (2012), “Getting the Biggest Bang for the Buck

in Fiscal Policy”, Confessions of a Supply-Side Liberal, May

29, 2012.

McCulley P and Z Pozsar (2013), “Helicopter Money: Or

How I Stopped Worrying and Love Fiscal-Monetary Coop-

eration”, Global Society of Fellows, 7 January.

Teulings C and R Baldwin (eds.) (2014), Secular Stagnation:

Facts, Causes, and Cures, A VoxEU.org eBook, 10 Septem-

ber, CEPR Press.

Turner A (2013), “Debt, Money and Mephistopheles: How

Do We Get Out of This Mess”, Cass Business School Lec-

ture, 6 February.

Wood R (2012), “The Economic Crisis: How to Stimulate

Economies Without Increasing Public Debt”, Center for

Economic Policy Research (CEPR) Policy Insight No.62,

August.

Regulation - enforcement

US regulatory feeding frenzy on HFT is wholly misguided

New York-based Steve Wunsch castigates regulators and prosecuting agencies for their

over-zealous persecution of market traders.

I’LL grant the definitions of “fix” are all over the map. Still, I can’t help noting the irony in a minor modern nanny making it his mission to “fix” the markets. Timothy Massad, Chairman of the US Commodity Futures Trading Commission (CFTC), during a victory lap on CNBC news channel celebrating his agency’s US$1.4 billion share of the US$4.4 billion set-tlement between global agencies and six banks over currency fixes, said: “What I’m trying to do is fix the markets, ensure integrity of the markets.”1

The nannies have been fixing the allegedly broken capital markets for decades now, primarily by replacing conflicted humans with presumably pristine machines and other arms-length competition processes designed to stop the professionals from fix-ing things in their favour.

The contrast between the two ways of doing things is stark. The markets began as price-fixing cartels, conspiracies that went from fixing commissions, trading increments and spreads to running “fixes” for gold, Libor, currencies, etc., all of which added up to

fantastic wealth for professionals in the City of London or on Wall Street. The nan-nies, in contrast, took it upon themselves to eliminate those conflicted structures and the wealth they created. Although the old structures were over three centuries in the making, while the nannies have only been at it for the eighty years since the Securities and Exchanges Commission began in 1934, the nannies are winning. This is most unfortunate.

The reality is that it was precisely through the selfish fixing conspiracies of unmolested markets that the uniquely modern miracle of growth finally appeared on the world stage. After millennia of seemingly permanent and universal poverty, such conspiracies lifted first the English-speaking peoples, but then others, to previously unimaginable prosper-ity in two successive industrial revolutions and global empires based, to put it succinctly in modern terms, on the freedom from nan-nies trying to fix things.

The emergence of dominant stock exchange monopolies, the ultimate rigged enterprise, at the end of the seventeenth and eighteenth centuries in London and New


York, respectively, set the pattern for forming enterprises around new technologies that carries forward to this day in a global enrich-ing that is gradually spreading to everyone.

DIY monopolisationsWhereas Old World monopolies were licensed to the King’s cronies as patents or other royal privileges to operate without competition, the paradigm established by the original stock exchanges, first in London and then in the New World, was one of Do It Yourself (DIY) monopolisations: no king, patent, license or other government pro-cess required or allowed. And the cornuco-pia of wealth that poured forth from such DIY monopolies, from the stock exchanges through Standard Oil to Microsoft and beyond, is still enriching us.

Sure, the rich are benefiting most, but the poor have benefited too. My favorite statistic in this regard is that the portion of people in the world living on less than a dollar a day dropped from 41 per cent in 1981 to 14 per cent in 2008.2

Unfortunately, now that the nannies are involved, in fact are fully globally dominant as they attack the rigging paradigm at the heart of capital markets, it is almost certain that the enriching will cease, that it will grind to a halt amidst nonsense from self-inter-ested nannies about the need to fix what wasn’t broken.

SpoofedThere is an old saying: Fool me once, shame on you. Fool me twice, shame on me. Perhaps due to such antiquated human wis-dom, prosecutors in the current rigging crime du jour called “spoofing”, face a dilemma.

How do you get human jurors to worry that machines might play the same trick over and over again on other machines? Never mind that a human wouldn’t be so stupid as to let that happen. But how do you get humans to be concerned about the feelings of machines in the first place, or crimes against them? And can machines be victims when both the putative perpetrators and victims are effec-tive robots working on behalf of that cur-rently most-hated of all human types, the high frequency trader, or HFT?

No harm, no foulThese problems are compounded from the prosecutor’s perspective by the fact that each instance of the spoofing crime is so small in its effect that it has no noticeable harm associated with it. In fact, even if you add up all the tiny instances, it still amounts to negligible harm. Not to mention that if a human did accidentally get caught up in the machine versus machine battle of spoofing and other HFT games, that human would “suffer” only one instance of that negligible harm. So wouldn’t this be an obvious case where that other old human saying, “No harm, no foul”, would apply?

Spoofing is where a trader places visible orders he doesn’t expect to fill on one side of the market, to sell, say, above the current offer, in order to create the false impression that there are more sellers around than there really are. If the trick works, the sell orders will not fill, but will spook or “spoof” the market downward to the point where the trader’s previously placed buy order will fill, after which he will immediately cancel the “false” sell orders. For an HFT, the strategy has a double benefit. He buys at the bid and


he collects the coveted liquidity rebate as a “maker” of liquidity, as opposed to being a “taker” of liquidity that pays a fee. If he is an aggressive spoofer, he might try to reverse the position with an opposite side spoofing trade, with all of the order placements, can-cellations and executions in both directions done in a fraction of a second.

“Rigged market” violationsAlthough new enough that most people have still never heard of it, spoofing is elbow-ing its way to the top of the “rigged market” violations that are bedevilling banks in all their businesses. The total amount of fines for rigging crimes, mostly, at the moment, for fixings, are already staggering, and continue to mount with no end in sight. According to the Financial Times, reporting after the cur-rency fix settlements: “The fines took the total to US$56.5 billion, making it the most expensive year for banks on record since 2007 . . . The global probe has triggered a cascade of further civil, criminal and antitrust investigations by 20 authorities worldwide against more than 15 banks over allegations of collusion and manipulation in the forex market“.3

Regulatory witch-huntThe addition of spoofing to the other fix-ing or rigging crimes promises to capital-ise on the hatred of HFT and finally send some of those presumably guilty Wall Street types to jail. This is likely because regula-tors are in full witch-hunt cry, their market structure and civil authorities now backed for the first time by agencies with criminal prosecution powers, such as the federal US Department of Justice (DoJ) and the New

York Attorney General’s office headed by Eric Schneiderman. Even the Federal Bureau of Investigation is involved, so these HFT-related spoofing-type crimes (and there are several others, with different names), will soon make their association with HFT a very serious matter, indeed. This is absurd, because their association with HFT is what in reality makes these crimes so trivial or victimless in their effect. Nonetheless, it is for the very reason of their association with HFT that jail is finally on the cards for these recidivist miscreants.

Judgment DayThe spoofing crime happens on such a small scale and so quickly – generally in less than a second – that it is probably not much dif-ferent in effect from all the other HFT strat-egies into which it naturally blends. These net about one tenth of a penny per share on average, or about US$1.25 billion a year for all HFTs together, inclusive of all com-missions, rebates and liquidity fees paid or received.

So assuming spoofing is typical of HFT strategies (and there is no reason to assume otherwise), at an average trade size of two hundred shares, which is typical in today’s high frequency equity market, we’re talking a take for the spoofer of only twenty cents per crime. Multiply that by ten or a hundred, as the inflated claims of prosecutors allege, and it is still trivial.

So the problem for the prosecutor is to convince jurors that if the HFT does this over and over again, he will make millions. But even if jurors believe that computers can be fooled over and over again to play the same losing game, the flesh and blood


victim would never be so stupid. Secondly, he doesn’t trade frequently anyway and, thus, only “suffers” once. In fact, for the human “victim”, all of the costs and rebates that matter to the HFTs boil down to a pittance.

False regulatory concernsThe all-in cost, including any spoofing, is subsumed within a small brokerage com-mission that has come down significantly in recent years to about US$8 per trade, and a ridiculously small bid-offer spread of a penny per share round trip in active stocks, or half a penny each way.

So, whether one talks about the trivial 20 cents per trade that an HFT might suffer (and go ahead, multiply it by 100 if you like), or the small brokerage commission and spread that a regular investor would pay, neither of which is directly attributable to spoofing any more than any general HFT activity is, it melts away as a crime. No rational person would spend ten seconds worrying about it.

Even less so if he realised that, at most, regulators’ concern over spoofing is a false cover, as they misuse their investor protec-tion role to expand into protecting HFTs from other HFTs. Since when do such pro-fessionals need regulatory help?

Hiding behind nanny’s skirtEven if spoofing did cost them money, wouldn’t they be better off just program-ming their algos to recognise they were being picked off by spoofers and then pick them off by, for example, looking for oppor-tunities where they can quickly lift those offers or hit those bids that were not meant to execute? At least one commercial product of a former spoofer advertises that it can spot

spoofing as it occurs. 4 Why do such sophis-ticated players need to hide behind the skirts of nannies?

Fortunately for prosecutors, jurors will probably have read or heard of Michael Lewis’s Flash Boys, or will have otherwise imbibed the conventional wisdom on the evils of HFTs that the book espouses, and thus won’t be swayed by such realities. The book and all of the media outlets highlight-ing it, such as 60 Minutes, implied that rig-ging, repeated zillions of times, costs the public zillions of their hard-earned savings and thus destroys public confidence in mar-kets as well as the American dream.

Although all of these untrue claims are unsupported in the book or anywhere else, jurors will probably be as gullible as the rest of the public on this point and will be only too happy to convict, if only to just find out if there are any actual humans behind all that HFT technology who will scream as any ordinary witch would when burned.

Piñata During his victory lap on CNBC, CFTC Chairman Massad took the opportunity to emphasise his agency’s need for more resources. Perhaps shrewdly, given that his tin cup was out, he pivoted away from his agency’s US$1.4 billion share of the cur-rency fix settlement specifically to highlight spoofing in his pitch for more resources, he said: “We’re very stretched in terms of our resources. We need more resources to go after more things, more bad behav-ior . . . Spoofing for example. We have new authority to go after spoofing where peo-ple enter orders that they really don’t mean to complete in order to move the market.


That’s a very resource intensive investiga-tion, because you must look at a lot of order data, which is very voluminous. It’s a huge information technology challenge. If we had more resources we could do more on that.” 5

Extortion opportunityWith regulators of every description piling in, with academic market structure issues becoming regulatory issues, then civil issues, then criminal issues, and with money flow-ing ever more freely toward regulators who cannot resist the extortion opportunity (although they don’t keep the fines, not yet anyway, in spite of some recent proposals in that direction), real people should ask some fundamental questions.

Since all of the “crimes” are just differ-ent means of making an intermediation turn, and regulators have been on that case since the SEC set out to bust the block trad-ing conspiracy with an electronic National Market System (NMS) in 1975, which has distinctly not increased confidence, why should we expect a different result now?

NMS, the ultimate regulatory reform to “fix the markets, ensure the integrity of mar-kets”, produced HFT, which is universally hated, and market confidence has been in the tank ever since.

Biggest question of allWhy, exactly, should we expect more reforms and more regulators to improve confidence, when it has been declining all along in rough proportion to regulatory umbrage and the number of regulators involved in reform?

And the biggest question of all: now that the investment banking revenue model has been eviscerated by nanny state reforms,

shouldn’t someone be asking whether that had anything to do with the fact that tech-nology IPOs dropped from 300 per year in the 1990s to 30 per year now?6

Who is the fool, who is being spoofed, if regulators are able to keep us on this self-serving treadmill without answering these questions? •

Endnotes1. Massad appeared on CNBC’s Closing Bell, Nov. 12,

video.

2. “The total number of dollar-a-day poor people in the

world fell by three-quarters of a billion between 1981 and

2008 in spite of an increase in the total population of poor

countries of about two billion. As a result the fraction of

the world’s population that lives below a dollar a day has

fallen from more than 40 per cent to 14 per cent.” The

Great Escape: health, wealth, and the origins of inequality,

Angus Deaton, Princeton University Press, 2013, p.44, Kin-

dle location 791.

3. Financial Times, November 13, 2014, “Front Page: Six

banks hit with fines of $4.3 billion in global forex rigging

scandal.”

4. See Trillium’s “Surveyor” product. Trillium was the first

firm hit with spoofing charges (by FINRA), which were set-

tled in 2011.

5. Massad appeared on CNBC’s Closing Bell, Nov. 12,

video.

6. Peter Thiel, Wall Street Journal Digital Live confer-

ence, interviewed by WSJ business editor Denis K. Berman,

7:00 a.m. 11/13/14. Speaking of the annual rate of tech-

nology IPOs, he said there were “maybe three hundred

tech IPOs in the late nineties, maybe thirty now.” Thiel,

monopoly-whisperer in his new book, Zero to One, (also

venture capitalist and PayPal co-founder), mentioned this

drastic decline in technology initial public offerings as he

speculated on the reasons for the lack of new company

formation and productivity improvement in the modern

American economy.

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OTC Derivatives

Derivatives markets in China to be built upon G20 reforms

Sol Steinberg of OTC Partners is upbeat China can develop an effective OTC derivatives market

in line with global regulatory requirements.

WHEN members of the Group of 20 (G20), met in Pittsburgh in 2009 in the wake of the global financial crisis, they committed to reforms that ushered in a more calculated approach to systemic risk in the financial industry, and along with it, a new market structure for over-the-counter (OTC) derivatives.

Anchored by the principles of mandatory reporting of OTC derivatives transactions, mandatory clearing through central coun-terparties (CCPs) and mandatory trading on exchanges or electronic trading platforms, the new market G20 planned for the OTC derivatives space stressed transparency, risk controls, and improved protections against market abuses.

In some of the world’s most established OTC derivatives markets, those changes are well underway. In the US OTC derivatives market, trade reporting and central clear-ing are well established, and trading of OTC swaps on US Swaps Execution Facilities (SEFs) is mandated for many instruments, with trade volumes on the facilities building slowly but steadily. The EU has passed EMIR

and implemented trade reporting. As such, legislative frameworks are being finalised and adopted for rolling out central clearing and trading on automated platforms glob-ally, and this includes among other Asian nations, China, whose regulator has com-mitted the country to the G20 reforms.

In China, where interest rate swaps, credit default swaps and many of the instru-ments that make up global OTC derivatives markets have not been traditional tools of finance, the commitment of the country’s regulators to the post-financial crisis G20 reforms, means China is essentially build-ing an OTC derivatives market without the shackles of legacy systems. China’s com-mitment to global financial reform will essentially give one of the world’s largest economies a swaps market designed from the ground up for transparency, regulatory oversight and management of systemic risk.

Chinese finance has witnessed another revolutionary year in terms of its evolution and maturity. After working to avoid another destructive credit binge, Chinese authorities have also pushed to foster growth through-out the financial markets, resulting in near


record activity in certain sectors. Even with a slowdown in growth, the Chinese markets are on track to realise a solid year ahead.

Year of recovery2013 was the first year of this recovery, data shows that operating income and profit of the securities sector reached RMB 159 billion (a year-on-year increase of 23 per cent) and RMB 44 billion (a year-on-year increase of 34 per cent) respectively. 2013 was the true start of a rebound trend that has been in the making since 2010, when Chinese securi-ties started to slide. For the year, domestic securities firms in China saw a year-on-year increase in profits of nearly 3 per cent for the majority of its 115 licensed brokerages.

Chinese exchanges have also seen a significant uptick. 2013 reported the first increase since 2010, with a year-on-year increase of 48.94 percent. Brokerage income also went up 8 percent. Margin financing and securities lending contributed just under 12 percent and overall assets under manage-ment by brokerage firms topped RMB 5.2 trillion, nearly tripling in size from 2012.

Growth and more growthTotal turnover of China’s securities mar-kets have risen every year since 2010, while brokerage income accounted for half of the total income of the securities sector, a year-on-year rise of over 7 per cent. The margin financing and securities lending business grew quickly in 2014, contributing to more than 10 per cent of the total income of the securities sector for a third straight year, making it an important source of income for brokers in addition to revenue from broker-age business and proprietary trading.

Assets managed by domestic brokers, almost tripling in size from previous years, and the net income of the asset man-agement business reached a seven-year peak, producing a wave of innovation. Restructuring and market development swept through the securities sector: many brokers grew internet finance strategies; the credit business saw significant growth; secu-rities companies competed in the wealth management market as a result of the rapid development of asset management busi-ness; companies specialising in quantitative investment, program trading and alternative investment entered a new era of proprietary investment; the reform of the IPO registra-tion mechanism and the expansion of the over-the-counter (OTC) market occurred; and broker mergers started to gather momentum, resulting in “mega-brokers” in the securities sector.

Navigating reform These reforms also hastened business inno-vation, forcing securities firms to change their business model from outdated agency business to wealth management and capital intermediary services. These new innova-tive businesses have optimised the income structures of securities firms.

Despite rising profitability, the securi-ties sector faced challenges due to the pace of change. For example, online account opening strengthened competition among brokers for commissions, while the rapid growth of capital-intensive business resulted in higher liquidity risks. Finding a way to navigate reform and innovation is an indus-try-wide test. 2015 will see openings and tri-als in the competitive landscape arising from


trends such as business diversification and disintermediation, deepening innovation and transformation, as well as a more strin-gent regulatory risk requirements.

Internet of thingsInternet finance emerged as a new model for financial services, combining tradi-tional financial services with the “Internet of things”. As new communication platforms become more intertwined with our everyday activities, allowing people to share contents and comment and communicate online, social media is presenting the financial mar-ket with more and more unique opportuni-ties especially in mainland China.

The introduction of internet finance helps to reduce information disproportion in traditional business models. It overcomes geographical constraints and eliminates the need for transitional players within the supply chains, thus redefining the demand- supply equivalent model. Brokers should consider the internet as a means to boost their core competencies and more. Firms should develop appropriate strategies to tackle challenges presented by the mass market, deciding on whether to compete directly with other players providing similar products or design products that cater for niche market demands.

SCH and mandatory clearingThe balance between demand for secu-rity and convenience is crucial from a client perspective in selecting web-based services.These two qualities are contradictory, with security being the ultimate concern for inter-net services. Firms are only able to design an ideal product by achieving a delicate balance

between both security and convenience. The rise of internet finance will present securities firms with more development opportuni-ties, on condition they can alter the way they strategically view their business and under-stand clients’ needs. Doing so will enable securities firms in China to seize the oppor-tunities that internet finance offers.

Beginning in 2014 with mandatory clear-ing by the Shanghai Clearing House (SCH) of new RMB interest rate swaps with tenors of no more than five years, China is build-ing central clearing into the foundation of a its interest rate swaps market. Central clear-ing has been an early success of OTC swaps market reform, with some SEFs in the US reporting that a few non-US clients have chosen to trade on SEFs while not required to do so because of the benefits central clear-ing offers in controlling counterparty risk.

Fifth OTC Asian-clearing nationVia the SCH, China was the fifth Asian nation to begin OTC clearing. On its inaugu-ral opening day, the SCH cleared 59 interest rate swaps between 15 financial institutions worth a total notional amount of 5 billion yuan, equivalent to US$827 million. On July 1, clearing of Chinese yuan interest rate swaps became mandatory onshore in China for dealers and clients.

Thirty-five direct clearing members were admitted prior to launch, including nine foreign banks. Some notable foreign banks did not make the cut, prior to the launch of mandatory trading of yuan interest rates swaps. Of these, some were hesitant about the SCH’s complaince rules, whilst others failed to make the grade. Authorised insti-tutions, licensed corporations and other


Chinese persons who are counterparty to a clearing-eligible transaction are required to clear through a CCP if both entities have a clearing threshold and are not exempted from clearing obligations.

China has moved aggressively on other G20 goals as well. In China, only one trade repository should be designated for the pur-poses of the mandatory reporting obligation. The reporting obligation for Chinese per-sons will remain unchanged, i.e. their report-able transactions will have to be reported if their positions exceed a specified threshold, which will be assessed based on the total amount of gross positions held.

For licensed corporations, and local authorised institutions, the reporting obli-gation will apply if they are counterparty to the transaction or the transaction has a Chinese nexus. For foreign authorised firms, the reporting obligation will not apply if its Chinese branch is neither involved as a counterparty to, nor as an originator or executor of, the reportable transaction, or its Chinese branch is the originator or executor of the transaction, but the reportable trans-action does not have a Chinese nexus.

A T+2 reporting schedule will provide market participants some leeway to ensure they can meet reporting obligations.

Reporting to global trade repositories will not suffice for the purposes of any man-datory reporting obligation under Chinese law. Its law prohibits the disclosure of state secrets and the waters remain muddy as to what that constitutes. In fact, there are reports that some US China-based firms firms have stopped trading with each other in China because of concern that report-ing their trades to US trade repositories, as

would be required by two US firms, would be a violation of Chinese privacy law. Due to concern that the mandatory reporting obli-gation may compel market players to breach confidentiality obligations under overseas laws, Chinese regulators will try to build in a degree of flexibility into regime to avoid this.

As of April 2014, three jurisdictions – China, Indonesia and the US – reported having regulations requiring organised plat-form trading. In China, mandatory trading will not be imposed at the outset; it will be phased in later. Once mandatory trading on designated facilities is in place, fines will be imposed for breaches of mandatory trading obligations that will be comparable to those of other major jurisdictions globally.

Legislation will seek to clarify when failures to comply with trading, as well as clearing and reporting obligations should be penalised and when they may be excused. Chinese regulators should be able to take disciplinary action against parties that breach their obligation and regulators are also pro-posing a civil penalty regime whereby civil or administrative fines might be imposed for compliance breaches.

Chinese regulators will continue to revise the regulatory authority role in capturing and monitoring the activities of dealers and advisors, as well as capturing the activities of clearing agents. They will also have to work to clarify regulations as they relate to port-folios of OTC derivatives. Finally, regulators will devote emphasis to identifying, register-ing and regulating systemically important players on the Mainland and have a high degree of oversight with respect to these firms, including a registry of names and posi-tions that should be kept with regulators. •

Capital markets - China

China’s securities industry to undergo metamorphosis

Andy Chen of the Asia Financial Risk Think- Tank examines the impact regulatory change will

have on China’s nascent securities industry.

IN February last year, the Securities Association of China (SAC) published its guidelines for the Comprehensive Risk Management Practice of Securities Companies and the Liquidity Risk Management Guideline of Securities Companies – both being important mile-stones in the development of capital mar-kets within China.

Under the SAC rule-book securities, firms operating within China are required to meet strict international standards of risk man-agement and liquidity risk. Indeed, under the new regime securities, businesses have been issued a strict timetable to achieve a Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) of 100 per cent by 2015, as opposed to the banking sector’s 2018 deadline in line with those of the regu-lator and international community.

In order to meet this challenge of becom-ing compliant, Chinese securities firms will have a steep learning curve to follow, one informed by lessons from their international competitors, together with those of their own mistakes and successes, as they strive

to improve their quality of risk management over the coming years. This is a challenge that many believe will have important impli-cations for both China and its nascent capital markets infrastructure.

The risk management guidance pub-lished by the SAC is similar to that issued by the China Banking Regulatory Commission (CBRC), which is itself highly informed by the Basel III international framework devel-oped by the Basel Committee of Banking Supervisors (BCBS) in the wake of the 2008 great financial crisis (which itself is informed by the Basel II framework with an added emphasis on liquidity). And this is particu-larly so with regards to the computation of LCR and NSFR.

However, whilst the Chinese govern-ment and its regulatory agencies may be keen to embrace best international practice and sign-up for internationally agreed finan-cial stability measures, of which Basel III is an important component, the fact remains that Basel III (and Basel II for that matter) was designed for mature banking and capi-tal markets dominated by mostly Western nations, rather than emerging economies,


such as China. This issue is further com-pounded by the fact that Basel III and CBRC frameworks and guidance are very much bank focused, rather than securities industry specific.

Short-term implicationsGiven these issues, the desire to bring China’s banking and capital markets infra-structure in line with that of its international competitors may have some negative short-term implications for Chinese securities firms, two of which we detail below.

First and foremost, securities firms in China have a far lower net income, limited scale and smaller capital and asset base than their major banking peers. According to fig-ures supplied by the SAC in 2014, there were 115 licensed securities companies in China with a total asset base of RMB 2,100 billion and RMB 159.2 billion of total income as of 2013. Further, the average return on equity (ROE) is only 7.6 per cent, this being far lower than China’s banking sector and inter-national competitors.

The strict guidelines and time frame the SAC has adopted will require huge invest-ment in risk management capabilities and infrastructure in order for them to meet international standards. Smaller businesses may not be able to afford such investment, which will result in consolidation and reduced competition within the sector.

Further stymiedSecondly, due to significant differences in the size and scope of capital market infra-structure in other economies, never mind that of the banking sector in China itself, Chinese securities companies and security

industry development may be further sty-mied in playing catch-up in risk manage-ment standards, let alone achieving those standards met by China’s banks. By way of example, in the United States securities companies own some 18 per cent of total assets in the US economy, whilst in China this figure relative to the Chinese economy is a meagre 1 per cent.

As if the challenge for China’s securities sector was not daunting enough, the sector is further handicapped by the fact that the liquidity of China’s banking sector is based on that of the size of market capacity, which in turn has determined that the CBRC has adopted a LRC of 100 per cent to be met by 2018, which is the same as its international competitors under the Basel III framework.

Strict LRC deadline:NOWRegrettably such largesse does not apply to the securities sector, despite its lack of rela-tive size and assets compared to the bank-ing sector, who have been set an almost impossible LRC 100 per cent deadline of this year (2015). Whilst this may not prove burdensome in the short-term when lever-age is quite low, this may well change mov-ing forward and impact other areas of future growth.

As it stands today, the short-term fund-ing channel is dominated by the banking sector and, given the nature of liquidity in this sector, it has a tendency to run dry at the month’s end or end of quarter. By com-parison, the NSFR funding ratio requires far longer time lines for its funding and limited cash exposure due to inflationary concerns.

As such, many believe that the SAC’s rule-book will affect and change the business


composition of the securities sector with a growing emphasis on asset management and intermediary business, as firms struggle to meet the new regulatory requirements.

CDS market failureFurther, all this change may very well impact detrimentally future business innovation, particularly in the following three areas out-lined in the following paragraphs.

Firstly, innovation and development may be impaired in the credit default swap (CDS) arena. The CDS market in China differs markedly from that of other nations in that these products can only be issued to pro-vide protection on certain “state-sanctioned” bonds, rather than a comprehensive basket of bonds found on Chinese exchanges - which may explain the low participation rate of firms offering this service.

Further, despite regulatory efforts to develop the CDS market since 2010, the hedging function of CDSs is impaired by low liquidity and the limited nature of capital optimization. Under the new SAC regime matters are now compounded by the higher LCR requirements of which CDSs have a negative influence on LCR (net cash out-flow) and leverage (total risk exposure). In a nutshell, the development of the CDS mar-ket will be stymied further, this despite regu-lators’ desire to expand it – a case of double think!

HQLA demandsSecondly, the regulatory changes may impact the RMB-denominated stock mar-ket. The SAC’s rule-book now demands that the high quality liquid asset (HQLA) weighting of stocks in China is 50 per cent

and that amount cannot exceed 15 per cent of the overall total HQLA. Whilst this reduces volatility in LCR, it will limit expo-sure and other activities within capital mar-kets, specifically marginal trading - the latter providing opportunities for liquidity angula-tion, speculation and income volatility.

As such, the SAC guidelines will heighten concerns securities firms may have in expanding their marginal trading busi-ness, or actually entering this field in the first place. Much of this is due to the fact that securities firms will be required to add an additional liquidity reserve, which, depend-ing on size, this activity will exhaust rapidly.

Additional funding costsThird, but not least, is the likely impact the SAC rule-book will have on the long-term funding channel. In line with other gov-ernments and regulatory authorities, the Chinese government wishes to encourage longer-term funding to add further stability to the NSFR.

However, China suffers from a small and under-developed long-term funding sector, unlike its overseas competitors. Given this small capacity, additional demands upon it are likely to raise funding costs, whilst add-ing further pressures on profitability and ROE.

The Beijing authorities are keen to develop China’s capital markets infrastruc-ture, with an emphasis on direct investment, asset securitisation and growing the institu-tional investor sector.

As such, the country is experiencing a period of rapid change as it moves away from a bank-dominated financial system, similar in many ways to the European Union, to a


more evenly balanced mix of deep capital markets that are able to allocate resources where they are most needed within the Chinese economy.

An opportunity bonanza?As such, the new regulatory environment offers plenty of opportunities for securities businesses to enhance their risk manage-ment capabilities and learn from their inter-national competitors: twin processes that should add to the bottom line for those will-ing to take the challenge.

Getting in on the act of further develop-ing China’s capital markets and its securi-ties sector, and further reinforcing Beijing’s commitment to radical change, the China Securities Regulatory Commission (CSRC) in 2014 issued its “Nine Articles for China” to inform and encourage reform of China’s capital markets infrastructure. And chief among its wish list is a desire to make the market more transparent, more competitive, more innovative and more price competitive.

As such, and with the “Nine Articles”, now is the time for comprehensive mar-ket reform, a harmonisation of both direct and indirect investment, together with an increase is the size of China’s capital mar-kets within China’s overall economy. Suffice to say, we are witnessing exciting times in China.

Emphasis on vanilla brokerageIt’s interesting to compare China’s economy and state of its capital markets with those of the United States or the European Union. Major differences exist as to the percentages certain segments take up in the overall GDP of each country or trading bloc. For example,

in China there is far too much reliance on the vanilla brokerage business, whilst asset management languishes far behind in terms of GDP contribution.

Industry feedback is also positive, with many believing new business lines such as OTC Derivatives, interest rates products, structured products and Private Equity are poised for considerable growth, all of which will contribute to a tripling of income the securities industry enjoys over the next five years.

Learning from past mistakes and those of its competitors, the Chinese authorities are committed to growth and reform. The SAC guidelines of February last year are very much part of this process, particularly given China’s desire not to repeat 2013’s “cash crunch”. For the securities sector the push for better risk management and liquidity can only be positive in the long run.

Many hurdlesLet’s not get carried away, though, for, as dem-onstrated in this paper, certain tweaks are nec-essary if China is to achieve its stated ambition of deeper capital markets in an orderly fashion.

Yes, it’s true that Beijing and its numer-ous government agencies are committed to growth and further spreading prosperity, and comprehensive capital markets are essential for this in our interconnected modern global economy.

Securities firms are very much part of this process and will have a huge opportunity to expand and grow in importance relevant to the rest of the economy. However, numer-ous hurdles exist before this ambition can be achieved, not least the need for better staff, regulatory oversight and more capital. •

Accounting - CVA

Accounting hurdles for CVA in the region

Yin Toa Lee of E&Y explains how regulatory change and new accounting standards impact

credit adjustment in banks and business.

DETERMINING the fair value of deriva-tives and issued debt has been one of the key issues for the Asian banking sec-tor in recent years. Whilst Asian-based banks survived the 2008 financial crisis reletively unscathed, this has not pre-vented them from adopting new valu-ation methodologies in order to better gauge their positions and exposures in line with their Western counterparts.

With new standards and regulations, such as International Financial Reporting Standard on fair value measurement (IFRS 13) and the new regulatory charge under Basel III related to valuation adjustments as a result of credit, Asian banks have to fundamentally re-think their approach to managing counterparty credit risk. Asian financial centres, such as Hong Kong and Singapore, both mem-bers of the Basel Committee on Banking Supervision, will certainly be impacted by these changes.

Hong Kong and Singapore have been two of the most important gateways for trad-ing and financing in Asia. Local companies and banks deal with counterparties from all

over the world with highly different account-ing practices and regulatory oversight. The counterparty credit risks that these entities have to manage are affected by numer-ous factors. As a result, when the entities account for valuation adjustments, these adjustments may create enormous income statement volatility. For banks, these adjust-ments may have in impact on their regula-tory capital requirements.

Credit valuation adjustmentIn particular, the new credit adjustment charge under Basel III and the new account-ing standard IFRS 13, which has been in effect since January 1, 2013, will likely cause further volatility in results and significant capital hits in the trading book for banks. These and future changes in regulatory rules and accounting standards mean that credit adjustments will remain high on the agenda of senior management of reporting entities.

The credit and liquidity crisis, along with the widening of credit spreads over recent years has highlighted the need for better measurement of counterparty credit risk arising on derivative portfolios. Accounting


standards, both IFRS and US GAAP, also make it clear that credit risk should be reflected in the fair value of derivatives.

Debit valuation adjustmentWhile it is requisite that reporting enti-ties should incorporate credit risk in their fair value measurement, entities have dif-ferent practices in doing so. For example, it is common for entities to record a CVA on derivative portfolios for counterparties with positive expected exposure.

This means that entities record a loss and a decrease of the positive expected exposure when the credit rating of counterparties wors-ens. However, entities do not always record adjustments to reflect the changes of their own credit ratings in their derivative liabilities or issued debt (i.e. debit valuation adjustment (DVA) and own credit adjustment), which will be discussed later in this paper.

DVA is a type of credit valuation adjust-ment that entities can record. It adjusts the measurement of derivative liabilities to reflect the entity’s own default risk. When the entity’s own default risk increases, theo-retically, it should recognise a gain on these liabilities with the DVA because the value of its liabilities has decreased. The basis of recording such DVA is that the risk of default of the reporting entity should be considered in a fair value measurement just as the coun-terparty’s default risk is.

MonetisationThe key issue raised by reporting entities around DVA is monetisation. Entities that do not record a DVA may argue that DVA is hard to monetise; therefore, it would not be a relevant component of fair value.

Some entities may also feel that recording a profit when the credit quality of the entity is decreasing may appear counterintuitive.

Taking these inconsistencies into account, the introduction of IFRS 13 requires entities to start recording a DVA. The standard is explicit that own credit must be incorporated into the fair value measurement of a liabil-ity based on the concept of an exit price (as opposed to the IAS 39’s “settlement price”). HKFRS 13 also states that any liability valu-ation which does not incorporate own credit is not a fair value measure.

Similar to the existing guidance in US GAAP, the standard includes an assumption that the non-performance risk incorporated in the valuation of a liability should reflect a hypothetical transfer price involving a mar-ket participant of equal credit standing to the reporting entity on the measurement date.

Uncertainties and conflictHowever, the implications of such an assumption on the DVA recorded for deriva-tive liabilities are unclear to some constitu-ents who believe this concept may conflict with the requirement to consider the exit price in the principal market for the deriva-tive liability. If the market participants for over-the-counter derivatives are assumed to be dealers, these constituents question how non-performance risk can be assumed to remain unchanged in such situations when the reporting entity is below investment grade, as dealers with the same level of non-performance risk likely do not exist.

Notwithstanding these concerns, the application of this guidance under US GAAP has resulted in a generally consistent view on the need to incorporate the effect of


own credit risk in the fair value of derivative liabilities. Hence, with IFRS 13 being effective for more than two years, entities in Asia will also have to apply the similar DVA require-ment on their non-performance risk. They may consider using the same calculation approach by utilising their existing model for positive exposures adjustments for DVA.

Own credit adjustment (OCA)OCA is the adjustment made to issued debt instruments accounted for under the fair value option to reflect the default risk of the entity. It is common for banks to record an OCA, attributable mainly to the clarity of both HKFRS and US GAAP requirements.

In recent years, bonds, especially RMB-denominated bonds, are becom-ing a more popular financing tool in Hong Kong because of volatility in the economy. Companies and banks may see themselves having an increasing debt portfolio.

As a result of widening credit spreads over the past few years and variability in these spreads, their own credit adjustment on issued debt could generate significant volatility in the income statement. The mag-nitude of own credit profits reported by a number of multinational banks has rein-forced concerns that some have about the economic relevance of such adjustments.

Balance sheet mismatchesAlthough not many companies and banks currently elect to the option to fair value their own debt, such an option might be more popular in the not far too distant future to eliminate balance sheet mismatches in the case of a failed derecognition of assets in securitisation transactions as well as

hybrid instruments issued with embedded derivatives.

Like DVA, recording a profit as a result of OCA on issued debt, when the credit qual-ity of the bank is deteriorating, may appear counterintuitive. Additionally, there is also a regulatory requirement to remove the vari-ation of OCA from Tier 1 capital. To address these impacts that OCA may bring to an entity’s income statement, the new account-ing standard of IFRS 9 Financial Instruments, which is mandatory in 2018, clarifies that OCA should not be recorded in the income statement. The standard proposes that enti-ties should instead record OCA in other comprehensive income within shareholders’ equity with no subsequent recycling in profit or loss, even if an own credit gain is mon-etised through the repurchase of own debt. There has not been a similar proposal under US GAAP.

Exit priceDetermining an IFRS compliant exit price is also a common challenge – some deriva-tives are rarely transferred post-inception, so determining the appropriate price for a sub-sequent sale is largely hypothetical.

There is a concern among these report-ing entities that the adoption of IFRS 13 and the clear reference to an exit price approach will require them to move to using market-observable credit spreads in the valuations of derivatives which would lead to significant volatility in their profit or loss.

Banks in Hong Kong and Singapore are under the supervision of the Hong Kong Monetary Authority (HKMA) and Singapore Monetary Authority (MAS) on their coun-terparty credit risk. Whilst guidance has been


issued by the regulators for banks to follow, many remain in a state of flux in the imple-mentation of CVA, as well as counterparty credit risk measurement and management.

First off the postSince Basel II’s implementation in 2008, multi-national banks headquartered in Europe or the United States were among the first to have sought and received approval under the regulation to calculate exposures on derivatives using their own models. As such, they were often first to implement CVA measurement and management capa-bilities ahead of peers elsewhere.

Additionally, these banks with both reg-ulatory-approved exposure models (for risk) and mature CVA desks tend to adopt differ-ent approaches and platforms for regulatory and accounting calculations. Noticeably in these banks, risk models are typically cali-brated to use historical data, while the CVA desk uses market implied data for its pricing purposes.

Bank subsidiary challengeBanks that do not have regulatory expo-sure model approved, however, typically have largely aligned exposure calculation methodologies and platforms for risk and CVA management, with differences only in the way some aspects such as netting and break clauses are reflected. For banks that have less well established or no active CVA management capability, risk models may be used for the CVA exposure calculation.

Many banks operating in Hong Kong and Singapore are subsidiaries of large mul-tinational banks, and are often required to follow their head office’s risk management

policy. However, many have far fewer resources available than in their home coun-try, which on occasion can represent a real challenge in the management and calulation of credit risk in an efficient manner.

The introduction of Basel III will have an impact on the differences between regula-tory and accounting calculations in a num-ber of ways. Some changes brought about by Basel III will likely be reflected in the regula-tory numbers only. Basel III also introduces a CVA volatility charge, which is designed to cover potential changes in the value of the bank’s accounting CVA.

Basel III a key driverThis is for most banks a very material addi-tional capital charge and is driven solely by the bank’s regulatory models for exposure and market risk, and the bank’s associated credit hedges, rather than the approaches implemented in the CVA desk.

The accounting measure of CVA, DVA and OCA will also impact the bank’s capital position. This is why many financial institu-tions feel that Basel III will be a key driver in their considerations for changes to their CVA models and policies. For instance, as firms develop “CDS proxy mapping” methodolo-gies, they may do so by adapting existing practices in the CVA desk. Basel III require-ments are also leading most banks to invest substantially in updating their existing infra-structure to deliver improved capability for exposure measurement and management across risk and front office.

One of the main areas of difference between the accounting and regulatory approaches arises in the treatment of own-credit-related adjustments. While IFRS 13


advocates a symmetrical treatment incorpo-rating counterparty credit risk for derivative assets (CVA) and own credit risk for deriva-tive liabilities (DVA), the current proposals under Basel III take different approaches to CVA and DVA.

The new CVA volatility charge under Basel III has attracted a lot of comment from the industry mainly related to the calibration of this charge; however, market participants by and large accept the need for it.

The treatment of DVA under Basel III has proved to be far more contentious. Basel III explicitly requires banks to “derecognise, in the calculation of Common Equity Tier 1 (CET1), all unrealised gains and losses that have resulted from changes in the fair value of liabilities that are due to changes in the bank’s own credit risk”. The requirement is simple and transparent. It also ensures that

a worsening of creditworthiness does not result in an increase in regulatory capital.

This proposed regulatory approach introduces a significant disconnect between the accounting and regulatory treatment of CVA and DVA.

To appropriately manage and account for credit risks, Asian companies and banks will have to involve different departments, such as accounting, risk management, compli-ance and IT.

Besides designing and implementing a proper credit risk measurement and man-agement process, entities should ensure adequate training for different stakehold-ers in the company on credit and funding adjustments.

They should also take this opportunity to review their counterparty exposures and fine tune their strategy •

Call for papers

Contact:Christopher [email protected]


33

Opinion

Deregulation, non-regulation and ‘desupervision’

Professor William Black examines the causes of the mortgage fraud epidemic that has swept the United States.THE author of this paper is a leading academic, lawyer and former banking regulator specialising in ‘white collar’ crime. As one of the unsung heroes of the Savings & Loans debacle of the 1980s, Professor Black nowadays spends much of his time researching why financial markets have a tendency to become dys-functional. Renowned for his theory on ‘control fraud’, Prof. Black lectures at the University of Missouri and Kansas City. He is the author of ‘The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry.’ A prominent commenta-tor on the causes of the current financial crisis, Prof. Black is a vocal critic of the way the US government has handled the banking crisis and rewarded institutions that have clearly failed in their fiduciary duties to investors.

The following commentary does not nec-essarily represent the view of the Journal of Regulation and Risk – North Asia. “The new numbers on criminal refer-rals for mortgage fraud in the US are just in




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Counterparty risk - CVA

CVA “pricing” issues across Asia Pacific

Ben Watson of Maroon Analyltics surveys many of the obstacles holding back CVA development in the

region and what can be done to remove them.

THE seizure of financial markets in September 2008 has made banks and regu-lators, globally, reconsider how counter-party credit risk should be managed for OTC derivative exposures. There are three approaches to this problem; one approach is to use Central Counterparty Clearers (CCPs), a second approach the use the Credit Support Annex (CSA) addendum to of the ISDA agreement and third is to apply a Credit Valuation Adjustment (CVA) charge against the exposures and hedge the default exposure to an unsecured counterparty.

All three approaches to the management of counterparty credit have pricing implications and in all three cases Asian banks are lagging behind in pricing. As an example, banks in Australia, the US and Europe in most cases will pass on the charge CVA to their unsecured counterparties, but in much of Asia this is cur-rently not so. There are three different types of CVA banks have to deal with. Regulatory CVA as required under Basel III, Accounting CVA as required as part of IRIS 13, and the counterparty risk management pricing of the market price of counterparty credit.

Singapore and Hong Kong both require banks that are incorporated in their jurisdic-tion to be Basel III compliant and that requires banks to set aside capital based on the market price of counterparty credit risk. Accounting standards also require derivatives to be marked at their fair value, and that means accounting for the CVA as an income item rather than as an asset or liability. While many Asian banks are complying with the regula-tory and accounting requirements, very few are actually treating CVA as a pricing issue.

The reluctance for Asian banks to price counterparty credit issue is in part an emerg-ing market issue of underdeveloped markets. However, possibly the biggest impediment is some combination of a lack of skills, knowl-edge, management and leadership. This is not just an issue for the banks, but also local regulators. Local regulators have taken the view that pricing is a commercial decision for the banks and this is not their role to say how a bank should price derivatives. The problem is, however, that pricing CVA in Asia presents real challenges that just may need some push from the regulators.

Without the market pricing CVA, it is


going to be difficult for banks to reduce the CVA capital charge as it comes from CVA hedging and that should be a function of pric-ing. The current lack of skill and knowledge with respect to pricing CVA within Asian banks (ABs) is going to make implementing CVA challenging.

The knowledge gapIt is not something that can happen without first addressing the knowledge gap. Delays in implementing CVA will also disadvan-tage ABs as there is a comparative advantage from the pricing and risk management of Wrong-Way-Risk (WWR) which can only be addressed if a bank can price CVA correctly in the first place. CVA is a very challenging cal-culation, be it here in Asia or elsewhere.

Traditional credit risk is concerned with the loss of principal and/or coupons of a bond or loan and in these cases we usually know the Exposure at Default (or EAD) in advance. Counterparty Credit Risk is different as the EAD is not known with any certain and must be estimated.

Counterparty credit is also different in that a bank could be in both an Asset and Liability position at any one time with the same coun-terparty and may involve many hundreds or even thousands of complex trades.

NettingWhere legally allowed to do so, netting of assets and liabilities is permitted. However, the netting rules are complex and conse-quently CVA becomes a portfolio calculation. On default, any liability exposure to the coun-terparty must be paid in full; however, any asset exposure becomes a claim on default. As it is only the asset positions that are subject to

the bankruptcy rules, the valuation of CVA is akin to an option on the underlying exposures with the strike where the mark-to-market of a derivative trade is zero.

From a quantitative finance perspective, the pricing of CVA becomes challenging. For example, a single currency swap is viewed as a swaption, which may not be too difficult to measure if there is an established swap-tions market for that currency. More difficult is pricing CVA on a cross currency swap, as this requires a swaption market to value to the Libor indices plus a long dated FX options market for the notional exchanges.

There are two issues here for Asian banks (ABs) - one is a thin or non-existent options market for the underlying exposures. This is a symptom of under-developed and shallow capital markets. Regulators can address struc-tural impediments to deepen the markets but this is not a quick fix.

Lack of quant desksThis issue could also be addressed by improv-ing transparency and price visibility. Market associations could work with local banks to publish reliable prices. Regulators could also require mandatory price submissions. Many regulators may be thinking that this type of intervention in the markets is beyond their remit, this is not so with the mandatory reporting of trades.

The second issue is that ABs have under invested in their quantitative resources evi-denced by the fact that in Singapore there are only two ABs that have proper quant desks that are focused in building internal quant libraries. By contrast all major Australian banks have significant quant teams. Many ABs have opted to outsource their quant solutions to


external vendors. While outsourcing may allow a banks to “buy” some sophistication, it does not represent an investment in intel-lectual capital.

A pricing issue, not complianceThere are not enough skills or knowledge within the ABs to have a proper conserva-tion with management on what needs to be done. In many cases, the CVA conservation has been left to the risk management func-tion as part of the Basel III implementation. This is missing the point – CVA should be seen as pricing issue, not just one of Basel III compliance.

The valuation of CVA also requires esti-mates of the probability of default. The Basel Committee made it explicit that CVA should reflect the market price of counterparty credit. Their motivation for insisting on market measures for CVA is that they prefer banks to hedge counterparty credit, and thus CVA cap-ital relief would come from the hedging of the CVA exposure. The implication is the prob-ability of default should be a “risk-neutral” as implied from credit spreads or CDS spreads rather than a “real-world” measure. The prac-tical outcome is that to price CVA, the market price of credit needs to be observable and this means either visible CDS or credit spreads.

China hopes evaporateCredit markets in Asia have been growing strongly, but from a very low base. Many new bond issues are bought from yield per-spective and are never seen in the secondary market which make price visibility difficult or impossible.

The CDS market globally has declined since 2008 and is now less than half the

size at its peak. To compound matters the number of Asian names that trade is only a small fraction of the total CDS market. There was hope of a visible credit market in China when they tried to establish the equivalence of a domestic CDS market with Credit Risk Mitigation Agreement (CRMA) of 2010.

These (CRMA) contracts are similar to a CDS except that they are referenced to a specific loan or bond rather than a reference entity. Unfortunately, this market has failed to thrive mainly because: most loans in China are done via a bilateral basis and there is no market viability; a lack of market uniformity in the CRMA contract makes them hard to trade and because the CRMA contract does not allow for capital relief under Basel II sec-tion 162 provisions of cross-default.

Proxy pricingLack of price visibility is clearly a hindrance in calculating the market price of the probability of default, but this problem has not stopped CVA pricing and hedging in the rest of the world. Basel III allows for proxy hedges to be used when there is no CDS contract against a particular counterparty. This proxy could be a credit index or a counterparty that is simi-lar to the one you are trying to calculate CVA for. This would suggest iTraxx Asia-Ex Japan index would attract a lot of interest, but this has not been the reality.

Using this index may be problematic if we are trying to hedge counterparty credit, as the constituents of the index is dominated by Asian banks and some sovereign names, and this may not reflect the type of corporate credit that may attract CVA. A lack of credit price visibility in Asia could be addressed by a pan-Asian contribution service that is owned by the


local banks where contributors are rewarded with better price visibility. Again regulators could assist in making the pricing visible by mandating that banks contribute prices.

Globally, regulators have been keen to see CVA being priced and passed onto the unsecured counterparties. The motivation for this is they do not want to see a failure to price counterparty credit risk becoming a competi-tive advantage. While there is no legal obliga-tion to pass this charge on, the regulators are keen to remind banks that CVA is deducted at the accounting level and there is also a CVA capital charges if left unhedged. Banks in such jurisdictions have become motivated to pass the CVA charge on where possible.

This is in contrast with a number of ABs who have been making accounting adjust-ments below the line for CVA but without CVA pricing from the front office. The conse-quence is that these Asian banks may well be writing business at a loss.

Further, due to the portfolio approach required to price CVA, an incremental CVA charge is always less to existing counterpar-ties. This means there is a competitive advan-tage in CVA pricing to your existing client base as opposed to new clients. Without CVA being passed on to the client, banks are not able to use incremental CVA to defend their existing client base. The biggest lost opportu-nity for ABs in failing to address CVA is the competitive advantage in being able to man-age Wrong-Way-Risk (WWR).

WWR is when the probability of default is positively correlated with the exposure. That is when your counterparty probability of default increases when your exposure to them increases. This is often referred to as a cross-gamma issue where the delta of an exposure

is influenced by some other factor, and in this case the probability of default. The standard CVA calculation assumes no WWR which is a gross simplification as WWR is almost always evident.

There have been many examples of WWR in recent times – e.g. IDR / Indonesian Sovereign CDS spread in 2008, or facing AIG on a bought CDS exposure during the GFC. An example of WWR that is often given is buying put protection from a company on its own stock – the value of the put peaks when the company goes bankrupt and is unable to pay. WWR becomes a risk issue in that you will end up hedging the credit exposure at expensive levels and unwind them at cheap levels and it becomes a real slippage cost when trying to hedge the counterparty credit.

While WWR is not an Asian issue per se, the prevalence of export-led economies, heavy reliance on FX and offshore funding along with shallow capital markets would suggest WWR would be a big risk fac-tor within Asian banks. Identifying WWR involves looking at how your counterparty’s exposures move with changes in the prob-ability of default. Banks that are able to do this analysis are able to identify which coun-terparties, what products and what markets are likely to cause WWR.

Once you are able to understand your books in such a way you can make decisions on how to manage this risk. Management of WWR may involve exiting certain markets, putting limits on certain clients in certain mar-kets or charging extra to cover the expected cost of hedging. The technically correct way to hedge WWR is to match the cross-gamma with another product that exhibits the same properties. •

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Documents

Journal of Regulation & Risk, North Asia_ Feb 2015