Journal of Regulation & Risk - North Asia, Volume I, Edition III/IV, Winter 2009/10

Articles & Papers

Issues in resolving systemically important financial institutions Dr Eric S. Rosengren

Resecuritisation in banking: major challenges ahead Dr Fang Du

A framework for funding liquidity in times of financial crisis Dr Ulrich Bindseil

Housing, 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 Rizzi

Measuring & managing risk for innovative financial instruments Dr Stuart M. Turnbull

Red star spangled banner: root causes of the financial crisis Andreas Kern & Christian Fahrholz

The ‘family’ risk: a cause for concern among Asian investors David Smith

Global financial change impacts compliance and risk David Dekker

The scramble is on to tackle bribery and corruption Penelope Tham & Gerald Li

Who exactly is subject to the Foreign Corrupt Practices Act? Tham Yuet-Ming

Financial markets remuneration reform: one step forward Umesh Kumar & Kevin Marr

Of ‘Black Swans’, stress tests & optimised risk management David Samuels

Challenging the value of enterprise risk management Tim Pagett & Ranjit Jaswal

Rocky road ahead for global accountancy convergence Dr Philip Goeth

The Asia-Pacific regulatory Rubik’s Cube Alan Ewins and Angus Ross

Journal of regulation & risk north asia

Volume I, Issue III, Autumn/Winter 2009-10

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Journal of Regulation & Risk North Asia 1

editorIan Watson

Chief sub-editorFiona Plani

editorial administrator, north asiaChristopher Rogers

editorial standards BoardDr Giovani Barone-Adesi, Dr Colin Lawrence, Luo Ping, Dr Patrick McConnell, Dr Michael Ong, Dr John Pattison, William Ryback, Dr Kariya Takeaki, Simon

Topping, Dr Peter Treadway, Lawrence Uhlick and Dr Lawrence White.Contributors

Dr Ulrich Bindseil, Prof William Black, Dr Willi Brammertz, James Coffman, David Dekker, Dr Fang Du, Alan Ewins, Dr Christian Fahrholz, Dr Philip

Goeth, Markus Grund, William Isaac, Ranjit Jaswal, Dr Andreas Kern, Umesh Kumar, Gerald Li, Kevin Marr, Richard Mazzochi, Tham Yuet-Ming, Tim Pagett,

Joseph Rizzi, Angus Ross, David Samuels, Stephan Schoess, David Smith, Prof Lynn Stout, Penelope Tham and Prof Stuart Turnbull.

Design & layoutLamma Studio Design

PrintingDG3

DistributionDeltec International Express Ltd

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5/F, Suite 502, Wing On Building, 71 Des Voeux Road, Central, Hong KongTel (852) 2132 9620 Fax (852) 3007 0229

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

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

China, Hong Kong, Japan, Korea and Taiwan.

© Copyright 2009 institute of regulation and risk, north asiaMaterial in this publication may not be reproduced in any form or in any way

without the express permission of the Editor.

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.

INSTITUTE OF REGULATION & RISK NORTH ASIA


Volume I, Issue III – Autumn/Winter 2009-10

ContentsQ&A – William M. Isaac 9Q&A – Dr Eric Rosengren 17Book overview – Dr Willi Brammertz 27Opinion – Professor William Black 33Debate – James Coffman 41Accounting update – Markus Grund 47Regulatory update – Richard Mazzochi 51 ArticlesIssues in resolving systemically important financial institutions 59Dr Eric S. Rosengren

Resecuritisation in banking: major challenges ahead 67 Dr Fang Du

A framework for funding liquidity in times of financial crisis 75Dr Ulrich Bindseil

Housing, monetary and fiscal policies: from bad to worst 87Stephan Schoess

Derivatives: from disaster to re-regulation 95Professor Lynn A. Stout

Black swans, market crises and risk: the human perspective 101Joseph Rizzi

Measuring & managing risk for innovative financial instruments 109Dr Stuart M. Turnbull

Red star spangled banner: root causes of the financial crisis 119Andreas Kern and Christian Fahrholz

The ‘family’ risk: a cause for concern among Asian investors 125David Smith

Global financial change impacts compliance and risk 131David Dekker

The scramble is on to tackle bribery and corruption 135Penelope Tham and Gerald Li

Who exactly is subject to the Foreign Corrupt Practices Act? 143Tham Yuet-Ming

Financial markets remuneration reform: one step forward 151Umesh Kumar and Kevin Marr

Of ‘Black Swans’, stress tests & optimised risk management 159David SamuelsChallenging the value of enterprise risk management 165Tim Pagett and Ranjit Jaswal

Rocky road ahead for global accountancy convergence 171Dr Philip Goeth

The Asia-Pacific regulatory Rubik’s Cube 177Alan Ewins and Angus Ross

INSTITUTE OF REGULATION & RISK NORTH ASIA








Editorial commentTHIS double issue of the Journal should provide readers with much food for thought on current and future financial management and financial sector policy. This edition also represents our first 12 months of covering matters of importance to our readers in the governance, risk management and compliance sector within financial services. And what a difference a year has made. Last November, the global financial community was staring into the abyss, with stock indices heading south at an alarming rate. Concerted efforts by central banks, treasury heads and govern-ments prevented a financial meltdown on a par with the Great Depression. However, the fact remains, the global economy has sustained a severe shock, with many leading economies only just emerging from the longest recession on record. Further, government debt has grown exponentially as a result of bank bailouts and stimulus measures to kick-start the global economy. As the Governor of the Bank of England, Mervyn King, succinctly summed it up by paraphrasing Winston Churchill: “Never in the field of financial endeav-our has so much money been owed by so few to so many. And, one might add, so far with little real reform.” While we are not out of the woods yet – with many fearing a double-dip re-cession if the drip-feed of state aid is removed too soon – a positive aspect of the financial crisis has been the level of debate it has engendered on how to reform global banking and prevent a repeat performance in future. At the heart of this debate is what to do with systemically important ‘too big to fail’ institutions. In one camp you have the European Commission’s Neelie Kroes, Mervyn King, Thomas Hoenig of the Kansas City Fed, and former IMF chief economist Simon Johnson, all calling for systemically threatening institu-tions to be broken up. In the opposing camp you have Deutsche Bank’s Josef Ackermann, Prof Charles Calomiris and the Federal Reserve’s Ben Bernanke, re-jecting such calls, believing that they can be managed by better regulation. Whatever the outcome of this debate, be assured that the Journal will continue to cover these and other issues impartially throughout 2010.

Christopher rogers General Secretary

Institute Of Regulation & Risk – North Asia


AcknowledgmentsTHE Secretariat of the Institute of Regulation and Risk – North Asia could not have published this edition of the Journal without a great deal of assistance and advice from professional associations, international monetary and finan-cial bodies, regulatory institutions, consultants, vendors and, indeed, from the industry itself.

A full list of those who kindly assisted would be impossible, but the Secretariat would like to thank: The Federal Reserve – Washington D.C., the Federal Reserve Bank of Boston, the European Central Bank; BaFin; Central Banking Publica-tions; the Baseline Scenario; FinReg21; Voxeu; Deloitte; Linklaters; RiskMetrics; Standard & Poor’s; Royal Bank of Scotland; Allen and Overy; Mallesons Stephen Jacques; PricewaterhouseCoopers; FRS Global and DLA Piper for their kind per-mission to reproduce material from their respective publications and websites.

Detailed comments and advice on the text and scope of contents from William Isaac, Prof William Black, Dr John C. Pattison, Philip Goeth, Colin Shaftsbury, Robert Pringle, Dr Michael Ong, Dr Heong Wee Chong and Stephan Schoess were invaluable; we are also grateful to Ian Watson and Fiona Plani of Edit24.com for their due diligence in setting out, editing and correcting the text.


Q&A

Obama and financial reform: is it an oxymoron?

Central Banking’s Robert Pringle poses some salient questions to former FDIC

chairman, William M. Isaac.

QuestION: What is your verdict on the Obama administration’s proposals for the reform of financial regulation?

ansWer: The Obama Administration’s proposals are disappointing on several lev-els. First, they rushed them out in June with-out first doing a proper post mortem on the causes of the current crisis. Congress enacted and President Obama signed in May of this year a law establishing a bipartisan commis-sion to study the causes of the financial crisis. I do not understand why the Administration felt it necessary to propose reform legislation before the bipartisan commission could even be established, much less complete its work. Getting the right reforms in place, no matter how long it takes, is much more important than enacting the wrong reforms in a hurry.

Second, the proposals addressed issues that had nothing to do with the crisis, such as creating a new consumer advocacy agency and eliminating the industrial loan company charter, while ignoring things that were at the heart of the crisis, like reforming Fannie Mae and Freddie Mac. Moreover, it is difficult to understand the proposal’s rationale for

elimination of the thrift charter in the middle of a depression in the housing sector.

Third, the proposals do not address the enormous problem of highly pro-cyclical regulatory and accounting policies. The Basel capital rules use backward looking models that do not require sufficient capital in good times and demand too much capital in dif-ficult times. The same is true of loan loss reserving policies.

‘Horribly pro-cyclical’Banks pay little to no deposit insurance pre-miums in good times when the FDIC fund is strong and are required to pay excessive premiums when the banking industry is struggling. Mark-to-market accounting is horribly pro-cyclical, inflating bank earnings and capital in good times and senselessly destroying earnings and capital in down-turns like the current one. These issues are at the heart of the current crisis and must be addressed.

Fourth, the proposals risk creating greater moral hazard by permanently extending bank-type regulation and the bank safety net to large non-bank firms.

Journal of Regulation & Risk North Asia10

Q: What about the proposals for a Systemic Risk Council?a: Unfortunately, the Administration’s proposal does not treat this seriously. Potentially, the creation of a strong and effective Systemic Risk Council should be the most important reform of all. But the Administration’s proposal would cre-ate a Systemic Risk Council dominated by Treasury. It would rely on Treasury’s staff and the Secretary of the Treasury would be its chairman. The Treasury has had a hand in creating any number of banking crises over the centuries and is one of the most important agencies that must be monitored by the Council.

The Council needs its own staff – prob-ably running into the hundreds - and should have an independent chairman appointed by the President and confirmed by the Senate for a six-year term. Q: What were the most serious policy mis-takes made in handling the crisis? A: We handled the crisis in an ad hoc fashion with highly inconsistent actions that caused most people to question whether anyone was in charge and whether we had a plan to stop the contagion effect. For example, when Indy Mac (a large thrift in California) failed, only the insured depositors were made whole.

When WAMU (a very large thrift) failed, both the insured and uninsured depositors were made whole, but $20 billion of bonds were exposed to losses, and $7 billion of equity that had been infused by investors just months prior to the failure was wiped out. On the other hand, everyone was pro-tected at Wachovia. Everyone was protected at Bear Stearns, while everyone was wiped

out at Lehman. AIG was rescued, including its bank creditors, while the preferred share-holders at Fannie and Freddie were hit with big losses.

The first priority in the midst of a bank-ing crisis is to maintain order and confidence. There are other important policy considera-tions – such as minimizing taxpayer expense, protecting the deposit insurance fund, and limiting the creation of new moral hazards – but those concerns must take a back seat to maintaining public confidence. I do not believe we took care of priority number one during this crisis.Q: Did official actions make the crisis worse?a: In September, 2008, they did. Senior officials went to Congress and publicly demanded $700 billion of taxpayer funds on an emergency basis to avert financial Armageddon. I still believe that this legisla-tion was not needed and had the effect of panicking the public.

Off the cliffThe US economy fell off the cliff in October, following this very public spectacle. Consumers and businesses slammed shut their wallets and check books and have yet to re-open them. The rationale for the $700 billion funding was to purchase toxic assets from the large banks. None of the money was in fact used for this purpose, which underscores how poorly thought out the legislation was.Q: How should public policy makers deal with the moral hazard created by banks and other institutions deemed too big to fail? a: We have faced this issue for decades without resolution, and it is not clear to


me there is a solution. There will always be some firms that are too large and too complex to be allowed to fail – at least in an uncontrolled fashion. When I was chair-man of the FDIC we “rescued” Continental Illinois, the nation’s seventh largest bank. We kept the bank from failing, but we did so in a way that replicated the most important aspects of a failure while maintaining order and stability in the financial system.

Shareholder wipeoutFor example, the shareholders of Conti-nental were wiped out and the senior man-agement and most members of the board of directors were replaced. At the same time, we issued a blanket guarantee that all gen-eral creditors would be protected against loss or delay in receiving their funds. A lot of large banks went down during the 1980s, includ-ing nine out of the 10 largest banks in Texas, but they were handled in a way that main-tained confidence in the financial system.

I believe we made some serious mis-takes during the current crisis, but rescuing large institutions, such as Bear Stearns and Wachovia, was not one of them. Q: But surely the safety net that the US has very publicly put under the big banks has cre-ated enormous moral hazard and a licence to gamble with taxpayers’ money to a far greater extent than ever before. a: My advice would be to stop fretting about too-big-to-fail and accept that it will be with us forever. I believe our focus should instead be on preventing our largest insti-tutions from getting to the point of failure. Higher capital is a critical step, as is getting rid of the pro-cyclical Basel capital models and the highly pro-cyclical mark-to-market

accounting. Having a strong, effective, and independent Systemic Risk Council is also a very important step. We should take a very close look at the off-balance sheet activities of banks and require capital against those activities to the extent appropriate. Being much smarter about supervision of banks is also very important. For example, allowing banks to purchase massive amounts of fully insured brokered deposits is not good super-vision. Prudential regulators should devote greater attention to incentive pay arrange-ments in banks to make sure the arrange-ments are rewarding the right things and not encouraging the wrong things.Q: Aren’t some banks too large and complex to manage? Shouldn’t these be broken up?a: If the management of a large bank dem-onstrates that the institution is too large and complex to run in a prudent manner, then the regulators should not hesitate to make changes in management and/or force the institution to divest businesses and shrink to a more manageable size.

Managing complexityI believe that boards and regulators must be smarter and firmer in their oversight of these companies. It is really not about size, it is about complexity and the ability to under-stand and manage that complexity. It is also about making sure the companies have plenty of capital and reserves to weather any storms, including those that can arise from off-balance sheet activities. It is also about ensuring that management has the incen-tives to do the right things and not the wrong things in running the company.

I do not believe in breaking up financial institutions just because they are large.


Q: It seems that the competition authorities both in Europe and the US may be prepared to take a tougher view of anti-trust issues in finance. Would this be helpful?a: I have always seen a lot of merit in sensible anti-trust enforcement. Anti-trust enforce-ment was a major issue in bank acquisitions and mergers in the 1960s and 1970s. I cut my teeth on it as a young bank lawyer in the 1970s. Anti-trust enforcement became an anach-ronism beginning in the 1980s, as policy-makers seemed to decide that there were too many small banks and the system would be stronger if we allowed significant consolidation. Q: What would be the objective of such anti-trust action?a: Well, this is a difficult issue. During the 1960s and 1970s, the goal was to prevent excessive concentration in specific markets, such as Cleveland, Ohio. When this was coupled with the inability to expand out of state, it resulted in a large number of regional banks around the country and no dominant players on the national level. Nationwide banking has eliminated large numbers of larger banks, producing greatly increased concentration of the banking system.

Genie and the bottleOne can argue that the current system is more competitive in that giant firms from around the globe are competing more aggressively for consumer and middle market business. This is probably correct. So those who argue for stronger anti-trust enforcement are probably not trying to promote more competition but to prevent major concentration in the financial sector.

It is not clear to me how one puts that genie back in the bottle. Q: Do you agree that there is a need for international agreement on procedures for dealing with failing systemic institutions in a crisis?a: It is not a pressing issue in my mind. Simpler is better in government, just as it is in the private sector. International supervisors need good lines of communications, but if we force them to have committee meetings during a financial crisis, I am pretty sure that will not be an improvement over a system in which each country takes responsibility for cleaning up its own messes. I would remind folks who propose even greater international structure that the colossally bad Basel II capi-tal standards are a product of that system, along with a number of other bad ideas, such as mark-to-market accounting. Q: Several commentators have proposed that each systemically significant firm should develop a plan for winding up its operations quickly in a crisis. What is your view?a: I suspect those commentators have never held a significant position in banking or bank regulation and have never dealt with a banking crisis.

Alternatively, other systemically impor-tant institutions could commit to resolu-tion procedures and provide accompanying financing (if deemed desirable) if any of their members were to fail, shielding taxpayers from the costs.

In the United States, we have such a sys-tem today – the federal deposit insurance system. The banks are jointly liable for all losses suffered by the FDIC and must restore the FDIC fund within a few years after a banking crisis subsides. The government


guarantees this system, as it must, but it is clearly paid for by the banks. In addition, we have the Federal Reserve System – which is also paid for by the banks – to provide liquid-ity. Also, the Fed and the FDIC typically use a fair amount of moral suasion to get banks to support those in trouble. Insurance com-panies also have a mutual protection system at the state level for protecting policy holders when a company gets into trouble. Q: Moving to capital requirements, as you know this has been exhaustively discussed among regulators for many years, yet policy makers have in practice allowed banks to hold less and less capital. How did this happen?a: I have been involved in the banking industry for 40 years, and capital has been an important issue during that entire period and beyond. Bank regulators lost their bearings begin-ning in the 1990s when they decided to implement the Basel capital accords to use capital models to equalise bank capital requirements throughout the world.

Back to basics I pin the responsibility for this on the Federal Reserve and the Treasury. They were so eager to equalise capital in banks throughout the world that they were willing to reduce US standards in order to achieve parity. The FDIC argued strenuously against the Basel capi-tal rules. It is time to return to some higher absolute standards below which no bank may go. And it is time to allocate appropri-ate amounts of capital to off-balance sheet exposures.Q: One fashionable idea at present is to introduce counter-cyclical capital ratios but I understand there are huge difficulties involved

in developing practicable proposals to imple-ment the idea internationally and they could well be dropped. What is your view?a: This is not some new-fangled idea. It is the essence of good bank supervision. Prudential regulators should always lean against the prevailing winds. The Federal Reserve was notorious for doing that in the 1960s and 1970s. When the economy was overheating and bubbles were developing, the Fed would adopt a go-slow approach and require banks to increase their capital.When the economy was in a slump, the Fed would ease its capital demands. Regulators did not micro-manage the credit-granting process, but they did require banks to build stronger buffers, including loan loss reserves, when things appeared to be overheating.Q: Will not a systemic regulator suffer from the same swings in euphoria as market participants? a: It should not, if it is structured properly with good leadership. Its raison d’etre will be to monitor and alert the regulators, Congress, the media, and the industry to developing systemic risks.Q: If as seems inevitable some body has to take on these so called “systemic” respon-sibilities, it will doubtless in most coun-tries be the central bank. Wouldn’t that get them too close to politics and threaten their independence?a: I do not believe any single agency has the wisdom and experience to carry out this duty, and I believe in checks and balances. Plus, I believe in a strong central bank with complete political independence. Anointing the Fed as the systemic risk regulator would be wrong on all counts. I believe we need to establish a Systemic


Risk Council that is independent from any single agency.

Its board would comprise the Secretary of the Treasury and the chairmen of the Fed, the FDIC, and the SEC. Its chairman would be independent of those agencies, would be appointed by the President and confirmed by the Senate for a six-year term, and would have a great deal of autonomy (the board would be advisory in nature).

The Council would have its own staff and would have access to all information the government possesses regarding the finan-cial system, including confidential exam data and classified information. Finally, the Council would undertake the SEC’s current responsibilities for overseeing the Financial Accounting Standards Board.Q: Would it not be much better to revert to traditional, tried and tested central banking crisis management policies: lender of last resort, constructive ambiguity and tough punishment for bank managements and banks that fail?a: Yes, we need to get back to the basics. But we should not stop there. We need other safeguards as well, such as the Systemic Risk Council; simpler and stronger capital and loss reserve regulation; elimination of pro-cycli-cal regulatory and accounting regimes; less reliance on models and greater reliance on on-site examinations and judgment in bank management and regulation; and making sure the incentive compensation models are encouraging the right behaviours. Q: What is your view of the argument put forward by Simon Johnson, former chief econ-omist at the IMF, that the banking lobby has become too powerful? a: I do not know how to measure that

assertion to prove that it is true or false. Banking has always had a reasonably strong lobby, which it has needed as banking is a favourite political target. But I could not say that banking is more powerful than the trial lawyers, the teachers’ union, retired people, trade unions, or any other potent lobbies. As long as they are playing by the rules, we can-not do much about it in a democracy.Q: In your testimony to Congress on March 12 you emphasised what you see as the dis-astrous role of mark-to-market accounting in this crisis. If you are right, it seems incred-ible that governments should have allowed banking systems to come close to collapse and economies to sink into recession just for want of enough common sense to suspend this rule. What is the explanation? What has been the response to your testimony?a: I believe the FASB and SEC went down the path towards mark-to-market account-ing with good, albeit terribly mistaken, inten-tions. They were warned not to do so in the early 1990s by the chairmen of the Fed and FDIC and the Secretary of the Treasury, cau-tioning them that mark-to-market account-ing would be highly pro-cyclical and make it difficult to get out of downturns (as we learned during the Great Depression, when we abandoned mark-to-market accounting in 1938).

Admission of guilt Once the crisis began in 2007, it was very difficult for the FASB and the SEC to turn around on the issue for two principal rea-sons: (i) it would be an admission that they were wrong and played a large role in cre-ating the crisis, and (ii) they were concerned that the markets would react negatively to


the accounting change because it might be viewed as a cover-up of the problems.

When I began calling publicly for sus-pension of mark-to-market accounting nearly two years ago, it was difficult to get any attention on the issue, as most people never heard of it, much less understood it. We have done an enormous amount of edu-cation and most people have now heard of mark-to-market accounting and know it is a very bad thing. That’s great progress.

Time to call a haltNow we need to finish it off. It is utterly bad accounting with no redeeming virtue. It is better disclosure that we need, and that can be provided in very clear footnotes to bal-ance sheets. We should not be destroying hundreds of billions of dollars of bank earn-ings and capital simply because markets stop functioning properly. Q: How would you compare the official man-agement of this crisis to the Savings and Loans crisis of the 1980s in which you were involved as chairman of the FDIC?a: I do not believe the comparison is very favourable in terms of the handling of the current crisis. Very serious economic prob-lems in the 1970s – mostly rampant inflation – led to extremely serious problems in the financial system during the 1980s. The Fed raised interest to over 21 per cent to break inflation’s back. This in turn bankrupted the entire thrift industry due to their large port-folios on long-term, fixed rate mortgages and bonds. It also led to a depression in the agricultural sector, as farmers could no long afford to operate and service the debt on their farms. A very serious recession ensued in which unemployment reached double

digits. A bubble in the energy sector burst. The major banks in the country were loaded up with third world debt for which there was no market because it was feared widespread defaults would occur. The result was massive problems throughout the banking system. Approximately 3,000 banks and thrifts failed, including a number of the largest banks in the country (nine out of the 10 largest banks in Texas, for example).

The problem bank list still stood at 1,500 at the end of 1991 after the 3,000 failures. The FSLIC, which was the thrift counter-part of the FDIC, was badly insolvent and was taken over by the FDIC. So, during the 1980s, significant economic problems led to widespread problems in the banking sys-tem. Government policymakers handled the banking problems in a way that maintained confidence in the system. Indeed, once the 1981-82 recession ran its course, we began the longest peacetime expansion of the economy in history, despite having to handle thousands of banks and thrift failures.

At the onset of the current crisis, there was barely a cloud on the economic hori-zon when problems in the financial system emerged. Highly pro-cyclical regulatory and accounting policies magnified the problems in the financial system. Poor crisis manage-ment by the government made matters much worse and led to a general loss of con-fidence in the financial system. This, in turn, caused businesses and consumers to stop spending and investing, leading to a serious economic downturn. •

(Editor’s note: This interview originally appeared in the August 2009 editon of Central Banking magazine.)


Q&A

Central bankers, systemic risks and auditing standards

Dr Eric Rosengren and guests field questions on the economic crisis from concerned Hong

Kong bankers and financiers.

on the evening of tuesday, May 5, 2009 more than 100 senior bankers from hong kong’s financial services sector gathered to hear the President and Ceo of the federal reserve Bank of Boston, Dr eric rosengren, deliver a lecture on systemic risk and regulation – a full transcript of this paper appears on page 59 of the Journal. Joining Dr rosengren on the speakers’ panel were Martin Wheatley, Ceo of the securities and futures Commission (sfC); anthony neoh, former chairman of the sfC; stephen roach, chairman, asia, Morgan stanley; and robert Pringle, the event modera-tor. Below is an edited transcript of the audience Q&a session. a full transcript of the event’s proceedings is available on our website, www.irrna.org.

Introduction Moderator: Robert Pringle – Good evening ladies and gentlemen. Let me first start by congratulating the Institute of Regulation and Risk for creating this event and the opportunity for a dialogue on the future of regulation. The G20 meeting in London has

mandated far-reaching action to reform the regulation of the financial sector and, in par-ticular, they encouraged the IMF, Financial Stability Board, and the Basel Committee to make far-reaching recommendations.Question: Roger Clark Spyer, Citic Ka Wah Bank – “We’ve all talked about systemic risk, lax regulation, defective products, high lev-erage, mispricing; all of which have been apparent in recent years. Then comes a cata-lyst that collapses the house of cards and the system is in big trouble. Now the problem as I see it – one with which regulators and eve-ryone else has been struggling – is the ques-tion of accounting practices.

Fuel to the fireWhen you have big problems, such as a for-est fire, you want effective tools to fight that fire. You don’t pour oil or petrol on a forest fire. The accounting practices of “fair value” and markets, where there was no liquidity and no value, to me was like pouring petrol on a forest fire.

I may be a simple banker, but I have always believed there is one thing that is fun-damentally important in banking and that


is you always look at the cash flows. When you look at any proposal, the only thing that ever repays anything is cash flow. Cash flows and liquidity had to be the key to solving the issues we were facing. So now I think a lot of regulators have moved into this and much of the actual action that has been taken has been to establish the funding of cash flows of the instruments that have been causing all the problems.

Tools to do the jobSo why not look at the accounting practices in that the key is the cash flow, net present value being the key to how you value any asset in this sort of situation. Why not look to the fundamentals and the way we resolve these issues when they crop up? So that’s my comment; I think that all the regulations in the world won’t stop the crisis, so let’s look at the tools we can use to resolve these issues as well as the causes of the problems.

Moderator: Thank you very much. Yes, Anthony Neoh has already touched on the controversial role of accounting and mark-to-market accounting in the various downward spirals that we’ve seen . . . the liquidity spiral and the asset price spiral. (This has gone on) . . . until asset prices reach levels that nobody’s trading at, but which somehow, still, one has to mark-to-market, in order to assess how the crisis should be met.

Would anyone like to respond to that?a: Anthony Neoh – “As an investor, as a depositor in a bank, as a member of an audit committee of a bank … I am very much a victim of this (crisis) and I cannot see my way through it all. But let me try and make sense of it although, to tell you the absolute truth, I have not been able to do so thus far.

Mark-to-market accounting actually works very well when you don’t have disrupted markets. The whole thing basically comes to a halt when you actually don’t have a market and so the whole question is: what is mar-ket? Markets, in fact, work when everything has a clear price … and very quickly. When you have a great deal of liquidity, nobody complains. When you have a whole portfo-lio of stuff that you cannot sell and nobody wants to buy, then the question remains: What’s the market value?

Nobody has been able to figure this out, so the standard-setters say there are two ways you can deal with it:

1) If you don’t intend to sell it, just put this on the back-burner and say this is being held for investment, held for maturity, whereas before you were selling it. In fact, you’ve just reclassified it. Now the question is that having reclassified this, then have you got the money to actually pay for it when in the end, when it matures, it still doesn’t sell for anything?

Seat of distrustWhat then is the value of this portfolio and whether in fact your accounts are telling people the truth? That is the conundrum … when the IASB and FASB, in grappling with these problems, come up with very mixed signals. That is where I find the seat of dis-trust among various parties. One would have to be very clear as to where we are heading.

2) The other thing would be that the price of something – of cash you might say – is net present value which, in fact, comes into an assessment of loan portfolios, as you well know. But this begs the question: if you use net present value, what kind of discount


rate do you apply? If you use a loan discount rate, which is your interest rate on the loan, then you may be using one based on eco-nomic conditions that were in effect many months ago.

Now if you use that discount rate, it does not tell you what the present risk is because you are now in a much riskier situation. So how do you deal with the provisioning of your loan portfolio? When you do so, you must look at the present macroeconomic situation. If you do that, then what kind of models do you use?

Partial migrationThat is an issue we have to grapple with when we make financial reports. I can tell you that what we did in one bank (I was a member of the audit committee), we first looked at our loan portfolio and said let’s migrate these into various parts and then look at the loans we say are bad. As such, we used a net present value based on the loan interest rate, but that doesn’t tell you anything because the loan interest rate could have been decided three years ago. And now we are in a much riskier situation. Then the next thing we do we is look at the present (bad) situation based on a very large portfolio of loans and, looking at the market for these kind of securitised loans, what would be the additional mark-down that you would have to make?

This is what I would say are “finger in the air” statistical models which are based on historical information. So what we do is add something else . . . At the moment , all of this is alchemy . . . and we are all indulg-ing in alchemy right now. How good is this alchemy, we don’t know. A lot of it is based on statistical models which are historical and

don’t take into account some recent activ-ity. Just how these activities will work out in the future, I don’t know . . . which is why we are, at the moment, in my view, in a kind of ‘no man’s land’. I don’t know where we go from here. I’d like to raise this issue with Dr Rosengren and ask him where exactly are we going? eric Rosengren: I don’t think I can answer exactly where we’re going, but I would say that accounting is a critical component of the financial infrastructure, and so it has to be very carefully worked out. Liquidity risk was never fully incorporated into market accounting and so I think it’s come as a sur-prise not only to many accountants, but also to many financial economists who have not seen the kind of liquidity risk that we’ve seen over the last year and a half. So it’s not all that surprising that the accounting infrastructure was not prepared for some of the financial outcomes that we’ve actually seen.

‘Judgment’ here to stay That being said, many accounting standard boards have started taking into account that liquidity is very relevant in terms of coming up with an accurate price. We’re never going to get rid of judgment. Mark-to-market accounting was part of an attempt to say that we don’t need judgment and I think that, unfortunately, that’s not going to be possible in any kind of accounting regime. Mark-to-market works very well in a very liquid economy, but obviously when there are a lot of liquidity pressures it doesn’t work nearly as well. Judgment is going to have to play a much larger role and I think some of the changes that have recently occurred in accounting


standards actually recognise that and recog-nise that in an appropriate way.Roger Clark spyer: Looking at the concept of cash liquidity, there are ways to manage a lot of the available instruments and a lot of the issues that we might be facing in this sort of crisis. The Federal Reserve, or whoever is leading the solution, can fix the liquidity, can fix the interest rate when it’s serious enough, and this is basically what they’ve been doing in the last six months.

Calmer watersMost regulators and most of the coun-tries that have come round to this way of thinking, have fixed it this way. They have created funding vehicles where you fix the boundaries and set the parameters and give cash flows the chance to come through against the funding source within a funding structure. This structure enables you to see it through to maturity, through to calmer waters where you can resolve issues in a market which is now stabilised and back to a normal basis. eric Rosengren: This brings up one more observation, as Anthony highlighted . . . another aspect of an accounting system is to give as accurate as possible a portrayal of the financial condition of the firm and I think the loan portfolio is a good example where you have cash flow. One of the reasons why we have bank examiners is that there are significant disagreements of what cash flow actually is. So particularly for something like construction law, where contractually they may not have to release payment until the project is actually completed, you have a situation where the examiner views that in the current environment, cash flow will be

minimal because once the project is done you won’t be able to get people to rent the space. But the bank may believe that cash flow will come from renting out the building. So whether it’s cash flow, mark-to-market, or whatever, judgment exists.

Cash flow is not a whole solution either because in bad times, and around bank exams, accounting statements can change quite dramatically. Part of that reflects a rea-sonable difference of opinion about what cash flows are. And one of the roles that the bank examination process does play is to try to make sure that the accounting system is accurate for the financial statements of the bank during difficult times. Anthony Neoh: We’ve been concentrat-ing a lot on the valuation of assets. Roger (Roger Clark Spyer) has been talking about liquidity and assets. But you can place a fair value on liability as well. One of the rea-sons why many banks have reported prof-its in the past quarter is because of possible reclassification. At the same time these banks have actually written down their lia-bility and as a result have written into their income statements an income which does not actually arise.

Fair valueThis is an issue I still don’t understand, because the moment you put a fair value on a liability you basically can repay that liability at a lower rate. Now, if you only do this in a bankruptcy or a receivership, then once a financial institution writes down its liability at fair value, then it must realise that it is no longer a going concern. But at the same time, the auditors have declared that the financial institution is still a going concern, despite the


writing down of its liability. So this is one of the inconsistencies that need to be ironed out: how we can actually reconcile fair value with reality?Moderator: Thank you very much. This is such a critical issue but highly technical. The Institute could have a whole session on the accounting rules and their role in this crisis. I’m sure we could go on all day about this. But I think there’s another question from a gentleman towards the back of the room.

Treacherous pathQ: eberhard Brodhage, general manager, Commerzbank, Hong Kong: I think you’re leading us down a very treacherous path with technical issues such as liability valu-ation. When I started out in banking the statement was that banks were different. We deserved the trust of our clients and our stakeholders and I do not think we have it anymore. We have reached a situation where we are no different from airlines, or supermarkets or second-hand car sales-men. My question is: What regulations do you see as effective in terms of implement-ing and re-installing that trust? The relationships that we have with our clients are more long lasting than those of somebody that buys a car or who goes to a supermarket. So I think we need that trust in order to function in our economic, financial role. I don’t see that happening at the moment. I see liability accounting in the financial results and find it hard to believe that we can actually produce a profit when a bank says we do not need to repay our debt at the level at which we have promised to pay it. So how can we rebuild that trust? Moderator: Thank you very much indeed

for that fundamental question. I think many people have already raised the question of when will banks get back to making money out of knowing their customers individually. And I hope I don’t offend anybody here by saying that there seems to be a general per-ception that they’ve got quite a way away from that special knowledge they once had from knowing their customers. However, I’m speaking in the presence of many experts here. Who on the panel would like to take up the gentleman’s question?a: Martin Wheatley: I think you have to go back to the model of banking that existed when I first entered the securities industry. This was the 3-6-3 model of banking. You borrowed at 3%, you lent at 6% and you went home at three in the afternoon after a nice long lunch with your clients. [audience laughter]. If you haven’t got a long-term rela-tionship with your client because the risk has been passed on and passed on and passed on, you do not have the same trusted bank-ing relationship that you had 20 years ago. That’s the nature of how the industry has developed and I don’t know if it’s possible to go back, but it is one solution.

Problems remaineric Rosengren: I would just make one observation. Disclosure and transparency have been a problem during this crisis in that there have been a number of instances where institutions have, within weeks or months of disclosing very significant problems, announced that they have no problems. And so, this takes us back to accounting, and also takes us back to what supervisors are will-ing to say in public. It is very hard to have a great deal of confidence when somebody


announces that they have no problems and shortly after fails.

Prevention not cure So part of the issue I think is that we need to do a better job, both as supervisors, and as bankers, accurately reflecting the extent of the problems that institutions are fac-ing. I think that’s one of the challenges that have occurred during this crisis and I think there’s probably more to be done on both the banking side and the supervisory side to make sure that some of the issues that we’ve seen over the past year-and-a-half do not reoccur. stephen Roach: Can I just follow up and ask a question based on what you just said. We have the results of these stress tests that are due out later this week. One scenario is that we pretty much know what the US Treasury is going to reveal in terms of who needs to raise capital. Let’s just say that they found some serious systemic problems out there in several key systemically relevant institutions.

If they were then to – along the lines of what you just suggested – release those problems in the midst of what is still a very serious crisis, could that not trigger another cascading wave of angst that could have contagious impacts on institutions who may be in better shape than the ones that could be identified as problematic?eric Rosengren: Part of the goal of the stress test is to get a more accurate portrayal of what the financial condition is and to try to restore some confidence that the finan-cial statements and the financial conditions of firms are as stated. You do raise a signifi-cant issue which is whether or not it could

become destabilising and I think to off-set that possibility, the US Treasury would announce well in advance that they would be more than happy to provide some capital to make sure that an organisation remains stable, through the stress test and through the next several years.

That is an unusual statement relative to what we’ve had in the past, a willingness to inject capital into an organisation should it be needed. So I think that it’s trying to off-set some of what we’re going to get from the added disclosure and transparency that stress tests will provide. Q: Joseph Poon, deputy CeO, Hang seng Bank: Actually the risk of a systemic risk is not really a new issue; it was apparent to my generation prior to the stock market crash of 1987. And further, I recall Alan Greenspan saying in his famous “irrational exuberance” speech that falling asset prices should not really concern the central banker, unless they impacted the real economy.

Implosion riskHere may lie the root of some of the prob-lems. I think it was Stephen (Stephen Roach) who raised the issue that, in terms of policy direction, the risk of an implosion of a highly leveraged investment bank or hedge fund or whatever, also came up in the early ’90s. And if we go back to reports way back in the ’90s, the Bank of International Settlements had been warning against these very issues. Further, we then saw the establishment of the Financial Stability Forum in 1999 – this only involved the G7 countries initially and not any Asian countries. Obviously, this matter has now been amended with the inclusion of Hong Kong and Singapore.


One wonders, whether the regulators should be in these forums. It could be very counter-productive to spend the next three years debating whether or not it’s a twin peak or what the most effective model should be – to regulate the financial services sector. Rather I think the point should be that if we don’t act on past mistakes.

Burning platformI don’t care what regulatory environment you have, you’re going to end up with the same problems. And I wonder whether G7 managed to avoid a burning platform in the first place, even having set up the Financial Stability Forum not long after the Asian financial crisis of ’97/’98, which was very serious to us here.

Hong Kong, and many other Asian countries, went through a life stress test between 1997 and 2004. Within that we also endured a life test in the form of the SARS epidemic. And so in terms of what has been described as a radical stress test in the US, I suggest you look at the Hong Kong model and see how we lived through a 65 per cent fall in property prices from peak to trough, which I’m pretty sure that the US will not go through.

But that was quite a stress test, wasn’t it? I don’t think there was a requirement at any stage for the banks to raise additional capital, just in case. I think there might be some lessons here in Asia that the western world can learn from, because we actually have the blessing and the benefit of having lived through those seven or eight years and going into this mega crisis, and I can tell you as a banker, I feel quite relaxed for some rea-son [audience laughter].

For you it’s a big problem, a huge prob-lem. To start with, all the toxic stuff thrown around the world, I think Asia probably caught about 10 per cent, 50 per cent in the US, 40 per cent in Europe, that sort of thing. Even China has a very good rule – a loan-to-deposit rule – of 75 per cent. Who are we to say that’s a stupid rule? I’m aware of discussions going on in Europe right now saying maybe we should have more rigid regulations on loan-to-deposit. We’ve lived through heavy deleveraging. Our loan to deposit ratio here in Hong Kong was 140-150 per cent – now it’s around 50-60 per cent. We’ve lived through that painful period of adjustment. And I can see the US and Europe going through exactly that now, and it will not be very quick and not very easy.

Simple, robust regulationModerator: You made a very good point tonight and the Western authorities and bankers should pay more attention to the Asian crisis. Mervyn King, Governor of the Bank of England, recently called for regu-lation to be simple and robust. And you’ve given an excellent example of a simple and robust rule; but to listen to discussions amongst regulators recently, it is very far from being simple. In fact it’s getting more and more complicated and seems to be sow-ing the seeds for the next crisis. I intervene with my own personal comment. Q: Johanna Chua, chief economist, Asia Pacific, Citi: Two questions actually. Earlier there was talk of systemic regulators, and from a practical perspective, who should be the systemic regulator? If the Fed or the Central Bank takes that role, what does it


imply in terms of the independence of the Central Bank, which is an integral part of monetary policy? And the second question is related to the discussion about monetary policy and whether or not it should not just target inflation but also look at asset price as well, to the extent that part of what’s feeding into this crisis is not what’s purely driven by policy but also because this crisis is very dif-ferent from previous crises.

’Riskless assets’It is not driven by capital flow looking for higher returns on riskier assets, part of it is actually driven by the savings glut of a lot of the central banks in Asia and elsewhere looking for riskless assets and the inability of emerging market countries to gener-ate riskless assets that get flooded into the treasury and provide some sort of floor in terms of the long end rates in the US. So the question is whether it’s enough to say that monetary policy targets inflation asset prices and has control of the short end of the curve, and what that means in terms of the long end of the curve where you have global capital flows and no real alterna-tive to reserve currency to drive longer end rates? What does that mean in terms of monetary policy?Moderator: A lot of big questions there. Eric, do you want to start?a: eric Rosengren: I’ll start. Martin Wheatley and Stephen Roach raised their comments as well so let me follow up on both their comments a little bit. In terms of monetary policy, in the United States we have a dual mandate based on inflation and unemployment. Other central banks just have inflation, but if I try to use the Federal

Plus rate in the case of the United States, to take care of inflation, unemployment and financial stability, you’re asking an awful lot from one instrument.

I think one of the issues that I would highlight is that particularly for asset bubble types of situations, the asset bubbles I’m really worried about are the ones that are occurring through leveraged institutions. I don’t think all asset bubbles are the same. In terms of the dotcom decline, it had much less of an impact than what we’re going through right now and I think one of the reasons for that is that the dot com was mostly equity financed, so it had a wealth impact, but not nearly the same impact on leveraged institutions.

Supervisory policyWhat’s different about now, and what was different about the Japanese experience of the early 1990s, was that leveraged institu-tions were impacted and the shrinking of these leveraged institutions has had a much broader impact than just the wealth effect. This is something that we have to be con-cerned about and I think in many instances, supervisory policy may be a more effective way of addressing that concern than mon-etary policy alone. So I’m not sure monetary policy should ignore those issues, but hav-ing a broader tool set is probably going to be a more effective way of addressing the situation.

Martin’s question of whether you can identify it is a difficult one to answer and it’s the same question with asset bubbles, to the extent that leveraged institutions are growing very rapidly, to the extent that cer-tain asset classes are growing in multiples of the economic growth of the economy.


I think that does raise some questions on how that’s occurring and I don’t think it’s all that difficult to say that most of the cri-ses we’ve seen are really through lever-aged institutions that were, in effect, either having a concentration risk in terms of the asset classes that were focused on or they dramatically increased leverage. I think that some of these instances are observable, not just after the fact, but actually as they are occurring.

Discount windowThe risk organisation in most countries has macroprudential responsibilities. But every country also has microprudential respon-sibilities, and should try to look not only at the solvency risk of individual institutions, but also at the macroprudential which is not something that’s charged with any entity in the United States, and to my knowledge in most countries there’s no organisation that does that. It may be housed within the Central Bank to think about that because the Central Bank does have the discount win-dow. So if you’re offering discount you have to think about solvency risk and liquidity risk and these are features that you would expect any systemic regulator to have to think about.

I would say that we’re unlikely to have one model as we don’t have one model of central bank and we don’t have one model of how banks and other financial institutions are supervised. We probably won’t have one model for how a systemic regulator would work, and probably it does make sense to have some experimentation. In the United States we’re going to have to see what Congress decides and whether the Federal

Reserve winds up being responsible. But I think it is important for some organisation to take responsibility.

Leverage buildupstephen Roach: One quick question here. You expressed your concerns over the rapid build up of highly leveraged institutions. Is part of that problem a reflection of the fact that the Federal Reserve set the price of leverage too low? The policy interest rate, if it had been higher that would have dis-couraged the systemically risky build-up of leverage? Would it also have discouraged the equally reckless leverage of American households which are now in such dire straits?eric Rosengren: It’s very difficult to use a monetary policy tool to target one asset. It’s much easier to do it through supervisory pol-icy. So I think that there were lessons learned about what we should have done differently regarding supervisory policy.

Monetary policy toolWe can change the cost of capital when you raise the federal funds rate and presumably when you raise other interest rates as well, you’re not only affecting the housing sector, you’re affecting all sectors of the economy. So do you want to slow down the entire economy if you think that the housing sector is growing too fast?

There may be other types of tools that could be much more effective at address-ing that. You have to look at all the tools and ask: What is the most effective way of deal-ing with the problems at hand? And I’m not sure that I’d want to wholly rely upon mon-etary policy to do that.•


Book overview

Unified Financial Analysis: the missing links of finance

Dr Willi Brammertz, senior adviser, FRS Global, offers a condensed overview of his

recently published book.

in the wake of the financial crisis many proposals for new regulation and improved oversight have been put for-ward. one can already discern two com-mon threads which will force regulators to rebuild the information base of report-ing from scratch. these are as follows:

• Stress testing of financial institutions which emphasises the measurement of “value change” instead of “value as such”. This has already been done in the US and European banks can expect the same in the future;

• A shift from the regulation of individual financial institutions to a systemic regu-lation. There are currently proposals in various stages of realisation for creating systemic risk supervisors in the US, UK and continental Europe.Current regulatory reporting is, by and

large, based on traditional bookkeeping, in the sense that values are the starting point for further manipulation and reporting. This is even true for the latest Basel II enhance-ments. However, a system that is based on book value – even if calculated on a “fair

value” basis – will never be able to derive value change since all connections between risk factors and value are lost once value has been established.

When solely value is required by regula-tors, they are unable to calculate value change as needed (e.g. in stress testing). Even worse, such a regulatory approach necessarily leads to inconsistent results on a systemic level, as it is impossible to derive value without making numerous assumptions. These assumptions however are hidden, and thus inconsistency on an aggregate level is likely. Another draw-back is the reliance of regulators on informa-tion controlled by the regulated.

New management neededDespite the obvious drawbacks of the cur-rent information regime, it has not been fundamentally challenged. Although there are many proposals for new regulation, there is no debate as to whether the current set of required information can deliver the needed results. What is needed is a conceptual dis-cussion regarding the base information that must be reported. For regulation to be ready for any future crises, it needs a new and


modern risk management methodology surpassing what is currently found in banks. This implies moving the focus of thinking from value towards the drivers of value or its underlying inputs, which amounts to a small Copernican revolution in finance.

Elementary particles in financeThe invention of double-entry bookkeep-ing, with the balance sheet as a condensed representation of the value of an enterprise, is considered by many as one of the decisive inventions of the Middle Ages, laying the foundation for progress in modern times. Given the technical resources of the time – essentially paper, pen and ink – it was impos-sible to systematically store background information on how these values, such as FX and interest rates, creditworthiness of coun-terparties and so forth, materialised.

This approach was used right up to the middle of last century and became inad-equate only towards the end of the century, especially in financial sector risk, where other management systems were developed in parallel.

Recently, regulators – as owners of last resort – had come to par with top level risk management requirements, such as stress tests and systemic risk analysis. Despite this development, regulators seem to continue to base their reports on the medieval regime using value – book or fair – as calculated by the regulated, as their primary input.

We propose to enable micro- and macro-prudential regulators to effectively exercise their mandates by giving them new analytical tools. These tools are based on a conceptual framework with a set of some 30 standardised “contract types” at the core,

sharing approximately 200 common finan-cial attributes among them.

Our experience with financial institu-tions in many jurisdictions has shown over the years that this small set of concepts suf-fices to model well over 95 per cent of the number of existing financial contracts with precision. As there is a common set of con-cepts, with an identical level of granularity underlying the analysis of every institution, the information can easily be consolidated at a systemic level to identify systemic net posi-tions, exposures, etc.

The diagram at the top of the opposite page details functions that are referred to during the remainder of this article.

At the core of the model is the financial contract, which is a mutual promise of coun-terparties to exchange cash flows according to a set of rules. These rules determine when cash flows occur during the contract’s life, their type, and how their value is calculated.

Important risk factorsMarket risk factors, Counterparties and Behaviour are set input factors of environ-mental circumstances, which can change unexpectedly and therefore constitute important risk factors: • Many financial contracts include rules

which refer to market prices in order to calculate the value of cash flow (e.g. a floating bond may be reset on a specific rate from the swap curve). In general, market risk factors are in direct corre-spondence with the major asset classes of bonds, foreign exchange, equities and commodities.

• The mutual promises defined in financial contracts are, in reality, not always kept.


The counterparty input category encom-passes all the data to describe the ability of the counterparty to meet its obliga-tions quantitatively.

• Some rules governing the exchange of cash flows are not mechanically deterministic: the funds deposited in a checking account may be withdrawn at short notice, annuities may be prepaid and credit lines may be drawn. These rules, which can only be formulated for aggregates of contracts, must be statis-tically derived (Behaviour). Since they are uncertain, they are part of the risk sources.Given these input elements, it is always

possible to derive fully the value, income, sensitivity and risk which depend on them.

It is important to note that in such a sys-tem, value is not an input but an output, which can be calculated not only under cur-rent conditions (risk factor, counterparty or behavioural assumptions) but also under shocked conditions. Moreover it can be cal-culated according to any valuation principle (nominal, fair or market) but also as required by public accounting standards.

Missing linkSuch an analytical methodology would meet the conditions for stress tests or any other modern financial analysis. A crucial ingredient to applying it on a systemic level is the standardisation of financial contracts using the above-mentioned 30 or so con-tract types.

. . .

FinancialContracts

Markets

Counter-parties

Behaviour

Risk factors

Input elements

Analysis elements

t

Financial events e1 e2 e3 en

Liquidity Value

Income Sensitivity

VaREaRLaR

Chart 1. Model core – the financial contract


Unfortunately, this is a missing link in the current regulatory regime and the new regulatory proposals. Rectifying this should be high on the agenda of regulators since standardisation is unlikely to come from the financial industry itself. The industry has a poor track record in this regard, with even sophisticated banks treating financial contracts as little more than heaps of data attributes rather than as objects which encode cash flow generation logic. Moreover, such a change is not in the immediate self interest of financial institutions and will therefore only come about by regulation.

Implementing change: the institutionHow then would this work in practice? The process is similar to a bank introducing an Enterprise-wide Risk Management (ERM) system or an Asset & Liability Management (ALM) system – both of which require all financial transactions as input.

Banks manage their financial contracts using many transaction systems and each system treats contracts differently. An ALM (or ERM) system contains a set of contract types that is implicitly standardised. An enterprise-wide implementation of an ALM system therefore means mapping the myriad different product types defined by transac-tion systems into the clearly defined contract types of the target ALM system.

‘Special’ contract typeWhen such a mapping process is successfully undertaken, cash flow generation patterns of the transactions stored in different source systems and their dependence on market, counterparty and behavioural conditions are clearly defined and well understood.

In a regulatory context, each bank, insurance company or other regulated entity would have to undertake the same exercise, the only difference being that tar-get standard contract types would need to be defined by the regulator. Financial institutions would be obliged to map their contracts into one of the standard contract types.

A contract that cannot be mapped exactly would have to be approximated or marked as a “special” contract type. Once this is achieved, financial contracts can be well understood by any participant of the financial system: regulators, investors and last, but not least, the financial institution itself.

With such a system in place, the benefit to regulators would be immense, especially if complemented with counterparty and market information. A regulator could eas-ily run systemic stress tests and other types of analyses. Analytical power would be combined with high consistency and the regulatory burden on firms could fall drasti-cally, since regulators could perform the tests themselves.

Everyday realityWe would end up with the ideal situa-tion of better regulation for a fraction of the cost compared to today’s systems – in other words smarter regulation. Besides regulators, banks and insurance compa-nies would also benefit, whereas today they struggle with a multitude of transac-tion systems and a lack of a clearly defined contract types.

Admittedly, there are serious obstacles to achieving such change in practice. Disclosure


to regulators of transaction and counter-party data at the scale and detail proposed here would be met with fierce opposition by financial institutions.

There are also genuine privacy and con-fidentiality concerns that must be addressed. However, the financial crisis has turned many previously “unthinkable” events into everyday reality, and bringing about this change so that regulators have the power they need to regulate effectively could be another one of them.

Implementing change: the regulatorAt the level of regulators, we would have to see an internationally co-ordinated effort to establish a set of Regulatory Accounting Principles (RAP) incorporating the design principles discussed above. RAP would need to be put in place in parallel to Generally Accepted Accounting Principles (GAAP) because there is an inherent conflict between the GAAP objective of transparency that is indispensable to investors, and financial stability which is the purpose of macro-pru-dential regulation. Transparency cannot be compromised systematically without more damage to investor confidence in the quality of public financial statements.

RAP would also have to establish a standard-setting board to maintain a com-prehensive, standardised taxonomy of styl-ised contract types as described above. This board would not only define the attributes and their meaning, it would also define the algorithms to generate financial events and cash flows and finally the derived analysis elements – liquidity, value, income, sensitiv-ity and risk.

This is relatively straightforward and

could be modelled in the same way as the IASB, which also provides an XBRL tax-onomy of its IFRS reporting concepts. This would establish the information infrastruc-ture between the different levels of the global regulatory edifice.

OutlookImplementation of a regulatory framework along the lines of this proposal would probably have an impact on the finan-cial services industry that goes beyond its immediate regulatory effect. Thinking in terms of stylised contracts removes a layer of obscurity that is the purpose of many institutions’ product jungle and “innova-tion”. As was the case with risk-based pricing in Basel II, the genie of higher transparency cannot be kept in the bottle, thus increasing understanding of consum-ers as well as price competition.

Too important to failSo, is there an alternative to such a system?

We believe not. Given the speed with which banks return to business as usual it must be feared that the only lesson learnt in this crisis is that banks are too important to fail. Such an environment is the breeding ground for systemic crisis which cannot be controlled by the lender – and owner – of last resort. The regulators must become at least as smart as the regulated. •

Notes 1. See: Brammertz, et. al. “Unified Financial Analysis

– the missing links of finance”. Wiley 2009 for the full argument.

2. See: The positions of the CFA Institute Centre for Financial Market Integrity.


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.


White-collar criminology has demon-strated several theories and findings critical to regulating risk. Unfortunately, regulators, economists, prosecutors, and accountants rarely read or are aware of modern crimi-nological findings. This essay introduces the reader to four criminology theories essen-tial to regulating risk and avoiding crisis. “Control fraud” theory explains how the person that controls a seemingly legitimate entity uses it as a “weapon” to defraud.

Accounting ‘weapon’ In the finance sector, accounting is their weapon of choice. Individual control frauds can cause greater losses than all other forms of property crime combined. Control fraud theory explains why accounting control frauds are uniquely able to escape effective regulation, prosecution and private market discipline.

The recipe for a financial firm opti-mising accounting control fraud has four ingredients:• Grow extremely rapidly (e.g. like a Ponzi

scheme);• Make loans to the uncreditworthy

(because they provide superior nominal yields and allow far faster growth);

• Employ extreme leverage; and • Establish minimal loss reserves.

The result is mathematically guaranteed – not a “risk” – the firm will report exceptional short-term accounting profits as long as the financial bubble expands. The exceptional profits, particularly in the US context, lead to exceptional income for the person control-ling the financial firm (typically the CEO).

The firm’s record posted “profits” defeat potential regulatory restrictions.

Most regulatory restrictions kick in when banks suffer losses and fail their regulatory requirements. Highly profitable firms are normally the regulators’ lowest supervisory priority. The record profits also combine with modern executive compensation, particularly in the US, to create an opti-mal means of converting firm assets to the CEO’s benefit through seemingly normal corporate mechanisms.

Corrupt CEOs optimise this process by weighting their compensation heavily towards the short-term – which is optimal for accounting fraud. Fraudulent CEOs can often escape prosecution if they limit their looting to these “normal” corporate com-pensation mechanisms. It is vital to under-stand the failure of the firm does not mean the failure of the fraud scheme. The CEO running an accounting control fraud can become rich almost immediately.

Distinctive patternThere are exceptions to this rule, however, for the four ingredients create a distinctive pattern of business operations and busi-ness outcomes that an alert regulator can use to identify and counter accounting con-trol frauds. In order to make large numbers of bad loans, an accounting control fraud will suborn its internal and external con-trols so that they do not block loans to the uncreditworthy.

Accounting control frauds are adept at using compensation to induce supposed controls to “bless” grossly inflated asset val-ues and hide real losses. Normal on-site, “full scope” bank examination procedures will identify this characteristic pattern of mak-ing extraordinarily bad loans. Regulators that


understand accounting control fraud mech-anisms will correctly infer that the record profits are “too good to be true” and badges of fraud rather than success. Similarly, if the regulators intensively review every failure, the “autopsy” process will reveal the distinc-tive pattern of accounting control frauds. They can then “triage” and make closing the accounting control frauds reporting the greatest profits their top priority.

Credulous regulatorsRegulators can also use their understanding of accounting control fraud to use regulations that will limit the creation of new frauds and terminate existing frauds. Accounting con-trol frauds’ Achilles’ heel is growth. The US agency regulating savings & loans (S&Ls) successfully re-regulated the industry and doomed all the accounting control frauds by restricting growth.

The record profits are even more effective against private market discipline than they are against credulous regulators. Lenders and investors are eager to provide funds to highly profitable firms. Instead of providing “discipline”, lenders fund accounting con-trol frauds’ rapid growth. The combination of extreme growth, making bad loans, high leverage, and extraordinary executive com-pensation produces exceptionally expensive failures.

Financial bubblesDuring the S&L crisis, the Enron, WorldCom, et al crisis, and the current cri-sis, private lenders acted as “vectors” that spread, rather than contained, the fraud epidemic. The same dynamic was com-mon in many other nations. Epidemics of

accounting control fraud can produce, and hyper-inflate, financial bubbles. The sec-ond and third criminology theories explain why the business practices that optimise accounting control fraud can produce these bubbles and why these bubbles can be self-sustaining for many years. At any given time a small number of industries and assets are the best available setting for accounting control fraud.

Optimisation will lead to accounting fraud naturally clustering in these supe-rior settings. When an environment creates strong incentives to act criminally, we term it a “criminogenic environment.” Neither the creation of such an environment nor the ini-tial clustering requires any conspiracy.

‘Gresham dynamic’The initial clustering will produce “learn-ing effects”. Other CEOs will observe that the initial fraud’s business practices produce guaranteed, record profits. CFOs that fail to emulate these practices will fail to achieve exceptional bonuses and appreciation of their stock. More importantly, their CEOs will fail to come close to their maximum pos-sible compensation.

This produces a “Gresham’s dynamic” in which bad ethics tend to drive good eth-ics out of the marketplace. The same type of dynamic operates with regard to internal and external controls by appraisers, audi-tors, rating agencies and other professionals that are supposed to provide effective “pri-vate market discipline.” Cheaters prosper. The control frauds only need to corrupt a small percentage of the appraiser profes-sion in order to guarantee that they can inflate asset values.


The initial criminogenic environment will produce the clustering of accounting control frauds in the same industry following similar business practices. A lender cannot simply decide to grow rapidly in a mature field (such as home lending in the US) by making honest loans. A lender that wants to take market share from rivals honestly will typically have to cut its interest rate on loans and its rivals are likely to match that cut. The result is reduced profitability and only a very small increase in the quantity of home loans demanded.

Increased fees, chargesBy lending to the uncreditworthy, how-ever, accounting control frauds are able to grow extremely rapidly and increase the interest rate and fees that they charge. In the case of US housing lenders, the result was an immediate large and guaranteed surge in short-term “profits” and a shift in the demand curve for housing outward from the origin – which will cause home prices to surge as well. Because account-ing control frauds rise extremely rapidly to optimise their short-run “profits,” they will generally continue to lend to uncreditwor-thy borrowers even as the bubble extends for years and hyper-inflates. The Gresham’s dynamic and “learning effects” (and, more technically, the false market price signals that such lenders provide) combine to encourage other firms to mimic their busi-ness practices.

The same dynamic greatly aids the cover-up of the true losses because extending the life of the bubble and increasing its rate of inflation make it easy to obscure loss rec-ognition through the repeated refinancing

of troubled loans. The ability of epidemics of accounting control fraud to hide such losses can fool regulators that do not understand accounting control frauds. The same dynamic makes “private market discipline” an oxy-moron. Understanding these two crimino-logical concepts (one borrowed from health and the other from economics), allows effec-tive public intervention to prevent epidemics of accounting control fraud. When we fail to regulate or supervise financial firms effec-tively we create a criminogenic environment because we, de facto, decriminalise account-ing control fraud. Even groups like the FBI, which have agents that specialise in white-collar crime investigations, cannot effectively prosecute a control fraud epidemic.

Most nations have far less capability than the FBI to investigate elite white-collar crime. The regulators rarely have sufficient expertise and the staff, but compared to even the FBI they generally have greater staff and staff with vastly more industry expertise. Similarly, the way to reverse a Gresham’s dynamic is to take prompt action to ensure that cheaters do not prosper. Regulatory enforcement is often the quickest way to demonstrate this fact.

Trust betrayedAt law, the defining element of fraud that distinguishes it from other forms of theft is deceit. To commit a fraud, I get you to trust me – and then I betray that trust. As a result, fraud is the optimal means to destroy trust, particularly when it comes from our most elite business leaders and simultaneously suborns our top professionals and elected officials. Regulators did not shut down the markets during this crisis – bankers did.


Bankers shut down the markets because they no longer trusted other bankers. Long before fraud becomes endemic it can make markets fail. The first failure, of course, is that the regulatory agencies did not iden-tify and promptly resolve the accounting control frauds that produced the epidemic of mortgage fraud in the US. I noted, and a Fitch review of a small sample of non-prime loan files supports the statement, that the non-prime lending specialists followed a distinctive pattern of lending practices that is irrational for honest firms but optimises accounting control fraud.

Sectoral failuresFitch stressed that normal underwrit-ing would have disclosed that enor-mous numbers of non-prime loans were facially uncreditworthy. Normal bank examination should also have disclosed that pattern. Any review of a sample of the underlying files by the auditors, rat-ing agencies, or investment bankers that securitised these facially bad loans would have revealed the same evidence. So, both the private sector and the public sec-tor failed to prevent an easily preventable epidemic of mortgage and accounting fraud – which would also have caused the housing bubble to pop.

The initial regulatory failure was not the product of inept staff. The Clinton and Bush administrations sharply reduced regulatory staffing (the FDIC lost over three-quarters of its personnel and it often used “early outs” to induce the early retirement of their most expensive (and most experienced) staff.

The Clinton and Bush administra-tions’ hostility to regulation often led to

the appointment of regulatory leaders that despised regulation. Institutions that were not regulated by the federal government made 80 per cent of all non-prime loans. Federal Reserve Board Member Gramlich warned Alan Greenspan that there was a housing bubble and asked him to send Federal Reserve examiners in to find the facts about non-prime lending.

Chairman Greenspan refused both requests. The Federal Reserve, alone among the US banking agencies, had statutory authority to regulate the normally unregu-lated mortgage lenders, so Greenspan’s refusal was fatal. The federal regulators com-pounded the criminogenic environment by acting aggressively to “pre-empt” state attempts to crack down on predatory mort-gage lending.

The failure of the federal regulatory agencies to clean up non-prime lending, even at the banks and S&Ls it did regulate, even after the FBI warned of the “epidemic” of mortgage fraud, is inexcusable and a tes-tament to the terrible power of their anti-regulatory ideology to blind them.

The second regulatory failure was after the housing bubble and accounting fraud epidemic became inescapably evi-dent in 2006. As soon as housing prices stalled, the uninsured non-prime lending specialists began to collapse. By spring 2007 the entire secondary market in non-prime mortgage loans died and has not been resurrected.

Meaningful hearingsThe US Congress finally began to con-duct meaningful oversight hearings and we discovered that the rating agencies had


done no meaningful underwriting on the “toxic waste” collateralised debt obliga-tions (CDOs) backed by non-prime loans. The regulators now knew that the largest banks did not know how large their losses were – and were desperately seeking to avoid knowing (and disclosing) those facts. Instead of cracking down on the largest banks (those that followed lending practices that were rational only if they were engaged in accounting fraud) by demanding that they get the information necessary to value their assets, the government subsidised them and termed them “too big to fail.”

’Epidemic’ warningThe third regulatory failure can be inferred from the FinCEN data, and it is disturbing that FinCEN has never drawn the inference and put pressure on the federal regulatory agencies to cure the failure. There are roughly 10,000 federally regulated banks and S&Ls that make mortgage loans. Mortgage fraud became more common after the FBI’s 2004 warning that it was “epidemic.” Regulations mandate that federally regulated banks and S&Ls file Suspicious Activity Reports when they find evidence of mortgage fraud.

In the last full fiscal year for which FinCEN has released data, there were more than 62,000 SARs filings. The FBI reports that 80 per cent of all losses from fraud occur in cases in which lender personnel are involved in the fraud. Recall that non-federally regulated mortgage lenders made roughly 80 per cent of the non-prime loans and that such lenders (1) are not subject to federal rules requiring them to file SARs and (2) virtually never file SARs voluntar-ily. Because mortgage fraud is far more

common in non-prime loans than prime loans, the first stage approximation in trying to estimate the total amount of mortgage fraud in a single year is to multiply 62,000 by five.

Extrapolating from the SARs filed by fed-erally regulated lenders to the entire lending population would greatly understate the true incidence of mortgage fraud for two principal reasons (1) the FBI estimates that lenders only discover about one-third of all mortgage frauds and (2) FinCEN’s data indi-cates that even regulated mortgage lenders typically do not file SARs when they spot mortgage fraud.

FinCEN released data recently on SARs filed for mortgage fraud in the first six months of this year. Those data indicated that non-compliance with the rules requir-ing the filing of SARs is the norm among federally regulated lenders. FinCEN’s data shows that mortgage fraud SARs expanded in the first-half of 2009 – 3½ years after the non-prime market began to collapse and 2½ years after the secondary market collapsed.

That indicates that the mortgage fraud epidemic continued to grow worse even as the non-prime market collapsed. The FBI clears roughly 1,000 cases of mortgage fraud annually, so one can see that the statute of limitations will foreclose prosecution of the great bulk of mortgage fraudsters unless something dramatic is changed.

Rise in filingsThis essay, however, focuses on the regu-lators rather than the prosecutors. The October 2009 FinCEN report on mortgage fraud SARs provides these facts essential to


evaluating whether the regulators have been effective:

In the first half of 2009, approximately 735 financial institutions submitted SARs, or about 50 more filers compared to the same period in 2008. The top 50 filers sub-mitted 93 per cent of all MLF SARs, con-sistent with the same 2008 filing period. However, SARs submitted by the top 10 fil-ers increased from 64 per cent to 72 per cent. While FinCEN (and the banking regulators) do not appear to have made any regulatory inferences from this data. We can. • The great majority of federally regulated

mortgage lenders do not file SARs when they find evidence of mortgage fraud. Honest lenders should want to make criminal referrals. Control frauds are gen-erally reluctant to file criminal referrals because they do not want to encourage the FBI to send agents to their banks.

• A literal two handfuls of banks and S&Ls make the overwhelming majority of all criminal referrals. That means that the great majority of banks and S&Ls mak-ing criminal referrals for mortgage fraud do so rarely, even though mortgage fraud is epidemic.

• FinCEN does not report any crackdown by the regulators enforcing the rules requiring the filing of SARs despite mas-sive industry non-compliance with the rules. FinCEN does not even urge or demand that the agencies enforce the law.

• FinCEN does not provide any informa-tion suggesting that the federal regulatory agencies are using the SARs data to pri-oritise their examinations, enforcement actions, and closures. The most obvious

strategy is that the federal banking and S&L regulators should prioritise for immediate examination any lender that made significant amounts of non-prime loans but is not one of the 10 lenders that actually makes a meaningful number of SARs filings.

In conclusionTo summarise, the FinCEN data confirm the existence of a massive epidemic of account-ing control fraud that hyper-inflated the housing bubble and triggered a global eco-nomic catastrophe. It supports the conclu-sion that de-supervision and the perverse incentives produced by modern executive compensation created an intensely crimino-genic environment.

Accounting control fraud is well designed to defeat regulators and private market discipline that fail to understand the fraud mechanism. “Risk,” as we think of it conventionally in finance, was not the rel-evant concept. Accounting control fraud is a sure thing as long as the financial bubble is expanding.

The FinCEN data also confirms that the regulatory and private market discipline fail-ures are continuing and are impairing our ability to prosecute the elite frauds. •

(Editor’s note: Professor William K. Black is due to visit Hong Kong in May, 2010 as master of ceremonies for an Audit & Accounting evening ‘dialogue’ that the Institute is organising in con-junction with the International Auditing and Assurance Standards Board. Further details can be found on our website at: http://www. irrna.org)


Debate

An insider’s perspective on regulatory capture in the US

James Coffman, a former regulatory enforcement officer at the SEC, takes issue

with online blogger, ‘Bond Girl’.

in august this year, an industry insider who specialises in municipal bonds and uses the blogsite psuedonym ‘Bond girl’ launched a fusillade against regulatory capture by us industry insiders over the past decade on the popular regulatory reform website: Baseline scenario. taking unbrage at this assault on the regulatory profession, James Coffman, who spent 27 years with the securities exchange Commission (seC), decided to set the record straight. a full transcript of the online bloggers’ debate appears below.

Bond girl . . . In June, the Obama administration released a report outlining various financial regulatory reforms. The proposed reforms are intended to meet five objectives, essentially: (1) to eliminate regu-lators’ tunnel vision; (2) to regulate certain financial products and market participants that have so far evaded supervision; (3) to protect consumers from unfair and decep-tive sales practices; (4) to provide a frame-work for responding to financial crises and the failure of major financial institutions; and (5) to promote these efforts globally.

Much of the subsequent policy debate has been focused on whether or not the reforms detailed in the report address these objectives. This is a political triumph for the administration because it distracts from the report’s one glaring omission – how to address a culture of sustained affinity between the supervisors and those who are supervised.

The administration’s proposal appears to portray the financial crisis as nothing more than an accident of reasoning. Because financial regulation in our country evolved in a fragmented manner, regulators’ percep-tions of risk were determined by their respec-tive niches when a holistic understanding of risk was required to predict a market failure of this magnitude.

Extended powersIt logically follows then that the administra-tion’s preference would be to create a meta-regulator (in this case, by extending the powers of the Federal Reserve and estab-lishing an advisory council) to oversee the supervisory project as a whole and seek out system-wide threats. While I am sure no one


would dispute that a holistic understanding of risk is required to assess financial stabil-ity, an even more basic condition of effective regulation is that regulators are motivated to provide honest information about the institutions they supervise. I am not inclined toward conspiracy theories and I obviously do not buy into the caricature of industry players sold by the mainstream media.

That said, it is clear that there is a large degree of regulatory capture going on in the financial sector, either directly through pro-fessional incest or indirectly through shared intellectual sympathies, which some players have been able to exploit to such an extent that it has reduced standards for the entire industry. It is also clear that this is hardly a novel development.

Financial institutions did not amass tril-lions of dollars of toxic assets and tangle themselves up in a destructive web of credit derivatives by accident. Financial institutions did not produce and maintain technology allowing them to take advantage of tradi-tional investors by accident. A thief was not able to operate a multi-billion-dollar Ponzi scheme for decades by accident.

Considerable complacencyWe are not talking about the occasional rogue trader here who has bribed his com-pliance officer. Even within the existing reg-ulatory architecture, these activities required a considerable amount of complacency (to be polite) by financial regulators across agencies, over the course of many years, and through many cycles of political appointees from both parties.

I would argue that the fundamental flaw in financial regulation is that it is based on

the assumption that regulators are not self-interested individuals like the rest of us. We think about regulation only in terms of how to engineer the incentives of the regulated and ignore the fact that regulators them-selves rarely have a stake in doing their job well, which in any other occupation would limit the motivation and types of individu-als a position attracts. We all know how the performance of a consistently good trader is rewarded. How is the behaviour of a consist-ently good regulator rewarded?

‘Deep capture’On the other hand, it is not too difficult to see what incentives regulators have used o establish a collaborative posture with the industry (again, to be polite), especially within the organisation in which the admin-istration wants to concentrate regulatory responsibilities. The presidents of the Federal Reserve Bank of New York generally come from or end up at investment banks. So many Goldman Sachs employees have held positions in the Treasury and Fed banks in their careers it is a cliché.

Even beyond this, there is probably some value transferred just through the association or intellectual sympathy with industry-types (what Jon Hanson would refer to as “deep capture”) that results in regulators having a bias they do not recognise.

If one revisits what Fed officials were say-ing about financial innovation leading up to the crisis, it is not difficult to see that (1) they thought they were thinking holistically about the risks financial innovation posed, and (2) they were not being intellectually honest in the information they presented about the industry. Even the more prescient regulators


figured innovation was a good thing at the time. As a rule, supervisors were disposed to explain away risk by market discipline because they believed themselves to belong to a club of people with special, sophisti-cated knowledge of the markets, and this is something they value. From the perspective of some in the financial industry, it is some-thing that can be traded.

Sheila Bair’s argument in the regulatory turf war spectacle that is underway would be that these examples illustrate the risk of con-centrating supervisory responsibilities in one entity. But it is not a matter of luck whether we get a regulator that is more or less sway-able by the industry. By virtue of regulators’ incentives, the financial industry is basically self-regulated.

It is unlikely that consumers will ever hold much influence over the realities of the financial regulatory process because they are not organised in comparison to the financial industry, which concentrates significant resources in the creation of inef-ficient regulators. By and large, consumers are not well-informed about what they have at stake in the regulatory process and, even if they were, that would not be the sole determinant of how they define themselves politically.

Social entrepreneursAdding further layers of guards to guard the existing guards ultimately results in infinite regress. I do not think it is cynical to sug-gest that – absent of an actual paradigm shift with respect to accountability in the financial industry – we are just going to have more of the rent-seeking that has gone on to date and the economic calamities that ensue.

For my part, I would propose opening up financial regulation to a small group of social entrepreneurs. Let people establish for-profit companies that can compete for government contracts to stress test the hold-ings of financial institutions independently and audit their records.

Public scrutinyThese contracts can be funded by fees charged to the industry that pass through the federal budget and are subject to pub-lic scrutiny. Although the fee income that supports these entrepreneurs would derive from industry operations, the social entre-preneurs will not have the power to establish the fees themselves, which should reduce the “shopping” behaviour that already exists in financial regulation and with the rating agencies.

Some degree of slack will develop as with any form of delegation, but that may be reduced to some extent by adding per-formance-based metrics to the terms of con-tracts or by giving the companies a portion of recoveries when they identify instances of fraudulent behaviour (similar to what the Internal Revenue Service does with its whis-tle-blower programme).

Even if social entrepreneurs pull their employees from the same pool of talent as the financial institutions they inspect, the opportunity to profit should make them less sympathetic to industry interests and encourage them to invest in furthering their expertise. I would hope this is some-thing most people in the financial industry would support. It would be an opportunity to show the industry still cares about actual capitalism.


James Kwack, of www.baselinesce-nario.com received the following mail mis-sive from James Coffman in response to Bond Girl’s recent guest post: “Filling the Financial Regulatory Void.” Coffman agreed to let Baseline Scenario and the JRNNA publish a full transcript of this email.

Human failings overplayedCoffman: Bond Girl’s “Filling the Financial Regulatory Void” provided insight into human deficiencies in the current finan-cial regulatory system. But it overplays the human failings of regulators and concludes with a proposed solution that, in all likeli-hood, would turn out worse than the current situation.

But first, in the interest of full disclosure, I should tell you that I retired two years ago from a management position in the enforce-ment division at the SEC after 27 years. So I was (and in my heart, I suppose I still am) a financial regulator. That background prob-ably should be taken into account by anyone who reads this response.

There is no doubt that “regulatory cap-ture” exists and is a meaningful factor in the recent failures of our regulatory system. Many of us in the enforcement division dealt with the problem regularly when we sought input from those in the agency who were responsible for regulating aspects of the securities markets.

Over time, regulatory policies and prac-tices had emerged that seemed to contradict the purpose, if not the letter of the law. In other cases, over-arching issues (e.g. increases in fees charged by investment companies despite growth that should have resulted in economies of scale and decreasing fees)

simply were not addressed in any meaning-ful way.

But the majority of regulators I worked with were critics of the problem of “capture,” not victims. Much of the problem arose from decades of deregulation dating back to the beginning of the Reagan administration.

Elected de-regulators appointed their own kind to head regulatory agencies and they, in turn, removed career regulators from management positions and replaced them with appointees who had worked in or rep-resented the regulated industries.

These new managers and, in many cases, the people they recruited and promoted, advanced or adhered to a regulatory scheme that, at least with respect to the most impor-tant issues, advanced the interests of the regulated.

Bond Girl is right, the industry “captured” the regulators and the regulatory system. But not in the passive sense that true regulators over time came to identify too closely with the interests of the regulated.

This is not a case of financial regulators falling victim to the Stockholm syndrome. The vast majority of capture resulted from intentional efforts by the finance industry to advance their narrow interests at all costs and defeat meaningful regulation.

Top-down buyoutUnfortunately, we live in a country that can be bought from the top down and the finance industry exploited the situation very success-fully. But do not blame the regulators. Career regulators are as much the victims of these events as the public’s economic welfare.

The creation of paid social entrepreneurs to perform regulatory functions will not


enhance regulation nor reduce “capture”. I’ve sued too many CPAs over the years for bad audits to believe the answer lies in cre-ating a new class of auditors. Audit clients often “capture” their auditors. The result is bad audits resulting in uncorrected and undisclosed financial fraud.

The victims are always the sharehold-ers and the market. Besides, using money to “incentivise” a new, private class of regulators plays directly into the hands of the finance industry. No matter what the regulatory fee structure may be, government will never be in a position to compete with the financial industry when it comes to “incentivising” regulators-for-hire.

Look elsewhereWe need to look elsewhere for solutions to the problems that hamper our financial reg-ulatory system.

First, we need to look at the structure of the finance industry. Commercial banks got into trouble in large part because they ware-housed (often off the books) toxic securities underwritten by their investment banking counterparts within the holding company structure.

Similar abuses in the past resulted in separating investment banking from com-mercial banking. We should try it again. Insurance should be split off as well.

Second, no institution should be allowed to become too big to fail. Those that have already achieved that status should be bro-ken up.

Third, we must put in place an effective financial consumer protection agency which can counteract the worst consumer practices of a too powerful industry.

Fourth, investment banks should be made to eat what they kill. Public owner-ship of investment banks coincided with the industry’s decline into extremely reckless risk-taking. Investment bankers should be required to own a significant percentage of the equity in the institutions in which they work (something approaching 50 per cent, to pick a number). Having a significant portion of their net worth tied up in such stock would provide an incentive to carefully identify and measure risk. It should also reduce outsized compensation for investment bankers.

Fifth, there should be greater limits placed on the ability of political appointees to oust career regulators. Make capture more difficult.

Sixth, more financial products and firms should be subject to government registration and reporting.

Seventh, regulators should not be forced to wear conflicting hats. One cannot pro-mote an industry while protecting the public from it. Don’t ask regulators to be industry cheerleaders.

Limits can be placed on regulators to ensure that they not act without consid-eration of the impact of their actions. But over-regulation is not what got us in this position. Cheerleaders purporting to be regulators did.

Bonus planFinally, the government should adopt a bonus plan for regulators, run by regula-tors (who would rotate off after short, fixed terms, to prevent back-scratching among board members) to provide incentives for regulators to excel at the job of regulation. Recognised, protected and incentivised reg-ulators will resist capture. •


Accounting update

New international models for loan loss provisioning

BaFin’s Markus Grund outlines important revisions arising from the G20, IASB and

FASB draft overhaul of IAS 39.

this autumn may bring answers to important current accounting questions. By then, the international accounting standards Board (iasB) and the financial accounting standards Board (fasB) should have formulated new models for loan loss provisioning.

The final report of a relevant G20 working group recommends that a broader range of information should be taken into account in future loan valuation. Further, the IASB says it is also planning to present a draft for the complete overhaul of IAS 39 this autumn.

This is to include principles regarding the recognition and measurement of finan-cial assets and liabilities also, particularly, of derivatives. The time frame is ambitious, with a likely driving factor the extensive analyses on the subject of loan loss pro-visioning submitted by the Procyclicality working group of the Financial Stability Forum (FSF).

Ongoing discussionsThe subject in itself is nothing new and has been discussed for years. The focus is on two

basic approaches which differ in the point in time at which risks are recognised in the bal-ance sheet. The Incurred Loss Model (ILM) only recognises losses already incurred as part of risk provisioning. The Expected Loss Model (ELM), also known as “through-the- cycle provisioning” or “dynamic provision-ing”, also takes into account expected future losses.

Asset impairmentsThe first method, the ILM, has to date dominated in US-GAAP and International Financial Reporting Standards (IFRS) accounting, as set out for example in IAS 39 and SFAS 114. The ILM requires objective evidence of impairment of a financial asset (IAS 39.59 et seq.). The main area of applica-tion for loan loss provisioning is the “Loans and Receivables” category.

Although the standards for loan loss provisioning in IFRS and US-GAAP are formulated differently, there are actually few material differences. In practice, the primary differences lie in the fact that although both standards provide scope for discretion, they are used in different ways.


This is not to state categorically that US-GAAP reserves are higher than IFRS reserves − or vice versa. The general rule is that the level of loan loss provisioning var-ies according to country and the responsible supervisor.

Procyclical effects of ILM and ELMDuring an upturn, the incurred loss model means that companies establish lower reserves than would be the case with the expected loss model, since few defaults occur. However, in a downturn, there are more defaults, so losses increase very quickly.

Cause and effectThe conclusion: an ILM clearly has procy-clical effects. On the other hand, an ELM leads to higher reserves established during an upturn and lower profits reported than with an ILM. In a downturn, reserves estab-lished previously under the ELM compen-sate the losses, as the defaults were already taken into account shortly after the loans were granted. This is at least the idea behind the models.

Of course, more precise definitions of the terms are necessary before such a model can be put into practice. To date it does not seem to exist a consensus between the standards setters of what exactly an ELM or “dynamic provisioning” means. However, if the models are structured appropriately, there should be a reduction in the procyclicality of loan loss provisioning which is still evident today.

Future rulesThe quality of the parameters forming the basis of such a model is key here. They include the homogeneity of loan portfolios

and the time series used to determine the expected default rates. The G20 working group recommends that the standard setters focus on these details in particular in their analyses and discussions. The objective of the future rules regarding provisioning must be to contribute to the stability of the finan-cial markets and to safeguard the interests of the investors in timely and transparent information.

This is a difficult balancing act, as the SEC has been criticising over time, cases of crea-tive accounting through excessive establish-ment of reserves in the US. The amount of profit can actually be influenced by the level of reserves established. Under the existing accounting standards, it is not always pos-sible to determine exactly when an objective impairment criterion is met.

A popular example discussed in both the-ory and practice is the question of whether a customer loan has to be impaired when the borrower becomes unemployed or when he falls behind with his payments. It is up to the respective credit institution to decide, as there is scope for both interpretations in a principle-based standard. The provisioning can therefore be completely different for one and the same case. In terms of whole loan portfolios, this seemingly harmless question may result in formidable effects.

Reserves ‘cushion’Consideration must also be given to the fact that it is not particularly important whether the reserve is too high or too low – that is often in the eye of the beholder. For example, the bank supervisor would not see a major problem with establishing large reserves, because in times of crisis they could serve as


a cushion. The real question is – what is an appropriate level for reserves? The search for the answer reveals that an ELM takes into account the total maturity of the loan port-folio and does not focus on an individual period, as accounting does.

Interesting propositionAnalysts prefer just this kind of perspective because they are particularly interested in the overall quality of the portfolio and the losses to be expected over the whole cycle. When losses occur and how they are distributed across the different periods are of secondary importance in this method.

The UK Financial Services Authority (FSA) recently made an interesting concili-atory proposition concerning the ILM and the ELM – the Economic Cycle Reserve (ECR). This proposition sees the established ILM remain in place for the determination of profits, but also addresses the notion of provisioning for hard times. This is done by means of a distribution constraint, which ensures that a portion of equity is reserved as a buffer for the risks expected from loans granted.

Distribution constraintThe level of the distribution constraint could be determined by the compa-ny’s management in consultation with the supervisory authorities. It would be explained in a footnote in the annual financial statements. However, it is also conceivable that the level of the distribu-tion constraint be determined on the basis of a fixed percentage.

This would have the practical advan-tage that difficult discussions between the

company and the supervisory authorities about the appropriateness of the limit would be avoided.

The advantage of the ECR model is that accounting would continue to be based on the ILM, but that the expected losses from the loan portfolio would be clearly recog-nised within equity. The disadvantage would be that there would be no incentive to estab-lish reserves, since the tax burden would be unaffected by the amount of reserves estab-lished. Many questions about the details remain unanswered.

BaFin’s responseAs the discussions currently stand, Germany’s Federal Financial Supervisory Authority (BaFin) is in favour of a model which clearly differentiates between the actual losses incurred and those still expected but which addresses both components in the balance sheet. However, the time frame for transition to such a model remains a crucial point.

Demanding that banks establish addi-tional reserves in the current climate would worsen the crisis. In its position as super-visor, BaFin sees that the transition will not be possible until the market situation returns to normal. Until then, there is time to work on the right solution for investors and supervisors, even if there are conflict-ing interests. •

(Editor’s note: We would like to thank BaFin and the German authority’s in-house editorial team for kindly granting us permission to reproduce an edited version of this article, which first appeared in their Q3/09 journal, BaFin Quarterly, published in October this year.)

H O W WA S H I N GT O N FA I L E D A M E R I C A

W I L L I A M M . I SA AC with P H I L I P C . M E Y E R

SENSELESS PANIC

F O R E W O R D B Y P A U L V O L C K E R


Regulatory update

The future of structured products in Hong Kong

Mallesons Stephen Jacques partner Richard Mazzochi discusses proposed reforms relat-

ing to structured products in the territory.

hong kong’s securities and futures Commission (sfC) recently issued a consultation paper (Paper) that will dra-matically affect the structuring, distribu-tion and post-sale treatment of unlisted structured products in hong kong. the Paper, which also applies to unit trusts, mutual funds and investment-linked assurance schemes, blesses the use of funds that invest substantially in finan-cial derivatives. however, its cousin, the structured product, is to be subject to extensive new rules.

The SFC is not acting in isolation. The Paper needs to be considered against the recent controversy concerning Lehman Brothers and an international trend to tighten the regulation of structured products (par-ticularly if sold to retail investors). There are, however, Hong Kong-specific factors which influence the SFC’s attitude. They arise out of defaults under a retail structured product known as Lehman Brothers Mini-bonds.

These were linked to the credit of sev-eral well-known entities and collateralised by highly rated credit-linked instruments.

Lehman Brothers effectively funded amounts due under a swap with the issuer of the Mini-bonds.

In apparent response to these issues, the Paper proposes that:• special purpose vehicles (SPVs) make

extensive disclosure about any under-lying collateral or swap. Swaps must be at a “fair market value and on the best available terms”. Collateral is subject to extensive eligibility criteria, includ-ing the need to be readily marketable, rated and diversified. The Mini-bond would not satisfy these requirements because the collateral, whilst highly rated, was not liquid or tradeable.

Directors’ relationshipsThese changes arise out of the inability to quickly liquidate the security support-ing Mini-bonds. SPVs will be required to be “independent” of other transaction parties. An accusation made during the Mini-bond crisis was that the issuer was not independent of the trustee because its directors were employed by an entity related to the trustee; and,


• trustees “use . . . best efforts” to enforce rights in relation to the collateral. The trust deed must not contain any term that may “undermine” any applicable provision of the SFC’s new rules. It is unclear what this means but it may deny trustees commonly accepted protections including the power to insist on proper instructions and indemnification before they take action.

Mini-bonds were sold to more than 40,000 retail investors in Hong Kong. The trustee was unable to seek instructions in respect of a product as complex as Mini-bonds from such a diverse group of investors. The SFC’s proposal is to require trustees to take action despite these difficulties.

Trustees’ rightsThe SFC’s approach differs from recent

English authority (such as Elektrim SA vs Vivendi Holding 1 Corp [2008] EWCA Civ 1178) which supports a trustee’s right to insist on receiving instructions and suit-able indemnification from investors before taking action.

The UK’s Financial Services Authority (FSA) has worked with the Committee of European Securities Regulators (CESR) on a range of issues arising out of the insolvency of Lehman Brothers. Key issues include:• whether complex products can be sold

without advice on an “execution-only” basis;

• the equivalent regulation of products with an equivalent risk profile (regardless of whether the product is a bond, fund or other structure); and

• whether structured deposits should

be regulated like other investment products.The Paper contains proposals relating to

similar issues and other international devel-opments, described as follows:

Product suitability – an expanded role for issuers?

The first significant development is the proposal that product manufacturers deter-mine whether a structured product is suitable for its target investors. The Paper proposes that an issuer confirm to the SFC that a product is “designed fairly and is appropriate for the market(s) for which it is intended”. Issuers would therefore be required to take responsibility for product suitability. This issue is also being tested under the common law.

The traditional view is that product man-ufacturers are not responsible for determin-ing the suitability of a product. Responsibility rests with distributors because they have the relationship, and direct contact, with inves-tors. That view accords with the decision in the English case, Seymour & Another v Caroline Ockwell & Co & Another [2005] EWHC 1137 in which a product provider was held not to owe a duty of care to a cus-tomer in the absence of direct contact with the customer.

UK court caseThis approach is now being examined by an English court in Financial Services Compensation Scheme Limited vs Abbey National Treasury Services plc [2008] EWHC 1897 (Ch). A key claim in the case is that the product provider collaborated in the development and promotion of a structured capital-at-risk product with an entity which


marketed the product through independent financial advisers.

The product provider created the prod-uct but did not deal directly with investors. In response, the product provider denies any liability for negligence or misrepresentation on the basis that it did not provide invest-ment advice nor did it issue the product pro-motional material.

The outcome of the case will further clarify whether there exist circumstances in which product manufacturers will be held liable for the mis-sale of products they cre-ate, in respective of whether such liability exists on a regulatory level.

Different approachMeanwhile, the FSA and European regula-tors have already determined to pursue a dif-ferent approach:• the FSA has issued regulatory guidance

detailing the responsibilities of prod-uct providers and distributors, which includes a requirement that product design be “fair”;

• CESR has issued a consultation paper which adopts a similar concept, requiring product providers to be satisfied that a product is fit for distribution before mak-ing it available to retail investors; and

• a Standing Committee of the International Organisation of Securities Commissions (IOSCO) will examine suitability standards for retail and whole-sale investors and might go so far as to restrict the offer of particular types of products to particular types of investors.The SFC’s approach is a change in direc-

tion for Hong Kong, but one which is con-sistent with developments in Europe and

which could also ultimately be reflected under the common law.

Product pricing and structuring transparency.

The Paper proposes that issuers give extensive information to investors and the SFC including:• firm (fair and reasonable) product

price quotations, at least weekly, unless the tenor of the product is one calen-dar month or less. Break funding and unwinding costs may be taken into account;

• indicative (fair and reasonable) product valuations daily with material fluctua-tions explained; and

• more extensive financial reporting in English and Chinese.The Technical Committee of IOSCO

has recently recommended (in its paper entitled “Transparency of Structured Finance Products”) enhanced post-trade transparency.

Post-trade transparencyDespite objections by industry partici-

pants, including that a post-trade transpar-ency regime is expensive and inappropriate because structured products are illiquid and “non-standard” (meaning customised so that it is difficult to make comparisons between products), the Technical Committee recom-mends that IOSCO’s members (including Hong Kong) develop a post-trade transpar-ency regime that should take into account several factors including:• the size of the issue; • whether the product was publicly

offered;


• whether there is a broad investor base;• the degree of standardisation; and• the cost involved.

Market participants in Hong Kong are concerned about a number of key issues that emanate from these proposals. In particular, whether:• secondary pricing must be made publicly

available;• such pricing need only be provided

upon request by the distributor acting on behalf of its clients rather than “posted” and made available to all investors; and

• there are circumstances in which pricing can be suspended – for example, extreme stock market volatility.

Product and client classification – reas-sessing the “retail investor”.The SFC proposes that “unlisted derivative products” should only be sold to retail inves-tors that possess “derivative knowledge”. Unlisted derivative products may not be sold to retail investors on an “execution only” basis (that is, without advice).

Knowledge will be taken to exist if the cli-ent undergoes training or attends courses on derivative products. A similar knowledge test will be applied when distributors conduct “know your client” procedures in respect of individuals that qualify as professional inves-tors under the SFC’s Code of Conduct.

Rigorous testThe objective in Europe is similar but the steps taken are different. The European Markets in Financial Instruments Directive (MiFID) requires a rigorous suitability test to be applied to advised sales.

Execution only sales need not be suitable

but must be “appropriate” or relate either to listed shares or to products that are “non-complex” (that is, a product the structure of which is so simple that clients can be expected to understand the product and its associated risks).

Complex instruments can only be sold to retail clients on an advised basis. The appropriateness test is narrower than the suitability test in that distributors need only assess whether the client has the knowledge and experience necessary to understand the risk in relation to the product. Suitability, on the other hand, also requires an examination of an investor’s financial circumstances and investment objectives.

A key difference between the approach taken in Europe and that proposed by the SFC is the SFC’s move away from a subjec-tive assessment of investor knowledge and experience to an objective requirement that the investors undergo training.

Key differenceIt remains to be seen whether that training will be conducted by distributors in respect of particular products or by other organisations with a view to investors obtaining accredita-tion to invest in derivative products.

It is also unclear whether the SFC will have regard to IOSCO’s future review of the treatment of sophisticated clients. There is a growing preference to treat individuals that would otherwise be exempt because of the size of their investment as retail, rather than as wholesale, investors.

The SFC’s proposal that retail and pro-fessional investors undergo training appears to make it more difficult to draw distinctions between classes of investors.


the scope of offering regulation and disclosure

The Paper applies to all “unlisted struc-tured products” which term is not yet defined but will include equity-linked deposits and all forms of asset-linked products. Issuers of equity-linked deposits will need to sub-stantially amend their offering documents to comply with the more extensive disclosure standards that apply to other retail struc-tured products.

There is no proposal to change the regu-lation of currency and interest rate-linked deposits.

Key fact statementThe SFC proposes that structured prod-uct offering documents include a key fact statement (KFS). The KFS is a user-friendly statement intended to not exceed four pages in length. A template is attached to the Paper together with an extensive description of the items that must be dis-closed in an offering document.

Correspondingly, the European Com-mission issued a paper in April 2009 which sets out its policy on the regulation of retail products (including deposits). The proposal is to apply the MiFID selling process to all products, as well as require UCITS’ summary disclosure (UCITS are a set of European Union directives that enable collective investment schemes to be sold throughout the EU.).

Unified treatmentSimilar to the SFC’s approach, the intention is to unify the regulatory treatment of differ-ent products with similar economic features. CESR proposes that a Key Information

Document (KID) is issued. The technology will be similar to that being developed by CESR for UCITS.

However, it is unclear whether the requirement to issue a KID will be limited to retail sales.

Structured fundsThe funds industry will welcome the SFC’s proposal to recognise the investment by non-UCITS schemes in financial derivative instruments. The aim is to provide a level playing field with UCITS III schemes (which already enjoy an expanded power to invest in various types of unlisted financial deriva-tive instruments).

Unlike structured products, the Paper does not propose any radical change to the way funds are structured and distrib-uted or pricing is offered in the secondary market. It is unclear however, whether unlisted structured funds will be treated as “unlisted derivative products” and there-fore require investor training if sold to retail investors.

ConclusionThe initial market response to the Paper is mixed – market participants are weighing up their responses, which are due before the end of December 2009. Many of the key proposals are influenced by interna-tional trends and proposed reforms in other jurisdictions.

It would be difficult for the SFC to refuse to adopt similar reforms (particularly when the failure of Mini-bonds has had such a dramatic effect in Hong Kong). The trend is clearly closer international co-operation and consistency. •

Issues in resolving systemically important financial institutions 59Dr Eric S. Rosengren

Resecuritisation in banking: major challenges ahead 67Dr Fang Du

A framework for funding liquidity in times of financial crisis 75Dr Ulrich Bindseil

Housing, monetary and fiscal policies: from bad to worst 87Stephan Schoess

Derivatives: from disaster to re-regulation 95Professor Lynn A. Stout

Black swans, market crises and risk: the human perspective 101Joseph Rizzi

Measuring & managing risk for innovative financial instruments 109Dr Stuart M. Turnbull

Red star spangled banner: root causes of the financial crisis 119Andreas Kern and Christian Fahrholz

The ‘family’ risk: a cause for concern among Asian investors 125David Smith

Global financial change impacts compliance and risk 131David Dekker

The scramble is on to tackle bribery and corruption 135Penelope Tham and Gerald Li

Who exactly is subject to the Foreign Corrupt Practices Act? 143Tham Yuet-Ming

Financial markets remuneration reform: one step forward 151Umesh Kumar and Kevin Marr

Of ‘Black Swans’, stress tests & optimised risk management 159David Samuels

Challenging the value of enterprise risk management 165Tim Pagett and Ranjit Jaswal

Rocky road ahead for global accountancy convergence 171Dr Philip Goeth

The Asia-Pacific regulatory Rubik’s Cube 177Alan Ewins and Angus Ross

JOURNAL OF REGULATION & RISK NORTH ASIA

Articles & Papers








Systemic regulation

Issues in resolving systemically important financial institutions

Dr Eric S. Rosengren, President & CEO of the Boston Federal Reserve, calls for greater

co-operation on global systemic risk.

the events of the past two years have brought matters of regulation and risk to the top of the list of concerns for national and international policymakers. [1] in the past year, crises and resulting failures of a number of large internationally active financial firms have rippled across and weakened the global economy. events demonstrated the glaring absence of resolution powers in the united states – except in the case of banks – and demonstrated the limited ability of us authorities to intervene in troubled non-depository financial institutions, at least before the passage of the tarP legisla-tion in the final quarter of 2008.

This state of affairs left the United States lacking the tools to smoothly address the fail-ures of “systemically important” institutions – those whose disorderly failure could poten-tially lead to a drop in confidence in the global banking system, seize-ups in credit markets, the collapse of other financial institutions, and worsening economic conditions. [2] Many others, including Chairman Bernanke, have noted the urgent need to address the lack of

resolution authority. [3] Of course, difficul-ties in dealing with financial troubles in sev-eral European countries have shown that the United States is not alone. So clearly, the role played by financial institutions in the current crisis has laid bare the need to rethink how systemically important financial institutions should be regulated and, if they fail, how they should be resolved.

As you know, policy-makers in the US and many other countries are right now working through the intricate and challeng-ing issues associated with creating a more effective regulatory structure, making forums like this both timely and important.

Preventing contagionIn a recent talk, [4] I expressed my view that we need to have organisations with explicit responsibility for financial stability (that is, charged with making sure that “contagious” failures of financial institutions do not occur, and alert to trends emerging across a swath of interconnected institutions and their counterparties. [5] I argued in that talk that a regulator explicitly charged with address-ing financial stability probably could have


spotted some of the financial trends leading up to the crisis. In my remarks today, I would like to make some observations related to questions about the powers a systemic regu-lator would have needed in order to miti-gate some of the problems we have seen. As you consider the perspectives I share this evening, I encourage you to keep at the back of your mind the scale of these regulatory challenges.

Systemic regulatorIn the end we need to be able to address these complex questions and adequately empower those in the systemic-regulatory and resolution roles. If we cannot, we will do well to find other ways to limit systemic risks. In particular, I will focus on the need for a systemic regulator to be able to address firms’ global operations, and the increased use of financial derivatives.

These are key issues because financial institutions are likely to have a larger global presence over time, and to be more active in financial derivatives. Both trends represent the normal outgrowth of globally integrated economies and financial markets and are not necessarily unwelcome or unhealthy. But the critical point is that the roles and powers of supervisors and regulators have not kept up with these developments.

Allow me to make one important dis-tinction at the outset. My remarks in this paper touch on both systemic regulation and on the resolution of systemically impor-tant institutions. Clearly these roles could be carried out by either one entity or by two separate entities – a systemic regulator and a resolver of systemically important institu-tions. My remarks touch on both functions,

while for simplicity I tend to refer in my own shorthand to a “systemic regulator” – but the distinction is important.

The financial crisis has highlighted the pressing need for better resolution proce-dures. For banking organisations, the FDIC has the ability to place banks under receiver-ship without going through bankruptcy pro-ceedings. However, these resolution powers apply only to banks, not other non-bank financial firms, and do not apply to bank holding companies. The resolution power of the FDIC allows the FDIC to conduct an orderly resolution of the bank, which pro-tects depositors and provides the least-cost solution to the government. In the case of bank holding companies and non-depos-itory financial institutions, insolvency must be addressed in bankruptcy court.

Unfortunately, bankruptcy procedures are designed to provide a clear priority among creditors, but do not provide any special provisions for an insolvency that has broad systemic implications. In such situations, it is very possible that a preferable public policy would be to minimise systemic implications rather than follow the normal creditor prior-ity set out in the bankruptcy code.

The Lehman failureConsider this argument in relation to the Lehman Brothers failure. The government lacked any resolution powers in the case of investment banks, and Lehman had no immediate merger possibilities, so Lehman was forced to file for bankruptcy. The Lehman failure had broad implications for the financial system and economy. The firm was internationally active, engaged actively in derivatives contracts, and a counterparty


to many other financial institutions glo-bally, which has resulted in a plethora of legal actions in multiple jurisdictions. Had there existed the authority and procedures to resolve Lehman outside of bankruptcy proceedings, there may have been a more orderly wind-down of the firm’s operations.

Challenging situationOf course, the Lehman failure suggests that even with resolution powers in place this would have been a very challenging situ-ation – Lehman would have been difficult to wind down, in part because of the scope of its global operations. Lehman Brothers operated in over 40 countries and had over 650 distinct legal operating entities outside of the US. While there were many separate legal entities outside the US, the firm was managed globally – meaning many of its risk management and operating platforms stretched across its many distinct entities.

Foreign jurisdictionsIn the event Lehman Brothers had been placed in receivership in the US, it is unclear how Lehman’s operations outside the US would have been treated in foreign jurisdictions. In such situations it is possi-ble that a country would try to “ring fence” assets so that liability holders in the coun-try would be paid prior to returning funds to a foreign parent. Such a situation raises a number of interesting questions con-cerning the role of a systemic regulator. I would like to provide my own perspective on some of these questions – “straw man” approaches, if you will:• First, for globally active and systemically important US institutions, I suspect that the

potential disruptions to operations associ-ated with ring fencing will likely mean that capital support of foreign operations (that is, capital injections) will be a critical part of the resolution procedures. As a consequence, the systemic regulator would need to have the power to inject capital or request that the Treasury inject capital.• Second, given the speed with which failures have occurred, it may be difficult to incorporate legislative oversight of the resolution process in the short-term – so an understanding of such arrangements should be worked out between Congress and the systemic regulator.• Third, international agreements on receivership procedures for globally active institutions will be necessary. What institu-tions or agencies will have a role in negotiat-ing these procedures? I certainly believe that a systemic regulator should have a role.• Fourth, I would note that policy-mak-ers will have to sort out the appropriate uses of conservatorship (operating the bank as a going concern) versus receiv-ership (which has the goal of liquida-tion) in the case of systemically important institutions.• Fifth, a systemic regulator may need the ability to require reductions in foreign expo-sures as a systemically important financial institution encounters problems. This might include the ability to require that foreign subsidiaries and branches be sold to avoid broader systemic problems, as financial problems increase.• Sixth, perhaps the systemic regulator must be able to influence the “home/host” rules that govern the division of labour in the supervision of internationally active firms.


• Seventh, a systemic regulator may need the ability to require higher capital require-ments for globally active financial institu-tions that will be difficult to resolve if they become insolvent. Beyond these challenges related to global operations, a second prob-lem highlighted by the crisis is the difficulty in managing the derivatives book of global financial institutions.

Costly unwindingWhile derivatives contracts were a problem in the case of Lehman’s failure, they were particularly acute in the case of American International Group (AIG). Because of the presence of complicated, interrelated finan-cial contracts, the unwinding of the deriva-tives positions of AIG has been costly and time consuming.

Increasingly, derivatives and other forms of structured finance are inherent in the oper-ations of large global financial institutions. However, the presence of a small number of global financial institutions as significant counterparties or dealers in the derivatives markets has made such institutions very dif-ficult to resolve, whether through bankruptcy or through receivership. This raises several interesting issues and questions, which I will provide my own current views on:• First and very importantly, I believe a systemic regulator should have the ability to require that transactions be moved to an exchange as the contract becomes standard-ised and widely used.• Second, I believe that in finding the most efficient way to resolve complicated finan-cial transactions in the event a major player becomes insolvent, the systemic regulator would need the ability to explore whether

bankruptcy, receivership, conservatorship, or governmental equity ownership would provide the best model for resolving compli-cated financial transactions that affect a large number of financial institutions around the globe. • Third, a systemic regulator may need the ability to require financial institutions to reduce their derivatives exposure as they become financially troubled. This might include the ability to require the selling of broker or dealer operations in major markets as a firm’s financial position deteriorates.• Fourth, a systemic regulator will likely seek higher capital requirements for firms that are active counterparties or dealers in complicated financial products.

Future resolution challengesWhile the problems of 2008 highlighted the difficulty of resolving financial institu-tions with large global operations and active involvement in derivatives, these problems are likely to be even more important in the future as commercial banks expand opera-tions further overseas. Looking forward, as more and more customers of financial institutions are either global themselves, or have supply lines and sales channels that are global, they will expect their financial institu-tions to have global operations.

US banks that are internationally active hold 18 per cent of assets in foreign offices. Over time, foreign operations seem more likely to grow than contract in an increasingly global economy. As US financial institutions become more involved around the globe, it is likely that these institutions will become more important in their host countries and more difficult to resolve should they become


financially troubled. In this regard, I would suggest the following about some of the key issues that will emerge:• First, a key issue will involve the willing-ness of home and host countries to supervise and, more importantly, potentially bear the burden of financially supporting the opera-tions of a large and systemically important financial institution, if it becomes troubled. This could alter what we have tradition-ally seen as the roles of home and host supervisors.• Second, it will be important to determine how best to structure US financial firms abroad, to minimise the potential for disrup-tion if the firm becomes insolvent. Of course, foreign firms have significant involvement in the US economy. Some foreign banks operate large subsidiaries in the US; oth-ers have very large branch operations. As a result, if the parent company has financial problems, it can have a downstream impact on the US economy. Should foreign banks shrink as a result of financial problems, US borrowers may find it more difficult to secure financing.

This too raises several questions, about which I observe the following:• First, it will be important to determine whether there should be a preference for branch versus subsidiary structures in sys-temically important institutions.• Second, where the financial institutions are large relative to the size of the home country, there will need to be expectations and obligations of the home country. How explicit these should be will need to be determined. We should note that in some countries, systemically important financial institutions figure very prominently in the

country’s economy – more so, in relation to the country’s GDP, than any one US finan-cial institution does in relation to US GDP.

Derivatives contracts have become increasingly important for financial institu-tions – to support their customers, to serve as brokers or dealers, and to hedge their own positions.

Over time, the size of the gross deriva-tives positions of the five largest commer-cial banking organisations most engaged in derivatives activity has become quite large relative to their assets. These positions are likely to get larger over time, and substantial derivatives operations are likely to be impor-tant for more and more financial institutions. Given their complexity and likely growth, we need to explore the implications for bank regulation and the role of a systemic regu-lator, and indeed to better understand their potential impact. [6]

In conclusion Greater integration of the world economy and financial markets is both desirable and inevitable. However, our ability to manage insolvency risk of key players has not grown with these developments. The presence of globally active financial institutions involved in derivatives operations worldwide requires a major rethinking of how we supervise and regulate systemically important institutions. Until global resolution policies are adopted, resolution of internationally active organisa-tions will remain problematic.

Both of the issues I have discussed in this paper – global activity and derivatives involvement – would be important for any regulator charged with systemic responsi-bilities. Of course, a systemic regulator will


need to consider many other issues besides the two I have highlighted today – including issues such as leverage, liability management, and securitisation – but given the constraints on time these additional issues will have to be a topic for another day.

Bankruptcy laws and resolution proce-dures are national. Home country financial supervisors have a national focus, and bank regulations apply within the firms’ national borders. However, as financial firms increas-ingly span national borders, much greater co-ordination is necessary. This is particu-larly true as the size of financial institutions’ on- and off-balance sheet exposures become large relative to the home country’s financial capacity to provide emergency support to the financial institution. In some countries the focus of financial institution resolution has seemingly been the protection of govern-ment-run deposit-insurance programmes – a local mindset at odds with a potentially global issue. Increasingly their attention will need to focus on potential systemic prob-lems with global ramifications.

I hope the issues raised in this paper have provided a sense of the urgency, and also the complexity, of these issues. I have given my own views on some of the key questions that policymakers must ultimately consider. I’ll conclude by noting that the complexity of these issues makes it no less important that we address them, for the good of all partici-pants in our economies. •

Notes:[1] Of course, the views I express today are my own, not necessarily those of my colleagues on the Board of Governors or the Federal Open Market Committee ( FOMC).

[2] In remarks on April 14, 2009, Chairman Bernanke noted that: “Large, complex financial institutions tend to be highly interconnected with other firms and markets. For example, AIG. A disorderly failure of AIG would have put at risk not only the company’s own customers and cred-itors but the entire global financial system.

Historical experience shows that, once begun, a financial panic can spread rapidly and unpre-dictably; indeed, the failure of Lehman Brothers a day earlier, which the Fed and the Treasury unsuccessfully tried to prevent, resulted in the freezing up of a wide range of credit markets, with extremely serious consequences for the world economy.

Catastrophic consequencesThe financial and economic risks posed by a col-lapse of AIG would have been at least as great as those created by the demise of Lehman. In the case of AIG, financial market participants were keenly aware that many major financial institu-tions around the world were insured by or had lent funds to the company. The company’s fail-ure would thus likely have led to a further sharp decline in confidence in the global banking sys-tem and possibly to the collapse of other major financial institutions.

At best, the consequences of AIG’s failure would have been a significant intensification of an already severe financial crisis and a further worsening of economic conditions. Conceivably, its failure could have triggered a 1930s-style glo-bal financial and economic meltdown, with cata-strophic implications for production, incomes and jobs. (from “Four Questions about the Financial Crisis,” ; see http://www.federalreserve.gov/news-events/speech/bernanke20090414a.htm)

[3] In remarks on April 14, 2009, Chairman Bernanke noted “that federal regulators urgently


need a new set of procedures for dealing with a complex, systemically important financial insti-tution on the brink of failure. Such rules already exists for banks: If a bank approaches insolvency, the FDIC is empowered to intervene as needed to protect depositors, sell the bank’s assets, and take any necessary steps to prevent broader con-sequences to the financial system.

However, for an insurance conglomerate like AIG, or for a large financial holding company that owns many subsidiary companies, these rules do not apply. Among other things, a good system for resolving non-bank financial institutions would allow federal regulators to unwind a failing com-pany in ways that minimise disruptions in finan-cial markets.

An effective regime would also provide the authorities greater latitude to negotiate with creditors and to modify contracts entered into by the company, including contracts that set bonuses and other compensation for management.” (from “Four Questions about the Financial Crisis,” avail-able at http://www.federalreserve.gov/newsev-ents/speech/bernanke20090414a.htm)

[4] “Could a Systemic Regulator Have Seen the Current Crisis?” See: http://www.bos.frb.org/news/speeches/rosengren/2009/041509.htm

[5] As I have noted in earlier talks, unlike most prudential supervisors that focus on the solvency of individual financial institutions, a financial-stability regulator would clearly need to take more of a “macro” perspective on financial trends (and their crosscurrents and unintended consequences).

‘Contagious’ failuresMy assumption is that a financial-stability regulator would be charged with making sure that what I will call “contagious” failures of financial institutions do not occur. Such

failures could involve a large group of finan-cial intermediaries, all with a prominent shared risk exposure, or could involve one key player becoming insolvent but many other financial institutions failing because of their exposure as counterparties to that institution.

Identifying systemic problemsThis definition does not require that the involved organisations are depository institutions, nor does it hinge on the presence of deposit insurance. A key point is that the systemic regulator cannot just look institution by institution, but needs to think about the potentially difficult trends emerging across a swath of interconnected institutions and their counterparties. And while it may go without saying, for a systemic regulator to be effective, the regulator must be able to identify whether actual systemic problems are emerging. This involves, in part, assessing the “feedback effects” that might result from initial problems.

How things work[6] As I noted in a recent speech, an effective sys-temic regulator would need to have very detailed understanding of institutional practices and prod-ucts – simply put, how things really work, in good times and bad. For example, the complexities of the servicing business model and the reasons why it presents challenges in a declining market. Another example is the market for credit default swaps, which ballooned but still seems less well understood than is desirable. •

(editor’s note: We would like to thank the Federal Reserve Bank of Boston for allow-ing the Journal of Regulation & Risk – North Asia to reproduce Dr Rosengren’s speech delivered in Hong Kong on May 5, 2009.)


Securitisation

Resecuritisation in banking: major challenges ahead

Dr Fang Du of the US Federal Reserve System looks at the forgotten frameworks

associated with the pillars of Basel II.

in the process of Basel ii development and implementation, most financial insti-tutions and banks, as well as regulators, have focused their efforts and resources on wholesale and retail frameworks, while the securitisation framework, anal-ogous to Pillar ii and Pillar iii is being labelled as “forgotten”. the pillars, though extremely important, were given minimal attention by Basel ii project offices in banks and regulatory agencies until the financial crisis broke out.

This phenomenon occurred due to mis-conceptions about the creditworthiness of securitisation products, since roughly 90 per cent or more of tranched securities yielded from securitisation were crowned with tri-ple-A ratings prior to the current financial crisis. This misconception directly influenced progress in implementing the Basel II securi-tisation standards which, in my opinion, has lagged behind the progress of implementing Basel II wholesale and retail frameworks for at least four or five years.

Regardless of the size and complexity of the bank, the Basel II project office suffers

from a severe shortage of securitisation pro-fessionals; it lacks the knowledge of select products and instruments that are defined as securitisation exposures; it faces the chal-lenges of identifying securitisation exposures across multiple business lines; and it lacks the framework to systematically handle cap-ital calculations corresponding to a variety of approaches.

Risk ‘disconnect’The current financial crisis unveils flaws

of the creditworthiness embedded in secu-ritisation products, especially products such as CDO-squareds. Practitioners from the financial and banking industries and regula-tors from banking supervision and regula-tion agencies had raised concerns for years about the risk assessment and measurement for securitisation/resecuritisation exposures.

There exists a disconnect between the perception of risk for business lines that originate the underlying assets and those which securitise the underlying assets, and another between the risk valuation for lenders who use conventional credit risk methods and securitisers who use market


risk driven methods. Generally, professionals in securitisation programmes lacked suffi-cient knowledge of how consumer business lines – such as mortgage, home equity and credit card – booked their loans and assessed credit risk such as defaults and prepayments corresponding to their internal policies and procedures.

Mathematical problem By the same token, the business lines that sold these loans to securitisation programmes had little understanding of how these loans were packaged and structured and of how structural features link to rating grades. Raters in rating agencies who assigned investment ratings to these structured products were technically qualified on one hand, employing advanced statistical modelling and compu-tation skills, while lacking minimal banking and portfolio management experience on the other. Somehow, the process for assign-ing ratings evolved to become more or less an academic mathematical problem-solving exercise rather than truly comprehending the fundamentals underlying these financial products.

Consequently, lenders switched their focus to short-term asset turnover rather than to long-term customer relationships, which induced the widespread adoption of lax underwriting criteria. As revenues swelled, securitisers generated abnormal demand on loans/lines by accelerating the packaging speed and producing a range of creative fancy financial products while ignor-ing whether the risk attached to securitisa-tion products was actually compatible with the supporting underlying assets.

Rating agencies deviated from their

traditional rating practices and adopted fan-cier quantification techniques to issue rat-ings for these structured products without thoroughly testing whether the underlying assumptions used in modelling approaches were commensurate with the real situation and whether the risk measures, reflected through correlations, delinquencies, defaults and loss severities, would be sustainable through a severe economic downturn.

Most of the risk ratings assigned to the resecuritisation products have failed accu-racy and stability measures in the current financial turmoil. The risks embedded in the resecuritisation products were severely understated. Some, if not all, resecuritisation products have severely damaged their own reputations, as pointed out in The Economist on May 14, 2009: “Ludicrously complex securitised products, the CDO-squareds and -cubeds, have gone forever.”

Enhanced treatmentsThe gross underestimation of credit risk for resecuritisation exposures inspired the Basel Committee on Banking Supervision (BCBS) to enhance the existing Basel II securitisation framework, which previously did not distin-guish between the different levels of credit risk inherent in resecuritisation and those of traditional securitisation products. In July 2009, BCBS issued enhanced capital treat-ments that specifically apply to resecuritisa-tion exposures.

This article is composed of three sections. The first section introduces the definition of resecuritisation exposures and provides sev-eral examples. The second presents a new set of risk weights designed specifically for rese-curitisation exposures corresponding to both


short-term and long-term risk ratings. The enhanced operational criteria, which directly impact the capital charge, will be explained in the third section for the significant role that they play in the resecuritisation capital framework.

Resecuritisation defined The following definition of resecuritisation is an excerpt from ‘Enhancements to the Basel II framework’:

“A resecuritisation exposure is a securi-tisation exposure in which the risk associ-ated with an underlying pool of exposures is tranched and at least one of the underly-ing exposures is a securitisation exposure. In addition, an exposure to one or more rese-curitisation exposures is a resecuritisation exposure.”

There are two key components worth noting in this definition. The first is that a resecuritisation exposure reflects a tranched exposure with the credit risk separated into at least two different levels with different seniorities. The second piece refers to the underlying pool in which there is at least one exposure classified as a securitisation exposure. The US Basel II final rule for the advanced approach defines the securitisation exposure as “an on-balance sheet or off-bal-ance sheet credit exposure that arises from a traditional or synthetic securitisation”.

This definition would cause challenges for many, if not all, banks that are engaged in securitisation relevant businesses such as origination and/or investment in identify-ing all resecuritisation exposures. For some resecuritisation products often supported by CDO underlying pools such as CDO-squareds, CDO-cubeds and even higher

power CDOs, resecuritisation exposures may be relatively easy to recognise since the product names speak for themselves. CDO of ABS also qualifies as a resecuritisation exposure.

A typical example for this class is RE-REMIC, which has recently shown growth potential in the United States. RE-REMIC is a repackage of securities backed by residential mortgage backed securities (RMBS) or by commercial mortgage backed securities (CMBS). The underlying pool for RE-REMICs varies in its many forms, rang-ing from a mix of prime jumbo RMBS and Alt-A securities to only one downgraded or potentially downgraded AAA tranche to existing CMBS bonds.

For example, Morgan Stanley has launched a $210 million RE-REMIC with only one bond as the underlying pool, the Goldman Sachs Mortgage security 2007-GG10. Conversely, Bank of America is work-ing on a similar RE-REMIC transaction, but the underlying pool includes multiple CMBS securities, exactly nine super-senior com-mercial pass-through certificates securitised between 2006 and 2007.

Moody’s rating Finally, Citigroup’s underlying pool for the RE-REMIC transaction, Citigroup Mortgage Loan Trust 2009-7 Group 5, contains two classes, 5A1 and 5A2, rated Aaa and C respectively by Moody’s and was backed by Class A-2 Mortgage Pass-Through Certificates – Series 2005-60T1 transaction – from CWALT, Inc, which is backed by mort-gages that are considered Alt-A.

The example of CDO-squareds or RE-REMICs demonstrated above is


relatively straightforward for determining whether a tranched exposure is a resecuri-tisation exposure. The challenge remains to identify resecuritisation exposures for which the underlying asset pool is composed of a mix of loans, bonds and securitisation secu-rities. As illustrated in the Basel II enhance-ment, any tranched position exposed to a pool of many asset types containing at least one securitisation exposure is considered a resecuritisation exposure.

Identification problemBanks possessing securitisation positions or engaging in originating securitisation trans-actions should go through all of these expo-sures, check the composition of underlying asset pools, and check whether there is at least one asset categorised as a securitisation exposure in the underlying pool.

This identification process is time-con-suming and burdensome for many banks. Given the complexity of the structural fea-tures built into some resecuritisation prod-ucts, if banks are not sure whether the position should be identified as a resecuriti-sation exposure, they are encouraged to con-sult their national supervisors.

Given that many banks have currently faced difficulties in identifying some of their securitisation exposures across multiple business lines, the additional requirement of separating resecuritisations from securitisa-tions expands the workload of the Basel II securitisation implementation.

Exposures linked to one or more rese-curitisation exposures are also classified as resecuritisation exposures. If a bank bought a guarantee to hedge an inherent risk in a resecuritisation tranche, this guarantee

is classified as a resecuritisation exposure. Similarly, the credit default swap (CDS) used as a risk mitigation tool on a resecuritisation security such as a CDO-squared tranche is treated as a resecuritisation exposure. To make the matter more complicated, the identification of resecuritisation exposures associated with ABCP programmes will be structure dependent and may need to be determined on a case-by-case basis.

Generally speaking, a pool-specific liquidity facility with full coverage would not be classified as a resecuritisation exposure unless the underlying asset pool includes at least one resecuritisation exposure. Conversely, the programme-wide credit enhancement representing a tranched posi-tion would be classified as a resecuritisation exposure as long as one of the asset pools contains securitisation exposures such as CBOs or CDOs.

The current financial crisis clearly high-lights the higher risk inherent in resecuriti-sation exposures. To make the capital charge commensurate with the risk level, BCBS has expanded risk weight tables of securitisations for both standardised and IRB approaches by distinguishing the risk embedded in rese-curitisation exposures from that of traditional or synthetic securitisation exposures.

IRB approachThere is a significant increase in the risk weights for resecuritisation exposures, but the granularity plays no role in this new set. Table 1 (see page 72) presents the risk weights applied to securitisation and resecuritisa-tion exposures by using the IRB approach. Assuming that a bank held a senior position of a $100 million AAA RE-REMIC security,


the capital charge would be $1.6 million ($100 million x 20% x 8%) based on a new risk weight, which is roughly three folders high to a non-enhancing capital charge, $0.56 million ($100 million x 7% x 8%). Although this is just an example, the impact of the new approach is significant. The standardised approach has also made corresponding changes to increase risk weights on resecuritisation exposures (see Table 2 on page 72).

Chart 1 (see page 72) shows the signifi-cant increase in the risk weights for resecu-ritisation exposures under the IRB approach. For the same investment grade, the risk weight for a resecuritisation exposure is roughly three times the risk weight of a securitisation exposure. For non-investment grades, the difference between securitisation and resecuritisation risk weights is also large, although the multiplier is not as high as that of investment grades.

Important roleThe senior resecuritisation exposure clearly plays an important role in the Basel II securi-tisation framework. A senior resecuritisation exposure means that this resecuritisation exposure has a first priority claim, exclud-ing fees due under interest rate or currency derivative contracts, and fees due or other similar payments on the cash flows from the underlying pool. In addition, the underlying pool must not include any resecuritisation exposures.

For example, CDO-cubeds have to slot into the non-senior category. If a resecuriti-sation does not have a first claim on the cash flow or the underlying exposures include at least one resecuritisation exposure, this resecuritisation exposure has to use the

risk weights proposed for non-senior rese-curitisation exposures. The current finan-cial turmoil clearly exhibits the mistakes or shortcomings of insufficient due diligence performed on investing tranched securities.

No questions askedInvestors put too much faith on rating agen-cies’ rating assignments and relied too much on rating distributions for these types of securities without thoroughly understand-ing either the credit risk associated with the underlying pool or the structural features of the securitisation which may disrupt the pay-ment schedule. Moreover, none questioned the sustainability of the rating methodolo-gies, which had not previously been tested through a full economic cycle. Sellers/servic-ers, ABCP sponsors and SPV administrators might have made similar mistakes.

As a supplemental request for enhance-ments to the Basel II framework, BCBS has proposed additional operational criteria for credit analysis that apply to the securitisation framework for both SA and IRB approaches as well as for securitisation exposures on the banking book and the trading book.

Regardless of whether the securitisa-tion exposure is on- or off- balance sheet, banks are required to have a comprehensive understanding of the risk associated with this exposure. Three core building blocks – the underlying asset pool, the structure of a securitisation transaction, and the quality of sellers/servicers – directly impact the risk characteristics of a securitisation exposure.

Prior to the financial crisis, many securi-tisers and raters unfortunately did not realise that understanding the risk characteristics of underlying asset pools is the foundation


Table 1. Risk weight table for securitisation and resecuritisation exposures using the IRB approach

Securitisations Resecuritisation exposure

Long-term Rating

Senior,Granular

Non-senior,Granular Non-granular Senior Non-senior

AAA 7 12 20 20 30

AA 8 15 25 25 40

A+ 10 18 35 35 50

A 12 20 35 40 65

A- 20 35 35 60 100

BBB+ 35 50 50 100 150

BBB 60 75 75 150 225

BBB- 100 100 100 200 350

BB+ 250 250 250 300 500

BB 425 425 425 500 650

BB- 650 650 650 750 850

Below Deduction

Table 2. Risk weight table for securitisation and resecuritisation exposures using the standardised approach

Long-term rating Securitisation exposures Resecuritisation exposure

AAA to AA- 20 40

A+ to A- 50 100

BBB+ to BBB- 100 225

BB+ to BB- 350 650

B+ and below or unrated Deduction

0

100

200

300

400

500

600

700

800

900

Non-senior

Senior

Non-granular

Non-senior, GranularSenior, Granular

BB-BBBB+BBB-BBBBBB+A-AA+AAAAA

Chart 1. Risk weight table for securitisation and resecuritisation exposures under the IRB approach


for supporting the performance of tranched securities. I have pointed out this weakness at the beginning of this article.

BCBS has expanded the operational criteria and now requires banks to fully understand, on an ongoing basis, the risk characteristics of the underlying pool, which is quite specific and includes but is not lim-ited to exposure type, delinquency status such as 30, 60, and 90 days past due, default rate, prepayment rate, an internally or exter-nally developed average credit score, and average loan-to-value ratio.

If the underlying assets are relevant to real estate, banks are required to moni-tor the foreclosure rate, property type, and occupancy status in a timely manner. Banks are also requested to track the risk factors that are linked to concentration risk, such as industry and geographic diversification.

Resecuritisation makes the risk moni-toring process more complex. Banks need to develop a two-stage tracking procedure to monitor at least two layers of underlying asset pools. The first stage of the risk moni-toring process deals with the top layer of the underlying asset pool, which includes at least one securitisation exposure.

Risk characteristicsThe second stage reviews the bottom layer of one or multiple underlying asset pools which support the securitisation exposure(s) in the top layer. For the top layer of the underly-ing asset pool, banks need to understand the risk characteristics associated with these tranched securities, such as issue risk, rating stability, tranche thickness, senior or mez-zanine position, triggers built into the struc-ture, and the payment waterfall. To further

drill down underlying exposures, the second stage of the procedure deals with the bottom of the underlying asset pool(s), which can be wholesale or consumer loans and lines, cor-porate bonds, municipal bonds, and other financial assets other than tranched securi-ties. The previous paragraph explained the risk monitoring process for the bottom of underlying asset pool.

Structural featuresThere is no doubt that understanding the risk characteristics of the underlying asset pool is essential, but understanding the structural features of the securitisation is just as crucial because they directly affect the credit risk of tranched securities. The level of credit enhancement is taken into account in determining the values of tranched securi-ties; for instance, loss multiples 4 – 5x of base case losses for triple-A and 2 – 3x for single-A according to one NRSRO’s criteria.

Additionally, the formation of credit enhancement varies through the structure of subordination, over-collateralisation, reserve accounts, or excess spread. Other structural features such as early amortisation triggers, termination events triggers, and diversifica-tion triggers built into the securitisation trans-actions would redirect or interrupt the cash payment to investors when breaching them.

Therefore, enhancements in the Basel II framework require the bank to have a thor-ough understanding of all structural features built in securitisation transactions, specifi-cally although not limited to the contractual waterfall and waterfall related triggers, credit enhancements, liquidity enhancements, market value triggers, and deal specific default definitions of default.


The third building block in securitisation is understanding the risk associated with sellers/servicers. At a minimum, banks need to know sellers’ underwriting standards and practices and the servicers’ MIS system for tracking underlying assets’ performance and fund collection/transfer.

Misunderstanding or ignoring any of these three building blocks would cause banks to possibly mis-specify and incorrectly measure the risk in securitisation exposures. The expanded operational criteria proposed recently by BCBS definitely raise not only the bar but also the challenge for banks to comply. If banks fail to comply with these criteria for credit analysis, they will have to deduct the securitisation exposure with a risk weight of 1,250 per cent.

Daunting challengeCapital charges raised in enhancing the Basel II securitisation framework are better aligned with the risk yield from resecuriti-sation exposures. Moreover, expanding the operational criteria imposed on securitisa-tion transactions will make the securitisation

market healthier and more transparent. The challenge for banks to comply with these enhancements and regulations remains daunting. We are most likely to see increas-ing demand for extra resources specialising in securitisation products, MIS reporting, system integration, new data entry, data quality con-trol, and risk monitoring and measuring. •

References1. Basel Committee on Banking Supervision, “Pro-

posed enhancements to the Basel II framework”, January 2009

2. Deloitte, “Speaking of Securitisation”, June 20093. S&P, “US CMBS Rating Methodology and Assump-

tion for Conduit/Fusion Pools”, June 26, 20094. Moody’s, “Moody’s Credit Card Report”, July 8,

20095. Deutsche Bank, “Asset-Backed Securities”, July 8,

20096. Basel Committee on Banking Supervision,

“Enhancements to the Basel II framework”, July 2009

7. FFIEC, “Risk-Based Capital Standards: Advanced Capital Adequacy Framework – Basel II; Final rule”, December 7, 2007


Editorial deadline for Vol II Issue I Spring 2010

February 28th 2010


Central banking

A framework for funding liquidity in times of financial crisis

In this paper the ECB’s Dr Ulrich Bindseil looks at optimum central bank support for

bank funding during a liquidity drought.

this article revisits one of the key central bank responsibilities relating to financial stability, namely the one to provide extra funding liquidity support to banks in a financial crisis through market operations. While the impor-tance of this task has been confirmed during the current financial crisis, it is still subject to misunderstandings, even after being debated for 200 years.

in fact, today’s academic doc-trines on this subject are strongly, but incompletely inspired by 19th century authors (see e.g. goodhart, 1999). also, an analytical framework to understand how these measures work and how the central bank should decide upon them seems to be missing. to start, recall briefly the “top two” in the all-time charts of quotations on liquidity support operations of central banks in financial crisis.

“We lent by every possible means con-sistent with the safety of the bank,” said Jeremiah Harman, director of the Bank of England, during a hearing of the Lords’

Committee in 1832 when summarising the Bank’s actions in the panic of 1825 as (found e.g. in Bagehot 1873).

“We lent . . . by every possible means, and in modes that we never had adopted before; we took in stock of security, we pur-chased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on depos-its of bills to an immense amount; in short, by every possible means consistent with the safety of the Bank . . . seeing the dreadful state in which the public were, we rendered every assistance in our power.”

‘Creativity’ to the rescueFirst, it is useful to note that the forego-ing statement is about aggregate liquidity injection into the financial system, under circumstances of a collective financial mar-ket liquidity crisis, and not about emergency liquidity assistance to individual banks (as often wrongly assumed). Second, Harman explains the Bank of England’s action as hav-ing been creative and pro-active, i.e. to have innovated to find the best ways to support funding liquidity of financial institutions, the


only constraint to creativity relating to central bank risk taking.

Why exactly should the central bank be so engaged in liquidity support to banks in a financial crisis as described by Harman? Three main reasons may be considered:

(1) Negative externalities of illiquid-ity (and bankruptcy). The central bank may be ready to engage in liquidity sup-port measures because of the potential negative externalities of bank stress and bank default (see e.g. Brunnermeier et al (2009). As a public player, it should have overall welfare in mind, i.e. encompassing externalities.

(2) The central bank is the only eco-nomic agent not threatened by illiquidity. Central banks have been endowed with the monopoly and freedom to issue the legal tender: central bank money. Therefore, central banks are never threatened by illi-quidity and it seems natural (even from a purely commercial perspective) that in case of a liquidity crisis, in which all agents rush towards securing their liquidity, the central bank remains more willing than others to hold (as collateral or outright) assets which are not particularly liquid.

Power of the ‘haircut’(3) Haircuts as a risk mitigation tool if credit risk is asymmetric. Haircuts are a powerful tool to mitigate liquidation risk of collateral in the case of the default of the cash taker (i.e. collateral provider) in a repo operation – however only if the cash taker is more credit risky than the cash lender. Indeed, in case of a haircut, the cash taker is exposed to the risk of default of the cash lender, since in case of such default, he is uncertain to get the

collateral back. This is why haircuts between banks of similar credit quality tend to be low, while banks impose potentially high haircuts if they lend cash to e.g. hedge funds. This also explains why banks would never question haircuts imposed by the central bank (see also Ewerhart and Tapking, 2008).

Inertia principleThe other most quoted statement of 19th century central banking literature is due to Bagehot (1873) himself, and states the so-called “inertia principle” according to which the central bank should maintain its risk control framework at least inert and accept that its risk-taking increases auto-matically in a crisis situation:

“If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security on what is then commonly pledged and easily convertible, the alarm of the solvent mer-chants and bankers will be stayed. But if securities, really good and usually convert-ible, are refused by the Bank, the alarm will not abate, the other loans made will fail in obtaining their end, and the panic will become worse and worse.”

In contrast to Harman, Bagehot does not emphasise the pro-activeness of meas-ures taken, but the fact that the central bank must remain “inert” and not tighten its risk control framework (e.g. by restricting the set of eligible collateral for advances), such as other market players would do. While the emphasis is hence somewhat different, Bagehot can also be said to turn this quo-tation around the duality of liquidity sup-port and risk-taking.

Starting from this duality, we provide


a general framework for understanding the decisions of central banks with regard to liquidity support operations in finan-cial crisis. This framework allows refining and generalising the relatively simple 19th century doctrine on the subject, which is still so widely quoted today, however often with no or little emphasis on the central bank risk-taking constraint.

The simple system of accounts intro-duced in this section allows capturing the interaction between central bank opera-tions and banks’ funding liquidity in a financial crisis. The system consists of the balance sheets of four entities, namely the central bank, two banks and one house-hold. Without loss of generality, we assume that the two banks are initially identical. The household is the sole source of exog-enous liquidity shocks.

It may substitute bank deposits with banknotes (“ΔB” = change of banknotes held by household), which affects refi-nancing needs of banks. Moreover, the household may shift deposits between banks 1 and 2 (“Δd” is a deposit shift from bank 1 to bank 2).

Liquidity effects bufferThe banks are supposed to buffer out the liquidity effects of the household’s decisions through changes in central bank refinanc-ing. The absence of an interbank market reflects the fact that interbank markets tend to break down in a liquidity crisis. For sim-plicity, the central bank is assumed to not impose reserve requirements on banks, such that banks’ deposits with the central bank are normally zero.

The corporate and government sector

are relevant here in so far as they have issued debt (each 150, as far as contained in the financial accounts presented) and take loans from banks (corporates in total 200). (See tables overleaf).

Constrained borrowingFunding stress of banks may result in this framework from deposit withdrawals, if the borrowing from the central bank is poten-tially constrained. There are essentially three ways the central bank can, through financial operations, influence the funding stress of banks:

First, the central bank may lend to banks through different more or less con-venient types of lending operations, such as standing facilities or reverse transac-tions allocated through some auction or fixed rate procedure, and at various differ-ent maturities.

Second, the central bank defines col-lateral eligibility and haircuts for its lend-ing to banks. Indeed, central bank lending is never uncollateralised. Hence, the quan-tity of central bank eligible collateral after haircuts limits a bank’s borrowing poten-tial with the central bank.

Third, the central bank may change the total amount and the structure of its outright holdings of securities. In our closed system of financial accounts, any such changes will be reflected in opposite changes of securities holdings of the bank-ing system.

The idea is that by working on these interactions, the central bank can reduce the funding liquidity stress on banks, and thereby slow down or stop a financial cri-sis or prevent it from breaking out, such


that banks do not stop lending to the real sector.

In the words of Ben Bernanke (Speech: “The Crisis and the Policy Response”, 13 January 2009): “Liquidity provision by the central bank reduces systemic risk by assuring market participants that, should short-term investors begin to lose confi-dence, financial institutions will be able to meet the resulting demands for cash with-out resorting to potentially destabilising fire sales of assets.

Moreover, backstopping the liquidity

needs of financial institutions reduces funding stresses and, all else equal, should increase the willingness of those institu-tions to lend and make markets.”

Avoiding fire sales is considered essen-tial in preventing that a liquidity crisis turns into an economic disaster as fire sales fur-ther depress asset prices and thereby set in motion a vicious downward spiral (asset fire sales lead to lower asset prices and implied write-offs, increasing capital stress on banks which needs to be addressed through further fire sales, etc.).

Household

Deposits with bank 1 100 - ΔB +Δd

Equity 400Deposits with bank 2 100 - ΔB - Δd

Banknotes 200 + ΔB

Total assets 400 Total liabilities 400

Bank 1

Government bonds 50 Deposits of HH 100 – ΔB/2 + Δd

Corporate bonds 50 Borrowing from CB 70 + ΔB/2 - Δd

Loans to corporates 100Equity 30

Deposits with CB 0


Bank 2

Government bonds 50 Deposits of HH 100 – ΔB/2 + Δd

Corporate bonds 50 Borrowing from CB 70 + ΔB/2 - Δd

Loans to corporates 100Equity 30

Deposits with CB 0


Central Bank

Government bonds 50 Deposits of HH 200 + ΔB

Corporate bonds 50 Deposits of banks 0

Lending to banks 140+ ΔB Equity 40

Total assets 240+ ΔB Total liabilities 240


Liquidity buffers of banks may be defined either as a deterministic or as a stochastic concept.

A deterministic concept would be, for instance, “Distance to illiquidity” = DTI = the maximum amount of deposit with-drawals that a bank can handle before hav-ing to fire-sale corporate bonds and loans. A stochastic concept would be: “Probability of liquidity” = PL = the probability that the bank does not need to fire-sale assets.

Government bondsTo calculate both measures for the banks in our example, one needs to know what the central bank accepts as collateral. Assume that the central bank accepts government bonds without any haircut, corporate bonds with a 20 per cent haircut, while loans of banks to corporates are not accepted at all as central bank collateral.

The central bank borrowing potential of each bank is then 90. The actual central bank borrowing of each bank is 70. Hence, the DTI of each bank is 20. The possibility to sell perfectly liquid assets, namely gov-ernment bonds, is not relevant for liquid-ity buffers of banks, since such bonds are anyway accepted without haircut as cen-tral bank collateral.

To calculate the probability of liquid-ity, PL, we need in addition to take an assumption on the probability distribution of ΔB and Δd.

Assume, which is obviously a sim-plification, that both are independently normally distributed, i.e. and respectively. Therefore, total deposit withdrawals to each bank are, writing now, as simply as one can calculate, the probability of

liquidity of each bank using the cumula-tive Gaussian distribution:

PL DTI 1 DTI 1 probabilityof illiquidity 1 PID D= = - - = - = -v v

U Uc cm m

If for instance, then, with DTI = 20, we obtain PL = 1-0.004, i.e. banks become illiquid (i.e. need to start fire-selling assets) with a four basis points probability (PI = 0.04 per cent).

In a financial crisis, everything will turn worse for the banks in terms of funding liquidity, even beyond the already assumed breakdown of the interbank market.

First, private asset values (in our exam-ple: values of corporate bonds and of loans to banks) fall and become more volatile. The implied losses eat into the banks’ capi-tal, implying deteriorating perceived credit quality, which may trigger further fund-ing problems. Second, asset fire sale costs increase because of the decline in market liquidity of all asset classes except govern-ment bonds. Third, deposits become more volatile (also, but not exclusively due to increased credit risk).

Declining assets Finally, the potential borrowing of banks from the central bank suffers in terms of declining asset and hence collateral values. The central bank may also want to increase haircuts on the collateral it accepts; it would need to do so if it wanted to keep its risks unchanged, in view of the increased asset price volatility (assuming that haircuts aim at protecting, at some confidence level, against loss of collateral value during the liquidation period).

The following table shows how the


financial crisis (columns 1-3) and changes of central bank operations (columns 4-7) affect banks’ funding liquidity stress indi-cators DTI and PI = 1-PL. (2) modifies the base scenario in terms of assuming that corporate bond prices fall by 10 per cent. (3) in addition assumes that deposit vola-tility increases from 6 to 8. In (4), in addi-tion the central bank increases its haircuts from 20 per cent to 30 per cent to protect itself against increased volatility of collat-eral values. In (5), the central bank in con-trast lowers haircuts to 10 per cent. In (6), the central bank makes outright purchases of non-liquid assets (corporates) and sells Government bonds. In (7) the central bank makes loans of banks to corporates par-tially eligible. The highest level of funding liquidity stress is reached in scenario (4) with a probability of illiquidity of 7.5 per cent. In scenario (7), the central bank man-ages to push the level of funding stress on banks to a level even lower than the one in the base scenario (1).

Vicious downward spiralIn a financial crisis, banks are suddenly under both liquidity and solvency stress, and their individual optimisation unavoidably brings them to the conclusion that they should

restrict lending and risk taking vis-à-vis other market participants, which may trig-ger a vicious downward spiral that leads to a socially sub-optimal equilibrium. As shown in the previous section, the central bank can support funding liquidity of banks in a crisis in a decisive way.

Risk budget toleranceBut what about Harman’s “safety of the central bank”? How important should risk management aspects be for the central bank when deciding on financial stability meas-ures? What increase in its total risk budget should the central bank tolerate? Three different basic answers were given to this question:

(1) Ensure above all credit risk protec-tion. According to this approach, the cen-tral bank should protect itself – not on the liquidity side, where it is, in contrast to all other banks, not threatened, but on the side of credit risk. After all, the central bank is not the best credit risk manager. Hence, when a crisis with all implied extra risks breaks out, it should put emphasis on additional risk con-trol measures.

(2) Active additional risk taking. This approach has been advocated by Buiter and Sievert (internet blog posted August 12,

Table 1: Effects of financial crisis and of central bank measures on funding liquidity of banks.

Scenarios: (1) (2) (3) (4) (5) (6) (7)

Corp bond value decline 0 10% 10% 10% 10%(3) but CB sells 50 Govt bonds, buys

50 Corp bonds

(3) but CB accepts top 20% credit claims at

haircut of 40%Deposit volatility 6 6 8 8 8

Haircut on corp bonds 20% 20% 20% 30% 10%

DTI 20 16 16 11.5 20.5 24 28

PI = 1-PL 4 38 228 753 52 13 2


2007): “Dealing with a liquidity crisis and credit crunch is hard. Inevitably, it exposes the central bank to significant financial and reputational risk. The central banks will be asked to take credit risk (of unknown) mag-nitude onto their balance sheets and they will have to make explicit judgments about the creditworthiness of various counterpar-ties. But without taking these risks the central banks will be financially and reputationally safe, but poor servants of the public interest.”

The main argument for active extra risk taking seems to be that the marginal social returns of risk taking by the central bank increase substantially during a crisis.

(3) Inertia principle. As quoted in the introduction, Bagehot 1873 suggests to con-tinue lending against what has been “good securities” in normal times, i.e. he neither invites the central bank to join the flight to quality, nor does he insist that extra liquidity support measures should be invented.

Beyond the general arguments in favour of central bank funding liquidity support to banks in a crisis, three arguments in favour of inertia per se may be brought forward.

Complex trade-offFirst, only inertia ensures that banks can really plan well for the case of a crisis. The possibility that the central bank would make more constraining risk control measures or would reduce collateral eligibility in crisis sit-uation would make planning of banks much more difficult (including stress testing).

Second, the central bank is unlikely to be able to re-assess the complex trade-off between optimal financial risk management and optimal contribution to financial stabil-ity anyway at short notice, since both sides

are difficult to quantify even in normal static conditions. Therefore, ideally, it designs a risk control framework in normal times with which it also feels comfortable in a financial crisis.

Third, ex ante equivalence between (i) a series of consecutive accesses of banks to the borrowing facility and (ii) a longer-term refinancing through open market opera-tions (besides the penalty rate and possible stigmatisation) requires full trust of the bank into central bank inertia with regard to all access conditions to the borrowing facility.

Vast scienceTo go beyond these three maybe stereotypi-cal approaches, it is useful to be more pre-cise on the risk-taking of the central bank, namely in the context of the simple financial accounts presented in section 2. As meas-uring risk is a vast science in itself, only the simplest example of a risk measure will be considered here.

Assume that corporate bond and loan portfolios are perfectly granular and that their change in value is N 0, 2

vA^ h in the period considered. In a reverse repo, the central bank has normally a zero return, but when the asset value decline depletes the bank’s capital, then the bank defaults and the central bank would sell the collat-eral, whereby the liquidation value would suffer, of course, from the asset value decline.

Government bond prices would be unaffected, whereby it is assumed that the banks use first their corporate bonds and, only second, their government bonds as collateral. The percentage expected loss on reverse repos collateralised by corporate


bonds will be, with h being the haircut on corporate bonds and f xDA ^ h being the den-sity function of percentage changes in asset values, and q max h,E/ CB CL=- +^^ hh , with E = Equity of bank, CB = corporate bond holdings of the bank, and CL = cor-porate loans of the bank:

E loss in% on reverse repocollateralised with corporate bonds

x h f x dxq-

= -3-

DA^ ^h h#

The boundary q of the integral is explained as follows: if the haircut on cor-porate bonds is higher than the relation between bank equity and risky assets, then

losses will only arise if the asset value decline exceeds the haircut. If in contrast the haircut is lower than bank equity divided by risky assets, losses kick in only when the asset declines exceed bank equity divided by risky assets.

For corporate bond outright holdings, the expected loss (conditional on asset value declines) is simply:

E loss in% of corporate bondoutright holdings of the central bank

x.f x dx0

-=

3-

DA ^ h#

Obviously, outright holdings are more risky for the central bank, as they do not

Table 2: Effects of financial crisis and of central bank measures on funding liquidity of banks.

Central bank corp. bond holding Haircut

0% 10% 20% 30%

0Probability bank illiquid (in bp) 1 25 304 1743

Central bank E-loss 8.2 5.3 2.5 0.9





1.00

0 5 10 15

0.95

0.80

0.85

0.90

Fund

ing

Liqu

idity

of b

anks

Central bank risk (E-Loss)

Figure 1: An example of the trade-off between central bank risk taking and funding liquidity support of banks (funding liquidity measure = 1 – probability of illiquidity)


benefit from the protection provided by the capital buffers of banks. The total E-loss as risk measure can now be compiled easily for various combinations of corporate bond out-right holdings of the central bank and hair-cuts, starting from the balance sheets as in section 2 and assuming e.g. 20%2 =vA and

8D2 =v . Table 2 (see previous page) provides

the E-loss and the probability of illiquid-ity for a number of combinations of policy parameters.

It may be noted that some combination of policy parameters do not seem to be efficient in the sense that there are other combina-tions that better support funding liquidity of banks with the same risk, or that provide the same funding liquidity support but at lower risk. The different risk-liquidity outcomes are summarised in the scatter chart below.

Conceptual model of the liquidity-support/risk taking trade-off of central banks in a financial crisisLet L be a variable that captures the funding liquidity comfort of banks. L depends both on the state of the financial system (working of interbank markets, deposit volatility) and on central bank operations and risk control measures of the central bank. The measure L could be specified for instance as the average of individual banks’ probabilities of remaining liquid. The minimum central bank support is provided if all the central bank liquidity sup-ply is through outright holdings and adjust-ments of holdings of government bills. In this case, there is no way for banks to do any individual liquidity adjustment directly via the central bank. Instead, everything has to be done via interbank markets or securities sales or purchase in the market.

A somewhat higher L is reached if the central bank introduces reverse operations and standing facilities, but collateral consists only of treasury bills, haircuts are on the high side, liquidity is provided only to highly rated counterparties, proportionality limits apply (e.g. no bank may borrow more than a cer-tain percentage of some components of its balance sheet). Higher and higher levels of L are reached if gradually each of these dimen-sions is relaxed further, i.e. a wider range of collateral is accepted, haircuts are lowered and limits are relaxed.

Finally, a maximum L can be reached in the extreme scenario that the central bank lends freely at any time, i.e. uncollateralised to all banks without limits. The only reason for a bank to default under such an approach would be the supervisory withdrawal of the banking licence due to violation of capital adequacy. Apart from this, market control over resource scarcity would be removed completely.

A “mad” bank could buy in one day anything. There would be no guarantee of economically rational behaviour – extreme leveraging and risk-taking would be possi-ble (and likely if capital is depleted anyway). Incentives to lie to supervisors to delay the point of licence withdrawal would be strong. The central bank liquidity supply would likely be extremely concentrated to weak banks. The central bank’s risk taking would be enormous and would depend fully on how early the supervisor withdraws bank-ing licences. Eventually, the credibility of the currency will suffer under such an extreme approach.

Let R be the total risk taking of the cen-tral bank, as captured through some risk


measure such as expected loss, value-at-risk, or expected shortfall. In practice, the risk measure should contain market risk and credit risk.

Let M={M1,M2,…,Mn} be the array of parameters describing the liquidity supply and associated risk control framework of the central bank. Elements could be, for instance, as follows: • {M1} = Width of collateral set (assum-

ing that assets are ranked from the best suited to the least suited as collateral)

• {M2}, {M3}, {M4}= 1- haircuts on collat-eral of type 1, 2, 3

• {M5}, {M6}, {M7}= outright holdings of assets of type 1,2,3

• …• {Mn} = maturity spectrum of open-

market operationsThe elements of the array are defined

such that liquidity support and risk taking increase with the value of the respective parameter. Assume that before the crisis, the array of measures is M(0)={M1\

(0),M2(0),…,

Mn (0)}. Let the state of the financial system be

captured in a variable x. In fact, this variable could also be perceived as an array, contain-ing elements such as the functioning of the interbank market; the level of capital buffers of banks; the stability of funding sources, etc. For the sake of simplicity, we treat this as a single parameter in the presentation below and understand in the sense that the higher x, the more impaired in the financial system.

For each combination of measures M and for each crisis intensity x, L and R take certain values: R=R(M1,M2,…,Mn, x) with R increas-ing in each of the measures Mi and in x and L=L(M1,M2,…,Mn, x) with L increasing in

each of the measures Mi and decreasing in x.Moreover, policy makers have policy

preferences with regard to providing liquid-ity services and risk taking to the market. Assume that W( ) is total welfare, and at the same time the preference function of the central bankers. Then: W=W(R, L) with W( ) decreasing in R, and increasing in L. For every crisis, and for every intensity of the crisis, the optimal specification of the array {M1,M2,…,Mn}, will normally be different, and will also be different from the pre-crisis array. Denote by x0 the pre-crisis level of x, and by x1 its level in a certain crisis. Also denote with M* the array of measures that is optimal, given certain preferences of a central bank and for a specific value of the variable x.

The inertia principle could be interpreted in this setting as saying that M*(x0) = M*(x1). In practice, we however did not observe dur-ing the 2007-2009 crisis universal inertia, but changes in both directions. The optimality of a widening of the collateral set for instance would mean that for the relevant element i of the array M, Mi*(x0) < Mi*(x1) , i.e. the central bank would choose more “liberal” parameters of its liquidity provision meas-ures in the crisis. But one could observe also cases in which Mi*(x0) > Mi*(x1), i.e. in which restrictive measures were taken in the crisis. For instance, the ECB, within the current crisis, decided at some point in time (announced on September 4, 2008) that it would increase the haircut on a number of assets. Also, it announced on January 15, 2009 that it would no longer accept certain types of ABS (namely multiple-layer ABS).

The choice of M, R, L, W, can also be illus-trated in a possibility set/preference ordering framework. For every level of risk taking R,


one can achieve a maximum value of L by choosing rightly the values of the array M (and vice versa). Amongst all pairs on the efficient frontier, the pair chosen eventually will depend on the preferences of the cen-tral bank decision-makers, and will be the one where the possibility set is tangent to an indifference curve.

The outbreak and intensification of a crisis will always lead to an increase of risk- taking by the central bank. Writing R(M*(x1),x1) shortly as R*, this can be expressed as ∂R*/∂x > 0. Whether R(M*(x1),x1) > R(M*(x0),x1), i.e. whether the measures taken will increase or decrease total risk taking relative to inertia is less clear. For the liquidity of the banking system: ∂L*/∂x < 0, and again whether L(M*(x1),x1) > L(M*(x0),x1) is not totally clear. According to Buiter and Sibert (2007), these two

inequalities should certainly hold. In any case, it is important to note that the point (R(M*(x0),x1), L(M*(x0),x1)) will rarely be on the efficient frontier, i.e. not adjusting any measures, i.e. showing full inertia, will rarely be efficient.

This is further illustrated in the chart below. To simplify notation in the chart, we write (R(M*(x0),x1), L(M*(x0),x1)) as RL(M*(x0),x1).

The chart shows three possibilities in terms of where the (R,L) combinations could be in the case of the central bank remaining inert in a crisis. The three cases are different in terms of how R and L change when mov-ing through a change of M to the new opti-mum. In addition, it could in theory be that RL(M*(x0),x1) = RL(M*(x1),x1) , i.e. the case underlying the inertia principle. This is only a special case that has limited likelihood

R = Central bank risk taking

L =Fundingliquidity

of thebanking

system

Efficient frontier of(R,L) pairs for x0

Efficient frontier of(R,L) pairs for x1

RL(M*(x1), x0) - inertia -alternative possibilities

Central bankindifference curves

RL(M*(x0), x0)

RL(M*(x1), x1)

Figure 2: Liquidity support and central bank risk-taking: efficient frontier, central bank preferences, and optima in stable times and in a financial crisis.


and plausibility in practice. In developing further the outlined framework, two issues may be of particular interest: First, systemic issues were ignored in the simple exam-ples provided but are, of course, relevant in practice. The framework allows for easy inte-gration of more sophisticated models with systemic effects of the relationship between the central bank operations model for banks’ funding liquidity.

Second, the moral hazard dimension could be explored within this framework. The starting point of this could be the insight that central bank risk-taking and moral haz-ard are closely correlated in the sense that if central bank losses can be avoided, also no undesired re-allocation of resources towards excessive risk takers takes place. Hence, a conservative central bank risk management appears largely equivalent to addressing

moral hazard issues. Approaching the moral hazard problem from the risk management perspective has the general advantage that there are well-developed tools for measur-ing and managing financial risks, while such are absent for moral hazard. •

LiteratureBagehot, W. (1873) Lombard Street: A description of the money market. London: H.S. King.Brunnermeier, M, A. Crockett, C. Goodhart, A. D. Per-saud, H. Shin (2009), “The fundamental principles of financial regulation”, Geneva Reports on the World Economy 11, International Centre for Monetary and Banking Studies. Ewerhart and Tapking (2008), “Repo markets, coun-terparty risk, and the 2007/2008 liquidity crisis”, ECB Working Paper Series, No. 909, Frankfurt am Main. Goodhart, C.A.E. (1999), “Myths about the lender of last resort”, International Finance, 2: 339–60.


Economic capital

Housing, monetary and fiscal policies: from bad to worst

OCC chief economist, Stephan Schoess, argues that the current US federal economic

stimulus package is fatally flawed.

the past two years have been interest-ing. the current financial and economic crisis, unless superseded by an even big-ger crisis in the foreseeable future, will be discussed and analysed in detail by academics and political scientists over the coming years. Whether these analyses will come to definite conclusions about the cause for the crisis and the reason for the recovery, should there be a recovery, is questionable.

But how did the US get from what seemed like a stable economy to this crisis? In many ways, the current situation is the culmination of the mishandling of past cri-ses (the Asian crisis, Russian default, Long-Term Capital, Tech Bubble, etc) which were merely papered over rather than fundamen-tally solved. Instead of letting the forces of free markets sort things out, governmental authorities avoided in each instance the nec-essary short-term pain by applying surface patches on an otherwise unsustainable path of growth-at-all-costs, thereby laying the groundwork for the next, bigger crisis.

These pseudo-solutions accomplished

three things: First, lessons learned, if any, were ephemeral. Second, they revealed the extent to which any pain whatsoever, short-term or otherwise, is to be avoided. Third, and maybe most importantly, reac-tions of the authorities to systemic risks, as in the case of Long-Term Capital, gave the implicit guarantee that bigger financial insti-tutions have nothing to worry about. It was presumed, and in hindsight accurately, that should failure occur the rescue must follow.

The bursting of the Tech bubble in 2000 wiped out $7 trillion in market value. Since investments in the stock market are prima-rily equity financed, there was little or no spillover into the economy’s financial sector.

Fed funds rate slashedNevertheless, government “feared” a reces-sion, even more so after the 9/11 attacks, and pursued for the next three years “accom-modating” monetary and fiscal policies. The Federal Reserve began to slash the Fed funds rate from 6.5 per cent in January 2001 to 1.75 per cent by year end and then to one per cent in 2003. The Fed pursued this policy despite the fact that the US economy had officially


begun to recover in November 2001. It wasn’t until almost three years into the economic expansion that the Fed began to increase the Fed funds rate in baby steps – 25 basis points at a time – beginning in June 2004 from one per cent to 5.25 per cent in August 2006. It is during this time of monetary easing that the foundation for the next asset bubble – the housing bubble – occurred.

Great investmentLending borrowed capital, the essence of banking, is inherently risky. That risk is amplified when interest rates are very low. Because houses are bought on margin, low interest rates spur demand for houses. Due to the short-run constant housing stock, a surge in demand increases not only the building of additional homes, but also the prices of existing homes. When people saw house prices rising and were assured by officials and other “experts” that they would continue to rise because of favourable fun-damental conditions, Americans decided that houses were a great investment, and so demand and prices kept rising.

In fact, prices were rising because interest rates were low. When the Federal Reserve, fearing inflation – or perhaps another asset bubble – began raising interest rates in 2005, the bubble began leaking air and eventu-ally burst. It carried the banking industry down with it because banks were so heavily invested in financing, directly and indirectly, the housing market.

The effects of the housing boom and bust were amplified by numerous factors including the use of sub-prime mortgages, adjustable rate mortgages, and (ex-post) excessive risk-taking encouraged by the very

low interest rate environment. The housing boom allowed buyers to purchase homes with no down payment and homeowners to refinance their existing mortgages, extracting equity, often multiple times, thus maintain-ing highly levered positions. A consump-tion boom, not accompanied by industrial production and capital spending increases, followed. The increase in US consumption satisfied by imports, largely provided by China and other Asian countries, led to rising domestic industrial production, income and consumption in the exporting countries, and ultimately drove up the demand for energy and other commodities.

The world experienced, between 2001 and 2007, the greatest synchronised eco-nomic boom in the history of capitalism. One unique feature of this synchronised boom was that nearly all asset prices increased around the world: real estate, equities, com-modities, art, even fixed-income securities. It also invited additional marginal borrowers to enter the market.

Record profitsEveryone along the food chain stood to benefit from this process: home appraisers, mortgage originators, securitisation bankers, and rating agencies earned additional fee incomes. Government at federal, state and local levels received more tax revenues. And commercial and investment banks earned record profits on their trading and portfolio holdings during this time.

But all bubbles eventually burst. When housing prices started to stall and then decline, government’s housing policies designed to promote “the American dream” instead produced a pandemic nightmare.


Trillions of dollars in mortgages written to buyers with slender or no equity led to a wave of delinquencies and defaults. Since borrowers’ losses were limited to their small or nonexistent down payments, the lion’s share of losses was transmitted into the financial system whereupon it collapsed.

Tax advantagesToo much of the world’s savings went into housing. Such over-investment in housing would not have occurred under truly free-market conditions. In addition to artificially low interest rates provided by the Fed, sev-eral other factors contributed to the over-investment.

Home ownership is subsidised through at least two important tax advantages, which serve to understate the true cost of home ownership. First, interest payments on mort-gages and local real estate taxes are deduct-ible at the federal income tax level. Second, a home is the only asset with tax breaks for purposes of capital gains calculations.

Moreover, most local jurisdictions in the US require that home mortgages are in the form of non-recourse loans. This structure has important economic consequences. First, marginal home buyers might decide to enter the market especially if no, or minimal, down-payment is required, because they face no downside risk. Second, rational mortgage defaults are based on simple calculations of outstanding mortgages and home values, thus leading to more defaults.

Though the Community Reinvestment Act had been enacted in the 1970s, this piece of legislation was extended under the Clinton Administration and was pushed by both the Clinton and the Bush administrations. The

Act all but forces financial institutions to pro-vide mortgage loans to risky borrowers that otherwise would not be made.

Government has created this flawed framework within which individuals and firms will seek to maximise profits and all participants have responded to this frame-work in a completely rational way.

Individuals became home owners due to subsidies and little or no downside risk. They extracted home equity to fund other-wise unaffordable consumption purchases. Individuals indeed felt richer and behaved accordingly.

Financial institutions generated huge profits while providing funding for the hous-ing market. They participated in the process of slicing and dicing the pieces, repackag-ing them into asset-backed securities and selling them to investors around the world. This securitisation provided additional fee income and at the same time increased the availability of cheap funds for the next round of mortgages.

In agencies they trustedFinancial institutions also moved their fund-ing to the shorter end, willing to take liquid-ity risk. They either expected future lower rates or relied on the Fed’s willingness to provide liquidity and cut interest rates in case of a downturn in the housing market.

Investors participated in this process, chasing yield to increase their earnings on fixed-income investments if even by a few basis points. They “trusted” the stamp of “approval” given by the rating agencies. After all, these rating agencies, few in number, exist with an implicit government mandate.

All financial market participants probably


knew that, due to the positive correlation between return and risk, competition in the financial market will ultimately increase the risk. Rational firms will accept this higher risk and the risk of bankruptcy if profits are high. After all, if profits are high, the costs of reducing risk are, by definition, also high. And given limited liability, bankruptcy is not the end of the world.

Grotesque over-leveragingThings did not turn out as expected. The entire US financial system, particularly Congress-controlled Fanny Mae and Freddie Mac, were revealed to be grotesquely over-leveraged. Thus, problems at a few institu-tions spread rapidly to others. Such a wave of bank failures can bring down the entire financial sector and the real economy along with it. But the risk of that happening is exogenous to any single bank’s decision-making process.

Banks and other private financial insti-tutions are not responsible for assuring the stability of financial markets or of the econ-omy at large. This responsibility is, if at all, allocated to the Federal Government, more specifically to the Federal Reserve. The Fed should have been on guard for asset bub-bles, particularly with respect to the housing industry given the close and intricate con-nection between the housing market and the banking industry. The Fed failed miser-ably at this task. None of the other federal oversight agencies, including the Federal Government, did any better.

This is startling considering that the cri-sis is not unique in recent human history. The experience of Japan during the 1990s should at least have put federal agencies

and the government on notice to develop contingency plans. But lacking such plans, government’s responses to the developing crisis were at best ad hoc and at worst may actually have contributed to the depth and breadth of the current recession.

The costs to society for this crisis are indeed huge and include not only the reduc-tion in home values and other financial asset prices. It also includes the cost of the under-employment and misallocation of scarce productive resources, such as labour and machines. And inappropriate responses to the crisis by government could in the end dwarf all costs already incurred.

Money market interest rates rose dra-matically in August 2007. Diagnosing the reason for this sudden increase correctly was essential in determining what responses would be appropriate. If liquidity was the problem, then providing more liquidity by making borrowing easier at the Federal Reserve discount window would be appro-priate. But if counterparty and credit risk was behind the sudden rise in money-market interest rates, then a direct focus on the qual-ity and transparency of the banks’ and other financial institutions’ balance sheets would have been appropriate.

Wrong treatmentThe Federal Reserve and the Treasury mis-diagnosed the rise in spreads as one of liquidity, and, as a consequence, prescribed the wrong treatment. The Fed created the Term Auction Facility (TAF) in December to provide more liquidity to the market. But TAF did not seem to make much difference. If the reason for the increased spreads was counterparty and credit risk as distinct from


liquidity constraints, the results should not have been surprising.

Another policy response in February 2008 was the Economic Stimulus Act of 2008. The major component of the bill included a temporary tax rebate sending cash totalling over $100 billion to individuals and families. It was incorrectly anticipated that recipients of the cash would use the additional funds to spend and thus jump-start consumption and the economy.

Dollar depreciationA third policy response was the very sharp reduction in the federal funds rate from 5.25 per cent in August 2007 to two per cent in April 2008. The major consequence was a significant depreciation of the US dollar and a sharp increase in commodity prices, especially energy. Oil prices doubled to over $140 per barrel in July, before falling back down as expectations of world economic growth declined. But by then the damage of the high energy and commodity prices had been done to the real economies around the world.

The crisis suddenly worsened in September and October 2008. The credit crunch further weakened an economy already suffering from the lingering impact of oil price rises and the housing bust. On Friday following the Lehman failure, the US Treasury announced a new rescue pack-age. The $700 billion TARP was introduced on September 23. The draft legislation was exceedingly broad, devoid of detail, sug-gested no oversight and entailed practically no restrictions on the use of funds. The reac-tion by the public was decidedly negative. It became clear that government had no real

plan, though it claimed that passage of the bill was absolutely necessary or the economy would collapse.

Treasury’s first TARP iteration focused on buying “toxic” assets. This failed to materi-alise due to problems associated with pric-ing these assets. In the second iteration, TARP was to be used to boost banks’ bal-ance sheets. This did not work either, as the $45 billion invested in Citibank and Bank of America turned out to be insufficient. Next, Treasury decided instead to extend loan guarantees of $306 and $118 billion, respec-tively, to the two institutions.

The latest initiative, TARP 2.0, renamed the Financial Stability Plan, tries to entice private capital, in partnership with an ever-shifting government, to buy the toxic assets in an effort to set a price. So far, little has been accomplished and the ultimate verdict of success or failure of TARP is still out.

Bill goes unreadThe second stimulus programme of $800 billion signed by the current administration dwarfed the previous stimulus. The bill was pushed through Congress without anyone reading the 1,000 plus pages. The adminis-tration claimed that refusing to pass the bill was no option. According to its claim, the already existing structural deficit of $1.2 tril-lion would lead to disaster, but an additional $800 billion would either create or save 3.5 million jobs and would lead the US out of the recession.

After having purchased commercial papers, government securities and mort-gage-backed securities in unprecedented amounts, the FOMC in March 2009 announced it would purchase up to $300


billion in long- term government bonds, with the intent of lowering mortgage rates and other rates on consumer debt. It also declared its intention to increase its pur-chases of mortgage-backed securities guar-anteed by Fannie Mae and Freddie Mac by $750 billion.

The above is an incomplete list of gov-ernmental reactions. The interventions range from Treasury’s $60 billion Student Loan purchases to the granting of a $500 billion line of credit to the FDIC; from FDIC’s $1.4 trillion liquidity guarantees to its $126 bil-lion bailout for GE; from the Fed’s $1.8 tril-lion commercial paper funding to its $900 billion Term Auction Facility, HUD’s $300 billion Hope for Homeowners (the plan to prevent home foreclosures), and the Cash for Clunkers programme.

Policy evaluationAfter two years in a state of perpetual crisis and $14-plus trillion in government spend-ing, bailouts, guarantees and commitments, what has actually been accomplished? Do implemented policies move the US back onto a long-term, sustainable path? Do imple-mented policies make any economic, i.e. common sense? Has anyone learned from past bubbles or is the government repeating the same mistakes?

The current US situation is often com-pared to Japan’s housing bubble some 20 years ago. Undoubtedly the US has a more dynamic and flexible economic system, ena-bling, therefore, a faster and more efficient recovery. But Japan entered the crisis as a creditor nation with huge current account surpluses, a relatively small financial sec-tor, a household sector sitting on trillions in

savings and during a time when the rest of the world was growing and able to pick up the slack.

Deeper in debtYet despite Japan’s huge advantages, its willingness to spend itself out of the reces-sion, its attempt to prop up failing compa-nies, its propensity to intervene everywhere at any time and its zero-per cent monetary policy, the results have been dismal. Japan’s public sector is now the most indebted in the developed world. Japan’s results can be interpreted in two ways.

One school holds that Japan just did not act “swift and bold” enough. The other argues that government spending drains resources from productive sectors to less productive ones. As a consequence, gov-ernment can only make things worse, as it appears to have done in Japan. So what is the likely outcome for the US?

• The Real Estate Market – Prices for real estate have continued their downward trend despite efforts to the contrary. Since far more homes are on the market for sale at current prices than there are buyers, the rational approach would have been to let home prices decline until equilibrium is reached. Instead, US governmental agencies try to avoid this pain at any and all costs.

The Fed initiated in November 2008 a programme to buy up to $500 billion in mortgage-backed securities and up to $100 billion in GSE debt in a bid to lower mort-gage lending rates to around five per cent, a historic low. It is not clear how more easy money and housing incentives can cure the affliction of over-investment in housing caused by easy money.


None of the preferential tax subsidies have been eliminated. To the contrary, a new one was added by the Obama administra-tion. “First-time” home buyers now receive a tax credit of up to $8,000 for buying a home.

The stimulus bill also includes many “refinancing” subsidies and incentives for current home owners whose home values are “under water”. But the results are not encouraging. A large portion of loans modi-fied under these programmes goes into delinquency within a few months.

Loose mortgage underwriting led to the multi-trillion dollar sub-prime lending debacle. Now a parallel sub-prime mar-ket has emerged, all made possible by the Federal Housing Authority (FHA), which now insures nearly one in three new mort-gages, up from two per cent in 2006.

Fiscal policiesMany of these mortgages have low or no down payment requirements, high risk bor-rowers, and in many cases shady mortgage originators. Using a leverage of almost 40:1, the FHA is almost certainly going to need a taxpayer bailout in the months ahead. The days of home buying with little or no money down are back – now directly subsidised and insured by the government.

It appears that all elements that went into the making of this crisis remain. Moral haz-ard has increased, additional subsidies have even been added and policies that interfere in the free interplay of supply and demand have been strengthened. Nobody can accuse the US government of not using “swift and bold” spending programmes to support the declining real economy. By the end of this fiscal year, US deficit spending will approach

15 per cent of GDP. Though the government claims a multiplier of 1.5, empirical studies come to the conclusion that deficit spending multipliers are significantly below a single-digit multiplier and actually turn negative down the road.

No free lunchesThere are no free lunches with regard to spending, whether public or private. Any increased government debt must be repaid eventually by higher taxes, which are a dis-incentive to productivity and investment. This higher tax burden will mitigate any short-term stimulus from its long-run effects on the economy provided by the spending programme.

In reality, jobs created by government are generally unprofitable in the sense that they use up more resources than they produce. If the opposite were true, profit-seeking pri-vate firms would have already funded these activities. In this way, government spending tends to drain the private sector of produc-tive resources while subsidising unprofitable enterprises, projects and ideas. After having wrongly allocated trillions into the hous-ing sector, more misallocation of precious resources is the worst possible outcome.

Given the precarious longer-term finan-cial position of the federal government due to built-in structural deficits, unfunded Social Security and Medicare liabilities of over $100 trillion, and ambitious new social programmes on its plate, it is more than questionable whether the previous and the current stimulus bills were prudent. Few seem to ask how these massive deficits will be financed. Since almost all governments around the world enacted some form of


“stimulus” programme, global savings might not be sufficient to finance these massive undertakings. The gap between demand for and supply of funds might lead to signifi-cantly higher interest rates which in turn will hamper any recovery, to the crowding out of the private sector thus further diverting pro-ductive resources to unproductive projects, or to inflation if the debt is monetised.

Most economists agree that the Fed’s easy monetary policy following the dotcom bubble led directly to and fuelled the housing bubble. To mitigate the effects of the current recession, the Fed lowered the federal funds rate to the zero to 25 basis point range, added more than $1 trillion to the monetary base, and decided, among other things, to directly intervene in the mortgage-backed security, commercial paper, GSE debt and Treasuries markets. Moreover, the Fed involved itself in rescue operations for banks, insurances and other firms through direct asset purchases and/or the granting of guarantees.

Over-leveraged societyThe Fed’s actions are designed to prop up home prices and to encourage more bor-rowing by an already overleveraged society. Its latest adventure – the purchase of long-term government securities – potentially signals to the market that the Fed stands ready to monetise a substantial part of the additional public debt. Overall, the Fed has gone deeper and further than ever before in its history. These interventions are not any longer just acts of monetary policy – they cross the line into fiscal policy and direct credit allocation. But the real test for the Fed will come when the economy begins to turn around in earnest. There are essentially two

questions: First, will the Fed still have the independence and the political will to raise interest rates early and fast enough? and, second, how does the Fed expect to reduce the monetary base? Since a large portion of its balance sheet contains assets of dubi-ous quality, who will be willing to buy such assets, how quickly, and at what prices?

ConclusionsThe US has been living beyond its means for years. It has financed its excess consumption by borrowing from abroad. The last thing this over-stimulated economy needs is more stimuli. What the economy needs is a true market driven restructuring, in which bubble activities shrink and resources are re-allo-cated into lines of production that conform to what consumers want and can afford.

Instead, the opposite is being done and a great opportunity is being missed. The private sector should be increased at the expense of the public sector. Inefficient and badly-run firms should die rather than be kept alive with trillions in subsidies. Moral hazard should be decreased rather than increased. More transparency is needed, not less. Households should be encouraged to deleverage rather than be enticed to bor-row and spend. Losses should be privatised rather than socialised.

The policies will create huge costs that must be shouldered by a decreasing portion of the still-productive private sector. Worse, the seeds for the next crisis have been sown. And the next crisis might make the current one look like child’s play. But then again, the US just might be able to muddle through. After all, was it not in January this year that the country entered the “Age of Hope.” •


Insurance

Derivatives: from disaster to re-regulation

UCLA’s Professor Lynn A. Stout discusses why derivatives re-regulation will avert a

CDS crisis of epic proportions.

When credit markets froze up in the autumn of 2008, many economists pro-nounced the crisis both inexplicable and unforeseeable. that’s because they were economists, not lawyers.

Lawyers who specialise in financial reg-ulation, and especially the small cadre who specialises in derivatives regulation, under-stood what went wrong. In fact, some even predicted it. [1] That is because the roots of the catastrophe lay not in changes in the markets, but changes in the law. Perhaps the most important of those changes was the US Congress’ decision to deregulate finan-cial derivatives with the Commodity Futures Modernisation Act (CFMA) of 2000.

It was the deregulation of financial derivatives that brought the banking system to its knees. The leading cause of the credit crisis was widespread uncertainty over insur-ance giant AIG’s losses speculating in credit default swaps (CDS), a kind of derivative bet that particular issuers won’t default on their bond obligations. Because AIG was part of an enormous and poorly-understood web of CDS bets and counter-bets among the

world’s largest banks, investment funds and insurance companies, when AIG collapsed, many of these firms worried they too might soon be bankrupt. Only a massive US$180 billion government-funded bailout of AIG prevented the system from imploding. This could have been avoided if we had not deregulated financial derivatives.

Derivatives ‘de’-regulation?Wait a minute … some readers might say: What do you mean, ‘de’-regulated deriva-tives? Aren’t derivatives new financial prod-ucts that have never been regulated?

Well, no. Derivatives have a long history that offers four basic lessons. First, derivatives contracts have been used for centuries, pos-sibly millennia. Second, healthy economies regulate derivatives markets. Third, deriva-tives are regulated because while derivatives can be useful for hedging, they are also ideal instruments for speculation. Derivatives speculation in turn is linked with a variety of economic ills – including increased systemic risk when derivatives speculators go bust. Fourth, derivatives traditionally are regulated not through heavy-handed bans on trading,


but through common-law contract rules that protect and enforce derivatives that are used for hedging purposes, while declaring purely speculative derivative contracts to be legally unenforceable wagers.

A brief history of derivatives …Finance economists and Wall Street traders like to surround derivatives with confusing jargon. Nevertheless, the idea behind a deriv-ative contract is quite simple. Derivatives are not really “products” and they are not really “traded.” They are simple bets on the future – nothing less and nothing more. Just as you might bet on which horse you expect to win a horse race and call your betting ticket your “derivative contract”, you can bet on whether interest rates on bank deposits will rise or fall by entering an interest rate swap contract, or bet on whether a bond issuer will repay its bonds by entering a credit default swap contract.

These sorts of commercial wagers are neither new nor particularly innovative. Although derivatives have gone by many different names, derivatives contracts have been around for centuries. (Readers may read the 1884 US Supreme Court case of Irwin vs. Williar, [2] which demonstrates both that derivatives trading was common in the 19th century – although derivatives were then called “difference contracts” – and that derivatives were subject even then to regula-tion.) Originally, most commercial derivatives were bets on the future prices of agricultural commodities, like the rice derivatives traded in Japan in the 15th century or the corn and wheat futures still traded on the Chicago Mercantile Exchange today. To use the lan-guage of derivatives traders, the “underlying”

– that is, the thing being bet upon – was the future market price of rice, wheat or corn.

The first “financial” derivatives, in the form of stock options, became common in the 1800s. The 1990s saw an explosion in other types of derivatives contracts, including bets on interest rates (interest rate swaps), credit ratings (credit default swaps), and even weather derivatives. By 2008, the notional value of the derivatives market – that is, the size of the outstanding bets as measured by the value of the things being bet upon – was estimated at $600 trillion, [3] amounting to about $100,000 in derivative bets for every man, woman and child on the planet.

This sudden development of an enor-mous market in financial derivative con-tracts was not the result of some new idea or “innovation.” Rather, it was a consequence of the steady deregulation of financial deriv-atives trading.

… and of derivatives regulationJust as derivatives have been around for cen-turies, so has derivatives regulation. In the US and UK, derivatives were regulated pri-marily by a common-law rule known as the “rule against difference contracts.”

The rule against difference contracts did not stop you from wagering on anything you liked: sporting contests, wheat prices, inter-est rates. But if you wanted to go to a court to have your wager enforced, you had to demonstrate to a judge’s satisfaction that at least one of the parties to the wager had a real economic interest in the underlying and was using the derivative contract to hedge against a risk to that interest.

Because, of course, wagers can be used to hedge against risk. For example, if you


own a corporate bond and you are worried the issuer might default, you can reduce your risk by entering a CDS contract, essentially betting against the issuer’s creditworthiness.

Derivatives versus speculationIf the bond decreases in value, the CDS will increase in value. Similarly, if you own a $500,000 home, you can hedge against the risk your home will burn down by making a bet with an insurance company that will pay off $500,000 if the home actually burns. (Most of us call these wagers “homeowner’s insurance,” although a typical Wall Street derivatives dealer might label them “home value swaps.”) Using derivatives this way is truly hedging, and it serves a useful social purpose by reducing risk.

But as judges have recognised for cen-turies, at least until recently, derivative bets are also ideally suited for pure speculation. Speculation is the attempt to profit not from producing something, or even from provid-ing investment funds to someone else who is producing something, but from predicting the future better than others predict it. [4] A spec-ulator might, for example, try to make money predicting wildfires by buying home insur-ance on houses in Southern California with-out actually buying the houses themselves.

Similarly, a speculator might hope to make money betting on a company’s for-tunes by buying CDS on the company’s bonds without buying the bonds themselves. Unlike hedging, which reduces risk, specula-tion increases a speculator’s risk in much the same way that betting at the track increases a gambler’s risk. Highly speculative markets are also historically associated with asset price bubbles, reduced returns, price manipulation

schemes and other economic ills. Common-law judges accordingly viewed derivatives speculation with suspicion. Under the rule against difference contracts and its sister doctrine in insurance law (the requirement of “insurable interest”), derivative con-tracts that couldn’t be proved to hedge an economic interest in the underlying were deemed nothing more than legally unen-forceable wagers.

This didn’t mean derivatives couldn’t be used to speculate. But the rule against dif-ference contracts forced speculators to think about how they could make sure their fellow gamblers paid their bets. The answer was for the speculators to set up private exchanges with membership requirements, margin requirements, netting requirements, and a host of other rules designed to make sure that, despite the legal invalidity of specula-tive derivatives contracts, speculating trad-ers would make good on their contract promises. In the process, the exchanges kept derivatives speculation in check and under controlled conditions.

CFTC and SEC involvementEventually, the control was increased when government regulators like the Commodities Futures Trading Commission (CFTC) and Securities Exchange Commission (SEC) were empowered to oversee trading on particular exchanges. Meanwhile, off the exchanges, the rule against difference con-tracts kept “over the counter” speculation in derivatives in check.

At least, it kept speculation in check until the rule was dismantled. The dismantling process began when the United Kingdom passed its Financial Services Act of 1986,


“modernising” the UK’s financial laws by eliminating the old rule against difference contracts and making all financial deriva-tives, whether used for hedging or for specu-lation, legally enforceable.

US regulators, worried that Wall Street banks might lose out on a lucrative new market, followed suit in the 1990s by creat-ing ad hoc regulatory exemptions for par-ticular types of financial derivatives such as currency forward contracts and interest rate swaps. Soon the US also embraced whole-sale deregulation with the passage of the CFMA in 2000. The CFMA not only declared financial derivatives exempt from CFTC or SEC oversight, it also declared all financial derivatives legally enforceable.

The CFMA thus eliminated, in one fell swoop, a legal constraint on derivatives spec-ulation that dated back not just decades, but centuries. It was this change in the law – not some flash of genius on Wall Street – that cre-ated today’s $600 trillion financial derivatives market. So why re-regulate derivatives?

Speculation and systemic riskThe results have proven unfortunate, to say the least. Yet it is surprising the unregulated over-the-counter derivatives market didn’t go sour even sooner. Even before AIG, deriv-atives speculation had already led to the col-lapse of Barings Bank in 1995; the failure of hedge fund Long Term Capital Management (LTCM) in 1998; the Enron bankruptcy in 2001; and the collapse of investment bank Bear Stearns in 2008, a few months before AIG’s fall.

These examples show why it is essen-tial for policy-makers thinking about how derivatives affect risk in the marketplace to

distinguish, as the common law did, between using derivative contracts to hedge and using them for speculation. Hedging provides a social benefit by reducing the hedging party’s risk. But when speculators use derivatives to try to profit from predicting future events, they increase their risk, just as gamblers increase their risk by betting. Unchecked derivatives speculation thus adds risk to the system by making it possible for individual speculators, like AIG (and Barings and LTCM and Enron and Bear Stearns) to lose very large amounts of money very unexpectedly.

Hedging deceptionBut wait … some readers might say. Couldn’t AIG have been an unusual case, a “rogue” insurance company that succumbed to speculative fever? Isn’t it possible that most financial derivatives users wisely confine their derivatives deals to true hedging?

Given the stigma attached to specula-tion, it’s not surprising that most parties to derivatives contracts claim, at least in public, that they use derivatives for hedging and not for speculation. In some cases this seems a rather transparent attempt at deception. (Hedge funds, for example, should really call themselves “speculation funds”, as it is quite clear they are using derivatives to try to reap profits at the other traders’ expense.)

Perhaps more often, derivatives traders incorrectly describe themselves as “hedging” when they use derivatives to offset some of the risk associated with taking a speculative position. This is much the same as a racetrack gambler claiming she is “hedging” because, in addition to betting on a particular horse to win, she also buys a betting ticket for the horse to show (place).


Yet the data suggests that speculation, not hedging, drives over-the-counter finan-cial derivatives markets. For example, we know the CDS market was dominated by speculation in 2008. We know this because by year-end, the notional value of the CDS market had reached $67 trillion. [5] At the same time, the total market value of all the underlying bonds issued by US companies outstanding was only $15 trillion. [6] When the notional value of a derivatives market is more than four times larger than the market for the underlying, it is a mathematical cer-tainty that most derivatives trading is specu-lation, not hedging. And business history, including very recent history, shows deriva-tives speculation increases systemic risk.

It is possible, of course, that deriva-tives speculators provide other benefits to the market that offset the social cost of this increased systemic risk. Although from a social perspective speculation is a zero-sum game – one trader’s gains necessarily come at another trader’s expense, just as gamblers can only make money by taking money away from other gamblers – economists some-times claim speculators add useful liquidity to markets and that speculation can improve the accuracy of market prices.

Huge social costsThe derivatives industry routinely repeats this mantra. Yet there is virtually no empirical evi-dence to establish the value of the supposed liquidity and “price discovery” benefits from derivatives speculation, much less evidence that shows the value of those benefits exceeds the enormous social costs of derivatives spec-ulation. (Recall that US taxpayers have spent nearly $180 billion on the AIG bailout alone.)

Although few observers appreciated it at the time, the CFMA’s deregulation of finan-cial derivatives was a novel legislative experi-ment. It was almost as if the US Congress said to itself, “let’s see what happens if we suddenly removed centuries of law!” Now we know what happens. The experiment has not turned out well.

What to do?The answer seems obvious: go back to what worked so well, for so long, before. The old common-law rule against difference con-tracts was a simple, elegant legal sieve that separated useful hedging contracts from purely speculative wagers, protecting the first and declining to enforce the second. This no-cost, hands-off system of “regulation” (there is no cheaper form of government interven-tion than refusing to intervene at all, even to enforce a deal) did not stop speculators from using derivatives.

But it did require speculators to be much more careful about their counter-parties and to develop private enforcement mech-anisms such as organised exchanges that kept speculation confined to an environ-ment where traders were well-capitalised and knew who was trading what, with whom and when. This approach kept runa-way speculation from adding intolerable risk to the financial system. And it didn’t cost a penny of taxpayer money.

During the roaring 1990s, when financial derivatives were being widely applauded as risk-reducing, highly-effi-cient (and, for Wall Street, highly profit-able) financial “innovations,” the old rule against difference contracts had little appeal. Maybe it has more now. •


References1. See, e.g, Rick Schmitt, Prophet and Loss, Stan-ford Magazine March/April 2009 40-47 (describ-ing efforts of CFTC Chair Brooksley Born to warn about and regulate financial derivatives in the late 1990s); Lynn A. Stout, Betting the Bank: How Derivatives Trading Under Condi-tions of Uncertainty Can Increase Risks and Erode Returns in Financial Markets, 21 J. Corp. L. 53 (1995); Lynn A. Stout, Why The Law Hates Speculators: Regulation and Private Ordering in the Market for OTC Derivatives, 48; Duke L. J. 701, 769-771 (1999) (arguing that deregulating financial derivatives might increase market risk, erode returns and lead to price distortions and market bubbles).2. 110 US 449 (1884)

3. Barrett Sheridan, The $600 Trillion Deriva-tives Market, Newsweek, October 27, 2008 http://www.newsweek.com/id/164591.4. See Lynn A. Stout, Irrational Expectations, 3 Legal Theory 227 (1997) (discussing theories of speculation).5. Bank for International Settlements, Quar-terly Review Statistical Annex at A103 Table 19 [Amounts Outstanding of Over-The-Counter (OTC) Derivatives] (December 2008).6. Id. at A97, Table 16B (about Domestic Debt Securities).

(Editor’s note: The IRRNA wishes to thank FinReg21 for kindly allowing the Journal to reproduce this article by Professor Stout. See: www.finreg21.com).


Behavioural risk

Black swans, market crises and risk: the human perspective

Senior investment strategist Joseph Rizzi examines how innate psychological traits

contributed to the financial meltdown.

We have passed the first anniversary of the 2008 market meltdown. looking back, the question is what, if anything, have we learnt, especially concern-ing risk management? Many are busy rounding up the usual suspects includ-ing deregulation, flawed incentives and ‘Black swans’.

The question is, especially as it pertains to risk management, if the crisis was so obvi-ous after the fact, why did so many experts fail for so long to see it beforehand? A plau-sible explanation is they were unable to imagine the crisis due to behavioural blink-ers. Success seems to breed disregard for the possibility of failure. Most individuals have a model of how the world works. When chal-lenged by events, we try to explain them away. Although we know how risk decisions should be made, less is known about how these decisions are actually made.

Behavioural economics provides insight into risk-assessment errors and possible remedies. This article outlines and applies a behavioural risk framework to address judgment bias and develop appropriate

responses. Behavioural economics rec-ognises that decision processes influence perception and shape our behaviour. The framework supplements current quantitative risk management by improving responses to risk over time.

Risk is exposure to the consequences of unknown events. Risk can be classified along two dimensions. The first concerns high-frequency events with relatively clear cause-effect relationships, such as missing your connecting flight. Other risks such as health problems occur infrequently. Consequently, the cause-effect relationship is unclear. The second dimension is impact severity. No matter how remote, high-impact events can-not be ignored because they can threaten an institution’s existence, as was demonstrated in the market crisis.

‘Fat-tailed’ loss distributionsMany financial risks, such as option selling, are low-frequency, high-impact events char-acterised by their “fat-tailed” loss distribu-tions. Investors incurring such risk can expect mainly small positive events but are subject to a few cases of extreme loss. These risks are


difficult to understand and even more diffi-cult to predict. First, there is insufficient data to determine meaningful probability distribu-tions. In this case, the statistics are descriptive, not predictive. Consequently, no amount of mathematics can tease out certainty from uncertainty. Second, and perhaps more importantly, infrequency clouds perception. Risk estimates become anchored on recent events. Overemphasis on recent events can also produce an under-appreciation of risk during a bull market as instruments are priced without regard to the possibility of a crash. These facts lead to risk mis-pricing and the procyclical nature of risk appetite.

Structural breaksBehavioural finance examines how risk managers gather, interpret and process information. Specifically, it concentrates on perception and cognitive bias. It recognises that models can influence behaviour and shape decisions. These biases can corrupt the decision process, leading to suboptimal results as emotions override self-control.

Overconfidence occurs when we exag-gerate our predictive skills and ignore the impact of chance or outside circumstances. Overconfidence is usually reflected by a belief that past trends continue. Unfortunately, structural breaks in historical patterns can and do occur. Risk managers took credit for results during the boom while failing to con-sider the impact of randomness and mean reversion, thus creating an illusion of control. Compounding this is their selective recall of confirming information to overestimate their ability to predict the correct outcome, which inhibits learning. Disappointments and surprise are characteristics of processes

subject to overconfidence. Industry and product experts are especially prone to overconfidence based on knowledge and control illusions. Knowledge is frequently confused with familiarity. This is reflected in the number of industry experts including, most famously, the former Federal Reserve Chairman Alan Greenspan who missed the collapse of the housing and structured credit bottom. Their past experiences and ana-lytical framework act as blinkers. Thus they overlook emerging issues that they could not even have imagined.

Control reflects the unfounded belief in our ability to influence or structure around risk. Risk is accepted because we believe we can escape its consequences due to our abil-ity to control it. Examples include the per-ceived ability to distribute or hedge risk. Risk transfer, however, does not eliminate risk. Furthermore, it interjects counterparty risk. It is similar to buying flight insurance from another passenger on the same plane.

Cost versus gainIn the event of an improbable, but still pos-sible high impact event, such as a plane crash or a market crisis, correlations go to one. This was illustrated by the problems faced by many hedged institutions that had AIG as their counterparty.

This reflects an optimistic underesti-mate of costs while overestimating gains. Optimism is heightened by anchoring when disproportionate weight is given to the first information received. These time-delayed consequences magnify overconfidence as individuals weigh short-term performance at a higher level than longer-term conse-quences. Statistical bias involves confusing


beliefs for probability and skill for chance by selecting evidence in accordance with our expectations. Economics is a social science based on human behaviour. Prices are not determined by random number machines. Rather, they come from trades by real peo-ple. Thus, history is not data and the future is not output.

Hidden risksStatistically based risk management practices are inherently limited. They are unable to reflect the hidden risk that market conditions may change. Formerly diversified positions begin moving together triggering unexpected losses. The changes are unexpected because such movements are unfamiliar. We tend to view the unfamiliar as improbable and the improbable is frequently ignored.

Another statistical error prevalent dur-ing boom is extrapolation bias. This occurs when current events or trends are assumed to continue into the foreseeable future inde-pendent of historical experience, sample size or mean reversion. Undoubtedly, this resulted in many of the projections underly-ing structured credit models. Naive reliance on extrapolation leads to disaster.

Since the subjective probability of an event depends on recent experience, expec-tations of low-frequency events, such as a market or firm collapse, are very small. These types of events are ignored or deemed impossible, particularly when recent occur-rences are lacking. This causes a false sense of security as risk is underestimated, or assumed away, and capital is mis-allocated. Unlikely events are neither impossible nor remote. In fact, unlikely events are likely to occur because there are so many unlikely

events that can occur. Thus, the longer the time period, the higher the likelihood of a ‘Black Swan’ event occurring.

There are also social aspects to decision making when individuals are influenced by the decisions of others as reflected in herd-ing. Herding occurs when a group of individ-uals mimic the decisions of others. Through herding, individuals avoid falling behind and looking back if they pursue an alternative action. It is based on the social pressure to conform and reflects safety by hiding in the crowd. In doing so, you can blame any failing on the collective action and maintain your reputation and job. Even though you recog-nise market risk, it pays to follow the crowd. This is referred to as a positive feedback loop or momentum investing, which can produce short-term self-fulfilling prophecies.

Herding amplifies credit cycle effects as decisions become more uniform. The cycle begins with a credit expansion leading to an asset price increase. Investors rush in to avoid being left behind using rising asset values to support even more credit. This explains why bankers continued risky practices even though they feared this was unsustainable and leading to a crisis.

‘Group think’Eventually, an event occurs, such as a move by the central bank, which triggers an asset price decline. This causes losses, a decline in credit, and an exit of investors, which strains market liquidity and leads to further price declines. These declines will continue until the negative feedback loop runs its course. “Group think’’, or organisational pressure, enhances cognitive biases. It occurs when individuals identify


with the organisation and uncritically accept its actions. Once the commitment is made, inconsistent information is suppressed. Thus mutually reinforcing individual biases and unrealistic views are validated.

Experts are prone to group think. They tend to limit information from all but other expert sources. Thus, they repeat statements until they become accepted dogma, regard-less of their validity, due to a lack of critical thinking. The subprime collapse illustrates this fact. The industry participants used the same consultants and models for their pro-jections. The consultants based their reports and recommendations on the surveys of industry participants. Once the perception of a bull market took hold it was reinforced and accepted uncritically. When the crash occurred, the experts were taken by surprise by a supposed “perfect storm”.

Dancing to the musicThis is illustrated in a June, 2006 Business Week cover story which surveyed risk offic-ers at numerous institutions, including Bear Stearns and Lehman. They believed that despite the risks taken, they were safer than ever. This belief was based on complex risk models and market diversification. The faith in risk management encouraged institutions to increase their risk exposures believing they were under control.

During a late stage boom with high sen-timent levels, behavioural risk factors domi-nate and quantitative risk measures will be unreliable. This is reflected in Charles Prince’s famous comment: “As long as the music is playing, you have to get up and dance.” This is characterised as “irrational exuber-ance” where prices are driven principally by

momentum and herding reflected in high liquidity levels. Also, bank managers are products of their experience. For most, their experiences were limited to bull markets. Thus, they could not imagine an end to the favourable market conditions.

The market crisis of 2009? The setting: A declining economy and falling markets triggered aggressive Federal Reserve interest rate cutting and liquidity injections in 2001 to 2002. Liquidity-driven technicals improved, resulting in falling risk premiums increasing credit asset prices.

A credit bubble formed as liquidity-driven technical’s surpassed fundamentals. Momentum traders, who trade based on price changes, dominated the market. This evolved into simple “trend chasing” late in the cycle. This was reflected in historically low credit-risk spreads in the real estate, leveraged buyout and structured credit mar-kets. Spread narrowing and a flattening yield curve reduced the attractiveness of the tradi-tional carry trade, putting pressure on insti-tutional accrual and trading budgets.

In their search for yield, institutions adopted a procyclical, asset-heavy strategy. This involved short-funded leveraged invest-ments in higher-risk assets for the institu-tion’s own account instead of distribution. The strategy is reflected in principal finance, mer-chant banking, bridge loans and warehousing activities. This caused a major credit boom. Such cycles, while predictable, are difficult to manage for several reasons. First, financial institution compensation is tied to peer group comparisons. Thus, firms and individuals not following their peers suffer. Next, organi-sations frequently discourage pessimism.


Therefore, conservative risk managers and bankers are pressured to become optimistic or leave. Finally, institutions fear losing “star” bankers if their risk activities are curtailed.

Frequently, positive short-term results mask long-term risks. Seemingly high returns can reflect the subjective probability of an event that has not occurred in the time period studied. Investing in such instruments is profitable most of the time. Eventually, a “beyond the data” event occurs. Individuals, institutions and regulators succumbed to a bias of assuming the absence of evidence-implied evidence of risk absence.

The concerns: The appropriateness of the asset heavy portfolio strategy depends on several factors. Pricing and trading disci-pline is needed to ensure an adequate risk premium is earned. Maintaining discipline, however, becomes increasingly difficult as the cycle continues.

Increased bonusesNext, the strategy involves incurring increased systematic or beta risk expo-sure versus value-adding alpha returns. Structured products are less liquid than mar-ket investments. Consequently the return on structured products reflects compensa-tion for liquidity risk. This risk was poorly reflected in risk management models. The liquidity premium was mischaracterised as alpha, leading to increased bonuses.

Institutions were investing in assets with the wrong distributions for leveraged finan-cials. Essentially, they were selling unhedged out-of-money puts on an extreme event such as a market crisis. Valuing these risk posi-tions requires reflecting the value of options not purchased to hedge the positions. Failure

to do so overstates the profitability of these assets.

Unfortunately, firms continued to underestimate the likelihood and impact of unlikely events. Widespread credit risk under-pricing existed due to an emphasis on nominal returns. This suggests a correction when investor emphasis shifts from return on capital to return of capital.

Low risk sensitivityIt is difficult to price rationally when risk seems remote, and hard to measure when conditions seem favourable. The last market correction occurred more than three years ago and was largely forgotten by the first half of 2007. Thus risk sensitivity diminished. This recognition problem is rooted in the complex nature of financial risk.

Reinforcement: The complexity of low frequency, high-impact risk is compounded by institutional factors such as budgets and compensation systems that reinforce the behavioural bias effect. These systems favour “consistent” earnings and misread low-fre-quency/high-impact risk “profitability.”

Risk models also contribute to the problem by presenting the illusion of safety and control, which leads to over-optimism. Consequently, models underestimated low frequency, high-impact cyclical risk. The underlying exposure builds during a bull market as apparent risk declines, while the losses materialise in the bear market cycle. This anomaly is due to social and psychological biases resulting in bounded rationality. Ignoring these facts sub-stitutes an inaccurate normative model for the real world. The “black box” models became “black holes” that engulfed many institutions.

The objective is to supplement existing


quantitative risk management with behav-ioural finance developments. In so doing, it can reduce future losses during the credit cycle as risk management evolves to a more balanced system incorporating human behaviour. This requires taking low-prob-ability, worst-case scenarios seriously, and developing appropriate responses. The proc-ess is similar to earthquake engineering, which does not attempt to predict a shock. Rather, the focus is on constructing a struc-ture to withstand a certain shock level.

Decision-making involves identify-ing alternatives, obtaining information and applying our preferences. Decisions become at risk when facing uncertainty and bias, and are amplified by institutional factors. This framework is illustrated in Figure 1 (below).

We will now turn to the implications of DAR for risk management. Risk man-agement has become a procedural ritual anchored in an almost religious reliance on quantitative models. The elaborate risk models bred a false confidence by ignor-ing the human element in markets. Shifting sentiment, extreme reactions and herding based on overconfidence and the illusion of control led to self-deception and unpleasant

surprises. Markets are social and not physical phenomena. A shift in thinking about risk is needed. See Figure 2 (opposite page).

We must be prepared for the conse-quences of an event regardless of its proba-bility in this new and unstable environment. This means recognising human propensity to underestimate the probabilities of catas-trophes. Most institutions and managers are unable to resist the temptation to grow through opaque risk escalation.

This is especially true as the memories of the last disaster fade. Controlling this prob-lem requires adapting a precautionary “fire-code” approach, which limits the propensity of markets and institutions to self-destruct. This establishes before-the-fact safety codes regarding exposures and capital in individual institutions. Equally, regulatory firewalls are needed to limit the spread of problems in complex tightly coupled market networks. These “fire codes” can be developed by Boards of Directors. Their cost, however, will proba-bly require some regulatory encouragement.

ConclusionMarkets are recovering. While no two cycles are identical, we must resist the temptation

DAR

Uncertainty Beyond the Data EventsInformation Asymmetry

Opaqueness

BiasOver-ConfidenceIllusion of Control

Optimism

AmplifiersIncentives

BureaucracyRegulation

Figure 1. Decisions At Risk (DAR)


to say: “This time it is different.” The deeper we are into illiquid credits, products and structures, the more difficult it becomes to manage risk. The key is to recognise that risk is managed by people, not math-ematical models. The focus should be on the consequences of exposures regardless of probability. This requires understand-ing the portfolio impact of an event, not its prediction. Recognising the difficulty in maintaining discipline, a precautionary fire code approach imposed by directors and regulators is needed to prevent the self-destructive behaviour that so surprised Alan Greenspan.

Organisational obstacles inhibit appro-priate responses to high-impact, low-prob-ability risks. Chief among the obstacles are short-term compensation systems which reinforce behavioural biases. This leads to a potentially fatal neglect of the longer-term build of risk. As Robert Merton noted: “The amount of risk we take personally, individu-ally, or collectively is not a physical given constant. We choose it. Behavioural finances offers a means to choose wisely as it affects both individual decision-making and mar-ket efficiency. You ignore behavioural risk at your own peril.•

References1. Danielsson, J; “The Emperor Has No Clothes:

Limits to Risk Modelling”, Journal of Banking and Finance, 2002

2. Thorton, D. Henry and A. Carter, 2006, “Inside Wall Street’s Culture at Risk,” Business Week (June 12).

3. Nakamotos, M. and Wighton, P., “Bullish Citigroup Is Still Dancing to the Beat of the Buy-out Room”, Financial Times, July 10, 2007

4. Scholes, M., “Crisis and Risk Management”, AEA Papers and Proceedings, May, 2000.

5. Then President of New York Federal Reserve, T. Geithner, as quoted in the Financial Times, May 12, 2005.

6. Bernstein, P., “The New Religion of Risk Manage-ment”, Harvard Business Review (March-April, 1996).

7. Mcloskey, D.N. and Zilink, S., The Cult of Statisti-cal Significance, (Ann Arbor, Michigan, University of Michigan Press, 2009).

8. Perrow, C., The Next Catastrophe (Princeton, NJ: Princeton University Press) 2007.

9. Greenspan, A., Testimony before the House Committee on Oversight and Reform, Congres-sional Hearing, October 23, 2008.

10. Merton, R.C., interview by N. Nickerson, 2008. “On the Markets and Complexity”, Technology Review (April 3, 2008).

Figure 2. Risk paradigm shifts needed

Pre September 14, 2008 ParadigmGaussian distributions

Frictionless MarketsComplete InformationRational Participants

RiskStable Systems and External ShocksIndividuals as Primary participants

Profit Maximizing Self InterestEquilibrium

Post September 14, 2008 ParadigmFat Tails and Path Dependency

Arbitrage LimitsAsymmetric Information

Biased ParticipantsUncertainty

Internally Unstable SystemsInstitutions as Primary Participants

Principal Agent ConflictCreative Destruction


Risk management

Measuring & managing risk for innovative financial instruments

The University of Houston’s Dr Stuart M. Turnbull highlights complex issues

surrounding financial products.

in the current credit crisis, the issues of improper valuation and inadequate risk management in the use of credit deriva-tives have been at the centre of the credit market turmoil. the crisis raises the questions of how do we measure the risk of innovative financial products and how do we manage the risk?

Innovative financial instruments are typically illiquid and pose several challenges for their valuation and the measurement and management of the risks associated with them. Measuring risk at some specified time horizon requires the ability to price different assets in future states and to compute differ-ent risk measures. Managing risk requires the means to alter a risk profile, either via the use of hedging instruments, or through contractual mechanisms such as master agreements, or institutional such as clearing houses. This paper, which addresses some of the many issues that arise when a new form of financial instrument is introduced, is an abridged version of Turnbull (2009).

To be concrete, we consider a particular example of an innovation. However, we stress

that the focus is on general issues that arise and the analysis is applicable for any form of instrument. Given that credit derivatives have been the catalyst for the credit crisis, we consider the issues that arise in the pricing of credit derivatives written on a portfolio of obligor related assets. For example, the port-folio could be residential mortgages, credit cards, bonds or derivatives. Each asset will generate a cash flow provided that default does not occur. The event of default will gen-erate a terminal payment. The focus of this paper will be on the general issues that arise and not on minute contract details.

The issuesWe start in section two with issues relat-ing to pricing. The design characteristics of an instrument that affect both the demand side and the supply side are discussed in section three. In section four we discuss the factors that influence the level of liquidity. Counterparty risk affects all contracts and with an innovation there are additional dif-ficulties. We discuss these issues in section five. Risk management requires the abil-ity to generate the probability distribution


describing the value of a portfolio of assets at some future specified horizon. For an inno-vation there is usually limited data, which restricts the complexity of models and implies that model testing will be difficult. There are also managerial issues that can impact the risk management function. Risk management issues are discussed in section six. We address issues relating to the use of credit ratings in section seven. The last sec-tion summarises the conclusions.

PricingAt the centre of the credit crisis has been the issue of how to price different types of collat-eralised debt obligation (CDO). Here we con-sider some general form of CDO structure and identify some of the different issues that must be addressed both for pricing and hedging. For a CDO there are two ways to tackle the issue of pricing: a bottom-up approach and a top-down approach. A bottom-up approach starts by modelling the event of default and the loss given default for the individual assets in the collateral pool of the CDO. [1] The use of any form of realistic model requires the esti-mation of model parameters, implying that there is a trade-off between the complexity of the model and the availability of data.

Bottom-up approachWhile the bottom-up approach is a logi-cal starting point, for some types of assets the approach is infeasible, as either the data requirements become overwhelming or the underlying assets too complex. This neces-sitates taking a top-down approach.

To price the tranches of a CDO requires modelling the cash flow generated by the assets in the collateral pool. In a bottom-up

approach, for each asset in the collateral pool, the process describing the event of default and the loss given default must be estimated. To model the cash flow generated by the assets in the collateral pool necessitates considering how the event of default by one asset will affect the remaining assets. A popular approach is to use a copula function. A copula function knits together the marginal distribution functions to give the joint distribution. [2] The basic model used for pricing and risk management has been the normal copula. The normal copula requires specifying the marginal distributions describing the probability of default for each obligor and a correlation matrix. The critical issue for modelling default dependence is the specification of this correlation matrix. In the Merton (1974) model, it is the correlation of asset returns.

Top-down approachRecovery rates vary with the state of the economy: if the state of the economy is declining and the frequency of defaults increasing, recovery rates decrease. This affects the loss distribution, as default prob-abilities and recovery rates are negatively correlated: Consequently, it is necessary to jointly model the probability of default and the loss given default. [3]

A top-down approach directly models the cash flows generated by the portfolio of assets in the collateral pool without explicit identification of individual assets, thus reduc-ing the magnitude of the problems associated with parameter estimation in the bottom-up approach. The typical formulation assumes that there are a number of different types of events that cause a loss to occur. Each time an event occurs, the portfolio suffers a loss, the


size of the loss depending on the type of event. With this approach the number of parameters that must be estimated is greatly reduced. For example, in Longstaff and Rajan (2008) there are three types of events: The interpretation of these events being that one type of event models default by individual obligors; the sec-ond event sector or group defaults; and the third event economy-wide defaults.

Implications for innovationsIn the simplest form of the model there are six parameters to estimate: three jump sizes and three volatilities. The benefit of this par-simony is that models can usually be cali-brated, while the cost is that the model may do a poor job in describing the dynamics of the prices of different structures over time.

For new financial products there is a real trade-off between the complexity of models and the availability of data. The critical issue is that of modelling default dependence. The copula approach is simple, though static. The use of the normal copula is perhaps the least demanding in terms of the number of parameters that must be estimated. For risk management, a credit rating transition matrix is used and a multifactor equity return model to generate the correlation matrix.

For pricing, credit default swap prices are used to infer the intensity for each obli-gor. It is usually assumed the recovery rate is some fixed known value. Often equity returns are used to generate the correlation matrix, though there is little theoretical justi-fication. Alternatively, the correlation matrix is assumed to be described by one param-eter that is calibrated so that the model price matches the price of one tranche, usually the equity tranche. In practice, for pricing both the

bottom-up and top-down approaches rely on calibration. The limitation of this approach is that model imperfections and the lack of liquidity of prices are compounded into the calibrated parameters. In some cases a model is calibrated to match the prices of tranches on an index, where the asset pool is different from the assets in the pool of the CDO under con-sideration, making parameter calibration even more unreliable. This difficulty arises because of the lack of data for the new product.

The design of an instrument defines its risk sharing characteristics and appeal to different clienteles of potential users. [4] To stimulate usage, the design should attempt to anticipate features that will appeal to end-users. On the demand side it should help to reduce the costs of achieving some service, such as altering the risk profile facing an investor. On the supply side, it should be designed to reduce the costs associated with hedging, for example by meshing with the features of extant instruments that can be used for hedging. The design of the innova-tion directly affects its risk characteristics.

Risk characteristicsTo identify the risk characteristics of a new instrument requires identifying the condi-tions under which different features of an instrument affect its risk profile. Certain design features may make an instrument extremely sensitive to underlying factors and market disruptions. For example, the design of subprime collateralised debt obligation (CDO) tranches can make the tranches quite sensitive to the state of the housing market. This was one of the reasons for the contagion in the recent credit crisis. This design char-acteristic was completely missed by all the


players: rating agencies, regulators, financial institutions and investors. [5]

Special investment vehicles invested in long-term assets and financed their pur-chase by issuing asset-backed commercial paper (ABCP). With the fall in house prices and increased uncertainty about the value of the underlying collateral, vehicles had to reduce the amount of ABCP, forcing them to sell assets in order to meet claims. The uncer-tainty about collateral valuation increased and investors eventually refused to purchase new ABCP.

The rating agencies had anticipated mar-ket disruptions and insisted on vehicles hav-ing multiple backstop lines of credit. What they had not anticipated was the effects of “wrong way” feedback. The valuation of the collateral became increasing difficult as the value of the vehicles’ assets (mostly illiquid assets) declined. This triggered the selling of illiquid assets, causing further price declines and eventually the closing of these markets.

LiquidityWith any new innovation there will initially be limited liquidity. Liquidity for an innovation depends on many factors, such as the ability to grow both the supply and demand, the ease of pricing the innovation, the transparency of the pricing process, the existence of hedging tools and the costs associated with hedging. [6] The ability to hedge and speculate makes an instrument attractive to a wide range of investors. [7] An innovation will attract certain types of investors on the demand and supply sides and the actions of these different groups affect the level and the stability of liquidity in the market. The level of liquidity will depend on the state of the sector and economy. If

macro shocks to the economy or to a sector adversely affect investors’ confidence, causing investors to exit positions, this will decrease the level of liquidity.

EducationWith the launching of a new innovation comes the need to build both supply and demand by educating potential users about the usefulness of an innovation, its risk-return characteristics and identifying any accounting or regulatory issues that might impede adoption. The range of possible uses will affect the size of both the supply and demand and thus the size of the group of investors willing to trade the instrument and thus its liquidity.

The complexity of an innovation also affects its appeal to different clienteles and the amount of education required to reach end users. A credit default swap is a simple contract to shift credit risk, while a collater-alised debt obligation (CDO) is a complex product. The complexity of this class of instruments limits its appeal (at least in the ideal world [8]) to investors with the ability to analyse the risk profile and to understand the frailty of the underlying assumptions. [9]

Ease of pricingInvestor’s inability to analyse and price a new product is directly affected by the nature of the assets underlying the product, the complexity of the design and the availability of data. If it is relatively easy to determine the price, this aids investor misunderstanding of the role different factors have upon price and helps to increase their confidence in the model prices and hence liquidity. The struc-ture of an innovation plays an important role


in the ease of pricing. If the reference portfo-lio is complex and the structure of the inno-vation complex, as is the case for CDOs, then this greatly increases the data requirements and analytic skills needed to understand the complexity of the structure. Difficulty to readily analyse such structures increases the uncertainty about the valuation and decreases the liquidity of the bonds.

New financial instruments trade in the over-the-counter market. Buyers and sell-ers must contact dealers to obtain bid/ask quotes and judge the depth of the market. The ability of investors to see posted bid/ask quotes on a regular basis via a third party screen helps to improve transparency of the pricing process, especially for less sophisti-cated investors. It also provides information about the depth of the market. If a contract can become standardised, this increases the level of transparency. The ability to standard-ise, however, depends on the complexity of the contract.

Counterparty riskCounterparty risk is the risk that a party to a contract might fail to perform, when called upon to honour its contractual com-mitments. It exposes the other party to the contract to a mark-to-market risk.[10] Steps to mitigate counterparty risk span a wide spectrum, from limiting total expo-sure to individual counterparties, exposure to particular sectors, master contract agree-ments that facilitate netting, “haircuts” in pricing, posting of collateral and payment in advance. Some of these approaches are model independent. Limiting the total exposure to a particular obligor requires information systems that can keep track

of the total exposure to a particular obligor. This may be difficult for structured products, where the same obligor can appear in many different tranches.

Implications for an innovationFor a new innovation the difficulty of esti-mating the effects of counterparty risk are compounded due to the limited data and liquidity. First, there is limited information available to help in specifying the joint dis-tribution describing the occurrence of the risk event for the counterparty and the ref-erence asset. Second, for a new product, the financial institutions offering the product need to develop the necessary back-office facilities to keep track of the counterparties associate with the product. Third, the finan-cial institution needs to carefully consider whether there is “wrong-way” dependence. The posting of collateral provides protection if the value of the collateral is not positively dependent on the same factors that affect the counterparty.

The posting of additional collateral may further weaken the creditworthiness of the counterparty.[11] It is important to recognise ex ante this form of “wrong way” depend-ence. Another issue is whether the collateral is traded in a liquid market. If not, then ques-tions about the valuation of the collateral can arise, especially if there is wrong-way dependence.

To risk manage a new financial inno-vation necessitates identifying the differ-ent dimensions of risk associated with the innovation. Apart from the traditional list of issues, there are many additional dimen-sions to risk that are difficult to quantify. We call these additional elements “dark risk”.


For example, what is the best way to address the estimation of model parameters in a non-stationary environment, given limited data? How does the complexity of an instru-ment and parameter uncertainty affect the pricing and risk management?[12] There are managerial considerations, such as account-ing system for an innovation and the ability of senior management to understand the innovation.

Any form of model should be tested for accuracy. If a model’s parameters are calibrated so that the model matches existing prices on a particular day, as is standard practice, the issue is whether the model is useful for hedging. Many models can match price though they do a poor job hedging, implying that they are mis-specified and of limited value for risk management. With limited data and possibly illiquid prices, model testing is problematic.

Unintended consequencesThe introduction of a new innovation may generate a series of unintended conse-quences. For example, the introduction of subprime mortgage-backed CDOs was ini-tially profitable for the issuers. This created a demand for these types of mortgages. To ensure an adequate supply, originators low-ered their underwriting standards, as they were rewarded on the basis of volume and shifted the risk of mortgage defaults to the arrangers – the issuers of the CDOs).[13] This lowering of underwriting standards increased the probability of default for the mortgages contained in mortgaged backed bonds. However, the data used to model the risk of the CDOs was from a prior period and did not reflect the changing conditions.[14]

A risk manager needs to look not just

an innovation in isolation, but the incen-tives facing different players that contribute to the innovation and the consequences of the incentives. The risk manager also needs to recognise that holding different examples of an innovation may result in a concentra-tion of risk.

Accounting incentivesFor example, holding different types of mort-gage backed CDOs, may result in a concen-tration of risk if the same bond appears in different CDOs. Standard and Poor’s reports that just 35 different borrowers appear in nearly half of the 184 collateralised loan obliga-tions that it rates. [15] The risk manager needs the ability to identify the underlying assets in an innovation. This means that the data about the underlying assets must be available.

When an innovation is introduced, often an existing accounting framework for another security is adopted to account for trades in the innovation. Traders would be familiar with the characteristics of the existing accounting scheme and “fit” the new product into the existing framework. Traders’ incentives are inherently short-term in nature, given the typical way of determin-ing bonuses that concentrate on the profits generated over the accounting year.

They have incentives to engage in trading activities that generate profits over the short run at the expense of long-term profits. The challenge for risk managers is to understand the incentives generated by the accounting system and the types of trades that it encour-ages traders to undertake. Risk managers must try to distinguish between trades that generate short run profits and those that are in the best interest of the firm. Risk managers


face another obstacle, that of ignorance on the part of senior management.

When an innovation is introduced, sen-ior management may not understand the nature of the innovation, its risk character-istics and how the accounting treatment fits the innovation and the incentives generated by the accounting system. They often refuse to acknowledge their ignorance and rely on the traders and their quants to characterise the profitability and risk.[16]

However, the incentives of the trad-ing desk are usually not aligned with those of senior management. Traders are rewarded on the basis of the profitability of their desk over the accounting year, while senior management are rewarded on the basis of their business. Risk man-agers are unlikely to receive support if senior management is ignorant and do not understand the issues, relying on the traders and quants for guidance.[17]

Mark-to-modelIn recording the value of an illiquid asset, a model price is usually used. For an innova-tion, the operational risks are greater than those associated with a seasoned product. The list of potential areas of risk is long and includes such issues as the accounting incen-tives generated by the accounting system, model risk, complexity risk (the more com-plex a product the greater the risk of pricing and trading errors), settlement risk and legal risk.[18]

To determine the value of an innovation these operational costs should be included. For certain types of instruments a credit rat-ing is often a prerequisite in order to increase the marketability of the innovation. For risk

managers and investors not involved in the discussion between the issuer and the rating agency, the methodology used to determine a rating is not transparent. However, trans-parency is necessary in order to understand how a rating is defined, the methodology and the type of data used.

Understanding a credit ratingThe first requirement is to understand what criteria a rating agency is using as a measure of credit worthiness. A rating scheme is an ordinal ranking: an instrument with a triple A rating has in some sense less credit risk than an instrument with a double A rating. [19] A rating may be either an assessment of a probability of a defined event occurring or the expected loss if the defined event occurs. The second requirement is to understand the methodology.

Knowledge about the methodol-ogy allows the identification of the model assumptions and the opportunity to exam-ine their robustness. However, the ability to test or judge robustness requires knowl-edge about the market. This may be miss-ing for new innovations, implying that risk managers will have to rely on professional judgment.

The third requirement is to know the type of data employed when determining a rating and whether there is sufficient data to test the robustness of assumptions. In the recent credit crisis the rating agencies accepted the data from the originators, without doing any form of checking about whether distribu-tional assumptions had changed.

The fourth requirement is to consider whether conflicts of interest that rating agencies face have affected their objectivity,


especially as rating agencies have little legal exposure given their use of a First Amendment defence – see Coffee (2008). [20] For innova-tions, there is often limited data availability and the rating methodology is untested. For risk managers and investors the challenge is to interpret what information a rating actually conveys about an innovation given the tenta-tive nature of the methodology.

ConclusionsIn this paper we have discussed some of the diverse challenges of measuring and manag-ing risk of innovative financial products. The list of the different dimensions of risk that an innovation introduces is long: model restric-tions, illiquidity, limited ability to test models, design characteristics, counterparty risk and related managerial issues. Given the uncer-tainty about model valuation and estimated risk metrics, how can risk managers respond? Stress testing a model of unknown validity may generate a false sense of security.

For scenario analysis to be useful, risk managers need to understand the different factors that affect the product. This requires the ability to think outside the confines of their limited pricing models, something that was missing in the current credit crisis. The use of credit ratings for an innovation is problematic. All parties within a com-pany – senior management, traders and risk managers – have important roles to play in assessing, measuring and managing risk of new products. The company’s directors also have a responsibility to ensure that these duties are being fulfilled. •

Notes1. The precise nature of the assets we leave unspeci-

fied. Examples of possible candidates would be mortgages, asset backed securities or credit default swaps on asset-backed securities.

2. For an introduction to the use of copula functions applied to finance, see Schönbucher (2003, ch. 10) and O’Kane (2008, ch. 14).

3. Dullmann and Trapp (2004) test a number of differ-ent latent factor models.

4. There is a large amount of literature about security design, see Allen and Gale (1995).

5. A more detailed explanation is given in Crouhy et al (2008).

6. The interaction between market and funding liquidity is discussed in Brunnermeier and Peder-sen (2009).

7. In the current credit crisis, some commentators have recommended that the purchase of credit default swaps be restricted to investors who own the underlying asset. This would greatly reduce the liquidity of the CDS market.

8. From the credit crisis, it is clear that many investors failed to understand the instruments’ risk charac-teristics.

9. The complexity issue is discussed in Rowe (2005).10. Consider the case of a credit default swap where

there is the risk that the protection seller might default and for simplicity we assume there is no risk that the protection will default. If the protection seller defaults before the reference obligor, then to restore the protection buyer to the position prior to default necessitates pricing a swap with the same premium.

If the credit worthiness of the reference obligor has deteriorated, then the value of the swap to the protection buyer would be positive, implying a mark-to-market loss. If the reference obligor defaults and the protection seller defaults prior to settlement, the protection buyer is exposed to the full loss from the reference obligor. See Turnbull (2005) and Pykhtin (2005).


11. In the current credit crisis, concern has been expressed about the consequences of AIG being downgraded and whether it had the ability to post collateral arising from all the contracts it had writ-ten.

12. Some of the issues are discussed by Rowe (2009).13. For a more detailed analysis of the associated

incentives, see Crouhy, Jarrow and Turnbull (2008).14. The rating agencies had a policy of accepting data

from originators without any auditing to check the reliability of their assumptions about the default date.

15. See Sakoul (2009).16. Arrogance and ignorance were the prime drivers

behind the collapse of Barings Bank in 1995. See the Report of the Board of Banking Supervision.

17. The role of risk managers versus traders is dis-cussed in Blankfein (2009).

18. For a new innovation it is necessary to establish the legal identity of the counterparty and to know the judicial system governing any disputes with the contract. Different legal systems may accord differ-ent treatments for the contract. A good introduc-tion to operational risk is given in Crouhy, Galai and Mark (2001, chapter 13).

19. The ordinal nature of rankings means that they cannot be compared across different types of instruments, such as corporate versus municipal bonds.

20. The rating of credit structures has been a very profitable business for the rating agencies. Moody’s reported in 2006 that 43 per cent of total revenues came from rating structured products.

ReferencesAllen, F. and D. Gale. Financial Innovation and Risk Shar-ing, 2nd Edition, M.I.T. Press, Cambridge, Mass.Blankfein, L. (February 8, 2009). “Do not destroy the essential catalyst of risk”, Financial Times (London).Brunnermeier, M.K., and L.H. Pedersen (2009). Market

liquidity and funding liquidity”, Review of Financial Stud-ies, 22, 6, 2201-2238.Coffee, J.C. (April 22, 2008). “Turmoil in the US credit markets: the role of the credit rating agencies”, Tes-timony before the United States Senate Committee on Banking, Housing and Urban Affairs.Crouhy, M.D. Galai and R. Mark (2001). Risk Manage-ment, McGraw Hill, New York.Crouhy, M.G., R. Jarrow and S.M. Turnbull (Fall 2008). insights and analysis of current events: the subprime credit crisis of 2007, Journal of Derivatives, 16, 1, 81-110.Dullmann, K.&M. Trapp (2004). “Systematic risk in recovery rates – an empirical analysis of US corporate credit exposure”. WP Deutsche Bunderbank, Frank-furt. Gagliardini, P. and C. Gourieroux (August 2003). “Spread term structure and default correlation”, W.P. Lugano and University of Toronto.Longstaff, F.A. and A. Rajan (2008). “An empirical analysis of the pricing of collateralised debt obligations”, Journal of Finance, 63, 2, 529-563.Merton, R.C. (1974). “On the pricing of corporate debt: the risk structure of interest rates”, Journal of Finance, 29, 449-470.O’Kane, D. (2008). Modelling Single Name and Multi-name Credit Derivatives, Wiley, New Jersey.Pykhtin, M. (2005). Counterparty Credit Risk Model-ling, Risk Book, London. 12Report of the Board of Banking Supervision, Inquiry into the

Circumstances of the Collapse of Barings (1995), BoE.Rowe,

D. (2005). “The danger of complexity”, Risk, 18, 4 (April), 91.

Rowe, D. (2009). “Second-order uncertainty”, Risk, 22, 4

(April), 85.

Sakoul, A. (February 16, 2009). “S&P sees new systemic risk in

CLO defaults”, Financial Times (London).

Schönbucher, P. J. (2003). Credit Derivatives Pricing Model,

Wiley, New Jersey.

Turnbull, S. M. (2005). “The pricing implications of counter-

party risk for non-linear credit products”, Journal of Credit Risk,

1, 4, 3-30.

H O W WA S H I N GT O N FA I L E D A M E R I C A

W I L L I A M M . I SA AC with P H I L I P C . M E Y E R

SENSELESS PANIC

F O R E W O R D B Y P A U L V O L C K E R


Macroeconomics

Red star spangled banner: root causes of the financial crisis

Andreas Kern and Christian Fahrholz draw inspiration from the economics model

devised by Heckscher-Ohlin-Samuelson.

in this short note we inquire into the root causes of the present financial cri-sis by drawing on a heckscher-ohlin-samuelson (hos) model. at the origin of the current crisis are global imbalances originating from distorted relative prices in real production. thus financial repres-sion in countries seeking to suppress real appreciation has resulted in exces-sive labour-intensive production and a global capital shortage. seemingly, some rather controlled economies have bent the tune of real and particularly financial globalisation, thus producing the rather awkward anthem ‘red star spangled Banner’. Crisis remedies, hence, have to rely on revamping the team play in finan-cial globalisation affairs.

We argue that in particular a low level of financial development and subsequent polit-ically induced financial repression in emerg-ing market economies has put the chains on relative prices and real exchange rates respectively, supporting macroeconomic stability and spurring economic growth in the short-term not only within emerging

economies, but also in mature economies (cf. Rodrik 2008, Eichengreen 2007).

Consequently, rather controlled econo-mies have concentrated on exporting labour-intensive production, which in the presence of command economy style distortions has been reflected in a remarkable savings glut.

Distorted competition To cope with distorted competition in inter-national production – due to the suppressed upward pressures in real wages abroad – few options exist for more mature economies: possible reactions of rather flexible market economies comprise of lowering real wages and/or pushing ahead with the marginal product of other factors, such as capital including financial services or land.

As depressing real and correspondingly nominal wages considerably is not a viable option for rather flexible market economies, subsequently, practicing a laissez-faire stance towards financial markets, an increase in the marginal product of capital and excess lend-ing has been the natural outcome of dis-torted international competition. According to our line of argument, suppressing real


appreciation in rapidly growing economies results in the production of high net saving surpluses, i.e. an export of real appreciation pressures and severe global imbalances, which are at the heart of the present financial crisis. In the following sections, we present an overview of how we formalised our argu-ment based on comparative statics referring to a HOS- model.

Real interest rateIn doing so, we assume the representative economy to produce two goods with known characteristics, i.e. one good is labour-intensive in production and the other one capital-intensive, while technologies and preferences in the two countries are identi-cal. After the Stolper-Samuelson proposition given a specific relative factor price, a rise in the real interest rate can be traced back to a decline in relative good prices in terms of a labour-intensive good. This is to say that a corresponding reduction in the produced amount of capital-intensive goods relative to labour-intensive goods may be due to a change in factor prices, i.e. the real interest rate.

An according change in the rental rate on capital shifts the economy towards labour-intensive goods production. Therefore, there is a drop in relative deployment of capital per labour. For the sake of simplicity and tak-ing the Walras’ Law into consideration, we model the market distortion as a minimum rental rate on capital assets, which can be interpreted as financial repression with the aim of preventing real appreciation. In line with the Lerner symmetry, a wage rate policy including a far too low real wage rate would yield the same result.

As a result of the Stolper-Samuelson Effect, an artificially high minimum rental rate on capital assets leads to higher rela-tive good prices in terms of labour-intensive good production. Hence, we reach a new equilibrium with less capital-intensive pro-duction in order to compensate the high level of financial returns. Accordingly, capital that would have been employed in produc-tion in the case of no financial repression must be off-set in terms of ‘stalled invest-ments’, labelled as. This is to say that some portion of capital has been squeezed out of economic production relative to original fac-tor endowments.

A flexible interest rate will always ensure that capital will, at all times, be fully employed. However, adding politically induced market distortions to the capital market with a bind-ing minimum on the rental rate of capital, a market clearing via the price mechanism could potentially not occur. By the same token, such financial repression does not allow for re-investment within the domestic economy but results in an export of savings/investments.

Balance-of-paymentsIn order to show that a savings glut results from financial repression and leads to a cor-responding drop in capital intensity, we have to take a look towards balance-of-payment issues. Although such an approach presents an ex post view on the international flow of real quantities and according claims and liabilities, a closer look at the balance-of-payments prepares the ground for the sub-sequent analysis of ‘excess savings’ from the viewpoint of international trade.

The following equations link financial


repression and its resulting de-capitalisation, which must be equivalent to “excess savings” in the related country.

The subsequent equations in (4) highlight the fact that capital and finan-cial accounts, i.e. investments abroad and changes in the reserve level(If-dR) balance the current account (X-M). The latter trade balance must then be identical to the level of “fundamental savings’’, which are not invested in the domestic economy, plus the ‘excess savings’ due to the de-capitalisation in the course of financial repression in terms of “stalled investments”.

Simple linkThe basic link between financial repression and excess savings is rather simple: For com-petitive firms to access financial funds on capital markets at the higher interest rate, they need to sell off their products at least at the higher relative price. When finan-cial repression puts a binding constraint on firms, the goods price will only be attained if the relative scarcity of capital increases. This will apply only if a sufficiently large share of capital is unemployed in production.

We now consider the world economy consisting of two countries with free trade and zero transaction costs. The mature coun-try (A), representing the group of flexible market economies, has completely liberal-ised financial markets, in which the interest on capital assets is determined freely by mar-ket forces. The representative real apprecia-tion controlling economy (C) has imposed some form of financial market repression to support their economic development strat-egies, leading to an upward bended mini-mum real interest rate, though still in line

with competitive cost conditions. Let a bar of the variable represent the level of that vari-able in the integrated equilibrium. Let index represent goods and index countries A and C. The set of divisions of world endowment among involved countries in line with the integrated equilibrium concept can thus be described in the form of factor price equali-sation (FPE) set:

If the integrated equilibrium is to be rep-licated, the global savings glut must be at the same level as in the integrated economy. But ‘excess savings’ do not arise in liberalised financial markets in country A. However, the real appreciation controlling country C must build up ‘excess savings’ (equivalent to some form of de-investments ) in order to comply with the higher interest rate.

Beyond this, we only need to satisfy the conventional restrictions in terms of employed factors. These require that both countries use the integrated equilibrium techniques, and that the integrated equilib-rium output in both sectors can be divided among the countries. In a stable equilibrium, demand will exactly exhaust employed fac-tors in the two countries, which exist in the overall reduced ratio of capital per labour.

New equilibriumUnder the conditions noted above, interna-tional trade equalises factor prices between the financially liberalised economy A and the financially repressed economy C. The according distortion in relative factor prices resulting from financial repression shifts the economy to a new equilibrium. Here capital intensity in the production of the labour-intensive good has decreased. At the same time, capital intensity in the capital-intensive


production within country A has increased. In the face of a global market, free com-modity trade fully equalises factor prices and thus exports warped relative prices from real appreciation controllers to flexible economies.

Now we have to demonstrate how economic integration in the form of trading between a mature, flexible market economy A and a non-mature, real appreciation con-trolling economy C are impacting on both economies. In particular, we are interested in investigating how financial repression in one country affects the production in the other country.

In the HOS-model framework it is par-ticularly the Rybcsynski theorem that deals with the effects of endowment changes. With one factor price fixed, i.e. financial repression and an upward bent rental rate for capital, our result is just the Rybcsynski theorem in reverse. When we look at country C with financial repression and an upward bent rental rate for capital, not trading with country A the warped relative price leads to a change in production. The decreasing pro-duction of the capital-intensive good reflects the expansion of savings, exactly necessary to eliminate the excess demand for capital-intensive goods (i.e. investments).

‘Stalled investments’In our stylised framework, the country C’s opening of trade with country A would even further increase country C’s “excess sav-ings” in terms of “stalled investments” and the ruled-out demand for capital-intensive goods in country C respectively. The rea-son is that country C would be quasi forced to generate the full integrated amount of

savings to sustain a higher interest rate for both economies. In country A, the absence of financial repression results in a relatively lower but ‘natural’ (Wicksell) interest rate.

However, once trade commenced, the flexible market economy of country A comes to share country C’s high real interest rate. The fact that country A shares the high inter-est rate under trade follows from the fact that trade links goods prices, while both countries remain diversified, meaning that producers still face competitive cost conditions.

Economic bubbleIn effect, trade forces country C to bear the burden of “excess savings” to maintain coun-try C’s comparative advantage and hinder a real appreciation. But, forcing capital markets in country A to increase capital rental rates implies that opening to free trade will lead to a deviation of the capital rental rate from its economic fundamental value. This would lead to an over-utilisation of capital and increasing capital intensity in country A’s economy. Accordingly, an economic bub-ble emerges at the heart of country A, which cannot be detected by simply looking at iso-lated country-specific fundamentals.

‘Excess savings’ of country C are indeed exported to the flexible market economy in country A. The previously outlined balance-of-payments arithmetic has already shown that real appreciation controlling is achieved by a contraction of capital-intensive good production in terms of ‘stalled investments’, fuelling the current account surplus of coun-try C.

However, such balance-of-payment matters only depict the ex post view on eco-nomic formation. We have now to set forth,


how distorted relative factor and good prices affect the formation of import-export rela-tions ex ante. Regarding import demand and export supply between country A and C fills this niche and buttresses the results gained thus far.

As we have already argued, a surge in relative price levels results in an increased production of labour-intensive goods and a contraction of capital-intensive production respectively. Accordingly, we may now argue that the upward bended relative price cor-responds to country C’s real exchange rate and inversely affects its terms of trade. This is to say that country C improves its terms of trade with the help of financial repression.

As indicated in the FPE set, resulting ‘excess savings’ in country C are transferred in terms of an export supply of labour-intensive goods. At the same time, country A heavily borrows from country C and absorbs these ‘excess savings’, which, in turn, allows for spurring capital-intensive production in country A. From the viewpoint of country C, this is simply an export of its real appreciation pressure towards country A via its down-ward bended terms of trade. Interestingly, it is the labour force in country C that bears the burden of internal economic adjustment to suppressed real appreciation.

Conclusions and outlookAs we argued in the beginning, financial crisis stems from distortions in global real production. To put it bluntly, real under-valuation in context of financially, and thus real exchange-rate-suppressed economies, is one of the primary causes of the current international financial crisis. In contrast to conventional monetary approaches, we have

set forth an analytical framework of interna-tional trade economics in order to investigate the root causes of recent financial turmoil in a broader context.

We demonstrate how economic dynam-ics in an asymmetric global financial inte-gration process have contributed to fuelling international liquidity and thus contributed to an expansion of financial markets in mature, flexible market economies beyond their fundamental economic capacity. In this regard, our central assumption has been that financial repression has been applied in non-mature economies in order to prevent real appreciation pressures, as well as to sta-bilise economic growth processes in these economies.

Push factorHowever, these policy measures have worked as a push factor and a driving force behind international capital flows to mature financial markets. For this reason, we argue that latter non-mature economies are the ‘producers’ of the global savings glut, which, in turn allows for capital intensification in the sector of capital-intensive production in mature and thus financially developed and liberalised economies. At the same time, the according absorption of international liquidity also reflects global asset shortages (Caballero et al. 2008) as depicted in the fall of global capital intensity in the integrated world equilibrium.

Furthermore, the combination of both the saving glut and a lack of appropriate financial market regulation has been fuel-ling consumption and production in these mature economies beyond their fundamen-tal capacities. From this perspective standard


approaches and measures applied in assess-ing financial and macroeconomic vulner-abilities must have failed to show signs of overexpansion and misalignments.

In fact, a large current account defi-cit in combination with a stable US dollar exchange rate and increasing labour produc-tivity in the US have been rather persuad-ing policy makers and investors to put trust in the sustainability of global imbalances in recent years.

Nevertheless an artificial contraction of capital-intensive production in real apprecia-tion controlling economies lies at the heart of the economic expansion of financial indus-tries and consumption in the US beyond their fundamental limits.

Economic vulnerabilitiesAccording to this view from the production side, it becomes apparent that accruing real misalignments between mature and non-mature economies in a globalised world are a root cause of the current global financial crisis. For that reason, any policy measure aimed at restoring misaligned economic structures will lead to a freeze of a subopti-mal equilibrium, exposing mature and non-mature economies to substantial economic vulnerabilities in the near future.

Nevertheless such demand-side ori-ented measures are possible instruments which may deliver short-run relief to the global economy and employment in the US and other mature economies. At this stage, however, escaping costly structural adjust-ments on the supply side in form of indus-trial cutbacks and rising unemployment will hardly be possible.

In order to prevent a potential collapse

of the global economy in the medium to the long run, correcting structural misalignments should be high on the policy agenda. Hence, fixing structural misalignments on a global scale with the help of international policy co-ordination may represent the natural order of things.

Revamping the latter ideas may help to surmount the discontent from current inter-national financial crisis. Obviously, advanced and rather controlled economies can hardly get along together in a world that is glo-balised in real but not in financial terms. In order to reap the benefits of extensive glo-balisation in the long run, crafting a financial and thus ‘real’ sound globalisation is war-ranted. •

ReferencesCaballero, Ricardo J., Emmanuel Farhi, and Pierre-Olivier Gourinchas, “Financial Crash, Commod-ity Prices and Global Imbalances,” NBER Working Paper No. w14521, 2008. Eichengreen, Barry, “The Real Exchange Rate and Economic Growth,” See: http://www.econ.berkeley.edu/~eichengr/real_exc_rate_econ_grow.pdf, 2007). Rodrik, Dani, “The Real Exchange Rate and Economic Growth.” See: http://www.brookings.edu/econom-ics/bpea/~/media/Files/Programs/ES/BPEA/2008_fall_bpea_Paper/2008_fall_bpea_rodrik.pdf, 2008).

(Editor’s note: We would like to thank Dr Christian Fahrhols of Friedrich-Schiller-University Jena and University of Mannheim, Dr Andreas Kern, Jean Monnet Centre of Excellence, Free University Berlin, and Voxeu [http://www.. voxeu.org] for kindly allowing the Journal to reproduce in full this article, which is part of Voxeu’s global crisis debate series.)


Compliance

The ‘family’ risk: a cause for concern among Asian investors

RiskMetrics’ David Smith sounds a warning on related party transactions in

the Asia-Pacific region.

traDitional models of corporate governance in many emerging asian countries see companies doing business with related parties. these related party transactions are often a source of concern for investors, given sometimes opaque disclosure requirements and, in some regimes, no requirement for shareholder approval.

With Asian businesses being in many cases linked to a controlling family, state institution, or group of companies, trading amongst related parties is often unavoidable and can, in certain circumstances, lower the cost of doing business.

However, while related party transac-tions have long been accepted as a common characteristic of Asian business operations, the risk to minority shareholders of expropri-ation via abusive related party transactions is material.

Beware party transactionsAbusive related party transactions com-monly take the form of over- or underpaying for an asset, providing loans to a majority or

controlling shareholder or its associates, or the assumption of liabilities of/provision of guarantees to an associated entity, although a wide variety of abusive related party trans-actions exist.

Analysts, however, should be aware of the risk of value seepage to their holdings as a result of abusive related party transactions that have the effect of transferring wealth from a listed entity to an entity linked to the controlling shareholder.

Analyst’s perspectiveThis paper seeks to develop a framework for analysing related party transactions from an analyst perspective, highlighting key triggers for concern and providing guid-ance on areas to which analysts should pay particular attention. In doing so, the paper first provides an overview of related party transactions; second, considers the nature of abusive related party transactions; and third, develops a framework for analysis.

The UK-based International Accounting Standards Board (IASB) defines a related party transaction as “a transfer of resources, services, or obligations between related


parties regardless of whether a price is charged”, while the US-based Financial Accounting Standards Board (FASB) adds that such a transaction may not necessar-ily “ . . . be given accounting recognition; for example, one entity may receive services from a second, related entity without charge and without recording a receipt of services”.

IAS 24 and FAS 57In essence, a related party transaction sees one party provide goods or services to another party, with this party associated in some way with the vendor (here, both IAS 24 and FAS 57 provide guidance on defini-tions of control and influence).

The provision of these goods or services may or may not result in payment, and may

or may not involve a formal agreement or contract. In many cases, these transactions are neither extraordinary nor abnormal, and are entered into at arms length and in the normal course of business. Related par-ties may operate in related business areas (providing services or inputs to a sister com-pany), or may simply share a common par-ent company.

Related party transactions present a sig-nificant challenge to analysts in Asia given the wide range of ownership structures in this region. In Asia, related party transactions occur where listed companies are members of a larger conglomerate (e.g. a Chaebol or Keiretu), are part of a group of businesses controlled by one ultimate shareholder (e.g. portfolio companies belonging to an

Box 1: Related Parties under IAS 24

Pursuant to IAS 24.9, a party is related to an entity if: (a) directly, or indirectly through one or more intermediaries, the party: (i) controls, is controlled by, or is under common control with, the entity (this

includes parents, subsidiaries and fellow subsidiaries); (ii) has an interest in the entity that gives it significant influence over the entity;

or (iii) has joint control over the entity; (b) the party is an associate of the entity; (c) the party is a joint venture in which the entity is a venturer; (d) the party is a member of the key management personnel of the entity or its

parent; (e) the party is a close member of the family of any individual referred to in (a)

or (d); (f) the party is an entity that is controlled, jointly controlled or significantly

influenced by or for which significant voting power in such entity resides with, directly or indirectly, any individual referred to in (d) or (e); or

(g) the party is a post-employment benefit plan for the benefit of employees of the entity, or of any entity that is a related party of the entity.


entrepreneur), or are linked via shareholder agreements, uneven voting rights, or other control-related mechanisms. In a number of cases, voting interest is not a direct function of economic interest.

These transactions ordinarily take one of two forms:

1. A nonrecurring trade, including in many cases the purchase/sale of property, the purchase/sale of a business unit, assumption of liabilities/obligations, or the purchase/sale of intangible items.

2. Recurring/ongoing trades, where a firm agrees to continuously supply inputs/services to a related party for a set time.

Abusive elated party transactions While in many cases related party transac-tions in Asia are on normal terms and are in the interests of minority shareholders (for example, through the reduction of trading costs), a subset of these transactions are det-rimental to minority shareholders.

These transactions have the effect of transferring wealth from these parties as a result of the abusive nature of such agree-ments, and whilst their structure and design vary from case to case, all retain a common element – a controlling shareholder expro-priates wealth to the detriment of minority shareholders.

‘Tunnelling’ transactionsThese “tunnelling” transactions (Cheung et al, 2007) may also involve a parent company selling an asset at an inflated price to a listed subsidiary, buying an asset at a reduced price from a listed subsidiary, or a major share-holder securing a loan guarantee from the listed entity (Berkman et al, 2008).

A combination of weak regulation, weak enforcement and, in many cases, unneces-sarily complex transactions that are chal-lenging for analysts to decipher facilitate such transactions.

Weak boardsThese weaknesses are often compounded by weak boards, with over-stretched or cap-tive directors not providing lively and spirited debate. These captive directors are recruited, nominated and elected by major sharehold-ers, with minority shareholders dislocated from this process. An extension of the owner/manager model of corporate governance is that in many cases genuinely independent directors are rare – directors are appointed with the consent and approval of the owner/manager and, as such, debate and discussion is perhaps likely to be less rigorous.

Lack of independent directorsWe have contended in a number of articles on Asian corporate governance that Asia often lacks truly independent directors – related party transactions are one area where this lack is felt.

Compounding this, director training in Asia is often lacking, with many directors insufficiently prepared for the complexities of the transactions presented. The complexity of these transactions means that decipher-ing circulars and associated documentation is often challenging for analysts (including asset owners and regulators).

The Byzantine nature of ownership, the stages of separation of ownership and con-trol, and the multiple trades involved in a single transaction mean that more often that not time-poor analysts face insurmountable


hurdles in preventing such expropriation. While the complexity of transactions is indeed an issue, the analyst is able to follow several steps when considering a transaction in order to assess the likelihood of it being abusive.

Sectional guideThis section presents a guide to assessing related party transactions developed in order to aid analysts in their assessment of related party transactions. While these steps are not a panacea, they allow the analyst to triage transactions and focus in more detail on those that at one or more points, fail.1. Analysts should, at the outset, seek to understand the parties to a transaction. Exploring linkages, understanding relation-ships, and examining control and influence is the first and perhaps most important aspect of assessing related party transactions. Indeed, tracing ownership linkages – especially graphically – can aid analysts in understand-ing the rationale and process for a transac-tion. Following this, analysts should examine in detail the asset/service being traded. Is the asset fully or partially owned by the vendor? In the case of the service, are there defined parameters to the service agreement?2. Next, analysts should examine in detail the pricing and valuation of the asset. What valuations are attached to the asset/service? Who has provided the valuation? Is evidence of the valuation provided? Analysts should be wary of valuation companies that may be linked to one or more parties to a transac-tion, or that have no track record in providing such valuations. 3. A follow-on issue to pricing is the terms of payment. Analysts should examine in detail

the compensation involved, the terms of pay-ment (cash, exchange of assets, assumption of liabilities, etc), and whether such compensa-tion is appropriate. If the compensation is via a share-swap, analysts should consider whether valuations ascribed are fair and reasonable.4. Finally, the fundamental question that analysts should ask is: Why? Why now? Why this method? Why this asset? If disclosure does not include such justification analysts should seek to engage more with the parties to understand the rationale. Why is the asset owned by a parent company the ideal asset to acquire? Where a diversifying acquisition is proposed, why is diversification appropri-ate (especially since it involves acquiring an asset unrelated to the parent company)?

Conflicts of interestIn following these steps, analysts should be able to better understand the dynamics of a proposed transaction and be able to iden-tify those transactions that warrant closer attention. Throughout this process, analysts should also pay close attention to potential conflicts throughout the transaction. Are directors conflicted? Are advisers to direc-tors/shareholders conflicted? Are valuation providers conflicted? While many jurisdic-tions have regulations designed to prevent such conflicts, analysts should be cautious when examining advice.

However, this process – including ulti-mate approval by shareholders – relies on: (a) related party transactions being put to shareholder approval (subject to a thresh-old-based approach), and (b) sufficient information disclosed in timely fashion to analysts, and (c) shareholder voting mecha-nisms being appropriately developed so as


to enfranchise minority shareholders, and disenfranchise related parties.

Shareholder approvalWhere one of the three steps is missing, shareholders will be unable to effectively protect their economic interests. Where related party transactions are not subject to shareholder approval, there is very little ave-nue for preventing such transactions. Where insufficient information is disclosed, analysts should engage with listed companies (and regulators) to ensure that such information is disclosed (including terms of the transac-tion, price of the transaction, time periods for service provision where appropriate, etc).

Finally, where voting is done on a show of hands, for example, with controlling shareholders permitted to vote, the ability to effectively analyse a related party transaction is worthless.

Final thoughtsRelated party transactions are a feature of Asia, and often essential to ongoing business for Asian enterprise. This paper has high-lighted the risk of abusive related party trans-actions to investors in Asia and has outlined a process for analysing such transactions.

Weak exogenous (shareholder, regula-tory) oversight is often coupled with weak endogenous (e.g. Board) oversight, creating a monitoring vacuum. Where such a vacuum exists, the potential for abusive related party transactions exists and shareholders should be cautious when investing. The risk to minority shareholders from abusive related party transfers is that a slow seepage of value may impact on fund performance.

Perhaps, though, shareholders should

focus attention both on a micro-level (i.e. do we trust this management team?) and a macro-level (i.e. are the right regulatory checks and balances in place to ensure my interests are protected?).

The former can be addressed through a lengthy and rigorous due-diligence proc-ess. However, shareholders should engage on a macro-level as well, ensuring that the regulatory framework is suited to the needs of international investors. Indeed, while this paper has approached related party transac-tions from the perspective of the investor, there is much that regulators can do. Where IAS24 has not been adopted, incorporating IAS24 would be useful.

Limitations of IAS 24However, regulators should recognise the limitations of IAS 24 with regard to the defi-nitions of related parties, and should seek to develop locally-tailored definitions that are sufficiently broad so as to capture related party transactions, but not so vague as to put an undue burden on listed companies.

Regulators should be aware of the risks to their reputation – and the reputation of the jurisdiction as an investment destina-tion – that stem from the incidence of abu-sive related party transactions. Analysts will ultimately ascribe a higher return on equity hurdle, or a higher return threshold, or a higher discount rate when making invest-ment decisions. Capital may be withdrawn, and may be slow to return following an eco-nomic downturn.

Assessing and curbing abusive related party transactions is in the interest of share-holders, regulators and listed companies themselves. The threat to shareholders is


material and analysts should be cautious when considering related party transactions in Asia in order to mitigate this risk. •

BibliographyAharony, J., Lee, J. & Wong, T.J. (2000), “Financial Pack-aging of IPO Firms in China”, Journal of Accounting Research, 38 (Spring), pp103-126Berkman, H., Cole, R.A. & Fu, L.J. (2008), “Expropriation through loan guarantees to related parties: Evidence from China,” Journal of Banking & Finance, 33(1)CFA Institute Centre for Financial Market Integrity (2009), Related-Party Transactions – Cautionary Tales for Investors in Asia. Available at: http://www.cfapubs.org/doi/pdf/10.2469/ccb.v2009.n1.1.Cheung, Y.L., Jing, L., Rau, P.R. & Stouraitis, A. (2006), “Tunnelling, propping and expropriation: evidence from connected party transactions in Hong Kong”, Journal of Financial Economics, 82(2)Cheung, Y.L., Jing, L., Rau, P.R. & Stouraitis, A. (2007),

“How does the grabbing hand grab? Tunnelling assets from Chinese listed companies to the State”, City University of Hong Kong Working Paper.Kim, W., Lim, Y., & Sung, TY (2004), “What Determines the Ownership Structure of Business Conglomerates? On the Cash Flow Rights of Korea’s Chaebol”, ECGI – Finance Working Paper No. 51/2004; KDI School of Public Policy & Management Paper No. 04-20. Related Party Disclosures, International Accounting Standard No. 24 (International Accounting Standards Bd. 2009), available at: http://www.iasb.org (last visited June 19, 2009).Interests in Joint Ventures, International Accounting Standard No. 31 (International Accounting Standards Bd. 2009), available at: http://www.iasb.org (last visited June 19, 2009).

(Editor’s note: The author wishes to thank RiskMatrix Asia’s Dr Heong Wee Chong for his valued contribution to this paper.)


Reprints AvailableArticles & Papers

Issues in resolving systemically important financial institutions Dr Eric S. Rosengren

Resecuritisation in banking: major challenges ahead

Dr Fang Du

A framework for funding liquidity in times of financial crisis Dr Ulrich Bindseil

Housing, 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 Rizzi

Measuring & managing risk for innovative financial instruments Dr Stuart M. Turnbull

Red star spangled banner: root causes of the financial crisis Andreas Kern & Christian Fahrholz

The ‘family’ risk: a cause for concern among Asian investors David Smith

Global financial change impacts compliance and risk

David Dekker

The scramble is on to tackle bribery and corruption Penelope Tham & Gerald Li

Who exactly is subject to the Foreign Corrupt Practices Act? Tham Yuet-Ming

Financial markets remuneration reform: one step forward Umesh Kumar & Kevin Marr

Of ‘Black Swans’, stress tests & optimised risk management David Samuels

Challenging the value of enterprise risk management Tim Pagett & Ranjit Jaswal

Rocky road ahead for global accountancy convergence Dr Philip Goeth

The Asian regulatory Rubik’s Cube

Alan Ewins and Angus Ross


Volume I, Issue III, Autumn Winter 2009-2010

ContactChristopher RogersGeneral Secretary

[email protected]


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 providersIn 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


transformation! So how are we going to monitor the financial peer-to-peer model and how are we going to control compliance on these kinds of networks? Companies such as PayPal and Linden Labs (Second Life) mention they have this under control and that even transactions of under US$4 can be monitored for unusual behaviour, but how true is this? And even if they can do this, how are other companies in, for exam-ple, the console game world handling their micro-transaction strategy and compliance requirements?

Transparency, trustworthiness Compliance is not just creating a Suspicious Activity Report or a Currency Transaction Report upon suspicious behaviour or breaches of thresholds; its application is expanding as it is increasingly linked to risk management. Compliance is about follow-ing up on requirements set out by regulators, providing transparency to all stakeholders and managing risks that can impact busi-ness processes or the financial institute’s reputation (trustworthiness) and financial solvency.

Based on what is mentioned in the pre-vious paragraph the following controls and processes need to be put in place to enable confidentiality and trustworthiness for cus-tomers and monitored financial service pro-viders alike. The first step in confidentially is placing a lock on the door and making sure that nobody with bad intentions enters your financial institute or your financial trust ring. The lock is based on:

• Verification of people and/or organi-sations seeking a (financial) relationship against lists such as the Sanctioned and

OFAC. They are accepted or denied access and sometimes informed upon to the local regulators and law enforcement authorities.

• All financial information (read: trans-actions) entering your financial structure, or is moved over your technical infrastructure, is screened for possible violations (against lists such as Sanctioned and OFAC). It is not sufficient to only check the originator and the final destination/beneficiary, All involved parties (correspondent banking providers or corresponding service providers) need to be screened. Next year’s most important changes in payment systems and payment networks (like NACHA and SWIFT) actually evolve around the “involved parties” part.

This year, 2009, is the year of Cross Border Payment enhancements. On NACHA this means that BSA Travel rule information is added to international transactions (to pro-vide more information to involved parties about WHO is actually involved) and SWIFT will come with the Cover Payments adjust-ments that basically come down to adding similar information to the cover messages (MT202s). There is already even talk that all payment networks come to a uniform for-mat (ISO 20022) for exchanging payments across themselves.

Know your customerThis technology is referred to as Filtering software. When used in the customer on-boarding and on-going process, the cus-tomer information is scanned to identify and block any attempts by people with bad intentions to make use of your banking serv-ices. The on-boarding is also the step where you would gather information to Know Your Customer (KYC) and perform the first


Customer Due Diligence (CDD). The results of these two tasks should result in an initial risk determination by means of Basel and Solvency standards.

Political exposureThis actually brings me to one point that was not yet mentioned in the reasons behind Filtering, but which is actually part of both KYC and CDD. Filtering is also used to identify new or current customers as to their being manipulated or being the manipula-tor themselves, using the Politically Exposed Persons (PEP) list – a priority in Europe since the enactment of the 3rd European AML Directive, with many countries following suit. To make sure there are no misunderstand-ings, being a PEP (political exposed person) is not against the law but it is very important to determine for evaluation of potential riski-ness of a person or group.

But Filtering needs to also include the checking of transactions (with highest prior-ity on international financial activity) against the list, and perhaps even retroactively, by re-checking those already checked and passed against every new version of the OFAC and Sanctioned lists. This is of absolute impor-tance to prevent an enemy within, which can cause even greater damage than possible external threads. History has provided two very nice examples of that – the computer virus Trojan Horse and the original for which it was named.

So Filtering is touching your financial institute at the heart of its operation (no matter what service you provide), because sometimes a physical person needs to be involved to make an additional assessment if something is really suspicious and should be

stopped. Many complex factors are involved in a Filtering decision process such as typ-ing mistakes, aliases, use of abbreviations, and cultural and character set differences. Although Filtering is a very complex proc-ess with many angles, it should be provided to the Compliance officer in a simple and factual manner to allow him/her to make a conscious decision in a short time-frame. Many technology vendors fight complex-ity with even more complexity, but this can be avoided via a simple and clear presenta-tion which provides, in turn, clear auditing records for transparency.

Having said that, let us move on to the monitoring of what is happening internally at financial service providers or financial institute. What is happening internally is as important a part of Compliance as the lock on the door.

Customer profilingThe second step to compliance is the inter-nal monitoring of what happens within your financial institute, a process that is called pro-filing. Profiling in its simplest form is gather-ing and building statistics about the financial behaviour of customers and making deci-sions whether or not suspicious activity is shown. But it is much more elaborate when we look at reaching full compliance or trying to fight financial crime.

The simplest form of profiling is deter-mining if a customer is deviating from his/her regular behaviour over a period of time. If that is the case, then typically a compliance officer would look at such an indicator and determine the final outcome: ”suspicious and a violation” or “not suspicious and false positive”. The determination of suspicious


behaviour based on deviations of previous or historical personal activity is not the best detection rule, so another way to detect sus-picious behaviour is to compare a person’s or organisation’s behaviour against that of its peers.

This gives far better results and is actually a technique that has been used in statistical research for many years with large success, but requires categorisation (or segmenta-tion) and a significant sample size to provide the best results. The technique described is called peer grouping. For the proper use of peer grouping you need to have done the KYC and CDD work correctly, otherwise you are comparing apples with oranges and only wasting time looking at the wrong kind of information.

Case of the rogue traderTherefore, statistics are a very important tool to look at customers’ behaviour, but you should not only look at your customers. Employees could also be a potential compli-ance problem and, with them, the products you sell, if they are used in a bad manner. Recent examples on the importance of employee and products monitoring are: The case of the rogue trader at SocGen; senior management manipulating figures to get higher bonuses (short-term gains); the trad-ers of financial investment vehicles result-ing in the credit crises as we know it (the traders should have been monitored more closely with a market surveillance solution to avoid, for example, insider trading and other specific indicators or problems to come; the overly complex investment products that masked the impact of a part or parts retreat-ing in value; market abuse and manipulation

of the markets that bring financial systems to a standstill.

Once all statistical information is avail-able, more informed decisions based on facts are possible, plus this enables audit ability and confidentiality for all stakeholders.

The statistical information (on custom-ers, employees and products) helps to deter-mine the riskiness of a financial institute. It can also be used to help the monitoring and spur requests for enhanced due diligence to reduce false positives and making the com-pliance teams more productive, cost-effec-tive and pro-active (solve a problem before it actually becomes one!). It reduces the chance of abuse of products or the possible impact of losses when products that are sold are not balanced well enough and it will also be easier to calculate the risk (read: financial exposure to the balance).

Compliance is unfortunately still consid-ered by the largest part of the financial service providers as a cost, whereas it is actually one of the best ways to save and earn money. If you know your customer better, you are bet-ter able to detect when something is really out of the ordinary and you are better able to service them with value added [financial] products (watch out for tipping off). This will result in a better appreciation of your efforts by the customer, enabling confidentiality and TRUST.

In retrospect, we can state that the lesson learnt from the credit crises, is that the finan-cial institutions and the regulators (even governments) did not know the risks they had embarked upon. Local governments, now being stakeholders in troubled financial institutes want to push internal and external transparency. •


Legal & Compliance

The scramble is on to tackle bribery and corruption

Penelope Tham and Gerald Li of RBS take a compliance officers’ slant on the US

Foreign Corrupt Practices Act in the region.

asian countries are trying to enhance their reputation among investors by targeting bribery and corruption with increasing vigour. in this respect, there has been a higher level of interna-tional co-operation under applicable legal instruments, including the 1977 organisation for economic Co-operation and Development (oeCD) Convention[1] and the united nations Convention against Corruption.[2] thus a number of asian nations follow the principles set out in these instruments.

A lack of awareness about local and inter-national anti-bribery and corruption laws has triggered high risks for multinationals in Asia. This poses challenges for Compliance or Risk officers in these organisations. This paper briefly examines regional and certain foreign laws with extra-territorial reach.[3] and also provides ideas on how to manage these risks.north asia: The war on bribery and cor-ruption ranks high on the agenda across the region as corruption constitutes an obstacle to investment and economic development.

Various forms of laws and regulations have been implemented in past years to pre-vent corruption and to establish sanctions frameworks. (a) China: Bribery and corruption laws in China make it a criminal offence for individ-uals or corporations to accept or offer bribes in exchange for unfair or improper benefits. Criminal liability triggers at differing thresh-old amounts. Penalties for non-compliance under China laws range from administrative discipline, to fines and confiscation of illegal gains for organisations, to lengthy imprison-ment and even death sentences.[4]

Of significance is an “Opinion on Several Issues Concerning the Application of Laws to Commercial Bribery Cases” (the Opinion), jointly issued by the Supreme People’s Court and the Supreme People’s Procurate in 2008.[5] This provides clarification on China’s brib-ery and corruption laws, contained primarily in the China Criminal Law.

The Criminal Law distinguishes between bribery involving state officials and “com-mercial bribery” (involving persons who are not government officials). The Criminal Law is unclear as to the precise scope of China’s


bribery laws. In particular, it had previously been unclear how commercial bribery fell into the Criminal Law regime and whether it constituted a criminal offence at all.

The Opinion clarifies, in relation to com-mercial bribery, that any person from a state owned enterprise (SOE) is deemed to be a government official. This clearly brings commercial bribery within the Criminal Law regime. It is a warning to corporations who may have turned a blind eye to corrupt activities in China in the belief they were an integral part of doing business there.

Rio Tinto caseAlthough there are no reported cases of the death sentence being applied to a foreign executive or a local manager of a multina-tional corporation, there are no legal impedi-ments to it being applied across the board.

Consequently it is now more important than ever for foreign investors to take precau-tions to avoid the threat of criminal investiga-tion, such as that currently being made against four employees (including one Australian national) of mining giant Rio Tinto for alleg-edly luring managers at an SOE steel com-pany to hand over secret information relating to negotiations for an iron ore deal.[6]

(b) hong kong: Enforcement of anti-cor-ruption laws in Hong Kong is among the strictest globally. A recent case reflects the zeal of Hong Kong’s enforcers, the Independent Commission Against Corruption (ICAC).[7] which enforces The Prevention of Bribery Ordinance (PBO).[8]

In March 2009, an employee from a construction company[9] was sentenced by the ICAC to two months’ imprisonment for violating the PBO. The employee had offered

mooncakes[10] to policemen with whom he had dealings during the end of his compa-ny’s project. This occurred shortly before the Chinese Mid-Autumn Festival, a time when cakes are traditional gifts.[11]

(c) Japan: Japan has also taken an increas-ingly hard line against overseas corrup-tion. This is illustrated by the January 2009 conviction of three senior directors of a Japanese company for bribing a high rank-ing Vietnamese official with US$820,000 in exchange for the award of trunk road con-struction projects in Ho Chi Minh City. The directors were sentenced to between 18 months and two years’ imprisonment, all suspended for three years.[12]

(d) korea: The strength of the Korean Independent Commission Against Corrup-tion (est. January, 2002),[13] was given a boost on August 3, 2007[14] by the extension of ‘whistle-blower’ protection to the report-ing of bribery of persons exercising a private function and not just of public officials. (e) taiwan: Taiwan’s anti-corruption stat-ute (modelled on FCPA) prohibits bribery of Taiwanese government officials and also prohibits Taiwanese nationals from bribing government officials abroad.[15] The recent high-profile case involving ex-president Chen Shui-bian is illustrative of the serious-ness with which the law is enforced.[16]

Recent trends: united states: The hallmark of the FCPA has always been its extra-territorial reach. This reach continues to touch emerging mar-ket economies: in December 2007, Lucent Technologies was convicted for paying senior Chinese government officials to make ‘pre-sales trips to the US to visit Lucent’s facilities.


According to the US Department of Justice payments made by Lucent bore little or no nexus to pre-sales activities: senior Chinese officials were reimbursed by Lucent for visit-ing non-existent Lucent facilities in the US – a case evincing fraud as well as bribery.[17] Lucent was fined US$2.5 million.

In December 2008, Siemens AG and sev-eral of its subsidiaries agreed to pay US$350 million in disgorgement to the US Securities and Exchange Commission (SEC); and fur-ther agreed to the imposition of an inde-pendent monitor for a period of up to four years. Here, the SEC alleged a wide range of corrupt payments had spread across several of Siemens’ divisions. Significantly in some cases, including Siemens’ China division, the sole jurisdictional basis for certain bribes was based on the use of correspondent bank accounts: between 2002 and 2007, Siemens allegedly paid approximately US$22 mil-lion to business consultants who used some portion of those funds to bribe government officials in China in connection with a US$1 billion project to construct metro trains and signalling devices.[18]

united Kingdom: Increasingly, the UK is under pressure to reform its currently frag-mented laws. It is often criticised for failing to meet international standards, particularly those required by the OECD. To date, there has only been one successful UK enforcement case since the A-T Act made it an offence under English law for bribery of an overseas official. A director of a UK-based company was convicted of bribing Ugandan officials and was given a five-month suspended sentence on September 26, 2008.[19] To coun-ter such criticism, in March this year the UK Ministry of Justice published a draft Bribery Bill

which is intended to update and consolidate the patchwork of anti-corruption legislation: Section 108 of the A-T Act; the Prevention of Corruption Act 1916; the Prevention of Corruption Act 1906; and the Public Bodies Corrupt Practices Act 1889.[20]

Corporate criminal offenceThe most important feature of the draft Bill is the introduction of a corporate criminal offence of negligently failing to prevent bribery com-mitted by a person performing services on behalf of the organisation – i.e. ‘third parties’ .[21] The three elements to this offence are:

(i) A person performing services on behalf of an organisation bribes another per-son; (ii) the bribe is in connection with the organisation’s business, and (iii) a respon-sible person or a number of persons is/are negligent in failing to prevent a bribe being made or offered.

There is a defence for organisations with proof of adequate set procedures to prevent those performing services from paying bribes. The draft Bill proposes that such defence should not, however, be available if the negligence in question was that of a director, officer or manager of the organisation.[22]

It is worth contrasting this limited pro-posed defence with those available under the FCPA. The FCPA has two defences not present in the draft Bill: (1) the ‘facilitation payments’ exception; and (2) the promotional or marketing expenses affirmative defence.

Under the FCPA, it is a defence to show that a bribe is a small facilitation payment made in order to expedite actions routinely performed by a foreign official. For example, a small sum (e.g. US$50) paid to a customs


official to expedite clearance.[23] This defence is not, however, captured in the draft Bill; and the making of facilitation payments remains a criminal offence in the UK.

Another FCPA defence is the market-ing expenses defence. Under US law, certain payments may be made to government offi-cials in connection with promoting or dem-onstrating a firm’s product or services or in connection with the execution of a contract with a foreign government. Again, no such defence exists in the draft Bill.[24]

Challenges (a) Use of agents or ‘third parties’ – The use of third-parties – anyone that a multinational might use as a facilitator to assist in secur-ing or conducting business in the region, but cannot be easily monitored – is the most challenging area for companies. Such par-ties may be perceived as useful; but they are attracting more scrutiny than ever before from international and local regulators.[25]

Agents provide valuable information about doing business in a country and help in negotiating contracts. But they are sometimes used to disguise corruption or to distance firms from the suspicion of it: the problem is the perception that the use of third parties to pay bribes affords a degree of protection to the briber. As a matter of law, this is a dangerous assumption.[26] In the UK, the A-T Act provides that any payment by the third party is considered as being made on behalf of the UK organisation.[27]

Organisations that use third par-ties should therefore introduce controls to minimise these risks. Such controls should include: criteria for the preselection of agents; a due diligence process to investigate

agents before they are appointed; contracts with agents, which include a clear prohibi-tion against corrupt activity; and an ongoing compliance review.

In some banks, agents undergo the same “know your client” process as is applicable when clients are on-boarded.

(b) Use of charities – To the extent that payments made by third parties to legitimate charities are wholly and exclusively for chari-table intent purposes, this poses few prob-lems. The real concern or ‘red flag’ is that, in many cases, the charities concerned are simply ‘fronts’ or ‘masks’ used by third parties attempting to circumvent firm anti-bribery and corruption policies.[28] Therefore any payments that are requested by third party agents to be paid to local charities must be scrutinised carefully and should be subject to appropriate sign-offs by management before being paid.

Voluntary payment (c) Facilitation Payments – While making a facilitation payment is a criminal offence in the UK, when the A-T Act was passed, the UK government made clear it was difficult to think of circumstances where the making of small facilitation payments – typically a voluntary payment for lower-paid govern-ment officials, prompting them to complete a task expected of them anyway – in coun-tries where this is normal practice, would lead to prosecution. This statement is not, however, captured in the draft Bill; indeed, the UK Law Commission has categorically rejected a facilitation payment defence. This causes practical difficulties for organisations in crafting a consistent policy where they have a nexus to the UK.[29]


Establishing an effective compliance culture or ‘Compliance Mindset’ across each country is paramount. No magic formula exists, but the starting point is your organisa-tion’s corporate values and compliance ethic. Any compliance programme should, at a minimum, include the following:

(i) A clear statement of the value of the organisation’s reputation and the impor-tance of ensuring that it is not damaged.

(ii) Emphasis on the need to mitigate the risk of the organisation becoming a vehicle for bribery and corruption.

(iii) Training to ensure all staff have a com-mon understanding of the regional in-country rules as applicable to the global organisation.

(iv) An awareness programme of foreign regulators, like those in the US and the UK who impose onerous extraterritorial legal requirements on multinationals.

How to cultivate the desired mindset?(a) Focus on Management Role Model-

ling. Articulate the importance of senior management acting as ‘role models’ – as ‘perception is reality’. To this end, you may consider engaging the support and com-mitment of senior management – utilising ‘Compliance Mindset’ toolkits (e.g. E-cards, posters and round-table discussions) by way of bespoke programmes aimed at reinforc-ing the tone at and from the top towards enterprise-wide control.

Beyond lip serviceTo move beyond paying lip service to the code, firms should bring key managers to a ‘round-table’ forum where specific case studies are discussed. It is only by working through these issues that staff, together with managers, will develop an understanding

that what may in the past have been accept-able now has serious consequences.

(b) Focus on Policies and Procedures – including gift-giving and corporate hos-pitality. An organisation’s policy should, as a minimum, assist staff to: understand the organisation’s expectations of staff behaviour regarding anti-bribery and corruption; under-stand the concepts of bribery and corruption; assess what is or may be construed as a bribe; understand when and how to report and to whom to report; understand when to request approvals for deviation and from whom.

Customary, modest giftsA simple, yet flexible, process that works regionally will ensure consistency. It is important for such policies to specify in what circumstances gifts or entertainment may legitimately be given to state- and non-state officials, and to establish internal procedures to provide guidance and pre-authorisation procedures.

Such gifts or entertainment should be customary, modest, reasonable and pro-portionate to the seniority of the recipient and directly related to the business being conducted. Care must also be taken when engaging agents to ensure that relevant agency contracts contain applicable protec-tion (for example, anti-bribery representa-tions and warranties).

It should be noted that any anti-brib-ery and corruption policy that is adopted is necessarily a bespoke ‘living document’ to be updated and refreshed regularly. Not knowing your responsibilities or not having appropriate risk management, supervision and internal controls in place will never be a valid excuse for non-compliance should


the regulators come knocking on your door.In many organisations, anti-bribery and corruption training is made compulsory by senior management. Attendance at such training is made part of the criteria for assess-ment during the regular performance review cycle. Global computer-based training pro-grammes are increasingly available (thus it is easy for staff to complete the training) and relatively cost effective.

Staff should be required to complete the training within a stipulated time. If this is not done then managers must act swiftly to address non-compliance. And as good role models, senior managers should be the first to complete or attend required training sessions.

ConclusionLack of awareness of applicable laws and regulations covering bribery and corruption, especially those with extra-territorial reach, exposes global organisations to an increased risk of prosecution at home and abroad.

Given the trend for emerging market countries to enact comprehensive legislation in order to attract foreign investment and the continuing enforcement zeal of jurisdictions with established laws in this arena, it is vital that organisations have appropriate policies and procedures to address the issues. These must clearly set out what is acceptable behav-iour and have clear procedures for staff to fol-low and to escalate issues where necessary. This must include proper training for staff.

Most importantly, management must encourage the right Compliance Mindset and culture within the organisation to ensure that employees act appropriately. This is a challenge in some markets where local

players may not adhere to the same stand-ards; and firms may perceive themselves to be at a competitive disadvantage.

However the cases show that it is very much the case of “penny wise, pound fool-ish” as the sanctions and penalties imposed can be severe. Worst of all, the damage to a firm’s reputation may be incalculable. •

References1. See: e.g. Organisation for Economic Co-operation

and Development Convention. Available at SSRN: http://www.oecd.org/

2. See: e.g. United Nations Convention against Cor-ruption Preamble. Available at SSRN: http://www.unodc.org/

3. The relevant laws to be discussed: (1) the United States (US) Foreign and Corrupt Practices Act of 1977 (FCPA); and (2) the United Kingdom (UK) 2001 Anti-Terrorism, Crime and Security Act.

4. See: ‘Asia Pacific and China. Our Anti-bribery and Corruption Service offerings’. KPMG China – Anti-bribery policy and procedure development. SSRN: http://www.kpmg.com.cn/redirect.asp?id=9784

5. Simmons & Simmons – PRC Clampdown on Corruption, February 17, 2009. SSRN: http://www.elexica.com/briefdoc.aspx?id=7290

6. See: e.g. ‘Rio Tinto pulls out Australian staff from Shang-hai office’, South China Morning Post, July 16, 2009.

7. See: Hong Kong ICAC. SSRN: www.icac.org.hk/en/home/index.html

8. See: Prevention of Bribery Ordinance (Chapter 201, Laws of Hong Kong). Extract of sections 3, 4, 5, 10, 12AA and 16. Soliciting or accepting an advantage. SSRN: www.csb.gov.hk/hkgcsb/rcim/pdf/english/central/pobo_e.pdf

9. PBO governs both public and private sectors. In the private sector it is illegal for an employee to solicit or accept advantages when conducting his employer’s affairs without the employer’s consent.


10. When facing a charge of corruption, it is no defence to claim that it is customary for advantages to be offered in that profession or trade.

11. Moon cake case exposes risks of Hong Kong brib-ery ordinance. SSRN: http://www.asialaw.com/Arti-cle/2163660/

12. Simmons & Simmons – Pacific Consultants Inter-national directors found guilty in Japan of bribing a Vietnamese official, May 8, 2009. SSRN: http://www.elexica.com/briefdoc.aspx?id=7457

13. See: ‘Korea’s anti-corruption efforts and the role of the KICAC’, May 3, 2002, Dr Chul-Kyu Kang, chairman, Korea Independent Commission Against Corruption.SSRN: http://unpan1.un.org/intradoc/groups/public/documents/APCITY/UNPAN019163.pdf

14. See: ‘Amends Law: Prevention of Corruption Act (GLIN ID 77462)’ SSRN: http://www.glin.gov/view.action?glinID=202034#

15. See: Taiwan Economic News, July 10, 2002 as refer-enced in ‘A Cross-Cultural View of Corruption, pages 5 and 6. SSRN: http://wpweb2.tepper.cmu.edu/jnh/corruption.pdf

16. See: The Wall Street Journal – WSJ.com, Sept 14, 2009 – ‘Former President of Taiwan Gets Life Sentence’. SSRN: http://online.wsj.com/article/SB125289842296107859.html

17. Shearman & Sterling LLP – FCPA Digest – Cases and Review Releases Relating to Bribes to Foreign Officials under the Foreign Corrupt Practices Act of 1977 (as of March 1, 2009), Section B: Foreign Bribery Criminal Prosecution under the FCPA, page 32.

18. Shearman & Sterling LLP – FCPA Digest – Cases and Review Releases Relating to Bribes to Foreign Officials under the Foreign Corrupt Practices Act of 1977 (as of March 1, 2009), Sec-tion D: SEC Actions Relating to Foreign Bribery, pages 119 to 121. See also: Section A: Recent Trends and Patterns in FCPA Enforcement,

page i. FCPA enforcement has escalated: 2008 saw the announcement of a number of FCPA enforcement actions with unprecedented fines and penalties, likely spurred on by a Bush admin-istration keen to stamp out corruption; and the Sarbanes-Oxley Acts’ increased focus on inter-nal controls.

19. Simmons & Simmons – First UK conviction for bribery overseas, September 30, 2008. SSRN: http://www.elexica.com/briefdoc.aspx?id=6990

20. Simmons & Simmons (see note 19 above).21. The Criminal Accountability of Companies and

Their Boardrooms, May 14, 2009. SSRN: http://www.rjw.co.uk/news-events/news/

22. See: Draft UK Bribery Bill Would Expand Scope of UK Anti-Corruption Initiatives and Jurisdic-tion, April 8, 2009. By Roger M. Witten, Kimberly A. Parker, Jay Holtmeier, Steven P. Finizio, D. Jason. SSRN: http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=8940

22. Shearman & Sterling LLP – FCPA Digest – Cases and Review Releases Relating to Bribes to Foreign Officials under the Foreign Corrupt Practices Act of 1977 (as of March 1, 2009), Section A: Recent Trends and Patterns in FCPA Enforcement, page xii.

24. Simmons & Simmons – Bribery and corruption: a bill with more bite, February 25, 2009. SSRN: http://www.elexica.com/briefdoc.aspx?id=7305

25. See: Shearman & Sterling LLP (note 22, above). 26. See: Joint Committee on the draft Bribery Bill:

Memo-randum submitted by Norton Rose LLP, June 23, 2009. SSRN: www.nortonrose.com/knowledge/.../pub21672.aspx?lang...

27. See: e.g. Explanatory Notes to Anti-Terrorism, Crime And Security Act 2001. SSRN: www.opsi.gov.uk/acts/acts2001/en/ukpgaen_20010024_en_1

28. See: e.g. Stars quit charity in corruption scandal. The Guardian, January 10, 2001. SSRN: http://www.guardian.co.uk/uk/2001/jan/10/davidhencke

29. See: Simmons & Simmons (note 24, above).


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 provisionThe 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


“minimum value” required for the FCPA to kick in.

The term “foreign official” is very broadly applied and includes not just employees of the government, but also employees of state-controlled enterprises (for example, national airlines) and public international bodies such as the International Olympic Committee, the United Nations, the OECD, the World Bank and the International Red Cross.

Who is subject to the FCPA?In view of the high degree of involvement by the government in the local economies of many North Asian countries, this has meant that companies doing business in North Asia will, more often than not find themselves dealing with a foreign official and hence be subjected to the FCPA.

The FCPA applies to issuers and domes-tic concerns. “Issuers” means any company (including a foreign company) that has secu-rities listed on any US stock exchange and any company which is required to file reports under the US Securities Exchange Act. This includes companies whose American Depository Receipts (ADRs) are traded on the US exchanges.

The term “domestic concern” is even broader and includes any US citizen, national or resident, as well as any business entity formed under the laws of any US state, or which has a principal place of business in the United States. US parent corporations may also be held liable for the acts of their foreign subsidiaries

The FCPA was amended in 1998 so that foreign companies and foreign persons who take any action towards furthering a cor-rupt payment to a foreign official while in

the US also became subject to the FCPA. The accounting provisions only apply to US issuers.

There are two parts to the accounting provisions, namely the books-and-records provision and the internal controls provision. The books-and-records provision requires issuers to keep books, records and accounts in reasonable detail, so as to accurately and fairly reflect the issuer’s transactions and dis-position of assets, whereas the internal con-trols provision requires that issuers maintain reasonable internal accounting controls to prevent and detect FCPA violations.

US regulators have regularly resorted to using the accounting provisions when they cannot establish bribery. This is because there is no requirement that a false record or deficient internal controls be attributed to a bribe. A common mistake made by many corporations is to devote an inordi-nate amount of already limited resources to determining whether they are dealing with a foreign official (as opposed to a commercial enterprise, because they believe that dealings with a non-foreign official would make the relationship immune from the FCPA, and hence, more lax standards can be imposed on the particular dealing).

Internal controls deficiencyThis is risky because where a bribe is paid to a commercial party, the FCPA’s accounting provisions may potentially still have been violated, as the payment may be consid-ered to have been inaccurately recorded in the books (for example, how was the com-mercial “bribe” or “kickback” described in the books?) or the fact of the bribe may be blamed on an internal controls deficiency.


Furthermore, given that bribery (includ-ing commercial bribery) is illegal in many parts of North Asia, a more efficient use of company resources may very well be to prioritise the prevention of bribery per se, instead of devoting limited resources to establishing if a particular dealing is with a “foreign official”.

Real regulatory risksUnder the FCPA, knowledge to show a cor-rupt intent is very broadly construed, and can be based on a deliberate ignorance of facts or simply from burying one’s head in the sand. A pattern common to many FCPA cases is where the bribe is paid through an interme-diary, or where a company or its executives knew of “red flags” indicating a likelihood that the intermediary would engage in pro-hibited behaviour, but avoided doing any-thing about this. There are therefore real regulatory risks that come with third-party business partners such as acquisition targets, joint-venture partners, suppliers, distribu-tors, agents and consultants.

Common red flags include unusually high commissions, a lack of transparency in expenses and accounting records, or where the business partner or intermediary does not appear to have the right qualification to provide the particular service. Another com-mon warning sign for businesses in North Asia is when a foreign official insists that a particular “consultant” or company be used for a project.

Another FCPA risk is the concept of successor liability, as past FCPA cases have shown that the US regulators do not view a merger or acquisition as extinguishing liabil-ity for past wrongful conduct and will hold

the new company or newly-acquired sub-sidiary responsible for past violations.

All of these have led to companies hav-ing to carry out due diligence on business partners or target companies to protect themselves from liability.

After the enactment of the FCPA in 1977, there was little political will to enforce the provisions, especially because many US corporations complained that the FCPA created an uneven playing field because non-US companies were able to continue paying bribes to obtain business. Partly due to US pressure, in 1997, the Organisation for Economic Co-operation and Development (OECD) adopted a treaty to address for-eign bribery – the OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions (OECD Convention).

The OECD Convention was a milestone in the fight against international bribery because most major multinational com-panies were, and still are, based in OECD countries. The OECD Convention came into force in 1999, and since then has been rati-fied by 37 countries.

Four plead guilty In North Asia, the two countries that would have similar FCPA-type foreign bribery pro-visions are Japan and South Korea. This is how four Japanese executives from Pacific Consultants International ended up plead-ing guilty in November 2008 to paying US$820,000 in bribes between 2003 and 2004 to the former deputy director of Ho Chi Minh City’s transport department in a road project funded by the Japanese government.

But what makes the FCPA (and the


OECD Convention) so far-reaching is that these anti-bribery provisions give govern-ments a long-arm jurisdiction which allows them to control the business activities of its multinationals across the globe. The second reason why these provisions are particularly powerful is the concept of corporate liabil-ity. Hong Kong, for example, has draconian anti-bribery provisions on its statute books (more of this later).

Reputational damageHowever, there is no corporate liability for bribery in Hong Kong and in the absence of corporate liability, most corporations would be tempted to wash their hands of any accountability if it is simply a case of one of its employees having been found to have engaged in bribery, because whilst this may carry some reputational damage, it is easier for the corporation to distance itself. However, where the corporation itself risks being punished with massive fines, this increases the will of big corporations to take the prevention of bribery seriously.

As a sign of things to come, it is worth not-ing that the DOJ has prosecuted more FCPA actions in the past two years than in the pre-ceding 20 years. In a May 26, 2009 Wall Street Journal interview with Mark Mendelsohn, deputy chief in the Justice Department divi-sion overseeing FCPA prosecutions (entitled “U.S. Cracks Down on Corporate Bribes”), it was reported that at least 120 companies are under investigation.

In addition to more aggressive enforce-ment, the financial penalties imposed have increased exponentially. As an illustration, in May 2005, DPC (Tianjin), the Chinese sub-sidiary of a US medical device manufacturer

paid US$1.6 million in bribes, and was pun-ished with a $2 million criminal penalty and $2.8 million in disgorgement. Fast-forward to May 2009, Novo Nordisk, a Danish pharma-ceutical company, paid $1.4 million in bribes but, by comparison, had to pay a $9 million criminal penalty (four times as much), $3 million in civil penalties and $6 million in disgorgement.

Aside from the severe financial penalties, other ways in which corporations could be punished for FCPA violations include being disqualified from government contracts. This can potentially ruin a company if its main customer entails doing business with the US government (for example, a pharmaceutical company).

Another more recent development has been increased action against individuals, resulting in jail time for company executives, as opposed to mere action against corpora-tions. For example, in January 2009, Mario Covino, an Italian executive of Control Components, a Californian-based valve company pleaded guilty to illegal payments of approximately US$1 million to employees of state-owned entities in countries such as China, India, Korea, and Malaysia.

Two-year jail termIn December 2008, Misao Hioki, a Tokyo executive with Bridgestone Corpn was sen-tenced to two years in federal prison and an $80,000 criminal fine for authorising con-tracts with illegal commissions for govern-ment officials throughout Latin America. In September 2008, Shu Quan-Sheng was given 51 months in prison for offering to pay bribes to officials of a Chinese space research agency on behalf of a French company.


Another trend that corporations should be aware of is that there are now many more ways for wrongdoing to come to the atten-tion of the regulators. Firstly, in an economic downturn, there tend to be more disgrun-tled ex-employees who are eager to disclose wrongdoing to regulators. A second avenue is where voluntary reporting by one corpo-ration can lead to other parties within the same industry being implicated – leading to industry-wide investigations.

Co-ordinated investigationsIn November 2008, Mark Mendelsohn revealed that the DOJ was beginning to expand its focus from the more traditional industries of oil and gas and medical devices, to include legal services providers, freight-forwarders and financial services.

Thirdly, information is being shared more regularly among regulators world-wide – the Siemens case is a good exam-ple, where the US and Munich authorities (who together imposed penalties totalling $1.9 billion against Siemens) co-ordinated the revelation concerning the outcome of their investigations. Finally, due diligence conducted on business intermediaries and in joint-ventures/acquisitions have led to more violations being uncovered and being reported voluntarily.

Corporations need to be aware that the regulators in the US have also become increasingly adept at using non-FCPA legis-lation to bring charges against corporations and individuals. In addition to the use of the conspiracy charge, there is a possibility that other charges can include anti-money laundering provisions, travelling to commit the offence under the US Travel Act, fraud,

racketeering, obstruction, even tax violations (for example, because unlawful payments cannot be deducted under the tax laws as a business expense, an improper deduction may expose a company to tax penalties) and so on.

Fearsome as the FCPA and the OECD foreign bribery provisions are, many multi-nationals would do well to remember that attention needs to be paid to local anti-corruption laws too when doing business in Asia. One oft-quoted example is the position with facilitation payments – in its crudest form, these are in effect “small bribes” which the FCPA and the OECD provisions exempt on the basis that payments for routine gov-ernment decisions are not prohibited. What is often overlooked is the fact that many countries in Asia prohibit such payments altogether.

Local regional initiativesNorth Asia, made up of South Korea, Japan, China, Taiwan and Hong Kong, is a mixture of countries that covers the broad spectrum of Transparency International’s Corruption Perception Index (CPI), with Hong Kong and Japan positioned favourably on one end, China not so favourably on the other, and South Korea and Taiwan somewhere in the middle.

This year has seen a flurry of anti-bribery initiatives by governments in the region. These appear to have been motivated, in part, by a desire to ensure that as they implement economic rescue plans through massive spending, the resources and monies being pumped in by the governments themselves end up where they are supposed to.

In China, there were media reports that


its top prosecution agency planned to pay up to RMB200,000 (US$29,000) for infor-mation on graft. This year also, the Chinese government invited the public and govern-ment insiders to report tips to telephone and internet hotlines and it was reported that the new hotline was overwhelmed when it was launched on June 22, 2009, with more than 17,000 tips. In both cases, what is not entirely clear is how much protection would be given to graft whistle-blowers.

Spotlight on constructionMore recently, China’s Supreme People’s Procuratorate announced that it would launch a two-year campaign to fight corrup-tion in the construction sector and that the campaign will focus on corruption resulting in substandard construction, construction without a permit, and land use approval. The deputy procurator-general said the nation-wide procurators had investigated 16,830 bribery cases in the sector from January 2006 to June 2009, accounting for 46 per cent of all commercial bribery cases during that time.

In Japan, the Foreign Ministry was reported in March 2009 to have established a hotline and information desk for receiving tips regarding the misuse of official develop-ment assistance, including bribery and bid-rigging.

In South Korea, as the government con-sidered pumping three trillion won (US$2.1 billion) into the economy through public projects to create jobs, the chairman of the country’s Anti-Corruption and Civil Rights Commission stressed that anti-corruption efforts would be made at the same time.

In Taiwan, a new law that would put offi-cials under scrutiny if their personal assets

suddenly increased passed its first reading in Taiwan’s legislature in March 2009. Under the bill, civil servants suspected of corruption would be required to provide the sources of their income and assets if their total value seemed out of line with their salaries and the same would apply to suspects’ spouses and dependants.

As for Hong Kong, a March court case caused sleepless nights for many a compli-ance officer in the region, when the local anti-graft agency, the Independent Commission Against Corruption charged a construction company director for giving away moon-cakes. Every September, the Mid-Autumn Festival is celebrated by millions of Chinese people across Asia and in the weeks leading up to the Festival, thousands upon thou-sands of moon cakes, a pastry synonymous with the festival, are presented as customary gifts to business associates.

‘Ignorance’ plea rejected In this case, the hapless defendant was sen-tenced to two months’ imprisonment for bribery, after he pleaded guilty to presenting 15 boxes of moon cakes to officers of a traffic police team. In Hong Kong, it is an offence to offer any benefit to an employee of the government or a public body where there are “dealings of any kind”, even if the deal-ings are not ongoing, but only anticipated. In this case, the moon cakes were presented 11 days before the Mid-Autumn Festival to the traffic team from which the company director had obtained a series of roadwork approvals.

The Hong Kong court rejected the defendant’s plea that he had not realised it was an offence and that what he did was


part of Chinese custom. The anti-bribery provision in question is a draconian one. There is no need for the prosecution to show any corrupt intent on the part of the defend-ant (unlike the FCPA).

Presumption of intentThis provision presumes that corruption was intended if there are dealings and a benefit/gift is presented – the only way to escape conviction is for the defendant to show that there was lawful authority or a reason-able excuse (for example, if the government employee happened to be the defendant’s good friend of many years preceding any “dealings”, moon cakes have always been exchanged and a reasonable number of moon cakes was given).

Secondly, the provision applies where a benefit/gift is offered not just to a government

employee, but also to any employee of a pub-lic body such as Ocean Park, a famous local tourist attraction, or the Hong Kong Tourism Board. Third, there is no minimum value involved, so that offering a piece of moon cake would have been as much an offence as 100 boxes of moon cakes. Harsh as it sounds, similar statutory presumptions can be found in the anti-bribery statutes of Singapore and Malaysia.

This case is a good example of how corporations should have reliable, on-the-ground knowledge of what the regulatory and anti-bribery environment of a country is really like, to make sure that its operations stay out of trouble. This means keeping eyes and ears open for news on the latest regu-latory enforcement by overseas and local authorities and keeping up-to-date on legal developments. •


Reprint Service

ContactChristopher RogersGeneral [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




Journal of Regulation & Risk North Asia

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


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.


Legal & Compliance

Financial markets remuneration reform: one step forward

In view of the Goldman Sachs bonus furore, Linklater’s Umesh Kumar and Kevin Marr,

examine issues surrounding salary caps.

Within the wider review on regulatory reforms in the financial services sector, remuneration practices at financial insti-tutions have come under particular scru-tiny. a general consensus has emerged amongst political leaders and regulators that some remuneration structures at financial institutions encouraged risky decision-making and contributed at least in part to the conditions leading to the global financial crisis.

The UK’s Financial Services Authority recently published a new Remuneration Code covering certain large banking institu-tions, and the political currency of this issue makes it likely that remuneration reforms of some form will be implemented in other jurisdictions in the near future. This arti-cle will discuss some of the key issues and drivers behind the remuneration reform debate and will look at some current pro-posals in this area, in particular the new FSA Remuneration Code.

Financial services remuneration reform shares some characteristics with recent efforts to impose controls on executive pay

at public companies, such as “say on pay” requirements.

These initiatives are not mutually exclu-sive and have a number of common aims, such as ensuring that management has a vested interest in the ongoing health of the firm. However, the genesis of remuneration reform in the financial services sector was the global financial crisis, which revealed weaknesses unique to financial institutions, in particular the strong prevalence of variable compensation (i.e. bonuses) even amongst non-senior executive staff and the large potential exposure of financial institutions through their loan and trading books.

Underlying concernAs such, while executive pay initiatives have focused on improving transparency and upholding shareholder rights, the underlying concern in the financial services remunera-tion debate is eliminating systemic factors that are believed to have contributed to the global financial crisis. This has a bearing on the nature of the proposals, as will later be related.

Partly through the efforts of multilateral


forums such as the G-20 Financial Stability Board, there has emerged a high level con-sensus on the general principles of financial institution remuneration reform. The pro-posals to date have typically addressed many, if not most, of the following general topics:• The role of the board of senior management in remuneration oversight. This includes the composition and independence of remu-neration committees and the role they play in designing and monitoring compensation policies.• Independence of risk and compliance func-tions from other areas of business. This is aimed at ensuring that risk and compliance units have the authority and autonomy to properly monitor and manage risky behav-iour. For example, some proposals require that the compensation of risk and compli-ance personnel is not determined or influ-enced by the business units they are meant to be monitoring.• Balance of fixed and variable compensation. If an employee’s compensation package is largely based on variable factors, the concern is that he or she will be incentivised to take riskier actions. • Variable compensation adjusted for future risk. One subject of popular outrage dur-ing the financial crisis has been instances of bankers earning large bonuses based on trading gains that turned out to be illu-sory. Under this principle, firms would be required to take appropriate risk factors into account when calculating performance-based compensation.• Deferral of bonus payments. Re- quiring bonuses and other variable com-pensation to vest over a period of time would arguably allow firms to more properly

evaluate the individual’s contribution, while giving the employee an incentive to perform well over the long term.• Flexibility of bonus arrangements. There have been concerns about firms being tied into bonus arrangements requiring large payouts that turned out to be unjustified. Related to this is the question of whether firms should be allowed (or required to) have clawback rights on bonuses for employ-ees who have engaged in misconduct or misrepresentation. • Severance/early departure restrictions. In response to a perception that generous severance packages have in some cases been a “reward for failure”, some proposals include limits on severance pay in cases of poor performance, or limits on early vest-ing of deferred compensation for departing management. • Disclosure of remuneration practices. Some proposals include requirements for firms to disclose their remuneration policies. Public companies may of course already be subject to various disclosure requirements.

Within these general topics, there is plenty of room for debate. For example, which firms should the remuneration requirements cover? Should it apply to all firms or only firms of a certain size or that have certain businesses? On an individual level, which employees should be subject to these controls?

Staff recruitment, retentionMore generally, should the new regulations allow firms to exercise some discretion within the spirit of the requirements or should there be fixed limitations (e.g. on the ratio of fixed to variable compensation or the minimum


deferral period for bonus compensation)? The remuneration debate is of course shaped by local legal, economic and political considera-tions, in particular concerns about the impact of remuneration restrictions on firms’ ability to recruit and retain staff, as well as the general competitiveness of the local financial market.

This no doubt helps explain why, at least in part, remuneration reform initiatives have generally not progressed quicker despite wide popular support. To date, the UK has taken the lead in examining and implement-ing remuneration reform initiatives. As in other countries, UK authorities have looked at the issue of remuneration in the context of wider reforms to be considered in light of the financial crisis. However, the UK is so far notable in that it has published a new “Remuneration Code” to take effect in 2010 for certain large financial services providers, as discussed further below.

The direction the UK would take on remuneration reform was first indicated in the Financial Services Authority (FSA) October 2008 “Dear CEO” letter (a commu-nication to major banks and building socie-ties) that set out the regulator’s initial views on remuneration policies in light of the financial crisis. The FSA encouraged firms to review their remuneration policies and ensure that they were consistent with sound risk management. The annex to the letter set out a number of basic “criteria for good and bad remuneration policies” with the FSA’s “initial thoughts” on good remuneration practices.

In March 2009 the FSA issued the “Turner Review” , a comprehensive analysis of the financial crisis undertaken by the head of the FSA, Lord Adair Turner. On the topic

of remuneration, Turner noted that, while it is difficult to gauge exactly what role remu-neration policies played in the financial crisis, it is “likely that past remuneration policies, acting in combination with capital require-ments and accounting rules, have created incentives for some executives and traders to take excessive risks . . .”

Rules-based regimeTurner noted that this has not been a key area of focus for banks or regulators in the past. Accordingly, Turner said that “the FSA will therefore include a strong focus on the risk consequences of remuneration policies within its overall risk assessment of firms” and referenced the then-draft Remuneration Code as one means of enhancing industry practices.

More generally, the Turner Review pro-vided a clear indication that the FSA (and likely its peer regulators around the world) would be turning away from the previous “light touch” supervisory approach to a more prescriptive, rules-based regime.

On August 12, 2009 the FSA published its long-awaited Remuneration Code. The Code will take effect from the start of 2010 and will initially apply to certain large finan-cial institutions, generally large banks, build-ing societies and broker dealers. The FSA has estimated that the Remuneration Code will initially only apply to 26 firms.

Notably, the Code will not apply to over-seas firms doing business in the UK – this limitation was likely imposed in the final version to address concerns that doing so would harm London’s competitiveness compared with other financial centres. The Remuneration Code consists of eight


principle areas, with relevant guidance in each:1) Role and duties of the remuneration committee: remuneration committees should be independent, with a majority of non-executive directors;2) Procedures for ensuring that risk and compliance functions have appropriate input into the remuneration process;3) Remuneration for risk and compliance personnel to be determined independently of other business areas;4) Profit-based measurement and risk-adjustment: bonus pools to be calculated based on actual profits as opposed to tran-sitory gains, with adjustments for risk and liquidity factors;5) Where compensation is largely based on a person’s performance, the performance is measured over a longer time horizon;6) Non-financial performance metrics to form a significant part of the performance assessment process;7) Long-term incentive plans to take into account future risk factors; and8) Remuneration structures should take into account sound risk management principles.

On the last principle, the FSA retreated from its position in the draft version of the Remuneration Code that essentially required firms to have fully flexible bonus policies, defer the majority of bonus compensation and link the vesting of deferred rewards to performance measures. These provisions attracted criticism during the consultation period as being “overly prescriptive” and jeopardising London firms’ competitiveness.

As a result, the FSA recast these provi-sions as non-binding “guidance” under new

principle 8’s high level direction to align remuneration with “effective risk manage-ment”. Principle 8 now includes several “good practice” recommendations, such as ensuring that a firm can avoid paying bonuses in loss years, deferring a “signifi-cant proportion” of bonus compensation for at least three years, and linking bonus pay-ments to division or firm performance. It remains to be seen how closely firms adhere to these “guidance” provisions in practice.

Firms affected by the Remuneration Code were required to submit a “remunera-tion policy statement” by the end of October 2009, setting out, amongst other things, the firms’ remuneration policies and procedures and how they address the eight principles of the Code. The remuneration policy state-ments will not be made public, but will no doubt be studied by the FSA to determine the impact of the new Code on market participants.

Capitulation chargeAlthough the Remuneration Code presently applies only to a small number of firms, it is significant in that it represents the first com-prehensive regulation to be implemented following the financial crisis. In that regard, it has attracted some criticism from both sides of the debate, with some observers, includ-ing opposition political figures, accusing the FSA of having “capitulated” to banks’ lobby-ing efforts (notably on the “watering down” of principle 8), while others have expressed concern about UK firms’ competitiveness compared to firms from other jurisdictions that have not yet implemented changes.

The FSA has in fact acknowledged that it does not want to carry the torch


alone indefinitely. In an interview with the Financial Times after the Remuneration Code was issued, FSA chief executive Hector Sants said, “It’s fine to be at the forefront for 12 months, but if there is no international momentum beyond that, it isn’t competitive to be out on your own.”

Walker ReviewNonetheless, by taking the lead the UK has arguably staked out a more influential position in the remuneration debate, and other regulators will certainly be looking to the FSA’s experience in shaping their own reforms. Remuneration was also discussed in the “Walker Review” , a separate review of corporate governance in the British banking industry undertaken by Sir David Walker. The Walker Report was published for con-sultation on 16 July 2009, and conclusions are expected by November 2009.

Because the Walker Review’s mandate was to examine the banking crisis from a corporate governance perspective, many of its recommendations on remuneration are particularly aimed at increasing the trans-parency and oversight of the compensation process. These include:• Increasing the remit of the firm’s remu-

neration committee to all “high earn-ers” in the firm, not just executive board members;

• If the directors’ remuneration report is approved by less than 75% of the votes on a non-binding shareholders’ resolution, forcing the chairman of the remuneration committee to stand for re-election in the next year;

• Imposing disclosure requirements of high earners’ pay (in bands), indicating

numbers of executives in each band and the main elements of salary, bonus, long-term compensation and pension contribution;

• Restrictions on early vesting of share awards for high earners who leave the firm.Most of Walker Review recommendations

are proposed to be implemented through revisions to the Financial Reporting Council’s Combined Code on Corporate Governance. Therefore, it appears that UK listed financial institutions will be most directly impacted by the Walker Review recommendations. As the consultation has not yet concluded at the time of this writing, it is not yet clear exactly how the Walker Review recommendations will fit in with other proposals, notably the FSA’s new Remuneration Code, which may impact many of the same entities.

The FSA issued a statement “welcom-ing” the Walker Review recommendations and indicating that it would respond to the Walker consultation and issue a response paper following the final recommendations.

Other remuneration reform initia-tives included the September 2009 G-20 Pittsburgh summit, where remuneration reform was a major topic of discussion. One point of disagreement was whether there should be hard limits on bonuses and other variable compensation, as advocated by the French and German delegations. The United States and the United Kingdom opposed this approach. In the end, the “Implementation Standards” that the G-20 endorsed at the conclusion of the summit provide only that bonuses should be limited to a percentage of total net revenues to the extent an institution would have difficulty meeting capitalisation


standards. The Implementation Standards leave the determination of the percentage to the national regulators. In other respects, the Implementation Standards are gener-ally consistent with the principles in the FSA Remuneration Code and cover many of the same issues (such as deferral of bonuses, independence of risk and compliance units and bonus clawbacks). Although the Implementation Standards are not binding on any of the G-20 members, they do rep-resent a baseline of international agreement on remuneration reforms.

United StatesThe United States, where bonus compen-sation is perhaps most firmly entrenched, recently made the first formal moves towards implementing remuneration controls. On October 22, 2009, the US Federal Reserve (the Fed) issued a proposal that would give it the authority to review and, if necessary, require a bank to amend its compensation policies on risk management grounds.

The proposal encompasses two super-visory initiatives: a focused review of com-pensation practices at 28 “large, complex” institutions, and a more flexible review of compensation practices at other banks as part of their regular examination process.The new requirements would apply only to institutions regulated by the Fed (i.e. nation-ally chartered banks) and not state chartered banks or savings and loan associations. The Fed’s proposal has attracted criticism from those who view it as an intrusion into the business judgment of firms and an unwar-ranted, and politically motivated, departure from the regulator’s non-interventionist pol-icy. At the same time, some have noted that

the Fed has, thus far, taken a comparatively more flexible approach than the FSA in the UK. Although the Fed’s proposal would cover all employees, regardless of seniority, whose activities affect the firm’s risk pro-file, the Fed has generally avoided the more prescriptive measures of the FSA rule and is framed as a set of relatively high-level prin-ciples. Given the business linkages between New York and London, this has led to con-erns about potential imbalances in remuner-ation requirements across the Atlantic. The consultation period on the Fed’s proposal will run through November 2009.

European UnionOn July 13, 2009, the European Com-mission published proposed amendments to its Capital Requirement Directive (CRD Amendment) that include general obligations on firms to have remuneration policies “consistent with … sound and effective risk management.”

The proposed legislation would apply to all EU credit institutions and firms regulated under MIFID. The remuneration portion of the CRD Amendment takes the form of high-level principles which, although bind-ing if enacted, give firms flexibility as to how the principles will be applied. Firms found to be not compliant may be required to change their policies, hold additional regulatory cap-ital and pay fines to their national regulator. If the CRD Amendment is approved by the European Parliament and Council it will take effect in late 2010 at the earliest.

East AsiaIn Asia, where banks had relatively less direct exposure to the trading losses incurred by their American and European counterparts,


comprehensive remuneration reform has not yet emerged as a major topic of discus-sion. To the extent financial institution remu-neration has been discussed, it has generally been addressed narrowly, in the context of other issues, as opposed to being viewed as a component of systemic risk.

However, Hong kong has recently taken initial steps toward addressing remuneration issues more broadly.

In March 2009, the Hong Kong Monetary Authority (HKMA) required Hong Kong licensed banks to ensure that bonuses of front-line retail sales staff are not calculated solely on the basis of financial performance. And on October 30, 2009, the HKMA announced that it would conduct an industry consultation on a draft remuneration guideline for institutions it regulates. The text of the HKMA’s guide-line was not publicly available at the time of this writing, but it is expected to be generally consistent with the G-20 Implementation Standards. The HKMA has said that it plans to issue its remuneration guideline by the end of 2009 and would expect banking institutions to be in full compliance by the end of 2010.

In other countries, some limits on remu-neration have been implemented, but these generally serve more general corporate gov-ernance aims. For example, in March 2009, Taiwan’s Financial Securities Commission (FSC) passed a regulation requiring certain financial institutions to disclose their execu-tive’s compensation details if they fail to meet certain financial targets, such as capital adequacy ratios.

Despite the lack of dialogue on remuner-ation reform in Asia to date, regulators in the region may begin to consider the issue more seriously if and when other regulators follow

the FSA’s lead. Given the large presence of international institutions in the Asian bank-ing market, harmonisation of standards may grow in importance as banks become sub-ject to remuneration controls in their home jurisdictions and other regions where they operate.

ConclusionRemuneration reforms for the financial services industry are slowly moving closer to reality. The UK has taken the first step in this direction, and it is likely that others will look to the FSA’s experience as a model. The agreement on Implementation Standards at the G-20 summit suggests some coalescing of international opinion on the subject, but it remains to be seen how this will continue to develop at the national level. •

References1. The Turner Review: A Regulatory Response to

the Global Banking Crisis, March 18, 2009.2 Turner Review, at 80. 3. Policy Statement 09/15, Reforming remunera-

tion practices in financial services: feedback on CP09/10 and final rules, August 12, 2009.

4. FSA accused of back-pedalling on bonuses, Finan-cial Times, August 12, 2009.

5. A Review of Corporate Governance in UK banks and other financial industry entities, Sir David Walker, July 16, 2009.

6. FSB Principles for Sound Compensation Prac-tices: Implementation Standards, Sept 25, 2009.

7. Directive of the European Parliament and of the Council amending Directives 2006/48/EC and 2006/49/ECas regards capital requirements for the trading book and for re-securitisations, and the supervisory review of remuneration policies, July 13, 2009.


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


in the downturn – it must be able to do two things:

(a) Focus on risk from an enterprise per-spective. This means hunting out the subset of risks across the company that are severe enough to threaten the whole enterprise, even if these risks look unlikely (e.g. a 40 per cent fall in house prices), unprecedented (e.g. seizing up of global funding markets), and take the form of hidden concentrations and risk interactions.

(b) Marshall objective evidence about the consequences in terms of capital adequacy and bank risk appetite. This is because seem-ingly ‘unlikely’ enterprise risks will not be paid enough attention unless their qualities are quantified and set starkly against busi-ness objectives and commitments to stake-holders, e.g. on safeguarding solvency.

Stress testing programThe need to focus on enterprise risks and bring together evidence from across the bank means that program for stress testing and exploring downturn capital adequacy must be led from the top of the bank. This helps ensure that the results shape company strategy: Executives who understand stress tests and find the results credible will apply them. As Box 1 (opposite page) makes clear, regulators and industry bodies are calling for the involvement of top management in enterprise stress testing as a key post-crisis reform.

Regulators believe the stress testing program many banks had in place before the crisis needs improvement. They say the ‘worst case’ scenarios applied by banks were too mild, that some banks treated stress tests largely as back-room quantitative exercises,

and that the results were often difficult to combine across businesses to capture the true level of enterprise risk.

A senior regulator at the Bank of England went further earlier this year and said that:

“. . . stress testing was not being mean-ingfully used to manage risk. Rather, it was being used to manage regulation [and] as regulatory camouflage.”

We believe bank senior executives and boards should keep in mind a number of issues when building a stress testing pro-gram to counter these criticisms.

Sensitivity, shockFirst, consider all of the analysis that should be legitimately supported with stress testing, from local business planning to risk man-agement and enterprise capital adequacy. Second, it is important to understand and consider the great range of stress testing techniques available, from simple sensitivity tests that shock a single risk factor in a small sub-portfolio, to much broader historical and hypothetical scenario testing of the bank’s global risk portfolio.

To keep things clear, it can be helpful to think about the bank’s stress tests in terms of two categories: (a) Micro stress testing to identify specific issues of concern and miti-gate their effects; and (b) Macro stress test-ing to quantify the impact of worst-case economic scenarios.

Micro stress testing, for example, might use a mix of expert judgment and quantita-tive techniques to look at a particular sub-portfolio in terms of one or more risk factors, such as the bank’s exposure to a rise in the default rate in the automotive industry.

We believe micro stress testing should


be encouraged, but it is not sufficient from an enterprise perspective, particularly when conducted largely within business lines. Regulators say that limited enterprise level integration of stress tests meant banks had “. . . insufficient ability to identify correlated tail exposures and risk concentrations across the bank.”

Macro stress testing, by contrast, looks at how broad macro-economic stresses might affect the whole bank and uses a variety of sophisticated quantitative techniques to translate these deteriorations into their impact on risk factors and to help the bank see the effect.

Macro stress testing can be used for a

variety of purposes, such as enterprise busi-ness planning and also to strengthen capital adequacy processes. For example, regulators have made it clear that a transparent, audit-able process for translating stress testing into capital adequacy decisions will be required to comply with supervisory Pillar II of Basel II – and they are sending out clear signals that this will be a key area of interest when they look at bank capital adequacy processes in the post-crisis industry.

The second key point is that, at the enter-prise level, stress testing is about uncovering hidden enterprise dependencies and routes to worst-case losses. This is not the same thing as trying to predict upcoming risk

Box 1: Stress Testing and Senior Management – Pressure from the Regulators

• ‘Supervisorsshould...verifytheactiveinvolvementofseniormanagementin the stress testing program [and] evaluate how stress testing analysis impacts the bank’s decision making at different management levels includ-ing strategic business decisions’

Principles for Sound Stress Testing Practices and Supervision, Basel Committee, Consultative Document, January 2009

• Itisessentialthatseniormanagementareinvolvedinoverseeingacom-prehensive and co-ordinated stress and scenario testing program ....Senior management buy-in and involvement is essential in defining scenarios, dis-cussing results, assessing potential actions, and in constructing an effective [stress testing] governance framework.

Stress and Scenario Testing, Financial Services Authority, Consultation Paper 08/24, December 2008, page 12 and page 20

• ‘Seniormanagement involvementwas important to theeffectiveuseofstress tests, especially macro scenarios [and particularly] when the tests revealed vulnerabilities that firms found costly to address’.

Senior Supervisors Group, Observations on Risk Management Practices During the Recent Market Turbulence, March 2008, page 17


events or trying to sort out which risk events are most likely to happen.

Instead, the focus, in our view, must be on understanding how risk interactions and concentrations within the bank’s portfolios might worsen losses in a difficult environ-ment, and this means exploring:

• Joint default probability – the tendency of customers to default together when things get bad;

• Risk factor correlations – the way that a deterioration in one key risk factor (e.g. default probability) prompts a sharp dete-rioration in another (e.g. loss given default); and;

• Risk interactions – the tendency for a shock in one area of risk management (e.g. credit) to lead to shocks in other areas (e.g. bank funding liquidity).

Pooling the evidenceOf course, this is easier said than done. Among other factors, banks may need to:

• Build long-time series of credit risk data to help the bank estimate default rates and loss given default rates in downturn envi-ronments. Banks may need to set up data consortia to pool evidence from particu-lar geographic or industry credit segments where data is sparse;

• Analyse stress migration rates for credit ratings using sector-specific data to under-stand how portfolios can deteriorate for a year or so after a stress event;

• Build data sets and methodologies for understanding how risk factors such as default rates and loss given default rates are correlated in specific industries and types of collateral;

• Explore how changes in macro-

economic indicators drive bank credit losses. There are various methodological challenges here, including how to strip out the correlation effects from industry-level historical data, and then add back in the correlation factors that are relevant to the bank’s own portfolio.

However, while stress testing must become more sophisticated and accurate in terms of granular risk interactions, it must not be allowed to become a purely quantita-tive back-room exercise.

Regulatory investigations suggest that banks must become more adept at draw-ing together experts in risk from across the organisation to establish a company-wide view and approach to stress testing, e.g. making sure that fundamental credit insights from experts in commercial lending reach other bank areas such as capital markets.

Likewise, some investigations have attributed the relative success of some risk managers during the crisis to their greater knowledge of how bank business areas make their money, because this helped them “. . . identify relevant stress scenarios or pro-vide warning when assumptions underly-ing single-factor stress tests were inaccurate measures of risk.”

This suggests that the key challenge for executives is building the right blend of bank-wide information sharing, modelling capabilities and executive judgment into the bank’s stress testing program.

The role of executive judgment will not end with appraising the bank’s own stress test results. Regulators are also urging banks to consider what the second-order effects of a worst case analysis might be. That is, whether peer banks might be similarly


affected by a worst-case scenario and what this might mean in terms of risk contagion, e.g. will a credit risk worst case scenario lead to liquidity hoarding? Stress testing is often thought of as a tool for uncovering risks that already exist in the bank’s existing portfolios, but it must also become part of how the bank thinks about future business strategy.

Otherwise the bank’s performance anal-ysis systems will make businesses that gen-erate apparently unlikely, but potentially very severe, losses look more profitable than they really are. The enterprise risk costs will have been left out of the equation. Likewise, the bank will also end up selling credit and other products at a price that does not reflect the enterprise risks they generate.

The answer is not to put some blan-ket wash of conservatism on all decisions. Instead, banks must systematically differen-tiate between the profitability of businesses and deals that create costly enterprise threats, compared with those that do not.

Strategic levelAt a strategic level, this may mean giving

stress testing and downturn analysis more prominence as tools for capital allocation, so that the capital costs of enterprise-level risks can be taken into account when assessing the profitability of a burgeoning bank activ-ity. Business lines that put the enterprise at risk need firm limits, but they should also pay a capital cost for the risks they attract well before those limits are reached.

It also is important to make sure risk costs are reflected in tactical decisions, such as pricing. Incremental transactions that generate enterprise concentrations and risk correlations should attract a risk capital

cost that rises in line with the bank’s expo-sure. This will make the bank’s pricing less attractive in the market as enterprise risk rises, counteracting the tendency in bank-ing markets to overshoot during booms. It will not always be popular with business chiefs at the top of the business cycle, which is the point!

ConclusionFrom a senior management perspective,

the three strands of improved enterprise risk management that we have discussed cannot easily be separated.

Senior executives and boards must become more responsive to enterprise risks, even when the probability of a particular risk event does not seem high. But working out which risks and risk interactions are the most important to a particular enterprise is not easy in advance, so corporate governance must be supported by systematic processes for uncovering risk concentrations, correla-tions, interactions and dependencies.

Senior executives then have to look at the results both in terms of their enterprise’s risk appetite and in terms of second-order risk contagion across the industry. Once the bank has done this, the new information must drive how the bank behaves in terms of the businesses it chooses to acquire or grow, the exposure limits it sets in relation to its risk appetite, and the price the bank is willing to offer for deals that increase concentrations.

That way, the bank will direct its capital towards businesses and transactions that create long-term competitive advantage and away from those that periodically destroy value and threaten the enterprise. •


Risk management

Challenging the value of enterprise risk management

PricewaterhouseCoopers’ Tim Pagett and Ranjit Jaswal discuss how to get the most

out of a post-crisis ERM environment.

the impact of the credit crunch on so many institutions over the past 24 months has underlined the critical importance of effective enterprise risk Management (erM) in creating and sustaining favour-able financial performance and prevent-ing financial losses. Despite significant investment in risk management tools, models and processes, many financial organisations’ erM programmes may not be keeping pace with mounting risk pressures and more exacting stakeholder demands. the authors of this paper look at how financial institutions can use some of the lessons learnt from the crisis to ensure their erM programmes deliver tangible and intangible commer-cial value.

From major natural disasters to the con-tinuing turbulence in the financial markets, an increasingly uncertain business, social and economic environment is driving more organisations to challenge whether their so- called Enterprise Risk Management (ERM) capabilities are fit for purpose. The pressure on ERM to deliver is likely to be heightened

still further by the impact of capital con-straints, increasing systematic risk within the financial markets and the pressure by share-holders to deliver returns in an increasingly volatile market.

A good deal of the pre-crisis invest-ment, thinking and challenge in the field of ERM focused on the enhancement of risk measurement and modelling capabilities, re-inforced by the often penned mantra – if you can’t measure it you can’t manage it. If there is one thing the crisis reinforces, it is that risk management is so much more than just models and measurement.

Control frameworkThat said, risk models are an indispensable input into the ongoing management of the business. However, to be effective the risk models must operate within a comprehen-sive and fully functioning Internal Control Framework that incorporates, at a mini-mum, a full consideration of the impact of risk concentrations and economic, financial and operational stress. Further, there is no substitute for a deep and systematic under-standing of the risks involved in the business


and for common sense and judgment in challenging whether the business is fully addressing those risks, be it either operation-ally or strategically. The financial crisis dem-onstrated that many market participants, commentators and risk management pro-fessionals were totally unprepared for deal-ing with the impact of such severe moves in market factors.

Probability factorRisk management has been criticised for failing to “predict” the onset of the crisis – which is possibly fair given the extraordinary levels of investment that have been focused on determining the “probability” of an event occurring. In fact, by far the majority of tools and techniques applied in the market are based on the principles of probability. That said, much of this investment was driven from a desire to meet the management chal-lenge of “don’t just tell me what could hap-pen – tell me how likely it is”.

However, crisis conditions serve as a sali-ent reminder of the importance of giving equal consideration to the “art of the pos-sible” and not just the “science of the prob-able”. Risk management, now more than ever, is as much about preparing for what has not happened before as it is for under-standing, managing and preparing for what has been experienced in the past.

Given the huge market value losses in many financial institutions, it is perfectly rea-sonable to challenge the cost and value of risk management. However, as the world shows some of the early signs of recovery, it is critical that ERM must be viewed as an investment in the company’s future rather than sim-ply as a cost factor of doing business. ERM

needs to be refined rather than consumed by the business. It would appear that share-holders, customers and regulators alike hold this view as the pressure continues to mount for management to further strengthen ERM culture, processes and functions, resulting in growing prominence and responsibilities of Chief Risk Officers and their teams. There is increasing pressure to strengthen the role of risk management functions as the sec-ond line of defence after line management, and in this environment it is critical that risk teams have the freedom and the capability to take an independent view from business management – but increasingly on a co-ordinated basis.

ERM programmes cannot work in a vacuum; they need to be relevant to, and integrated into every aspect of the business to make a difference, not only to the business but also to cost-effectively meet the needs of regulators and shareholders. Never before has there been a period of history that rein-forced the need to ensure that it isn’t just risk managers who are responsible for risk.

Strategy failings It is notable that many institutions that had developed what they believed were robust and sophisticated ERM capabilities still suf-fered some of the worst losses and dam-age to value. Failings in funding strategy, investment strategy, people, compensation and incentive management, information technology, governance and overall com-munication all contributed to undermining the “effectiveness” of these institutions’ ERM programmes.

What marked out companies that mini-mised the lasting impact of this crisis were


those that maintained continuous, timely, rigorous and consistent identification, com-munication and consideration of risk across the decision-making management chain incorporating all elements of the value-chain.

Raising the barFurther impetus for the development of truly integrated ERM within the financial services industry is coming from the explicit consid-eration of ERM within rating agency financial strength evaluations, analysts’ expectations on risk disclosures, improving shareholder confidence and the move to prudent risk-based regulation (e.g. Basel II for Banks and Solvency II for EU Insurers).

Analysts and investors are taking an ever keener interest in how effectively risks are being managed and translated into rewards. Further, the inclusion of ERM in financial strength evaluations by rating agencies is helping to raise the bar for ERM and driving all financial institutions to integrate the risk and control practices that operate through-out their businesses in a systematic fashion.

Key evaluation criteria include the extent to which risk considerations are integrated into strategic planning and capital allocation. While challenging across differing geogra-phies and business models, these increasing demands will reward firms which are able to align risk and capital management more closely, and use their ERM programmes to provide a more informed, assured and coherent risk-based platform for strategic and operational evaluation.

Real value should ultimately only come from ensuring that risk understanding, rig-our of control and appropriate constraints

and incentives are embedded into business planning and capital allocation. True align-ment of interests within the business around a consistent and cohesive view of risk will only really be achieved on an enterprise-wide basis when organisations can overcome their internal barriers to work on a common definition of what matters most.

The recent crisis has reinforced the need for more development in the area of stress and scenarios and more focus on develop-ing contingency plans for what could go wrong rather than remedial plans for what has gone wrong. Moving from the “science of the probable” to the “art of the possible” will not happen unless the industry learns from the lessons of the past and incorporates risk anticipation into its overall planning and business process.

ERM integrationIronically, one of the critical barriers to suc-cessfully achieving truly integrated ERM would appear to be one of the easiest to remove – in clarifying roles and responsibili-ties and aligning with incentives and com-pensation. There is anecdotal evidence from this crisis that poor collaboration/co-ordina-tion across an institution created confusion about who ‘owned’ risk and how it should be managed. More broadly, it seemed that risk management was seen as someone else’s job and that ERM was not really relevant to the institution as a whole.

That said, an area where alignment and integration should be fairly readily achieved is in the convergence of the functions of Risk Management and Finance (including the Actuarial Function for Insurers). Each of these functions rely to a greater or lesser


extent on the use of complex and bespoke models, methodologies and disciplines to provide support to internal and external stakeholders – using for the most part the same data on which the business makes its strategic and operational decisions. They are for all intents and purposes focusing on two sides of the same coin.

Blind faithHowever, in many instances operational and political struggles over roles and respon-sibilities continue to limit cohesion. One popular approach to resolve this has been the promulgation of Enterprise Wide Data Warehouses and Finance system. Although this is great for ensuring data quality, having one “data set” does not solve the problem of having one “mind-set” in what to do with the data and how it should be presented and communicated.

In today’s risk environment, there is clearly a danger that poor information or ‘blind/naive reliance’ on complex models has generated false confidence and encouraged institutions to accept too much risk. Equally, limited risk insight or a desire to “avoid blind/naïve reliance” on complex models has not necessarily led to overcautious approaches where institutions have assumed too little risk – rather they too have accepted greater levels of risk out of ignorance rather than by design.

A key test of an organisation’s ability to deal with these challenges on an enterprise-wide basis is its ability to demonstrate the alignment of its people with its strategy – functionally, culturally and operationally. At the centre of this test is the quality, timeli-ness and reliability of its risk assessment,

the effectiveness of aggregation monitoring and the confidence of its people to use this risk analysis to identify commercial oppor-tunities and set commercial objectives. The development of a coherent portfolio view of the threats and opportunities facing the business is likely to be difficult without such assessment.

It is acknowledged, that having such a portfolio view across the organisation will require a cohesive and comprehensive alignment of performance and risk-related metrics, but the speed and contagion nature of the recent crisis would appear to reinforce the observation that the existing alignment of risk and financial metrics is somewhat limited. Bringing risk considerations into the forefront of business planning and perform-ance management is paramount and does require integrated measures that bridge all functions of the organisation, risk manage-ment and finance included.

Risk adjusted viewTo add to this, many organisations are look-ing at ways to make risk a more visible and telling element for strategic evaluation, capital allocation and performance man-agement. Through the development and application of common metrics that bridge risk and reward, closer alignment between risk management and its partners will be the key foundation for a risk adjusted view of the business.

Metrics must incorporate a balance between qualitative and quantitative inputs. Investment in refining the “science of the probable” with the “art of the possible” must be at the core and this means the develop-ment of quantitative metrics for operational


and strategic risks using integrated stress and scenario analysis. In this way, measures that align risk and finance such as Risk-Adjusted Return on Capital (RAROC) should pro-vide much more coherent and comparable insights into the trade-off between risk and reward.

Potential benefitsThe potential benefits of these measures would surely include:• Greater application of risk management

and financial disciplines in key business processes such as strategy, planning and valuation;

• More robust and aligned financial, strategic and operational plans and projections (for example by challeng-ing management and the business to consider ranges of upside and down-side outcomes it requires them to better define their appetite for risk and earnings volatility);

• A more coherent and consistent view of the business from risk and finance; and

• Better, faster and more robust decisions based on common data.Closer alignment between risk and

finance functions rests on both the stand-ardisation and simplification of the reporting, control, modelling, transactional and data elements of risk and finance and the care-ful consideration of roles and responsibili-ties. There must also be enhanced incentives to leverage predictive/forecasting analytics, such as stress testing risk and reward sce-narios as part of the budgeting and planning process. The fast-shifting commercial and regulatory environment must surely bring the disciplines closer together.

It is potentially unrealistic to say that many institutions have already achieved truly integrated ERM programmes which are effectively aligned and implemented across the organisation. In light of this, early expectations of dividends from ERM may prove dangerous.

ERM is still a developing manage-ment discipline and more advanced com-ponents, ranging from risk modelling to risk-adjusted performance management, present challenging new frontiers for many organisations. Integrating ERM into each decision-making and the risk-taking value chain should provide a more disciplined and insightful ‘economic’ approach to running the business, and offer greater assurance for boards and external stakeholders. But there is much work to be done and many frontiers to be breached.

Fundamental shiftsAt a time when margins are coming under increasing pressure and the economic slow-down is limiting business opportunities, an improved understanding of a risk-adjusted view should assist institutions to identify and clarify opportunities that may be missed by their competitors and target investment where they can earn the best return.

Now, more than ever, institutions need to look at how to instil risk considerations into the fabric of the business and address what may be fundamental shifts in their cul-ture and operating model to ensure that this happens. Those that do not may struggle to attract capital and sustain competitiveness in what looks to be an increasingly unfamiliar and challenging risk, regulatory and com-mercial environment. •


Accounting standards

Rocky road ahead for global accountancy convergence

Dr Philip Goeth, Deloitte’s regional FSI head, summarises obstacles preventing a

unified global accounting standard.

the objective of a truly global set of accounting standards has progressed a long way. in recent years, in particular with the incorporation into european law in 2002 (effective in 2005), account-ing in accordance with the international accounting standards Board (iasB) and international financial reporting standards (ifrs) has become widely accepted and used across the globe.

Now more than 110 countries have adopted IFRS as their predominant set of accounting rules. In Asia, Hong Kong, Singapore, the Philippines, Australia and New Zealand are already using IFRS, and China has enacted Chinese Accounting Standards (CAS) which are substantially in line with IFRS.

However, “widely used” does not yet mean “global”. The US is still using their own US GAAP, even though since 2008 the SEC has allowed non-US companies (Foreign Private Issuers) to file under IFRS. Equally, in Asia, Japan, Korea, Taiwan, Thailand, Malaysia and Indonesia, to name a few, have not yet fully adopted IFRS and are following

their own convergence road maps. In addi-tion the US, in accordance with their road map, as developed by the SEC, will decide in 2011 the extent and timing of any switch to IFRS.

Clearly, the US moving to FRS would be seen as a major step towards the realisa-tion of the globalisation objective. However, to achieve this goal, the IASB and FASB, which have been following a co-operation plan to converge the two standards, still need to agree on a number of important issues. The convergence plan was laid out in a Memorandum of Understanding between the FASB and the IASB called A Roadmap for Convergence between IFRSs and US GAAP – 2006-2008 1, and covers a wide range of issues.

Best use of time?In a progress report and timetable

for completion2, the IASB and the FASB recently confirmed the importance of con-vergence, reflecting that “trying to eliminate differences between two standards that are in need of significant improvement is not the best use of the FASB and the IASB


resources – instead, a new common stand-ard should be developed that improves the financial information reported to inves-tors”. Accounting for Financial Instruments in particular has been identified as one of the key co-operation projects.

Fair value critiqueNot surprisingly though, this smooth

and widely co-ordinated process to develop accounting standards for financial instru-ments was impacted by the global finan-cial crisis. The best known disruption was triggered by rather harsh criticism that the application of accounting standards in the Banking industry, fair value (FV) measure-ment in particular, have exacerbated the financial crisis.3 This criticism has lead to an intense discussion within the accounting industry on the role of FV accounting and the viability of this measurement concept during periods of market illiquidity.

Currently, it seems that FV accounting has weathered the storm: An SEC report4 holds a rather positive view on the mat-ter, and both the IASB and the FASB have meanwhile proposed changes to their frameworks supporting the fair value meas-urement model. However, as discussed in more detail below, in this process, the goal of convergence seems to have fallen slightly out of focus, at least for the time being.

Generally, it can be said that the global financial turmoil and the associated politi-cal pressure resulted in an increase in the activities of both the IASB and the FASB. A good example of this is the process or lack of due process associated with the October 2008 amendments to IAS 39 and IFRS 7 concerning the reclassification between

certain categories of financial instruments (in particular: reclassification from Held for Trading to Held to Maturity). These changes were pushed through rather hastily based on political influence.5

Meanwhile, accounting standards have reached the highest level of political atten-tion, with the subject matter being a key issue for the G20 conference where they have focused on the reshaping of financial mar-ket regulation. In the final report of the G20 Working Group 1, called Enhancing Sound Regulation and Strengthening Transparency, the G20 made detailed recommendations on accounting matters.6 Further, it was out-lined that accounting standard setters should “examine changes to relevant standards to dampen adverse dynamics associated with fair value accounting, including improve-ments to valuations when data or modelling is weak”. Finally, a reduction of complexity of accounting standards for financial instru-ments and enhanced presentation standards relating to the measurement of financial instruments was emphasised.

Where convergence seems to workA good example of an area in which the

cooperation between the IASB and the FASB appears to be working, and convergence is likely to be achieved (quickly), is in the defi-nition of fair value. The IASB has issued an Exposure Draft (ED) on the matter in May 2009.7 This ED contains guidance on meas-uring fair value, in order to fill some gaps in the framework and to consolidate the valua-tion methodology, which is currently spread over various standards and considered as not always consistent.

One of the IASB’s objectives for the


project is to increase convergence between IFRS and US GAAP, and this ED looks to converge with FAS 157, the US Standard on fair value.8 In the ED, FV is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price). In the absence of an actual transaction at the measurement date, a fair value measure-ment assumes a hypothetical transaction in the most advantageous market for the asset or liability. The ED is accompanied by an outline of the basis for conclusions, as well as by some examples.9 It is planned that the ED will become an IFRS in 2010.

Another area where the co-ordination seems to work relates to the recognition and de-recognition of financial instruments. In March 2009, the IASB published an expo-sure draft De-recognition ED/2009/3 (pro-posed amendments to IAS 39 and IFRS 7). The approach proposed for financial assets focuses on the existence of control. This dif-fers from the current guidance in IAS 39, which is primarily concerned with “risks and rewards” (control being a secondary test). In more detail, the ED proposes that an entity should de-recognise an asset only in the fol-lowing circumstances: • the contractual rights to the cash flows

from the asset expire; or• the entity transfers the asset and has no

continuing involvement; or• the entity transfers the asset and retains

a continuing involvement in it but the transferee has the practical ability to transfer the asset for the transferee’s own benefit. A major criticism of the proposed model

is the accounting for certain repurchase obligations (repos), which would qualify for de-recognition in most cases. This topic is controversial because the banking industry generally views such transactions as secured borrowings.

As agreed at the joint meeting in July 2009, the FASB will join the IASB’s delib-erations following the implementation of the FASB’s recent amendments to the de-recognition and related disclosure require-ments under US GAAP. The goal of this is to ensure that the IASB and FASB will consider the lessons learned and experiences gained from the application of those amendments in practice, in order to develop a converged de-recognition standard.

Where convergence needs more timeAn area in which the IASB and FASB

seem to need more time for convergence is determining the criteria for the classification and measurement of financial instruments. The IASB has recently issued an ED10 on the matter, which proposes to overhaul the cur-rent system quite significantly: In the future, IFRS proposes all recognised financial assets and financial liabilities that are currently within the scope of IAS 39 to be meas-ured either at amortised cost or fair value. Measurement at amortised cost would be required for a financial instrument that has only “basic loan features” and is managed on a contractual yield basis (unless the instru-ment is designated as at fair value through profit and loss). In the case of equity instru-ments that are not held for trading, the ED proposes an option to designate such assets irrevocably as at fair value through other comprehensive income. During the


process of drafting the ED, the IASB consid-ered whether to allow reclassifications in or out of the three new categories after initial recognition and concluded that reclassifica-tions should be allowed if there is a change in the entity’s business model.

This rule set differs materially from the framework that the FASB intends to enact for US-GAAP: In a board meeting in October 2009, the FASB confirmed that they favour a model that focuses on fair value, with changes in fair value recognised either in net income or in other comprehensive income. This means that the mixed measurement model of the IASB with its wider scope of cost accounting for loans is not currently supported by the FASB.

Request for informationAnother area requiring further align-

ment relates to impairment, in particular valuation of loans. Loan loss provisioning is a key topic on the agendas of both standard setters, given that the G20 is “analysing the potential contribution of loan loss provision-ing to procyclicality with a view to recom-mending that accounting standard setters consider enhancements to loan loss provi-sioning practices and standards”. The IASB has issued a topical Request for Information on an expected loss model, and an ED on the matter is expected to come out soon.11

As set forth in the discussion document and as outlined in recent progress reports, the IASB is considering replacing the current “incurred loss” model with a more precisely defined “expected loss” model. In the discus-sion process, the board also considered the potentially anticyclical dynamic provisioning model as promulgated by the Bank of Spain.12

However, it seems that the expected cash flow/expected loss model, which is believed by many to be procyclical, will prevail. The ED will most likely also provide clear principles regarding cash flow estimates on a collective (portfolio) and an individual basis (including the interplay between those bases), forecasting of cash flows, and the treatment of trade receivables.

Further, the determination of the initial expected spread, practical aspects of apply-ing the effective interest method (including variable rate instruments) and the interaction with Basel II requirements have been topics discussed in the process to-date. Important clarifications are also expected relating to point-in-time versus through-the-cycle-estimates, expected value versus most prob-able value and use of entity specific versus market data.

The FASB is equally focused on the topic: In a recent meeting13 the board analysed var-ious methodologies on loan loss provision-ing for the “fair value – other comprehensive income category”, differentiating between incurred loss models, various expected loss models, and hybrid approaches. It remains to be seen if the two boards will converge in their views. Given the tight time frame within which the IASB intends to issue its new standard, to achieve such co-ordination seems quite a challenge.

The political dimensionThis short summary, which is not meant

to be complete, shows quite clearly that the pressure to come up with results has put stress on convergence, with time pressure pushing the IASB and the FASB to work on individual concepts in what appears a rather siloed manner. Although both boards


continue to send representatives to each other’s meetings, divergence in material matters is still apparent.

Level playing fieldSir David Tweedie, head of the IASB, has

recently addressed this point in an interesting speech he gave to ECOFIN on October 20:

“I want to emphasise that the alternative of adopting a portion of the FASB approach to impairment, promulgated in April, would not bring about a level playing field. Furthermore, on many issues, EU financial institutions would not want us to adopt the US approach on impairment. As I said in June, given the urgency of the fundamental issues surrounding IAS 39, none of us can afford the potential protracted back-and-forth resulting from piecemeal changes in international and US standards that would undermine the comprehensive and desper-ately needed reform that is under way.

“In our discussions with the FASB aiming to reach a common global approach, we will emphasise our position in favour of a mixed measurement model over one that requires full fair value measurement on the balance sheet. We will seek to reach common agree-ment on a forward-looking model for loan-loss provisioning and a simplified hedging methodology.

“I remain optimistic that we can over-come our current differences. I know that my counterpart at the FASB, Bob Herz, is equally committed to reconciling any dif-ferences. To this end, we have enhanced our co-operation over recent months and have stepped up the joint meetings of our boards and staff.”

This comment needs to be read in the

context of a recent interview of Robert Herz, the head of the FASB. In an interview pub-lished recently by Accountancy Age,14 Herz expressed the view that the IASB’s ability to “resist undue European pressure will be a critical issue as the US decides whether to adopt global accounting rules”. He further said that “the US wants to make sure that the standards it uses come out of a standard set-ter which has the appropriate public policy objectives and is not being geared or har-assed to do things in a way that is not consist-ent with that public policy objective … there are concerns especially among the investor community that what we may end up with are standards which are not geared towards the public policy objectives that we hold fairly sacred in the US … As one congressman once said to me: ‘It’ll be a cold day in hell when I let a Frenchman tell me what to do’.”

Will the G20 prevail?These messages make the politi-

cal dimension of accounting convergence quite clear. While this dimension has always existed, through the financial crisis it has cer-tainly gained attention to an unprecedented level. However, while the conflict might be real, there is hope that the overarching goal of convergence, as re-emphasised by the G20, will finally prevail. Clearly the IASB and FASB will vigorously attempt to come up with solutions to the divergence, as a true global standard that is acceptable to all major financial centres is the desired target that seems to be shared by all participants. Significant cost reductions and an increase in comparability and transparency will be the consequence – an opportunity not to be missed. •


References1. Dated February 27, 2006, available on the IASB

website.2. Dated September 2008, same source as above. 3. See e.g. “Financial crisis presents a test for fair

value accounting”, Financial Times February 13, 2008.

4. Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabi-lization Act of 2008: Study on Mark-To-Market Accounting.

5. See e.g. “Sarkozy seeks accounting change”, Finan-cial Times 30.9.2008.

6. In particular relating to strengthening the loan loss provisions methodology by “considering alternative approaches for recognising and meas-uring loan losses that incorporate a broader range of available credit information”.

7. With comments due on November 28, 2009.8. See for existing differences the recent compari-

son in the IASB document “Wording differences between the IASB exposure draft Fair Value Measurement and FASB Statement of Financial Accounting Standards No.157 Fair Value Meas-urements”.

9. A recent summary of the received comment letters outlined that many commentators would welcome additional examples, in particular relat-ing to financial instruments – a comment that is shared by the author.

10. ED issued July 14, 2009, comment deadline was September14, 2009.

11. On the IASB website, the draft is announced for October 2009.

12. For a good overview of the various approaches, including the Spanish model, see CEBS, Position paper on a countercyclical capital buffer, July 17, 2009.

13. October 21, 2009. 14. October 15, 2009.


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ContactChristopher RogersGeneral [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





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


Comparative regulation

The Asia-Pacific regulatory Rubik’s Cube

Allen & Overy’s Alan Ewins and Angus Ross run their comparative ruler across

regulatory environments in Asia.

the asian regulatory environment is colourful, complex and has many mov-ing parts. asian governments and regu-lators are grappling with what at present appears to be the aftermath of the mar-ket turmoil (although a further market turndown cannot of course be ruled out globally as and when the effects of the bail-outs and stimulus packages have washed through the international system).

That grappling involves a fine balance that needs to be struck among various driv-ers, including pressures and political obliga-tions created by the G20 (and the Financial Stability Board) process, the spectre of pro-tectionism and regulatory arbitrage across the Asian markets, and the need for the various Asian jurisdictions to maintain their competitiveness on the world financial stage. This is all coupled with the extent to which broader market reforms will ulti-mately be persevered with in the light of the game of ‘Market Scrabble’ that now seems to grip commentators (i.e. will it be a U, V, W or something else-shaped recovery).

Hong Kong has proved to be an inter-esting case study in this regard. First off the mark, at the end of 2008 with Securities and Futures Commission (SFC) and Hong Kong Monetary Authority (HKMA) reports to the Hong Kong Financial Secretary on responses to the minibonds debacle; in the midst of a multi-pronged consultation programme to address issues in relation to sales of struc-tured products in the territory and potential changes to the legislation as well as the rel-evant codes and guidance; and the HKMA having now started consulting in relation to the risk management aspects of the remu-neration policies of banks (the first Asian jurisdiction to tackle this issue full-on).

Hong Kong When combined with a significantly tougher stance on market misconduct, including insider dealing, which has led to a raft of convictions over the past year or so, and the anti-money laundering consultation exer-cise just completed to meet Financial Action Task Force requirements, it is clear that not only is Hong Kong attempting to keep its own house in order but also to look to its


international obligations with an eye to the future regulatory landscape internationally. So what of elsewhere in the region?

SingaporeSingapore has taken a broadly similar approach to the crisis to Hong Kong, having had its own significant share of minibonds fall-out. Its moves towards market reform in relation to structured products have essentially mirrored the Hong Kong devel-opments, covering such things as product highlights and cooling-off periods.

The attitudes of the two jurisdictions regarding settling the Lehman Brother Minibond problems have been somewhat different, of course. Hong Kong procured monetary settlements by the distributors, with investors told essentially to draw a line under this issue and move on; the Monetary Authority of Singapore (MAS) took a dif-ferent path, disciplining the distributors for their failings and leaving it to the investors to seek their own redress by way of the island’s law courts.

Not surprisingly, the MAS has also issued guidelines in relation to fair outcomes for investors (mirroring, for example, the Financial Services Authority developments in the United Kingdom), together with enhanced licensing and notification changes, designed to improve investor protection.

ChinaChina appears likely, according to the results of a recent survey that we conducted, (“Asian Regulatory Survey 2009” http://www.alleno-very.com/AOWeb/binaries/53423.PDF), to forge its own path in terms of regula-tion, given its strengthening role in the

international economy and the correspond-ingly weakened influence of Western regu-lators following the global financial crisis.

According to the preliminary version of the OECD Regulatory Reform Review for China (Defining the Boundary between the Market and the State), “China’s regulatory reform has made impressive progress over the past decade and is gaining momentum. Much remains to be done, but a very good foundation has been laid”.

Most commentators would tend to agree with this.

On one hand, there have been increased requirements for liquidity and credit control stress tests for banks, derivatives documen-tation advances and other developments.

On the other hand, there is an element of tension at present in the market as the result of problems arising between Western institutions and domestic State-Owned Enterprises (SOEs) from failed derivatives contracts.

Those problems represent a test of the Rule of Law which is proving to be delicate, given the Government’s professed support of the SOEs modified by its insistence that the SOEs do indeed have the burden of proving their cases. A fine line.

JapanJapan has indicated that it has, in general, no objection to any statement issued in the G20 process. The Minister of the Financial Services Agency, Mr. Kamei, went on to say that any capital-related issues under the Basel Accord, which is a central plank of the G20 reforms, should be applied to those Japanese “Mega” banks that are carrying on international activities, not to the domestic


banking market. The domestic banks are already to some extent catered for under the Japanese regulations, but it is clear that this split will exercise the Japanese regulators going forward.

One of the more interesting aspects of responses to the crisis has been the de-con-struction of the “firewall” regulations, allow-ing banking and securities groups to provide more homogenised services to clients. This has been with a view to increasing Japan’s competitiveness as an international financial market.

However, it comes at a time when much has been made during the course of the G20 process of the need for greater differentiation during the product selling process of “clas-sic” banking (i.e. deposits and vanilla deposit products) from so-called “casino” banking (i.e. more exotic products).

For example, Hong Kong and Singapore have made express stipulations as regards the need to ensure clear water between the sales of banking and investment products. At the same time the United Kingdom, as part of the overall process, has been driving forward proposals on “living wills”, which are designed ultimately to simplify financial conglomerates.

These types of issue demonstrate the challenges of reaching broad consensus and implementation of reforms at an interna-tional level.

IndonesiaIndonesia’s response to the market turmoil has been very inward-looking, given the recent change in the law requiring the use of the Indonesian language in every agree-ment, including commercial documents.

That potentially has implications for inter-national financial documents, and needs to be urgently clarified by the Indonesian regu-lators to avoid any question of international documents needing to be translated. There are also various derivatives cases currently on foot relating to suitability and mis-selling which tie into these concerns.

IndiaIndia’s developments have been more along the lines of foreign investment and partici-pation in Indian entities, not so much in the context of mainstream regulatory reform.

KoreaKorea went through a “Big Bang” in its finan-cial services industry earlier this year, where the agenda was very much to evolve into a major player in the region.

Amongst other things it was intended to liberalise product offering in Korea by moving away from the model of institu-tions being permitted to sell only a relatively restricted list of specified instruments, to the more internationally recognisable “excep-tions” model, where businesses can sell unless restricted or prohibited.

One point to bear in mind in this regard is the debate that has recently been trig-gered in various jurisdictions as to whether some products are inherently inappropriate (i.e. too risky) to be sold to (essentially retail) investors. For example, Australia has put for-ward the possibility of banning sales of par-ticular products in that type of case. It is fair to say the Korean “Big Bang” proved to be the victim of extremely unfortunate timing given the market turmoil.

The controversy surrounding the Korean


Rule of Law issues created under the KIKO litigation (concerning instruments which took a view on the movement of the value of the Won, which generated fiercely fought mis-selling cases in the jurisdiction) has not assisted.

Nor has the recently announced possi-bility of imposing controls on foreign bank liquidity. Notwithstanding the economic improvements over recent months, the reg-ulatory model appears to be something of a work-in-progress.

TaiwanTaiwan has been in a similar position to Korea in relation to derivatives contracts entered into by foreign institutions with Taiwanese entities.

ThailandThailand is considering its options in rela-tion to launching its own “Big Bang”, which would be designed to advance Thailand’s interests as an international financial centre, but that seems to be in its early stages.

The Bank of Thailand, in August of this year, did implement some relaxations of the rules for investment in foreign securities and derivatives, permitting certain types of

institutional investors (including Thai securi-ties companies) to invest directly in foreign securities, allowing onshore banks to enter into certain derivative contracts and some relaxation of the restrictions on Thai resi-dents entering into currency derivatives.

However, it is fair to say from a more international perspective that Thailand’s involvement at the head of ASEAN in the G20 process has arguably been more in the context of the bigger picture International Monetary Fund and World Bank reforms. It is clear from the above that this is a cru-cial turning point in the development of the international markets.

There is a struggle in Asia between the creation of internationally coherent markets and, in some places more than others, the protection of the home patch. The roll-out of G20/Financial Stability Board initiatives needs to be viewed in that light.

The Japanese Prime Minister, Yukio Hatoyama, has recently said, in Thailand, at a regional leadership meeting of Asian coun-tries, that his “vision of forming an East Asia Community was largely welcomed by par-ticipants” at the meeting. That community does, as he recognised in his remarks, look a long way off. •

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Documents

Journal of Regulation & Risk - North Asia, Volume I, Edition III/IV, Winter 2009/10