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A fter weeks of intense lobbying, bankers in
London are more hopeful that Britain’s
regulators may now be prepared to make
faster and further than elsewhere, with a tough
new, totally-redesigned liquidity regime for the
banking system that is widely seen as a retreat
Legal brakes cloud pay some changes to the stringent new bank from the internationalist rule-making of recent
liquidity regime before final rules are pub- years.
clawback proposals lished, probably at the end of September or Due to start being implemented during the
- page 19 beginning of October. But discussions over the last quarter of this year, the centrepiece of
controversial proposals are being complicated the proposal is a requirement that banks and
Commodities by differences between the Financial Services investment firms must be self-sufficient for
US-UK cross-border deal Authority (FSA), the country’s financial regu- liquidity purposes. All regulated entities – banks,
raises trading cost fears lator, and the Bank of England, according to building societies, and investment firms, includ-
- page 21 those involved. ing foreign subsidiaries and branches in Britain
Liquidity risk management has been exposed – must have adequate liquidity; and they must
Insurance oversight during the 2007-09 financial crisis as a key not depend on other parts of their group to
Securitisations challenge the weakness of the banking system on both side survive liquidity stresses, unless permitted to
regulators - page 22 of the Atlantic. Remedial action is underway do so by the FSA.
in Europe, the US, and at the global level. Bankers are not only worried that the FSA is
But regulators in Britain have pushed ahead out of step with developments else- to page 9
www.globalriskregulator.com
Global Risk Regulator September 2009
2 www.globalriskregulator.com
Global Risk Regulator September 2009
“whether and to what extent third party opening up of the ratings business to he noted. “But this seems to be largely
due diligence services have been utilised, competition.The problems with the credit lip service, embodied in promises that
and a description of the information that ratings industry are the result of 70 years the Administration will examine the pos-
such third party reviewed in conducting of financial prudential regulation of banks sibilities.”
due diligence services.” And, where third and other financial firms, argues White. Both the Coffee and the White approach-
party due diligence services are employed Over that time, ratings have been used in es win some support among lawmakers.
(whether by NRSRO, issuer or underwrit- numerous regulations, from the determi- Rating agencies see difficulties with each
er) the firm used must provide written nation of capital adequacy, to a prohibition of them, however.
certification. on banks holding speculative bonds. What particularly exercised Senate
The trouble is, says Coffee, this require- Banking Committee members during the
ment is optional for all parties. “The most Head-to-head early-August hearing was the question of
serious failing in the proposed legislation due diligence. Chris Dodd, the Democrat
is that it ducks the issue of enforcement committee chairman from Connecticut,
and relies solely on SEC monitoring and declared he was “stunned” to discover
disclosure.” that CRAs did not “undertake to verify
One answer, he suggests, could be to the information that issuers provide when
make the rating agencies subject to the getting a rating.” He just assumed that
threat of litigation. CRAs have “long and they did, he said. Tennessee Republican
uniquely been immune from liability to Bob Corker said: “We were all shocked
their users,” unlike accountants or invest- John Coffee that there is no due diligence.”
Lawrence White
ment banks. Coffee does not want to
subject rating agencies to class action The case for the defence
litigation every time a rating proves to be
Offering opposing remedies for
Defending the exclusion from the
inaccurate. Rather, he wants the threat of rating agencies' performance
Administration’s reform legislation of any
litigation used to “induce the rating agen- mandatory due diligence requirement,
cies not to remain wilfully ignorant and to The situation was compounded in 1975, Treasury assistant secretary Michael Barr
insist that due diligence be conducted and when the SEC created the NRSRO cate- contended that the “government should
certified to them with regard to struc- gory, which was for a long time restricted not be in the business of designing the
tured finance” issues. to a select few rating agencies. As only methodologies of rating agencies or vali-
The legislation should be drafted, Coffee the ratings of NRSROs could be used in dating them in any way... but [CRAs will
told lawmakers, “so that it does not truly regulations, this gave their judgements have] to disclose whatever due diligence
expose rating agencies to any risk of the force of law. That created a barrier they do.”
liability – at least if they either conduct to entry into the ratings business, and led Stephen Joynt, the chief executive of Fitch
a reasonable investigation themselves or to an oligopolistic industry, where three Ratings, the only representative at the
obtain verification from others (such as agencies – Standard & Poor’s, Fitch Ratings hearing from one of the big-three CRAs,
a due diligence firm) that they reasonably and Moody’s Investor Services – account robustly insisted that “due diligence is not
believe to be competent and independ- for the vast majority of the turnover. currently, nor should it be, the responsibil-
ent.” ity of credit rating agencies.” The “burden
Stephen Joynt
of due diligence belongs on issuers and
More regulation misguided underwriters.”
In sharp contrast to Coffee, professor
“Due diligence is Pressed on this point, Joynt explained that
Lawrence White, said the “urge for great- not the his agency was not “staffed up” in a way
er regulation is understandable – but it is responsibility of that would allow Fitch to “audit or check
misguided and potentially harmful.” The credit rating every one of the loan packages that are
heightened regulation of the rating agen- agencies” put together in a financing.”
cies “is likely to discourage entry [of new Several Democrats and Republicans clear-
firms into the industry], rigidify a specified If regulatory reliance on rates were ended, ly favoured requiring CRAs to undertake
set of structures and procedures, and “the entire NRSRO superstructure could mandatory due diligence, even though
discourage innovation in new ways of be dismantled, and the NRSRO category they had apparently been told by Joynt in
gathering and assessing information, new eliminated,” insists White. Banks and other pre-hearing discussions that this would
technologies, new methodologies, and financial firms would still have to meet severely impact rating agency profits.
new models... and may well not achieve prudent regulatory requirements. They So far, however, policy makers and politi-
the goal of inducing better ratings from would, for example, have to ensure their cians have not resorted to compulsion on
the agencies,” he told the Senate banking bond holdings were safe by either doing either side of the Atlantic. A CRA reform
committee. “Ironically, it will also likely the research themselves or using third Bill introduced in Congress in May by
create a protective barrier around the party advisors, thus opening the market Rhode Island Democrat Senator Jack Reed
incumbent credit rating agencies,” White to new ideas and new entrants. (the Rating Accountability and Transparency
added. The Administration’s reform proposals Enhancement Act) only requires certifica-
His proposed solution is the elimination “do – briefly – entertain the possibility of tion if due diligence services are used to
of regulatory reliance on ratings and the reducing regulatory reliance on ratings,” ensure that appropriate and comprehen-
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Global Risk Regulator September 2009
sive information is received by the rating back the idea of greater disclosure of such “with careful consideration of each regula-
agency. information. But ultimately, the responsibil- tion, rather than wholesale elimination. A
At the same time, CRA regulations passed ity for the quality of this information must better solution is continued recognition
in the EU last spring require a credit rating rest with the issuers and underwriters, the and oversight of NRSROs with the goal of
agency to “adopt, implement and enforce agencies say. Fitch’s Joynt even wants issu- improving the performance and usefulness
adequate measures to ensure that the ers and underwriters to be forced by law of ratings.”
credit ratings it issues are based on a thor- to undertake this due diligence. Some banking committee members also
ough analysis of all the information avail- challenged the Administration’s pro-
Ratings have often been
able to it and that is relevant to its analysis posal that the Securities and Exchange
according to its rating methodologies. It used in regulation for “posi- Commission (SEC), America’s chief security
shall adopt all necessary measures so that tive and constructive rea- markets regulator, should retain oversight
the information it uses in assigning a credit sons, to try and limit risk” of rating agencies. Under current plans, the
rating is of sufficient quality and from reli- SEC will create a new dedicated office for
able sources.” The rating agency must say – Stephen Joynt the supervision of agencies that must all
whether it considers the quality of the Joynt was equally forceful on the question register and become designated NRSROs.
information used to be satisfactory and to of the reliance of ratings in regulation. He An investor body has suggested, instead,
what extent it has verified it. does not favour the idea of a blanket elimi- the creation of an independent credit
The main rating agencies have, them- nation of such use of ratings, or the termi- rating agency oversight board to conduct
selves, taken a number of initiatives in nation of the NRSRO designation. Ratings examinations of the agencies’ operations
recent months to improve the integrity have often been used in regulation for and enforce the rules.
of their structured finance ratings and “positive and constructive reasons, to try Treasury assistant secretary Barr argued
enhance disclosure and transparency of and limit risk,” he reminded lawmakers. that a dedicated SEC office was the best
their approaches. They say that they will In prepared testimony, he said that if there way of ensuring accountability of those
not rate issues if they deem the quality was a serious move to eliminate ratings in responsible for rating agency oversight.
of the information to be insufficient, and regulation, this should be done over time GRR
Fresh doubts over the future appeal to bond investors and obtain the term bond. And it was this type of hybrid
tax deductions available on debt issu- that became so popular in the middle
of banks’ hybrid capital ance in many countries. Hybrids are thus years of the decade, because yields were
cheaper and less dilutive than common higher than on other types of bank debt.
From page 1
equity. Straight debt instruments are not, But as early as 1998, the Basel Committee
on the other hand, eligible as Tier 1 capital, became sufficiently alarmed at the appear-
management firm Schroders, commented which is a bank’s chief line of defence if it ance of these instruments that it limited
in a recent research note. These securities runs into trouble. them to 15% of total Tier 1 capital. All
turned out to be toxic, he reckons. Hybrids do also vary considerably in hybrids taken together are restricted to
The quality of bank capital – as distinct design, depending on the jurisdiction in a maximum of 50% of eligible Tier 1
from the level of capital – is currently which they are issued. In some countries, capital, while the balance – or ‘Core Tier
under review by regulators at the Basel they have been around for many years 1’ – must comprise common equity and
Committee, which sets prudential stand- – for example, British banks have long reserves.
ards for banks around the world. And The financial crisis has exposed the inher-
Roger Doig ent contradictions in hybrid securities.
the European Commission, meanwhile,
is drawing up new rules to ensure that
“Many investors “Hybrid instruments are a classic case of
hybrid capital is more effective in future would be happy everybody – bank issuers, investors, regu-
at absorbing bank losses on a “going if hybrids were lators – wanting to have their cake and
concern” basis – something that, as the consigned to the eat it. That was shown to be impossible
crisis revealed, many of these securities dustbin of finan- once the crisis hit,” says one rating agency
fail to do. cial innovation” credit analyst.
However, many analysts doubt whether The impact of the crisis on European
it is possible for the market to reinvent included a sizeable portion of preference hybrids is illustrated by the market value
hybrids in a form that can meet the more shares in their regulatory capital. What is index for euro-denominated Tier 1 issues,
demanding regulatory requirements for newer is the “innovative” type of hybrid which has slumped by a third since August
loss absorption, while still being sufficient- that pushed the boundaries even further, 2007, and sterling-denominated Tier 1
ly attractive to traditional institutional notable by incorporating call options and issues, down 40% (declines that include
bond investors such as insurance compa- ‘step ups.’ Despite being issued as per- the affect of issues dropping out of the
nies and pension funds. petuals, the inclusion in innovative instru- index, as well as changes in market val-
Hybrid securities are designed to meet ments of a big step-up in interest after, say, ues).
nearly contradictory objectives: to be five or ten years is intended as a strong Among the more damaging blows to
sufficiently equity-like to get regulatory signal that the bank will exercise its option the market for these instruments was
approval for inclusion in banks’ Tier 1 to call them back at that time. This makes Deutsche Bank’s decision not to exercise
capital, while being debt-like enough to these instruments look more like a fixed- call options, first on plain vanilla subor-
4 www.globalriskregulator.com
Global Risk Regulator September 2009
dinated bonds, late last year, and then from happening in the first place, Doig Regulators were slow to wake up to
on Tier 1 hybrid securities earlier this argues. In regulatory parlance, hybrids this problem. It is, however, examined at
year – an unprecedented decision that provided ‘going concern’ capital support, some length by Adair Turner, chairman of
undermined the market’s basic assump- not ‘going concern’ capital – but ‘going Britain’s Financial Services Authority, in
tions about innovative capital instruments. concern’ capital was needed to stop banks his seminal review of the two-year long
Other banks followed suit. failing. Taxpayers were therefore left as crisis, published in March. Failure of hybrid
Banks have also been taking advantage capital providers of last resort. capital to absorb losses “calls into ques-
of the slump in hybrid prices to buy the “The only capital that really absorbs loss- tion the quality of the instruments,” says
instruments back at large discounts to es on a ‘going concern’ basis is common Turner. The regulatory approach to these
par (or exchange them for other instru- equity. It turns out,” says Doig, “that instruments “merits re-examination.”
ments) booking profits that flow through hybrids only provide leverage.” And, as The Basel Committee, which is currently
into reserves, and thus into Core Tier 1. equity is depleted in a stress situation, “reviewing issues related to the quality,
This has boosted the capital position of hybrids constitute an increasing part of a consistency and transparency of capital
the weaker banks, but increased investor bank’s capital. with a particular focus on Tier 1 capital,”
resentment towards these types of hybrid is expected to unveil proposals before the
securities. Soft default end of the year. It is not clear whether
Gerry Rawcliffe Some hybrids issued in continental Europe Scott Bugie
do, in fact, provide some loss absorbency
European
on a ‘going concern’ basis. In Germany,
Hybrids are part Commission
for instance, they sometimes provide for
of the problem principal to be written down in stress policy is raising
rather than part conditions. But rather more typically the concerns that
of the solution value of Tier 1 hybrids only becomes hybrid coupons
impaired after bankruptcy. The only way will not be paid
they become loss absorbing on a ‘going
Events have left regulators, investors and concern’ basis is if the bank issuer defers they will include hybrid capital proposals.
rating agencies (see box, page 6) looking payment of coupons or does not exercise But regulators indicate that hybrids are
foolish, according to Schroder’s Roger the call option. Banks are, however, reluc- certainly a topic the Basel Committee
Doig. Bond investors’ conviction that tant to do either because of the negative intends to address before long.
hybrids were really bonds was based on signal such actions send to the market, To a large extent, the market has already
what they thought was a “gentlemen’s and a concern about the lasting damage given its verdict on the value of hybrids
agreement” with issuers that the bonds it will do to relations with the investor as regulatory capital. A research analyst
would be called at par on the first call base. at one investment firm in London says: “it
date, despite the legal form of the hybrids Failure to pay coupons or exercise a is Core Tier 1 that really matters, now, in
being perpetuals, he says. “Once banks call option could leave investors with, appraising banks. This is the absolute focus
were under stress that ‘gentlemen’s agree- in effect, zero coupon perpetuals, which of credit analysts. It may not much matter
ment’ started to fall apart.” really amount to a ‘soft default.’ This whether regulators allow banks to issue
Meanwhile, regulators realised, to their is what “horrifies institutional investors hybrid capital in future if analysts discount
dismay, that the loss absorption features of such as insurance companies and pension it from their calculations.”
hybrids generally only worked in the event funds,” says Doig, because they often have That seems to be acknowledged by at
of insolvency, and that they were there- liabilities matched against the duration of least some capital planners within the
fore useless in preventing bank failures their investments. banks. “If Core Tier 1 remains the focus
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Global Risk Regulator September 2009
Reforms boosted by
Bernanke second term?
Obama’s reforms stand a better chance after reappointment of Fed
chief. But confirmation hearings may focus on Fed's ‘excessive power’
By Nick Paraskeva Ben Bernanke
www.globalriskregulator.com 7
Global Risk Regulator September 2009
to bottom and end to end.” This would tor proposal. He says he would not expect in one basket”.
avoid having regulators that “can be played the administration to advocate a unified The current US system has separate char-
off one another, forced to pull punches for regulator, but not to block the idea either. ters for both federal and state banks.
political reasons, or that are too compro- Sheila Bair, who as FDIC chairman heads State-chartered banks tend to be main-
mised by other missions to act”. the federal agency that insures customer street focused and close to consumers
“Having four competing agencies doesn’t deposits at US banks, opposes the proposal. and their communities. The FDIC currently
make sense. In no other area of the federal “Concentrating power in a single regulator supervises state banks in addition to its
government is there such competition,” would inevitably benefit the largest banks deposit-insurance role, and Bair claims the
says Richard Carnell, Associate Professor and punish community ones,” she said. This loss of this supervisory role would limit
of Law at Fordham University School of would lead to more industry consolidation the agency’s ability to identify risks to the
Law. at a time when there was already concern system. “This is not about protecting turf.
Carnell says he has heard a lot of US sena- about dependence on banks considered This is about protecting consumers and
tors voicing support for the single regula- too-big-to-fail. “We can’t put all our eggs the safety of our financial system.” GRR
French central bank chief to bolster capital ratios and allow banks to
focus on their core task of financing the
economy.”
C hristian Noyer, governor of the Bank Noyer, who is also a council member of Noyer praised international prudential
of France has become the first senior the European Central Bank in Frankfurt, rules developed over many years, but said
central banker in the Group of 20 sys- said there were several reasons why he they only produced their desired effects
temically important countries to publicly doubted the usefulness of a leverage ratio. if they are applied by all countries. “The
dissent from the proposed introduction First, in the absence of single accounting adoption of the Basel II framework by the
of a leverage ratio to measure large banks’ standards, “a comparison between banks US looks to be one of the most important
capital adequacy. He is “doubtful” that belonging to different accounting universes and urgent issues,” he says.
such a ratio would help regulators antici- will mean absolutely nothing.” Second, that However, Tim Geithner, US Treasury
pate the formation of asset price bubbles, sort of ratio did exist in the US and “proved Secretary, wants the Basel II standard
he said at the beginning of September in a of no help, precisely in the country where replaced, according to reports. He is
speech at the Argentinean central bank in the crisis pressing for a new broader international
Buenos Aires. emerged.” agreement.
The Basel Committee, which effectively Finally, in the On the question of multilateral surveil-
sets the rules for banks around the world, present cir- lance, Noyer observed that “the crisis
has announced that it is considering the cumstances, took us by surprise because it broke
idea of a leverage ratio to supplement its “it could add out at the heart of the system, i.e. in
internationally adopted risk-based capital to the reluc- the US financial system. Central bankers
adequacy measure. tance of and the International Monetary Fund, the
Although a leverage ratio has been in use banks to be Washington-based multilateral agency, had
in the US for some years, most other coun- active lend- been prepared for a sovereign solvency
tries have not followed suit, at least until ers in the or liquidity crisis such as those in Asia
the financial crisis erupted two years ago. interbank during the late 1990s, “but we were hit by
Recently, the Swiss decided to implement money mar- a liquidity and solvency crisis in advanced
a leverage ratio, and the Basel Committee ket, there- countries’ financial institutions.” Therefore,
has been examining closely how such a
Christian Noyer fore reducing one lesson of the crisis “is that surveil-
ratio might work internationally. market liquidity and still increasing the lance must be strengthened across the
Earlier this year, the G20 group of coun- over-reliance of the banking sector on the board, including macroeconomic, financial
tries also agreed on the need for a “sim- central bank counterparty.” and regulatory areas,” the French central
ple, transparent, non-risk based measure Noyer said that it is nonetheless essential banker said.
which is internationally comparable... and to enhance the counter-cyclical nature of He added: “Just when supervision needs
can help contain the build up of leverage capital requirements. For instance, “imple- to become more international, we must
in the banking system.” menting a forward-looking provisioning avoid national myopia through domestic
However, neither the US leverage ratio system and an additional capital require- regulation.” In what appeared to be a jibe
nor the risk-based capital adequacy ratio ment at the cycle peak would be effective at Britain, Noyer said: “This is clearly the
accurately indicated the bank weaknesses measures to make capital requirements case in the area of liquidity.” Britain has
exposed by the crisis. The leverage ratio more counter-cyclical.” In the light of been accused of adopting a protection-
simply measures Tier 1 capital in relation profits announced by the major banking ist approach with its proposed liquidity
to a bank’s balance sheet assets, whereas groups, and the large payouts to traders, regime that requires all banks, including
the more sophisticated Basel Committee chief executives or shareholders in the foreign branches and subsidiaries, to be
measure sets a minimum 8% ratio of capi- form of dividends, “I would like to stress self-sufficient in determining their liquidity
tal to risk-based assets. that these profits should primarily be used needs. GRR
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Global Risk Regulator September 2009
Bankers still hope to ease And, in Brussels, the European is scheduled for the fourth quarter of
Commission is currently designing new 2009.
new UK liquidity regulations
liquidity rules for inclusion in the fifth Despite these concerns, the FSA has dis-
round of amendments to the Capital played “every intention of ploughing on
Requirements Directive, planned for this with its plans regardless of what the rest
From page 1
autumn. A key part of this exercise will of the world does,” say those involved. “A
be the guidelines on the size and com- year ago, regulators in Britain concluded
where, but also that Britain’s proposed position of banks’ liquidity buffers that it was essential to put new liquidity rules
rules are more restrictive than those are now the subject of a public consul- in place quickly. But the world has moved
now under consideration at the EU-level, tation. The guidelines have been drawn on,” says Patrick Fell, director of the
notably in relation to the makeup of the up by the London-based Committee of regulatory practice at PwC, the profes-
liquidity buffers that banks must hold. European Banking Supervisors (CEBS), sional services firm. “By putting down a
which advises the European Commission marker early, the FSA helped others to
Patrick Fell on bank regulation. develop their ideas and decide what they
“Now it is It is these important global and EU ini- could agree with. But now it is important
important that tiatives that have prompted bankers in that regulators move forward together at
regulators move Britain to appeal to the FSA to slow down the global and EU levels,” he adds.
forward together its rapid unilateral push to introduce a Banking industry representatives believe
at the global and new liquidity regime there. They worry that if a Basel Committee agreement on
EU levels” that the FSA’s proposed framework will liquidity regulation looked likely within
be quickly overtaken by new global rules, a matter of months, then British regula-
“Currently, the FSA’s proposals are more and that they will have to bear the costs tors might be prepared to delay. The FSA
detailed, and potentially more constrain- and upheaval of implementation twice would “almost certainly prefer to move
ing, than liquidity regimes in overseas within a relatively short period. towards an international liquidity stand-
ard to avoid level-playing field issues. And
jurisdictions,” three trade associations “We are concerned that it would not want us to make changes
said in March, in a joint response to
this proposed regime could twice,” says one industry representative.
the regulator’s first consultation paper
on the matter (see GRR February and therefore trigger regulatory Just how advanced the Basel Committee
April, 2009). “We are concerned that retaliation, in which each is with its liquidity project is far from
this proposed regime could therefore clear. Getting Committee agreement to
jurisdiction seeks to ring- major rule changes has, in the past, often
trigger regulatory retaliation, in which
each jurisdiction seeks to ring fence
fence more and more liquid- proved difficult. Negotiating the Basel
more and more liquidity within its own ity within its own borders in II capital adequacy framework took ten
years.
borders in more and more prescrip- more and more prescriptive
tive ways,” added the joint letter from In addition to these timing questions,
ways – Industry joint letter bankers are also concerned about sig-
the British Bankers’ Association (BBA),
the International Swaps and Derivatives The time and expense of implementing nificant differences that have emerged
Association (ISDA), and the London Britain’s proposals are already being lik- between the British and EU approaches
Investment Banking Association (LIBA). ened to other major regulatory changes to the composition of liquidity buffers.
“The new liquidity regime should not,” in recent years, such as the introduction Banks will be required to maintain buff-
they said, “dissuade the diversity of firms of the Basel II capital adequacy frame- ers of highly liquid, high quality assets as
in the UK financial markets from continu- work, and the EU’s sweeping Markets in
Financial Instruments Directive (MiFID). Tim Buenker
ing to be active here” – a clear hint that “What CEBS
some firms would consider pulling out of The cost to firms of new IT systems,
reporting requirements, training and so considers as
the London market if the rules became eligible assets is
too onerous. on, is estimated by the FSA at £150-£200
million. quite remarkably
The FSA set out its new liquidity standards wider than the FSA
in a consultation document in December. “Taken as a whole,” the three trade
associations say in a second letter to definition”
It has since published two further consul-
tation documents, on liquidity reporting the FSA, “the [proposed] liquidity frame-
and transition measures. work with its three pillars – of Systems a defence if they experience difficulties in
Meanwhile, the Basel Committee, which and Controls, Liquidity Asset Buffer and accessing alternative sources of funding
sets prudential standards for banks Reporting – is not dissimilar to a Basel during periods of stress.
around the world, issued liquidity risk II implementation for which 12 months Under the FSA’s approach, eligible buffer
management principles a year ago, and is was accepted by the FSA as a reasonable assets – which have to be sufficient for
in the midst of another project to devel- lead time.” a bank to survive at least a two-week
op more specific internationally consist- By contrast, the systems and controls period of stress – include government
ent approaches for cross-border banks. standard for the new liquidity regime debt instruments issued by countries
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Global Risk Regulator September 2009
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Global Risk Regulator September 2009
B ankers around the world aren’t keen on guesstimates about the future, particularly The Basel Committee’s principles, which
accounting standard-setters’ ideas for when they could open the door to boards are a response to recommendations made
improving the way banks make provisions wanting to manipulate loan loss reserves by G20 leaders in April, are intended to
for loan losses, improvements demanded to smooth profits. help the IASB develop new rules for meas-
by world leaders and banking regulators in How banks provide for losses, the basis uring financial assets and liabilities within
the wake of the global financial crisis. on which the losses are assessed and how the standard-setter’s International Financial
Initial ideas put forward by the International Reporting Standards (IFRS). The IASB’s
Accounting Standards Board (IASB), whose “We fundamentally disa- work will ultimately result in the replace-
accounting rules are required or accepted gree with the notion held ment of IAS (International Accounting
in more than 100 countries outside the Standard) 39, the current, and often con-
by some that additional troversial, IFRS rule for measuring the
US, are seen by a broad spectrum of the
banking industry as too costly and too regulatory capital buffers value of financial instruments.
complex. required by prudential regu-
And in outlining a more forward-looking lators should be recorded in Information request
loan loss model than the current, much The IASB issued a request for information
criticised, “incurred loss” approach, the the Income Statement and in June, with a comment period ending on
standard-setters are accused by some of impact profit and loss” September 1, on the feasibility of a so-
conceptual confusion with the aims of – Paul Chisnall called expected cash flow approach under
banking regulators. The regulators, at the which interest revenue is recognised on
behest of the Group of Twenty (G20) the process interacts with economic cycles the basis of expected cash flows, includ-
leading economies, are seeking to devise have been spotlighted by the Group of ing expected losses**. The information
bank capital and reserve rules that are Twenty leaders in their efforts to strength- request received 55 comment letters, not
countercyclical, that is they dampen rather en the framework of the financial system. only from banks and their trade bodies but
than encourage the cyclical extremes of The alleged shortcomings of the incurred also from national accounting rule-setters,
economies. Critics say the incurred loss loss model are at the heart of the debate. accountants, insurers, market organisations
model, under which losses can only be and professional services firms.
recognised when they’ve occurred, means Chris Lucas The expected cash flow approach is
provisions are low in boom times and high intended to overcome the criticism that
in recessions, in effect allowing banks to “We do not the incurred loss model overstates interest
over-lend at the top of cycles and forcing consider that the revenue in periods before a loss occurs.
them to overly restrict credit in recessions. expected cash Furthermore, critics say that if a loss has
A forward-looking approach that took flow approach is been incurred, it’s not always clear when
account of expected, as well as incurred, an improvement” the loss took place. And they say the
losses would be more countercyclical. approach is internally inconsistent because
“We do not consider that the expected The Basel Committee, the body of top expected losses are implicit in the initial
cash flow approach (as outlined by the banking supervisors that in effect regulates measurement of the loan, but not taken
IASB) is an improvement in accounting international banking, urged in August that into account in determining the effective
standards nor does it seem to achieve the loan loss provisioning should be robust and interest rate used for subsequent meas-
objectives of bank regulators who wish to based on methods “that reflect expected urement.
see losses recognised earlier and larger credit losses in the banks’ existing loan The IASB acknowledges that the expected
loan loss allowances created,” says Barclays portfolio over the life of the portfolio.” cash flow approach has problems, some of
Group finance director Chris Lucas in “The accounting model for provisioning which are common to the incurred loss
comments opposing any change. should allow early identification and recog- model. There’s a need, for example, to esti-
So-called loan loss accounting is one of the nition of losses by incorporating a broader mate initially, and subsequently re-estimate,
major regulatory issues thrown up by the range of available credit information than credit loss expectations for individual loans
global credit crisis. The question has set presently included in the incurred loss and portfolios of loans.
banking regulators, trying to assess the risks model and should result in an earlier The British Banker’ Association (BBA), the
to a bank’s future solvency, against account- identification of credit losses,” the Basel trade body representing banks British and
ing rule-makers seeking to give investors regulators said. To address concerns about foreign operating in the UK, says it is impor-
an accurate picture of the present financial procyclicality, the new standards should tant to differentiate the IASB project, and
state of a firm. Accounting standard-set- provide for valuation adjustments to avoid the G20 request for strengthened account-
ters are instinctively opposed to making misstatement of both initial and subse- ing recognition, from projects aimed at
www.globalriskregulator.com 11
Global Risk Regulator September 2009
tackling procyclicality being conducted by applying the cash flow model may be without undue cost.
the Basel Committee and others. significant and, “Given the very different Japanese banks generally manage loans
The latter projects, also being carried out natures of loans in a bank’s portfolio, may on a borrower-by-borrower basis, rather
at the request of the G20, “are designed call for simplification of the model where than a loan-by-loan, the JBA says.
to build up counter cyclical buffers to its benefits may be less obvious. “In order to apply the proposed approach
absorb losses which may arise over the to each borrower, a completely new
economic cycle as opposed to the life of Piling on the criticism system needs to be developed solely for
an existing asset,” notes BBA executive “In any event, the expected cash flow the purpose of adopting this approach
director Paul Chisnall. approach will result in a tremendous separately from the contract management
The BBA supports the IASB’s efforts to overhaul of operational systems in the system for customer transactions.”
see how expected losses could be incor- areas of risk, accounting and controlling, The Australian Bankers Association (ABA)
porated within the financial reporting and reporting which we expect to be welcomed the moves towards an expect-
framework and understands the regula- material,” the two UBS executives say in ed loss model. But the industry body has
tors desire to tackle procyclicality. But their joint comment. “serious concerns” about the feasibility
Chisnall says it’s vitally important that The Federation Bancaire Francaise, the of the proposed model and the ability of
measures introduced by banking regula- French banking industry trade body, also Australian banks to implement it at a rea-
has concerns. The expected cash flow sonable cost or within a reasonable time.
Paul Chisnall
model is “too complex”, it says, and would David Bell
It’s important that be difficult to implement while incurring
measures to build significant costs.
up capital buffers Concerned
The approach could be based on a
do not undermine ‘through-the-cycle’ method using statisti- about ability of
general purpose cal credit risk data developed for pruden- Australian banks
financial reporting tial purposes, while provisions could be to implement
assessed on a collective portfolio basis, proposed model
tors to build up counter cyclical capital the French federation says.
buffers do not undermine general purpose The Canadian Bankers Association “Whilst appearing conceptually simple
financial reporting as required by IFRS. says changing to an expected cash flow when applied to a single fixed rate prod-
“We fundamentally disagree with the approach would be “a highly complex and uct, the proposed model becomes increas-
notion held by some that additional regu- resource intensive exercise”. And with ingly difficult when trying to incorporate
latory capital buffers required by pru- Canada in the midst of adopting IFRS, the the impacts of redraw facilities, early
dential regulators should be recorded in approach “would introduce unacceptable redemptions and variable rate products,
the Income Statement and impact profit risk to Canadian-based financial institu- particularly when contained within port-
and loss. In our view, IAS 1 disclosures tions’ ability to achieve full IFRS compli- folios,” ABA chief executive David Bell
of capital are the correct way of provid- ance by 2011”. A modified incurred loss says. GRR
ing information to investors about capital model, as suggested by the International
requirements, including counter-cyclical Banking Federation, would reduce pro-
buffers.” *Guiding principles for the replacement of IAS 39
cyclicality by recognising losses earlier in
In their comments on the IASB’s informa- – Basel Committee, August 2009.
the credit cycle without the deterrents of **Request for Information (‘Expected Loss Model’)
tion request, Ralph Odermatt, head of the expected cash flow approach. Impairment of Financial Assets: Expected Cash
group accounting policy, and Urs Bluemli, The Japanese Bankers Association (JBA) Flow Approach – IASB, June 2009.
head of group portfolio risk control, at also believes the expected cash flow
Swiss bank UBS, say the complexity in approach is not capable of being applied
12 www.globalriskregulator.com
Global Risk Regulator September 2009
Newsroom
Key backing for Basel (G20) leading economies, gathering ahead an appropriate set of indicators, such
of the G20 leaders’ summit in Pittsburgh as earnings and credit-based variables,
regulators' agenda in late September, urged rapid progress in as a way to condition the build up and
developing stronger prudential regulation release of capital buffers. In addition, the
BASEL – In a crucial early September
by requiring banks to hold better capital. Committee will promote more forward-
move, major countries firmly backed
Nout Wellink, Chairman of the Basel looking provisions based on expected
global banking regulators in efforts to
Committee and President of the losses.
strengthen the global banking system, and
Netherlands Bank, said “central banks Issue recommendations to
provided clear direction on two conten-
and supervisors have responded to the reduce the systemic risk associated with
tious issues – the quality of bank capital
[global financial] cri- the resolution of cross-border banks.
and the use of a leverage ratio.
sis by strengthening The Committee will also assess the need
The measures, developed in the wake of
microprudential regula- for a capital surcharge to mitigate the risk
the global financial crisis, are intended
tion, in particular the of systemic banks.
to reduce substantially the chances and
Basel II framework. We The Basel Committee will issue concrete
severity of future stresses in the financial
are working toward proposals on these measures by the end
system.
the introduction of a of this year. It will carry out an impact
As GRR went to press, the governing
Jean-Claude macroprudential over- assessment at the beginning of next year,
body of the Basel Committee on Banking
Supervision, meeting for the first time in
Trichet lay which includes a with calibration of the new require-
countercyclical capital ments to be completed by end-2010.
its expanded, 27-member country form,
buffer, as well as practical steps to address Appropriate implementation standards
agreed on raising the quality and transpar-
the risks arising from systemic, intercon- will be developed to ensure a phase-in
ency of banks’ Tier 1, top quality, capital
nected banks”. of these new measures that does not
with common shares and retained earn-
The Central Bank Governors and Heads impede the recovery of the real economy.
ings predominating. This clearly signals
of Supervision reached agreement on the Government injections will be grandfa-
that so-called hybrid capital, combining
following key measures to strengthen the thered.
the features of both debt and equity, is
regulation of the banking sector: Wellink emphasised that “these measures
essentially out of the running when it
Raise the quality, consistency and will result over time in higher capital and
comes to assessing the loss absorbing
transparency of the Tier 1 capital base. liquidity requirements and less leverage
capacity of regulatory capital (see page 1).
The predominant form of Tier 1 capital in the banking system, less procyclicality,
The Group of Central Bank Governors
must be common shares and retained greater banking sector resilience to stress
and Heads of Supervision, as the Basel
earnings. Appropriate principles will be and strong incentives to ensure that com-
Committee’s oversight body is called, also
developed for non-joint stock companies pensation practices are properly aligned
agreed that the new leverage ratio intend-
to ensure they hold comparable levels with long-term performance and prudent
ed to supplement the international Basel
of high quality Tier 1 capital. Moreover, risk-taking”.
II bank capital rules should ultimately
deductions and prudential filters will be The oversight group also endorsed the
come under the Pillar 1 capital require-
harmonised internationally and generally following principles to guide supervisors
ments of the three-pillar Basel capital
applied at the level of common equity in the transition to a higher level and
accord. This would end arguments that
or its equivalent in the case of non-joint quality of capital in the banking system:
favour putting the leverage ratio, a fixed
stock companies. Finally, all components Building on the framework for
ratio of capital to a bank’s assets designed
of the capital base will be fully disclosed. countercyclical capital buffers, supervisors
to limit excessive leverage, under the
Introduce a leverage ratio as should require banks to strengthen their
Pillar 2 supervisory review provisions of
a supplementary measure to the Basel capital base through a combination of
Basel II, which critics believe would allow
II risk-based framework with a view to capital conservation measures, including
individual national regulators too much
migrating to a Pillar 1 treatment based actions to limit excessive dividend pay-
latitude.
on appropriate review and calibration. To ments, share buybacks and compensation.
European Central Bank president Jean-
ensure comparability, the details of the Compensation should be aligned
Claude Trichet, who chairs the oversight
leverage ratio will be harmonised inter- with prudent risk-taking and long-term,
group, said the agreements reached
nationally, fully adjusting for differences in sustainable performance, building on the
among 27 major countries “are essential
accounting. Financial Stability Board (FSB) sound com-
as they set the new standards for banking
Introduce a minimum global pensation principles.
regulation and supervision at the global
standard for funding liquidity that includes Banks will be required to move
level”.
a stressed liquidity coverage ratio require- expeditiously to raise the level and qual-
Banking sources said the significance of
ment, underpinned by a longer-term ity of capital to the new standards, but
the agreement lies in its resolving conten-
structural liquidity ratio. in a manner that promotes stability of
tious issues and in setting a clear path
Introduce a framework for national banking systems and the broader
for Basel Committee officials to follow as
countercyclical capital buffers above the economy.
they work on the reforms of the Basel II
minimum requirement. The framework Supervisors will ensure that the capital
capital framework set out earlier this year.
will include capital conservation measures plans for the banks in their jurisdiction
The expanded governing body met as
such as constraints on capital distribu- are consistent with these principles.
Finance Ministers of the Group of Twenty
tions. The Basel Committee will review
www.globalriskregulator.com 13
Global Risk Regulator September 2009
Newsroom
G20 finance ministers Still, the mood music at Saturday’s meet- Among the key provisions of the new Act
ing contrasted with the tense G20 summit is an extension in the authority of BaFin,
paper over differences five months ago when fear stalked the the German federal financial regulator,
corridors of governments and banks were to impose higher capital requirements
LONDON – Finance ministers of the
on tenterhooks as to their fate, Reuters on individual banks, banking groups and
Group of Twenty (G20) leading econo-
news agency reported. financial holding groups in certain cases,
mies agreed on strengthening the financial
“Then, we were meeting after two quar- according to an explanatory note issued
system at their early September meeting
ters of (economic) freefall, unprecedented by the international law firm, Clifford
in London, but their final communiqué
in world history. Today everyone was in Chance.
papered over differences on key issues.
a calmer mood,” said Russian Finance BaFin will be able to require a capital
As GRR went to press, the ministers,
Minister Alexei Kudrin. increase where the (1) level of capital
meeting ahead of the end-September G20
A senior G20 official said there “were under existing rules is deemed insufficient
leaders summit due to be hosted by US
no big emotional battles, no fists on the to cover all identified risks; (2) if the
President Barack Obama, backed the prin-
desks and no shouting.” “risk-bearing capacity” of the institution is
ciple of setting global standards on pay
Ministerial bag carriers were only up until not guaranteed; (3) in order to create an
and rewards in the financial sector, includ-
the early hours of the morning to thrash additional “equity capital buffer” to guard
ing provisions for clawing back bonuses if
out a common agreement, rather than against an economic downturn; and (4) to
an employee’s activities eventually prove
staying up all night in previous summits. address “specific business circumstances”
loss-making.
The G20 set up, revived last year to pio- the start-up activities of a new institu-
But the meeting rejected French and
neer global financial regulation initiatives, tion. Such action can also be pre-emptive.
German calls for caps on the amounts
appears to be bedding down, making it And as the new law does not set any
that banks can pay out as bonuses. The
easier to focus on detail. thresholds for such action, BaFin will have
UK and US believe such caps would be
“What’s been very important is the very considerable discretion in deciding when
difficult, if not impossible, to enforce.
strong support that the G20 expressed it is necessary.
The meeting urged rapid progress in
toward keeping momentum in the finan- Another important provision in the new
requiring banks to hold more and better
cial reform effort,” said Mario Draghi, the law is the introduction of so-called “ring-
capital once recovery is assured, and in
Bank of Italy governor who heads the fencing.” This allows BaFin, in a crisis situ-
general reiterated previously agreed poli-
Financial Stability Board, which the G20 ation, to impose a ban on payments by a
cies across a range of issues, including sys-
has told to implement its financial reform bank or insurance company to its intra-
temic risk, liquidity risk, non-cooperative
agenda. group creditors. That is, prevent a foreign
jurisdictions, and accounting standards.
“Much has been done but ministers and entity in Germany moving liquidity abroad
The ministers urged the consistent and
governors recognised it’s not time for to its non-German parent company or
coordinated implementation of inter-
complacency and more is in the making,” affiliate (as happened in the case of the
national standards, including the Basel II
Draghi said. Lehman Brother subsidiary in Britain
bank capital rules now adopted in most
There is renewed pressure on banks to when its US parent collapsed). If such reg-
leading economies apart from the US.
come up with a “living will” – a process ulatory action is taken, BaFin must inform
A US Treasury department official told
lawyers warn could take some time as the home supervisor of the group.
reporters on the sidelines of the meeting
many banks have complex structures that One measure in the legislation that has
that the US remains committed to imple-
would need simplifying. attracted significant attention in the
menting Basel II. Divisions emerged in
German press is the extension of BaFin’s
London over proposals made just ahead
New German financial regs powers to request the dismissal of mem-
of the meeting by US Treasury secretary
bers of banks’ and insurance compa-
Timothy Geithner setting out core prin- law comes into force nies’ supervisory boards if they are not
ciples for the reform of the international
adequately qualified or not trustworthy,
regulatory capital and liquidity frame- BERLIN – A controversial new finan- or if they act negligently in the exercise of
work, which some have interpreted as a cial law giving additional powers to the their control functions.
replacement for Basel II. Geithner said he German regulator and increasing its ability But probably the most controversial
wanted a comprehensive agreement on to intervene in the running of financial amendment, according to the Clifford
the international framework by the end of firms during times of crisis, came into Chance explanatory note, is the extension
next year with implementation in national effect at the beginning of August. This of BaFin’s powers to prohibit a bank from
jurisdictions by end-2012. European new law (the Strengthening of the Financial distributing profits to its shareholders and
officials said the reforms of the Basel II Markets and Insurance Supervision Act), holders of subordinated (hybrid) capital
framework already underway would do which introduces amendments to exist- instruments. Until now, the regulator
the job. ing banking and insurance supervision could only prohibit or limit the distribu-
Translating pledges into concrete action is legislation, also imposes further reporting tion of profits to shareholders if the bank
proving to be more painstaking as vested requirements on both types of financial did not have adequate “own funds” within
national interests emerge and economic institution and widens the information the meaning of the regulatory capital
recovery takes the heat out of pressures available to the regulator to provide early requirements on liquidity.
to reform. warning of potential future risks. Now BaFin may resort to these measures
14 www.globalriskregulator.com
Global Risk Regulator September 2009
Newsroom
as soon as a bank’s asset position, earn- push on both side of the Atlantic for mul- and the implementation of more efficient
ings position or financial standing justifies tilateral clearing. clearing processes,” he adds.
that it will not be able to permanently Regulators want to see as much as pos- “Although the OTC markets, including
fulfil the regulatory or liquidity require- sible of the OTC business cleared through CDS, remained open and functioning
ments. Hence, comments Clifford Chance, central counterparties (CCPs). Several effectively during the crisis, we recognise
the new law “allows for severe limitations CCPs have been formed to clear the that further improvements in market
of shareholders’ rights based on a mere more standardised credit default swap infrastructure should continue to be
forecast of a bank’s ability to fulfil supervi- (CDS) contracts, including one in London made.”
sory requirements.” and another in Frankfurt. However, Krohn cautions “that all CCPs
Among other provisions highlighted by “It was not easy for both these CCPs to need to demonstrate an exceptional level
Clifford Chance is BaFin’s authority to be ready in time, but they have executed of financial and operational robustness.”
impose higher liquidity standards on indi- the job well,” is the verdict of Godfried What has become quickly apparent in the
vidual institutions as the regulator deems De Vidts, Head of European Affairs, at marketplace is a sharp difference in the
necessary to safeguard a bank or a group inter-dealer broker ICAP. “These were the volume performance of Europe’s first two
of banks. Such intervention is restricted first steps towards a more robust solution CCPs – Frankfurt-based Eurex Credit
to cases “where the sustainable liquidity for Europe,” he says. Clear, part of Eurex, a Deutsche Boerse/
of the institution can otherwise not be But the test will be how much of the huge SWX joint venture, and ICE Clear Trust in
guaranteed.” BaFin’s discretion to impose volume of business is eventually cleared London, a unit of Atlanta-based Interconti
liquidity requirements is, therefore, nar- this way. The big derivative firms argue nentalExchange.
rower than in the case of its discretion to that much of their business is too cus- In its first month, ICE Clear Europe
demand increases in regulatory capital. tomised to be cleared through CCPs. The cleared €204 billion ($290bn) in notional
In addition to these measures, the legisla- precise proportion that might be deemed value across 2,000 European CDS index
tion introduces new disclosure require- standardised, and thus eligible for multi- transactions, with open interest of €22bn
ments that are intended to enable BaFin lateral clearing in Europe, is the subject of ($31bn). By contrast, Eurex processed a
to better identify risk concentration continuing discussion between officials of total volume of just €120m by
within groups of banks and insurance Charlie McCreevy, the EU internal mar- 1st September, on eight CDS transactions
companies. The parent entity of a group kets Commissioner and representatives of (5 index, 3 single name transactions).
is obliged to disclose to the regulator derivatives industry. Other CCPs are also expected to launch
certain intra-group transactions, in par- Few Commission staff have been avail- in Europe. These include LCH.Clearnet
ticular loans, investments, guarantees, able for comment during the peak holiday SA (France), which is likely to get started
and off-balance transactions. All trans- season. But Brussels sources close to the by end 2009, and the Chicago Mercantile
actions that individually or collectively matter report that officials are broadly Exchange Group (CME) after it receives
(with one counterparty) reach 5% of the pleased with the take up of CCP clearing Recognised Clearing House approval from
own funds required at group level have services. the Financial Services Authority, the UK
to be reported to BaFin annually. There Earlier, in a July 31 press release marking financial regulator.
are other reporting requirements, too, the start of CDS clearing for contracts In July, the CME Group, hired Andrew
for those institutions whose prudential on single names and indices on European Lamb, erstwhile chief executive of LCH
requirements are based on the “leverage entities, the European Commission Clearnet Ltd, in London, to assist with its
ratio” (the ratio of their own funds to described the industry moves as a recognition application, and head what will
the sum of their balance sheet total, plus “major step towards financial stability.” be called CME Clearing Europe. The CME
liabilities deriving from off balance-sheet Nevertheless, it said it will “monitor the has just received US regulatory approval
transactions). migration of the CDS onto CCPs and for its CDS clearing there,
take account of the progress made by Meanwhile, ICE Trust in the US has dis-
Centralised credit swaps market participants in the CDS area when closed that it cleared $1.9trn (in notional
formulating its policy orientations for terms) across 22,000 transactions in
clearing starts in EU over-the-counter (OTC) derivatives in North American CDS indexes between
general.” March and end-August this year, with
LONDON – The opening weeks of From the industry side, Christian Krohn, open interest of $187bn.
multilateral clearing of credit derivative director for regulatory policy at the
contracts in Europe, required to start Securities Industry and Financial Markets
no later than July 31, under a European Supervisors want more
Association (SIFMA), a global body rep-
Commission-imposed deadline, are being resenting investment banks and broker- credit swap data disclosure
viewed with cautious satisfaction by regu- dealers, says the derivative industry’s
lators and the industry. Concern in both “commitment to improving [the way the FRANKFURT – More information
the US and EU about the potential sys- market functions] is shown by the scale should be disclosed by participants in
temic and operational risks of over-the- of resources it has dedicated to central the European credit derivative market,
counter (OTC) derivatives, particularly clearing of CDS. We support extending according to a report* released in late
credit default swaps – the most common the scope of CDS contracts eligible for August by the European Central Bank
type of credit derivative – has led to a clearing, expanding participation in CCPs (ECB). And greater transparency, it says, is
www.globalriskregulator.com 15
Global Risk Regulator September 2009
Newsroom
needed for regulators to assess the sys- tors for other markets, including loan, markets and products, published in early
temic risk posed by this business. credit and even equity markets. Thus, September.
The 93-page report, which is based on these instruments are playing a broader It follows calls last November from
data derived from a survey of 31 of role in the determination of prices. leaders of the Group of 20 systemically
Europe’s largest financial institutions, Finally, the report also highlights the important countries for a review of the
comes amid moves to intensify systemic significant widening in sovereign CDS scope of financial regulation “with a spe-
supervision and subject the private, over- spreads in mid-March 2009. It says: “The cial emphasis on institutions, instruments
the-counter (OTC) derivatives markets to potential policy implications in terms of and markets that are currently unregu-
tougher regulation in both the EU and US. the impact that these exceptional CDS lated.” Madrid-based IOSCO’s task force
Undertaken by the Banking Supervision spreads could have on the credit rat- on unregulated markets and products
Committee – comprising supervisors ings of sovereign governments in illiquid (TFUMP) focuses particularly on two
from EU countries that are not ECB environments and the possibility of high-profile financial sectors – the
members, as well as those that are – the negative feedback loops warrant further securitisation and credit default swap
report focuses on the market in credit research for financial stability monitoring (CDS) markets. A consultation paper on
default swaps, the principal type of cred- purposes.” TFUMP’s proposals was issued in May.
it derivative. Areas where the report suggests In comments accompanying September’s
Although the credit default swap (CDS) improvements in transparency are desir- final report, TFUMP co-chairman Jean-
market constitutes only around 7% of able include extended disclosure of Pierre Jouyet, who is also president of
the OTC derivatives market, in notional counterparty risk, notably indicators of the Autorité des Marchés Financiers,
terms, it grew very rapidly in the years counterparty concentration exposure, described the report as a major step in
before the financial crisis, and is seen both for individual institutions and for IOSCO’s response to one of the major
by many observers as one cause of its the market as a whole. recommendations of the G20. The task
severity. In addition, differences between the force report aimed to expand the field
The report has four key findings and major data sources, in terms of their of regulation so that financial markets
identifies four areas where improve- data coverage and methodologies, also are better supervised, while proposing
ments in disclosure and transparency need to be bridged, while improvements recommendations to address the main
are necessary from a systemic risk man- are also needed in terms of public expo- weaknesses of the debt market high-
agement perspective. sure. The most active institutions should, lighted by the crisis, he said.
One key finding is that CDS market says the report, regularly disclose their The report acknowledges that initiatives
remains highly concentrated and is today total gross notional amounts and gross have been taken by the securitisation
even more concentrated than it was market values for bought and sold CDS, and CDS industries to improve trans-
before the 2007-09 financial crisis. In as well net market values for uncollater- parency and the functioning of the mar-
Europe, the top ten counterparties of alised derivative transactions. kets. But TFUMP still sees the need for
each surveyed large bank account for Finally, increased transparency in regard regulatory action designed to improve
62-72% of its CDS exposures (when to turnover volumes for trades – for confidence in currently unregulated
measured in terms of gross market instance, aggregated daily turnover vol- financial markets and products by pro-
value). The increased concentration is umes – is desirable for both non-dealer moting fair, efficient and orderly markets.
explained by the fact that some major market participants and regulators, the “These steps are important,” the report
players have either disappeared or report argues. says, “to the recovery of the interna-
exited the market, including dealers such tional financial system.”
as Bear Stearns, Lehman Brothers and *Credit Default Swaps and Counterparty The securitisation market was at the
Merrill Lynch, and sellers of protection, Risk epicentre of the financial crisis, but has
such as monoline insurers and hedge subsequently shrunk dramatically in size.
funds.
A second finding is the interconnected
IOSCO proposes new rules In recommending that originators
and/or sponsors should retain a long
nature of the CDS market, with dealers for unregulated markets term economic interest in a securitisa-
being tied to each other through chains tion – known as skin in the game – the
of OTC derivative contracts. This results MADRID – Originators and/or the
task force is proposing a controversial
in increased contagion risk, says the sponsors of securitised credit products
approach already adopted in the EU and
report. In practice, the transfer of risk should be required to “retain a long-
US, but fiercely resisted by the industry.
through CDS has proven to be limited, term economic exposure” in them,
Regulators should also require, the final
as the major players in the CDS market says the International Organisation of
report says, greater disclosure by issuers
trade amongst themselves and increas- Securities Commissions (IOSCO), the
to investors of all verification and risk
ingly guarantee risks for financial refer- body that represents over 100 securi-
assurance practices; require independ-
ence entities. ties regulators around the world. It is
ence of service providers (accountants
A third finding is that CDS are widely one of the key recommendations in
and valuers of the underlying credit
– and increasingly – used as price indica- its final report on unregulated financial
pool) engaged by the issuer; review
16 www.globalriskregulator.com
Global Risk Regulator September 2009
Newsroom
investor suitability requirements; and framework for banks was completed by tional approval to adopt the advanced
encourage the development of tools regulators from North America, Europe measurement approach in 2010. “Bank
by investors to assist in understanding and Japan in 2004, and has been intro- Negara is in the process of reviewing
complex financial products. duced in many countries around the our preparations and we expect final
TFUMP also recommends that when world – but not the US – since 2007. certification before that date,” he added.
countries adopt any additional regula- John Lee, head of Asia Pacific financial Maybank is also reported to be making
tory powers in this area, they do so in risk management at financial services preparations for Pillar 2 and Pillar 3.
a manner that promotes international firm KPMG, in Malaysia, told the news Meanwhile, OCBC Bank and OCBC Al-
coordination of regulation. service that the country’s banks were Amin Bank plan to be ready to adopt
In the case of the CDS market, the con- at various stages in their Basel II imple- the Basel II advanced methodology by
cerns are different, and relate mostly to mentation projects. “Basel II is a pivotal the stipulated deadline pending the
inadequate risk management practices milestone in achieving better risk and release of the finalised rules by the cen-
and regulatory structure and oversight capital management,” he said. tral bank. OCBC Bank country chief risk
issues. This market has experienced huge Bank Negara governor Zeti Akhtar Aziz officer Choo Yee Kwan reportedly said
growth in recent years, and the value had said that Malaysian banks were well compliance with Pillar 2 would follow
of outstanding CDS is now a multiple positioned for the advanced implemen- a year after implementation of Pillar 1.
of referenced bonds, the report notes. tation of Basel II in 2010. Under the Although the Pillar 3 timeline in Malaysia
The “size of the market, counterparty Basel II framework, there are alternative has yet to be determined, OCBC, at
exposures and the interconnectedness ways of measuring the adequacy of risk- group level, had already included Pillar
of the market participants can be seen based capital – the advanced method 3 market disclosure information in its
to present a systematic risk to financial using sophisticated internal models, a 2008 annual report, he said.
market stability.” simple method and an intermediate Some of the key challenges banks cited
The TFUMP recommends that regula- method. in adopting Basel II include the collec-
tors facilitate the formation of central Most Malaysian banks that have chosen tion of data history for the development
counterparties (CCPs) to clear stand- to comply with the less sophisticated of advanced methodologies, availability
ardised types of CDS. This is already approaches of Basel II have been in of skilled resources and sufficient invest-
happening on both sides of the Atlantic, compliance with this international capital ment in IT infrastructure, the wire serv-
it notes. Central counterparties should standard since January 2008. ice reported.
also make transaction and market infor- However, some of the country’s banks
mation available to inform the market such as Malayan Banking, OCBC Bank How to kill a black swan
and regulators. Appropriate financial and United Overseas Bank, have chosen
resources and risk management practic- to skip the adoption of the simple (or BRUSSELS – There’s a danger that ani-
es also need to be available to minimise standardised) approach and move direct- mosity towards mathematical modelling
the risk of CCP failure, the report says. ly to the advanced approaches. sparked by the global financial crisis
Regulators should also encourage finan- Basel II is based on three Pillars. could result in regulatory reform being
cial institutions and market participants Minimum capital levels are set under motivated by an ill-informed nostalgia
to work on standardising CDS contracts the requirements of Pillar 1, while Pillar for a simpler past, a top international
to facilitate CCP clearing; facilitate 2 involves supervisory assessment of banking regulator told a financial risk
appropriate and timely disclosure of banks’ risk management, and Pillar 3 conference over the summer.
CDS data relating to price, volume and deals with banks’ public disclosure of Maarten Gelderman, head of quantita-
open-interest by market participants, information about their risk-taking. tive risk management at the Dutch
electronic trading platforms, data provid- KPMG’s Lee told the wire service that central bank and a key figure on the
ers and data warehouses; and support all banks were also working towards Basel Committee of global banking regu-
efforts to facilitate information sharing complying with Pillar 2 and Pillar 3. lators, said the crisis highlights the need
and regulatory cooperation. The deadline indicated by Bank Negara, for those involved in the modelling of
the Malaysian central bank, for compli- financial risk “to be humble and more
Malaysia banks set for ance with these pillars is the beginning honest”. They need also to explain what
of 2010 for banks which have adopted they are doing more clearly to members
‘advanced’ Basel II in 2010 the standardised capital measurement of the boards of financial firms, said
approach. Gelderman who chairs the validation
PETALING JAYA – Malaysia’s banks are
“These banks are certainly occupied in subgroup of Basel Committee’s stand-
on track to adopt the Basel II advanced
preparing and ensuring that various criti- ards implementation group (SIG). The
approach to capital adequacy meas-
cal milestones are fulfilled to meet the subgroup monitors the validation of sys-
urement from the beginning of 2010,
impending timeline,” he added. tems used in the modelling of credit risk
according to a mid-August report by
Malaysian Banking’s Basel II project under the Basel II bank safety rules.
The Sun On-line, a local on-line news
director, Ariffin Morad said his group Gelderman said he wanted “to kill the
service. The Basel II capital adequacy
had obtained Bank Negara’s condi-
www.globalriskregulator.com 17
Global Risk Regulator September 2009
Newsroom
black swan” and express his “per- to improve our modelling,” Gelderman how they value illiquid assets. The aim
sonal frustration” with the popularity said. That means becoming become more is to make it easier for investors and
of Professor Nassim Nicholas Taleb’s skilled in volatility and correlation and other users of financial statements to
best-selling 2007 book The Black Swan: “possibly more skilled in the normal dis- understand the true state of the financial
The Impact of the Highly Improbable. tribution.” affairs of a firm.
Taleb is professor of risk engineering The Financial Accounting Standards
at the Polytechnic Institute of New New chairman will oversee Board (FASB), the standard-setter,
York University and holds professor- issued in late August an exposure draft
big CEBS upgrade (discussion document) on a proposed
ships in related fields at a number of
institutions. The book’s title refers to accounting standards update intended
LONDON – Strengthening supervisory to improve disclosures about fair value
the sort of high-impact/low probability
cooperation in the European Union and measurements, that is valuations based in
events that upset previous, commonly
ensuring a smooth transition to the new the first instance on current, or market
held beliefs such as the assumption that
European Banking Authority are seen as prices.
all swans could safely be assumed to be
the major tasks facing Giovanni Carosio, The update would affect all firms
white until black swans were discovered
the new chairman of a key EU banking required to make disclosures about
in Australia. Taleb has criticised bankers
regulatory body. recurring and nonrecurring fair value
and economists for falling into the trap
Carosio took over, with effect from measurements. The deadline for com-
of thinking sophisticated mathematical
September 1, the chairmanship of ments is October 12.
models and risk-management systems
the Committee of European Banking “A number of constituents have recom-
would protect them from the black swan
Supervisors (CEBS), the body of top mended that the Board improve disclo-
of the global financial crisis that occurred
banking supervisors from EU mem- sures about fair value measurements. The
after the book was published.
ber states that advises the European Board believes that the increased trans-
Gelderman believes Taleb’s book has
Commission, the EU’s Brussels-based parency resulting from the proposed
given voice to all those who were mysti-
executive arm, on the technical aspects disclosures would benefit financial state-
fied by the mathematics of risk manage-
of banking regulation. He is deputy direc- ment users,” FASB Chairman Robert
ment and humiliated at times by the
tor general of the Bank of Italy and had Herz said in a statement.
arrogance of its proponents. The financial
been CEBS vice chairman since January Fair value accounting rules divide assets
crisis caught the experts out, to the sat-
2008. into three categories, levels 1,2 and 3.
isfaction of the mystified and humiliated.
Under current proposals for radically Level 1 asset values are determined from
“The risk we’re running is that we’re
reforming EU financial regulation, the market prices; Level 2 valuations are
moving in a direction where regulatory
Commission plans to give executive often based on prices for similar assets
reform is mainly motivated by nostalgia
powers over banking regulation in the in liquid markets; and Level 3 assets,
– so (the cry is) no large banks – large
EU’s 27 member states to the new which are often illiquid, are valued using
banks are bad – no financial conglomer-
European Banking Authority which will complex mathematical models.
ates, back to Glass-Steagall and retreat
replace CEBS. A European Insurance FASB said users of accounts want more
to national boundaries!”
Authority and a European Securities information about fair value measure-
But going back to “the good old times”
Authority will have parallel functions ments that use significant unobservable
is not a good idea, Gelderman told the
for insurance and securities markets. inputs, that is, Level 3 inputs, because of
Risk Capital 2009 conference.
Commission officials hope the new the greater degree of uncertainty and
“We benefit from the fact that we are
structure is up and running next year. subjectivity in this area. The Board has
able to model things; that we are able
Carosio succeeds Kerstin af Jochnik in therefore proposed that firms show how
to have a systemic feel on risk; that we
the chair of the London-based CEBS. their valuation of level 3 assets would be
are able to analyse complex products;
Af Jochnik, who held the position from affected if “reasonably possible” alterna-
and that those products add value to the
January 2008, has been appointed man- tive scenarios were to be used.
economy in general.”
aging director of the Swedish Bankers’ The proposal also addresses requests
But modellers need to communicate
Association. from users for segregating informa-
better, Gelderman said, “We need to find
ways of explaining what we’re doing to tion for different classes of assets and
board members. We need to have more FASB wants daylight on liabilities that are determined based on
room for common sense – don’t model valuing illiquid assets their nature and risk characteristics and
everything, think about the question of their placement in the fair value hier-
what happens if we enter a recession NORWALK, Connecticut – US account- archy (that is, Level 1, 2, or 3). Further,
and banks lower interest rates.” ing standard-setters, criticised earlier users need more robust disclosures
“Finally in order to kill the black swan this year for bowing to political pressure about aluation techniques and inputs for
and ensure that this book disappears, to give banks more discretion in valuing both Level 2 and Level 3 measurements
we all remain in our jobs and we don’t some of their toxic assets, are propos- because many regard these as less reli-
lose the benefits of modelling, we need ing that firms disclose more clearly able than Level 1 measurements.
18 www.globalriskregulator.com
Global Risk Regulator September 2009
Legal brakes cloud pay handled not by setting caps on pay but by
relating it to a bank’s regulatory capital.
clawback proposals
If supervisors judge a bank’s remunera-
tion policies to be dangerous, they should
require the bank to increase its capital
Politicians are keen on clawback provisions for banker pay. But levels to an extent that matches the risk.
Politicians tend to see the issue in “moral”
taking back bonuses may be unenforceable in some countries terms – bankers are too highly rewarded
By David Keefe for an activity that has resulted in mod-
estly paid taxpayers having to bail-out
www.globalriskregulator.com 19
Global Risk Regulator September 2009
20 www.globalriskregulator.com
Global Risk Regulator September 2009
raises commodity fears CFTC and the FSA, joint actions could
include improving direct access rights to
trade execution and audit trail data; mutual
The latest transatlantic agreement between regulators to curb on-site visits to exchange operators; shar-
energy market speculation could increase trading costs ing of exchange regulations and notices;
sharing of disciplinary notices; and looking
www.globalriskregulator.com 21
Global Risk Regulator September 2009
Insurance regulation
Insurance securitisations tional excess of loss coverage and so-
called “uninsurable” risks. But insurance
securitisations remain largely untested,
R egulators face a challenge to under- committed to better understanding it, emerged. And even after a decade of activ-
stand insurance securitisation, the and crucially, to developing the necessary ity, the market share of insurance-linked
technique whereby insurers sell their tools for supervising it effectively,” Gross securities and other new forms of insur-
insurance liabilities to investors, according said in a statement. ance risk transfer remains small compared
to a new study by the organisation repre- Securitisations broadly fall under the to traditional approaches to risk transfer,
senting the world’s insurance supervisors. financial instruments category and include in particular reinsurance. Nevertheless
“How insurance securitisation structures contingent capital, options, swaps and the market is growing, particularly in the
will react under extreme liability loss catastrophe, or cat, bonds. Cat bonds, for US where “uninsurable” risks are com-
scenarios is an issue yet to be fully tested instance, are often used by insurance com- paratively bigger. Insurance-linked securi-
and a potential concern to many supervi- panies instead of traditional catastrophe ties issuances peaked at more than $15
sors,” says the report by the International reinsurance. They transfer, via a special billion in 2007 from $1.3 billion raised ten
Association of Insurance Supervisors purpose insurer or vehicle (SPV), the risks years previously.
(IAIS). The Basel-based IAIS represents of major natural catastrophes such as Asset-backed securitisations, such as the
insurance regulators from nearly 140 hurricanes happening from an insurance mortgage-backed instruments so notori-
countries, brought together with the aim company sponsor to investors. Investors ously associated with the global financial
of developing international standards for lose the principal amount they invest if the crisis, and liability-based arrangements
the insurance industry. catastrophe occurs and triggers payment such as insurance securitisations share key
Effective and timely cooperation among to the sponsor. structural and operational characteristics
supervisors is critical, says the IAIS. This is Capital market assumption of insurance – the development of liability-based secu-
because more often than not the ceding risks is located in between more tradi- ritisations drew largely on the experience
company, the insurer transferring risks,
and the special purpose insurer taking on US regulation consistent the US regulatory system
is consistent with interna-
the risks, reside in different jurisdictions.
with international rules tional standards “our pri-
Alternative risk transfer America’s state-based sys- time that the US has sub- mary focus as stewards of
Insurance securitisation is one of a number tem of insurance regula- mitted to an examination the world’s largest insur-
of forms of alternative risk transfer (ART) tion shows wide observ- under the IMF’s financial ance market remains pro-
in the insurance world that the report says ance of the core princi- stability programme. As tecting US consumers.”
constitute valid sources of risk capital for ples for insurance super- well as insurance, the self- President Barack Obama’s
insurers and also reinsurers, the firms that vision developed by the assessments cover bank- proposals for the reform-
“insure the insurers”. ART arrangements International Association ing, securities and payment ing US financial regulation
range from self insurance and captive of Insurance Supervisors systems. The US Treasury would leave the present
insurance companies to so-called finite (IAIS), according to a self- is co-ordinating the exer- state-based system pretty
reinsurance and financial instruments such assessment by US insur- cise which is due to be much intact. But it would
as options and swaps. They enable risk to ance regulators. completed in 2010. create an Office of National
be transferred from insurance companies The NationalAssociation of “The FSAP self-assess- Insurance (ONI) within
to capital markets, thereby raising funds Insurance Commissioners ment process has given us the US Treasury, which
that insurers can use to pay claims arising (NAIC), which represents an opportunity to clearly would be responsible for
from certain types of losses. the nation’s state insurance demonstrate the many monitoring all aspects of
“Insurance securitisation constitutes a supervisors, said in early ways insurance regulation America’s insurance indus-
genuine global practice, with global regu- September it had joined in the US is absolutely try and co-ordinate policy
latory implications,” says Al Gross who with other US financial consistent with interna- at the international level.
chairs the IAIS’s technical committee regulators in completing tional standards,” NAIC The ONI would have
which is specifically charged with develop- a self-assessment under president Roger Sevigny some pre-emptive powers
ing global insurance standards. an International Monetary said. over state laws if they con-
“Although still relatively small, this prac- Fund’s Financial Sector NAIC chief executive flicted with federal policy
tice, which has been growing over the Assessment Programme Therese Vaughan said that on international insurance
years, offers great potential as well as (FSAP). This is the first while it is important that issues.
presenting new risks. As such, we are
22 www.globalriskregulator.com
Global Risk Regulator September 2009
Insurance regulation
British insurers claim Solvency II will European Insurance and Occupational
Pensions Supervisors (CEIOPS), the body
cause £50 billion equity call of EU national insurance supervisors that
advises the European Commission, the
As Europe’s insurance supervisors get Europe. The ABI would not release a copy EU’s executive arm, on the technical
down to the details of how the radical of the letter, but confirmed the accuracy aspects of insurance regulation.
Solvency II regime will be implemented in of the FT’s report. The Financial Services Authority (FSA),
the European Union, the British insurance “It’s a scare number,” says Nick Holmes, the UK’s financial services watchdog, is
industry let out a howl of pain. a London-based analyst at Nomura a member of CEIOPS. The ABI’s Haddrill
The Association of British Insurers (ABI), International, according to Bloomberg said the FSA supports the trade body’s
the industry’s trade body, wrote to UK news. “It’s part of the industry’s lobbying concerns.
finance minister Alistair Darling in August process to persuade the government to The German insurance industry asso-
saying it fears the new regime, which is step in and stop this happening.” ciation, GDV, has also reportedly writ-
due to come into effect in EU member The European Parliament passed the ten asking the German government to
countries in 2012, will oblige insurers to Solvency II framework directive, setting intervene.
tap investors for more than £50 billion out the general principles of the regime, In his letter to Darling, Haddrill says the
($82 billion; €57.3 billion) in fresh equity. earlier this year after several years of impact of Solvency II, which is intended to
ABI director general Stephen Haddrill haggling and quantitative impact studies get insurers to match their capital more
said the initial impact of Solvency II that tested the rules with insurers. The closely to the risks they face, is close to
would increase the capital requirements Solvency II framework is modelled on requiring fresh equity capital equal to the
of British insurers, who form Europe’s the same three-pillar structure of capi- industry’s current market capitalisation of
largest national insurance industry, by tal requirements, supervisory oversight more than £50 billion.
between £30 billion and £70 billion. UK and market discipline as the international “This huge over-capitalisation will mean
insurer shares fell on the news. Basel II capital adequacy regime for banks, investment returns in insurance will fall.
The letter, a copy of which was obtained but adjusted for the more complex world Companies will exit the market, prices
by the UK Financial Times newspaper in of insurance. will rise over, cover will reduce and inno-
September, says the “extreme” propos- Solvency II implementation measures are vation will lessen,” Haddrill wrote.
als could destabilise the industry across being developed by the Committee of
of asset-backed securitisations. and deeper market for insurance securi- a regional approach. However, both direc-
But there are fundamental differences tisations providing completely separate tives still leave plenty of latitude to the 27
between the two forms. protection against extreme events. EU member-states.
The most important difference is that But these approaches give rise to basis Nevertheless, some common threads are
while it’s common in asset-backed deals risk – the risk that the loss as modelled emerging among most regulatory regimes.
for the originator to consider the asset could be significantly less than the actual These include: the creation in law of the
transferred to the SPV as a “true sale”, in losses and claims faced by the ceding category of the special purpose insurer;
liability-based securitisations the sponsor insurer. the differentiated nature of the special
retains a contractual liability to the under- purpose insurers, in particular in relation
Al Gross
lying policyholders, notwithstanding the to licensing, on-going supervision and
“Insurance
economic transfer of risk. This is the same capital requirements; the subordination of
securitisation
as with a traditional reinsurance contract. investors’ claims on the assets of special
constitutes a
“This fundamental distinction lies at the purpose insurers to those of the cedant;
genuine global
heart of the different regulatory and and the fully funded nature of the special
practice, with global
supervisory treatment given to securitisa- purpose insurer. Importantly, a common
regulatory
tion arrangements by banking and insur- element in most supervision is the reli-
implications”
ance supervisors,” the report says. ance on both quantitative and qualitative
To give investors certainty and transpar- “The degree of basis risk is a key con- information in assessing the soundness of
ency, some insurance securitisations have sideration for supervisors in determining special purpose insurers.
used so-called non-indemnity triggers the amount of reinsurance credit to give The IAIS itself is developing dedicated
– triggers based on model outputs, indi- to the coverage or whether the coverage standards and guidance on the supervision
ces, parameters or combinations of these offered is reinsurance or a derivative,” the of insurance risk transfer to the capital
– that act as proxies for the sponsor’s report says. markets. GRR
actual losses. Developments in regulation have followed
In addition, the evolution of standard- national policies on the issue, resulting Developments in (Re)Insurance Securitisation
in a variety of dissimilar frameworks and – Global Reinsurance Market Report Midyear
ised products relying on, for instance,
approaches. The European Union’s efforts, Edition (International Association of Insurance
parametric loss triggers (for instance, the Supervisors, August 2009)
function of a measured value such as wind in particular the Reinsurance and Solvency
speed) has helped to develop a broader II directives, provide the only example of
www.globalriskregulator.com 23
Global Risk
Global Risk Regulator
Regulator September 2009
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