Journal of Regulation & Risk

J
OURNAL OF REGULATION & RISK

NORTH ASIA
In association with
Volume VI, Issue 4 Winter 2015
Articles, Papers & Speeches

US Federal Reserves financial services stability agenda
Lael Brainard
CCP risk management, recovery and resolution arrangements
David Bailey
Looking ahead as the Renminbi internationalises

If Europe wants growth, reform its financial services system
Is the concept of moral hazard a myth or reality?
Why bail-in securities should be considered fools gold
After AQR & stress tests, where next for EU-banking?
City of London determined to plumb new depths
Compliance with risk targets: efficacy of the Volcker Rule
Higher capital requirements: the jury is out
Will Basel III operate to plan as its proponents desire?
Alexa Lam
Nicolas Vron
Philip Pilkington and Macdara Dwyer
Avinash D. Persaud
Thorsten Beck
William K. Black
Josef Korte and Jussi Keppo
Stephen Cecchetti
Xavier Vives
Helicopter money can reverse the present economic cycle
Biagio Bossone
US regulatory feeding frenzy on HFT is wholly misguided
Steve Wunsch
Derivatives markets in China to be built upon G20 reforms
Sol Steinberg
Chinas securities industry to undergo metamorphosis
Andy Chen
Accounting hurdles for CVA in the region
Yin Toa Lee
CVA pricingissues across Asia Pacific
Ben Watson
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Editor Emeritus
Prof. Stephen (Steve) Keen
Editor-in-Chief
Christopher D. Rogers
Editor
Rachel Banner
Sub Editor
Macdara Dwyer
Editorial Contributors
Amit Agrawal, David Bailey, Thorsten Beck, William K. Black, Biagio Bossone,
Lael Brainard, Stephen Cecchetti, Rowan Bosworth-Davies, Andy Chen, Josephine Chung, Macdara Dwyer, Stuart Holland, Sara Hsu, Steve Keen, Jussi Keppo, Josef Korte, Alexa Lam, Yin Toa Lee, Paul McPhater, Bart Naylor, Avinash
P. Persaud, Philip Pilkington, Alex J. Pollock, Stephen S. Roach, Sol Steinberg,
Joseph Stiglitz, Mayra Rodrguez Valladares, Yanis Varoufakis, Nicolas Vron,
Xavier Vives, Ben Watson, Steve Wunsch, Erin Yelden
Design & Layout
Lamma Studio Design
Printing
DG3
Distribution
Deltec International Express Ltd
ISSN No: 2071-5455
Journal of Regulation and Risk North Asia
23/F, Suite 2302, New World Tower One, 16-18 Queens Road,
Central, Hong Kong SAR, China
Tel (852) 8121 0112
Email: christopher.rogers@irrna.org
Website: www.irrna.org
JRRNA is published quarterly and registered in Hong Kong as a Journal. It is
distributed free to governance, risk and compliance professionals in China,
Hong Kong, Japan, South Korea, Philippines, Singapore and Taiwan.
Copyright 2015 Journal of Regulation & Risk - North Asia
Material in this publication may not be reproduced in any form or in any way
without the express permission of the Editor or Publisher.
Disclaimer: While every effort is taken to ensure the accuracy of the information herein, the editor
cannot accept responsibility for any errors, omissions or those opinions expressed by contributors.
Journal of Regulation & Risk North Asia
Volume VI, Issue 4 Winter 2015
JOURNAL OF REGULATION & RISK

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

Lael Brainard
David Bailey
Alexa Lam
Nicolas Vron
65
73
79
87
95
To join the conversation, learn more and stay ahead visit
regulationasia.com
Articles (continued)
Avinash D. Persaud
Thorsten Beck
William K. Black
Stephen Cecchetti
Xavier Vives
Biagio Bossone
Steve Wunsch
Sol Steinberg
Andy Chen
Yin Toa Lee
CVA pricing issues across Asia Pacific
Ben Watson
101
111
115
121
125
129
133
137
143
147
151
157
11597 LN Full Pg Ad A4.indd 1
8/21/14 10:39 AM
Foreword
THOUGH numerous opinions on how to deal with the European
economic crisis have been expressed in social media, only the
consensus view in favour of austerity has been aired within the
European Unions formal bodies.
That will now change after the Greek elections that brought
Syriza (and its coalition partner Independent Greeks) to power.
Austerity will be opposed, not merely on political grounds, but on
the basis of its appropriateness as an economic policy as well.
Given the history of Greeces entry into the Eurozone, there is a danger that this debate
will be sidelined by historical issues, by arguments over the morality of Greece seeking debt
forgiveness given this history, and by assertions that Greeces problems reflect its administration and corruption, rather than austerity.
This would be a mistake. The election of Syriza should instead be an opportunity to turn
the debate towards the two key economic issues: what caused the economic crisis of 2008;
and what is the best way to end the economic depressions afflicting both Greece and Spain,
and the stagnation affecting the rest of the Eurozone?
This is also the time to abandon rigid adherence to previously agreed policies, simply
because they were agreed to in the past. We now have half a decade of experience with which
to assess the effectiveness of those policies, and with the election of Syriza we now have a
test of how politically sustainable those policies are as well. Neither augur well for business
as usual. The depth and duration of the downturn caused by austerity were far greater than
predicted. The election of an anti-austerity party in Greece and the likelihood that this will
be followed by other victories in other countries this year shows that sustained economic
austerity is not politically sustainable.
Since austerity has proven neither effective nor sustainable, then Europe has to work out
policies that are. To do so, empirical knowledge, sound logic, and the dispassionate consideration of alternative ideas must rule the debate. This journal is a contribution to that end.
Prof. Stephen (Steve) Keen
Editor Emeritus
OIS Discounting and Counterparty

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Both OIS Discounting and the Credit Value Adjustment create complexity for banks for different
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This 2 day workshops will provide you with the tools to be able to understand the challenges and
opportunities OIS and CVA present.
This workshop is led by Ben Watson. Ben has worked for more than 20 years
as a quantitative analyst in investment banking. Until 2012 he was the APAC
head of Quantitative Analytics a global Investment Bank. Today Ben is the
CEO of Maroon Analytics Australia, a consultancy that specialises in providing
quantitative solutions to banks, financial institutions and corporates. From 2011
to 2013, Ben was heavily involved with a successful OIS migration at a Global
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Day 1
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OIS and CSA Pricing
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Counterparty Credit Risk & CVA

Introduction to Counterparty Credit
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Anyone that needs to know how the introduction of OIS and CVA will impact them and their
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For more details or a brochure, please email Ben directly

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Acknowledgements
THE editorial management team of the Journal of Regulation and Risk North Asia
could not have published this edition of the Journal without a great deal of assistance and advice from professional associations, international monetary and
financial bodies, regulatory institutions, consultants, vendors and, indeed, from
the industry itself.
A full list of those who kindly assisted with the publication of this issue of the
Journal is not possible, but the Editor-in-Chief and Editor would like to extend a
special thank you to Prof. Stephen (Steve) Keen, Head of Economics, History and
Politics, Kingston University London, for his generous assistance in generating
copy for this edition of the Journal; specifically, arranging the Q&A with Prof.
Yanis Varoufakis and opinion piece from Stuart Holland. Further thanks must also
be extended to the following organisations and institutions for their generous assistance,
support and permission in allowing the Journal to reproduce articles and papers from
their respective publications and online websites: the Board of Governors of the US Federal Reserve System; the Bank of England; the Hong Kong Securities and Futures Commission; New Economic Perspectives; Dealbook, The New York Times; Triple Crisis;
Project Syndicate; VoxEU; the Peterson Institute for International Economics; MRV Associates; and TabbForum.
Detailed comments and advice on the text and scope of content from Amit
Agrawal; Assoc., Prof. William K. Black; Macdara Dwyer; Sara Hsu; Prof. Thorsten Beck; Fanny Fung; Ben Watson; Les Kovach; Dominic Wu; Steve Wunsch;
Erin Yelden, together with Michael C.S. Wong and Phillip Dalhaise of CTRisks.
Further thanks must also go to the China Banking Regulatory Commission,
Hong Kong Institute of Bankers, the Beijing & Shanghai Chapters of the Professional Risk Managers International Association and the Hong Kong Chapters of
the Global Association of Risk Professionals and Institute of Operational Risk
Management, Asia Financial Risk Think Tank, together with SWIFT and Wolters
Kluwer Financial Services, for their kind assistance in helping to distribute the
Journal to their respective memberships and client-base in Greater China, Japan,
South Korea, Philippines and Singapore.
COLLATERAL MANAGEMENT, COUNTERPARTY RISK AND CVA

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June 23rd 2015
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It is critical for you and your business, in the current regulated nancial market to have
up to date knowledge of Collateral Management, Counterparty Risk and CVA.
This seminar, led by Chris Hunt, along with other leading industry experts, will help you
understand the key concepts, values, risks and processes undertaken by leading players
in the marketplace today.
Chris Hunt has extensive experience in the
Collateral, Counterparty Risk and CVA space,
having worked in that eld at UBS as well as at
Fortis, Barclays Capital and Standard Chartered
Bank. Chris holds an MBA from the London
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For further details on Chris please visit
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Q. What am I going to learn from this course and how will I be able to apply it?
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Q&A
End of the Euro is nigh without

radical EU-wide reforms
A bruised and battle-weary Chris Rogers raises
a flag of truce, following an encounter with
University of Athens economist,Yanis Varoufakis.
ITS not often one gets to interact personally with their heroes, so it was with
great relish and delight that I grasped
an opportunity to engage in intellectual
swordplay with one of Europes leading heterodox economists and political
activist in his homeland, Professor Yanis
Varoufakis of the University of Athens courtesy of the Journals new honourary
Editor Emeritus, Professor Steve Keen
of Kingston University.
Before moving to the Question and Answer
section of this article, its necessary to give
a brief introduction to Prof. Varoufakis for
those unfamiliar with his work and personal
background; a career greatly impacted by the
2008 financial crisis and subsequent woes of
his country of residency, Greece, where presently hes running for election to the Greek
Parliament as a standard-bearer of the the
Greek political reform movement, SYRIZA.
A duel-citizen of Australia and Greece,
Prof. Yanis attended university at Essex and
Birmingham in the UK and was awarded his
PhD in economics also from the University
of Essex. He began his professional career as
a university lecturer, influencing undergraduates and postgraduates on three continents.

Leading critic of economic orthodoxy
A prolific author and committed blogger,
Prof. Varoufakis has published numerous
academic papers and two seminal books on
the 2008 financial crisis and its aftermath,
these being The Global Minotaur: The True
Origins of the Financial Crisis and the Future of
the World Economy, London and New York:
Zed Books; and Modern Political Economics:
Making sense of the post-2008 world, London
and NewYork: Routledge, (with J. Halevi and
N. Theocarakis) 2010.
A leading figure in the heterodox economics movement and vociferous critic of
economic and monetary policy conducted
after the GFC on both sides of the Atlantic
Ocean, Prof. Varoufakis is much in demand
by journalists and on the international
speakers circuit. As such, the staff of the
Journal and I thank Prof.Varoufakis for taking
valuable time out from the Greek Election
campaign to share his valuable insights with
our readers. The full text of the Q&A appears
overleaf:
Chris Rogers: Prof. Varoufakis, since the

demise of Lehman Brothers in September
2008 and the ensuing great financial crisis
(GFC), it would seem rather obscene that
central bankers and monetary policy have
been obsessed with deflation, rather than
remedying the actual causes of the crisis
itself. Is this a fair analysis?
Transferring losses
Prof. Varoufakis: Central bankers and policy makers were obsessed not so much with
deflation but with transferring the losses
of financial institutions onto the shoulders
of citizens. When this transfer produced
deflationary forces, only then did they enter
into Quantitative Easing (QE) territory in
an attempt to stem them. Since then, they
have been trying to contain deflation without doing anything that might restore a
modicum of bargaining power to labour or
income to the dispossessed.
Chris Rogers: Given collapsing global oil
prices, an emerging car loan subprime crisis brewing in the United States, slowdown
in China and continued economic woes in
Japan, together with fears over Greece igniting another round of sovereign debt crisis
within the European Union, is it fair to say
we may be entering a perfect storm again
and a repeat of events similar to those witnessed in 2008?
Major discontinuity
Prof. Varoufakis: Whether the next phase
of the global crisis will take the form of a
major discontinuity or a slow burning, ever
increasing loss of socio-economic potential is not something that we can predict.
12
What is clear is that, under the current policy

mix, the world is facing either what [Larry]
Summers described as secular stagnation or
another Lehman moment. Not a great set of
options.....
Chris Rogers: Turning to the EU and the
Eurozone itself, would it be prudent for the
EU Commission and European Central
Bank to countenance the rapid introduction of a two-tier Euro, specifically a hard
Eurozone with Federal Germany at its helm,
and asoftEurozone headed by France?
1930s comparisons
Prof. Varoufakis: If Europe continues the
way it is now going, there will be no soft
and hard euro. The euro will disintegrate, the
result being a Deutsch mark zone east of the
Rhine and north of the Alps and an assortment of national currencies everywhere else.
The former zone will be gripped by deflation
and the latter by stagflation.
Chris Rogers: With reference to the second
question and your response, is it correct, as
many now argue, that the economic and
social ramifications of the 2008 great financial crisis are greater in many G20 nations
today than those suffered during the Great
Depression of the 1930s?
Prof. Varoufakis: It is not useful to make
such comparisons. While it is true that the
crisis transmission mechanisms are more
poignant now than then, let us not forget
that 1929 set in train the process leading to
the carnage of the the Second World War:
hardly a minor repercussion.
Chris Rogers: Back to European matters
and the development of a nascent banking union within the EU. Do you believe it
wise of political and economic policymakers
to concentrate on a banking union when
centrifugal forces within the EU are growing,
rather than dissipating, presently?
Death embrace continues
Prof. Varoufakis: A banking union would
be a godsend. It would break up the death
embrace between insolvent banks and
insolvent states. Alas, we created a banking union in name so as to ensure it never
happens in practice. And so the said death
embrace continues.
Chris Rogers: Is it not the case that recent
US unemployment figures (December 2014)
and the third quarter 2014 GDP growth figure of 5 per cent seem a little unbelievable,
particularly given that most statistical analysis demonstrates all gains and that, since
the supposed US recovery, more within
the top 5 per cent have accumulated, at the
expense of the average Joe on Main Street?
Macro data prosper.....people suffer
Prof. Varoufakis: If you look at the US
labour market closely, you find that the
number of Americans wanting a full time job
and not having one has remained more or
less constant over the last few years.
Employment growth has not kept up
with labour supply which, in the United
States, rises faster than in Europe. As for
income growth, it is no great wonder that,
courtesy of low investment and QE, asset
price increases and share buybacks boost the
income of the top one per cent further, while
wages are languishing on a filthy floor. And
so macro data prosper while most people

suffer.
Chris Rogers: Since late 2014, and continuing during the first weeks of 2015, we have
heard many Cassandra-like voices warning
of a Greek exit from the Eurozone, should
left of centre political parties gain power in
late Januarys parliamentary election. Is this
view overstated and fearmongering, no less?
Prof. Varoufakis: It is pure fearmongering
for the purposes of dissuading Greek voters
from voting for SYRIZA. It is that cynical.The
powers-that-be know that Grexit (Greek
exit) would unleash destructive powers that
they cannot control. So they are bluffing,
hoping that Greeks will fall for this piece of
terror a second time after 2012. It looks as if
they cannot fool the Greek voters twice.
EU, democracy-free zone
Chris Rogers: An economically prosperous
EU would seem essential for the wellbeing
of the global economy, given this assumption. What exactly are EU policymakers and
the constituent member national governments thinking about in hailing austerity as
a panacea, rather than implementing a massive fiscal expansion similar in impact to that
of Marshall Aid nearly 70 years ago?
Prof. Varoufakis: You are making the wrong
assumption that EU officials are in the business of promoting shared prosperity. I wish
that were true. No, they are in business of
perpetuating their bureaucratic authority within an institution that was designed
as a democracy-free zone and as a mediator between various powerful, oligopolistic
13
vested interests for whom austerity is a

golden opportunity to maximise their social
power over the rest of society. And if gigantic
unemployment and a humanitarian crisis is
the result, so be it.....
Chris Rogers: A new Bretton Woods agreement and re-imposition of capital controls
would seem more beneficial, rather than
all the supposed free trade orthodoxy we
keep hearing about from both sides of the
Atlantic. Would you agree?
Prof. Varoufakis: Capital controls have even
been adopted by the IMF, recently, as essential shock absorbers and stabilisers. A new
Bretton Woods agreement would need to
configure what I call a global surplus recycling mechanism that prevents bubble-creating financial flows during thegoodtimes and
limits the extent to which the burden of adjustment falls on the shoulders of weaker nations
and citizens during the badtimes.
Politically, the trouble is that, unlike in
1944, today there exists no equivalent to the
then United States to convene such a conference and underpin the resulting agreement.
Only the G20 can do this collectively. But with
Europe in a state of comic idiocy and with the
United States ungovernable, the prospects are
dim.
Chris Rogers: May we thank you for sharing
your engaging and somewhat controversial
answers with the Journal of Regulation & Risk
- North Asia and bid you luck in your effort
to seek elected office in Greece on 25th of
January. I and the staff at the Journal look
forward to following your career, regardless of
the outcome of the election.

NORTH ASIA
Opinion
Deregulation, non-r
egulation
and desupervision
Legal &
nce
Complia
Professor William
Black examines the
causes of the mortga
ge fraud epidemic
has swept the United that
States.
THE author of this

paper is a leading
academic, lawyer
and they implicitly
and former banking
demonstrate three
critiregulator specialisin
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g in white collar
and a wholesale
crime. As one of the
failure of private market
unsung heroes of
discipline of fraud
the and other forms
Savings & Loans
of credit risk. The Financial
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163
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Global
comp
Contact:
Christopher Rogers
Editor-in-Chief
christopher.rogers@irrna.org
14
Opinion
The four lemmings of

quantitative easing
Yale economist Stephen Roach urges the ECB to
take a long hard look at its quantitative easing
road-to-nowhere before its far too late.
PREDICTABLY, the European Central
Bank has joined the worlds other
major monetary authorities in the greatest experiment in the history of central
banking. By now, the pattern is all too
familiar. First, central banks take the
conventional policy rate down to the
dreaded zero bound. Facing continued
economic weakness, but having run out
of conventional tools, they then embrace
the unconventional approach of quantitative easing.
The theory behind this strategy is simple:
unable to cut the price of credit further, central banks shift their focus to expanding its
quantity. The implicit argument is that this
move from price to quantity adjustments
is the functional equivalent of additional
monetary-policy easing. Thus, even at the
zero bound of nominal interest rates, it is
argued, central banks still have weapons in
their arsenal.
But are those weapons up to the task?
For the European Central Bank and the
Bank of Japan, both of which are facing formidable downside risks to their economies
and aggregate price levels, this is hardly an

idle question. For the United States, where
the ultimate consequences of quantitative
easing remain to be seen, the answer is just
as consequential.
The three Ts
Quantitative easings impact hinges on the
three Ts of monetary policy: transmission (the channels by which monetary
policy affects the real economy); traction
(the responsiveness of economies to policy
actions); and time consistency (the unwavering credibility of the authorities promise
to reach specified targets like full employment and price stability).
Notwithstanding financial markets
celebration of quantitative easing, not to
mention the US Federal Reserves hearty
self-congratulation, an analysis based on the
three Ts should give the European Central
Bank cause for pause.
In terms of transmission, the US Federal
Reserve has focused on the so-called wealth
effect. First, the balance-sheet expansion of
some US$3.6 trillion since late 2008 which
far exceeded the US$2.5 trillion in nominal
gross domestic product growth over the

quantitative easing period boosted asset
markets.
ECB constrained
It was assumed that the improvement in
investors portfolio performance reflected
in a more than threefold rise in the S&P 500
from its crisis-induced low in March 2009
would spur a burst of spending by increasingly wealthy consumers. The Bank of Japan
has used a similar justification for its own
policy of quantitative and qualitative easing.
The European Central Bank, however,
will have a harder time making the case for
wealth effects, largely because equity ownership by individuals (either direct or through
their pension accounts) is far lower in Europe
than in the United States or Japan.
For the European Union, specifically
those members of the Eurozone, monetary
policy seems more likely to be transmitted through banks, as well as through the
currency channel, as a weaker euro it has
fallen some 15 per cent against the dollar
over the last year boosts exports.
Traction problems
The real sticking point for quantitative easing
relates to traction. The United States, where
consumption accounts for the bulk of the
shortfall in the post-crisis recovery, is a case
in point. In an environment of excess debt
and inadequate savings, wealth effects have
done very little to ameliorate the balancesheet recession that clobbered US households when the property and credit bubbles
burst.
Indeed, actualised annualised real consumption growth has averaged just 1.3
16
per cent since early 2008. With the current

recovery in real gross domestic product on
a trajectory of 2.3 per cent annual growth
two percentage points below the norm of
past cycles it is tough to justify the widespread praise of quantitative easing.
Japans massive quantitative and qualitative easing campaign has faced similar traction problems. After expanding its balance
sheet to nearly 60 per cent of gross domestic product double the size of the the US
Federal Reserves the Bank of Japan is
finding that its campaign to end deflation
is increasingly ineffective. Japan has lapsed
back into recession, and the Bank of Japan
has just cut the inflation target for this year
from 1.7 per cent to 1 per cent.
Denial of risks
Finally, quantitative easing also disappoints
in terms of time consistency. The US Federal
Reserve has long qualified its post-quantitative easing normalisation strategy with a
host of data-dependent conditions pertaining to the state of the economy and/or inflation risks.
Moreover, it is now relying on ambiguous adjectives to provide guidance to financial markets, having recently shifted from
stating that it would maintain low rates
for a considerable time to pledging to be
patientin determining when to raise rates.
But it is the Swiss National Bank, which
printed money to prevent excessive appreciation after pegging its currency to the euro in
2011, that has thrust the sharpest dagger into
quantitative easings heart. By unexpectedly
abandoning the euro peg on January 15
just a month after reiterating a commitment
to it the once-disciplined Swiss National
Bank has run roughshod over the credibility

requirements of time consistency.
With the Swiss National Banks
assets amounting to nearly 90 per cent of
Switzerlands gross domestic product, the
reversal raises serious questions about both
the limits and repercussions of open-ended
quantitative easing.
And it serves as a chilling reminder of the
fundamental fragility of promises like that
of the European Central Banks President
Mario Draghi to do whatever it takes to
save the euro.
In the quantitative easing era, monetary
policy has lost any semblance of discipline
and coherence. As Mr. Draghi attempts to
deliver on his nearly two-and-a-half-yearold commitment, the limits of his promise like comparable assurances by the
US Federal Reserve and the Bank of Japan
could become glaringly apparent. Like

lemmings at the cliffs edge, central banks
seem steeped in denial of the risks they face.
Editors note: The publisher and editors of the Journal of Regulation & Risk
- North Asia would like to extend their
thanks to Stephen S. Roach, senior fellow at Yale Universitys Jackson Institute of
Global Affairs and a senior lecturer at the
Yale School of Management, together with
Project Syndicate for allowing the Journal to
re-print an amended version of this article,
which first appeared on Project Syndicates
website on 26 January, 2015. Readers are
kindly reminded that copyright belongs to
Mr. Roach and Project Syndicate. The original
source material can be found at the following website link: http://www.project-syndicate.org/columnist/stephen-s--roach.
Subscribe
today
Contact:
Christopher Rogers
Editor-in-Chief
ournal of reg
ulation & risk
north asia
Articles & Papers
Volume I, Issue III,
Autumn Winter 2009-2010
nce
Complia
Issues in resolving
systemically important
financial institution
s
Resecuritisation
Dr Eric S. Rosengren
in banking: major
challenges ahead
funding liquidity
Dr Fang Du
in times of financial
crisis
Housing, monetary
Dr Ulrich Bindseil
and fiscal policies:
from bad to worst
Derivatives: from
Stephan Schoess,
disaster to re-regulati
on
Black swans, market
Professor Lynn A. Stout
crises and risk: the
human perspectiv
e
Measuring & managing
Joseph Rizzi
risk for innovative
financial instrumen
ts
Red star spangled
Dr Stuart M. Turnbull
banner: root causes
of the financial crisis
The family risk:
Andreas Kern & Christian
a cause for concern
Fahrholz
among Asian investors
Global financial
change impacts
David Smith
compliance and
risk
h
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17
Opinion
Can a central bureau prevent

systemic risk? Not likely!
Alex J. Pollock of the AEI pours cold water on
the belief that the Financial Stability Oversight
Council can control against systemic risk.
IN a typical political over-reaction to a
financial crisis, as happens each cycle, the
US Congress created the notorious DoddFrank Act of 2010. Ironically, this act is
named after two of the biggest political
promoters of Fannie Mae and Freddie
Mac, the government-sponsored institutions which greatly helped inflate the
housing bubble and then failed in 2008.
The act did nothing to reform Fannie
and Freddie, but it did cultivate a vast
efflorescence of regulatory bureaucracy,
which has by now been multiplying for
four years and continues its inexorable
spread.
Among the creations of the Dodd-Frank Act
is the Financial Stability Oversight Council,
often referred too as the FSOC (called effsock). The Financial Stability Oversight
Council is a committee of regulators assigned
with the responsibility of identifying and
preventing the ill-defined threat of systemic
risk. It is not clear that this is even possible.
The utter failure of central banks, regulators
and economists in general to understand the
great 21st century bubbles or to foresee their
disastrous consequences certainly suggests it

is not.
This unlikelihood of success is accentuated by the nature of the committee as a
congress of turf-protecting regulatory fiefdoms. But of course politicians in the wake
of a financial crisis have to be seen to be
doing something! Setting up a committee
is something which can always be done.
An analogous international committee of
central bank and regulatory bureaucracies,
the Financial Stability Board, was similarly
established.
The Faith in Bureaucracy Act
The FSOC has unprecedented power to
expand its own jurisdiction, escaping democratic checks and balances, by meeting in
secret to designate financial companies as
systemically important financial institutions or SIFIs. This subjects such companies to additional regulatory controls. You
would not think that Congress would give
an unelected bureaucratic committee the
ability to expand its own jurisdiction, but
the Dodd-Frank Act displays throughout a
nave assumption of the virtue, as well as the
knowledge, of government bureaucracies.

It should have been entitled, The Faith in
Bureaucracy Act.
What good the committee?
Systemic risk is a readily available rationale
for the expansion of regulatory bureaucracy,
but no one has offered a clear definition of
systemic risk. Justice Potter Stewart of the
US Supreme Court famously said of pornography that he could not define it, but he
knew it when he saw it. With systemic risk,
we cannot define it, and we do not know
it when we see it, or we do not see it at all,
because we are looking somewhere else.
How good can a committee composed
of jealous regulatory fiefdoms be at knowing
systemic risk when it sees it? The problem is
exacerbated because systemic risk is created
by what we do not know, and therefore cannot see intellectually.
Even more to the point, systemic risk is
caused by what we think we know, when
really we dont. For example, the following
passages detail instances where financial
actors as a group, including regulators and
central bankers, thought they knew.
Classic group think failure
The classic group think failure prior to the
great financial crisis (GFC) of 2007-2008 was
the view that US house prices could not go
down on a national average basis. This was
plausible, given how large the United States
is and how diversified its economy. That this
idea was widely believed and acted upon
was a key factor in falsifying it, with disastrous consequences, needless to say.
Then we have this marvellous contention doing the rounds prior to the GFC that
20
central banks globally had achieved the

Great Moderation. Of course, the Great
Moderationfor which central banks, including the US Federal Reserve, warmly congratulated themselves, turned out to be the great
series of bubbles.
Our delusions of grandeur are not just
confined to central bankers though. Again,
prior to the GFC, global regulators under
the guise of the Bank for International
Settlements were all of the opinion that bank
capital requirements should be based on risk
weightings. It was another quite plausible
idea, believed in and worked on by thousands of intelligent and diligent regulators
and bankers. It led to thoroughly unsound
heights of leverage.
Can it get worse? You bet!
Of course, this would all have not been
possible without the fact that new financial techniques in risk management justify
higher leverage, allegedly. Techniques such
as tranched mortgage-backed securities,
structured investment vehicles (SIVs), and
credit default swaps (CDSs) were all clever
structures created by clever people, but
could not survive what turned out to be their
hyper-leverage to house prices falling (see
first item in this list).
Such group think and delusions are not
confined to one specific group or agency.
All regulators and central bankers are government employees, which leads us to this
blinder that government debt isrisk free.
Of course it is understandable that they
want to promote the debt of their employers:
the governments and the politicians who
control them.
Still, this idea was particularly silly, given
the large number of government defaults

that litter financial history.
Countries dont go bankrupt
Last, but not least in our list, is the view
held by many that Countries cannot go
bankrupt. This memorable line of Walter
Wriston, the Chairman of what was then
Citicorp, helped lead the parade of banks into
the tar pit of the sovereign debt crisis of the
1980s. This parade had been cheered on by
official voices as the success of petro-dollar
recycling. Of course, it is true that countries
dont enter bankruptcy proceedings quite
the reverse, they just default.
Did the bureaucracies, which are now
members of Financial Stability Oversight
Council, in previous crises see in advance
that all thisknowledgewas false, any better
than anybody else? Nope. Are they exempt
from cognitive herding? Nope. Will they
have superior insight into the false beliefs
and fads of the next crisis? That is most
improbable.
Government is much to blame
A deep and fundamental problem of a
government committee like the Financial
Stability Oversight Council is that governments themselves are major creators of
systemic risk, including of course the US
government. This is especially true of central bank money-printing blunders, like that
which set off the hugely destructive Great
Inflation of the 1970s, or that which stoked
the US housing boom as it turned into a
bubble in the early 2000s.
Indeed, the US Federal Reserve, the central bank to the world as long as the dollar
is the dominant global currency, is itself the
single greatest creator of systemic risk and

the biggest SIFI of them all. The Federal
Reserve and the US Treasury, whose lowrate bonds the Federal Reserve has so generously been buying, are the most senior
members of the Financial Stability Oversight
Council. Is the Financial Stability Oversight
Council going to indict the actions of the
Fed, however culpable, for creating systemic
risk? Nope.
Likewise, is the Financial Stability
Oversight Council going to criticise other
parts of the government, lets say a Congress
or a Department of Housing which promotes poor quality mortgage loans as a bubble expands? A Department of Education
which pushes extreme levels of student debt
with no credit underwriting? A government
pension guarantor which is hopelessly insolvent? No, it wont.
Fannie and Freddie
The former government-sponsored enterprises, Fannie Mae and Freddie Mac, were
principal inflators of the US housing bubble.
They made boodles of bad loans and bought
billions in subprime mortgage-backed securities, growing in mortgage credit risk to over
US$5 trillion. Their collapse escalated the crisis of 2008.
They are now government-owned and
controlled entities, which still have over
US$5 trillion in assets and more than half
of the entire mortgage credit risk of the
country, combined with zero capital. They
demonstrably represent systemic risk, if anybody does. But does the Financial Stability
Oversight Council designate them as systemically important financial institutions?
In a nutshell, no. And, why not? Because
21
a committee chaired by the Secretary of the

Treasury in partnership with the Federal
Reserve, and filled with government officers, is constitutionally incapable of dealing
with the systemic risks created by the government. The egregious failure to address
Fannie and Freddie, in itself, deflates the
FSOCs intellectual credibility.
In general, systemic risk reflects exaggerated asset prices which have become highly
leveraged. I like to ask audiences of mortgage lenders, What is the collateral for a
mortgage loan?The house, which seems
the obvious answer, is incorrect. The correct
answer isthe price of the house. The price
is the only way the lender can recover value
from the collateral. The price of the asset is
what supports the debt.
The essential question about risk and
systemic risk is therefore: how much can a
price change? The answer is: a lot more than
you think. It can go up more than you think,

and it can go down a lot more than you
think. That is why your worst-case scenario
is nowhere near as bad as what actually happens in a crisis, and why risk, to paraphrase
an old banker, is the price you never believed
you would really have to pay.
How do we know how much a price
can change? How indeed? Our ignorance of
future prices has just been demonstrated yet
once again by the unforecasted more than
50 per cent drop in the price of global oil
supplies.
Will the Financial Stability Oversight
Council, staffed as it is, be better than anybody else at knowing how much prices
will change? Did it identify the coming
collapse in the price of oil as a looming risk
factor? It did not. Given past and recent
experience, there is no reason to think it
will do any better in the future.
JOURNAL OF REGULATION
& RISK NORTH ASIA
Editorial deadline for

Vol VII Issue I Summer 2015
May 15th 2015

22
Opinion
The secret of great wealth is

a crime never found out Balzac
Former Fraud Squad investigator, Rowan
Bosworth-Davies, lambasts the failure of the
political class to tackle City of London criminality.
MY good friend, Ian Fraser, author of
Shredded: Inside RBS, The Bank That
Broke Britain, argues that Thomas
Pikettys Capital in the Twenty-First
Century was perhaps the most important book published in 2014. Similarly,
Paul Krugman, in the New York Review,
praises this tour de force by the Paris
School of Economics professor as a
magnificent, sweeping meditation on
inequality.
The books big idea is that we havent just
gone back to 19th century levels of income
inequality were also on a path back to
patrimonial capitalism, in which the commanding heights of the economy are controlled not by talented individuals but by
family dynasties. Here, I would argue, the
word family should be interpreted in its
widest context, to include corporate bodies
and, increasingly, criminal organisations.
Pikettys influence runs deep. It has
become commonplace to say that we are living in a second Gilded Age or, as Piketty
likes to put it, a second Belle poque
defined by the incredible rise of the one
per cent. But it has only become a commonplace thanks to Pikettys work. He and
his colleagues (notably Anthony Atkinson
at Oxford and Emmanuel Saez at Berkeley),
have pioneered statistical techniques that
make it possible to track the concentration of
income and wealth deep into the past back
to the early twentieth century for America
and Britain, and all the way to the late eighteenth century for France.
The result has been a revolution in
our understanding of long-term trends in
inequality. Before this, most discussions of
economic disparity more or less ignored
the very rich. But even those willing to discuss inequality generally focused on the gap
between the poor or the working class and
the merely well-off, not the truly rich; on college graduates whose wage gains outpaced
those of less-educated workers, or on the
comparative good fortune of the top fifth of
the population compared with the bottom
four fifths not on the rapidly rising incomes
of executives and bankers.
It therefore came as a revelation when
Piketty and his colleagues showed that the
incomes of the now famous one per cent,
and of even narrower groups, are actually

the big story in rising inequality. And this
discovery came with a second revelation:
talk of a second Gilded Age was nothing of
the kind. In America, in particular, the share
of national income going to the top one per
cent has followed a great U-shaped arc.
Risible idea of merit
Before World War I, the one per cent received
around a fifth of total income in both Britain
and the USA. By 1950, that share had been
cut by more than half. But since 1980 the
one per cent has seen its income share surge
again and in the US its back to what it was
a century ago.
Back then, great wealth tended to be
inherited; and the idea that todays economic elite are people who have legitimately
earnedtheir position, is frankly risible.
I posit that it simply isnt possible to
earn your way to significant wealth. No
one working lawfully for someone else in
an employed position, and paying full tax
contributions on that salary, as well as purchasing a commensurate home property,
together with educating children in a private
manner will ever save enough money to be
considered to be sufficiently wealthy as to
enter the top one per cent.
Robber barons
Frankly, my friends, we have returned to the
days of the robber barons, the organised
criminal groups and dynastic families who
largely owned and controlled the wealth in
America at the turn of the nineteenth century,
and whose spiritual and criminogenic counterparts are alive and well today in Russia
and parts of the old former Communist Bloc,
24
Pakistan, India, Malaysia, Indonesia, China,

parts of Sub Saharan Africa and the Middle
East, as well as in parts of the UK, the EU
and America
We, in the West, notably London and
New York, have become the facilitators of
the movement of that criminal capital. We
have become economic prostitutes, selling
our services and our abilities to the highest bidder, in return for vast amounts of the
dirty criminal money that flows out of these
countries into the City of London or New
York, to be washed, cosseted, protected and
moved on into the subterranean world of the
offshore banking industry, free from oversight and interdiction.
New dynastic elites
My own belief is that the changes being
predicated in the UK and the USA for the
better facilitation and distribution of such
capital are leading to the emergence of a
new series of dynastic elites. These are all
closely aligned to the deliberate and systematic destruction of a socio-political status that had deliberately sought to achieve
a far greater equality of the distribution of
wealth to a much wider subset of citizens
by engineering a deliberately liberalmodel
of economic dissemination, maintained by
elevating the power of the rule of law to a
pre-eminent position in Western Capitalist
Societies. The aim of enforcing this new
regulatory legal regime had been to protect
the new ideas underpinning the policies of
Consensus in the UK and of The New
Dealand its aftermath in the USA.
The end of World War II left the United
Kingdom with an appetite for a broader
distribution of wealth and a strengthening
of social security, while more conservative

instincts held fast to a belief in individual initiative and private property.
Post-war intervention
The practical resolution of this tension
in politics by the two Chancellors was a
Keynesian-style mixed economy with moderate state intervention (regulatory control
underpinned by statute) to promote social
goals, particularly in education and health.
The Bank of England enjoyed a centrist,
prudent controlling role and oversaw various
levels of financial borrowing policy, as well
as Exchange Controls. As with other laws
introduced during the war-time crisis, the
overriding aim was to ensure as fair a distribution of capital as possible, and to maintain rigid controls on speculation in capital
holdings, an unnecessary practice which it
was believed could undermine and thereby
damage both the war-time and early peacetime economy.
These policies were continued by successive consensualist Governments even after
the War, despite their apparent unfairness
towards the interests of the uber-rich.
Until the pips squeak
Dennis Healey, speaking at the Labour
conference on 1 October 1973, said,I warn
you that there are going to be howls of
anguish from those rich enough to pay over
75 per cent on their last slice of earnings.
In a speech on 18 February 1974, Healey
went further, promising he would squeeze
property speculators until the pips squeak
and confronted Lord Carrington, the
Conservative Secretary of State for Energy,
who had made 10m profit from selling
agricultural land at prices 30 to 60 times as

high as it would command as farming land.
The consensus on wealth redistribution
dominated British politics until the economic
crisis of the late 1970s which led to the end of
theGolden Age of Capitalismand the rise
of monetarist economics. The Conservative
administration of Margaret Thatcher institutionalised a far greater emphasis on a free
market approach to government, while at
the same time dedicating itself to what was
called the rolling back of the nanny State
andthe dismantling of Socialism.
Relief, Recovery, Reform
In the USA, the era of the New Deal was
underpinned by the realisation that the
seeds of the economic austerity and the era
of severe hardships caused by the collapse
of the US economy in the aftermath of the
Wall Street Crash, had been predicated, to
a great extent, by unregulated speculative
trading on margin, during which criminals
and dishonest speculators had manipulated
the US securities market so as to destroy its
very foundations.
Unregulated speculation coupled with
the highly dangerous practice of naked
shorting or selling stock the seller did not
own, with a view to driving down the price
of the underlying security, undermined the
legitimacy of the US stock market, thus
deterring natural users from wishing to
engage with its services.
The period of economic reconstruction witnessed a huge Keynsian economic
re-engineering project. The programmes
focused on what historians call the 3 Rs:
Relief, Recovery, and Reform. That is, Relief
for the unemployed and poor; Recovery of
25
the economy to normal levels; and Reform

of the financial system to prevent a repeat
depression.
Honest banking
The Truth in Banking legislation, coupled
with the work of the SEC, and the power of
its lawyers and investigators, working with
Justice Department Prosecutors to maintain
strict controls over the conduct of business
on American exchanges, protecting them
from predators and encouraging ordinary
men and women to invest in them, was fundamental to the post-depression American
Dream.
It was only the emergence of Chicagoschool monetarist economic theorists in both
the US and the UK, that spelt the end of the
era of consensual politics, and the deliberate
de-regulation of financial markets.
These policies were very largely driven
by theoretical economic analyses: both
Thatcher in the UK and Reagan in the USA
had their gurus who whispered economic
radicalism in their ears.
Crooks, wiseguys and thieves
The policy, on both sides of the Atlantic, to
engage in a policy of financial de-regulation,
led to a concerted attack on the effectiveness of the law enforcement components
which underpinned the protection of market integrity; they were now described as
protectionistandcontra-preneurial, antithetical to the efficient running of a free market. Certainly by the mid 1980s, the powers
of criminal investigatory action were being
effectively curtailed.
What the proponents of unfettered freedom of markets failed to realise, whether
26
deliberately or by mistake, was that, by

allowing greater freedoms for markets to
develop entrepreneurial skills and increasing efficiency in the management or risk,
they opened the door to every crook, wiseguy and thief, whose very existence had
hitherto been made much more difficult by
the existence of strong laws and powerful
prosecutors.
Once those powers were revoked, there
was nothing left to prevent the markets from
being turned into a criminal free-for-all,
which is what they rapidly became.
Prosecutions
Nevertheless, there was a clear agenda on
the part of successive Governments on both
sides of the Atlantic to play down the protectionist powers of the criminal law, leaving
the regulation of the markets in the hands
of enthusiastic amateurs, academics, and
bankers, who had every incentive to see a
continuation of the status quo.
In the UK, despite the real successes of
the prosecutions of the first Guinness trial
in 1987, which stemmed originally from the
successful investigations of Ivan Boesky and
others in the USA, quickly followed by the
even greater success of the criminal convictions sustained in the Blue Arrow case, these
two major city fraud cases were to be the
last prosecutions of anyone even remotely
associated with positions of power and
social significance within the City of London
Establishment.
The City and its powerful friends were
frightened rigid by the Guinness prosecution and had decided that they did not want
the conduct of their affairs being investigated
by Police Fraud Squad detectives men and
women who really were capable of quickly

grasping the innate criminality of the conduct alleged, and doing something swiftly
and effectively about it.
Political lobbying
Treating socially elevated financiers in the
same way as they treated East End villains
running dodgy break-out companies,
knocking them up in the early hours of the
morning, locking them up at Holborn police
station and treating them generally like the
criminals they undoubtedly were, was a
most unpleasant experience, and some of
the weaker blue-bloods had a tendency to
talk too much to the cops, too quickly, in the
hope of more lenient treatment.
Such was the social damage being caused
by these cases, that a concerted period of
lobbying of selected politicians, civil servants
and law officers was begun, to amplify the
perception of damage to the reputation of
UK plc being caused by such trials.
Closing of ranks
The dropping of the other Guinness cases,
coupled with the indecently swift reversal
of the convictions of the defendants in the
Blue Arrow case by the Court of Appeal,
demonstrated just how scared the political and financial controllers of the British
Establishment had become of allowing
City fraud scandals to be dealt with by the
cops and tried by ordinary juries, who had
also demonstrated, only too well, that they
clearly understood the issues at trial and
were perfectly capable of potting the bluebloods and convicting them of major crimes.
After the Court of Appeal reversals in the
Blue Arrow case, a friend of mine who was
a senior lawyer at the Serious Fraud Office

told me that the message being sent down
from the top, was that there would never
again be a prosecution along the lines of the
Blue Arrow trial.
The salient point underpinning this
entire farrago is that, ever since those days in
1989, no important City criminal scandal has
ended in the dock of the Central Criminal
Court, and the concomitant regime of laissez-faire and light touch regulation which
has been perpetrated ever since has allowed
the banking and financial establishment to
commit crimes on a wholesale basis, secure
in the knowledge that they will never be
dealt with by the police.
Culture of impunity
If you wonder why so many bankers have
been paid so much money in the intervening years, well you can make a great deal of
criminal profit in 25 years if you are secure
in the knowledge that the police will not be
looking at you! Imagine what Al Capone
or Lucky Luciano could have siphoned
off if they had known that they were free
from law-enforcement oversight, and that
is exactly the situation with regard to the
British Banking Sector in the last quarter of
a century!
In the UK, the emergence of the civil
regulatory regime that was spawned by the
passing of the Financial Services Act 1986,
began an era which gave all the appearances
of being a regulatory-positive agenda, but
which, in practice, began and continued a
concerted policy of unpicking the influence
of law enforcement.
Successive administrations, the Securities
and Investments Board, the Financial
27
Services Authority, now the Financial

Conduct Authority, have rigidly steered clear
of prosecuting anyone of stature in the banking industry.
Naming and shaming
It took many years of naming and shaming to get the FSA to begin prosecutions
of practitioners for even the most egregious
cases of insider dealing, and even then,
the defendants were always relatively minor
employees, the majority of whom pleaded
guilty.
Despite this development, the FCA has
even now consistently refused to prosecute
any senior banker for any of the concerted
criminal activities which have marked out
the banking leitmotif.
You only have to look at the activities of
all the major banks in the perpetration of the
institutionalised level of PPI fraud, which
has lasted for many years, to understand the
truth of this allegation. The monies made in
the pursuit of profits and thegrabbing of the
biggest share of the customers wallet, which
so identified the PPI fraud era, has enriched
many bankers a hundredfold.
Drug cartels, Libor & FX
Add into this the other levels of criminal
fraud perpetrated against clients, the deliberate lying about the valuations of debtsecured securities followed by the fraudulent
foreclosure on loans, the false enrichment of
bankers at the expense of clients criminally
forced out of their contractual obligations,
and you begin to see a positive policy of
criminal activity being widely perpetrated.
Then you start to look at the level of foreign money laundering, sanctions busting
28
and other breaches of anti-terror controls

being imposed by governments, many if not
most of which were routinely ignored by
the banks. HSBC led the way with billions
of dollars recovered from their money washing activities on behalf of the Mexican Drug
Cartels. Libor and Forex manipulations are
among the more recent exposs.
For these, and for other reasons, I assert
that the level of criminality is so widespread
in the banking galre that it is impossible to calculate the amount of money they
have created for themselves, and which has
been paid to them in the form of bonuses.
While their basic salaries may remain relatively modest, they have more than made up
for the wealth they have absorbed through
other payment abuses and tax avoidance.
I lived through the era of change as a
detective at the New Scotland Yard Fraud
Squad, and I watched with mounting irritation and bemusement while perfectly proper
cases we should have been investigating
were undermined by Government lawyers.
Later, as a regulator, I observed the spineless kowtowing of the regulatory regime
towards those who were facilitating the
movement of the growing levels of criminal
money being slushed through the UK financial sector. I believe that it is now too late to
put the genie back into the bottle; we must
live with the fact that the City of London is
run by a gang of organised criminals who
make Al Capone look positively benign.
Without their intervention, as an integral component in the onward transmission
of the billions of foreign dirty money which
comes to London, I seriously wonder how
UK plc would survive if we had to run our
affairs lawfully and properly.
Leader opinion
A simple answer to the Euro

crisis exists, why not use it?
Former Labour Party stalwart and confidant of
Jaques Delors andYanis Varoufakis, Stuart Holland, offers Europe a way out of present crisis.
THE electoral success of Syriza in the
recent Greek parliamentary elections
raises serious questions as to whether
the new Greek Prime Minister, Alexis
Tsipras, and his Finance Minister, former
academic and accidental political activist,
Yanis Varoufakis can fulfill the political
mandate of Syriza to renegotiate Greek
debt with the Troika of the European
Commission, ECB and IMF never mind
overcome entrenched German intransigence personified by Germanys present
Chancellor, Angela Merkel.
But this is only part of the wider question of
whether the European Union can resolve
the present crisis afflicting much of the
Eurozone. As many are aware, the best way
to reduce debt and deficits is by growth, as
witnessed by US President Bill Clintons second administration in the late 90s.
An answer to our present predicament
exists and was addressed by myself and
Minister Varoufakis in our Modest Proposal
announced in November 2013 in Austin,
Texas. A proposal that now provides the
framework for the negotiating position the
Syriza government of Tsipras will undertake

with Greeces creditors in the weeks and
months ahead.
There have been three revisions to the
Modest Proposal originally outlined by Yanis
Varoufakis and myself, prior to the noted US
Economic Historian Prof. James K. Galbraith
joining our cause in 2013. The main thrust
of our proposal is based on the argument I
made to Jacques Delors (the then President
of the European Commission) in 1993 that
the deflationary debt and deficit conditions
of the Maastricht Treaty needed to be offset
by a bond financed investment recovery on
the lines of that undertaken in America by
President Roosevelt via the New Deal in the
1930s.
At that time, I recommended that these
should be issued by a European Investment
Fund, which consequently was established
in 1994 and is today a sister institution of the
European Investment Bank (EIB).
In response to the proposal of a
European Fund for Strategic Investment
(EFSI) by Polish Finance Minister Mateusz
Szczurek, Wolfgang Schuble, the present German Finance Minister under Frau
Merkel, has stressed that there should not be

any increase in debt.
EIB bonds are not national debt
But EIB bonds and lending for project
finance do not count towards national
debt. Nor is an EFSI needed to fulfil the EIB
bond funded European recovery that the
present European Commission President
Jean-Claude Juncker made his top priority in his adoption address to the European
Parliament in July 2014.
The European Investment Fund can issue
bonds to co-finance the EIB and does so by
recycling global surpluses. Thus the South
African Minister of Finance, Nhlanhla Nene,
declared at a meeting of the BRICS (Brazil,
Russia, India and China) in Washington on
September 25th last year that they would
buy eurobonds if these were to finance a
European recovery.
Neither should governments fear markets or rating agencies. When Standard
& Poors downgraded Eurozone member
states debt in January 2012, it stressed that
key reasons for this decision were simultaneous debt and spending reduction by governments and households, the weakening
thereby of economic growth, and inability of
European policymakers to assure any economic recovery within their ranks.
No new criteria needed
Last year Bill Gross, when still head of the
Pimco fund, also called for European recovery, stressing that pension funds needed
growth to secure retirement income,
whereas low to near zero interest rates in
Europe would not underpin said recovery,
much as is the case in the USA. Similarly,
30
Norways sovereign wealth fund has cut

its investments in private equity in Europe
because of low growth.
The Chinese CIC sovereign wealth fund
also made losses on its private sector investments after the onset of the financial crisis,
and declared that it wanted public investment projects with a maturity of at least 10
years. The Gulf States have assets of some
US$1.1 trillion presently, much of which is
under-invested or making poor returns.
Nor are any new criteria needed for an
investment led recovery. Apart from the
TENS of the Trans-European Transport
and Telecommunications Networks, the
Amsterdam Special Action Programme
of 1997 gained the agreement of the EIB
that it would invest in health, education,
urban regeneration, green technologies and
finance for small and medium-sized firms
all areas that ECB President Draghis more
than US$1 trillion quantitative easing programme will fail to reach. Eurogroup chair
Joerem Dijsselbloem recently recognised
in the Financial Times that a new institution
such as the EFSI is not needed.
So what is blockingaction this day? Little
other than the Merkel-Schuble presumption
that Germany would have to pay.Yet this is not
the case. EIB bonds are project financed, not
serviced by German or any other taxpayers.
They have no formal guarantees by governments, and have not needed them since 1958.
Besides which, those member states that want
a joint EIB-EIF funded European recovery,
such as France, Italy and Greece need not
be blocked by Germany.They, or Jean-Claude
Juncker, could move an enhanced cooperation procedure on the European Council
which does not need unanimity.
Book review
Policy failures at the heart of

the US 2008 financial crisis
Bartlett Naylor of the Public Citizen provides a heartfelt review of Jennifer Taubs
book charting the US mortgage debacle.
WHATS most compelling about Jennifer
Taubs new book, Other Peoples Houses:
How Decades of Bailouts, Captive
Regulators, and Toxic Bankers Made
Home Mortgages a Thrilling Business,
is her authoritative argument that the
recent financial crisis did not result from
isolated policy decisions and fraudulent business practices of the few years
leading to 2008. Instead, our recent Wall
Street crash played out already proven
policy failures from the savings-and-loan
(S&L) crisis of the 1980s onwards.
Even moral hazard, the surrender of discipline for banks too-big-to-fail that epitomised the bailouts of 2008, Taub reminds
us, originated in 1984 with the bailouts of
Continental Illinois National Bank and successive taxpayer rescues of American Savings
and Loan, the largest S&L in the nation.
Professor Taub, a colleague and friend,
teaches at Vermont Law School and previously served as associate general counsel
at Fidelity Investments. With unique credentials, she can explain the intentional
complexity of Wall Street products and
Washington regulation without glossing

over contradiction and nuance.
Unlike the majority of crash pathologies
that focus on Washington players such as
Timothy GeithnersStress Test, Sheila Bairs
Bull by the Horns, or Andrew Ross Sorkins
Too Big to Fail, Taubs book spends quality
time outside the Washington DC beltway.
Nobelman family
Her narrative follows real individuals,
from rogues who pillage the banks along
with their lieutenants, to regulatory chiefs
often aligned with industry interests, a few
heroes who actually understand and fulfill
their responsibility to protect taxpayers, and
finally, victims of this morass. And we meet
the Nobelman family.
The Nobelmans and their mortgage
help connect this three decade story of
dysfunction. In 1984, Harriet and Leonard
Nobelman borrowed US$68,250 for a onebedroom condominium. American Savings
and Loan Association held the loan.
Over the years, American Savings would
be bailed out several times in several reincarnations. In one sale, it went to Washington
Mutual. When that firm failed, it went to JP

Morgan during the height of the 2008 financial crisis, completing the more than 20 year
arc from the S&L crisis.
The Nobelmans also ran into financial
trouble when, in 1990, they lost their jobs
and encountered health problems. They
sought not a bailout, but bankruptcy relief.
The Supreme Court eventually ruled
against the Nobelmans.
Because lenders understood a mortgage
didnt come with the same consumer protection as other loans, Taub contends that
Nobelman v. American Savings Bank gave
lenders added incentive to place people in
homes they could not afford.
The London Whale
Taub doesnt pin the 2008 financial crisis on
this decision alone. For example, she runs
through a devastating critique of deregulation of the last 15 years in the chapterLegal
Enablers of the Toxic Chain. After the banks
made reckless loans, the pools of mortgages
won lax accounting oversight with risk disguised by unsupervised bets at institutions
with far too much debt.
JP Morgan, the inheritor of American
Savings, figured near the centre of that toxic
chain right through to the notorious London
Whale bets of 2012 that dramatised banking
too big to manage and regulate.
Responding to the 2008 crash, reformers
brought many ideas to Congress, including
reversal of the Nobelman decision. The real
impact, Taub recounts, would be in loanmaking itself. With the potential for bankruptcy, economists of the Cleveland Federal
Reserve Bank speculated that it worked
without working, as loan makers would be
32
less likely to make unaffordable loans in the

first place, and seek an out-of-court settlement in the case of problems.
Following passage in the House of
Representatives of a principal reduction
measure, Sen. Richard Durbin (D-Ill.) proposed a parallel reform in the Senate. But he
ran into a buzz saw of 60 financial service,
insurance and real estate firms that unloaded
US$40 million in lobbying in the first quarter
of 2009 to fight this and other reforms.
President Barack Obama, who originally
endorsed the idea as a presidential candidate
in the Primaries, reversed course under the
advice of his new Treasury Secretary Timothy
Geithner. Durbins measure drew 45 votes,
all Democrats. Without White House support, it fell short. Obama gave it away on
the way to the White House, concluded
Barney Frank, the Massachusetts Democrat
who chaired the House Financial Services
Committee.
Taub frequently notes the pernicious role
of money in financial policy, both in large
dollar flows and in micro-deals. For example, Lewis Ranieri, the originator of mortgage-backed securities, sought a favourable
tax ruling on a proposed structure, but ran
into opposition from a Treasury Department
analyst. So Ranieri hired the analyst away
from the Treasury. Such mischief forms the
tapestry of policy.
Other Peoples Houses achieves numerous goals history, deconstruction of financial products, policy critique. Throughout her
book, Taub returns to the real people who
suffer at the hands of financial rogues and
their legal enablers. Too often, these victims
appear as statistics; Taub reminds us they
have real names.
Book prcis
Life, Liberty and the pursuit

of Inequality
NewYork-based trader SteveWunsch makes an
impassioned plea that the USA return to past methods that underscored its Liberty and prosperity.
IS the stock market rigged? Are interest rates, currencies and commodities
manipulated and rigged, too? Yes, say
regulators. But not to worry, they say.
Were onto it. Were writing new rules
and fining the perpetrators billions. Soon
well put a few behind bars, so this never
happens again. Should we breathe a sigh
of relief? Or should we worry anew?
Unfortunately, we should worry.
In my new book, Life, Liberty and the pursuit
of Inequality, I show how the freedoms of
the English-speaking peoples led to prosperity precisely through the ability of stock
exchange founders to design and run their
markets as they saw fit, without input or
oversight from regulators. Did this result in
rigging? Yes, it did. But their rigging created
the paradigm that enabled London and
New York to lead their countries and, ultimately, the world, toward the first glimmers
of self-sufficiency and wealth for all.
That paradigm, which I call the do-ityourself monopoly, first appeared tentatively around 1690 in London as forerunners
of the London Stock Exchange, and then
moved around 1790 to New York as forerunners of the New York Stock Exchange,
but this time explicitly, as evidenced by such
documents as the Buttonwood Agreement.
As the do-it-yourself monopoly reached
full flower with the robber barons in the
latter part of nineteenth century America,
it underwrote a succession of the worlds
wealthiest men and the worlds biggest
businesses, as the United States became the
worlds greatest economic power.
Principles of liberty abandoned
Today, the evident economic malaise of the
wealthy western countries is traceable to
their having abandoned the principles of
freedom that made them wealthy, in particular with regard to how they design and
run their capital markets. The collapse of the
US initial public offer (IPO) markets ability to fund new technology companies and
industries is examined in detail and seen as
the clear consequence of this abandonment.
And the rest of the west is following the
USs lead in this and many other instances
incompatable with notions of liberty.
Scores of global regulators, including
over a dozen in the United States alone, are

now pushing principles pioneered over the
last four decades by the US Securities and
Exchange Commission (SEC). Following the
SECs guidance, they are reshaping capital
markets so as to eliminate manipulation,
rigging, spoofing and other vestiges of oldfashioned human intermediation as they
force markets to be transparent, fair, competitive and, above all, electronic.
Over-regulation dooms economies
The regulators are confident they are on the
right track, and have thousands of pages of
laws and regulations to back them up, such
as Dodd-Frank and the National Market
System in the US, the Markets in Financial
Instruments Directive (MiFID) in Europe,
and similar rules in Canada, Australia and
other countries. But the problem is that
these well-meaning regulators are actually
eliminating the whole value that markets
once had to society, which was to create new
companies and jobs.
Thus, regardless of whether governments succeed with their extraordinary fiscal
and monetary interventions, such as austerity and quantitative easing, the big surprise
will be that the intervention they are most
certain of bringing transparency, fairness,
efficiency, etc. to capital market structure
will in fact be what dooms their economies.
Imaginary harms
And the confidence they are trying to revive
will not do so, because lack of confidence is
now a permanent accompaniment of regulatorspolitical ambitions, a self-perpetuating
narrative that constantly renews itself on
their alleged ability to address what I show
34
to be imaginary harms. Investors never did

complain about regular continuous equity
market trading costs, which always had
seemed low and reasonable to them.
Now, under high frequency trading
(HFT), costs are down 90 per cent from
where they were and the public is furious.
They hear HFT is a rigged game, so they
know theyre getting ripped off somehow,
even if theyre not, and even though they
have no way of assessing the practical value
to them of the SECs complex and confusing
creation.
And why would anyone complain about
fixings, when everyone got the same price
whether they were buyers or sellers? The
answer is, they didnt. There was safety in
numbers in those fixings: lots of people both
buying and selling at the same time and
price. So they naturally trusted the bankers
who got them the fixing price. But regulators saw that intermediaries must have been
making something somewhere, so they
busted the bankers for rigging.
Loss of safety in numbers
Customers now see in the news that bankers are abandoning fixings and skittish
about participating lest they get fined again.
And since everyone now knows fixings are
rigged, courtesy of the reformers self-justifying narrative, customers are less interested
anyway. The net effect is that fixings are losing the safety-in-numbers characteristic that
was their chief attraction.
In short, in order to restore confidence,
regulators created HFT in stock markets,
which all investors hate, and they turned fixings into fraught affairs that customers are
scared of. But never mind confidence. The
regulators accidental assault on confidence

is the least of our worries, as I show in some
detail by looking both back a few centuries
to see how markets should be run, and then
ahead to the future to show what we will be
missing by having them run by regulators on
opposite principles.
Historical drivers of prosperity
If markets had been run on the principles of
modern regulators when they were forming, they would not have formed in the
first place. And since, as I also show, the
exchanges were the essential triggers of the
Industrial Revolution, blocking them would
have prevented the Industrial Revolution
from emerging, which would have meant
that this extraordinary historical event that
began lifting the worlds people out of seemingly permanent and universal poverty,
would not have happened, either.
As demonstrated by my re-examination
of some authoritative but overlooked historical works, the principles that pertained
when the New York Stock Exchange and
London Stock Exchange were forming are
the key to understanding such mysteries as
what triggered the Industrial Revolution in
the first place, why it was originally only a
British phenomenon, and why it eventually
left Britain and settled in America.
Killing, actual killing
This chain of logic also shows that modern
regulation would have prevented the emergence of the British Empire and the United
States as dominant economic powers. But
these are not just retrospective curiosities.
As I also show, the same regulatory principles are killing the prospects for prosperity
today across the world, with the United

States leading the downturn. And its not
just money.
The same forces that are killing jobs are
also behind the killing, actual killing, of many
people. The tolerance of inequality that
Americas founders and the British before
them invented with their freedoms was not
only the foundation of prosperity, but it was
also the foundation of peace.
Its absence today is the cause of the
national and global conflicts over inequality
that underlie the haves versus have-nots
disputes that are erupting in violence from
Ferguson, Missouri to Paris, France, to Iraq
and Syria. The English-speaking peoples
once led the worlds peoples to tolerance
for inequality. The question now is, can they
lead them back?
We can turn back the tide
The signs are not positive. On current trajectory, the more likely evolution of the global
disputes over inequality, of which the War on
Terrorism is both a cause and a consequence,
is toward atrocities that will result in millions
of deaths. While these trajectories cannot
be altered by democratic debate, as advocated by the likes of Frances Thomas Piketty
Capital in the Twenty-First Century and
other inequality gurus, I suggest there is a
way to rescue the nations and peoples of the
world from these impending tragedies. And
that is by eliminating the cause of our current
problems: the SEC.
By removing this scourge, we can break
up the logjam blocking both the free flow of
capital and the human interaction of individuals working to improve themselves that
is the real source of peace.
35
Letter from an economist
Is a government surplus sustainable,

never mind desirable?
Heterodox economist Prof. Steve Keen shows
how government obsession with surplus
budgets is antithetical to financial stability.
THE preventive arm of the European
Unions Stability and Growth Pact specifies the requirement of a close to balance
or in surplus position for member states
government budgets. In this opinion
brief, I want to consider whether a sustained government surplus is possible,
by considering its monetary impact on
the private sector.
In order to simplify this analysis I will initially ignore the external sector (exports and
imports plus net foreign payments), and
divide the economy into two sectors, these
being the private sector and the government
sector. If the government runs a surplus,
then government taxes on the private sector
exceed the subsidies paid to it by the government. This necessitates the running of a
deficit by the private sector with the government. Lets call the difference between taxes
and government subsidies NetGov. The
flow of funds to the government of NetGov
has to be matched by a private sector deficit of exactly the same amount, as shown in
Figure 1 (where a surplus is shown in black
and a deficit in red).
Figure 1: A two-sector picture of the

economy.
Private:
deficit = NetGov
Government:
surplus = NetGov
The question now arises as to how

exactly the private sector generates the flow
of money needed to finance the government
surplus. It could run down its existing stock
of money; but that means a shrinking private
sector, when the objective of the government surplus is to enable economic growth
to occur.
So for the government to run a surplus,
and for the economy to grow at the same
37
time, the private sector has to produce not

only enough money to finance the government surplus, but also enough money for
the economy to grow as well.
How can it do this?
There is only one method to achieve this,
namely the non-bank subsector has to borrow money from the bank subsector. As the
Bank of England recently emphasised, bank
lending creates money (see Money Creation
in the Modern Economy, Michael McLeay;
Amar Radia and Ryland Thomas, Bank of
England Quarterly Bulletin, 2014 Q1, pp.1427). Bank creation of money by lending must
therefore exceed NetGov.
To represent this we need a three-sector
model, with the non-bank sector borrowing
from the banks. Lets call the flow of funds
from the banking sector to the non-bank
sector NetLend. Then for the government
Figure 2: A three-sector model to
explain how the private sector can
finance a government sector surplus
and still grow.
Banks:
deficit =
NetLend
Government:
surplus =
NetGov
Private:
surplus =
NetGov + NetLend
38
Figure 3: A shrinking private sector

whereby the private sector desists
from borrowing and repays debt.
Banks:
surplus =
NetLend
Government:
surplus =
NetGov
Private:
deficit =
NetGov + NetLend
to run a surplus, and for the private nonbank sector to grow at the same time, the
banking sector has to run a deficit: new
lending (money going out of the banking
sector) has to exceed loan repayments and
interest (money coming into the banking
sector). This situation is shown in Figure 2.
Indebtedness to banks
The private sectors money stock is growing at the rate of NetGov + NetLend, but
its indebtedness to the banks is growing at
the faster rate of NetLend (since NetGov is
negative). This combination of a growing
economy, and a government sector surplus,
means that the rate of growth of private sector debt has to exceed the rate of growth of
the private non-banks money stock. The
private sectors net indebtedness must therefore grow faster than the economy.
Clearly this cannot go on forever, for at
some point the non-bank sector will stop
borrowing, or attempt to de-lever. Then

the banking sector ceases running a deficit
and instead runs a surplus, as does the government. This necessitates a private sector
deficit: outflows of money from the private
sector exceed inflows and its money stock
shrinks. That situation, which is incompatible with a growing economy, is shown in
Figure 3.
Tipping point
Therefore, we can see that the medium-term
consequence of a government running a
sustained surplus is an economic crisis when
the private sector is unable or unwilling to
continue going into debt a tipping point.
The only way to avoid this situation is if
the external sector which weve ignored till
thus far is in deficit with the nation: payments by the country to the rest of the world
amount to less than its receipts from the rest of
Figure 4: A shrinking private sector
when the private sector desists from
borrowing and repays debt.
Banks:
surplus =
NetLend
Private: surplus =
NetExt + NetGov +
NetLend
External:
deficit =
NetExt
Government:
surplus =
NetGov
Figure 5: The sustainable long-term

situation deficits by banks and the
government.
Banks:
deficit =
NetLend
Private: surplus =
NetExt + NetGov +
NetLend
External:
balance =
NetExt
Government:
deficit =
NetGov
the world. Lets call the balance of payments

NetExt.
The banks, the government and the private
sector can all run surpluses if NetExt is bigger
than the government surplus and the scale of
private sector deleveraging.
This situation, shown in Figure 4, is sustainable for some countries in isolation, but
not for all, since the sum of all external sector
deficits must be zero. Therefore, in general,
a sustained government surplus is not sustainable, since it will lead to a private sector
debt crisis. By the process of elimination, the
only long term sustainable situation is that
shown in Figure 5: both the government and
the banking sector must run deficits, while
the private non-bank sector runs a surplus.
In a monetary economy, it follows that
the only sustainable policy is that the government runs a deficit, where the size of
the deficit is related to the desired rate of
economic growth.
39
Comment
Stock-listing in China
post-Alibaba hurrah
State University of New Yorks Sara Hsu, gives
a brief analysis of what 2015 may offer in terms
of stock market growth and pitfalls in China.
CHINAS stock exchange rallied at the
outset of 2014, marking the largest start
of the year rally since 1993. This has
been attributed in part to the governments announcement on December 31
that it will allow first-time small home
buyers to be eligible for housing fund
loans. Relaxation of price controls on
railway bulk cargo, packages and privately invested cargo were also behind
the stock surge. However, the rally belies
the existence of underlying deterrents to
listing on the Shenzhen and Shanghai
stock exchanges.
Alibabas case illustrates this problem.
Alibaba officially listed on the New York
Stock Exchange in the United States in
September of 2014, and not on the Shenzhen
or Shanghai stock exchanges in mainland
China, to the chagrin of many yield-seeking
Chinese citizens. As Alibabas listing underscores, Chinas domestic stock exchanges
remain unappealing IPO destinations for
many a business. Excessive listing rules and
procedures coupled with inadequate supervision and presence of fraud and insider
trading, have rendered the Chinese stock

markets a second-best choice for competitive and innovative companies. But theres
potential.
Chinas stock market is the third largest in
the world by market capitalisation, weighing
in at some US$3.7 trillion in 2013. However,
despite recent reform proposals that have
attempted to improve the listing process by
proposing a registration-based listing system that would allow companies that meet
criteria for making a public offering (instead
of the current system in which the China
Securities Regulatory Commission approves
IPOs), Chinas stock market remains one
of the poorest performing stock markets in
the world. This fact can be easily discerned
from a quick glance at the MSCI Index, calculated by Morgan Stanley, and even in the
Shanghai Composite Index itself.
The stock market has often been criticised for channelling funds to state-owned
companies and their subsidiaries, via other
state-owned companies that purchase
shares. This does not reflect a market-based
environment, but rather is reminiscent of
earlier practices of earmarking bank loans
for state enterprises. Insider trading is also

a problem, as is accounting fraud. A recent
crackdown on rat trading has sought to
eradicate fund managers practice of purchasing shares using personal accounts and
selling them for a profit once they gain in
value. Accounting fraud presents investors
with incorrect information, including incorrect revenue recognition and fraudulent
asset information, among other abuses.
Potential for improvement
Chinas stock market does have potential
to improve. Despite being branded early
on as a casino by Wu Jinglian, a Chinese
economist, and others, in which speculation,
accounting fraud, and stock price manipulation play a large role, Carpenter, Lu, and
Whitelaw (2014) show that stock prices are
now informed by real indicators of risks and
returns.
In addition, Ya, Ma and He (2014) find
that herding behaviour, in which investors
mimic the behaviour of others by making
the same stock purchasing choices, is not an
issue in Shanghais and Shenzhens A-share
stock markets. These are positive findings
that show the market is developing in some
fundamental ways. These findings demonstrate that while the companies that list
on Chinas stock market may be inefficient
or distorted, and the process that lists the
companies may be slow and cumbersome,
the market itself prices risks and returns
efficiently.
Important implications
Poor performance can likely be chalked
up to the underlying companies themselves. Although subject to further rigorous
42
analysis, this conclusion has important implications.This means that if stock market reform
improved the quality of companies that list,
performance may improve. This resonates
with research that shows that listed non-state
owned firms perform better on Chinas stock
markets than do state-owned firms.
Enhancing accounting and auditing
standards of listed companies and encouraging the listing of innovative companies
over static state-owned companies would
increase the quality of Chinas stock markets
and prevent the financial brain drain that
China has recently experienced as the most
innovative companies have listed outside of
the country. As China restructures, it is critical that innovative companies have sufficient
access to funding. Further reform of mainland
stock exchanges will benefit both the listing
companies themselves and Chinas financial
economy.
Stock market alluring option
If indeed, as research shows, the stock market is now efficient, then deepening capital
markets through the stock market should not
be an impossible task. There is an increasing
possibility that the stock market will grow up
to be quite an alluring option.
Indeed, some analysts have predicted
a bull market for Chinese stocks in 2015 as
economic conditions in China, the US, and
Europe generally improve, notwithstanding
the recent oil-induced panic. Looser domestic
monetary policy and a larger reform agenda
can play a role in enhancing Chinas economic
outlook. Capital markets are also expected to
become more international. Coupled with
reform of the stock market itself, these policies
may lead to additional stock growth in 2015.
Comment
Living wills are very much a

live issue for regulators
Mayra Rodriguez Valladares of MRV Associates stresses thatliving willshave not gone
away and remain on the regulatory agenda.
AT a Washington conference on financial reform last November, Jeremiah O.
Norton, a member of the board of the
Federal Deposit Insurance Corporation,
was asked what the US midterm elections meant for ending too big to fail.
He demurred that he was not in a position to comment on what elected officials
may or may not do. What he said next,
however, really tells me that irrespective
of election results, bank regulators like
him are determined to carry on with their
ambitious bank reform agenda. I intend
to do my job today and tomorrow like I
did yesterday, trying to make the banking sector safer for Americans, he said.
When attending panellists were asked if they
have ended the problem of too big to fail
banks, they all agreed with Mr. Norton on
the view that we are not where we should
bein terms of financial reforms.
In the eyes of an array of academics
and regulators at the conference, globally
systemically important banks remain too
large, significantly leveraged, interconnected
globally and reliant on wholesale lending.
Moreover, the 11 largest banks in the United

States have not been able to write credible
bank resolution plans, commonly known as
living wills, that would explain to regulators
how they could be resolved across multiple
jurisdictions around the world in an orderly
manner and without taxpayers supporting
them.
Jeffrey Lacker, the president of the
Federal Reserve Bank of Richmond, made
it clear in his keynote address that to end
the problem of too big to fail, we need to
stop thinking that bankruptcy is not a viable
option for banks.
Noting that the Dodd-Frank Act lays
out a path to make bank resolution possible,
he said that the process had already proven
valuable, because some banks have been
reorganising and getting rid of unnecessary
subsidiaries.
In a revealing comment, he said that living wills should not assume that the current
banking structure was a given. That seemed
to be a hint that if banks do not make their
wills credible, regulators could force banks
to have simpler structures that could be
resolved more easily if in a stressed situation.
When I asked Mr. Lacker what would

happen if by next year big banks living wills
are still not credible, he emphasised that
both the Federal Reserve and the FDIC had
tools under Dodd-Frank that they could use
to compel banks to make necessary changes.
He added that it may take more guidance
from the bank regulators.
We are both still learning in the process,
he said. For banks to rely less on short-term
funding or to make changes in their subsidiaries will not be popular, said Mr. Lacker, but
the changes are feasible.
Other speakers at the conference were
not as optimistic about banks making the
necessary changes needed to protect taxpayers. A Stanford professor, Anat R. Admati,
expressed her concern about whether
banks even know themselves well enough
to write credible wills.She also emphasised
that banks have beentravelling at an explosive speed for no reason.
We keep talking about hospitals and
backstops if banks implode, but we do not
talk enough about speed limits, that is, the
needed regulations to curb their reckless
behaviour for the sake of society,she said.
From a regulatory perspective, a number of challenges exist to credible living
wills. Regulators do not have an answer as
to whether they and governments would
cooperate effectively in the event that a large
global bank had to be resolved in multiple
jurisdictions.
When there is market stress, the fear
is that regulators might ring fence good
assets, irrespective of what that might do
to the liquidity and normal functioning of a
banks subsidiary in another country.
Although the International Securities
44
Dealers Association has made significant

strides to work with the industry on how
derivatives contracts would be managed
during a resolution, to avoid the kind of
chaos that ensued during the bankruptcy of
Lehman Brothers, what will really happen is
still a big unknown to many, including both
bankers and regulators.
Moreover, where liquidity would come
from during a bank resolution is also a big
question. If banks could access the Federal
Reserve discount window, that would immediately turn out to be like a bailout. Yet, if
there is a market perception that the government or regulators will provide any liquidity,
that might exacerbate market stress at a time
that we want to calm markets down.
According to Mr. Thomas Hoenig, the
vice chairman of the FDIC, a bank resolution will mean making difficult choices.
During his keynote speech, he said that his
agency was compelled to declare that the
living wills of the banks were not credible,
because of the erroneous assumptions that
banks made.
Some banks lack understanding about
relying on government supportduring a resolution, he explained. He was asked whether
he still stood by his comments of last March
at Boston University, that the contents of
banks living wills should be made available
to the public. Without hesitation, he said yes,
adding that, if banks felt that there was information that was truly proprietary,then they
need to make a convincing case as to why
that information should not be disclosed.
At least that way the market could then
possibly have a chance of exerting market
discipline if it were not satisfied with the
opacity of banksliving wills.
Comment
The end of (monetary) history:

Bretton Woods 70 years on
Prof. ErinYeldan of Bilkent University laments
the demise of theBretton Woodsagreement and
subsequent ascent of global financialisation.
AS we bid farewell to 2014, it may prove
worthwhile to celebrate the 70th anniversary of one of the most innovative and
exciting episodes of homo economicus:
the Bretton Woods Monetary Conference.
Hosted in 1944 at the Mount Washington
Hotel in New Hampshire, USA, the conference established the World Bank and
the IMF (later referred to as the Bretton
Woods Institutions) and set the gold
standard at US$35.00 an ounce with fixed
rates of exchange to the US dollar.
Based on John Maynard Keyness famous
dictum, let finance be a national matter,
and on the productivity advances of Fordist
technology and institutional structures, the
global economy expanded at a fast rate over
the postwar era, from 1950 to the mid-1970s.
Per capita global output increased by 2.9 per
cent per year over this period, which later
came to be referred to as theGolden Age of
Capitalism.
The conditions that created the Golden
Age were exhausted by the late 1960s,
however, as industrial profit rates started to
decline in the USA and Western Europe due
to increased competition, particularly from

the Asiantigersordragons South Korea,
Taiwan, Hong Kong, and Singapore. In the
meantime, Western banks were severely
constrained in their ability to recycle the
massive petro-dollar funds and the domestic
savings of the newly emerging baby-boom
generation.
Trumpets of doom
Trumpets for theend of financial repression
intensified with the so-called McKinnonShaw-Fama hypotheses of financial deregulation and efficient markets. A global process
of financialisation was commenced, lifting
its logic of short-termism, liquidity, flexibility,
and immense capital mobility over objectives of long-term industrialization, sustainable development, and poverty alleviation
with social-welfare driven states.
A number of leading economists, among
them Joseph Stiglitz, Daron Acemoglu and
Gerald Epstein, had long cautioned against
the dangers of excessive financialisation
and deregulation. Under the new financialised capitalism regime, loanable funds
are increasingly diverted away from the real
sphere of the economic activity and towards

speculative finance.
Casino capitalism
The global economy has grown too slowly
and allocated too small a portion of its scarce
savings into physical fixed investments that
would enhance employment and generate incomes for the working poor. An everincreasing portion of global profits are now
generated from speculative finance, rather
than productive activities.
According to the International Labour
Organisations estimates in the World of
Labour Reports, financial profits currently
constitute almost 50 per cent of aggregate
profits. This ratio was only a quarter in the
early 1980s.
As accumulation patterns diverged away
from industry towards speculative finance,
employment faltered and the global economy entered a phase of casino capitalism
with international productivity gaps being
maintained due to structurally persistent
differences in physical infrastructure and
human capital.
Great Recession
We know where this story led. As the speculative bubbles of finance erupted in 2008,
a real-sector crisis developed that would
lead to what has been labelled by many as
the Great Recession. Output declined in
2009, for the world as a whole, for the first
time since the 1930 crash. Some 20 million
people were added to the reserve army of
the unemployed, bringing the total to above
200 million, or 7 per cent of the global labour
force.
The main policy intervention in response
46
to the crisis monetary expansion was

again based on the conventional recipes of
the Bretton Woods system. Under a policy
referred to for public relations reasons by
the esoteric name of quantitative easing,
the US Federal Reserve amassed a total
of US$3 trillion worth of assets from the
finance markets. This equalled roughly 20
per cent of US GDP. In turn, interest rates
fell all around the globe to virtually zero; yet
unemployment barely fell to the pre-recession levels, despite the fact that the labourforce participation rate was reduced sharply
to its 1970s level.
The end of history
These large monetary interventions barely
made a dent in the real sector, with GDP in
the USA and elsewhere remaining stagnant
throughout the Great Recession. Figures
from the US Bureau of Economic Analysis
detailing the US monetary base, its GDP
and the Fed Effective Interest rate for the
years from 2006 through to 2014 make for
uncomfortable reading. They illustrate vividly, the most decisive example of the end
of history monetary history, that is.
The dramatic expansion of the monetary
base and the equally dramatic collapse of
interest rates are clear. Everything works in
textbook fashion up to that point. But the
effect in terms of real output is overwhelmed
by the conditions of the Great Recession.
In the absence of an effective real rise of
investment demand, the expansion of monetary base and the collapse of the interest
rates have had a negligible effect on GDP.
That means that the instruments of
monetary policy are virtually powerless.
What a nightmare for a central banker!
Comment
European Unions economic folly

threatens continental chaos
Columbia Universitys Prof. Joseph Stiglitz
believes urgent reform of the Eurozone is necessary if it is to avoid certain catastrophe.
AT long last, the United States is showing signs of recovery from the crisis that
erupted at the end of President George
W. Bushs administration, when the nearimplosion of its financial system sent
shock waves around the world. But it
is not a strong recovery; at best, the gap
between where the economy would have
been and where it is today is not widening. If it is closing, it is doing so very
slowly; the damage wrought by the crisis
appears to be long term.
Then again, it could be worse. Across the
Atlantic, there are few signs of even a modest
US-style recovery: the gap between where
Europe is and where it would have been in
the absence of the crisis continues to grow.
In most European Union countries, per capita GDP is less than it was before the crisis.
A lost half-decade is quickly turning into a
whole one. Behind the cold statistics, lives
are being ruined, dreams are being dashed,
and families are falling apart (or not being
formed) as stagnation depression in some
places runs on year after year.
The EU has highly talented, highly
educated people. Its member countries have

strong legal frameworks and well-functioning societies. Before the crisis, most even
had well-functioning economies. In some
places, productivity per hour or the rate of
its growth was among the highest in the
world.
Self-inflicted malaise
But Europe is not a victim. Yes, America
mismanaged its economy; but, no, the US
did not somehow manage to impose the
brunt of the global fallout on Europe. The
EUs malaise is self-inflicted, owing to an
unprecedented succession of bad economic
decisions, beginning with the creation of
the euro. Though intended to unite Europe,
in the end the euro has divided it; and, in
the absence of the political will to create
the institutions that would enable a single
currency to work, the damage is not being
undone.
The current mess stems partly from
adherence to a long-discredited belief in
well-functioning markets without imperfections of information and competition. Hubris
has also played a role. How else to explain
the fact that, year after year, European officials forecasts of their policies consequences
have been consistently wrong?
Badly flawed models
These forecasts have been wrong not
because EU countries failed to implement
the prescribed policies, but because the
models upon which those policies relied
were so badly flawed. In Greece, for example,
measures intended to lower the debt burden
have in fact left the country more burdened
than it was in 2010: the debt-to-GDP ratio
has increased, owing to the bruising impact
of fiscal austerity on output. At least the
International Monetary Fund has owned up
to these intellectual and policy failures.
Europes leaders remain convinced that
structural reform must be their top priority. But the problems they point to were
apparent in the years before the crisis, and
they were not stopping growth then. What
Europe needs more than structural reform
within member countries is reform of the
structure of the eurozone itself, and a reversal of austerity policies, which have failed
time and again to reignite economic growth.
Those who thought that the euro could
not survive have been repeatedly proven
wrong. But the critics have been right about
one thing: unless the structure of the eurozone is reformed, and austerity reversed,
Europe will not recover.
Democracy denied
The drama in Europe is far from over. One of
the EUs strengths is the vitality of its democracies. But the euro took away from citizens
especially in the crisis countries any say
over their economic destiny. Repeatedly,
48
voters have thrown out incumbents dissatisfied with the direction of the economy
only to have the new government continue
on the same course dictated from Brussels,
Frankfurt, and Berlin.
But for how long can this continue? And
how will voters react? Throughout Europe,
we have seen the alarming growth of
extreme nationalist parties, running counter
to the Enlightenment values that have made
Europe so successful. In some places, large
separatist movements are rising.
Now Greece is posing yet another test
for Europe. The decline in Greek GDP since
2010 is far worse than that which confronted
America during the Great Depression of the
1930s. Youth unemployment is over 50 per
cent. Prime Minister Antonis Samarass government has failed, and now, owing to the
parliaments inability to choose a new Greek
president, an early general election will be
held on January 25.
The left opposition Syriza party, which
is committed to renegotiating the terms
of Greeces EU bailout, is ahead in opinion
polls. If Syriza wins but does not take power,
a principal reason will be fear of how the
EU will respond. Fear is not the noblest of
emotions, and it will not give rise to the kind
of national consensus that Greece needs in
order to move forward.
The issue is not Greece. It is Europe. If
Europe does not change its ways if it does
not reform the eurozone and repeal austerity
a popular backlash will become inevitable.
Greece may stay the course this time. But
this economic madness cannot continue forever. Democracy will not permit it. But how
much more pain will Europe have to endure
before reason is restored?
Advisory - Asia IT focus
Regulatory change is a business

opportunity, not a burden
Singapore-based Amit Agrawal highlights
some of the pressing regulatory and compliance issues banks must face during 2015.
NAVIGATING the compliance, regulatory and operational risk landscape
has, without doubt, poised the biggest
headache for senior management and
front-line staff within financial institutions since the plethora of reforms implemented after the 2008 financial crisis.
And the pressures arent likely to ease
any time soon, given the ongoing widespread compliance failures over the past
12 months.
Gazing back through 2014, one can only
be but amazed at the amount of regulatory
reform and gains made, despite widespread
scepticism and intense industry blow-back.
Among the key achievements of 2014
has been the successful deployment of Basel
III across the European Union and other
reforms emanating out of the European
Commission. These have paved the way for
a reduction of systemic risk through measures relating to the safety and soundness of
both banks and market infrastructure and
to the effective resolution of failing banks;
advancing the wholesale and retail conduct
regimes; and setting out the supervisory stall
for assessing risk governance, risk culture

and risk data.
Looking forward to 2015 and beyond, its
apparent that reforms to date constitute only
the beginning of a long journey ahead, rather
than the end of the road. Both the USA and
the European Union continue to issue forth
with further reforms, compounded by new
initiatives emerging from the G20 gatherings
and the Basel Committee in Switzerland. All
of this fuels further uncertainty, thus making
it difficult for institutions to plan ahead and
allocate resources.
Avoid over-complexity
As the Basel II compliance process demonstrated prior to the onset of the 2008
financial crisis, large whole scale regulatory
change programmes must take a firm-wide,
business-focused view if they are to be successful. Any operational and technology
change should run in tandem with business
model reviews to enable a more structured,
effective and cohesive outcome that helps
avoid over-complexity.
Glancing back to 2014 once more, there
is little doubt what proved the greatest
headache to senior management, compliance and operational heads and risk managers in financial institutions. And there will be
no let-off this year, as illustrated by the following analysis.
Exponential IT investment
One of the most pressing issues during 2014,
and which remains true during 2015 is IT
expenditure and exponential costs associated with it, as risk and regulation continue
to demand large-scale technological investment to comply with the new regulatory
environment we find ourselves in. Chartis
forecasts that global risk IT expenditure in
financial services will rise by 14 per cent and
exceed a spending level of US$30 billion, by
the close of 2015.
Much of this growth will be accounted
for by businesses in North America, with
financial institutions picking up most of the
pace in an effort to mitigate against stiff fines
and penalties imposed by various regulatory
agencies and the US Department of Justice,
together with State supervisors and enforcement agencies. Thomson Reuters estimates
that US authorities imposed penalties and
settlements fees that cost financial services
firms more than US$40 billion.
Highest growth in Tier 1 banks
The highest growth in spending is expected
to be amongst the Tier 1 firms who have
been among the greatest offenders, many
of which remain firmly in the crosshairs of
regulators and enforcement agencies. Its
expected that these firms alone will increase
expenditures by some 24 percent compared
with 2014 outlays, whilst Tier 2 and Tier 3
firms are expected to increase expenditures
50
by 9 per cent and 10 per cent respectively,

according to the Chartis research.
In total, it was estimated that financial
institutions in the United States invested
more than US$28 billion on automated risk
management and regulatory IT systems during 2014, and that this figure is expected to
rise to nearly US$32 billion through 2015.
Next of our pressing issues is costs associated withcapitalandliquidity. Liquidity
monitoring for financial institutions is a key
to profitability for many firms. It can reduce
credit/settlement risks during large value
payments and managing banks cash inflow/
outflow. The implementation of liquidity
requirements will start from the beginning
of this year and is expected to be finalised by
2019.
LCR, NSFR & leverage ratio
The following is just a back-of-an-envelope exercise in liquidity ratios that banks
and financial institutions need to begin
implementing as of now: first, we have
the Liquidity Coverage Ratio (LCR). This
is a mandate whereby banks are expected
to maintain a minimum 60 per cent LCR,
which will increase by 10 per cent each year
through to 2019, at which time the LCR will
constitute 100 per cent.
Next, we have the Net Stable Funding
Ration (NSFR). 2015 will kick-start this
initiative, with this year and 2016 being an
observation period, after which banks and
financial institutions will be required to
report their NSFR positions. From January
2018 banks will be expected to hold sufficient stable deposits to fund all their longterm lending.
Finally, we have the leverage ratio;
as of January this year onwards, banks are

required to report their leverage ratios in any
and all financial statements.This will become
a binding requirement by 2018. Presently,
the Basel Committee has proposed it to be
3 per cent of a banks tier 1 capital. However,
heightened financial concerns mean this
minimum requirement may be revised
upwards and is thus likely to change.
Centralisation
Another pressing concern for banks and
financial institutions is their centralised risk/
compliance operation model. Outsourcing
and shared services is a more than two decades old strategy to improve back-office
efficiency. Financial institutions use different
operational models and approaches for this
method to work consistently.
Each model has its own set of merits/
demerits and thus it is vitally important
that operational models be aligned with the
organisational strategy.
Its expected that outsourcing will reduce
in relevance as more and more businesses
move to more centralised operational models, aligning them with the rest of their
business to better manage risk and make
efficiency savings, thus driving down overall
costs.
Reports, reports, reports
Next on our pain index is regulation and
supervision. Moving through 2015, its
anticipated that regulators will require banks
to provide more and more reports of their
activities, in line with new regulatory requirements, which obviously translates to more
supervision. This will place another burden
on the banks in terms of people, systems and
quality assurance to support such reporting.

This will also have a direct impact on banking procedure for data capture, data reconciliation (across system/regulators), control
process and review/governance procedures.
A pressing question that needs to be
answered during this process is about the
ability of banks and financial institutions to
aggregate risk quality accurately and across
risk types, activities and geographies and to
use this information to manage emerging
risks. One should not think of it as a business burden and cost centre; rather, it should
be viewed as a business opportunity to add
to the bottom line.
Overlap and underlap
Moving on, our next topic of concern is governance. As a result of the 2008 financial
crisis, banks have been pressurised by regulators to introduce enhanced risk management structures and reporting procedures,
many of which arenew, shall we say, with
clear roles and responsibilities. This has led
to increased overlap and underlap in many
institutions as they struggle to cope with the
plethora of imposed changes.
The silver lining in all of this is that, given
the huge amount of work undertaken thus
far, best procedures and practices are emerging, thereby allowing for benchmarking and
for banks to raise the bar in terms of risk
management and risk governance.
As such, our maxim should read:A wellgoverned bank takes the amount of risk
that gives maximum value to shareholders,
subject to constraints imposed by laws and
regulations.
Nearing the end of our pain threshold, our next pressing concern focuses on
51
culture and conduct. It is to be hoped that

during the course of 2015, banks will spend
more time building business-focus change
capabilities so that they can address the
regulation challenge more effectively and in
a timely manner during a period of extreme
flux.
People of the right calibre
Banks need to ensure they hire the right
people for the job. Although time lines for
the implementation of new requirements
are strict and aggressive, properly addressing
this challenge requires assembling the right
team of experts with a sound understanding of compliance, firm-wide risk requirements, process excellence and technology
capabilities.
This is of particular importance as focus
shifts from defining the regulatory response
to implementation and execution. While
there remains a vital role for compliance in
interpreting new regulatory requirements,
this should not be to the detriment of building a true change capability
Nearing the finish line, our final area
of concern is that all-encompassing one of
infrastructure and infrastructure redesign.
Silo effect
Its a well known fact within the industry that
different divisions within banks have historically been re-creating rather than sharing
systems.
This problem is further compounded
by mergers that result in banks inheriting
numerous IT systems and processes, thus
adding to complexity, system architecture
and army of staff required to service them
which equates to a lot of inefficiencies. Its
52
to be hoped centralisation and cost-sharing

will eliminate much of this inefficiency and
reduce costs in the long run.
The new regulatory paradigm is meant
to achieve a safer, more stable banking environment, protecting the banks, shareholders
and taxpayers alike from the horrors of 2008.
In this new era, banks need to change their
approach to executing regulatory change,
and recognise it as opportunity which
enhances the underlying business model.
To do this successfully, banks must recognise the symbiotic relationship between
process efficiency and compliance, and build
into the foundations of every change programme a clear view not only of the regulatory imperative, but where it aligns with a
client or business improvement goal.
A clear strategy
This is not an immediately obvious relationship, but there is a clear link between achieving successful regulatory change and driving
process improvements.
Furthermore, this illustrates how process
improvement is an essential component of
any solution, helping banks to achieve longterm compliance and true business benefit.
Investment banks dealing with the current
high volume of regulatory reform must turn
their current challenges into opportunities to
drive strategic change.
By moving away from a short-term,
fragmented approach to implementing regulatory change programmes, and building a
clear strategy that uses process improvement as a means to achieve compliance,
banks can begin to reduce the complexity, and cost of their response to the new
regulatory environment.
Advisory - BCBS 239
BCBS 239: How to simplify your

data architecture
Markits COO, Paul McPhater, details four key
areas banks must focus on if they are to achieve
BCBS 239 compliance by January, 2016.
THE crux of BCBS 239, set forth by
the Basel Committee on Banking
Supervision (BCBS), is the laying down
of standards for risk data aggregation and
reporting. Data is at the heart of it, and
its an opportunity to look at the cost and
synergies of data and improve the decision-making process enterprise-wide.
Regulatory fatigue aside, the January 2016
deadline for compliance with BCBS 239 is
tight. While not currently mandatory for all
banks, there are indications that the standards are considered to be best practice for
all. There are four key areas: risk data aggregation (RDA), risk reporting, supervisory
review, and governance; and in this article,
we review each in turn.
BCBS 239 dictates that data should be
aggregated on a largely automated basis.
With so many data sources, legal entities and
geographies, this means simplifying current
architectures into a single hub. The aim is to
enable banks to make much better use of all
the data they gather. A central platform will
also provide a comprehensive assessment of
risk exposures at a global consolidated level.
The quality of data is also under the

spotlight, as controls around data accuracy
are being tightened. Managing the quality of data is made harder as it is a shared
resource. Empowering data creators and
users enables them to take ownership of the
data. The same standards and rules need to
be applied across the enterprise so that data
doesnt need to be cleaned multiple times.
Risk should have the same data as the back
office, finance, operations or legal.
The system needs to be both flexible and
scalable. This is the only way accurate risk
data can be produced on an ad hoc basis
or during times of stress/crisis for all critical
risks, a key requirement of BCBS 239.
There also needs to be sufficient depth
and breadth of data for the reporting needs
of different parts of the business to be satisfied. Different parts of the business need
information presented to them in different
ways, and the system needs to be able to
handle such diversity.
While all of these capabilities may
already exist in pockets throughout the
bank, best practice now needs to be executed on an enterprise-wide basis. Sounds
like a challenge? Perhaps. But an enterprisewide risk data management platform is

achievable.
BIS stocktaking report
Next up on our list is the fact that without
data that is accurate, reconciled and validated, risk reporting may be useless. In its
stocktaking report on BCBS 239 progress at
the end of 2013, the Bank for International
Settlements (BIS) highlighted how banks
had assigned themselves higher ratings on
the risk reporting than they did on the corresponding data aggregation principles.
This raised the question as to how reliable and useful risk reports can be when
the data within these reports and the processes to produce them are not in place. The
reports being produced need to be accurate,
clear, complete, useful and frequent. The end
game is simple: to enable informed decisions
based on accurate information.
When you consider what a risk report
usually looks like a bunch of spreadsheets
and how long it has taken to produce
typically not a quick process, but rather a
complex and time-consuming one that happens across silos the ongoing challenge
becomes clearer.
All roads lead back to data
Exact reporting requires data that is accurate, reconciled and validated. Outside the
data architecture issues, an historic reliance
on manual processes and inconsistencies
in reconciliation procedures also hamper
progress. BCBS 239 also requires firms to
fully incorporate risk appetite into their risk
reporting, which adds an additional layer to
the challenge.
54
Risk management executives must be

empowered to make informed decisions,
and all roads lead back to the data. As a
result, its vital that banks have a system in
place that can cope with the vast volumes of
data across the institution. BCBS 239 is big
on interdependencies across all three areas
of the principles: governance and infrastructure, RDA, and risk reporting. Without
adherence to principles governing data,
reporting adherence simply cannot happen.
The third key area on our list, and probably the most contentious as far as senior
management and boards of directors are
concerned, is the issue of data ownership.
Dealing with data is an issue of which senior
management has long been aware.
Elephant in the room
As Moodys so aptly put it in a report issued
towards the tail-end of 2013: It is often the
elephant in the room a big something to
be dealt with, but one that is almost always
too big to tackle, or one that is postponed as
tomorrows problem.
With BCBS 239, a banks board and senior management are now very much centre stage as the owners of the dreaded data
problem. And its not just the Tier 1 banks
that need to take notice; there is an increasing belief that this regulation is merely a
footnote that it isnt the end game.
Under BCBS 239, there are some key
questions to which senior managers must
know the answer. Among these are: What
are the limitations that prevent full risk data
aggregation? Do I understand what those
limitations are and their impact in terms of
coverage? How are the reports Im reading and on which Im making decisions
impacted by these limitations? Do we have

adequate resources deployed to meet the
standards required? Have we agreed to service level standards with our outsourcers?
Who has responsibility for what? Is there a
stratification of control from executives to
management and business leads to day-today users?
Not just another regulation
As mentioned, if BCBS 239 is not the end
game, then it makes sense for all banks to
take notice. The financial crisis exposed risk,
data and IT failures throughout the entire
community, so looking to BCBS 239 as a
starting point for minimum standards of best
practice makes sense.
Why would the regulators stop at
the global systemically important banks
(G-SIBs) or the domestic systemically
important banks (D-SIBs)? Surely the ultimate goal has to be better risk management
for all.
Our fourth and final key area in this
paper is the fact that RDA isnt about moving data; its about access to the source and
for the end user. To think of BCBS 239 as
just another regulation is to misunderstand
its end game. Solving the challenges it lays
down requires a strategic approach. RDA
needs executive sponsorship, for a start;
after all, executives will now be responsible
for approving the RDA and risk reporting
framework.
Holistic approach
A strategic approach will require a holistic
mapping of the risk data universe, and this
will be no small challenge. Given the deadline of January 2016 for BCBS 239, the focus
needs to be on accessing data, not moving it.

There remains a lot of uncertainty around
how best to tackle BCBS 239. Other regulations somehow seem more pressing, and
cost is an ever-present issue. A key mind shift
that needs to happen is at the executive level.
Given that the boards of banks now
have ultimate responsibility for RDA and risk
reporting, they will require a greater understanding of the risk data challenges within
their institutions. To achieve that will require
an overhaul of data governance which, if
applied correctly, should result in significant
cost savings in operations and IT.
Mapping out the risk data universe
means challenging the data and your people.
Where is your data? What data do you have?
What data dont you have? Can you access
the data? Do you know its provenance?
What are you going to include, and what are
you not going to include? What is the data
dictionary for the firm? Who owns what?
Once all this is determined, the rules and
logic must be created, then cleansed, aggregated and golden copies created.
Risk data aggregation isnt about moving data, either; a warehouse isnt the answer.
Risk data aggregation is about access: to the
source and for the end user. It all needs to be
mapped out and traceable. Data quality is
paramount.
During the financial crisis, lack of data
quality and data itself was a fundamental
issue. Being able to access the right data at
the right time and get it to the right people
means banks can make more money and
lose less money. BCBS 239 is part of risk data
aggregation its a great start and all agree it
needs to be done. Risk data is in the spotlight
and needs attention.
55
Regulatory round-up
Hong Kong regulatory year in

review and outlook for 2015
Josephine Chung Of Compliance Plus surveys
capital market reforms in Hong Kong during
2014 and advises on what to expect in 2015.
SINCE the global financial crisis in
2008, Hong Kong regulators have been
consulting to adopt reforms in the
Over-the-Counter (OTC) Derivatives
market and to tighten the reporting and
record-keeping obligations of financial
institutions. The Hong Kong Monetary
Authority (HKMA) and the Securities
and Futures Commission (SFC) jointly
set up the new OTC derivatives regime
which aims to enhance the stability of
the financial market by increasing transparency of the OTC derivatives market.
The SFC also proposed amendments to the
Professional Investor (PI) Regime and
further consulted on the Client Agreement
Requirements in order to protect PIs adequately. Financial institutions are therefore
required to review and update their compliance policy and procedures in order to reflect
the new changes of the SFC regulation.
In January 2014, the electronic trading
regulations came into effect, which included
the sufficient and adequate management
and supervision of the electronic trading
systems and the internet trading behaviours;
risk management had to be put in place with

adequate monitoring on trade orders including pre-trade control and post-trade monitoring; records on the designs, development
and operation of the trading system must be
kept properly.
The SFC reminded all the licensed corporations (LCs) to maintain effective policies, procedures and control to monitor the
adequate compliance with cross-border
business activity and prudent risk management measures including complying with
the Know your client and Anti-money
Laundering (AML) guidelines.
Cybersecurity concerns
In June 2014, all LCs should have an effective
business continuity plan implemented in
order to ensure that key business functions
can be recovered in a timely fashion in case
of operation disruptions.
In November 2014, the SFC had heightened concerns on Cybersecurity issues,
and two circulars were delivered to the
LCs regarding internet trading security. The
SFC demanded the LCs to have formal
Information Technology (IT) governance
and management policies in place. Adequate

information management control, monitoring and contingency plan must be put in
place to ensure network security and prevent
material system failures.
Amendments to PIs regime
In September 2014, the SFC published
consultation conclusions on the proposed
amendments to the PIs regime. These
amendments will come into effect on 25
March 2016. Paragraph 15 of the Code
of Conduct for Persons Licensed by or
Registered with the Securities and Futures
Commission (the Code) will be replaced
by the new paragraph 15 written in the conclusion. The new paragraph 15 sets out the
terms of exemptions from the Code requirement on the different categories of investors.
There are two key amendments:
1. When dealing with individual PIs, intermediaries will no longer be capable to
waive the investor protection provisions
of the Code. Thus, intermediaries will
be required to treat the PIs in the same
manner as the retail investors in order to
ensure the suitability of a recommendation or solicitation.
2. The SFC introduced a principles-based
Corporate Professional Investor assessment (CPI Assessment) for the investment vehicles, family trusts and corporate
PIs that are not institutional investors.
Further suitability changes
Apart from the amendment to paragraph
15, the SFC also proposed further suitability
requirements to be incorporated in the Code
by referencing the client agreements as a
58
contractual term. A new clause on suitability and non-derogation will also be inserted
into client agreements, and a new paragraph
6.5 will be added to prohibit the inclusion
of clauses which are inconsistent with the
Code or anything inaccurate or misleading
in the description of services.
The effective date and the confirmation of the details will be published in the
upcoming consultation conclusion on this
client agreement requirement.
With regard to preparation for the
amendments to the PIs regime, its recommended that intermediaries should now
develop and discuss policies and procedures
in detail to reflect the change, including the
new CPI Assessment, and introduce training
for relevant personnel so as to be ready for
compliance.
On the other hand, with the pending
details and effective date of the client agreement requirement, intermediaries should
prudently begin reviewing their current
agreements for compliance with the new
paragraph 6.5 of the Code in advance.
OTC derivatives regulatory regime
In November 2014, the HKMA and the SFC
announced the consultation conclusion on
the OTC derivatives reporting and record
keeping rules. This consultation conclusion set out the mandatory record keeping
requirements and reporting obligations for
the registered intermediaries/LCs.
The SFC intended to introduce the OTC
Derivative Transactions Reporting and
Record Keeping Rules (Rules) to the Hong
Kong Legislative Council (LegCo) for
negative vetting in the first quarter of 2015,
and expected to commence the relevant
mandatory reporting and record keeping

obligations for regulated entities in the first
quarter of 2015.
New and expanded licences
Further public consultation will be conducted on the detailed rules for mandatory
clearing and related record keeping obligations, as well as the oversight of systemically
important participants (SIP) and reporting
and related record-keeping obligations for
Hong Kong persons.
The HKMA and the SFC introduced
two new regulated activities (RAs): one
is dealing in OTC derivative products or
advising on OTC derivative products (Type
11) and the other is providing client clearing services for OTC derivative transactions
(Type 12). They also widen the scope of Type
9 (asset management) and Type 7 (provision
of automated trading services).
An application period of 3 months and a
transition period of 6 months, starting from
the commencement date of the OTC derivatives regime, were proposed for the licensed
persons to continue their OTC derivative
activities for a limited period of time. This
allows the SFC and the HKMA to set a time
frame for receiving applications and, thereafter, to process licensing or registration
applications with minimal disruption to the
market.
Mandatory reporting products
In addition, the Rules specified the mandatory reporting obligations in phases by
different types of products. The first phase
of mandatory reporting covered interest
rate swaps (IRS), non-deliverable forwards (NDF) and overnight index swaps
(OIS). Forward rate agreements (FRA)

and foreign exchange (FX) derivatives
other than NDF will be covered in the future
phases.
The three pillars of reporting obligations
are:
1. Persons other than authorised institutions (AIs), approved money brokers
(AMBs) and LCs - the persons based
in, or operating from Hong Kong (Hong
Kong persons) such as dealers.
2. AIs, AMBs and LCs - these are a counterparty, or they have conducted business
in Hong Kong on behalf of an affiliate,
or they have entered in on behalf of a
counterparty in their capacity as a person
licensed or registered to carry out a Type 9
RA for that counterparty.
3. Central counterparties (CCPs) - the
recognised clearing houses (RCHs)
and those authorised to provide automated trading services (ATS-CCP)
The reportable transactions must be
reported to the HKMA via the Hong Kong
Trade Repository (HKTR), which is the
electronic reporting system developed by
the HKMA. However, the SFC also allows
the use of reporting agents which could be
an overseas TR for the purpose of complying
with overseas regulations under this regime.
Hong Kong persons and Type 9 LCs are
exempted from the reporting and recordkeeping obligation in the first phase.
With regards to record-keeping obligations, the following applies for all reporting
entities, other than Type 9 LCs and Hong
Kong persons:
- Sufficient records to demonstrate compliance with reporting obligations;
- Where relying on exempt person relief,
59
records sufficient to demonstrate that

they were entitled to such exemption;
- Where relying on the relief in respect of
transactions reported by an affiliate, the
confirmation received from the affiliate;
- Records as specified when relying on
exemptions or relief related to transactions that have matured or been terminated during the grace period; and
- Where the reporting was done through
an agent, records relating to the agents
appointment and to demonstrate monitoring of the agents compliance.
The records of a reportable transaction
must be kept for as long as the transaction
exists and for a further 5 years after the transaction has matured or been terminated.
Advice for regulatory changes
Readers with businesses and operations in
Hong Kong overseen by the SFC are advised
to plan now (January/February 2015) for
the new regulatory environment and heavily revised OTC transaction regime. This
can be best implemented via the following
considerations:
1. Consider the licensing requirements
under the new/extended licensing regime
- The current Type 9 LCs should consider
whether they need to apply to the SFC for
approval to engage in the expanded Type
9 RA. If the current licence is subject to a
condition prohibiting the management
of futures contracts for investment purposes, it is necessary to consider whether
to lift the condition or one will still be prohibited from investing in listed futures,
despite being able to invest in OTC derivatives.
- If you currently provide a discrete service
60
of advice on OTC derivative products, you

will also be required to apply the Type 11
RA license.
2. Consider the qualification for deemed
licensing
- Be reminded that the corporate applicants
that apply to be deemed licensed for Type
11 RA, must have at least two persons
who are approved as responsible officers
in relation to Type 11 RA, each of whom
must have been carrying out the activity
of dealing, trading or advising on OTC
derivative products in Hong Kong for at
least two years immediately before the
commencement date of the new regime.
- The Type 9 RA LCs does not require one
to show that he/she has been carrying out
the activity of managing OTC derivative
products in the past, but it does require
one to have a responsible officer who
has at least 2 years relevant experience
of managing OTC derivative products in
Hong Kong or overseas over the past 6
years immediately before the commencement date of the new regime.
3. Business Plan and compliance policies
- Business plan should be updated to
reflect the addition of expanded Type 9
RA and/or Type 11 RA with details below:
Description of the types of OTC derivative products that you propose or currently
manage and/or advise on
Updated organisation structure showing
the licensed persons engaging in the RA of
OTC derivative products
Operation procedures for managing and/
or advising on OTC derivative products
Brief summary of your history, managing
and/or advising on OTC derivative products.
Internal control and contingency plans
in relation to managing and/or advising on

OTC derivative products.
4. Mandatory reporting and record-keeping plan:
- Review and upgrade the internal infrastructure to ensure you can identify
OTC derivative transactions that need
to be reported; collate information that
needs to be submitted to the HKTR for
each reportable transaction and subsequent event.
- Consider appointing a suitable agent
to report on your behalf. Please bear in
mind that you will remain responsible
for any failure to report by the agent.
- Revise your record-keeping arrangement to ensure that you have kept the
required records in the required form

and manner.
- Update your compliance and procedures to reflect the mandatory reporting
and related record-keeping obligation
for the OTC derivative transaction.
To conclude, Hong Kong regulators have
been revising and developing regulations to
regulate the manners of the financial institutions. Licensed corporations must catch
up rapidly with the amended regulations so
as to safeguard their current business activity, revising their compliance policy and
procedures in accordance with the development and reformation of the SFC rules and
regulations.
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today
& RISK NORTH ASIA

Vol VII Issue I Spring 2015
Contact:
Christopher Rogers
Editor-in-Chief
May 15th 2015
ournal of reg
ulation & risk
north asia
Articles & Papers
Issues in resolving
s
Resecuritisation
in banking: major
challenges ahead
funding liquidity
Dr Fang Du
crisis
Housing, monetary
Dr Ulrich Bindseil
from bad to worst
Derivatives: from
Stephan Schoess,
on
Black swans, market
nce
Complia
human perspectiv
&
l
e
Lega
Joseph Rizzi
risk for innovative
financial instrumen
ts
Red star spangled
banner: root causes
The family risk:
a cause for concern
Fahrholz
Global financial
change impacts
David Smith
compliance and
risk
The scramble is on
David Dekker
to tackle bribery
and corruption
Who exactly is subject
Li
Practices Act?
Financial markets
Tham Yuet-Ming
remuneration reform:
one step forward
Of Black Swans,
Umesh Kumar & Kevin
Marr
risk management
Challenging the
David Samuels
value of enterprise
risk management
Tim Pagett & Ranjit
whichRocky road ahead for global accountanc
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NORTH ASIA

65
73
79
87
95
Lael Brainard
David Bailey
Alexa Lam
Nicolas Vron
101
111
115
121
125
129
133
137
143
147
151
CVA pricing issues across Asia Pacific
157
Avinash D. Persaud
Thorsten Beck
William K. Black

Stephen Cecchetti
Xavier Vives
Biagio Bossone
Steve Wunsch
Sol Steinberg
Andy Chen
Yin Toa Lee
Ben Watson
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Financial stability
US Federal Reserves financial

services stability agenda
Governor Lael Brainard of the US Federal
Reserve outlines the tools available to the Fed
in pursuit of its commitment to stability.
ALTHOUGH its founding statute makes
no explicit mention of financial stability, the Federal Reserve was created in
response to a severe financial panic more
than 100 years ago, and safeguarding
financial stability is deeply ingrained in
the mission and culture of the Federal
Reserve Board. Today, financial stability
is more important than ever to the work
undertaken by the Board of Governors
and regional Federal Reserve Banks
spread across the breadth of the US
Federal Reserve Board. With the lessons
from the crisis still fresh, we are in the
process of strengthening our financial
stability capabilities.
In carrying out the work of financial stability, the Federal Reserve is seen as the agency
with the broadest sight lines across the economy and one that has some important stability tools, as well as a critical first responder
when a crisis hits. But it also faces limitations
as a financial stability authority.
The Federal Reserve is predominantly
a supervisor of banks and bank holding
companies in a system with large capital
markets, several independent agencies have

responsibilities for regulation of non-bank
financial intermediaries and markets, and
no US agency yet has access to complete
data regarding bank and non-bank financial
activities.
Financial stability
Recognising these limitations, the Federal
Reserve is likely to actively use the tools
under its authority, which means placing a
strong emphasis on structural resilience in
the largest and most complex institutions,
while strengthening less tested time-varying
tools to lean against the build-up of risks
and, in some circumstances, looking to the
unique capacity of monetary policy to act
across the financial system.
It will also need to cooperate closely with
other regulators to develop well-rehearsed
working protocols and a joint sense of
responsibility for financial stability, while
respecting that each independent agency
has its own specific statutory mandate and
governing body.
In the wake of the financial crisis, the
Congress and the Federal Reserve itself
became more deliberate and explicit about

the responsibility for safeguarding the stability of the financial system. The Wall Street
Reform and Consumer Protection Act - usually referred too as the Dodd-Frank Act,
enacted in July 2010, charged the Federal
Reserve with specific authorities for the purposes of safeguarding financial stability.
The four pillars
At the Federal Reserve, we created the Office
of Financial Stability Policy and Research to
strengthen our cross-disciplinary approach
to the identification and analysis of potential
risks to the financial system and the broader
economy, and to support macro-prudential
supervision of large financial institutions;
then, following its creation, participation on
the Financial Stability Oversight Council
(FSOC).
This work is carried out by staff in that
office as well as in many areas across the
Board and is overseen by the Boards newly
created Committee on Financial Stability.
This work comprises four pillars, which are
in varying stages of advancement. The pillars are: surveillance of the possible risks
that could threaten financial stability; macroprudential policy; working across the regulatory perimeter; and monetary policy.
Surveillence
Starting with surveillence first, research and
historical case studies suggest that increasing
valuation pressures accompanied by rising
leverage, widening maturity mismatches,
and the erosion of underwriting standards
often provide important warning signals.
The research that informs this work, by
helping to identify financial patterns likely
66
to be associated with rising risks of financial crisis, continues to grow. But its predictive power is still limited; it remains difficult
to identify, ahead of time, credit booms that
are likely to cause severe damage, such as
the subprime housing crisis, from those that
do not, such as the high-tech boom, in part
because risk-taking by financial market participants cannot always be well-observed.
Over time, our surveillance and that of
others will benefit, as the Office of Financial
Research, established by the Dodd-Frank
Act, makes progress in facilitating the sharing of previously siloed data sets among the
independent regulators and as international
impediments are overcome, allowing more
comprehensive analysis of financial transaction flows across different types of financial
intermediaries and activities.
Buttresses
This regular, systematic surveillance of financial vulnerabilities is buttressed by three
other valuable types of analysis. First, we use
the detailed information gathered through
bank examinations and loan reviews that are
the regular work of our supervisors to assess
emerging risky practices; these reviews
helped identify deteriorating underwriting
standards in the leveraged loan market.
Second, we undertake periodic analyses
of potential systemwide consequences of
possible, particularly salient shocks, such as
a sharp rise in the level or volatility of interest rates, including possible bottlenecks that
could impede orderly adjustments.
Finally, when there is a close brush
with specific risk events, we closely study
the behaviour of markets and institutions for insights into possible structural
vulnerabilities that might be revealed and

assess possible policy actions.
Macroprudential policy
The ultimate objective of our surveillance is
to build resilience of firms and markets and
to counter risks early enough to prevent
disruptions to financial stability that could
damage the real economy. While the macroprudential toolkit is larger than it was precrisis, there is a substantial amount of work
remaining to implement some of these tools.
In particular, as I will discuss in more
detail, the ability of the available tools to
counteract time-varying risks has yet to be
tested in the United States
First, the Federal Reserve is well along in
promulgating an important system of new,
through-the-cycle safeguards that together
should deliver much greater structural resilience and make excessive risk-taking costly
for the large, complex institutions that pose
the greatest risks to the financial system.
Second, the Federal Reserve is assessing
the kinds of broad time-varying regulatory
tools that might further buttress resilience
during periods in which risks associated
with rapid credit expansion are building.
Toolkit
Third, the Federal Reserve is exploring tools
that can be varied over the cycle to target
specific activities, recognising that we will
have limited authorities relative to some foreign financial regulators in operating on the
borrowing side and outside the regulatory
perimeter of the banking system. Lets take
each in turn, beginning with our first tool,
that beingstructural resilience.
We are relatively far advanced, and
compare favourably to other jurisdictions,

in implementing a framework of rules and
supervision that compels large, complex
financial institutions to build substantial
loss-absorbing buffers and to internalise the
costs of undertaking activities that pose risks
to the system.
This framework represents a substantial
improvement on structural resilience relative
to the pre-crisis framework across a number of dimensions: it is forward looking in
assessing risks under severely stressed conditions, and it is explicitly macroprudential in
design, so that bank management internalises risks not only to the safety and soundness of their own institution, but also to the
system as a whole.
Belts and suspenders
Reforms undertaken in recent years help
ensure that institutions that are large, internationally active, and interconnected face
significantly higher capital and liquidity
charges when undertaking risky activities.
The core of the framework is the requirement of a very substantial stack of common equity to absorb shocks and to provide
incentives against excessive risk-taking.
The new framework imposes belts
and suspenders on the capital cushion by
requiring a simple, non-risk-adjusted ceiling on leverage as well as requiring the
largest banking firms to satisfy two sets of
risk-based capital requirements: one derived
from internal models and a second based on
standardised supervisory risk weights.
Beyond that, the largest, most complex
firms will face an additional common equity
requirement that reflects the risk they pose
to the system and an additional layer of loss
67
absorbency on top of that to provide adequate support to operating subsidiaries in

resolution.
Stress tests
Large financial institutions are also required
to maintain substantial buffers of high-quality liquid assets calibrated to their funding
needs and to their likely run risk in stressed
conditions. Similar to the equity cushions,
the liquidity buffers are calibrated to affect
disproportionately those financial institutions that pose the greatest risks.
Regular stress tests of both capital and
liquidity at our largest banking firms provide a key bulwark in the new supervisory
architecture.
Minimum capital requirements must be
met under severely adverse macroeconomic
conditions and, for the very largest firms, in
the face of severe market shocks, including
the failure of a firms largest counterparty.
By providing a forward-looking assessment that takes into account correlations
among risks under stressed conditions, these
stress tests on capital and liquidity are powerful tools for building resilience in our largest banking firms.
Limitations
But they also have some limitations. For
instance, while the severity of the stresses
can be varied from year to year, it is difficult
to introduce entirely new scenarios each year
to target specific sectoral risks without introducing excessive complexity.
And while the new US framework
requires that capital buffers are calibrated for
the riskiness of their assets and exposures,
the proportion of capital required does not
68
vary systematically to counter the cyclicality

that arises through elevated asset valuations
and other channels.
Next in our toolkit is time-varying broad macroprudential tools.
While our efforts are far advanced in building structural resilience, progress is less
advanced in developing time-varying tools
that counter the build-up of excesses across
the system broadly or in a particular financial sector. These efforts are in earlier stages
of elaboration and more of a departure from
recent practice. Here we can learn from
financial authorities in other countries that
have recent experience deploying a broader
array of macroprudential tools.
Countercyclical capital
The classic case for time-varying broad
macroprudential tools is to lean against a
dangerous acceleration of credit growth at a
time when the degree of monetary tightening that would be needed to slow it down
would be highly inconsistent with conditions in the real economy.
The Basel Committee agreed on a common countercyclical capital buffer framework for addressing such circumstances, and
the Federal Reserve and the other US banking agencies issued a final rule to implement
the Basel III countercyclical capital buffer for
US banking firms in 2013.
Under the rule, starting in 2016 and
phasing in through 2019, the US banking agencies could require the largest, most
complex US banking firms to hold additional capital in amounts up to 2.5 per cent
of their risk-weighted assets if the agencies
determine it is warranted by rising risks.
We are currently considering how best to
implement the countercyclical capital buffer.

The existing research would suggest that
indicators related to debt growth, leverage,
and other signs of growing financial imbalances would provide guidance on when to
implement the buffer and when to deactivate it.
Time-varying tools
The countercyclical capital buffer may
enhance financial stability by building additional resilience at systemic banking institutions near the height of the credit cycle.
However, it may prove to be less effective in leaning against credit growth, since,
as credit booms progress, there is greater
potential for capital to be relatively cheap,
asset valuations to be inflated, and risk
weights to be incorrect.
Moreover, the countercyclical capital buffer has some practical limitations: it
applies to a subset of the US banking system and is designed to act with a one-year
lag. It also cannot be used efficiently to target specific asset classes that appear frothy,
a challenge I turn to next, namely our focus
on time-varying sector-specific tools.
A blunt instrument
The countercyclical buffer may be a relatively
blunt tool for circumstances where the buildup of risk is highly concentrated in a particular sector. This was, of course, the challenge
US policymakers faced early in the recent
housing bubble, with home prices rising and
capital markets developing the complicated,
opaque securities built on subprime mortgages that would ultimately cause damage
throughout the financial system.
Indeed, property booms are perhaps the
most common macroprudential challenge
that have confronted financial authorities in advanced economies over the years,
although macroprudential challenges have
also surfaced in other sectors, such as the
corporate lending boom that confronted
Korea in the mid-to-late 1990s.
In addition to time-varying broad
macroprudential tools, such as countercyclical capital buffers and dynamic provisioning,
many financial authorities have the authority
to promulgate rules that target activity in a
specific sector.
For instance, Swiss authorities activated,
in early 2013, a countercyclical capital buffer
that added 1 percentage point of capital
requirement for direct and indirect mortgage-backed positions secured by Swiss
residential property, and then increased this
amount in 2014 to 2 percentage points.
Lending-side tools
In the United States, there is a more limited
set of authorities the Federal Reserve could
exercise, either on its own or jointly with the
other banking agencies to address sectorspecific risks.
Most commonly, as we have seen with
leveraged lending, the banking regulators
acting together can use the tools of supervisory guidance and intensive supervision to
discourage banks from taking on additional
risk on safety and soundness grounds.
Moreover, the annual supervisory stress
tests can be tailored to increase the severity
of losses in specific portfolios of loans or the
market shock. However, these authorities
fall short of direct restrictions on activities in
a particular sector.
Such supervisory actions usually flow
from microprudential concerns about the
69
safety and soundness of individual institutions rather than macroprudential concerns

about the stability of the entire system.
Section 165 Dodd-Frank
By contrast, section 165 of the Dodd-Frank
Act provides that the Federal Reserve could
restrict the activities of banks with assets
greater than $50 billion or non-bank systemically important financial institutions
(SIFIs) designated by the FSOC to prevent
or mitigate risks to the financial stability of
the United States, thus providing potential
macroprudential authority.
In addition, the Federal Reserve has
authority under the Securities and Exchange
Act of 1934 to set initial and variation margin requirements for repurchase agreements
and securities financing transactions, which
applies across the financial system.
This authority was used to curb perceived
excesses in the equity markets through the
mid-1970s with what was seen as limited
success, and it has not been used in such a
manner since.
Minimum margin requirements
There is some interest in exploring whether
imposing minimum margin requirements
on additional forms of securities credit could
prevent margins from compressing during
booms and likewise help mitigate destabilising procyclical margin increases at times of
stress, reducing the associated fire sales in
short-term wholesale funding markets.
Consideration of the usefulness of these
authorities is in preliminary phases. It is
being undertaken as part of a broad review
of macroprudential authorities and not with
regard to developments in any particular
70
sector. For purposes of comparison, it is

instructive to focus on how central banks in
several advanced economies have dealt with
housing booms in recent years.
Financial authorities in the United
Kingdom, Sweden, Switzerland, and New
Zealand have recently confronted rapidly
rising residential housing prices in macroeconomic environments where there were
compelling reasons not to use the policy rate
as the first line of defence.
They responded by imposing strictures
on borrowers, through loan-to-value or
debt-to-income limits, in some cases in
concert with disincentives to lenders, and in
many cases in an escalating pattern.
Restrictions on borrowing
Indeed, restrictions on borrowing are among
the most commonly employed macroprudential tools and, according to some
research, among the most effective in stemming the build-up of borrowing.
This is not a problem we face today. If
anything, the most pressing problem currently facing housing authorities in the
United States is to restore vitality to the single-family housing market, where construction activity remains puzzlingly weak.
However, if, in the future, a mortgagecredit-fuelled house price bubble were to
re-emerge, the banking regulators could
perhaps impose higher risk weights on
mortgage loans with certain characteristics either directly or through expectations
around stress testing.
This approach would be slow, perhaps
requiring upwards of a year to adjust, and
narrow in its scope of application, and it
may prove ineffective at times when bank
regulatory capital comfortably exceeds the

required thresholds.
Third pillar
The third pillar of our financial stability
agenda is working across the regulatory
perimeter. In some cases, foreign central
banks acted in concert with other financial
authorities to address the buildup of risk in
their housing sectors.
In the American context, the Federal
Reserves work is embedded in a larger web
of efforts by other financial authorities. In
parallel to the Federal Reserves own efforts
to formalise its financial stability surveillance and policy making, the network of
independent financial agencies is enhancing
cooperation through the formal structure
and responsibilities of the FSOC, as well as
through joint rulemakings and joint supervisory efforts.
It is vitally important that the bank and
market regulators actively work to share
assessments of risks across the financial system and to develop joint macroprudential
efforts to address risks that stretch across
regulatory perimeters.
Realistically, however, those efforts are in
early stages and must respect differences of
mission and mandate, authority, and governance structures.
The CFPB by way of example
As an example, the Consumer Financial
Protection Bureau (CFPB) has authority to
adjust the definition of qualifying mortgages
(QM), which affects mortgage credit at all
lenders, whether inside or outside the banking regulatory perimeter. It is worth noting, however, that the Consumer Financial
Protection Bureau operates primarily under

a consumer protection mandate.
While the ultimate consequences of a
mortgage credit boom have, in the past,
proved very costly for families, the danger
to consumers in the initial stages of such a
boom may be too unclear to warrant timely
action.
Recognition of the limits to the macroprudential framework brings us to a consideration of monetary policy a powerful tool
with broad reach, but also relatively blunt.
Fourth pillar: monetary policy
This brings us to our fourth and final pillar,
that of monetary policy. Monetary policy is
the only tool available to the Federal Reserve
that has far-reaching effects on private credit
creation across the entire financial system
and one of the few tools that can be changed
rapidly (although its effects have famously
long and variable lags).
While recognising the far-reaching
effects of monetary policy on financial conditions, there are good reasons to view monetary policy as the second line of defence. It is
better viewed as a complement, rather than
an alternative, to macroprudential tools. In
many circumstances, standard monetary
policy and financial stability considerations
will reinforce one another.
Nevertheless, there may be times when
standard monetary policy and financial
stability considerations conflict. In several
recent instances, foreign economies have
faced some tension between high unemployment and shortfalls in inflation relative to the central banks target, on the one
hand, and financial stability concerns associated with rapidly rising real estate prices
71
on the other. In the United Kingdom, policymakers put in place a range of measures
to limit the build-up of risks in the housing
market, and, partly as a result, the housing
market appears to be cooling somewhat.
Nonetheless, policymakers in the United
Kingdom have acknowledged the potential
for monetary policy adjustments to play a
role in the pursuit of financial stability.
UK knockout punch
The Bank of Englands 2013 forward guidance had a specific financial stabilityknockout for monetary policy accommodation if
the Financial Policy Committee judges that
the stance of monetary policy poses a significant threat to financial stability that cannot be contained by the substantial range
of mitigating policy actions available to the
Financial Policy Committee.
If, in the future, the United States did
face a similar dilemma, where financial
imbalances are growing rapidly against a
backdrop of subpar economic conditions,
the Federal Reserve may consider monetary
policy for financial stability purposes more
readily than some foreign peers because our
regulatory perimeter is narrower, the capital
markets are more important, and the macroprudential toolkit is not as extensive.
A second line defence
Even in these circumstances, however, it
is important to be prudent about the role
of monetary policy, recognising that the
necessary adjustments in monetary policy could have broader economic consequences within the economy. For example,
a tightening in monetary policy sufficient
to limit strong credit growth could depress
72
employment and potentially trigger a sharp

correction in financial markets.
These limitations should lead us to be
circumspect regarding the use of monetary
policy as a tool to address financial stability
risks; it should perhaps be viewed as a second line of defence.
But it is equally important to acknowledge the potential usefulness of monetary
policy for addressing risks to financial stability and to the broader economy, and to
continue expanding our work on the appropriate role of financial stability in our monetary policy framework.
Conclusion
In short, while the United States Federal
Reserve System has an inherent responsibility for financial stability, it has an incomplete
set of authorities and a limited regulatory
perimeter in a financial system that has large
capital markets and a fragmented regulatory
structure much of this due to thefederal,
hence fractured, structure of our political
governance.
It is therefore important that we
actively use the tools under our authority which place particular emphasis on
building structural resilience at the largest,
most complicated institutions via tougher
through-the-cycle standards, along with
broad countercyclical measures to limit the
build-up, and potential consequences, of
risks to financial stability.
This should be done while exploring
the design of time-varying sector-specific
tools, and, at times, looking to monetary
policy as a powerful tool that unlike any
other operates across the entire financial
system.
CCP Exchanges
CCP risk management, recovery

and resolution arrangements
David Bailey of the Bank of England enquires if centralised counterparty exchanges
have becomesuper-systemicinstitutions.
THIS conference [the Deutsche Boerse
Group and Eurex Exchange of Ideas]
comes at a very timely point, just over
five years on from the G20 summit in
Pittsburgh that placed such a significant
focus on central clearing. In the EU we
also have a new Commission settling in
and so it seems an appropriate juncture
at which to reflect on the progress of the
last five years and the challenges that lie
ahead.
I think we can all agree that the G20 mandate to centralise the clearing of standardised
OTC derivatives has increased the systemic
importance of CCPs; I will even borrow a
phrase I have heard one of my fellow speakers use previously to note that CCPs are
emerging as super-systemic institutions,
with increasing importance across multiple
jurisdictions.
It is also clear that, recognising this, the
international community has made very significant and tangible progress to ensure that
CCPs are being held to higher risk standards
and regulatory expectations.
As the supervisor of some of the largest
CCPs, which clear securities and derivatives

denominated in over seventeen currencies
across the globe, the Bank of England has
been heavily engaged in the international
efforts to promote the right standards and
expectations of CCPs, and also to ensure that
they are implemented in practice.
Robust risk standards
But it is important to recognise that we have
not reached the end of our journey more
can, and must, be done. I will therefore
outline my views on the progress made to
date, internationally and within the UK, to
develop and strengthen risk management
standards at CCPs, CCP recovery arrangements and resolution tools for CCPs.
It is critical that we maintain our momentum in these areas and I will highlight the
key points of focus from my perspective.
In particular, further progress is needed to
ensure that recovery and resolution regimes
are robust, credible and well understood so
that they can be used to successfully minimise the impact of a failing CCP on financial
stability.
Let me start with the first area: CCP risk
standards. Robust risk standards, implemented consistently across jurisdictions are

clearly essential to ensure that CCPs deliver
the outcome that we, and the G20, expect of
them; that is, to safeguard the financial system through the effective management of
counterparty credit risk.
International principles
Internationally, the 2012 CPMI-IOSCO
Principles for Financial Market Infrastructure
PFMI), as implemented within the EU by
EMIR (European Market Infrastructure
Regulation), have represented a significant step forward, resulting in more rigorous expectations of CCPs across their
business and including important areas such
as counterparty, liquidity and operational
risk management.
Within the UK, the PFMIs form a key
foundation stone of the Bank of Englands
supervisory approach and our regulatory
framework is consistent with these standards. As part of our approach, we require
CCPs to complete annual self-assessments
against the PFMIs which provide an effective test of the CCPsimplementation of, and
commitment to, the standards the international regulatory community has set.
Centre of approach
Furthermore, and recognising the importance of UK-based CCPs across multiple
jurisdictions, we [the Bank of England] have
placed the PFMI Responsibilitieson international co-operation at the heart of our
supervisory approach. Making regulatory
cooperation effective between the relevant
regulators of CCPs is a priority for the Bank
as our CCPs perform important activities for
74
firms and markets in the European Union,

United States and globally. For that reason,
we operate regulatory colleges for UK CCPs
at both the EU level, as mandated by EMIR,
and globally.
These arrangements are important in
allowing us to inform our international
counterparts of developments at UK CCPs,
and to benefit from their valuable input,
expertise and experience in supervising
CCPs and firms in many other jurisdictions.
Our experience is that the supervisory expertise brought together through these arrangements means that colleges can be greater
than the sum of their parts.
We see this collegiate model as an effective template for all CCPs that operate on a
multi-jurisdictional basis and we advocate
the use of such arrangements more widely.
Not an end-point
Whilst the PFMIs have taken us a long way,
we do not believe that they represent an
end-point to our regulatory journey; rather
they must be viewed as a very useful baseline
that must continue to evolve and develop to
continue to provide for effective CCP risk
management.
Indeed, we have already identified areas
in which the international standards could
benefit from additional guidance, which will
be important to ensure robust and consistent
interpretation and implementation across
the G20, particularly with regard to counterparty credit risk standards.
For example, one clear area of the current
international standards that could be further
developed to strengthen CCPscounterparty
credit risk management relates to stress testing requirements. Whilst the PFMIs and
EMIR do require an appropriately and prudently sized default fund, there is no requirement for CCPs to disclose the details of the
stress tests which they use, which ultimately
determines the size of these default funds.
Therefore, it may be difficult for participants
to fully compare the level of stress that CCPs
can withstand.
Viewed as minimum
Furthermore, we would welcome the
development of standardised approaches
to designing stress scenarios, which could
include standardised regulatory stress tests
for CCPs as we have seen in the banking
sector. However, it is crucial for these to be
set in context. Standardised stress tests must
be well-designed to incorporate the diversity
of business models of CCPs globally.
And more importantly, they could only
be viewed as minimum stress tests, which
would complement more tailored and
potentially much more rigorous internal
stress testing, developed and implemented
by individual CCPs.
The last thing I will say on CCP risk
standards is, however, that a consistent regulatory framework is not enough. Ensuring
CCPs are robust and resilient relies on a joint
effort from regulators, the CCPs and their
users alike. We, and I stress we, must hold
the CCPs to the highest risk standards.
CCP recovery arrangements
In this regard, we welcome the forthcoming guidance from CPMI-IOSCO on public quantitative disclosure standards for
CCPs, which will represent a step in the
right direction to put clearing members and
participants in a better position to use only
those CCPs that are sufficiently well riskmanaged, not simply those that are the most
cost-effective. Clearing members must stand
ready to justify their choices to regulators
and other stakeholders on request.
Now I will turn to recovery: what happens in the event that a CCPs pre-funded
resources are not sufficient? No matter how
strict the regulations are, or how good a
CCPs risk management is, the possibility of
an extreme event, one that we might even
consider implausible, that causes financial
distress or failure is something that we cannot and indeed must not ignore.
Supervisors need to carefully consider
what actions a CCP could take to maintain
its economic viability whilst also continuing
to provide its critical clearing services.
Potential tools
The Bank of England therefore welcomes
the recently published CPMI-IOSCO report
on recovery of FMIs which provides clear
guidance to CCPs on how to answer this
very important question and develop their
own recovery arrangements.
Potential tools identified in the report
includeassessment rights, that is, the right
to call for additional resources from members, variation margin haircutting and, ultimately, contract termination, or tear-up.
Within the UK we have already required
CCPs to prepare recovery plans and introduce arrangements to allocate extreme
losses. This means that they have put in
place loss-allocation arrangements to meet
uncovered losses arising from a clearing member default, and for non-clearing
member default losses that could threaten
solvency.
75
From our domestic experience, we know

that there is no one-size-fits-all recovery plan. Plans must take into account the
specific CCP, the nature of its products and
the markets in which it operates. This is
reflected in the approaches the UK CCPs
have taken in developing their own recovery
arrangements.
Possibility of failure
These arrangements will continue to be
developed and fine-tuned in response to
the rigorous periodic tests that the CCPs will
undertake and arrangements may need to
be updated as clearing services, CCP participants and central clearing mandates evolve.
We will also consider whether UK CCPs
need to make any more changes to bring
them in line with the recently published
CPMI-IOSCO guidance.
One point that I will emphasise is that
there is the potential for CCPs to suffer
losses, or even fail, for reasons other than
member default. For instance, a CCP could
incur losses on its investment policy or
through operational issues.
Despite the strict requirements in EMIR
and the PFMIs that reduce the probability of
this failure, there is still a tail risk that these
could create uncovered losses that would
exceed the CCPs capital. Therefore, CCPs,
together with their clearing members and
regulators, must consider the recovery tools
that they would employ if a non-default loss
depletes the CCPs capital.
CCP resolution tools
It is, however, important that recovery
arrangements do not disincentivise effective
management by CCPs of their non-default
76
risks. CCPs should bear at least the first

tranche of the loss with an amount of their
own capital, providing a clear incentive to
prudently manage these risks.
Finally, however, if a CCP decides to
implement its recovery plan, it must properly disclose information on the risks and
liabilities that its clearing members will face
in extremis so that its participants can truly
understand and manage the risks and properly scrutinise the CCPs management of
these risks. This is in line with CPMI-IOSCO
guidance, and reinforced via our supervisory
approach.
The final question I will touch upon
in this paper is: what would happen if it
appears likely that a CCPs recovery plan will
not work in practice; or if a CCP can only
remain viable by taking actions that could
undermine wider financial stability?
Prudent and robust
A CCPs risk management should be prudent and robust, and its recovery plans
should be designed to be fully comprehensive and effective.
However, it is incumbent on us, as
authorities, to consider what happens if they
are not. In this case, resolution authorities
will need to step in with effective and comprehensive stabilisation powers to act as a
final backstop; and to provide continuity to
the CCPs critical economic functions, whilst
providing an orderly wind-down for any
non-systemic operations.
The UK has been at the forefront of
developing thinking around the appropriate
resolution tools for CCPs. Earlier this year
we put in place a domestic resolution regime
for our UK CCPs. This is a significant step
forward which provides the BoE, as resolution authority, with some of the tools necessary to facilitate the resolution of a failing
CCP. We welcome the recently published
annex to the Financial Stability Boards (FSB)
Key Attributes on resolution and we aim
to further develop our domestic resolution
regime to bring it in line with these international standards.
Protect financial stability
We anticipate achieving this via the forthcoming European legislative proposal on
CCP resolution which we expect to be proposed in 2015. Ensuring that we, and other
resolution authorities, have a comprehensive
set of tools to effectively resolve a CCP will
be a clear priority for that legislation.
In my view, an effective resolution regime
must offer national resolution authorities
flexibility to assess the specific circumstances
of a CCPs failure and to react in the most
appropriate manner to protect financial
stability.
To do this, resolution authorities must be
able to act in a timely and forward-looking
way, even potentially before recovery actions
have been exhausted, and with a variety of
tools, to respond to the specific nature and
cause of the CCPs business failure. However,
there is, of course, a trade-off between resolution flexibility and ex-ante transparency for
CCP participants.
No Creditor Worse Off
To alleviate this concern, participants should
be given reassurance that any resolution
actions would be accompanied by relevant
safeguards, including a No Creditor Worse
Off safeguard, which would limit the
individual losses to the losses they would

experience in insolvency. This should provide some degree of ex-ante transparency
about the size, but perhaps not the exact
form, of the loss. The next obvious question
is: what tools should this legislation provide?
Here we can be informed by the experience of developing the European Bank
Recovery and Resolution Directive (BRRD).
In my view there should be a flexible resolution toolkit for CCPs. In particular, resolution
authorities need the power to recapitalise a
failing CCP in a timely manner, including
through writing down liabilities and converting them to equity.
Existing shareholders should be the first
to bear the losses if this approach is to be
taken.
Total loss absorbing capacity
There is also an important question as to
whether CCPs are resolvable in their current
forms, and within that, whether changes
to the liability structure of CCPs are necessary to make this approach credible, without recourse to taxpayer funds. The FSB
has recently proposed that there must be
a minimum level of Total Loss Absorbing
Capacityfor banks and we will need to consider carefully whether and how this concept
could be effectively translated to CCPs.
In a similar vein, writing down operating
liabilities through some form of initial margin haircutting should also be considered.
There may, of course, be other solutions,
and the legislative proposal should consider
a full suite of tools to ensure that the CCP
resolution regime can be timely, credible,
well-understood and effective. Finally, one
important point that an effective resolution
77
regime must address relates to information sharing.

To ensure that resolution plans
are practicable and timely, resolution authorities must communicate
and cooperate with other resolution
authorities and relevant regulators,
through Crisis Management Groups or
other similar arrangements, to explain
what specific plans and tools would be
adopted for each CCP in a non-exhaustive range of crisis scenarios, as has
already been done by banks.
Given the increasing importance of
CCPs across jurisdictions, this active
international cooperation and engagement is essential and we are actively
considering how to embed this alongside the college arrangements for UK
CCPs that I referred to earlier.
So to conclude we have made real
progress since 2009 to increase CCP
risk standards and to ensure these have
been implemented effectively.
However, we must regularly take
stock of the standards to ensure that
they keep pace with market practices
as they evolve, and to ensure that the
standards are being implemented consistently internationally.
Furthermore, CCPs, their users

and their regulators must not ignore
the possibility that, despite these risk
standards, a CCP could get into financial distress. CCPs must therefore put
in place well-considered and appropriate recovery arrangements, while resolution authorities should be provided
with a full suite of tools that will deal
with the unique risks posed by CCPs.
These are necessary steps in promoting the G20s objectives, with respect to
central clearing, in a manner consistent
with an objective to promote financial
stability.
Good progress is being made and,
recognising the importance of the CCPs
that we supervise within the UK, we are
committed to playing a leading role in
taking these steps.
Editors note: The publisher of the
Journal would like to thank David Bailey,
Director, Financial Market Infrastructure,
the Bank of England and the BoE itself
for allowing the Journal to re-publish this
article in full, the original of which can
be accessed via the following link: http://
www.bankofengland.co.uk/publications/
Pages/speeches/2014/781.aspx
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Foreign exchange
Looking ahead as the Renminbi

internationalises
Alexa Lam, the deputy head of the HKSFC,
charts the global rise of the RMB and issues
some sage advice to Hong Kong and China
THE internationalisation of a currency
refers to the process where its use has
expanded beyond the borders of the
jurisdiction where it is issued, and markets around the world have come to
accept the currency as a unit of account, a
medium of exchange and a store of value.
This paper will examine important prerequisites for the Renminbi (RMB) to succeed as
an international currency, a likely roadmap
from here on and the role of offshore RMB
centres. The last section of this paper offers
some suggestions on how Hong Kong could
compete in the new paradigm of multiple
offshore RMB centres around the globe.
After more than 30 years of rapid growth,
China is now the worlds second largest
economy. A persistent and enormous trade
surplus and foreign capital inflows have
led to a sharp increase in Chinas foreign
reserves, causing uncomfortable pressure
due to a substantial international payment
imbalance.
The risk of hot money has become a
difficult subject, one invariably linked to the
need for a market mechanism to set RMB
exchange and interest rates, and expand

two-way flows of capital. In 2009, China
started to promote the cross-border use of
RMB in a calculated manner, starting with
foreign trade.
This is very much a broad-fronted initiative designed to improve the terms of trade
and the balance of international payments,
to lower exchange rate risk in international
trades and official reserves, and to maintain
control over macroeconomic measures and
monetary policy.
Currency review
After the 2008 global financial crisis, the
stability and credibility of major international currencies such as the USD and euro
came under pressure. There were calls to
commence a review of the de facto single
global reserve currency system. In hindsight,
Chinas initiative to promote the cross-border use of RMB could not have come at a
better time.
While the paths to internationalisation
taken by other currencies the US dollar,
GB pound, euro and the Japanese Yen differed, each having been uniquely shaped
by a confluence of world events, deliberate

policy and historical opportunities, there are
discernible commonalities among them.
Commonalities
First among these commonalities is the fact
that a currencys strength and dominance
are directly co-related with the strength of
the underlying economy. Second, appropriate government support (including domestic and international policies) is vital. Third,
the formation and development of offshore
markets determines the breadth and depth
of the internationalisation of a currency.
And, fourth, as a currency assumes greater
influence, it also has greater international
responsibilities.
For the RMB to become an international
currency, certain prerequisites must be in
place, chief among these being that China
must have an open economic system and
a relatively free flow of cross-border capital,
thus driving a greater market demand for
RMB to be the payment and settlement currency for trades, services and investments.
Further, Chinas domestic financial system, financial market and relevant rules and
regulations are relatively well developed to
enable price discovery, and offshore RMB
markets have gained sufficient depth and
liquidity to support a healthy velocity and
provide a global network to complement the
functioning of the onshore market.
Prerequisites
Other prerequisites necessary for the RMB
to become a truly global currency are that
the value of RMB is relatively stable, and that
the exchange rate and interest rate formation
mechanism is sufficiently market-oriented
80
and transparent. Added to this is a requirement that the political situation is stable
and that the country has good international
relations, together with a high level of international credibility underscored by reliable
legal institutions.
Having detailed certain prerequisites
necessary for a currency to gain internatiional credence, its now possible to gauge
how China has navigated the internationalisation journey thus far.
After China ushered in modernisation
and reforms in 1978, trade between China
and her neighbours quickly blossomed.
Traders in the region started to accept payment in RMB. Although the currency was
not freely convertible, these traders were
happy to take the currency which they could
use to settle future trades with their Chinese
customers.
2010 sea change
As we all know, some 30 years later (in 2009),
China officially allowed cross-border trade
settlement in RMB in a pilot scheme covering five Chinese cities. The market initially
responded very slowly. The one-way trend
of appreciation of the RMB, the higher funding cost, and the lack of banking and financial products to hedge and manage currency
risks gave foreign traders little incentive to
settle their trades in RMB.
This situation started to change in 2010,
when RMB became easily transferrable
within Hong Kong. By 2013, close to 12 per
cent of all Chinas foreign trades were settled in RMB. As this percentage is still much
lower than the percentage in other countries
or trading blocs1 , we could expect this percentage to increase. Meanwhile, the RMB
has already become the second most-used

currency in global trade finance, after the
USD, and the 7th most-traded currency in
the world as of November 20142.
Creating inroads
Trade alone cannot sustain a long-term
international demand for a currency. A broad
and deep offering of financial, investment
and derivative products and services in RMB,
and the accompanying freedom to hold, use
and transfer RMB assets, must be readily
available. The RMB falls short in these areas.
While RMB is freely convertible under current accounts (e.g. payments for trades and
services), this is not so for capital accounts
(e.g. investments).
China started creating inroads into its
otherwise closed capital account as early as
2004, when Hong Kong was encouraged to
develop an infrastructure allowing individuals to open RMB bank accounts in Hong
Kong.
While initially there were severe restrictions on transfers between accounts, Hong
Kong nevertheless quickly built a decent
liquidity pool which supported the first offshore RMB investment products RMB
bonds and treasuries of 2-3 year duration
issued by Chinese financial institutions and
the Chinese Ministry of Finance.
First big bang
While restrictions abound, these bonds, and
the RMB bank accounts underpinning them,
served the historic function of developing
and testing the infrastructure for the circulation of the RMB outside mainland China,
and the linkage between the offshore and
the onshore markets.
The year 2010 saw what was arguably

the first Big Bang when funds in RMB bank
accounts in Hong Kong became freely transferrable. Hong Kong quickly experienced
a flourishing of first-in-the-world offshore
RMB investment products RMB mutual
funds, and listed RMB securities. The following year, Hong Kong worked closely with
mainland China to create a new innovation
the RMB Qualified Foreign Institutional
Investors (RQFII) scheme.
The concept of the RQFII is quite simple.
It is a QFII quota denominated in RMB. The
ingenuity behind the RQFII is that it used
the Hong Kong asset management platform
to connect the offshore RMB liquidity with
the onshore securities market. Riding on
the back of the RQFII, Hong Kong rapidly
developed a wide range of RMB investment
products.
Premier offshore market
The Mainland continued to roll out measures to support the development of Hong
Kongs offshore market: foreign direct investments and overseas direct investments could
be made directly in RMB, and the Chinese
Ministry of finance commenced a regular
programme of treasury issuance in different
tenors in the Hong Kong market. Over time
this will anchor Hong Kongs position as the
premier offshore RMB bond market.
Just as it was supporting the development of the Hong Kong offshore market,
China also commenced a calculated programme of pushing the RMB footprint to
other parts of the world. It entered into
swap agreements with a total of 29 central
banks3, with an aggregate agreed value of
RMB 3,000 billion. Meanwhile, replicating
81
the experiments conducted in Hong

Kong, China gradually expanded the RMB
Clearing Bank arrangement and the RQFII
scheme to other markets. Today, the UK,
Singapore, South Korea, France, Germany,
Qatar, Canada and Australia each has in its
jurisdiction a China-designated RMB clearing bank and a modest RQFII quota.
Outlook for internationalisation
Looking to the future, the Chinese
Governments Communique of the Third
Plenary Session of the 18th CPC Central
Committee (November 2013) concluded
that it must promote reforms through
opening-up. The determination is very
clear. The country will, through a wider
opening of its economy, push through internal structural reforms which until now have
proven extremely difficult.
China has just launched the ShanghaiHong Kong Stock Connect programme. The
Mainland-Hong Kong Mutual Recognition
of Funds scheme is expected to follow soon.
Each of these is a bold move and a seminal
event in the history of Chinas financial markets; these two programmes will support a
wider and deeper use of the RMB globally as
an investment currency and a store of value,
and quicken the pace of the opening of the
countrys capital account.
Offshore RMB business
These two bold steps have significant implications for the countrys financial market
reforms. So far, offshore RMB business has
been developed first on the Greater China
platform, then in Asian countries with a
close political and economic relationship
with China, and subsequently across to the
82
European and North American Continents.

Apart from the inherent strengths of a potential offshore market, international geopolitics
is a key factor in determining where offshore
RMB business will be developed next.
Today, for foreign governments who
desire new business opportunities from
China, the prospect of developing RMB offshore business with a toolkit consisting of
an offshore RMB clearing bank, a swap line
with the Chinese central bank, The Peoples
Bank of China (PBOC), and a modest RQFII
quota has replaced the giant panda as the
most coveted gift from China.
In the next five to 10 years, as RMB internationalisation deepens with the opening of
the capital account and the liberalisation of
Chinas capital markets, the RMB will likely
join other international currencies including
the USD, euro, GBP and Yen to form a more
plural international financial and monetary
system, while the USD continues to occupy
a dominant role.
RMB appreciation
Regions with stable bilateral or relationships
with China such as those other countries in
BRICS (Brazil, Russia, India and China),
the Silk Road Economic Belt and the 21st
Century Maritime Silk Road 4, the Middle
East, Africa and South America are likely to
be offered the opportunity of developing offshore RMB business.
China has so far deftly combined calculated policy initiatives with sheer economic
strength to launch the debut of the RMB.
Aided by the 2008 global financial crisis, and
the currencys steady one-way appreciation
trajectory, investor interest in offshore RMB
assets, particularly bonds, continued almost
unabated, until the one-way appreciation

of the currency began to pause, and even
reverse, in the last 12 months.
Key to success
In the longer term, as the RMB exchange
rate becomes more market driven, the global
marketplace will ultimately decide if the RMB
has an integral place in financial markets.
This will be determined largely by whether
there is genuine long-term demand for the
currency, not just for trade and investment
but also for long-term needs and liabilities,
and the relative cost and ease with which
RMB can be acquired and put to use.
For offshore centres, long-term growth
momentum must come from the inherent
strengths of their market liquidity, talent,
innovation and infrastructure.
As interest rates and exchange rates in
China become more market oriented, there
will be freer cross-border capital flows and
transactions. The connection and transactions between offshore markets and onshore
markets will deepen.
More RMB investment, financing, derivatives, trading products and tools will also
emerge from the offshore markets. This will
both feed and stimulate velocity and the
degree of international utility of the currency
the key to whether RMB will succeed as a
global currency.
What for Hong Kong?
Hong Kong enjoys a significant lead over
other offshore RMB centres. It has the largest
offshore RMB liquidity pool (over RMB1 trillion), a critical mass of talent and the necessary infrastructure. Currently, it processes 90
per cent of Chinas RMB-settled cross-border
trade. It has the lions share (RMB270 billion)

of the aggregate worldwide RQFII quota
(RMB870 billion), which it has fully invested
in the onshore equity and debt markets.
Hong Kong also offers a broad spectrum
of RMB banking and financial services, and
the widest choice of offshore RMB investment products. RMB businesses in other
offshore centres often need to access Hong
Kongs liquidity pool. A growing number
of RMB products offered in other centres
are also packaged or managed out of Hong
Kong. Competition, however, is heating up.
Replicating Hong Kongs success
London recently completed the offering of
RMB denominated treasuries (RMB3 billion)
issued by the UK government. While these
bonds were not issued under the RQFII
scheme, it is the worlds first RMB bond issue
by a foreign government, a move that immediately jumpstarted the creation of offshore
RMB assets in the London market.
At present, markets such as London and
Singapore, being the trading hub respectively of the EU and ASEAN blocs, have a
relative advantage over Hong Kong in the
areas of foreign exchange, fixed income and
derivatives trading.
As the pioneer, there is a cost in the
development of innovative products and
solutions but these could be easily replicated
by others.
While the one country, two systems
framework has dealt Hong Kong a strong
hand as it plays the role of the international
market on Chinese soil, under this framework any policy change in China is likely to
impact the Hong Kong market more than
other offshore centres.
83
While Hong Kong was previously

Chinas only partner in experiments involving the cross-border use of RMB, China has
today demonstrated a readiness to replicate
the Hong Kong experience in other markets,
giving Hong Kong little time to consolidate
its position. Moreover, the recently established Shanghai Trade Zone indicates that
some of the market liberalisation experiments could be first tested there rather than
in Hong Kong.
Maintaining its position
There is no longer any implicit guarantee
of exclusivity. The question for Hong Kong,
therefore, is how it can maintain its position
as the lead offshore centre in the new paradigm of multiple offshore RMB markets?
The pace and progress of RMB internationalisation are of necessity dictated by the
degree in which difficult domestic reforms
are implemented. In the process, China will
need to test ideas and find solutions. Hong
Kong should continuously assess the progress of these reforms, proactively identify
Chinas needs, provide expertise, advocate
solutions and offer to trial run them.
There are several pressing issues on
Chinas reform agenda. Interest rate and
exchange rate liberalisation are no doubt two
difficult tasks.
Two-pronged approach
Another key policy objective is to develop
orderly fund flows between the onshore
and offshore markets. To fully open its capital account and converge with international
markets, China will need to put in place
transparent systems and regulation. There
is also the all-important financial security
84
concern that massive inflows and outflows

of international liquidity under an open capital account could exacerbate volatility and
destabilise the onshore market.
Before Chinas capital account becomes
fully convertible, Hong Kong should adopt
a two-pronged approach. One prong is to
compete by offering a comprehensive range
of RMB products and cost-effective solutions, a robust and efficient infrastructure
and a worldwide network of coverage.
One of the functions of an offshore market is to help the onshore market in price
discovery and operational risk management.
Hong Kong, in particular, should quickly
develop a deeper offshore RMB bonds market with vibrant secondary trading to assist
in price setting, and a vibrant RMB forex
trading platform with multi-tiered products
and derivatives.
Cementing the lead
Hong Kong should also actively participate
in the PBOC-led development of the RMB
Cross-border inter-bank Payment System
to solidify Hong Kongs position as the
leading offshore RMB settlement centre.
Additionally, Hong Kong must continue
to cement its lead as the offshore centre for
RMB wealth and asset management through
renewed efforts in product innovation.
The other prong is to focus on areas
where other offshore centres may not enjoy
the same degree of access. These areas
include: helping China in setting marketoriented policies for orderly cross-border
flows between the onshore and offshore
markets; designing and jointly administering appropriate industry-wide systems and
regimes to support and regulate product and
business development and innovation to

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

others is the one that succeeds in developing a broad, sustainable and genuine
demand for Renminbi for commercial
and investment needs.
Endnotes
1. Approximately, the percentage in 2013 of EU
trades that were settled in euro was about 65 per cent,
the percentage in 2012 of Japan trades settled in Yen
A crucial role
Monetary co-operation and maintaining
financial stability is another area where the
trust between the Hong Kong and Mainland
regulators could help cement for Hong Kong
a crucial role. Hong Kong has withstood
the onslaught of the 1997 Asian Financial
Crisis and the 2008 Global Financial Crisis.
Severely tested on both occasions, Hong
Kongs financial system and infrastructure
weathered both crises very well.
As the onshore market becomes exposed
to the contagion of global market dislocations, Hong Kong could share its experience
and establish a cross-border platform with
the Mainland to jointly monitor and manage
volatile cross-border flows of international
liquidity.
This is a crucial function, one which
quite naturally Hong Kong is best suited to
perform.
was about 40 per cent, and the percentage in 2013 of

US trades settled in USD was about 90 per cent.
2. Source: RMB Tracker published by SWIFT in
November 2014.
3. Those monetary authorities include Korea, Hong
Kong, Malaysia, Belarus, Indonesia, Argentina, Iceland, Singapore, New Zealand, Uzbekistan, Mongolia,
Kazakhstan, Thailand, Pakistan, United Arab Emirates,
Turkey, Australia, Ukraine, Brazil, the United Kingdom,
Hungary, Albania and the European Central Bank.
4. The Silk Road is a general term used to geographically describe the ancient trade and culture
routes between China and Central Asia, South Asia,
Europe and the Middle East that originally took form
during the Han Dynasty, about AD 200 BC. In 2013,
China proposed two new themes based on the traditional concept of Silk Road. One is Silk Road Economic Belt, proposed by Chinese President Xi Jinping
during his official visit to Kazakhstan in September
2013, which covers 9 provinces of west China and all
the West Asian countries. The other is 21st Century
Maritime Silk Road, also proposed by President Xi
Seizing the opportunity

As the RMB capital account becomes fully
convertible, Hong Kong should quickly seize
the opportunity to develop a comprehensive
range of multi-currency transactions, services and products to encourage the expanding use of RMB in Hong Kong.
In a free and open market environment,
during his official visit to Indonesia in October 2013,

which aims at strengthening Chinas economic partnership with countries in South and Southeast Asia. Both
proposals were emphasised by Chinas Prime Minister
Li Keqiang in his government work report in March
2014, and adopted as Chinas latest national strategy of
developing diplomatic and co-operation engagements
with countries along both routes.
85
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Capital markets
If Europe wants growth, reform

its financial services system
Nicolas Vron of the Peterson Institute issues
advice to EU policymakers for developing a
pan-Europe capital markets infrastructure.
EUROPES crisis has been a banking and
financial system crisis at least as much as
a crisis of unsustainable public finances
and sclerotic economies. Banking system
dysfunction has crippled the European
economy from the start of the crisis in
2007 to mid-2012, when the survival of
the euro itself was threatened. Since mid2012, more energetic policy efforts have
been devoted to bank crisis resolution
and the creation of a more sustainable
architecture for banking policy, known
as banking union.
A healthy banking union can only be a part
of the solution to securing a prosperous
future, however. Europes entire financial
system needs to be reformed to strengthen
financing, particularly for high-growth businesses, and jumpstart growth. The goal of
this ambition is what is currently referred to
in Brussels as capital markets union (CMU).
Banking union and capital markets
union are at different stages of design and
execution, necessitating different approaches
for each. Part of the reason why the euro area
economy has not bounced back yet is that
banks have been constrained in their lending by the sorry state of their balance sheets.
The banking union has belatedly triggered a
process of balance sheet repair, but this process is still far from complete.
Banking union refers to the centralisation of supervisory and resolution authority
in two European-level bodies: a newly created supervisory arm within the European
Central Bank (ECB) and a new Brusselsbased agency, the Single Resolution Board
(SRB).
SRB fully functional by 2016
The ECBs supervisory arm is fully operational and has been the licensing authority
for all banks in the euro area since November
4, 2014, just after a year-long comprehensive
assessment of the areas 130 largest banking
groups was completed.
The SRB will gradually start operations in
2015 and become fully operational in early
2016, when it acquires the authority to bail
infailing banks by imposing losses on their
creditors as well as to use its own resources
for bank resolution (the Single Resolution
Fund or SRF).1
By contrast, Europes capital markets union is

not even on the drawing board yet. A senior
European financial policymaker describes
the CMU asa concept under construction.2
CMU, major structural impact
On July 15, 2014, Jean-Claude Juncker, on his
way to becoming president of the European
Commission, announced the establishment of a European CMU to develop the
weak and fragmented non-bank segment of
Europes financial system.
While the banking union will have the
biggest economic benefit in the short run, a
well-designed capital markets union would
have major long-term structural impact by
making the European financial system more
resilient, efficient, and competitive.
Jonathan Hill, who holds the unwieldy
title of European commissioner for financial stability, financial services, and capital
markets union, has announced his intention to develop an action plan by the summer of next year [2015] (...) [as a] roadmap
to developing an ambitious Capital Markets
Union.3
The CMU agenda is widely seen as
being primarily about new EU legislation.
Since the European legislative cycle from
initial proposal to entry into force typically
takes at least 18 months to two years, the
CMU is not likely to have much economic
impact before 2017, unless the behaviour of
market participants changes in anticipation
of its creation.
Four main economic factors
Presently, there are four main factors that
could contribute to the economic impact of
banking union. The first of which was the
88
unanimous decision of euro area member

states in late June 2012 to initiate this union
by pooling their sovereignty over banking policy at the supranational level, and
to entrust the corresponding supervisory
authority to the ECB, signalled their political
solidarity and commitment to the integrity
of the euro area.
This development enabled the ECB to
proceed with its outright monetary transactions (OMT) programme, announced less
than three months later. This step succeeded
in calming the euro areas shaky sovereign
debt markets.
Greater market discipline
Second, the announcement of a banking
union has already led to greater market discipline in the European banking system.
Before mid-2012, most situations of bankweakness in Europe were met by public
bailouts and/or nationalisations, at least in
countries not under formal assistance programmes by the International Monetary
Fund and the European Union.
Since then, a belated backlash against
overly generous bank bailouts during 2007
12 has imposed the principle that shareholders and subordinated creditors should
lose their money before any public assistance is provided, and even stricter discipline
is expected to apply from 2016, when new
anti-bailout legislation enters into force.
Third, EU policymakers hope that the
results of the comprehensive assessment
will restore trust in the European banking
system, even though the demand for credit
is likely to remain anaemic in several member states for a long time. A firmer judgment on the success of the comprehensive
assessment should be possible in early

spring 2015, assuming that no nasty surprises ruin the credibility of the process, as
had sadly been the case in earlier stress testing exercises in 2010 and 2011. A successful
assessment will likely ease the credit supply
problem, which has constricted European
growth since 2007.
Less fragmentation
Fourth, the ECBs actions as a banking
supervisor in the next 12 to 18 months could
reverse the euro area financial systems
harmful fragmentation along national lines
since 201011. The ECB should prevent
national supervisors from forcing banks to
ring-fence their internal capital and liquidity along national lines and should work at
reducing the high home bias in their portfolios of euro area sovereign debt.
The ECB can also favour the emergence
of more integrated pan-European banking
groups through more cross-border acquisitions. Despite these steps, the onset of banking union also coincides with a phase of
bank deleveraging, resulting in more scarce
credit in parts of Europe and highlighting
the insufficient diversity of Europes financial
system, in which banks are the dominant
actors.
Expect no miracles
The ECB is trying to stimulate the development of market-based alternatives to
bank financing through its consideration of
purchases of asset-based securities (ABS)
in the next few months. But no miracles
should be expected on this front: Many
obstacles to cross-border capital market
integration in the European Union are
deeply embedded in legislative frameworks

and entrenched in financial industry structures. Complementing the current bankdominated system with a spare tyre4 of
non-bank finance requires legislative and
structural changes, which is what the CMU
agenda is about.
Its essential for the purpose of clarity to
definecapital markets, which in this paper
is shorthand for a variety of equity and credit
market segments that are small compared
with banks, and thus play a smaller role
in the process of channelling savings into
investments in Europe. The list includes
venture capital, private equity investment,
public equity issuance and initial public
offerings, corporate bond issuance, corporate debt securitisation, direct purchase of
loans by insurers and investment funds from
banks, and credit intermediation by specialised non-bank financial firms such as leasing
companies or consumer finance companies.
Full EU-wide CMU coverage
By developing these and other financial
market segments, the CMU agenda aims
to make Europes financial system more
efficient and competitive, more resilient
thanks to greater diversity, more responsive
to monetary policy signals, and more able to
respond to the financing needs of a vibrant
innovation-driven economy.
The European Commission has also
made clear that, unlike the banking union,
the CMU would cover all EU member states,
including the United Kingdom because of
its status as host to Europes largest financial
centre in London. CMU policy should not
freeze market structures in their currently
underdeveloped form. On the contrary,
89
policy should improve the environment for

the development of new forms of intermediation i.e. channelling savings toward
productive investment and new financing
contracts, with effective but not excessive
controls against systemic risk.
Setting the right CMU framework
In this respect, it is odd that some early blueprints for CMU read like a catalogue of market segments, as if each of these needed specific legislation to fulfill its potential.5 Rather
than this curiously top-down government
driven impulse, a more growth-friendly
CMU approach should embody the principle of setting the right general framework
that is conducive to the development of
efficient financial services and contractual
arrangements.6
An ambitious CMU agenda will face
challenges from powerful interests threatened with displacement. Many banks will
resist competition from alternative financing channels. Banking advocates will warn
against the perils of shadow banking and
regulatory arbitrage, while ignoring that
their own core features of deposit collection
and high leverage call for targeted and onerous regulation.
Scepticism & national interests
A capital market development agenda will
run into deep ideological scepticism from
those who view markets with suspicion, a
view that is influential among politicians and
the general public in large parts of continental Europe. This view is abetted by the failure of economists to produce a convincing
model for the financial sector around which
a market-friendly consensus could coalesce.
90
Finally, as previously mentioned, the

agenda may centralise regulatory policy at
EU level to encourage market development,
even though this would not be the primary
end of the CMU project, unlike banking
union. Such a move is sure to encounter stiff
resistance from interests invoking national
sovereignty in the United Kingdom and
elsewhere.
The UK situation is unique because of
the high concentration in London of wholesale market activity, private equity, hedge
funds, and other segments. Representatives
of the City of London often highlight the
benefits to the European Union of having a
globally leading financial centre on its territory. But they typically fail to acknowledge
that the regulatory framework for the City
should support the broader European public
interest and not only the local interest of the
UK.7
Six areas for inclusion in CMU
As Simon Gleeson, a prominent British legal
expert on financial services regulation, put it,
We still do not have sufficient European
control of the City of London to leave other
European governments happy with the fact
that increasingly Europe has only one financial centre, and that is it.8 This issue must
also be considered within the current UK
domestic political context, which is marked
by uncertainty about government attitudes
towards the European Union and even
about continuation of EU membership.
Policymakers should concentrate on six
specific areas for inclusion in the European
Unions nascent CMU agenda these are
covered by increasing potential economic
impact and political difficulty. Our first area
of inclusion should focus on the regulation

of specific market segments. This area commands the broadest discussion and consensus so far. Possible items include defining
simple and transparent securitisation products; amending the Transparency Directive
to facilitate market access for medium-sized
companies; and harmonising frameworks
for private placements. Onerous national
rules that require non-bank lenders that do
not take deposits to have a banking licence
could also be dismantled.
Prudential frameworks
The second area should focus on a review of
prudential frameworks. Regulators should
reconsider capital and liquidity requirements for financial firms that unnecessarily
discourage investment in unrated corporate
credit and other market segments.
In particular, prudential requirements on insurers and pension funds have
tended to mimic banking requirements,
partly ignoring the fact that these players
can legitimately take different risks from
those taken by banks because of the longer
maturity of their liabilities. The Solvency II
Directive (for insurers) and the Occupational
Pension Funds Directive should be reviewed
accordingly.
EU-wide auditing regulator
The third area should cover financial transparency, accounting, and auditing. While
banks can use their relationships with borrowers to assess their credit worthiness,
capital market investors need reliable public
financial data. But public financial information in the European Union at present is of
variable and often poor quality and not easily
comparable across the 28 member nation

states.
A reform agenda could (1) harmonise
EU regulation of auditors and create an EU
regulator for the largest audit firms (something that recently adopted EU audit legislation signally failed to achieve); (2) establish
a European chief accountant with authority over the enforcement of International
Financial Reporting Standards (IFRS),
either within the European Securities and
Markets Authority (ESMA) or as a new EU
agency; and (3) require the use of IFRS by all
unlisted banks to enable consistent banking
supervision.9
The fourth area should focus onsupervision
of financial infrastructure. Financial market infrastructure firms that carry potential
systemic risk, primarily central counterparties (CCPs, known as clearing houses in the
United States), remain subject to a national
framework for their supervision, contingent
liquidity support, recovery, and resolution.
Existing major barriers
This existing framework creates major barriers to cross-border capital market integration. The European Union should support
the establishment of a global (treaty-based)
supervisor and resolution authority for
CCPs, with the establishment of an EU-wide
supervisory and resolution agency for CCPs
as a second-best alternative.
The fifth area of focus should be insolvency and debt restructuring frameworks.
Present European insolvency frameworks
work too slowly. They result too often in
liquidation, and they fail to protect employment and private creditor rights.
Furthermore, differences across national
91
insolvency frameworks hamper the emergence of pan-European credit markets,

not least for securitisations. Out-of-court
restructuring is also underdeveloped in
Europe. While full harmonisation would be
unrealistic, EU framework legislation could
help overcome national obstacles. Even partial harmonisation might foster cross-border
market integration.10
Taxation
The sixth and most contentious area of focus
should be taxation. Differences between
national tax regimes for savings products
pose a major obstacle to cross-border capital
market integration.
Member states should seek more convergence in this area, either by unanimity or
through enhanced cooperation, as well as
simplification and stabilisation of national
tax regimes.
In addition, the European Union should
build on existing studies and national experiences to rebalance the differential tax treatment, which generally favours debt over
equity.
The third and fourth areas could transfer
some regulatory and supervisory functions
from the national to the EU level. It would
be a mistake to bar such a transfer a priori.
EU-level supervision already exists within
the ESMA for derivatives trade repositories
and credit rating agencies.
be reformed to better fit its supervisory role,

as suggested in President Junckers mission
letter to Commissioner Hill. A location in
London for such new supervisory functions,
inside or outside ESMA, could mitigate UK
concerns.
The EU debate on CMU over the next
few months should determine whether a
realistic legislative reform agenda for the
next half-decade could include all six of
these items, or only some of them.
The debate should also shape which
reforms are of highest priority, and in what
sequence they should be adopted.
The European Commission will need
to consult widely and will face challenging tradeoffs. But capital markets union can
become a major component of the European
agenda of structural reform, and the current moment of opportunity should not be
missed.
Endnotes
1. The SRF will reach its steady-state dimension in 2024.
2. Speech by Steven Maijoor, chairman of the European
Securities and Markets Authority (ESMA), at the Finance
for Growth Conference in Brussels, November 6, 2014,
www.esma.europa.eu/content/Capital-Markets-Unionbuilding-competitive-efficient-capital-markets-trustedinvestors.
3. Capital markets unionFinance serving the economy,
speech in Brussels, November 6, 2014, http://europa.eu/
rapid/press-release_SPEECH-14-1460_en.htm
4. This expression was popularized by the then-chairman
London-based ESMA?
Other categories of supervised financial
firms may be subjected to either ESMAs
authority or one or several specialised agencies that are to be created. Simultaneously,
ESMAs governance and funding should
92
of the Federal Reserve Board when he advocated a similar policy of capital market development in Asia following
that regions crisis in 199798. See Alan Greenspan, speech
at the 1999 Financial Markets Conference of the Federal
Reserve Bank of Atlanta, www.federalreserve.gov/boarddocs/speeches/1999/19991019.htm.
5. See, for example, Hugo Dixon, Unlocking Europes
register that would cover the entire banking union area.
capital markets union, Centre for European Reform (Lon-
See the Decision of the ECB of 24 February 2014 on
don), October 2014.
the organisation of preparatory measures for the collec-
6. The phrase Ordnungspolitik, Policy of order in Ger-
tion of granular credit data by the European System of
man, is a familiar reference in European economic debates
Central Banks, https://www.ecb.europa.eu/ecb/legal/pdf/
to government action that focuses on setting the right
oj_jol_2014_104_r_0008_en_txt.pdf.
framework conditions for economic development, as
10. Separately, in order to move towards a more com-
opposed to the dirigiste approach of directly promoting
plete banking union, a specifi c European insolvency regime
or protecting individual economic actors, sectors, or in this
should be created for banks, at least the largest ones.
case, market segments.

7. See International Regulatory Strategy Group, Briefing
on the principles that should underpin the development
of a Capital Markets Union in Europe, City of London /
TheCityUK, 2014.
8. UK House of Lords, transcript of evidence taken
before the Select Committee on the European Union, SubCommittee A on Economic and Financial Affairs, September 9, 2014.
9. On a related theme, it is worth noting that the ECB
has taken steps towards the gradual formation of a credit
Editors note: The publisher and editor

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

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Derivatives: from
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risk for innovative
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Red star spangled
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a cause for concern
Fahrholz
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change impacts
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compliance and
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and corruption
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one step forward
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Umesh Kumar & Kevin
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risk managemen
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Challenging the
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Rocky road ahead
Tim Pagett & Ranjit
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Dr Philip Goeth
Rubiks Cube
impacts
l change
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co
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manage
products
potent
head of
details a kets.
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33
93
Moral hazard
Is the concept of moral hazard

a myth or economic reality?
Philip Pilkington and Macdara Dwyer question the validity of utilising moral hazard to
inform central banking and regulatory policy.
THE concept of moral hazard first began
to appear in the economics literature
in the 1960s and 1970s. It arose out of
the growing body of literature called
contract theory that was emerging in
economics, especially that surrounding
the work of Kenneth Arrow. A Google
Ngram search reveals that the term took
off in its modern form in 1975. By the
year 2000, the term was appearing in
published work nearly 15 times more
frequently than it was in 1975.
how the various agents will maximise their

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

the heading of what has become known in
economics as information asymmetry.A
leading textbook lays out the problem in
light of the following example: After an
owner of a firm hires a manager, the owner
may be unable to observe how much effort
the manager puts into the job The hidden
action case, also known as moral hazard, is
illustrated by the owners inability to observe
how hard his manager is working. (Green
et al 1995, p477)
What follows is typically a landslide of
complex mathematics, which tries to show
Insurance heritage
The term moral hazard has an older, but
more archaic sense, meaning outright fraud
or immorality bordering on criminality
(Dembe & Roden, 2000). Moral hazard
as a concept rather than a term began life
in the insurance industry in the middle of
the nineteenth century. It described behaviour arising from the unique relationship
between the insurer and the insured.
First described in The Practise of Fire
Underwriting (1865) as the danger proceeding from motives to destroy property by
fire, or permit its destruction, moral hazard
indicated the risky or negligent behaviour

engendered by individuals aware that
another party will pay the ultimate price for
recklessness. This origin/etymology had a
lasting influence on the concept and it was
used almost exclusively by this industry until
the twenty-first century.
Unwarranted use
That is not to say that moral hazard has
an actual definition in popular discourse
it would be more accurate to say that it is
understood as any behaviour by organisations or individuals in which future (invariably negative) consequences are borne by
other entities. This flexibility and broadness
has resulted in it being applied to a variety of
situations where empirical observation indicates it is unwarranted.
These are usually situations in which
a vested interest or an ideological mentality has used the term to argue for solutions
detrimental to their perceived goals.This is
apparent in the number of situations and
problems that the term has been applied to.
From the beginning it was freighted with
subjective moral connotations and wasused
by stakeholders to influence public attitudes
to insurance(Rowell & Connelly 2012).
Larry opines
More recently, it has been used by the health
insurance industry in the United States to
argue against radical alterations in US healthcare coverage or government intervention
in the market for private health insurance
(Gladwell 2005). Since the financial crisis of
2007-8, however, popular and media uses of
the term have massively increased
When the financial crisis of 2008 was just
96
emerging on the scene talk began to emerge

about moral hazard. Once of the first to
weigh in on the debate was Larry Summers
who argued against the importance of moral
hazard at that point (Summers 2007).
Summers was trying to justify the fact
that it was looking increasingly likely that
the US government and the Federal Reserve
would have to step in to pour money into
insolvent financial institutions. He said that
the risk of moral hazard was at least as bad,
if not worse, than the risk of not acting at all.
Summers never made the case, however,
that moral hazard had not been the main
precipitant of the crisis. Granted this would
have been a rather controversial position to
take at that particular moment in time but it
was also one that was in all likelihood true.
Savings & Loan scandal
The present crisis has quite famously not
provoked extensive legal investigation so
potential examples of cases that we might
scrutinise as falling under the category of
moral hazardare hard to come by. But we
do have extensive legal accounts of the savings and loan (S&L) crisis of the 1980s. In his
seminal work on the crisis, prosecutor and
economist William K. Black does not find
any strong evidence that any of the typical
channels of moral hazard played a large
role in the crisis.
Indeed, Black suggests it was Federal
deposit insurance that contributed to the
unpalatable events of the 1980s, which is
summed up in the following extract: S&L
control frauds generally relied on deposit
insurance to fund their Ponzi growth. Federal
deposit insurance was a key attraction to
opportunistic control frauds and the primary
reason they clustered in the S&L industry.

But that does not mean it was essential.
S&L control frauds were consistently able
to defraud uninsured private market actors.
ACC/Lincoln Savings was able to sell over
US$250 million in worthless junk bonds
the worst security in America primarily
from three branches in one state.
Import of control fraud
Following on, Black contends that:It is true
that Keating targeted widows because they
generally lacked financial sophistication, but
Keating also sold ACC stock to sophisticated
investors. He beat the shorts, and (worthless) ACC stock sold at a substantial share
price after five years of continuous fraud.
[Michael] Milken sold US$125 million of
(worthless) ACC junk bonds to (purportedly
ultrasophisticated) investors in 1984 (Black
2005, pp254-255 My emphasis).
Rather, what Black and other investigators found over and over again was that the
main culprit for allowing financial institutions to over-extend themselves was simple
accounting fraud. Large companies were
able to use their clout in both regulatory
circles and among the accounting agencies
to effectively cook the books. The CEOs of
these companies did not care a great deal
whether the companies would go insolvent or not because they were able to make
massive personal gains while running the
companies.
Key culprits
While deposit insurance certainly made it
easier for many companies to cook the books
during the savings and loan crisis, it was not
key to understanding the crisis. The key
culprits were regulatory capture and simple

accounting fraud while the motivations were
typically simple greed and an overarching
sense that even if the whole thing collapsed
ones personal wealth would remain intact.
In the recent crisis we saw a re-emergence of this dynamic in the acronym
that emerged out of the financial industry
IBGYBG which stood for Ill be gone,
youll be gone. No such similar acronym
has yet surfaced that indicated that actors
were thinking in terms of:If trouble occurs,
the authorities will bail us out.
In the US in the 19th century we see
banking crises every decade or so. Indeed,
we can count in this era at least seven major
panics: 1819, 1837, 1857, 1873, 1884, 1893
and 1896. As the careful reader will note,
these crises increased in frequency in the
later part of the 19th century as the financial
system became more developed.
Homo speculatis
A further two crises took place in the early
19th century in 1901 and 1907, the latter of
which led to the founding of the Federal
Reserve in 1913. Now, during the 19th century there was not much risk of what would
today be called moral hazard. If a bank
failed it was allowed to go under. Those that
held a stake in the bank and also often
those that held savings deposits at the failed
bank would be allowed to go bankrupt.Yet
despite this fact these crises occurred with
increasing intensity every few years.
The fact is that the moral hazard argument has it all wrong. It implicitly rests on
a view of man as a homo economicus, a
rational agent who learns from his mistakes, rather than the homo speculatis that
97
he actually is. People are extremely prone

to herd behaviour, especially in the financial markets, as the great economic historian Charles Kindleberger noted well
(Kindleberger 2005). Allowing institutions
to go under does not result in some sort of
evolutionary process in which the bad elements are weeded out and the good allowed
to prosper.
sovereign debt crisis in the Eurozone started

to boil over the moral hazard was adopted
by those that opposed bailouts.They claimed
that backstopping a countrys sovereign debt
would incentivise them to engage in reckless
borrowing practices.
The irony is, of course, that countries like
Ireland and Spain had been running fiscal surpluses before the crisis and it was the
banks that led to the deficits and public debt
Bad banker meme
build-ups. It was precisely because there
The sad fact of the matter is that the com- was no central bank standing behind their
petitive market does not self-regulate; rather private banks that huge amounts of pubit simply has a tendency to go haywire every lic debt had to be issued to backstop these
now and then. The moral hazard argument banks. Some pointed to Greece which had
is one only put forward by people who, at been running fiscal deficits prior to the crisis
some level, believe that in the long-run (Gerson 2012).
financial markets are somewhat efficient.
During the financial crisis a commenta- More conspiracy than fact
tor or interested observer was either against Few enquired whether these deficits were
the banks or they were likely in some way structural and largely caused by the actual
tied to the banks.The hostility to the industry setup of the Eurozone system and instead
transcended political divisions and was basi- many commentators and politicians leapt
cally a consensus opinion.
on the moral hazard argument. A sort of
The same was the case with the moral conspiracy theory was generated that said
hazard argument. Because it became that the Greeks had basically concocted a
basically synonymous with the bad scheme to game the system and if they were
bankernarrative adopted by all sides few bailed out they would only repeat the grift.
questioned it. But when examined in any
Looked at from any reasonable point
detail it becomes clear that it was always a of view, however, the moral hazard arguthoroughly free market and anti-regulatory ment is either an abstraction that does not
argument.
adequately explain real world motivation
again, there are no documented cases of
Sovereign debt crisis
those in charge of large institutions actually
Those that had deployed it on the left, and acting in this manner or it is something
those who believed that the government bordering on conspiracy theory where it
has a role to play in regulating the economy is imagined that government officials and
more generally, quickly found their chickens bankers conspire to defraud whomever is
coming home to roost when the argument above them without any evidence of this
began to be used to justify austerity. As the conspiracy ever being discovered.
98
In terms of public finance, good macroeconomic theory tells us that government

deficits especially large government deficits are mostly endogenous; that is, they
are generated by large-scale macroeconomic
shocks that cause tax revenue to decline
and unemployment compensation to rise.
Indeed, there is good reason to think that this
stabilises the economy and prevents it from
falling into an almost bottomless depression
(Godley & Lavoie 2006).
Popular lexicon
Government deficits are rarely opened up by
the choice of irresponsible politicians outside
of war or social upheaval. Again, the onus
should be on those making the moral hazard argument with respect to public finances
to give examples to the contrary. Otherwise
we must assume that this is not a serious
explanation and is likely just a cover for an
underlying politically motivated argument.
The way thatmoral hazardhas entered
the common lexicon is a perfect good case
study in the transference of pseudo-technical, morally-loaded terminology to common
consciousness. It is also a good case study of
the way such terms, imbued with moralistic
meaning can be utilised to justify or prevent
a variety of strategies that threaten particular
interests.
Linguistic gymnastics
The representational gymnastics of the term
moral hazard is equally apparent within
a very narrow timeframe, namely, from the
period 2004-2014. It began it from a warning
against universal health-care coverage (visible in post-Katrina handwringing over purportedly excessive relief funds). Since then,
the phrase has shifted and was absorbed by

left-liberal opinion during the financial crisis
as a way of traducing the alleged immorality
(and implied illegality) of the banking industry and its members. It gained its greatest
exposure through this channel.
These commentators, at loss for an explanation, but desirous of scapegoats, transformed the insurance and health lobbies
dismal belief in reckless individual behaviour
and applied it to an industry held to blame for
the series of complex economic and financial decisions of an aggregate of millions of
individual policy-makers, lenders, borrowers, agents and auxiliary service workers. The
degree to which this simplistic and easily
assimilated narrative has saturated popular
understanding of the ongoing financial crisis
should not be underestimated.
Popularised on the silver screen
Take this exchange from a popular sequel to
an earlier movie about Wall Streets excesses
called Wall Street: Money Never Sleeps
both of which are what would have been
called in times past morality plays; that is a
genre of Tudor plays that served to instruct
the public about the evils of society and how
to overcome them. The principal bankers
of New York in a dramatised (but thinlyveiled) depiction of the Lehman Brothers
collapse gather to discuss the potential
ramifications and possible strategies for the
insolvency of a fictional investment bank,
Keller Zabel Investments. A federal bail-out
is proposed. The dialogue runs as follows:
Bretton James (interjecting): What about
moral hazard, Jack? We bail out Keller Zabel,
whos to say its not going to happen again
and again?
99
Louis Zabel:You vindictive bastard! Who

are you to talk about moral hazard?
Bretton James: Sorry Lou, the Street
needs to make a statement here to the
world.
Totemic expression
In the film, it is made clear thatKeller Zabel
reached such dire circumstances through
incompetence, herd mentality and confusion rather than through self-assurance that
government agencies or other financial institutions would automatically assist in case of
difficulty or default. But such complex and
morally ambiguous realities did not accord
with public and journalistic appetites during
and after 2008.
So, the media turned a moralistic and
loaded concept previously utilised by specific vested interests in order to appeal to a
public desirous of simplistic moral tales
and applied it to the financial institutions.
However, this usage, once out of the bag,
became a totemic expression that might be
used to banish any innovative or undesirable policy alteration by appealing to the
ingrained moral determinism created by its
initial use. The short-sightedness of those
who began its use must be clear in this
regard.
Further risks
Today it is used ad nauseam to make the
case that any country or institution which
requires funding in order to prevent economic collapse or depression will only end
up taking advantage of such well-meaning
intervention.
And it is thus that the term becomes
the key argument in favour of the policies
100
of economic depression and stagnation that

we see across the world today.
The widespread use of the term also raises
another important risk: if the major economies were to experience another banking
crisis in the next few years would the term be
used to ensure that governments and central
banks did not intervene? In such a situation
we would likely see a wave of bank failures
as we did in the US in the period 1929-1933
as the economy plunged into the depths of
depression.
In their justified moral outrage there is
every chance that the public might demand
policy action that would ultimately serve to
do ruinous damage to the economy and to
their own employment prospects.
Politically motivated
The fact is that the moral hazard argument is
a politically motivated one. Not only does it
cloud our judgement when trying to understand the real dynamics of what happened
in the run-up to the 2008 financial crisis,
but it also furnishes ready-made artillery
for those who want to engage in Scorched
Eartheconomic policies that will only lead to
ruin for the countries that implement them.
People engaged in such debates should
think long and hard about using such terms
opportunistically lest they give rise to forces
that they would otherwise want to keep
under control.
.Editors note: The publisher and editor of
the Journal of Regulation & Risk - North Asia
would like to thank Macdara Dwyer, the
Journals associate UK editor, for his cooperation with Philip Pilkington in assisting with
the research and writing of this paper.
Policy brief bank bail-ins
Why bail-in securities should

be considered fools gold
Avinash D. Persaud of the Peterson Institute
cautions against investors and regulators
treatingbail-insecurities as a panacea.
BAILOUTS and bail-ins of failing
financial institutions have been hotly
disputed in the global financial crisis of
the last five years. At the height of the
crisis, several failing banks were bailed
out with taxpayer money so they could
service their debts, but as public outrage
mounts, policymakers are increasingly
looking at bailing in these institutions
before using taxpayer funds.
Bail-ins, also called haircuts, require the
troubled institutions creditors to write off
some of the debt or agree to a restructuring
of the debt, which reduces their holdings.
The public has demanded the imposition
of these costs on creditors and bondholders, arguing that if bad lending as well as bad
borrowing went unpunished it would be
encouraged. Additionally, the yawning fiscal
deficits that have followed bailouts have led
to unpopular fiscal retrenchment.
Consequently, eliminating bailouts has
become a political imperative on both sides
of the Atlantic. The clear intention of the
Dodd-Frank Act (2010) in the US was to
end taxpayer bailouts through more bail-ins.
The European Unions Bank Recovery and

Resolution Directive (BRRD), which came in
to force in January this year, requires creditor
bail-in before public funds can be accessed.
Bail-ins and creditor haircuts have long
been a feature of resolutions and recapitalisations when banks have become, or
are on the verge of becoming, gone concerns. This time the public outcry against
bailouts has also led to the development of
something new the automatic bail-in of
creditors of institutions that are still going
concerns. This mechanism and its attendant
instruments are the focus of the remainder
of this paper.
The Financial Stability Board and national
regulators among them the US Federal
Reserve Board and the European Central
Bank (ECB) are formalising rules requiring the 30 globally systemically important
banks (GSIBs) to hold an additional layer of
capital. Estimates range from 4 to 7 per cent
of risk-weighted capital or approximately
US$1.2 trillion globally or US$250 billion in
the US and more in Europe. A banks losses
would be met by this additional buffer first
before the minimum capital adequacy level
is touched. To put the size of this new buffer

into context, between 2009 and 2012, the 16
largest US banks raised just US$24 billion of
new equity capital and the 35 largest banks
in Europe raised only US$23 billion. But the
proposal is that this additional layer of capital
need not be in the form of equity or retained
earnings.
A political trade-off
We may be witnessing a political tradeoff where bankers give in to the substantially higher overall capital requirements
demanded by politicians if part of this additional capital is in instruments that, compared with issuing more equity, are cheaper
and do not dilute the bankers control and
pay in the good times. These bail-in securities, commonly known as cocos, convert into
equity once a banks capital falls below a preannounced level.
Even before the ink is dry on these proposals, banks have started to issue cocos and
the market has quickly grown to a capitalisation of US$150 billion. The case for bail-in
securities is that bailouts create moral hazard, i.e., they encourage reckless lending by
banks in the secure knowledge of a rescue if
desperate times ensued. Bailouts also allow
depositors, creditors, and investors to relax
their monitoring of banks knowing that
taxpayers will foot the bill if things fall apart.
Many see both behaviours as critical in perpetuating boom-bust cycles.
Idiosyncratic bank failures
In fixed exchange rate regimes, such as the
eurozone, there is the added potential of a
doom-loop, where increased public debts
and sovereign credit downgrades undermine
102
the remaining healthy banks that hold many

of their assets in government securities.
Higher public debts in Europe and elsewhere, as a result of bailouts, have also led to
cuts in safety nets to the most vulnerable and
in public investment.
The case of moral hazard may be overstated. An important element of financial
crisis is commonly considered safe assets,
like housing, becoming risky, not starting off
as risky, but the focus of this paper is on how
these new bail-in instruments fare when
clouds first appear on the horizon.
Bail-in securities may make sense for
an idiosyncratic bank failure like the 1995
collapse of Baring Brothers, which was the
result of a single rogue trader. But they do
not make sense in the more common and
intractable case where many banks get into
trouble at roughly the same time as the
assets they own go bad.
Fools gold is no alternative
On such occasions these securities, which
may also have encouraged excessive lending,
either will inappropriately shift the burden of
bank resolution on to ordinary pensioners
or, if held by others, will bring forward and
spread a crisis. Either way they will probably
end up costing taxpayers no less and maybe
more. In this regard, fools gold is an apt
description. Fools gold has a metallic lustre that gives it a superficial resemblance to
gold. However, it is an iron sulphide, one of
the ancient uses of which was to spark fires.
Either we need real gold more equity
capital or not. Fools gold is no alternative!
Banks are required to hold a minimum
amount of capital assets able to absorb a
loss. They generally cant meet permanent
losses by borrowing, for instance, because it

would need to have the resources to repay
those loans with interest. Bank capital is primarily made up of retained earnings and the
sale of equity held in near-cash instruments.
What is safe, what is risky
The minimum amount of capital held by
internationally important banks is set under
the Basel Accord and is a ratio of the banks
risk-weighted assets. The idea is that the
riskier the assets the more capital banks
need to hold. The 30 GSIBs hold approximately US$47 trillion of assets, US$18 trillion
of risk-weighted assets, and US$2.5 trillion
of capital. Many issues surround this framework, such as the assessment of what is safe
and risky and what requires social insurance,
but further discussion of these is outside the
scope of this paper.
When a going concerns capital falls
below a preannounced ratio of its riskweighted assets, bail-in securities automatically convert into more equity to absorb the
concerns losses. Cocos are bonds that pay
a coupon in good times and convert into
equity that could be lost completely without any recourse in bad times. This new
equity injection automatically dilutes existing shareholders. The range of instruments
that have a similar effect goes beyond cocos
and includes other hybrids (financial instruments bearing characteristics of both debt
and equity) or wipeout bonds.
Trigger level
One of the critical issues for cocos and similar
instruments is the point at which they automatically convert from debt-like to equity
(i.e., the trigger level). Too low a trigger and
in effect the instrument converts directly into

a loss. Too high a number and it may give
the false impression that the bank is about to
topple over. Banks fear the latter more than
the former.
In periods of financial stress, financial
markets quickly become febrile rumour
mills where expectations right or wrong
become self-fulfilling. If a banks counterparties are reluctant to extend short-term
advances it is quickly done for. Most of the
early cocos had low trigger levels. To offset
the tendency to set trigger levels too low,
some newer instruments have dual triggers,
with the first trigger leading not to conversion but suspension of the coupon payment.
Exponential growth
Although the picture is still emerging, it
appears that regulators at the Financial
Stability Board are progressing towards an
international agreement that by 2019 the
30 GSIBs should carry total loss absorbing
capital (TLAC) of around 16 to 20 per cent
of risk-weighted assets, but when factoring
in other buffers this will effectively be 21 to
25 per cent.
Critically, only part of that will need to
be in the form of equity or retained earnings.
The rest will be in the form of bail-in securities, because for a banker issuing equity is
more expensive than debt. The 30 GSIBs
would require over US$1 trillion of new bailin securities.
The market for bail-in securities has
already grown from virtually nothing in 2010
to a cumulative issuance of approximately
US$150 billion towards the end of 2014,
despite the fundamental uncertainty about
regulations regarding the amount of capital
103
required and the features of eligible bail-in

securities.
Dash for cocos
This growth is perhaps a testament to the
hunger for assets and yield in the marketplace today. Credit Agricoles coco issued in
February 2014, which offered a 7.8 per cent
coupon, generated US$25 billion of orders
chasing a US$1.75 billion issue. Since then
the Credit Suisse index of coco yields has
fallen to 6 per cent.
The trend line is straight, where each
year more cocos are being issued than in the
previous, suggesting that a target of US$1.2
trillion may be possible if raised over several years, though the proposed 2019 target
is tight. By the end of 2014, still ahead of
formal agreement on what constitutes an
eligible bail-in security, an estimated US$85
billion worth of cocos will have been issued.
Recent issuers include Banco Bilbao
Vizcaya Argentaria, Barclays, UBS, Crdit
Agricole, SNS Reaal, Socit Gnrale, and
KBC Bank. Deutsche Bank and HSBC are
reportedly debating issues on the order of
US$6 billion. Approximately 80 per cent of
the issuance has been from European banks
(including those headquartered in the UK
and Switzerland).
Regulators ire
In the absence of the scrutiny that will
come when one of these instruments is
converted, there is little information on
who is buying. Early indications suggest it
is investors focused on short-term gains,
namely retail investors, private banks, and
hedge funds, not the buyers regulators want.
Regulators are particularly keen that banks
104
not hold cocos. The banking system is more

systemicthan almost any other because of
its unusual degree of interconnectivity: One
banks loan is anothers deposit.
If banks held the bail-in securities of other
banks, trouble at one bank would instantly
spread to other banks. Interconnectivity
would be reinforced, not dispersed. This
interconnectivity would also exist if the
holders received a significant amount of
their funding from banks, such as leveraged
special investment vehicles, hedge funds, or
private equity firms.
Regulators say that they want long-term
holders of these instruments. It is likely
that they will propose that in order to count
towards TLAC, a bail-in security must have
a maturity of at least 12 months, possibly
longer, with a view to attracting long-term
investors to own these assets. Banks have
followed suit and many of the issued bonds
have maturities of 5 to 10 years.
Asset concentration
Long-term holders are primarily pension
funds and life insurance companies as they
have the long-term liabilities. Many throw
sovereign wealth funds into the mix; they
did step up to the table in 2007 and 2008 in a
few high-profile bank capital raisings.
However, once defined as funds that are
not backed with short-term liabilities like
foreign exchange reserves, they are not as
large in aggregate as many think. Cumulative
assets are not much more than US$6 trillion. Pension fund assets in advanced countries are close to US$22 trillion. While this
appears to dwarf the potential size of the
bail-in security market, most of these assets
are concentrated in the three countries that
rely on private rather than public pension

provision (US, UK, and the Netherlands)
and where a fair portion of the assets are in
annuity programmes with little capacity for
investment risk.
UKs FCA intervention
In countries such as Germany, France, Italy,
Spain, Belgium, and Portugal, there is a
severe mismatch between the proportion of
risk-weighted assets of banks and the proportion of pension assets held there.
There are other, major problems with
pushing these instruments on to pension
funds and life insurance firms. A key danger
is that taxpayers would be saved by pushing
pensioners under the bus. If a crisis has not
been prevented, it is unlikely that the direct
and indirect consequences of delivering a
loss to pensioners are lower, and more fairly
distributed, than giving taxpayers a future
liability. The opposite is far more likely to be
the case.
Indeed, it is interesting that in 2014 the
UKs new Financial Conduct Authority
(FCA) used its consumer protection powers for the first time in suspending the sale
of cocos to retail investors on the grounds
that the instruments were highly complex
andunlikely to be appropriate for the mass
retail market. The authority also stated that
there is growing concern that even professional investors may struggle to evaluate and
price cocos properly.
Taxpayers on the hook again!
If pension funds suffered losses on cocos,
taxpayers would very likely be pressurised
into bailing them out. Given the greater
fragmentation of the savings markets such
a bailout will probably be even more complicated, messy, and politically sensitive than
bailing out a handful of banking institutions.
Another problem is that from an investment and economic perspective these are
the wrong type of instruments for pensioners and life insurers to own. Financial instruments offer returns above the risk-free rate
as compensation for different risks.
The principal investment risks are credit,
liquidity, and market risks. They are identifiably separate types of risks because each
must be hedged differently. Distinct investors, courtesy of their unique liabilities, have
innate abilities to hedge certain risks and
natural inabilities to hedge others.
Market reluctance to buy
The right economic and investment strategy
for an investor is to hold those risks for which
they have a natural ability to hedge and to rid
themselves of risks that they cannot hedge.
That strategy will lead pension funds and
life insurance companies away from bail-in
securities, unless the authorities attract them
in some other way. It also suggests that their
current reluctance to buy them is deliberate
and not a result of unfamiliarity.
Liquidity risk is the risk that if one has
to sell an asset tomorrow it will fetch a far
lower price than if one could afford the time
to wait to find the particular buyer. To hedge
liquidity risks one must have time to wait
perhaps through long-term funding or the
long-term liabilities that pension funds and
life insurance companies have.
But having time does not help to hedge
credit risks. The longer a credit risk is held
the more time there is for it to blow up.
Being required to hold a General Motors
105
bond for one day carries little risk. Being

required to hold it for 25 years carries significantly greater risk.
Choosing the right instrument
Credit risk is best hedged by diversifying across a wide range of credit risks and
actively managing the spread of risk in the
way that a bank or a credit hedge fund can
do far more easily than a traditional pension
fund.
The right instruments for institutions
with long-term liabilities, like pension funds
and life insurance, are instruments offering a
higher return because they are illiquid rather
than because they carry substantial credit
risk.
Examples of these instruments include
infrastructure bonds (especially where there
are guarantees or hedges on the construction risk and market risk), asset-backed
securities, and real estate development the
exact type of assets they have historically
purchased.
From a private investment perspective,
bail-in securities are best held by investors
able to diversify and monitor a wide range
of liquid credit risks, such as hedge funds. It
should be no surprise that they appear to be
the ones currently buying them.
Encouraging pension funds and life
insurance companies to follow would not be
in their best interests.
Regulatory interference
If, in a liquidity crisis, the price of a credit
instrument falls sharply not because it is no
longer performing but because the market is
so spooked by a background of turmoil that
there is no liquidity in the asset class then
106
it makes sense for institutions who can

comfortably own liquidity risk, like pension
funds and life insurance companies, to buy
them at that point. They should then keep
them until their price has recovered and the
greater part of their future return no longer
reflects a liquidity risk but a credit risk.
Allowing pension funds and insurance
companies to do that not only makes good
sense for them they are earning a return
for taking a risk they have a natural ability to
hedge but it also makes for a more resilient financial system. Life insurance companies complain that regulators of savings
institutions make it hard for them to do that
through regulatory requirements to hold
certain assets, mark their assets to market
prices, and adhere to short-term measures
of solvency.
Passing the regulatory buck
It would also be hard usually for internal
reasons for them to buy bail-in securities
when they are cheap if they had previously
owned them at a time when they were
expensive. If they had bought bail-in securities during the good times and suffered
an unanticipated loss later, regulatory and
internal pressures (investment losses tend to
trigger regret rather than a desire to find bargains) would conspire to reduce their appetite to purchase the better valued of these
instruments just when the market most
needs buyers and differentiation.
The regulation of long-term savings
institutions is a subject for another paper,
though I will make the observation here
that bank regulators appear to be putting
the safety of banks into the hands of a different part of the financial sector long-term
savings institutions not regulated by them

and without much coordination with that
sectors regulator.
Heterogeneous resilience
But there is an important point here on systemic resilience that will further inform this
discussion on what kind of instruments and
behaviour would reduce the scale of financial crises and the attendant need for taxpayer support.
Financial sector liquidity is about diversity not size. A market with only two players,
where one player wants to buy whenever
the other wants to sell, perhaps because one
has short-term liabilities and focus and the
other long-term liabilities and focus, is more
liquid than one with a thousand players
who, because they all use the same model
of value and risk, want to buy or sell assets at
the same time.
Homogeneity of behaviour is the route
to liquidity crises. Heterogeneity creates
resilience. To limit the economic disruption
and costs of a financial crisis the forces of
homogenous behaviour must be tempered
and the sources of heterogeneity encouraged. Observers of economic or financial
cycles would recognise this as the need for
instruments or investment behaviour that
counters the procyclicality of finance.
Liquidity test failure
A simple test of whether a new policy or
instrument will help deal with a liquidity crisis is whether it will moderate the collective
enthusiasm to buy assets during a boom or
the crowd mania to sell them during a crisis.
The dynamics of financial markets suggest that bail-in securities will fail this test.
Short-term investors, such as hedge funds,

who buy these instruments do so today and
will do so in the future because they see no
near-term risk of a bail-in. Their investment
philosophy will be that in the long run you
need to be out or you are dead.
The longer their belief that short-term
risks are low is validated, the more confident
they will get and the more they will want to
own these instruments, sending their yields
lower. The more these yields fall, the more
the banks will be encouraged to issue more
of these securities, enabling them to lend
more.
Temper bank behaviour
Incidentally, because they are short-term in
focus they will not, as it was hoped of holders of these instruments, invest in monitoring long-term developments and emerging
concentrations of risk. They will assume that
they are not holding these instruments long
enough for it to matter to them and anyway
someone else is doing that. It is therefore
unlikely that these instruments would temper bank lending prior to a crash.
If prior to the global financial crisis we
had a going concern, total loss absorbing
capital limit of 25 per cent of risk weighted
assets, and half of that capital was in bail-in
securities, banks may have had even more
assets on their books not less.
Confidence in financial markets generally comes in only two flavours: high or low.
In the US, over the past 15 years, the Federal
Deposit Insurance Corporation (FDIC) has
closed 532 banks an average of 35 each
year. Yet, in 2003, only three banks were
closed and in 2004 four. None were closed
in 2005 and 2006.
107
During the four years before the global

financial crisis, when confidence was riding high, the yields on subprime mortgages
were low, falling within 1.0 per cent of AAA
corporate bonds in 2004. It wasnt just
short-term financial participants who were
overconfident.
Historic lessons
Prior to 2007, Financial Stability Reviews at
central banks regularly supported the notion
that the new risk management techniques
and bumper estimates of bank capital suggested banks had never been so safe and the
search for systemic risk was concentrated
elsewhere.
It is contrary to the lessons of history to
suppose that if bail-in securities were around
then, their yields would have constrained
banks from issuing more and lending more.
Even today, when the economy is far from
free of the clutches of the global financial crisis, bail-in yields at close to 6.0 per cent are
below long-run average equity returns.
When an event changes perceptions of
risk, short-term investors in these bail-in
securities will trample over each other to
reach the exit before bail-in. These investors are not interested in hanging on, not just
for reasons of potential losses but because
a bail-in is not an eventuality they have the
institutional capacity to manage.
Contagious mechanisms
Funds that trade in liquid debt securities cannot easily become owners of illiquid bank equity. As they form a disorderly
queue at the exit, the price of these securities
will collapse, triggering a series of contagious
mechanisms.
108
We have seen these before, notably

in the Asian financial crisis between 1997
and 1999, during the first, credit derivative
phase of the global financial crisis between
2007 and 2008, and to some extent during the October 1998 Long-Term Capital
Management (LTCM) crisis.
Faced with collapsing prices, and declining confidence, the rating agencies will
downgrade bail-in securities. More stoical
holders of bail-in securities who had resisted
the urge to sell in the first wave will now be
forced to sell as a result of investment mandates limiting the holdings of low-rated
instruments. If the size of the market were
US$1.2 trillion then it would be significant
enough.
However, there will be wider knock-on
effects where these instruments are being
used as collateral for other instruments or
where their prices are used to price other, less
liquid, assets. Hedge fund clients will bolt for
the exit, forcing hedge funds to raise liquidity
by selling otherwise unconnected assets.
Bail-ins may exacerbate crisis
These indirect effects will give an impression that strong, hidden undercurrents are
driving financial markets, which will cause
aggregate uncertainty to rise, triggering a
general risk aversion and further liquidation
of assets. There are many avenues through
which the correlation of asset prices tends
towards 1 during a period of stress.
Collapsing asset prices will undermine
the position of banks. Bail-in securities will
bring forward and spread a crisis, not snuff it
out. As recently as February 2013, long after
policymakers had insisted that the time for
bailouts was over, the Dutch government
decided to nationalise SNS Reaal and spend

US$5 billion paying off senior creditors, protecting depositors in full, and cleaning up
the bank. The Dutch finance minister said
that this was necessary because not doing
so would have posed a serious and immediate threatto the stability of the financial
system.
Loss expectations
A similar approach was taken in August
2014 in the rescue of the Portuguese Banco
Espirito Santo, even though there was a
good case to let it fail due to the unusual and
precarious situation the bank was put in by
its controlling shareholders.
Supporters of cocos argue that Europe
required only another 150 billion of capital
to offset bank losses, and bail-ins of this large
but manageable sum would not be destabilising. This is how it might look long after the
embers of a financial crisis have cooled. But
in the middle of a crisis, when bail-ins would
be triggered, speculation of potential losses is
many times greater than the realised losses
once the system has been stabilised.
At the time of Lehmans default it was
widely reported in the press that losses could
range from US$270 billion to US$360 billion,
as it was feared that many counterparties
would not honour their side of derivative
contracts. When the dust settles, counterparties survive, and the administrator and
lawyers have done their chasing, the net
payout will be just US$6 billion.
Difficult to adjust market dynamics
It would be wrong to conclude that all
would have been fine if only there were
another US$6 billion of capital. Bailouts risk
encouraging reckless bankers and creditors and depositors who take their eyes off
the ball. The global financial crisis has also
powerfully illustrated how the socialisation
of risks can hobble policymakers from fully
responding to the economic consequences
of a financial crisis and can have seriously
adverse distributional consequences.
But the market dynamics that deliver
financial crises cannot easily be adjusted to
deliver bank resolutions that are free from
recourse to taxpayers or severely adverse
economic consequences.
Credit economies are founded on confidence and there are no easy market mechanisms to recover from the disruption of that
confidence. Bail-in securities will help to
address idiosyncratic bank failures where the
circumstances are unique to one institution,
confidence in the system is not at risk, and
the scope for contagion is limited.
Bank resolution
But authorities are already quite good at
resolving these individual gone concerns,
often with the help of some creditor bail-in
or haircut. In the US, the FDIC has been
doing so routinely and quite effectively for
decades. In the UK, the oft-quoted example
is the tidy wind up by the Bank of England
of Barings Bank in 1995 after Nick Leesons
trading bets on the Nikkei 225 futures rid the
bank of all its capital.
The circumstances that the authorities
are much less good at resolving are those
where many banks run into trouble around
the same time. It is in these situations that
bail-in securities are likely to make matters
worse not better.
Regulators envisage bail-in securities will
109
be bought and held by long-term investors

like pension funds or life insurance companies. But these are the wrong kinds of
assets for investors with long-term liabilities.
Regulators should know better.
Import of credit risk
Pension funds and insurance companies
need assets that provide higher yields as
compensation for liquidity risk not credit
risk. Credit risk, like that embedded in bailin securities, is a risk that rises with time and
is best held by investors with access to a wide
range of credit risks that they actively diversify and manage over the short term and not
by investors who buy and hold for a long
time.
If regulators prohibit banks and retail
investors from holding these instruments
they will be held by short-term, leveraged
investors like hedge funds. This appears to
be what is already happening with institutional investors staying away and hedge
funds chasing the extra basis points.
But if hedge funds own a US$1 trillion
plus bank bail-in securities market, it will
likely lead to a crisis being brought forward
and spreading. A test of whether a new
policy or instrument will help deal with a
liquidity crisis is whether it will moderate
the collective enthusiasm to buy assets during the prior boom or to sell them during the
subsequent crisis. Bail-in securities held by
hedge funds or other short-term, leveraged
institutions would fail this test.
Bail-in securities no panacea
During the boom years when short-term
risks appear low and this assessment is
repeatedly validated over short periods of
110
time, these investors will demand more

bail-in securities, driving down their yield,
encouraging their issuance, and enabling
banks to expand their balance sheets and
loan portfolios.
Short-term investors, aware that they are
not in a position to be converted into a longterm equity investor, will try to preempt any
change in the environment that suggests
what was previously safe is no longer so.
When a few read signs of trouble ahead
and start to exit, others will quickly follow.
There will be a herding and self-feeding
effect across the asset class, putting scrutiny on good and bad banks alike as yields
on cocos rocket across the board and rating
agencies follow, with widespread downgrades of the securities.
The full gamut of the alternatives to bailin securities to mend the banks, revive the
economy, and limit the cost to taxpayers, is
outside the scope of this paper.
My remit here is to show that bail-in
securities are not the silver bullet. In practice, they will likely make matters worse. If
more gold plating of bank capital is what is
required, then this fools gold will not do.
Editors note: The publisher of the Journal
would like to thank Avinash D. Persaud,
non-resident senior fellow at the Peterson
Institute for International Economics and
emeritus professor at Gresham College, UK
and the Peterson Institute itself for allowing
the Journal to re-print an abridged version of
this Policy Brief, which was first published
in November, 2014. The original full document can be accessed at the following link:
http://www.iie.com/publications/interstitial.
cfm?ResearchID=2706
Banking union
After AQR & stress tests, where

next for EU-banking?
Much more needs to be done if the nascent
EU banking union is to escape the notion its
half-bakedargues Casss Thorsten Beck.
THE ECB published the results of its
asset quality review and stress tests of
Eurozone banks on the 26 October, 2014.
This paper argues that, while this process
had clear shortcomings, it still constitutes
a huge improvement over the three previous exercises in the European Union.
Nevertheless, the banking union is far
from complete, and the biggest risk now
is complacency by all parties involved in
this process. A long-term reform agenda
awaits Europe.
The European Central Bank (ECB) in the
final quarter of 2014 published the results
of a year-long painstaking process to go
through the books of the 130 largest and
most important banks of the Eurozone,
adjusting balance sheets and testing the sensitivity of their capital position to two different scenarios, one of which includes a severe
economic downturn.
This exercise constitutes the entry point
to the Single Supervisory Mechanism, where
the European Central Bank has direct supervisory responsibility for most of these 130
banks and indirect responsibility for the rest
of the banks in countries that are members

of the Single Supervisory Mechanism.
There is a lot to be said and criticised
about the asset quality review (AQR) and
stress tests, but it certainly constitutes a
huge improvement over the three previous exercises in the EU, particularly the
fact that this assessment was a top-down
approach driven and monitored by the
ECB that focused on creating a level playing field in asset valuation and stress testing
across banks in the Eurozone. And, that by
combining the asset quality review with the
stress tests it increased the transparency and
reliability of the stress tests.
Shortcomings
However, there are also clear shortcomings,
the most important of these being that the
stress test still does not include the scenario
of a sovereign default; it does not include the
adverse scenario of deflation, an issue that
was less of a concern when the stress test
scenario was developed earlier this year;.
And, finally, It focuses exclusively on the
risk-weighted capitalasset ratio and not on
the leverage ratio. For instance, 14 of the 130
banks before the asset quality review, and 17

banks after, are below the 3 per cent leverage
ratio, and that does not take into account yet
the effect of the stress tests themselves.
Glaring discrepancies
The results provide interesting insights into
the shortcomings of national supervision,
as the asset quality review has revealed
glaring discrepancies in asset classification.
For example, more than 20 per cent of the
reviewed debtors were reclassified as nonperforming in Greece, Malta, and Estonia,
and even 32 per cent in Slovenia. In the case
of one bank, that share even amounted to 43
per cent.
This suggests a high degree of regulatory
forbearance. These discrepancies between
published balance sheets and adjusted
numbers presented in the ECB clearly point
to the consistency advantages of supranational supervision.
Overall, the comprehensive assessment
identified a capital shortfall of 24.6 billion
across 25 participating banks after comparing the projected solvency ratios under
the adverse stress test scenario against the
threshold of 5.5 per cent tier 1 capital relative
to risk-weighted assets.
Capital raising
Taking into account capital raisings during
2014, only 13 banks still face a net capital
shortfall of a total of 9.5billion, a rather small
number. Among these 13 banks, four are in
Italy, three in Greece, two in Slovenia, one in
Portugal, one in Austria, one in Ireland, and
one in Belgium thus a certain concentration in crisis countries.
The number of banks with (net) capital
112
shortfalls seems exactly what the doctor prescribed not too low, so that the test would
be considered rigorous enough, not too high,
in order to not shake the market.
As recognised by the ECB itself, this is just
a starting point into the Single Supervisory
Mechanism; as capital requirements become
tighter, additional capital shortfalls might
appear.
The initial reaction seems to indicate
that the ECB has achieved two of the objectives of the exercise: transparency and confidence building. The third objective repair
of banksbalance sheets where necessary is
still a work in progress.
Where next?
While this seems a good starting point for
the first pillar of the banking union, it again
lays open the limitations of the second and
third pillars. The 13 banks that have net capital shortfalls have a nine month window to
come up with recapitalisation/restructuring
plans.
While the ECB is involved as supervisor, it is not in itself a resolution authority a
responsibility still at the national level. The
Single Resolution Mechanism only comes
into force in 2016, and even then it is not an
effective supranational mechanism like the
Single Supervisory Mechanism, but rather
the result of a compromise, a mix of national
and supranational frameworks.
A third pillar, a joint deposit insurance
funding scheme has been quietly dropped.
The evolution of the Eurozone crisis over
the past five years, on the other hand, provides sufficient arguments for a fully fledged
banking union. This is best summed up by
the two glaring examples of Cyprus and
Portugal. Cyprus demonstrates clearly that a

deposit insurance scheme is only as good as
the sovereign backing it. The banking union
in its current form does not address this.
Half-baked banking union
Meanwhile, the recent failure of the
Portuguese Banco Espirito Santo in the final
quarter of 2014 demonstrates the limitations of effective resolution in fiscally weak
countries.
Ultimately, the Portuguese government
had to rely on Troika funding to resolve the
bank, in light of the precarious fiscal position
of the Portuguese government.
So, where does all this leave us? There
are two ways to look at the current situation,
corresponding to the glass-half full and glass
half-empty attitudes. On the one hand, the
fact that some basic elements of a European
financial safety net have been put in place is
a great success.
On the other hand, this compromise is
far from the financial safety net that an integrated European banking market would
need and a half-baked banking union
might actually backfire, as some observers
have pointed out (Schoenmaker 2012).
A lot has been accomplished though,
such as, a single supervisor that can internalise cross-border externalities. Matching
the perimeter of banks with the regulatory perimeter can reduce distortions in the
supervisory process.
Big step for Europe
And given the risk of political capture of regulators that we could observe across Europe
(both in the core and periphery), this is also
progress. Given how politically sensitive
banking has been across the European

Union, this is indeed a big step for the
Eurozone.
Further, bank resolution frameworks
across Europe are being strengthened, on
the national level, but also with the bail-in
clause on the European level. The Single
Resolution Mechanism with all the caveats explained a little further in this paper is
an important first step in the right direction
towards resolving failing banks in a more
effective way than done during the recent
crises.
There are still several issues open, among
these: What are the relative roles of the
European Banking Authority and the ECB
in supervising banks in Europe? How will
fragilities be addressed during the 14-month
transition period between now and the date
the Single Resolution Mechanism takes
effect on 1 January 2016? How effective can
the ECB be as supervisor, having to deal with
19 different banking laws?
What has been missed?
A European bank resolution mechanism
that deserves the name.The current arrangement is too complicated and still relies too
much on the subsidiarity principle, where
first national authorities are in charge and
only then the European mechanism comes
in place.
A single banking market requires a single financial safety net. A proper funding
mechanism is missing.
While there is some money available,
funded by the banking industry itself, it
seems too small to serve for the purpose of
having to restructure a relatively large bank
somewhere in Europe. A public backstop is
113
missing. Even if the resolution fund under

the Single Resolution Mechanism were
less limited than it is under current plans,
such a fund will never be enough for a systemic banking crisis. A public backstop is
necessary.
Irrational sentiment
Zero risk weights for government bonds
further increase incentives to hold government debt and facilitate the Sarkozy carry
trade. Most importantly, the banking union
just agreed on is a forward-looking structure,
designed for the next crisis, but not supposed
to address the current crisis.
So, are we there yet? There is an increasing sentiment that the Eurozone is about to
exit the crisis. With both Ireland and Portugal
having exited Troika programs, Greece
showing signs of economic recovery, and the
crisis in Cyprus being less deep than feared,
there are understandable hopes that the
worst might be behind us.
And there seems to be an important
positive trend across Europe, which is the
return to market discipline. The fact that
many banks have accessed markets to raise
additional equity in 2014, supposedly before
being forced to do so by the ECB, can very
well be interpreted as the return of market
discipline.
Jumping the gun
In the absence of a European banking union
and a Eurozone mechanism to recapitalise
banks, this may be premature. In addition,
recent bank failures have seen junior creditors being bailed in rather than bailed out
(SNS Reaal in the Netherlands and Cyprus),
even though the bail-in rule supposedly only
114
kicks in after 2016 once the Single Resolution

Mechanism supposedly goes live. The discussion on the banking union is related to a
broader question about the role of the banking
system in European finance.
As pointed out by many observers,
European financial systems are heavily bankbased, with a limited role for non-bank financial providers and capital markets (European
Systemic Risk Board 2014). This exacerbates
the link between governments and banks, as
there are a limited number of non-bank buyers
of government bonds. It makes financial systems more concentrated and results not only
in larger banks, but also a stronger reliance on
large banks.
Post the asset quality review and stress tests
and post-banking union agreement, the largest
risk is not necessarily the half-baked nature of
the banking union, but rather the complacency
that might follow from the feeling we have
done it. A long-term reform agenda awaits
Europe. We are certainly not there yet!
References
European Systemic Risk Board (2014), Is Europe
Overbanked?, Advisory Scientific Committee Report
4, June.
Schoenmaker, D (2012), Banking union: Where were
going wrong, VoxEU.org, 16 October.

would like thank Thorsten Beck, Professor of
Banking and Finance, Cass Business School,
together with VoxEU for allowing the Journal
to publish an amended version of this article,
which first appeared on the VoxEU website on
10 November, 2014. A transcript of the original
article can be accessed via the VoxEU website:
www.voxeu.org.
Regulation
City of London determined to

plumb new depths
William K. Black, former US regulator,
despairs of the Britains desire to win gold
in global race to regulatory bottom.
ON June 20, 2012 the UK Commercial
Secretary to the Treasury, Lord Sassoon
of Ashley Park gave a speech to the
British Bankers Association (BBA) the
group the US government under the
guise of the Federal Deposit Insurance
Corporation found to have helped organise the worlds largest price rigging cartel
and fraud in the form of the rigging of the
London Interbank Offered Rate (Libor).
The financial crisis occurred under thenew
neo-liberal Labour administration when its
championing of the three des financial
deregulation, desupervision, and de facto
decriminalisation combined with modern
executive and professional compensation,
together with the effective elimination of
joint and several liability to make the City
of London the most criminogenic environment in the world for financial control
frauds.
Naturally, the UK Conservative Party
(the Tories), the senior partners in the present UK coalition government, have decided
that the answer to this disaster is to doubledown on the former Labour administrations
embrace of the three des. Indeed, the first

words in Lord Sassoons prepared speech
were: Thank you, Philip [Hampton]; Sir
Hampton of course being the person who
prepared the notorious report for Tony Blair
the former British Prime Minister in his
neoliberal heyday, that called for dramatically increasing the three des in every
regulatory context.
Incongruous remarks
Sir Hampton, after holding a senior position
with one serial criminal enterprise Lloyds
TSB, was, at the time of Lord Sassoons
talk, the Chairman of the Board of an even
larger serial criminal enterprise, the Royal
Bank of Scotland (RBS). In a cruel twist of
irony, the UK government, which owns 80
per cent of RBS after bailing it out under the
Premiership of the Labour Partys Gordon
Brown the former UK Treasury Minister
under Tony Blairs ten-year helm, turned to
Sir Hampton to help run one of the many
banks he did so much to destroy.
On February 3, 2012, a few months
before Lord Sassoons BBA speech to the
bankers, Sir Hampton made the front pages
of the British newspapers for his somewhat

incongruous comments that top bankers had creamed it by hauling in high pay,
while shareholders had received diddly
squatfor ten years.
Regulatory aversion
That too was a consequence of Sir Hamptons
anti-regulatory architecture. His open hostility to vital regulation (of bank compensation)
meant that top bankers had made tens of
millions of dollars for looting their banks
while the fraud epidemics they led caused
the Great Recession that resulted in shareholders receivingdiddly squatand borrowers being left with huge losses and debts.
As late as February 3, 2012, he continued to oppose any regulation of executive compensation as being proposed by
the European Commission. Sir Hampton
claimed that it was necessary for RBS to pay
huge bonuses to its CEO in order to get the
best people, even though he had just witnessed a full decade in which such bonuses
led to the worst people being made wealthy
whilst they looted the UKs largest banks
and tanked the countrys economy.
Win the race to the bottom
Lord Sassoon, following in Sir Hamptons
illustrious footsteps, continued to push the
mantra that the City of London needed to
win the global financial regulatory race to
the bottom in his June 2012 BBA speech.
He stated: Now I would like to focus this
evening on some of the work that has been
done and the work that still needs to be
done to secure the future of the UK as the
worlds number one financial hub. And
what we need to do truly to bring about a
116
new Golden age for British banking one

that is some improvement on the pre-2008
model.
Lord Sassoon said that the UK should
learn some (unstated) regulatory lessons
from the financial crisis brought on by the
three des. That crisis devastated the UK,
but Lord Sassoon claimed that the UKs
critical need was to aggravate the threedes
to ensure that the City of London continued to win the regulatory race to the bottom emphasised in the following passage:
[I]t is also important that we do not allow
regulation to worsen the existing problems
that Europe faces. I carefully read the BBAs
own Banking Industry report, published
last month [May 2012], which rightly drew
attention to the negative effect that global
regulation and the uncertainty around it was
having on the industry.
Bankers glee
The senior UK bankers, of course, are
delighted that the City of London wishes to
continue to create the criminogenic environment under which they were guaranteed
to cream it while shareholders got diddly
squat and borrowers and customers were
bankrupted or suffered huge losses. The
bankers championed the three des before
the financial crisis and after the financial
crisis.
Lord Sassoon then emphasised how
total the Tories commitment to the big UK
banks was no matter how many frauds
the senior bankers committed while looting their banks, no matter how many
unsophisticated customers they ripped off
through the sale of unsuitable investment
products, and no matter how many small
businesses were denied credit or ripped

off through exotic derivatives (swaps) the
Tories would of course, plough on in support of the bankers.
Exasperated complicity
Surprisingly, Lord Sassoon did express exasperation that the bankers failed to make it
easier for the Tories to help them by ending
the practice of having a huge new scandal
disclosed every month: However it may feel
at times to you in the industry, this is a government that wants to see a thriving banking industry. Not just to support the rest of
the economy but to be a world leading, successful industry in its own right. Now, you
still dont always make it easy for us or for
yourselves. Every board pay dispute, every
new mis-selling scandal, every deserving
SME refused credit, complicates our shared
agenda but we will, of course, plough on.
On every regulatory issue that could
impair the City of Londons determination
to retain the weakest financial regulation,
Lord Sassoon made it clear that the Tories
were firmly in the bankers corner. Indeed,
such was his entrenchment in the bankers
corner that Lord Sassoon made it irrevocably
clear that if it were a choice betweeninnovation and avoiding a financial crisis (stability) the Tories would pick financial crisis
any day of the week.
Hostility to EU
Such madness is well illustrated in the following paragraphs from his speech: We
must not allow innovation to be stifled in
the name of stability. So, we are strongly
resisting the Commissions proposals for a
Financial Transaction Tax. A proposal that
would harm growth, increase market volatility and drive business away from Europe
is insane. Similarly, we are challenging the
ECBs location policy in the European Courts
because it is not acceptable for a body that is
meant to promote single market principles
to force clearing houses dealing with large
Euro based transactions to locate within the
Eurozone.
With steam seemingly venting from his
nostrils, Lord Sassoon continued to lambast
European meddling by claiming that:The
recent proposals from the European
Parliament that variable remuneration
[bonuses] should be limited to no more than
fixed pay are also of concern. Capping variable remuneration in this way will inevitably
lead to an increase in fixed costs as banks
increase fixed pay.
Dire warnings
Now fully into his anti-European Union
stride, Lord Sassoon claimed that much of
the progress made in recent years to align
risk with reward, through deferral and claw
backs, will be lost. He continued:The proposal, if enacted, would also make it more
difficult for banks to retain capital in a stress
scenario, and would also make it harder for
financial institutions to claw back pay in
cases of poor performance reducing the
alignment of employee incentives and risk.
The only issue with the above sentiment
is the fact that the UK has not align[ed]
risk with reward in its compensation and
bonus plans. Indeed, it has chosen to make
it very difficult to claw back even massive
bonuses that prove to have been based
entirely on inflated reported income. Lord
Sassoon admitted that effective financial
117
regulation is actually critical to maintaining

bank safety: A well regulated sector is key
to competitiveness, reassuring customers
that they can have confidence in the markets
they are using. A strong and proportionate
regulatory system is an essential platform for
the success of the City; not a hindrance to it.
Vigorous regulation unwanted
The reality, however, is that he knew his
audience was composed of bankers not
banks. Bankers know that vigorous banking
regulation is good for honest banks, which is
why they strive so mightily to prevent vigorous banking regulation.
Lord Sassoon followed those remarks
with this ode to the three des: And on the
PRA [the then newly proposed Prudential
Regulator division of the Bank of England]
side, I want to read an extract from what Sir
Mervyn King said in his Mansion House
speech a year ago because I found it hugely
encouraging. This is what the Governor said:
The style of regulation will also change with
the PRA. Process more reporting, more
regulators, more committees does not lead
to a safer banking system.
Hugely encouraged
More financial reporting and regulators are
essential in the UK because they would lead
to a safer banking systemif they were used
competently and vigorously. The UK had far
too few regulators and needed much better
information systems that would draw on
more reporting.
The now former Governor King
(replaced by the UK Chancellor George
Osbornes Canadian choice pick and former employee of Goldman Sachs, one Mark
118
Carney) was a failed regulator, yet the Tories

werehugely encouragedthat at the time he
had abandoned none of his anti-regulatory
dogmas despite the financial crisis.
The Tories picked the Bank of England
to be the new regulator to ensure the continuation of weak regulation and supervision
and the de facto decriminalisation of financial fraud by elite bankers, while creating the
political illusion of change by moving financial regulation from the equally neo-liberal
Financial Services Authority.
Love of the three des
Unsurprisingly, the Tories also substantially reduced the Serious Fraud Offices
already grossly inadequate budget and staff
to ensure that it remained a paper tiger.
The ensuing Libor scandal, and the Serious
Fraud Offices unwillingness and inability
to take on even the fraud mice eventually
became such a political embarrassment that
the Serious Fraud Office was forced to start
an investigation of the mice and the Tories
found it politically expedient to provide a
budgetary supplement to the Serious Fraud
Office to fund a modest investigation.
Lord Sassoon was so enamoured of
the three des that he emphasised that the
Tories answer to the financial crisis was a
reduction in the number of regulators and
the information they received from the
banks. He said: I believe that we can operate prudential supervision at lower cost than
hitherto by reducing the burden of routine
data collection and focusing on the major
risks to the system. It is vital that we collect
and process data only where the supervisors
have a need to know. Targeted and focused
regulation, allowing senior supervisors to
exercise their judgement, does not require

ever-increasing resources.
Kumbaya regulation
This point is subtle and I will expand on the
point in many future articles, but the most
abused and dangerous word in destroying
effective regulation is risk. It has become
the weapon of choice to try to justify that
which has proven catastrophically harmful
to the public and a goldmine to corrupt
CEOs.
The word risk is used in a financially
illiterate and anti-scientific manner to enable the imposition of the three des for the
purpose of deliberately crippling what criminologists refer to as oursystem capacityto
detect, investigation, and sanction the most
damaging white-collar crimes. Proponents
of risk-based regulation have consistently created Kumbaya regulation systems
in which the most severe risks are ignored
under the disingenuous rubric of riskfocused regulation.
Intellectual gymnastics
In a bizzare twist of the imagination via
intellectual gymnastics worthy of a gold
medal, the con is underpinned by the following contentions. They, the Kumbaya
proponents, assume (contrary to reality) that
industry members rarely engage in serious
misconduct and therefore, a paltry number
of regulators can, if they risk-focus on the
rare bad apple regulate an entire industry
successfully.
Conversely, the same Kumbaya proponents claim that there are innumerable
lesser violations and that those lesser violations are unimportant, even cumulatively, so
the failure to sanction white-collar criminals

for minor violations of the law is no big deal
nobroken windows white-collar spheres
where wed have to arrest CEOs or even
desirable. Further, the regulators will never
have enough resources (staff and finances)
to sanction all of these lesser violations
because they are so numerous and it would
be a waste of societal resources to sanction
large numbers of lesser violations.
The proverbial bottom line is that regulatory resources might as well be slashed and
we should regard the fact that violations
of the laws by elite white-collar perpetrators will rarely be sanctioned as a great leap
forward.
Competitive objective
This bottom line is a superb means of maximising the risk of producing a criminogenic
environment and multiple examples of
Greshams dynamic. That means that the
Kumbaya proponents faux risk-focused
rubric has, recurrently, dramatically increased
the risk to the public purse and the gain to
elite criminals operating openly within the
City.
Lord Sassoon noted to the bankers
that winning the regulatory race to the bottom was an explicit or implicit mandate of
the UKs financial anti-regulators. In his 12
June British Bankers Association presentation, he said: We agreed with the Vickers
Commission and introduced an amendment
to give the Financial Conduct Authority a
competition objective. We dont, though, see
the need for an explicit international competitiveness objective.
He continued in this vein by stating:
We believe that it is getting the substance
119
right proportional, fair, transparent regulation which will lead to a more competitive
London and UK sector not the introduction of a further competitive markets objective of an ill-defined kind.
It is absolutely insane for financial regulators to havea competition objective.It is,
however, nirvana for corrupt senior bankers.
The City of London, ultimately, caused the
UK enormous harm both in the run-up to
the 2007/2008 global financial crisis and its
austerity riddled aftermath. Its culture is corrupt and it functions as a parasite that saps
the real economy rather than as an engine
of growthas some would have us believe.
All the UKs major legacy parties
Labour, the Conservatives and the Liberal
Democrats, together with the UKIP lead
by Nigel Farage agree with Lord Sassoon
that this sentence from his speech is
Subscribe
today
sensible which reveals how widespread

that insanity has spread among UK elites.
Indeed, Sassoon et al revel in the fact
that:While other Western financial centres
have lost their competitive edge, London
has strengthened its position as number
one in the global index. Key players across
the sector are locating here.
That final riposte is very bad news.
The City of London was already the
financial cesspool of the world, the most
criminogenic environment for financial
fraud, and the cause of immense losses of
jobs and wealth by tens of millions of people of the UK. The City of London is actively
working to race even further to the bottom,
and the politicians from all the major parties remain eager to help make the City of
London ever more corrupt at the expense
of the public.
ournal of reg
ulation & risk
north asia
Articles & Papers
Issues in resolving
s
Resecuritisation
in banking: major
challenges ahead
funding liquidity
Dr Fang Du
crisis
Housing, monetary
nce
Dr Ulrich Bindseil
Complia
from bad to worst
Legal &
Derivatives: from
Stephan Schoess,
on
Black swans, market
Professor
Lynn A. Stout
human perspectiv
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Joseph Rizzi
risk for innovative
financial instrumen
ts
Red star spangled
banner: root causes
The family risk:
a cause for concern
Fahrholz
Global financial
change impacts
David Smith
compliance and
risk
The scramble is on
David Dekker
to tackle bribery
and corruption
Li
Practices Act?
Financial markets
Tham Yuet-Ming
one step forward
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Contact:
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120
163
Volcker rule
Compliance with risk targets:

Efficacy of the Volcker Rule
Far from reducing risk-taking by covered
institutions, the Volcker Rule has the opposite
effect, argue Josef Korte and Jussi Keppo.
MORE than four years after the Volcker
Rule was codified as part of the Dodd
Frank Act in an attempt to separate
allegedly risky trading activities from
commercial banking, we present evidence finding that those banks most
affected by the Volcker Rule have indeed
reduced their trading books more substantially than those less impacted by
the legislation. However, there are no
corresponding effects on risk-taking if
anything, affected banks take more risks
and use their trading accounts less for
hedging.
TheVolcker Rule, passed as part of the Dodd
Frank Act in July 2010, has been appraised
as one of the most important changes to
banking regulation since the global financial
crisis. By restricting banks business models
and prohibiting allegedly risky activities, the
rule ultimately aims at increasing resolvability and reducing imprudent risk-taking by
banks, and therefore at increasing financial
stability.
This is done by banning banks from
proprietary trading and limiting their
investments in hedge funds and private

equity. Four years after the enactment of
DoddFrank and with the final rulemaking
by regulatory agencies recently presented,
it is time to evaluate whether the Volcker
Rule has already had any major impact on
the affected banks business models and
risk-taking.
Although full compliance is not required
until July this year, major affected bank
holdings in the US have already repeatedly
announced reconfigurations of their business models. Apparently in an effort to comply with the Volcker Rule, these banks have
declared that they have shut down proprietary trading desks and sold their shares in
hedge funds.1
Despite those public compliance pronouncements, the effect of the Volcker Rule
could be dubious. First, the final rules stipulate a long list of exemptions for example,
activities that might be seen as similar to
proprietary trading or hedge fund investments, but are explicitly exempted from
the ban. Second, as banks can take risks in
many different ways (e.g. increasing leverage
or risks in the trading or the banking book,
or decreasing the hedging of the banking

book), there is no reason to assume that a
decrease in the size of the trading book or its
particular activities decreases banks overall
risk.
Grey areas
Further, regulators may find it difficult to differentiate between prohibited and permitted
activities such as trading on behalf of customers, market-making, or hedging. Hence,
affected banks might be able to keep their
risk targets without raising the leverage or
the riskiness of their banking books.
Consequently, several authors have
argued that the effect of the Volcker Rule on
bank business models, overall bank risk, and
financial stability might be rather limited.
This might be a consequence of grey
areas, creative compliance, reduced transparency, or simply other levers banks pull to
keep their risk targets (see, e.g., Kroszner and
Strahan 2011, Richardson et al. 2010, Chung
and Keppo 2014).
So, what exactly are the effects of the
Volcker Rule to date?
Existing theoretical and empirical
research cannot ultimately clarify the predicted effects of the Volcker Rule. Firstly,
papers evaluating the impact of the Volcker
Rule are still relatively scarce (presumably
because it is not yet fully implemented).
Conflicting evidence
And secondly, although numerous studies evaluate the historical precedents of the
Volcker Rule e.g. the GlassSteagall Act
there is no clear consensus in the literature regarding the impact of a separation of
commercial and investment banking on
122
banksrisk (Barth et al. 2000, Barth et al. 2004,

Benston 1994, Saunders and Walter 1994,
Stiroh 2006, Stiroh and Rumble 2006).
Motivated by the conflicting evidence,
the work-in-progress implementation, and
banks early compliance announcements,
we analyse in a new working paper (Keppo
and Korte 2014) whether and how banks are
already complying with the rule and what
the effects are of this compliance.
For this, we construct a comprehensive
dataset of all Bank Holding Companies
(BHCs) in the US covering a timespan of ten
years on a quarterly basis.
We rely on the assumption that those
BHCs that traditionally had their business models geared towards activities now
banned or limited by the Volcker Rule (i.e.
institutions with comparably large trading
books and large non-bank investments) are
affected most and should hence show the
strongest reactions.
Trading books
To begin with, we find that banks on average reduce the size of their trading books
relative to total assets after the passing of
the Volcker Rule. This, of course, can only be
traced back to the Volcker Rule by comparing the development over time and across
groups of differently affected institutions.
Indeed, we find that those BHCs that are
presumably most affected by the Volcker
Rule had even stronger reductions in their
trading books, above and beyond the average effect.
Moreover, when comparing affected
banks and hedge funds, we do not find a
similar trend in fact, hedge fund assets
have even been rising. The reduction of
banks trading books is quite an intuitive

reaction, and also corresponds with the public announcements by most of the banks that
see themselves affected by the Volcker Rule.
Risk-taking
Extending our model towards actual risktaking by BHCs, however, we find less
obvious results. While overall bank risk
(expressed, for instance, in the composite
measure of a banks distance to default) has
decreased after the enactment of the Volcker
Rule, we do not find a pronounced effect
on the BHCs that are particularly affected. If
anything, the risk reduction effect is smaller
for the affected banks.
Turning to the volatility of trading returns,
we find those to be largely unchanged after
the Volcker Rule; again, if anything, affected
banks get more volatile trading books. The
same applies to liquidity risk; if anything,
affected banks hold less liquid assets. If the
reduction of bank risk is an objective of the
rule, our findings suggest that the Volcker
Rule has so far not led to its intended
consequences.
Nevertheless, there might be trading
that is wanted and hence permitted as an
exemption from the Volcker Rule. In fact, the
Volcker Rule explicitly stipulates that trading accounts held for hedging purposes are
permitted.
Increase in correlation
If affected banks were increasingly using
their trading accounts for hedging of banking book returns, we would expect the correlation between trading and banking returns
to strongly decrease or to be negative after
the introduction of the Volcker Rule.
We test for this and find neither to be the

case. Rather, while the correlation between
trading and banking returns has indeed
decreased after the Volcker Rule became
effective, the opposite is true for the most
affected banks, which even experienced a
significant increase in the correlation.
Taken together, our findings can be
interpreted as evidence for successful risk
targeting although banks shifted portfolios
to become at least more compliant with the
Volcker Rule, they keep their risk targets (e.g.
by hedging their banking businesses less).
This explains why we find a significant
decrease in the trading asset ratio, but no significant shift in overall risk. Further, possibly
because of the continuing trading activities,
the banking book risks have not, or at least
not yet, risen significantly.
Serious risks and concerns
To be fair, the final regulatory rulebook for
the Volcker Rule was only published just
over a year ago and as of the time of writing
it is not yet fully binding for banks. However,
our results (together with several banksselfdeclared compliance) identify serious risks in
the Volcker Rule.
Since banks risk-taking incentives have
not changed, the remaining assets in the
trading book have been used less in the
hedging of banking book returns. Thus,
American regulators might want to analyse
further possible implementation risks and
unintended consequences to ensure increasing bank, and thereby, financial stability.
Our findings also have important implications for other global regulatory bodies
and supervisors those in the European
Union, for example who are currently
123
debating the introduction of similar separations between commercial banking and

investment/trading business.
Banks and the Volcker Rule, in V V Acharya,T F Cooley, M

P Richardson, and I Walter (eds.), Regulating Wall Street:
The DoddFrank Act and the New Architecture of Global
Finance, John Wiley & Sons: 181212.
References
Saunders, A and I Walter (1994), Universal Banking in the
Barth, J R, R D Brumbaugh, and J A Wilcox (2000), The
United States: What Could We Gain? What Could We
Repeal of GlassSteagall and the Advent of Broad Banking,
Lose?, Oxford University Press.Stiroh, K J (2006),A portfo-
Journal of Economic Perspectives, 14(2): 191204.
lio view of banking with interest and noninterest activities,
Barth, J R, G J Caprio, and R Levine (2004),Bank Regulation
Journal of Money, Credit and Banking, 38(5): 13511361.
and Supervision: What Works Best?, Journal of Financial
Stiroh, K J and A Rumble (2006),The dark side of diversifi-
Intermediation, 13(2): 205248.
cation:The case of US Financial Holding Companies, Jour-
Benston, G J (1994), Universal Banking, Journal of Eco-
nal of Banking & Finance, 30(8): 21312161.
nomic Perspectives, 8(3): 121143.

Chung, S and J Keppo (2014), The Impact of Volcker Rule
Endnote
on Bank Profits and Default Probabilities,Working paper.
1. See, e.g., Susanne Craig, Goldman Moves to Comply
Keppo, J and J Korte (2014), Risk Targeting and Policy Illu-
With Volcker Rule, New York Times, 10 May 2012; Lloyd
sions Evidence from the Volcker Rule, Working paper.
Blankfein, Goldman Sachs CEO Views the World From
Kroszner, R S and P E Strahan (2011), Financial regulatory
Wall Street, Remarks at the Economic Club, 18 July 2012;
reform: Challenges ahead, American Economic Review,
Dakin Campbell and Jody Shenn, Citigroups Raytcheva
101(3): 242246.
Survives Volcker Rule as Prop Trader, Bloomberg, 25 June
Richardson, M, R C Smith, and I Walter (2010), Large
2014.
& RISK NORTH ASIA

Vol VII Issue 1 Summer 2015
May 15th 2015

124
Basel III
Higher capital requirements:

the jury is out
Stephen Cecchetti of Brandeis International
Business School calls for higher bank capital
standards in lieu of all available evidence.
REGULATORS forced up capital
requirements after the Global Financial
Crisis triggering fears in the banking industry of dire effects. This paper
argues that the capital increases had little
impact on anything but bank profitability. Lending spreads and interest margins are nearly unchanged, while credit
growth remains robust everywhere but
in Europe. Perhaps the requirements
should be raised further.
During the Basel III debate, a key concern
was that higher capital requirements might
damage economic growth. By forcing banks
to increase their capitalisation, long-run
growth would be permanently lower and
the adjustment itself would put a drag on the
recovery from the Great Recession.
Unsurprisingly, the private sector
saw catastrophe, while the official sector was more sanguine. The Institute of
International Finance (2010) is the most
sensationalist example of the former, and the
Macroeconomic Assessment Group (2010a
and 2010b) one of the most staid cases of the
latter.1
With four years of evidence behind us,

my reading is that the optimists were not
optimistic enough. Since the crisis, capital
requirements and capital levels have both
gone up substantially. Yet, outside the still
fragile Eurozone, lending spreads have
barely moved, bank interest margins have
fallen, and loan volumes are up.
To the extent that more demanding
capital regulations had any macroeconomic
impact at all, it would appear to have been
offset by accommodative monetary policy. In
what follows, I summarise the evidence for
this conclusion and its policy implications.
For more details, see CEPR Policy Insight 76,
Cecchetti (2014).
Higher capital requirements
To begin, it is important to appreciate how
much higher the new international capital
standards are. Basel III is more rigorous than
its predecessor in three fundamental ways:
the definition of what constitutes capital is
tighter, the coverage of what counts as an
asset is broader, and the required ratio of the
two is higher.
Overall, I estimate that risk-weighted
capital requirements increased by factor of

10 to 20 (albeit from a level that was abysmally close to zero).
Not only have requirements gone up,
but capital levels have, too. According to the
Basel Committee on Banking Supervisions
(various years) quantitative impact assessments, from the end of 2009 to the end of
2013, capital for the 102 largest global banks
(based on the new stringent definitions) rose
from 5.7 per cent to 10.2 per cent of riskweighted capital.
Margins and costs squeezed
The recent study by Cohen and Scatigna
(2014) shows that two-thirds of this increase
has been from retained earnings, with
the remaining third coming from capital
issuance.
Contrary to the predictions of the privatesector doomsayers, as banks were increasing
their capital levels, they were shrinking their
return on assets, cutting their net interest
margins and reducing their operating costs.
BIS (2014) provides data on banks in 15 large
advanced and emergingmarket countries.
Comparing 2013 results with the 2000
2007 average, we see that return on assets
fell roughly 40 basis points, interest rate
spreads fell by an average of more than 30
basis points, and operating costs by closer to
75 basis points. At the same time, bank credit
to the non-financial private sector was rising.
except in the Eurozone
I should note that Europe is something of an
exception. There, lending spreads are generally up and loans down. The explanation
for this is likely to be two-fold. First, there
is the way in which supervisors conducted
126
European stress tests and capital exercises.

Instead of requiring banks to raise additional
capital to offset a shortfall as the 2009 US
stress test did authorities allowed them to
meet capital ratios by shedding assets.
In fact, Eurozone banks did not raise
capital. Instead, they reduced both their
total assets and their risk-weighted assets.
Second, a number of continental European
banks remain under pressure to further raise
their levels of capitalisation.
The Eurozones problems are consistent
with the commonly held belief that banks
with debt overhangs do not lend a belief
that is substantiated by data of the sort that I
describe in Cecchetti (2014). Europes banks
still need capital to reduce the overhang.
Countercycle capital buffer
In fact, fears about higher capital requirements have not been borne out. I draw two
principal conclusions from this accumulated
evidence.
First, the predictions that higher capital
requirements would drive up interest margins and reduce credit volumes are very
clearly at odds with the evidence of smaller
spreads and increased lending. Insofar as
there was any macroeconomic impact at
all, it appears to have been inconsequential.
Instead, it is high levels of capital that lead to
healthy lending.
Second, the evidence is bad news for
the Basel IIIs countercyclical capital buffer.
The idea of the buffer is that, when they are
confronted with a credit boom, authorities
should raise capital requirements to limit the
expansion.
By using prudential tools to lean against
credit booms, regulators can help to stabilise
the financial system and the real economy.

But, as Aiyar et al. (2014) note, for the countercyclical buffer to work, there are three preconditions: first, capital requirements have
to bind before they are raised; second, equity
has to be costly and difficult to raise in the
short term; and third, alternatives to bank
credit have to be relatively unavailable and
costly.
Summary
On all three counts, the experience I have
summarised is not very encouraging.
Lending spreads do not appear to be the
first-order response to higher capital requirements; loan volumes do not look sensitive to
changes in capital so long as banks are reasonably well capitalised; and at the stage in
the business cycle when the countercyclical
buffer would be needed, banks business is
likely to be booming and profitable, making
it cheaper and easier to raise equity.
We need to continue to study this episode, doing a proper statistical analysis that
controls for macroeconomic conditions and
policy responses.
At this stage, however, it seems reasonably safe to conclude that supervisors and
bank regulators should seriously consider
requiring further additions to bank capital,
given that the social costs of post-crisis capital increases appear to have been small; and
the efficacy of time-varying capital requirements in moderating credit fluctuations is
questionable to say the least.
Endnote
1. Full disclosure, Please note I was Chair of the
Macroeconomic Assessment Group.
References
Aiyar, S, C W Calomiris, and R Wieladak (2014),
Identifying channels of credits substitution when
bank capital requirements are varied, Bank of England Working Paper 485, January.
Bank for International Settlements (2014), 84th
Annual Report, June. Results of Basel III Monitoring
Exercise.
Cecchetti, S G (2014), The Jury is In, CEPR Policy
Insight 76, December.
Cohen, B H and M Scatigna (2014),Banks and capital requirements: channels of adjustment, BIS Working Paper 443, March.
Institute of International Finance (2010), Interim
Report on the Cumulative Impact on the Global
Economy of Proposed Changes in the Banking Regulatory Framework, June.
Macroeconomic Assessment Group (2010a),
Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements:
Interim Report, August. Macroeconomic Assessment Group (2010b),Assessing the macroeconomic
impact of the transition to stronger capital and
liquidity requirements: Final Report, December.
Editors note: The publisher and editor of

the Journalof Regulation & Risk - North Asia
would like to extend thanks to Stephen
Cicchetti, Professor of International
Economics at the Brandeis International
Business School, together with VoxEU for
allowing the Journal to publish a slightly
amended version of this article, which
first appeared on the VoxEU website on 17
December, 2014. Readers are reminded
that copyright remains the sole preserve of
the author and VoxEU. A transcript of the
original article can be accessed via theVoxEU
portal via this link: http://www.voxeu.org/
article/verdict-higher-capital-requirements.
127
Basel III
Will Basel III operate to plan

as its proponents desire?
Prof. Xavier Vives of the IESE Business
School queries ability of Basel III and regulators to prevent another financial crisis.
BANKING has recently proven much
more fragile than expected. This column argues that the Basel III regulatory response overlooks the interactions
between different kinds of prudential
policies, and the link between prudential policy and competition policy.
Capital and liquidity requirements are
partially substitutable, so an increase in
one requirement should generally be
accompanied by a decrease in the other.
Increased competitive pressure calls for
tighter solvency requirements, whereas
increased disclosure requirements or
the introduction of public signals may
require tighter liquidity requirements.
The recent financial crisis has exposed the
failures of regulation. We have witnessed
how the three pillars of the Basel II approach
namely capital requirements, supervision,
and disclosure and market discipline have
been insufficient to prevent or contain the
crisis. Banking has proved much more fragile
than expected.
Among the problems that have surfaced is the danger of an overexposure to
wholesale financing, as demonstrated by the

demises of Northern Rock and Bear Stearns.
Another startling development has been
the large impact of public news, such as the
decline of the ABX index of credit derivatives
on subprime mortgages in 2007, credited
with inducing the run on structured investment vehicles (SIVs) in the summer of that
year (see, e.g., Gorton 2008) and consequentially contributing greatly to the 2008 financial crisis.
FAS rule 157
The effects of disclosure requirements have
also been dramatic, such as the implementation in 2007 of Financial Accounting
Standards (FAS) rule 157 a piece of markto-market accounting legislation which
was credited with aggravating the consequences of the bursting of the real-estate
bubble by forcing banks to disclose large
losses on their portfolios of mortgagebacked securities.1
The regulatory response has been, in
the so-called Basel III process, to increase
capital requirements, introduce liquidity
requirements and strengthen transparency
requirements.2 Apart from this, structural

reform has been proposed in the US, the UK,
and in the EU in order to separate traditional
banking from market-oriented activities to a
certain degree. Some of these measures have
already been implemented.
Problems with the Basel approach
Furthermore, in the immediate response to
the crisis, antitrust concerns were set aside
and large banks were allowed to merge in
the United States, the United Kingdom, and
Spain among other countries not to mention the amount of state aid granted to the
banking sector with the effect of distorting
competition.
The approach in the Basel III process
has been to calibrate capital and liquidity
requirements independently, with the latter
still not quite settled, and to think about disclosure requirements separately. With regard
to competition policy, the standard idea has
been to enforce it independently of the level
of prudential regulation.
I argue inVives (2014) that this approach
may prove problematic:Capital and liquidity requirements are both necessary but
partially substitutable in the regulatory
aims of keeping the probabilities of insolvency and illiquidity in check. This means
that an increase in one requirement should
be accompanied by a reduction in another
requirement to accomplish regulatory objectives in an efficient way......
Optimum prudential policy
Continuing with this theme:.....The optimal levels of capital and liquidity requirements are not independent of the level of
disclosure in the market. For example, more
130
disclosure may need to be accompanied by

a higher liquidity requirement in order to
keep the probability of illiquidity in check.
Optimal prudential policy is not independent of the level of competitive pressure that
banks face.
I obtain these results in a model of crises that distinguishes solvency from liquidity
problems, and which is based on a simple
game of strategic complementarities with
incomplete information (e.g. Morris and
Shin 2004, Rochet and Vives 2004).
The financial intermediary obtains unsecured wholesale financing that may not be
renewed depending on the information
received by fund managers. If this happens,
the intermediary typically will need to liquidate some assets at fire sale prices in order to
meet its debt obligations. Those sales can be
moderated by holding more liquidity.
Solvent but illiquid
The result is that there is a range of fundamentals of the investment portfolio of the
bank for which the entity is solvent but
illiquid. The intermediary faces a coordination failure that leads to fragility in the sense
that a small change in the environment may
move the equilibrium of the investors game
from safe to unsafe.
This fragility is linked positively to the comovement of investors actions or, in more
technical terms, to the degree of strategic
complementarity of their actions.
I find then that strategic complementarity and fragility are increasing in the weakness of the balance sheet of the intermediary
(high level of wholesale short-term financing and low level of liquid reserves), market
stress parameters (such as the extent of fire
sales penalties of early asset sales or of the

cost of funding), and the precision of public
signals about the fundamentals.
Substitutability of capital and liquidity
The probabilities of insolvency and illiquidity
can be controlled with capital and liquidity
requirements. If the regulator aims to cap the
probabilities of insolvency (to mitigate moral
hazard) and illiquidity (to mitigate contagion
risk), it can accomplish this by setting minimum capital and liquidity requirements.
Those requirements are partially substitutable, and typically a change in the environment that calls for an increase in one
will imply a decrease (at least weakly) in the
other.
For example, higher fire sales penalties
to liquidate assets will call for an increased
liquidity requirement and a relaxed solvency
one, whereas increased competition raising
funding costs will call for an increased solvency ratio and a stationary liquidity ratio.
The latter prescription is important when
the regulator faces a liberalisation episode
such as that of Savings and Loans in the US
in the 1980s. In this case the failure to tighten
solvency requirements led to disaster.
Implications of public signals
A more subtle change in the environment is
in disclosure requirements or the introduction of strong public signals. In an environment with weak balance sheets and market
stress, bad news provided by a strong public
signal may coordinate expectations on a run
equilibrium.
This is what seems to have happened
with the SIVs crisis in 2007. The SIVs were
mostly funded short term in the wholesale
market, and investors had poor information

when deciding whether to roll over their
loans given the opaque nature of residentialbased subprime securities.
The introduction of the ABX index in
2006 provided a potent public signal about
the state of subprime mortgages, and when
this index started to decline in early 2007 it
eventually triggered a run on the SIVs.
All the conditions that make investors
actions co-move strongly were present: a
high level of unsecured short-term financing
in particular, coupled when the crisis started
with high fire sales penalties, and a strong
public signal in relation to the accuracy of
private signals.
Concluding remarks
With hindsight, and according to my analysis, the regulator should have tightened
liquidity requirements when the ABX index
was established.
If properly calibrated, the liquidity
requirement would have decreased the profitability of special investment vehicles, but
avoided the run.
Similarly, the regulator should have
established a liquidity ratio when introducing the mark-to-market accounting FAS
rule 157 in 2007 in order to avoid increasing
the risk of illiquidity.
In conclusion, independently of the
debate on the right amount of capital (see
e.g. Admati et al. 2013 and Corsetti et al.
2011), regulators should look at the interaction between capital, liquidity, and disclosure
requirements.
Regulators should take into account also
the level of competitive pressure when setting prudential requirements. This implies
131
that competition policy and prudential

policy are not independent either. Taking
these interactions into account in a holistic
approach will lower the likelihood of regulatory blunders and improve the chances of
the Basel III process delivering the expected
results.
Footnotes
1. See the testimony of former FDIC chairman
William Isaac at the US House of Representatives
Committee on Financial Services on 12 March 2009.
2. In regard to disclosure (Pilar 3 of the Basel
approach) in BIS (2014) it is stated that in the wake
of the 20072009 financial crisis, it became apparent that the existing Pillar 3 framework failed to
promote the early identification of a banks material
risks and did not provide sufficient information to
enable market participants to assess a banks overall
capital adequacy.
References
Admati, A, P de Marzo, M Hellwig, and P Pfleiderer
(2013), Fallacies, Irrelevant Facts, and Myths in the
Discussion of Capital Regulation: Why Bank Equity
is Not Socially Expensive, Stanford University GSB
Research Paper 13-7.
BIS (2014), Review of the Pillar 3 Disclosure
Requirements, Basel Committee on Banking
Supervision, Consultative Document.
Corsetti, G, M Devereux, J Hassler, G Saint-Paul,
H-W Sinn, J-E Sturm, and X Vives (2011), A New

Crisis Mechanism for the Euro Area, in The EEAG
Report on the European Economy 2011, CesIFO:
7196.
Morris, S and H S Shin (2004), Coordination Risk
and the Price of Debt, European Economic Review
48: 133153.
Gorton, G (2008),The Panic of 2007, in Maintaining stability in a changing financial system, Proceedings of the 2008 Jackson Hole Conference, Federal
Reserve Bank of Kansas City.
Rochet, J C and X Vives (2004), Coordination Failures and the Lender of Last Resort: Was Bagehot
Right After All?, Journal of the European Economic
Association 2(6): 11161147.
Vives, X (2014),Strategic Complementarity, Fragility,
and Regulation, Review of Financial Studies 27(12):
35473592.

would like thank Xavier Vives, Professor of
Economics and Finance and academic director of the Public-Private Sector Research
Center at IESE Business School; CEPR
Research Fellow, together with VoxEU for
allowing the Journal to publish an amended
version of this article, which first appeared
on the VoxEU website on 22 December,
2014. A transcript of the original article can
be accessed via the VoxEU website: www.
voxeu.org.
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Monetary policy
Helicopter money can reverse

the present economic cycle
Chairman of the Group of Lecce, Biagio Bossone,
urges fiscal and monetary policy makers to abandon
supply-side prescriptions and to dropmoney.
HIGH debt and deflation have afflicted
Japan, the Eurozone, and the US.
However, the monetary and fiscal policies implemented so far have been disappointing. This paper discusses the
importance of helicopter money in the
form of overt monetary financing in
addressing these problems. Overt money
financing is the policy with the highest
impact in raising demand and output
without increasing public debt and interest rates.
The G20 leaders may well have committed
themselves to endorse a highergrowth target 2.1 per cent by 2018, or US$2 trillion
at their November meeting in Australia
the Brisbane Action Plan but as predicted
seem incapable of agreeing to a combined
and coordinated meaningful monetary and
fiscal policy mix that would substantially lift
aggregate consumer demand and economic
growth globally.
Fiscal and monetary policy cordination is
urgently required to facilitate any meaningful
global economic recovery. The International
Monetary Fund (IMF), if reports are to
believed, are examining more than 900

structural/infrastructure policies, and more
will be needed to reach growth targets.
However, the required locomotive power to
substantially lift consumer demand is far and
away beyond that which can be harnessed
from supply-side policies. However, a mere
handful of well-chosen, coordinated macroeconomic policies could ensure success.
Seeds of new crisis
As we have witnessed at the beginning of
2015, present economic policies are failing
to provide for growth and stability. In the
Eurozone, Germany is now running both a
budget surplus and a large current account
surplus, thus providing none of the powerful locomotive potential it could provide to
revive the Eurozone block of nations.
There are also growing concerns including at the Bank of International Settlements
and the Financial Stability Board that the
ultra-low interest rate policies adopted by
Japan, the US and the Eurozone are creating large risks in the form of the mispricing of risk, asset overvaluation, downward
price dynamics, and a new financial crisis.
Quantitative easing has raised asset prices,

but the new money allegedly created has
failed to stimulate spending and inflationary
expectations to the extent that was originally
anticipated.
Helicopter money
As provocatively discussed by Friedman
(1969), helicopter money is a policy whereby
new money is created by the central bank
and provided directly to households and
private businesses. Grenville (2013) notices
that central banks have no mandate to give
money away (they can only exchange one
asset for another), and that such decisions
need to be backed by the budget-approval
process.
In most countries, therefore, central
banks cannot conduct helicopter money
operations on their own helicopter money
must involve fiscal policymaking.1 Buiter
(2014) focuses on the application of helicopter drops through overt monetary financing, whereby the central bank creates new
money to finance a fiscal stimulus.
He identifies the conditions under which
such a helicopter drop increases aggregate
demand. One of these conditions is the
irreversibility of the new money base stock
creation, which constitutes a permanent
addition to the total net wealth of the economy, which is made possible by the (fiat)
money base being an asset for the holder but
not a liability for the issuer (Buiter 2004).
Irreversibility
Such irreversibility can be attained if overt
monetary financing operations are executed
by one of two routes. The first is by having
the government issue interest bearing debt,
134
which the central bank would buy and hold

in perpetuity, rolling over into new government debt when the existing debt on its balance sheet reaches maturity.
In this case, the government would face
a debt interest servicing cost, but the central
bank would make an exactly matching profit
from the difference between the interest rate
it receives on its debt and the zero cost of
its money liabilities, and would return this
profit to the government.
A second route is having the central bank
buy government securities which are explicitly non-interest bearing and never redeemable. In terms of the fundamentals of money
creation and government finance, the choice
between these two routes would make no
difference (Turner 2013).
Composition shift
Note that the irreversibility condition has
nothing to do with the fact that, at any future
date, the central bank might decide to withdraw part or all of the liquidity injected in the
system by selling its own bonds. In this case,
the holders of liquidity would exchange it for
the bonds sold by the central bank, but the
total net worth of the economy would not
change only its composition would (shifting from more to fewer liquid assets).
The addition to the economys net worth
originally operated through the overt monetary financing would not be undone by
any new open market operation. Note that
where overt money financing operations are
run by the Treasury, without involving the
central bank (see opposite page), neither of
the two routes above is necessary, since the
Treasury directly finances the budget by issuing money or a money-like instrument.
In relation to overt money financing, we

claim the following: First, it is the combination of monetary and fiscal policy that has
the greatest impact in raising demand and
output (McCully and Pozsar 2013, Turner
2013).
No increase in public debt
Second, overt money financing is most likely
to turn deflation into inflation in the shortest
time. Unlike quantitative easing, it flows to
households with a relatively high marginal
propensity to consume ordinary goods and
services. Hence, demand and consumer
goods prices both rise relatively early under
overt money financing.
Third, overt money financing does not
trigger Ricardian Equivalence effects (in
contrast with conventional bond financing)
since the intertemporal budget constraint of
the state is permanently relaxed by the corresponding new money stock.
Fourth, it creates no rise in interest rates
and hence there is no crowding-out. Fifth, it
always increases demand (Buiter 2014).
And, finally, most importantly, overt
money financing involves no increase in
public debt, whereas conventional bond
financing does.
Central banks and public debt
Government bonds held by the central
bank are usually counted as part of general
government debt (public debt). Indeed, this
might be considered an anachronism since
the central bank, as well as the Treasury, are
both organs of the state.
Conceptually, in a consolidated publicsector balance sheet there would be no new
debt creation if the government received
new money from the central bank to finance

the state budget.
However, this is not quite the case in
reality, for a number of possible reasons.
Where central banks are partly privately
owned by commercial banks, there is a justifiable separation. Another justification may
be that many central banks areindependent
agencies, and separable from government
influence. A third reason is that financial
markets see through the consolidated public sector balance sheet and recognise that a
central bank may sell government bonds to
the private sector at any time.
Except for the case where the central
bank creates money to finance the budget in
exchange for new government bonds, helicopter drops do not cause the public debt to
increase.
High level of coordination
This equally holds when: (1.)New helicopter
money flows from the central bank directly
into the private bank accounts of individuals and businesses (see, for instance, Kimball
2012). (2.)Overt money financing operations are implemented under the two routes
above (Bossone and Wood 2013). (3.) The
Treasury (not the central bank) issues new
money and uses it to finance its own budget
(Wood 2012). (4.)The Treasury (not the central bank) issues a pseudo-money instrument to finance tax cuts (Bossone et al. 2014).
The first two cases require a great deal
of coordination between a (possibly) independent central bank and the Treasury,
implying that they have to come to an agreement in order to engineer an overt money
financing operation. On the other hand, the
third and fourth cases do not involve the
135
central bank, thus simplifying overt money

financing execution; yet, the government
needs to exert a great sense of fiscal discipline in order to avert the risk of abusing the
money financing.
The issues touched upon in this article are important for a number of reasons.
First, if the above taxonomy is not clearly
understood, then the policy of overt money
financing could be misinterpreted, and its
significance not appreciated, including by
key policymakers who have, to date, seemingly turned a blind eye to it.
Second, quantitative easing has failed
to deliver what was promised and is likely
to be disruptive as normal interest rates
are restored. A new approach to monetary
policy needs to be developed to impact consumer demand much more rapidly. Third,
as the case of Japan where the public debt
level is very large shows, successive rounds
of quantitative easing and bond-financed
budget deficits do not prove effective.
Fourth, the afflicted countries just survived the global financial crisis. However,
with public debt already at danger levels,
they are currently incapable of responding
to any new crisis that may emerge by using
large-scale conventional bond financed deficit spending. Fifth, Eurozone countries are
again sliding into depression and deflation.
Current policies need to be radically altered
to create the requirements for widespread and
strong economic recovery. Finally, there has
been much conjecture about whether or not
some advanced countries have entered an era
ofsecular stagnation(Teulings and Baldwin
2014). Overt money financing offers the most
effective monetary and fiscal policy response
to secular stagnation.
136
Endnotes
1. Buiter (2014) considers the ECB as one possible
exception in particular circumstances.
References
Bossone B (2013), Unconventional Monetary Policies
Revisited (Part I),VoxEU.org, 4 October.
Bossone B (2013), Unconventional Monetary Policies
Revisited (Part II),VoxEU.org, 5 October.
Bossone B, M Cattaneo and G Zibordi (2014), Which
Options for Mr. Renzi to Revive Italy and Save the Euro?
Economonitor, 3 July.
Bossone B and R Wood (2013), Overt Money Financing:
Navigating Article 223 of the Lisbon Treaty, EconoMonitor, 22 July.
Buiter W H (2004) Helicopter Money: Irredeemable
Fiat Money and the Liquidity Trap, NBER, Working Paper
10163.
Buiter W H (2014), The Simple Analytics of Helicopter
Money:Why it Works Always, Economics,Vol. 8, 2014-28.
Friedman M (1969),Optimum Quantity of Money,Aldine
Publishing Company. 1969. p. 4.
Grenville S (2013), Helicopter Money, VoxEU.org, 24
February.
Kimball M (2012), Getting the Biggest Bang for the Buck
in Fiscal Policy, Confessions of a Supply-Side Liberal, May
29, 2012.
McCulley P and Z Pozsar (2013), Helicopter Money: Or
How I Stopped Worrying and Love Fiscal-Monetary Cooperation, Global Society of Fellows, 7 January.
Teulings C and R Baldwin (eds.) (2014), Secular Stagnation:
Facts, Causes, and Cures, A VoxEU.org eBook, 10 September, CEPR Press.
Turner A (2013), Debt, Money and Mephistopheles: How
Do We Get Out of This Mess, Cass Business School Lecture, 6 February.
Wood R (2012), The Economic Crisis: How to Stimulate
Economies Without Increasing Public Debt, Center for
Economic Policy Research (CEPR) Policy Insight No.62,
August.
Regulation - enforcement
US regulatory feeding frenzy

on HFT is wholly misguided
New York-based Steve Wunsch castigates
regulators and prosecuting agencies for their
over-zealous persecution of market traders.
ILL grant the definitions of fix are all
over the map. Still, I cant help noting the
irony in a minor modern nanny making it
his mission to fix the markets. Timothy
Massad, Chairman of the US Commodity
Futures Trading Commission (CFTC),
during a victory lap on CNBC news
channel celebrating his agencys US$1.4
billion share of the US$4.4 billion settlement between global agencies and six
banks over currency fixes, said: What
Im trying to do is fix the markets, ensure
integrity of the markets.1
The nannies have been fixing the allegedly
broken capital markets for decades now,
primarily by replacing conflicted humans
with presumably pristine machines and
other arms-length competition processes
designed to stop the professionals from fixing things in their favour.
The contrast between the two ways of
doing things is stark. The markets began as
price-fixing cartels, conspiracies that went
from fixing commissions, trading increments
and spreads to runningfixesfor gold, Libor,
currencies, etc., all of which added up to
fantastic wealth for professionals in the

City of London or on Wall Street. The nannies, in contrast, took it upon themselves
to eliminate those conflicted structures and
the wealth they created. Although the old
structures were over three centuries in the
making, while the nannies have only been
at it for the eighty years since the Securities
and Exchanges Commission began in
1934, the nannies are winning. This is most
unfortunate.
The reality is that it was precisely through
the selfish fixing conspiracies of unmolested
markets that the uniquely modern miracle of
growth finally appeared on the world stage.
After millennia of seemingly permanent and
universal poverty, such conspiracies lifted
first the English-speaking peoples, but then
others, to previously unimaginable prosperity in two successive industrial revolutions
and global empires based, to put it succinctly
in modern terms, on the freedom from nannies trying to fix things.
The emergence of dominant stock
exchange monopolies, the ultimate rigged
enterprise, at the end of the seventeenth and
eighteenth centuries in London and New
York, respectively, set the pattern for forming

enterprises around new technologies that
carries forward to this day in a global enriching that is gradually spreading to everyone.
DIY monopolisations
Whereas Old World monopolies were
licensed to the Kings cronies as patents or
other royal privileges to operate without
competition, the paradigm established by
the original stock exchanges, first in London
and then in the New World, was one of Do
It Yourself (DIY) monopolisations: no king,
patent, license or other government process required or allowed. And the cornucopia of wealth that poured forth from such
DIY monopolies, from the stock exchanges
through Standard Oil to Microsoft and
beyond, is still enriching us.
Sure, the rich are benefiting most, but the
poor have benefited too. My favorite statistic
in this regard is that the portion of people in
the world living on less than a dollar a day
dropped from 41 per cent in 1981 to 14 per
cent in 2008.2
Unfortunately, now that the nannies are
involved, in fact are fully globally dominant
as they attack the rigging paradigm at the
heart of capital markets, it is almost certain
that the enriching will cease, that it will grind
to a halt amidst nonsense from self-interested nannies about the need to fix what
wasnt broken.
Spoofed
There is an old saying: Fool me once, shame
on you. Fool me twice, shame on me.
Perhaps due to such antiquated human wisdom, prosecutors in the current rigging crime
du jour called spoofing, face a dilemma.
138
How do you get human jurors to worry that

machines might play the same trick over and
over again on other machines? Never mind
that a human wouldnt be so stupid as to let
that happen. But how do you get humans to
be concerned about the feelings of machines
in the first place, or crimes against them?
And can machines be victims when both the
putative perpetrators and victims are effective robots working on behalf of that currently most-hated of all human types, the
high frequency trader, or HFT?
No harm, no foul
These problems are compounded from the
prosecutors perspective by the fact that each
instance of the spoofing crime is so small
in its effect that it has no noticeable harm
associated with it. In fact, even if you add
up all the tiny instances, it still amounts to
negligible harm. Not to mention that if a
human did accidentally get caught up in the
machine versus machine battle of spoofing
and other HFT games, that human would
suffer only one instance of that negligible
harm. So wouldnt this be an obvious case
where that other old human saying, No
harm, no foul, would apply?
Spoofing is where a trader places visible
orders he doesnt expect to fill on one side
of the market, to sell, say, above the current
offer, in order to create the false impression
that there are more sellers around than there
really are. If the trick works, the sell orders
will not fill, but will spook or spoof the
market downward to the point where the
traders previously placed buy order will fill,
after which he will immediately cancel the
false sell orders. For an HFT, the strategy
has a double benefit. He buys at the bid and
he collects the coveted liquidity rebate as a

maker of liquidity, as opposed to being a
takerof liquidity that pays a fee. If he is an
aggressive spoofer, he might try to reverse
the position with an opposite side spoofing
trade, with all of the order placements, cancellations and executions in both directions
done in a fraction of a second.
Rigged market violations
Although new enough that most people
have still never heard of it, spoofing is elbowing its way to the top of therigged market
violations that are bedevilling banks in all
their businesses. The total amount of fines
for rigging crimes, mostly, at the moment, for
fixings, are already staggering, and continue
to mount with no end in sight. According to
the Financial Times, reporting after the currency fix settlements: The fines took the
total to US$56.5 billion, making it the most
expensive year for banks on record since
2007 . . . The global probe has triggered a
cascade of further civil, criminal and antitrust
investigations by 20 authorities worldwide
against more than 15 banks over allegations
of collusion and manipulation in the forex
market.3
Regulatory witch-hunt
The addition of spoofing to the other fixing or rigging crimes promises to capitalise on the hatred of HFT and finally send
some of those presumably guilty Wall Street
types to jail. This is likely because regulators are in full witch-hunt cry, their market
structure and civil authorities now backed
for the first time by agencies with criminal
prosecution powers, such as the federal US
Department of Justice (DoJ) and the New
York Attorney Generals office headed by

Eric Schneiderman. Even the Federal Bureau
of Investigation is involved, so these HFTrelated spoofing-type crimes (and there are
several others, with different names), will
soon make their association with HFT a
very serious matter, indeed. This is absurd,
because their association with HFT is what
in reality makes these crimes so trivial or
victimless in their effect. Nonetheless, it is
for the very reason of their association with
HFT that jail is finally on the cards for these
recidivist miscreants.
Judgment Day
The spoofing crime happens on such a small
scale and so quickly generally in less than
a second that it is probably not much different in effect from all the other HFT strategies into which it naturally blends. These
net about one tenth of a penny per share
on average, or about US$1.25 billion a year
for all HFTs together, inclusive of all commissions, rebates and liquidity fees paid or
received.
So assuming spoofing is typical of HFT
strategies (and there is no reason to assume
otherwise), at an average trade size of two
hundred shares, which is typical in todays
high frequency equity market, were talking
a take for the spoofer of only twenty cents
per crime. Multiply that by ten or a hundred,
as the inflated claims of prosecutors allege,
and it is still trivial.
So the problem for the prosecutor is to
convince jurors that if the HFT does this
over and over again, he will make millions.
But even if jurors believe that computers
can be fooled over and over again to play
the same losing game, the flesh and blood
139
victim would never be so stupid. Secondly,

he doesnt trade frequently anyway and, thus,
only suffers once. In fact, for the human
victim, all of the costs and rebates that
matter to the HFTs boil down to a pittance.
False regulatory concerns
The all-in cost, including any spoofing, is
subsumed within a small brokerage commission that has come down significantly
in recent years to about US$8 per trade, and
a ridiculously small bid-offer spread of a
penny per share round trip in active stocks,
or half a penny each way.
So, whether one talks about the trivial 20
cents per trade that an HFT might suffer (and
go ahead, multiply it by 100 if you like), or
the small brokerage commission and spread
that a regular investor would pay, neither
of which is directly attributable to spoofing
any more than any general HFT activity is,
it melts away as a crime. No rational person
would spend ten seconds worrying about it.
Even less so if he realised that, at most,
regulators concern over spoofing is a false
cover, as they misuse their investor protection role to expand into protecting HFTs
from other HFTs. Since when do such professionals need regulatory help?
Hiding behind nannys skirt
Even if spoofing did cost them money,
wouldnt they be better off just programming their algos to recognise they were
being picked off by spoofers and then pick
them off by, for example, looking for opportunities where they can quickly lift those
offers or hit those bids that were not meant
to execute? At least one commercial product
of a former spoofer advertises that it can spot
140
spoofing as it occurs. 4 Why do such sophisticated players need to hide behind the skirts
of nannies?
Fortunately for prosecutors, jurors will
probably have read or heard of Michael
Lewiss Flash Boys, or will have otherwise
imbibed the conventional wisdom on the
evils of HFTs that the book espouses, and
thus wont be swayed by such realities. The
book and all of the media outlets highlighting it, such as 60 Minutes, implied that rigging, repeated zillions of times, costs the
public zillions of their hard-earned savings
and thus destroys public confidence in markets as well as the American dream.
Although all of these untrue claims are
unsupported in the book or anywhere else,
jurors will probably be as gullible as the rest
of the public on this point and will be only
too happy to convict, if only to just find out
if there are any actual humans behind all
that HFT technology who will scream as any
ordinary witch would when burned.
Piata
During his victory lap on CNBC, CFTC
Chairman Massad took the opportunity
to emphasise his agencys need for more
resources. Perhaps shrewdly, given that his
tin cup was out, he pivoted away from his
agencys US$1.4 billion share of the currency fix settlement specifically to highlight
spoofing in his pitch for more resources,
he said: Were very stretched in terms of
our resources. We need more resources
to go after more things, more bad behavior . . . Spoofing for example. We have new
authority to go after spoofing where people enter orders that they really dont mean
to complete in order to move the market.
Thats a very resource intensive investigation, because you must look at a lot of order
data, which is very voluminous. Its a huge
information technology challenge. If we had
more resources we could do more on that.5
Extortion opportunity
With regulators of every description piling
in, with academic market structure issues
becoming regulatory issues, then civil issues,
then criminal issues, and with money flowing ever more freely toward regulators who
cannot resist the extortion opportunity
(although they dont keep the fines, not yet
anyway, in spite of some recent proposals in
that direction), real people should ask some
fundamental questions.
Since all of the crimes are just different means of making an intermediation
turn, and regulators have been on that case
since the SEC set out to bust the block trading conspiracy with an electronic National
Market System (NMS) in 1975, which has
distinctly not increased confidence, why
should we expect a different result now?
NMS, the ultimate regulatory reform to
fix the markets, ensure the integrity of markets, produced HFT, which is universally
hated, and market confidence has been in
the tank ever since.
shouldnt someone be asking whether that

had anything to do with the fact that technology IPOs dropped from 300 per year in
the 1990s to 30 per year now?6
Who is the fool, who is being spoofed,
if regulators are able to keep us on this selfserving treadmill without answering these
questions?
Endnotes
1. Massad appeared on CNBCs Closing Bell, Nov. 12,
video.
2. The total number of dollar-a-day poor people in the
world fell by three-quarters of a billion between 1981 and
2008 in spite of an increase in the total population of poor
countries of about two billion. As a result the fraction of
the worlds population that lives below a dollar a day has
fallen from more than 40 per cent to 14 per cent. The
Great Escape: health, wealth, and the origins of inequality,
Angus Deaton, Princeton University Press, 2013, p.44, Kindle location 791.
3.
Financial Times, November 13, 2014, Front Page: Six
banks hit with fines of $4.3 billion in global forex rigging

scandal.
4. See Trilliums Surveyor product.Trillium was the first
firm hit with spoofing charges (by FINRA), which were settled in 2011.
5.
Massad appeared on CNBCs Closing Bell, Nov. 12,
video.
6.
Peter Thiel, Wall Street Journal Digital Live confer-
ence, interviewed by WSJ business editor Denis K. Berman,
Biggest question of all

Why, exactly, should we expect more reforms
and more regulators to improve confidence,
when it has been declining all along in rough
proportion to regulatory umbrage and the
number of regulators involved in reform?
And the biggest question of all: now that
the investment banking revenue model has
been eviscerated by nanny state reforms,
7:00 a.m. 11/13/14. Speaking of the annual rate of technology IPOs, he said there were maybe three hundred
tech IPOs in the late nineties, maybe thirty now. Thiel,
monopoly-whisperer in his new book, Zero to One, (also
venture capitalist and PayPal co-founder), mentioned this
drastic decline in technology initial public offerings as he
speculated on the reasons for the lack of new company
formation and productivity improvement in the modern
American economy.
141
Credit Risk
Market Risk
Operational Risk
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OTC Derivatives
Derivatives markets in China

to be built upon G20 reforms
Sol Steinberg of OTC Partners is upbeat China
can develop an effective OTC derivatives market
in line with global regulatory requirements.
WHEN members of the Group of 20
(G20), met in Pittsburgh in 2009 in the
wake of the global financial crisis, they
committed to reforms that ushered in a
more calculated approach to systemic
risk in the financial industry, and along
with it, a new market structure for overthe-counter (OTC) derivatives.
Anchored by the principles of mandatory
reporting of OTC derivatives transactions,
mandatory clearing through central counterparties (CCPs) and mandatory trading on
exchanges or electronic trading platforms,
the new market G20 planned for the OTC
derivatives space stressed transparency, risk
controls, and improved protections against
market abuses.
In some of the worlds most established
OTC derivatives markets, those changes are
well underway. In the US OTC derivatives
market, trade reporting and central clearing are well established, and trading of OTC
swaps on US Swaps Execution Facilities
(SEFs) is mandated for many instruments,
with trade volumes on the facilities building
slowly but steadily. The EU has passed EMIR
and implemented trade reporting. As such,

legislative frameworks are being finalised
and adopted for rolling out central clearing
and trading on automated platforms globally, and this includes among other Asian
nations, China, whose regulator has committed the country to the G20 reforms.
In China, where interest rate swaps,
credit default swaps and many of the instruments that make up global OTC derivatives
markets have not been traditional tools of
finance, the commitment of the countrys
regulators to the post-financial crisis G20
reforms, means China is essentially building an OTC derivatives market without the
shackles of legacy systems. Chinas commitment to global financial reform will
essentially give one of the worlds largest
economies a swaps market designed from
the ground up for transparency, regulatory
oversight and management of systemic risk.
Chinese finance has witnessed another
revolutionary year in terms of its evolution
and maturity. After working to avoid another
destructive credit binge, Chinese authorities
have also pushed to foster growth throughout the financial markets, resulting in near
record activity in certain sectors. Even with

a slowdown in growth, the Chinese markets
are on track to realise a solid year ahead.
Year of recovery
2013 was the first year of this recovery, data
shows that operating income and profit of
the securities sector reached RMB 159 billion
(a year-on-year increase of 23 per cent) and
RMB 44 billion (a year-on-year increase of
34 per cent) respectively. 2013 was the true
start of a rebound trend that has been in the
making since 2010, when Chinese securities started to slide. For the year, domestic
securities firms in China saw a year-on-year
increase in profits of nearly 3 per cent for the
majority of its 115 licensed brokerages.
Chinese exchanges have also seen a
significant uptick. 2013 reported the first
increase since 2010, with a year-on-year
increase of 48.94 percent. Brokerage income
also went up 8 percent. Margin financing
and securities lending contributed just under
12 percent and overall assets under management by brokerage firms topped RMB 5.2
trillion, nearly tripling in size from 2012.
Growth and more growth
Total turnover of Chinas securities markets have risen every year since 2010, while
brokerage income accounted for half of the
total income of the securities sector, a yearon-year rise of over 7 per cent. The margin
financing and securities lending business
grew quickly in 2014, contributing to more
than 10 per cent of the total income of the
securities sector for a third straight year,
making it an important source of income for
brokers in addition to revenue from brokerage business and proprietary trading.
144
Assets managed by domestic brokers,

almost tripling in size from previous years,
and the net income of the asset management business reached a seven-year
peak, producing a wave of innovation.
Restructuring and market development
swept through the securities sector: many
brokers grew internet finance strategies; the
credit business saw significant growth; securities companies competed in the wealth
management market as a result of the rapid
development of asset management business; companies specialising in quantitative
investment, program trading and alternative
investment entered a new era of proprietary
investment; the reform of the IPO registration mechanism and the expansion of the
over-the-counter (OTC) market occurred;
and broker mergers started to gather
momentum, resulting in mega-brokers in
the securities sector.
Navigating reform
These reforms also hastened business innovation, forcing securities firms to change
their business model from outdated agency
business to wealth management and capital
intermediary services. These new innovative businesses have optimised the income
structures of securities firms.
Despite rising profitability, the securities sector faced challenges due to the pace
of change. For example, online account
opening strengthened competition among
brokers for commissions, while the rapid
growth of capital-intensive business resulted
in higher liquidity risks. Finding a way to
navigate reform and innovation is an industry-wide test. 2015 will see openings and trials in the competitive landscape arising from
trends such as business diversification and

disintermediation, deepening innovation
and transformation, as well as a more stringent regulatory risk requirements.
Internet of things
Internet finance emerged as a new model
for financial services, combining traditional financial services with theInternet of
things. As new communication platforms
become more intertwined with our everyday
activities, allowing people to share contents
and comment and communicate online,
social media is presenting the financial market with more and more unique opportunities especially in mainland China.
The introduction of internet finance
helps to reduce information disproportion
in traditional business models. It overcomes
geographical constraints and eliminates
the need for transitional players within the
supply chains, thus redefining the demandsupply equivalent model. Brokers should
consider the internet as a means to boost
their core competencies and more. Firms
should develop appropriate strategies to
tackle challenges presented by the mass
market, deciding on whether to compete
directly with other players providing similar
products or design products that cater for
niche market demands.
SCH and mandatory clearing
The balance between demand for security and convenience is crucial from a client
perspective in selecting web-based services.
These two qualities are contradictory, with
security being the ultimate concern for internet services. Firms are only able to design an
ideal product by achieving a delicate balance
between both security and convenience. The

rise of internet finance will present securities
firms with more development opportunities, on condition they can alter the way they
strategically view their business and understand clients needs. Doing so will enable
securities firms in China to seize the opportunities that internet finance offers.
Beginning in 2014 with mandatory clearing by the Shanghai Clearing House (SCH)
of new RMB interest rate swaps with tenors
of no more than five years, China is building central clearing into the foundation of a
its interest rate swaps market. Central clearing has been an early success of OTC swaps
market reform, with some SEFs in the US
reporting that a few non-US clients have
chosen to trade on SEFs while not required
to do so because of the benefits central clearing offers in controlling counterparty risk.
Fifth OTC Asian-clearing nation
Via the SCH, China was the fifth Asian
nation to begin OTC clearing. On its inaugural opening day, the SCH cleared 59 interest
rate swaps between 15 financial institutions
worth a total notional amount of 5 billion
yuan, equivalent to US$827 million. On
July 1, clearing of Chinese yuan interest rate
swaps became mandatory onshore in China
for dealers and clients.
Thirty-five direct clearing members were
admitted prior to launch, including nine
foreign banks. Some notable foreign banks
did not make the cut, prior to the launch
of mandatory trading of yuan interest rates
swaps. Of these, some were hesitant about
the SCHs complaince rules, whilst others
failed to make the grade. Authorised institutions, licensed corporations and other
145
Chinese persons who are counterparty to a

clearing-eligible transaction are required to
clear through a CCP if both entities have a
clearing threshold and are not exempted
from clearing obligations.
China has moved aggressively on other
G20 goals as well. In China, only one trade
repository should be designated for the purposes of the mandatory reporting obligation.
The reporting obligation for Chinese persons will remain unchanged, i.e. their reportable transactions will have to be reported if
their positions exceed a specified threshold,
which will be assessed based on the total
amount of gross positions held.
For licensed corporations, and local
authorised institutions, the reporting obligation will apply if they are counterparty
to the transaction or the transaction has a
Chinese nexus. For foreign authorised firms,
the reporting obligation will not apply if
its Chinese branch is neither involved as
a counterparty to, nor as an originator or
executor of, the reportable transaction, or its
Chinese branch is the originator or executor
of the transaction, but the reportable transaction does not have a Chinese nexus.
A T+2 reporting schedule will provide
market participants some leeway to ensure
they can meet reporting obligations.
Reporting to global trade repositories
will not suffice for the purposes of any mandatory reporting obligation under Chinese
law. Its law prohibits the disclosure of state
secrets and the waters remain muddy as
to what that constitutes. In fact, there are
reports that some US China-based firms
firms have stopped trading with each other
in China because of concern that reporting their trades to US trade repositories, as
146
would be required by two US firms, would

be a violation of Chinese privacy law. Due to
concern that the mandatory reporting obligation may compel market players to breach
confidentiality obligations under overseas
laws, Chinese regulators will try to build in a
degree of flexibility into regime to avoid this.
As of April 2014, three jurisdictions
China, Indonesia and the US reported
having regulations requiring organised platform trading. In China, mandatory trading
will not be imposed at the outset; it will be
phased in later. Once mandatory trading on
designated facilities is in place, fines will be
imposed for breaches of mandatory trading
obligations that will be comparable to those
of other major jurisdictions globally.
Legislation will seek to clarify when
failures to comply with trading, as well as
clearing and reporting obligations should be
penalised and when they may be excused.
Chinese regulators should be able to take
disciplinary action against parties that breach
their obligation and regulators are also proposing a civil penalty regime whereby civil or
administrative fines might be imposed for
compliance breaches.
Chinese regulators will continue to revise
the regulatory authority role in capturing
and monitoring the activities of dealers and
advisors, as well as capturing the activities of
clearing agents. They will also have to work
to clarify regulations as they relate to portfolios of OTC derivatives. Finally, regulators
will devote emphasis to identifying, registering and regulating systemically important
players on the Mainland and have a high
degree of oversight with respect to these
firms, including a registry of names and positions that should be kept with regulators.
Capital markets - China
Chinas securities industry to

undergo metamorphosis
Andy Chen of the Asia Financial Risk ThinkTank examines the impact regulatory change will
have on Chinas nascent securities industry.
IN February last year, the Securities
Association of China (SAC) published
its guidelines for the Comprehensive
Risk Management Practice of Securities
Companies and the Liquidity Risk
Management Guideline of Securities
Companies both being important milestones in the development of capital markets within China.
Under the SAC rule-book securities, firms
operating within China are required to meet
strict international standards of risk management and liquidity risk. Indeed, under
the new regime securities, businesses have
been issued a strict timetable to achieve a
Liquidity Coverage Ratio (LCR) and Net
Stable Funding Ratio (NSFR) of 100 per cent
by 2015, as opposed to the banking sectors
2018 deadline in line with those of the regulator and international community.
In order to meet this challenge of becoming compliant, Chinese securities firms will
have a steep learning curve to follow, one
informed by lessons from their international
competitors, together with those of their
own mistakes and successes, as they strive
to improve their quality of risk management

over the coming years. This is a challenge
that many believe will have important implications for both China and its nascent capital
markets infrastructure.
The risk management guidance published by the SAC is similar to that issued by
the China Banking Regulatory Commission
(CBRC), which is itself highly informed by
the Basel III international framework developed by the Basel Committee of Banking
Supervisors (BCBS) in the wake of the 2008
great financial crisis (which itself is informed
by the Basel II framework with an added
emphasis on liquidity). And this is particularly so with regards to the computation of
LCR and NSFR.
However, whilst the Chinese government and its regulatory agencies may be
keen to embrace best international practice
and sign-up for internationally agreed financial stability measures, of which Basel III is
an important component, the fact remains
that Basel III (and Basel II for that matter)
was designed for mature banking and capital markets dominated by mostly Western
nations, rather than emerging economies,
such as China. This issue is further compounded by the fact that Basel III and CBRC
frameworks and guidance are very much
bank focused, rather than securities industry
specific.
Short-term implications
Given these issues, the desire to bring
Chinas banking and capital markets infrastructure in line with that of its international
competitors may have some negative shortterm implications for Chinese securities
firms, two of which we detail below.
First and foremost, securities firms in
China have a far lower net income, limited
scale and smaller capital and asset base than
their major banking peers. According to figures supplied by the SAC in 2014, there were
115 licensed securities companies in China
with a total asset base of RMB 2,100 billion
and RMB 159.2 billion of total income as of
2013. Further, the average return on equity
(ROE) is only 7.6 per cent, this being far
lower than Chinas banking sector and international competitors.
The strict guidelines and time frame the
SAC has adopted will require huge investment in risk management capabilities and
infrastructure in order for them to meet
international standards. Smaller businesses
may not be able to afford such investment,
which will result in consolidation and
reduced competition within the sector.
Further stymied
Secondly, due to significant differences in
the size and scope of capital market infrastructure in other economies, never mind
that of the banking sector in China itself,
Chinese securities companies and security
148
industry development may be further stymied in playing catch-up in risk management standards, let alone achieving those
standards met by Chinas banks. By way
of example, in the United States securities
companies own some 18 per cent of total
assets in the US economy, whilst in China
this figure relative to the Chinese economy
is a meagre 1 per cent.
As if the challenge for Chinas securities
sector was not daunting enough, the sector
is further handicapped by the fact that the
liquidity of Chinas banking sector is based
on that of the size of market capacity, which
in turn has determined that the CBRC has
adopted a LRC of 100 per cent to be met by
2018, which is the same as its international
competitors under the Basel III framework.
Strict LRC deadline:NOW
Regrettably such largesse does not apply to
the securities sector, despite its lack of relative size and assets compared to the banking sector, who have been set an almost
impossible LRC 100 per cent deadline of
this year (2015). Whilst this may not prove
burdensome in the short-term when leverage is quite low, this may well change moving forward and impact other areas of future
growth.
As it stands today, the short-term funding channel is dominated by the banking
sector and, given the nature of liquidity in
this sector, it has a tendency to run dry at
the months end or end of quarter. By comparison, the NSFR funding ratio requires far
longer time lines for its funding and limited
cash exposure due to inflationary concerns.
As such, many believe that the SACs
rule-book will affect and change the business
composition of the securities sector with a

growing emphasis on asset management
and intermediary business, as firms struggle
to meet the new regulatory requirements.
CDS market failure
Further, all this change may very well impact
detrimentally future business innovation,
particularly in the following three areas outlined in the following paragraphs.
Firstly, innovation and development may
be impaired in the credit default swap (CDS)
arena. The CDS market in China differs
markedly from that of other nations in that
these products can only be issued to provide protection on certainstate-sanctioned
bonds, rather than a comprehensive basket
of bonds found on Chinese exchanges which may explain the low participation rate
of firms offering this service.
Further, despite regulatory efforts to
develop the CDS market since 2010, the
hedging function of CDSs is impaired by
low liquidity and the limited nature of capital
optimization. Under the new SAC regime
matters are now compounded by the higher
LCR requirements of which CDSs have a
negative influence on LCR (net cash outflow) and leverage (total risk exposure). In a
nutshell, the development of the CDS market will be stymied further, this despite regulators desire to expand it a case of double
think!
HQLA demands
Secondly, the regulatory changes may
impact the RMB-denominated stock market. The SACs rule-book now demands
that the high quality liquid asset (HQLA)
weighting of stocks in China is 50 per cent
and that amount cannot exceed 15 per

cent of the overall total HQLA. Whilst this
reduces volatility in LCR, it will limit exposure and other activities within capital markets, specifically marginal trading - the latter
providing opportunities for liquidity angulation, speculation and income volatility.
As such, the SAC guidelines will
heighten concerns securities firms may have
in expanding their marginal trading business, or actually entering this field in the
first place. Much of this is due to the fact that
securities firms will be required to add an
additional liquidity reserve, which, depending on size, this activity will exhaust rapidly.
Additional funding costs
Third, but not least, is the likely impact the
SAC rule-book will have on the long-term
funding channel. In line with other governments and regulatory authorities, the
Chinese government wishes to encourage
longer-term funding to add further stability
to the NSFR.
However, China suffers from a small and
under-developed long-term funding sector,
unlike its overseas competitors. Given this
small capacity, additional demands upon it
are likely to raise funding costs, whilst adding further pressures on profitability and
ROE.
The Beijing authorities are keen to
develop Chinas capital markets infrastructure, with an emphasis on direct investment,
asset securitisation and growing the institutional investor sector.
As such, the country is experiencing a
period of rapid change as it moves away from
a bank-dominated financial system, similar
in many ways to the European Union, to a
149
more evenly balanced mix of deep capital

markets that are able to allocate resources
where they are most needed within the
Chinese economy.
An opportunity bonanza?
As such, the new regulatory environment
offers plenty of opportunities for securities
businesses to enhance their risk management capabilities and learn from their international competitors: twin processes that
should add to the bottom line for those willing to take the challenge.
Getting in on the act of further developing Chinas capital markets and its securities sector, and further reinforcing Beijings
commitment to radical change, the China
Securities Regulatory Commission (CSRC)
in 2014 issued its Nine Articles for China
to inform and encourage reform of Chinas
capital markets infrastructure. And chief
among its wish list is a desire to make the
market more transparent, more competitive,
more innovative and more price competitive.
As such, and with the Nine Articles,
now is the time for comprehensive market reform, a harmonisation of both direct
and indirect investment, together with an
increase is the size of Chinas capital markets within Chinas overall economy. Suffice
to say, we are witnessing exciting times in
China.
Emphasis on vanilla brokerage
Its interesting to compare Chinas economy
and state of its capital markets with those of
the United States or the European Union.
Major differences exist as to the percentages
certain segments take up in the overall GDP
of each country or trading bloc. For example,
150
in China there is far too much reliance on

the vanilla brokerage business, whilst asset
management languishes far behind in terms
of GDP contribution.
Industry feedback is also positive, with
many believing new business lines such as
OTC Derivatives, interest rates products,
structured products and Private Equity are
poised for considerable growth, all of which
will contribute to a tripling of income the
securities industry enjoys over the next five
years.
Learning from past mistakes and those
of its competitors, the Chinese authorities
are committed to growth and reform. The
SAC guidelines of February last year are very
much part of this process, particularly given
Chinas desire not to repeat 2013s cash
crunch. For the securities sector the push
for better risk management and liquidity can
only be positive in the long run.
Many hurdles
Lets not get carried away, though, for, as demonstrated in this paper, certain tweaks are necessary if China is to achieve its stated ambition
of deeper capital markets in an orderly fashion.
Yes, its true that Beijing and its numerous government agencies are committed to
growth and further spreading prosperity, and
comprehensive capital markets are essential
for this in our interconnected modern global
economy.
Securities firms are very much part of this
process and will have a huge opportunity to
expand and grow in importance relevant to
the rest of the economy. However, numerous hurdles exist before this ambition can be
achieved, not least the need for better staff,
regulatory oversight and more capital.
Accounting - CVA
Accounting hurdles for CVA

in the region
Yin Toa Lee of E&Y explains how regulatory
change and new accounting standards impact
credit adjustment in banks and business.
DETERMINING the fair value of derivatives and issued debt has been one of the
key issues for the Asian banking sector in recent years. Whilst Asian-based
banks survived the 2008 financial crisis
reletively unscathed, this has not prevented them from adopting new valuation methodologies in order to better
gauge their positions and exposures in
line with their Western counterparts.
over the world with highly different accounting practices and regulatory oversight. The
counterparty credit risks that these entities
have to manage are affected by numerous factors. As a result, when the entities
account for valuation adjustments, these
adjustments may create enormous income
statement volatility. For banks, these adjustments may have in impact on their regulatory capital requirements.
With new standards and regulations, such as

International Financial Reporting Standard
on fair value measurement (IFRS 13) and the
new regulatory charge under Basel III related
to valuation adjustments as a result of credit,
Asian banks have to fundamentally re-think
their approach to managing counterparty
credit risk. Asian financial centres, such as
Hong Kong and Singapore, both members of the Basel Committee on Banking
Supervision, will certainly be impacted by
these changes.
Hong Kong and Singapore have been
two of the most important gateways for trading and financing in Asia. Local companies
and banks deal with counterparties from all
Credit valuation adjustment

In particular, the new credit adjustment
charge under Basel III and the new accounting standard IFRS 13, which has been in
effect since January 1, 2013, will likely cause
further volatility in results and significant
capital hits in the trading book for banks.
These and future changes in regulatory rules
and accounting standards mean that credit
adjustments will remain high on the agenda
of senior management of reporting entities.
The credit and liquidity crisis, along with
the widening of credit spreads over recent
years has highlighted the need for better
measurement of counterparty credit risk
arising on derivative portfolios. Accounting
standards, both IFRS and US GAAP, also

make it clear that credit risk should be
reflected in the fair value of derivatives.
Debit valuation adjustment
While it is requisite that reporting entities should incorporate credit risk in their
fair value measurement, entities have different practices in doing so. For example, it
is common for entities to record a CVA on
derivative portfolios for counterparties with
positive expected exposure.
This means that entities record a loss and
a decrease of the positive expected exposure
when the credit rating of counterparties worsens. However, entities do not always record
adjustments to reflect the changes of their
own credit ratings in their derivative liabilities
or issued debt (i.e. debit valuation adjustment
(DVA) and own credit adjustment), which
will be discussed later in this paper.
DVA is a type of credit valuation adjustment that entities can record. It adjusts the
measurement of derivative liabilities to
reflect the entitys own default risk. When
the entitys own default risk increases, theoretically, it should recognise a gain on these
liabilities with the DVA because the value
of its liabilities has decreased. The basis of
recording such DVA is that the risk of default
of the reporting entity should be considered
in a fair value measurement just as the counterpartys default risk is.
Monetisation
The key issue raised by reporting entities
around DVA is monetisation. Entities that
do not record a DVA may argue that DVA
is hard to monetise; therefore, it would
not be a relevant component of fair value.
152
Some entities may also feel that recording a

profit when the credit quality of the entity is
decreasing may appear counterintuitive.
Taking these inconsistencies into account,
the introduction of IFRS 13 requires entities
to start recording a DVA. The standard is
explicit that own credit must be incorporated
into the fair value measurement of a liability based on the concept of an exit price (as
opposed to the IAS 39s settlement price).
HKFRS 13 also states that any liability valuation which does not incorporate own credit
is not a fair value measure.
Similar to the existing guidance in US
GAAP, the standard includes an assumption
that the non-performance risk incorporated
in the valuation of a liability should reflect a
hypothetical transfer price involving a market participant of equal credit standing to the
reporting entity on the measurement date.
Uncertainties and conflict
However, the implications of such an
assumption on the DVA recorded for derivative liabilities are unclear to some constituents who believe this concept may conflict
with the requirement to consider the exit
price in the principal market for the derivative liability. If the market participants for
over-the-counter derivatives are assumed to
be dealers, these constituents question how
non-performance risk can be assumed to
remain unchanged in such situations when
the reporting entity is below investment
grade, as dealers with the same level of nonperformance risk likely do not exist.
Notwithstanding these concerns, the
application of this guidance under US
GAAP has resulted in a generally consistent
view on the need to incorporate the effect of
own credit risk in the fair value of derivative

liabilities. Hence, with IFRS 13 being effective
for more than two years, entities in Asia will
also have to apply the similar DVA requirement on their non-performance risk. They
may consider using the same calculation
approach by utilising their existing model for
positive exposures adjustments for DVA.
Own credit adjustment (OCA)
OCA is the adjustment made to issued debt
instruments accounted for under the fair
value option to reflect the default risk of the
entity. It is common for banks to record an
OCA, attributable mainly to the clarity of
both HKFRS and US GAAP requirements.
In recent years, bonds, especially
RMB-denominated bonds, are becoming a more popular financing tool in Hong
Kong because of volatility in the economy.
Companies and banks may see themselves
having an increasing debt portfolio.
As a result of widening credit spreads
over the past few years and variability in
these spreads, their own credit adjustment
on issued debt could generate significant
volatility in the income statement. The magnitude of own credit profits reported by a
number of multinational banks has reinforced concerns that some have about the
economic relevance of such adjustments.
Balance sheet mismatches
Although not many companies and banks
currently elect to the option to fair value
their own debt, such an option might be
more popular in the not far too distant future
to eliminate balance sheet mismatches in
the case of a failed derecognition of assets
in securitisation transactions as well as
hybrid instruments issued with embedded

derivatives.
Like DVA, recording a profit as a result of
OCA on issued debt, when the credit quality of the bank is deteriorating, may appear
counterintuitive. Additionally, there is also a
regulatory requirement to remove the variation of OCA from Tier 1 capital. To address
these impacts that OCA may bring to an
entitys income statement, the new accounting standard of IFRS 9 Financial Instruments,
which is mandatory in 2018, clarifies that
OCA should not be recorded in the income
statement. The standard proposes that entities should instead record OCA in other
comprehensive income within shareholders
equity with no subsequent recycling in profit
or loss, even if an own credit gain is monetised through the repurchase of own debt.
There has not been a similar proposal under
US GAAP.
Exit price
Determining an IFRS compliant exit price
is also a common challenge some derivatives are rarely transferred post-inception, so
determining the appropriate price for a subsequent sale is largely hypothetical.
There is a concern among these reporting entities that the adoption of IFRS 13 and
the clear reference to an exit price approach
will require them to move to using marketobservable credit spreads in the valuations of
derivatives which would lead to significant
volatility in their profit or loss.
Banks in Hong Kong and Singapore are
under the supervision of the Hong Kong
Monetary Authority (HKMA) and Singapore
Monetary Authority (MAS) on their counterparty credit risk. Whilst guidance has been
153
issued by the regulators for banks to follow,

many remain in a state of flux in the implementation of CVA, as well as counterparty
credit risk measurement and management.
First off the post
Since Basel IIs implementation in 2008,
multi-national banks headquartered in
Europe or the United States were among the
first to have sought and received approval
under the regulation to calculate exposures
on derivatives using their own models. As
such, they were often first to implement
CVA measurement and management capabilities ahead of peers elsewhere.
Additionally, these banks with both regulatory-approved exposure models (for risk)
and mature CVA desks tend to adopt different approaches and platforms for regulatory
and accounting calculations. Noticeably in
these banks, risk models are typically calibrated to use historical data, while the CVA
desk uses market implied data for its pricing
purposes.
Bank subsidiary challenge
Banks that do not have regulatory exposure model approved, however, typically
have largely aligned exposure calculation
methodologies and platforms for risk and
CVA management, with differences only in
the way some aspects such as netting and
break clauses are reflected. For banks that
have less well established or no active CVA
management capability, risk models may be
used for the CVA exposure calculation.
Many banks operating in Hong Kong
and Singapore are subsidiaries of large multinational banks, and are often required to
follow their head offices risk management
154
policy. However, many have far fewer

resources available than in their home country, which on occasion can represent a real
challenge in the management and calulation
of credit risk in an efficient manner.
The introduction of Basel III will have an
impact on the differences between regulatory and accounting calculations in a number of ways. Some changes brought about by
Basel III will likely be reflected in the regulatory numbers only. Basel III also introduces a
CVA volatility charge, which is designed to
cover potential changes in the value of the
banks accounting CVA.
Basel III a key driver
This is for most banks a very material additional capital charge and is driven solely by
the banks regulatory models for exposure
and market risk, and the banks associated
credit hedges, rather than the approaches
implemented in the CVA desk.
The accounting measure of CVA, DVA
and OCA will also impact the banks capital
position. This is why many financial institutions feel that Basel III will be a key driver in
their considerations for changes to their CVA
models and policies. For instance, as firms
develop CDS proxy mapping methodologies, they may do so by adapting existing
practices in the CVA desk. Basel III requirements are also leading most banks to invest
substantially in updating their existing infrastructure to deliver improved capability for
exposure measurement and management
across risk and front office.
One of the main areas of difference
between the accounting and regulatory
approaches arises in the treatment of owncredit-related adjustments. While IFRS 13
advocates a symmetrical treatment incorporating counterparty credit risk for derivative

assets (CVA) and own credit risk for derivative liabilities (DVA), the current proposals
under Basel III take different approaches to
CVA and DVA.
The new CVA volatility charge under
Basel III has attracted a lot of comment from
the industry mainly related to the calibration
of this charge; however, market participants
by and large accept the need for it.
The treatment of DVA under Basel III
has proved to be far more contentious. Basel
III explicitly requires banks to derecognise,
in the calculation of Common Equity Tier 1
(CET1), all unrealised gains and losses that
have resulted from changes in the fair value
of liabilities that are due to changes in the
banks own credit risk. The requirement is
simple and transparent. It also ensures that
a worsening of creditworthiness does not

result in an increase in regulatory capital.
This proposed regulatory approach
introduces a significant disconnect between
the accounting and regulatory treatment of
CVA and DVA.
To appropriately manage and account for
credit risks, Asian companies and banks will
have to involve different departments, such
as accounting, risk management, compliance and IT.
Besides designing and implementing a
proper credit risk measurement and management process, entities should ensure
adequate training for different stakeholders in the company on credit and funding
adjustments.
They should also take this opportunity to
review their counterparty exposures and fine
tune their strategy

NORTH ASIA
Opinion
Deregulation, non-r
egulation
and desupervision
Legal &
Call for papers
nce
Complia
Professor William
Black examines the
causes of the mortga
ge fraud epidemic
has swept the United that
States.
THE author of this

paper is a leading
academic, lawyer
and they implicitly
and former banking
demonstrate three
critiregulator specialisin
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g in white collar
and a wholesale
crime. As one of the
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unsung heroes of
discipline of fraud
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163
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135
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Contact:
Christopher Rogers
Editor-in-Chief
155
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Counterparty risk - CVA
CVA pricing issues across

Asia Pacific
BenWatson of Maroon Analyltics surveys many of
the obstacles holding back CVA development in the
region and what can be done to remove them.
THE seizure of financial markets in
September 2008 has made banks and regulators, globally, reconsider how counterparty credit risk should be managed for
OTC derivative exposures. There are three
approaches to this problem; one approach
is to use Central Counterparty Clearers
(CCPs), a second approach the use the Credit
Support Annex (CSA) addendum to of the
ISDA agreement and third is to apply a
Credit Valuation Adjustment (CVA) charge
against the exposures and hedge the default
exposure to an unsecured counterparty.
All three approaches to the management of
counterparty credit have pricing implications
and in all three cases Asian banks are lagging
behind in pricing. As an example, banks in
Australia, the US and Europe in most cases
will pass on the charge CVA to their unsecured
counterparties, but in much of Asia this is currently not so. There are three different types
of CVA banks have to deal with. Regulatory
CVA as required under Basel III, Accounting
CVA as required as part of IRIS 13, and the
counterparty risk management pricing of the
market price of counterparty credit.
Singapore and Hong Kong both require

banks that are incorporated in their jurisdiction to be Basel III compliant and that requires
banks to set aside capital based on the market
price of counterparty credit risk. Accounting
standards also require derivatives to be
marked at their fair value, and that means
accounting for the CVA as an income item
rather than as an asset or liability. While many
Asian banks are complying with the regulatory and accounting requirements, very few
are actually treating CVA as a pricing issue.
The reluctance for Asian banks to price
counterparty credit issue is in part an emerging market issue of underdeveloped markets.
However, possibly the biggest impediment is
some combination of a lack of skills, knowledge, management and leadership. This is
not just an issue for the banks, but also local
regulators. Local regulators have taken the
view that pricing is a commercial decision for
the banks and this is not their role to say how
a bank should price derivatives. The problem
is, however, that pricing CVA in Asia presents
real challenges that just may need some
push from the regulators.
Without the market pricing CVA, it is
going to be difficult for banks to reduce the

CVA capital charge as it comes from CVA
hedging and that should be a function of pricing. The current lack of skill and knowledge
with respect to pricing CVA within Asian
banks (ABs) is going to make implementing
CVA challenging.
The knowledge gap
It is not something that can happen without
first addressing the knowledge gap. Delays
in implementing CVA will also disadvantage ABs as there is a comparative advantage
from the pricing and risk management of
Wrong-Way-Risk (WWR) which can only be
addressed if a bank can price CVA correctly in
the first place. CVA is a very challenging calculation, be it here in Asia or elsewhere.
Traditional credit risk is concerned with
the loss of principal and/or coupons of a bond
or loan and in these cases we usually know
the Exposure at Default (or EAD) in advance.
Counterparty Credit Risk is different as the
EAD is not known with any certain and must
be estimated.
Counterparty credit is also different in that
a bank could be in both an Asset and Liability
position at any one time with the same counterparty and may involve many hundreds or
even thousands of complex trades.
Netting
Where legally allowed to do so, netting of
assets and liabilities is permitted. However,
the netting rules are complex and consequently CVA becomes a portfolio calculation.
On default, any liability exposure to the counterparty must be paid in full; however, any
asset exposure becomes a claim on default. As
it is only the asset positions that are subject to
158
the bankruptcy rules, the valuation of CVA is

akin to an option on the underlying exposures
with the strike where the mark-to-market of a
derivative trade is zero.
From a quantitative finance perspective,
the pricing of CVA becomes challenging. For
example, a single currency swap is viewed as
a swaption, which may not be too difficult
to measure if there is an established swaptions market for that currency. More difficult
is pricing CVA on a cross currency swap, as
this requires a swaption market to value to
the Libor indices plus a long dated FX options
market for the notional exchanges.
There are two issues here for Asian banks
(ABs) - one is a thin or non-existent options
market for the underlying exposures. This is
a symptom of under-developed and shallow
capital markets. Regulators can address structural impediments to deepen the markets but
this is not a quick fix.
Lack of quant desks
This issue could also be addressed by improving transparency and price visibility. Market
associations could work with local banks
to publish reliable prices. Regulators could
also require mandatory price submissions.
Many regulators may be thinking that this
type of intervention in the markets is beyond
their remit, this is not so with the mandatory
reporting of trades.
The second issue is that ABs have under
invested in their quantitative resources evidenced by the fact that in Singapore there are
only two ABs that have proper quant desks
that are focused in building internal quant
libraries. By contrast all major Australian banks
have significant quant teams. Many ABs have
opted to outsource their quant solutions to
external vendors. While outsourcing may

allow a banks to buy some sophistication,
it does not represent an investment in intellectual capital.
A pricing issue, not compliance
There are not enough skills or knowledge
within the ABs to have a proper conservation with management on what needs to be
done. In many cases, the CVA conservation
has been left to the risk management function as part of the Basel III implementation.
This is missing the point CVA should be
seen as pricing issue, not just one of Basel
III compliance.
The valuation of CVA also requires estimates of the probability of default. The Basel
Committee made it explicit that CVA should
reflect the market price of counterparty credit.
Their motivation for insisting on market
measures for CVA is that they prefer banks to
hedge counterparty credit, and thus CVA capital relief would come from the hedging of the
CVA exposure. The implication is the probability of default should be arisk-neutralas
implied from credit spreads or CDS spreads
rather than areal-worldmeasure. The practical outcome is that to price CVA, the market
price of credit needs to be observable and this
means either visible CDS or credit spreads.
China hopes evaporate
Credit markets in Asia have been growing
strongly, but from a very low base. Many
new bond issues are bought from yield perspective and are never seen in the secondary
market which make price visibility difficult or
impossible.
The CDS market globally has declined
since 2008 and is now less than half the
size at its peak. To compound matters the

number of Asian names that trade is only a
small fraction of the total CDS market. There
was hope of a visible credit market in China
when they tried to establish the equivalence
of a domestic CDS market with Credit Risk
Mitigation Agreement (CRMA) of 2010.
These (CRMA) contracts are similar to
a CDS except that they are referenced to a
specific loan or bond rather than a reference
entity. Unfortunately, this market has failed to
thrive mainly because: most loans in China
are done via a bilateral basis and there is no
market viability; a lack of market uniformity
in the CRMA contract makes them hard to
trade and because the CRMA contract does
not allow for capital relief under Basel II section 162 provisions of cross-default.
Proxy pricing
Lack of price visibility is clearly a hindrance in
calculating the market price of the probability
of default, but this problem has not stopped
CVA pricing and hedging in the rest of the
world. Basel III allows for proxy hedges to be
used when there is no CDS contract against
a particular counterparty. This proxy could be
a credit index or a counterparty that is similar to the one you are trying to calculate CVA
for. This would suggest iTraxx Asia-Ex Japan
index would attract a lot of interest, but this
has not been the reality.
Using this index may be problematic if
we are trying to hedge counterparty credit, as
the constituents of the index is dominated by
Asian banks and some sovereign names, and
this may not reflect the type of corporate credit
that may attract CVA. A lack of credit price
visibility in Asia could be addressed by a panAsian contribution service that is owned by the
159
local banks where contributors are rewarded

with better price visibility. Again regulators
could assist in making the pricing visible by
mandating that banks contribute prices.
Globally, regulators have been keen to
see CVA being priced and passed onto the
unsecured counterparties. The motivation for
this is they do not want to see a failure to price
counterparty credit risk becoming a competitive advantage. While there is no legal obligation to pass this charge on, the regulators are
keen to remind banks that CVA is deducted
at the accounting level and there is also a CVA
capital charges if left unhedged. Banks in such
jurisdictions have become motivated to pass
the CVA charge on where possible.
This is in contrast with a number of ABs
who have been making accounting adjustments below the line for CVA but without
CVA pricing from the front office. The consequence is that these Asian banks may well be
writing business at a loss.
Further, due to the portfolio approach
required to price CVA, an incremental CVA
charge is always less to existing counterparties. This means there is a competitive advantage in CVA pricing to your existing client
base as opposed to new clients. Without CVA
being passed on to the client, banks are not
able to use incremental CVA to defend their
existing client base. The biggest lost opportunity for ABs in failing to address CVA is the
competitive advantage in being able to manage Wrong-Way-Risk (WWR).
WWR is when the probability of default
is positively correlated with the exposure.
That is when your counterparty probability of
default increases when your exposure to them
increases. This is often referred to as a crossgamma issue where the delta of an exposure
160
is influenced by some other factor, and in this

case the probability of default. The standard
CVA calculation assumes no WWR which is a
gross simplification as WWR is almost always
evident.
There have been many examples of
WWR in recent times e.g. IDR / Indonesian
Sovereign CDS spread in 2008, or facing AIG
on a bought CDS exposure during the GFC.
An example of WWR that is often given is
buying put protection from a company on its
own stock the value of the put peaks when
the company goes bankrupt and is unable to
pay. WWR becomes a risk issue in that you
will end up hedging the credit exposure at
expensive levels and unwind them at cheap
levels and it becomes a real slippage cost
when trying to hedge the counterparty credit.
While WWR is not an Asian issue per
se, the prevalence of export-led economies,
heavy reliance on FX and offshore funding
along with shallow capital markets would
suggest WWR would be a big risk factor within Asian banks. Identifying WWR
involves looking at how your counterpartys
exposures move with changes in the probability of default. Banks that are able to do
this analysis are able to identify which counterparties, what products and what markets
are likely to cause WWR.
Once you are able to understand your
books in such a way you can make decisions
on how to manage this risk. Management of
WWR may involve exiting certain markets,
putting limits on certain clients in certain markets or charging extra to cover the expected
cost of hedging. The technically correct way
to hedge WWR is to match the cross-gamma
with another product that exhibits the same
properties.
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Journal of Regulation & Risk - North Asia, Winter 2015 Edition

Journal of Regulation & Risk - North Asia, Winter 2015 Edition