September 2012

Global Risk Regulator
Volume 10 Issue 8

ISSN 1741-6620


Basel III implementation
Banks seek EU delay - page 2

US setback on money fund rules threatens global split
By Melvyn Westlake

Regulatory capture

It can be effectively countered, says new book - page 3

While Washington regulators struggle to impose reforms on money market funds, parallel international plans are moving rapidly ahead

US Regulatory roundup
Latest financial reform developments - page 6



Stories on: Basel III in Mexico, Singapore, Malaysia, India; Consultation launched on EU conglomerates' capital; Basel II finally comes to Turkey, Russia; Tighter exchange traded fund rules; Forex fears prompt new guidance; Basel sets 2% capital charge on clearing house exposures; Study evaluates US short-selling ban; Consultation on Senior figures say complicated regulation threatens to make things regime for failing financial worse for the financial system, not better. Call for return to simplicity infrastructure providers By David Keefe

nternational regulators are determined to press ahead with reforms to the structure of the $4.7 trillion global money market funds industry, despite the defeat in late August for similar proposals drafted in the US by the Securities and Exchange Commission (SEC). This raises the possibility of a future split in the global regulatory standards applied to a systemically important industry that forms a key part of what is dubbed the shadow banking sector. Leaders of the Group of 20 largest economies agreed at their November 2010 summit in Seoul to ask international standard setting bodies to develop recommendations to strengthen the oversight and regulation of shadow banking. One strand in this exercise, dealing with money

market funds (MMFs), is being undertaken by the International Organisation of Securities Commissions (IOSCO), the Madrid-based agency comprising securities regulators around the world, including America’s SEC. The US is very actively involved in this international reform exercise. A senior SEC staffer is cochairing the task force drafting the IOSCO’s final recommendations on money market funds Mary that are being prepared for a Schapiro critical meeting of G20 finance ministers in November. But the setback for reforms in the US has surprised and perturbed international regulators. In an unusual move, Masamichi to page 8

Simplify the rules or drown in a tide of complexity
here is growing concern among past and present regulators that the overwhelming complexity of financial regulation could backfire and have the unintended effect of hobbling effective supervision and crisis control. In remarks to GRR, Sheila Bair, who as chairman of the Federal Deposit Insurance Corporation (FDIC) helped steer America through the 2007-09 global financial crisis, said she agreed fully with the criticisms of complexity made by Bank of England executive director Andrew Haldane in late August*. “We’re drowning in complexity,” said Bair who now leads the Systemic Risk Council (SRC), a private-sector, non-partisan body that advocates better financial regulation with a focus

- pages 12-18

Insurance regulation
- page 19

(1) Cool response to G20 systemic risk approach (II) US insurers fear impact of Basel III and Dodd-Frank
- page 21

- page 23

Regulators' lack of vision tests financial system

on systemic risk. At the height of the financial crisis Bair was ranked by Forbes magazine as the second most powerful woman in the world after German chancellor Angela Merkel. “The public is tired of rules they don’t understand,” she said, adding: “We should be simplifying the rules, we should be simplifying the institutions for which the rules are made, but it’s going in the opposite direction.” She suggested in effect that a vicious circle was being created by the slow pace of reform, as exemplified by the incomplete implementation of America’s 2010 Dodd-Frank Wall Street Reform Act, coupled with the complexity of so many of the rules. The more complex a rule is, the harder and
to page 10

Global Risk Regulator

September 2012
These moves prompted the German Banking Industry Committee to call for a year’s delay – to January 1, 2014 – in the implementation of the new capital regime. "This is the only realistic option," said Uwe Froehlich, president of the association of German cooperative banks, who was speaking on behalf of the industry commitee, an umbrella organisation for all German lenders. His comments came a few days before the EBIC letter was dispatched.

EU banks seek Basel III implementation delay
Industry fears political ruckus over capital rules will not leave sufficient time to prepare for new regime's 2013 introduction
trialogue with European Commission officials, to make sufficient progress towards a deal on the EU version of Basel III, known as the Capital Requirements Directive/ Capital Requirements Regulation (CRD IV/CRR). Negotiations over this legislation have taken much longer than predicted. Many of the thorniest questions remained unresolved when talks were halted for Europe’s long summer break. he European banking industry is calling for a delay in the implementation of the tough new Basel III capital requirements, due to be introduced at the start of 2013. However, there is some disagreement over the extent of the delay needed. German bankers would like to see the introduction of the new rules pushed back by a full year, while the British Bankers’ Association (BBA) wants a more nuanced approach, with some elements of the new regime implemented more swiftly than others. In a letter sent in early August to key members of the European Parliament, senior officials in the EU executive and the current leadership of the bloc’s finance ministers, the banking industry’s umbrella body says: “The technical constraints faced by credit institutions cannot be ignored.” Proposed rule changes, it adds, “should be [introduced] to a realistic implementation timetable that recognises the practical difficulties [credit institutions] face.” The letter was sent by the European Banking Industry Committee (EBIC), which comprises trade bodies spanning almost the entire gamut of EU credit institutions – banks, public and private, large and small, as well as building societies, leasing companies and finance houses. It follows the failure of lawmakers and national governments, meeting in so-called

Banks not stalling

Peter Konesny In order to implement new rules, banks “need precise final details, particularly for the IT systems”
The Council, comprising national governments, suspended its work in this area until September, while the European Parliament decided to vote on the proposals only towards the end of October. EBIC says it is “highly concerned about the considerable delay which the legislative process is experiencing. As a consequence of this delay financial institutions will not have sufficient time to prepare for, and adapt to, the new provisions if the implementation date for the new rules remains unchanged from 1 January 2013, onwards.”

However, at the European industry level there was “only agreement on a reasonable period of time for implementation. It is not very precise because of the different positions of the members,” acknowledges Peter Konesny, head of banking supervision and policy at the German association of savings banks and, as chairman of the EBIC working group on banking supervisory practices, one of the two signatories to the committee’s letter. For its part, the British Bankers’ Association is concerned that calling for a year’s delay may be interpreted as foot-dragging by the banks. Some aspects of the proposed rules can be carried out reasonably quickly, says the BBA, such as implementing the new capital definitions. By contrast, it reckons the counterparty valuation adjustment may well take a year. So, the aim should be to get some understanding with regulators over what is possible and what is not. Bankers in Berlin emphatically insist that the German industry is not stalling over the introduction of Basel III. Gerhard Hofmann, a board director responsible for regulatory issues at the association of

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cooperative banks and EBIC vice-chairman, blames the delay on the complexity of the proposals and the difficulties of getting agreement in Brussels on EU legislation. It could be late October or even November before the legislation is finally approved. Implementing the rules in the remaining two or three months before the present start-date is simply not possible, he says. “It is not possible to change the IT systems, educate the staff, prepare internal procedures and do everything else necessary to implement this huge package.” Banks have been preparing as much as possible. But it is necessary to have the final legislative text and legal certainty before they can do more, adds Hofmann, a former Bundesbank supervisor. “Banks could incur considerable investment risk.” Precise final details are needed, in particular, for IT systems, argues Konesny. For instance, he explains, some IT providers in Germany have already said that they cannot provide the systems needed because of the continuing uncertainty over the final provisions of CRD IV/CRR.

September 2012
opines. All the major banks in the EU are required under the capital adequacy exercise conducted in recent months by the European Banking Authority, the supervisory watchdog, to maintain a minimum 9% core Tier I capital ratio. The major banks were stress tested to ensure that they met this target ratio. Those that failed were obliged to make up the shortfalls. This 9% ratio is an on-going requirement, and is stricter than demanded under Basel III during the initial transition years, notes Konesny. Meantime, the German cabinet agreed in mid-August to push ahead quickly with the introduction of Basel III rules, approving a Bill that was described as sending a “signal” to institutions including the EU parliament and the European Commission “to share the urgency.” GRR ago. Academics, commentators and official enquiries have all pointed to the impact that the undue influence of special interests has played in causing a relaxation in regulatory constraints in the period preceding the crisis. The US financial sector, for example, is reported to have spent $2.7 billion in federal lobbying between 1999 and 2008, and $1.4 million daily lobbying Congress during the crisis. Yet regulatory capture is the one major area that has not received much attention from policymakers as they draw up an extensive array of regulatory reform proposals. Perhaps that is because many studies have suggested that capture is unavoidable. This has even led to calls for further deregulation, on the grounds that no regulation would be better than regulation captured by industry. But this “inevitability” theory is being challenged. “Regulatory capture is partly – and perhaps largely – preventable,” assert Carpenter, Moss and Wachtell Stinnett. The relationship between policymakers and market participants in the regulation of financial markets does, though, contain a paradox, reckons Pagliari. In a dynamic and technically complex environment such as the financial markets, regulatory authorities are required to develop a constant and close interaction with the market participants under their surveillance in order to stay abreast of rapidly changing financial markets, to monitor the build-up of risks, and to understand the impact of their regulatory policies. However, the same proximity between regulators and market actors that is required

Gerhard Hofmann Delay is caused by the complexity of the proposals and Brussels wrangling
Moreover, there is no danger that banks can benefit from any implementation delay by, say, reducing their capital levels, Konesny

Wrestling the many-headed hydra of regulatory capture

Fatalism over capture is rejected in a persuasive new book. Reform of decision-making processes can often prevent it


By Melvyn Westlake
organisation. But it assumes that it is possible to establish exactly where the “public interest” resides in a given regulatory issue, as the editor of the volume, Stefano Pagliari, an ICFR research associate, points out. The uncertainty surrounding the impact of financial regulatory policies, and the presence of sometimes competing objectives, such as ensuring stability and a stable flow of credit to the economy, often makes the task of identifying the public interest ex ante quite challenging.

egulatory capture is not inevitable, as is sometimes claimed. It may be impossible to eliminate altogether, but much more can be done to effectively counter the phenomenon and mitigate its consequences. This is the central message of a collection of essays by academics, former regulators and representatives of interest groups, published in a new book* by the International Centre for Financial Regulation (ICFR). The London-based ICFR is a research and training organisation that promotes best practice in financial regulation. What makes regulatory capture so difficult to address is the many diverse forms it takes. Definitions vary widely. According to one essay, regulatory capture is “the result or process by which regulation (in law or application) is, at least partially, by intent and action of the industry regulated, consistently or repeatedly directed away from the public interest and towards the interests of the regulated industry.” That is the definition employed in the essay jointly authored by Professor Daniel Carpenter, of Harvard University, Professor David Moss of the Harvard Business School and Melanie Wachtell Stinnett, Director of Policy at The Tobin Project, a US research

What makes regulatory capture so difficult to address is the many diverse forms it takes
A definition that gets round this problem is provided by Lawrence Baxter, a Professor at the Duke Law School in the US. He argues that regulatory capture is present “whenever a particular sector to the regulatory regime has acquired influence disproportionate to the balance of interests envisaged when the regulatory system was established.” Whatever the precise definition, regulatory capture is seen by many observers as a significant contributing factor to the financial crisis that erupted five years


Global Risk Regulator
for regulators to effectively perform their responsibilities has also been described as opening the regulatory process to the risk of unduly favouring narrow industry interests at the expense of the public. This distortion in the process is commonly defined as “regulatory capture,” says Pagliari. The most important source of disagreement, he notes, among the different scholars and commentators in this volume of essays concerns the mechanisms through which regulatory policies come to diverge from the public interest and unduly favour narrow interest. Four aspects of the financial policymaking process that make financial regulatory policymaking particularly prone to capture are identified by the various contributors. strong incentives to constantly monitor and seek to steer the action of regulators, other stakeholders face greater challenges in coordinating and mobilising the organisational and informational resources required to compete with the financial industry groups in the marketplace for influencing regulation. Moreover, a survey of respondents to financial consultations conducted by Pagliari and colleague Kevin Young, a Fellow at Princeton University, found that less than 10% of the private actors responding to financial regulatory consultations belong to trade unions, consumer protection groups, non-governmental organisations (NGOs), and research institutions.

September 2012
financial industry and regulatory agencies. Regulators often find that their best working opportunities lie with the firms they regulate. The reverse trend is also evident, with individuals from the industry taking up regulatory positions. This revolving door is a more common feature of the regulatory scene in the US than in Europe where regulatory bodies have instead been characterised by career silos with bureaucrats spending most of their career in the state sector.

Regulators often find that their best working opportunities lie with the firms they regulate
But, there is the clear risk that this revolving door could create incentives for regulators to be lenient towards prospective future employers. A third channel for influencing regulatory policies is ‘intellectual capture’ or ‘cognitive capture’ – the ascendency of a particular set of beliefs or ideas, or what FSA chairman Adair Turner has called the ‘intellectual zeitgeist,’ which enabled the influence of bank lobbies to hold sway before the crisis. At that time, the prevailing beliefs emphasised the efficiency of financial markets at

Stefano Pagliari Sees a paradox

The “institutional context”

in the regulatory relationship between policy makers and maket participants

The first is the asymmetrical nature of different stakeholders’ participation in the regulatory process. It is not just the concentration of large resources in the hands of a restricted range of financial firms. A greater imbalance among different social groups often exists in terms of technical information. Regulatory capture theorists have highlighted how “capture” is more likely when regulation is highly complex and information asymmetries between the regulated industry and the regulators are greater. The complexity inherent in financial regulatory policies and the built-in advantage that the financial firms targeted by specific regulation have in terms of knowledge and information compared with other stakeholders are factors that increase the dependence on industry for expertise. Many analysts have lamented the lack of engagement in financial regulatory debates of stakeholders other than the financial firms affected, such as deposit holders, investors, and consumers of financial services. Besides being disadvantaged vis-àvis financial industry groups in terms of financial resources and technical expertise, these groups’ voices remain hindered by their diffuse nature and the resulting ‘collective action problems.’ While the financial groups who are the primary target of the regulation will have

A second aspect of the financial policymaking process that opens financial regulatory policymaking to capture is what is referred to as the “institutional context.” Financial industry groups continue to maintain a preferential access to regulators and to interact with them in an often opaque and discretionary environment, with many discussions occurring behind closed doors. In some cases, regulatory agencies have been granted an explicit mandate to promote the interests of certain groups over others. For instance, certain regulatory agencies such as the US Office of the Comptroller of the Currency are statutorily directed to promote the interests of the banks under their oversight. Similarly, the mandate of Britain’s Financial Services Authority (FSA) includes a clause to “have regard to” the competitiveness of the financial services industry, an element which has been described as skewing the incentives of regulators, and increasing the risk they will prioritise the role of the international champion of the City of London over other statutory duties. In addition, different regulatory agencies rely on levies applied to the financial industry as the primary source of funding. Financial industry representatives in some cases have a direct representation on the board of regulatory agencies, thus potentially influencing key decisions and the selection of executives. In particular, the governance of the Federal Reserve System has come under the spotlight in recent years, since executives of banks that are regulated by the Fed and that have received emergency loans during the crisis often serve on its board of directors. And then there is the question of the ‘revolving doors’ that exist between the

There is the clear risk that this revolving door – as people move between regulatory agencies and the financial sector – could create incentives for regulators to be lenient towards prospective future employers
understanding and allocating risks, their self-stabilising nature, and the benefits of financial innovations for the real economy. The final channel of influence over regulatory policies identified by regulatory capture theorists is through the political process. Politicians (governments and legislative bodies) establish the mandates that independent regulatory agencies need to follow, and grant them the resources and powers to perform these tasks. So, the relationship between regulators and their political masters may create additional avenues for capture, as different stakeholders seek to change the course of action of regulators indirectly through the political process. In countries such as the US, the financial industry remains one of the major contributors to politicians’ electoral cam-


Global Risk Regulator
paigns across the political spectrum and it is therefore able to exercise a significant influence over the voting behaviour of Congress on certain regulatory issues. Alternatively, given the significant impact that certain financial regulatory issues may have on the rest of the economy, politicians may interfere in the actions of regulators in order to achieve key political objectives such as economic growth, employment, social and economic stability. With so many channels and mechanisms for influencing regulation, what can be done to prevent capture, or at least mitigate it? A wide range of strategies are proposed by different contributors to the ICFR book. These are grouped into three broad “agendas” by Pagliari: 1) measures promoting greater balance and diversity in the competition among different stakeholders; 2) reforms of the institutional sumer groups, retail investor associations, housing associations, trade unions, foundations, think tanks, and NGOs, whose creation has been sponsored by the European Parliament following the crisis with the objective of establishing a more effective counterweight to industry lobbying in regulatory debates. Creating “proxy advocates” within a particular regulatory institution could provide another possible solution. These advocates are internal panels given the job of providing regulators with expertise and information from a consumer perspective, challenging regulatory policies, and to represent the public interest at large in the decision making process. This mechanism is common outside of finance, where different utilities regulators have established standing panels of consumer representatives. The European Commission has also set up the Financial Services User Group, while Britain’s FSA has a Consumer Panel.

September 2012
pressure from narrow groups. At the same time, if a regulatory agency is given conflicting responsibilities that require the agency to further the goals of industry at the same time that it is responsible for a general public-interest mission, it is likely that industry pressure and a focus on short-term economic concerns will trump the long-term public-interest goals. What is needed in reforming the institutional context for regulatory policymaking, summarises Pagliari, is a clear and unbiased mandate, adequate internal procedures which expose regulatory decisions to a variety of views, an adequate framework to manage conflicts of interest from the revolving door issue, and appropriate funding. These are important prerequisites for regulators to be able to carry out their duties without unduly favouring certain special interests.

David Moss

Dan Carpenter

Lawrence Baxter Attempting to define regulatory capture
Additionally, a third set of proposals emphasised by regulatory capture theorists concerns the checks and balances needed to ensure that regulatory agencies are constantly held accountable and challenged. These include increasing the transparency of the financial regulatory process; granting the right of different stakeholders to appeal some regulatory decisions to the courts; and the creation of external independent watchdogs with the responsibility to check the operations of regulatory authorities in order to detect deviation from the public interest. The regulatory agenda that has emerged since the crisis has neglected such “low hanging fruits,” concludes Pagliari, and largely focused on fixing gaps in the regulation of specific sectors. Analysis developed in the essays, he says “highlights the fact that paying attention to the process through which financial regulations are designed and implemented is equally important in order to build a more resilient financial regulatory system.” GRR *The Making of Good Financial Regulation: Towards a Policy Response to Regulatory Capture

Stakeholder group

“Regulatory capture is preventable”
context within which regulators operate; and 3) opening up the regulatory process to different external checks and balances. In the first case, one proposed approach involves the creation of participatory mechanisms such as subjecting regulatory policy to public consultation. This already happens increasingly, but has proved inadequate in mustering participation from a wide range of stakeholders.

Proxy advocates

Other approaches include what are termed “tripartism” and “proxy advocates.” The capacity of consumer groups and NGOs to effectively engage in the policymaking process is constrained by the fact that most of such bodies active in financial regulatory policymaking are too small, disperse, and underfunded. One answer might be for policymakers’ to subsidise the creation of consumer groups. This is, for instance, the approach adopted in the case of Finance Watch, a new organisation comprising different con-

Under a more recent move, the three new European Supervisory Authorities for banking, insurance and the securities markets are obliged to establish stakeholder groups whose members include financial services practitioners as well as academics, “end users” and consumer groups. But as pointed out in an essay by David Strachan, a former regulator, now cohead of Deloitte’s Centre for Regulatory Strategy, achieving a consensus within a panel that contains such different interests – industry representatives and consumers – is likely to be a challenge. Yet, other proposals suggest strengthening competition between different elements within the financial industry. Some kinds of firms will benefit from stronger regulation and could be a countervailing force against the risk of capture within the industry itself. Strachan proposes the establishment of a ‘standing body of practitioners’ reflecting the composition of the financial services industry as a whole and therefore less susceptible to the demands of particular interest groups. A second set of proposals in the book focus on institutional biases which create incentives for regulatory actors to favour financial industry groups under their supervision. The mandate given to the regulatory agency, for instance, may determine its vulnerability to capture. Giving regulatory agencies a broad jurisdiction makes it more likely that they will be able to resist


Global Risk Regulator

September 2012

US regulatory round-up
A selection of news items generated by the American regulatory reform agenda
Washington’s regulatory conveyor belt is spewing out new rules required under the Dodd-Frank Wall Street Reform and Consumer Protection Act, which became law on July 21, 2010. Banks and other market participants are struggling to keep up with the detail. By the law’s second anniversary, some 123 (30.9%) of its 398 total rulemaking requirements had been finalised, according to law firm Davis Polk, and rules had been proposed that would meet 134 (33.7%) more. Around 121 proposed deadlines for rulemakings were estimated to have been missed. Rules had not yet been proposed to meet 141(35.4%) rulemaking requirements
international standards developed by the Basel-based Committee on Payment and Settlement Systems (CPSS) and the International Organisation of Securities Commissions (IOSCO), in Madrid. In addition, the final rule establishes requirements for advance notice of proposed material changes to the rules, procedures, or operations of a designated FMU for which the Fed is the supervisory agency. The advance notice requirements set the threshold above which a proposed change would be considered material and thus require an advance notice to the Fed, and also include provisions on the length of the review period. With two exceptions, the final rule is substantively similar to that initially proposed. It includes a new provision that would allow the Fed Board to waive the application of certain risk management standards to a particular type of designated FMU, where the risks presented by or the design of that designated FMU would make application of certain standards inappropriate. In addition, the Fed Board has revised the illustrative list of changes that do not require an advance notice, in part to include changes to a designated FMU's fees, prices, or other charges.

distress, including selling off businesses, finding other funding sources if regular borrowing markets shut them out, and reducing risk. The plans must be feasible to execute within three to six months, and banks were to "make no assumption of extraordinary support from the public sector," according to the documents. Recovery plans differ from living wills, also known as "resolution plans," which are required under the 2010 Dodd-Frank financial reform law. Living wills aim to end bailouts of too-big-to-fail banks by showing how they would liquidate themselves without imperilling the financial system. Recovery plans, on the other hand, are helpful in ensuring banks and regulators are prepared to manage periods of severe financial distress or instability. This summer, nine global banks submitted living wills to the Fed and Federal Deposit Insurance Corporation.

CFTC proposes the first swaps to be cleared
A new rule was proposed by the Commodity Futures Trading Commission (CFTC) in late July to require certain credit default swaps and interest rate swaps to be cleared by registered derivatives clearing organisations (DCOs). It represents the first clearing determination by the Commission under the DoddFrank Act. The proposed rule requires market participants to submit a swap that is identified in the rule for clearing by a DCO as soon as technologically practicable and no later than the end of the day of execution. The Dodd-Frank Act prevents market participants from transacting a swap that is required to be cleared unless that person submits the swap for clearing to a DCO. The Act also requires the Commission to determine whether a swap is required to be cleared by either a CFTC-initiated review or a submission from a DCO for the review of a swap, or group, or class of swaps. Initially, the proposed determination covers four interest rate swap classes and two credit default swap classes. But other swaps submitted by DCOs, such as agricultural, energy and equity indices, will be

Final rule adopted for financial market utilities
A final rule was unanimously approved by the Federal Reserve Board in late July establishing risk-management standards for certain financial market utilities (FMUs) designated as systemically important. FMUs, such as payment systems, central securities depositories, and central counterparties, form the plumbing in the financial system, providing the infrastructure to clear and settle payments and other transactions. The final rule, which becomes effective on September 14, this year, implements two provisions of Title VIII of the Dodd-Frank Act. It establishes risk-management standards governing the operations related to the payment, clearing, and settlement activities of designated FMUs, except those registered as clearing agencies with the Securities and Exchange Commission or as derivatives clearing organisations with the Commodity Futures Trading Commission. The risk-management standards are based on the recognised 6

Five banks told to make secret recovery plans
Regulators in the US have instructed five of the country's biggest banks to develop plans for staving off collapse if they faced serious problems, emphasising that the banks could not count on government help. According to Reuters news agency, the two-year-old programme, which has been largely secret until now, is in addition to the "living wills" the banks crafted to help regulators dismantle them if they actually do fail. Documents obtained by the new agency show the Federal Reserve and the Office of the Comptroller of the Currency first directed five banks – Citigroup, Morgan Stanley, JPMorgan Chase, Bank of America and Goldman Sachs – to come up with these "recovery plans" in May 2010. They told banks to consider drastic efforts to prevent failure in times of

Global Risk Regulator
considered by the CFTC at a later date. The decision to focus initially on credit default swaps and interest rate swaps is because of their importance in the market and the fact that a significant percentage of these swaps are already being cleared. The proposed rule will not apply to those entities that are exempt from the clearing requirements, notably non-financial firms hedging commercial risk. But regulations are also proposed to prevent evasion of the clearing requirement and deter abuse of any exemption or exception to the clearing requirement provided under Dodd-Frank Act. Finally, a DCO will be required to post on its website a list of all swaps that it will accept for clearing and clearly indicate which of those swaps the CFTC has deemed must be cleared. The deadline for public comment on the proposed rule is 30 days after publication in the Federal Register. to get foreign banks to increase their capital levels,” Abernathy is quoted as saying. “Conceding that point in light of lower capital levels carried by many foreign banks, that desideratum could surely be achieved with far less complexity and without imposing serious harm on the American economy.” In a separate statement, the ABA said it will “work for capital rules that are countercyclical, that do not worsen a credit crunch, and are appropriately related to reasonable measures of risk.” Policymakers, it added, “must not ignore the contractionary nature of increasing capital standards.”

September 2012
allow for robust analysis of such a complex rulemaking, all banks are exposed to heightened risks in capital adequacy, mission, and operational integrity,” he wrote. A third letter came from trade organisations representing banks in every state in America, saying they needed more time “to provide [regulators] with the very best information possible” to aid them in completing the new rules.

Senators urge larger capital hike for biggest banks
Two Senate Banking Committee lawmakers sent a letter to Federal Reserve Chairman Ben Bernanke in early August urging the central bank to require the largest US banks to hold more capital. Senators David Vitter, a Republican from Louisiana, and Sherrod Brown, a Democrat from Ohio, said regulators should demand higher capital for systemically important financial institutions (SIFIs) and that the current proposed standards are a “baby step in the correct direction.” In their joint letter to Bernanke, the senators say: “You must have the Sherrod board revisit the pro- Brown posed rule to implement Basel III and modify the rule to include a SIFI surcharge significant enough to change the incentives for the largest banks.” Modifying the proposed rule and requiring the biggest banks to have stronger capital reserves would help preserve the safety and soundness of the American financial system, the senators assert, and will help ensure that megabanks are no longer ‘too-big-to-fail’ or will require another taxpayer bailout. “Your proposed rule on capital standards misses a huge opportunity to address the too-big-to-fail issue by setting the so-called SIFI surcharge far too low,” say Brown and Vitter. “We urge you to revisit your proposed rule and modify it so David Vitter that megabanks fund themselves with proportionately more loss-absorbing capital per dollar of assets than smaller regional or community banks.” GRR

Extension of comment period granted
Washington bank regulators have extended the comment period on their Basel III proposals by 45 days, to October 22. The extension was announced in early August by the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Camden Insurance Corporation. The Basel III capital Fine framework was issued on June 7 in the form of three notices of proposed rulemaking (NPRs), totalling 700 pages (see GRRs for June and July). A comment period of three months was originally given, but various banking organisation subsequently clamoured for a further 90 days. Much of the “harmonised, comprehensive capital framework” will impact all of America’s 7,300. The first of several letters, requesting a comment-period extension of “at least an additional 90 days,” was sent jointly by the American Bankers Association and the Financial Services Roundtable. “These proposals,” they said, “would be the most material changes to US capital standards since 1989 and will have significant immediate and ongoing impact on the nature of financial services” in America. This was followed by a letter from Camden Fine, chief executive of the Independent Community Bankers of America, arguing that the “size, scope and impact of these proposals represent a challenging obstacle” for his member banks. “Without an appropriate extension of the proposals to

US Basel III developments
Basel III slammed as detrimental to America
Wayne Abernathy, executive vice president for financial institutions, policy and regulatory affairs at the American Bankers Association (ABA) has described the Basel III international capital requirements as detrimental to the US economy. Noting that Fed experts estimate that US banks will be required to raise capital levels by $60 billion, Abernathy said in early August that this will be a “body blow” to the American economy, according the Bloomberg news service. “That is a lot of money, particularly when you understand that it is to be used to do nothing…” Abernathy is quoted as saying. “Banks would set aside another $60 billion just to provide the same amount of financial services as they do now. Effectively, those $60 billion would be gathered from the economy and shelved.” Without Basel standards, American Wayne Abernathy banks could receive $60 billion from investors to support $600 billion in new loans and financial services. “Maybe the Basel standards are needed


Global Risk Regulator
US setback on money fund rules threatens global split
From page 1

September 2012
Masamichi Kono Says “IOSCO will continue its work on the basis of the mandate given to it”
to block Schapiro’s proposals a “national disgrace.” They said it was a victory for an industry lobby that had campaigned ferociously against the reforms. Changing the structure of MMFs has been on regulators’ agenda since the industry was effectively bailed out during the financial crisis. At the height of the turmoil, in 2008, the Reserve Primary Fund became do not have to comply with the mark-tomarket valuation standards. As a consequence, they have historically been viewed as a safe, liquid and easily accessible short-term home for the deployment of cash held by municipal and corporate treasurers, cash managers and the like. At the same time, MMFs have become a crucial part of the funding strategies of banks in the US, Europe, Japan and elsewhere. But to some regulators, money market funds look suspiciously like banks themselves. Paul Tucker, a deputy governor of the Bank of England, has described them as “narrow banks in mutual-fund clothing.” That is why they are viewed as manifestly part of the shadow banking sector.

Kono, IOSCO board chairman and a top official at Japan’s Financial Services Agency, issued a three-paragraph statement reaffirming that “IOSCO will continue its work on the basis of the mandate given to it” by the G20 leaders and the Financial Stability Board to develop policy recommendations for MMFs. The IOSCO board is due to approve the final recommendations at a meeting in early October. Although these final recommendations are not yet public, the interim recommendations issued for public comment in April were closely in line with the parallel domestic US proposals that proved so divisive at the SEC.

John Rogers “The industry has won this particular battle, but that does not mean that the war is over”
the second money fund in history to “break the buck” when its shares dropped from $1.00 to $0.97 in the wake of the Lehman Brothers' bankruptcy. That event triggered a wide-spread "flight to quality" as many investors in prime money funds (money funds that invest primarily in short-term bank and corpo-

Previous reforms

Schapiro's retreat

Just a week before Mary Schapiro, SEC chairman, had been expected to unveil proposals to restructure MMFs, she was forced to abandon them. Three of the Commissioners, constituting a majority, were refusing to support the proposals, which were intended for public comment. A disappointed Schapiro called on other policymakers to “consider ways to address the systemic risks posed by money market funds,” urging them to “act with same determination that the staff of the SEC has displayed over the past two years.” The issue, she insisted, is “too important to investors, to our economy and to taxpayers to put our head in the sand and wish it away.” Two Republican Commissioners who opposed Schapiro’s proposals, Daniel Gallagher and Troy Paredes, countered that the changes being suggested were “not supported by the requisite data and analysis,” and risked “effectively ending prime money market funds as we know them.” The more surprising, third opponent of the proposals, Democrat Commissioner Luis Aguilar, worried they would cause investors to move their money “from regulated, transparent money market funds into the dark, opaque, unregulated market.” But advocates of the reforms, such as former SEC chairman Arthur Levitt called the decision by the three commissioners

Christopher Donahue “The idea that this means total victory is just not true. To us this is a continuing effort”
rate debt) moved their investments out of such funds and into government securities or government money funds. The heavy redemptions contributed to a lack of liquidity in the short-term debt markets, further weakening the financial sector. The growth of MMFs is largely the result of a special exemption granted by the SEC three decades ago, which allows them to seek to maintain a stable $1.00 net asset value by using cost accounting. This means that, unlike all other mutual funds, they

Some changes to MMF rules were adopted by the SEC in 2010, aimed at strengthening disclosure requirements, tightening maturity, diversity and credit quality standards and imposing new liquidity requirements. However, these changes were only ever seen as “an important first step” in the agency’s efforts to strengthen the money market regime. In June, Schapiro told US lawmakers that money market funds as currently structured continued to “pose a significant destabilising risk to the financial system” and remained “susceptible to the risk of destabilising runs.” That’s because MMFs have no ability to absorb a loss above a certain size without breaking the buck; and investors in these funds have every incentive to run at the first sign of a problem. Despite the rule changes in 2010, fund “sponsors” (the asset managers – and their corporate parents – who offer and manage these funds) have had to use their own capital to absorb losses or protect their funds from breaking the buck, the SEC chairman argued. Indeed, according o a review undertaken by Commission staff, sponsors have voluntarily provided support to money market funds on more than 300 occasions since they were first offered in the 1970s, Schapiro claimed. Her abandoned proposals included two alternative approaches to address these structural problems: first, money market funds could be required to float the net asset value (NAV) and use mark-to-market valuation like every other mutual fund; or, second, they could be required to hold a tailored capital buffer of less than 1% of 8

Global Risk Regulator

September 2012

fund assets, adjusted to reflect is quoted as saying. The 10 bigthe risk characteristics of the gest money-fund managers and fund. This capital buffer would the Investment Company Institute be used to absorb the day-to(ICI), the industry association, are day variations in the value of a estimated to have spent a commoney market fund's holdings. bined $16 million in the first half To supplement that buffer in of 2012 and $31.6 million last year times of stress, it would be comin trying to scuttle MMF reforms. bined with a 3% so-called “holdICI chief executive Paul Schott back” of investors’ money for Stevens denies that money mar30-days. The other 97% would ket funds accelerated the financial Luis Aguilar be redeemed in the normal way. Dan Gallagher Troy Paredes crisis of 2007-08. He told lawmakThat holdback would constitute ers in June that “some regulators and private sector executives, was set a "first-loss" position and could continue to view money market be used to provide extra capital to a up only in June. Anticipating the defeat of fund reform through the outdated lens money market fund that suffered losses Schapiro’s proposals, the Council said in of 2008.” The structural changes being greater than its capital buffer during that a statement at the end of July that “if the considered by Schapiro “would destroy SEC fails to move forward, we believe the money market funds, at great cost to 30-day period. Similar approaches were contained in FSOC should use the full range of authori- investors, state and local governments and IOSCO’s April consultation paper, ties given it under the Dodd-Frank Act to the economy,” he argued. although they were only part of a much effectuate the proposed reforms.” wider menu of reform options proposed The options now Paul Schott for the MMF industry worldwide, of which Exactly what powers the treasury-chaired Stevens the US accounts for 60%, or $2.7 trillion FSOC or Federal Reserve might now “Some regulain assets and Europe some $1.5 trillion. consider deploying is still a matter of tors continue to Before the financial crisis, however, US conjecture. According to Dennis Kelleher, view money fund money market funds alone were estichief executive of Better Markets, a pubmated to have reached $4 trillion. reform through lic interest advocacy organisation, there In Europe, 90% of the industry is reckthe outdated lens are three possible avenues open to the oned to be in three countries – France, of 2008” FSOC. One avenue would be to directLuxembourg and Ireland. ly designate MMFs for supervision and Regulators at the Federal Reserve are said John Rogers, chief executive of the CFA regulation by the Federal Reserve. The to be pretty sore about the failure of the Institute, a global association that sets statutory authority given to FSOC under SEC proposals to go forward, although standards for investment professionals, the Dodd-Frank Act is broad enough to opposition among the Commissioners and a member of the Systemic Risk allow it to designate classes of firms, such had been well flagged. The proposed MMF Council (SRC), says “the industry has won as MMFs, for new or heightened standreforms have been urged by US treas- this particular battle, but that does not ards and safeguards if they pose a threat ury secretary Tim Geithner and several mean that the war is over.” to US financial stability, Kelleher says in a top Fed officials, including chairman Ben Dennis blog post. Bernanke and Bosten Fed president Eric Kelleher Alternatively, FSOC can direct the SEC Rosengren. Few people doubt that regulato impose new or heightened standards tors will now be looking for other ways and safeguards to MMFs when circumThere are three to reduce the perceived risk that the MMF possible avenues stances warrant. The Commission can be industry poses. directed to take systemic risk-mitigating that FSOC can Indeed, the Fed and the treasury are actions regarding money market funds believed to have been preparing for the take now that include risk-based capital requirepossibility that the financial industry might ments, leverage limits, liquidity requireprevail in stopping the SEC proposed reforms. The whole issue is certain to There are a “lot of raw feelings” both ments, concentration limits, and other be kicked back to the Financial Stability among regulators and within the industry requirements. Oversight Council (FSOC), the powerful and it is going to take a bit of time for the In addition, under proposals that have panel of regulatory bosses that Congress dust to settle and the situation to become not yet been implemented, FSOC may in charged under 2010 Dodd-Frank reform clear, he adds. Certainly the industry future have the power to identify, designate and regulate systemically significant Act with monitoring the country’s finan- expects the regulators to try again. “The idea that this means total victory non-bank firms, including asset managers. cial threats. In fact, that is exactly what another is just not true. To us this is a continu- Other approaches have been cited by new body, the Systemic Risk Council, ing effort,” Christopher Donahue, chief top officials at the Fed. Governor Daniel is urging. This Council, an independent, executive of Federated Investors, a fund Tarullo has suggested that the US central non-partisan body that brings together management firm that gets nearly half bank, possibly in conjunction with foreign a galaxy of former regulators, academics its revenue from money market funds, regulators, could curtail banks' reliance 9

Opponents of SEC proposals

Global Risk Regulator
on money funds for funding. And, Boston Fed president Eric Rosengren has floated the idea that the banks that sponsor money funds could be required to hold additional capital against the risk those funds present, a move that would only apply to about half of the industry. This last idea would involve the inclusion of break-the-buck capital scenarios in the next round of Fed stress test for large bank holding companies. Some of these companies sponsor large MMFs. And, where the stress tests revealed risks of the buck being broken, those risks would have to be supported by additional capital from the bank holding company. The CFA Institute’s John Rogers is a little sceptical about some of the indirect routes of trying to regulate MMFs via the banks. And where more specific regulations are sought by the FSOC, he notes, the task would have to be remitted back

September 2012
to the SEC as the agency directly responsible for money market funds (unless regulation of the industry or individual funds are imposed under the systemicthreat powers). Ultimately, Rogers thinks the SEC will be asked by FSOC to try again, perhaps looking at a broader range of potential changes to the industry’s practices, with greater chance of winning acceptance. GRR
supporting policy measures: a delayering of the Basel structure; placing leverage on a stronger regulatory footing; strengthening supervisory discretion and market discipline; regulating complexity explicitly; and structurally re-configuring the financial system. “I think Haldane’s speech was as much an attack on the Basel II advanced approaches [to modelling risk], which he has done before, and I wholeheartedly agree with him,” Bair said. Bair’s remarks reflected her long-standing advocacy of the leverage ratio. As chairman of the FDIC, the federal banking supervisory agency that insures customer deposits at America’s banks, she insisted on stricter capital requirements than those proposed by the international accord. Her demands helped stall the introduction of Basel II in the US because she wanted the package to include the leverage ratio that now forms such an important element of Basel III. After she had fought Basel II for so many years because it resulted in precipitous capital declines, Blair said it would be “disheartening” to disown Basel III which is designed to correct Basel II’s faults. “The evidence shows that for the larger institutions that got in trouble during the crisis, the leverage ratio was a much better predictor than a risk-based ratio of whether they were going to fail or not. It’s simple, it’s easier for examiners to enforce and it’s easier to understand,” Blair says. Like any simple rule, the leverage ratio is less subject to gaming. And while it’s true the leverage ratio is less risk sensitive, there’s a supervisory process that accompanies it. However, a good risk-based ratio should capture a bank loading up on risk, Bair says, adding that she had always said that both types of ratio are needed. At present the Basel III rules prescribe a 3% leverage ratio, which Haldane noted means bank equity can in principle be leveraged up to 33 times. Most banks would say a loan-to-value ratio of 97% was imprudent

Simplify the rules or drown in a tide of complexity
From page 1

longer it takes to finalise; the longer it takes to finalise a rule, the more watered down it gets under pressure from the financial services industry critics “who then turn around and criticise the regulators for being too bureaucratic with their lengthy rules,” she said. Bair said she was in “wholehearted agreement” with Haldane’s attack on the complexity of regulation - made at the annual Jackson Hole, Wyoming get-together of central bankers - and his criticism of the use of models to set the level of regulatory capital banks need as a buffer to absorb shock losses. Above all, Bair is fully behind Haldane’s advocacy of the risk-insensitive leverage ratio of capital to assets as a guide to a bank’s health. The leverage ratio is simpler and more efficient than risk-based capital ratios. But Bair, who as FDIC chief fought for the leverage ratio to be included in the international Basel III bank reform package, is more protective of Basel III than Haldane. His Jackson Hole paper, written with Bank of England colleague Vasileios Madouros, was interpreted in some quarters as calling for the capital accord to be torn up and for a return to a few simple standards on capital and total borrowing. There are “some very good things about Basel III in terms of improving the definition of what counts as capital, what counts as tangible common equity and, finally, the instituting of a leverage ratio,” Bair said.

Sheila Bair: “Disappointed and dismayed” over the slow pace of reform implementation under the Dodd-Frank Act. “Regulators need to aim for simplicity and finalise these reforms”

Jackson Hole, that the first Basel bank capital accord weighed in at 30 pages long. Basel II, which was agreed in 2004 and formalised the use of banks’ internal models to set capital requirements, came in at 347 pages, while Basel III, which sets much tougher capital rules and introduces new liquidity requirements, comprises 616 pages. “The length of the Basel rulebook, if anything, understates its complexity,” said Haldane who is on the Basel Committee of global banking supervisors that’s responsible for devising Basel III. Analysts said Haldane’s views were more nuanced than some commentators allowed and that he was simply arguing for a rethink on models, a greater role for the leverage ratio and a “delayering” of the complexity of Basel III. Provocative Haldane Haldane, who is executive director for Haldane suggests simplification and streamfinancial stability at the UK central bank, lining the framework might be achieved pointed out to fellow central bankers at through a combination of five mutually-


Global Risk Regulator
for a borrower, Haldane said, although a 3% leverage ratio means banks are just such a borrower. For the world’s largest banks, the leverage ratio needed to guard against failure in the crisis would have been above 7%, he noted. ment, capital markets and securities market regulation, including former Federal Reserve chairman Paul Volcker, sponsor of the Volcker Rule banning banks from proprietary trading under the Dodd-Frank Act.

September 2012
potential source of instability in the financial system, she noted. The SRC, which strongly supports Schapiro’s proposals, made clear early on that the risk that emergency government support may again be needed to stem large outflows from money market funds remains a serious challenge for US and other markets. In the event of the SEC failing to act promptly on these measures, the FSOC should use its powers under DoddFrank to move forward with reforms to protect taxpayers against the risk of a need for bailouts in the future, the SRC said. But in her remarks to GRR, Bair acknowledge that FSOC has no power to intervene directly. Unfortunately, the FSOC can’t write its own rules, so it has to follow a circuitous process if it thinks a particular regulatory agency isn’t dealing with a systemic problem, Bair said. On the controversial Volcker rule banning proprietary trading, she said her personal view was that anything to do with proprietary trading should be walled off from federally insured banks but accepts this is not going to happen. She said it was extremely difficult to distinguish market-making from proprietary trading because market-making needs inventory to meet customer demand and that means in effect taking market positions in order to maintain inventory.

“For the larger institutions Systemic Risk Council that got in trouble during Concerns over the slow progress of regulators and standard-setters prompted the the crisis, the leverage ratio creation of the SRC. The council has said it was a much better predic- will monitor and evaluate the activities of tor than a risk-based ratio those with the Congressional mandate to develop and implement Dodd-Frank proof whether they were going visions related to systemic risk, including to fail or not. It’s simple, the Financial Stability Oversight Council it’s easier for examiners to (FSOC), America’s systemic risk watchdog, and the Office of Financial Research, the enforce and it’s easier to bureau set up within the US Treasury to understand” – Sheila Bair improve the quality of financial data availBlair said that in terms of complexity, she would focus on Basel II and the use of models in the advanced approaches to measuring risk. “I think we should get rid of the advanced approaches, using the simpler standardised approach for the risk-based capital ratios. We need to put a lot more emphasis on the leverage ratio to constrain risk at institutions.” In respect of Basel III in the US, where regulators have extended the comment period on the implementation proposals to October 22, Bair said there’s still an issue with complexity, despite many analysts believing the US version of Basel III to be simpler than the international accord. “It’s all focused on the risk-based rules and my personal view is those rules need to be simplified. I don’t think models have any place in setting regulatory capital. I think models are fine as part of your risk management tools, but they’re not reliable,” she said. And just how unreliable was seen recently with the so-called “London Whale” fiasco, J P Morgan Chase’s multi-billion dollar derivatives trading blunder. “London Whale shows that if you let banks use models to set their regulatory capital, they will have incentives to have a model that gives lower capital,” she said. Bair believes Basel III will go into effect in America, although meeting the January 2013 implementation deadline may be a tough proposition given the extension of the comment deadline to October 22. Since June Bair, who left the FDIC last year after a five-year stint as chairman, has chaired the SRC. The Council comprises a diverse group of experts in invest-

able to policymakers. The SRC expects to evaluate and provide commentary on the existing efforts of regulators to design and implement a

Andrew Haldane “The length of the Basel rulebook, if anything, undertates its complexity”
credible and globally-coordinated systemic risk oversight function. Activities include reports and commentary to the FSOC and its member regulators as they adopt regulations to prevent a repeat of the global financial crisis. Bair said she was deeply frustrated with the slow pace of reform in the US. “I am disappointed and dismayed. Regulators need to aim for simplicity and finalise these reforms,” she said of DoddFrank, enacted two years ago but still only a third to a half implemented. But she acknowledged it’s harder to write a simple rule than a complex one. “We can’t even get things done like money market mutual fund reform,” Bair adds, referring to the failure of the Securities and Exchange Commission (SEC) in August to agree on reforms of the $2.7 trillion US money market fund industry (see page 1). It’s extremely disheartening that three of the five SEC Commissioners didn’t back SEC chairman Mary Schapiro’s reforms, Bair said. The irony is that the SEC had watered down the original proposals. Meanwhile, money market funds remain a

Basel III is “all focused on the risk-based rules and my personal view is those rules need to be simplified. I don’t think models have any place in setting regulatory capital. I think models are fine as part of your risk management tools, but they’re not reliable” – Sheila Bair
Banning any profits made from hedge transactions would be one way of curtailing the use of hedging as a ruse for proprietary trading. Greater transparency and disclosure of the models used for trading would be helpful in determining exactly what banks were up to, Blair said but noted that there’s no provision for that in the rule. GRR
*The dog and the frisbee – paper by Andrew Haldane and Vasileios Madouros, Bank of England, August 2012 .


Global Risk Regulator Newsroom
director of the Monetary Authority of Singapore (MAS) told journalists when introducing the authority’s annual report in late July. Singapore-incorporated banks Countries in Latin America and Asia are will meet Basel III minimum capital moving swiftly to adopt the Basel III capiadequacy requirements two years ahead tal standards, sometimes more quickly of the Basel Committee’s timeline of and more strictly than the internationallyJanuary 1, 2015 (for banks to reach the agreed version requires. Here are some minimum core Tier 1 ratio of 4.5%). recent developments monitored by GRR. FRom the beginning of 2015, SingaporeanMexico - The regulatory agency for incorporated banks must meet MAS’ banks, in Mexico City, announced in capital adequacy requirements that are mid-August that the country's banks will 2% higher than the Basel III global capital adopt Basel III rules in September, sooner standards, Menon explained. than previously expected. This would He also said that MAS will be stepping make them the first in the world to adopt up consolidated supervision of financial the new standards. All have capital levgroups. “We are increasingly focusing on els above the minimum required under areas such as mitigating intra-group conBasel III, said Guillermo Babatz, head of tagion risk, preventing the multiple use Mexico's banking and securities commisof capital within the group, and limiting sion. group concentration risk exposures.” Under the Basel III framework, banks Malaysia - Basel III capital rules are are required to maintain top-quality unlikely to be overly onerous for the capital equivalent at 7 percent of their major Malaysian banks in light of their risk-bearing assets. According to Reuters, satisfactory core capitalisation, according Babatz said at a conference: "The reason to a report issued by the credit rating for adopting [the rules] ahead of schedule agency Fitch in early August. is that the system is really very strong." The gradual transition to higher capital The commission had previously slated standards from Basel II would over time adoption of the rules for the start of enhance the resilience of the domestic 2013, when the transition to Basel III is banking sector as a whole, Fitch said. due to begin globally. Adopting the new “Compliance does not appear to be a rules will encourage Mexican banks to major challenge.” stay disciplined and not rely too much The rating agency estimates the consolion subordinated debt and other types of dated common equity Tier 1 (CET1) capicapital "that are not so resistant in times tal ratio of the eight Malaysian banks to of crisis," he said. range between 8% and 11% at end-March Singapore – The Basel III capital stand2012 under the Basel III guidelines, which ards will be implemented early in the are currently in the consultative stage. island state, Ravi Menon, the managing The average CET1 ratio is estimated to bloc. These draft standards are intended to Consultation launched on ensure that the entities that comprise the EU conglomerates’ capital financial conglomerate apply the appropriate calculation methods for the determiThe three pan-European supervisory nation of the required capital at the conauthorities (ESAs) for banking, insurglomerate level. ance and securities markets have jointly Financial conglomerates combine banking, launched a public consultation on methods insurance and securities and investment for calculating the required capital to be businesses in various combinations, which held by EU financial conglomerates. The is why all three ESAs are involved in their consultation document was issued at the regulation. end of August by the European Banking The draft standards are based on the Authority, the European Securities Markets European Commission’s proposed legAuthority and the European Insurance and islation for implementing the new Basel Occupational Pensions Authority. III capital rules for banks in the EU. It proposes draft regulatory technical This legislation, known in Europe as the standards that will become part of the sinCapital Requirements Directive and Capital gle rulebook, and aims to enhance regulaRequirements Regulation (CRD IV/CRR) is still tory harmonisation across the 27-country the subject of negotiation. That means that

September 2012

Basel III global monitor – Latin America and Asia

be 8.7% on a Basel III basis, slightly lower than 9.3% under the present Basel II framework. The estimated capital ratios are higher than the 7% floor for CET1 under the new framework, which comprises the 4.5% regulatory minimum and 2.5% capital conservation buffer. India – Banks in India will have to raise between Rs1.5 trillion and Rs1.75 trillion ($31.4 billion) in equity capital, and they further Rs3.25 trillion in subordinated debt, to meet the Basel III standards by the government’s March 2018 deadline, Duvvuri Subbarao, governor of the Reserve Bank of India (RBI) predicted in early August. And, a big slice of this sum – estimated after allowance for internallygenerated earnings – would need to be raised by the public sector banks. The government is constrained from helping them raise the necessary capital by its fiscal deficit, the governor said. But, one option, he noted would be for the government to reduce its stake in the public sector banks to below 50%. Talking to journalists, Subbarao said he was hopeful that the banks in the private sector would be able to raise their share of the capital that the sector needed. “In the last five years, these banks had raised Rs 500 billion in equity.” The RBI announced in December that Basel III would be implemented more stringently than required under the international framework, both in the level of capital that banks must hold and in the speed of transition to the new regime. Basel III is due to take full effect around the world from the start of 2019. the draft conglomerate technical standards might be changed in coming months once the CRD IV/CRR legislation is finalised. The consultation paper frames the draft standards around a number of general principles and three methods of calculation. The principles include: elimination of multiple gearing; elimination of intra-group creation of own funds; transferability and availability of own funds; and coverage of deficit at financial conglomerate level having regard to definition of cross-sector capital. The three methods of calculation are: the accounting consolidation method; the deduction and aggregation method; and a method that combines the other two. Deadline for public comment on the consultation paper is October 5.


Global Risk Regulator

September 2012

Basel II finally comes to Turkey and Russia
ISTANBUL/MOSCOW – Turkish banks' capital ratios were predicted to drop by an average of about 1 percentage point this summer as they switch the Basel II capital standards. That was the judgment of rating agency Fitch in a comment note issued at the end of July. Turkey is one of the last major emerging market economies, along with Russia, to adopt the Basel II capital framework finally hammered out by international regulators on the Basel Committee in 2004. It began to be implemented by many countries around the world three or four years later. Only the US among the developed countries has not yet fully adopted it. However, Washington now aims to subsume all the critical elements of Basel II into its proposals for implementing the more sweeping Basel III capital and liquidity rules. Meanwhile, a select group of Russian banks are on track to comply with Basel II standards by 2014, according a Moscow Times report at the beginning of August. State-owned giants Sberbank, VTB and Gazprombank, as well as privately controlled Alfa Bank, are among five "pilot" banks that have begun the process of implementing these standards, it said. In the case of Turkish banks, Fitch says they are generally well capitalised. The sector as a whole reported a total regulatory capital adequacy ratio of 16.2% at end-May 2012, and leverage is moderate, despite recent rapid credit growth. “Strong capitalisation generally remains a positive rating driver for Turkish banks, and we are reassured by tight regulatory oversight, which should help prevent a rapid build-up of sector leverage,” the rating agency concludes. Turkish banks have been operating Basel I and Basel II in tandem for about a year, and switched fully to the latter in July. They now have to hold more capital against certain assets, notably sovereign bonds, and capital relief on large portions of their retail portfolios will be lower than originally expected, says Fitch. “This should reduce the risk of a marked further increase in system leverage. We expect the banks' capital ratios to fall by

an average of about 100 basis points.” The rating agency reckons Basel I favoured Turkey. As a member of the Paris-based Organisation for Economic Cooperation and Development, Turkish sovereign and bank exposures attracted no capital charges. This is no longer the case under Basel II. “The move towards a ratings-based approach means that risk weightings for Turkish sovereign exposure increase, in light of the sovereign's sub-investment grade.” At the same time, Turkey’s Banking Regulation and Supervision Authority (BRSA) is tough in its application of Basel II. Under its rules, foreign currency-denominated Turkish sovereign bonds attract a 100% risk weight (previously 0%). Turkish banks are large investors in Turkish sovereign bonds, so capital ratios will suffer. BRSA's treatment of residential mortgage loans is also stricter than recommended under the international version of Basel II. Despite intense bank lobbying, these loans still attract a 50% risk weight (against 35% under the international version), while risk weights for credit card receivables and consumer loans with maturities up to 12 months are 150%, rising to 200% for maturities over two years (against 75% for unsecured retail loans under international Basel II). In Russia, Sberbank, the country’s biggest lender is some nine months into the "active phase" of introducing Basel II, according to the director of its risk department, Vadim Kulik. The bank’s risk-analysis models must be in place by 2013, he is reported to have said at the beginning of August, because they are required to function for a year before the regulator can give them its approval. The compliance process has obliged the country's biggest lender to develop over 600 such risk models, Kulik said. All of Sberbank's clients, he added, will have a credit rating, akin to those ascribed to banks and governments by rating agencies such as Standard and Poor's, Moody's and Fitch. Implementing Basel II is a priority of the Central Bank and financial regulators and is part of the Kremlin's drive to make Moscow an international financial centre, Kulik explained.

Adoption of international accounts in US years away
ORLANDO, Florida – US adoption of international accounting rules is not coming any time soon, the “absolute soonest” being five to six years’ time, according to the head of a leading US accounting body. Gregory Anton of the American Institute of Certified Public Accountants (AICPA) told delegates at AICPA’s EDGE conference in Orlando in August not to expect any movement on the controversial issue until after the November US presidential elections at the earliest. Anton’s remarks, as reported by Accountancy Age magazine, followed the unsurprising news in July that staff with the US stock market regulator, the Securities and Exchange Commission (SEC), had at the end of a two-and-ahalf year study made no recommendation either way on whether America should adopt the International Financial Reporting Standards (IFRS) accepted in more than 100 countries (see GRR, July/ August 2012). Anton said the AICPA supports giving US companies the option to use IFRS, and supports the issue of one set of highquality standards, but warned that the "absolute soonest" IFRS will be seen in the US will be in five to six years' time. His comments follow a number of setbacks to the IASB's project to converge global accounting standards. The SEC's decision to kick IFRS adoption into the long grass was followed by a spat between the International Accounting Standards Board (IASB), the London-based standard-setting authority for IFRS, and its US counterpart, the Financial Accounting Standards Board (FASB), over a solution to contentious loan impairment accounting rules. A joint meeting between the IASB and FASB held in July to discuss accounting for the impairment of financial instruments ended in acrimony, with FASB pulling back from issuing a methodology for an "expected loss" approach to loan provisioning, Accountancy Age reported. IASB chairman Hans Hoogervorst said the failure to come to an agreement was "deeply embarrassing".

Global Risk Regulator Newsroom
Regulators consult on regime for failing FMIs
BASEL/MADRID – International regulators are consulting on proposals for dealing with financial market infrastructure (FMI) providers that run into difficulties threatening their viability or even fail completely. FMIs, such as systemically important payment systems, central securities depositories, securities settlement systems, central counterparties and trade repositories, play an essential role in the global financial system. The disorderly failure of an FMI can lead to severe systemic disruption if it causes markets to cease to operate effectively. Accordingly, regulators have decided that all types of FMIs should generally be subject to regimes and strategies for recovery and resolution. Concerns over the potential disruption of an ailing FMI have been heightened by the separate policy of international regulators to reform the vast over-thecounter (OTC) market and ensure that as large a proportion of transactions as possible are cleared through central counterparties (CCPs). A consultative report, setting out the principles for the recovery and resolution of FMIs was published* at the end of July by the Basel-based Committee on Payment and Settlement Systems (CPSS) and the International Organisation of Securities Commissions (IOSCO), the Madrid body representing securities agencies in over a 100 countries. Principles for FMIs and Key Attributes for the effective resolution of financial institutions in general have been set out in earlier reports. Notably, under the key attributes report, countries are required to establish resolution regimes that allow for the resolution of a financial institution in circumstances where recovery is no longer feasible. An effective resolution regime, regulators say, must enable resolution without systemic disruption or exposing the taxpayer to loss. The late-July consultation report focuses on the issues that should be taken into account for different types of FMIs when putting in place effective recovery plans and resolution regimes in accordance with the Principles and the Key Attributes. As part of this exercise, the authors’ calculations they increased trading costs in the equity and options markets by more than $1 billion. The study* was carried out by Robert Battalio and Paul Schultz, professors of finance at the University of Notre Dame’s Mendoza College of Business; and Hamid Mehran an assistant vice president in the NY Fed’s research and statistics group. They say that a re-examination of the 2008 restrictions is particularly important in light of the latest wave of bans in Europe, including the restrictions imposed by Spain and Italy in July. To provide additional evidence, the three authors also considered the market effects of short-selling in August 2011, when the debt-rating agency Standard and Poor’s lowered the US sovereign long-term credit rating, prompting the S&P 500 share index to fall 6.66% on the next trading day. At the time, there was no short-selling ban in place. But the authors found no evidence that stock prices declined following the rating downgrade as a result of short-selling. In fact, stocks with large increases in short interest earned higher, not lower,

September 2012

consultation report also sets out how the specific key attributes apply to FMIs. Ensuring that FMIs can continue to perform critical operations and services as expected in a crisis, the report says, is central to the recovery plans – sometimes called ‘living wills’ – they must formulate and the national resolution regime that applies to them. Maintaining critical operations should allow FMIs to serve as a source of strength and continuity for the financial markets they serve, the report adds. In remarks accompanying the consultation report, CPSS chairman Paul Tucker, who is also Bank of England deputy governor for financial stability, said: "The vital role of the financial system's infrastructure makes it essential that credible recovery plans and resolution regimes exist. FMIs need to be a source of strength and continuity for the financial markets they serve." Deadline for public comments on the report is September 28.
*Recovery and resolution of financial market infrastructures

Crisis ‘short selling’ ban in US brought no benefit
NEW YORK – The US ban on ‘short selling’ introduced at the height of the financial crisis did more harm than good, according to a study published by the New York Federal Reserve in early August. Restrictions on the short selling of financial stocks were imposed in September 2008, at a time of intense market stress by the US and a number of other countries. They were imposed because regulators feared that short-selling could drive the prices of those stocks to artificially low levels. Short-selling entails borrowing shares and then selling them in the expectation that they can be repurchased later at a lower price. But the new analysis of this period suggests that the ban did little to slow the decline in the prices of financial stocks; in fact, prices fell more than 12% over the fourteen days in which the ban was in effect. Moreover, the bans produced adverse side effects. According to the

returns during the first half of August 2011. Moreover, stocks that had triggered circuit-breaker restrictions and therefore could not be shorted on the day the downgrade was announced actually had lower returns than the stocks that were eligible for shorting. A statistical exercise conducted to determine the relationship between short-selling and stock returns found that the two variables are minimally correlated. “Taken as a whole,” the authors conclude, “our research challenges the notion that banning short sales during market downturns limits share price declines. If anything, the bans seem to have the unwanted effects of raising trading costs, lowering market liquidity, and preventing short-sellers from rooting out cases of fraud and earnings manipulation. Thus, while short-sellers may bear bad news about companies’ prospects, they do not appear to be driving price declines in markets.”
*Market Declines: What Is Accomplished by Banning Short-Selling?


Global Risk Regulator Newsroom
ESMA tightens regime for exchange traded funds
PARIS – New guidelines have been issued by the European Securities and Markets Authority (ESMA), the pan-EU supervisory watchdog, aimed at tightening the regulatory regime for Exchange Traded Funds (ETFs) and other types of indextracker funds authorised to be sold to European retail investors. “These comprehensive guidelines are aimed at strengthening investor protection and harmonising regulatory practices across this important EU fund sector,” said ESMA chairman Steven Maijoor, in comments accompanying the late-July publication of the guidelines. Publication follows a review by the watchdog of current regulatory standards for authorised funds known as Undertaking for Collective Investment in Transferable Securities (UCITS) and those ETFs that are part of the UCITS universe. This review concluded existing requirements are not sufficient to take account of the specific features and risks associated with these types of fund and practice. The new guidelines,* which apply to national securities markets regulators and UCITS management companies, are intended to strengthen investor protection and ensure greater harmonisation in regulatory practices across the EU. They set out the information that should be given to investors about index-tracking UCITS and UCITS ETFs, together with specific rules for these collective undertakings when entering into overthe-counter financial derivative transactions and efficient portfolio management techniques. The guidelines also set out the criteria for financial indices in which UCITS may invest, including the provision for investors of the full calculation methodology of such indices. And, it will only be permissible to invest in financial indices which respect strict criteria regarding the rebalancing frequency and their diversification. In addition to the guidelines, ESMA also launched a specific consultation on the appropriate treatment of repo and reverse repo arrangements when used by ETFs and other UCITS. In particular, the watchdog is proposing a distinct regime for repo and reverse repo arrangements which, unlike securities lending arrangements, would allow a proportion of the assets of the UCITS to be non-recallable at any time at the initiative of the UCITS. The proposed guidelines include safeguards to ensure that the counterparty risk arising from these arrangements is limited, and that the collective undertaking entering into such arrangements can continue to Stephen execute redemption Maijoor requests. The consultation period will run until September 25 2012. Once adopted by ESMA, the guidelines on repo and reverse repo arrangements will be integrated into the guidelines on ETFs and other UCITS issues in order to have a single package of rules. The final package, comprising both sets of guidelines, will become effective two months after publication on the ESMA website of the translations into the official EU languages.
*Guidelines on ETFs and other UCITS issues; Consultation on recallability of repo and reverse repo arrangements

September 2012

slow the speed of adjustment. “Yet I see it is more a case of ‘too little, too late’,” Dombret said. Regulators must deliver on their promise “and extend regulation and oversight to all systemically important financial institutions, instruments and markets,” he added. Today’s interconnected financial markets cannot effectively be regulated nationally – close international cooperation is warranted, Dombret said. A balance must be struck between achieving a level regulatory playing field and providing sufficient flexibility for the peculiarities of national financial systems. Finally, rigorous implementation monitoring will be indispensible. “As the old saying goes: Trust but verify,” he concluded.

Forex risk fears prompt new guidance
BASEL – Global banking regulators, fearing that the rapid growth of the world’s massive currency market means huge trade settlement risks are unabated, are proposing new guidance on managing those risks. The Basel Committee of global banking supervisors, which sets standards for international banking, says the $4 trilliona-day global foreign exchange market has made significant strides since 2000 in reducing the risks associated with the settlement of currency transactions. Settlement risks have been mitigated by payment-versus-settlement (PVP) arrangements, which ensure final transfer of payment in one currency occurs only if final transfer in another currency takes place, and by the increasing use of close-out netting (a form of netting consequent upon a predefined event, such as a default) and collateralisation. However, substantial settlement risks remain due to the rapid growth of the currency market, the Committee said in a consultative paper issued in August*. Many banks underestimate their principal risk – the risk of outright loss on the full value of a trade due to a counterparty’s failure to settle – and other risks by not taking into account the duration of the exposure between trade execution and final settlement. Furthermore, while settlement via PVP methods now accounts for the majority 15

Euro crisis spurs need for regulator collaboration
SALZBURG, Austria – Europe’s sovereign debt crisis, which is not least driven by systemic problems in some countries, underscores the urgent need to make the financial system more resilient, according to German central banker Andreas Dombret. International collaboration between regulators has never been so challenging, and never has it been so important, Dombret, a member of the Bundesbank’s executive board, told a financial regulation seminar in Salzburg in August. He acknowledged the sovereign debt crisis in the European Union’s eurozone has given fresh impetus to calls to water down or delay regulatory reform. Some argue that the ongoing uncertainty in financial markets and the weak global economy are good reasons to ease up on regulatory pressure, that the financial sector is being asked to do too much too soon, and that regulators should

Global Risk Regulator

September 2012

of currency trading by value, many banks do not have a good understanding of the potential residual risks, including replacement costs (the cost of replacing an unsettled transaction at current market prices) and liquidity risks. And the growth of the currency market suggests that the absolute value settled by potentially riskier gross non-PVP methods may not be less than before PVP methods existed. “While such risks may have a relatively low impact during normal market conditions, they may create disproportionately larger concerns during times of market stress,” the Basel Committee says. The guidance, which updates earlier advice from 2000, is organised into seven “guidelines” on governance, principal risk, replacement cost risk, liquidity risk, operational risk, legal risk, and capital for currency trading. Key recommendations emphasise that a bank should ensure all settlement risks are effectively managed and that its practices are consistent with those used for managing other counterparty exposures of similar size and duration; banks should settle as much as practicable through PVP arrangements; and when analysing capital needs, all settlement risks should be considered, including principal risk and replacement cost risk, while ensuring sufficient capital is held against these exposures.
*Supervisory guidance for managing risks associated with the settlement of foreign exchange transactions – Basel Committee consultative document, August 2012 with October 12 comment deadline.

US strives for level playing field on systemic risk
WASHINGTON – The US Federal Reserve is working with supervisors and central banks outside the US to ensure that rules relating to systemically important financial firms are enforced in a consistent way, US Treasury Secretary Timothy Geithner told Washington lawmakers in late July. “Everybody wants a level playing field,” said Geithner who as treasury secretary chairs the Financial Stability Oversight Council (FSOC), America’s systemic risk watchdog established by the DoddFrank financial reform legislation. He was responding to concerns raised at

separate Congressional hearings held by the Senate banking committee and the House of Representatives’ financial services committee on the FSOC’s 2012 annual report*. “In this area as in many others, if you end up raising standards in the US and leaving them lower and weaker outside the US, risk will just shift to those [nonUS] markets and hurt us too,” Geithner said in the context of global efforts to end the “too-big-to-fail” problem that resulted in taxpayers having to rescue several financial firms during the 200709 financial crisis. The Group of Twenty (G20) top economies have backed the listing of 29 big international banks, eight of them American, as global systemically important financial institutions (G-SIFIs) liable to greater supervisory oversight than less important banks, including the imposition of capital surcharges of up to 2.5%, to increase their capacity to absorb losses. Global regulaTimothy tors are working to Geithner identify insurers that might fall into the G-SIFI category. Under Dodd-Frank, US banks with $50 billion or more in assets are subject to additional regulatory requirements. FSOC is in the process of determining which US non-bank institutions such as insurers, securities firms and hedge funds, for instance, should be subject similar additional oversight The Congressional lawmakers echoed insurance industry fears in particular that insurers would be unfairly penalised under “bank-centric” regulations and that America’s own efforts would clash with the G20’s. Geithner agreed with the Fed that standards on capital and leverage designed for banks would have to be adapted to recognise the specific differences between the insurance and banking businesses and in a way that mitigates insurance industry concerns. In July FSOC made its first SIFI designations, namely the identification of eight financial market utilities (FMUs) as systemically important because of their key “plumbing” role in clearing and settling financial transactions. The eight FMUs are: The Clearing Payments Co; CLS Bank International; Chicago Mercantile

Exchange; the Depository Trust Co; Fixed Income Clearing Corp; ICE Clear Credit; National Securities Clearing Corp; and the Options Clearing Corp. The Treasury Secretary told lawmakers the FSOC chose the eight in a carefully designed process that gave the firms a fair opportunity to contest the Council’s judgments. FSOC will now ensure the firms are run with “conservative cushions” against risk. Geithner noted FSOC’s annual report identifies the continuing European sovereign debt and banking crisis as the biggest risk to America’s economy. The fact that the financial system still confronts a challenging and uncertain overall economic environment is among the most important of potential threats confronting the financial system. The threats underscore the need for continued progress in repairing the remaining damage from the global financial crisis and enacting reforms to make the system stronger for the long run, Geithner said.
*Financial Stability Oversight Council 2012 Annual Report.

Rebalance Basel’s three pillars, urges UK's Haldane
JACKSON HOLE, Wyoming – Rebalancing the three-pillar structure of the international Basel bank capital adequacy accord would provide greater scope for supervisory judgment in financial regulation, UK central banker Andrew Haldane said in his wide-ranging remarks on the complexity of current regulation (see page 1). Noting that the “Tower of Basel” is underpinned by the three pillars of regulatory capital standards (Pillar 1), supervisory discretion (Pillar 2) and market discipline (Pillar 3), Haldane said that so far the weight borne by the pillars has been heavily unbalanced. Most of the strain has been taken by Pillar 1, he said in a paper* given in late August at the annual central bankers’ economic policy symposium organised in Jackson Hole, Wyoming by the Federal Reserve Bank of Kansas. Haldane’s main message to the forum was that the type of complex financial regulation developed over recent decades may be sub-optimal for crisis control. The paper was co-written with Haldane’s


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Bank of the England colleague, Vasileios Madouros. For the Basel accord “simplifying Pillar 1 rules would help rebalance the Basel scales.” That would not only strengthen Pillar 1, but could simultaneously strengthen Pillars 2 and 3, said Haldane, who is executive director for financial stability at the UK central bank. A rebalancing away from prescriptive rules provides greater scope for supervisory judgment under Pillar 2. In other professions, such as medicine, prescriptive rules have generated the problem of not being able “to see the wood from the trees.” “What is true of doctors is almost certainly true of bank supervisors. In the pre-crisis period being required to monitor many small, rule-based risks may have caused supervisors to overlook potentially life-threatening ones. This ticked-box approach failed to save the banks, just as in medicine it fails to save lives,” said Haldane. “Supervision suffered the same fate as the autistic savant – penny-wise but pound foolish,” he concluded. Breaking free of that psychological state calls for a fresh approach, one which is less rules-focussed and more judgment based. That alternative approach to financial supervision is beginning to be recognised. It’s the approach that will underpin the Bank of England’s new supervisory model when it assumes regulatory responsibilities next year, Haldane said. In the paper, Haldane argues that regulatory responses to financial crises, past and present, have been to increase complexity with “a combination of more risk management, more regulation and more regulators”. As the Basel accords have evolved over time, so has the opacity and complexity associated with increasingly granular, model-based risk-weighting. Meanwhile, detailed rule-writing in the form of legislation has increased dramatically, as has the scale and scope of resources dedicated to regulation. He used a set of empirical experiments to measure the performance of regulatory rules, simple and complex. Haldane found that simple rules such as the leverage ratio and market-based measures of capital outperform more complex riskweighted models and multiple-indicator measures in their crisis-predictive performance. “The message from these experiments is clear and consistent. Complexity of models or portfolios generates robustness problems when understanding a complex financial system over plausible sample sizes. More than that, simplicity rather than complexity may be better capable of solving these robustness problems.” *The dog and the frisbee – paper by Andrew Haldane and Vasileios Madouros of the Bank of England, August 2012.

September 2012

ComFrame aim should be local insurance regimes
BRUSSELS – Global regulators’ plans for the supervision of large cross-border insurance companies should aim at recognising local regimes rather than setting a new single regulatory standard for groups, according to Europe’s insurance industry. Insurance Europe, the Brussels-based federation of the Europe’s national insurance industry trade bodies formerly known as the CEA, says that some of the specifications in the draft framework for the so-called ComFrame project for overseeing big international insurers are too prescriptive. The American Insurance Association (AIA), the leading US property and casualty trade body, fears the draft includes prescriptive proposals for internationally active insurance groups (IAIGs) “that can be interpreted as setting forth a new prudential regulatory regime as well as capital standards requirements which could have adverse consequences for insurers.” The European body wants a phased approach to be taken to the introduction of ComFrame (Common Framework for the Supervision of Internationally Active Insurance Groups) by the International Association of Insurance Supervisors (IAIS), the Basel-based grouping that develops international standards for the insurance industry. The views of Insurance Europe and AIA were contained in their comments on the IAIS’s July consultation paper on a draft framework for ComFrame. Regulators argue ComFrame would increase the efficiency with which they oversee complex cross-border insurance groups rather than add another layer of requirements to existing national rules (see GRR, July/ August 2012). It’s estimated that around 50 of the world’s largest insurers would

qualify for ComFrame supervision. No date has been fixed for ComFrame’s coming into effect. The project is separate from the IAIS’s efforts under the aegis of the Group of Twenty top economies to identify any insurers that might fall into the G-SIFI (global systemically important financial institution) and thereby be liable to additional regulatory requirements and supervision. Insurance Europe said a global framework for group supervision is an appropriate response to the increasing globalisation of insurance markets to ensure policy holders are appropriately protected and confidence in insurance markets is promoted. “ComFrame is an ambitious project which we can still see potential benefits in for both supervisors and the industry,” Insurance Europe says. But it believes ComFrame should focus on aiding supervisory understanding of IAIGs and not blur this with the potential creation of a separate prudential regime for IAIGs through setting standards for valuation and capital requirements. The creation of a two-tiered approach to group supervision, where prudential requirements differ between insurance groups, must be avoided “as this would create opportunities for regulatory arbitrage and may lead to unforeseen consequences.” The AIA believes ComFrame’s goal should be to promote private market expansion rather than setting up a new prudential regime that’s both unnecessary and counterproductive.

Basel sets 2% capital charge for clearing house exposure
BASEL – Global banking regulators have ruled that from January 2013 an amount equal to 2% of a bank’s exposure to certain central clearing counterparties (CCPs) will be added to the total riskweighted assets of that bank for regulatory capital purposes, a less painful outcome than many bankers had feared. The Basel Committee of global banking supervisors issued the interim rule in July as part of the efforts by leaders of the Group of Twenty (G20) top economies to reduce the systemic risk in the financial system seen as inherent in the $650 trillion privately traded over-the-counter (OTC) derivatives markets. A G20 aim


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is the get the bulk of OTC trading cleared through CCPs. Clearing houses, an established feature of exchange-traded derivatives markets, stand as buyer to every seller and seller to every buyer in the market, thereby obviating the risk of loss to an individual trader arising from a counterparty default. The capital rule for banks is one of the final elements of the international Basel III bank capital and liquidity package that’s due to start coming into effect from January 2013. The Basel Committee said its framework for capitalising bank exposures to CCPs builds on the new Principles for Financial Market Infrastructures developed by the Committee on Payments and Settlement Systems and the International Organisation of Securities Commissions (IOSCO), the umbrella body for the world’s securities market regulators. The principles are designed to enhance the robustness of the essential infrastructure, including CCPs, supporting global financial markets, the Committee said. Where a CCP is supervised in a manner consistent with these principles, exposures to such CCPs will receive a preferential capital treatment. In particular, trade exposures will receive a nominal risk-weight of 2%. In addition, the interim rules published in July allow banks to choose from one of two approaches for determining the capital required for exposures to default funds. One is a risk sensitive approach on which the Committee has consulted twice over the past years, and the other a simplified method under which default fund exposures will be subject to a 1250% risk weight subject to an overall cap based on the volume of a bank's trade exposures. The rules also include provisions on indirect clearing that allow clients to benefit from the preferential treatment for central clearing. The rules allow for full implementation of Basel III, while still recognising that additional work is needed to develop an improved capital framework, the Committee said. Further work in the area is planned for 2013. Dealer sighs of relief at the Committee’ ruling – earlier drafts were criticised for providing insufficient incentive to clear OTC derivatives – are in contrast to the alarm generated by the margin requirements proposed for noncentrally-cleared derivatives (see GRR, July/ August 2012). Dealers fear margin calls of up to 15% of notional value, running to hundreds of trillions of dollars, will cause a major drain on the liquidity of the financial system.
Capital Requirements for bank exposures to central counterparties – Bank for International Settlements, July 2012.

September 2012

Legal advice sought on global trade tagging site
BASEL – Global regulators are seeking legal advice on where best to locate the key operating elements of their planned system for tagging financial trades. The Group of Twenty (G20)-backed system aims at avoiding the problems, with their associated threat to the financial system as whole, encountered in tracking transactions entered into by Lehman Brothers and other firms stricken in the global financial crisis. America’s futures market regulator, the Commodity Futures Trading Commission (CFTC), has meanwhile launched a website – – for over-the-counter (OTC) derivatives traders to register with the CFTC’s Interim Compliant Identifiers (CICIs) which are intended ultimately to comply with the so-called Legal Entity Identifier (LEI), 20-digit alphanumeric code tagging system promoted by the G20 grouping of the world’s top economies. The Financial Stability Board (FSB), the body tasked with coordinating the implementation of the global financial reforms agreed by the G20 in the wake of the financial crisis, said in August it’s seeking views on the appropriate jurisdiction for the global oversight body and the Central Operating Unit (COU), the pivotal operating arm of the LEI system. The system will uniquely identify parties to financial trades. G20 regulators plan to have the framework ready by March 2013, although it’s expected to take several years before the system is fully rolled out (see GRR, June 2012). A major consideration for global regulators is that the legal framework of the jurisdiction where the global LEI Foundation is set up supports the operation of the global LEI system in terms of intellectual property and data protection laws, tax legislation, dispute settlement arrangements, regulatory framework and judicial system. Legal experts are invited to provide views on a pro bono basis by September 10. A key FSB aim is to develop and implement a detailed plan for the formation of the COU that supports the federated nature of the LEI system via the setting up of the not-for-profit global LEI Foundation, or similar legal equivalent, by private sector participants. The LEI Foundation will be directed by a board under the supervision of a Regulatory Oversight Committee (ROC) which has ultimate authority over the system. Under ROC supervision, the COU will be responsible for ensuring the application of uniform operational standards and protocols around the world. The COU is expected to be the contracting and operational body of the system and will have legal personality. Other key considerations in setting up the LEI Foundation are that it should be shielded from undue influence by capital donors as well as local authorities. The legal system of the jurisdiction in which it’s located must ensure that neither can exercise control over the Foundation or the COU. The legal system must also respect the governance structure of the LEI system. The US CFTC in August designated the Depository Trust and Clearing Corporation (DTCC), which processes financial trades for thousands of institutions worldwide, and SWIFT – the Society for Worldwide Interbank Financial Telecommunications – as providers of CICIs. SWIFT, the member-owned communications platform provider connecting 10,000 financial firms in 210 countries, and DTCC will manage and operate the new CFTC website. Meanwhile, DTCC and SWIFT are among the more than 100 institutions from some 25 countries that have joined the Private Sector Preparatory Group (PSPG) that the FSB called for (see GRR, July/August 2012) to support the LEI implementation group in its work in setting up the global LEI system. PSPG members include both financial and non-financial firms, data and technology providers, and academics. The FSB said implementation work on the LEI system will now be taken forward in three streams: a government and legal workstream; an operations workstream; and an ownership and relationship data workstream.


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September 2012

Insurers cool on Group 20 systemic risk approach
Critics say regulators' G-SIFI ideas aren’t in accord with acknowledged low level of risk that exists in the industry

Insurance regulation


lobal regulators’ proposals for identifying systemically important insurers won’t help them target appropriate policies at relevant activities, according to an influential body that lobbies on behalf of the world’s leading financial firms. Institute of International Finance (IIF) regulatory affairs director Andrés Portilla says that because traditional insurance business is not a source of systemic risk, it’s important that additional policy measures applied to any insurers categorised as systemically important financial institutions (SIFIs) are specifically designed to focus on non-traditional, non-insurance activities. Portilla’s remarks were contained in the IIF’s comments on the May proposals from the International Association of Insurance Supervisors (IAIS) on methods of identifying whether an insurer falls into the G-SIFI (global systemically important financial institution) category and thereby liable to additional regulatory oversight and burdens. The IAIS is the Basel-based body of national insurance regulators that seeks to develop international standards for the insurance industry. The IIF, which is perhaps better known as a banking industry advocate, is increasingly engaged in insurance industry issues as insurers become the target of global regulation. The Institute has long argued against what it sees as the shortcomings of approaches to systemic risk that rely on designating groups of firms, whether banks or non-bank financial institutions, global or local Contrary to the express aim of the leaders of Group of Twenty (G20) top economies, such approaches “increase moral hazard and create market distortions arising out of such firms being seen as ‘special’ and potentially too big to fail,” Portilla says. G20 leaders have backed the IAIS’s proposals for identifying insurance companies that could be classified as G-SIFIs, firms that could threaten the stability of the financial system if they were to get into trouble. Seared by the 2007-09 global financial crisis, policymakers both at the G20 and

national levels are developing regulatory frameworks that seek to bring to an end the need for taxpayers to rescue financial firms deemed too-big-to-fail because of their importance to the financial system. Firms identified as systemically crucial will be subject to greater supervisory scrutiny, stiffer regulatory requirements and have to show how they can be safely wound up if they get into trouble without calling upon the taxpayer.

Andrés Portilla Designating firms as SIFIs increases “moral hazard”

later this year. Any initial list of insurer G-SIFIs is expected to be issued in the first half of 2013. The US, meanwhile, is pursuing its own path to identifying domestic SIFIs within the terms of the Dodd-Frank Act. Banks with $50 billion or more in assets are already classified as SIFIs. The Financial Stability Oversight Council (FSOC), the systemic risk watchdog created by DoddFrank, has yet to determines its list of non-bank SIFIs – securities firms and hedge funds, for instance, as well as insurers. As GRR went to press, the IAIS had yet to publish the comments it received on its ideas for assessing whether an insurer is a G-SIFI. But the handful of comments made available independently after the July 31 deadline, including the IIF’s, suggest the IAIS approach doesn’t reflect the IAIS’s own expressed view that traditional insurance business represents little if any systemic risk.

No evidence

Under the aegis of the Financial Stability Board (FSB) - the body that coordinates the implementation of the post-crisis financial reforms agreed by the G20 - the Basel Committee of the global banking supervisors has already identified 29 big international banks as G-SIFIs and thereby liable to capital surcharges of up to 2.5%.

Michaela Koller Disappointed that IAIS does not reflect differences between banks and insurers
Working with the FSB, the IAIS proposed in May ways of determining which insurance companies, if any, fall into the G-SIFI category. The IAIS didn’t suggest any concrete policy measures with its proposed methodology and IAIS officials have said in the past that capital surcharges might not be appropriate for G-SIFIs engaged in traditional insurance. Policy measures are expected to be published for comment

Insurance Europe, the Brussels-based federation of Europe’s national insurance industry trade bodies which was formerly known as the CEA, said the proposed methodology doesn’t reflect the IAIS’s earlier finding that there’s little evidence of traditional insurance generating systemic risk. “We are disappointed that the approach proposed by the IAIS does not adequately reflect the fact that banking and insurance business models can have very different impact on economic and financial stability,” Insurance Europe director general Michael Koller says. The IIF’s Portilla reckons many of the IAIS’s qualitative comments aren’t reflected in the methodical assessment, which seems to have influenced “to an unwarranted degree” by the Basel Committee’s approach to bank G-SIFIs. Koller argues the methodology developed by the Basel Committee doesn’t work for insurance. “The limited adjustments that have been made to [the Basel approach] by the IAIS are not sufficient to reflect the existing structural differences between the two sectors,” she adds. And American Insurance Association (AIA) senior vice president Stephen Zielezienski also thinks the IAIS’s methodology, and the process for developing it, may not reflect the IAIS’s conclusion that traditional insurance shows little evidence of generating


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September 2012

Insurance regulation
systemic risk. The AIA is America’s leading property and casualty insurance trade body. The Basel Committee uses an indicatorbased approach to identify bank G-SIFIs that comprises five broad categories: size, interconnectedness, lack of readily available substitutes or financial institution infrastructure, global (cross-jurisdictional) activity and complexity. The IAIS’s proposal is for an indicatorbased assessment approach similar to the Basel Committee’s with considerable overlap in the categories of indicators. But there are several important differences

No case for capital surcharges

There is no case for subjecting any insurer deemed to be in the global systemically important financial institution (G-SIFI) category to blanket capital surcharges in the manner applying to bank G-SIFIs, the Institute of International Finance (IIF) said in its comments on the proposed methodology for identifying insurer G-SIFIs. Regulators need to ensure that non-traditional insurance activities attract a capital treatment which is commensurate with the risks they pose and this treatment should Stephen form an important part of the regulation Zielezienski of insurance firms or groups which underThinks G20 take such activities. The emphasis should should follow however remain on the appropriate capital the US approach treatment of activities, the IIF said. when determin- Regulators won’t disclose their ideas on policy measures for any insurers that might ing whether insuers are SIFIs fall into the G-SIFI category until later this year. Meanwhile, the IIF believes the following should also be borne in mind by regulareflecting the particularities of the insurtors when developing measures: ance business model.  Great care and attention must be The approach involves three steps – the devoted to identifying indicators and other collection of data, an indicator-based analytical measures providing evidence of assessment of the data, and a process for insurers having systemic characteristics. supervisory judgment and validation. There  Because traditional insurance busiare 18 indicators under five categories: ness is not a source of systemic risk, it is size, global activity, interconnectedness to important that any additional policy measother players in the financial system, nonures applied to such firms are specifically traditional insurance and non-insurance designed to focus on non-traditional, nonactivities, and substitutability of products insurance activities by insurers. and services.  General indicators such as size, The IAIS’s approach is similar to that global activity and interconnectedness are devised by FSOC for identifying non-bank not, in themselves, a reliable guide to sysSIFIs, according to credit rating agency temic importance. While these may have Moody’s Investors Service. Writing in a some bearing on the nature or intensity of June report, Moody’s senior credit officer supervision, they should not be the trigger Laura Bazer said both the IAIS and FSOC for special regulatory or supervisory treatseek to identify groups whose distress ment intended to address systemic risk. or failure could hurt the financial system  Any assessment needs to include based on their size, interconnectedness a thorough assessment of the adequacy of and lack of substitutability. group-wide risk management, governance For determining whether a non-bank finanand controls. This and a carefully crafted cial firm is a SIFI, FSOC has introduced policy response will have the benefit of a three-stage framework for evaluating providing incentives for sound risk managecompanies across industry sectors. FSOC ment practices. will evaluate the systemic riskiness of non Enhanced supervision, conducted bank firms that have more than $50 billion on a truly global basis through the operain total consolidated assets and meet at tion of supervisory colleges and paying due least one of several additional thresholds, attention to resolution issues, is likely to be including whether a firm has $3.5 billion a key part of the policy response. or more in derivative liabilities, at least $30 billion in CDSs and at least $20 bil-

lion in outstanding bonds issued. The first stage is to identify firms fitting the criteria, the second to conduct an internal review based on publicly available information, and the third to contact companies that merit further review. However unlike the FSOC approach, said Bazer, the IAIS methodology adds the criteria of international activity and type of activities in which an insurer engages. This last criterion recognises the unique features of insurance, such as the long horizon of insurance liabilities, the concept of pooling of risks, insurable interest, and cash claims patterns.

Laura Bazer Reckons few insurers are likely to be on the G-SIFI list

On the basis of the IAIS proposal, Moody’s reckons few insurers are likely to make the very short first list of insurer G-SIFIs when it appears in 2013. However, US insurers such as Prudential Financial, MetLife and American International Group (AIG) are likely to be on the list, while Germany’s Allianz, France’s Axa and Switzerland’s Swiss Re would be subject to the assessment process based on their size and global activity, the rating agency says. AIA’s Zielezienski thinks the G20 should follow the US regulations for determining whether non-bank financial companies, including insurers, should be federally regulated as SIFIs. “Aligning (the global) methodology with the fully developed US SIFI process would also prevent the waste of public and private resources that would result from multiple designation procedures under differing criteria,” said Zielezienski. The AIA recommends that the insurer G-SIFI methodology be modified to include a set of transparent, risk-related comparative benchmarks that can be used to initially screen all types of financial institutions, including insurance companies,” said Zielezienski. GRR


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September 2012

US insurers fear impact of Basel III and Dodd-Frank
merica’s central bank must, in formulating new capital standards, unequivocally confirm that it recognises the differences between insurers and bank holding companies. If not, federal banking supervisors should allow insurers a three-year delay at least to comply with the Basel III international capital rules designed for banks, representatives of the insurance industry have told Washington lawmakers. “If they continue with the ‘one-size-fits-all’ approach which we disagree with, [the rules] at least should have a longer implementation period,” Charles Chamness, chief executive of industry trade body the National Association of Mutual Insurance Companies (NAMIC), said. Chamness acknowledged to the House of Representatives’ financial services committee that America’s Dodd-Frank Wall Street Reform Act, enacted in 2010 to remedy the faults in the financial system exposed by 2007-09 global crisis, left the country’s state-based system of insurance largely intact.

Fed’s new powers will bring some insurers within the ambit of global banking rules; concerns over unintended consequences
reform first came into view, that insurers would be unfairly ensnared in stringent, stable-door shutting rules designed for the banking industry that caused the crisis. Unlike banks whose short-term liabilities are always vulnerable to panic runs by depositors and investors, insurers have long-term, statistically quantifiable liabilities in the form of future claims that are funded by up-front premiums: a panicproof business model that’s virtually incapable of producing threats to the financial system. The industry is keen to point out that the failure during the crisis of American International Group (AIG), once the world’s largest insurer and in 2008 the subject of a massive US taxpayer bailout, was due to laxly supervised trading in toxic financial products and not in any way to its insurance business which remained sound throughout.

federal intervention. However, he agreed that industry fears might be overcome if Fed chairman Ben Bernanke’s intimations earlier in July that the US central bank is working to recognise the differences between insurance and bank holding companies. The problem’s emerged from the application of the Dodd-Frank reforms and from the plans of federal banking supervisors to implement the tough international Basel III bank capital and liquidity rules backed by world leaders in the wake of the 2007-09 global financial crisis.

Charles Chamness “The Fed continues to take a bank-centric approach to regulation”
Under Dodd-Frank, the Fed has responsibility for financial holding company regulation, which includes its application to insurers that own savings and loan firms. Prior to the Dodd-Frank reforms such savings and loan holding companies (SLHCs) were regulated by the now defunct Office of Thrift Supervision. Furthermore, the Fed in applying the Basel III rules in the US is proposing new capital rules for all banks, bank holding companies and SLHCs. The latter would be subject to the same capital standards as banks at the holding company level, except for certain unique insurance activities. Analysts estimate between 25 and 30 insurers operating thrift businesses could be subject to Fed oversight under the proposed standards. AIG, for instance, would be a leading candidate. The Fed’s plans “represent a one-size fits all approach that simply does not make sense for an SLHC engaged predominately in the business of insurance,” Chamness told a Congressional panel in late July. In August the Fed and its co-federal banking supervisors extended the comment deadline on their June Basel III implementation proposal to October 22 from September 7 to allow people more time to understand, evaluate and comment on them. The proposal, in the form of three separate notices of proposed rulemaking, sets out the new, internationally agreed minimum standard for the level and quality of bank

Only notionally exempt

“Even though insurance was not directly targeted by the Dodd-Frank Act, it has created large amount of potential market turmoil and uncertainty for insurers” – Charles Chamness
“Unfortunately,” he said, “even though the insurance industry was not directly targeted, the DFA (Dodd-Frank Act) has created large amount of potential market turmoil and uncertainty for insurers.” He and other industry witnesses argued that in fact the Act is freighted with unintended consequences for insurers over a range of issues, including capital standards, the Volcker Rule banning proprietary trading, systemic risk and accounting standards. At the heart of the concerns is the insurance industry fear, evident since the massive wave of post-financial crisis regulatory

Insurance Information Institute president Robert Hartwig said Dodd-Frank explicitly recognised the unique nature of insurance and that insurance business was not the cause of the financial crisis. “Consequently, insurance was not the focus of the DFA and insurers were carved out or exempted from much of the regulation to which banks and other financial institutions were subjected,” said Hartwig whose Institute is a New York-based international property and casualty insurance trade association. “However, a number of provisions of Dodd-Frank, when fully implemented or because of potential misinterpretations of the Act’s intent, could reduce the ability of insurers to accumulate capital or mitigate risk and thereby negatively impact the economy as a whole,” he believes. NAMIC’s Chamness is concerned in particular about an issue that critics say will result in insurers being unfairly penalised by so-called “bank-centric” regulation and threaten the sanctity of America’s statebased system of insurance regulation with


Global Risk Regulator

September 2012

Insurance regulation
capital and introduces elements of the earlier Basel II accord that have not previously been applied in the US. Chamness said it was imperative the Fed recognised the “striking differences” between the activities of many of the bank holding companies traditionally regulated by the Fed and insurance-connected tions between regulators and inappropriate decisions.” The application of the Basel III capital requirements to mutual insurance SLHCs will have many significant consequences, including requiring many firms to adopt new accounting practices. “It will not fully recognise forms of capital that state insurance regulators have recognised for more than a century, like surplus notes. It will result in unintended and unwarranted differentiation between [publicly listed] and mutual insurers who own banking organisations. And it will result in significant disruption in business functions in advance of the 2013 effective date of the rules. This is obviously not a consequence that Congress intended.”

Robert Hartwig Provisions in the Dodd-Frank Act could reduce insurers' ability to accumulate capital or mitigate risk
SLHCs that will be supervised in the future. The distinctions include significantly different financial reporting, accounting standards, capital requirements and other operational activities, he said. “The information and standards that are critical to supervising an SLHC which is overwhelmingly engaged in insurance activities is fundamentally different than the information and standards critical to regulating traditional bank holding companies. The risk and exposure of insurance companies and the nature and utilisation of their assets and liabilities can be significantly different from banks.” “Unfortunately, notwithstanding a genuine effort to understand the business of insurance, the Federal Reserve continues to take a bank-centric approach to regulation making little allowance for insurance specific standards,” Chamness said. Firms new to the Fed’s regulatory process that are still trying to interpret the meaning of bank-centric requirements, there is frequently insufficient time to process and respond to comment periods. The practical result of some regulations may not be immediately apparent and the Congress should urge the Fed to go slow and work closely with insurance companies it now oversees, he said. “Furthermore, rather than working with state regulators and relying on professional expertise of the functional regulators, the Federal Reserve is engaging in detailed investigations into insurance company operations. Such activities are duplicative, time-consuming and costly for both government and the insurance company, and could lead to conflicting determina-

One good sign

However, Chamness took it as a “good sign” that Fed chairman Bernanke had separately told lawmakers, when testifying in July on the Fed’s semi-annual report to Congress, that the Fed would work to recognise the differences between insurance and bank holding companies. Later US Treasury Secretary Timothy Geithner, in his role as chairman of the Financial Stability Oversight Council (FSOC), America’s systemic risk watchdog, told lawmakers that he agreed with Bernanke that standards on capital and leverage designed for banks would have to be adapted to recognise the specific differences between the insurance and banking businesses and in a way that mitigates insurance industry concerns. Geithner was testifying on FSOC’s 2012 annual report. FSOC has still to determine which non-bank financial firms, including insurers, should be categorised as SIFIs – systemically important financial institutions liable to additional regulatory oversight and requirements. In the light of Bernanke’s remarks, Chamness said the Fed should recognise that state risk-based capital models for insurers provide a foundation sufficient to satisfy the minimum risk-based capital and leverage requirements of the Collins Amendment to Dodd-Frank. The Collins Amendment aims at equalising consolidated capital requirements for bank holding companies and SLHCs with minimum ratios established under prompt corrective action rules. Meanwhile what Dodd-Frank “gives with

one hand it also takes away with the other” in respect of the Volcker Rule, according to Thomas Quaadman, vice president with the capital markets competitiveness centre of the US Chamber of Commerce, the business federation. Dodd-Frank exempted insurer companies from the Volcker Rule, recognising that asset liability management is for insurers by its very nature a form of proprietary trading but one in which the ultimate beneficiaries are policy holders, Quaadman said in his testimony. However, insurers that own banks are not exempt from the Volcker Rule, which is named after former Fed chairman Paul Volcker who first proposed the measure as a way of preventing US banks from making speculative investments that don’t benefit their clients. Quaadman noted insurers may own a bank for a variety of reasons such as lowering transaction costs or providing additional services to customers. Several insurance companies have already spun off their banks to avoid being entrapped by the Volcker Rule.

Thomas Quaadman While insurers were intended to be exempt from the Dodd-Frank Act, they will still be affected
“So while these insurance companies do not engage in the type of proprietary trading envisioned in the Volcker Rule and were intended to be exempted by Congress, they are still forced to make business decisions based upon regulatory interpretations that make them less efficient,” Quaadman said. He added even if insurance companies are completely exempt from the Volcker Rule, the subjective trade by trade regulatory scrutiny of market making and underwriting practices may make it more difficult for insurance companies to play their traditional role in the debt and equity markets. GRR


Global Risk Regulator

September 2012

Regulators’ lack of vision tests financial system
Insurance industry leader Walter Kielholz says failure to grasp the differences between financial sectors threatens confusion



egulators have bitten off more than they can chew with their efforts to restructure the global financial system in the wake of the 2007-09 crisis. Crucially, they lack a clear vision of how the financial sector should look in the future which means the outcome could undermine the proper role of banks, insurers and pension funds in the economy. The proposals being worked on in the United States and the European Union will affect organisations in many different sectors of the economy. The EU has some 30 large regulatory projects scheduled for completion within the next 12 months, while the Dodd Frank Wall Street Reform Act, passed by the US Congress in 2010, is thousands of pages long.

plans, it's important to recall the role and set up of the financial sector. One major factor that differentiates financial intermediaries within the sector is the extent of their investment horizons. Banks have a short term investment horizon. They acquire assets such as loans, fixed mortgages, advances, trade financing, etc., usually at fixed maturities. In times of crisis, banks face the threat of insufficient liquidity should all their depositors decide to withdraw their money without the loans having fallen due.

Different scenario

What matters most is to ensure that the reform efforts do not distort competition, either within or between sectors or financial centres
From the beginning of the global reform process initiated by the Group of Twenty (G20) largest economies, there has been criticism that while the overall process as coordinated by the Financial Stability Board is well organised, the end-result is reliant on uncertain legislative and administrative action at the national level. The final outcome in the case, for example, of the G20 efforts to regulate global systemically important financial institutions (G-SIFIs), with the aim of ensuring that taxpayers won’t have to rescue them if they were to fail, might be far from satisfactory, unbalanced and difficult to implement. What matters most is to ensure that these efforts do not distort competition, either within or between sectors or financial centres. By implementing measures globally and at the same time, regulators aim to minimise the risk of unintentional side effects resulting for inconsistent or incomplete implementation of reforms. To understand the implications of all these

Insurers, particularly life insurers, face a completely different scenario. They help individuals to build up long-term savings, including insurance coverage. To achieve this, they conclude long-term contracts (policies), which either cannot be terminated prematurely or only on very unfavourable terms. Pension funds have an even longer investment horizon. They help their members to collectively save via an occupational pension plan and then pay out the accumulated benefits as a pension, generally over a long period of time. Pension funds are very long-term investors and invest in a large share of real assets to protect themselves against inflation. Theoretically, pension funds and insurance companies can invest anti-cyclically. In boom times, they usually do not experience extraordinary inflows of funds which must be invested at high prices. When faced with a crisis, they do not experience any abrupt outflows, enabling them to capture opportunities which others are unable to do because of insufficient liquidity. The modern economy is based on the assumption that all three kinds of financial intermediaries can optimally play their specific role. Regulators must recognise that the risks inherent to the various types of financial intermediaries could not be any more different. In a recent study*, the consultancy firm Oliver Wyman showed that due to various factors but mainly regulatory require-

ments, insurance companies and pension funds are investing their capital for too short a period. On the other hand, banks are investing their capital for too long a period. Oliver Wyman estimates that five years is too long a horizon. The outcomes of this maturity-mismatched allocation of funds are that many companies in the real economy lack long-term capital, banks face increased liquidity risks, and pensioners and those with insurance-based savings products receive too low a return. As a reinsurer, Swiss Re fears that regulations from the banking sector will be applied indiscriminately to the insurance industry, particularly concerning systemic risks. The methodology proposed by the International Association of Insurance Supervisors (IAIS) for assessing whether an insurer falls into the G-SIFI category is very much aligned with the indicator-based approach used by the Basel Committee of global banking supervisors to identify 29 bank G-SIFIs liable to capital surcharges of up to 2.5%.

Regulators are in danger of introducing new risks, such as the moral hazard that could result from signalling which institutions will be more strongly regulated
In some instances, regulators are attempting to solve problems which do not actually exist in the insurance sector, such as the “too-big-to-fail” issue that the bank G-SIFI rules are designed to tackle. Regulators are in danger of introducing new risks, such as the moral hazard that could result from signalling which institutions will be more strongly regulated, as well as creating market distortions. We are concerned because the outcome may prevent the different financial market participants from carrying out their intended roles. What is lacking is a clear vision of how the ideal financial sector should look.

*The Real Financial Crisis: Why Financial Intermediation is Failing – Oliver Wyman, January 2012 Walter Kielholz is chairman of the Swiss-based global reinsurer Swiss Re. He is also chairman of the European Financial Services Round Table and a board member of the Institute of International Finance.


Global Risk Regulator Global Risk Regulator

September 2012
September 7) – www.federalreserve. gov. Oct 28-30 – Risk Management Association annual risk management conference –Dallas, Texas (www. Oct 29-Nov 1 – Sibos financial services industry annual conference – Osaka, Japan – (

Diary: conferences, meetings and deadlines
Sept 14 – Deadline for comment on US Commodity Futures Trading Commission’s proposals on margin requirements for uncleared swaps – ( Sept 20 – ISDA annual Europe conference – London ( Sept 24-26 – American Bankers Insurance Association annual conference – Phoenix, Arizona Sept 28 – Deadline for comment on Basel Committee’s proposed principles for effective risk data aggregation and risk reporting ( Sept 28 – Deadline for comment on Basel Committee’s consultation on margin requirements for non-centrally cleared derivatives ( Sept 28 – Deadline for comment on consultation on recovery and resolution of financial market infrastructures – (


October 10 – Financial markets serving the real economy and society? Finance Watch conference – Brussels ( October 10-12 – International Association of Insurance Supervisors annual conference – Washington ( Oct 11-13 – Institute for International Finance 30th anniversary membership meeting – Tokyo ( Oct 12 – Deadline for comment on Basel Committee’s update of its guidance for managing currency market settlement risk – ( Oct 14-16 – American Bankers Association’s annual convention – San Diego, California Oct 17 – Annual BBA international banking conference – London (www. Oct 22 – Deadline for comment on US proposals for implementing Basel III bank rules (extended from

November 9-10 – G20 finance ministers’ meeting – Mexico. November 20 – Liquidity and Market Regulation conference – London (

Dec 3-7 – Riskminds international conference – Amsterdam (

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