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ournal of Regulation & Risk North Asia
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Volume V, Issue II – Summer, 2013

Articles, Papers & Speeches
On being the right size: Essays in evolution Global banking reform five years after the crisis A better alternative to the Basel capital rules Regulation of cross-border OTCs: A middle ground Lessons from the crisis: The flaws of inflation targeting Macroprudential rebalancing in a period of economic stress Dynamics of disintegration: Germany and the Euro Europe’s interests best served by complying with Basel III The science of fiscal policy & alchemy of monetary policy Central bank fixation with low inflation prolongs recession The Brown-Vitter bill: An exposé of lunacy Dodd-Franks extra-territorial reach irks the European Union Macroeconomic stabilisation under modern monetary theory Are ineffective AML & CFT laws impeding investor confidence?
Andrew G. Haldane Daniel K. Tarullo Thomas M. Hoenig Elisse B. Walter Otmar Issing Jean-Pierre Landau Prof. Christian Fahholz and Dr. Gernot Pehnelt Nicolas Veron Prof. Jeffrey Frankel Prof. Laurence M. Ball Assoc., Prof. William K. Black Mayra Rodríguez Valladares Steve Randy Waldman Gavin Sudhakar

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When you have to be right

Publisher & Editor-in-Chief Christopher Rogers Editor Emeritus Dr. John C. Pattison Editor Elizabeth Dooley Chief Sub Editor Fiona Plani Editorial Contributors Prof. Laurence M. Ball, Assoc., Prof. William K. Black, Rowan Bosworth-Davies, Satyajit Das, Elizabeth Dooley, Dr. Christian Fahrholz, Prof. Jeffrey Frankel, Andrew G. Haldane, Thomas M. Hoenig, Otmar Issing, Per Kurowski, Jean-Pierre Landau, Dr. Gernot Pehnelt, Christopher Rogers, Judy Shelton, Prof. Rajiv Sethi, Gavin Sudhakar, Daniel K. Tarullo, Assoc., Prof. Jennifer S. Taub, Mayra Rodríguez Valladares, Prof. Yanis Varoufakis, Nicolas Veron, Steve Randy Waldman and Elisse B. Walter Design & Layout Lamma Studio Design Printing DG3 Distribution Deltec International Express Ltd ISSN No: 2071-5455 Journal of Regulation and Risk – North Asia 5/F, Suite 502, Wing On Building, 71 Des Voeux Road, Central, Hong Kong Tel (852) 2982 0297 Email: christopher.rogers@irrna.org Website: www.irrna.org JRRNA is published quarterly and registered as a Hong Kong journal. It is distributed to governance, risk and compliance professionals in China, Hong Kong, Japan, Korea, Philippines, Singapore and Taiwan.
© Copyright 2013 Journal of Regulation & Risk - North Asia Material in this publication may not be reproduced in any form or in any way without the express permission of the Editor or Publisher.
Disclaimer: While every effort is taken to ensure the accuracy of the information herein, the editor cannot accept responsibility for any errors, omissions or those opinions expressed by contributors.

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Volume V, Issues II – Summer, 2013

JOURNAL OF REGULATION & RISK NORTH ASIA

Contents
Foreword – Christopher Rogers 5 Acknowledgments – 7 Q&A – Robert Pringle 9 Debate – Christopher Rogers 13 Opinion – Assoc., Prof. Jennifer S. Taub 17 Opinion – Per Kurowski 21 Opinion – Rowan Bosworth-Davies 25 Book review – Prof. Rajiv Sethi 31 Book review – Judy Shelton 35 Comment – Satyajit Das 39 Comment – Mayra Rodríguez Valladares 43 Comment – Prof. Yanis Varoufakis 47 Regulatory update – Christopher Rogers 51

Articles, Papers & Speeches

On being the right size: Essays in evolution Andrew G. Haldane Global banking reform five years after the crisis Daniel K. Tarullo A better alternative to the Basel capital rules Thomas M. Hoenig Regulation of cross-border OTCs: A middle ground Elisse B. Walter Lessons from the crisis: The flaws of inflation targeting Otmar Issing Macroprudential rebalancing in a period of economic stress Jean-Pierre Landau Dynamics of disintegration: Germany and the Euro Prof. Christian Fahholz and Dr. Gernot Pehnelt

59 73 85 91 99 109 115

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Articles (continued)
Europe’s interests best served by complying with Basel III Nicolas Veron The science of fiscal policy & alchemy of monetary policy Prof. Jeffrey Frankel Central bank fixation with low inflation prolongs recession Prof. Laurence M. Ball The Brown-Vitter bill: An exposé of lunacy Assoc., Prof. William K. Black Dodd-Franks extra-territorial reach irks the European Union Mayra Rodríguez Valladares Macroeconomic stabilisation under modern monetary theory Steve Randy Waldman Are ineffective AML & CFT laws impeding investor confidence? Gavin Sudhakar 123 129 135 139 149 155 165

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Foreword
First and foremost, may we offer our readers an apology for the lateness of this publication of the Journal – this delay has been caused by the unexpected death of our Editor, Mr. Ian Watson, who will be greatly missed by our small editorial team and those who dealt with him in the production of the Journal. After an extensive search for a replacement, the Institute of Regulation & Risk - North Asia, is pleased to announce that Ms. Elizabeth Dooley will join the Journal as our new Editor and will build upon the good works of Mr. Watson during his four years at the helm. This issue of the Journal, as usual, should provide readers with an eclectic mix of papers, opinion and comment on current and future financial management, financial sector policy and macroeconomics gleaned from leading authorities across the World - much of which is informed by the economic events of 2007/8 and efforts to mitigate against another financial shock in future. Obviously, opinion is divided on many of these prescriptions and the likely impact they will have both regionally and worldwide in the coming months and years ahead. Since the appearance of our last Journal, much has changed - Japan has a new Prime Minister and Governor of the Bank of Japan, the U.S. has made large administration changes, most notably in the Treasury Department with the departure of Timothy Geithner, whilst Mark Carney, the former Governor of the Bank of Canada, replaces Governor Mervyn King at the Bank of England - the first time ever that a non-UK citizen has been charged with running one of the World’s oldest central banks. Regretfully, in many areas matters remain much the same, epitomised by the continued Euro sovereign debt crisis and outrage at the terms of the bailout of Cyprus and its beleaguered and obese banking and financial services sector. Indeed, since the March shenanigans surrounding the Cypriot bailout, rather than taking fright at the continued weaknesses in the European Union, U.S. and Japan economies, stock indices and markets globally have experienced a further bout of what can only be described as ‘irrational exhuberism’. Whether, following the Cyprus bailout/bail-in, this is fuelled in part by investor search for high yields and depositor fears that their funds are no more at risk in stocks and bonds than being left in bank accounts that can be seized to bailout failing banks is one question that continues to undermine one of the key notions of a stable economy, namely, bank deposit guarantees. Christopher Rogers Publisher & Editor-in-Chief

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Acknowledgments
THE editorial management of the Journal of Regulation and Risk – North Asia could not have published this edition of the Journal without a great deal of assistance and advice from professional associations, international monetary and financial bodies, regulatory institutions, consultants, vendors and, indeed, from the industry itself.   A full list of those who kindly assisted with the publication of this issue is not possible, but the Publisher and the Editor would like to thank the following organisations for their generous assistance and support: The Board of Governors of the U.S. Federal Reserve System; the U.S. Securities and Exchange Commission; the U.S. Federal Deposit Insurance Corporation; the U.S. Commodities Futures Trading Commission; the Bank of England; Bruegel; the Peterson Institute for International Economics; Johns Hopkins University; New Economic Perspectives; The Cato Institute; the Pareto Commons; VoxEu; the American Banker; MRV Associates; Interfluidity; Wiley Publications and Yanis Varoufakis blog for their kind permission to reproduce material from their respective publications and websites. Detailed comments and advice on the text and scope of contents from Prof. Laurence M. Ball, Prof. Jeffrey Frankel, Steve Randy Waldham, Assoc., Prof. William K. Black, Dr. John C. Pattison, Prof. Rajiv Sethi, Nicolas Veron, Prof. Lawrence Baxter, Per Kurowski and Assoc., Prof. Jennifer Taub were invaluable; we are also grateful to Fiona Plani of Edit24.com for her due diligence in setting out, editing and correcting the text.     Further thanks must also go to the China Banking Regulatory Commission, Beijing & Shanghai Chapters of the Professional Risk Managers International Association and the Hong Kong Chapter’s of the Global Association of Risk Professionals and Institute of Operational Risk Management, together with SWIFT and Wolters Kluwer Financial Services, for their kind assistance in helping to distribute this journal to their respective memberships and client-base in Greater China, Japan and Korea, Philippines and Singapore.

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Q&A

Global financial system is irredeemably broken down
Robert Pringle, acclaimed author of The Money Trap, crosses foils with the Journals’ new editor, Ms. Elizabeth Dooley.
Elizabeth Dooley: Your recently published book,“The Money Trap - Escaping The Grip of Global Finance” touched upon many sensitive nerves, not least the fact, that in its present unreconstituted trajectory the global financial system is irredeemably not fit for purpose. In your book, you dwell at some length on how national governments have incentivised the main actors and players in the global financial services sector to behave contrary to their own best interests. Can you expand on this theme a little further? Robert Pringle: The global financial system (GFS) provides the wrong incentives for two main reasons: first, it is weak, and, second, it is still based mainly on national policies and regulations. Thus, instead of focussing on customer services, clever bankers spend time finding ways round the regulations, for example by moving operations to places with less stringent rules, or to jurisdictions that apply them less strictly. Often, regulation has encouraged harmful swings in economic activity and credit. Because the system is seen to be weak, banks have also invested much time and money in lobbying regulators. They can Journal of Regulation & Risk North Asia influence new rules before they come into effect – as we have seen with the lobbying over Dodd-Frank – and in the process of implementing rules. Also, despite the efforts of the G-20 group of leading economies and the Financial Stability Board (the international regulatory body), financial regulation remains essentially national. Protectionist tendencies Indeed, the entire monetary system – with its characteristic model of independent central banks following forms of inflation targeting with flexible exchange rates – is inward looking. It forces policy makers to focus on what is good for their country alone, rather than the international community more widely. This is incompatible with the proper workings of a globalised world economy. It encourages nationalist measures such as protectionism. ED: You have stressed that in your opinion the financial crisis that engulfed the world in September 2008, and continues to this day, is a symptom of a dysfunctional monetary and banking system. As such, could you explain how 9

and when the system began to go off the rails in earnest? RP: We have been through a number of credit and financial cycles over the past 40 years. Each time, the response of the central banks and governments has been similar – to tighten up regulation, to put a floor under the banks, and to try to prevent recessions by expansionary monetary and fiscal policies. Each time central banks and governments alike claimed that these measures would fix the problem; in fact they merely made the next crisis worse. As the managers of private sector financial institutions learned to anticipate such responses, they did not take enough care about their business decisions. Together with a bonus-based compensation culture, this encouraged excessive risk-taking. ED: Given the origination of the present crisis is attributed in part to the sub-prime crisis that engulfed the U.S. beginning in March 2007, does it not strike you as odd, given the level of malfeasance that has been uncovered, that no senior executive of a systemically important financial institution has to date appeared before a court, never mind faced imprisonment over their actions? RP: Anger is fully justified and an important pressure for real change. In my book I argue the case for fundamental reform, both of banking and of money. I advocate linking finance forever to the real economy, and to establish ways to stop bankers and other financial intermediaries from gambling with our money. Pending such fundamental reforms, 10

we should return to an ethic of personal responsibility. Top executives should come under stronger pressure to resign as soon as something shameful happens in their organisation, even if they were not directly or personally responsible for it. Only in this way will they make efforts to ensure they know as much as possible about what is going on. At present, the only incentive is to know as little as possible about what is going on so that they can deny any connection with any scandal. Regulation alone cannot fix this problem. At the end of the day it is a last resort, albeit an ethical one. ED: Turning our attention to the present travails in Europe, specifically regarding Southern European members of the Eurozone, do you believe the Euro is doomed to fail given recent events in Cyprus and growing fears for Slovenia? RP: The Euro area is confronting problems that all countries living in a global world economy and financial system have yet to face. Having your own currency, like the U.S. dollar or Japanese Yen, does not protect you from these dilemmas and problems. Having your own currency merely enables local politicians to promise to spend money – the people’s money – and allows governments to more easily postpone taking the hard decisions needed to exist within a global world economy. Whilst I expect the Euro to survive in one shape or other, recent events in both Italy and Cyprus suggests its present membership decrease over the coming 12 months. However, despite all the Cassandra’s and recent upheavals that have occurred in Journal of Regulation & Risk North Asia

the Eurozone, the Euro presently remains intact. Further, I would go as far to say, that those countries that have the political will to implement needed reforms – and most of the current members have such political determination – will be able to remain in the Eurozone. Indeed, if current reform plans are fully implemented, the Euro area will emerge stronger in the long run as a result of this crisis. ED: Despite a raft of regulatory initiatives and increased risk management measures across the U.S., UK and European Union since the financial meltdown of 2008 - not to mention Basel III, recent events such as the failure of MF Global and US$5.8 billion trading loss at JP Morgan’s London operations - large globally active financial institutions have failed to heed previous lessons. Is this a fair assessment of the present state of play across much of the industry? RP: It shows that the culture of aggressive, risk-taking investment banking is still prevalent in the leading institutions. Again, the top people could say they were not aware of such risk-taking. But it is their responsibility to set the tone and to monitor such risk-taking effectively. This underlines the need to split up the big banking groups, and to increase the pressure for such break-ups. Governments should stop pretending that “more regulation” or “better regulation” can ensure a stable and safe banking and financial system. This is not only false but also dangerous, as it takes responsibility further away from the management of individual firms to keep their capital and liquidity strong enough to withstand shocks. It also Journal of Regulation & Risk North Asia

fails to encourage firms to make their own assessment of risks. ED: Would you agree that the Wall Street Reform and Consumer Protection Act, more commonly referred too as the Dodd-Frank Act, has made banking safer in the U.S.? RP: I welcomed Dodd-Frank when it was passed as a step in the right direction, but banks’ lobbying power is watering it down and will continue to water it down further when it comes to full implementation. My view now is that this monstrously complex piece of legislation proves that the current banking and finance system should be abolished. It has reached the end of the road. Either we go for a fully nationalised finance system, with extensive state direction, or we need to construct a reformed system where individuals are able to choose what level of risk they are willing to accept for the money they place with financial intermediaries and to accept the consequences. ED: Given the establishment of bilateral trade agreements that have excluded the U.S. dollar as an international settlement currency in recent months, do you believe the dollar will retain its primacy as the international currency for conducting business? RP: The dollar should take its place in a global network of currencies linked to a common benchmark or standard. We need a reference point, or platform, against which currencies, including the dollar, euro and pound, can measure themselves. I suggest one way of defining such an international currency, which I call the Ikon, in my book.• 11

Debate

Forget “too-big-to-fail”, say hello to “too-big-to-prosecute”
Attorney General Holder’s Freudian slip could prove a “watershed moment” in cutting banks down to size argues Chris Rogers.
Eyebrows were more than a little raised recently following the public disclosure by the United States highest ranking public prosecutor that banks deemed systemically important were all but immune from being prosecuted for any criminal behaviour. The remarks made by U.S. Attorney General Eric Holder during a Senate Judiciary Committee hearing in relation to questions concerning the HSBC money laundering scandal caused howls of derision across the political spectrum and re-ignited passions concerning too-big-to-fail, a lack of criminal prosecutions in relation to the bank crisis of 2008 and slow progress in the implementation of Dodd-Frank Act. Holder’s Freudian slip of the tongue was no mere one-off. His well considered remarks to Senators in March echoed similar statements made by another luminary of the U.S. Department of Justice (DoJ), Assistant Attorney General Lanny Breuer, who managed to transgress not once, but twice in a two month time frame. Breuer, for those who need reminding, was the genius behind last Journal of Regulation & Risk North Asia December’s US$1.92 billion no jail, no prosecution settlement with HSBC following the revelation of a litany of money laundering and other criminal transgressions stretching back to the beginning of the millennium. His raison d’être for this dubious decision being that had he pursued criminal charges, “HSBC would almost certainly have lost its banking license in the U.S., the future of the institution would have been under threat and the entire banking system would have been destabilised.” Breuer, having courted the derision of many for his handling of the HSBC scandal in December, decided to go one step further this January when agreed to participate in an interview for the U.S. public broadcaster PBS’s Frontline current affairs programme titled “The Untouchables.” During this broadcast, Breuer waxed lyrically that U.S. Justice does not apply to the largest active banks on Wall Street – a contention fully backed up by the empirical evidence, or lack thereof since the onset of the financial crisis five years ago. Unsurprisingly, following a wave of outrage over Breuer’s unimpressive performance and excuses given for not 13

upholding his oath of office – he was after all the head of the DoJ’s criminal prosecutions division - he tendered his resignation some 24 hours after the programme aired. For many bankers on Wall Street and further afield, 2012 had been an exacting year of which many had hoped to put the“annus horribilis” of mis-selling, money laundering, the Libor scandal and “London Whale fiasco” behind them as they embarked on a new year. As such, Breuer’s interjections in January from a PR perspective were unwelcome to say the least, certainly in terms of the negative publicity they engendered, not too mention further reputational risks that all this entailed for many of the world’s largest banks – most of which have operations in the U.S.. Hence, the Attorney General’s comments in March came as an utter bombshell to the tranquillity many yearned for. Systemic importance Having fought a rear guard action to downplay Assistant Attorney General Breuer’s comments on too-big-to-prosecute, toobig-to-jail during much of January and February, the banking sectors well-oiled PR and lobbying machine was hard at work undermining undesirable elements of the Dodd-Frank Act and U.S. adoption of the more onerous elements of the Basel III international Accord. No doubt, many considered Wednesday, 6 March just a normal day on Capitol Hill, and as such, were unprepared for the tsunami that was to be unleashed by Holder later that afternoon during a routine grilling by the Senate’s Judiciary Committee. Lulled into what may have been a false sense of security having successfully fielded questions on drone policy and gun control 14

under questioning from the Republican Senator for Iowa, Charles Grassley, Holder all but admitted what many had believed for many years, namely, that the Justice Department – together with other regulatory and supervisory bodies - was either unwilling, or unable to press charges or seek criminal prosecutions against large systemically important financial institutions for fear of the damage this could cause, not only to the U.S. economy, but that of the world. Negative impacts In reply to the Senator’s enquiry, Holder said: “The size of some of these institutions becomes so large that it does become difficult for us to prosecute them when we are hit with indications that if you do prosecute, if you do bring a criminal charge, it will have a negative impact on the national economy.” He further added that “this is a function of the fact that some of these institutions have become too large.” Such comments by leading officials within the Obama administration can usually be brushed aside or ignored. However, Holder’s remarks, specifically those relating to too-big-to-fail, pinched a nerve that had been causing trouble to many since the 2008 bank bailouts. Indeed, given that the Obama administration has been trumpeting the fact that the issue of too-big-to fail had been resolved in one passage of the Dodd-Frank Act and that no more public money would be required to bailout failing institutions due to the Resolution authority contained therein, both Holder’s and Breuer’s remarks cast serious doubt on this contention. Obviously, by straying off message, Holder’s remarks managed to reopen Journal of Regulation & Risk North Asia

existing wounds in those both opposed to the Dodd-Frank Act itself, and those who believed that it did not go far enough to strengthen bank regulation, curtail casinostyle gambling or prevent outright malfeasance. Speaking in the aftermath of the Attorney General’s faux pas, Camden Fine, the head of the Independent Community Bankers of America, said that Holder’s more than candid remarks “didn’t just throw fuel on the fire, it threw an entire refinery on the fire.” Meanwhile, whilst The American Bankers Associations’ Wayne Abernathy, suggested that Holder’s comments were “muddled” and certainly not helpful to the dialogue on too-big-to-fail or prosecuting wrongdoer’s within finance, colleagues over at the American Banker magazine called his comments“an amazing admission”and possible turning point in the debate about large financial institutions. Extraordinary indictment The too-big-to-prosecute syndrome, read too-big-to-jail, is not just restricted to the “land of the free and the brave,”for it would seem that the infection has spread to that other citadel of Anglo-American capitalism, namely, the City of London. In a much publicised interview given to The Daily Telegraph in December last year in the wake of the Libor scandal, the record fine imposed on HSBC by U.S. authorities and the JPMorgan Chase “London Whale fiasco,”the newly appointed head of the UK’s Prudential Regulation Authority, Andrew Bailey, expressed similar sentiments to those two other fellow travellers, namely Breuer and Holder, when he all but confirmed that“some banks had grown too large to prosecute.” Journal of Regulation & Risk North Asia

Pushed on the politically sensitive issue of why no criminal charges had been brought in the UK against those involved in rigging interbank lending rates, Bailey had this to say: “It would be a very destabilising issue. It’s another version of too important to fail”, he added, that “because of the confidence issue with banks, a major criminal indictment, which we haven’t seen and I’m not saying we are going to see… this is not an ordinary criminal indictment.” Trouble in the City As in the U.S., there has been considerable public and political disquiet in the UK at the fact that no individual or institution has been brought to account over the banking crisis that began with Northern Rock in 2007, government bailouts of Royal Bank of Scotland, and Lloyds Banking Group following its merger with Halifax Bank of Scotland in late 2008. So too the insignificant progress made in mitigating against too-big-to-fail and criminality of the City. The UK government and its regulatory agencies have not only failed to act fully on the recommendations of the Vickers’ Commission’s findings, but have thus far failed to impose sanctions, fines or successfully prosecute any of those involved with the Libor abuses, not too mention those institutions headquartered in the City which U.S. authorities have issued fines to, among them Barclay’s Bank, Standard Chartered and HSBC. Indeed, the only scalp has been that of Barclay’s former CEO, Robert Diamond, who was forced to resign having lost the trust of the Bank of England. Further, the Conservative-led Coalition government has done all in its power to thwart European 15

Union legislation on excessive remuneration and the introduction of a“Tobin Tax”on securities transactions - this despite inflicting austerity on the economy at a time when the banks themselves are averse to lending. Whilst Bailey’s comments did little by way of endearing himself to the British public and certainly could not be construed as a tipping point - they were after all made in the print media - the same cannot be applied to either Breuer’s or Holder’s public pronouncements. In the aftermath of the HSBC no-prosecution deal, Breuer positively courted the media in relation to the exceptionally large deal he’d managed to strike with the bank - evidently forgetful of the large pile of incriminating evidence that sat on his desk. Having managed to raise a huge media storm in December, he was once more in January playing with media fire and consequently got more than a little singed - obviously having brought too-bigto-fail and too-big-to-prosecute back into the public domain, a matter that both irritated and delighted many in equal measure. The Attorney General’s testimony to the Senate Judiciary Committee was in a different league to that of his junior in the DoJ. Not only did we have the most senior prosecuting counsel in the U.S. underscore the fact that it was all but impossible to seek criminal prosecutions against too-big-to-fail banks, but compounding this admission was the fact that his words were being transmitted live via a TV broadcast, recordings of which were soon placed on the Internet and went “viral” within hours. The blogosphere also magnified and dissected Holder’s comments to such an extent that a virtual point of“criticality”was reached that very evening. 16

In light of these two intertwined facts, the issue of too-big-to-prosecute (too-big-tojail) and too-big-to-fail were once more at the forefront not only of the general publics mind, but also of legislators on Capitol Hill a dangerous chemical cocktail indeed! What of the substance of Attorney General Holder’s remarks themselves? It is a question that has been raised by those who sympathise with his dilemma, his detractors and by those either adverse to mega banks or to the Dodd-Frank Act in general for a multitude of reasons, the most significant of course being that it has failed to curtail the banks, and thus failed to fix too-big-to-fail. Most of these issues should not be of interest to the Attorney General of the DoJ. They are after all regulatory or legislative issues. That said, out and out criminality should be of primacy concern to Holder. As such, both he and Breuer have contributed to continued recklessness of degenerate banks by failing to uphold the letter of the law, of which no single man or institution should be above. With regards bringing banks to heal and mitigating against too-big-to-fail, Holder’s comments were a godsend and have shaken up the dialogue on how to prevent another systemic event and taxpayer bailout. Whilst many contend that Holder’s outburst has strengthened the hands of Senator’s Sherrod Brown and David Vitter in their efforts to introduce a legislation to cap bank size, the chances of this effort are close to zero. Rather, what we see is an opportunity for one Elizabeth Warren to elevate her status in the Senate by striking fear into both the systemically important banks and those whom are entrusted by the U.S. government to supposedly regulate them.• Journal of Regulation & Risk North Asia

Opinion

Thirteen ways of looking at a London whale
Assoc., Prof. Jennifer S. Taub of Vermont Law School eviscerates JPMorgan Chase’s “tempest-in-a-teacup” moment.
Wallace Stevens’ Thirteen Ways of Looking at a Blackbird came to mind this March after listening to testimony at the US Senate subcommittee hearings focusing on the activities of the “London Whale” incident at JPMorgan Chase’s London operations. The Senator Levin-led bipartisan Permanent Subcommittee on Investigations’ 301-page report: JPMorgan Chase Whale Trades: A Case History of Derivatives Risks and Abuses, makes for some uneasy reading by those involved in last year’s tempest-in-a-teapotturned-US$6.2 billion trading loss. A regulator from the Office of the Comptroller of the Currency (OCC) who testified at the hearings, admitted finding new information in the report that he thought he and his colleagues at the Comptroller’s Office, still needed to“digest.” In the spirit of the Stevens’ poem, there are at least thirteen facts that can be gleaned from both the report and testimony: First and foremost, is the fact that JP Morgan saw it coming: A potential US$6.3 billion loss within the synthetic credit portfolio Journal of Regulation & Risk North Asia (SCP) at the Chief Investment Office (CIO) was predicted through the bank’s own comprehensive internal risk measure. Despite its own internal findings, the bank’s market risk executive, Peter Weiland dismissed the prediction as “garbage.” Second, was the building up of risk: The portfolio did not reduce risk, as was projected by senior management, but actually added risk: The SCP trades violated internal risk limits, yet more risk was added. The OCC saw the risk breach reports but did not act. Third, this was not a rogue trader or rogue desk – the CEO, Jamie Dimon, was aware of key facts. According to Ina Drew, head of the CIO, who “resigned” last year as a result of the “London Whale” debacle, Dimon was aware of the CIO trading. The report also details he was informed of the risk limit breaches. Fourth, we have the cover up: The bank CIO unit changed its pricing practices to make losses on portfolio positions look smaller. This phantom pricing continued even after the story of the whale broke and after it was clear another part of the bank priced the same positions as the CIO had in 17

the past – at the mid-point between the bid/ ask spread. Gambling with deposits Fifth, was the potential for fraud: Levin noted that the bank agreed that “books were cooked.” The bank arguably made false statements to the public, policy makers and regulators, whilst Levin focused on the statements made by CFO, Doug Braunstein in April 2012. Sixth, is the issue of gambling with Federally-Insured Deposits, and not as claimed, hedging positions: The bank could not point to specific assets it was hedging, and appeared to be engaging in proprietary trading, using insured deposits, a practice which would arguably violate the Volcker Rule, set out in Section 619 of the DoddFrank Act. Seventh, the bank’s positions lacked transparency: JP Morgan claimed in April 2012, that it had disclosed trading positions to regulators when it had not. Levin called this and other statements made by Mr. Braunstein an attempt to“calm the seas.” Regulator ignorance Eighth, denotes minimised losses to regulators: The bank may have told regulators losses were just US$580 billion at a time when they had ballooned to US$1.2 billion. Ninth, the regulator was in the dark: Scott Waterhouse, lead OCC examiner for the bank said he did not find out about the London Whale risky trades until the Wall Street Journal broke the story in April 2012. According to Waterhouse the whale “did not surface to our attention”until that time. Tenth, is the fact that red flags were 18

ignored: The OCC failed to investigate the trading activity even after learning of the multiple risk limit breaches. In addition when the bank applied a new value at risk (VaR) model and the VaR dropped by 50 per cent using that model, the OCC did not inquire as to why and failed to look at the portfolio. Levin called this a“pretty bright red flag.” Eleventh, is that bullying tactics were utilised: Chief executive, Jamie Dimon apparently yelled at bank examiners and called them “stupid” when he did not agree with their recommendations. Mr. Dimon apparently also instructed the bank to withhold daily profit and loss reports from the OCC. When former CEO, Mr. Braunstein revealed that he had resumed providing reports to the OCC, Mr. Dimon raised his voice and said it was up to him to decide whether or not reports should be resumed. Mr. Dimon had previously told the OCC that they did not require that level of information. Twelfth, is the fact that JP Morgan skimped on information technology expenses: The bank did not want to pay to automate the new VaR model, so an employee regularly worked late into the night manually entering, sometimes incorrectly, data into a Excel spreadsheet for the US$350 billion portfolio. The OCC was apparently unaware of this fact. The Volcker Rule And last, but by no means least, is our thirteenth fact, namely implementation of the Volcker Rule, or lack thereof. Comptroller Thomas J. Curry of the OCC failed to provide a date by which he thought the Volcker Rule would be implemented. However, he did indicate that the London Journal of Regulation & Risk North Asia

Whale experience with the CIO would affect the rule making. Mr. Curry, who was sworn into office just days before the news broke of the affair, seemed to imply that this socalled “portfolio” hedging that JP Morgan Chase claimed to have engaged in would be banned under the rule, as many argue the Dodd-Frank statute already prohibits. Bruno Iksil After the first day of the hearings, for some welcome respite, I was reminded of Stevens’ poem, and in particular the third stanza: “The blackbird whirled in the autumn winds. It was a small part of the pantomime”. The blackbird connection? Bruno Iksil, former JP Morgan Chase trader dubbed “The London Whale” never appeared at the hearing. Residing in France, outside the reach of the Senate’s subpoena authority, Iksil himself was not in the building. Indeed, if one took a close look, even his trading was a really small part of the investigation, the hearing, and its broader implications. Tip of the iceberg This is a point made by Josh Rosner, coauthor with Gretchen Morgenson of Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Created the Worst Financial Crisis of Our Time. Indeed, on Barry Ritholtz’s Big Picture blog, Rosner contends that internal control problems at JPMorgan Chase “appear to be pervasive.” The whale problem may just be the tip of the iceberg, so to speak. He also notes that the whale loss itself is less than other related litigation expenses. The bank has already paid out more than US$8.5 billion in settlements since 2009 relating to matters covered Journal of Regulation & Risk North Asia

in the Levin report. The hearing also raises again the question of whether banks are still “too big to fail.” Further, Ina Drew did not aid those who argued that nothing was amiss with the status quo. She headed up the CIO, earning US$14 million in 2011 alone, but claimed that she was unaware they were 1,000 per cent over their risk limit. And, when Levin asked her how big the hedge was and she said she had no idea, she defended this by pointing out that the bank had a US$2.2 trillion balance sheet – implying it was either too trivial or perhaps impossible to track. Levin remarks Senator Levin also attempted to create a larger frame for the hearing, asserting in his opening remarks that: “The Whale trades exposed problems that reach far beyond one London trading desk or one Wall Street office tower. The American people have already suffered one devastating economic assault, rooted largely in Wall Street excess. They cannot afford another. When Wall Street plays with fire, American families get burned. The task of federal regulators and this Congress is to take away the matches. The Whale trades demonstrated that this task is far from complete”. Also incomplete is accountability. One can only hope that the next time a banker is cross-examined about arguably materially misleading statements, it is in a court of law, not a Senate hearing room, and that the prosecutor has carefully reviewed at least thirteen ways of looking at a white collar crime. I won’t hold my breath. The statute of limitations will probably run before that happens –“The river is moving. The blackbird must be flying.” • 19

Opinion

The “Mistake” that dare not speak its name
Per Kurowski, a former World Bank executive director, lambasts the Basel Committee for castrating banks.
In an Op-Ed I wrote for the Daily Journal of Caracas in November, 1999, I opined that: “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause its collapse”. Fast forward to June 2004, and that “systemic error” I’d railed against was duly introduced by the Basel Committee via the Basel II Accord – which introduced capital requirements for banks based on perceived risks, like those reflected in credit ratings, ignoring the fact, that these risks were already being cleared for by the markets. Under Basel II, with its emphasis on riskweighted capital requirements, the Basel Committee had unwittingly laid the foundations for the “perfect storm”, which unleashed the North Atlantic financial crisis of 2007-08. Despite causing great damage to the global economy, central bankers and policy-makers have temporarily cushioned us from most of its costs by means of kicking Journal of Regulation & Risk North Asia the can down the road. Today, almost six years after the first rumblings of the financial crisis were heard, our friends in Switzerland seem as blinkered as ever in their inability to recognise their “mistake”, never mind address it. Perhaps it is just too big for the regulatory establishment to acknowledge! Mark Twain, wrote that: “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain”. And the weatherman could predict sunshine or rain, and he could be right or wrong. If rain was announced and it rained, no problem for the banker, as he had either never lent the umbrella or had already taken it back. If rain was announced, but the sun shined, the banker may have lost some good tanning opportunities, but that’s about all. If sunshine was announced, and the sun shined, there are of course no problems for the banker. But, if sunshine was announced, and it rained, then the bankers would be in serious trouble. And this could be why Mark Twain also said: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so”. 21

But our global bank regulators, the Basel Committee, and its sister organisation, the Financial Stability Board, they too loved sunshine and hated rain. And they felt, perhaps to be on the safe side, that they should also layer on their own preferences and fears on top of those of the bankers themselves. Hubris dosed wisdom And so even though all major bank crises to date have resulted from excessive bank exposures to what was perceived as “absolutely safe”, and never ever from excessive exposures to what was perceived as “risky”, the regulators, in their much hubris-dosed wisdom, decided to safeguard our banking system, by requiring the banks to hold much more capital against those assets perceived as “risky”than against those assets perceived as “absolutely safe”. And this allowed the expected risk and cost of transaction adjusted margins of the banks, when lending to or investing in“safesunny” zones, to be leveraged immensely more than the same margins when operating in “risky-rainy” areas. And that of course translated directly into much higher expected risk-and-regulatory adjusted returns on bank equity when bathing in the sun, than when dancing in the rain. Lower risks - higher returns In other words, before the establishment of the present global regulatory environment, banks decided who to lend to, depending on who produced them the highest risk and cost adjusted margin, and of course, as long as that margin could be leveraged to exceed the bank’s cost of capital. Those were the days when one unit of risk and cost adjusted 22

margins paid to the bank, meant the same, no matter who paid it. But now, because of these capital requirements – more-risk more-capital, less-risk less-capital – banks have come to prefer giving a loan to a borrower who provides it with a lower expected risk and cost adjusted margin than what other borrowers offer, only because they are authorised by the regulators to leverage the first many times more than the latter. In other words, banks have already adjusted for perceived risks in the“numerator” in the asset side of the balance sheet, by means of interest rates, the size of the exposure and other contractual terms. And so, when regulators forced banks to also adjust for perceived risks in the “denominator”, in the liabilities and equity side of the balance sheet, with capital requirements based on this, they caused the whole risk-adjusting equation to enter a state of chaos. Wheel of fortune In other words, all roulette bets have exactly the same expected pay out. But some bets, such as those made on a number, usually take you out faster from the game than those made, for example, on colour. So what if the regulators decided that playing for a longer time was the equivalent of playing it safe, and that therefore the pay out of any bets on colour should be increased considerably? Forget about roulette as a viable betting game. What about a handicap system that awards good golfers like you more strokes than bad golfers like me? Forget about golf as a viable competition game. First and foremost the consequence of what was much more mis-regulation than de-regulation; was Journal of Regulation & Risk North Asia

that it introduced a huge distortion which makes it impossible for banks to help the economy by assigning economic resources efficiently. The result is that now, more than the markets, the regulator´s hand guides the banks. In turn banks create excessive exposures to what is perceived as‘absolutely safe’, whilst holding very little capital. Mind-boggling leverage From a regulatory point of view, this is as bad as it gets. I repeat, in banking, the really big bangs result from excessive exposures to what was ex-ante perceived as absolutely safe but that, ex-post, turned out to be very risky. And it will cause any perceived safehaven to become, sooner or later, dangerously overpopulated, and therefore risky. Just reflect on the fact that Basel II allowed banks to lend to Greece, or to buy AAA-rated securities collateralised with mortgages to the subprime sector, holding only 1.6 per cent in capital. The implication of an authorised leverage of 62.5:1 is indeed mind-boggling. Favouring the“infallible”, those who are already favoured with lower risk premiums results de-facto in an odious discrimination against the “risky”, i.e., those who are already discriminated with higher risk premiums. The “risky” will then have even less access to bank credit, or need to pay more in interest, so as to make up for that competitive regulatory disadvantage in order to deliver the same returns on bank equity as the “infallible”. Castrated lending This increased regulatory aversion against perceived risks, figuratively castrates the banks, affecting most those agents who Journal of Regulation & Risk North Asia

operate on the fringes of the real economy, those who usually most need access to bank credit, and those who usually find themselves among “The Risky”, such as medium and small businesses and entrepreneurs. And that is a true disaster for a real economy which, needs“The Risky”risk-takers to help it move forward, as well as for all our young who anxiously wait for a new generation of jobs. We do not sing“God make us daring!” psalms in our churches for nothing. And some minimalistic capital requirements also provided the banks with the most potent growth hormone, which helped many of them to grow into “too-big-to-fail” globally active financial institutions. Also, since banks are required to hold the least capital against debts of “infallible sovereigns”, this translates into a subsidy of the interest rates they pay, which causes the proxies for the risk-free rate, such as U.S. Treasuries, to emit the wrong signals. Not a laughing matter Given ones levity thus far, the fact remains that this is no laughing matter - quite the reverse in fact. As such, regulators, elected policy-makers, senior civil servants, central bankers and international financial bodies need to take a deep collective breath in order to address what is to be done to combat this onerous piece of global regulatory oversight. If banks are given specially rewarded access to “absolutely safe” investments, are we the citizens, our pension funds, our widows and orphans, supposed to take care of the needs of funds of the“risky”? Is it not the banks that are supposed to do this, leaving us others with the option to invest in what is safe? Of course, it can 23

only help to widen the gap between the haves, the past, the developed, the old,“The Infallible” and the have-nots, the future, the developing, the young,“The Risky”. A capital “Mistake” Many argue that the problem originates with the credit rating agencies. Not so. The problem resides with regulators using credit ratings excessively. In January 2003, in a letter published by Financial Times, I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds”. With Basel II, the regulators bet our banking system on risk models and credit ratings being correct, while in fact their responsibility should be to prepare for when risk models and credit ratings are incorrect, something which will happen, sooner or later. For sure, these capital requirements for banks are not a minor mistake, but rather, a capital“Mistake.” From a regulatory point of view, by just looking at the empirical evidence, one could even make a case for higher bank capital requirements for exposures perceived as“absolutely safe”, over exposures perceived to be “risky”. Saving face This is why someone very close to the regulators, on hearing my arguments, told me bluntly that the real problem was how to find a way for regulators to save face. But surely the need is not for regulators to save face, but rather to be held truly accountable, in order to make it less possible for global initiatives, like the Basel Accord, to develop anew with little scrutiny, and within what effectively amounts to small mutual admiration clubs. 24

Something needs to be done, urgently. It is not the role of the Basel Committee to act as risk manager for the world, which now seems to be digging us even deeper into the hole. With Basel III, where capital requirements are still based on perceived risk, it wants to add liquidity requirements, which are also based largely on the same perceived risks. Let´s face it: Hollywood would never authorise a Basel III production using the same scriptwriters and directors responsible for a Basel II box office flop. Single capital requirement If a certified financial advisor was offering the same advice to a wealthy developed old retiree than to an undeveloped poor young professional, he would have his certification immediately revoked. And yet the Basel Committee does just that when expecting banks to act in the same way for both constituencies, and seemingly favouring more the “après moi le deluge” constituency. By means of a very careful transition we need, with a Basel IV, to move to one single capital requirement for any bank asset, around 8 to 12 per cent, depending on where the different economies might be in their economic cycle. And I mention this because I can think of few things that are as pro-cyclical as current capital requirements. But if bank regulators cannot refrain from meddling, why then not base the capital requirements on job-creation-potential-ratings, or environmental-sustainabilityratings? At least then the banks would have a purpose. As present, the banks are only performing better for those who possess good credit ratings, “The Infallible”, leaving all rest,“The Risky”, out in the cold. • Journal of Regulation & Risk North Asia

Opinion

The failings of regulators: Why don’t they do their job?
UK-based Rowan Bosworth-Davies lambasts the UK authorities for their lack of oversight of the financial services sector.
When, in 1984 as a New Scotland Yard Fraud Detective, I went to study financial regulation as it was then carried out by the Securities and Exchange Commission (SEC) and other agencies in Washington D.C., I was introduced to a group of regulators that had a culture and an uncompromising track-record of taking on the biggest financial criminals and bringing them to justice. I had gone to study with the SEC because I had become only too aware of the tidal wave of new financial crimes we were having to deal with in London, crimes which were being predicated by the then UK Conservative government’s policy mantra of de-regulation and opening up the City of London up to a far greater degree of financial competition. Having repealed exchange controls, thus opening up the channels of financial free flows, and having encouraged a policy of enabling foreign financial companies to set up business in London, the then sitting Prime Minister - the recently deceased Margaret Thatcher - was determined to put Journal of Regulation & Risk North Asia London firmly in place as the third staging post of a 24/7 trading market, which could facilitate the global dealing in financial products, so that when the Tokyo market closed, the UK market would be open, and the US market would open before we closed. This era of free-flowing financial operability brought with it a whole new range of financial criminals who were willing to hitch a ride on the coat-tails of the major players, and their activities were landing on the few desks of the small specialist squad of detectives of which I was a member. It was quickly proved to be useless to seek to involve the civil servant regulators at the Department of Trade and Industry (DTI), very few of whom wanted to dirty their hands or earn the wrath of their political masters. New types of crime I quickly became aware that we were dealing with crimes, the likes of which we had not hitherto experienced and which would cause British juries difficulties if we, the detectives, were not capable of presenting our cases in ways which a British jury would comprehend. In many cases, these types of 25

scams were making use of American trading methods and language, about which we knew very little, and I discussed this problem with my boss at the Fraud Squad. An incredibly far-sighted man, he asked me to put together a position paper, which he used to lobby for some budget, and then told me to organise a visit to America to go and study with the SEC and the other US regulators, from whose experiences and skills we might learn. White-collar criminality Thus it was that I ended up studying financial regulation in Washington, Philadelphia, Chicago and New York, a lengthy period of immediate and direct study which I doubt few modern financial regulators have been able to, or indeed, would wish to replicate! This visit taught me a large number of truths, but chief among them was the realisation that those who handle other people’s money, for which they get paid commissions, brokerage, bonuses, or any other kind of financial reward, have to be looked upon as potential white collar criminals, and dealt with accordingly! Draconian penalties I say this because that is how the SEC viewed them and dealt with them, and they reserved some very draconian penalties for those who broke the rules. In order to bring order and discipline to their financial markets, the various financial regulatory agencies worked very closely with the Department of Justice, investigating cases in tandem, and sharing the evidence so that criminal charges could be brought in step with regulatory wrongdoing. 26

Yes, it would be nice if we could think that the financial sector was a well-ordered, good-mannered, lawful, transparent and ethical environment, peopled by men and women who paid more than just lip-service to the concepts of integrity and honour. But alas, it isn’t and that is all there is to it! These employees get paid big money to take the big risks, including the risk of getting caught. They are there to insulate their executives and main board directors from direct involvement in the crimes they commit, so that the upper echelons in the management food chain can always claim they were unaware what was going on when rampant wrong-doing is uncovered. Deaf, dumb and blind They will always benefit from the outcome of the criminal conduct, but as long as they do not need to be dragged into the dayto-day debate, they can continue to operate on the basis that they were deaf, dumb and blind to what was happening on the floors below. We cannot whinge and whine for something we shall never see, and we should not be surprised when the inhabitants of the Square Mile behave in the way we all know they will. If they commit crimes of every financial kind, which they do, then we only have ourselves to blame for allowing them to do so. So we have to recognise them for the kind of animal they are, which is potential organised criminals, because the other lesson of overriding importance that I learned was that the only thing that financial services practitioners fear is being prosecuted for criminal offences. If they are convicted, then that is the end of their careers, it is the Journal of Regulation & Risk North Asia

one-way street to the door marked‘Exit’, and it means ejection into social and commercial outer darkness. ‘Good Chaps’ syndrome It is the only way, and I mean the ‘only’ way to regulate financial practitioners, to instil in them such a fear of committing a crime, which they know will be prosecuted, that they will toe the line. It is a draconian, uncompromising penalty, but it works, and that is what I cannot seem to get into the mind-set of the British regulatory galère, who are all imbued with the ‘Good Chaps’ syndrome and oozing with the desire to softpedal on the wrong-doings of those whom they regulate. People who work in the banking and finance industry have one ambition in mind and that is to make as much money for themselves as they possibly can in the most unreasonably short space of time - an issue the eminent economist Jeffrey Sachs has now formally recognised as afflicting much of Wall Street. Therefore, to assume that they will want to do this ethically, honestly, reasonably, transparently or honourably, is to ignore all the evidence to the contrary. Capacity too ire Like the SEC do, they must be assumed to have the capacity to behave like criminals, and the regulatory regime must be geared towards that end-game. You don’t regulate these people by doing nice, you find out what they are doing through intelligenceled detection; you focus on the weak links and turn them; you get the evidence against the top players, and you go in hard and bring them down. It isn’t pretty, it isn’t nice, and it Journal of Regulation & Risk North Asia

takes a special kind of professional to carry it out, former properly trained detectives, and Customs and Revenue investigators. All the while we employ these charming young commercial solicitors, chartered accountants, ex-DTI staffers and former financial services sales people in these roles, we are never going to be able to prosecute, never mind gain a successful criminal verdict. The young regulators who worked at the SEC, and particularly in the Enforcement Division were young, dynamic criminal lawyers, yes, criminal lawyers, who had a good understanding of how regulatory law and criminal law interlinked. They had careers to build, and they wanted to go after the biggest targets they could and bring them down hard, so there was no shirking of duties, and being nice to the regulated sector. Above all, there was no regulatory capture obvious in their relationships. Undo influence Regulatory capture is what happens when regulated industries are able to gain influence over their regulator, so that regulation that ostensibly serves the public interest actually supports the interest of the industry concerned. A summation of this modern day phenomena is detailed on the UK-based website Moneyterms, which states: “...Some economists argue that regulatory capture is inevitable, most that it is a significant risk. It occurs because those who are regulated have a high stake in influencing regulation to favour them. Each firm’s profits are heavily influenced by regulation, so they will each put a lot of effort into influencing the regulator, whereas few individual consumers will have a sufficiently large stake to expend 27

much effort. Another advantage that the regulated industry has over consumers, and often over the regulator, is expert knowledge of the industry. This allows the industry to marshal the facts and arguments needed to influence the regulator, far more easily than consumers, and often more easily than regulators. Conflicts of interest among individuals who run the regulator may also lead to regulatory capture. It is not uncommon for people to move between working for the regulator and working for the industry: for example working for a financial regulator and then in a compliance role in a bank....” Carrying a candle Let us consider the case of Hector Sants, the former chief executive of the Financial Services Authority and present executive board member of Barclays Bank, if we need any more proof of the accuracy of this last assertion. Now, I am not saying that Mr. Sants was carrying a candle for Barclays Bank while he was a regulator and was responsible for ensuring that their regulated activity was all it should be. I am advised by friends of mine who worked at Barclays under the benign regime of Roberto ‘The Don’ Diamante, that they were regularly getting hauled in to account for their actions of which the FSA did not approve. They turned up and got their wrists slapped, but nothing ever happened to them. So, what can you say? Damning report It transpires, the UK Parliament’s Treasury Select Committee has said a great deal about the way in which the now defunct Financial Services Agency had handled their role, and 28

much of what they have had to say has not been pleasant. You have to understand the way in which Government agencies speak publicly about other agencies within their ambit. The normal practice is not to be seen, publicly, to be disparaging of the other’s actions. Carefully worded phrases are usually adopted, which contain vague allusions, recognisable to those familiar with the argot, and which indicate a sense of displeasure. It is unusual for a Government agency like the Treasury sub-committee to be very outspoken. In October 2012, the Treasury Select Committee published a devastating critique entitled: The FSA’s Report into the failure of RBS, which identified serious concerns over the FSA’s oversight of the Royal Bank of Scotland (RBS). The MPs on the committee were unimpressed, concluding that the FSA could and should have intervened in the bank’s takeover of ABN Amro. Its members believe the regulator should have stopped the takeover, and they criticise the FSA for failing to investigate the failure. Public explanation The report further states that: “In December 2010 the FSA initially felt that a 298-word statement about RBS’s failure was explanation enough. This reflects serious flaws in the culture and governance of the regulator. It also reflects a fundamental misunderstanding of its duty to account for its actions to the public and Parliament. In view of the vast amounts of public money committed to propping up RBS, Lord Turner’s comment that a Report into the demise of RBS “would add little, if anything, to our understanding of what went wrong” Journal of Regulation & Risk North Asia

was inadequate. He should have grasped the need for a public explanation of how that situation had arisen, something which he has subsequently acknowledged. We would not expect the new chairmen of the regulators to repeat the error.” Serious indictment The Committee’s report says the FSA’s own report, which describes “failures and inadequacies in the regulation and supervision of capital, liquidity, asset quality and a failure to appropriately analyse the risks relating to the ABN Amro acquisition’ is a serious indictment of ‘both the senior management and leadership... in place at the time”. The FSA report, it adds, not only highlights the oversight of the Chairman and Chief Executive, but also their predecessors, “regardless of the prevailing assumptions and political pressures”. New role and duties The Treasury Select Committee has made its displeasure about the FSA felt further in a report published this January titled: Appointment of John Griffith-Jones as Chairdesignate of the Financial Conduct Authority. In this, the Treasury Committee’s Sixth Report, the members define clearly the intended new role and duties of Griffiths-Jones in the following statement: “...He must restore the credibility of the conduct regulator. The FCA is the successor to a body which, failed consumers. Although it devoted a great deal of time and effort to conduct matters, it left consumers exposed to some of the worst scandals in UK financial history.” The report goes on to describe the creation of a‘box-ticking’culture,“whose benefits Journal of Regulation & Risk North Asia

were far from evident and which still failed to pick up major failures in the making”, calling for Mr. Griffith-Jones and his board to ensure that the new organisation adopts a “radically different approach”, in the following statement: “We note that the PRA, which has assumed responsibility for most prudential aspects of the FSA’s work, has done this, with its adoption of a move to judgement-based regulation. The board of the FSA also appeared to fail in its oversight of the work of the Authority. He and his new board colleagues will need to demonstrate stronger strategic leadership than their FSA predecessors...” Evidently, it is clear to see that the Committee have serious reservations over the stewardship of the FSA and its ability to act as an independent arbiter in the lead up to the bank bailouts of 2007/08. Subsequent regulatory mishaps under the FSA’s then leadership, most notably, the Libor scandal and money laundering activities of HSBC and Standard Chartered Bank are also brought into question. Indeed, Michelle McGagh of the UK-online news publication, Citywire, in a hard-hitting editorial, enquires: “Should the financial regulator be fined for its mistakes...?” Alas, it is not to be, for despite the stinging rebukes by a Parliamentary watchdog, Mr. Sants, for all his efforts, or lack thereof, has not only received a Knighthood courtesy of the UK government and the Queen for his somewhat vacuous services, but also walks into a well-remunerated position with one of the banks he was supposedly regulating at the Financial Services Authority. • 29

Book review

Of Bulls and Bair: Fighting to save Main Street from Wall St.
Barnard College Professor Rajiv Sethi applauds Sheila Bair’s account of her time at the FDIC during a period of crisis.
Sheila Bair’s new book, Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself, is both a crisis narrative and a thoughtful reflection on economic institutions and policy. The crisis narrative, with its revealing first-hand accounts of highlevel meetings, high-stakes negotiations, behind-the-scenes jockeying, and clashing personalities will attract the most immediate attention. But it’s the economic analysis that will constitute the more enduring contribution. Among the many highlights are the following: a discussion of the linkages between securitisation, credit derivatives and loan modifications, an exploration of the trade-off between regulatory capture and regulatory arbitrage, an intriguing question about the optimal timing of auctions for failing banks, a proposal for ending too big to fail that relies on simplification and asset segregation rather than balance sheet contraction, a fullthroated defence of sensible financial regulation, and a passionate critique of bailouts for the powerful and politically connected Journal of Regulation & Risk North Asia even when such transactions appear to generate an accounting profit. Conflict of interest Let’s start with securitisation, derivatives and loan modifications. Under the traditional model of mortgage lending, there are strong incentives for creditors to modify delinquent loans if the costs of doing so are lower than the very substantial deadweight losses that result from foreclosure. But pooling and tranching of mortgage loans creates a conflict of interest within the group of investors. As long as foreclosures are not widespread enough to affect holders of the overcollateralised senior tranches, all losses are inflicted upon those with junior claims. In contrast, loan modifications lower payments to all tranches, and will thus be resisted by holders of senior claims unless they truly see disaster looming. One consequence of this “tranche warfare” is that servicers, fearing lawsuits, will be inclined to favour foreclosure over modification. But this is not the end of the story. Bair points out that the interests of those using credit derivatives to bet on declines in home 31

values are aligned with those of holders of senior tranches, as long as the latter continue to believe that foreclosures will not become widespread enough to eat into their protected positions. This is interesting because these two groups are taking quite different price views: one is long and the other short credit risk. Bair notes that some of the “early resistance” to the Financial Deposit Insurance Corporation’s (FDIC) loan modification initiatives came from fund managers who “had purchased credit default swaps protection against losses on mortgage-backed securities they did not own. The irony is that they were joined in this resistance by holders of senior tranches who were relying on the protective buffer provided by the holders of junior claims. Divided investor interests This protective buffer turned out to be insufficiently thick. Vigorous opposition to loan modifications amplified the decline in home values and ended up hurting even holders of the most senior claims. The process of eviction is costly and time consuming for creditors, and debtors have no incentive to maintain properties that they are on the verge of losing. Once the costs of repair and reselling are taken into account, recovery on subprime foreclosures can be as little as a quarter of the outstanding loan amount. Some of these losses could have been avoided if the interests of different groups of investors had not been so divided. Another interesting discussion in the book concerns the trade-off between regulatory arbitrage and regulatory capture. A fragmented regulatory structure with a variety of 32

norms and standards encourages financial institutions to shop for the weakest regulator. In the lead up to the crisis, such regulatory shopping occurred between banks and nonbanks, with mortgage brokers and securities firms operating outside the stronger regulations imposed on insured banks. Diversity of views But Bair also notes that the “three biggest problem institutions among insured banks - Citigroup, Wachovia, and Washington Mutual - had not shopped for charters; they had been with the same regulator for decades. The problem was that their regulators did not have independence from them.” This illustrates the problem of regulatory capture. Bair argues that while a single monolithic regulator would put an end to regulatory arbitrage, it could worsen the problem of regulatory capture: “A diversity of views and the ability of one agency to look over the shoulder of another is a good check against regulators becoming too close to the entities they regulate.” It’s a point that she has made before, and clearly believes (with considerable justification) that the FDIC has provided such checks and balances in the past. It was able to do so in part through its power under the law and in part through the power to persuade. Favoured policy A very different kind of trade-off concerns the timing of auctions for failing banks. One of the policies that Bair favoured at the FDIC was the quick sale of failing banks prior to closure in order to avoid a period of government stewardship. She recognises, however, that there are some costs to this. Journal of Regulation & Risk North Asia

Bids from prospective buyers who have not had time to closely examine the asset pool of the failing institution will tend to be lower than the expected value of these assets, given the need to maintain adequate margins of safety in the face of risk. Waiting until a more precise estimate of the value of the bank’s assets can be obtained can therefore result in higher bids on average. But there are also costs to waiting: a “deterioration of franchise value” occurs as large depositors and business customers look elsewhere, and this can offset any gains from a more precise valuation of the asset pool. Bair seems to have concluded that sale before closure was always the best course of action, but I suspect that this need not be the case, especially when the asset pool is characterised by high expected value but great uncertainty, and the bulk of deposits are insured. In any case, it’s a question deserving of systematic study. Political preference Bair describes herself as a lifelong Republican and was a McCain voter before the 2008 U.S. Presidential election. Yet she seems quite immune to partisan loyalties and pressures. Her description of Barney Frank is positively affectionate. She has kind words for some Democrats (such as Elizabeth Warren and Mark Warner), but offers blistering criticism of others (Robert Rubin, Tim Geithner and Larry Summers in particular). Among Republicans too, she is discerning: Bob Corker’s efforts on financial reform are lauded, but the “deregulatory dogma” overseen by Alan Greenspan comes under forceful attack. She laments the “disdain” for government and its“regulatory function” Journal of Regulation & Risk North Asia

and describes as a “delusion” the idea that markets are self-regulating. These are clearly not the views of a political partisan. Opposition to derivatives On policy, Bair is opposed to the use of derivatives for two-sided speculation (when neither party is hedging) and would require an insurable interest for the purchase of protection against default. She describes synthetic collateralised debt obligations and naked credit default swaps as “a game of fantasy football,” with no limit to the size of wagers that can be placed. She calls for a “lifetime ban on regulators working for financial institutions they have regulated.” And she argues, as did James Tobin a generation ago, that the attraction of the financial sector for some of the best and brightest of our youth is detrimental to long term economic growth and prosperity. No review of this book would be complete without mention of the bailouts, which troubled Bair from the outset, and which she now feels were excessive: “To this day, I wonder if we overreacted... Yes, action had to be taken, but the generosity of the response still troubles me... Granted, we were dealing with an emergency and had to act quickly. And the actions did stave off a broader financial crisis. But the unfairness of it and the lack of hard analysis showing the necessity of it trouble me to this day. The mere fact that a bunch of large financial institutions is going to lose money does not a systemic event make... Throughout the crisis and its aftermath, the smaller banks - which didn’t benefit at all from government largesse - did a much better job of lending than the big institutions did.” 33

What bothers her most of all is the claim that the bailouts were justified because they made an accounting profit: “The thing I hate hearing most when people talk about the crisis is that the bailouts “saved the system” or ended up “making money.” Participating in bailout measures was the most distasteful thing I have ever had to do, and those ex post facto rationalisations make my skin crawl... The bailouts, while stabilising the financial system in the short term, have created a long-term drag on our economy. Because we propped up the mismanaged institutions, our financial sector remains bloated... We did not force financial institutions to shed their bad assets and recognise their losses... Economic growth is sluggish, unemployment remains high. The housing market still struggles. I hope that our economy continues to improve. But it will do so despite the bailouts, not because of them.”

insurer makes money), this does not mean that there was no subsidy in the first place. Furthermore, the cost to taxpayers should take into account any loss of revenues from more sluggish growth. If Bair is right to argue that the bailouts were excessively generous, to the point that growth prospects were damaged for an extended period, the loss of tax revenue must be included in any assessment of the cost of the bailout. As noted previously, there are many accounts in the book of meetings and decisions, and a number of speculative inferences about the actions and intentions of others. Some of these will be hotly disputed. But focusing on these details is to miss the larger point. The crisis offers us an opportunity to think about the flaws in our economic and political system and how some of these might be fixed. It also suggests interesting directions in which economic theorising could be advanced. The book helps Instinctively repugnant with both efforts, and it would be a great The ideal policy, according to Bair, would pity if these substantive contributions were have been to put insolvent institutions into drowned out in a debate over conversations the “bankruptcy-like resolution process” and personalities. • used routinely by the FDIC, but she recognises that the legal basis for doing so was not Editors note: The publisher and editor of available at the time. She therefore signed on the Journal would like to thank Prof. Rajiv to measures that were instinctively repug- Sethi for allowing us to publish an amended nant to her, and tried to corral and contain version of this book review which first them to the largest extent possible. appeared on the authors blog in late 2012. The argument that the bailouts “made Prof. Sethi’s original review can be accessed money”is specious for two reasons. First, the at the following address: http://rajivsethi. funds provided were given well below mar- blogspot.com. We would also like to remind ket value, and the cost to taxpayers should be readers that Bull by the Horns - published by computed relative to the value of the service the Free Press - is now available to purchase provided. If insurance is provided at a frac- from bookshops across much of the Asia tion of the actuarially fair price, and no claim Pacific region in both hardback and paperis made over the period of insurance (so the back copies. 34 Journal of Regulation & Risk North Asia

Book review

The Money Trap: Escaping the Grip of Global Finance
Judy Shelton of the Atlas Economic Research Foundation lauds Robert Pringle’s call to reform the global monetary system.
To read Robert Pringle’s new book, The Money Trap, is to experience the slow joy of recognising that someone out there in the world of intellectual propriety and academic correctness is willing to state the case that the global financial crisis can be traced in large part to the lack of an orderly international monetary system. Pringle has done a great service in bringing to the debate over the causes of what is now called: “the worst recession since the Great Depression” the notion that the global exchange rate regime matters; we cannot ignore the damaging impact of chaotic exchange rates among leading currencies if we are to identify what brought on the financial meltdown that has since devastated real economies around the world. But even more important, Pringle’s careful analysis and assiduous tracing of events leading to the crisis provide the reader with a template for evaluating potential paths to meaningful international monetary reform. In this, he has done a service to mankind – for as Pringle notes repeatedly throughout this work, the achievement of monetary and Journal of Regulation & Risk North Asia financial stability should be pursued as a “global public good.” It is important to note the unique credentials of the author – unique in that one would not normally expect the chairman of Central Banking Publications and the founder of the Central Banking Journal to be making the argument that fundamental reform of international monetary arrangements is needed. A stinging critique Pringle occupies a prestigious position among those who closely follow developments affecting international money and capital markets, having served in a senior capacity at The Economist and The Banker (as editor) as well as becoming first executive director of the Group of 30, an influential think tank. His experience in advising leading commercial banks and governments on economic policy issues has brought him into the highest circles of high finance. One wonders whether Pringle will find himself less welcome at the same watering holes as a result of delivering this stinging critique of status quo global monetary and financial 35

arrangements. Not that he is totally alone in advancing such doubts about the wisdom of our current monetary non-system. More radical reform A special bonus contained in The Money Trap is the foreword written by Robert Skidelsky – yes, Lord Skidelsky, the eminent biographer of economist John Maynard Keynes – who sets the tone for the book from the outset with his declaration that: “this seemingly never-ending crisis demands a more radical reform of the world monetary and banking systems than anything yet attempted or even imagined by governments.” Most people consider Keynes as having been the ultimate promoter of economic “stimulus” programmes through government intervention, both fiscal and monetary. Yet it was also Keynes who wrote, in his 1923 work, A Tract on Monetary Reform, that, “what is raised by printing notes is just as much taken from the public as is a beerduty or an income-tax.”And it was Keynes, too, who noted in the same publication:“The metal gold might not possess all the theoretical advantages of an artificially regulated standard, but it could not be tampered with and had proved reliable in practice.”

construction of a credible world monetary standard.” He traces through recent monetary history starting with Keynes’s conception of bancor (combining the French words for “bank”and“gold”) as the new international money unit for settling international payments imbalances. A section is devoted to the Triffin dilemma – referring to the fatal flaw of the Bretton Woods agreement, which relied on a single national currency, the U.S. dollar, to serve as the only money convertible into gold – and suggestions to turn the International Monetary Bank into a global central bank.

Tyranny of floating rates But one discerns a more than nostalgic appreciation for the views of French economist Jacques Rueff, who championed the classical gold standard in the last century as the key to maintaining a broad liberal order based on democratic values, social cohesion, and the economic welfare of citizens. Rueff believed floating exchange rates were anathema to monetary discipline; such a lawless regime would encourage protectionism and an uncertain trade and investment climate, ultimately leading to recession and unemployment.“If I defended tirelessly Daring act for half a century the principle of monetary The very mention of “gold” and “standard” convertibility,” Rueff is quoted, “it is not by within the context of a contemporary book any attachment to an orthodoxy that, in addressing the foibles of a global monetary money matters, would make no sense, but and financial system that has no interna- because I love liberty and because I am contional standard – no unit of account to serve vinced it is not a free gift.” as a benchmark for economic value – would Pringle clearly recognises that the probbe a daring act indeed. But Pringle comes lems caused by the global financial crisis close with his acknowledgment that at the are, to an alarming degree, fulfilling Rueff’s centre of fundamental reform“should be the dire prophecy. In Pringle’s view, it makes 36 Journal of Regulation & Risk North Asia

no sense to separate the topic of monetary reform from an analysis of banking, finance, and financial markets; they must all be integrated if we are to break out of “the money trap” that now threatens economic and political stability around the world. International currency Pringle considers it a grave sin of omission that a whole generation of economists has failed to build an environment of rulesbased monetary relations, or create an international currency, to preserve the benefits of free trade and enhance the productive flow of financial capital. Instead, in the wake of economic collapse, governments are all too eager to embrace a “back to business as usual” approach that neglects to address the underlying cause of the global financial crisis, namely: the lack of a coherent monetary system. Central banks have been complicit in this dereliction of duty, likewise failing to propose radical changes to the existing non-system of exchange rates among currencies. Boom-and-bust If we do not create a new monetary regime as a mechanism to hold central banks accountable for maintaining a standard – if we do not “enshrine society’s long-term interest in sound money,”as Pringle states – the world is destined to fall back into another disastrous boom-and-bust cycle facilitated by overly accommodative monetary policy and exacerbated by the banking and financial industry’s pursuit of profits through arbitraging differential interest rates among major central banks. It’s a frightening scenario, and one that Journal of Regulation & Risk North Asia

comports with my own fears. The next money meltdown is likely to unleash antigovernment and anti-banking social protests that will make the “occupy Wall Street” movement appear rather quaint. How can we avoid such a calamitous future? Herein lies the essential value of Pringle’s book. He dares to explore potential ways to escape “the money trap” – to transcend monetary nationalism in favour of building a truly international monetary order based on a common standard of value. “Let us start by looking at what might be the ideal features of a currency standard,”Pringle suggests,“and then see how close the world could get to such an idea.” He continues: “It should mimic the classical gold standard in enabling monetary, commercial and economic unification to take place without requiring political integration. It should rest on consent. The supranational element should be kept to a minimum; certainly it should be able to function without a world government or central bank. Countries should be free to remain fully sovereign if they wished, while also being able to share or pool sovereignty through various political institutions as they saw fit. Thus they should be able to opt out of the world currency standard, just as they could (and did) suspend the gold standard in emergencies, though the attractions and prestige of being a full member of the club would mean that few would wish to do so (few, if any, countries ever left the gold standard voluntarily, before its collapse in the 1930s). At the international as at the national levels, peoples would embrace order to increase practical liberty. It would be a rule of laws and norms rather than of men.” 37

Pringle has given us a beautiful statement of purpose juxtaposed against a background of current failings. For those who have long sensed that the global crash and its damaging effects on the real economy are strongly linked to our dysfunctional monetary regime, it will be a most gratifying read. Four key issues The Money Trap provides a superb explanation of how we got in this mess (Part I); what we need to understand in order to properly evaluate various potential approaches to finding our way out (Part II); the four key issues that will drive the discussion on future monetary reform (Part III); and how we can apply the genius of past great economic thinkers – from Fisher through Keynes, Rueff to Hayek and Triffin – toward the goal of profoundly changing existing monetary arrangements (Part IV). Contemporary economists are invoked as well, with the author’s assessment of different proposals. Readers will find themselves brought quickly up to speed on recent developments and innovative ideas; they may also be quite intrigued with Pringle’s concept for defining the currency unit as a fraction of the total of tradable equity claims on real assets in the global economy. Wisdom of Buchanan Citing the wisdom of James Buchanan, the Nobel Prize-winning economist and a founder of the public choice school, who has noted that “the market will not work effectively with monetary anarchy,” Pringle concludes The Money Trap with his personal observations on how we can realistically make the leap to a new monetary order 38

in tandem with his own thoughts on the emerging global financial system. He stresses the need to bind banking to the real economy and to reduce the ability of the financial industry to exploit its power over regulatory authorities. Pringle also emphasises the importance of turning away from using mountains of foreign reserves as a cushion against future currency shocks, a practice he finds irrational. And he criticises the euro-dollar seesaw, which punishes all those countries that are fixed to either currency, yet trade with both the dollar and euro regions. Urges a voluntary system Finally, Pringle adjures the world to put into place a wholly voluntary system wherein the supply of money would be self-regulating. “Such a monetary standard,” he writes, “could be developed using the technology available as a result of the progressive globalisation of capital markets.” As Pringle elaborates: “The key step is for major governments to agree not on a common currency but on a common monetary unit of account in which citizens can have confidence. Further steps would be needed to realise the potential of such a reform, but it would open up the prospect of bringing the public good of international monetary stability back to the world economy for the first time in 100 years.”• Editors note: The publisher and editor would like to thank Ms. Sheldon and the Cato Institute for allowing the Journal to publish an abridged version of this review. Further details on Mr. Pringle can be found at: www.themoneytrap.com Journal of Regulation & Risk North Asia

Comment

Cyprus solution will exacerbate the European debt crisis
Irrespective of the fate of Cyprus, the way the problem was solved sets a very dangerous precedent opines Satyajit Das.
Financial markets have taken Cyprus in their stride. But it is important not to underestimate the potential fallout. The impact of relatively small events is unpredictable. The 1931 collapse of the small Austrian bank Creditanstalt precipitated a major financial panic. Today, one the smallest countries in Europe, with little over one million people representing some 0.2 per cent of the European Union’s combined population and gross domestic product, economically speaking, Cyprus, may prove a key inflection point in the Euro debt crisis. The well anticipated European Union (EU) bailout package announced in the middle of March included the controversial provision that ordinary depositors pay a “tax” or “solidarity levy” on Cypriot bank deposits, amounting to a permanent write down in the nominal value of their deposits. The deposit levy was 6.75 per cent on deposits of less than Euro 100,000 (the ceiling for European Union account insurance) and 9.9 per cent for all deposits above that threshold. Initially, the Cypriots had pressed for a Journal of Regulation & Risk North Asia Euro 17 billion-rescue package. However, the unprecedented write down of bank deposits was designed to raise around Euro 5.8 billion to reduce the size of the required bailout package to Euro 10 billion, consistent with the requirements of the International Monetary Fund (IMF) and Eurozone members like Germany. It was also designed to avoid losses to the European Central Bank (ECB) which has major exposures to Cypriot banks via its Emergency Lending Assistance (ELA) Program, estimated at as much as Euro 10 billion. Other sources of funding Economist and commentator Karl Whelan, writing in Forbes magazine, memorably described the EU proposal to allocate part of the burden to depositors as“a stupid idea whose time had come”. The parliament in Cyprus failed to pass the necessary enabling legislation, instead exploring alternative strategies including confiscation of pensions, additional taxes, and other sources of funding. Unsuccessful discussions were held with Russia for a financing package to secure Cyprus’position 39

and protect the interests of the Russian state, its citizens, and banks who have substantial exposures within the small island nation. With no other source of funding available and the ECB threatening withdrawal of emergency funding, Cyprus faced default and rapid economic collapse. Under duress, the Cypriot government agreed an amended plan on March 25, 2013. Whilst maintaining most of the original elements, the plan appears to amend the deposit levy, with“small”depositors (below Euro 100,000) being protected and exempt from the levy. Good bank bad bank As a result a major restructuring of the two largest banks will take place. The troubled Laiki Bank will be divided into a good bank (including small depositors and emergency ECB funding) to be absorbed into the Bank of Cyprus and a bad bank, which will be liquidated over time. Shareholders, bondholders, and ultimately larger depositors in Laiki Bank will be forced to absorb losses, the size of which is uncertain. There are some suggestions that losses may be capped at 40 per cent. Shareholders, bondholders, and large depositors in Bank of Cyprus will then be written down so that the bank achieves a capital ratio of nine per cent. Other measures include “temporary, proportionate and non-discriminatory”capital controls to prevent funds being taken out of Cyprus. There will also be a reduction in the size of Cyprus’ financial sector to the EU average by 2018. Two aspects of the agreed package are noteworthy: the bailout package (Euro 10 billion) cannot be used to re-capitalise banks, 40

which limits its utility. Second, the plan does not need Cypriot parliamentary approval as it is no longer a “tax.” The transfer of losses on large depositors will take place under recently adopted bank restructuring laws passed at Brussels’insistence. The measures stave off the risk of immediate collapse and Cyprus having to leave the Euro. But the plan does not address Cyprus’ problem. As in Greece and Portugal, privatisation proceeds and the revenue from increased taxes may not reach targets. The bank-restructuring plan may not raise sufficient funds. It is likely to encourage remaining deposits to flee Cyprus when capital controls are eased, compounding the problems. As with Greece, there is a risk that Cyprus will need additional assistance, entailing further write-offs in a depositor’s fund. The proposed restructuring effectively cripples the Cypriot banking industry, which is a major part of the economy and employs over 50 per cent of workers. The transfer of losses to depositors and imposition of capital controls make it highly likely that activity will shift to other locations. Dangerous precedent Russian businesses are unlikely to continue to patronise Cyprus. Press reports quoted one Russian business man’s wry observation that the EU had killed Cyprus in one day: “When the Russians leave who is going to stay at the Four Seasons for US$500 a night? Angela Merkel?” Economic activity in Cyprus is expected to contract by between 15-25 per cent over the next few years. Unemployment will also rise. The slowdown will reduce the Cypriots Journal of Regulation & Risk North Asia

capacity to pay back its international creditors. Irrespective of the fate of Cyprus, the solution adopted will exacerbate the European debt crisis. Firstly, the transfer of losses to depositors creates a dangerous precedent. In 147 banking crises since 1970 tracked by the IMF, no depositors, irrespective of the amounts held and the banks with whom the deposits were placed, suffered losses. Capital flight Depositors in weak banks in weak countries now may consider the risk of loss or confiscation. This may trigger capital flight from banks in Greece, Portugal, Ireland, Italy and Spain. If depositors withdraw funds in significant size and capital flight accelerates, then the ECB, national central banks and governments will have to intervene, funding affected banks and potentially restricting withdrawals, electronic funds transfers and imposing cross-border capital controls. Bank runs and capital flights are difficult to control once they commence. As outgoing Bank of England Governor Sir Mervyn King argued, it was not rational to start a bank run but rational to participate in one under way. Secondly, the Cyprus bail-in provision will make it increasingly difficult for European banks, especially in vulnerable countries, to raise new deposits or issue bonds. The ECB, national central banks, and governments will have to cover any funding shortfalls. Thirdly, the Cyprus arrangements undermine the credibility of the ECB and EU and measures announced last year to combat the crisis, which have underpinned the recent relative stability. Journal of Regulation & Risk North Asia

The ECB’s OMT (Outright Monetary Transactions) facility allows it to purchase sovereign bonds to assist nations to finance and lower their cost of borrowing. The facility, which has not yet been used, requires the affected country to apply for assistance. After Cyprus, it will be politically difficult for countries like Italy and Spain to ask for assistance if required, knowing that if a future debt restructuring is necessary then domestic taxpayers face a loss on their bank deposits. Cyprus highlights the shortcomings of the EU’s much vaunted “banking union.” The arrangements did not provide sufficient funds to undertake any required re-capitalisation of banks, an alternative to the levy on deposits. Cyprus also highlights the lack of a Eurozone-wide consistent deposit protection scheme, backed by EU funds. Popular resistance Fourthly, the Cyprus package highlights the increasing reluctance of countries like Germany, Finland, and the Netherlands as well as the IMF to support weaker Eurozone members. Domestic political consideration and popular resistance to commitment of further taxpayer funds to such bailouts make such assistance increasingly problematic. Fifthly, the negotiations surrounding the Cyprus bailout revealed policy-maker’s lack of understanding of the problems and the effects of policies. It also revealed significant differences between Eurozone members and also between Europe and the IMF. Sixthly, by agreeing to potentially indefinite capital controls the EU has effectively created a two-tier euro, undermining the single currency in the long term. The problems in Europe will affect the 41

U.S. in many ways. Europe is America’s largest trading partner and the slowdown in economic activity will not only affect exports but also American businesses operating in Europe. Second order effects will include the effects on China and other emerging markets which trade with Europe, which will flow on to U.S. businesses. A second channel of transmission will be the currency markets. The weak U.S. dollar has assisted the U.S. economy. Concern about the European real economy and also the debt crisis will put upward pressure on the dollar, which will no doubt reduce American export competitiveness. A final channel of transmission will be the banking system. Problems in European banks, including funding difficulties, will flow through into large U.S. money centre banks, which in turn will pass them on to smaller banks and the U.S. financial system. In any debt crisis, there are several

possible methods of allocating losses. The borrower bears the losses, either through austerity or bankruptcy. The lenders bear the losses. Some rich relative (in Europe, read Germany) bails out the indebted borrower. Another option is to just ignore such issues, fudge the numbers, and hope that fortunate events will remedy the problems. Europe has now tried all of the above. Unfortunately, in each attempt at resolution, as shown by the proposed Cyprus package, the measures have become the problem rather than the solution, and alas, in the future, Europe’s problems will not be confined to Europe. • Editors note: The publisher and editor would like to extend their thanks to Satyajit Das for allowing the Journal to publish an amended version of this paper. We also wish to remind our readers that copyright for this particular article remains the sole preserve of Satyajit Das.

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Contact Christopher Rogers Editor in chief christopher.rogers@irrna.org

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Legal & Complia nce

ournal of reg ulation & risk north asia
Volume I, Issue III,

Articles & Papers

Autumn Winter 2009-2010

Issues in resolving systemically important financial institution s Resecuritisation Dr Eric S. Rosengren in banking: major challenges ahead A framework for funding liquidity Dr Fang Du in times of financial crisis Housing, monetary Dr Ulrich Bindseil and fiscal policies: from bad to worst Derivatives: from Stephan Schoess, disaster to re-regulati on Black swans, market Professor Lynn A. Stout crises and risk: the human perspectiv e Measuring & managing Joseph Rizzi risk for innovative financial instrumen ts Red star spangled Dr Stuart M. Turnbull banner: root causes of the financial crisis The ‘family’ risk: Andreas Kern & Christian a cause for concern Fahrholz among Asian investors h y of whic Global financial change impacts David Smith anies – man legiscompliance and risk reds of comp anies. The US by hund comp even-The scramble is on to tackle bribery David Dekker and corruption Practices were Fortune 500 these scandals by to Corrupt Who exactly is subject Penelope Tham & Gerald Foreign gs in the lature responded FCPA in 1977. to the Foreign Corrupt Li nnin US the to begi Practices Act? The its ting the isions Special Financial markets A), has Tham Yuet-Ming tually enac remuneration reform: main prov s, and the Watergate Act (FCP one step forward discloision when the e are two prov era, Ther ntary ry the Risk Umesh bribe e Kumar mana Watergate called for volu & Kevingeme SEC and Of ‘Black Swans’, stress tests & optimised Marr nt – the antihad mad r Both the risk management Prosecuto companies that ard FCPA nting provisions. Challenging the J) have juristo Rich David Samuels value of enterprise accou Justice (DO SEC risk management sures from contributions aign. rally, the rtment of ble US Depa Tim Pagett & Ranjit and road ahead for global FCPA. Gene isionsRocky questiona presidential camp Jaswal the accountanc y convergence 1972 nting prov diction over The rs Nixon’s Asian regulatory the accou s as against issue revealed Dr Philip Goeth Rubik’s Cube prosecutes edings disclosures provision

to the subject actly is s Act? Who ex Practice Corrupt , DLA Foreign Yuet-Ming

er, Tham mines the In this pap consultant, exa Asia. g Kong FCPA in Piper Hon ious effects of the pernic

ry ents these ative proce and Alan Ewins and Angus estic paym d the anti-bribe However, administr Ross ble dom civil and companies questiona had been channelle through prosecutes ry provisions Standard & not just n business. whereas the DOJ funds that Poor’s anti-bribe outlines the tints to obtai but illicit s for the edings. positive bene David Samuels n governme to subsequent inves individual proce to foreig fits of bank Exchange through criminal mation led rities and stress The infor that testing on the US Secu h revealed ision the bottom to makes it ery prov gations by ) whic line. anti-brib bribery provision It is a h funds” big challe ion (SEC ing The “slus miss nge cal kept Com for banks ’s antiaanyth ey or robust issuers and politi to build ide mon The FCPA mean approach to mana downturn n officials many US of worst offer or prov als (“foreign” capital adequ s to foreig or stress scena ging the risk uncov illegal to n -case n offici acy progra pay bribe byobtai rios that, almos er risk conce definition, a voluntary of value to foreig ms to intent to ntrations and ess to are triggered up with t encies, ) with the parties. busin risk unlik and; applyi by appar h any corlater came ely or unpre “non-US” directing ng these impro dependThe SEC cedented event ently to drive e under whic payments ing business, or for vemen busine programm s. illicit retain eported disclosure through perfor ss selection – for examp ts given de sponsorn. which self-r the SEC was can inclu Howe le, any perso solving the holiof a ver, of value poration adjusted pricing mance analysis and likely with problem of fying , usethe ation Anything riskperated risk it would identithat takes stress ent, conce educ co-o that t ntratio loym and and into account. ance ns and depen cies travel e emp test results The resul that give rise mal assur ship for dennt action. ise of futur e is no to worst-case an infor vital s. Ther USD$300 day home, prom enforceme if the indust outcomes is meal than from and s ry is to thrive be safe that more masvidual banks – and if indi- Top-level oversight unts, drink disclosure ble payments (a are turn e disco was the Buildin 147 the lessons past two years to been mad questiona of the proces g a more robust and to competitive million in in the 1970s) had comprehens s for uncov advantage. Banks that unt ive ering threat tackle the issue sive amo prise s to be is the enterclearly lauded by invest headh Asia ors and regula on will ance challe , in part, a corporate Risk Nort coming years governnge.The board lation & tors in the of industry of Regu and must have most impor recuperation Journal the motivation top executives tantly, will and the clout be able to delive and, scrutinise and tained profita call a halt to to r sus- able bility gains. apparently Meanwhile, activities if that are well profitthese are not banks term placed to take in the longer consolidatio interests of advantage the enterprise of the the n process need intended risk can understand or do not fit to be profile of the the risks embed sure they But organ portfolios of contrary isation ded in the potential acquis ing corporate to popular opinion, impro . itions. To improve governance venterp is tion rise risk manag not just a quesand strengthen of putting ement the ‘right’ investor confid executives banks can take ence, we think board members in and the lead in place and appropriate three related giving them Better board incentives. areas: and senior For sight and execut the bank ive overcontro to make the sions when agement; re-inv l of enterprise risk they are difficu right deciman- busine igorated stress lt, e.g. when ss growth testing and looks good or when risk managemen in the upturn, Journal of Regulation t looks expen & Risk North sive Asia
163

Of ‘Black Swans’, stre ss tes optimised risk manag ts & ement

42

Journal of Regulation & Risk North Asia

Comment

Bank Operational Risk: Always a bridesmaid, never a bride!
MRV Associates’ Mayra Rodríguez Valladares laments lack of global attention paid to operational risk management
BANKS and the financial regulatory world have changed dramatically since the turn of the millennium and since I started consulting and training on global financial regulations more than a decade ago. Nowhere is this more apparent than with the Basel Accords uniform, international capital standards for banks. Unfortunately, and despite all the Basel Committee’s good intentions, the neglect of operational risk remains the same today as it did on January 1, 2000. Credit risk may best be equated to the bride at her wedding, upon whom all eyes are fixed. And while one might argue that in the mid2000s the bride should have received even more attention, since the 2008 global financial crisis, the Basel Committee on Banking and Supervision, together with numerous domestic regulators have once more focused much of their attention on credit risk by means of revamping regulations and issuing numerous consultative papers. September 2010 saw the release by the Basel Committee of its Basel III guidelines, with substantial enhancements in the area Journal of Regulation & Risk North Asia of credit risk; the new Accord also has provisions for leverage, liquidity, capital conservation and pro-cyclicality buffers, as well as more stringent buffers for systemically important financial institutions. Not content with this, further guidance on credit was issued yet again late last year. Now that for many the crisis is in the rear-view mirror, market risk has been allowed to play the role of bridesmaid. The Basel Committee recently issued guidelines on market risk-weighted assets and has focused on how to measure the risk of traded assets. Yet, operational risk does not even get an invite to the wedding party, despite the fact that the worst bank losses in the last four decades have been due to operational risk, rather than credit or market risk. Operational risk is the breach in the dayto-day running of a company due to people, processes, systems/technology and external threats. Think Herstatt Bank, Barings, Allied Irish Banks and, more recently, Société Générale, UBS and JPMorgan Chase. In all of these operational risk cases, failures in people, processes, systems or external threats led to liquidity, credit or reputational 43

risks. In some of the aforementioned cases, these operational risks led to the demise of the businesses involved. Failure to agree Despite the aforementioned cases, and the fact that the Basel Committee itself issued supervisory guidelines in 2011 on this topic, I have heard numerous bankers, and even the odd regulator, relay different definitions for what constitutes operational risk. Fraud and settlement risk are the most typical and yet, operational risk encompasses a lot more than these examples, encompassing everything from human error to vendor selection, model errors, and making provisions for natural disasters and terrorism. If market participants cannot agree on a definition of operational risk is, how can we believe banks have sound practices in place to identify, measure, control and monitor it, or moreover, have sufficient capital to withstand possibly rare, but high impact operational risk events? Paucity of data For any market participant who thinks the three Basel II and III methods for credit risk are complex or leave too much to the discretion of the banks, you really need to take a look at Basel’s guidance for operational risk measurement found under Pillar I. As with credit risk, a bank must be approved by its bank supervisor to use one of three methods starting with the most general, one size fits all, Basic Approach, to the Advanced Measurement Approach where banks get to use their own historical internal loss data. Unlike credit and market risk, the market is clearing lacking in any strong 44

and cohesive operational risk measurement model. Indeed, operational risk is much harder to measure than other risks because of the paucity of high quality data. Even in instances where operational risk can be measured, most risk managers are reluctant to capitalise on it, since this results in a lower return on equity. Additionally, other than insurance for some operations risk aspects, there are no operational risk derivatives to hedge it. You can try to tell people not to lie, but given human nature that strategy may prove ineffective. You can fire people and try to send them to jail, as many have been clamouring for this year, but so many aspects of operational risk fail to rise to the level of an enforcement action, despite the fact that they can certainly cause banks to lose tremendous amounts of money. Identify, measure, control Even where one is able to identify, measure and control this type of risk, operational risk officers are left with the challenge of figuring out how to allocate capital for the probability that it may appear, for example, in the form of high impact fraud, insider trading, settlement failure or natural disaster. Risk officers often find they can under-allocate capital for operational risk and are not prepared when it materialises. Or they can end up allocating capital to survive the impact of a natural disaster only to find that the impact was a lot less severe than had been anticipated. At the end of the day, capital is not free, and no one wants to over-allocate. Recently, much of the U.S. media and market participants have been highly focused on salacious and often puerile e-mails from alleged professionals at Journal of Regulation & Risk North Asia

Standard & Poor’s, JPMorgan Chase and Morgan Stanley about their possible fraudulent role in rating or packaging of structured finance collateralised debt obligations comprised of mortgage-backed securities. The failures at these organisations due to fraud, lack of good controls and misuse of models are all extremely important, because they continue to show the neglect of operational risk at incredibly large and well-known global financial institutions. Systemic risk? Also noteworthy is the fact that some banks must now pay out high mortgagerelated settlements. This includes Bank of America’s unprecedented US$10.3 billion settlement with Fannie Mae in January. Bank of America will survive this loss, just as JPMorgan survived the ‘London Whale,’ but could other U.S. banks survive these losses without causing systemic risk? The market has become so accustomed to banking scandals in the last twelve months, that poor operational risk management and procedures have become widely accepted as the cost of doing business. Shareholders, unfortunately, are not demanding improved operational risk management. It is difficult to believe that banks are very well capitalised given how much they are having to spend regularly on settling fraud, insider trading, and money laundering cases. Lack of transparency Given the lack of transparency, it is practically impossible to establish whether or not a bank is identifying, measuring and controlling its operational risks effectively. Bringing operational risk out more in the open could Journal of Regulation & Risk North Asia

really be helped by the uniform implementation and supervision of Basel Pillar III, that requires more detailed disclosure on banks’ on- and off-balance sheet risks and information on how credit, market, and operational risk is measured. Unfortunately, this pillar is implemented differently by banks in Europe and is not implemented at all by American banks. Further, supervisors can use a lot of discretion in assessing what inputs and models banks use to measure financial risks; given that the market for operational risk measurement models is not as advanced as the those used to measure credit and market risks, it is difficult to know what banks are doing to measure their operational risk. Hence, any market participant wanting to understand how a bank identifies, measures, controls, or monitors risks, especially operational risk, is left with little useful information to go by. The market should be very concerned whether banks are truly adequately capitalised for unabated fraud, such as misrepresentations of securities or insider trading, settlement failures and other operational failures. Banks have failed in the past due to operational risk, and they could certainly do so again. If shareholders and bondholders do fail to demand more accountability and transparency from banks, Basel III operational risk guidelines will never make it to any wedding. • Editors note: The publisher and editor would like to thank MRV Associates and the American Banker for allowing the Journal to reproduce a modified version of this article which first appeared in late February on the American Banker website. 45

Opinion

Macroeconomic experiments: Abenomics versus EU austerity
Professor Yanis Varoufakis of the University of Athens contrasts Japan’s new economic policy with that of Europe’s.
In the long, unending wake of the global financial crisis originating in 2007, desperate governments and central banks the world over are trying their hand at experimental economic policy mixes epitomised by the United State’s and United Kingdom’s programmes of quantitative easing. Japan and the Eurozone of 17 member states of the European Union offer a glimpse of how radically different anti-crisis experiments can be in these economically stressed times. Recently, Japan has been making the news with reports that its new leaders – the new prime minister and the new governor of the Bank of Japan – have joined forces to stop their nation’s so-called ‘lost decade’ from turning into three lost decades. Prime Minister Shinzo Abe’s government has committed to a stimulus package (an impressive 2 per cent of national income in 2013 alone) that will attempt to rekindle the real economy. Haruhiko Kuroda – Prime Minister Abe’s new choice of Bank of Japan governor – has audaciously declared that the Bank of Japan will fight deflation by Journal of Regulation & Risk North Asia purchasing financial titles (e.g. government bonds, mortgages) to an extent, and at a pace, never seen before in economic history – in fact doubling the country’s monetary base in two short years. Boldest Keynesian move Quite clearly, Prime Minister Abe and Governor Kuroda are aiming their doublebarrelled shotgun at the great foe of deflationary negative growth, which like a rogue samurai, is slashing into Japan’s capacity to reproduce itself as an advanced, prosperous social economy in the 21st century. What makes the escapade even more remarkable is not just the size of their commitment but also their starting point. Japan’s national debt is by far the highest in the civilised world – some 220 per cent debt to gross domestic product ratio, or a staggering JPY 1,178,279.33 billion – making the decision to allow the budget deficit to rise to more than 11 per cent in 2013 the boldest Keynesian move since U.S. President Ronald Reagan’s expansionary fiscal policies in the early 1980s. Similarly, the Bank of Japan’s decision to spend US$1.5 trillion in 47

order to accomplish in two years what Ben Bernanke’s U.S. Federal Reserve did during the past six years of‘quantitative easing’(and without controlling the world’s reserve currency) is perhaps even more daring. Idle and neutered Turning to the Eurozone we are faced with another audacious experiment. In an aggregate economy that is in recession, the deepest austerity is being imposed upon the fastest shrinking national economies that make up the Eurozone. Meanwhile the European Central Bank is watching idly, too neutered by political and monetary policy considerations in Berlin, and too constrained by its’ Charter, to follow the European Central Bank’s president Mario Draghi’s instincts. Total Eurozone debt is less than 100 per cent of the Eurozone’s annual income (compared to Japan’s 230 per cent), the aggregate budget deficit is running below 6 per cent (about half that of Japan), while the European Central Bank becomes exposed to a molehill of paper assets (when compared to BoJ’s already mountainous ones). Diametrically opposed policies Clearly, of the two economies, the Eurozone is the one that has significantly more room within which to accommodate expansionary fiscal and monetary policies. And yet, it is Japan that is taking the plunge, firing both its barrels at its stagnation nemesis. One possible justification of the two diametrically opposed policy settings in Europe and in Japan might be that these two advanced economies are facing very different challenges. 48

Europe’s leaders like to imagine that, unlike Japan, Europe is not facing a longlasting recession, let alone deflation. For them, there is no need for Eurozone governments to loosen up the purse strings, or for the European Central Bank to flood the financial markets with digital euros. What matters to them is that the crisis is utilised to force upon the Eurozone’s laggards (the Club Mediterranean nations, in particular those of Cyprus, Greece, Portugal, and Spain) the reforms that will help them regain their ‘competitiveness’, both within the European Union and globally. While the two economies are very different, their current predicaments are eerily similar. If I am right, this means that Europe’s leaders may be deluding themselves in thinking that the Eurozone’s crisis is fundamentally different to that of Japan’s. Zombification of banks Japan’s and Europe’s crises began when their financial sector imploded following the burst of gigantic bubbles caused by earlier capital inflows into the money and the real estate markets. In both economies, governments tried to keep the banks afloat with injections of capital and liquidity that failed to restore their capacity to borrow and to lend. Both in Japan and in the Eurozone, the zombification of the banking system was ‘bought’ at the cost of taxpayers and to the detriment of the real economy. The result was a fall in the incomes from which the banking losses and the public debts had to be repaid. In both realms politicians had too cosy a relationship with bankers and did not dare expropriate them, cleanse the banks and sell Journal of Regulation & Risk North Asia

them back to the private sector (as Sweden did in 1992 or South Korea in 1998). The result of these political failures, both in Japan and in the Eurozone, have been a carbon copy of one another. Put differently, Japan and the Eurozone are in different phases of the same type of crisis, with Japan at a more advanced stage of this common disease, courtesy of having had an earlier start. The Eurozone is unique in world economic history in that it comprises of governments with no central bank to back their economic policies and a European Central Bank with no government to work with. In this sense, the Eurozone is a very different kettle of fish when compared to Japan. These differences reveal deep weaknesses that the Eurozone has and Japan is free of. The Eurozone’s complacency in the

face of stagnation means the ‘Japanese disease’, which is now spreading throughout Europe, is going to do even more damage to Europe than it did to Japan over the past two decades. Moreover, when the time comes for Europeans to reach the same conclusions that both Prime Minster Abe and Governor Kuroda have now turned into policy, the Eurozone will lack the institutions to put them into practice. The most likely result will be the Eurozone’s disintegration; a development which, ironically, will undoubtedly damage Japan’s recovery – just as it will damage the rest of the global economy. • Editors note: The publisher and editor of the Journal would like to thank Prof. Yanis Varoufakis for allowing the Journal to publish an amended version of this paper.

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Advertising deadline for Vol. V Issue IV Winter 2013/14

November 20, 2013
Contact Chris Rogers christopher.rogers@irrna.org

Journal of Regulation & Risk North Asia

49

Regulatory update

European Union finally agrees to limit bankers remuneration
Despite fervent lobbying and UK objections, the EU has finally adopted CRD IV – Chris Rogers details its impact in Asia.
After a protracted legislative journey reaching back to July, 2011, the European Union (EU), following a vote by the European Parliament on 16 April, has agreed to adopt a series of measures to cap bankers’ bonuses to curb speculative risk-taking, step up capital provisions to help banks cope better with crises and stiffen supervision curbing excessive remuneration of bankers. The new rules known collectively as CRD IV extend to most EU-headquartered banks within the 27 member states and their subsidiary operations outside of the EU, together with non-EU headquartered banks operating within the EU. The legislation is expected to take full effect next January and will have important implications for Asia Pacific banks with extensive operations within the EU. Before considering the likely impact of the EU’s CRD IV provisions on Asian banks operating across the 27 member states, a little background is necessary for our understanding. On 20 July 2011, the European Commission (EC) published its proposals Journal of Regulation & Risk North Asia to implement the international standards on bank capital requirements recommended by the Basel Committee on Banking Supervision – more commonly referred to as the Basel III International Accord. The EC proposals divided its Capital Requirements Directive (CRD) into two legislative instruments, namely the Capital Requirements Regulation (CRR) and the CRD IV Directive. Directive becomes law across EU Within the EU policy framework a “Directive” essentially means that all member states are obliged to transpose all terms and conditions relating to the “Directive” into national law. A“Regulation”bypasses member state legislative scrutiny and is applicable in its entirety as part of the EU’s harmonisation process to facilitate the “Single Market”. Hence, CRD IV will apply directly across the EU ensuring no divergence in prudential standards. The CRR contains provisions relating to the“single rule book”, including the majority of provisions relating to the Basel III prudential reforms. At the same time, the CRD IV Directive introduces provisions concerning remuneration, enhanced governance and 51

transparency, together with the introduction of buffers. As with the present CRD, both the CRR and CRD IV Directive will apply to credit institutions and investment firms that fall within the scope of the EU’s Markets in Financial Instruments Directive. Impact of new provisions Whilst both the CRR and CRD IV have a wide ranging impact on capital, capital buffers, liquidity and leverage, for the benefit of readers, the remainder of this paper will restrict itself to issues of corporate governance and bankers remuneration. With regards corporate governance, provisions are found in both the CRR and the CRD IV Directive. Combined, these new provisions seek to reduce excessive risk taking by firms and ultimately the accumulation of excessive risk within the financial system itself. In essence, the CRD IV Directive contains additional requirements on the nature and composition of management bodies and risk management arrangements within firms. At the same time, CRR requires firms to make increased Basel III Pillar 3 disclosures about their corporate governance arrangements. Risk management implications From a risk management perspective, these new arrangements provide that a banks management body will be responsible for the overall risk strategy and for the adequacy of the risk management system, and that the management body must establish a separate risk committee, composed of non-executive members, to deal specifically with risk issues. The management body will remain ultimately accountable for the banks risk 52

strategy, whilst the banks must have a risk management function independent from their operational and management functions and with sufficient authority, stature and resources. The principle of proportionality, taking into account the size and complexity of the activities of the financial institution, as well as different corporate governance models, applies to all of the aforementioned measures. Effects on remuneration in Asia Presently, it is expected that the greatest impact that the new EU regulatory environment will have on Asian institutions is contained within the CRD IV “Directive”. Specifically this relates to those elements dealing with bank executive remuneration, or the so-called“bonus cap.” A detailed summary is outlined below from documentation issued by the EU following the Parliamentary vote to adopt the Commission’s and the Council of the European Union’s recommendations of the February 27 and March 5 respectively, with the added provision of additional transparency and disclosure requirements for certain individuals who earn more than EUR 1 million per year under the 5th of March guidance communiqué. The main details of these provisions are as follows: • Variable remuneration cannot exceed a maximum of one times fixed remuneration. • The cap on variable remuneration of one times fixed remuneration can be increased to two times fixed remuneration with shareholder approval. • For shareholder approval to increase the permitted ratio to two times fixed remuneration, the approval will need the votes of Journal of Regulation & Risk North Asia

at least 66 per cent of shareholders owning half the shares represented, or of 75 per cent of the votes if there is no quorum. • If a ratio of more than one times fixed remuneration is approved by shareholders, 25 per cent of the variable remuneration must be paid in long-term deferred instruments. The deferral period for such instruments must be a minimum of five years. • In calculating the value of these longterm deferred instruments for the purposes of ensuring compliance with the ratio cap, it will be possible to discount the present value of those instruments thereby increasing the (effective) ratio cap beyond 1:2. This means, for example, if (i) a ratio cap of 1 (fixed remuneration) to 2 (variable remuneration) was approved by shareholders, (ii) 25 per cent of the variable remuneration was paid in qualifying long-term deferred instruments, and (iii) a 50 per cent discount rate were permitted for those long-term deferred instruments, this would effectively enable a maximum ratio cap between fixed and variable remuneration of 1 to 2.5. • The applicable discount rates that may be applied to qualifying long-term deferred instruments will be determined in due course by the European Banking Authority (EBA), taking into account matters such as inflation, levels of risk and the length of the deferral period. It is expected that, whilst any permitted discounting would enable institutions to set an effective ratio of greater than 1 to 2, the effective ratio would be closer to 1 to 2 rather than 1 to 3. • The long-term deferred instruments will be subject to claw back during the deferral period and may also be “bail-in-able” (meaning that they are subject to full or Journal of Regulation & Risk North Asia

partial write-down in the event of an insolvency event of the institution). • Two years after implementation of the new provisions, the European Commission will lead a review into what practical impact the new limits on variable remuneration have had, and in particular whether they have resulted in restrictions on competitiveness and any institutions relocating outside of the EU. Possible implementation delays Whilst the Commission, Council of the European Union and European Parliament are hopeful that CRD IV can be implemented in January, 2013, this is conditional on a detailed review of the legal drafting and translation into other official EU languages, together with a formal adoption by the Council of Ministers. If translation can be completed in time for the legislation to be published in the Official Journal of the European Union before July 1, 2013, then CRD IV implementation will proceed as planned. If this deadline slips, then the“Directive”will be implemented as of July 1, 2014. For most institutions which operate a bonus payment cycle within the EU where bonuses are paid in the first quarter following the end of a performance year, there is a strong possibility, if the July deadline is achieved, that this will impact variable remuneration payable in the first quarter of 2014 in respect of the 2013 performance year. Should however the deadline fails to be met, this will roll over to the next financial year, namely, 2015. At the time of writing, a detailed legislative text concerning these provisions has yet to be published by the EU. Additionally, 53

further guidance is expected from the European Banking Authority on a variety of issues, among these, permitted discounting of long-term deferred instruments. Regulatory and Supervisory bodies in all of the EU’s 27 member states are also required to issue local rules regarding implementation, or to amend existing rules. Scope of the Directive Despite intense industry lobbying and numerous objections raised by the UK, CRD IV, as detailed previously, will be applied to the majority of banks headquartered in the EU, or with extensive operations within the EU regardless of the institutions’ host nation. Further, all EU-based or headquartered banks with operations overseas fall under the “Directive”. As such, the scope of application of these rules will therefore be the same as under the current Capital Requirements Directive III (CRD III), which applies to all credit institutions and investment firms that fall within the scope of the Markets in Financial Instruments Directive. Growing pressure & inconsistencies Hedge funds, private equity houses and investment managers will also be subject to the requirements on remuneration under the Alternative Investment Fund Managers Directive (AIFMD), which in general terms mirrors the current remuneration requirements under CRD III and does not include any such ratio cap. There has, however, been growing pressure from some elements within the EU for the proposed ratio cap on variable remuneration eventually to be incorporated within AIFMD and thereby extended to hedge 54

funds, private equity houses and investment managers. A major concern for both employers and employees is which staff - the so-called “identified staff”- will actually be captured by the new rules once fully adopted. At present, it remains unclear under CRD IV what actually constitutes “identified staff,” i.e., under CRD III only those staff who had a material impact on a firm’s risk profile were supposed to be captured, rather than a carte blanche application across all the firms’ employees. However, due to considerable inconsistencies in the application of this rule found in institutions across the EU, it was decided that the EBA would issue new guidance later in the year, with the aim strengthening the criteria presently in CRD III. Shareholder approval issues Given the number of foreign banks headquartered in the EU, or with operations captured by the new rules, a degree of uncertainty remains concerning the shareholder approval requirement for these businesses. As detailed previously, the 1:1 ratio cap on fixed to variable remuneration can be increased to 1:2 with shareholder approval. One possibility is that the EU may expect that the shareholders of the non-EU parent company would have to vote on the issue at a general meeting. The other possibility is that the non-EU parent company would effectively be deemed as the shareholder for these purposes. Most legal experts are of the opinion that the former of the two is the most likely outcome. Under the existing remuneration requirements of CRD III, those institutions that are of a smaller size and whose activities Journal of Regulation & Risk North Asia

present less systemic risk can, under the socalled “proportionality principles”, choose to dis-apply some of the more restrictive remuneration requirements, including the requirements that a minimum of 40 per cent of variable remuneration be deferred for at least three to five years, and that a minimum of 50 per cent of variable remuneration must be paid in shares or other instruments. Further, deferred but uninvested remuneration must be subject to performance adjustment. Competitive pressures It remains to be seen whether such institutions will also have the opportunity to dis-apply the ratio cap on fixed to variable remuneration under such proportionality principles, particularly given the significant variations across the EU member states as to what actually constitutes a “smaller firm”. Readers are therefore advised to check with each respective country’s regulatory body for a concise definition. Given the extra-territorial reach of CRD IV in relation to employee remuneration, and its application to staff working within the EU for firms that are domiciled outside of the EU – namely, foreign firms with European headquarters or those whose operations are captured by the new rules – CRD IV will have significant implications, particularly for firms already accustomed to paying variable remuneration, or a multiple of several times fixed remuneration. Indeed, such changes will apply considerable pressure to decrease overall levels of pay. However, due to competitive pressures or other considerations, institutions may find it unacceptable to reduce total compensation Journal of Regulation & Risk North Asia

and may resort to increasing base salaries significantly. That said, it is predicted that many institutions may be reluctant to do so for a number of reasons. The challenge will therefore be to find ways in which payments or benefits can be made to employees, with such payments or benefits being categorised for the purposes of the ratio cap as fixed remuneration rather than variable remuneration, whilst conceptually still being seen as separate from and different in nature to base salary. In anticipating the proposed ratio cap, various approaches have been considered as to how such payments and benefits might be structured. Examples include one-off payments to employees entering into new employment contracts, new contractual restrictions, or the provision of various forms of fixed employment allowances. Other options Other possible mitigation strategies could involve increasing base salaries whilst including contractual provisions to decrease salaries after some time (for example, two years). The use of short fixed-term employment contracts may also be an option. Some institutions have also considered the use of possible new classes of shares for employees with very low initial values, but with the potential for significant growth, which would therefore not result in the value of the variable remuneration exceeding the cap. Whether any of these approaches will work in practice is uncertain and much will depend greatly on the detail of the forthcoming legislative guidance from the European Banking Authority and implementing rules from local regulators themselves. • 55

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Articles, Papers & Speeches
On being the right size: Essays in evolution
Andrew G. Haldane Daniel K. Tarullo

Global banking reform five years after the crisis A better alternative to the Basel capital rules
Thomas M. Hoenig Elisse B. Walter Otmar Issing

Regulation of cross-border OTCs: A middle ground Lessons from the crisis: The flaws of inflation targeting
Jean-Pierre Landau

Macroprudential rebalancing in a period of economic stress Dynamics of disintegration: Germany and the Euro
Prof. Christian Fahholz and Dr. Gernot Pehnelt Nicolas Veron

Europe’s interests best served by complying with Basel III The science of fiscal policy & alchemy of monetary policy
Prof. Jeffrey Frankel

Central bank fixation with low inflation prolongs recession
Prof. Laurence M. Ball

The Brown-Vitter bill: An exposé of lunacy
Assoc., Prof. William K. Black Mayra Rodríguez Valladares Steve Randy Waldman Gavin Sudhakar

Dodd-Franks extra-territorial reach irks the European Union Macroeconomic stabilisation under modern monetary theory Are ineffective AML & CFT laws impeding investor confidence?

Bank regulation

On being the right size: Essays in evolution
The Bank of England’s Andrew Haldane questions the scientific literature supporting the existence of too-big-too-fail banks.
The title of this paper is drawn from neither finance nor regulation. Instead it is drawn from evolutionary biology. In 1928, evolutionary biologist JBS Haldane wrote an important article whose title I have borrowed, On Being the Right Size. His point was simple. The sheer size of an object, institution or animal determined their structure, and as their size rose, their structure needed to strengthen more than proportionately if they were to remain robust and resilient. This principle is sometimes enshrined in the so-called“square-cubed”law. A proportional rise in an object’s size causes its area to rise by the square, and its volume by the cube, of that rise. At one level, this is simple mathematical geometry. Yet in the real world, it carries fundamental implications for evolutionary structure. Take the animal kingdom for example: the square-cubed law explains why a flea, even if it were the size of a man, would not be capable of jumping to the moon. It explains why a hippopotamus cannot turn somersaults. And it explains why King Kong and Godzilla were physiological Journal of Regulation & Risk North Asia impossibilities – the mere weight transfer associated with a single step would have shattered their thighbones. Folding under their own weight When the world’s biggest banking beasts took a step too far in 2008, they too folded under their own weight. Their physiological structure proved inadequate to make them robust and resilient.That is the essence of the “too big to fail” problem. In the language of Haldane, international policymakers have concluded that many of the world’s largest banks are not the right size given their existing physiological make-up. Over the past few years, initiatives to solve the too-big-to-fail problem have come thick and fast. The good news is that at their root, each has aimed to strengthen the structure of the world’s biggest banks. However, claims that they have solved the too-big-tofail problem appear to be premature, and somewhat over-optimistic. Worse, they risk sending a false sense of crisis comfort. To see why such a cautious conclusion is warranted, we begin by tracking the structural evolution of the financial system over 59

the past few decades. We then consider the three most prominent policy initiatives aimed at tackling too-big-to-fail systemic surcharges, resolution regimes and structural reform. Evolution of the financial system The past fifty years have seen seismic shifts in the structure, size and composition of the global financial system. These changes gave birth to the too-big-to-fail problem. Chart 1 (see page 71) plots the ratio of banking sector assets-to-GDP, and its cross-country dispersion, for a set of 14 advanced countries over the past 140 years. For the better part of a century, between 1870 and 1970, financial deepening in these countries followed a modestly upward trend. Over this period, the average bank assets-toGDP ratio rose from 16 per cent to over 70 per cent, or less than 6 percentage points per decade. Since 1970, this trend has changed trajectory. The ratio of bank assets-to-GDP has more than doubled over the past 40 years, rising from around 70 per cent to over 200 per cent, or over 30 percentage points per decade. In other words, since 1970 financial deepening has occurred five times faster than in the preceding century. Negative GDP impact For some individual countries, the rise has been more dramatic still - in the UK for example, the ratio has risen five-fold. In cross-country studies, financial deepening of this type has generally been found to have a positive effect on medium-term growth (Beck and Levine, 2004). Taken literally, this would suggest that the rise in banking scale 60

over recent decades has provided a significant tailwind to medium-term growth in advanced countries. Or so it seemed in the pre-crisis period. Such conventional wisdom however has recently been called into question. IMF research has suggested that financial deepening can be growth-positive, at least within limits. Indeed, there is a threshold at which private credit-to-GDP may begin to have a negative impact on GDP growth (Arcand, Berkes and Panizza, 2012). That threshold is found to lie at a private credit-to-GDP ratio of around 80-100 per cent, consistent with earlier cross-country evidence suggesting that, at credit-to-GDP ratios above unity, output volatility tends to increase (Easterly, Islam and Stiglitz, 2000). Bank concentration & scale This threshold lies significantly below current levels of financial depth in most advanced economies. In other words, taken at face value, this evidence suggests that at its current scale, banking could be acting as a headwind to medium-term growth. Accompanying this dramatic rise in banking scale has been an equally dramatic rise in banking concentration. The U.S. has undergone the most dramatic upwards shift, with the share of the top three banks rising from around 10 per cent to 40 per cent between 1990 and 2007 - see Chart 2 (page 71). Other countries saw a less dramatic rise in concentration but from a much higher starting point, driven by financial liberalisation. The top three banks for instance accounted for between two-thirds and threequarters of assets in the UK, Switzerland and Journal of Regulation & Risk North Asia

Germany. However, it has also spawned an acute problem for society due to escalating expectations of state support for the banking system – usually referred too as “moral hazard.” Self perpetuating “doom loop” These expectations generate lower funding costs, in particular for the largest banks, which in turn encourages further expansion and concentration, worsening the toobig-to-fail dilemma. This illustrates what Allesandri and Haldane (2010) describe as a self-perpetuating“doom loop”. The size of the resulting “implicit subsidy”from the state to the big banks has been the subject of recent study and controversy (Noss and Sowerbutts, 2012). There are a number of possible methods for estimating the subsidy. Perhaps the simplest is found by comparing the “standalone” and “support”ratings assigned to debt issued by large banks. The difference between these ratings gives an estimate, used by the market when pricing debt, of the probability of state support. Implicit subsidies Chart 3 (see page 71) plots the difference between these ratings for the 29 institutions deemed by the Financial Stability Board (FSB) last year to be the world’s most systemically important. In the pre-crisis period, this difference averaged a staggering 1.3 notches and suggests that, while non-trivial, too-big-to-fail may not have been a firstorder driver of the rising scale and concentration in banking. Yet even small notches of support can translate into bigger implicit subsidies if Journal of Regulation & Risk North Asia

balance sheets become too large, as in the case of the world’s largest banks. From 2002 to 2007, the implied annual subsidy to the world’s largest banks averaged US$70 billion per year using a ratings-based measure (Chart 4 page 71). That is roughly 50 per cent of the average post-tax profits of these banks over the same period. As the crisis struck, this implicit promise became explicit. Financial support was extended to the banking system in the form of capital injections, guarantees and liquidity insurance. On some estimates, this support rose to three-quarters of annual GDP in some countries. In response to these interventions, there has predictably been a further ratcheting-up in ratings-implied degrees of state support to banks. “Pigouvian tax” By 2009, the ratings difference had more than doubled to above three notches, with the implied monetary subsidy rising to over US$700 billion per year, a figure well in excess of average annual pre-crisis profits of these firms. Even if an over-estimate, the scale of the implied subsidy signalled something dramatic was at play. Too-big-to-fail had become hard-wired into the structure and pricing of the financial system. One way of interpreting these implicit subsidies is as the market’s best guess of how much a policymaker would be willing to pay each year to avoid the failure of the world’s biggest banks. They proxy the expected social costs of big bank failure. In the jargon, they capture a systemic externality. This notion of a systemic externality has underpinned recent academic and policy efforts to solve the too-big-to-fail problem. 61

Brunnermeier et al., (2009) use this framework to motivate levying a tax – a“Pigouvian tax” – on institutions posing systemic risk externalities. This tax would be set at levels, which offset the effects of the bank’s actions on wider society. A number of academics have since proposed measures along broadly Pigouvian lines (Archarya et al., 2010). Systemic surcharge Rather remarkably, policy reforms in practice have followed closely in the spirit of these proposals. In 2010, the FSB announced its intention to introduce a“systemic surcharge” of additional capital on the world’s largest banks. In July 2011, the Basel Committee published a methodology for measuring systemic importance based on indicators of bank size, connectivity and complexity, with additional capital of up to 2.5 per cent depending on this score. In November 2011, the FSB endorsed this methodology and announced the 29 systemically important entities to which it would apply. This framework will be finalised this year, before being phased-in from 2016. Indeed, legislation is already in place, or is being drawn up, to implement the systemic surcharge in the United States and Europe. Step in right direction These proposals are clearly a practical step in the right direction. By boosting levels of capital in the system, the probability of big bank failure will be reduced. In 2007 you would have got good odds back that something as seemingly elliptical as a Pigouvian tax on systemic risk would have found its way onto the regulatory statute books. Now we have 62

it. The practical question, however, is how far systemic surcharges take us in tackling the systemic risk externality. In other words, at current levels by how much have systemic surcharges reduced expected losses for the financial system? This is an empirical question and one, which must, in order to assess it, consider the impact of capital surcharges on the expected losses facing the 29 institutions identified by the FSB. Using each of these banks’ balance sheets, we generate a measure of default probability using the Merton (1974) contingent claims model. We assume that the base level of equity for these banks is 7 per cent (the new Basel III minimum) and that, in the event of default, they suffer losses on their assets of around 30 per cent. To keep things simple, banks’ assets are assumed to be normally distributed, in line with Merton (1974), and default occurs only when a bank’s capital has been fully exhausted. Expected losses Assume initially that default risks across banks are independent. This is a highly conservative assumption, as in practice bank default probabilities are highly correlated at times of stress. Indeed, bank correlation coefficients in crisis often head towards one. For that reason, this thought-experiment provides a lower bound on expected losses across the financial system. Chart 5 (see page 72) shows expected losses across the 29 banks at different levels of the systemic surcharge. In the absence of any surcharge, expected losses across the system are just less than US$200 billion per year. Were every large bank instead to face the maximum capital surcharge of 2.5 Journal of Regulation & Risk North Asia

per cent, then expected system-wide losses would fall by around 60 per cent relative to their base level. And to remove 90 per cent of the systemic externality – expected losses of around US$5 billion - a surcharge of over 7 per cent would be needed. Fire sale externalities A more plausible experiment would be to assume a non-zero correlation among bank defaults. For example, the failure of a large bank, which caused it to fire-sale assets could impose externalities on other large banks holding these same assets (Wagner, 2009). To place an upper bound on expected losses in the face of these fire-sale externalities, assume instead a correlation coefficient of one. Chart 5 (see page 72) illustrates the impact on expected system-wide losses of a high degree of default correlation among the big banks. The expected system-wide loss increases to around US$750 billion per year – similar in size to the implicit subsidy at its peak. A 2.5 per cent surcharge now only reduces expected system-wide losses to around US$350 billion per year. To lower expected system-wide losses to be around US$5 billion per year would require a surcharge of around 15 per cent – six times its current upper limit. Gloomy prognosis If anything, these thought-experiments probably produce conservative estimates of system-wide losses and the necessary systemic surcharge. For example, bank asset returns are in practice much fatter-tailed than the log-normal distribution. And in practice, banks are likely to default well before their Journal of Regulation & Risk North Asia

capital is fully exhausted. Relaxing either assumption would push up estimates of expected losses and the surcharge necessary to curtail these losses (Schanz et al., 2012). Nonetheless, if expected system-wide losses are a reasonable proxy for the systemwide externalities large banks pose; this analysis delivers a rather gloomy prognosis. At current levels of the surcharge, a large chunk of the systemic externality would remain untouched. If too-big-to-fail is the problem, then systemic surcharges seem to offer only a partial solution. Capital surcharges lower systemic externalities by lowering default probabilities for the world’s largest banks. An alternative way of lowering those externalities would be to reduce the collateral damage associated with their failure. Resolution regimes This has been a key motivation for a second strand of the reform debate – the design of effective resolution regimes. Few examples better illustrate the costs of getting this wrong than the spiralling queues outside branches of Northern Rock in September 2007. Despite being a medium-sized retail bank, Northern Rock’s failure caused systemic disruption and put taxpayers’ money at risk. In response, in 2009 the UK put in place a special resolution regime for banks, providing the Bank of England with tools for winding-down a failed bank. As the crisis illustrated, financial failure, which causes systemic disruption is not confined to banks. And to avoid taxpayer bailout, losses may need to be imposed on a wide class of bank creditors, including holders of debt as well as equity – for example, by “bail-in”. Over recent years, these resolution 63

lessons have been enshrined in banking legislation. For example, in the United States Title II of the Dodd-Frank Act was passed in July 2010. It creates a new regime for the liquidation of financial companies, banks and non-banks, which pose a systemic financial stability risk. It enables losses to be imposed on creditors in resolution, while also prohibiting state bailouts. Lowering societal costs Internationally, in November 2011 the G-20 endorsed the FSB’s Key Attributes of Effective Resolution Regimes, developed by an international working group chaired by the deputy governor of the Bank of England, Paul Tucker. Efforts are now underway to align national resolution regimes with these principles. As part of that, in Europe a draft directive on bank recovery and resolution was published in June 2012. Such initiatives are an important practical step in the right direction, lowering the societal costs of bank failure. As with systemic surcharges, it is striking how much progress has been made in so short a space of time on so complex an issue. The practical question is how far this takes us towards removing the too-big-to-fail externality. Evolutionary trajectories During a bank resolution, one way of ensuring continuity of banking services is by transferring assets and/or liabilities of a failing firm to a third party. But the only entity with sufficient financial and managerial resource to absorb a large asset or liability portfolio, without suffering chronic indigestion, is another big bank. So it was during the crisis 64

for example, that Bear Stearns was swallowed by JPMorgan Chase, Merrill Lynch by Bank of America and Washington Mutual by Citigroup. This makes for a rather uncomfortable evolutionary trajectory, with rising levels of banking concentration and ever-larger toobig-to-fail banks. Levels of banking concentration have risen in many countries since 2007, precisely because of such shotgun marriages by over-sized partners. In other words, resolving big banks may have helped yesterday’s too-big-to-fail problem, but at the expense of worsening tomorrow’s. One way of avoiding this problem is to re-capitalise a bank by bailing-in its creditors, rather than transferring its assets. But resolution rules of this type are not problem-free either. Like all policy rules, they face what economists call a time-consistency problem. Whether a rule is followed in practice depends on the balance of costs and benefits at the time crisis strikes, not at the time the rule is written. That is why policy might in practice lack consistency over time – hence time-inconsistency. Bailout or bail–in? Consider that trade-off when a big, complex bank hits the rocks. On the one side is a simple but certain option - state bailout. On the other side is a complex and less certain option – resolution. Policymakers face a trade-off between placing losses on a narrow set of taxpayers today (bail-in) or spreading that risk across a wider set of taxpayers today and in the future (bailout). If governments are risk-averse and wish to smooth the pain across taxpayers and across time, then bailout may look attractive Journal of Regulation & Risk North Asia

on the day – financial history certainly suggests so. The history of big bank failure is a history of the state blinking before private creditors (Haldane, 2011). Recent crisis experience has written another chapter in this history. Next time may be different. For example, the public backlash against future bailouts could reinforce governments’ resolve to impose losses on creditors. And recent U.S. legislation in principle locks the tax-payer cashbox and throws away the key. Limits of Dodd-Frank Looking forward, the issue is whether this exante rule is ex-post credible. As Chart 6 illustrates (see page 72), implied levels of support for the U.S.’s biggest banks are much higher than before the crisis. More telling still, is that the passage of Dodd-Frank appears to have had little impact on levels of implied state support. It is early days for this new resolution regime and credibility may take time to be earned. Nonetheless, at present the market believes that the time-consistency problem for big banks is as acute as ever. Even if it might appear the expedient option on the day of crisis, it is questionable whether bailout is the optimal response over the medium-term. Sovereign CDS spreads Chart 7 (see page 72) looks at the response of bank and sovereign credit default swap (CDS) spreads around the time of bank bailouts in a selection of crisis countries. While bailouts lowered bank CDS spreads, as might be expected, bailout came at the expense of a rise in sovereign CDS spreads. It is not difficult to see why. The financial Journal of Regulation & Risk North Asia

crisis has caused huge damage to the balance sheets of governments in advanced economies. For the G-20 countries, the IMF forecast that the debt-to-GDP ratio will rise by almost 40 percentage points between 2007 and 2016, to almost 120 per cent. At these levels, public sector debt may be a significant drag on medium-term growth (Rogoff and Reinhart, 2010). For economies with large banking systems and without a credible resolution regime, this leaves policymakers caught between a rock and hard place. When the call comes to ride to the banking rescue, governments may be unable to afford not to. But nor, at least over the medium term, can they afford to.This is just one of the dilemmas facing advanced countries today. Structural reform One way of lessening this dilemma, and at the same making resolution and bailin more credible, is to act on the scale and structure of banking directly. Perhaps not surprisingly, recent regulatory reforms have sought to do just that. They have taken seriously the maxim that if a bank is too big to fail, then it is too big. The result has been detailed proposals for structural reform in a number of advanced countries. In the United States, the “Volcker rule” has been introduced. This prohibits U.S.operating banks from undertaking proprietary trading and restricts private equity activity. The rule was tabled in October 2011 and became law in July 2012. Banks have two years to comply. In the United Kingdom, the proposals of the “Vickers Commission” include placing a ring-fence around retail banking activities, supported by higher levels 65

of capital. The final version of these proposals was tabled in September 2011 and legislation to enact them is planned by 2015. Banks will have until 2019 to comply. Most recently in Europe, the “Liikanen plan” was announced in October 2012. It proposes that the investment banking activities of universal banks be placed in a separate entity from the remainder of the banking group. There are at present no plans to legislate these proposals. A question of separation As with other reform strands, it is remarkable how quickly radical structural reform proposals are finding their way onto the statute book. And although different in detail, these proposals share a common motivation: separation of certain investment and commercial banking activities. In theory, such a separation delivers financial stability benefits of two distinct types (Boot and Ratnovski, 2012). First, separation reduces the risk of crosscontamination. Riskier investment banking activities, when they go wrong, can pollute and dilute the financial resources of the retail bank. This potentially inflicts losses (or fear of losses) on depositors. It may also constrain banks’ability to make loans to the real economy when it might most need them. This is a crisis-time benefit of separation. Cross-subsidisation Second, separation can secure an improved pre-crisis allocation of financial resources from a societal perspective. High private return investment banking activities may crowd-out the human and financial resources devoted to high social return 66

commercial banking activities. Investment banking activities might also piggyback on the cheaper cost of deposit funding. In effect, universal banking allows privately optimal, but socially sub-optimal, cross-subsidisation. This is a benefit of separation in normal times. Both of these costs were evident ahead of, and during, the recent crisis. Ahead of crisis, resources gravitated to the investment banking side of the fence. Between 2000 and 2007, UK banks’ trading books rose six times as fast as their banking books. Human capital made the same journey, helped by investment banking salaries rising four times as fast as commercial bank salaries since 1980. In the teeth of crisis, risk cross-contamination became a potent factor. Open questions Basic banking services in universal banks were often subject to severe disruption from trading book losses, which exceeded by many multiples the capital allocated to them. That is why national deposit insurance schemes were extended and in some cases became temporarily unlimited. It is also why repeated attempts have had to be made to resuscitate weak credit growth over the past few years. So how far will existing structural proposals take us in harnessing these benefits? Volcker, Vickers and Liikanen seek legal, financial and operational separation of activities. So in principle each ought to prevent cross-contamination at crisis time. Whether they do so in practice depends on loopholes in, or omissions from, the ring-fence. And each of the existing proposals has open questions on this front. For example, the Volcker rule separates Journal of Regulation & Risk North Asia

only a fairly limited range of potentially risky investment bank activities, in the form of proprietary trading. The Vickers proposals mandate only a limited range of basic banking activities to lie within the ring-fence, namely deposit-taking and overdrafts. And the Liikanen plans allow a wide range of derivative activity to lie outside of the investment banking ring-fence. Ring-fence to string vest It could be argued that these loopholes are modest. But as the history of the GlassSteagall Act demonstrates, today’s loophole can become tomorrow’s bolt-hole, and today’s ring-fence tomorrow’s string vest. At a minimum, this suggests the need for full and faithful implementation of the spirit as well as the letter of the Volcker, Vickers and Liikanen plans if risk cross-contamination is to be avoided. A larger question-mark still hangs over whether these proposals will lead to a seachange in the allocation of resources to retail and investment banking. The cultures of investment and retail banking are quite distinct. Retail banking relies on forming long-term relationships, while investment banking is inherently shorter-term and transactional. Housing these sub-cultures under one roof makes achieving the necessary separation of cultures and capital a significant operational headache. Acid test At a minimum, such a separation of culture and capital is likely to require entirely separate governance, risk and balance sheet management on either side of the ring fence. Without that, human and financial resource Journal of Regulation & Risk North Asia

allocation either side of the ring-fence will become blurred. For example, without separate debt issuance for retail and investment banking, the cost of debt for a big bank will be a blended mix. The implicit subsidy in funding costs would then remain and with it become one of the main distortions associated with too-big-to-fail. Only time will tell whether cultural separation can be achieved under the existing structural reform proposals. In the go-go years, will these reforms be sufficient to prevent the grass always appearing greener on the riskier side of the (ring-)fence? This is the acid test of the structural reform agenda. Progress has been made over the past few years towards eliminating too-big-tofail, with further progress on implementation planned. But today’s task is even more daunting than before the crisis. The big banks are even bigger. The system itself is more concentrated. Further reforms? Despite reform efforts, the market’s best guess today about tomorrows implicit subsidy is far larger than before the crisis struck, at over US$300 billion per year (see Chart 3 on page 71). The market believes that illicit state promise is even more likely to be kept. The wrong conclusion to draw would be that existing reforms have failed or are unnecessary. On the contrary, these reform initiatives, while necessary, may be insufficient to eliminate the too-big-to-fail externality. If so, what are the alternatives? Re-sizing the capital surcharge is one possibility. This would further reduce default probabilities among the biggest banks, thereby lowering the expected system-wide 67

losses associated with big bank failure. Taking the earlier illustrative example, to reduce materially expected system-wide losses for the world’s largest banks would require a capital surcharge several times larger than its current upper limit. Interestingly, this would take bank capital ratios to levels not dissimilar to recent quantitative estimates of their optimal value (Miles et al., 2011; Hellwig et al., 2011). Limitations on bank size Placing limits on bank size is a second option. By reducing balance sheet exposures, this measure would reduce directly systemwide losses in the event of big bank failure. The Dodd-Frank Act includes an explicit limit on the maximum deposit market share of U.S. banks, capping it at 10 per cent. But this does not prevent banks rising to a scale, relative to GDP, at which they could imperil state solvency. For that reason, limiting bank size relative to GDP has recently been proposed by a number of commentators and policymakers, among them Fisher (2011), Hoenig (2012), Johnson and Kwak (2010), and Tarullo (2012). Complete divorce Full structural separation of investment and commercial banking, a modern-day GlassSteagall Act, has continued to attract support. The main benefit this would bring, relative to structural ring-fencing, is that it would eliminate loopholes from the ringfence and better ensure that the distinct cultures of retail and investment banking were not cross-contaminated. That would lessen the risk of basic banking activities being starved of human or 68

financial capital, both ahead of and during crisis. Full separation may also be operationally simpler to implement than the existing structural proposals. Finally, enhanced banking competition would potentially help to reduce some of the problems of too-big-to-fail by reducing the degree of banking concentration. Greater exit from banking, through enhanced resolution regimes, could help. But a bigger problem still is bank entry: the UK went 100 years without a new retail bank being set up. One potential barrier to banking entry is the difficulty of switching deposit accounts and loan contracts. A shared banking platform containing customer account details would dramatically reduce the frictions in search and switch for deposit and loan products for customers (Leadsom, 2012) and could lower material barriers for new banking entrants. Counter arguments A powerful counter-argument to all of these more radical proposals is that they could erode the economies of scale and scope associated with large banks. These economies clearly do exist in banking, as they do in other industries. For example, fixed costs are large in finance, and spreading them widely ought to deliver productivity improvements. The interesting question is at what point these economies of scale are exhausted. Indeed, informational and managerial diseconomies of scale are likely at some scale, whatever the business line. In his classic theorem, Ronald Coase tells us that firms will seek a privately-optimal size, which balances the benefits of economies of scale against these diseconomies (Coase, 1937). So how Journal of Regulation & Risk North Asia

does all of this apply in banking? The empirical evidence on economies of scale and scope in banking is surprisingly patchy. Early studies, using data from the 1980s, failed to find scale economies much beyond bank asset sizes of around US$100 million (Pulley and Braunstein, 1992). Empirical studies in the 1990s nudged up the optimal bank scale to around US$10 billion (Amel et al., 2004; Mester, 2005). Questionable data Most recently, a small number of studies using data from the 2000s have pointed to scale-economies at much higher asset thresholds. For example, Wheelock and Wilson (2012) find scale economies for banks with assets up to US$1 trillion and Feng and Serilitis (2009) for bank with assets up to around US$1.5 trillion. Using data on banks with assets in excess of US$100 billion, Mester and Hughes (2011) not only find scale-economies, but also argue that these may increase with bank size. At face value, these findings pose a real challenge to policy options which re-size banks. Or do they? Bank of England research has re-examined the evidence on economies at different banking scales (Davies and Tracey, 2012). As Chart 8 (see page 72) shows, in standard models there is evidence of scale economies for banks with assets above US$100 billion. Indeed, these economies tend to rise with banking scale. Too-big-to-manage However, this finding is based on estimates of banks’ funding costs, which take no account of the implicit subsidy associated Journal of Regulation & Risk North Asia

with too-big-to-fail. Removing this subsidy raises banks’ funding costs, lowers estimates of bank value-added and thereby reduces measured economies of scale. As Chart 9 (see page 72) shows, once an allowance is made for the implicit subsidy, the picture changes dramatically. There is no longer evidence of economies of scale at bank sizes above US$100 billion. If anything, there is now evidence of diseconomies which rise with bank size, consistent with big banks becoming “too big to manage”. This evidence reconciles Coase’s theorem with the too-big-to-fail phenomenon. In line with Coase, banks have chosen the size, which maximises their private value. But implicit subsidies may have artificially boosted the privately-optimal bank size. Subtracting this subsidy, removing the state crutch, would suggest a dramatically lower socially-optimal banking scale. Physiological impossibilities What about economies of scope? A recent study by Boyd and Heitz (2011) conducts a simple but compelling thought-experiment. They compare the lowest-available estimate of the social cost of the crisis with the highest-available estimate of the private benefit of scale and scope economies in banking. The social costs of too-big-to-fail exceed the private benefits of scale economies by an order of magnitude. In his 1928 article, JBS Haldane observed that when“you drop a mouse down a thousand-yard mine shaft it walks away, a rat is killed, a man is broken, a horse splashes”. In short, when big banks disappeared down the mineshaft in 2008, their splashes generated a tsunami. To prevent this from happening 69

again, their physiology needs to change. And whilst existing change initiatives may be occurring in the right direction, it is possible that they are insufficient in degree. There may be a distance to travel before banking is the right size. • References
Acharya,V, Pedersen, L Philippon,T and Richardson, M (2010) “A tax on systemic risk”, NYU SternWorking Paper Admati, A., DeMarzo, P ., Hellwig, M. and Pfleiderer, P (2011),“Fallacies Irrelevant Facts and Myths in the Discussion of Capital Regulation: Why Bank Equity is not Expensive” (March 23, 2011). Rock Center for Corporate Governance at Stanford University Working Paper No. 86 Alessandri, P and Haldane, A (2010) “Banking on the state”, Bank of England Amel, D and Barnes, C and Panetta, F and Salleo, C, (2004).“Consolidation and efficiency in the financial sector: A review of the international evidence,” Journal of Banking and Finance, Elsevier, vol. 28(10), pp. 2493-2519, October. Boot, A and Ratnovski L (2012) “Banking and Trading”, International Monetary Fund Working Paper WP/12/238 Boyd, J and Heitz (2011) “The Social Costs and Benefits of T oo-Big-T o-Fail Banks:A bounding exercise”, Working Paper Brunnermeier, M, Crockett, A, Goodhart, C, Persaud, A and Shin, H (2009),“The Fundamental Principles of Financial Regulation,” London, Centre for Economic Policy Research. Cecchetti, S and Mohanty, M and Zampolli, F (2011). “The real effects of debt”, BIS Working Papers 352, Bank for International Settlements. Coase, R.H. (1937) “The Nature of the Firm,” Economica, New Series,Vol. 4, No. 16. (Nov 1937), pp. 386-405

Davies, R and Tracey, B (2012) “T oo big to be efficient? The impact of too big to fail factors on scale economies for banks ”, Mimeo Easterly,W., Islam, R., and Stiglitz, J. (2000), “Shaken and Stirred, Explaining GrowthVolatility,” Annual Bank Conference on Development Economics.World Bank,Washington D.C. Feng, G., and A. Serilitis (2009). “Efficiency, technical change, and returns to scale in large US banks: panel data evidence from an output distance function satisfying theoretical regularity.” Journal of Banking and Finance, 34(1), pp.127 – 138. Fisher, R (2011) “Taming the T oo-Big-T o-Fails: Will Dodd-Frank be the ticket or is Lap-band surgery required?” Remarks before Columbia University’s Politics and Business Club Hoenig,T (2012), “Back to basics:A better alternative to Basel Capital Rules”, Speech to The American Banker Regulatory Symposium, September 14. Hughes, J and Mester, L (2011),“Who said large banks don’t experience scale economies? Evidence from a risk-return-driven cost function,” Working Papers 11-27, Federal Reserve Bank of Philadelphia. Johnson, S and Kwak, J (2010), “13 Bankers: The Wall Street Takeover and the Next Financial Meltdown”, Pantheon. Jorda, O and Schularick, M and Taylor,A (2011),“Financial Crises, Credit Booms, and External Imbalances: 140 Years of Lessons,” IMF Economic Review, Palgrave Macmillan, vol. 59(2), pp. 340-378, June. Leadsom, A (2012),“How an old hand would change Barclays”, Financial Times Opinion Editorial, July 4. http://www.ft.com/cms/s/0/fb094718-c5f7-11e1-b57e00144feabdc0.html#axzz2A6YBHLDV Levine, R (2004).“Finance and Growth:Theory and Evidence,” NBER Working Papers 10766. Merton, Robert C., (1974) “On the Pricing of Corporate Debt:The Risk Structure of Interest Rates”, Journal of Finance,Vol. 29, No. 2, (May 1974), pp. 449-470. Mester, L.J. (2008). “Optimal industrial structure in banking,” in Handbook of Financial Intermediation,

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Arnoud Boot and Anjan Thakor, eds. Amsterdam: North-Holland, pp.133 – 162. Miles D,Yang J and Marcheggiano, G (2012) “Optimal Bank Capital”, Economic Journal. Noss, J and Sowerbutts, R (2012),“The Implicit Subsidy of banks” Bank of England FS Papers Series, FS Paper No 15. Panizza, U and Arcand, J-L and Berkes, E, (2012). “T oo Much Finance?,” IMF Working Papers 12/161, International Monetary Fund. Philippon,T and Reshef,A (2009).“Wages and Human Capital in the U.S. Financial Industry: 1909-2006”, NBER Working Papers 14644, National Bureau of Economic Research, Inc. Pulley, L. B. and Y. M. Braunstein (1992) “A composite cost function for multiproduct firms with an application to economies of scope in banking”, Review of Economics and Statistics, 74(2), 221-30. Reinhart, C and Rogoff, K, (2010). “Growth in a Time
Percent 500 450 400 350 300 250 200 150 100 50 1870 1890 1870 1910 1890 1930 1910 1950 1930 1970 1950 1990 0 1970 1990

of Debt,” American Economic Review,American Economic Association, vol. 100(2), pp. 573-78, May. Segoviano, M and Goodhart, C (2009),“Banking Stability Measures,” IMF Working Paper 09/04 (Washington: International Monetary Fund). Schanz, J, Aikman, D, Collazos, P , Farag, M, Gregory, D and Kapadia, S (2011),“The long-term economic impact of higher capital levels”, Bank of England, Mimeo Tarullo, D (2012) “Financial Stability Regulation” , Speech At the Distinguished Jurist Lecture, University of Pennsylvania Law School, Philadelphia, Pennsylvania Wagner,Wolf, (2009) “In the Quest of Systemic Externalities:A Review of the Literature ”, mimeo Wheelock, D.C., and P .W. Wilson (2012). “Do Large Banks have Lower Costs? New Estimates of Returns to Scale for U.S. Banks.” Journal of Money, Credit, and Banking, 44(1), 171 – 199.
UK Concentration (%) Concentration (%) United States 90 90 Germany 80 80 Switzerland UK 1921-70 70 70 60 50 40 30 20 10 60 50 40 30 20 10

Chart 1: Bank Chart assets/GDP 1: Bank assets/GDP in selected countries in selected countries Chart 2: Banking Chart concentration 2: Banking concentration in selected countries in selected countries
Percent UK United States 500

MaximumMaximumMinimum range Minimum range Average Average

Germany 450 Switzerland UK 1921-70
400 350 300 250 200 150 100 50

0 0 0 1921 1931 1941 1921 1951 1931 1961 1941 1971 1951 1981 1961 1991 1971 2001 1981 2011 1991 2001 2011

Source: Jorda, Schularick Source: Jorda, and Taylor Schularick (2011) and Taylor (2011)

Source: Bank of England Source:calculations, Bank of England Capie, calculations, F. and Webber, Capie, A. F. and Webber, A. (1985), FDIC, Bundesbank, (1985), FDIC, Swiss Bundesbank, National Bank Swiss National Bank

Chart 3: Ratings Chart uplift 3: Ratings for systemic uplift for institutions systemic institutions Chart 4: Implicit Chart subsidy 4: Implicit for systemic subsidy for institutions systemic institutions
Notches 4 Notches 4 US$ bn 1,200 1,000 800 600 400 200 04 05 02 06 03 07 04 08 05 09 06 10 07 11 08 0 09 10 11

US$ bn 1,200 1,000 800 600 400 200 0

3

3

2

2

1

1

02

03

04

05 02

06 03

07 04

08 05

09 06

10 07

11 08

12 09

0 10

11

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0 03

Source: Moody’s, Source: Bank of Moody’s, England calculations Bank of England calculations

Source: Bank of England Source:calculations Bank of England calculations

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Chart 5: Expected system-wide loss

US$bn

Chart 6: Bank ratings uplift in the US
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Source: Bank of England calculations

Source: Moody’s, Bank of England calculations

Chart 7: Sovereign and Bank CDS during bailout announcements
Average CDS - Banks Average CDS - Sovereigns CDS Index: -20 days = 1 3.0 2.5 2.0 1.5 1.0 0.5 -20 -16 -12 -8 -4 0 4 8 12 16 20 0.0

Chart 8: Economies of scale (assuming no implicit subsidy)
95th percentile Mean Constant returns to scale Estimated scale economies 1.30 1.25 1.20 1.15 1.10 1.05 1.00 0.95 0.90 0.85 <100bn 100bn500bn 500bn- 1tn 1tn- 2tn >2tn 0.80

Total assets (US$)

Source: Markit, Bank of England calculations

Source: Capital IQ, Bank of England calculations

Chart 9: Economies of scale (implicit subsidy-adjusted)
95th percentile Mean Constant returns to scale Estimated scale economies

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Asia, Australia, Africa 1.25
1.20 1.15

writers, editors, press & 1.10 public relations practitioners
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1.00 0.95 0.90 0.85 >2tn 0.80

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Journal of Regulation & Risk North Asia

Total assets (US$)

Bank regulation

Global banking reform five years after the crisis
Governor Daniel K. Tarullo of the U.S. Federal Reserve System believes its too early to claim victory in taming global finance.
More than five years after the failure of Bear Stearns marked an escalation of the financial crisis, and nearly three years since the passage of the Dodd-Frank Act, debate continues over the appropriate set of policy responses to protect against financial instability. In recent months, there has been, in particular, a renewal of interest in additional measures to address the too-big-to-fail problem. In some respects, the persistence of debate is unsurprising. After all, the severity of the crisis and ensuing recession, and the frustratingly slow pace of economic recovery, have properly occasioned much thought about the structure of the financial system and the fundamentals of financial regulation. Continuing discussion of these issues is part of a protracted policy debate over financial regulatory reform. Some argue that little has changed and that the needed reform is a single, dramatic policy change (though that single policy differs considerably among those taking this view). Others argue that reforms already enacted are sufficient to Journal of Regulation & Risk North Asia ensure financial stability. However, many others contend that there has already been too much of a regulatory response, which is suppressing credit extension and faster economic recovery. I think most of us would acknowledge, upon reflection, that a good bit has been done, or at least put in motion, to counteract the problems of too-big-to-fail and systemic risk more generally. At the same time, I believe that more is needed, particularly in addressing the risks posed by shortterm wholesale funding markets. I would therefore like to highlight the importance of what has already been accomplished and, at somewhat greater length, to identify what I believe to be the key steps that remain. Before turning to these subjects, though, I begin with a brief reprise of the origins of the financial crisis, to remind ourselves of the vulnerabilities that led to the crisis and that remain of concern today. It should, but does not always, go without saying that proposed solutions should actually help solve the problems at hand, and do so in a manner that minimises the costs to otherwise productive activities. 73

Beginning in the 1970s, the separation of traditional lending and capital market activities established by New Deal financial regulation began to break down under the weight of macroeconomic turbulence, technological and business innovation, and competition. Growth of shadow banking During the succeeding three decades these activities became progressively more integrated, fuelling the expansion of what has become known as the shadow banking system, including the explosive growth of securitisation and derivative instruments in the first decade of this century. This trend entailed two major changes. First, it diminished the importance of deposits as a source of funding for credit intermediation, in favour of capital market instruments sold to institutional investors. Over time, these markets began to serve some of the same maturity transformation functions as the traditional banking systems, which in turn led to both an expansion and alteration of traditional money markets. Ultimately, there was a vast increase in the creation of so-called cash equivalent instruments, which were supposedly safe, shortterm, and liquid. Symbiotic relationship Second, this trend altered the structure of the industry, both transforming the activities of broker-dealers and fostering the emergence of large financial conglomerates. There was, in fact, a symbiotic relationship between the growth of large financial conglomerates and the shadow banking system. Large banks sponsored shadow banking entities such 74

as Structured Investment Vehicles (SIVs), money market funds, asset-backed commercial paper conduits, and auction rate securities. These firms also dominated the underwriting of assets purchased by entities within the shadow banking system. Though motivated in part by regulatory arbitrage, these developments were driven by more than regulatory evasion.The growth and deepening of capital markets lowered financing costs for many companies and, through innovations such as securitisation, helped expand the availability of capital for mortgage lending. Similarly, the rise of institutional investors as guardians of household savings made a wide array of investment and savings products available to a much greater portion of the American public. Adverse feedback loop But these changes also helped accelerate the fracturing of the system established in the 1930s. While the increasingly outmoded regulation of earlier decades was eroded, no new regulatory mechanisms were put in place to control new risks. When, in 2007, questions arose about the quality of some of the assets on which the shadow banking system was based – notably, those tied to poorly underwritten sub-prime mortgages – a classic adverse feedback loop ensued. Investors formerly willing to lend against almost any asset on a short-term, secured basis were suddenly unwilling to lend against a wide range of assets, notably including the structured products that had become central to the shadow banking system. Liquidity-strained institutions found themselves forced to sell positions, which placed additional downward pressure Journal of Regulation & Risk North Asia

on asset prices, thereby accelerating margin calls on leveraged actors and amplifying mark-to-market losses for all holders of the assets. The margin calls and booked losses would start another round in the adverse feedback loop. Highly vulnerable Severe repercussions were felt throughout the financial system, as short-term wholesale lending against all but the very safest collateral froze up, regardless of the identity of the borrower. Moreover, as demonstrated by the intervention of the government when Bear Stearns and AIG were failing, and by the aftermath of Lehman Brothers’ failure, the universe of financial firms that appeared too-big-to-fail during periods of stress extended beyond the perimeter of traditional safety and soundness regulation. In short, the financial industry in the years preceding the crisis had been transformed into one that was highly vulnerable to runs on the short-term, uninsured cash equivalents that fed the new system’s reliance on wholesale funding. The relationship between large firms and shadow banking meant that strains on wholesale funding markets could both reflect and magnify the too-big-to-fail problem. Fast-moving episodes These were not the relatively slow-developing problems of the Latin American debt crisis, or even the savings and loan crisis, but fast-moving episodes that risked turning liquidity problems into insolvency problems, almost literally overnight. However, note that while the presence of too-big-to-fail institutions substantially exacerbates the Journal of Regulation & Risk North Asia

vulnerability created by the new system, they do not define its limits. Even in the absence of any firm that may individually seem too big or too interconnected to be allowed to fail, the financial system can be vulnerable to contagion. An external shock to important asset classes can lead to substantial uncertainty as to underlying values, a consequent reluctance by investors to provide short-term funding to firms holding those assets, a subsequent spate of fire sales and mark-to-market losses, and the potential for an adverse feedback loop. In short, an effective set of financial reforms must address both these related problems of too-big-to-fail and systemic vulnerability. Extensive reform As is obvious from the scope of the DoddFrank Wall Street Reform and Consumer Protection Act and the amount of activity at the regulatory agencies, reform efforts to date have been extensive. They have also been significant. Without trying to give a full review, let me draw your attention to some of the more notable accomplishments, which can be categorised in three groups. First, the basic prudential framework for banking organisations is being considerably strengthened, both internationally and domestically. Central to this effort are the Basel III changes to capital standards, which create a new requirement for a minimum common equity capital ratio. This new standard requires substantial increases in both the quality and quantity of the lossabsorbing capital that allows a firm to remain a viable financial intermediary. Basel III also established for the first time an international 75

minimum leverage ratio which, unlike the traditional U.S. leverage requirement, takes account of off-balance-sheet items. Stricter reforms for larger firms Second, a series of reforms have been targeted at the larger financial firms that are more likely to be of systemic importance. When fully implemented, these measures will have formed a distinct regulatory and supervisory structure on top of generally applicable prudential regulations and supervisory requirements. The governing principle for this new set of rules is that larger institutions should be subject to more exacting regulatory and supervisory requirements, which should become progressively stricter as the systemic importance of a firm increases. This principle has been codified in Section 165 of the Dodd-Frank Act, which requires special regulations applicable with increasing stringency to large banking organisations. Under this authority, the Federal Reserve will impose capital surcharges on the eight large U.S. banking organisations identified in the Basel Committee agreement for additional capital requirements on banking organisations of global systemic importance. Move to orderly liquidation The size of a surcharge will vary depending on the relative systemic importance of the bank. Other rules to be applied under Section 165 – including counterparty credit risk limits, stress testing, and the quantitative short-term liquidity requirements included in the internationally negotiated Liquidity Coverage Ratio (LCR) – will apply only to large institutions, in some cases with stricter 76

standards for firms of greatest systemic importance. An important, related reform in DoddFrank was the creation of orderly liquidation authority, under which the Federal Deposit Insurance Corporation can impose losses on a failed systemic institution’s shareholders and creditors and replace its management, while avoiding runs and preserving the operations of the sound, functioning parts of the firm. This authority gives the government a real alternative to the Hobson’s choice of bailout or disorderly bankruptcy that authorities faced in 2008. Similar resolution mechanisms are under development in other countries, and international consultations are underway to plan for cooperative efforts to resolve multinational financial firms. Focus on derivatives A third set of reforms has been aimed at strengthening financial markets generally, without regard to the status of relevant market actors deemed as regulated or systemically important. The greatest focus, as mandated under Titles VII and VIII of DoddFrank, has been on making derivatives markets safer through requiring central clearing for derivatives that can be standardised, and through the creation of margin requirements for derivatives that continue to be written and traded outside of central clearing facilities. The relevant U.S. agencies are working with their international counterparts to produce an international arrangement that will harmonise these requirements so as to promote both global financial stability and competitive parity. In addition, eight financial Journal of Regulation & Risk North Asia

market utilities engaged in important payment, clearing, and settlement activities have been designated by the Financial Stability Oversight Council as systemically important and, thus, will now be subject to enhanced supervision. Significance of changes As you can tell from my description, many of these reforms are still being refined or are still in the process of implementation. The rather deliberate pace – occasioned as it is by the rather complicated domestic and international decision-making processes – may be obscuring the significance of what will be far-reaching change in the regulation of financial firms and markets. Indeed, even without full implementation of all such new regulations, the Federal Reserve has already used its stress test and capital-planning exercises to prompt a doubling in the last four years of the common equity capital of the nation’s 18 largest bank holding companies, which hold more than 70 per cent of the total assets of all U.S. bank holding companies. The weighted tier one common equity ratio - which compares high-quality capital to risk-weighted assets - of these 18 firms rose from 5.6 per cent at the end of 2008 to 11.3 per cent in the fourth quarter of 2012, reflecting an increase in tier one common equity from US$393 billion to US$792 billion during the same period. Vulnerabilities remain Despite this considerable progress, we have not yet adequately addressed all the vulnerabilities that developed in our financial system in the decades preceding the crisis. Most importantly, relatively little has been done to Journal of Regulation & Risk North Asia

change the structure of wholesale funding markets so as to make them less susceptible to damaging runs. It is true that some of the clearly risky forms of wholesale funding that existed before the crisis, such as the infamous SIVs, have disappeared or substantially contracted. But significant continuing vulnerability remains, particularly in those funding channels that can be grouped under the heading of securities financing transactions (SFTs). Repo, reverse repo, securities lending and borrowing, and securities margin lending are part of the healthy functioning of the securities market. But, in the absence of sensible regulation, they are also potentially associated with the dynamic I described earlier of exogenous shocks to asset values leading to an adverse feedback loop of mark-to-market losses, margin calls, and fire sales. “Maturity rat race” Indeed, some have argued that this dynamic is exacerbated by a “maturity rat race,” in which each creditor acts to shorten the maturity of its lending so as to facilitate quick and easy flight, in which creditors pay relatively little attention to the recovery value of the underlying assets. With respect to the too-big-to-fail problem, actual capital levels are substantially higher than before the crisis, and requirements to extend and maintain higher levels of capital are on the way. The regularisation and refinement of rigorous stress testing may be the single most important supervisory improvement to strengthen the resilience of large institutions. The creation of orderly liquidation authority and the process of resolution planning advance prospects for increasing 77

market discipline. But questions remain as to whether all this is enough to contain the problem. The enduring potential fragility of a financial system substantially dependent on short-term wholesale funding is especially relevant when considering the impact of severe stress or failure at the very large institutions with very large amounts of such funding. Implicit funding subsidy Concern about the adequacy of policy responses to date is supported by some recent research that attempts to quantify the implicit funding subsidy enjoyed by certain institutions by looking to such factors as credit ratings uplifts, differentials in interest rates paid on deposits or in risk compensation for bank debt and equity, and premiums paid for mergers that would arguably place the merged firm in the too-big-to-fail category. The calculation of a precise subsidy is difficult, and each such effort will likely occasion substantial disagreement. But several measures provide at least directionally consistent results. In sketching out the kinds of steps needed to address these remaining vulnerabilities, let me begin with wholesale funding generally, before circling back to the question of too-big-to-fail. Short-term wholesale funding At a conceptual level, the policy goal is fairly easy to state: a regulatory charge or other measure that applies more or less comprehensively to all uses of short-term wholesale funding, without regard to the form of the transactions or whether the borrower was a prudentially regulated institution. 78

The aspiration to comprehensiveness is important for two reasons. First, the risks associated with short-term funding are as much or more macroprudential as they are firm-specific. From a microprudential perspective, SFTs are low risk, because the borrowing is short-dated, over collateralised, markedto-market daily, and subject to remargining requirements. The dangers arise in the tail and apply to the entire financial market when the normally safe, short-term lending contracts dramatically in the face of sudden and significant uncertainty about asset values and the condition of counterparties. A regulatory measure should force some internalisation by market actors of the systemic costs of this intermediation. Equivalent controls Second, to the degree that regulatory measures apply only to some types of wholesale funding, or only to that used by prudentially regulated entities, there will be a growing risk of regulatory arbitrage. Ideally, the regulatory charge should apply whether the borrower is a commercial bank, broker-dealer, agency Real Estate Investment Trust (REIT), or hedge fund. Stating the goal is easy, but executing it is not, precisely because short-term wholesale funding is used in a variety of forms by a variety of market actors. Determining appropriately equivalent controls is a challenging task and, with respect to institutions not subject to prudential regulation, there may be questions as to where, if at all, current regulatory authority resides. And, of course, there is the overarching problem of calibrating the regulation so Journal of Regulation & Risk North Asia

as to mitigate the systemic risks associated with these funding markets, while not suppressing the mechanisms that have become important parts of the modern financial system in providing liquidity and lowering borrowing costs for both financial and nonfinancial firms. For all these reasons, it may well be that the abstract desirability of a single, comprehensive regulatory measure may not be achievable in the near term. Minimum capital Still, at least as a starting point, we would do well to consider measures that apply broadly. One option is to change minimum requirements for capital, liquidity, or both at all regulated firms so as to realise a macroprudential, as well as microprudential, purpose. In their current form, existing and planned liquidity requirements produced by the Basel Committee aim mostly to encourage maturity-matched books. While maturity mismatch by core intermediaries is a key financial stability risk in wholesale funding markets, it is not the only one. Even if an intermediary’s book of securities financing transactions is perfectly matched, a reduction in its access to funding can force the firm to engage in asset fire sales or to abruptly withdraw credit from customers. Contagion risks The intermediary’s customers are likely to be highly leveraged and maturity transforming financial firms as well, and, therefore, may then have to engage in fire sales themselves. The direct and indirect contagion risks are high. Thus, the long-term and short-term liquidity ratios might be refashioned so as to Journal of Regulation & Risk North Asia

address directly the risks of large SFT books. Similarly, existing bank and broker-dealer risk-based capital rules do not reflect fully the financial stability risks associated with SFTs. Accordingly, higher, generally applicable capital charge applied to SFTs might be a useful piece of a complementary set of macroprudential measures, though an indirect measure such as a capital charge might have to be quite large to create adequate incentive to temper the use of short-term wholesale funding. By definition, both liquidity and capital requirements would be limited to banking entities already within the perimeter of prudential regulation. The obvious questions are whether these firms presently occupy enough of the wholesale funding markets that standards applicable only to them would be reasonably effective in addressing systemic risk and, even if that question is answered affirmatively, whether the imposition of such standards would soon lead to significant arbitrage through increased participation by those outside the regulatory circle. Universal minimum margining In part for these reasons, a second possibility that has received considerable attention is a universal minimum margining requirement applicable directly to SFTs. The Financial Stability Board has already issued a consultative paper, and received public comment, on the idea. Under such a regime, all repo lenders, for example, could be required to take a minimum amount of over-collateralisation as determined by regulators (the amount varying with the nature of the securities 79

collateral), regardless of whether the repo lender or repo borrower were otherwise prudentially regulated. This kind of requirement could be an effective tool to limit procyclicality in securities financing and, thereby, to contain the risks of runs and contagion. Discrete aspects Of course, it also raises many of the issues that make settling on a single policy instrument so hard to achieve, and the decision on calibration would be particularly consequential. Still, the concept has much to be said for it and seems the most promising avenue toward satisfying the principle of comprehensiveness. It is definitely worth pursuing. As you can tell, there is not yet a blueprint for addressing the basic vulnerabilities in short-term wholesale funding markets. Accordingly, the risks of runs and contagion remain. For the present, we can continue to work on discrete aspects of these markets, such as through the diminution of reliance on intraday credit in tri-party repo markets that is being achieved by Federal Reserve supervision of clearing banks and through the money market fund reforms that I expect will be pursued by the Securities and Exchange Commission. Limits on rehypothecation We might also think about less comprehensive measures affecting SFTs, such as limits on rehypothecation, when an institution uses assets that have been posted as collateral by its clients for its own purposes. But I do not think that the post-crisis programme of regulatory reform can be judged complete until a more comprehensive set of measures to address this problem is put in place. 80

Before discussing policies specifically directed at too-big-to-fail, let me say a word about the capital regime that should be applicable to all banks, on top of which any additional requirements for systemically important institutions would be built. The first order of business is to complete the Basel III rulemaking as soon as possible. The required increases in the quality and quantity of minimum capital, and the introduction of an international leverage ratio, represent important steps forward for banking regulation around the world. U.S. banks have increased their capital substantially since the financial crisis began, and the vast majority already have Tier 1 common riskbased ratios greater than the seven per cent requirements dictated by Basel III. Seek changes The new requirements, while big improvements, are not as high as I would have liked, and the agreement contains some provisions I would have omitted or simplified. In coming years we may well seek changes. Indeed, I continue to be a strong advocate of establishing simpler, standardised risk-based capital requirements and am encouraged at the initial work being done on the topic of simplification by the Basel Committee. And we will certainly simplify the final capital rules here in the United States so as to respond to the concerns expressed by smaller banks. But opposing, or seeking delay, Basel III would simply give an excuse to banks that do not meet Basel III standards to seek delay from their own governments. It would be ironic indeed if those who favour higher or simpler capital requirements were unintentionally to lend assistance to banks Journal of Regulation & Risk North Asia

that want to avoid strengthening their capital positions. In turning to specific policies to address too-big-to-fail, the first task is to implement fully the capital surcharge for systemically important institutions, the LCR, resolution plans, and other relevant proposed regulations. But, completion of this agenda, significant as it is, would leave more too-big-to-fail risk than I think is prudent. Further work What more, then, should be done? As I have said before, proposals to impose across-theboard size caps or structural limitations on banks – whatever their merits and demerits – embody basic policy decisions that are properly the province of Congress. However, that does not mean there is no role for regulators. On the contrary, Section 165 of the Dodd-Frank Act gives the Federal Reserve the authority, and the obligation, to apply regulations of increasing stringency to large banking organisations in order to mitigate risks to financial stability. In any event, it is unlikely that the problems associated with too-big-to-fail institutions can be efficiently ameliorated using a single regulatory tool. The explicit expectation in Section 165 that there will be a variety of enhanced standards seems well advised. Three complimentary ends We should be considering ways to use this authority in pursuit of three complementary ends: ensuring the loss absorbency needed for a credible and effective resolution process; augmenting the going-concern capital of the largest firms; and addressing the systemic risks associated with the use of wholesale funding. Journal of Regulation & Risk North Asia

There is clear need for a requirement that large financial institutions have minimum amounts of long-term unsecured debt that could be converted to equity and thereby be available to absorb losses in the event of insolvency. Although the details will, as always, be important, there appears to be an emerging consensus among regulators, both here and abroad, in support of the general idea. Debt subject to this kind of bail-in would supplement the increased regulatory capital in order to provide greater assurance that, should the firm become insolvent, all losses could be borne using resources within the firm. “Gone” and “Going” concerns This requirement for additional “gone concern” capital would increase the prospects for orderly resolution, and thereby counteract the moral hazard associated with expectations of taxpayer bailouts. Switzerland has already adopted a requirement of this sort, and similar proposals are being actively debated in the European Union. A U.S. requirement, enacted under the Federal Reserve’s Section 165 authority, would both strengthen our domestic resolution mechanisms and be consistent with emerging international practice. With respect to “going concern” capital requirements, there is a good case for additional measures to increase the chances that large financial institutions remain viable financial intermediaries even under stress. To me, at least, the important question is not whether capital requirements for large banking firms need to be stronger than those included in Basel III and the agreement on capital surcharges, but how to make them 81

so and with what specific risks in mind. In this regard, I would observe that our stress tests and capital-planning requirements have already strengthened capital standards by making them more forward-looking and more responsive to economic developments. Enhance stress tests As we gain experience, and as the annual process becomes smoother for both the banks and the Federal Reserve, we have the opportunity to enhance the stress tests by, for example, varying the scenario for stressing the trading books of the largest firms, so as to reflect changes in the composition of those books. As to regulatory measures of capital outside the customised context of stress testing, one approach is to revisit the calibration of two existing capital measures applicable to the largest firms. The first relates to leverage ratio. U.S. regulatory practice has traditionally maintained a complementary relationship between the greater sensitivity of risk-based capital requirements and the check provided by the leverage ratio on too much leverage arising from low-risk-weighted assets. Off-balance-sheet assets This relationship has obviously been changed by the substantial increase in the risk-based ratio resulting from the new minimum and conservation buffer requirements of Basel III. The existing U.S. leverage ratio does not take account of off-balance-sheet assets, which are significant for many of the largest firms. The new Basel III leverage ratio does include off-balance-sheet assets, but it may have been set too low. Thus, the traditional complementarity of the capital ratios 82

might be maintained by using Section 165 to set a higher leverage ratio for the largest firms. The other capital measure that might be revisited is the risk-based capital surcharge mechanism. The amounts of the surcharges eventually agreed to in Basel were at the lower end of the range needed to achieve the aim of reducing the probability of these firms’ failures, enough to offset fully the greater impact their failure would have on the financial system. At the time these surcharges were being negotiated, I favoured a somewhat greater requirement for the largest, most interconnected firms. Systemic risks Here, after all, is where the potential for negative externalities is the greatest, while the marginal benefits accruing from scale and scope economies are hardest to discern. While it is clearly preferable at this point to implement what we have agreed, rather than to seek changes that could delay any additional capital requirement, it may be desirable for the Basel Committee to return to this calibration issue sooner rather than later. The area in which the most work is needed is in addressing the risks arising from the use of short-term wholesale funding by systemically important firms. The systemic risks associated with runs on wholesale funding would, almost by definition, be exacerbated if a very large user of that funding were to come under serious stress. There could also be greater negative externalities from a disruption of large, matched SFT positions on the books of a major financial firm than if the same total Journal of Regulation & Risk North Asia

activity were spread among a greater number of dealers. Thus, in keeping with the principle of differential and increasingly stringent regulation for large firms, there is a strong case to be made for taking steps beyond any generally applicable measures that are eventually applied to SFTs or shortterm wholesale funding more generally. Disadvantages One possibility would be to have progressively greater minimum liquidity requirements for larger institutions under the LCR and the still-under-construction Net Stable Funding Ratio (NSFR). There is certainly some appeal to following this route, since it would build on all the work done in fashioning these liquidity requirements. The only significant additional task would be calibrating the progressivity structure. However, there are at least two disadvantages to this approach. First, the LCR and, at least at this stage of its development, the NSFR, both rest on the implicit presumption that a firm with a perfectly matched book is in a fundamentally stable position. As a microprudential matter, this is probably a reasonable assumption. But under some conditions, the disorderly unwind of a single, large SFT book, even one that was quite well maturity matched, could set off the kind of unfavourable dynamic described earlier. Better insulated Second, creating liquidity levels substantially higher than those contemplated in the LCR and eventual NSFR may not be the most efficient way for some firms to become better insulated from the run risk that can lead Journal of Regulation & Risk North Asia

to the adverse feedback loop and contagion possibilities discussed earlier. A more interesting approach would be to tie liquidity and capital standards together by requiring higher levels of capital for large firms unless their liquidity position is substantially stronger than minimum requirements. This approach would reflect the fact that the market perception of a given firm’s position as counterparty depends upon the combination of its funding position and capital levels. It would also supplement the Basel capital surcharge system, which does not include use of short-term wholesale funding among the factors used to calculate the systemic “footprint” of each firm, and thus determine its relative surcharge. Run susceptibility While there is decidedly a need for solid minimum requirements for both capital and liquidity, the relationship between the two also matters. Where a firm has little need of short-term funding to maintain its on going business, it is less susceptible to runs. Where, on the other hand, a firm is significantly dependent on such funding, it may need considerable common equity capital to convince market actors that it is indeed solvent. Similarly, the greater or lesser use of shortterm funding helps define a firm’s relative contribution to the systemic risk latent in these markets. If realised, this approach would allow a firm of systemic importance to choose between holding capital in greater amounts than would otherwise be required, or changing the amount and composition of its liabilities in order to reduce the contribution it could make to systemic risk in the event of 83

a shock to short-term funding channels. The additional capital requirements might be tied, for example, to specified scores under an NSFR that had been reworked significantly so as to take account of the macroprudential implications of wholesale funding discussed earlier. Meaningful counterweight If one wished to maintain the practice of grounding capital requirements in measures of assets, another possibility would be to add as a capital surcharge a specified percentage of assets measured so as to weight most heavily those associated with short-term funding. To provide a meaningful counterweight to the risks associated with wholesale funding runs, the additional capital requirement would have to be material. The highest requirement would be at just the point where a firm had the minimum required level of liquidity. The requirement then would diminish as the liquidity score of the firm rose sufficiently above minimum required levels. If the requirement were significant enough and likely to apply to any large institution with substantial capital market activities, it might also be a substitute for increasing the capital surcharge schedule already agreed to in Basel. Increasing stringency I readily acknowledge that calibrating the relationship would not be easy, and that the stakes for both financial stability and financial efficiency in getting it right would be significant. But I think this approach is worth exploring, precisely because it rests upon the 84

link between too-big-to-fail concerns and the runs and contagion that we experienced five years ago, and to which we remain vulnerable today. Whether it proves feasible, or whether we would have to fall back on the more straightforward approach of strengthening liquidity requirements for systemically important firms, the key point is that the principle of increasing stringency be applied. Of late I find myself in two minds on the question of bringing to a close the major elements of regulatory change following the financial crisis. On the one hand, I strongly believe that all the regulatory agencies should complete as soon as possible the remaining rulemakings generated by DoddFrank and Basel III. No victory yet It is important that banks and other financial market actors know the rules that will govern capital standards, proprietary trading, mortgage lending, and other activities. In fact, we should monitor whether these rules end up having significant unintended effects on credit availability and, if so, modify them in a manner consistent with the basic aims of safety and soundness and consumer protection. On the other hand, I equally strongly believe that we would do the American public a fundamental disservice were we to declare victory without tackling the structural weaknesses of short-term wholesale funding markets, both in general and as they affect the too-big-to-fail problem. This is the major problem that remains, and I would suggest that additional reform measures be evaluated by reference to how effective they could be in solving it.• Journal of Regulation & Risk North Asia

Bank capital rules

A better alternative to the Basel capital rules
Thomas M. Hoenig, director of the FDIC, urges global regulators to radically rethink their approach to bank capital standards.
Having been involved in central banking and financial supervision my entire career; I understand the importance of having the right market conditions and regulatory framework for an economic system to thrive. And most certainly I know that the foundation of a strong financial system is strong capital. For these reasons I wish to add a personal perspective on the present global discussions regarding Basel III. After reading the entire 1,000-plus page proposal, I would encourage the Basel Committee on Banking Supervision and the international regulatory community itself to step back and rethink the Basel capital standards. It may be helpful first to recall how the Basel Accords have evolved since the first agreements was reached in 1988. Following the implementation of Basel I, many in economics and finance, together with many of the world’s largest banks, wanted a more sophisticated and flexible risk-based capital standard. The U.S. chaired the Basel II Committee then, and with others, agreed that such Journal of Regulation & Risk North Asia change was necessary for the largest firms to remain globally competitive. Basel II and III were also given the task of satisfying various competing national interests, adding further complexity to the equation. As a result, the number of Basel risk weights evolved from five to thousands under the present framework. Basel’s poor record Basel III is intended to be a significant improvement over earlier rules. It does attempt to increase capital, but it does so using highly complex modelling tools that rely on a set of subjective, simplifying assumptions to align a firm’s capital and risk profiles. This promises precision far beyond what can be achieved for a system as complex and varied as that of U.S. banking. It relies on central planners’ determination of risks, which creates its own adverse incentives for banks making asset choices. The poor record of Basel I, Basel II and Basel II.5 is that of a system that is fundamentally flawed. Basel III is a continuation of these efforts, but with more complexity. It also is more prolific since it applies across all 85

banking firms. Directors and managers will have a steep learning curve as they attempt to implement these expanded rules. They will delegate the task of compliance to technical experts, and the most brazen and connected banks with the smartest experts will game the system. Private unease, public dissent In private discussions I find a good deal of uneasiness about Basel III’s ability to be more effective than previous Basel efforts; however, there appears to be an impending sense of no return. However, in my opinion we not only can go back, but we must. In my remarks to follow, I will set out my views on the role of capital and the flaws of Basel III, and then will suggest a simpler alternative designed to take us back to the basics. Capital is the foundation on which a bank’s balance sheet is built. There can be no fortress balance sheet without fortress capital. In a market economy, capital insulates a firm from unexpected shifts in risk and from losses on loans and investments gone bad. A reliable capital measure facilitates the public’s and the market’s understanding and judgment of the financial condition of a firm and industry. And finally, while essential to the health of a firm, capital has its limits. Even high levels of capital cannot save a firm from bad management or save an industry from the cumulative effects of excessive risk taking. Prior bank capital levels In judging the role of capital, it is useful to look back at bank capital levels in the U.S. before the presence of our modern safety net. Prior to the founding of the Federal Reserve 86

System in 1913 and the Federal Deposit Insurance Corporation in 1933, bank equity levels were primarily market driven. In this period the U.S. banking industry’s ratio of tangible equity to assets ranged between 13 and 16 per cent, regardless of bank size. Without any internationally dictated standard or any arcane weighting process, markets and the public required what would seem today to be excessively high capital levels. With the introduction and expansion of the safety net of deposit insurance, central bank loans and ultimately taxpayer support, the market’s capital demands changed. While the safety net protects depositors from loss and promotes stability in the system, its secondary effect has been to erode the market’s role in disciplining banks. Depositors and other creditors have come to understand that the safety net protects them far more importantly than does bank capital or good management. Pertinent questions It is important to ask where these changes have taken us. One of the most significant results has been that bank supervisors, rather than the market, have been left the difficult task of determining adequate capital for the industry. Unfortunately this has led to a systematic decline in bank capital levels. Between 1999 and 2007, for example, the industry’s tangible equity to tangible asset ratio declined from 5.2 per cent to 3.8 per cent, and for the ten largest banking firms it was only 2.8 per cent in 2007. More incredible still is the fact that these ten largest firms’ total risk-based capital Journal of Regulation & Risk North Asia

ratio remained relatively high at around 11 per cent, achieved by shrinking assets using ever more favourable risk weights to adjust the regulatory balance sheet. It is no coincidence then that the financial industry in 2008 was unable to withstand the pressures of a declining market, nor bear anywhere near the losses that the taxpayer eventually assumed. Capital rules failure It turns out that the Basel capital rules protected no one: not the banks, not the public, and certainly not the FDIC that bore the cost of the failures or the taxpayers who funded the bailouts. The complex Basel rules hurt, rather than helped the process of measurement and clarity of information. Basel III introduces a leverage ratio and raises the minimum risk-weighted capital ratios, but it does so using highly arcane formulas, suggesting more insight and accuracy than can possibly be achieved. Where the markets assess, demand and adjust intrinsic risk weights on a daily basis, regulators using Basel look backwards and never catch up. For example, people knew well in advance of the recent financial crisis that the risk on home mortgages had increased during the period between 2005 and 2007, yet no changes were made to the risk weights. Basel III still looks backward as demonstrated by the few changes made regarding the weights assigned to sovereign debt. Time to start over Finally, it is noteworthy to observe how much the industry’s capital level diverges depending on which Basel measure is reported. For Journal of Regulation & Risk North Asia

the ten largest U.S. banking organisations as of the second quarter of 2012, total Tier I equity capital was US$1.062 trillion. Total adjusted tangible equity capital was US$606 billion. In a crisis, which number counts? Given the questionable performance of past Basel capital standards and the complexities introduced in Basel III, the supervisory authorities need to rethink how capital standards are set. Starting over is difficult when so much has been committed to the current proposal. The FDIC is no different from other U.S. and international regulatory agencies where committed staff has devoted enormous effort to drafting and implementing Basel III. However, starting over offers the best opportunity to produce a better outcome. An alternative to Basel How might we better assess capital adequacy? Experience suggests that to be useful, a capital rule must be simple, understandable and enforceable. It should reflect the firm’s ability to absorb loss in good times and in crisis. It should be one that the public and shareholders can understand, that directors can monitor, that management cannot easily game, and that bank supervisors can enforce. An effective capital rule should result in a bank having capital that approximates what the market would require without the safety net in place. The measure that best achieves these goals is what I have been calling the tangible equity to tangible assets ratio.Tangible equity is simply equity without add-ons such as good will, minority interests, deferred taxes or other accounting entries that disappear in a crisis. Tangible assets include all assets 87

less the intangibles[1]. This tangible capital measure does not remove the complexities from the balance sheet. It does not attempt to differentiate risks among assets. It does not tier the measure into any number of refined levels. There is no governmental exante endorsement of risk assets or capital allocations. Simpler, stronger measure Instead, this tangible capital measure is a demanding minimum capital requirement within which management must allocate resources within the overall capital constraint. This simple measure accepts that firms quickly shift their allocation of assets to take advantage of changing risks and rewards. This simpler but fundamentally stronger measure reflects in clear terms the losses that a bank can absorb before it fails and regardless of how risks shift. It provides a consistent and comparable measure across firms. Since the federal safety net is the current substitute for capital in protecting the depositor, it also is reasonable that the supervisor should expect the same minimum capital, as would the market without the safety net. As noted earlier, the equity ratio for the banking industry before the safety net was implemented ran between 13 and 16 per cent. Therefore, the starting point for any discussion of an acceptable level of tangible equity for all banking firms should be well above the 3.25 per cent level now implied by the Basel III proposal. Assessing institutional risk Finally, under this simpler approach there remains the challenge of more precisely 88

assessing individual institutional risk and judging whether this minimum capital is adequate. That judgment should be determined through the periodic examination process, which for the largest banks has become de-emphasised in favour of stress tests. It is the often-ignored Pillar II of the Basel standards. This is no simple task. However, it is through this process, properly conducted, that supervisors can best assess a financial firm’s fundamental operations, liquidity, asset quality and risk controls. Some disregard it perhaps because they claim regulatory capture. My own experience is that commissioned examiners as a rule are highly skilled professionals, able to effectively assess bank risk. If the financial supervisors’record needs improvement, we must hold accountable the leadership of the regulatory agencies. The examination process, effectively conducted, holds the best potential to identify firm-specific risks and adjust capital levels as needed. Too little capital Some argue that a simple measure with a relatively stronger minimum capital level would reduce liquidity in the market, constrain loan growth and undermine the economy. I offer a different perspective. First, experience tells us that economies compete best from a position of strength, and a strong economy will always have banks with strong capital and balance sheets. The recent recession and credit crunch were made worse because banks had too little capital as they entered the crisis. They were forced to sell assets and shrink their balance sheets in the absence of a Journal of Regulation & Risk North Asia

strong capital cushion to absorb losses. The U.S. economy would have been significantly less harmed had the financial industry been holding adequate capital in the run up to the 2008 crisis. Liquidity & leverage Second, the term“increased liquidity”is often used when the objective is really “increased leverage.” In the growth phase of an economic expansion, borrowing is readily available, and firms and individuals easily borrow funds. Some describe this as a liquid market. A more appropriate description is leveraging up. Liquidity is the ability to convert assets to cash without loss. Leverage is expanding the balance sheet using debt. It is therefore often the case that greater balancesheet leverage results in less balance-sheet liquidity. This is especially true in a crisis. Third, a reasonable capital level does not inhibit economic growth. It sustains it. For example, a ten or higher per cent tangible capital to tangible asset ratio, depending on exam findings, allows a dollar of capital to support as much as ten dollars of loans and other assets. Leverage is permitted, and credit is available and supportive of longterm growth. Sustainable growth is enabled. Excessive growth is impeded. Equitable treatment Finally, a simple, understandable and enforceable capital standard when measured consistently, not subject to manipulation, and enforced uniformly across the industry provides for equitable treatment of all firms within the industry, from smallest to largest. In contrast, the Basel Accord would permit a commercial bank to be judged as Journal of Regulation & Risk North Asia

“adequately”capitalised having a Tier I leverage ratio of 4 per cent, which implies an even lower tangible equity ratio, so long as the total risk weighted capital ratio is above 8 per cent, and the Tier I risk weighted risk capital ratio is above 6 per cent, and the common equity Tier I risk weighted capital ratio is above 4.5 per cent. This is more complicated than simple, more confusing than clear and more easily gamed than not. In reading the Basel proposal, I am convinced that much of its complexity derives from the complexities and conflicts embedded in the combination of commercial banking and broker/dealer activities. The safety net’s enormous subsidy encourages ever-greater risk taking as firms attempt to achieve a higher return on equity than would otherwise accrue from operating the payments system and serving as a financial intermediary. In other words, from what they would earn from commercial banking. Incentive to higher risk The safety net’s subsidy facilitates the use of leverage and provides an incentive toward higher risks that are hidden in opaque instruments, in trading activities and in derivatives. It bestows an advantage to subsidised firms not afforded to others. Solving this problem requires a fundamental restructuring that separates banking from trading activities [2]. Now, in the mistaken belief that the subsidy can be neutralised, and that risks and shifting risks can be captured, measured and properly and quickly capitalised using financial models, we get Basel III. It’s time we acknowledge that no Basel model can accomplish this complex objective. Markets move too quickly, and human nature is too 89

dynamic. Basel III will not improve outcomes for the largest banks since its complexity reduces rather than enhances capital transparency. Basel III will not improve the condition of small and medium-sized banks. Applying an international capital standard to a community bank is illogical, particularly when models have not supplanted examinations in these banks. To implement Basel III suggests we have solved measurement problems in the global industry that we have not solved. It continues as an experiment that has lasted too long. Acknowledge limits We would be wise to acknowledge our limits, to simplify the system, to confine the subsidy, and to reduce the taxpayers’ exposure to enormous future liability. It is time for international capital rules to be simple, understandable and enforceable. I understand where the proposal stands and how much has been invested in drafting Basel III, but I believe the Committee should agree to delay implementation and revisit the proposal. Absent that, the United States should not implement Basel III, but reject the

Basel approach to capital and go back to the basics. By doing so, we can focus on efforts that will create a well-managed, well-capitalised, well-regulated financial system that actually supports economic growth.• Endnotes
[1] The measure of tangible equity and tangible assets used here differs from the GAAP measures, which excludes intangible assets such as goodwill, by also excluding deferred tax assets. Deferred tax assets are excluded because they are not available for paying off creditors when a bank fails, that is, they are “going concern” assets but not “gone concern” assets. [2] My proposal to limit activities supported by the public safety net by restricting commercial banking organizations to traditional banking activities and limited other intermediation activities can be found at http://www.fdic.gov/about/learn/board/ Restructuring-the-Banking-System-05-24-11.pdf

Editors note: The publisher and editor of the Journal would like to thank the Federal Deposit Insurance Corporation and the office of Thomas Hoenig for allowing us to produce an amended version of this speech.

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ournal of Regulation & Risk North Asia

Editorial deadline for Vol. V Issue IV Winter 2013/14

November 15th 2013
Journal of Regulation & Risk North Asia

90

Derivatives

Regulation of cross-border OTCs: A middle ground
SEC Commissioner Elisse B. Walter sees “substituted compliance” as a silver bullet to regulating the global derivatives market.
Today at the Securities and Exchange Commission and in government agencies around the world, regulators are shaping the rules that will govern the way over-the-counter derivatives are transacted. It’s a crucial task given the magnitude and importance of this market to the international financial system, presently estimated to be worth in excess of US$639 trillion by the Bank for International Settlements. In the process, regulatory and supervisory bodies the world over are grappling with the fact that these transactions rarely respect national boundaries. They are complex transactions that routinely cross borders, and are potentially subject to multiple sets of rules. To ensure our regimes work effectively, we need to have a common sense, flexible approach to the cross-border regulation of the derivatives market. As most are aware, following the financial crisis there was a new focus placed on the regulation of over-the-counter (OTC) derivatives – and for good reason. The experiences of companies like AIG highlighted Journal of Regulation & Risk North Asia how the default – or even the threat of a potential default – of a single party involved in a series of derivatives transactions could create widespread instability. Spill-over We all witnessed that it didn’t matter whether the counterparty or trading desk was based in the U.S. or overseas, or whether the contract was executed in Miami or Milan. What mattered was that the potential spill-over ultimately limited the willingness of market participants worldwide to extend credit. In the United States, Congress passed the Dodd-Frank Act in August 2010 mandating the creation of a new regulatory environment to govern this multi-trillion dollar market – a market that U.S. regulators previously had been largely barred from regulating. Split responsibilities The Commodities Futures Trading Commission (CFTC) was given responsibility for “swaps,” and the Securities and Exchange Commission (SEC) for a portion of the OTC derivatives market known as“security-based 91

swaps” – those which include, for example, swaps based on a security, such as a stock or bond, or credit default swap. Increased focus But the increased focus on OTC derivatives regulation was not exclusively restricted to the United States. Other regulators and governments across multiple jurisdictions, among them Canada, the European Commission, Hong Kong and Japan, also sought to address the tremendous risks associated with derivatives transactions. And they came to the conclusion that a worldwide comprehensive scheme of regulation would be necessary. Consistent with this effort, the leaders of the G-20 group of leading economies committed to a global effort to regulate OTC derivatives with the stated goals of mitigating systemic risk, improving market transparency, and protecting against market abuse. A key element of the policy statement concerns how we intend to apply our rules to cross-border activities. We have committed to issuing this cross-border proposal before fully implementing our regulatory framework. To help ensure we get this right, both the SEC staff and I have spent countless hours meeting with other regulators in the U.S. and around the globe who are also dealing with these same issues. Sensible and crucial Of course, trying to get all the various regulatory pieces to fit together in a sensible way is crucial for a derivatives market that is international in scope. This is because a party to any transaction needs to know which laws it 92

must abide by when its transaction touches more than one country. This cross-border challenge has not manifested itself in the same way for other securities and financial products as it has for the OTC derivatives markets – in part because of the way in which those markets developed. Consider securities regulation, which predated the technology that made crossborder transactions feasible on a large scale. For many years’ securities regulation was largely crafted with only domestic markets and domestic market participants in mind. Over time, as cross-border activities became more common in various parts of the securities arena, regulators began to address questions that arose on an issueby-issue basis. A holistic approach to considering cross-border securities transactions generally wasn’t considered because, frankly, it wasn’t needed. Now, with derivatives, it is. Explosive growth In sharp contrast to the traditional securities markets, the multi-trillion dollar OTC derivatives market became a significant market well after the advent of global trading – exploding in size over the last 20 years, operating relatively seamlessly across jurisdictions, and evolving largely without regulatory restraints. Today, cross-border derivatives transactions are the norm, not the exception. Therefore, once regulations are implemented across the major derivatives jurisdictions, the majority of derivatives transactions could be subjected to multiple regulatory regimes. The potential for conflicts among those regimes is obvious. Against this backdrop of conflicting or contradictory rules, market Journal of Regulation & Risk North Asia

participants have the ability to move – or restructure – their OTC derivatives activity with relative ease, avoiding more regulated markets, in search of less regulated ones. After all, derivatives are contracts between counterparties and need not be anchored to any particular geographic location or specific market. A “race to the bottom” Some refer to the threat of migration to less regulated jurisdictions as regulatory arbitrage; others a “race to the bottom.” But whatever terminology used, this very real possibility threatens the objectives of all of us who seek to reduce systemic risk, improve transparency, protect against market abuse and ensure the global system functions properly. In a nutshell, both investors and markets deserve better. That means that getting these crossborder issues right for OTC derivatives is crucial. I know that. And my domestic and international counterparts know that. Yet, as we build this new framework from the ground up and with a common set of goals, we must accept that each jurisdiction necessarily is approaching derivatives reform from a slightly different direction. Differing perspectives Countries come at the process from different historical, legal and regulatory perspectives, and move forward at different speeds. No amount of effort is going to completely reconcile these differences. After many years of regulatory experience, I have learned that it may not be fruitful to try to convert one another to our own particular regulatory philosophies. Instead, we should continue Journal of Regulation & Risk North Asia

to expend our energy on a search for compatible, rather than identical, approaches to cross-border issues. Gaps, overlaps, conflicts This means ensuring that our different regulatory regimes do not produce the gaps, overlaps or conflicts that could disrupt the global derivatives market and lead to regulatory arbitrage. Focusing on “compatible” rather than “identical” regulation brings us close to a system that achieves our collective goals of mitigating systemic risk, improving transparency, and protecting against market abuse, while also recognising the legitimate and important differences between our regulatory regimes and markets. The importance of a compromise approach becomes evident when we look at the spectrum of approaches available. The “all-in” approach At one end of the spectrum is the view that any transaction that touches a jurisdiction – or a person in that jurisdiction – in any way, needs to be subjected to the entire range of regulatory requirements specific to that jurisdiction. This I will define as the “all-in” approach. Although this approach gives full weight to the unique requirements of local law, I am concerned that subjecting any derivatives transaction – that has any connection to a country – to all of the rules and regulations of that country risks unnecessary duplication and conflict. Indeed, to the extent that two sets of rules conflict, this approach would place market participants engaging in a cross-border 93

transaction in the untenable position of choosing which country’s requirements to violate. Market participants may have to withdraw from one of those markets or incur the costs associated with restructuring their business. Equivalence and recognition At the other end of the spectrum is the view that broad deference should be given to a foreign jurisdiction’s full regulatory regime – in lieu of one’s own regulatory regime – so long as it is comparable in its objective. Market participants, intermediaries, and infrastructures would be subject to one set of rules for their cross-border activity.The entire regime is recognised as comparable or not comparable. It’s all or nothing, an approach that is often referred to as “equivalence” or “recognition.” Along these lines, some proponents of this approach also demand reciprocal treatment. In other words, “I will recognise the comparability of your rules only to the extent that you recognise the comparability of mine.” At first glance, a recognition approach may appear reasonable and consistent with a desire to reduce conflicts, inconsistencies, and duplicative requirements among regulatory regimes. Serious concerns However, as I have discussed the details with my foreign counterparts, I have developed increasingly serious concerns about the potential consequences of an“all or nothing” approach to cross-border OTC regulation. Recognition may be an important tool in crafting cross-border regulation in some 94

contexts, but wholesale recognition cannot be the exclusive tool if it means that critical regulatory requirements in one regime are jettisoned as a result. Further, I become particularly concerned when such wholesale recognition is combined with reciprocity. In other words, “I refuse to recognise your regime unless you recognise mine as equivalent in all respects.” Quid pro quo consequences In my opinion, tying recognition and reciprocity does not move us toward our united goals. This is a because a regulator might feel compelled to recognise a foreign country’s regulations as “equivalent”, solely to avoid the quid pro quo consequences of not having its own regulations deemed“equivalent” in return. In turn, the regulator might feel pressure to gloss over major differences and make a sweeping equivalency determination – that is even when a regime imposes a critical policy requirement and the foreign regime does not. Forced to submit This type of recognition, driven by the threat of reciprocity could actually create regulatory gaps between these so-called “equivalent” regimes, allowing certain market participants to exploit the differences and escape important requirements by simply choosing to comply with the more permissive regime. Additionally, a regulator may feel forced to submit to the threat of not being eligible for recognition treatment because its own regulated entities could suffer if the foreign country does not recognise that equivalence exists. This could happen when Country A Journal of Regulation & Risk North Asia

chooses not to allow market participants from Country B to do business in Country A unless Country B deems the other country’s regulatory regime to be equivalent. I am particularly concerned that this forced recognition approach could substantially disrupt an established market and spark a regulatory race to the bottom, as regulators facing such “equivalency” determinations realise the apparent futility of maintaining comparatively higher standards in key policy areas. Sparking a trade war On the other hand, such a situation could spark a type of trade war in financial services, and lead to fragmentation of the global marketplace. Given that neither of these are welcome developments, perhaps we require a third way, or middle ground In short, subjecting every OTC derivatives transaction that touches the United States in some way to all aspects of U.S. law – that is, the “all-in” approach - ignores the realities of the global marketplace. And yet, treating clearly different regimes as equivalent across all key policy areas risks are set to create regulatory gaps, regulatory arbitrage, and a potential regulatory race to the bottom. Middle ground Given the aforementioned issues, it is my contention that a middle ground actually exists to resolve the problems highlighted thus far. That said, the Commission has not yet, as a body, proposed the specifics of this approach. However, I personally support an approach that would permit a foreign market participant to comply with requirements imposed by its home country that are Journal of Regulation & Risk North Asia

comparable with U.S. regulation, so long as it abides by U.S. requirements in areas where the home country’s regulations are not comparable. I refer to this as approach as“substituted compliance”, one that accepts the inevitable differences between regulatory regimes when those differences nevertheless accomplish similar results. There’s no “my way or the highway.” Instead, parties may substitute compliance with one regulatory regime for another. But we would reserve the right to insist upon compliance with our own regulations when necessary. It’s an approach that focuses on what we see as real threats to the Dodd-Frank goals of stability, transparency, and investor protection. Flexibility For example, the SEC could make a determination that would allow market participants based in a foreign jurisdiction to follow their own jurisdiction’s capital requirements. But at the same time, the SEC could require these market participants to follow SEC rules concerning, for instance, public reporting requirements, if the foreign jurisdiction itself did not have a comparable set of public reporting requirements. This approach provides flexibility to market participants and regulators alike, allowing us to eliminate duplicative regulation when it is truly duplicative, while recognising that regulatory regimes will necessarily differ in some respects. While “substituted compliance” does envision looking at different pieces of a jurisdiction’s set of rules, I do not believe that the ultimate determination of substituted compliance will be based on a line-by-line 95

comparison of those rules. Instead, in making a substituted compliance determination, one would look at key categories of regulation. Retain focus on outcomes In addition, one would keep the focus on regulatory outcomes, not the means of achieving those outcomes. Of course, in making these determinations, one would look not just at the way in which a country’s laws and regulations are written, but also, and crucially, at how that country supervises and enforces compliance with its rules. At this point, I cannot stress how important this aspect of the “substituted compliance” approach is to me. After all, effective regulation does not end with the writing up of rules. Rules must be the starting point and effective supervision and enforcement of those rules is key not only to achieving the G-20 goals, but also to advancing the SEC’s core mission to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. For all of these reasons, I believe that the “substituted compliance”approach provides a workable method and a necessary balance within the global market and regulatory environment in which we operate. Public reporting requirement During discussions with the SEC staff, I have learned that the distinction between substituted compliance and what I call recognition and reciprocity is sometimes elusive. Given this unfortunate fact, the problem can best be summed up in the following illustration. Let’s consider the public reporting requirements I mentioned earlier in this 96

paper. As most are aware, the Dodd-Frank Act requires that transaction, volume, and pricing data of all security-based swaps be publicly disseminated in real time, except in the case of block trades. These requirements are designed to promote transparency and efficiency in the security-based swap market, by providing more accurate information about the pricing of security-based swap transactions, and thus about trading activity. Promoting transparency and efficiency in the security-based swap market is one of the primary goals of the new regulatory framework established by the Dodd-Frank Act. It is not an afterthought. Bringing sunshine Given the key role that public transparency requirements play in U.S. efforts to bring sunshine to the largely opaque OTC derivatives markets, I fully expect that public reporting would be one of a number of key categories of requirements that would be the focus of a substituted compliance determination for foreign regulatory regimes. But the fact that a foreign regulatory regime might not be comparable to ours with respect to public transparency should not be fatal to an SEC substituted compliance determination in other areas. In fact, the SEC could still recognise other areas of a foreign regulatory regime – such as mandatory clearing or capital requirements. Foreign market participants would, however, continue to be subject to the SEC rules regarding public reporting. This outcome under a substituted compliance approach contrasts markedly with what might be described as the “rock and Journal of Regulation & Risk North Asia

a hard place” approach that an equivalence determination for an entire foreign regulatory regime would present. If the SEC were to adopt such a “recognition and reciprocity” approach, we would be faced with the difficult choice: either not make an equivalence determination with respect to the foreign regime, or to determine that a foreign regulatory regime is “equivalent” – even if a key aspect of our regulatory regime were absent. Much needed stability I recognise, of course, that the differences between substituted compliance in specific regulatory areas and an equivalence determination for an entire foreign regulatory regime raise difficult issues and there are many competing interests. And regulators, myself included, can have very strong views about what constitutes the right approach. I nonetheless am committed to resolving these and other difficult issues. I am also gratified that our regulatory partners are equally determined to fashion arrangements that support investor protection and capital formation, while bringing much needed stability to our global financial system. Aligning regimes Clearly it will be crucial to align the different regulatory regimes for cross-border transactions in a way that minimises the risk of gaps, conflicts, and inconsistencies. But this is not the only consideration in working through effective regulation in the cross-border arena. Also crucial will be for regulators to make sure that their different regimes work together, for example, to Journal of Regulation & Risk North Asia

provide comprehensive data on cross-border transactions. This is important because the relevant authorities must have an accurate view of the global derivatives market through access to data they need to carry out their mandates. Comprehensive information helps regulators identify and address systemic risk and promote stability across markets, as well as monitor, and protect against, market abuse. However, compiling comprehensive transactional data is challenging enough in a complex domestic market. And, it gets far more complicated in the cross-border world of derivatives, where for example, the vast majority of credit default swaps cross national borders. Fortunately we’re not starting from scratch. Regulation reporting goals It is estimated that at least some information on well over 90 per cent of outstanding gross notional amounts in credit derivatives were reported to a trade repository at the end of 2012. However, submission of this information was largely voluntary, and the result of substantial supervisory encouragement. Further, it did not include all the information regulators need to effectively oversee this market. One goal of regulation in this area is to increase the quality and quantity of information reported to trade repositories, so that regulators have the data they need to do their jobs. There are, however, challenges to getting the data that regulatory authorities require. Certain countries, for example, have privacy laws, blocking statutes, and other laws that restrict or limit the disclosure of certain 97

information about trade counterparties. Such measures may interfere with global regulatory reporting by prohibiting or limiting entities from reporting the identity of their counterparty into trade repositories – thereby undermining the usefulness of these repositories. Regulators internationally, as well as individual jurisdictions, are actively working to develop potential cures. Interim solution As an interim solution, some market participants have received temporary relief to submit reports to certain trade repositories with “masked” data – that is, data that includes some, but not all, of the required relevant information. This is of course a temporary, pragmatic fix to an immediate challenge arising from the new regulatory regime for reporting. However, it is clearly not a longterm solution. Regrettably, potential impediments are not solely the province of foreign law. Another challenge to getting data comes from the Dodd-Frank Act itself. That Act requires regulators to agree to bear certain potential costs arising from data sharing. In particular, before an SEC-registered trade repository can share information with a domestic or foreign regulator other than the SEC, the regulator must agree, among other things, to indemnify the trade repository for certain litigation expenses that may be incurred by the repository. The CFTC has a similar provision. Open-ended indemnification We understand that foreign authorities may be prohibited under their laws from satisfying the indemnification requirement. In fact, 98

even certain U.S. authorities, are not permitted to provide an open-ended indemnification agreement. Given the limitations of the indemnification requirements, foreign regulators have expressed concerns about their ability to directly access data held in an SEC or CFTCregistered trade repository. That is why the SEC has publicly advocated for a legislative fix and is considering ways to address this issue in our forthcoming proposal on crossborder issues. More generally, I can tell you that I personally am committed to doing what I can to make sure that comprehensive data on the global OTC derivatives market are made available to all regulators with a missionbased need for that information. As one of the regulators charged with reforming the OTC derivatives market, I believe the SEC and fellow regulators must strive for no less. Conclusion In short, I believe that the regulators of OTC derivatives across the globe working together in good faith and common purpose can bring about a more stable, more transparent, and fairer OTC derivatives market, while preserving its global, dynamic character. But I believe we will succeed only if we find the middle ground. There is far too much at stake, in my view, for regulators to do any less. • Editors note: The publisher and editor of the Journal would like to thank the Securities and Exchange Commission and the office of Commissioner Walter for allowing us to produce an amended version of this speech delivered in April this year. Journal of Regulation & Risk North Asia

Central banking

Lessons from the crisis: The flaws of inflation targeting
Former ECB executive board member, Otmar Issing, cautions central banks not to ignore past lessons on inflation targeting.
There is consensus that not since the Great Depression has the world seen a crisis of the dimension which became obvious after 2007. Fiscal policy became expansionary with exploding public deficits. Central banks worldwide reduced their interest rates to zero or at least to levels not seen before and on top conducted various unorthodox operations. The combination of these measures prevented a repetition of the collapse of production and surge in unemployment, which happened after 1929. At the same time a discussion started about what lessons should be drawn from this recent experience. Every crisis also opens an opportunity. The challenge of this crisis for policymakers and researchers is to identify which factors were decisive for all these problems and what could be done to increase our knowledge and improve policy to prevent a repetition of past mistakes and, hopefully, the emergence of new crises. To be clear, the idea cannot be to avoid any ups and downs of the economy. Cyclical Journal of Regulation & Risk North Asia movements are an unavoidable and even necessary element of any dynamic economy. However, in the future, any financial crisis of the dimension just seen must be prevented. A flood of studies on “lessons” gives the impression that research has taken up this challenge. On monetary policy, a legion of papers has already been published (e.g., Bean, 2010; Clarida, 2010; Fahr and others, 2010; Mishkin, 2010; and Svensson, 2009), and many more will follow. A number of papers discuss issues in the broader context of general macro and/or macroprudential aspects (Blanchard, Dell’Ariccia, and Mauro, 2010; and IMF, 2010). Pre-crisis consensus Most approaches start from what is seen as the pre-crisis consensus. Whereas the details may differ, the result boils down to inflation targeting as state-of-the-art monetary policy. And, after reflections on what lessons to take from the crisis – for a thorough analysis see Mishkin (2010) – the conclusion is that this strategy is still optimal. “The case for the basic monetary policy strategy, which for want of a better name, I have called flexible 99

inflation targeting, is still as strong as ever, and in some ways, more so”(Mishkin, 2010, p. 48). Another prominent advocate comes to this result: “In the end, my main conclusion so far from the crisis is that flexible inflation targeting, applied the right way and using all the information about financial factors that is relevant for the forecast of inflation and resource utilisation at any horizon, remains the best-practice monetary policy before, during, and after the financial crisis.” (Svensson, 2009, p. 7) Flaws in the strategy With all respect for highly influential research, this statement immunises the strategy against any critique [1]. And stating that a strategy, which fulfils these demanding conditions is best practice comes close to tautology. But beyond that, this defence of inflation targeting implies the pretension that previous versions fulfilled the principle of “using all information.” Looking back to the performance of the strategy, it is hard to accept this as a convincing statement. Most papers on “lessons”, such as those mentioned, start from the assumption that flaws in the strategy can be corrected by adding factors missing so far but do not put into question the concept as such. Is this not fighting the last war and risking losing the next one, too? A robust framework Would it not be more promising to start from identifying the principles of a framework that is robust under any conditions and challenges that lie in the future? This was at least our ambition at the European Central Bank (ECB) when we designed our strategy 100

under the motto,“The need for robustness in a world of uncertainty”(ECB, 2000)[2]. It is no exaggeration to say that for many years,“money”– in a very broad sense – was widely ignored in mainstream economics. To a large extent this was also the case in central banks. Overall, the fundamental argument was that for reasons of financial innovation, the historical relationships between “money”, nominal GDP growth, and inflation had broken down. Velocity had become unpredictably volatile[3]. This verdict on “money” refers, in the first place, to the relation between monetary aggregates and inflation. However, the neglect extended to monetary factors in general, including the composition of monetary aggregates and their counterparts, above all credit. Monetary factors Now the tide seems to turn. Interestingly, it is the financial crisis that has triggered the consideration of whether asset price booms caused by credit expansion should not be a matter of concern (Blinder, 2010; Mishkin, 2010). There should have been ample evidence before the crisis that money and especially credit can be a driving factor of asset prices. [4] Research by the BIS (e.g., Borio and Lowe, 2002; Borio and Lowe, 2004) and by the ECB (e.g., Detken and Smets, 2004) support the view that nearly all major unsustainable booms in asset prices were accompanied if not preceded by strong increases in credit and/or money. Monetary factors – I use this term in a broad sense, including credit in all its manifestations – can be used for the analysis of on-going asset price developments as well Journal of Regulation & Risk North Asia

as for forecasting those developments (ECB, 2010a; ECB, 2010b; Gerdesmeier, Reimers, and Roffia, 2009). A central bank that monitors the development of money and credit and takes these factors into account when making monetary policy decisions therefore implicitly applies a “leaning against the wind strategy”without having to identify the emergence of bubbles (or the opposite). The role of macroprudential tools In a world of globalised financial markets, “domestic” money and credit, and therefore asset prices (as well as domestic inflation), might be influenced by global developments. This aspect has been studied by a number of papers (e.g. Sousa and Zaghini, 2004; Borio and Filardo, 2007; Rüffer and Stracca, 2007; Alessi and Detken, 2009; Ciccarelli and Mojon, 2010). This leads to the question of what a central bank can achieve acting alone and what would then be the consequence for the exchange rate. As already discussed, notwithstanding the fact that macroprudential tools should play a major role, the challenge for monetary policy is how to integrate asset price considerations – that is,“leaning against the wind”– into the monetary policy strategy. For inflation targeting this seems very hard to do. Judging the transmission mechanism Inflation targeting, with all its refinement, is based on a forecast for (goods price) inflation using models in which monetary factors do not play an active role. Including“frictions”in such models might be useful as a research strategy, but cannot give practical advice to monetary policymakers (see e.g. Curdia Journal of Regulation & Risk North Asia

and Woodford, 2010). Svensson (2009, p. 7) makes a rather sober statement:“Before such extensions of the modelling framework are operational, policymakers and staff have to improvise and apply unusual amounts of judgement on the effects of the financial crisis on the transmission mechanism. Even with much better analytical foundations concerning the role of financial factors in the transmission mechanism, there will be of course, as always, considerable scope for the application of good judgement in monetary policy.” Anchoring expectations This “confession” raises fundamental questions on appropriate communication, on the predictability and credibility of the central bank, and finally on anchoring inflation expectations. Is it unfair to say that what was once seen, as the “beauty” of an approach connecting monetary policy decisions with the forecast of inflation seems now to be more or less dissolved? The fundamental problem of inflation targeting becomes obvious in a situation in which the forecast for (goods price) inflation signals“no need to change central bank interest rates”or might even indicate downward risks, whereas credit (and money) are rising together with asset price increases. The“risk taking channel”(Borio and Zhu, 2008; Adrian and Shin, 2009) explains how low interest rates foster the emergence of financial imbalances and create the risk of a collapse in asset prices (see also BIS, 2010), a theory which Rajan (2005) had already developed in the“search for yield”approach. How can the challenge stemming from low interest rates, the development of 101

money and credit, and risks of asset price imbalances be reconciled with the philosophy of inflation targeting? Is the solution as simple as ignoring the fundamentals of this approach and applying“good judgement”? A two-pillar strategy Taking asset price developments into account is a challenge for any monetary policy strategy. Monetary factors are and will remain an alien element in inflation targeting. However, they were important in the ECB’s monetary policy strategy.“Money”was given a prominent role from the beginning. In contrast to what is still said to discredit this strategy by calling it monetary targeting (Clarida, 2010, p. 2), the ECB explicitly rejected that approach from the start [5]. Monetary analysis and economic analysis are the “two pillars” of the ECB’s strategy, connected via crosschecking into an integrated approach (see e.g. Beck and Wieland, 2008). As intended from the beginning, monetary analysis was deepened and broadened over time (Issing, 2005). Analysing the developments of different monetary aggregates, components, and their counterparts by monitoring all aspects of credit is a huge challenge, but serves to deliver important insights (see Papademos and Stark, 2010; ECB, 2010b) [6]. Delivering price stability Important as money and credit are in the context of asset price developments, the fundamental question is which role these factors should play in a monetary policy strategy designed to deliver price stability. Neglect of money and credit was a common 102

factor not only in academic research (see e.g. Woodford, 2003; Eggertson and Woodford, 2003), but also in a number of central banks (see Meltzer, 2009). That said, being fully aware of all the problems demonstrated over time by a lot of research, I never understood how monetary policy could ignore “money” and how the central bank should not be concerned about“money creation.” There is of course a complex transmission mechanism from central bank money to the narrow and, even more so, to the broad monetary aggregates and credit – as well as the reverse – to nominal GDP, the real economy, and prices. Even the definition of what is“money”is anything but easy, and measuring“credit”is not simple either. Here is not the place to try even a modest assessment of the result of libraries of research. I would however like to make just two points. Linking monetary growth to inflation There is hardly any dissent from the view that in the long run, inflation is a monetary phenomenon. Lucas (1996) refers to the overwhelming empirical evidence and sees as a consequence that the relationship between monetary growth and inflation “needs to be the central feature of any monetary or macroeconomic theory that claims empirical seriousness.”Or as King (2002) phrased a headline:“No Money, no Inflation.” So, the question cannot be if, but rather how central banks should take this relationship into account when assessing risks to price stability and making monetary policy decisions. With its monetary policy strategy, the ECB has taken up this challenge. It has never claimed that its approach would provide the final answer. Journal of Regulation & Risk North Asia

However, it seems strange to me that critiques were directed mainly at giving monetary factors a role at all – without presenting an alternative that would meet this challenge in a better way. Higher inflation target? Admittedly, the strategy could not be formulated in an elegant model like (however, only initially) inflation targeting, and from the beginning it included an element of judgement. As a consequence, it lacked the “elegance”which made it obviously unattractive to academics. The discussion on the consequences of the crisis for the optimal monetary policy is on-going (see Issing 2010 and Issing 2011). As already mentioned, a number of central banks have reduced their interest rates to zero or close to zero [7]. While the nominal interest rate cannot be reduced below zero, the challenge from the “zero bound” has been discussed for some time. Central banks in the meantime have demonstrated that monetary policy has efficient tools also in such an environment. A price “too costly” Another approach to deal with this problem is to raise the inflation target in order to achieve more room for manoeuvre to reduce interest rates in case of major shocks. Blanchard, Dell’Ariccia, and Mauro (2010) argue in favour of raising the target, because the zero nominal interest rate bound has proven too costly in the context of the recent crisis. To avoid the costs of higher inflation, they suggest changes in the tax system and to the issuance of indexed bonds. Evidence Journal of Regulation & Risk North Asia

from a large bulk of studies conducted during times of high inflation does not suggest that this is either easy to implement or efficient. However, there is another dimension of economic and social costs, which go far beyond those calculations - the loss of credibility of central banks, having successfully convinced the public and markets that low and stable inflation is essential. By raising the inflation target, wellguided inflation expectations would lose their anchor. Why should people believe that a target once increased is now the “final”limit? What arguments could be used tomorrow in favour of another increase? It is hard to imagine that central banks could stabilise inflation around the new target. And even if they were successful, higher inflation volatility would be unavoidable. Defining price stability In this context, it has to be mentioned that defining “price stability” as an annual inflation rate of not more than 2 per cent is already not easy to explain to the general public. Such a number is already a compromise and violates in some respect the principles of stable money. It is not so long ago that “zero inflation” was debated, and there is still research on the optimal inflation rate that results in rates below 2 per cent [8]. How could a central bank like the ECB with a constitutional mandate of maintaining price stability argue that this is consistent even with a target of, for example, 4 per cent inflation? When the ECB evaluated its monetary policy strategy, it also studied the risk of the zero bound and the appropriate definition of price stability (Issing, 2003). As a result, 103

strong arguments against an “upper bound” of more than 2 per cent were presented. Raising the target A fundamental objection against the consideration to raise the target in order to have more room for reducing central bank interest rates in case of a major shock is the fact that the“need”for this flexibility is not independent of the preceding monetary policy. Raising the target, with all the consequences mentioned, would lead to stronger growth of money and credit, thereby contributing to, if not causing, monetary imbalances and asset price booms. According to the logic of the argument, the subsequent collapse of asset prices might implicitly deliver new arguments for further raising the inflation target [9]. As a consequence, it becomes obvious that the idea of raising the inflation target has to be seen in the context and as a consequence of an activist monetary policy with a strong commitment to steer output and employment. A dual mandate? This leads to the question of the mandate of the central bank, which is also discussed as a consequence of the crisis. No central bank will ignore the situation of the real economy and the impact of its policy. A central bank will take those considerations best into account by conducting a medium-termoriented monetary policy to maintain price stability, anchoring inflation expectations and avoiding fine-tuning. This is in line with a single mandate to maintain price stability. For a central bank with a dual mandate, it might be very difficult to explain the limits of what it can do – or 104

rather cannot do – especially in the case of structural unemployment. The most likely outcome of a dual mandate will be that the central bank is trying to achieve one objective at a time (Meltzer, 2009). This approach can hardly be reconciled with a monetary policy in which monitoring money and credit is an essential element of a medium-term orientation. Allocating responsibility Central banks, whether on the basis of a formal mandate for financial stability or as an informal obligation as a consequence of the recent crisis, will be confronted with a tremendous challenge. For a central bank with a medium-term orientation, taking developments of money and credit into account while focussing on maintaining price stability, implies a strong presumption that monetary policy itself will not cause major financial imbalances but further contribute to financial stability. This is not at all an argument against macroprudential supervision and regulation. How responsibility in this field should best be allocated is a difficult question. The independence of the central bank would clearly be hard to defend if it also had the competence and power to deal with individual financial institutions up to the question of whether or not such a firm should be closed. The crisis management and some forms of unorthodox measures or quantitative easing have also raised concerns about the relation of the central bank to the fiscal authority. Whatever the outcome, the world of central banking will undoubtedly never be the same (see e.g. Goodhart, 2010). However, Journal of Regulation & Risk North Asia

this is no reason to ignore the principles of sound monetary policy, which were developed over time. Progress in policy comes as a result of crises, and research has to work on the scientific foundation for conducting good policies. Both central banks and research have to take “lessons”– hopefully, the right ones.• Endnotes
[1] In this context it is interesting to follow the headlines under which this approach was presented: From “inflation targeting” to “inflation targeting with judgement” to “flexible inflation targeting” (see e.g., Svensson, 2005).To be fair, authors representing this philosophy acknowledge now that financial factors have to be taken into account. How far is this driving flexibility? [2] It is worthwhile to quote from this early publication (p. 45): “The ECB’s strategy embodies a ‘full information’ approach in a broad sense, that is, it is a framework that not only encompasses all relevant information, but also takes into account various, possibly different interpretations of this information. Against this background, the strategy adopted by the ECB represents a framework that reduces the risks of policy errors caused by overreliance on a single indicator or model. Since it adopts a diversified approach to the interpretation of economic conditions, the ECB’s strategy may be regarded as facilitating the adoption of a robust monetary policy in an uncertain environment.” [3] However, Meltzer (2009) shows that annual data delivers a stable relationship for the US. See also Lucas (2007). [4] For an interesting “loop” in research on the relationship between large movements in money and credit and boom-bust cycles in asset prices, see Fisher (1932) or Hayek (1933).

[5] See for example the headline,“Deciding Against a Monetary Target,” in Issing (2008, p. 93) and Issing, and others (2001). [6] An interesting approach is Shin and Shin (2011), which distinguishes monetary aggregates on the criterion of the money-holding sector and differentiates between bank and market-dominated financial systems. [7] Some suggestions to make this possible are purely hypothetical. [8] Schmitt-Grohé and Uribe (2010), for example, discuss optimal inflation rates of at most zero per cent a year. [9] Blanchard et al. (2010) also mention shocks like terrorist attacks. But is this a challenge for the zero bound?

References
Adrian,Tobias, and H. S. Shin, 2009,“Prices and Quantities in the Monetary Policy Transmission Mechanism,” International Journal of Central Banking, December. Alessi, Lucia, and Carsten Detken, 2009, “Real Time Early Warning Indicators for Costly Asset Price Boom/Bust Cycles:A Role for Global Liquidity,” ECB Working Paper No. 1039. Bean, Charles, 2010, “Monetary Policy After the Fall,” paper presented at the Federal Reserve Bank of Kansas City Annual Conference, Jackson Hole, August 28. Beck, Günter, and Volker Wieland, 2008, “Central Bank Misperceptions and the Role of Money in Interest Rate Rules,” Journal of Monetary Economics. Bank for International Settlements (BIS), 2010, 80th Annual Report (Basel). Blanchard, Olivier, Giovanni Dell’Ariccia, and Paolo Mauro 2010, “Rethinking Macroeconomic Policy,” Journal of Money, Credit and Banking,Vol. 42, No. 6, Suppl.

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Blinder, Alan S. 2010, “How Central Should the Central Bank Be?” Journal of Economic Literature, March. Borio, Claudio E.V., and Andrew Filardo, 2007, “Globalisation and Inflation: New Cross-Country Evidence on the Global Determinants of Domestic Inflation,” BIS Working Paper No. 227. Borio, Claudio E. V., and Philip Lowe, 2002, “Asset Prices, Financial and Monetary Stability: Exploring the Nexus,” BIS Working Paper No. 114. Borio, Claudio E.V., and Philip Lowe, 2004, “Securing Sustainable Price Stability: Should Credit Come in From the Wilderness?” BIS Working Paper No. 157. Borio, Claudio E. V., and Haibin Zhu, 2008, “Capital Regulation, Risk-Taking and Monetary Policy:A Missing Link in the Transmission Mechanism,” BIS Working Paper No. 268. Cicarelli, Matteo, and Benoit Mojon, 2010, “Global Inflation,” Review of Economics and Statistics. Clarida, Richard H., 2010, “What Has—and Has Not – Been Learned About Monetary Policy in a Low Inflation Environment? A Review of the 2000s”, October 12. Curdia,Vasco, and Michael Woodford, 2010, “Credit Spreads and Monetary Policy,” Journal of Money, Credit and Banking,Vol. 42, pp. 3–35. Detken, Carsten, and Frank Smets, 2004, “Asset Price Booms and Monetary Policy,” in Macroeconomic Policies in the World Economy, ed. by H. Siebert (Berlin: Springer). Eggertson, G., and Michael Woodford, 2003, “The Zero Bound on Interest Rates and Optimal Monetary Policy,” Brookings Papers on Economic Activity. European Central Bank (ECB), 2000, “The Two Pillars of the ECB`s Monetary Policy Strategy,” Monthly Bulletin, November. ECB, 2010a, “Asset Price Bubbles and Monetary Policy Revisited,” Monthly Bulletin, November. ECB, 2010b,“Enhancing Monetary Analysis,” Monthly Bulletin, November.

Fahr, Stephan, Roberto Motto, Massimo Rostagno, Frank Smets, and Oreste Tristani, 2010, “A Monetary Policy Strategy in Good and Bad Times: Lessons from the Recent Past,” presentation at the Sixth ECB Central Banking Conference, Frankfurt, November 18–19. Fisher, Irving, 1932, Booms and Depressions, (New York: Adelphi). Gerdesmeier, Dieter, H. E. Reimers, and Barbara Roffia, 2009,“Asset Price Misalignments and the Role of Money and Credit,” ECB Working Paper No. 1068. Goodhart, Charles A. E., 2010, “The Changing Role of Central Banks”, BIS Working paper No. 326. Hayek, Friedrich August, 1933, Monetary Theory and the Trade Cycle (London: Jonathan Cape). IMF, 2010,“Central Banking Lessons from the Crisis,” IMF Policy Paper, May 27 . Issing, Otmar, 2003, Background Studies for the ECB’s Evaluation of its Monetary Policy Strategy (Frankfurt: ECB). Issing, Otmar, 2005, “The Monetary Pillar of the ECB,” presentation at the conference,The ECB and Its Watchers VII, Frankfurt, June 3. Issing, Otmar, 2008, The Birth of the Euro (Cambridge: Cambridge University Press). Issing Otmar, 2010,“The Development of Monetary Policy in the 20th Century – Some Reflections, Revue bancaire et financière, June. Issing, Otmar, 2011, “Lessons for Monetary Policy: What Should Consensus be?”, IMF Working Paper NO 11/97. Issing, Otmar, Vitor Gaspar, Ignazio Angeloni, and Oreste Tristani, 2001, Monetary Policy in the Euro Area (Cambridge: Cambridge University Press) King, Mervyn A., 2002, “No Money, No Inflation,” Bank of England Quarterly Bulletin, Summer. Lucas, Robert E., 1996, “Monetary Neutrality,” Journal of Political Economy,Vol. 104, No. 3. Lucas, Robert E., 2007, “Central Banking: Is Science Replacing Art?” in Monetary Policy, A Journey from

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Theory to Practice (Frankfurt: European Central Bank). Meltzer, Allan H., 2009, A History of the Federal Reserve,Vol. 2, Book 2 (Chicago: University of Chicago). Mishkin, Frederic S., 2010, “Monetary Policy Strategy: Lessons from the Crisis,” prepared for the ECB Central Banking Conference, Frankfurt, November 18–19. Papademos, Lucas D., and Jürgen Stark, eds., 2010, Enhancing Monetary Analysis (Frankfurt: ECB). Rajan, Raghuram G., 2005, “Has Financial Development Made the World Riskier?” in The Greenspan Era (The Federal Reserve Bank of Kansas City). Rüffer, R., and Livio Stracca, 2007, “What is Global Excess Liquidity, and Does It Matter?,” ECB Working Paper No. 696. Shin, Hyun S., and Kwanho Shin, 2011,“Procyclicality

and Monetary Aggregates,” NBER Working Paper No. 16836. Schmitt-Grohé, Stephanie, and Martin Uribe, 2010, “The Optimal Rate of Inflation,” Centre for Economic Policy Research (CEPR) Discussion Paper No. 7864. Sousa, J., and Andrea Zaghini, 2004,“Monetary Policy Shocks in the Euro Area and Global Liquidity Spillovers,” European Central Bank Working Paper No. 309. Svensson, Lars E. O., 2005, “Monetary Policy with Judgement: Forecast Targeting,” International Journal of Central Banking, vol. 1(1), May. Svensson, Lars E. O., 2009, Flexible Inflation Targeting – Lessons from the Financial Crisis (Amsterdam: The Netherlands Bank, September 21). Woodford, Michael, 2003, Interest and Prices: Foundations of a Theory of Monetary Policy.

Journal of Regulation & Risk North Asia

Opinion

Deregulation, non-r egulation and ‘desupervision’
Professor William Black examines the causes of the mortga ge fraud epidemic has swept the United that States.

Call for papers
Contact Christopher Rogers Editor-in-chief christopher.rogers@irrna.org

THE author of this paper is a leading academic, lawyer and they implicitly and former banking demonstrate three critiregulator specialisin cal failures of regulation g in ‘white collar’ and a wholesale crime. As one of the failure of private market unsung heroes of discipline of fraud the and other forms Savings & Loans nce of credit risk. The Financial debacle Complia Professor Black nowadays of the 1980s, Crimes Enforceme Legal & nt Network (FinCEN) of his time researchin spends much released a study this week on Suspicious g why financial markets have a tendency Activity Reports (SARs) that to become dysfunctional. Renowne lated financial institution federally regud for his theory on s (sometimes) file ‘control fraud’, Prof. with the Federal Bureau of Investigati Black lectures at the on University of Missouri (FBI) when they find evidence of mortgage and Kansas City. He is the author of fraud. ‘The Best Way to Rob a Bank is to Own , DLA One: How Corporate Executives and Politician Epidemic warning Yuet-Ming es the s Looted the The er, Tham S&L Industry.’ A min FBI began warning prominent comment of an “epidemic” of In this pap consultant, exa a. tor on the causes a- mortgage fraud Asi in g A in of their the congressional testicurrent financial g Kon FCP crisis, Prof. Black mony in Septembe Piper Hon ious effects of the is a vocal critic of r the ago. It also warned 2004 – over five years way the US governme pernic that if the epidemic nt has handled the h were not dealt with it would y of whic banking crisis and rewarded cause a financial criinstitutions anies – man legis- that have clearly failed in their fiduciary sis. Nothing remotely adequate was reds of comp anies. The US done to by hund comp even- duties to investors. respond to the epidemic Practices were Fortune 500 these scandals by by regulators, law Risk mana to Corrupt enforcement, or gement in the private sector Foreign e responded FCPA in 1977. “market disnnings cipline.” Instead, the s to the The following commenta the ial latur The US its begi ting ision Spec has epidemic produced enac prov ry does not necrgate A), and essarily represent the hyper-inflated a bubble o- tually e are two main Act (FCP s, and the n the Wate view of the Journal in US housing prices era, whe Ther ntary discl e ry provision and the of bribe Regulation that produced Watergate called for volu and Risk – North Asia. SEC a crisis so severe that – the antihad mad r Both the it nearly caused the collapse Prosecuto companies that ard FCPA nting provisions. J) have juris- “The new numbers on criminal of the global financial to Rich accou Justice (DO refer- system and SEC sures from contributions aign. led to unprecedented rally, the rals for mortgage fraud in the US rtment of ble are just in many bailouts of US Depa FCPA. Gene isions and questiona presidential camp of the world’s largest n over the banks. 1972 nting prov st issuers Standard & led dictio Nixon’s the accou again Journal Poor’s Dav outl sures revea prosecutes ry provisions as n& ines edings of Regulatio Risk the North Asia these disclo estic payments posi ative proce and anti-bribe tive benefits id Samuels However, administr d the anies ble dom of bank stres civil and questiona had been channelle cutes comp s 33 through ision prose testi s not just ess. prov DOJ ng on the botto ry n busin eas the funds that anti-bribe ti- wher nts to obtai m line. It but illicit s for the eding s.is a big challe n governme to subsequent inves individual nge for banks proce a robus to foreig Exchange through criminal t appro to build mation led downturn rities and The infor of worst-case ach to managing the that capital adequ the US Secu h revealed risk uncov ision stress s it scenarios acy progra to make ery prov by defini gations by ) whic er risk conce that, almos ision ms to tion, are anti-brib bribery prov h funds” ntrations and ion (SEC t encies, triggered by anything cal The Commiss issuers kept “slus risk dependunlikely antior and; ’s politi ey appar applyi or and ently to unpreceden ide mon The FCPA drive busine ng these improvemen ted events. n officials many US offer or prov als (“foreign”mean s to foreig illegal to n or through perfor ss selection – for examp ts n offici Howe pay bribe t to obtai a voluntary of value to foreig le, the inten ver, solvin g to up with adjusted pricing mance analysis and the problem ) with fying parties. business the ting h any corrisklater came of identirisk that takes stress “non-US” concentratio direc The SEC into account. e under whic payments ing business, or for ns and depen cies that give test results programm denrise to worstillicit retain sor- case eported disclosure vital if the given de spon n. outcomes is indust which self-r the SEC was can inclu any perso ry isholiof value poration vidual banks likely with , use of a to thrive – and if indi- Top-level oversight Anything perated it would ent, education are to turn Building a t loym and co-o l and the lessons past ance that resul emp two trave more robust e The assur years for of the proces mal of futur to compe and compr is no nt action. an infor $300 ship home, promiseBanks that s for uncov ehensive s. There titive advantage. enforceme ering threat than USD day and meal tackle the issue prise s s be safe from sure that more to be is masdrink the clearly lauded head-on will enter, in part, a unts, by investors ents (a disclo e disco and regula ble paym was the coming years 147 tors in the ance challenge.The board corporate governbeen mad questiona of industry and must have million in in the 1970s) had most impor recuperation the motivation top executives tantly, will unt and the clout be able to delive and, scrutinise and sive amo tained profita call a halt to to h Asia r sus- able bility gains. apparently Risk Nort Meanwhile, activities if that are well profitlation & these are not banks term placed to take of Regu in the longer consolidatio interests of advantage Journal the enterprise of the the n process need intended risk can understand or do not fit to be profile of the the risks embed sure they But organ portfolios of contra isation ded in the ry potential acquis ing corporate to popular opinion, impro . itions. To improve governance venterp is tion rise not and strengthen of putting risk manag just a quesement the ‘right’ investor confid executives banks can take ence, we think board members in and the lead in place and appropriate three related giving them Better board incentives. areas: and senior For the bank sight and execut ive contro over- sions to make the agement; re-inv l of enterprise risk when they right deciman- busine are difficu igorated stress lt, e.g. when ss growth testing and looks good or when risk managemen in the upturn, Journal of Regulation t looks expen & Risk North sive Asia

to the subject actly is s Act? Who ex Practice Corrupt Foreign

Of ‘Black Swans’, stre ss tes optimised risk manag ts & ement

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107

Macroprudential policy

Macroprudential rebalancing in a period of economic stress
Jean-Pierre Landau, former deputy governor of the Banque de France, urges policymakers to get prudential.
Low interest rates and bank deleveraging combine to produce slow growth and rising financial risks in advanced economies. This column argues that appropriate macroprudential policies could contribute to redirecting risk taking, promoting growth and reducing uncertainty through more orderly deleveraging within the financial sector. In many advanced economies, policymakers try to stabilise and support activity while financial and non-financial agents undergo a process of balance sheet repair and deleveraging. The task is challenging. Headwinds borne out of deleveraging explain why – to quote Martin Wolf of the Financial Times “economies stagnate, while policy is aggressive.” Deleveraging is unavoidable and necessary. It can be, however, more or less costly depending on how it is conducted. In short, the policy mix matters. We are used to assessing the policy mix in the fiscal-monetary space. Today, it may be necessary to add a third dimension: prudential policies. Decisions taken in the Journal of Regulation & Risk North Asia prudential field have significant economic consequences. And, therefore, the mix between monetary and prudential policies may prove important and central in achieving the desired economic outcomes. Accommodative monetary policy Monetary policy is extremely accommodative in all advanced economies. At the same time, prudential standards imposed on banks are being tightened. Those actions are mutually supportive in the long run. In the short term, however, monetary and prudential policies are pulling in opposite directions. Accelerated deleveraging by banks impairs the monetary transmission mechanism. The conjunction of low interest rates and credit constraints distorts portfolio choices and asset prices. Interest rate risk is piling up in balance sheets while bank credit is impaired, especially for small and medium enterprises. Is a better mix is possible? Most analyses take a deterministic view of deleveraging. Historical experiences and precedents are used as benchmarks and references to conclude that the process has barely started. The overall spirit is well 109

captured by a column published in the July 2011 of The Economist entitled‘Deleveraging: You ain’t seen nothing yet’. A similar message is conveyed in Buiter and Rabati (2012): “There is a lot more private and public debt today in the advanced economies than has been the norm during peacetime periods”. An endogenous process Deleveraging is not deterministic. In fact, it is an endogenous process with many interactions and feedback loops between economic agents. The end point is undetermined as “safe levels of leverage are subject to change over time” (Eggertson and Krugman, 2010). There are many paths that might lead us there and not all of them will have the same effects. Depending on how deleveraging occurs, the total cost is different. The amount of losses to be taken by the economy is endogenous to the deleveraging process itself. Negative spiral As emphasised by Buiter, deleveraging is, first and foremost, a coordination problem. Deleveraging by one agent creates externalities on others. For instance, when households deleverage, firms are worse off and may have to shrink their own balance sheets. Deleveraging by banks imposes financing constraints on non-financial agents. With those externalities, the distinction between supply and demand constraints in credit distribution seems rather moot. Supply constraints in one part of the economy translate into weak credit demand in another. Because the path is indeterminate and the total amount of losses is endogenous, deleveraging generates its own uncertainty. 110

In turn, uncertainty pushes the banks to deleverage more as it deteriorates the quality of their loans’ portfolios. This circular and reciprocal relationship between deleveraging and uncertainty creates a negative spiral into which many advanced economies, especially in Europe, are currently caught. To break that spiral, one can think of three possible courses of action: • First, debt can be grouped in a single balance sheet and centrally managed; This is what ‘bad banks’ do, thereby taking uncertainty and risk away from the rest of the financial system. • Second, liquidity provision may alleviate funding constraints and limit fire sale externalities and spill overs; Liquidity also eases coordination problems. An anecdote presently circulating economics departments illustrates this particular issue: a German tourist checks into an Irish hotel for the night. While she proceeds to her room, she inadvertently leaves a €100 bank note on the desk. The hotel manager takes it and, while the tourist sleeps, rushes to the grocery store to settle a €100 debt. Debts extinguished In turn the grocery shop owner uses that same bank note to pay back a debt to a transport company, which immediately transfers to a cab driver who sends it to a tour operator to extinguish their own debts. Finally, the tour operator, who owes €100 to the hotelier, sends the note back to the hotel where it originated. When the tourist wakes up for breakfast, she finds the €100 waiting for her at reception. In the meantime debts equivalent to €500 have been extinguished and the leverage in the domestic economy Journal of Regulation & Risk North Asia

has been dramatically reduced. Involuntary, but also non-costly liquidity provision by a third party has allowed leverage to be substantially adjusted. Regulatory uncertainty The biggest contribution that policy can make however is to reduce uncertainty in the regulatory field. Financial regulation has been the focus of far reaching reforms since the crisis of 2008. Many of these regulatory changes have been assessed on the basis of their static advantages, with less consideration given to the dynamics they may create. Basel III exemplifies this regulatory process. Studies concur on its significant longterm benefits but diverge on the short run, depending on assumptions made on the transition process. To avoid unintended effects, it was decided to set ambitious targets and give the banks a long delay to adjust. In fact, that decision opened a period with no precise references to guide markets on the appropriate levels of capital requirements and leverage. It may have created a possible ‘race to the top’ and made the whole process more uncertain and disorderly. Interest rate risk Interest risk is typical of those that macroprudential policy is supposed to address. It is global and non-specific to any institution. One example of its systemic consequences can be seen in a bond market crash, one that builds up progressively, hence offering space for preventive measures. Interest rates on risk free assets (treasuries) are at an all-time low. Term premiums on government bonds are heavily negative Journal of Regulation & Risk North Asia

in advanced economies, at least once inflation and growth expectations have been factored in. Issuance of high yield securities is very high, both in absolute and in proportion of total debt. High yield corporate spreads have narrowed to levels last seen prior to the Eurozone debt crisis (BIS 2013). Making a judgment is difficult. Risks are by no means certain or one sided: “the upside and downside risks to the level of rates are roughly symmetric as of 2017” (Bernanke 2013). Their distribution is unknown, although one suspects that banks are holding a large chunk (Turner 2013). Finally, the potential consequences of an increase in long-term rates are difficult to predict. They would be different across institutions, according to their accounting regimes, their hedging strategies and their investment horizons. They would also depend on whether the adjustment is progressive or abrupt. Rebalancing bubbles On the other hand, there is evidence that interest risk has been associated with increased financial fragility with mounting leverage, and maturity transformation. Mutual funds and Exchange Traded Funds are accumulating significant exposures to interest rate risk backed by very short-term claims (Tett 2013).“Such financial structures are known to give rise to amplification and non-linear shocks if positions have to be liquidated quickly to face redemptions” (Stein 2013). The current policy mix has therefore produced a very contrasted and unbalanced situation. Market based intermediation is booming. Bubbles may be appearing in 111

some high yield segments of bond markets. At the same time, deleveraging has brought credit distribution by banks to a halt. This contrast may partly explain the increasing divergence in economic performance on both sides of the Atlantic. Redirecting risk The Euro economy, where banks account for more than 80 per cent of credit, is suffering more than the U.S., where markets play a dominant role in financial intermediation. Some rebalancing is necessary. The overall level of risk is not an issue, rather, the problem lies in the nature and the distribution of those risks. One objective of non-conventional monetary policies is to encourage risk taking. Introducing indiscriminate frictions would contradict that objective. The macroprudential response should aim at redirecting rather than impeding risk taking in the economy by reducing the incentives to take interest rate risk and increasing credit in the banking sector. Preventative measures Even where the threat is judged to be not immediate or of a great amplitude, there is a case for some preventative action. The essence of macroprudential policy is to act before imbalances have become so large that they threaten financial stability. In the case of interest risk, prudential action would also free monetary policy from the dangers of “financial dominance”(Hannoun 2012), a situation where so much risk has been piled up in financial intermediaries’ balance sheets that central banks may hesitate to raise policy rates where necessary. For 112

banks, the Federal Reserve has been stress testing some interest rates scenarios and their impact on balance sheets (Bernanke 2013). It is likely that most supervisors are quietly doing the same. Whilst it would be prudent to induce institutions to build up specific buffers, which could be drawn upon in times of stress, the systemic aspect is more difficult. After all, building up leveraged positions and maturity mismatches takes place in non-banking institutions, often outside the purview of supervisors. Macroprudential regulators should not shy away from formulating explicit warnings and backing them with specific actions (on margin requirements, for instance) when necessary. Trade-off To reduce uncertainty, regulators need to express a view (and to give guidance) on the appropriate path and modalities for deleveraging in the financial sector. In a sense they face a problem identical to the one confronted by central banks when they practice ‘flexible’ inflation targeting, and they need to adopt the same mind-set. ‘Flexible capital targeting’ would involve taking a view on the appropriate path to return to equilibrium after a shock. As central bankers know, this involves a tradeoff. Getting back too fast to target involves important and significant losses of output and costs. On the other hand, waiting too long risks endangering the credibility of the ultimate objective. It is a trade-off that was left unexplored in the regulatory field, and one, which would have brought about huge benefits in terms of making the regulators’ preferences explicit and transparent. Journal of Regulation & Risk North Asia

Eliminating uncertainty is clearly necessary. However, the very nature of prudential regimes places them in a constant state of flux. Now that the foundations of Basel III have been solidly established, regulators should perhaps consider a moratorium on any changes for a few years. And while the agenda may currently be full (Ingves, 2013), this would not prevent discussions and consideration of new measures and improvements to be introduced over time. Basel differentiation Another solution could be to significantly reduce capital requirements on new bank loans; certainly in the current environment, it makes sense to differentiate between marginal and average capital requirements. Indeed, differentiation of capital requirements, across time and across asset classes, is surely an integral part of the Basel regime? Whilst any forbearance should be excluded and capital requirements on past loans should be maintained and strengthened, by contrast, a favourable regime could be applied to new net exposures, a practice that the UK Financial Services Authority has been implementing since 2012 by “ensuring that no bank will be required to hold the additional capital requirements of the increased lending.” International cooperation Clearly, a great deal of international cooperation will be necessary to implement such an agenda, and as such, this may be difficult to achieve given the differences various parties may have in judging the reality and seriousness of risk. At the same time, and in conclusion, it is clear that current circumstances Journal of Regulation & Risk North Asia

offer an opportunity and testing ground for the implementation of efficient macroprudential policies.• References
Bernanke, B (2013), “Long Term Interest Rates”, speech, 1 March. BIS (2013), Quarterly Review, March. Buiter and Rabati (2012), “Debt of Nations”, CITI GPS, November. Eggertsson, GP, and Krugman, P (2010),“Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo approach” discussion paper. Financial Service Authority UK (2012),“Adjustments to FSA’s liquidity and capital regime for UK banks and building societies”, 27 September. Hannoun, H (2012), “Monetary Policy in the Crisis: Testing the Limits of Monetary Policy”, speech, BIS, February. Ingves, S (2013), “Where to next? Priorities and themes for the Basel Committee”, 12 March. Stein, J (2013),“Overheating in Credit Markets: Origins, Measurement, and Policy Responses”, speech, 7 February. The Economist (2011), “Deleveraging:You ain’t seen nothing yet”, 7 July. Tett, G (2013), “Remember lessons of 2007 in rush for junk”, Financial Times, 14 March. Turner, P (2013), “Benign neglect of the long-term interest rate”, BIS Working Papers 403, February. Wolf, M (2012), “We still have that sinking feeling”, Financial Times, 10 July.

Editor’s note: The publisher and editor of the Journal would like to thank Jean-Pierre Landau for allowing us to print an abridged version of this paper, which expands on remarks made at a Conference organised by the Julis-Rabinowics Centre, Princeton University, on March 1, 2013. 113

Sovereign debt crisis

Dynamics of Disintegration: Germany and the Euro
Christian Fahholz and Gernot Pehnelt contend that politics, and not economics, will be the final arbiter of the Euro’s fate.
The economic situation within the Eurozone member states appears increasingly dire. It has turned out that the rush of stabilisation and liquidity actions within the Eurozone only provides short-term relief. It seems as if the hesitant crisis management aggravates the European balance-of-payments crisis. Nevertheless, there might be a turning point in the Eurozone crisis as the dynamics of the Eurozone disintegration process may eventually alter the political-economic conditions. The reason is that both monetary and fiscal assistance will eventually come into conflict with electoral interests (Fahrholz and Pehnelt 2012). Once the electorate questions and challenges the inconsistencies of (seemingly) futile Eurozone crisis management, policymakers are likely to change their positions, and exiting from the Eurozone may then become what appears to be a feasible policy option. In this short note, we explain why the Eurozone integration process will most likely be reversed. In doing so, we set forth Journal of Regulation & Risk North Asia that some particular Eurozone members may eventually dispose of adequate financial resources for avoiding a messy disintegration process. The dynamics of the Eurozone disintegration can be illustrated by distinguishing between core and periphery members. In this respect, the Eurozone core – think of Germany, Finland, Luxembourg, and the Netherlands – is characterised by current account surpluses (net capital exporters or net creditors), while the Eurozone periphery is generally characterised by current account deficits (net capital importers or net debtors). Balance-of-payments A hallmark of the European balance-of-payments crisis is that the private financial sector has stopped lending for rolling over accumulated debt and for refinancing current account deficits of the Eurozone periphery. Yet, the financial assistance provided to the Eurozone periphery through the provisional European Financial Stability Facility (EFSF), in conjunction with the European Financial Stabilisation Mechanism (EFSM), the permanent European Stability Mechanism 115

(ESM), and other bilateral/multilateral arrangements, for instance, the European Central Bank (ECB) and the International Monetary Fund (IMF) have averted a fullfledged balance-of-payment crisis of the Eurozone periphery economies at the time of writing this paper. TARGET2 imbalances Apart from such forms of fiscal support, the financial assistance has also monetary dimensions. In this respect, particularly the formation of TARGET2 imbalances is a good indicator for the severity of the European balance-of-payments crisis. Basically, the TARGET2 is a prerequisite for turning the Eurozone into a common currency area. Without an automatic clearing of a net transfer of payments a periphery NCB, for example, would have to bid for funds to wire a payment to a core NCB. This would be akin to the situation of foreign exchange markets, where such a bid – buttressed by pledging adequate collateral – would increase the price of core funds relative to periphery funds. As a result a floating exchange rate regime would ensue and jeopardise the idea of a common currency area. In normal times – i.e., if financial investors trust one another – the private financial sector uses the TARGET2 to wire cross-border payments within the Eurozone and any imbalances are only of a temporary nature. No private sector incentives Usually, an initial TARGET2 imbalance is offset by private financial sector refinancing activities within the interbank market. In this case, all TARGET2 transactions finally offset each other. However, the TARGET2 116

still clears cross-border payment flows even in crisis times. Should the interbank market run dry, whereby no further off-setting transfer of payments from the core even out the temporary TARGET2 imbalances, as long as commercial banks within the periphery are able to pledge collateral at their NCB in exchange for central bank money, payments can still be wired across borders. This allows, for instance, for importing tradable’s in times of crisis. There is no settlement of ensuing irregular TARGET2-claims and liabilities, as is the case within the U.S. Federal Reserve System. One may argue that the TARGET2 system acts like an automatic stabiliser cushioning against the adversities of a sharp activation of the periphery current account. However, the problem mainly is that the increasing indebtedness of the Eurozone periphery via the TARGET2 monetary system does not create incentives for a return of the private financial sector. Crowding out The corresponding TARGET2 imbalances represent the Eurozone periphery’s inability to fund itself via private sector avenues. In doing so, the TARGET2 balances replace withdrawn deposits and foster the crowding out of eligible collateral within the private financial sector of the Eurozone periphery. This is why the formation of TARGET2 is an indicator of the severity of the Eurozone balance-of-payments crisis. Figure 1 (see opposite page) illustrates that TARGET2 imbalances started to become noticeable at the onset of the subprime crisis during the third quarter of 2007, and highly pronounced in the final months of 2008 Journal of Regulation & Risk North Asia

Figure 1. German TARGET2 Balances, 2003 – 2012 (Quarterly), bn. EUR

Figure 2. German Net International Investment Position, 2003 – 2012 (Quarterly), bn. EUR

Source: Deutsche Bundesbank Journal of Regulation & Risk North Asia 117

following the ‘Lehman credit event’. For about five years now, the TARGET2-claims recorded at the Deutsche Bundesbank have been sky-rocketing more or less every month (see Figure 1 overleaf). Having gained considerable momentum during the Eurozone crisis, the TARGET2 claims of Germany visà-vis the Euro-system currently amount to about 715 billion EUR [November 2012]. Stabilisation incentives As long as the TARGET2 properly works the Eurozone periphery economies have an incentive to allow for alleged, short-term stabilisation of struggling national financial sectors, so that the TARGET2 imbalances will further increase. Any such debt formation will eventually require restructuring. Whether financial assistance within the current balance-of-payments crisis is of a fiscal or monetary dimension, it always increases the risk exposure of the Eurozone core, particularly Germany.The financial manoeuvres impact, for instance, the German net international investment position (NIIP), i.e., the ‘wealth’of Germany (see Figure 2 overleaf). Run-up to the current crisis It may turn out that wealth in the form of claims on some future real production becomes irrecoverable. The ‘improving’ NIIP of Germany indicates a protracted Eurozone balance-of-payment crisis. The question arises why such risk exposures have been rather disregarded or underestimated for such a long time in the run-up to the current crisis. The following section elaborates why corresponding macro-economic imbalances within the Eurozone have emerged 118

and why such real misalignments have only recently been revealed. Reasons for mounting real misalignments between the core and periphery of Eurozone primarily stem from a ‘natural’ inclination towards overindebtedness in periphery economies. As the Eurozone membership is irrevocable, moral hazard behaviour evolved on the part of both markets and politics. At the end of markets, financial investors have taken excessive risk by treating Eurozone periphery and core economies’ debt essentially the same for many years. The implicit protection by the irrevocability of Eurozone membership has reduced market discipline and considerably lowered interest rates for periphery economies with the Eurozone. Power shift At the political end, the irrevocability of Eurozone membership has shifted the political bargaining power to the profligate economy and provided a leeway to passing some portion of their fiscal adjustment costs on to the rest of the Eurozone. Since problems in a single periphery economy may create a negative externality on other Eurozone members, the latter economies have little choice but to provide financial assistance. Sovereign members of the Eurozone may thus easily forgo the short-term fiscal adjustment costs necessary for safeguarding the Eurozone stability in the long run. Instead, national politics may comfort their electorates and specific interest groups at the expense of the long-term stability of the Eurozone (Fahrholz and Wójcik 2012). Hence, moral hazard within the Eurozone has led to excessive credit supply, Journal of Regulation & Risk North Asia

while there has neither been political incentives nor any means of enacting effective countermeasures that help curtail excessive credit demand. The resulting external macro-economic imbalances respectively real misalignments are now threatening the stability of the entire Eurozone. Rational procrastination Fiscal austerity and monetary accommodation characterises the current state of play in the EU crisis management. Both policies are apparently the natural order of play. However, the fundamental problem is that this type of EU crisis management has prompted a debt-deflation spiral that crunches its way through the periphery to the core of Eurozone. This section explores the range of possible turning points. In lieu of political forces endogenously changing the dynamics of the Eurozone balance-of-payment crisis, market forces may set in and alter the political-economic configuration of the current Eurozone. The pattern of EU crisis management consists of averting de facto defaults in the short term at the expense of increasing the overall level of indebtedness within the Eurozone. This strategy comes along with ever-broader ramifications. However, this is the outcome of rational but costly procrastination in the interest of all parties involved. Institutional drawbacks From the viewpoint of the Eurozone periphery, fiscal rescue packages and a dysfunctional monetary clearing mechanisms provide the opportunity to postpone necessary economic adjustments. Institutional drawbacks of the Eurozone set-up undermine structural Journal of Regulation & Risk North Asia

reforms needed for returning to sustainable levels of indebtedness. Such reforms are always costly in the short term. This applies to both the economic and the political sphere. The resulting delays, however, occur at the expense of further indebtedness. For periphery Eurozone members there are no incentives for voluntary opting-out of the Eurozone. The reason is that there is hardly any scope for increasing their export competitiveness by devaluation. Given a highly import-oriented production structure of the Eurozone periphery, possibly re-starting an economy by introducing a new national legal tender that devalues vis-à-vis the Euro cannot be conducive to export competitiveness in the short-term. Voter alienation Moreover, cutting off the bypass TARGET2 and other public and private sector assistance will represent a plunge into the economic abyss. It goes without saying that conditionality of fiscal support – the monetary bypass TARGET2 is unconditional – creates political hardship for every Eurozone periphery administration in the form of voter alienation. However, these governments weigh these political costs against the short-term severe adversities of exiting the Eurozone. Knowing, furthermore, that a (partial) break-up of the Euro would also leave the Eurozone core with significant losses, the Eurozone periphery has a very high propensity for accepting re-negotiable conditionality of fiscal support in the short term as well. From the Eurozone core perspective, particularly Germany, these economies are 119

able to preserve export-oriented production structures. Hence, such Eurozone members have an incentive to ensure that distressed periphery economies continue to repay their debt whilst purchasing tradable’s. In doing so, they forgo the adversities of economic adjustment and re-balancing real misalignments. This is to say that the Eurozone core avoids the short-term costs of decreasing production and employment. The tipping point Moreover, credit economies (i.e., net exporters) such as Germany gain from a depreciating Euro vis-à-vis the rest of the world that additionally strengthens its export competitiveness. In addition, the flow of funds from the Eurozone periphery to the core is advantageous to the liquidity of the German bond markets. Given the incipient redenomination risks within the Eurozone, the according financial safe-haven decisions are very much akin to a free lunch for Germany’s debt rollovers in the short term (Fahrholz 2012). The economic wrecking of the Eurozone is a result of rational but costly delay of thorough economic reform. Nevertheless, the internal dynamics of the Eurozone crisis, or the political-economic configuration, may adjust to altering financial investor expectations. The provision of fiscal rescue packages, for instance, will eventually come into conflict with electoral interests within the Eurozone core. Debt-deflation spiral Austerity will also force many European economies into recession for a prolonged period, endangering other Eurozone members’ export-oriented production structure 120

and starting a debt-deflation spiral sliding from the Eurozone periphery to the core. Given the political-economic configuration of the Eurozone and the prompted debt-deflation spiral, the Eurozone balance-of-payment crisis will not come to a halt at the doorway of the Eurozone core economies. This is true, particularly because as soon as these members directly face the adversities of futile EU crisis management – i.e., the repercussions of the pledged and paid-out fiscal and monetary assistance on its own creditworthiness – public administrations will most probably alter their policy position. Policy shift In particular, largely due to the devaluing of the Euro - and because of core Eurozone investors currently withdrawing from the periphery, and in turn Eurozone periphery savers transferring their assets to the core - such policy shift will take place when the benefits of expected higher export earnings vis-à-vis the rest of the world, as well as the advantages of declining costs of government debt are offset by non-Eurozone investor flight. This is likely to happen only as soon as concerns mount about future Eurozone core economies’ creditworthiness and at a time when a crucial faction of such financial investors realises that the current track of EU crisis management does not effectively shield against the crunches of the debt deflation spiral but eventually overburdens the financial capacities of the Eurozone core. At this stage, going for revaluation will become a politically feasible option for Eurozone core members. If sophistically managed, this may help to craft an economic Journal of Regulation & Risk North Asia

rebound and may also protect against lingering into the debt-deflation spiral. Rebalancing incentives The correspondingly altered political-economic configuration of the Eurozone puts an end to procrastination and muddlingthrough the Eurozone balance-of-payment crisis. At this point, incentives will crop up which will allow, for example, for negotiating a controlled dismantling of the Eurozone and/or a concomitant replacement of the Euro by national legal tenders or other currency arrangements. In general, real misalignments have to be rebalanced and the according mal-investments have to be worked out. While this applies to all economic centres in the world – e.g. the Americas and Asia – the weakest link in the chain remains the Eurozone. Within the group of sovereign Eurozone members, particularly Germany but also other core members may opt for revaluation as soon as the current benefits of undervaluation are gone. Boost for business The ensuing revaluation, in turn, could be a boost – and not a sting in the tail – to the Eurozone core economies’ export-oriented business sector. The reason is, firstly, that the business sector may also reap windfall profits from paying off Euro-denominated loans. Secondly, export earnings would rise as long as these economies gain from reduced import prices and the rather inelastic external demand for tradable’s in the short and medium-term. Although the Eurozone core would be likely to experience some welfare losses, this is not a problem for social Journal of Regulation & Risk North Asia

inclusion and political stability in the long run. The Eurozone balance-of-payment crisis erodes some of the real value of previous export volumes. However, the public would be unlikely to notice these real losses, as they simply would not have the tradable’s, which they had exported at earlier stages in the equation, at their disposal. The moderate re-balancing of real misalignments will take place only through price-level adjustments. This effect will be outpaced by a full-fledged economic recovery after the commencement of a new solid currency arrangement. It is certainly politics that will determine the timing of a U-turn concerning the opt-out of the Eurozone, as well as the scope of a subsequent economic recovery. The assets of the Eurozone core economies, unless not deteriorated in the course of the sliding debt-deflation spiral, are the best precondition for high returns on investment.• References
Fahrholz, Christian. 2012. “The dynamics of Eurozone disintegration”, EconoMonitor – A Roubini Global Economics Project, New York City, NY, URL: http://www.economonitor.com/blog/2012/10/thedynamics-of-eurozone-disintegration/, 30 October 2012. Fahrholz, Christian and Gernot Pehnelt. 2012. “Midand long-term risks of German Bonds”, Jena, GlobEcon Policy Brief 01-2012. URL: http://www.globecon. org/fileadmin/template/userfiles/-Research/GlobEcon_Policy_Brief_01-2012_Oct_2012.pdf. Fahrholz, Christian and CEurozoneary Wójcik. 2012. “The Eurozone needs exit rules”, Jena and Warsaw, CESifo Working Paper, No. 3845. URL: http://www. cesifo-group.de/portal/pls/portal/docs/1/¬1217000. pdf.

121

Basel III

Europe’s interests best served by complying with Basel III
Nicolas Véron contends that contrary to popular belief, it is the U.S. and not Europe that remains true to the intent of Basel III.
On Valentine’s day, February 14, Michel Barnier, the European Commissioner for Internal Market and Services, and Daniel Tarullo, Governor of the U.S. Federal Reserve, and person charged with regulatory and supervisory oversight at the Fed., indicated their agreement to quickly give the Basel III Accord binding force over, respectively, European and American banks. Whilst this news was most welcome, even more important than the exact timing is that the adoption should stay true to the international Accord. At this juncture in time, and contrary to many perceptions within Europe, this is more likely to be the case of the U.S. rather than that of the European Union. Basel III is the work of the Basel Committee on Banking Supervision, which includes 27 countries as its members (plus EU institutions and the International Monetary Fund as observers). The Committee is hosted by the Basel-based Bank for International Settlements, with a small permanent secretariat there. It is the crown achievement Journal of Regulation & Risk North Asia of the G-20’s financial regulatory reform agenda in the wake of the Lehman Brothers collapse. Other prominent initiatives have had only partial or mixed results, including the centralised clearing of over-the-counter derivatives, accounting standards convergence, the regulation of rating agencies, or restrictions on compensation practices or regulatory havens. A clear success By contrast, Basel III has moved ahead quickly and can be labelled a clear success for global financial regulation. It is already making a difference, and a positive one, in the way the global banking system operates. Credit for this goes to the Basel Committee’s members and to its successive chairmen and secretary-generals since 2007. Without going into all the details of a rather long text, Basel III makes the definition of regulatory capital much more rigorous; increases minimum capital requirements dramatically, from two per cent to seven per cent for the key ratio of common equity to risk-weighted assets; tightens the methodology to weigh the risk of assets; introduces a 123

minimum leverage ratio (capital to non-riskweighted total assets) to mitigate the risk of manipulation of risk weights; introduces additional requirements depending on the financial cycle and the systemic importance of some banks; and introduces regulatory standards and ratios for banks’ liquidity profile. Dimon attack The Accord has been criticised from all sides of the financial regulatory debate. Much of the banking community, including the Institute of International Finance, has argued that the increase in capital requirements would have a large negative impact on growth and that the liquidity ratios would be detrimental to market functioning. Jamie Dimon, the Chief Executive Officer of the U.S. based banking giant JPMorgan Chase, has lambasted the additional capital requirements for systemically important financial institutions, including his own, as “anti-American.” However, third-party studies suggest that bankers have been unduly crying wolf, and that the standards’ negative impact on bank business will be more than compensated by the resulting additional financial stability. Inefficient and toothless Conversely, a number of academics and advocates have argued that Basel III is insufficient, or even toothless, be it for the need for even higher capital requirements, the widespread gaming of risk-weighting calculations, the excessively long phasing-in period for the standards to take full effect, or the recent announcement that liquidity 124

standards are likely to be less stringent than initially envisaged. That said, none of these critiques present an obvious alternative or solution. Pushing minimum capital levels even higher would lead to widespread migration of financial intermediation towards the less-regulated shadow banking system. In essence, riskweighting is flawed, but the alternatives are worse and Basel III’s leverage ratio at least creates a backstop rule. The phasing in stage now looks rather steep to many banks, particularly in Europe, and in any case was arguably the most acceptable price to pay in the compromise to get the Accord passed in spite of opposition from some Basel Committee members. Complacency The watering down of liquidity ratios appears justified by the uncertainties surrounding the impact of this new and untested regulatory instrument, and the lessons learned from the Eurozone crisis regarding the possible credit risk and illiquidity of sovereign debt markets. In fairness, Basel III goes remarkably far for a consensus-driven Committee that had been much less bold in the past, especially with the previously considered comprehensive Accord (Basel II), which in the light of the crisis now appears to have been embarrassingly complacent. Beyond the Accord itself, the Basel Committee, in an unprecedented (though arguably long overdue) move, has designed a three-level process to nudge its members to adopt and implement its standards rapidly and consistently. Level One checks that each member jurisdiction has adopted rules that legally Journal of Regulation & Risk North Asia

mandate the application of Basel III by those for which it was intended, namely large internationally active banks. Level Two checks in detail the consistency of the legislation or regulation with all points covered in the text of Basel III. Level Three assesses how the Accord is implemented in practice. Regular reports The Basel Committee has published regular short reports to the G-20 since 2011, scoring countries’progress on Basel III and the adoption of earlier versions of the Accord (Level One). In October 2012 the Committee began to publish detailed reports on the consistency of adopted or proposed legislation/regulation with Basel III, with the first three reports devoted to Japan, the U.S. and the EU (Level Two). More recently, in January 2013, it published its first study on actual implementation, devoted to the consistency of risk-weighting across a sample of banks (Level Three). The picture that emerges is contrasted but encouraging from a global perspective. Eleven of the Committee’s 27 members (Australia, Canada, China, Hong Kong, India, Japan, Mexico, Saudi Arabia, Singapore, South Africa and Switzerland) have adopted Basel III, and all but India, who delayed until April 1, began their implementation of Basel III on January 1, 2013. “Trilogue” In the EU, nine Basel Committee members are represented, these being Belgium, France, Germany, Italy, Luxembourg, the Netherlands, Spain, Sweden, and the United Kingdom. The implementing legislation, known as the Capital Requirements Journal of Regulation & Risk North Asia

Regulation (CRR) and Fourth Capital Requirements Directive (CRD IV), was proposed by the European Commission in July 2011 and is in a final phase of discussion between the European Commission, European Parliament and European Council - usually referred to as a “Trilogue“ in Brussels terminology. In the U.S., the three federal agencies jointly in charge – the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) – published a regulatory proposal in June 2012 and are currently working on a final version. Work is also in progress in the remaining Basel Committee members, namely Argentina, Brazil, Indonesia, South Korea, Russia, and Turkey. “Funny equity” Among the three jurisdictions reviewed in more detail under the Basel Committee’s Level-Two process, Japan gets high marks for essentially complying with the Accord. Based on its June 2012 proposal, the U.S. is compliant on all areas tested but one: its rejection of any reference to credit rating agencies’ assessments in bank prudential regulation, enshrined in Section 939A of the Dodd-Frank Act of 2010, creates differences with parts of Basel III which keep references to credit ratings. This, despite the fact, that the Basel Committee has also tried to reduce the extent of such references. The EU is found “materially non-compliant” in two areas: its definition of capital, and an exemption that the review found one of the risk-weighting methods too broad. The definition of capital is by far the more important of the two, as it goes to the core 125

of capital regulation. After all, it is no good having high minimum requirements if the definition includes“funny equity”that is not genuinely loss-absorbing in a crisis. Such differences are attributable to differences in financial cycles and local politics. The EU thus finds itself in a state of banking system fragility, which has not been resolved by the recent improvements seen in market conditions. Forbearance is thus a temptation, despite the fact that experience suggests it is a losing crisis-management strategy. Lessons learned By contrast, Japan, Mexico and much of Asia have learned their lessons the hard way during the financial crises of the 1990s, and their banks have strong enough balance sheets for the early transition to Basel III to be an easy one. Banks in Canada and Australia have been thriving recently. Switzerland and the U.S., like the EU, have faced severe banking crises in 2007-08, but unlike the EU, have largely resolved them in 2009-10, which makes their implementation of Basel III requirements less challenging than that of several EU member states. The delay and somewhat spotty compliance in the EU stands in stark contrast to Europe’s championing and early adoption of Basel II in the early 2000s. It is not uncommon therefore for EU financial policy leaders to offer support for the Basel III process and yet to criticise it at the same time. Unfair critique In particular, the European Commissioner in charge of financial services has reacted angrily to the Basel Committee’s Level-Two 126

report on the EU, arguing that some of its findings “do not appear to be supported by rigorous evidence and a well-defined methodology,”while simultaneously affirming his “support [for] the Basel Committee’s intention to assess consistent implementation.” The Commissioner implies in his reaction that the EU’s CRR/CRD IV legislative proposal was assessed unfairly negatively in comparison with the reviews of Japan and particularly of the U.S. However, the Basel Committee’s LevelTwo assessment process has involved Europeans prominently: they represent no less than half of the respective assessment teams for both Japan (a six-member team led by the Banque de France’s Sylvie Mathérat and including members from the German and Swedish central banks) and the U.S. (a six-member team including members from the French and Italian central banks and the European Commission). No ‘anti-Europe’ bias As for the EU, the assessment team was led by Charles Littrell from the Australian Prudential Regulation Authority and included five other members from prudential authorities in Japan, New Zealand, Singapore, Switzerland, and the U.S., the teams being formed on the principle of no self-assessment. The Basel Committee has put a lot of effort into ensuring the quality and consistency of its assessment methodology, and there is no convincing evidence of antiEuropean bias from a detailed reading of the Level-Two reports. The Committees’ policy so far, has been not to react publicly to the European Journal of Regulation & Risk North Asia

Commissioner’s critique, but it is evident from the content of the Level-Two report on the EU, that the same arguments put forward in this critique, have been carefully considered by the assessment team before completion of the report. U.S. delay denounced The reaction from many stakeholders in Europe to the U.S. delay in the adoption of Basel III has been similarly shrill. The joint press release from the Federal Reserve, the FDIC and the OCC does nothing more than announce that the deadline of January 1, 2013 will be missed in the finalisation of the rulemaking process due to the large number of written comments received on the June 2012 proposals that justify more in-depth analysis. This has been widely denounced in continental Europe as a de facto abandonment of the effort, which in turn would justify significant delays in the EU’s own decision-making process on grounds of competitive fairness. As a result, the European Banking Federation sent a letter interpreting the U.S. press release as implying that“our U.S. competitors will not have matching obligations imposed on them in parallel [with the EU’s CRR/CRD IV], or in a foreseeable future.” Further, the President of the Italian Banking Association, Mr. Giuseppe Mussari, argued that“Basel III must be postponed, full stop.” Concurrent adoption In fact, the EU and the U.S. appear likely to adopt Basel III at around the same time, probably in the second quarter of 2013. However, as mentioned above, the Journal of Regulation & Risk North Asia

procedures are different. In the EU, CRR and CRD IV proposals are produced by a legislative co-decision process, which involves the European Parliament and the Council. Further, while CRR becomes directly applicable in all member states once adopted by the European Parliament and Council, CRD IV, as a directive, requires a degree of politicisation, as well as further transposition in all member states’ national legislation. In the U.S., the process is more technocratic as it is in the hands of the three federal agencies (the Federal Reserve, FDIC and OCC). However, it is also subject to the scrutiny of Congress, which may still impose further delay. Sound justifications Further, while on both sides, there is no indication that the points of “material noncompliance” found in the Basel Committee Level-Two preliminary assessments will be corrected in the final version, in the U.S., Section 939A of the Dodd-Frank Act prohibits reference to credit ratings in the prudential regulation of banks and this is unlikely to be abrogated by Congress any time soon. In this respect, the EU is ill placed to criticise the U.S., as it has itself put much blame on credit rating agencies in the crisis context and submitted them to increasingly stringent regulation. In the EU, there is no indication that the revision of the non-compliant parts of CRR are among the points that the co-legislators in the European Parliament and Council envisage to revise in the current final phase of legislative “Trilogue”. There would be sound justifications, however, for a second look in the EU that 127

would enable the adoption of a Capital Requirements Regulation that would be fully compliant with the Basel III Accord, as summarised in the following observations: First, is that the direct economic impact of the necessary changes would be limited, especially if the changes only apply to the large internationally active banks for which the Basel Committee’s standards are intended. Indeed, in his response to the Basel Committee’s Level-Two report on the EU Commissioner, Mr. Barnier argues in particular that the report’s reservations on the definition of capital of non-joint stock companies (presumably referring to so-called “silent participations” at some of Germany’s public banks) “concerns a single internationally active bank,” adding that the other material issue about the treatment of insurance subsidiaries“can arise only in very few banks.” Enhanced trust Such points are made to argue that the noncompliance with Basel III is not material, but that the argument can be reversed in the sense that correcting the non-compliance would not have a systemically detrimental effect on the EU economy. Second, full compliance with Basel III would enhance trust in European banks. The EU’s deviations from the international Accord feeds widespread presumptions in the investor community that at least some supervisory authorities in the EU tend to apply a high degree of forbearance to banks within their remit and are reluctant to force them to apply high and consistent capital standards. Such market sentiment is clearly detrimental to all EU banks (and 128

the European economy as a whole), including those (presumably many) among them, which are sufficiently capitalised. The costbenefit balance is without a doubt favourable to bringing CRR to full compliance with Basel III. Finally, the EU’s incomplete adoption of Basel III undermines the global authority of the Basel Committee, encourages other jurisdictions to introduce exceptions of their own, and diminishes the EU’s own moral stature in the global financial regulatory debate. In the past two decades, the EU has been a champion of global financial regulatory convergence, in particular with its endorsement of International Financial Reporting Standards in the early 2000s and support of Basel II and Basel 2.5 throughout the 2000s. The calculation was that global financial convergence and integration would support an agenda of harmonisation and integration within the EU itself. This calculation remains relevant, even after the shift from a G-7 to a G-20 global framework in which the EU member states’ relative influence is less than it used to be. The European Union’s co-legislators should revisit their stance and make the Capital Requirements Regulation fully compliant with Basel III before they put their final stamp on it.• Editor’s note: The publisher and editor would like to thank Mr. Nicolas Véron of the of the Brussels-based think tank, Bruegel, and the Peterson Institute for International Economics in Washington DC for allowing the Journal to publish a reformatted version of this paper. The original online copy of this paper can be viewed at www.bruegel.org. Journal of Regulation & Risk North Asia

Macroeconomics

The science of fiscal policy & alchemy of monetary policy
Harvard’s Prof. Jeffrey Frankel asserts that fiscal, not monetary policy, offers the best way out of the current economic malaise.
2013 marks the 100th anniversary of US federal income tax and the establishment of the Federal Reserve. What lessons have we learnt about macroeconomic policy since then? This column assesses the lessons learned and argues that under the conditions that have held in recent years, as in the 1930s, fis­ cal expansion is more likely to be effective in the short term than mon­ etary stimulus. Indeed, compared with fiscal policy, monetary policy seems more alchemy than science. This year represents the centenary of two significant institutional innovations in U.S. economic policy, namely: The Constitutional Amendment enacting federal income tax (February 1913); and, the law establishing the U.S. Federal Reserve System (December 1913). It took some time before the two new institutions became associated with the explicit concepts of fiscal policy and monetary policy respectively. It wasn’t until after the experience of the 1930s that they came to be viewed as potential instruments for managing the macroeconomy. John Maynard Keynes, of course, pointed Journal of Regulation & Risk North Asia out the advantages of expansionary fiscal policy in circumstances like the Great Depression, while Milton Friedman blamed the Depression on the Federal Reserve because it allowed the money supply to fall. In subsequent debates: • Keynes was associated with support for activist or discretionary policy. The aim was a countercyclical response to economic fluctuations: expansion in recessions, discipline in booms (1). • Friedman opposed activist or discretionary policy, believing that government institutions – whether monetary or fiscal – were unable to time their interventions effectively. However, what the great economists were both opposed to were procyclical policy moves such as the misguided U.S. tightening in 1937, at a time when the economy had not yet fully recovered. Post-war lessons After the Second World War, the lessons of the 1930s (see Eichengreen et al. 2009) were incorporated into all macroeconomic textbooks and, to some extent, permeated 129

the beliefs and actions of policymakers. But many of these lessons have been forgotten in recent decades, crowded out of public consciousness by other major economic phenomena, such as the high-inflation in the 1970s. Austerity-versus-stimulus Many politicians in advanced countries are repeating the mistakes of 1937 today. This is happening despite conditions (see Almunia et al. 2010) qualitatively similar to those that determined Keynes’policy recommendations in the 1930s (Eichengreen and O’Rourke 2010): high unemployment, low inflation, and rock bottom interest rates. The austerity-versus-stimulus debate (see Frankel 2012a, Corsetti 2012) has been thoroughly hashed out. On the one hand, proponents of austerity correctly point out that the long-term consequences of permanent expansionary macroeconomic policy – both fiscal and monetary – are unsustainable deficits, debts, and inflation. Procyclicalists On the other hand, proponents of stimulus correctly point out that in the aftermath of a recession, when unemployment is high and inflation low, the immediate consequences of contractionary macroeconomic policy are continued unemployment, slow growth, and debt-to-GDP ratios that go up rather than down. With conditions of excess supply in goods and labour markets, as opposed to full capacity and full employment, demand expansion goes into output and employment. Procyclicalists (see Frankel 2012b) both in the U.S. and Europe represent the worst 130

of both worlds. They push in the direction of expansion during booms (such as that of 2003-07 ) and in the direction of contraction during recessions (such as that of 20082012), thereby exacerbating both upswings and downswings. Counter-cyclicalists have it right: working in the direction of fiscal and monetary discipline during booms and fiscal and monetary ease during recessions. Less thoroughly aired recently is the question of whether, given recent conditions, monetary or fiscal expansion is the more effective instrument. This question was addressed clearly in 1937 by Sir John Hicks in a once-famous article entitled:“Mr. Keynes and the Classics: A Suggested Interpretation” (Hicks 1937). The graphical model is known to many generations of undergraduate students in macroeconomics under the label ‘IS-LM’. Which policy is more effective? Under circumstances that held true in the 1930s and do so again today – conditions not just of high unemployment and low inflation but also of near-zero interest rates – stimulus in the specific form of fiscal expansion is much more likely to be effective in the short term than stimulus in the form of monetary expansion. Monetary expansion is rendered relatively less effective because interest rates can’t be pushed below zero. This situation, labelled by Keynes as a liquidity trap, is today known as the ‘Zero Lower Bound’. Indeed, firms are less likely to react to easy money by investing in new factories and equipment if they cannot sell the goods produced in already existing factories. The hoary but still evocative metaphor is ‘pushing on a string’ Journal of Regulation & Risk North Asia

(that is, it is easier to stop an expansion than to end a severe contraction). Meanwhile, fiscal expansion is rendered relatively more effective, in that it doesn’t push up rockbottom interest rates and thereby crowd out private-sector demand. Hamstrung politics Despite the inability of central banks to push short-term nominal interest rates much lower, one should not give up completely on monetary policy, especially because fiscal policy is so thoroughly hamstrung by politics in most countries. Whilst quantitative easing, forward guidance and nominal targets may be worth trying, the effects of each are highly uncertain. That monetary policy is less effective than fiscal policy under conditions of high unemployment and zero interest rates should not be a novel position. However, many economists appear to have forgotten much of what they knew, and politicians may well have never even heard of the proposition. Multiplier effect Introductory economics textbooks have long talked about the Keynesian multiplier effect: the recipients of federal spending – or of consumer spending stimulated by tax cuts or transfers – respond to the increase in their incomes by spending more, as do the recipients of that spending, and so on. Again, the multiplier is much more relevant under current conditions than in more normal situations where the expansion goes partly into inflation and interest rates, and thus crowds out private spending. By the time of the 2008-09 global recession, even those who believed in fiscal stimulus, had Journal of Regulation & Risk North Asia

marked down their estimates of the fiscal multiplier (intimidated, perhaps, by newer theories of policy ineffectiveness). The subsequent continuing severity of recessions in the UK and other countries pursuing contractionary fiscal policies, apparently to the surprise of the politicians enacting them, suggested that multipliers are not just positive, but greater than one. The International Monetary Fund’s own research department (Blanchard and Leigh 2013) has reacted to this recent evidence and bravely confessed that official forecasts, including its own, had been operating with underestimates of multiplier magnitudes. New wave of research A new wave of econometric research estimates fiscal multipliers using methods that allow them to be higher in some circumstances than others. Baum, PoplawskiRibeiro and Weber (2012) allow the estimate to change when crossing a threshold measure of the output gap. Batini, Callegari and Melina (2012) allow regime switching across recessions versus booms. Others that similarly distinguish between multipliers in periods of excess capacity versus normal times (see Ramey 2012), include Auerbach and Gorodnichenko (2012a, 2012b), Baum and Koester (2011), and Fazzari, Morley and Panovska (2012). Most of this research finds high multipliers – above 1.0 – under conditions of excess capacity and low interest rates, though few have the courage to mention that this is what one would have expected from elementary textbooks dating back 50 years. Related studies confirm other conditions that matter for the size of the fiscal multiplier in precisely the way the 131

traditional textbooks say, for example (see Ilzetzki, Mendoza and Vegh 2011) that they are lower in small open economies because of the crowding out of net exports. Substantial uncertainty Needless to say, the effects of fiscal policy are subject to substantial uncertainty. One never knows, for example, when rising debt levels might suddenly alarm global investors who then abruptly start demanding higher interest rates, as happened to countries on the European periphery in 2010. For this reason alone, the U.S. would be well advised to lock in a long-term path towards debt sustainability, even while undertaking a little short-term stimulus. In the case of stimulus in the form of tax cuts, one never knows how much of the boost to disposable income will be saved by households rather than spent. We are also uncertain as to the magnitude of the negative effects of high tax rates, via incentives, on long-term growth. Indeed, it is true that monetary policy is much better understood than it was in the past. Monetary alchemy & fiscal science Nevertheless, if the question is whether monetary policy or fiscal policy can more reliably deliver demand expansion under current conditions, the answer has to be the latter. One might even dramatize the contrast by speaking of ‘monetary alchemy and fiscal science’. A much-admired paper by Eric Leeper (2010) had it the other way around, characterising monetary policy as science and fiscal policy as alchemy. It is true that the state of knowledge and practice at central banks, which actually set the instruments of monetary policy, is close to 132

the best that modern society has to offer. It is likewise true that the instruments of fiscal policy are set in a very political process that is poorly informed by the state contemporary economic knowledge and largely motivated by politicians’ desire to be re-elected. These political realities may be what Leeper had in mind. Modern chemistry Alchemists were neither stupid nor selfish. Nor did their wisdom fall on deaf ears. Rather, alchemy fell far short of modern chemistry. The term alchemy could be applied to preKeynesians such as US Treasury Secretary Andrew Mellon, whose Depression prescription was that President Herbert Hoover should “liquidate labour, liquidate stocks, liquidate farmers, liquidate real estate ... it will purge the rottenness out of the system”. It could also be applied to the UK ‘Treasury view’ circa 1929, defined by Churchill as the Treasury believing that “when Government borrow[s] in the money market it becomes a new competitor with industry and engrosses to itself resources which would otherwise have been employed by private enterprise, and in the process raises the rent of money to all who have need of it”. But in light of all that was learned in the 1930s, it would be misleading to characterise the current state of fiscal policy knowledge as ‘alchemy’.• References
Almunia, Miguel, Agustín Bénétrix, Barry Eichengreen, Kevin O’Rourke, and Gisela Rua (2010), “From Great Depression to Great Credit Crisis: Similarities, Differences and Lessons”, Economic Policy 25,62, 219-265. Auerbach, Alan and Yuriy Gorodnichenko (2012a),

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“Measuring the Output Responses to Fiscal Policy,” American Economic Journal: Economic Policy, 4(2), 1-27, May. Auerbach, Alan and Yuriy Gorodnichenko (2012b), “Fiscal Multipliers in Recession and Expansion,” NBER Chapters, in Alberto Alesina and Francesco Giavazzi (Eds.) Fiscal Policy after the Financial Crisis, Chicago, University of Chicago Press. Batini, Nicoletta, Giovanni Callegari and Giovanni Melina (2012), “Successful Austerity in the United States, Europe and Japan”, IMF Working Papers 12/190, International Monetary Fund. Baum,Anja and Gerritt Koester (2011),“The Impact of Fiscal Policy on Economic Activity Over the Business Cycle - Evidence from a Threshold VAR Analysis” Deutsche Bundesbank, Research Centre series, Discussion Paper Series 1: Economic Studies, 3. Baum, Anja, Marcos Poplawski-Ribeiro and Anke Weber (2012),“Fiscal Multipliers and the State of the Economy,” IMF Working Paper 12/286, International Monetary Fund, December. Blanchard, Olivier and Daniel Leigh (2013),“Growth Forecast Errors and Fiscal Multipliers”, IMF Working Paper 13/1, January, forthcoming in The American Economic Review, May. Corsetti, Giancarlo (2012), “Has austerity gone too far?”,VoxEU.org, 2 April. Eichengreen, Barry and Kevin H O’Rourke (2010), “A tale of two depressions: What do the new data tell us?”,VoxEU.org, 8 March. Eichengreen, Barry Kevin H O’Rourke, Miguel Almunia, Agustín S Bénétrix, and Gisela Rua (2009), “The effectiveness of fiscal and monetary stimulus in depressions”,VoxEU.org, 18 November. Fazzari, Steven, James Morley, and Irina Panovksa (2012), “State-Dependent Effects of Fiscal Policy”, UNSW Australian School of Business Research Paper, 2012-27,April. Frankel, Jeffrey (2012a),“The First World’s Fiscal Follies”, Project Syndicate, 19 July.

Frankel, Jeffrey (2012b), “The Procyclicalists: Fiscal austerity vs. stimulus”,VoxEU.org, 7 August. Friedman, Milton and Anna Schwartz (1963), A Monetary History of the United States, 1867–1960, Princeton University Press. Hicks, John (1937), “Mr. Keynes and the Classics: A Suggested Reinterpretation”, Econometrica, 147-59. Ethan Ilzetzki, Enrique Mendoza & CarlosVegh, 2011. “How Big (Small?) are Fiscal Multipliers?”, IMF Working Papers 11/52, (International Monetary Fund.) Forthcoming, Journal of Monetary Economics. Leeper, Eric (2010), “Monetary Science, Fiscal Alchemy,” NBER Working Paper 16510. Ramey,Valerie A (2012),“Government Spending and Private Activity”, first presented at the 2011 NBER conference ‘Fiscal Policy after the Financial Crisis’ in Milan, December. Romer, Christina and David Romer (2013), “The Most Dangerous Idea in Federal Reserve History: Monetary Policy Doesn’t Matter,” University of California, Berkeley, January. Spilimbergo, Antonio, Steven Symansky, and Martin Schindler, “Fiscal Multipliers,” Staff Position Note 2009/11, International Monetary Fund.

Authors notes 1.) It is a myth that he favoured big government more generally. Indeed, he said “the boom is the time for austerity” 2.) For an alternative perspective, see Romer and Romer (2013) for a discussion of ‘why monetary policy doesn’t matter’. Editors note: The publisher and editor of the Journal would like to thank both VoxEU and Harvard Kennedy School’s Prof. Jeffrey Frankel for allowing the Journal to reproduce a slightly amended version of this paper that was first published on the authors blog in January, 2013. 133

Journal of Regulation & Risk North Asia

Interest rate risk

Central bank fixation with low inflation prolongs recession
Prof. Laurence Ball of Johns Hopkins University questions the wisdom of a “low inflation” target to generate global growth.
Since the double-digit inflation of the 1970s, central banks have sought to reduce inflation and keep it low. This column argues that recent history teaches us that inflation has fallen too low. Raising inflation targets to 4 per cent would have little cost, and it would make it easier for central banks to end future recessions. Many central banks have adopted a common policy – an inflation target near 2 per cent. These central banks include the Fed (which calls it a ‘long run goal’), the ECB (which targets inflation ‘below, but close to 2 per cent’) and the central banks of most other advanced economies. A number of economists, such as Blanchard et al. (2010), have suggested a higher inflation target – typically 4 per cent.Yet this idea is anathema to central bankers. According to Ben Bernanke (2010a), the Federal Open Market Committee unanimously opposes an increase in its inflation goal, which‘would likely entail much greater costs than benefits’. I examine the case for a 4 per cent inflation target in a recent essay (Ball, 2013) and reach the opposite conclusions to those Journal of Regulation & Risk North Asia of Chairman Bernanke: A 4 per cent target would ease the constraints on monetary policy arising from the zero bound on interest rates, with the result that economic downturns would be less severe. This important benefit would come at minimal cost, because 4 per cent inflation does not harm an economy significantly. Recent history has demonstrated the problem of the zero bound. In response to the US financial crisis and recession, the Fed reduced its target for the federal funds rate from 5.25 per cent in August 2007 to a range of 0 to 0.25 per cent in December 2008. The target remains in that range today. Yet this sharp monetary easing has not restored full employment. The unemployment rate peaked at 10 per cent in 2009 and then stayed high; in April 2013, it was 7.6 per cent. Unemployment of 5 per cent – widely considered the natural rate just a few years ago – is nowhere in sight. During past recessions, the Fed has reduced interest rates and kept reducing them until unemployment fell to an acceptable level. But cutting interest rates has not been feasible since 2008. With nominal rates 135

already near zero, they cannot fall farther. Nobody would lend at a negative interest rate because one can do better by holding cash. As the US recession spread around the world, many other central banks reduced interest rates to 1 per cent or less. Like the US, their economies are stuck in the‘liquidity trap’described by Keynes (1936). The Fisher effect In general, a higher inflation target reduces the zero-bound problem. In long run equilibrium, a higher inflation rate implies that nominal-interest rates are also higher – the Fisher effect. When a recession occurs, rates can fall by more before hitting zero, making it more likely that policymakers can restore full employment. Suppose that central banks had been targeting 4 per cent inflation in the early 2000s rather than 2 per cent. Nominalinterest rates would have been two percentage points higher, allowing rates to fall by an extra two points before hitting zero. I estimate that this extra stimulus would have reduced average unemployment over 20102013 by two percentage points (Ball 2013). Risk of the zero bound Looking forward, the case for a higher inflation target depends on the risk that interest rates will hit zero in future recessions. Some economists believe that this risk is low. Mishkin (2011), for example, argues: “Although [the zero bound] has surely been a major problem in this recent episode, it must be remembered that episodes like this do not come very often. Indeed, we have not experienced a negative shock to the economy of this magnitude for over seventy 136

years. If shocks of this magnitude are rare, then the benefits to a higher inflation target will not be very large because the benefits will only be available infrequently.” In my view, Mishkin understates the risk of the zero bound. If we look beyond the US, the crisis of 2007-2009 is not unique in recent history. A completely separate financial crisis pushed Japanese interest rates to zero in 1997. It was only around 1990 that central banks began to target inflation rates of 2 per cent or less. The two largest economies that adopted this policy both hit the zero bound within 20 years. More generally, history suggests that the zero bound is dangerous if central banks target 2 per cent inflation. In my paper, I make this point by examining the eight US recessions since 1960. Looking at recession We can divide these recessions into two groups: First, recessions with low initial inflation. Three of the eight recessions began with inflation rates between 2 and 3 per cent. These episodes provide the most direct evidence on the zero-bound problem at low inflation rates. One of the three is the Great Recession of 2008-09, when the zero bound constrained monetary policy severely. Based on the Taylor rule that fits policy before 2008, Rudebusch (2009) finds that the optimal federal funds rate, ignoring the zero bound, fell to -5 per cent in 2009. The other two recessions that began with 2-3 per cent inflation are the first one in the sample, which occurred in 1960-61, and the last one before the Great Recession, in 2001. These two recessions were milder than most: their peak levels of unemployment were only 7.1 per cent and 6.3 per cent. In both Journal of Regulation & Risk North Asia

cases, the federal funds rate did not hit zero, but it came close.The funds rate fell to 1.2 per cent following the 1960-61 recession and 1.0 per cent following the 2001 recession. Low versus high inflation We have seen that, with low inflation, a severe recession reduces the optimal federal funds rate to -5 per cent and mild recessions reduce it to about +1 per cent. Comparing these cases, it seems likely that a recession of average severity would push the optimal rate below zero. Second, recessions with high initial inflation. In five of the eight recessions since 1960, inflation began above 4 per cent. With high inflation, nominal-interest rates were also high, so the Fed could cut them sharply without approaching zero. But what would have happened if inflation had started at 2 per cent? We can get an idea by examining real interest rates. If the nominal-interest rate, ‘i,’ cannot fall below zero, then the real rate, r=i-π , cannot fall below -π . One way to interpret the danger of low inflation is that it raises the lower bound on the real interest rate. Interpreting the dangers If inflation is 2 per cent when a recession begins, the bound on the real rate is -2 per cent at that point. However, the recession is likely to push inflation down somewhat. In the three recessions that actually started with 2-3 per cent inflation, the inflation rate fell to about 1 per cent before the economy recovered. History suggests, therefore, that initial inflation of 2 per cent will produce a bound of -1 per cent on the real interest rate. For the recessions that started with inflation above Journal of Regulation & Risk North Asia

4 per cent, we can gauge the relevance of a real-interest-rate bound by examining the lowest value reached by the real rate during the recession and subsequent recovery. In two of the five cases – the recessions of 1973-75 and 1980 – the real rate fell below -4 per cent. In these episodes, a lower bound of -1 per cent would have severely distorted monetary policy. During the recession of 1969-70, the real rate fell to a minimum of -2.3 per cent. In the recession of 1990-91, the minimum was -0.6 per cent; this episode would have been a near miss with a lower bound of -1 per cent. Only in one case, the recession of 1981-82, was the minimum real rate above zero. To summarise, history suggests that, with a 2 per cent inflation target, the lower bound on interest rates is likely to bind in a large fraction of recessions. The scourge of inflation Would 4 per cent inflation hurt the economy? Economists have suggested various costs of inflation, such as variability in relative prices and distortions of the tax system. But research has not shown that these effects are quantitatively important for moderate inflation. As Krugman (1997) puts it:“one of the dirty little secrets of economic analysis is that even though inflation is universally regarded as a terrible scourge, efforts to measure its costs come up with embarrassingly small numbers”. Some central bankers acknowledge that 4 per cent inflation does not greatly harm the economy. Nonetheless, they oppose adoption of a 4 per cent target because they think this action may actually cause inflation to rise above 4 per cent, or at 137

least create expectations of that outcome. Bernanke (2010a), for example, asserts that “inflation would be higher and probably more volatile” with a 4 per cent target and “inflation expectations would also likely become significantly less stable”. Maintaining credibility According to Bernanke (2010b): “The Fed, over a long period of time, has established a great deal of credibility in terms of keeping inflation low, around 2 per cent... If we were to go to 4 per cent and say we’re going to 4 per cent, we would risk a lot of that hard-won credibility, because folks would say, well, if we go to 4 per cent, why not go to 6 per cent? It’d be very difficult to tie down expectations at 4 per cent.” Mishkin (2011) makes a similar argument, asserting that “when inflation rises above the 3 per cent level, it tends to keep on rising”. We might call this view‘the addictive theory of inflation’. Like an alcoholic’s first drink, 4 per cent inflation may not do great harm by itself, but it is the first step in a dangerous process. Inflation expectations The rationale for this view is not clear. In other contexts, Bernanke and Mishkin argue that a central bank should determine its optimal policy, explain this policy to the public, and carry it out. Why can’t policymakers explain that the zero-bound problem makes 4 per cent inflation desirable, raise inflation to 4 per cent, and keep it there? Mishkin points to the 1960s, when inflation increased to 4 per cent and the Fed let it keep rising, but why must policymakers repeat that mistake? 138

History does not suggest that it would be “difficult to tie down expectations” if inflation rises modestly. Inflation expectations, as measured by surveys, have generally followed actual inflation with a lag. They followed inflation up during the 1960s and ‘70s, and after that they followed inflation down. If inflation rises to 4 per cent, it seems unlikely that expectations will overshoot this level. Since the double-digit inflation of the 1970s, central banks have sought to reduce inflation and keep it low. Recent history teaches us that inflation has fallen too low. Raising inflation targets to 4 per cent would have little cost, and would make it easier for central banks to end future recessions.• References
Ball, Laurence (2013),“The Case for 4 per cent Inflation”, Central Bank Review (Central Bank of the Republic of Turkey), May. Bernanke, Ben S (2010a), “The Economic Outlook and Monetary Policy”, Jackson Hole Symposium, 27 August. Bernanke, Ben S (2010b), “Testimony before the Joint Economic Committee of Congress”, 14 April. Blanchard, Olivier, Giovanni Dell’Ariccia and Paolo Mauro (2010), “Rethinking Macroeconomic Policy”, IMF Staff Position Note SPN/10/03. Keynes, John M (1936), The General Theory of Employment, Interest and Money, Macmillan. Krugman, Paul R (1997), The Age of Diminished Expectations: US Economic Policy in the 1990s, MIT Press. Mishkin, Frederic S (2011), “Monetary Policy Strategy: Lessons from the Crisis”, NBER Working Paper #16755. Rudebusch, Glenn D (2009), “The Fed’s Monetary Policy Response to the Current Crisis”, FRBSF Economic Letter 2009-17.

Journal of Regulation & Risk North Asia

Legislation

The Brown-Vitter bill: An exposé of lunacy
Former bank regulator and prosecutor, William K. Black, pulls no punches in his denunciation of proposed Senate bill.
U.S. Senators Sherrod Brown and David Vitter have introduced a legislative bill to the Senate entitled “Terminating Bailouts for Taxpayer Fairness Act of 2013.” Under President Obama, bipartisan bills to date have had a dismal effect on Capitol Hill. As the Democrats negotiate away the very elements necessary to create a good bill and add provisions that make parts of the bill harmful, seemingly in a bid to pick up a few token co-sponsors, the Republicans react by doing their bit to kill off any positive parts of the bill in their effort to enact the negative. The Brown-Vitter bill (BV) seems to exemplify all these problems. Not only would it fail to achieve its desirable outcomes, even if it was to become law, but it would also allow the largest fraudulent banks to continue to cripple any effective examination. The result is an enactment of a bill by the Republicans that is so bad it can only be described as criminogenic. One of the most essential actions we need to take is to eliminate systemically dangerous institutions (SDIs), a rough example Journal of Regulation & Risk North Asia of this being any bank with liabilities greater than US$50 billion. The Dodd-Frank Act passed in 2010 did nothing effective to end SDIs. Whilst BV could be a sensible, even vital reform, if only it were drafted with the aim of ending SDIs, its harmful provisions will likely be made worse by its possible amendments. Bill enshrines SDI problem The bill, in its current draft format, enshrines, rather than resolves, the problem of SDIs. The concept of SDIs is that their failures are likely to cause a global, systemic crisis. This is why the “too big to fail” (TBTF) concept developed. TBTF, however, was historically a misnomer. TBTF banks did indeed fail in America. The Federal Deposit Insurance Corporation (FDIC), however, ensured that when TBTF banks did fail, their general creditors did not suffer losses. The equity holders and subordinated debt holders would normally have been wiped out, if and when, a TBTF bank did fail. However, the regulatory concern was that if general creditors of an SDI suffered 139

losses when the SDI failed, it could cause a “cascade” of bank failures as their largest general creditors were typically other banks. The effect is the creation of three disastrous problems; any one of which should have been sufficient decades ago to convince Congress to get abolish SDIs. Woes of SDIs First, SDIs make a mockery of the phrase “free markets.” The metaphor used by a group of conservative New York University scholars to describe the competitive advantage to SDIs of the implicit subsidy that arises from bailing out the general creditors is akin to“bringing a gun to a knife fight.” Second, SDI failures risk causing global financial crises. And third, SDIs create so much economic power that inherently translates into dominant political power, thus crippling any democracy or democratic oversight by creating what amounts to crony capitalism. SDIs also fail to create any desirable advantages as they are so large that they are impossible to manage or regulate effectively. They are inefficient as well as dangerous.The only win-win situation on the horizon is to make banks more efficient and far less dangerous by getting rid of SDIs. Protect the taxpayer However, the focus of the BV bill was never on the abolishment of SDIs. Brown and Vitter’s comments make it clear that they agree with the first two problems caused by SDIs. “The truth, according to the markets, is that ‘too-big to-fail’ is alive and well with the Wall Street megabanks,” Vitter said.“Our number one goal is to protect the taxpayers 140

from financial risks and the best way to do this is by implementing a systemic solution, increasing the minimum amount of capital the mega banks are required to have.” The first problem with BV is so obvious that the fact that it is ignored by the media (and by Brown and Vitter) tells us that SDIs have so insinuated themselves into our psyches that even reformers cannot conceive of a world free of what Brown and Vitter describe as their scourge. If their “number one goal” is to protect us from SDIs, why don’t Brown and Vitter seek to rid the market of them? BV fails bailout test Brown and Vitter began the press release announcing their co-sponsored bill as follows:“Washington, D.C.– U.S. Sens. Sherrod Brown (D-OH) and David Vitter (R-LA) announced a new plan that would prevent any one financial institution from becoming so large and over leveraged that it could put our economy on the brink of collapse or trigger the need for a federal bailout.” BV does not do any of the things the sponsors claim in this sentence. The SDIs are already large enough that they pose a global systemic risk when they fail. BV does not limit the size of the SDIs or prevent them from growing. Fraudulent SDIs can be massively overleveraged under BV. As such, BV fails to eliminate the need for federal bailouts. Our second problem is the fact that higher capital requirements cannot, and do not, make SDIs safe. Higher capital requirements cannot protect us from the three disasters that SDIs cause. Brown and Vitter’s explanation for their bill contains this telling fact. “Prior to the crisis, Lehman Brothers Journal of Regulation & Risk North Asia

ostensibly had a capital ratio of 11 per cent, yet its assets were sold in bankruptcy for nine cents on the dollar.”

there is “pure” capital that will remain in the “pure capital” vault even after the bank is looted. It is dangerous to believe in such absurd myths. Misunderstand capital Brown and Vitter also appear to have forAnother major issue is that neither Brown gotten recent history, when Congress sucnor Vitter seem to understand “capital,” cessfully extorted the Financial Accounting accounting, or fraud. Brown and Vitter do Standards Board (FASB), demanding that not understand the import of the facts of they change generally accepted accounting the Lehman’s failure in September 2008. principles (GAAP) so that the largest banks “Capital” is merely an accounting residual: would not have to recognise their masassets – liabilities = capital. Accounting con- sive losses on their loans and toxic derivatrol frauds such as Lehman (see my House tives - the so called Mark-To-Market. This testimony for details) massively overstate accounting travesty remains the rule today, asset values. which means that we have systematically Frauds also use many scams to dramati- overstated bank asset values – which means cally understate liabilities. Indeed, Lehman in turn that we systematically overstate bank used an accounting scam to substantially capital. Brown and Vitter propose no change understate its debt levels. There are also to end this travesty. Instead they do little but scams that directly create fictional capital. spread fantasies about “pure”capital. See my description in earlier articles of the Icelandic banks’ scams in which they lent Fraud, what fraud? money to their shareholders to buy their In a nutshell, our two erstwhile Senators shares. ignore the real problem, namely, accounting control fraud. Lehman provides a chilling Dangerous delusions example of how much fictional capital and Further, Brown and Vitter do not understand accounting control fraud can create – and the ephemeral nature of capital. “Capital how much damage the controlling officrequirements will focus on common equity ers can do by looting “their” firms. George and other pure, loss-absorbing forms of Akerlof and Paul Romer described these capital.” Brown and Vitter’s conception that frauds in their 1993 article: Looting: The capital can be something that is “pure” and Economic Underworld of Bankruptcy for Profit. can be counted on to be there when the I assume for the purposes of analysis bank fails to “absorb loss” is a dangerous the accuracy of Vitter’s claim that Lehman’s delusion that demonstrates that Brown and asset valuations were overstated by 91 Vitter do not understand the most basic and cents on the dollar. At the same time it was critical concepts of finance, accounting, and reporting an 11 per cent (positive) capital regulation. level, its real capital level was in the range They seem to believe that there is some of a (negative) 85 per cent. Lehman could, vault in a bank that holds “capital”and that easily, have reported that it met the 15 per Journal of Regulation & Risk North Asia 141

cent capital requirement that BV proposes for “megabanks.” It would have required a few more scam deals, and that would have increased Lehman’s losses. Brown and Vitter however show no signs of understanding the basics of accounting control fraud. Fraud is a “sure thing” The fraud “recipe” for officers controlling a lender reads something like this: Grow like crazy by making really crappy loans at a premium yield, while employing extreme leverage, and providing only grossly inadequate allowances for loan and lease losses (ALLL)! Akerlof and Romer agreed with the conclusion of regulators and criminologists that this recipe produces a series of“sure things.” The lender is guaranteed to report record (albeit fictional) profits in the short-run, the controlling officers will promptly be made wealthy by modern executive compensation, and the lender will eventually suffer catastrophic losses. Fictional profits The officers who control a bank and use it as a“weapon”to defraud can easily produce vast amounts of fictional profits that can (partially) be retained so that they produce very high levels of reported capital. A higher capital requirement can slow down a fraud by reducing growth and leverage, but it will not prevent catastrophic losses and, if many controlling officers follow the same strategy, a hyper-inflated bubble that can produce a systemic crisis. Accounting control frauds are exceptionally adept at suborning the “independent professionals” who value assets and liabilities. The fraudulent controlling officers 142

deliberately create a “Gresham’s dynamic” that drives good ethics out of key positions in the professions. Lehman had no difficulty getting a subset of appraisers to overstate home prices and auditors to “bless” even their massively over-valued assets and its preposterously inadequate ALLL. Again, anyone who thinks there is “pure” capital has to believe in “pure” asset and liability valuations. I had not thought, after this crisis, that anyone still believed in such a myth, but then came BV. The bottom line is that BV will fail the banks precisely where success is most essential – within the arena of accounting control frauds. Fraud is “pervasive” As a group of conservative finance professors were recently forced to conclude as a result of their study, during the recent crisis fraud was“pervasive”at our“most reputable” banks – see Asset Quality Misrepresentation by Financial Intermediaries: Evidence from RMBS Market, by Tomasz Piskorski, Amit Seru & James Witkin (February 2013) (“PSW 2013”). The national commission that investigated the causes of the S&L debacle reported that at the “typical large failure” “fraud was invariably present.” The S&L frauds were control frauds. No one doubts that the Enron-era scandals were control frauds. Even conservative scholars that have investigated the most recent crisis have concluded that the SDIs engaged in “pervasive” fraud. The key persons who have not gotten the message about the need to deal with accounting control fraud if we wish to avoid future financial crises are Brown and Journal of Regulation & Risk North Asia

Vitter. This passage, from their description of the BV bill reveals that they have implicitly assumed fraud out of existence: “Requiring the largest banks to fund themselves with more equity will provide them with a simple choice: they can either ensure they can weather the next crisis without a bailout or they become smaller.” Accounting control fraud No, there is another choice – a choice that the officers controlling the SDIs have often decided was their superior option – accounting control fraud. Fraud is a“sure thing,”and the C– suites are filled with officers who love sure things. Again, notice that Brown and Vitter do not understand the import of Lehman’s massive overstatement of assets (and, therefore, capital) that they used as purportedly supporting the desirability of their bill. No capital requirement can“ensure”that a bank will not fail and will not be bailed out. Dream state Our bill sponsors though go one better in what can only be described as a dream state in trying to temper some form of regulatory fusion with private market discipline, which is best summed up in the following section: “Regulators may increase capital ratios as banks increase in size. Setting capital levels for the largest megabanks at levels required by the private market, absent government support, will ensure that they have an adequate cushion of equity in the event that the FDIC must put a megabank through orderly liquidation under Title II of Dodd-Frank.” This passage is another demonstration Journal of Regulation & Risk North Asia

that Brown and Vitter do not comprehend the importance of the Lehman fraud and the resultant catastrophic losses. Once more, they claim that their bill will“ensure”that we will never again have any expense when a “megabank”fails. How can they conceivably say that after Lehman’s failure? We need to go back to basic facts about finance. Lehman was an investment bank so it had no FDIC deposit insurance. Lehman was not treated as TBTF by the markets or the government. It was allowed to fail and its general creditors were not bailed out by the government. Lehman was not treated by the markets as immune to failure. The lie of Lehman’s As a result, it purported to maintain a higher capital level (11 per cent) than did most FDIC insured banks. But that higher reported capital level was a lie – an enormous lie by a grotesquely insolvent investment bank. Its reported capital level was chosen by its management “at levels required by the private market, absent government support.” Not only was the reported capital level a work of fiction but “the private market”also failed to spot for years the fact that Lehman was actually deeply insolvent. Lehman proves that one has to be delusional to believe that they can “ensure that they have an adequate cushion of equity” by setting a higher capital requirement. Congress’ role in successfully extorting FASB to hide real losses in order to overstate reported assets and capital also explains one of the several reasons BV cannot “ensure” the attainment of any of its stated goals. Another contention I have with BV is the fact, that contrary to their intent, the bill 143

does not eliminate the implicit Federal subsidy megabanks enjoy, and they the authors decry. I explained why the acronym TBTF was a misnomer. TBTF banks have failed. It actually refers to bailing out the general creditors. Brown and Vitter explicitly criticise the “implicit federal subsidy” enjoyed by the SDIs because they can borrow more cheaply than their competitors. No higher capital requirements But a close reading of their press release reveals that Brown and Vitter appear to believe that the SDIs can borrow more cheaply because the government never permits them to fail. Brown and Vitter do not understand that the implicit subsidy arises because the government ensures that when an SDI fails that its general creditors are bailed out. This explains why BV does not ban bailing out an SDI’s general creditors. BV, therefore, fails to remove the implicit federal subsidy that SDIs enjoy. A further issue with BV is the fact, as the bill is presently drafted, is that it does not significantly increase capital requirements for most SDIs. Vitter did not promise significantly higher capital requirements for SDIs. Further, he has conflated TBTF with “megabanks.” Megabanks are an important subset of SDIs because their assets are so massive, but most SDIs do not meet the BV definition of a “megabank”, namely, assets greater than US$50 billion. Media failure Again, the media has largely ignored this incredible failure by BV to require most SDIs to have substantially greater capital. Even if we were to assume, contrary to fact, that 144

higher capital requirements removed the three disastrous consequences of SDIs, BV leaves a massive loophole. BV only begins to increase a SDIs capital requirement substantially when it attains a size roughly 10 times larger than the US$50 billion threshold to become an SDI. BV redefines most SDI’s as “mid-size” and “regional” banks, but calling them that is a pure fig leaf. They are so large that they pose a systemic risk when they fail. BV’s eight per cent capital requirement is essentially a return to the status quo before Basel II. If our co-sponsors of this Bill were serious about SDIs they would be calling out for the reintroduction of the only effective means to make reported capital real, this being vigorous independent examination. Gresham’s dynamics As I have noted, officers running accounting control frauds find it easy to create Gresham’s dynamics that allow them to suborn appraisers and auditors who will bless massively inflated asset values while hiding real losses. A lender that follows the fraud recipe will produce record (fictional) income and can produce very large amounts of (fictional) capital. These results are “sure things” under the fraud recipe. Creditors do not “discipline”accounting control frauds – they fund their growth. Creditors love to loan to firms reporting record profits. Regulators are the only controls that the fraudulent CEO cannot hire and fire. Only skilled, vigorous examiners backed by tough supervisors have any hope of ensuring that reported bank capital bears any relationship to reality. Brown and Vitter do not appear to Journal of Regulation & Risk North Asia

understand the import of the Financial Crisis Inquiry Commission’s (FCIC) key finding that the regulators failed to act because of the competition in regulatory laxity, the creation of regulatory black holes, and the regulators’ experience that it was impossible to get the political appointees running their agencies to take action against banks that were reporting high profits (FCIC 2011: 307). Shock waves The key is for examiners to order banks to recognise losses on bad assets as soon as those assets are impaired – not when the default happens (which can be years later). In the S&L debacle, we sent shock waves through the frauds when we targeted the S&Ls reporting the highest profits and growth as our top priority for investigation because they were the most likely to be fraudulent. It is essential that we return to that strategy by appointing real regulators. Regrettably for me, the industry itself, and the general public, far from achieving this examiners nirvana, BV would have the opposite effect, as such, it is BV is criminogenic, and would eviscerate what one considers vigorous examination. Many influential officials try to impair vigorous regulation, which always starts with vigorous examinations. Keating saga In the S&L debacle, the Reagan administration tried to give the most notorious S&L CEO, Charles Keating (who ran Lincoln Savings), control of the federal agency regulating S&Ls. I blew the whistle on this effort, which led to the resignation in disgrace of one of our three presidential appointees Journal of Regulation & Risk North Asia

running our agency. A majority of the House co-sponsored a resolution calling on us not to go forward with reregulating the industry. Speaker Wright held the bill to recapitalise the FSLIC insurance fund (so that we would have the funds to close more control frauds) hostage to extort favours for Texas control frauds. Senator Cranston put a secret hold on the same bill at Keating’s behest. Keating used Alan Greenspan as a lobbyist to help recruit the five U.S. Senators who would become known as the “Keating Five” when my notes of the meeting were made public. Threat of legal proceedings The Office of Management and Budget threatened to make a criminal referral against the head of our agency, Edwin Gray, on the grounds that he was closing too many insolvent S&Ls. Yes, you read that sentence correctly. The top guy in Treasury for S&L policy testified against our agency in the challenge to the appointment of a receiver of an insolvent S&L. He opined that it was “arbitrary and capricious” to close S&Ls because they were insolvent. He also testified to Congress that we should simply run a Ponzi scheme by encouraging insolvent S&Ls to grow so that they could use the cash they obtained from deposit growth from new depositors to pay interest to existing depositors. The Reagan administration and Speaker Wright made a cynical secret deal not to reappoint Gray to a new term. The administration appointed Danny Wall as Gray’s successor. Wall proceeded to meet Wright’s demand that we force out our top supervisor in Texas. Wright’s complaint 145

was that he was homosexual, but everyone knew that Wright’s real complaint was that he was effective. Wall immediately ordered an end to our examination and the enforcement investigation of Lincoln Savings. Largest S&L failure This was Keating’s primary demand because he knew that our examination and enforcement investigation had already discovered a number of his frauds and that his control over Lincoln Savings could not survive our continued examination and enforcement investigation. Wall then removed the jurisdiction of the agency’s San Francisco office over Lincoln Savings because we persisted in recommending a takeover of Lincoln Savings after the Keating Five tried to intervene to prevent us from taking action against Lincoln Savings’ massive violation of the law. This led to a disaster. Lincoln Savings became the most expensive S&L failure and defrauded thousands of widows. The Texas state S&L commissioner was consorting with so called“ladies of the night” provided by the Nation’s second worst financial fraud, Vernon Savings (known as “Vermin” to its regulators). The California state S&L commissioner was secretly in business with Keating. The Texas Attorney General announced he was investigating us for discrimination against Texas S&Ls, particularly in our examination process. “Get Black … Kill Him Dead.” A couple of days later he announced we were guilty without any cumbersome investigation to slow him down. The COO of one the S&L our San Francisco office regulated 146

threatened our examiner-in-charge. The FBI informed us that organised crime controlled the S&L. Keating hired private counsel who had recently left a senior position at the Department of Justice (DOJ). They contacted William Weld, one of the most senior DOJ officials. Within days, the FBI was investigating us (the San Francisco office of the federal regulatory agency), rather than Keating. Keating twice hired private investigators to investigate me. He sued me and a number of regulators, for US$400 million in our individual capacities (in a Bivens suit). Keating boasted of spending US$50 million to attack our examination report of Lincoln Savings. Keating infamously put in writing his directive to his chief political fixer that his“highest priority”should be to“Get Black … Kill Him Dead.” “The secret file” Keating also created what became known as “the secret file”that supposedly had derogatory information on me and gave it to senior officials of our agency. They refused allow me to read and respond to the file. When I persisted, they gave the file back to Keating to prevent me from getting access to the file. I note these personal occurrences to explain several points that are essential to our understanding of BV. First, regulation can succeed. It is only now, with the experience of the current crisis where effective regulation and regulators were deliberately targeted for removal that we can see that Chairman Gray’s actions in promptly reregulating the industry saved many trillions of dollars by containing a surging epidemic of accounting control fraud in the 1980s. We can also see that our actions in Journal of Regulation & Risk North Asia

driving liar’s loans out of the S&L industry in 1990-1991 prevented a crisis that also would have cost trillions of dollars to resolve absent effective regulation. Second, the key is regulatory professionalism, knowledge of accounting control fraud techniques, vigour, and resoluteness. Pushback is inevitable and violent. The accounting control frauds cultivate powerful political allies. Akerlof & Romer insight Third, the examination process is the key value that a financial regulatory agency adds. Good examiners do not wait for the assets to blow up in massive defaults. They spot impaired loans early and they spot accounting control fraud schemes early. It is then incumbent on the agency’s leadership to back up the examiners with prompt, vigorous supervision, enforcement, receiverships, and criminal referrals. Akerlof and Romer examined a large amount of materials from our examiners and came to this key insight:“Neither the public nor economists foresaw that [S&L deregulation was] bound to produce looting. Nor, unaware of the concept, could they have known how serious it would be. Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself”(George Akerlof & Paul Romer.1993: 60). Provision of regulatory relief Fourth, the frauds recognise that the examinations are the key and their effort is always to impair the examination and the ability Journal of Regulation & Risk North Asia

of supervisors to require prompt corrective action on the basis of the examinations. I mentioned Speaker Wright holding the FSLIC recapitalisation bill hostage. The broader story is that the Texas control frauds hijacked the bill and festooned it with “forbearance” provisions designed to allow the frauds to stall the exams and vital supervisory actions. Fifth, the destruction of effective examination as a result of some of these forbearance provisions and the regulatory race to the bottom proved disastrous during the most recent crisis. Restoring effective financial examination and supervision (and criminal prosecutions) should be a national priority. Impaired examination Sixth, instead, BV, as introduced, is designed to further impair examination. The Senators’ description of this portion of the bill is disturbingly disingenuous: “Provide regulatory relief for community banks. By reducing regulatory burdens upon community banks, they can better compete with mega institutions. Because community institutions do not have large compliance departments like Wall Street institutions, this legislation provides common sense measures to lessen the load on our local banks. Creates an independent bank examiner ombudsman that institutions can appeal to if they feel that they have been treated unfairly by their examiner.” This provision, however, is not limited to “community” (very small) banks. Creating an ombudsman for examination will be a godsend to fraudulent SDIs. Keating ran a US$6 billion S&L – and spent US$50 million 147

attacking a single examination (roughly our entire budget for a region regulating hundreds of S&Ls). Wait till JP Morgan decides to fight an examination. It will be able to stall the examiners and supervisors for years. Hostile Ombudsmen The SDIs will hire away the Ombudsman, assuming he sides with the industry, and give him a wonderful sinecure (“revolving door”). The SDIs will lobby to try to ensure that the person selected as Ombudsman is hostile to effective regulation. Incredibly, BV recreates the worst of Keating’s abuses. ‘‘(e) Confidentiality – The Ombudsman shall keep confidential all meetings, discussions, and information provided by financial institutions.’’ Yes, Keating’s secret files will now become National policy. The bank gets to make ex parte presentations in person and writing with the Ombudsman – who is forbidden by statute from informing the regulatory agency of the charges and giving the examiner and the agency an opportunity to respond. Then, on the basis of ex parte smears, the Ombudsman can issue a report condemning the examiner or the agency. Institutionalised grave digger The grave danger is that one portion of BV will become law – the provisions that will be drafted by the fraudulent SDIs’ lawyer/ lobbyists that will expand the assault on any effort to restore what is already a crippled examination process. This is what happened when Speaker Wright was extorting us in 1986-1987. It was only a bit of clever amending by us with the invaluable aid of Representatives Jim 148

Leach and Henry B. Gonzalez that saved the Nation from disaster. I mentioned the cynical deal that the Reagan administration reached with Speaker Wright. The administration promised two things as part of the deal. It would not reappoint Ed Gray as chairman of the regulatory agency and it would not opposed the“forbearance”provisions that the control frauds’ lawyers had drafted to make effective examination and supervision impossible. Obama questions Will the Obama administration oppose this travesty of a bill posing as a reform aimed at the SDIs that would actually be a great boon to the SDIs because they could use it to assure that examination remains impotent? Will the Obama administration support a clean bill with the three provisions: No SDI may grow; All SDIs must shrink within five years to below US$50 billion (US$ 2013 equivalent) in assets: All SDIs will be subject to stringent examination and supervision during that five year divestment period. And will the Obama administration appoint regulatory leaders who will actually vigorously enforce the laws? • Editors note: The publisher and editor of the Journal would like to express their gratitude to Associate Prof. William K. Black of the University Missouri-Kansas City for allowing the Journal to republish an abridged version of this paper that first appeared on the authors website, New Economic Perspectives - www.neweconomicperspective.org - this May. Please also note that the original title has been altered to benefit our readership here in the Asia Pacific region. Journal of Regulation & Risk North Asia

Derivatives

Dodd-Franks extra-territorial reach irks European Union
MRV Associates’ Mayra Rodríguez Valladares details growing global concerns over the CFTC’s interpretation of Title VII.
Summer tends to be a quiet time for Europeans as many head out for nice holidays. This summer may be quite different; as European bankers, governments, and regulators are increasing their pressure on Commodity Futures Trading Commission Chairman Gary Gensler to curb what they deem is the CFTC’s extraterritorial reach with Dodd-Frank’s Title VII. Gensler and his supporters, however, are not satisfied that relying on foreign regulators to monitor U.S. derivatives activities abroad would protect the U.S. taxpayer if a breach in Dodd-Frank rules or a derivatives transactions failure were significant enough to disrupt markets. Due to the role of unregulated over-thecounter (OTC) financial derivatives in the 2008 financial crisis which began in the U.S. but whose influence was felt globally, the G-20 agreed in its Pittsburgh meeting in 2009 that “all standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms where appropriate, and cleared through central Journal of Regulation & Risk North Asia counterparties by end-2012, at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.” Failure of 2009 communiqué It is important to note that unlike Basel III, the international uniform capital standards for banks, the 2009 communiqué did not lead to international uniform financial derivatives standards. The members of the G-20, in varying degrees and at different speeds, have embarked in their own jurisdictions to reform the OTC derivatives market. Given the interconnected nature of these markets, international cooperation has very much been part of crafting derivatives financial regulation. Nonetheless, as noted by Gensler “due to different cultures, political systems and legislative mandates, some differences are inevitable.” Unlike with the Basel III bank capital standards, the U.S. has been faster at finalising and implementing derivatives rules as part of Dodd-Frank’s Title VII. 149

In July 2012, for example, the CFTC released guidance for financial institutions to address extraterritorial concerns raised both in the U.S. and abroad. Reporting exemptions were granted to numerous participants, but these are due to be revisited on July 12. Extraterritorial regulations Before highlighting the differences between the CFTC’s and others’ view on whether Dodd-Frank’s treatment of derivatives regulations is extraterritorial, it is extremely important to understand the size of the derivatives markets and the role of U.S. participants therein. According to the Bank for International Settlements, at the end of 2012, total global derivatives markets accounted for around US$633 trillion in notional amounts – more than ten times the size of the actual global economy itself. U.S. participants, with about US$223 trillion in notional exposure, account for over a third of the aforementioned global amount, representing a 270 per cent rise in just one decade. The data goes a long way to explain the desire of U.S. regulators such as the CFTC and the Securities and Exchange Commission, along with bank regulators, the Federal Reserve, the Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency, to see that derivatives markets are not only better regulated but also well supervised. U.S. derivatives transactions The disproportionate amount of derivatives transactions are between dealers; end-users such as commodity companies are incredibly small in comparison. In the U.S., 80 per cent of financial derivatives are interest rate 150

derivatives, 12 per cent are foreign exchange derivatives, about six per cent are credit derivatives, with the remainder being equity and commodity derivatives. The majority of U.S. players, to no one’s surprise, are banks. According to the OCC, while over 1,350 insured U.S. commercial banks and savings associations reported derivatives activities at the end of the fourth quarter 2012, derivatives activity in the U.S. banking system continues to be overwhelmingly dominated by a small group of large financial institutions. Specifically, JPMorgan Chase, Citibank, Goldman Sachs, and Bank of America represent 93 per cent of the total banking industry derivatives notional amounts and 81 per cent of industry net current credit exposure. Changes in management culture What many may not know, however, is that the top U.S. banks’ derivatives portfolios are about 96 per cent OTC, which until 2010 were unregulated, and only 3-4 per cent are exchange traded. For the banks to transition from OTC to clearable derivatives is requiring a massive change in risk management culture, not to mention business strategy and significant overhaul of how data is collected, verified, and reported to comply with Dodd-Frank. Moreover, U.S. regulators like CFTC and SEC, which had minimal exposure to OTC derivatives, have had to upgrade significantly their knowledge not only about these instruments, but how international banks such as JPMorgan and Bank of America conduct their derivatives business across multiple legal entities and geographies. Also extremely important, these entities Journal of Regulation & Risk North Asia

often book their derivatives not only in multiple legal entities in the U.S. but also abroad. Just because financial book trades are booked offshore does not mean that risk stays offshore, as has been seen with JP Morgan’s “London Whale” scandal, Citibank, AIG, Lehman, Long Term Capital Management and Bear Stearns. Complex supervisory tactics To illustrate the challenge of supervising derivatives activities, one need only look at one of the largest players, Bank of America, to gauge how complex matters presently are. Taking the publicly available living will executive summary that Bank of America published in 2012, which of course has very limited information, was nonetheless a reminder of how complex and opaque these institutions are. Bank of America has 2,000 subsidiaries globally formed in over 95 different jurisdictions. Over 38 per cent of the subsidiaries were formed in a foreign legal jurisdiction. The public executive summary of Bank of America’s living will highlights two key entities where most derivatives are probably booked. High-level but inadequate data First, there is Merrill Lynch International (MLI), a UK-based and regulated international broker-dealer that provides a wide range of financial services globally for business originated in Europe/Middle East/ Africa (EMEA), Asia/Pacific Region and the Americas. This entity amongst other things engages in equity and foreign exchange derivatives; there is also Merrill Lynch International Bank Journal of Regulation & Risk North Asia

Limited (MLIB) the primary non-U.S. banking entity of Bank of America Corp., which is incorporated in Ireland and regulated by the Central Bank of Ireland. However, MLIB operates globally for business originated in EMEA, Asia/Pacific Region and the Americas. MLIB engages in“debt derivatives trades. It trades flow rates, for example swaps, and over-the-counter derivatives principally with third-party institutions and affiliate companies.” In the living will executive summary, one can get high-level data on derivatives transactions and information about different legal entities but not the exact number and type of derivative per legal entity and per geography. Geographical issues Given the descriptions of MLI and MLIB, one can make an educated guess that this is where most Bank of America derivatives are booked, but as for where they are geographically, one would have to guess that the major geographies are probably the UK and Ireland. Complicating matters further, since U.S. banks are not fully compliant with Basel II, they are not abiding by Pillar III, which has uniform transparency guidelines. Hence, further sleuthing is necessary. Since UK and continental European regulators have required banks in their jurisdictions to be compliant with Basel II, Pillar III disclosures are available for some of Bank of America’s foreign legal entities such as MLI, but Pillar III is not implemented uniformly even where it is being required by European regulators. Not only does the aforementioned 151

represent a challenge to the CFTC, the Fed and the OCC from a supervisory perspective of these banks and their derivatives activities, if any large, interconnected firm were to fail, the process of resolving would truly test the FDIC in terms of Dodd- Frank’s Title I and II. CFTC guidance Gensler has argued that Dodd-Frank should apply to transactions entered into by “branches of U.S. institutions offshore, between guaranteed affiliates offshore, and for hedge funds that are incorporated offshore but operate in the United States.” His concern has been that although it’s possible that some U.S. jobs and markets may move offshore, that in a time of stress, “risk would come crashing back to the U.S. economy.” The guidance released by the CFTC in 2012 included a “commitment to permitting foreign firms and, in certain circumstances, overseas branches and guaranteed affiliates of U.S. swap dealers, to meet Dodd-Frank requirements through compliance with comparable and comprehensive foreign rules.” The CFTC calls this“substituted compliance.” This regulatory concept means that if other regulators have similar derivatives rules as we do, our derivatives participants’ offshore entities can comply with those rules rather than Dodd-Frank. International cooperation The CFTC proposed granting time-limited relief until July for non-U.S. swap dealers (and foreign branches of U.S. swap dealers) from certain Dodd-Frank swap requirements. In July, when the relief expires, various DoddFrank requirements will apply to non-U.S. 152

swap dealers. According to Gary Gensler “under this time-limited relief, foreign swap dealers may phase in compliance with certain entity-level requirements.”In addition, it provides relief for foreign dealers from specified transaction-level requirements when they transact with overseas affiliates guaranteed by U.S. entities, as well as with foreign branches of U.S. swap dealers. During my studies of Russian and Soviet politics, both in the U.S. and in the Former Soviet Union, the phrase often repeated was “trust but verify.” Unfortunately, this phrase again applies to international financial regulatory cooperation. International cooperation is critical, but each country must make sure that its regulations are being followed. In the U.S., because of the size and complexity of our derivatives participants, it is critical that their foreign subsidiaries are not given exemptions. OTC transactions abroad The list of firms’ whose derivatives implosions began in an offshore division but came back to U.S. shores is too long! Gensler’s concerns are very valid given the influence of U.S. market participants in U.S. and global derivatives markets and especially since large U.S. banks in particular often book a significant portion of their OTC derivatives transactions in legal entities abroad. Gensler is trying to manage an incredibly delicate position. On the one hand, he cannot be seen as the U.S. pushing its will onto others, and the CFTC has engaged in significant discussions with foreign regulators. On the other hand, the CFTC must protect U.S. taxpayers from being impacted by failed Journal of Regulation & Risk North Asia

derivatives transactions at U.S. institutions, whether the trades are booked in the U.S. or abroad. Much emphasis has been given in the media about regulations, but equally important if not more so is supervision. The CFTC is not only responsible for writing the rules and enforcing them when they are broken, they must also supervise market participants based on a risk based supervision approach. Compliance & risk management Not all supervisors utilise that framework; some bank and derivatives supervisors are more compliance-based, that is, they are more focused on whether market participants’ are complying with rules rather than really looking to see how participants conduct risk management – that is, the identification, measurement, control and monitoring of risks. Importantly, given austerity programs throughout Europe and our sequester in the U.S., bank and derivatives regulators have not been given the necessary budgets to increase the number of and capacity of existing regulators so that they can supervise and examine derivatives, something that for many is a completely new responsibility. It is precisely because of the interconnectedness of derivatives markets that the CFTC cannot afford to assume that other supervisors are properly monitoring the derivatives of U.S. participants offshore or foreign entities in the U.S.. Substituted compliance is an invitation for significant regulatory arbitrage. When our institutions import their derivatives implosions abroad back to the U.S., no foreign taxpayer will come to substitute our taxes for theirs. Journal of Regulation & Risk North Asia

References
Aguirre, Nanette Dodd-Frank Transaction Reporting, Derivatives Intelligence 10 May 2013. Bank of America Corporation Resolution Plan Public Executive Summary, July 2012. Barnier, Michel,‘International cooperation: a sine qua non for the success of OTC derivatives markets reform,’ European Commission in ‘OTC derivatives: new rules, new actors, new risks ,’ Banque de France’s Financial Stability Review No. 17, p. 41,April 2013. Dallara, Charles. ‘Containing extraterritoriality to promote financial stability,’ Institute of International Finance ‘OTC derivatives: new rules, new actors, new risks,’ Banque de France’s Financial Stability Review No. 17, p. 47,April 2013. Gensler, Gary, ‘International swaps market reform: Promoting transparency and lowering risk’ CFTC in ‘OTC derivatives: new rules, new actors, new risks, Banque de France’s Financial Stability Review No. 17, p. 62, April 2013. Bank for International Settlements, Statistical Release: Over The Counter derivatives statistics at end-December 2012, Monetary and Economic Department, May 2013 Lubben, Stephen ‘Resolution, Orderly, and Otherwise: Bank of America in OLA,’ University of Cincinnati Law Review, Forthcoming Seton Hall Public Law Research Paper No. 2037915 10 April 2012. Office of the Comptroller of the Currency, Quarterly Report on Bank Trading and Derivatives Activities Fourth Quarter 2012. Rodríguez Valladares, Mayra, Dodd-Frank as a Catalyst to Improve Energy Firms’ Risk Management, CME Group. 18 December 2012 Rodríguez Valladares, Mayra, ‘Dodd-Frank Poses Unique Challenges for Energy Firms,’ CME Group. 10 October 2012 Rodríguez Valladares, Mayra, “Will Dodd-Frank Survive After U.S. Election,”JLNIR, 5 November 2012.

153

Economic theory

Macroeconomic stabilisation under modern monetary theory
Interfluidity’s Steve Waldham casts a nottoo-uncritical eye over an economic theory that’s gaining widespread support online.
Over the past year or so, a macroeconomic perspective known as “modern monetary theory” (MMT) has grown surprisingly prominent in economic policy debates. As the result of collaboration between hedge fund manager, Warren Mosler and a number of academics associated with the post-Keynesian tradition, among them L. Randall Wray, Bill Mitchell, Pavlina Tchernova, and Eric Tymoigne, it draws heavily on the insights of Hyman Minsky, and Abba Lerner’s theory of “functional finance”. Mainstream unorthodox? Although both camps may be loathe to admit it, MMT bears a very strong resemblance to the more mainstream, though still unorthodox,“fiscal theory of the price level,” as developed by, among others, Eric Leeper, Christopher Sims, Michael Woodford, and John Cochrane. A summary of MMT’s view of stabilisation policy would suggest that the central macroeconomic policy instrument available to governments is in place to regulate the flow of“net financial assets”to and from the Journal of Regulation & Risk North Asia private sector. In short, governments create private sector assets by issuing money or bonds in exchange for current goods or services, or via simple transfers, only to destroy private sector financial assets via taxation. Benefits and costs Whilst advocates of MMT tend to view financial asset swaps or“conventional monetary policy”, as second order and less effective, they might acknowledge some impact. That said, I would argue that although the flow of net private sector financial assets is undoubtedly a powerful tool in macroeconomic policy, it is not one that is uniquely effective. Indeed, changes in the relative price of financial assets, the object of conventional monetary policy, and in their distribution can also have a powerful effect on behaviour, for which there are associated benefits and costs. My first question, therefore, is to consider the justification for MMT focusing almost exclusively on managing the level of “net financial assets”. Secondly, MMT proposes that a government that borrows in its own currency 155

cannot be insolvent in the same way as private businesses. The theory holds that as such, a government will never face a sharp threshold where it cannot meet promised payments, leading to a socially unanimous or even legal declaration of insolvency and an almost certain run on its liabilities. Flow of obligations That said, I would argue that while it is true that a government cannot be forced into insolvency for want of its capacity to pay in its own currency, that it is possible for it to find itself politically or institutionally unable to meet an obligation despite access to the printing press. It strikes me therefore as an open question the degree to which protection from formal insolvency protects government obligations from disruptive races to redeem. However, I think that few people would argue with the point made by MMT advocates that the value of money and government claims in real terms is absolutely variable. Governments do and properly should manage their flow of obligations with an eye to supporting that value, among other competing objectives, particularly, for example, full employment. Government obligations irrelevant A further point in the theory relates to the notion that the real value of money and government debt is not reliably related to any theory of government balance sheets. In particular, the stock of outstanding government obligations is largely irrelevant. The value of government obligations, according to MMT, is a function of financial flows. Government claims will retain their value so long as the 156

private and foreign sectors wish to expand their holdings of those claims at the current price level, that is so long as agents are willing to sacrifice real goods and services today to reduce their indebtedness, improve their financial position, or stimulate their export sectors. The value of government claims will come under pressure only when agents, on net, seek to increase indebtedness or redeem existing claims for real goods and services. Such a scenario is where supporters of MMT, quite rightly I believe, call out conventional economists on adherence to dogma that is ill supported by the data. Empirically, the relationship between government balance sheet quantities and either the price level or private/foreign willingness to absorb government claims is weak. Cause and effect Indeed, theories of the public balance sheet that have proven unreliable continue to be endorsed to avoid inconsistency in the edifice of neoclassical finance. It is true, after all, that in extreme cases, governments that experience hyperinflations go through periods of high indebtedness relative to GDP, but the barrier between cause and effect is murky to say the least. Indeed, common models of macroeconomic theory impose a“no Ponzi condition” that is absurd not only for governments, but also for private firms. All firms and governments do eventually end, and when they do, they usually leave substantial claims unsatisfied. Agents lend to corporations and governments not because they believe the debt will be paid down, but because they believe the almost certain eventual default Journal of Regulation & Risk North Asia

or debasement of claims is unlikely to happen within their investment time horizon. In the real world, governments and corporations balance actual gains from the transfer component of increased borrowing against increased hazard that the end will come quickly and potentially“distress costs”. Liquidity constraints Typically, governments and firms find these costs easy to manage as long as indebtedness grows no faster than “size”, whether measured in terms of revenue or asset values. And while may be risky to “lever up” – to increase debt faster than size – many firms and governments do so successfully. We have no reliable criteria of maximum leverage even for firms, let alone for governments. Governments are special. Their core asset is their taxing power. Their liabilities, whether notionally bonds or money, are best understood as preferred equity rather than debt. Governments, at the end of the day, face very diffuse liquidity constraints. This aside, I think MMT sometimes errs in the opposite direction. Its supporters, I believe are right that ultimately it is flow (actual or desired) between private agents in aggregate and governments that determine the value of government obligations. But the whole purpose of balance sheet analysis, in the private sector and the public sector, is to predict future flows. Taxation or inflation? That conventional theories of public balance sheets are foundationally stupid and overstate the hazards associated with large stocks of outstanding debt doesn’t invalidate the intuition that flow volatility is likely Journal of Regulation & Risk North Asia

to be proportional to the outstanding stock of government claims. Suppose, because of a sunspot, private holders of government claims get nervous and try to redeem them for current goods. If the net stock of claims in private sector hands is small, it takes very little taxation to offset that flow. If the net stock of government claims is large, than the desired flows might be massive, and governments might be faced with an unappetising choice between taxation, or accommodating inflation. There is little evidence that increasing the stock of government obligations can, by itself, increase the likelihood that the private sector will seek (impossibly but disruptively) to divest itself of those claims. But there are undoubtedly fluctuations in the private sector’s enthusiasm for holding money and government debt, and it strikes me as implausible that the difficulty of managing those fluctuations is entirely unrelated to outstanding stock of those claims. Private sector demand Whilst advocates of MMT are typically regarded as “left” economists, I believe the theory somewhat underplays the distributional costs involved in expanding the stock of government obligations. Government obligations, like all financial assets, are disproportionately held by the wealthy. If the government did not accommodate the private sector’s demand for net financial assets, preferring different policy levers to stabilise the economy, wealthy people might be forced to store wealth in the form of claims on real resources, and would have to oversee the organisation of those resources into value-sustaining projects. A large stock 157

of “risk-free” financial assets allows people wishing to carry wealth forward to shirk their duty to steward resources carefully and bear the consequences of investment failure. Thus, the availability of government obligations simultaneously degrades the quality of real investment (by disincentivising supervision) and magnifies the distributional injustice that attends failures of aggregate investment by shifting the burden of those shocks onto risk investors and workers. Mitigating injustice In theory, governments can mitigate this injustice by careful transfers and expenditures ex post. In practice however, those who disproportionately hold existing government obligations disproportionately hold political power, and resist the issue of new obligations that might dilute the value of existing claims. Further, a large stock of government claims serves as the lifeboat through which prior wealth inequality carries itself into the future. Absent an accommodative stock of government obligations, recessions would be crucibles that separate the deserving from the undeserving rich, and would thin the ranks of the rich generally. Recessions should be periods that decrease inequality, but the availability of default-risk free claims whose purchasing power is politically protected inverts the dynamic. Sustainable fiscal manoeuvres Supporters of MMT are right, I think, to argue that, for fiat-money issuers who borrow in their own currency, conventional government solvency criteria are false. They are right to argue that such governments have a 158

great deal more latitude to issue money and debt than conventional theories suggest. But such arguments shouldn’t be taken as license to defend carelessness in the distribution of new claims, or to treat expansions of money or debt as entirely cost-free. Serious advocates of MMT also consider distributional issues and quality of expenditure, and do not claim that deficits should be “carelessly” expanded. But in the heat of current policy debates, rhetoric about“deficit terrorists” and money being nothing more than spreadsheet entries is unhelpful. At its best, one of the major arguments of MMT is that the absence of short-term fiscal constraints creates space for government to craft policy that focuses on the productivity of the real economy. If the mobilisation of real resources is wise, fiscal manoeuvres will be rendered sustainable ex post. Government solvency If the real economy is mismanaged or left to languish and decay, no amount of “fiscal discipline”will save us. Indeed, the version of MMT that I like best is, oddly perhaps, wedded to an almost Austrian sensibility concerning real investment. Another argument put forward by MMT, and one that I agree with entirely, is that the “solvency” of a government is best understood as its capacity over time to manage the economy in a manner that avoids net outflows, where “net outflows” relates to attempts by non-government actors in aggregate to redeem government paper for current goods and services. Whilst some MMT enthusiasts object to any use at all of the word “solvency” when describing a currency-issuing government, I Journal of Regulation & Risk North Asia

believe this theory offers the best definition of government solvency. After all, what such a government must concern itself with is not the dictionary definition of insolvency per se, as in an inability to pay debts, but something quite different: a decay in the value of its claims in terms of real goods and services. Avoiding net outflows I also adhere to MMT’s claim that avoiding net outflows is easy in times like the present, when i) low quality and difficult to service debt in the private sector leaves many agents eager to reduce indebtedness and increase their holdings of financial assets; ii) there has been little inflation or devaluation in the recent past; and iii) resource utilisation is slack, as evidenced especially by high unemployment. It is incontestable that the avoidance of net outflows is more difficult when private sector agents’ balance sheets are healthy, or when agents come to expect inflation or devaluation, or when real resources (especially humans) are fully employed. Creating demand However, MMT also points to the fact that a sovereign government can always create demand for its money and debt via its coercive ability to tax. That is, if optimistic agents with strong balance sheets start up a spending spree, or if gold bugs fearful of devaluation ditch government paper for commodities, a government can reverse those flows by forcing private agents to surrender real goods and services for the money they will owe in taxes. Indeed, on the one hand, I consider this point is one of MMT’s deepest insights, and Journal of Regulation & Risk North Asia

its secret weapon. So long as a government’s taxing power is strong, so long as it is capable of persuading individuals to surrender highly valued real goods and services for the ability to escape liabilities imposed by fiat, exercise of that taxing power creates a floor beneath which the value of a currency, in real goods and services, cannot fall. However, relying too overtly on taxation to give value to a currency strikes me as dangerous and potentially counterproductive. A government’s taxing power is limited and socially costly. Governments must maintain a patina of legitimacy so that people pay taxes “voluntarily” or else they must intrusively or even brutally force compliance. In a decent society, it’s perfectly possible that governments will find it politically impossible to tax at the level consistent with price stability goals. Stabilising price levels After all, a wise, MMT-savvy government would try very hard to regulate the issue of government obligations over time in a way that avoids the need for sharp fiscal shifts in order to stabilise the price level. Avoiding the need for sharp contractions later on might imply slower issue of obligations than would be short-term optimal during recessions. However, once you acknowledge this kind of forward-looking dynamic, MMT starts to sound quite conventional as we start having to trade off the short-term benefits of fiscal demand stimulation with long-term “exit costs”. Whilst I am interested in and sympathetic to the idea of designing a government-guaranteed full employment policy that would be complementary to a vibrant 159

private sector and that would anchor rather than disrupt macroeconomic stability goals, however richly advocates of MMT have outlined such an institution in theory, we are very far from implementing such a thing in practice. Sustaining value I do agree that MMT offers a deep and powerful way to think about public finance, that a government’s “solvency constraint” is not a function of any accounting relationship or theories about the present value of future surpluses and ultimately lies in its political capacity to levy and enforce payment of taxes. However, this depends first and foremost on the quality of the real economy it superintends. The value that a government is capable of taxing is necessary to sustain the value of its obligations increases with the value produced overall. A government that wishes to be solvent should interact with the polity in a manner that promotes productivity. I would also point out that the political capacity to levy taxes depends upon either the legitimacy of, or the coercive power of the state. Legitimacy is best bet After all, a government that wishes to sustain the value of its obligations must either gain the consent of those it would tax or maintain an infrastructure of compulsion. In theory, either choice could be effective, although along with the libertarians, I like to imagine excessively coercive regimes are inconsistent with overall productivity, so that legitimacy is a government’s best bet. The two strategies are not mutually exclusive: a government could be sufficiently 160

legitimate as to be capable of taxing some fraction of the population without resistance and sufficiently coercive as to force the other fraction to pay up. That probably describes the best we can hope for in real governments. Whilst offering a perspective more powerful than many observers give it credit, MMT is not one to which I fully subscribe. The critiques offered are neither intended to discredit or dismiss MMT. Indeed, I maintain my stance that MMT offers a coherent and important perspective on fiscal and monetary issues that ought to be understood, on its own terms rather than in dismissive caricature, by anyone serious about macroeconomics. MMT should ultimately be judged, just as any other theory, by how useful it is, in terms of making sense of what we already know and in offering guidance for policy going forward. Inflationary deficit In response to Paul Krugman’s understanding of the MMT position as one where the only consideration is whether or not the deficit creates excess demand to such an extent to be inflationary, and where the perceived future of solvency of the government is not an issue, I disagree. In my humble opinion, a six per cent deficit would, under normal conditions, be quite expansionary; but it could be offset with tight monetary policy, so that it need not be inflationary. However, if the U.S. government has lost access to the bond market, the Fed is not in a position to pursue a tight-money policy. On the contrary, it has to increase the monetary base fast enough to finance the hole in revenue. The result is that a deficit that would be manageable with capital-market access Journal of Regulation & Risk North Asia

becomes disastrous without. The real question is why a deficit that would be inconsistent with price stability with “loose money” would be transformed into something sustainable with“tight money”. Public to private sector flow From an MMT-perspective, it is the flow of net financial assets from public sector to private, relative to the private sector’s willingness to absorb, that matters. Whether those net financial assets take the form of liquid cash or liquid treasury securities is second order. As Krugman himself has pointed out, conventional monetary policy is nothing more than a shift in the maturity of government obligations. If the private sector is unwilling to hold the expanding stock of dollar-denominated obligations at, in terms of real goods and services, prices consistent with our definition of price stability, MMT suggests the private sector will be unwilling to hold those obligations whether in the form of bonds or money. Tight money, loose fiscal An obvious objection is that bonds pay yields that might induce private sector agents to hold government paper at current prices, while money historically does not. Krugman’s sustainable “tight money, loose fiscal”scenario basically amounts to pointing out that the private sector can be induced to hold more paper if the public sector promises to make large on going transfers to those who hold its paper. Whilst advocates of MMT may have mixed feelings about using interest payments to increase the willingness of the Journal of Regulation & Risk North Asia

private sector to hold government paper, since most central banks now pay interest on reserves, these payments no longer serve to demarcate the “fiscal” obligations of the treasury, nor the “monetary” obligations of the central bank. Rather than being divided into “fiscal” and “monetary” policy, we end up with a “flow” and “yield” policy, where in order to stabilise the price level and real spending in the face of changes in private sector demand for government paper, the public sector can either modulate supply by adjusting the size of the deficit or surplus, or modulate demand via the yield by altering the interest paid on reserves or by selling term bonds. As Bill Mitchell puts it: “Our preferred position is a natural rate of zero and no bond sales. Then allow fiscal policy to make all the adjustments. It is much cleaner that way.” Accommodating net demand MMT views the size of the flow itself – that “six per cent deficit”– as the primary instrument of stabilisation policy. By holding the deficit constant in his thought experiment, Krugman deprives MMT of the means by which it would manage demand. MMT does not claim that fiscal policy can ignore private willingness to hold government assets. On the contrary, they take from Wynne Godley’s sectorial balance analysis that fiscal policy should accommodate the changing net demand of the private and external sectors for financial assets. Whilst MMT supports the theory that it is important not to lose access to the bond market, it suggests that the government’s power to tax is sufficient to maintain the private sector’s appetite to hold government 161

paper, whether in the form of bonds or of money. Therefore, there is little need to fret about “confidence” and unread theories of government solvency. The government can issue paper when the private and external sectors are willing to buy, and reduce deficits or even run a surplus when those appetites have been sated. Quality of expenditure I’ll end with a few miscellaneous comments: I’d like to see more attention paid to qualityof-expenditure concerns. That is, if a stable economy requires continuing government deficits to accommodate growing private sector’s demand for financial surplus, then the government must actually make choices about how to spend or transfer money into the economy. These choices will undoubtedly shape the evolution of the real economy, for better or for worse. Should we rely on legislators to make direct public investment choices? Should we put funds in the hands of individuals and then allow consumer preferences and private capital markets to shape the economy? How? Via tax cuts? A job guarantee? Direct transfers? Perhaps the government should delegate management of public funds to financial intermediaries, and rely upon banking professionals to find high value investments? Private/household distinctions While MMT focuses mostly on the liability side of the public balance sheet, many critics fear that ever-increasing public outlays imply increased centralisation of economic decision making that will lead to low quality choices. Whether that is true depends 162

entirely on institutional and political choices. These concerns can be and should be specifically addressed. MMT-ers sometimes blur the distinction between “private sector net savings”, which is necessarily backed by public sector deficits or an external surplus, and household savings, which need not be. In doing so, MMTers rhetorically attach the positive normative valence associated with “saving” to deficit spending by government. This is dirty pool, and counterproductive. The vast majority of household savings is and ought to be backed by claims on real investment, mediated by the liabilities (debt and equity) of firms. Household savings or real investment? There is no need whatsoever for governments to run deficits to support household saving. When household savings increases, an offsetting negative financial position among firms represents increase in the amount or value of invested assets, and is usually a good thing. Household savings is mostly a proxy for real investment, while “private sector net financial assets”refers to a mutual insurance program arranged by the state. It is a category error to confuse the two. Yet in online debates, the confusion is frequent. Saving backed by new investment requires no accommodation by the state. It discredits MMT when enthusiasts claim otherwise, sometimes quite aggressively and inevitably punctuated by the phrase “to the penny”. In general, the MMT community would be well served by adopting a more civil and patient tone when communicating its ideas. I’ve had several conversations with economists who have proved quite open to Journal of Regulation & Risk North Asia

the substance, but who cringe at the name MMT, having been attacked and ridiculed by MMT proponents after making some ordinary and conventional point. Much of what is great about MMT is that it persuasively challenges a lot of ordinary and conventional views. But people who cling to those views, even famous economists who perhaps “ought to” know better, are mostly smart people who simply have not yet been persuaded. Neither ridicule nor patronizing lectures are likely to help. My complaint is a bit unfair. The MMT community has been sinned against far more than it has sinned, especially within the economics profession. Whether you ultimately agree with them or not, the MMT-ers have developed a compelling perspective and have done a lot of quality work that has pretty much been ignored by

the high-prestige mainstream. But a sense of grievance may be legitimate and still be counterproductive.
 The Internet is a fractious place. Many MMT-ers are civil and patient, and devote enormous energy to carefully and respectfully explaining their views. There’s no way to police other peoples’ manners. Still, even by the standards of the online debate, MMTers have a reputation as an unusually prickly bunch. That might not be helpful in terms of gaining broader acceptance of the ideas. Despite my complaints and critiques, learning about MMT has added enormously to my thinking about economics. In practical terms, I think that MMT offers the most promising toolkit for crafting a desperately needed replacement of status quo central banking as our core means of stabilising the macroeconomy. •

J

ournal of Regulation & Risk North Asia

Advertising deadline for Vol. III Issue IV Winter 2013/14

November 20, 2013
Contact Chris Rogers christopher.rogers@irrna.org
Journal of Regulation & Risk North Asia

163

Compliance

Are ineffective AML & CFT laws impeding investor confidence?
Gavin Sudhaker of Sapling Solutions casts a critical gaze over recent trends in U.S. Securities law enforcement.
Money laundering techniques have evolved alongside technological innovations in the securities sector in recent years. Speedy and sophisticated trade execution, interconnected global reach, complex product offerings and adaptability have made the security industry an easy target for money laundering and terrorist financing. In turn, recent financial turmoil and a dramatic increase in insider trading, market manipulation and fraudulent securities activities, has begun to impede shareholder confidence in the securities regulatory regime. In the aftermath of 9/11 terrorist attacks upon New York and Washington D.C., the U.S. authorities enacted stringent legislation to counter terrorist financing (CTF), namely, the Patriot Act. Such legislation sought to strengthen existing laws, including the Bank Secrecy Act’s provisions on anti-money laundering (AML), whilst casting its net further to include financial institutions not previously covered by its provisions. Chief among these are investment advisers, broker-dealers and investment bankers. Journal of Regulation & Risk North Asia Under the expanded AML/CFT legislation, those covered by the Act have had to adopt minimum standards in four key areas, namely: a written code of AML policies and procedures; a designated AML compliance officer; on-going employee AML training; and finally, execution of an independent audit testing of the AML Compliance programme. Further, under this enhanced due diligence framework, those captured by the Act are required to maintain a strong Customer Identification Programme (CIP) and Suspicious Activity Reporting (SAR) procedures. Broker-dealers This brief overview aside, the remainder of this paper will focus on this enhanced legislative environment as it applies specifically to broker-dealers. Within the context of the U.S., all active broker-dealers fall under the governance of a self-regulating industry body - the Financial Industry Regulatory Authority (FINRA). The Authority’s Rule 3310 reiterates the importance of establishing and implementing sound AML compliance programmes to 165

all its members. However, many observers, including this author, question the effectiveness of this generic approach to AML/ CTF legislation, particularly in relation to the FINRA’s implementation guidelines as they apply to complex multi- layered global securities transactions. Congressional failings In the age-old worldwide money-laundering scheme, the securities industry, unlike other financial sectors, “risk lies mainly not in respect to the placement stage but rather in the layering and integration stages”, according to an FATF report on money laundering. Despite a strong linkage between the security and banking sectors, applying the current AML/CFT generic statute across broker-dealers fails to recognise the complexity involved in trading operations. Hence the burden of monitoring, remediating and reporting AML suspicious activity in a timely manner is shifted to the broker-dealers, who in practice are given limited guidance. Originally, the main intent of the Congress bid to expand its AML statute to include registered broker-dealers was to provide a consistent AML regulation across all financial institutions and to combat the threat of terrorist financing. However, due perhaps to lack of industry knowledge, Congress failed to consider the trading complexity involved in globally interconnected Over-the-Counter (OTC) globally markets. Grappling to comply By delegating its rule making and guideline drafting responsibilities to the FINRA, Congress failed to recognise the importance of the AML statute. In addition, the FINRA, 166

as a regulating agency, failed to tailor their rule-making and guidelines specifically towards the securities industry. As a result, with limited judicial branch intervention, broker-dealers are grappling to comply with this expanded AML statute, despite their best efforts. Specific guidance needed Hence, voluntary broker-dealer suspicious transaction reporting “remains relatively low in the securities sector in comparison to other sectors,”according to a private sector survey report by the Financial Action Task Force (FATF). Further, “due to lack of awareness and insufficient securities-specific indicators, broker-dealers are looking for enhanced specific guidance from international organisations and national authorities” in order to fully comply with AML statute. As an “inter-governmental body whose purpose is the development and promotion of policies, both at national and international levels,” the FATF works to combat money laundering and terrorist financing. The Task Force is therefore a“policy-making body”which works to generate the necessary political will to bring about national legislative and regulatory reforms in these areas.” Illicit trading The FATF report, published in October 2009 and submitted to the Organisation for Economic Co-operation and Development (OECD), suggests that“the securities industry provides money laundering with a double advantage – the ability to launder illicit assets generated outside the industry and the ability to use these illicit assets to generate additional illicit assets within the Journal of Regulation & Risk North Asia

securities industry, such as insider trading, market manipulation and securities fraud in the layering and integration stages.” In addition the study shows that “the securities industry evolves rapidly and is global in nature and provides opportunities to quickly carry out transactions across borders with a relative degree of anonymity.” Given the strong linkage between securities broker-dealers and the banking and insurance industries, “illicit trading in securities is often not limited to the securities broker-dealers.” Multiple jurisdictions An October 2008 Asia Pacific Group (APG) typology workshop report on money laundering within the securities industry states that a limited number of APG countries require that all suspicious transactions be reported. “Where such requirements do exist, securities related SAR reporting levels are low, hence potentially impeding the ability of these jurisdictions to investigate money laundering. The overall experience of some APG countries is that the securities industry is a method of generating illicit assets instead of a conduit for laundering illicit assets generated outside of the industry”, the report adds. Given the global nature of the securities industry, the expanded AML/CFT regulations fail to consider the imbalance found in policy enforcement across multiple country jurisdictions. The FATF’s report also elaborates on risk controls and the vulnerabilities of money laundering specific to the securities industry and includes recommendations to implement enhanced due diligence in Customer Due Diligence (CDD)/Know Journal of Regulation & Risk North Asia

Your Customer (KYC) detection points and AML regulatory information sharing policy changes to its member countries. Main goals The main goals of the expanded AML/CFT act were initially to: “1) detect and prevent money laundering; 2) comply with the BSA’s record keeping and reporting requirements; 3) comply with the U.S. PATRIOT act; 4) identify suspicious activities; 5) comply with the requirements of Office of Foreign Assets Control (OFAC) and other anti-money laundering regulations; 6) identify suspected/ actual money laundering; 7) identify suspected/actual terrorist financing; 8) identify suspected/actual proceeds of corruptions; 9) identify and isolate PEP’s (Politically Exposed Persons) and Senior Foreign Political Figures; and 10) minimise violations of the Foreign Corrupt Practices Act (FCPA).” A work in progress Today, in their efforts to combat “financial terrorism”, OECD member countries have taken several initiatives to improve AML and FCPA regulative information through sharing across member jurisdictions. By implementing monitoring software tools against OFAC database entries, member country regulators are able to intercept perpetrators of illicit money laundering and impose on them hefty sanctions and penalties. However, the fight against global money laundering remains a work in progress and appears to be directly correlated to the effectiveness of the foreign policy governing member countries’. As such, in order to promote global cooperation, the Securities AML regulatory framework requires better 167

alignment across its member countries. After all, a chain is only as strong as its weakest link. Similarly, a sovereign country must rely on all countries to establish effective AML/ CFT regimes to prevent, detect, prosecute and impose sanctions on criminal activity. Lack of adequate controls due to varying AML policies and controls across some under-developed jurisdictions can only be detrimental to the global fight against money laundering. Fitting the business model In recent years, the FINRA has introduced aggressive enforcement policies to invoke AML/CFT statutes against global brokerdealers and individual violators. Such initiatives have enhanced public and private awareness by highlighting the importance of this statute against the broker-dealer. This is illustrated in the case of U.S. vs. E*Trade, where worldwide broker-dealer E*Trade was fined US$1 million for its “inadequate AML program.” The case details show that “from January 1, 2003 to May 31, 2007, E*Trade did not have an adequate AML programme based upon its business model.” In addition the FINRA claims that “E*Trade did not have separate and distinct monitoring procedures for suspicious trading activity in the absence of money movement, therefore its AML policies and procedures could not reasonably be expected to detect the reporting of suspicious securities transactions.” This case also alleges that E*Trade “relied on its analysts and other employees to manually monitor and detect suspicious 168

trading activity without providing them with sufficient automated tools to do so.” Responding to this case settlement, Susan L. Merrill, the FINRA’s chief of enforcement, remarked that “brokerage firms’ AML programmes must be tailored to their business model.” Whilst the FINRA determined that E*Trade’s “approach to suspicious activity detection was unreasonable given its business model”, in settling this case, E*Trade “neither admitted to nor denied the charges, but consented to the entry of the FINRA’s findings.” Similarly, in the case of U.S. vs. Scottrade, Scottrade was “fined US$600,000 for its inadequate AML program.”Here, the FINRA claims that from the period April 2003 to April 2008, Scottrade“failed to establish and implement an adequate AML program tailored to its business model.” In addition, case details show that “Scottrade did not have any systematic or automated programmes designed to detect potentially suspicious money movement or securities transactions.” Once again, in settling this case, Scottrade “neither admitted to nor denied the charges, but consented to the entry of the FINRA’s findings.” Quick and dirty solutions These administrative proceedings case settlements clearly demonstrate the quick-anddirty solution which global broker-dealers opt for as a viable business solution against AML allegations within a global competitive network. With a lack of clear governance between the legislative and judicial due process in AML securities cases, many well-established global broker-dealers will no doubt continue Journal of Regulation & Risk North Asia

to opt for plea bargains as a“business nexus” element of their global operations. Given the speed and volume of trading involved, the complexity of day-to-day monitoring of global trading operations and settlements remains at the forefront of a growing range of challenges faced by brokerdealers in their efforts to comply with AML statutes. Under the generic guidelines provided by the FINRA, broker-dealers are compelled to implement state-of-the-art AML programs which tend to have a profound impact on its bottom-line. In short, any illicit insider trading, market manipulation and fraudulent activity within the securities industry is overshadowed by the FINRA’s requirements for broker-dealers to tailor their AML programmes to their own business model. Enforcement trends An AML survey report on the securities industry conducted by the U.S. General Accounting Office (GAO) in October 2001, noted that personal cheques were the most common form of acceptable payment received by broker-dealers. The report added that many brokerdealers “viewed the payment received with less AML concern, since they can usually be traced to accounts at depository institutions that have their own AML requirements.” However, more than a decade on, compliance with AML due diligence remains a growing challenge for broker-dealers in an ever-increasingly global and interconnected market. Indeed, case law trends show that the burden remains on the broker-dealers to implement sound AML detection points Journal of Regulation & Risk North Asia

to protect their reputation and survival in a global and highly competitive market. “Other” field most prevalent In recent years the FINRA has dramatically increased SAR-based AML enforcement activities against broker-dealers. In light of this development, the number of voluntary SAR filed by the securities and futures industries increased significantly from January 2003 to December 2008, from a total of 6,267 to 53,022 respectively. Further, when asked to define the type of suspicious activity observed, the field marked “Other” was the most prevalent characterisation of suspicious activity, followed by “Money Laundering/ Structuring.” Statistics show that the securities industry accounted for only five per cent of the 1,461 AML SAR inquires made between July 2009 and June 2010. The majority of these enquiries related to how to file a report correctly; whether or not it was necessary to file an SAR report; and advice on SAR sharing and disclosure to law enforcement agencies. Whilst the Obama administration has made plans to strengthen AML laws through the introduction of the DoddFrank Wall Street Reform and Consumer Protection Act, Title IV - commonly known as the “Registration Act” and requiring private equity funds with AUM over US$150 million to register with the SEC - only time will tell how effective this will be. Impractical language The FINRA presently oversees around 4,560 brokerage firms. However, the FINRA’s guidelines are at best generic when it comes 169

to enforcing AML regulation against brokerdealers and have been publicly criticised for failing to provide any meaningful guidance to promote AML awareness, transparency and accountability. One recent development can be seen in a statement made to the Securities and Exchange Commission (SEC) by the FINRA “to approve a rule change to establish a new registration category and qualification exam requirement for certain operations personnel.” As a result most executives in senior level positions in Wall Street will now have to register with the FINRA and pass a licensing exam. The requirement was classified by the FINRA as a “regulatory element”, with which all broker-dealer trade approving executives must comply. Heavily reliant However, such bold policy moves by the FINRA have yet to be measured against a complex global trading platform. Indeed, if this is yet another attempt by the FINRA to chase dirty money, it will take time to qualify its effectiveness in what has become a highly competitive commission fee-based industry. The fact that recent trends show that brokerdealers have come to rely heavily on other financial institutions, for example banks and clearing house brokers, to comply with AML/CFT statutes, remains nothing more than a secondary concern. Broad-brush policy Whilst broker-dealers do appear to be forthcoming in their voluntary AML inquiries, SAR and enhanced CDD/KYC due diligence measures, trends also show that the hefty price to pay for non-AML compliance 170

sends a clear signal to players in the securities industry that AML has become an integral part of the business model and trade lifecycle process. However, in today’s turbulent financial market, the current AML/CFT statute, as an extension of President Bush’s Patriot Act, appears to be nothing more than a broad brush policy approach aimed at financial sectors across the board. Such policy legislative initiatives are, in their very essence, a narrow interpretation of a generic intent to combat “global terroristic financing.” Out-of-line and unnecessary Congress surely needs to re-evaluate the costs and benefits of such policy in the securities industry, and to acknowledge industry risk. The challenge for the securities industry is surely to detect and report illicit AML activities at the layering and integration stages. Indeed, FATF and APG research cites that within the securities industry, money laundering is “a method of generating illicit assets” through activities such as insider trading, market manipulation and securities fraud, rather than as“a conduit for laundering illicit assets generated outside of the industry.” In an evolving global landscape, imposing such aggressive legislative AML regulatory policy is somewhat unnecessary within a non-cash based securities business model. Further, in a “trade anywhere” state of nirvana, surely the focus of Congress legislative intent should be the promotion of global wealth management that successfully enhances shareholder confidence and value. Given the strong linkage between the securities, banks and insurance sectors, Congress Journal of Regulation & Risk North Asia

needs to reconsider the long-term policy implications to the securities sector by circumventing “political anger”against a handful of wrongdoers.

Rebuilding investor trust In terms of enforcement, the SEC has failed to establish any effective governance of the securities industry. Rather than identifying market wrongdoers in the war against financial terrorism, the SEC seems to operate within a vacuum as it enters into an even bigger battle armed with ineffective firepower. As disjointed as they are, the SEC, FINRA and FinCEN, have failed to establish a systematic process for soliciting and sharing input from law enforcement agencies across the globe. In a recent statement the FINRA’s CEO, Richard Ketchum, stated that “it is imperative that the FINRA deal aggressively with wrongdoing in the industry to help rebuild Fight for justice investor trust and confidence in the markets.” Over the course of 2009 and 2010 Sutherland’s 2011 study of cases brought Call for legislative intervention against the SEC and FINRA shows that Such wishful policy statements do not pro- “SEC staff failed to prove fraud charges vide meaningful guidelines and frameworks approximately 57 per cent of the time in FY for the industry. Imposing additional rules to 2009-2010 and 13 per cent of respondents enforce security executive offices and back- got charges dismissed in the 237 charges litioffices to register with the FINRA will not gated by the SEC and FINRA which resulted prohibit wrongdoers from carrying out their in SEC Administrative Law Judge (ALJ) or illicit actions. Without legislative interven- FINRA Hearing Panel decisions.” tion, the American securities industry not The results suggest that broker-dealers only looks set to lose its competitive edge should fight for justice rather than settling in the global market, but with its radically cases by neither admitting nor denying the inefficient legislative AML policies will ulti- charges and consenting to the entry of SEC mately do little but destroy investor trust and and FINRA findings. Broker-dealers should confidence. lobby for the FINRA to introduce more speThere is clearly a need for the FINRA cific AML guidelines, rather than opting for to promote clear AML guidelines specific plea bargains. Journal of Regulation & Risk North Asia

to the securities industry. Only by defining SAR reporting requirements through foreign policy will the industry have a chance of filling the gaps between developed and underdeveloped countries’ SAR requirements. Without establishing any clear securities AML enforcement policy, the FINRA’s move to implement an aggressive approach appears to be nothing more than excessive. A recent 2011 case study conducted by Sutherland Asbill & Brennan (Sutherland), a global law firm with a practice in financial services, notes that “while broker-dealer firms and individuals often think that settling with the SEC and the FINRA makes the most sense, this study continues to show that in some circumstances, respondents will be better off if they try their cases and tell their stories in front of judges or hearing panels, especially where fraud is charged.”

171

In terms of money laundering prevention and detection, broker-dealers have a significant role to play in rebuilding shareholder confidence and value in the global securities markets. This is particularly relevant given that spending on surveillance programs by U.S. and European broker-dealers has been estimated to be around US$206 million in 2011 alone. Certainly in light of such massive financial regulatory overhaul, it is imperative for broker-dealers and governance alike that these back-office trading programs are developed and implemented as Enterprise Risk Management (ERM) solutions and are geared towards meeting AML requirements designed specifically for broker-dealers. Building robust programs Such an approach to ERM requires clear due diligence policies and procedures and should be managed over the long term. The development of policies and procedures must also ensure work to ensure that the firm and its employees consistently comply with policy requirements. Dedicated and on-going support from senior management and the board of directors are critical in the implementation of robust AML compliance programs. AML compliance officers must be empowered, and be designated clear roles and responsibilities if an effective global compliance program is to be maintained. The practical challenge for broker-dealers then lies in maintaining an effective SAR program whilst actively working to ensure “that the AML officer or the unit coordinates sufficiently with all points in its organisation that might require an SAR filing.” 172

In an increasingly complex global arena, access to a rigorous and flexible electronic surveillance program and the capability to report illicit activities proactively to law enforcement officials, is key to identifying potential wrongdoers. In addition, automated programs must be designed in accordance with SAR compliance rules. They should also have the capability to identify and isolate PEPs and Senior Foreign Political Figures, and to cross check the OFAC database for known terrorist organisations. Monitoring and validation Proactive SAR measures need to focus on the promotion and protection of a firm’s reputation, brand equity and goodwill within the global securities market. Indeed, despite industry risk in the layering and integration stages, customer due diligence is pivotal to the broker-dealer business operating model. Responsibility must lie with the broker-dealers themselves to account for and to implement enhanced due diligence CDD/KYC detection points, policies and procedures. Account types (trust, nominee and omnibus accounts, charity, non-profit organisation, shell companies etc.) need to be specified, and compliance programs independently tested periodically for efficiency. In addition, CIP policies and procedures must be able to validate and monitor secondary account holders and third-party vendors for AML compliance. In-house independence What is clear is that broker-dealers should not be reliant on other financial institutions, such as banks and clearing houses, as a Journal of Regulation & Risk North Asia

means of complying with due diligence and internal control within the AML/CFT statute. Having a consistent independent AML detection and validation policy across the organisation will enhance the effectiveness of internal controls. An effective new Client On-boarding (COB) Program is also a critical aspect of AML compliance. According to regulations, broker-dealers should also be able to identify and take appropriate actions against any “rogue employees”and to report illicit trading activities to law enforcement officials “in a timely manner. “ Being able to follow the code of business ethics in all aspects of the trading life cycle process, including trading, clearing, settlement and custody, will give brokerdealers the advantage when it comes to establishing sound business practice. Importance of training and guidelines In terms of AML training, the FINRA – AML Boot Camp and its educational series are a starting point for broker-dealers to train its employees in implementing the AML compliance program. The CCOutreach Broker-Dealer Program, the FINRA Annual Conference and Webinar are just some of the other resources available for industry practitioners to participate, network and share information with other AML compliance officers in the industry. The burden however remains on brokerdealers to implement effective working AML compliance governance programs. Such programs should include adequate tools and techniques to allow dealer-brokers to promptly report any suspicious activities to relevant law enforcement agencies. Training in the detection and mitigation of money Journal of Regulation & Risk North Asia

laundering within the process of wealth creation should also be made an integral part of any broker-dealer corporate governance practice. When it comes meeting wealth management considerations, the world is a flat market. In the new global regulatory regime, insider trading, market manipulation and securities fraud have come to the forefront of the securities industry. For broker-dealers, adapting to the growing demands imposed by the regulatory regime, despite a clear lack of guidelines, seems to have become a harsh reality. Greed a main motive The recent Global Financial Centres Index indicates that London remains the top financial hub city for broker-dealers and other financial services, followed by New York, Hong Kong and Singapore. Whether or not the recent aggressive tactics utilised in U.S. risk management enforcement policy against broker-dealers will result in the reduction or increase of risk is yet to be seen. As technology evolves, the AML regulatory regime needs to catch up with the increase in business demands. As long as greed remains the main motive, money laundering and other illicit activities will find ways to erode the fabric of the global enterprise markets. In any financial crisis, shareholder confidence and wealth creation will remain nothing more than a figure-ofspeech. At the end of the day, a regulatory environment lacking in any clear guidelines appears doomed to derail the market potential of a securities industry it set out to nurture and protect. • 173

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