ournal of regulation & risk north asia
Volume II, Issues II & III, Summer/Autumn 2010

Articles & Papers
Perspectives on regulatory reform after the 2008 crash Regulation or prohibition: the $100 billion question Economists’ hubris informed the financial tsunami of 2008 ‘Walker Review’ heralds new dawn in risk management Ideas have consequences: the importance of ‘narrative’ Minority shareholders blind to threat of expropriation ‘Swap tango’: a regulatory dance in two acts Beware Greeks bearing bonds: A tragedy in four acts Global financial crisis and the European Monetary Union Lehman Bros and Repo 105: a powerful case of addiction Regulating the rating agencies: Quick fix or political expedient? Macro-prudential councils: how to avoid future crises EC offers last opportunity for insurers to influence Solvency II Did we tame the beast: views on the US Financial Reform Bill Financial supervision and increased powers of discretion Global anti-trust regulation in the current financial climate Asset securitisation in China: Opportunities and challenges Is an undervalued renminbi the source of global imbalances? The regulators strike back: Basel and new liquidity rules Basel Committee’s enhanced framework for liquidity
Charles L. Evans Andrew G. Haldane Shahin Shojai & George Feiger David Millar Peter J. Wallison Fritz Foley et al Satyajit Das Michael Mussa Christian Fahrholz & Cezary Wójcik Jennifer S. Taub Lawrence White Enrico Perotti Eleanor Beamond-Pepler Lawrence Baxter Steve Randy Waldman Gavin Sudhakar Claas Becker et al Charles Wyplosz Thomas Dietz Michael Wong & Fai Y. Lam

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Publisher & editor-in-Chief Christopher Rogers editor emeritus Dr. John C. Pattison editor Ian Watson sub editor Fiona Pani editorial Contributors Prof. Lawrence Baxter, Toby Baxendale, Eleanor Beamond-Pepler, Prof. Lucian Bebchuk, Prof. Thorsten Beck, Claas Becker, Dr. Sergey Chernenko, Satyajit Das, Thomas Dietz, Charles L. Evans, Dr. Christian Fahrholz, Dr. George Feiger, Dr. Fritz Foley, Dr. Robin Greenwood, Andrew G Haldane, Fai Y. Lam, William M. Isaac, Prof. Laurence Kotlikoff, David Millar, Michael Mussa, Prof. Enrico Perotti, Jonathan Pickworth, Prof. Carmen M. Reinhart, Christopher Rogers, Shahin Shojai, Dr. V. Shunmugam, Gavin Sudhakar, Kavaljit Singh, Prof. Jennifer S. Taub, Steve Randy Waldman, Peter J. Wallison, Prof. Lawrence White, Prof.Cezary Wójcik Dr. Michael Wong, Prof. Charles Wyplosz 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@jrrna.com.hk Website: www.jrrna.com.hk 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 and Taiwan.
© Copyright 2010 Journal of regulation & risk - north asia Material in this publication may not be reproduced in any form or in any way without the express permission of the Editor or Publisher.
Disclaimer: While every effort is taken to ensure the accuracy of the information herein, the editor cannot accept responsibility for any errors, omissions or those opinions expressed by contributors.

Journal of Regulation & Risk North Asia


Volume II, Issues II & III – Summer/Autumn 2010


Foreword – Christopher Rogers Acknowledgments – Profile – Stephen S. Roach Debate – Prof Brad DeLong Opinion – Chris Rogers Opinion – Lucian Bebchuk Opinion – Laurence Kotlikoff Book overview – William M. Isaac Book review – Toby Baxendale Book review – Satyajit Das Comment – Dr V. Shunmugam Comment – Prof Thorsten Beck Historical analysis – Prof Carmen M. Reinhart Legal update – Jonathan Pickworth Regulatory update – Kavaljit Singh 5 7 9 19 29 39 41 45 49 53 59 65 71 77 83

Perspectives on regulatory reform after the 2008 crash Charles L. Evans Regulation or prohibition: the $100 billion question Andrew G. Haldane Economists’ hubris informed the financial tsunami of 2008 Shahin Shojai & George Feiger ‘Walker Review’ heralds new dawn in risk management David Millar Ideas have consequences: the importance of ‘narrative’ Peter J. Wallison Minority shareholders blind to threat of expropriation Dr Fritz Foley et al 91 101 123 133 139 149


Journal of Regulation & Risk North Asia

Articles (continued)
‘Swap tango’: a regulatory dance in two acts Satyajit Das Beware Greeks bearing bonds: A tragedy in four acts Michael Mussa Global financial crisis and the European Monetary Union Prof Christian Fahrholz & Dr Cezary Wójcik Lehman Bros and Repo 105: a powerful case of addiction Prof Jennifer S. Taub Regulating the rating agencies: Quick fix or political expedient? Prof Lawrence White Macro-prudential councils: how to avoid future crises Prof Enrico Perotti EC offers last opportunity for insurers to influence Solvency II Eleanor Beamond-Pepler Did we tame the beast: views on the US Financial Reform Bill Prof Lawrence Baxter Financial supervision and increased powers of discretion Steve Randy Waldman Global anti-trust regulation in the current financial climate Gavin Sudhakar Asset securitisation in China: Opportunities and challenges Claas Becker et al Is an undervalued renminbi the source of global imbalances? Prof Charles Wyplosz The regulators strike back: Basel and new liquidity rules Thomas Dietz Basel Committee’s enhanced framework for liquidity Dr Michael Wong & Fai Y. Lam 153 165 175 185 191 197 201 209 219 227 239 245 251 263

Journal of Regulation & Risk North Asia


IsAsia on the edge?
In 2011, Asia may continue to lead the world out of recession—or it could become the third wave of the economic crisis. Asia’s enormous investment opportunity
could be realized—or an uncertain regulatory environment might undermine its potential. Whichever scenarios develop will have major implications for risk managers at financial institutions across the region. The world’s leading risk practitioners and thought leaders will be discussing how to manage risk in Asia’s dynamic regulatory and financial environment. Join them at the region’s premier risk management conference.

GARP’s 7th Annual Asia Pacific Risk Convention Hong Kong | October 27-28, 2010

To learn more and register, visit www.garp.org

Creating a culture of risk awareness.


© 2010 Global Association of Risk Professionals. All rights reserved.

FIRST and foremost, may we offer our readers an apology for the lateness of this Journal appearing – the delay has been caused by a change of ownership and management structure which we trust will contribute greatly to our future efforts in raising issues of importance within the governance, risk management and compliance space here in Northeast Asia, together with the Asia region in general. These changes will be finalised by year’s end, at which juncture the Journal will become a standalone entity with a revised publication calendar and enhanced local coverage, supplementing our already extensive international coverage. This double issue of the Journal should provide readers with considerable food for thought on current and future financial management and financial sector policy. This edition of the Journal also appears exactly two years after events at Lehman Brothers in August and early September 2008 precipitated the largest financial crisis since the Great Depression of the 1930s, one which threatened to spill over into the general global economy unless massive and co-ordinated action was undertaken by the G-20 group of nations to mitigate against the worst effects of the crisis – the implosion of the banking system, large-scale economic dislocation and huge unemployment. Having stabilised the global banking system, many nations are now threatened by a sovereign debt tsunami as they adjust economic policy to the post-crisis environment in an effort to contain spiralling debt levels caused, in part, by bailing out the banking sector and issuing unlimited public guarantees over much of the debt many of the global “too-big-to-fail” banks hold on their balance sheets – the Greek crisis epitomising this current problem. Further, as a result of the trillions of dollars lost from the global GDP, hope was unleashed that stringent regulatory reforms would be embraced the world over to prevent a repeat of the 2008 crisis by reining in the worst excesses of the financial services sector. As promised, the US has been the first to enact legislation to regulate more effectively its banking sector, the outcome of which, the Dodd-Frank Act, informs much of the content of this current Journal. Suffice to say, many of our renowned contributors have mixed feelings over Dodd-Frank and are now focusing their attention on discussions within the Basel Committee, as it too tries to implement an international framework in an effort to make banking more robust and less of a threat to the global economy – more about which we shall hear in our next edition of the Journal towards the end of November. Christopher rogers Publisher & Editor-in-Chief

Journal of Regulation & Risk North Asia


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 Federal Reserve Bank of Chicago; the Bank of England; the Bundesbank; the Financial Services Authority, the Peterson Institute for International Economics, the American Enterprise Institute, the Roosevelt Institute, Harvard Legal Blog; the Pareto Commons; Voxeu; Interfluidity and DLA Piper 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 William Isaac, Prof William Black, Dr John C. Pattison, Prof Lawrence Baxter Prof Laurence Kotlikoff and Prof Jennifer Taub were invaluable; we are also grateful to Ian Watson and Fiona Plani of Edit24.com for their due diligence in setting out, editing and correcting the text. 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 of the Global Association of Risk Professionals for their kind assistance in helping to distribute this journal to their respective memberships in Greater China, Japan and Korea.

Journal of Regulation & Risk North Asia



Morgan Stanley stalwart Roach bids farewell to Asia Pacific
Chris Rogers profiles some of the highs and lows in Stephen S. Roach’s distinguished 40-year career as an economist.
after a career spanning almost three decades with Wall street leviathan Morgan stanley, and three years of that time most recently spent heading up Morgan’s operations in asia Pacific as chairman, stephen roach announced recently that he would be hanging up his spurs in the region. he said he would be heading back to the us for a well-earned rest and teaching assignments at Yale university’s Jackson institute for global affairs. roach will, however, remain a thought leader with Morgan stanley in the guise of non-executive chairman, a position that will allow him to keep tabs on asia on a monthly basis. One of Wall Street’s most respected and oft quoted economists, Roach has had a long and distinguished career since graduating from the University of Wisconsin – Madison with a bachelor’s degree in economics; this followed by a period of research undertaken at New York University for which he was awarded his doctorate. With Ph.D in hand, Roach journeyed to Washington, DC, where he joined the staff of Journal of Regulation & Risk North Asia the Brookings Institute as a research fellow. This at a time of rising political tensions and economic problems within the US as a result of the country’s involvement in Vietnam and huge costs associated with funding both the US military-industrial complex and President Lyndon B. Johnson’s push for a “Great Society”. The pull of public service being great, Roach joined the staff of the economics division of the Federal Reserve Board in 1972 and remained there until 1979 before moving on to his first position within the prestigious confines of Wall Street at Morgan Guaranty Trust Company – better known today as JP Morgan Chase. Days at the Fed Roach’s time at the Fed coincided with one of the more interesting periods of politics and monetary policy within DC spanning two Fed chairmen and three US presidents – Arthur Frank Burns and George William Miller, and Richard Nixon, Gerald Ford and Jimmy Carter respectively. Notwithstanding the politicisation of the Fed under Nixon, his tenure also occasioned that of the“oil shock” 9

of 1973 and onset of stagflation under the Carter administration. Although not directly involved in monetary policymaking decisions while at the Fed – and indeed Roach is on record years later as being highly critical of policy as conducted by the Fed during his six-year tenure – he has made it clear that his time spent in Washington influenced him greatly as an economist. Insidious inflation Pressed further, Roach had this to say:“Under Arthur Burns and then G. William Miller, the Fed failed to contain an insidious inflation. It did not appreciate the need to focus on real short-term interest rates, instead choosing to view its target largely in nominal terms. As such, monetary policy was highly stimulative as US inflation surged toward double-digit rates.” Roach’s views on Burns and Miller are in stark contrast to those of Paul Volcker who took over as Fed chairman not long after his own departure in 1979. Again, discussing the pre-Volcker years, he explained that the “Burnsian” view was to regard inflation as being driven by a series of exogenous and institutional factors that could not be controlled through monetary policy. As will become clear later, this is something Roach vehemently opposes, and indeed is an issue over which he took the president and CEO of the Federal Reserve Bank of Chicago to task while visiting Hong Kong in March. Volcker and the H-H Act Roach beleives that the passing of the Humphrey–Hawkins Act of 1978 was a “watershed moment” in the Fed’s almost 100-year history. By passing this Act, the US 10

Congress rejected and overturned prevailing Fed orthodoxy by modifying its mandate to focus on both full employment and price stability. Roach speaks highly of Paul Volcker – whom he terms a “hero” of his in central banking circles – during this episode in US history. Roach states that Volcker “dispelled any doubts over the ability of the Fed to contain inflation and used the Humphrey-Hawkins Act as political cover by pushing up the federal funds rate to 19 per cent in mid-1981, an experience that was critical in forming me as an economist; it showed me what monetary policy could do and shouldn’t do in managing the broader macro economy.“ Off to Wall Street After working for three years as a senior economic analyst at Morgan Guaranty, Roach, now a seasoned and well-respected economist and analyst, picked up his boots and decamped to Morgan Stanley – this in a period when brokerage and investment banking was still considered boring and Wall Street’s offices were adorned with such distinguished nameplates as Dean Witter Reynolds, Salomon Brothers, Smith Barney, Brown Brothers Harriman and, of course, Lehman Brothers. Whilst Roach’s 28 years at Morgan Stanley cannot really be said to have been “meteoritic” – Roach being more of a journeyman rather than one of the “masters of the universe’”– by the early years of this new century, his stature as an independently minded economist not afraid to fire off missives in all directions, had become well known and, indeed, appreciated by many outside the small world of investment Journal of Regulation & Risk North Asia

banking. As such, and given his known aversion to much of the “irrational exuberance” apparent within the greater investment community – including sections within Morgan Stanley itself – it came as a surprise to this author and many others when it was announced Roach would leave New York to take up the reins of leadership of Morgan Stanley’s operations in Asia, based in Hong Kong, but within a stone’s throw of that emerging Colossus, China. Top of the greasy pole Questioned on his appointment, Roach somewhat self-deprecatingly had this to say: “It was purely a reflection of senior management’s appreciation of my potential value – added to our Asian franchise – very much an outgrowth of the expertise I had developed on Asia in the decade prior to my appointment as chairman. He added: “It had little or nothing to do with my macro critique of markets, policies, or the financial services industry. Nor did I alter my negative view of macro and market risks once I became chairman, as my published commentary over the past three years clearly indicates.” Political leanings A “conservative” at heart – that’s conservative with a small‘c’– Roach has always stood out as an urbane thinker not prone to hyperbole or as a follower of the latest fads. Such qualities are most rare, but of great value in an economist, particularly if they happen to belong to the global chief economist for one of the largest“bulge bracket”investment banks in both Wall Street and the world. As for political affiliations, for a person who has travelled the world notching up Journal of Regulation & Risk North Asia

some 1.2 million miles during his three-year stint as chairman of Morgan’s in Asia, and who is well known for hob-nobbing with the great and the good across the region, Roach’s sympathies lie with the more liberal elements of the Democratic Party – as befitting someone with a wife and six daughters and family home in that “liberal” bastion of Connecticut. Donating to John Kerry’s failed presidential campaign in 2004 and Hillary Clinton’s run for the Democratic nomination in 2008, as Roach himself would observe, he has “placed a few wrong bets in his time.” One of the more interesting periods in Roach’s long career was during the 1990s, a period which saw him receive some unwelcome flak from sections of the media for his supposed initial support of policies associated with libertarian traditions, a matter he disputes and is at pains to dispel – at least to this author. NAFTA and Gramm Leech Bliley Roach looked back over the Bush (Snr) and Clinton years, ones that are associated with the wholesale movement towards liberalisation and deregulation, epitomised by the passage of the North America Free Trade Agreement (NAFTA) which came into force in January 1994, and the Financial Modernisation Act – better known as the Gramm Leech Bliley Act – which came into force in 1999 and overturned many of the provisions found in the Banking Act of 1933 (better known today as the Glass-Steagall Act). On the issue of NAFTA, Roach said that it was not too much of a focal point for him in the early 1990s. However, he did wish to elucidate further on the distinction between 11

trade liberalisation and financial deregulation, stating: “I supported the former and very much objected to the latter. ”Touching upon home ownership, he was quick to point out that he “strongly objected”to the political economy of excessive home ownership – arguing that the Community Reinvestment Act of 1977 (Carter administration) tilted the US body politic toward condoning anything and everything that promoted ever-higher rates of home ownership. Financial innovation He continued: “This was the political cover that successive administrations, Republicans and Democrats alike, used to validate the push toward “creative” subprime lending and so-called financial innovations such as CDOs that were billed as facilitating such lending. “ As Journal readers are no doubt aware, it was the growth of these products that subsequently led to the subprime crisis that overwhelmed Bear Stearns in March 2008 and paved the way for the financial crisis some six months later. Greenspan’s failings Turning his guns on Alan Greenspan’s nearly 20-year reign as boss of the Fed, Roach had this to say on its role in extending home ownership and loose monetary policy: “The Greenspan Fed was too accommodative of this development in two ways – it kept the cost of credit far too low and it extolled the “virtues” of financial innovations that allowed home ownership to rise to new highs. And it incorrectly viewed these innovations as self-cushioning in the event of a disruption in the housing market – failing to appreciate the perils of concentrated 12

counter-party risk.” Turning to some unwelcome media attention in the 1990s, Roach made it clear he is a firm believer in trade liberalisation and, if used correctly by policymakers and business alike, has many virtues. However, the framework or matrix for this policy must not be used for wanton destruction, particularly if people’s jobs are on the line. So it was quite surprising to learn that Roach himself, initially, had been caught up in the belief, or fad, that after the downturn of the early 1990s, the US economy was charging ahead by embracing a new faster productive paradigm – this period coinciding with NAFTA and a huge upswing in financial services. Ever-increasing revenues Indeed, it should be made clear here that the recovery of the early 1990s was not based on a manufacturing recovery but rather on everincreasing revenues from finance fuelled in part by Greenspan’s monetary policy at the Fed – which Roach has stated was “far too accommodative”for his liking. While Roach may have initially been supportive of the movement towards outsourcing and costing, it did not take him long to recognise that something was amiss and that even in the midst of a supposed economic recovery, unemployment remained sticky. His scepticism gave way to outright opposition once it became apparent to him that many in the US and other developed economies – notably the UK – were approaching this productivity enhancement in completely the wrong way and with many unintended consequences. Roach’s initial support for the new productive paradigm soon came back to haunt Journal of Regulation & Risk North Asia

him when certain sections of the media began vilifying Roach as the guru of cost cutting and the outsourcing of jobs to cheaper locations such as China and India. Indeed, not only did the Wall Street Journal pick up on this story, the BBC became involved when Newsnight anchorman Jeremy Paxman had the temerity, live on air, to invite interviewee Roach to issue an apology to all those who had lost their jobs. Roach was not amused, to say the least. Paul Krugman Again, and more recently Roach, who often appears on numerous financial news channels, was asked about Paul Krugman’s advice to US policymakers, urging them to put pressure on China to revalue its currency. Roach’s riposte was blunt and to the point: “We should take out the baseball bat on Paul Krugman . . . I mean, I think that the advice is completely wrong.” Roach, of course, having a completely different view on the reasons for the trade imbalance between the US and China. Wall St ‘permabear’ Having earned the moniker of“permabear“ for his downbeat assessments of the US and global economy during periods of seemingly unending economic exuberance – during 2003-2004 to be precise when he began to doubt the vitality of the US economy and chairman of the Federal Reserve Alan Greenspan’s loose money and low interest rates strategy to cement sustainable growth – which subsequent events proved Roach, and other members of the Cassandra fraternity (Professor Nouriel Roubini of New York University, William White of the Bank Journal of Regulation & Risk North Asia

of International Settlements and Raghuram Rajan of the IMF to name but three) correct following the subprime implosion beginning early 2007 and resultant 2008 banking crisis. In an interview with Howard Winn, which appeared recently in the South China Morning Post, Roach expanded on his philosophy and reasons for making his now famous call on the US economy, well before other peers in investment banking and central banks – not surprising given Greenspan’s inability to notice an asset bubble, be it housing or stocks. The ‘big call’ Roach explained:“When you’re on a big call, there’s a lot of pressure on you to explain yourself. When you walk down the hall of a major securities firm and you are known for your call, there is a lack of eye contact during this period when you are wrong. Eventually, if the world does not conform to your forecast, then self-doubt creeps in and there is pressure to change the view.” Roach, however, stuck to his guns, even though his own senior management at Morgan Stanley were betting on the fact that the ever-upward spiral of wealth generation would continue, a matter he fundamentally did not agree with. Whilst he tried to influence opinion internally, few would listen, even though, as Roach willingly admits, “I had a framework that led me to these conclusions and the conclusions and the framework still seemed to me to have rigour. It turned out I was right.” Having already noted that Roach is nether infallible – a fact he himself agrees with – nor easily persuaded if the facts supporting his position remain true, perhaps 13

a quote from John Maynard Keynes best sums up his moral rectitude and philosophy:“Looking again today at the statements of these fundamental truths which I then gave, I do not find myself disputing them. Yet the orientation of my mind is changed; and I share this change of mind with many others.” Asia and beyond Shifting focus to Roach’s three-year chairman’s tenure in Asia, the man is part of a pantheon of economists and investment gurus whose every pronouncement is carefully scrutinised by investors and media alike – his fellow soothsayers being Dr James (Jim) Walker, Jim Rogers, Jim O’Neil, Dr Marc Faber and Mark Mobius. While he abandoned the cloak of chief economist in 2007 with his elevation to heading up Morgan Stanley’s operations in Asia, Roach has maintained a prolific output of papers and articles concentrating on both the region’s emerging economies and it’s developed nations. Indeed, unable to cease putting quill to paper, he has managed to shoot off some 150 pieces, many of which formed the main body of a book published in late 2009: The Next Asia – opportunities and challenges for a new globalization. Twin powerhouses Understandably, Roach, like many of his peers, has been mesmerised by the meteoritic rise of both China and India as international economic powerhouses. Unlike certain contemporaries – those über bulls Jim Rogers and Goldman Sachs’stalwart Jim O’Neil, or even that perennial China bear, Jim Walker – Roach is neither a cheerleader 14

nor a Cassandra when it comes to pronouncements on China or India. He takes a more balanced and circumspect approach to his research. That said, having studied China’s rise from impoverishment since the reforming zeal of the visionary Deng Xiaoping in 1978, Roach, following many visits and meetings with China’s business and ruling elite, has learned to respect what he sees as one of the main strengths of the Chinese leadership – its pragmatism and willingness to adapt to changing circumstances to safeguard its continued economic progress and that of its one billion-plus inhabitants. Paradigm shift needed One matter Roach is emphatic about when it comes to China, and a major concern to leading Chinese economists such as Dr Ha Jiming of the mainland’s sole investment bank, China International Investment Corp (an institution which Morgan Stanley was closely associated with) is the over-reliance on what had originally formed the bedrock of its economy – its export-orientated economic model. This Roach believes, given China’s current aspirations, is unsuitable for the next phase of the country’s development. A paradigm shift from its external demand model to an internal demand model is now called for, he says. This was an issue brought clearly home to China in 2008 when its exports were crushed in the wake of the financial crisis, leading to widespread unemployment and social unrest. Around 20 million people in Guangdong province alone lost their livelihoods in the first six months of the downturn. In Roach’s opinion, the Five Year Plan Journal of Regulation & Risk North Asia

leadership gathering in China next year “will be a watershed period for China and the rest of the China-centric region.” Except for the brightest of analysts, a summation of Roach’s economic philosophy and the underpinnings of his beliefs is difficult to impart. This is particularly so concerning the strong moral and ethical convictions informing many of his pronouncements, and the vitriol and contempt he holds towards some, but not all, of those who command the reins of monetary policy, partcilarly when the tools and instruments they control are deployed incorrectly or contrary to the prevailing economic winds. Our final paragraphs detail in depth some of these views and much of what Roach holds dear via an examination of his thoughts relating to the causes of the financial crisis of 2008 and central banking responses in its wake. This was a crisis he alluded to as“the greatest threat to the global economy since the Great Depression of the 1930s.” Not wishing to do an injustice to Roach, this author hopes to reveal the full gamut of his views by affording him the opportunity to convey that which he finds important by publishing in full an account of off-the-cuff remarks he made at a recent central banking gathering in Hong Kong. Responses to the crisis This high-powered meeting was concerned with regulatory and monetary policy responses to the banking crisis and how such crises could be mitigated against in future. Roach’s remarks were made in front of an audience consisting of some 300 bankers, financiers and senior central banking figures Journal of Regulation & Risk North Asia

from the US, Japan and the UK.Among them were the president and CEO of the Federal Reserve Bank of Chicago, Charles Evans; the Bank of England’s executive director for financial stability, Andrew Haldane; and former Bank of Japan monetary policymaker, Professor Kazuo Ueda. (Presentations and points of view Roach referred/alluded to are published in full in the latter half of this quarter’s Journal.). Views on regulation Following keynote presentations by Evans, Haldane and Ueda and opening remarks by the chairman and editor-in-chief of Central Banking Publications, Robert Pringle, Roach took to the podium and instructed everyone that he wished to deal with four areas central to the current crisis and its aftermath. These were: regulation, monetary policy, central banking mandates, and the indefinite period of near-zero interest rates. On the matter of regulation, Roach opined that Evans had “not made any new revelations” about current Fed policy, with his (Evans’) comments in line with those of Fed chairman Ben Bernanke and his predecessor, Alan Greenspan. That is to say, the current principal focus of post-crisis policy adjustments should be in, and are indeed in, the regulatory arena. Principally, by shifting from a micro- to macroprudential regulation and focusing extensively on the establishment of a resolution authority as the answer to the problem of the“too-big-to-fail”moral hazard conundrum that the US faces – a matter Roach readily admits is insufficient in itself to prove of any real value. On the systemic risk front and despite Haldane’s warning about the skill set, or lack 15

thereof, of the omniscient proposed systemic risk regulator – a very important warning in Roach’s opinion – he countered:“We talk the talk of systemic risk, but I challenge anyone to clearly define the metrics that we use to measure it,”adding,“nevertheless, I take the point which the Fed makes, that we do need a new approach to regulatory policy. But I argue that’s a necessary, but hardly sufficient condition to avoid the mess we are currently experiencing occurring in future.” Monetary policy Regarding monetary policy, Roach turned his gaze and full might of his analysis towards his fellow guest speakers and exclaimed, rather contemptuously, that they had either failed to address, or only obliquely referred to what he called the“big gorilla”in the room – namely monetary policy. In passing, he pointed out a few areas that concerned him. He explained that since 2000 the inflation-adjusted federal funds rate – that is to say the nominal fund rate less the Consumer Price Index headline inflation – had been less than its long-term average of 1.9 per cent for all but one year and, that over the same period, the real Fed fund rate had been less than zero for about half the period in question. As measured by this calculation, this has been the most “accommodative monetary policy” the Fed had run since the 1970s. Uncomfortable comparisons Referring to the time he spent working for the board of governors at the Federal Reserve (1973-79) and the accommodative monetary policy it conducted, he said that this was “not one of the great periods of 16

high quality monetary policy in the US”and that he found it “not a comforting comparison that the Fed had reverted to past form.” He continued: “I think there is a monetary policy problem, and I think the regulatory issues are important, but I think there’s an equally important challenge for monetary policy.” More critically, he said the Fed had been quick to be critical about using monetary policy to deal with these types of financial instability issues – asset and credit bubbles – and continually citing that the federal funds rate is a blunt instrument that can do a lot of damage to areas of the economy that do not deserve to be impacted. Shouting match While there may well be some truth to this, he said he found it “rather ironic” when the President of the Chicago Fed (Evans) said we don’t want to be seen as being too subtle when we have these financial problems. We need to shout. To which Roach riposted that he considered the Federal funds rate a “pretty good way of shouting!” Continuing this train of thought, Roach added: “And I would say this idea of using a blunt instrument is important.” Looking back at the unfolding crisis, he said: “At its peak, the bubble distorted housing and, yes, consumer spending sectors in the economy amounted to some 80 per cent of US GDP. If that’s not deserving of a blunt instrument, I don’t know what is?” Moving to his third major area of concern, namely monetary policy mandates, Roach said he believed this required serious consideration and concurred with a point of view raised by Robert Pringle that financial Journal of Regulation & Risk North Asia

stability may need to be mandated and sanctioned by the state. He said: “I think we need to get serious about things, about the policy mandate that shapes and guides the conduct of US monetary policy.“ Historical precedents He then detailed some important historical precedents in the US that had informed monetary policy since the end of World War II, referring to this as “a bit of a history lesson here”. In 1946 post-Depression America, he said, Congress was adamant that never again would we have unemployment rates peak out at 25 per cent, as was the case in the 1930s. And so the Full Employment Act, setting the Fed’s target at just that, was enacted and added to its mandate. It worked for 30 years and then along came the “great inflation”and the same Congress said,“you guys made a mistake.” Thus in 1978 the Full Employment and Balanced Growth Act (known informally as the Humphrey-Hawkins Act) was passed, a move that added price stability to the Fed mandate. This was the“great dual mandate” and the Fed again did a terrific job courtesy of a courageous central banker, Paul Volcker, who went after the country’s rampant inflation. Roach added . . .“and again, I’d say, for 30 years that worked.” ‘Hard–wiring’ financial stability “And now we have another crisis, a crisis driven by a combination of asset and credit bubbles, and I’d say there is a good case to be made for rethinking the mandate again and adding financial stability to the central banks’ mandate – “hard-wiring” the accountability of central banks to deal with asset bubbles Journal of Regulation & Risk North Asia

and the distortions they can impart on the real economy.” Roach’s concluding remarks and final area of concern were, in his opinion, those that get right to the heart of the current policy debate and focus on the near record low interest rates policies central banks are deploying to allegedly safeguard a nascent economic recovery in many of the world’s leading economies . . . with particular scorn heaped on the Fed. He began by praising Evans and other Fed officials for their deft handling of the media when journalists asked about the Fed’s policy of maintaining interest rates at near zero for an indefinite period and questioning when this strategy was likely to end. Roach said:“Its a big question!” Lousy recovery, appropriate rates He continued with this line of exploration by enquiring: “Is it really appropriate right now for central banks [to be] globally maintaining interest rates set at the depths of the crisis.”He acknowledged, however, that central banks did the right thing in slashing rates to zero – as any emergency would suggest. Roach then queried the wisdom of this continued approach in light of the fact that, “Central banks themselves around the world are telling us the emergency is over.” And then he enquired of his fellow speakers: “Is it appropriate, given this fact, to maintain monetary policy at emergency levels now that the said emergency is allegedly over?” Continuing on this theme, he said:“Yes, we’ve heard the recovery is lousy, so why not have your policy setting at a lousy recovery setting given the leads and lags of monetary policy. This does not mean that the funds rate has to go from night to day, from zero 17

to a probable funds rate. Given this inflation rate, and the long-term average of the federal funds rate (1.9 per cent), a normal fund rate would be four per cent. Why not split the difference and deploy a progressive normalisation that takes you half-way there – two per cent – and then if the recovery turns out to be disappointing, you certainly have the opportunity to revert back to your emergency setting.” Rate policies peril Roach then warned audience and speakers alike:“But, if you leave the fund rate on hold at its emergency setting, you run the risk of taking us right back to the same movie that we all watched in the aftermath of the bursting of the equity bubble.” This was when “the Fed stayed too easy, for too long setting us up for a period of excessive monetary accommodation that played a critical role in leading to the credit and property bubbles that nearly brought the global economy to a very, very difficult place in the closing months of 2008.” Lessons learned In his concluding remarks, Roach observed that, “having listened carefully to the views expressed by our central banking colleagues from Japan, the UK and the US, I believe the lessons to be drawn from the experience of Japan over the past two decades are absolutely critical in informing the current policy debate.” Roach detailed the pointers that he considered the Fed had gleaned from Japan’s own experiences in their home-grown economic downturn and period of low growth since the late 1980s. Again, and rather 18

critically, he opined:“The Fed has a view that the main lesson to be drawn from Japan is all you have to do when you have a crisis – the bursting of bubbles – is to move quickly after the crisis and leave cleaning up the mess until afterwards.” Roach then launched into the Fed and its current interest rate policy strategy and its inability to learn from previous mistakes and policy blunders. “The mess we have lived through after this crisis (2008), is testament to the fact that this clearly is the wrong conclusion.“ Somewhat deprecatingly, he added:“The correct conclusion, in my opinion, is that in future policymakers need to be more preemptive in avoiding the types of problems we have just witnessed.“ Praise for William White Roach then paid homage to one of those who had been most prescient in raising alarm bells to the excesses of Fed policy some five years prior to the 2008 crisis – none other than William White, former chief economist and adviser to the Bank of International Settlements, about whom he stated: “In the words of Bill White, monetary policy should not be aimed at cleaning up messes afterwards; rather, central bankers need to lean against the wind to avoid messes in future.” Roach ended with this line: “While the current regulatory agenda is critical, important and necessary, it is not sufficient on its own to prevent crises. Central bankers globally need to be held accountable for monetary policy over the past decade and the very serious mistakes many made that led to the subprime crisis.” • Journal of Regulation & Risk North Asia


The blogosphere strikes back against Richmond Fed assault
U.C. Berkeley Professor Brad DeLong leads an armchair economic bloggers’ offensive against Richmond Fed’s Kartik Athreya.
folloWing publication of a critical paper against online economic bloggers by the richmond fed’s kartik athreya, a number of leading bloggers named by athreya in his article: ‘Economics is hard: Don’t let bloggers tell you otherwise,’ responded in kind with their own missives against the errant fed employee. among those manning their keyboards were leading luminaries Brad Delong, Mark thoma, scott sumner, arnold kling, ryan avent, Mathew Yglesias, tyler Cowen and nick rowe. While the publisher and editorial staff at the Journal of Regulation & Risk – North Asia (JRRNA) endeavour on all occasions to encourage open debate and dialogue, the Journal is only able to do so with the express authority of the parties themselves. Having made a formal request to publish in full Kartik Athreya’s article, the author, although honoured by such a request, humbly declined, no doubt wishing to avoid drawing further attention to himself from irate online bloggers. Though the Journal fully understands Mr Journal of Regulation & Risk North Asia Athreya’s reasoning, this episode highlights once again the unintended consequences of one’s actions or policy prescriptions within the polity, be this the blogosphere or the nation-state itself. This is a matter that William Isaac, former head of the Federal Deposit Insurance Corp (FDIC), is often at pains to highlight in his numerous papers and columns – not to mention his latest book, Senseless Panic. Voices from the blogosphere The JRRNA begins it trawl through the blogosphere and its reactions to Athreya’s paper – mostly negative – by visiting some of our favoured depositories of common sense. First off the starting blocks in condemning Athreya’s take was leading online blogger Scott Sumner who penned the following riposte: “In a recent essay, Kartik Athreya suggests that almost all economics bloggers are basically quacks, hardly worth paying attention to. OK, take a deep breath and don’t get defensive Sumner; constructive criticism is always welcome: To quote Athreya: “In summary, what I’d like to convince the public [about] is that economics is 19

far, far, more complicated than most commentators seem to recognise. Because if they did, they could not honestly write the way they now do. Everything“depends”and this is just the way it is. And learning what “it” depends on, exactly, takes enormous effort. Chatter, blogs and op-eds Moreover, just below the surface of all the chatter that appears in blogs and op-ed pages, there is a vibrant, highly competitive, and transparent scientific enterprise hard at work. At this point, the public remains largely unaware of this work. In part, this is because few of the economists engaged in serious science spend any time connecting to the outer world (Greg Mankiw and Steve Williamson are two counter-examples that essentially prove the rule), leaving that to a group almost defined by its willingness to make exaggerated claims about economics and over-represent its ability to determine clear answers.” That’s right; there’s no need to pay attention to Gary Becker, John Taylor, Paul Krugman, and all the other quacks who lack Athreya’s sophisticated understanding of the “science” of economics. BTW, any time someone wields the term ’science’ as a weapon, you pretty much know they are an intellectual philistine. Am I being defensive yet? Getting serious To get serious for a moment, in this essay Athreya is confusing a bunch of unrelated issues, among them the following: The style of bloggers – are they polite or not? The ideology of bloggers – their views on methodological issues; And, are bloggers competent 20

to deliver an ipinion on important public policy issues? I don’t recall ever reading a Greg Mankiw post that I didn’t feel knowledgeable enough to write. On the other hand, I’ve read lots of Mankiw posts that I didn’t feel clever enough to write. That’s an important distinction. Mankiw is a great economist in the “scientific” tradition, and he’s a great blogger – but for completely different reasons. He’s a great blogger for the same reason he is a great textbook writer. I don’t know if Krugman has done a lot of recent research on macro, but he knows enough about the literature to offer an informed opinion. Difference of opinion I often disagree with the views of Krugman, DeLong, Thoma, et al, on fiscal policy, but they can cite highly “scientific” papers by people like Woodford and Eggertsson for all their fiscal policy views. There must be dozens of economics bloggers who either teach at elite schools, or have a Ph.D from elite schools, and who are qualified to comment on current policy issues. Athreya also takes on those who (he claims) lack formal qualifications in economics. Here’s how he opens his essay: “The following is a letter to open-minded consumers of the economics blogosphere. In the wake of the recent financial crisis, bloggers seem unable to resist commentating routinely about economic events. It may always have been thus, but in recent times, the manifold dimensions of the financial crisis and associated recession have given fillip to something bigger than a cottage industry. Examples include MattYglesias, John Stossel, Robert Samuelson, and Robert Reich. Journal of Regulation & Risk North Asia

In what follows, I will argue that it is exceedingly unlikely that these authors have anything interesting to say about economic policy. This sounds mean-spirited, but it’s not meant to be, and I’ll explain why. Before I continue, here’s who I am: The relevant fact is that I work as a rank-and-file Ph.D economist operating within a central banking system. I have contributed no earth-shaking ideas to Economics and work fundamentally as a worker bee chipping away with known tools at portions of larger problems.“ Where to begin Where do I begin?Yes, bloggers who address important public policy issues sometimes “seem unable to resist” commenting on the biggest economic crisis since the 1930s. Unlike Athreya, I don’t judge people by their credentials, but rather by the quality of their arguments.Yglesias is the only person listed above that I read routinely. Although he is much more liberal than I, and we differ on many public policy issues, I find his reasoning ability on economic issues to be superior to the majority of professional economists that I have met or read. I guess no one will accuse me of being one of those “worker bees” who churns out ever more macro studies that follow accepted scientific methods. I notice that those economists had little or no useful advice to offer the Fed when the current crisis hit in 2008. Pragmatic suggestions I may be incorrect in my policy views, but at least I am trying to offer pragmatic policy suggestions. But maybe it’s not the fault of economists. Maybe there is nothing that could have been done to prevent this Journal of Regulation & Risk North Asia

crisis: Athreya continues:“I find the comparison between the response of writers to the financial crisis and the silence that followed two cataclysmic events in another sphere of human life telling. These are, of course, the tsunami in East Asia, and the recent earthquake in Haiti. These two events collectively took the lives of approximately half a million people, and disrupted many more. Each of these events alone, and certainly when combined, had larger consequences for human wellbeing than a crisis whose most palpable effect has been to lower employment to a rate that, at worst, still employs fully 85 per cent of the total workforce of most developed nations. Seismic qualifcations However, neither of these events was met by (i) a widespread condemnation of seismology, the organised scientific endeavour most closely “responsible” for our understanding of these events or (ii) a flurry of auto-didacts rushing to offer their own diagnosis for what had happened, and advice on how to avoid the next big one. Everyone understands that seismology is probably hard enough that one probably has little useful to say without first getting a Ph.D in it. The key is that macroeconomics, which involves aggregating the actions of millions to generate outcomes, where the constituents pieces are human beings, is probably every bit as hard.This is a message that would-be commentators just have to learn to accept. For my part, 17 years after my first Ph.D coursework, I still feel ill at ease with my grasp of many issues, and I am fairly confident that this is not just a question of limited intellect.” 21

This confuses two unrelated issues, the ability to predict a crisis and the ability to prevent a crisis. In 1932 no one could have predicted the rapid inflation that occurred during 1933. But we know exactly what policy choices caused that inflation, the sharp depreciation of the dollar that began in April 1933. We could have easily prevented the inflation (Thank God we didn’t). Fed monopoly We knew how to prevent the sharp fall in NGDP after mid-2008; we simply chose not to do so. In contrast, we do not know how to prevent earthquakes and tsunamis. Athreya ignores the role of the medium of account, and the importance of nominal shocks. Yes, the economy is incredibly complex, but nominal aggregates are relatively simple. The Fed has a monopoly on the supply of the medium of account. It’s their job to target some sort of variable linked to aggregate demand (prices, NGDP, etc). The tsunami of falling aggregate demand (AD) all around the world that occurred in late 2008 was not some sort of mysterious event, but rather reflected the loss of monetary policy credibility. The Fed has the tools to prevent something like that from occurring. Bernanke explained to the Japanese how to use those tools in 2003. Snake oil peddlers The fact that he refused to use them in 2008, and never explained why, is certainly grounds for criticism. A lot of the more scientific economists have a very limited understanding of economic history. Many do not realise that in the Great Depression some of the most promising ideas came from those 22

on the fringes, like George Warren and Irving Fisher, and that most“respected”economists were peddling snake oil. Today it is bloggers who are offering ideas on how to boost AD, the sort of ideas that almost everyone now agrees should have been tried in the 1930s, and it is respected economists who are often recommending that no further effort be made to boost aggregate demand. One example in the latter category is Athreya’s boss, the president of the Richmond Fed. According to press reports he is pressing for tighter money (as if money isn’t already tight.) Perhaps he’s not convinced that models linking nominal GDP growth with unemployment are sufficiently“scientific.” Disinflation In the 1930s many “respected” economists warned that inflation was just around the corner, even as prices kept falling. Today, many of the more conservative respected economists are issuing the same warning, despite the fact that the markets are signalling lower-that-target inflation and despite the fact that conservative economists (claim to) believe that markets are efficient. It seems to me that it is mostly bloggers (on both the left and the right) who insist that the real problem is disinflation. So who’s right Mr Scientific Economist, the bloggers with their market signals, or the scientists with their abstract models that were completely unable to predict the current crisis, are unable to explain 16 years of deflation in Japan, but are somehow able to tell us that inflation is the real long-term threat? I don’t think the real problem is that Journal of Regulation & Risk North Asia

bloggers oversimplify. If you disagree with someone, their views will always seems simplistic. The punch line No, the real problem here is that Athreya likes some simplistic models more than others: “The punch line to all this is that when a professional research economist thinks or talks about social insurance, unemployment, taxes, budget deficits, or sovereign debt, among other things, they almost always have a very precisely articulated model that has been vetted repeatedly for internal coherence. Critically, it is one whose constituent assumptions and parts is visible to all present, and can be fought over. And what I certainly know is that to even begin to talk about the effects of unemployment, debt, deficits, or taxes, one has to think very hard about many, many things. Examples of this approach done right in the context of some of the topics mentioned above are recent papers by Robert Lucas of the University of Chicago, Jonathan Heathcote of the Minneapolis Fed, or Dirk Kreuger and his co-authors.” When you combine this passage with his previous praise for Steve Williamson’s blog, it becomes pretty clear what sort of research Athreya considers scientific. Friedman’s approach What would be an example of non-scientific research? How about Milton Friedman’s partial equilibrium approach to monetary economics and business cycle theory? I am a big fan of Lucas’ work on rational expectations, especially the Lucas Critique. Journal of Regulation & Risk North Asia

Those were genuine improvements over Friedman’s macro theory. But that is all. Lucas’s insistence that good macro can only be done by carefully embedding all the assumptions in general equilibrium models with micro foundations turned out to be an intellectual dead end. There is not a single idea in monetary economics of use to policy makers that can’t be explained in partial equilibrium terms on the back of an envelope. If blogs had been around in the 1960s and 1970s, Friedman would have been the world’s best economics blogger. Bank of Japan example Here’s what Friedman said about the1998 Japanese crisis: “The governor of the Bank of Japan, in a speech on June 27, 1997, referred to the “drastic monetary measures” that the bank took in 1995 as evidence of“the easy stance of monetary policy.” He, too, did not mention the quantity of money. Judged by the discount rate, which was reduced from 1.75 per cent to 0.5 per cent, the measures were drastic. Judged by monetary growth, they were too little too late, raising monetary growth from 1.5 per cent a year in the prior 3½ years to only 3.25 per cent in the next 2½ years. After the US experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.” The same point is made in Mishkin’s 23

textbook. And Mishkin is a respected “scientific economist”by anyone’s standards. So why is it that 90 per cent of the respected scientific macroeconomists don’t understand this? Why do most keep insisting that the Fed has conducted an “accommodative” or “easy”money policy since 2008? Lack of intuition Maybe they think that doubling the base is easy money, and are unaware that the Fed started paying interest on base money in October 2008. As Cochrane pointed out, this means that reserves are now effectively bonds, not money. My claim is that despite all these fancy mathematical models, most scientific economists lack Milton Friedman’s intuitive grasp on what is really important, what is really going on below the swirling mass of data with which we are constantly bombarded. And I don’t pick Friedman merely because I happen to agree with his politics, Krugman is also very good at looking below the surface (when he doesn’t let ideology get in the way.) I’m afraid that we won’t get the answers we need from “worker bees.” Matt Yglesias may not have an economics Ph.D, but he has a sure grasp of the importance of preventing a sharp break in NGDP growth, something that some much more distinguished economists seemed to overlook in the turmoil of the recent financial crisis. Yglesias in the pulpit If Athreya really thinks we are so shallow, then I encourage him to enter the fray, start his own blog. I’d love to debate monetary policy with him. He might find out that bloggers know a bit more than he imagined.’ 24

Hot on the heels of Sumner’s acrid riposte to the Fed’s Athreya, the Associate Editor of the Atlantic Monthly and prolific multiple blogger himself, Mathew Yglesias, was quick to launch a broadside against the miscreant who voiced concerns over armchair pundits and their acolytes on the worldwide web. Quoting in full from Yglesias’s website, our supposed ill-informed commentator had this to say: ‘Kartik Athreya, a self-described “rankand-file Ph.D economist operating within a central banking system” who by his own admission has “contributed no earth-shaking ideas to Economics and works fundamentally as a worker bee chipping away with known tools at portions of larger problems” has published an essay condemning writ large bloggers and op-ed writers who’ve tried to explicate macroeconomic policy controversies in the wake of the financial panic of 2007-2008. Original sinner He names me by name as one of the sinners, and argues: “It is exceedingly unlikely that these authors [i.e. people like me] have anything interesting to say about economic policy. I think there’s a lot that’s wrong about Athreya’s essay, much of it explained by Scott Sumner, but most of all I think his argument hinges on two category errors, one about what I’m doing and one about what he’s doing. First me. Do I have anything interesting to say about economics? Well, “interesting” is relevant to audience. I should hope that Ph.D economists working in central banking systems aren’t learning about economics from my blog! That’s what grad school, conferences, the circulation of academic papers, Journal of Regulation & Risk North Asia

etc, is for. But perhaps you’re a citizen of a liberal democracy who speaks English and tries to keep abreast of political controversies. It’s the economy, stupid Well you’ve probably heard politicians talking a lot about jobs and the economy.You’ve probably noticed that voters keep telling pollsters that jobs and the economy matter to them. Jobs and the economy may matter to you! You may have seen that political scientists have found that presidential reelection is closely linked to economic performance, and thus deduced that the fate of a whole range of national policy issues hinges on economic growth. Well then I bet you are probably interested in the fact that a wide range of credible experts (with Ph.Ds, even) believe the world’s central banks could be doing more to boost employment. Is Athreya interested in this? Well, I hope he would know it whether or not he reads my blog – he’s working at a central bank somewhere and probably knows a lot more about this than most people. Conceit of policymakers But now to Athreya. His essay seems to partake of the conceit that what economic policymakers do is just economics and that for political pundits to second-guess their decisions would be on a par with me trying to second-guess someone doing particle physics. Completely apart from the fact that the “science” of economics is a good deal less developed than what you see in real sciences, the fact is that economic policy is economics plus politics. For example, according to Ben Bernanke, Journal of Regulation & Risk North Asia

the Fed could reduce unemployment by raising its inflation target but this would be a bad idea because it runs the risk of causing inflation expectations to become unanchored. That’s a judgment that contains some “economics” content but it’s largely a political judgment. It’s part of his job to make those judgments, but it’s the job of citizens to question them. At any rate, the next time anyone finds me claiming to have broken original ground in macroeconomic theory I hope someone will call the expertise police. But you don’t need a Ph.D in sociology to see how it might be the case that the Federal Reserve Board of Governors would be unduly attuned to the interests of college-educated Americans to the exclusion of the working class, or that the European Central Bank might be unduly attuned to the needs of Germans to the exclusion of Spaniards and Italians. [END] King’s fusillade With temperature’s rising on the blogosphere as news of Katrik’s literary assault filtered through the digital ether, Cato Institute Scholar and EconLog co-editor, not to mention a former economist himself for the Federal Reserve System, had this put-down for the young Athreya and the audacity of his claim: ‘Kartik Athreya writes, “Why should anyone accept uncritically that Economics, or any field of human endeavour, for that matter, should be easy to process and contribute to?”He suggests that bloggers supply more noise than signal on economic topics. I understand his point, but I disagree with it. It is a fair point that it is tempting when writing for an audience that includes nonprofessionals to try to oversimplify, to make 25

your views sound more well-grounded than they are, and to make others’ views sound sillier than they are. If you read just one economics blogger, you will get that blogger’s prejudices and blind spots along with whatever insights might be on offer. Collective efforts It is possible, however, for the collective efforts of many bloggers to produce more signal and less noise. That would be the case if the competitive market serves as a check on the more unsound ideas. I am not saying that it works that way, but it might. Athreya takes the view that the academic process of refereed journals is more rigorous and works well. I do not fully share that view. The peer-reviewed journal process may be better than anything else someone has come up with, but it is a deeply flawed process. It rewards ritual over substance, and trend following over originality. The process failed badly in the area of macroeconomics over the past 30 years, an era which I believe Paul Krugman is justified in describing as a Dark Age. Athreya draws an interesting contrast between reactions to the economic crisis and reactions to natural disasters. He points out that the tsunami in East Asia and the earthquake in Haiti combined to kill hundreds of thousands and to impose hardships on many others that are far worse than what has been inflicted by the recession. Economists’ hubris He continues by stating that neither of those ‘disasters’ was met by a denunciation of seismology for failing to predict them nor an outpouring of ill-informed speculation about 26

what happened. He may be forgetting the “God’s revenge” explanation proposed for the Haiti earthquake, but his point is well taken. My pushback would be that economists have claimed to know more about the process of recessions than seismologists have claimed to know about earthquakes and tsunamis. No seismologist I know of has ever said or had the temerity to claim that we have “conquered” such events the way that economists have in the past claimed to have conquered the business cycle. I agree with Athreya that non-economists should express opinions about macroeconomics only with great humility. Where I disagree is that I think that economists, too, need to show humility. Levels of proficiency In fact, I have thought about opening my hypothetical book on macroeconomics something along these lines: If a textbook covers a body of knowledge in order to raise the reader’s level of proficiency, then what should one call a book that covers a body of knowledge in order to raise the reader’s level of doubt? A doubt book, perhaps. Above all, what you are about to read (or discard, as the case may be) is a doubt book. Herbert Stein, in his memoir Economic Washington Bedtime Stories said that he had learned two things from experience about economic matters: 1.) Economists know very little. 2.) Non-economists know even less. Athreya is repeating the second point, and I agree However, I would also place stress on the first point. [END] Tyler Cowen of the Marginal Revolution made short work of Athreya with the following quip: ‘‘I would say that economics is Journal of Regulation & Risk North Asia

really, really, really, really, really, really, really hard. And that’s leaving out a few of the ‘reallys’.” It’s so hard that experts don’t always do it well. The experts are constantly prone to correction by non-experts, by practitioners, by people who are self-educated economic experts but not professional economists, and by people who know some economics and a lot about some other field(s). It is very often that we – at least some of us – are wrong and at least some of those other people are right. Furthermore those other people are often more meta-rational than a lot of professional economists. Even very simple problems can be quite hard, such as why nominal wages are sometimes sticky or why particular markets don’t always clear, in the absence of legal impediment. Why doesn’t the restaurant charge more on a Saturday night? You can imagine how hard the hard problems are, such as what level of public expenditure is consistent with an ongoing and workable democratic equilibrium. Argument aside Putting aside agreement and ideology, and just focusing on how one understands an issue, I’ll take my favourite non-Ph.D bloggers over most professional economists, six out of seven days a week. Not to estimate a coefficient, but to judge public policy, thereby integrating and evaluating broad bodies of knowledge? It’s not even close. Not wishing to be left out of the general mêlée, University of California Berkeley professor and a former USTreasury under- secretary to boot, Bradford DeLong: while ducking out of a long response to Athreya, had this Journal of Regulation & Risk North Asia

advice to offer our errant Federal Reserve employee by pointing him in the direction of the Federal Reserve Bank of Minneapolis president, Narayana Kocherlakota. DeLong suggested that Kotcherlokota could best emphasise to Kartik Athreya that,“someone who has taken a year of Ph.D coursework in a decent economics department (and passed their Ph.D qualifying exams) is unlikely to be able to say anything coherent about our current macroeconomic policy dilemmas.” Kocherlakota advice As Kocherlakota himself observes: “Why do we have business cycles? Why do asset prices move around so much? At this stage, macroeconomics has little to offer by way of answer to these questions. The difficulty in macroeconomics is that virtually every variable is endogenous – but the macroeconomy has to be hit by some kind of exogenously specified shocks if the endogenous variables are to move. The sources of disturbances in macroeconomic models are (to my taste) patently unrealistic. Perhaps most famously, most models in macroeconomics rely on some form of large quarterly movements in the technological frontier. Some have collective shocks to the marginal utility of leisure. Other models have large quarterly shocks to the depreciation rate in the capital stock (in order to generate high asset price volatilities). None of these disturbances seem compelling, to put it mildly. Macroeconomists use them only as convenient shortcuts to generate the requisite levels of volatility in endogenous variables …” If Narayana is right, Kartik is wrong. I’m betting on Narayana. • 27

Opinion: Dodd-Frank Act

Much Ado About Nothing: Dodd-Frank and all that . . .
After nine months’ gestation and with a cast of thousands, Chris Rogers is none too impressed by Congress’s latest production.
the financial reform bill that had preoccupied numerous parties in Washington since november last year finally garnered enough support to become law this month once President obama gives it his official seal of office. following much intense and often bitter debate in Congress between proponents of the bill, its opponents, and those that sought more far reaching reform, the us becomes the first leading economy to honour its g-20 obligations and overhaul its financial services sector in the wake of the 2008 banking meltdown. As the dust settles and the bill’s two leading sponsors, Senator Chris Dodd (pictured above) and Representative Barney Frank prepare for Washington’s long summer recess, a plethora of bankers, lawyers, academics and industry specialists now begin the onerous task of reviewing what has been officially termed the Wall Street Reform and Consumer Protection Act – otherwise referred to as the Dodd-Frank Act – to determine the full extent of the legislation’s impact on the financial services sector in the Journal of Regulation & Risk North Asia US in what was promised as the most wideranging reform undertaken since the days of Roosevelt and the Great Depression. Asian concerns Should our readers, many of whom work for the US and European-based too-big-toofail financial institutions in question – with many others working for more regional and local financial services businesses – actually care what legislation and reforms have been passed in Washington this summer? The answer must be an unequivocal “yes”. Yes, not only should we care, but we need to take stock of the Dodd-Frank Act and ask ourselves whether US lawmakers have enabled legislation which will make the global financial system safer or whether, to the contrary, have they enacted a bill which, for all its fine words and original intent, has failed in its stated ambition of reining in the worst aspects of Wall Street and casino capitalism. It is our view that each of us who reads this Journal should be highly concerned at what has transpired in Congress, particularly in the light of events from March to 29

November 2008, not only on Wall Street, but in financial services centres across the world as the banking sector teetered on the brink of disaster. Obviously, we should be concerned that the two leading epicentres of casino capitalism, namely Wall Street and the City of London – whose banks like mighty Leviathans bestrode the world – forced their governments between them to spend and issue guarantees totalling some US$15 trillion (nearly 25 per cent of annual global GDP) to bail out their financial services sectors. And this astronomical figure does not even include the cost of bailouts, be they private or public knowledge, within the Euro area or other G-20 nations. Fear of a ‘double-dip’ Again, we should be concerned that in the wake of the 2008 financial tsunami that swept all before it and threatened to pitch the world into a global depression, many of our governments here in Asia were forced to embark on massive stimulus programmes to mitigate the worst effects of the global downturn as export-orientated economies felt the full weight of a collapse in international confidence and orders, where friends and family members lost their jobs and their livelihoods – many within Asia’s own financial services businesses or those that service the financial sector. And now, when it seemed the crisis had passed, we have been confronted by the threat of a ‘double-dip’ depression, as those nations which borrowed huge sums to finance their emergency stimulus programmes, are forced to embark on tough austerity measures to satisfy the demands of the sovereign debt markets, operated in 30

many instances by the very same financial institutions that were the recipients of all this government largesse less than 20 months previously. The Dodd-Frank Act So yes, in a nutshell, we who work and run businesses in Asia need to be very concerned at what has transpired in Congress and whether the “Wall Street Reform and Consumer Protection Act” actually protects us from the effects of a possible collapse in one of the too-big-too-fail (TBTF) institutions, and the many knock-on effects and permutations such a calamity can, and indeed has had on our neck of the woods in the immediate past. But what of the Dodd-Frank Act itself, a bill that when jointly introduced into the Senate and House of Representatives on a windswept winter’s day in November last year offered hope that finally, following the disaster that engulfed all in 2008, US legislators would address the multiple causes that contributed to the demise of Bear Stearns, Lehman Brothers and nationalisation of Fannie Mae, Freddie Mac and AIG at great cost to the American body politic, whilst introducing the term“moral hazard’ into the lexicon of the English language as the world faces up to the complex issues surrounding the global TBTF institutions, many of which are housed in both Europe and Asia. Radical overhaul The original Dodd bill – Restoring American Financial Stability Act of 2009 – as introduced to the Senate, weighed in at a mighty 1,136 pages and within its vast volume of text contained detailed and radical proposals Journal of Regulation & Risk North Asia

to overhaul financial regulation, the most radical element of which was the call for a consolidated regulatory body outside of the authority of the Federal Reserve System. Further provisions included the establishment of a consumer financial protection agency, a systemic risk body, oversight of credit rating agencies, enhanced derivatives oversight, hedge fund and private equity reforms, bringing insurance under a federal regulatory umbrella, curtail government and the Fed propping up individual institutions at taxpayer expense, executive compensation limits/curtailments and, finally, new legislation to end too-big-too-fail. Dealing with TBTFs The TBTF provisions would force large complex interconnected institutions to issue hybrid debt securities for use in an emergency, provide for the establishment of “living wills” to be used if a company faced collapse and most importantly, empowering the Federal Deposit Insurance Corp (FDIC) to unwind failing institutions via receivership to be funded by a levy on institutions with assets over US$10 billion. Had Senator Dodd’s original proposals, as presented to the Senate, been passed into law, it is the opinion of this writer and many of the leading authorities with whom the Journal of Regulation & Risk – North Asia communicates, that the resultant legislation would have gone a long way towards addressing many of the problems highlighted by the banking crisis of September and October 2008 – for which the Journal commends Senator Dodd and all those associated with drawing up his original proposals. Journal of Regulation & Risk North Asia

Unfortunately, much that was good within Dodd’s original draft proposals, after months of debate, amendments and Congressional skirmishes never saw the actual light of day. Dodd undermined The reasons for this are manifold and worthy of a book. But due to space constraints, we can but highlight a few of the factors that undermined Dodd’s original intent. First and foremost, the Dodd bill was far more wide-reaching and radical in its scope than what the Obama administration – heavily influenced by Larry Summers and Treasury Secretary Timothy Geithner – had originally intended. The Dodd bill also deviated greatly from a similar bill simultaneously introduced into the House by Barney Frank. Specifically, Frank’s bill was more in line with the views of the Obama administration in that it did not call for a sweeping overhaul of the regulatory environment. Rather, it suggested the Office of the Comptroller of the Currency (OCC) be merged with that of the Office of Thrift Supervision (OTS); differences in how to approach TBTFs were also apparent. No GOP support As if matters were not sufficiently detrimental to Dodd as far as the Obama administration and sections of the Democratic party were concerned, his efforts were certainly undermined by the fact that the Republican leadership in Congress was opposed to any bill recommended by the Democrats lest it upset their business interest constituency. The Federal Reserve itself was also opposed to losing many of its supervisory powers 31

to an independent body and, as such, was more supportive of Frank’s proposals. Further, much of the financial services sector itself – and those businesses that utilised FX derivatives to hedge against currency movements – was opposed to much of the sweeping proposed reforms and fought a highly successful lobbying campaign to curtail the more onerous sections of the bill making the statute books. The lobbyists, many engaged by Wall Street firms, the American Banker’s Association and International Institute of Bankers, to name but a few, placed considerable pressure on legislators during the nine-month passage of the final Act, with sums in excess of US$1 million being spent each day at the height of the struggle. This was a disgrace by any perspective given the huge sums swiftly expended by the US public to bail the sector out at the height of the banking panic. Reconciliation process A comprehensive review and analysis of the battle for supremacy within Congress between opponents and proponents of the bill’s passage is beyond the scope of this paper and the author can offer limited background detail to inform our analysis of the actual bill which appeared for final confirmation in late June, 2010. That said, even after both the House and the Senate finalised and passed their own versions of a financial reform bill, both had to be reconciled within the Conference Committee, thus requiring further debate and compromise before a final Act could be presented to President Obama. An exception to the above must be made regarding several late proposals, which 32

together, could have had a serious impact on the final bill in their original form. It also needs stating that many other notable additions to the bill/bills were proposed but ultimately voted down and, as such, failed to gain mention in any form in the final act. Volcker amendment First, as though few readers need reminding, was the introduction of the ‘Volcker Rules’, drawn up by former chairman of the Federal Reserve Paul Volcker and initially championed by none other than President Obama in January this year. Apart from the fact that by introducing the Volcker Rules into the equation so late in the day, Obama threatened to upset leading Senate Democrats by changing the scope of the original Dodd bill. That said, the proposal were radical, calling not only for limits on the size of the largest banks, but also by divorcing their proprietary trading arms from the rest of the business – effectively by banning casino gambling by deposit-taking institutions, or institutions covered by the FDIC. Effectively, the Volcker Rules threatened to overturn 30 years of deregulation by emulating key elements of Glass-Steagall. Brown-Kaufman amendment In April, Senators Sherrod Brown and Ted Kaufman, tried, but ultimately failed in their attempts to introduce the Safe Banking Act into Dodd’s original bill, which like the Volcker Rules threatened to place leverage and market capitalisation caps on America’s TBTF banks – effectively the proposals, if passed, would have meant a number of America’s largest financial institutions being broken up into smaller constituent Journal of Regulation & Risk North Asia

parts – much in the way President Teddy Roosevelt dealt with Standard Oil at the beginning of the 20th century. Such a provision ultimately would simplify any resolution of a failing institution while militating against serious knock-on effects to numerous counter-parties. The Brown-Kaufman amendment was complimented by a proposal by Representative Paul Kanjorski, and adopted by the House, that would significantly enhance the authority of federal regulators to preemptively break up large financial institutions that – for any reason – posed a threat to financial or economic stability in the United States. Again, this amendment dealt with resolving the issue of TBTF and was seen as addressing several weaknesses with Dodd’s own proposals of only allowing regulators to intervene as a“last resort,”which in many instances could be far too late to prevent a national or global crisis. Blanche Lincoln Special reference must also be made to the Hon. Senator for Arkansas, Blanche Lincoln – perhaps under instruction by the indomitable former chair of the Commodity Futures Trading Commission, Ms Brooksley Born – in her desire to make derivatives transactions more transparent by mandating that all transactions be exchange traded, that FX swaps be regulated and that large financial institution swaps desks be spun off into separate entities. Again, this measure was seen as an effort to deal with issues of TBTF and interconnectedness – smaller institutions being easier to unwind than large complex ones. It was also part of a concerted effort to deal with the so-called “shadow banking” Journal of Regulation & Risk North Asia

side of the sector or, to put it bluntly, those activities that currently fall off the radar screens of regulators. Despite Dodd’s original intent in November, and the interjections of many members of Congress to contribute to a bill that actually dealt fully with many of the causes and activities that resulted in the banking crisis of 2008, the final Dodd-Frank bill as it was presented to the Senate at the end of June was a far cry from what many had expected or hoped for. Half-baked, half-hearted Under fire from all directions, and full of compromise, opt-outs, exceptions, outright contradictions and with glaring omissions, the bill to be presented to the President is half-baked, half-hearted and lacking in teeth to deal with the very real issue at hand, namely, preventing a rerun of that movie which was the great financial crisis of 2008. The bill in its final guise weighs in at a massive 2,319 pages of complex rules and procedures covering some 16 Titles with multiple sub-sections. Notwithstanding the fact that the final package is more than double its original length – some 250,000 words – no one can accuse the Dodd-Frank Act of not being wide-reaching or less than ambitious in its remit. Anti-climax It is something of an anticlimax, therefore, when it comes to specifics and actualities, preferring instead to add numerous discretionary powers to the existing regulatory bodies, or establish new bodies composed of the heads of existing bodies, such as the SEC, Fed and FDIC. It is thus a far cry from what 33

Glass-Steagall achieved in 1933 with a piece of legislation weighing in at a puny 45 pages, accessible by all and, ultimately, significantly more radical in scope than that which stands before us today. A detailed analysis of the Dodd-Frank bill is beyond us in this paper, therefore let us concentrate on some of the key elements of the legislation as passed by the Senate on July 15, some 10 days later than anticipated following the death of Senator Robert Byrd and after extortionate demands costing the US taxpayer a further US$19 billion to fund the enhanced regulation by Senator Scott Brown (Rep) – charged with responsibility for the funds management heavy state of Massachusetts – who objected to large complex financial institutions themselves having to cover the additional cost of regulating them. Frank duly relented and removed the offending provision from the final bill, thus leaving a rather large black hole to be filled. Living up to the hype Last-minute political shenanigans aside, we must ask ourselves if the bill has lived up to its original remit of removing risk from the financial system by constraining individual organisations’ risk-taking activities and capturing a broader set of organisations – including the so-called “shadow” banking system – in the revised regulatory environment, whilst enhancing consumer and investor protection . . . thus making the US financial services sector a safer place. A first glance at a summary of the legislation on both the Senate and House of Representative’s websites indicates, on the whole, that the bill addresses many of the problems and issues that resulted in the 34

banking meltdown of 2008, with the one glaring omission of any mention of government-sponsored entities. A closer examination of the actual text itself, though, paints a less complimentary picture and brings into question whether the bill has adequately dealt with the moral hazard of TBTF, those riskier elements of casino capitalism – derivatives, structured products and credit default swaps – excessive compensation, transparency, increased capital requirements and enhanced powers to prosecute acts malfeasance. More agencies To begin with, far from streamlining the US regulatory environment, Dodd-Frank actually increases the number of state and federal agencies from its current 115 agencies to a staggering 126 – the OTS being an exception to this rule via its consolidation into the OCC. Among the new agencies is the much fêted consumer protection agency – housed within the Federal Reserve and an overarching systemic risk agency, the Financial Stability Oversight Council, comprising the heads of the Fed, Treasury Secretary, SEC and FDIC. Unfortunately, it is first necessary to determine which financial institutions are actually systemically important – Bloomberg estimates that there are 184 banks worldwide each with assets exceeding US$50 billion. That’s just banks and not other complex financial institutions. Increased discretionary powers This brings us to our second observation, that while the bill has added significant powers to the existing regulatory agencies, as detailed in Title I, many of these are discretionary, Journal of Regulation & Risk North Asia

rather than mandatory. Indeed, a true picture of the regulatory environment established by Dodd-Frank will not become clear until next 2012 following an estimated 520 rule makings, 81 studies and 93 reports – a figure that varies significantly from one report to another. However, putting this in to perspective, Sarbanes-Oxley only required 16 new regulations and six studies – thus making Dodd-Frank some 30 times larger and more energy intensive than SOX. So much for ending uncertainty or a sense of urgency – meanwhile, if another crisis emerges, the miscreants can always count on the US taxpayer and Fed to bail them out. Much of the dialogue in Congress and consequential details in the Dodd-Frank Act centres on the vexed issue of“moral hazard,” currently associated with TBTF and the resolution of a TBTF in case of crisis that does not add to the burden of the US taxpayer, nor systemically threaten the rest of the financial services sector. Title II and ‘orderly resolution’ The Federal Reserve for its bank stress tests in 2009 identified 19 institutions which were deemed systemically important to the US financial system – and this figure did not include other complex financial institutions operating outside of banking – think AIG, Freddie or Fannie here or any institution with assets in excess of US$50 billion. Title II of Dodd-Frank and several other of theTitles in one way or another address the problem of TBTF, interconnectedness and an orderly resolution of a failing institution. Most of the resolution powers contained within the bill are handed over to Sheila Bair’s FDIC and cover all deposit-taking Journal of Regulation & Risk North Asia

institutions and those deemed of systemic importance to the financial services sector – it’s just not clear which financial services businesses currently cross this threshold. Nuclear option Further, to invoke its new winding-up authority, the FDIC will have to go through a convoluted process involving the Fed, Treasury and get three senior judiciary judges to sign-off on any winding-up resolution before it can be deployed. Indeed, as one critic noted, it is doubtful if this authority will ever be used, much like the authority to launch a nuclear weapon was never used. Lets think of this as a deterrent then, one which it is hoped will curtail risky behaviour by management and force shareholders to make sure these institutions have stringent risk management procedures in place. Enhanced capital requirements or cushions are called for in Dodd-Frank and are dealt with in detail under the Collins Amendment as drawn up by the FDIC and found in section 171 of the Act. This states that Federal banking agencies are required to establish minimum leverage and risk-based capital requirements to apply to insured depository institutions, bank and thrift holding companies and systemically important non-bank financial companies. and that these minimums must not be lower than that found today in FDIC insured banks. Notwithstanding the fact that Basel III is also currently considering these levels, this process, again discretionary, will not be fully implemented until 2012 at levels yet to be determined. Given how leverage played a crucial 35

role in the demise of Bear Stearns, Lehman Brothers and AIG, its seems at odds with Dodd-Frank’s stated ambition of making Wall Street safer that reference to leverage within the Act is oblique, to say the least, unless we refer back to Section 171. Regardless of capital cushions or requirements, many financial institutions up until September 2008 were leveraged up to 40 times their actual capital reserves. Greater leverage Provisions already existed prior to the implosion, for the Fed and SEC to monitor debtto-asset ratios and equity-to-asset-rations; however, under the SEC’s Christopher Cox, Greenspan and Bernanke at the Fed, such powers were never utilised. Capital requirements were also applied in Basel II – which many now blame for an excess of leverage once the US signed up to this agreement – this due to the fact that supposed enhanced risk management procedures allowed for greater leverage, which many of the ‘bulge bracket’ banks duly embraced . . . with tragic consequences for Lehman Brothers. By failing to mandate or make reference to such issues, Dodd-Frank effectively fails to mitigate against this problem and thus leaves the door open for a rerun of 2008. Limits, checks and balances What about the Volcker Rules, derivatives and compensation? Well, the Volcker Rule remains in name only, rather than divorce the banks from their huge risk-taking prop desks that use depositors’money to gamble on behalf of the bank itself – with the traders earning huge bonuses if they win and the taxpayer picking up the tab if it goes 36

horribly wrong. It was decided, at the behest of our good friend Scott Brown, that this was inappropriate. So he drove a coach and horses through the proposal; as such banks are allowed to utilise three per cent of their capital to gamble and own three per cent of outside entities such as hedge funds and private equity vehicles. So much for reducing systemic risk or mitigating against casino capitalism. It’s the same old story on executive compensation; risk-taking and short-termism rules whilst the Fed and SEC take another look at the issue. The same applies to malfeasance, up for a little judicial review and nothing concrete. Again, let’s visit Blanche Lincoln and bring derivatives on to the radar screen via central clearing of all trades. The rules here will be exceedingly complicated. Banks will be allowed to play in some of these markets and will be banned from others – at least, though, they bought the idea of a central clearing exchange. Electorate opts for change In November 2008, the US electorate voted for change and the election of President Obama promised a new era and a new start. By focusing on healthcare issues first Obama expended nearly all his dry powder, leaving little left to deal with the real problem at hand – a wayward Wall Street and failing economy. The world was looking for leadership on bank reform, as was the US electorate, and believed the US would deliver leadership in a time of international crisis. Two years down the line, it is clear neither team Obama or Dodd-Frank have grasped the nettle and placed the genie back in its bottle. Instead of concise meaningful Journal of Regulation & Risk North Asia

reform that addresses both TBTF and the causes of the crisis, we get opt-outs, omissions and delegation of powers to the same said agencies that failed to police Wall Street to begin with. Yes, there is good in the bill’s 2,319 pages, but much of this good is overwhelmed by ill- judged compromise in order to pass legislation that ought to have had more beef and teeth. Instead of mandating powers to the Fed and the Federal Deposit Insurance Commission – financial stability and similar powers to Chapter 11 respectively – DoddFrank actually increases uncertainty, for the time being at least or until the regulatory agencies finish their rule-makings, studies and reports – all of which are open to intense lobbying and further change. The best that can be said for the DoddFrank Act is that it is still very much a work in progress, one which could hit the

financial services sector in the short term by way of increased compliance costs and some curtailed profit-making activities by around five-10 per cent, according to some researchers’ recent reports. Much Ado About Nothing In the long run, should Wall Street dislike what it sees, nothing can stop it from decamping overseas and utilising regulatory arbitrage, and this includes those venerable institutions, the Basel Committee and G-20. In a nutshell, Dodd-Frank is like that Shakespearian favourite, Much Ado About Nothing; frivolous to say the least, somewhat obscure, but entertaining all the same. Unfortunately, it does not live up to the radicalism Dodd proposed in November, 2009 and, as such, fails in its ambition to radically overhaul finance . . . and make America a safer place to boot. •


ournal of regulation & risk north asia

Editorial deadline for Vol II Issue IV Winter 2010/11

November 15th 2010

Journal of Regulation & Risk North Asia



Credit rating agencies shocked at investor performance clause
Harvard Law School’s Lucian Bebchuk details proposals tabled by the US Senate to rate the rating agencies themselves.
in the new financial order being put in place by regulators around the world, reform of credit rating agencies should be a key element. Credit rating agencies, which play an important role in modern capital markets, completely failed in the years preceding the financial crisis. What is needed is an effective mechanism for rating the raters. There is widespread recognition that rating agencies have let down investors. Many financial products related to real estate lending that Standard & Poor, Moody’s, and Fitch rated as safe in the boom years turned out to be lethally dangerous. And the problem isn’t limited to such financial products: with issuers of other debt securities choosing and compensating the firms that rate them, the agencies still have strong incentives to reciprocate with good ratings. What should be done? One proposed approach would reduce the significance of the raters’ opinions. In many cases, the importance of ratings comes partly from legal requirements that oblige or encourage institutional investors and investment Journal of Regulation & Risk North Asia vehicles to maintain portfolios of assets that have received sufficiently high grades from the recognised agencies. Disappointment about the raters’ performance, and scepticism about the effectiveness of regulation, has led to calls to eliminate any regulatory reliance on ratings. If ratings are not backed by the force of law, so the argument goes, regulators need not worry about rating quality and can leave the monitoring of raters to the market. Failure to perform Proponents of this course of action such as Senators George LeMieux and Maria Cantwell, would remove references to the credit agencies in all major financial services laws. LeMieux stated: “We know that one of the main reasons why we had our financial debacle in 2008 was that credit agencies failed to do their jobs, they put AAA stamps of approval on products that deserve no such stamp, and the investing world relied upon the fact that these rating agencies were supposed to do their job and they failed.” Even if ratings were no longer required or encouraged by law, however, demand for 39

ratings – and the need to improve their reliability – would remain. Many investors are unable to examine the extent to which a bond fund’s high yield is due to risk-taking, and would thus benefit from a rating of the fund’s holdings. Given past experience, we cannot rely on market reputation to ensure that such ratings will be reliable. Judicial threat Another approach would be to unleash the liability system. On this view, if investors were able to take raters to court, raters’ incentives would improve. But while such judicial scrutiny may be effective in eliminating some egregious cases, it cannot ensure that raters do the right thing when courts are not expected to be able to tell after the fact what the right thing was. As such, there no substitute for providing raters with incentives to provide as accurate a rating as they can. This can be done by making raters’ profits depend not on satisfying the issuers that select them, but on performing well for investors. If raters’ profits depend on such performance – on the accuracy of their ratings – the profit motive would turn from a source of perverse incentives to a provider of beneficial incentives. Senate approval The US Senate voted in May to incorporate such a mechanism into the financial reform bill that will now have to be reconciled by the bill passed by the US House of Representatives. Under the Senate’s approach, regulators would create rules under which an independent regulatory board would choose raters. The board would be allowed to base its choices on raters’ past 40

performance. For such a mechanism to work well, it must link the number of assignments won by raters, and thus their compensation, to appropriate measures of their performance. Such measures should focus on what makes ratings valuable to investors who use them – their accuracy in forecasting financial health. Once developed, such a mechanism should not be limited (as, unfortunately, it is in the Senate bill) to ratings of structured financial products. It should apply to all products that rating agencies evaluate. All ratings of financial products raise the same incentive problems and could benefit from reform. Stiff raters’ resistance Predictably, the Senate’s bill encountered stiff resistance from the dominant ‘big three’ global rating agencies. Standard & Poor argued that such a mechanism would provide credit rating agencies with “less incentive to compete with one another, pursue innovation, and improve their models, criteria, and methodologies.” Well, such a mechanism would indeed reduce raters’ negative incentives to compete with one another to please issuers of securities, and to pursue innovations and improvements that enable raters to serve issuers better. But it would strengthen raters’ positive incentives to compete with one another to produce accurate ratings, and to pursue innovations and improvements that enable raters to achieve that far more socially beneficial goal. Rating agencies have been and should remain an important aspect of modern capital markets. But to make ratings work, the raters themselves need to be rated. • Journal of Regulation & Risk North Asia


Endemic fraud at heart of the bank crisis, so ‘let’s get radical’
Put paid to financial crises permanently via ‘limited purpose banking’, says Boston University economist Laurence Kotlikoff.
the obama administration as well as Congress continue to ignore the primary cause of our financial debacle and to propose reforms that badly miss the mark. The cause was first and foremost financial fraud, of which the US Securities and Exchange Commission’s fraud-based lawsuit of Goldman Sachs is just the latest evidence. The financial industry, aided and abetted by credit rating companies on the take, politicians on the make, and regulators on a break, systematically manufactured trillions of dollars of securities, which we now call toxic. And we call them toxic, not because they were risky, but because they were, phony. Fraud in vogue The fraud didn’t arise because banks were too large, too leveraged, and too interconnected, although these factors greatly exacerbated the financial fallout and need to be fixed. The fraud arose because large parts of the industry decided to make money the old fashioned way – by stealing it. When you Journal of Regulation & Risk North Asia issue liar mortgages, rate triple-C assets as triple A, insure the uninsurable, pay yourself massive and fully undeserved bonuses, shop for compliant regulators, and bribe politicians to change rules – that’s theft, plain and simple. Proprietary info key Proprietary information, not proprietary trading, was the key to the crime. “We’ll make you a mint. But no questions. If we disclose, others will learn and we’ll no longer beat the market.” Would that everyone could beat the market. And would that Wall Street’s wizards, as a group, actually had proprietary information of social value. But the information they were keeping private was their sale of snake oil. When the fraud surfaced, so did the questions. Was every asset toxic? Was every loan overvalued? Were any financial statements to be trusted? These questions were asked about every bank, no matter its pedigree, the tenure of its“top”management, or its regulator. And this new information, that there was no information, laid waste to one financial company after another. Today, two 41

plus years into the crisis, full non-disclosure prevails. No one can drill down on the web to the individual holdings and liabilities of any major financial institution, least of all our central bank – the Federal Reserve, which has printed $1.5 trillion to buy up . . . who knows precisely what? Bank paper death No one will swap something real for bank paper, which they suddenly suspect is worthless and aren’t permitted to inspect. Hence, financial plague, whether spread by truth or rumour, can strike any part of our financial system at any time. And if the plague hits our central bank, its paper, the “almighty” buck, will find few takers. The Fed has already laid the basis for such hyperinflation, having printed more money in two years than in the entire history of the republic. Were prices to skyrocket, we’d see a run on the banks, with people desperate to buy something real before their money becomes worthless. Federal Deposit Insurance Corporation (FDIC) insurance, guaranteeing that our dollars, as opposed to our purchasing power, are safe, would be no assurance. Bank run printing blitz And such a run would force Uncle Sam to douse the fire with a gas tanker. He’d be legally bound to meet his gargantuan explicit and implicit FDIC, money market fund, commercial paper, and other financialsector guarantees, which means printing trillions more. Could ‘Do Cry for Me Argentina’ really become top draw on iTunes?Yes. But there’s a simple cure for our financial 42

plague. It’s called Limited Purpose Banking (LPB). LPB implements what Bank of England Governor Mervyn King and former US Treasury Secretary and Secretary of State George Shultz, strongly advocate – namely transforming financial companies into financial piping (utility) companies who stick to their legitimate purchase, financial intermediation, rather than gambling with taxpayers’money. Unlike the Volcker Rule, which draws a line in the sand between commercial (good boy) and investment (bad boy) banks – a line easily crossed, LPB erects a concrete barrier between financial intermediaries with and without limited liability. LBP at a glance Under LPB, all financial corporations (banks, insurance companies, hedge funds, etc) would operate strictly as pass-through mutual fund companies. Investment banking would become a pure consulting service, and trading operations would simply match buyers and sellers, with no exposure. Mutual funds are, effectively, small banks with zero leverage. Their investments can lose value, but the funds themselves can never fail. Hence, LPB puts an end to financial collapse. LPB also replaces some 115 federal and state financial regulatory bodies with the Federal Financial Authority (FFA) – effectively an FDA for securities held by the LPB mutual funds. The FFA would use federal tax returns to verify income and employment statements on mortgage and commercial loan applications as well as on new tenders of stock. Journal of Regulation & Risk North Asia

It would hire multiple, non-conflicted private firms to appraise collateral and provide ratings. And it would oversee thirdparty custody of all mutual fund securities. Most important, it would disclose all details about individual mutual fund securities in real time. FFA transparency Markets don’t work when people can’t tell what they are buying. The FFA makes financial products transparent, but it doesn’t say which products can or can’t be sold. Once a new security is processed by the FFA, and fully disclosed on the web, it would be put up for auction to the mutual funds. This would ensure that households and firms receive financing at the lowest cost available. In addition to the 8,000 or so mutual funds now being marketed, LPB would feature cash mutual funds and insurance mutual funds. Cash mutual funds hold only cash and, consequently never break the buck (apart from the service fee). All other mutual funds would proclaim: this fund is risky and can break the buck. Cash mutual funds replace today’s checking accounts. We’d write checks against them and draw on our balances with debit cards and via automated teller machines (ATMs). Tontine mutual funds Insurance companies would sell tontinetype mutual funds, in which shareholders bet on things that can happen to them, like dying, and parimutuel funds, in which shareholders bet on impersonal events. The tontine dates to 1653 and survived Journal of Regulation & Risk North Asia

for centuries. The New York Stock Exchange first met inside the Tontine Coffee House. Tontines don’t pretend to insure the uninsurable – aggregate risk. But all idiosyncratic risks – longevity, property losses, early death, disability, medical costs, accidents, etc – can be insured by paying out the mutual fund’s assets (the pot) to those shareholders experiencing losses. Parimutual bets Parimutual betting dates to 1867 and is used in racetracks around the world. The horses here can be IBM defaults or not, Intel’s stock passing $120 or not, inflation exceeding five per cent or not, etc. In all cases, the fund’s pot is given, held by a third party custodian, and paid out to the winners. There is no liability left for the taxpayer. Mutual fun pots are natural financial firewalls – something desperately missing in our current system. It’s time to really fix our financial system. If we don’t, we should stop planning the flowers for the next Wall Street funeral and start digging a massive grave – one large enough to hold Uncle Sam. • Editor’s note The editor and publisher of this Journal wish to thank Professor Kotlikoff for allowing us to publish an amended version of this paper that originally appeared on Bloomberg’s news service. For those with an interest in Limited Purpose Banking, as proposed by Prof Kotlikoff in this paper, please proceed to page 49 and read a review of his new book, Jimmy Stewart is Dead, by Toby Baxendale. The book further details his ideas on LPB and the 2008 banking meltdown. 43

Book overview

Capitol Hill ‘complicit’ in lead-up to banking crisis
In a patriotic call to arms, former FDIC chief, William M. Isaac, pulls no punches in his new book, ‘Senseless Panic’.
The financial panic of 2008 and the ensuing deep recession did not have to happen and i am appalled by the enormous financial, human and political cost of it all. taxpayers, rightly so, are extremely angry about the events of 2008 and 2009 – they know instinctively that something does not smell right. I wrote this book – Senseless Panic: How Washington Failed America – to get out the truth about what happened and why and how we can prevent future crises. We, and I mean all of us and our great country, are in enormous trouble! If we do not take the time to learn what went wrong and how to fix it, we, our children, and their children, will pay a big price. If we let them, our political leaders will do everything in their power to hide their culpability for the mess in which our nation finds itself, and they will enact “politically easy” legislation that will not address the fundamental causes of the crisis and will in fact make things worse. Our leaders are already covering up their role in creating what I call the senseless panic of 2008, are Journal of Regulation & Risk North Asia trying to deflect blame to “greedy bankers,” and offering slogans rather than solutions to real and present dangers. Among other things, they are telling us the Troubled Asset Relief Program (TARP) was essential to calming the markets when, in fact, the TARP did far more harm than good. This book exposes the TARP for what it was – an ill-conceived programme hastily slapped together by a panicked government working too close for my comfort with a handful of Wall Street firms. It set off an economic and political firestorm from which we have yet to recover. Carter appointee I had the privilege of leading the Federal Deposit Insurance Corporation (FDIC) during the bank and thrift crises of the 1980s, having been appointed to the FDIC board of directors by President Carter in 1978 at the age of 34. Little did I know when I took the post that the country was about to experience the worst economic and banking crisis since the Great Depression – a crisis that would result in larger and more severe bank failures than in the 1930s. 45

Inflation had been high throughout the 1970s and it was getting worse. President Carter appointed PaulVolcker as chairman of the Federal Reserve in 1979 with the charge of getting inflation under control. Volcker raised interest rates rapidly and the prime rate soared to an incredible 21.5 per cent. Few financial institutions or borrowers could absorb that kind of rate increase. Following Ronald Reagan’s election in 1980, I was named chairman of the FDIC. The entire banking and thrift sector was in dire straits. A short recession occurred in 1980 followed by a deep and prolonged recession in 1981-82, with unemployment soaring to 11 per cent. Decade of failures From 1980 through 1991 some 3,000 banks and thrifts failed, including many of the largest in the country (nine of the 10 largest Texas banks, for example). The failed banks and thrifts had $650 billion of assets and cost the FDIC fund more than $100 billion (multiply those numbers by six to put them into relative terms to today’s banking system). It was an extremely difficult period, but the public’s confidence in the banking system held and financial panic was averted. Even as we handled thousands of bank and thrift failures, the economy improved and we enjoyed the longest peacetime economic expansion in history. Contrast this result in the 1980s with the worldwide financial panic that hit in the fall of 2008 and threatened to push the world into an economic depression. The economy was actually quite strong in pre-financial crisis 2007 unlike 19801982, so why did we experience such 46

different outcomes in the financial markets this time around? It is impossible to listen to or read a news report about the crisis of 2008 and beyond without being told that the problems in this latest crisis are much worse than in any period since the Great Depression of the 1930s. When people do talk about the 1980s, most refer only to the S&L crisis and seem not to be aware how serious the banking and economic problems were during that period. Most people – members of Congress included – would be surprised to learn that we were so concerned about the condition of our major banks during the 1980s that we developed a contingency plan to nationalise all of them. As late as the Presidential Debate of 1992, candidate Ross Perot asserted that the FDIC fund was horribly inadequate to cope with what he believed was the massive insolvency of our major banks. Navigating the storm In this book, I discuss how we were able to navigate the treacherous economic and banking waters in the 1980s without creating a financial panic and why we failed to contain the less serious problems in 2008 that nearly sank the financial system. Having lived 24/7 the banking and S&L crises of the 1980s, I examine the lessons we learned and failed to learn from that period and identify the mistakes that led to the senseless panic of 2008. It was a panic that would not have happened had our political leaders acquired even passing knowledge of what happened during the 1980s and how we dealt with the enormous problems. Many historians believe that World War II was a continuation of World War I. They Journal of Regulation & Risk North Asia

believe that the issues that led to the first war were not resolved and the Treaty of Versailles was terribly flawed, so after a 20-year hiatus the fight resumed. Similarly, I believe the banking and S&L crises of the 1980s were misunderstood by our political leaders, the wrong“fixes”were put into place during the 1990s, and those actions led us directly into the banking crisis of 2008. Based on what I have seen thus far from the Obama Administration and the legislative efforts on Capitol Hill, we have not gotten any smarter this time around and I fear for the future of our great nation. Prof Hurley’s thoughts This is what Prof. Cornelius Hurley of Boston University and former assistant general counsel in the Federal Reserve Board had to say after reviewing Bill Isaac’s latest missive against Washington: Before “too big to fail” became part of our lexicon, there was Bill Isaac, chairman of the FDIC in the 1980s. Drawing on his experience from that era leading the banking system out of a potential catastrophe, Isaac in his new book, Senseless Panic has provided us with a mustread analysis for anyone looking to understand the 2008 economic crisis. Senseless Panic offers both fresh insight and devastating analysis, showing how a pattern of governmental inaction and regulatory failures played leading roles in the meltdown. During the critical days in September 2008, when Congress was debating the original bailout package, Isaac was called on by a bipartisan group of legislators to educate Congress on the failings of the government’s plan. He played a crucial role in defeating the initial proposal in the House. Journal of Regulation & Risk North Asia

Though it eventually passed, Isaac presents a clear-eyed critique of TARP as unnecessary and a waste of taxpayers’money. Poor agency responses Isaac first gives readers a succinct and straightforward look at how in the 1980s the FDIC and Paul Volker’s Fed managed to stave off a brewing bank panic with unpopular but necessary steps. He provides a roadmap on how later the lack of political will, agency turf wars and boneheaded policy responses to the bank and S&L crises of the 1980s led to the current debacle. Isaac explains how banking regulators need to have the courage to promote unpopular counter-cyclical strategies to protect the financial markets. Isaac shows how the regulators botched the job, calling out a bipartisan collection of economic and political leaders including treasury secretaries, the SEC and FASB for their failed policies and poor reaction to the crisis of 2008. Senseless Panic is an important book, one that should be on the reading list of anyone interested in America’s economic well being. Isaac shows how the failure to understand and appreciate the banking crises of the 1980s turned the inevitable economic downturn in 2008 into an economic force of destruction. For the next generation of economic policymakers looking to head off an economic tsunami, Senseless Panic is the place to start. • Publishers note Excerpt taken from Senseless Panic, published by Wiley & Sons. All material is copyrighted and reproduced with the permission of the author and publisher. 47







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

Book review

Resurrecting George Bailey from ‘It’s a Wonderful Life’
Cobden Centre’s Toby Baxendale finds much to like in Prof Laurence Kotlikoff’s latest book, ‘Jimmy Stewart is Dead’.
JiMMY stewart plays george Bailey who is cast as the “honest” and trustworthy banker in the classic hollywood film, ‘It’s a Wonderful Life’. laurence kotlikoff’s book laments that in the real world of modern banking, such characters no longer exist. Laurence Kotlikoff himself is a Professor of Economics at Boston. Several Nobel Prize winners have endorsed the book: George Akerlof, Robert Lucas, Robert Fogel, Edward Prescott, and Edmund Phelps. I count 36 endorsements from the great and the good of the academic world on the back cover and front pages. I do not recall ever seeing this in a book. The book is written for the layman. It is light on economic theory, but does reference some other-worldly models. It is also good at explaining what on the face of it appear to be complex financial phenomena, but are in fact con tricks that in any other industry would earn you a prison sentence. Kotlikoff shows his readers how the financial system has failed in its fiduciary duty, and presents a simple and elegant solution for its Journal of Regulation & Risk North Asia salvation called Limited Purpose Banking (LPB). He also proposes a reduction of the financial service sector regulators in the US from its current 115 down to one: the Federal Financial Authority (FFA). In his opening remarks he discusses the Modigliani-Miller Theorem, written in 1958, showing in elegant math how in the absence of bankruptcy costs, leverage does not matter. If a company takes on more risk by borrowing more, its owners will offset that risk by borrowing less, leaving total debt in the economy unchanged. Leverage can be good Kotlikoff makes no mention of the fact that leverage in itself is not a bad thing if it is made up of people forgoing their consumption today, i.e. saving and committing it to projects that will deliver up goods in the future. This glaring omission does not impede him from telling the story of our financial meltdown and making a solid policy recommendation for this crisis. It does, however, prevent him from seeing the elephant in the room: that the credit creation process itself 49

is the source of the boom and the bust. The nature of fractional reserve banking is such that if you deposit your cash in a bank, it will lend it out many times over. This means that multiple claims come to exist on the original real money that was deposited. If you deposit £100 in bank A, which lends it to an entrepreneur who deposits it in Bank B, both you and the entrepreneur now have £100! Like magic, we have £200 in the system, with £100 of it created ex novo by the banking system itself! In the UK, with no legal reserve requirement, we have only £3 on average kept in deposit for every £100 of IOU’s promised by the banking system. Diamond-Dybvig Model Kotlikoff provides a mainstream justification for fractional reserve banking, citing the Diamond-Dybvig Model, which holds that we value immediate liquidity for emergencies. We do not need that money all the time, so banks can use this and get us a higher return in the meantime. Therefore, governments must do everything to prevent a bank run if more people want their money back than actually exists in the bank vaults. This is the theoretical understanding we have today and the model is used to justify all sorts of bank bailouts, as we have seen. Kotlikoff points out that whilst the bailouts have prevented a collapse of the system of fractional reserve banking, they do not preserve the purchasing power of money. The bailouts just guarantee that the money unit will still exist. This is a very good point. All the bailouts are being funded by more claims on the future taxpayer. In the UK, we have a system of money debasement called Quantitative Easing, which will just debase 50

and reduce our purchasing power. In effect, the bailouts do not do what they say they do on the tin, and our purchasing power is getting weaker by the day. It is hard enough to get politicians in the UK to acknowledge the scale of our official national debt, but we owe at least as much again “off balance sheet”, in unfunded pension liabilities and Private Finance Initiative obligations. Debasement will be the most popular way forward for all future governments, as they will not want to overtly extract more wealth from us. Dishonesty will be the preferred policy. Limited Purpose Banking would be a simple solution to all of this. Banks would be limited to their main purpose of matching savers to borrowers. All financial companies would act as pass-though mutual fund companies. They would be middlemen, never would they own the financial assets. They could thus never fail in the“run on the bank”sense – i.e. depositors wishing to withdraw money – but only if they were very bad at business. This is thus as near as you will get to risk-free banking. Never again would the economy be held liable to bail out the bankers. Role of regulation Kotlikoff foresees at least two mutual funds being offered, with custodians holding the assets: one that holds cash and one that holds insurance funds. He does stress that innovation could still happen, with a multiplicity of funds being offered. The Federal Financial Authority (FFA) would regulate the custody element of safekeeping of the various mutual fund assets. He assumes that regulators will be able to opine, like the current rating agencies, on Journal of Regulation & Risk North Asia

the soundness of the assets that have been bought by the fund. He would trust the government over the rating agencies. I personally would trust neither! In my industry, selling meat and fish, we have a number of free-market-created quality assurance bodies such as the British Soil Association for organic certification and the Marine Stewardship Council for fish sustainability, which require no government sanction. These have the confidence of both the consumer and producer. I would suggest that this and not a super regulator is the way forward. Cash funds are nice and easy; they hold cash and are 100 per cent reserved. They can never go up or down in value. These cash mutual funds represent the demand deposits of the new spec banking system. All services such as cheque writing and paying bills are done via this vehicle. Crackpot ideas I have written about 100 per cent reserve banking previously and Steve Baker has specifically examined the 100 per cent reserve banking proposal of Irving Fisher, to which Kotlikoff refers. He notes that the current economic profession considers these ideas to be“crackpot”; the Diamond-Dybvig Model remains dominant. He goes go on to say:“I want to be clear that I am not an advocate of narrow banking in of itself. Narrow banking is a small feature of LPB and would hardly suffice to deal with today’s multifaceted financial problems.” He notes that with the many cash mutual funds in place, the money measure in the USA – M1 – would correspond exactly with what the government had printed. So Journal of Regulation & Risk North Asia

to cover all obligations, a massive print-off in US dollars would need to take place, in other words the generation of many trillions of dollars to truly purge the system. What Kotlikoff misses is De Soto’s insight, based on the work of Fisher, that there will be a unique moment in history when instead of causing debasement; the printed money would cover all unfunded demand deposits, swapping them out for cash. Insurance mutuals Wipe out or retire these demand deposits and the banking system has no current creditors, only assets. Take out the equivalent amount of assets from the banking system, so the banking system has the same net worth as before, then put these assets into the mutuals and pay off the national debt. This is not inflationary, requires no debasement, and will help deliver up safe banking. Insurance mutuals would have all the other banking instruments such as CDOs in them and could market these funds to whomever they wished. These are essentially what we would term a hedge fund today, though Kotlikoff proposes that these be closed-end. This means you have to sell your shares in the fund to redeem your money. Consequently, long-term lending can take place in these funds without the fear of a maturity mismatch. The only money this type of fund can lose is what is invested in it. It could never in itself pull down the banking system. Author unease I sense that the author does not feel comfortable with the 100 per cent reserve label, with its“crackpot”associations. In discussing 51

the transfer of Citigroup, he says:“Here we’d need to swap all of CitiGroup’s debt for equity and prevent it from ever borrowing again to fund risky investments. We can now think of CitiGroup as a huge mutual fund with lots of different assets, one big commercial bank with 100 per cent capital requirement, or one LPB with a large number of different mutual funds corresponding to the different Citigroup asset classes.” He also points out that LPB could not actually be that far away if you take into account all the reserves that have already been created. This is something George Reisman also pointes out. Kotlikoff defensively shows how LPB would not reduce liquidity. It would not reduce real credit, i.e. savers forwarding money to borrowers. It would stop credit being created out of thin air via the banking system, the prime cause of the crisis, but this is not mentioned in his book. It would lead to an optimal-size financial sector. LPB the cure Our cash assets would be safe as you can get. Government could still monetise debt as it could still create cash from nothing. The currency and thus the purchasing power of money could not collapse by the actions of the banking system, but only by the actions of the government. Kotlikoff concludes: “Limited Purpose Banking is the answer. This simple and easily implemented pass-though mutual fund system, with its built-in firewalls, would preclude financial crises of the type we’re now experiencing. The system will rely on independent rating by the government, but private rating as well. It would require full 52

disclosure and provide maximum transparency. Most important, it would make clear that risk is ultimately born by people, not companies, and that most people need and have a right to know what risks, including fiscal risk, they are facing. Finally, it would make clear what risks are, and are not, diversifiable. It would not pretend to insure the uninsurable or guarantee returns that can’t be guaranteed. In short, the system would be honest, and because of that, it would be safesafe for ourselves and safe for our children.” Cause of ‘boom and bust’ Although I think he has failed to identify the state-sponsored banking system, with its fractional reserve credit creation point as the cause of booms and busts, his solution has many merits and many similarities with the solution proposed by Fisher, De Soto and others. He missed what I call the golden opportunity, or unique moment in history, to actually enact a reform that delivers up 100 per cent reserve of LPB and pays off the national debt and other unfunded obligations at the same time. My own solution is the De Soto 100 per cent reserve free banking solution with banks working within the existing commercial law to which all non-bank companies must adhere. However, both systems have the same effects and would do the job needed: to sort out the banking system, provide stability, and let capitalism flourish. Yet another workable solution has been proposed by the Cobden Centre’s Paul Birch. Kotlikoff’s contribution to the debate, with all the Nobel endorsements, is timely, and I hope policymakers worldwide give due attention to innovative solutions like these we find in Kotlikoff’s book. • Journal of Regulation & Risk North Asia

Book review

Hail to the publisher-led recovery in post-crisis reading
Author Satyajit Das casts a critical, albeit irreverent gaze across several recent tomes penned by a few well-known personalities.
not content with reviewing one book at a time, popular commentator, risk specialist and acclaimed author, satyajit Das, scrutinises several of the latest bestsellers from international authorities concerning the financial crisis, its origins and its consequences. Among the books reviewed by Das are the following recently published titles: • Carmen M. Reinhart & Kenneth Rogoff (2009) This Time is Different: Eight Centuries of Financial Folly; Princeton University Press, London; • Raghuram G. Rajan (2010) Fault Lines: How Hidden Fractures Still Threaten the World Economy; Princeton University Press; • Simon Johnson and James Kwak (2010) 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown; Pantheon Books, NewYork; • Nouriel Roubini and Stephen Mihm (2010) Crisis Economics: A Crash Course in the Future of Finance; Penguin; • Joseph Stiglitz (2010) Freefall: Free Markets and the Sinking of the Global Economy; Allen Lane, London; Journal of Regulation & Risk North Asia • Robert Pozen (2010) Too Big To Save: How to Fix the U.S. Financial System; John Wiley, New Jersey; • Yves Smith (2010) ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism; MacMillan. Thomas Carlyle, the Scottish Victorianera historian, christened economics the“dismal science”. In Eat The Rich, P.J. O’Rourke described economics as “an entire scientific discipline of not knowing what you’re talking about.” One can only quibble with the word“scientific”. New, more dangerous phase The publisher-led recovery – “crash literature” as it could be termed – in the global economy has entered a new and more dangerous stage. Economists have begun to hold forth on the problems. Keynesians, Monetarists, Cavaliers, Roundheads and Vegetarians are stirring to give their own views of reality and putative solutions. Worryingly, at least two of the books are now in the Best Seller lists for Business Books. A key characteristic of the emerging tidal 53

wave of books is the fact that almost everyone saw the writing on the wall, predicted the crisis and now moreover have solutions that can ensure that this was the crisis to end all crises. Unfortunately in the prediction stakes no economist can claim the prescience of Pope Benedict XVI. According to Italian Finance Minister Giulio Tremonti (as reported on Bloomberg News (20 November 2008)), the Pope, then merely Cardinal Joseph Ratzinger, in an article written in 1985 predicted that“an undisciplined economy would collapse by its own rules”. It is unclear which crisis the Holy Father was predicting, but given papal infallibility, probably all of them. Reinhart and Rogoff In the wonderfully titled This Time is Different, Carmen Reinhart and Kenneth Rogoff expand on their recent academic papers and empirical work on “eight hundred years” of financial crises. Marshalling a mind numbing array of statistics and data, the authors find similarities between financial crises. Their conclusion is that the cause is excessive debt accumulation by government, banks, corporations or consumers.The combination of excessive leverage and shortterm debt lies at the heart of the problem. If you are unsurprised at the predictable conclusions, This Time is Different provides solid empirical support for the intuitions. The book misses an essential point – it depends on identifying the correct base precedent that is being used for the economic state being studied. The interesting part of the book is the evidence of what happens after a financial crisis. The authors show that severe financial 54

crises share the following characteristics: Declines in real housing prices averaging 35 per cent over six years. Equity prices fall an average 56 per cent over 3.5 years. Unemployment rises an average of seven per cent during the down phase with an average length of four years. Output falls more than nine per cent over a two-year period. Government debt increases by an average 86 per cent in real terms, as a result of the collapse in tax revenues, counter-cyclical fiscal policy efforts and spiking interest rates. So much for a V-shaped recovery! But“this time is different”. To prevent future crisis, Mrs Reinhart and Mr Rogoff propose a new global financial regulator and improving the IMF (Mr Rogoff’s former alma mater where he was once chief economist). Puzzlingly, they are not optimistic about their reforms: “The persistent and recurrent nature of the‘this-timeis-different’syndrome is itself suggestive that we are not dealing with a challenge that can be overcome in a straightforward way.” Rajan’s ‘fault lines’ Raghuram Rajan, Professor of Finance at the University of Chicago Booth School of Business and former chief economist at the IMF (there seem to be a lot of those going around), did warn about the risk of the global financial crisis. His early warnings led to the economist’s version of a duel at dawn (only with irony and sarcastic epigrams) at a conference held at Jackson Hole. In Fault Lines, Rajan’s focus is on deepseated problems in the global economy, including the absence of income growth, employment, health care and the problems of global capital and trade imbalances. Journal of Regulation & Risk North Asia

Bravely, he argues that the over-borrowing that caused the problems was an entirely “rational” response to a deeply flawed economic and financial system. He also identifies growing inequality as a theme in the problems. He argues that these “fault lines” are the real problems rather than a group of greedy bankers taking irrational risks. 13 Bankers The Fault Lines position on bankers is at odds with 13 Bankers, co-written by Prof Simon Johnson and James Kwak, a former McKinsey consultant. Expanding on their earlier Atlantic Monthly piece, The Quiet Coup, the authors outline the thesis that big banks, especially in America, have used their economic power to gain political power. The economic power of the banks derives from their growing importance in the broader economy as measured by share of corporate earnings and stock market capitalisation. This economic strength is then leveraged using lobbying, campaign contributions and the transition of staff between Washington and Wall Street. Johnson and Kwak’s 13 Bankers sees a conspiracy in this arrangement and also considerable danger. Like all good conspiracy theories there is some validity in the argument. Paulson’s ‘shotgun’ wedding Suggestions of political influence and a palpable lack of transparency in recent government actions to bail out banks have emerged. There are allegations that previous US Treasury Secretary, Henry Paulson, may have“pushed”Bank of America to consummate its controversial acquisition of Merrill Lynch when it sought to withdraw after Journal of Regulation & Risk North Asia

additional losses came to light. The “closeness” between banks and government officials and regulators that has been exposed is increasingly part of the problem in dealing with the real issues. The thesis in 13 Bankers is similar to the work of Mancur Olson, the American economist. In his books (The Logic of Collective Action and The Rise and Decline of Nations), Olson speculated that small distributional coalitions tend to form over time in developed nations and influence policies in their favour through intensive, well-funded lobbying. The policies result in benefits for the coalitions and its members but large costs borne by the rest of the population. Olson thesis Over time, the incentive structure means that more distributional coalitions accumulate burdening and ultimately paralyse the economic system causing inevitable and irretrievable economic decline. Government attempts to deal with the problems of the financial system, especially in the US, Britain and other countries, may illustrate Olson’s thesis. Active, well-funded lobbying efforts and “regulatory capture” is impeding necessary actions to make needed changes in the financial system. The book, 13 Bankers, is grounded in a traditional American fear of a financial oligarchy, dating back to the fights between Thomas Jefferson and Alexander Hamilton over the “Bank of the United States” and Franklin Roosevelt’s Depression-era regulation of finance. While American banks may certainly be powerful and highly influential, the case for a conspiracy is not entirely convincing. 55

Bankers are keen to pick the pockets of anybody . . . including each other. The highly nuanced differences in the positions of individual banks are unlikely to be consistent. Bankers agree and disagree with each other on about the same number of issues. One online commentator noted the intersection between Wall Street, Constitution Avenue and Main Street was best named: “Confusion Corner”. In addition, the potential risks of such a powerful clique are not fully explained. Large banking and other industrial complex dominate many nations and economies with not always negative consequences. The authors’ remedy is to cap the size of banks as a percentage of the economy. This may not be effective without reform of campaign finance rules, restrictions on political appointees to many positions, reform of the central banking system and other measures. Dr Doom Nouriel Roubini (who had inherited the ‘Dr Doom’ mantle from Henry Kaufman) also predicted the global financial crisis. In case you didn’t know this, statements like the following ensure you are left in no doubt: “Roubini’s prescience was as singular as it was remarkable: no other economist in the world foresaw the recent crisis with nearly the same level of clarity and specificity.”The problems of joint authorship and reference to only one of them presents challenges within the English language. In Crisis Economics, Professor Roubini, with co-author Stephen Mihm, take a distinctly Minsky line in analysing the global financial crisis. They argue that financial crises are the result of a confluence of 56

historical and economic factors. Building on Hyman Minsky’s “stability is itself destabilising” hypotheses, Crisis Economics blends economic theory, behavioural economics and agency theory to try to explain the present crisis. The authors conclude that financial systems are inherently fragile and prone to collapse. Interestingly, while it is wary about the value of theories, statistics and mathematical economics and finance, Crisis Economics argues that crises are not only predictable, preventable and, with the Roubini/Mihm brand of medicine, curable. Stiglitz and ‘Freefall’ Professor Joseph Stiglitz’s book, Freefall: Free Markets and the Sinking of the Global Economy, and Robert Pozen’s Too Big To Save: How to Fix the U.S. Financial System, focus less on the cause of the crisis than on solutions. Stiglitz believes that the origins of the present crisis lie in neo-liberalism and its fascination with free markets and de-regulation. Correcting these problems, Prof Stiglitz produces an extensive list of policy reforms. On the way, the author launches into often abrasive attacks on the government’s actions to date. Unoriginal The analysis of the causes of the crisis is not original. His criticisms of policy actions range from insightful to assertions that need supporting facts. Freefall’s call to action disappointingly ends rather tamely in a series of well-worn prescriptions for stronger regulation (by the same apparatus that caused the problems) to correct market failures. Somewhere, Stiglitz finds the time to argue for a less materialistic society and adoption Journal of Regulation & Risk North Asia

of something akin to Bhutan’s measure of Gross Domestic Happiness (GDH). Too Big To Save is light on causes (thankfully) and long on lengthy lists of proposals. The proposals themselves focus on analysing alternative models for government stakes in banks, new board structure for large financial institutions, jurisdictional issues over systemic risks, and the securitisation of loans. None of the proposals are startling or differ much from that offered by others. Some are in the process of being implemented. Both Freefall and Too Big To Save tend to telesis, ascribing events to innate, inexorable facts. Reality is far more nuanced than such a simple view of history. Perhaps this is why economists generally tell you tomorrow why what they forecast yesterday didn’t happen today. Failure of regulation Both books also embrace regulation and regulators freely whilst being critical of regulators as lacking in skills and beholden to special interests. The faith in government activism is perverse. It fails to consider why a new set of rules will necessarily be more effective and existing regulators will be able to deal with complex issues well above their pay grades. This is particularly the case when the same regulators failed in the very same tasks in the lead-up to this crisis. This dissonance is striking. In ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism, Yves Smith, the creator of the Naked Capitalism website, provides an edgy and interesting antidote to the other books on offer. It is an‘anti-economics’ economics book that explores the failures of Journal of Regulation & Risk North Asia

the discipline itself as revealed by the global financial crisis. Problems run deep Ms Smith argues, consistent with Prof Rajan, that the proximate causes (excessive leverage, global imbalances and model failures) are symptomatic of deeper financial problems. ECONned focuses on a central issue – the role of economists as policymakers and the weaknesses of economic thought. The thesis is that economists, some in key policy- making roles, relied on dogma and ignored the dangers that eventually led to the financial crisis. The book’s coverage of the sequence of errors, misrepresentations and rationalisations of poor outcomes and instability is revealing. ECONned is strongest in its coverage of the role played by economists in the crisis and the flaws in the widely-used financial models and concepts that created the conditions for the crisis. American focus The books, with the exception of This Time is Different, which lurches around a spacetime continuum that would have made Dr Who giddy, are primarily American in focus. For the main part, the world appears to end at the Atlantic/Pacific oceans (Mexico and Canada are anyway American offshoots). American exceptionalism extends to financial crises, or must seem so to the reader. The style of these books varies. The tone is mostly the desiccated drone (reminiscent of John Cage’s experimental work from the 1960s). Some are deliberately academic in tone to achieve the correct type of un-readability. One assumes that they are weapons 57

deployed in the dawn duels between economic scholars. This Time is Different is not wholly successful in condensing its stupefying density of data and facts into an accessible tract. The book favours the repetition of minimalist music. Aaron Brown (who authored a lessthan-complimentary review in the Wilmott Magazine) noted that the book uses the word “inflation”154 times,“default”220 times and “crisis” 253 times. It also repeats the title phrase This Time is Different from time to time in a form of economic incantation. Freefall reads like a 19th century pamphlet with equal measures of vitriol, selfrighteousness and broad prescriptions, while 13 Bankers and ECONned are written intelligently with the non-technical layman, rather than the“econo-wonk”, in mind. Moment in the sun It seems that the global financial crisis is the economist’s moment in the sun. They are busily“solving”the problem, sometime with pet theories or, more often, rehashing old ones. Unsurprisingly, there have been spats between economists with allegiances to different camps. Most notable fights include Paul Krugman versus Stephen Roach, Martin Wolf versus Niall Ferguson, etc. If Friedman had been alive, then it would have been Milton versus all comers. If Keynes had been alive, then the jousts would have at least been witty and cultured. No modern economist can touch Keynes and John Kenneth Galbraith for pungent wit. Most economists, it seems, believe strongly in their own superior intelligence and take themselves far too seriously. In his open letter of July 22, 2001 to Joseph Stiglitz, 58

Kenneth Rogoff identified this problem: “One of my favourite stories from that era is a lunch with you and our former colleague, Carl Shapiro, at which the two of you started discussing whether Paul Volcker merited your vote for a tenured appointment at Princeton. At one point, you turned to me and said: ‘Ken, you used to work for Volcker at the Fed. Tell me, is he really smart?’ I responded something to the effect of:‘Well, he was arguably the greatest Federal Reserve chairman of the 20th century’. To which you replied:‘But is he smart like us’?” Economists have delusions of adequacy and a related assured self-confidence that they bring to any problem. Rogoff went on to note that in one of Stiglitz’s books – Globalisation and its Discontents, “. . . I failed to detect a single instance where you, Joe Stiglitz, admit to having been even slightly wrong about a major real world problem. When the US economy booms in the 1990s, you take some credit. But when anything goes wrong, it is because lesser mortals like Federal Reserve Chairman Greenspan or the then-Treasury Secretary Rubin did not listen to your advice.” Rogoff concluded that Stiglitz was indeed “. . . a towering genius. Like your fellow Nobel Prize winner, John Nash, you have a ‘beautiful mind’. As a policymaker, however, you were just a bit less impressive.” • Editor’s note: The editor and publisher of the Journal of Regulation & Risk – North Asia would like to thank Satyajit Das for allowing us to reprint this article. We respectfully remind readers that all copyright to the article remains the sole preserve of Mr Das. Journal of Regulation & Risk North Asia


‘Dark pools’ – the menace of opacity in financial markets
Dr V. Shunmugam of India’s Multi Commodity Exchange calls for the abolition of ‘dark pools’ that pose a systemic risk.
otC markets for derivatives have been much in the news recently and subject to great criticism, not only for their anticompetitive and secret nature, but also for contributing to the financial crisis of september and october 2008. in this paper, the author argues that the rising opacity and barriers to entry in the derivatives and over-the-counter markets have been sorely overlooked – particularly by legislators and regulators – leading to dark pools, flash trading and front-running. these unfair practises can, at any time, cripple markets. they undermine the premise of free market trade and should be abolished. While over-the-counter (OTC) markets for collateralised debt obligations (CDO) and credit default swaps (CDS) are blamed for the financial crisis of 2007-2009, what has been overlooked is the menace of rising opacity in the exchange-traded market. This raises questions about the fundamentals of this market’s very existence, i.e. transparency and equal access to one and all in the price discovery process. Journal of Regulation & Risk North Asia Traditionally, trading in securities had been executed in pits at a central location (Gorham and Singh, 2009), with traders exchanging buy and sell orders on their own or on behalf of their clients. In that system, personal interactions bred collusion among unscrupulous traders to front-run their competitors (Schlegel, 1993). Front-running refers to an illegal practice of executing orders on a security early with the advance knowledge of pending orders from customers/ competitors. Computerisation helped to eliminate front-running, and was better able to handle rising volumes, reduce transaction costs, and improve speed and accuracy. Naturally, the bulk of trade shifted to the online platform. Technology the key To attract volumes amid increasing competition, increased technology support and reduced delays became the fashion for online exchanges the world over. Online trading threw markets wide open to all armed with a desktop computer and access to a public network. It brought in the much-desired transparency, as trading 59

trading activities became visible through real-time price dissemination. The market order book – at least in terms of the best buy and sell orders and their respective quantities – could be viewed by participants. Soon, technology took over human involvement to change the way trading was done. Emergence of the ‘dark pool’ While exchange-traded securities markets had been struggling to build the much needed width and depth, large institutions that could have provided the same said width and breadth, found comfort in the absence of a regulatory framework monitoring trades taking place between then. Is it little wonder then that all those participating in this profitable exercise were tempted to start an informal electronic trade matching and settlement system – later termed “dark pools”. The emergence of these privately traded dark pools not only denied exchange-traded markets the necessary depth and width that they required, but also kept out wellresearched information that these institutions could have supplied and distributed to all participants in the open market system to make price discovery more efficient (Krause, 2008). ‘Cartel’ by any other name In essence, what was started as an“informal trading system” for a handful of big entities with vested interests became a lucrative business opportunity of matching, clearing, and settling trades and front-running the information that gets pooled into the system with them being the owners, managers and 60

traders themselves – a private monopoly or cartel if you like. Popular, risky, anti-competitive Admiring the many advantages inherent in this new-found system – particularly the lack of oversight and transparency necessary to inform a ‘free market’, many more large institutions joined the bandwagon, substantially raising the tally of dark pools and trade handled by them (Caplan et al, 2009). According to the Securities and Exchange Commission, the number of active dark pools dealing in stocks on major US stock markets trebled to 29 in 2009 from about 10 in 2002. For April to June 2009, the total dark pools volume was about 7.2 per cent of the total volumes of all US exchanges. Quintessentially private Dark pools are essentially a private or alternative trading system that allows participants to transact without displaying quotes publicly. Orders are anonymously matched and not reported to any entity, even the regulators (Younglai and Spicer 2009). Thus, the mainstream exchange-traded market does not have any clear picture about the volume of transactions happening in this parallel market or the prices at which they are being executed. Obviously, price discovery on the mainstream market, without dark pools information, becomes inefficient. Dangerous private monopoly Moreover, transactions carried out in dark pools effectively become over-the-counter in nature as the prices are not reported Journal of Regulation & Risk North Asia

and financial risks not effectively managed. More critically, these risks are highly contagious and can spread rapidly, hence posing a systemic-wide risk to financial markets as experienced in the collateralised debt obligations and credit default swaps markets in 2007-2008. Dysfunctional and rapacious With no clear dividing line between the ownership, management and participants in these markets, they are more prone to mismanagement and malpractices. Greed, competition and incentives drive their business – these markets remain opaque and inefficient. Dark pools defeat the very purpose of a fair and transparent market participated in by a large number of heterogeneous participants with diversified information converging on its platform. This fragmentation with some markets accessible to a privileged minority and others used by a vast majority can only be detrimental to the healthy evolution of markets. Misunderstood, much disliked No wonder experts think that dark pools can, anytime, blow splinters of systemic risks into the global economy, very much like how the subprime, lending-induced contagious risks reared their ugly heads to trigger the largest financial crisis since the Great Depression. According to reports (Younglai and Spicer 2009), a surge in the dark pool volumes in US markets is giving the SEC many a sleepless night. The regulator has reportedly been thinking the unthinkable and proposes to bring them into the mainstream of oversight. Its proposal, if implemented, Journal of Regulation & Risk North Asia

will require dark pools to make information about an investor’s interest in buying or selling securities public. An end to ‘dark’ transactions? Clearly, an attempt has finally been made to bring “dark” transactions under a regulatory scanner through accountability. For post-trade transparency, the Securities and Exchange Commission has also proposed that dark pools publicly announce trades happening on specific platforms. What remains to be seen are measures being taken now and in the near future to make these markets increasingly streamlined and to prevent them from becoming a systemic risk. This will require standardisation of their operations and risk management procedures as well. Flash trading – a minority privilege! Flash trading is a two-pronged strategy using superior technology and the privilege of a minority of traders to“flash trade”. This allows them to assess markets so that their algorithms can catch the reaction of mere mortals to take advantage of the overall market sentiment. As it becomes mass produced or serviced, the technology is expected to be affordable for many participants and investors. However, we shall have to wait and see if this actually transpires. Algorithmic adoption Apologists and dark pool proponents argue there is nothing really wrong if an organisation pays to reduce delays in seeking to profit from its investment – this is usually termed an “efficiency gain”. 61

As algorithmic trading becomes more widespread and adopted by the masses – thereby depositing and trusting their hard-earned wealth to complex software running on sophisticated hardware to multiply their earnings. Such a system may well do away with our inability to notice what occurs in less than a second, particularly given modern computational prowess that allow computers to recognise information and instructions in a blink of an eyelid – thus affording them to profit from this technology in much the same way as the privileged few have thus far enjoyed. Much like ‘front running’ However, what is most reprehensible is the practice of allowing a privileged minority to flash trade and track reactions with highspeed processing capacity and an algorithm that can take advantage of said reactions to reap benefits for themselves, their employees, their stockholders and their investors. This being akin to front-running. This is an example of a high-frequency trading system, with knowledge of asymmetric information, that confuses common investors by simultaneously issuing and cancelling orders, thereby either forcing them to sell at a loss or buy at a price much too high, which significantly impacts their ability to turn a profit. Which in turn gives the industry a poor reputation to the average investor. CBOE and Goldman collusion It was the Chicago Board Options Exchange (CBOE) which first pioneered flash orders early this decade to increase its execution speed (Patterson et al, 2009). This process of flash orders remained universally unknown 62

until a newspaper report in 2009 blew the whistle on how Goldman Sachs had made significant, but unusual, profits via this system. According to Rosenblatt, flash trading accounted for about 2.4 per cent of the total US stock volumes in June, 2009. ‘Chasing liquidity’ In fact, high-frequency trading was designed to make markets more efficient through liquidity augmentation, but its use for flash trade can defeat this purpose by misdirecting markets. This practice, which enables (still) unregulated hedge funds to employ high-frequency strategies without coming under the view of US regulation as applicable to brokers, also puts a big question mark on systemic stability of the financial system. Liquidity is important indeed. But can “chasing liquidity” at the expense of transparency and fairness be healthy for market growth? Market innovations for “forward mutation”and not“reverse mutation”? Self-defeating Market innovations such as dark pools and flash trade that evolved to circumvent the limitations of exchange-traded markets involve systemic risks like that of subprime lending that contributed greatly to the financial crisis. Moreover, they can defeat the very purpose for which markets were created, i.e. the deep-rooting of capitalism to help businesses de-risk their margins from information that moves prices in the marketplace. These practices have also information that moves prices in the market place. Journal of Regulation & Risk North Asia

These practices have also placed a barrier in front of markets wishing to function as a level playing field for participants ranging from large institutions to seasoned traders through to small investors. There is a pressing need for formulating appropriate regulations to stop all practices that offer a privileged minority an unfair advantage over a vast majority of general market participants. Mutation of markets Allowing a natural evolution of markets and discouraging the “mutated evolution” that these market innovations represent needs to be one of the regulatory priorities. If flash traders are allowed to get away with their continuous mutation of markets, what purpose is this evolution (of online markets) serving? This only points to a self-defeating weakness of marketsand the recent financial crisis has amply demonstrated how fragile the global financial system can be. Wisdom of capitalism Unfair practices like dark pools and flash trade erupting in the supposedly organised marketplace can only add to this fragility. The question is: how long will it be before these unfair practices are stopped from destabilising markets and destroying their efficiency? Markets are essential support institutions for the economic evolution of humankind. Can policymakers afford to allow the creation and continuation of mechanisms that can – at any time – destroy these institutions and make the public turn against the wisdom of capitalism? • Journal of Regulation & Risk North Asia

Caplan, Keith, Robert P Cohen, Jimmie Lenz, and Christopher Pullano (2009), ‘Dark Pools of Liquidity’, PriceWaterhouseCoopers,Alternatives Newsletter. Gorham, Michael and Nidhi Singh (2009), Electronic Exchanges: The Global Transformation from Pits to Bits, Elsevier. Krause, Reinhardt (2008), ‘Dark Pools Let Big Institutions Trade Quietly’. Investor’s Business Daily. Patterson, Scott, Kara Scannell and Geoffrey Rogow (2009), ‘Ban on Flash Orders Is Considered by SEC: Schapiro Sees Inequity While Exchanges Wrestle for Market Share in HighSpeed Trading’. Wall Street Journal, August 5. Schlegel, Kip (1993), ‘Crime in the Pits: The Regulation of Futures Trading’. American Academy of Political and Social Science. Securities and Exchange Commission (2009a), ‘SEC Issues Proposals to Shed Greater Light on Dark Pools’, October 21. Securities and Exchange Commission (2009b), ‘Strengthening the Regulation of Dark Pools’. SEC Open Meeting, October 21. Younglai, Rachelle and Jonathan Spicer (2009), ‘US SEC says ‘‘dark pools’’ are emerging risk to market’. Reuters, June 18.

Editors note This article is reproduced with the express consent of VoxEu. Originally hosted on their website – www.voxeu.com – this is an abridged version of the original paper updated for the purposes of the summer/ autumn edition of the Journal of Regulation & Risk – North Asia. All views contained herein are those of the author and do not necessarily reflect the views of his employers or the publisher and editor of the Journal and its employees. Copyright of this article is retained by the author. 63


Dodd-Frank fails to address bank and regulator incentives
Prof Thorsten Beck of Tilburg University offers a pessimistic assessment of the US Financial Reform Bill signed in July.
Does the recently passed financial reform Bill help mitigate against the next financial crisis or at least reduce its probability? Professor thorsten Beck in this paper argues the case for a firm “no”. his verdict is reached not because the reform steps themselves are damaging or wrong, but simply because they only provide for a framework that does little to change incentives for either banks or regulators. At the end of May, the US Senate passed its version of the Financial Reform Bill. While it still has to be reconciled with the House of Representatives’version, the outline of the regulatory reform in the US is slowly becoming clear. A thorough assessment of the Bill, however, is made difficult by its sheer size and bulk, some 2,300 pages, when compared to the tiny Glass-Steagall Act of 1933. Do the important changes to US regulatory structure and oversight improve stability? Beck argues that the Reform Bill is neither the silver bullet to ensure a safer financial system nor a complete flop. It is but one small step in the long march of Journal of Regulation & Risk North Asia reforming the framework governing financial institutions and regulators. Critically, it does little to change the incentives for banks and regulators. Financial sector regulation has different objectives that might imply a trade-off. While stability is at the top of policymakers’ agendas right now, they also aim for regulation that fosters competitiveness and“useful” innovation. Balkanisation The reform efforts have been driven by the large amount of taxpayers’ resources that have been put at the financial system’s disposal to avoid a meltdown. But political considerations, including the re-election opportunities of individual senators, have also had a major impact. While the balkanisation of the institutional structure of financial sector supervision has often been criticised, so has the lack of certain institutions. Both the House and the Senate versions foresee the creation of a new bureau of consumer financial protection (BCFP), with the purpose of providing consumers with better information and 65

protecting them from abusive and deceptive practices. While the House version sees an independent self-standing agency, the Senate version wants it to be independent, but housed in the Federal Reserve. Priority and standing power One wonders what priority consumer protection will have on the Federal Reserve’s Agenda, given its current focus on monetary policy and (more recently) financial stability. While this would speak for an independent self-standing institution, such a body might simply not have sufficient standing power against the Fed and other regulators, especially in its early years. As often, however, the important question will not be where it is housed, but rather what authority it will have. Moreover it will be important to focus on financial services rather than simply financial institutions. This implies subjecting car dealers and therefore car loans as well as real estate brokers to the oversight of this consumer protection bureau. OTS-OCC merger Another institutional change is the merger of the Office of Thrift Supervision (OTS) into the Office of the Comptroller of the Currency. (OCC) This aims at curbing banks from shopping around for the most lenient supervisor – supervisory arbitrage – and is certainly a step in the right direction. Similarly, the shifting of responsibility for supervising large financial institutions (including non-banks) to the Fed is aimed at avoiding the repeat of Lehman Brothers and AIG, where the authorities had the choice of either bailing out or liquidating. 66

But the question remains whether this additional supervisory responsibility for the Fed raises potential conflicts of interest between regulatory and monetary policy tasks. While one institution is being taken out of the regulatory framework, another is being added. The Financial Oversight Council (FOC) was established as a compromise between those that wanted to take powers away from the Fed and those that saw an increase in the Fed’s powers as necessary. Given its intended task of coordinating activities of different regulatory authorities, the FOC’s strength will depend on its strongest member, which is still the Fed. A political institution In theory, the FOC can have an important role to play in resolving co-ordination problems across different regulatory agencies. Co-ordination mechanisms, however, depend on the relative power of the institutions they co-ordinate with and the willingness to co-operate among the underlying institutions. Indeed, one cannot avoid drawing parallels with the attempt of the US government to co-ordinate activities of its multiple intelligence agencies – an attempt that so far could only be called a success in a very limited sense. It is also interesting to note that the FOC is headed by the Secretary of the Treasury and the staff supporting the FOC are housed at the Treasury Department, which makes the FOC effectively a political institution. An interesting and potentially important change is to take away the freedom of Journal of Regulation & Risk North Asia

security issuers to choose their credit rating agency – that is, effectively shopping around for the best rating (see Bolton, Freixas and Shapiro, 2009 for a theoretical analysis). In addition, firewalls are to be erected between the rating departments of rating agencies and the sales and marketing of products, often rated by the same agency. Perverse incentives Allowing the Securities and Exchange Commission to assign a credit rating agency is certainly a step towards reducing perverse incentives. But then again it might overload the agency and might simply shift the principal-agent problems away to a different level. Perhaps a better solution would have been to give these agencies the same status as auditors, i.e. force financial institutions to contract with one rating agency for a limited time period for all their issues and then switch to another one. Indeed, it certainly does not go far enough for those who want to take credit rating agencies completely out of the process of determining capital requirements. Perhaps as important – or possibly even more important – is that issuers of assetbacked securities have to retain an economic interest in a material portion of the credit risk in the future, increasing their incentive to screen and monitor properly. Political capture The risk of regulatory capture might be somewhat addressed by making the Fed more accountable to Congress, including subjecting the appointment of the President of the Federal Reserve Bank of New York to Senate approval. On the other hand, there is Journal of Regulation & Risk North Asia

also a clear and present danger of potential regulatory capture being replaced with that of political capture. As we have seen – prior to the build-up of the last bubble in housing, real estate and equities – this is a very real risk indeed. Another policy is that derivatives, some of which have up to now been traded over-the-counter (OTC), will be forced to be traded through central clearing houses. This can increase transparency, help reduce counterparty risk, and facilitate monitoring by regulatory authorities. While this will increase the costs of trading for financial institutions and other market participants, it is a cost that should be borne by these market participants given the external costs that a failure of one party can cause, not just for the markets, but for the economy at large – as we dramatically saw in the case of the failure of Lehman Brothers. Moreover, forcing transactions on clearing houses is certainly a better option than a financial transaction tax along the lines of what is currently being discussed in Europe. The ‘Volcker Rule’ Following the crisis, there has been a fierce discussion on limiting banks’ activities. One suggestion has been to turn back the clock and return to the Glass-Steagall Act with its separation of investment and commercial banking. Such a suggestion, however, seems to be rather driven by nostalgia of the good old times of boring and supposedly safe finance, ignoring that this restriction was not only part of a much larger set of restrictions (including on international capital flows), but also that it carried with it high costs. A somewhat less severe restriction, 67

also known as the Volcker Rule, and which is included in the current Bill, is to prohibit banks from proprietary trading, thus risking deposits and capital. Banks’ ownership of hedge funds or private equity funds would also be prohibited. As so often, the devil is in the detail – are banks allowed to trade on their books, e.g. swaps, to hedge lending positions? And where is the borderline between proprietary trading and simply hedging positions. Resolution authority One of the critical components is the expansion of resolution authority, beyond commercial banks. It is widely agreed among economists that bank resolution needs a special framework and cannot be undertaken in the insolvency framework for nonfinancial corporations, given the need for speed. While the Federal Deposit Insurance Corporation (FDIC) procedure for resolving failing banks has been relatively successful, as it helps resolve banks over a weekend, thereby not affecting the payment system and depositors’ access to their savings, this regime could not be applied to Lehman Brothers or AIG, given their status as an investment bank and an insurance company. Seize and wind-up The externality from a failure of such a large institution, however, is as large as in the case of commercial banks. The new Bill gives the government the right to seize and wind up any large financial institution that is considered in risk of failing. In this context, living wills, i.e. ex-ante plans for resolving systemically important financial institutions, will be 68

used. This is certainly an important step as it puts some burden of ex-ante planning on the institutions, effectively imposing a tax on them. But these living wills have to be updated regularly to fulfil their purpose of providing a blueprint for resolution. The Bill is, however, rather short on how such a resolution scheme would work. The Senate and the House versions still differ in the financing of the resolution of a large financial institution, with the House version creating a resolution fund, thus exante financing, while the Senate version provides for an ex-post financing solution. It is to be hoped that in the bargaining process currently underway to reconcile both the House and the Senate versions of the Financial Reform Bill on Capital Hill, that the Senate ex-post propositions will prevail. Moral hazard Should this not be the case, then the House ex-ante solution many representatives favour will result in the creation of a pot of money to “resolve” a financial institution, which in itself will create a moral hazard risk. Such a risk can only be avoided by Congress adopting a ex-post financing solution. This does not mean that a bank levy as suggested by the Obama administration is a bad solution, but it is better if it is included in the general budget, rather than being saved for rainy bank days (Beck and Losse-Müller, 2010). The reform bill addresses some issues, but also leaves out many others. The reformed framework adjusts rules and mechanisms for authorities to address the build-up of bubbles, to address fragility at an earlier stage, and to intervene more rapidly and effectively into weak and failing Journal of Regulation & Risk North Asia

institutions. Despite this, the Bill focuses mostly on institutional aspects more than on changing incentives for banks and regulators. It increases the number of institutions under regulatory oversight and increases the power of regulators vis-à-vis financial institutions and markets. Plus ça change? The Reform Bill does little to change incentives by banks in their risk-taking decisions, e.g. by making capital requirements a function of size and scope (Beck, 2009) or focusing on the interaction of banks’risk position when computing capital requirements (Adrian and Brunnermeier, 2009). It does not address the issue of macroprudential capital regulation, i.e. the idea that capital requirements might have to vary over the business cycle. Similarly, the incentives and accountability of regulators are not being strengthened – maybe the suggestion by Ed Kane of deferred bonus and pension payments for regulators, well after they leave office, should be reconsidered. Absence of Fannie, Freddie Furthermore, the bill does not address the risk of political capture. The same politicians now seeking stricter lending standards had called for extended home ownership only a few years ago. The future roles of Fannie Mae and Freddie Mac are notably absent from this Bill, and neither is the issue of mortgage subsidisation being addressed. And there seems to be rather more political oversight than less. While accountability of regulators is important, the line between accountability and capture is a thin one. Journal of Regulation & Risk North Asia

Will the new framework help prevent the next crisis or at least reduce its probability significantly? The answer is a firm no, not because the reform steps are damaging or wrong, but simply because they only provide the framework within which the different actors and, most importantly, regulators, central bankers and politicians will act. As illustrated by Ross Levine (2010), it was the violation or intentional ignoring of rules that led to the build-up of the bubble and the subsequent bust, not the lack of regulatory power or proprietary trading. The Financial Reform Bill, now enacted, will not necessarily be the last reform step. Current international regulatory reform discussions – Basel III – will have major implications also for the US, as will the current debate on financial sector taxation. While a global financial transaction tax seems off the table – the Tobin tax – developments in Europe and other G-20 countries concerning financial sector taxation might have an influence on future taxation in the US. • References
Adrian, Tobias and Markus Brunnermeier (2009), CoVaR, Princeton University mimeo. Beck,Thorsten (2009), Regulatory Reform after the Crisis: Opportunities and Pitfalls, CEPR Discussion Paper 7733. Beck, Thorsten and Thomas Losse-Müller (2010), Financial sector taxation: Balancing fairness, efficiency, and stability. VoxEU.org, 31 May. Bolton, Patrick, Xavier Freixas, and Joel Shapiro (2008), The Credit Rating Game, NBER working paper 14712. Levine, Ross (2010), An autopsy of the US financial system: Accident, suicide or negligent homicide? VoxEU. org, 25 May.


Historical analysis

This time is different: eight hundred years of financial folly
Prof Carmen M. Reinhart of the University of Maryland scours eight centuries of economic data for some pearls of wisdom.
this column, first posted on april 19, 2008 and regularly updated, argues that sovereign debt crises have historically followed financial crises. although data covering only the past 30 years might have given few hints about greece’s current problems, the reinhart-rogoff database spanning eight centuries reveals that today’s events are very much in line with historical experience. ‘History is indeed little more than the register of the crimes, follies, and misfortunes of mankind’. – Edward Gibbon.1 The economics profession has an unfortunate tendency to view recent experience in the narrow window provided by standard datasets. With a few notable exceptions, cross-country empirical studies of financial crises typically begin in 1980 and are limited in other important respects.2 Yet an event that is rare in a three-decade span may not be all that rare when placed in a broader context. In a recent paper co-authored with Kenneth Rogoff, we introduce a comprehensive new historical database for studying Journal of Regulation & Risk North Asia debt and banking crises, inflation, currency crashes and debasements.3 The database covers 66 countries across all regions. The range of variables encompasses external and domestic debt, trade, GNP, inflation, exchange rates, interest rates and commodity prices. The coverage spans eight centuries, going back to the date of independence or well into the colonial period for some countries. Historical highlights In what follows, we sketch some of the highlights of the dataset, with special reference to the current conjuncture. We note that policymakers should not be overly cheered by the absence of major external defaults from 2003 to 2007, after the wave of defaults in the preceding two decades. Serial default remains the norm; major default episodes are typically spaced some years – or decades – apart, creating an illusion that“this time is different” among policymakers and investors. We also find that high inflation, currency crashes and debasements often go handin-hand with default. Last, but not least, we find that historically, significant waves of 71

increased capital mobility are often followed by a string of domestic banking crises. The big picture What are some basic insights one gains from this panoramic view of the history of financial crises? We begin by discussing sovereign default on external debt. For the world as a whole (or at least the more than 90 per cent of global GDP represented by our dataset), the current period can be seen as a typical lull that follows large global financial crises. Figure 1 plots for the years 1800 to 2006 the percentage of all independent countries in a state of default or restructuring during any given year. Aside from the current lull, one element that jumps out from the figure comprises the long periods where a high percentage of all countries are in a state of default or restructuring. Indeed, there are five pronounced peaks or

default cycles in the figure. The first is during the Napoleonic War while the most recent cycle encompasses the emerging market debt crises of the 1980s and 1990s. Serial default on external debt – that is, repeated sovereign default – is the norm throughout nearly every region in the world, including Asia and Europe. Our dataset also confirms the prevailing view among economists that global economic factors, including commodity prices and centre country interest rates, play a major role in precipitating sovereign debt crises. During the past few years, emerging markets have benefited from low international interest rates, buoyant world commodity prices and solid growth in the United States and elsewhere.4 If things can’t get better, the odds are that they will get worse. US interest rates are likely to remain low, which helps debtor countries

Figure 1. Sovereign External Debt: 1800-2006 (percent of countries in default or restructuring)

Source: Reinhart and Rogoff (2008a).


Journal of Regulation & Risk North Asia

Figure 2. Capital Mobility and the incidence of banking crisis: All countries. 1800-2007.

Sources: Reinhart and Rogoff (2008a), Obstfeld and Taylor (2004).

enormously. Weaker growth in the US and other advanced economies softens growth prospects for export-dependent emerging markets in Asia and elsewhere; inflation is on the rise. Is this cycle different? Financial liberalisation Another regularity found in the literature on modern financial crises is that countries experiencing large capital inflows are at high risk of having a debt crisis. Default is likely to be accompanied by a currency crash and a spurt of inflation.The evidence here suggests the same to be true over a much broader sweep of history, with surges in capital inflows often preceding external debt crises at the country, regional, and global level since 1800, if not before. Also consonant with the modern theory of crises is the striking correlation between freer capital mobility and the incidence of Journal of Regulation & Risk North Asia

banking crises, as shown in Figure 2. Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically. The figure plots a three-year moving average of the share of all countries experiencing banking crises on the right scale. On the left scale, we employ our favoured index of capital mobility, due to Obstfeld and Taylor (2004),5 updated and backcast using their same design principle, to cover our full sample period; while the index may have its limitations, it nevertheless provides a summary of de facto capital mobility based on actual flows. As noted, our database includes long time series on domestic public debt.6 Because historical data on domestic debt is so difficult to come by, it has been ignored in many empirical studies on debt and inflation. Indeed, many generally knowledgeable 73

Figure 3. Domestic public debt as a share of total debt 1900-2006

observers have argued that the recent shift by many emerging market governments from external to domestic bond issues is revolutionary and unprecedented.7 Nothing could be further from the truth, which has implications for today’s markets and for historical analyses of debt and inflation. The topic of domestic debt is so important, and the implications for existing empirical studies on inflation and external default are so profound, that we have broken out our data analysis into an independent companion piece.8 Here, we focus on a few major points. The first is that contrary to much contemporary opinion, domestic debt constituted an important part of government debt in most countries, including emerging markets, over most of their existence. Figure 3 plots domestic debt as a share of total public debt over 1900 to 2006. For our entire sample, domestically issued debt averages more than 50 per cent of total debt for most of the period. Even for Latin America, the domestic debt share is typically 74

over 30 per cent and has been at times more than 50 per cent. Furthermore, contrary to the received wisdom, these data reveal that a very important share of domestic debt – even in emerging markets – was long-term maturity. The inflation-default cycles Figure 4 on inflation and external default (1900 to 2006) illustrates the striking correlation between the share of countries in default on debt at one point and the number of countries experiencing high inflation (which we define to be inflation over 20 per cent per annum). Thus, there is a tight correlation between the expropriation of residents and foreigners. As noted, investment banks and official bodies, such as the International Monetary Fund, alike have argued that even though total public debt remains quite high today in many emerging markets, the risk of default on external debt has dropped dramatically because the share of external debt has fallen. Journal of Regulation & Risk North Asia

Figure 4. Inflation and external default: 1900-2006

This conclusion seems to be built on the faulty premise that countries will treat domestic debt as junior, bullying domestics into accepting lower repayments or simply defaulting via inflation. The historical record, however, suggests that a high ratio of domestic to external debt in overall public debt is cold comfort to external debt holders. Default probabilities depend much more on the overall level of debt. This brings us to our central theme – the “this time is different”syndrome. There is a view today that both countries and creditors have learned from their mistakes. Thanks to betterinformed macroeconomic policies and more discriminating lending practices, it is argued, the world is not likely to again see a major wave of defaults. Indeed, an often-cited reason these days why “this time is different” for the emerging markets is that governments are managing public finances better, albeit often thanks Journal of Regulation & Risk North Asia

to a benign global economic environment and extremely favourable terms of trade shocks. Euphoria and depression Such celebration may be premature. Capital flow/default cycles have been around since at least 1800. Technology has changed, the height of humans has changed, and fashions have changed.Yet the ability of governments and investors to delude themselves, giving rise to periodic bouts of euphoria that usually end in tears, seems to have remained a constant. On a more positive note, our research at least raises the question of how a country might“graduate”from a history of serial default. Interesting cases country might “graduate” from a history of serial default. Interesting cases include Greece and Spain, countries that appear to have escaped a severe history of serial default not only by reforming institutions, but by benefiting 75

from the anchor of the European Union. Austria, too, managed to emerge from an extraordinarily checkered bankruptcy history by closer integration with postwar Germany, a process that began even before European integration began to accelerate in the 1980s and 1990s. We shall wait and see which emerging markets can graduate from serial default. • Editor’s Note The publisher would like to thank Prof Reinhart and Prof Rogoff for allowing us to re-print an amended version of their paper which was originally hosted on VoxEu – www.voxeu.org Footnotes
1 The History of the Decline and Fall of the Roman Empire, 1843. 2 Among many important previous studies include works by Bordo, Eichengreen, Lindert, Morton and Taylor. See

Michael Bordo’s “The crisis of 2007: Some lessons from history,” VoxEU, 17 December 2007. 3 “This Time Is Different: A Panoramic View of Eight Centuries of Financial Crises” National Bureau of Economic Research Working Paper 13882, March 2008a. 4 See Jeffrey Frankel, “An Explanation for Soaring Commodity Prices,” VoxEU, 25 March 2008. 5 Obstfeld, Maurice, and Alan M. Taylor, Global Capital Markets: Integration, Crisis, and Growth, Japan-U.S. Center Sanwa Monographs on International Financial Markets (Cambridge: Cambridge University Press, 2004). 6 For most countries, over most of the time period considered, domestically issued debt was in local currency and held principally by local residents. External debt, on the other hand, was typically in foreign currency, and held by foreign residents. 7 See the IMF Global Financial Stability Report,April 2007; many private investment-bank reports also trumpet the rise of domestic debt as a harbinger of stability. 8 Carmen M. Reinhart and Kenneth S. Rogoff “Domestic Debt: The Forgotten History,” NBER Working Paper 13946,April 2008b.

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Journal of Regulation & Risk North Asia

Legal update

UK Bribery Act poses hurdles for international business
DLA Piper’s Jonathan Pickworth details the effect the UK Bribery Act 2010 will have on those conducting business in Britain.
as well as dealing with local anti-corruption laws and the long reach of the us foreign Corrupt Practices act, international businesses based in asia now have a further compliance challenge in the form of new uk legislation. The Bribery Act 2010 (the Act), which is expected to come into force in October, will have far-reaching implications for every company doing business in, or via, the United Kingdom. In many ways it creates a platform for what could be the toughest enforcement regime in any jurisdiction. The effect will be far reaching – simply having a UK presence (subsidiary, office or operations) will create jurisdiction. The Act applies to British companies as well as foreign companies with operations in the UK, even if offences take place in a third country and are unrelated to UK operations. This means that the relevant criminal act can occur outside Britain and persons or companies in the UK can be liable. For example, if an Asian company has a British branch and engages in bribery in Africa, the company could be prosecuted in the UK for Journal of Regulation & Risk North Asia its failure to prevent bribery by a member of staff. The Act signals a complete reform of UK bribery law to provide a modern and comprehensive scheme of offences that will enable courts and prosecutors to respond more effectively to bribery at home or abroad. The nitty-gritty It is important to note that: • It is an offence to give or receive a bribe; • It is an offence to promise, offer, request or agree to receive a bribe; • There is a specific offence of bribing a foreign public official; • The new law is not just about bribing public officials because commercial bribery is also criminalised; • If a‘commercial organisation’commits any of the above bribery offences, a senior officer may also be guilty of the same offence; • There is a new strict liability corporate offence, which will apply to a commercial organisation that fails to implement “adequate procedures”, if an act of bribery is committed in connection with its business; • There is no exemption for facilitation payments; 77

• There is a broad scope and extraterritorial reach for companies and individuals; • The maximum penalty for individuals will be 10 years imprisonment and/or an unlimited fine; • The maximum penalty for a corporate will be an unlimited fine. (The highest fine imposed to date in the UK for a corruption case is £8.5 million); • All existing anti-bribery and corruption statutes will be repealed. ‘Adequate procedures’ Some of these points are examined in more detail below: For companies the most important point to note is that there is a new strict liability corporate offence of failing to prevent bribery. This offence should make it easier for the UK’s main prosecutor of corruption, the Serious Fraud Office, to prosecute companies when bribery has occurred. With the recent Innospec [1] court case casting some doubt on the corporate settlement and plea negotiation process in the UK, a new opportunity to pursue companies for a specific corporate offence may well be an attractive proposition for this organisation to show its prosecution mettle once the Act comes into force. There is a possible defence available to commercial organisations charged with the corporate offence if they can show (on the balance of probabilities) that they had in place “adequate procedures” to prevent an act of bribery being committed in connection with their business. This is, in effect, a requirement to show that the bribe was a rogue act committed against company policies and procedures. 78

The fact that adequate procedures are not defined in the Act led to a great deal of debate in Parliament about how businesses would be able to determine whether or not their procedures were, in fact, adequate. Draft bill amendment As a result, the draft Bill was amended so that we now have at section 9 a statutory obligation for the government to issue guidance on what constitutes adequate procedures. The government in power at that time pledged to issue the first set of guidelines before the new law comes into force so that businesses know what is expected of them. Post-general election and with a new coalition government in place it remains to be seen if the publication and implementation of these new rules and regulations will be delayed or amended. Jurisdiction The Act has a broad scope and extraterritorial reach which means that: • any individual ordinarily resident in the UK (whether or not a British national) can be prosecuted for bribery offences committed anywhere in the world; and • any partnership or corporate (whether or not incorporated in the UK) can be prosecuted if it does business in Britain (e.g. through a permanent establishment, subsidiary or other operation), even if the offence was committed outside the UK. Senior officers need to understand that they could be personally liable under the Act for offences committed by the company if they have consented to or connived in (turning a blind eye to) the commission of the main bribery offences (including bribing Journal of Regulation & Risk North Asia

a foreign public official but not that of failing to prevent bribery) and, if any part of the offence has taken place in the UK. If the offence is committed outside the UK, they will only be liable if the senior officer has a“close connection”with the UK (such as being a British passport holder or being ordinarily resident in the UK). For the purposes of the Act a senior officer is defined as a“director, manager, secretary or other similar officer”, a partner in a Scottish partnership, or any“person purporting to act in such a capacity”. Effects on non-UK parent firms The offence of failing to prevent bribery is committed by a company when it fails to prevent an“associated person”(an employee, agent or subsidiary) from offering, promising or giving a bribe. In order to prove the offence it has to be established that the associated person “performs services” for or on behalf of the defendant company in the normal course of business. The Act includes a presumption that an employee performs services for and on behalf of the company unless the contrary can be shown. In all other cases (for example, where a non-UK parent company and its UK subsidiary are involved), the Act says that the court will have to determine liability by “reference to all the relevant circumstances and not merely by reference to the nature of the relationship . . .” Although it is not clear when a foreign parent company might be held be held liable for the acts of its UK subsidiary, the Act does not rule this out and each case will have to be decided on its own facts. Journal of Regulation & Risk North Asia

Corporate liability often lacks a degree of certainty in UK criminal law and remains an issue for the lawmakers. Further clarity on the overarching issue of a parent company’s liability for a subsidiary in UK law is expected in due course as part of the Law Commission’s ongoing general review of the liability of businesses [2] (a consultation paper is expected in the summer). Collateral consequences It is worth noting that companies and individuals convicted of criminal offences in the UK can also face further damaging consequences in addition to fines and sentences of imprisonment – and the Act is no exception. Individuals convicted of bribery can be disqualified from being a director for up to 12 years. Companies convicted of bribery will receive a mandatory and permanent ban from taking part in European public procurement in perpetuity (in accordance with EU Procurement Directives [3]). This, of course, can have a devastating effect on a business (defence, medical devices, construction, etc) which relies on this type of work. Assets confiscated Individuals and companies can also have their assets confiscated under the Proceeds of Crime Act 2002. This is a draconian asset recovery regime which allows the total benefit of a crime to be confiscated, not just the profit element. For example, if a company has entered into contracts valued at £60 million by corrupt means and its accounts show that its profit was only £10 million pounds, the UK courts will take the £60 million figure as 79

the starting point for confiscation proceedings. We have not yet seen the full force of the asset confiscation regime used against a company but in a contested case it could potentially bring a company to its knees financially, as there is little room for judicial discretion or affordability considerations. Compliance is key Businesses and individuals that do all they can to stay on the right side of the law should have nothing to fear from this legislation. The overriding objective in introducing the new law was to make companies and their personnel take the issue of anti-bribery and corruption compliance seriously. With only a few months to go until the Act comes into force, there are still companies out there in the United Kingdom that are not yet fully prepared for the introduction of the new legislation, and many international companies may not even have acknowledged that this legislation is of relevance to the way they do business. Companies must act now For many companies there is significant work to be done before they are in a position to demonstrate that they take anti-bribery and corruption compliance seriously, and have the necessary procedures, systems and controls in place to prevent bribes being paid in connection with their business. Any company that does business in, or indeed out of the United Kingdom, needs to start reviewing their practices and procedures as a matter of priority. The guidance on adequate procedures was expected before Parliament’s summer recess which begins on July 22. It will give 80

general guidance, not rigid rules, which will set out a number of key principles which will help commercial organisations to do their part in the prevention of bribery. Key focus A key focus for larger organisations will be the responsibility of a corporate board of directors to design, implement and regularly review policies for preventing bribery. The last government expressed views that adequate procedures means: • a board of directors taking responsibility for anti-corruption programmes and appointing a senior officer accountable for its oversight; • assessment of risks specific to the company and its business, including risks linked to the nature or location of the organisation’s activities; • establishing clear policies and procedures, and training of new and existing staff in antibribery procedures; • having robust internal financial controls and record-keeping to minimise the risk of bribery; and • establishing whistle blowing procedures so that employees can report corruption safely and confidentially. If any company with a connection to the UK finds itself caught up in allegations of bribery, it can expect its anti-corruption compliance programme to be subjected to the most intense form of scrutiny by investigators and prosecutors. Different to the FCPA Many companies with international operations will have built their compliance programme around the US Foreign Corrupt Journal of Regulation & Risk North Asia

Practices Act. However, the new UK law has some significant differences, which need to be taken into account: • the Bribery Act makes it an offence to receive, as well as give, a bribe; • bribery of private individuals and companies is criminalised; • here is no need to prove corrupt intent (the test is an objective assessment as to whether there has been improper behaviour); • there is a strict liability corporate offence of failing to prevent bribery; • there is no exemption for facilitation payments; • there are no books and records provisions within the Act (although companies can be prosecuted for inaccurate accounts under the Companies Act 2006); • there is no statutory defence for legitimate promotional activities (FCPA provides for reasonable and bona fide business expenditures directly related to certain promotional activities); • the extraterritorial reach has a broader impact for companies and individuals; and • the prison sentences (up to 10 years) and the fines (unlimited) could be greater. New benchmark With provisions which are more far reaching than the US Foreign Corrupt Practices Act in many respects, the Act and the adequate procedures guidelines, could well set a new benchmark for international compliance programmes. Whether setting up a new programme or reviewing an existing programme, it is important to bear in mind that an effective anti-corruption programme should be capable of persuading a regulator or prosecutor Journal of Regulation & Risk North Asia

that the company is taking the issue seriously and has addressed all these questions. In these circumstances, showing that external specialist legal advice has been taken can prove invaluable. The countdown begins The clock is ticking and the new UK parliamentary bribery legislation will soon come into force. Companies located or registered in the Asia Pacific region that do business in the United Kingdom may have been unaware of the need for enhanced anti-corruption compliance, but they now need to take prompt action. In-house lawyers, risk managers and compliance officers have a vital role to play in raising internal awareness of the reach of the new UK law and stressing the importance of reviewing training programmes, procedures, systems and controls. It is only by setting the right tone at the top of the organisation and taking steps to mitigate the risks of corruption that international companies that do business in the UK can hope to remain out of the Bribery Act spotlight. • Notes
1. Sentencing remarks: R v Innospec (March 26, 2010) http://www.judiciary.gov.uk/docs/judgments_ guidance/sentencing-remarks-thomas-lj-innospec. pdf 2. Law Commission: Regulation, Public Interest and the Liability of Businesses http://www.lawcom.gov. uk/regulation_liability.htm 3. Directive 2004/17/EC: water, energy, transports and postal services Directive 2004/18/European Commission: public works, supply and service contracts.


Regulatory update

A question of sovereignty: capital controls gain credence
Does the move by Jakarta and Seoul to impose capital controls breach IMF protocols, asks PIRC economist Kavaljit Singh.
in June, south korea and indonesia announced several policy measures to regulate potentially de-stabilising capital flows which could pose a threat to their economies and financial systems. Seoul kicked off the process on June 13 when it announced a series of currency controls to protect the South Korean economy from external shocks. The new currency controls are much wider in scope than foreign exchange liquidity controls announced earlier in 2009. Jakarta quickly followed suit on June 16 when Indonesia’s central bank deployed measures to control short-term capital inflows. The policy measures introduced by South Korea’s central bank have three major components: restrictions on currency derivatives trades; enhanced existing restrictions on the use of bank loans in foreign currency; and, further tightening of existing regulations on the foreign currency liquidity ratio of domestic banks. The new restrictions on currency derivatives trades, include non-deliverable currency forwards, cross-currency swaps and forwards. Also, new ceilings have been imposed on domestic banks and branches of foreign banks dealing with FX forwards and derivatives. For Korean banks, there will be a limit on currency forwards and derivatives positions at 50 per cent of their equity capital. For foreign banks, the ceilings will be set at 250 per cent of their equity capital, against the current level of around 300 per cent. No-limit contracts Under the existing trading rules in Korea, banks can buy FX derivatives contracts without any limits. Many banks also rely heavily on borrowings from overseas to cover potential losses arising from forward trading. As a result of this lax policy regime, the FX derivatives trading substantially contributed to the rise in short-term overseas borrowings and external debt during 2006-2007. Officials state that almost half of the increase in their country’s total external debt of US$195 billion during this year was due to the increase in FX forward purchases by banks. In addition to new curbs on banks, the Korean authorities have also tightened the ceilings on companies’ currency

derivatives trades to 100 per cent of underlying transactions from the current 125 per cent. The currency controls will come into effect from July 2010. But these will be implemented in a flexible manner. A grace period of three months has been allowed to avoid any sudden disruptions in derivatives trading markets and banks can cover their existing forward positions for up to two years if they exceed the ceilings. A cause of systemic risk With regards the enhanced restrictions on the use of bank loans in FX, this has been done primarily to make sure that FX bank loans are for overseas use only. At present, bank loans in foreign currency are allowed for purchase of raw materials, foreign direct investment and repayment of debts. Only in certain cases can such loans be used for domestic use. Under the new rules, such loans will be restricted to overseas use only. As an exception, only the small- and medium-sized enterprises have been allowed to use FX financing for domestic use, to the extent that total foreign currency loans remain within the current levels. This policy measure is hugely significant since excessive foreign currency bank loans are considered to be major sources of systemic risks in many emerging markets. And finally, the Korean authorities have further tightened the existing regulations on foreign currency liquidity ratio of domestic banks. The domestic banks will monitor the soundness of FX liquidity on a daily basis and report it to authorities every month. The authorities have also recommended that foreign banks operating in Korea 84

establish liquidity risk management mechanisms as they are a major source of FX liquidity. According to the Bank for International Settlements (BIS), foreign banks account for the bulk – some 60 per cent – of short-term external liabilities of all banks operating in South Korea. Further, foreign banks are also the dominant players in inter-bank borrowing from abroad. In addition to these policy measures, the Korean authorities also announced the establishment of a headquarters inside the Korea Centre for International Finance to regularly monitor capital flows as part of developing an early warning system. The authorities have also supported the need to establish global financial safety nets through international co-operation. The agenda of global financial safety nets will be pursued as part of the ‘Korea Initiative’ at the Seoul G-20 summit to be held in November 2010. Meanwhile, the Korean authorities have explicitly ruled out imposition of any financial transactions taxes, such as in Brazil, or unremunerated reserve requirements, such as in Chile. Fear of capital exodus The imposition of currency controls by the Korean authorities has to be analysed against the backdrop of the global financial crisis. Despite its strong economic fundamentals, South Korea witnessed sudden and large capital outflows due to de-leveraging during the global financial crisis. It has been reported that almost $65 billion left the country in the five months after the collapse of Lehman Brothers in September 2008. South Korea’s export-oriented economy also suffered badly due to contraction in Journal of Regulation & Risk North Asia

global demand in the aftermath of the global financial crisis. Its economy shrank 5.6 per cent in Q4 2008, the country’s worst performance since 1998 when it was hit by the Asian financial crisis. Of late, the authorities have been concerned about sharp fluctuations in the Korean won, particularly in the wake of the European sovereign debt crisis and the negative impact on Korean exports. On May 25, the South Korean won’s three-month implied volatility touched 36.6 per cent, the highest level since January 2009. Vulnerable to sudden outflows Despite a relatively stable banking system, sharp currency fluctuations can make a small and open economy like South Korea highly vulnerable to sudden capital outflows.The over-arching aim of currency controls in South Korea is to limit the risks arising out of sharp reversals in capital flows, as witnessed during the global financial crisis.The controls are specifically aimed at regulating capital flows and stabilising its currency. Another policy objective of these policy measures is to curb country’s rapidly growing short-term foreign debt. Tight regulations have been imposed on banks on the amount of short-term loans they can obtain from abroad. South Korea’s higher shortterm foreign debt is a matter of serious concern. At $154 billion, its short-term external debt accounts for as much as 57 per cent of its FX reserves. A sudden shift in global market sentiment can trigger large reversals in short-term capital flows thereby precipitating a financial crisis of one sort or another. The relationship between excessive short-term external debt – intermediated Journal of Regulation & Risk North Asia

through the banking system – and subsequent financial crises is well-known. The Korean economy has suffered badly from the boom and bust cycles of short-term capital flows in the past. It is too early to predict the potential impact – positive and negative – of currency controls and other policy measures announced by the Korean financial authorities. This prediction is made harder still because some policy measures are medium- and long-term in nature. But it is expected that such restrictions will lead to a considerable reduction in shortterm foreign borrowings. Foreign banks may not find it profitable to carry out arbitrage trade due to regulatory restrictions and therefore may look for opportunities elsewhere. While many analysts believe that ceilings on forward positions will limit the amount of short-term foreign debt and deter “hot money” flows, it nevertheless remains to be seen to what extent these policy measures will help in reducing currency volatility. Indonesia plays ‘catch-up’ Following three days later – June 16, 2010 – Bank Indonesia, the country’s central bank, announced the following policy measures to tame short-term capital inflows; these come into effect from July and there will be a one-month minimum holding period on Sertifikat Bank Indonesia (SBIs). During the one-month period, ownership of SBIs cannot be transferred. Issued by central bank, the one-month SBIs are the favourite debt instruments among foreign and local investors because of their high yield (an interest rate of 6.5 per cent in early June 2010) and greater liquidity than other debt instruments. The central bank will increase 85

the maturity range of its debt instruments by issuing longer dated SBIs (nine-month and 12-month) to encourage investors to park their money for longer periods. So far, the longest maturity of its debt has been six months. New regulations have been introduced on banks’ net foreign exchange open positions. The central bank has also widened the short-term, overnight money market interest rate corridor and introduced non-securities monetary instrument in the form of terms deposits. These new curbs are in response to growing concerns over short-term capital inflows. Given the historically low levels of interest rates in most developed countries, Indonesia has received large capital inflows since 2009. Resilience during crisis Unlike other Asian economies such as Singapore and Malaysia, the Indonesian economy showed some resilience during the global financial crisis. Despite hiccups in the financial markets, the Indonesian economy registered a positive growth of six per cent in 2008 and 4.5 per cent in 2009, largely due to strong domestic consumption and the dominance of natural resource commodities in its export basket. Its relatively better economic performance has attracted large capital inflows in the form of portfolio investments since early 2009. Consequently, Indonesia’s stock market index was up 85 per cent in 2009, the best performer in the entire Southeast Asian region. The rupiah rose 17 per cent against the dollar last year. Yet due to the massive speculative capital inflows, the Indonesian authorities remain 86

concerned that its economy might be destabilised if foreign investors decide to pull their money out quickly. As a result, the steps taken by the central bank to maintain financial stability were of little surprise. As a balancing act however, the authorities have avoided any restrictions on long-term investment flows. Hot money inflows deterred? Analysts believe that these policy measures may deter hot money inflows into the country and monetary policy may become more effective. Yet they expect tougher measures in the future if volatility in capital flows persists. Some analysts also expect that the new curbs may shift capital flows to other financial assets such as government and corporate bonds. Despite recovering faster than developed countries, many emerging markets are finding it difficult to cope with large capital inflows. There is a growing concern that the loose monetary and fiscal policies currently adopted by many developed countries are promoting a large dollar“carry trade”to buy assets in emerging markets. Fears of asset inflation Apart from currency appreciation pressures, the fears of inflation and asset bubbles are very strong in many emerging markets. Since mid-2009, stock markets in emerging economies have witnessed a spectacular rally due to strong capital inflows. In particular, Brazil, Russia, India and China are the major recipient of capital inflows. The signs of asset price bubbles are more pronounced in Asia as the region’s economic growth will continue to outperform the rest Journal of Regulation & Risk North Asia

of the world. As a result, the authorities are adopting a cautious approach towards hot money flows and considering a variety of policy measures (from taxing specific sectors to capital controls) to regulate such flows. In May 2010, for instance, Hong Kong and China imposed new measures in an attempt to curb soaring real estate prices and prevent a property bubble. In emerging markets, strong capital inflows are likely to persist due to favourable growth prospects but the real challenge is to how to control and channel such inflows into productive economy. Contrary to the popular perception, capital controls have been extensively used by both the developed and developing countries in the past. There is a paradox between the use of capital controls in theory and in practice. Although mainstream theory suggests that controls are distortionary and ineffective, several successful economies have used them in the past. China and India, two major Asian economies and“success stories” of economic globalisation, still use capital controls today. Post-crisis, there is a renewed interest in capital controls (on both inflows and outflows) as a policy response to deter shortterm volatile capital flows. It is increasingly being accepted in international policy circles that due to limited effectiveness of other measures – such as higher international reserves – capital controls could protect and insulate the domestic economy from volatile capital flows and other negative external developments. Capital controls could also provide recipient countries greater leeway to conduct an independent monetary policy. Even the IMF is nowadays endorsing Journal of Regulation & Risk North Asia

the use of capital controls, albeit temporarily and subject to exceptional circumstances. A recent paper prepared by the Strategy, Policy, and Review Department stated: “In certain cases countries may consider price-based capital controls and prudential measures to cope with capital inflows.” This is a significant development given the IMF’s strong opposition to capital controls in the past. In October 2009, Brazil announced a two per cent tax on foreign purchases of fixed-income securities and stocks. Taiwan also restricted overseas investors from buying time deposits. Due to this measure, Taiwan has witnessed a decline in speculative money from overseas. Russia is also contemplating similar measures as its economy is more vulnerable to swings in capital flows. A question of sovereignty? In the present uncertain times, imposition of capital controls becomes imperative since the regulatory mechanisms to deal with capital flows are national whereas the financial markets operate on a global scale. Yet it would be incorrect to view capital controls as a panacea to all the ills plaguing the present-day global financial system. It needs to be underscored that capital controls must be an integral part of regulatory and supervisory measures to maintain financial and macroeconomic stability Any wisdom that considers capital controls as short-term and isolated measures is unlikely to succeed in the long run. It remains to be seen how the G-20 responds to the use of capital controls by its member-countries as a policy response to regulate speculative capital flows. Will G-20 take a collective stand on capital controls? • 87


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Articles & Papers
Perspectives on regulatory reform after the 2008 crash
Charles L. Evans

Regulation or prohibition: the $100 billion question
Andrew G. Haldane

Economists’ hubris informed the financial tsunami of 2008
Shahin Shojai & George Feiger David Millar

‘Walker Review’ heralds new dawn in risk management Ideas have consequences: the importance of ‘narrative’
Peter J. Wallison

Minority shareholders blind to threat of expropriation
Dr Fritz Foley et al Satyajit Das

‘Swap tango’: a regulatory dance in two acts

Beware Greeks bearing bonds: A tragedy in four acts
Michael Mussa

Global financial crisis and the European Monetary Union
Prof Christian Fahrholz & Dr Cezary Wójcik Prof Jennifer S. Taub

Lehman Bros and Repo 105: a powerful case of addiction
Prof Lawrence White Prof Enrico Perotti

Regulating the rating agencies: Quick fix or political expedient?

Macro-prudential councils: how to avoid future crises EC offers last opportunity for insurers to influence Solvency II
Eleanor Beamond-Pepler Prof Lawrence Baxter

Did we tame the beast: views on the US Financial Reform Bill Financial supervision and increased powers of discretion
Steve Randy Waldman Gavin Sudhakar

Global anti-trust regulation in the current financial climate Asset securitisation in China: Opportunities and challenges
Claas Becker et al

Is an undervalued renminbi the source of global imbalances?
Prof Charles Wyplosz Thomas Dietz

The regulators strike back: Basel and new liquidity rules Basel Committee’s enhanced framework for liquidity
Dr Michael Wong & Fai Y. Lam

IsAsia on the edge?
In 2011, Asia may continue to lead the world out of recession—or it could become the third wave of the economic crisis. Asia’s enormous investment opportunity
could be realized—or an uncertain regulatory environment might undermine its potential. Whichever scenarios develop will have major implications for risk managers at financial institutions across the region. The world’s leading risk practitioners and thought leaders will be discussing how to manage risk in Asia’s dynamic regulatory and financial environment. Join them at the region’s premier risk management conference.

GARP’s 7th Annual Asia Pacific Risk Convention Hong Kong | October 27-28, 2010

To learn more and register, visit www.garp.org

Creating a culture of risk awareness.


© 2010 Global Association of Risk Professionals. All rights reserved.

Central banking

Perspectives on regulatory reform after the 2008 crash
Chicago Fed President Charles L. Evans is sceptical that monetary policy alone can deal with financial ‘over-exuberance’ .
We are slowly emerging from the worst financial crisis since the 1930s. the hardships created by these exceptional circumstances for households and businesses are well known. governments and regulators around the world have responded to the crisis with a variety of aggressive and innovative policy actions, including giving special assistance to specific institutions. Now, as we slowly emerge from the crisis, we are engaged in a vigorous debate on how best to address the major weaknesses in our financial regulatory framework that were revealed by the crisis. Our goal, clearly, is to avoid another crisis of this magnitude. Financial reform will not be easy. We face complex problems that will require a comprehensive, multi-pronged approach. But reform is critical for ensuring our long-term economic stability. Today, I would like to offer my thoughts on some of the reform proposals that are being discussed. I should note that my remarks reflect my own views and are not those of the Chicago Federal Reserve Bank, Journal of Regulation & Risk North Asia Federal Open Market Committee or the Federal Reserve System. To highlight some of the changes that are being considered, there are proposals that would assign monetary policy a more active role in fighting asset bubbles; proposals that would strengthen current microprudential regulations; proposals that would introduce a systemic regulator and macroprudential regulations; and proposals that would create resolution authority – particularly for systemically important financial institutions. Implementation challenges Time does not permit me to discuss the specifics of each of these proposals. Instead, I would like to offer my thoughts on some of the challenges we are likely to face in implementing even the most well-thought-out policies. Let me be clear. I don’t bring up these potential challenges as roadblocks to the healthy debate that is underway. Rather, I offer them as issues we need to consider as we build a better financial infrastructure. One pre-emptive action that is being debated concerns the role of monetary 91

policy in combating asset bubbles. Given the rapid rise in some asset prices prior to the recent crisis, there are increasing calls for central banks to be more proactive in responding to signs that an asset bubble may be emerging and to raise their target rates in order to lower asset prices that, by historical standards, seem unusually high. In previous forums, I have discussed why I view these proposals with scepticism.[1] Sceptical about ‘asset’ values I won’t cover the same ground here again. Instead, let me just note that I am sceptical about our ability to easily and definitively sort out in real time whether a rapid increase in asset prices is associated with over-valuation. That is, how confidently can we state that we are in the midst of a bubble? I also think that monetary policy is too blunt a tool for pricking bubbles: It can’t be targeted precisely and it will affect other financial and macroeconomic variables in addition to the suspected bubble asset. In addition, the typical changes in interest rates that a central bank might contemplate are likely to be too small to produce big changes in asset prices. Fortunately, monetary policy is not the only tool that policymakers have to deal with financial exuberance. Regulation and market infrastructure In my view, redesigning regulations and improving market infrastructure offer more promising paths. Regulation may or may not be sufficient to avoid all of the events that create crises, but it should go a long way toward doing so. Better supervision and a sound regulatory infrastructure can also 92

increase the resiliency of markets and institutions and their ability to withstand adverse shocks that do occur. Within the existing structure, regulators have the ability to promote better, more resilient financial markets, either through rule-making or by serving as a co-ordinator of private initiatives.They can also encourage more and better disclosure of information – a key element of effective risk management. A number of initiatives along these lines have been taken and additional ones are being considered.[2] We can use existing regulatory tools more effectively, but we also need to address the shortcomings of current regulations. The ongoing work of the Basel Committee on Banking Supervision regarding the possible introduction of liquidity standards and adjustments to the existing capital requirements are examples of such efforts. Microprudential regulation While such enhancements to micro-prudential regulations are necessary, I would argue that they are not close to being sufficient to address the complex issues we faced during the recent crisis. Success in preventing and controlling potential risks requires very early and courageous action by policymakers. Typically, risks and problems in the financial system build over a number of years. There is an awful amount of uncertainty as to whether risks are developing; how they will be perpetuated; and when to take action. Microprudential regulations alone are not likely to resolve these issues. Let me illustrate the sort of problems a microprudential regulator faces with a specific example. As you know, the problems Journal of Regulation & Risk North Asia

with residential mortgages, particularly with subprime mortgages, were one of the key areas that precipitated the current crisis. Currently, the US financial system faces problems with commercial real estate (CRE) loans. US$1.5 trillion CRE ticking bomb At the end of 2009, depository institutions in the US held over $1.5 trillion in commercial real estate and construction loans on their books. In addition, there are currently nearly $800 billion in commercial mortgage-backed securities (CMBS) outstanding. Over the past two years, delinquencies on these loans and securities have been rising at an uncomfortably rapid rate. Click here for url link to Federal Reserve charts. Of the more than $1 trillion in commercial real estate loans held by depository institutions today, nearly four per cent are non-current.[3] This ratio was about 0.5 per cent before the crisis (June 2007). The picture is even worse for the riskier construction and land development loans. While these loans total less than $0.5 trillion, the non-current portion had risen from 1.5 per cent at the end of June 2007 to nearly 16 per cent by the end of last quarter. For CRE loans packaged into securities, serious delinquencies represent four per cent of all CMBS currently outstanding, up from nearly zero before the crisis. Rapid growth in delinquency Does such a fast rise in CRE and CMBS delinquencies mean that bank examiners missed clear signs of forthcoming problems and failed to take action? Commercial real estate loans are a key problem area for the Journal of Regulation & Risk North Asia

Figure 1. Commercial real estate — CMBS

banks in my district. I went to my supervisory staff and said:“I know you are struggling with commercial real estate loan portfolios. What are the difficulties? What do you think we needed to have done in the past in order to avoid the current problems?” I have to admit that their response made me pause. They said: “You know, Charlie, if we wanted to avoid the current situation, we needed to act very, very early – probably in 2004 or 2005.”That is a full two to three years before the onset of problems in the sector. Clearly, we needed to act very early. But at that time, it would have been difficult to argue convincingly in favour of reigning in this lending. The economy was coming out of the jobless recovery and just beginning to gain traction. And the banking industry had proven it could maintain profits through a recession, it had reduced problem loans back to historically low levels, and it appeared to have more than sufficient capital to cushion against potential losses.[4] Memories of S&L crisis linger Given previous problems with commercial real estate loans, my supervisors understood the potential risks. Here is a typical situation 93

they faced. Imagine you are an examiner and you go out to review a large financial institution in 2005. The institution is warehousing commercial real estate loans prior to securitization during a period when CMBS issuance is just taking off and, for every $1,000 in CRE loans, only $6 are noncurrent. Nonetheless, as an examiner, you have a discussion with the bank managers and you learn about their lending practices, and you kind of wonder,“How well-controlled is all of this?” The loan officers will give you some very good arguments about what their business is and how the risks are being controlled. First, they are not really storing the loans on their books. They are underwriting the loans with the full intention of packaging them into securities. They have to build up a critical mass before securitisation, but they are not going to keep the loans. Banks not in storage business From the banks’ perspective, they are not in the storage business. They are in the transportation business. It is rather short term – 60, 90 days. Presumably, the risk is only proportional to how long they are holding on to it – which is not very long. Furthermore, during this period, real estate prices are going up, delinquencies are negligible, and banks have a variety of hedges in place. They look at commercial real estate prices and think, if needed, they can get out of their portfolio at little cost. And even if some losses materialize, they have adequate capital. I have some interesting people on my staff who can push back in a pretty challenging fashion. But at the end of the day, after carefully considering the banks’ arguments, they think: “All right, I guess the loan officers are 94

looking at this pretty reasonably and are protecting their institution.” And the risk to the deposit insurance fund from all this activity seems pretty small. So, you end up being convinced that the activity is probably OK. Micro risk to macro risk Today, with hindsight, we know that while most of the micro risks appeared very small at the time, their sum was far less than the macro risk that was silently building up. That’s the key thing: A collection of negligible micro risks can add up to a far greater macro risk. Focusing on individual institutions and controlling risks on a firm-by-firm basis are not enough for detecting and controlling system-wide stress points. This is why we need macroprudential supervision and regulation. Suppose for a particular class of assets, values decline on an economy-wide basis. This means losses are going to be taken at the macro level. Perhaps managers at a few individual banks can be smart, foresee the price declines, and liquidate their positions in time to avoid large losses at their institution. But the macro economy has to take these losses, and that’s where we get stuck. Not everyone can get through the exit door at once; someone has to end up bearing the macro losses. Critical regulatory role This is why macroprudential regulations that aim to assess and control system-wide risks should play a critical role in our regulatory structure. For instance, dynamic capital requirements and loan loss provisions that vary over the cycle can temper some of the boom-bust Journal of Regulation & Risk North Asia

trends we have seen in the past. History shows that during boom times, when financial institutions are perhaps in an exuberant state, they may not price risks fully in their underwriting and risk-management decisions. During slumps faced with eroding capital cushions, increased uncertainty, and binding capital constraints, some institutions may become overcautious and excessively tighten lending standards. Both behaviours tend to amplify the business cycle. Varying required capital loan loss provisions over the cycle could serve to offset some of this volatility. We saw the advantages of a systemic, macroprudential approach first-hand during the implementation of the Supervisory Capital Assessment Program (SCAP), the so-called “stress tests.” Last spring, the Federal Reserve led a co-ordinated examination of the largest 19 US banks. “Stress tests” forward looking We reviewed the institutions simultaneously, applying a common set of assumptions and scenarios across all of them. Such an approach provided us with a view of these banks in their totality, as well as the financial condition of individual institutions on a stand-alone basis. The horizontal view was essential in assessing how risks taken individually by each bank are correlated and how they can add up to more than the sum of individual components. The review also had a forward-looking element that assessed the likely condition of the banks under a specific set of adverse economic conditions and determined the amount of capital the banks would need under these “stress” conditions. Journal of Regulation & Risk North Asia

Such procedures also enable supervisors to identify best practices in risk management and to push banks with weak controls to improve and adopt these industry best practices. Indeed, supervisors at the Federal Reserve have already begun to adopt such an approach. Making the right call However, even with such macroprudential strategies, we are going to face challenges. Let’s think about what, as a hypothetical macroprudential regulator, we would have to do. What should be the early call focus? What should we be looking at? When should we be looking at it? How confident are we that that we are actually going to be able to identify the problem? A macroprudential regulator is confronted with the same type of questions a microprudential regulator faces, but at a system-wide level. Consider these questions within the context of commercial real estate. The facts are, today, CMBS and CRE loans have large delinquencies. Could anyone have made this call confidently in time to arrest the problems we face today? From figure 2, we note that the outstanding volume of CMBS ramps up in 2004, 2005. At the same time, commercial real estate prices (shown in the middle panel) continue to rise well into 2007. On the bottom panel, we see the performance of loans originated during this period, depending on when the loans were made. Delinquent loans and credit cycle Loans originated later in the credit cycle are performing worse than older loans. For instance, loans underwritten in 2005 did not 95

reach a one per cent delinquency rate until about 42 months (3.5 years) after origination. In contrast, loans made in 2008 reached the one per cent delinquency mark only six months after origination. The progressively worsening performance of loans originated later in the credit cycle is likely due to looser underwriting standards that supported the issuance boom. With the benefit of hindsight, I can point to the inflection point in volume and say: “I should have put my finger on that right then.” At that point in the credit cycle,“shouting” would have been an important part of risk-control, as it would have emphasised potential risks to the market players. Risk pricing and market exuberance But I can’t imagine that supervisors’concerns would have been taken seriously in 2005 or 2006 – even if they started going out and shouting to the heavens that there is a big, big problem and we need to do more about it. Recall that, at that time, real estate prices were ramping up and delinquencies were low. Indeed, in 2007, the Federal Reserve, along with other bank regulators, issued a supervisory guidance on concentrations in commercial real estate.[5] We also gave a number of speeches prior to the crisis about risk pricing and about market exuberance – to little avail. These warnings were largely ignored and we got a lot of push-back from banks. During boom periods when risks are silently building up, there are a lot of people with a lot of money at stake who will come out against such pronouncements. So, if policy-makers do not follow words with actions, 96

then we are not likely to make much progress. Shouting and supervision – together – are essential. Multi-pronged approach I raised some potential issues with both micro- and macro-prudential regulations – how do we address these issues? This is where we would take full advantage of our multi-pronged approach to regulatory reform. If we are not certain that a particular approach may not be as effective as we would like, we can put more pressure on other levers to obtain a desired amount of risk control. So, if we think that macroprudential regulations may have some potential operational issues, we would need to implement more stringent capital and liquidity requirements than we would otherwise to overcome these issues. This is why we need a multi-pronged approach to a robust regulatory structure: a structure that takes full advantage of the existing tools supervisors have; a structure that supplements the existing one with dynamic capital requirements and a comprehensive approach to risk management; a structure that includes a macroprudential supervisor than can monitor and assess incipient risks across institutions and markets and, when necessary, impose higher regulatory requirements on firms that pose systemic risks. Disruptive ‘spillovers’ However, even with such a structure, it would be hubris on the part of policy-makers to assume that we would be able to prevent financial stress at all financial institutions. Therefore, we also need to contain Journal of Regulation & Risk North Asia

the disruptive spillovers that result from the failure of systemically important institutions without resorting to bailouts or ad hoc rescues. A necessary element of this is having a mechanism for resolving the failure of a systemically important institution.[6] This is something we currently lack in many cases, though there are proposals now under discussion that would provide this resolution power. Another issue that arises in the regulatory reform debate is whether the central bank should be entrusted with supervision and regulation responsibilities. There are many synergies between monetary policy and supervision and regulation that I and others have discussed in previous speeches. [7] Let me point out a couple of reasons why it might be optimal for a central bank to have a key role in financial stability and regulation. Lender of last resort The reality is that central banks have the unique ability to act as the “lender of last resort” during financial crises. The central bank cannot use this tool effectively if it is not knowledgeable about the financial condition of the institutions it might lend to, particularly if such loans need to be made at very short notice. The lender of last resort role inevitably thrusts the central bank into efforts to promote financial stability and avoid crises. If, however, central banks have no supervision and regulation tools, they are constrained to act with the only tool at their disposal – monetary policy. I already mentioned that I am sceptical about using monetary policy to control Journal of Regulation & Risk North Asia

financial exuberance. But without supervisory powers, there may be no choice. We know that time consistency issues can lead a central bank to choose inflationary outcomes in the short run, even though there is no long-run tradeoff between output growth and price stability. Rogoff’s timely advice Kenneth Rogoff – Professor of Economics at Harvard University – pointed out that one way to deal with this issue would be to appoint a conservative central banker who would be tougher than the public. This would ensure that appropriate decisions would be made and appropriate actions would be taken. Now, consider the reaction function of a central banker that has the additional responsibility for financial stability – but not the additional tools provided by a supervision and regulation role. Such a central banker might have to act against exuberance in financial markets more actively than it would otherwise. That would be entirely necessary and appropriate to preserve financial stability. However, that policy may not be the most appropriate one at that time for addressing the traditional goals of monetary policy of maximum sustainable employment and price stability. A central bank with three goals and only one lever is a recipe for producing some difficult policy dilemmas. Summation To sum up, it is clear that, in order to avoid a situation like the one we have faced in the past two years, we need to fortify our regulatory lines of defence. We need to change the 97

rules of regulation to be more efficient and effective in their design and implementation. But we also need to openly acknowledge the challenges policy-makers and regulators are likely to face in containing potential financial crises. Despite all the challenges, I believe that we can design a more effective regulatory structure through discussions such as the one we are having today. • Notes
1 For instance, see Evans (2009a and 2009b). 2 For instance, in recent years, regulators have actively supported the development of the Trade Information Warehouse (a central repository for trade reporting of over-the-counter credit derivatives contracts) and clearing houses for credit default swaps, such as ICE Trust. 3 Non-current loans are those that are 90 days or more past due plus loans in nonaccrual status. 4 At the end of 2004, return on equity at all commercial banks in the U.S. was 13.08 per cent, near its historical peak of 16.23 per cent in the second quarter of 1993. Return on assets were similarly high, and net charge-offs accounted for only 0.68 per cent of total loans, well below 1.31 per cent reached at the end of 2001. 5 See, “SR 07-1 Interagency Guidance on Concentrations in Commercial Real Estate” http://www. federalreserve.gov/boarddocs/srletters/2007/ SR0701.htm(external). More recently, the Federal Reserve issued a supervisory guidance on managing interest rate risk {“SR 10-1 Interagency Advice on Interest Rate Risk,” http://www.federalreserve.gov/boarddocs/srletters/2010/sr1001. htm(external)} and highlighted it in speeches (for instance, see Kohn (2010)). In addition, the Federal Reserve – along with the other Federal banking agencies – issued a policy statement on funding and liquidity risk management on March

17, 2010 (http://www.federalreserve.gov/newsevents/press/bcreg/20100317a.htm). 6 See Evans (2009c) for my views on the advantages of resolution authority and the issues it would address. 7 For instance, see Bernanke (2010), Evans (2010), Kashyap (2010), and Volcker (2010).

Bernanke, Ben S., 2010,The Federal Reserve’s Role in Bank Supervision, Testimony before the U.S. House Committee on Financial Services,Washington, DC, March 17. http://www.federalreserve.gov/ newsevents/testimony/bernanke20100317a.htm Evans, Charles L., 2009a.“The International Financial Crisis:Asset Price Exuberance and Macroprudential Regulation.” Remarks given at the 2009 International Banking Conference on September 24, 2009 in Chicago, http://www.chicagofed.org/webpages/ publications/speeches/2009/09.24_IBC_speech.cfm. Evans, Charles L., 2009b. “Should Monetary Policy Prevent Bubbles?” Remarks given at the ‘Asset Price Bubbles and Monetary Policy” Conference on November 13, 2009 in Paris, http://www.chicagofed. org/webpages/publications/speeches/2009/11.13_ BoF_speech.cfm Evans, Charles L., 2009c. “Too-Big-To-Fail: A Problem Too Big to Ignore” Remarks given at the European Economics and Financial Centre on July 1, 2009 in London. http://www.chicagofed.org/webpages/publications/speeches/2009/07.01_EEFC_ Speech.cfm Evans, Charles L., 2010a. CFA Society of Chicago Distinguished Speaker Series: Luncheon Economic Forecast.” Remarks delivered on March 4, 2010 in Chicago, http://www.chicagofed.org/webpages/publications/speeches/2010/03_04_CFA_speech.cfm Evans, Charles L. 2010b, CFA Society of Chicago Distinguished Speaker Series: Luncheon Economic Forecast, March 4. http://www.chica-


Journal of Regulation & Risk North Asia

gofed.org/webpages/publications/speeches/2010/ 03_03_CFA_speech.cfm Kashyap, Anil K, 2010 Examining the Link between Fed Bank Supervision and Monetary Policy, Testimony before the House Financial Services Committee, March 17. http://www.house.gov/apps/list/ hearing/financialsvcs_dem/kashyap.pdf Kohn, Donald L., 2010. “Focusing on Bank Interest Rate Risk Exposure.” Remarks delivered at the

Federal Deposit Insurance Corporation’s Symposium on Interest Rate Risk Management on January 29, 2010 in Arlington, Virginia. http://www.federalreserve.gov/newsevents/speech/kohn20100129a. htm (external) Volcker, Paul, 2010, Statement, Testimony before the House Financial Services Committee, March 17. http://www.house.gov/apps/list/hearing/financialsvcs_dem/kashyap.pdf

Journal of regulation & risk – north asia

Call for papers
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The US legisrather spea monithat will the first n Corrupt Practic Fortune 500 compa ld ers we saw outlines the ard & Poor’s Da we should ks, or ls by evenThe US Foreig beginnings in the were a year ago the financial wor is These days to these scanda vid Samuel than ban name that positive ben its About itutions lature responded s mation in Act (FCPA), has iders, a in 1977. credit cris ncial inst gate Special efits sfor the fina ice prov . enacting the FCPA when the Water of a tran months world at tored financial serv and future activities ed disclo- tually Watergate era, provisions to the testing on of bank stress in the last the financial are two main for voluntary mov ent is and There the bottom and the have It is a big made Prosecutor called nge that rs their curr sformed dly we ibery provisions, challenge banks line. nies that had the cha has tran than cove k at how rapi FCPA – the anti-br Both the SEC and the a robust for banks on the sures from compa ve pace. 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Meanwh er sus- able activ e change to apparent and the poration which was given retain ities if thes ile, banks e are mor that are and will placed to erate. energy ly profitproducts with the SEC e are not take adva any person. you gen consolida . But ther telecom, sponsorld and co-operated in the long ntage of the term interests of fic that tion process ncial it would likely s such as e products the banking wor value can include thes nce that it. the enterpris erAnything of industrie need can understa ies. The fina the intended ges in e known result an informal assura ion, use of a holie or do not ties with e compan an important nd the risks to be sure they risk as we hav and challen ement action. The for travel and educat be the portfolios rs and cabl ing embedde employment, But contrary profile of the organisa fit be safe from enforc more than USD$300 ship ing banking the future, not of potential d in the s, supplie clearly undergo promise of future threaten tion to popular acquisitio ing corporat ks will, in e our fund There is no To improve the disclosure that ld is mas- day home, opinion, imp . was (a ns. wor to mov and meals. The ban e rovnable payments s; they 135 by which and strengthe enterprise risk man discounts, drinks tion of putt governance is not million in questio just a ques the folio ult vehicles ines and port agement had been made n investor ing the ‘righ defa the 1970s) Black exam nces bank confidenc board mem our bala sive amount in e, we 147 s can take the lead bers in plac t’ executives and Professor William maintainepidemic that in three relat think appropri Better boar th Asia ate incentive e and giving them age fraud ed areas: Asia d and seni & Risk Nor s. sight and causes of the mortg or executive ation & Risk North For the bank ulation . control of of Regd States Journal of Regul over- sion to make ente has swept the Unite agement; Journal s when the right re-invigorated rprise risk man they are deci- business stress testi growth look difficult, e.g. whe ng and n s or when critiJournal of risk managemgood in the upturn, demonstrate three Regulation ent looks and they implicitly & Risk Nor wholesale expensive paper is a leading regulation and a th Asia THE author of this g cal failures of discipline of fraud and former bankin failure of private market academic, lawyer l sing in ‘white collar’ and other forms of credit risk. The Financia regulator speciali ) the 163 unsung heroes of ment Network (FinCEN crime. As one of the 1980s, Crimes Enforce this week on Suspicious debacle of the released a study Savings & Loans ys spends much that federally reguProfessor Black nowada why financial Activity Reports (SARs) (sometimes) file ns time researching financial institutio lated of his ation y to become dysBureau of Investig markets have a tendenc his theory on with the Federal mortgage evidence of ned for (FBI) when they find functional. Renow Black lectures at the fraud. ‘control fraud’, Prof. ri and Kansas City. University of Missou Rob ‘The Best Way to He is the author of te Epidemic warning ic” of One: How Corpora warning of an “epidem a Bank is to Own the The FBI began testitheir congressional Politicians Looted in Executives and years nta- mortgage fraud prominent comme ber 2004 – over five S&L Industry.’ A l mony in Septem c were of the current financia warned that if the epidemi l critor on the causes of the ago. It also cause a financia is a vocal critic not dealt with it would crisis, Prof. Black to adequate was done ent has handled the Nothing remotely way the US governm regulators, law d institutions sis. to the epidemic by g crisis and rewarde bankin y respond sector “market disfailed in their fiduciar enforcement, or private that have clearly and epidemic produced cipline.” Instead, the duties to investors. prices bubble in US housing hyper-inflated a it nearly tary does not neca crisis so severe that The following commen l of that produced of the global financia view of the Journal caused the collapse essarily represent the dented bailouts of – North Asia. system and led to unprece Regulation and Risk s on criminal referlargest banks. “The new number many of the world’s in the US are just in rals for mortgage fraud 33 Asia ion & Risk North Journal of Regulat

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-regulation Deregulation, non and ‘desupervision’

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

Journal of Regulation & Risk North Asia


Central banking

Regulation or prohibition: the $100 billion question
Andrew G. Haldane,Executive Director, Financial Stability, Bank of England, examines the social costs of systemic risk.
the car industry is a pollutant. exhaust fumes are a noxious by-product. Motoring benefits those producing and consuming car travel services – the private benefits of motoring. But it also endangers innocent bystanders within the wider community – the social costs of exhaust pollution. Public policy has increasingly recognised the risks from car pollution. Historically, they have been tackled through a combination of taxation and, at times, prohibition. During this century, restrictions have been placed on poisonous emissions from cars – in others words, prohibition. This is recognition of the social costs of exhaust pollution. Initially, car producers were in uproar. The banking industry is also a pollutant. Systemic risk is a noxious by-product. Banking benefits those producing and consuming financial services – the private benefits for bank employees, depositors, borrowers and investors. But it also risks endangering innocent bystanders within the wider economy – the social costs to the general public from banking crises. Journal of Regulation & Risk North Asia Public policy has long-recognised the costs of systemic risk. They have been tackled through a combination of regulation and, at times, prohibition. Recently, a debate has begun on direct restrictions on some banking activities – in other words, prohibition. This is recognition of the social costs of systemic risk. Bankers are in uproar. This paper examines the costs of banking pollution and the role of regulation and restrictions in tackling it. In light of the crisis, this is the US$100 billion question. The last time such a debate was had in earnest followed the Great Depression. Evidence from then, from past crises and from other industries helps define the contours of today’s debate.This debate is still in its infancy. While it would be premature to be reaching policy conclusions, it is not too early to begin sifting the evidence. What does it suggest? Systemic costs One important dimension of the debate concerns the social costs of systemic risk. Determining the scale of these social costs provides a measure of the task ahead. It helps calibrate the intervention necessary to 101

tackle systemic risk, whether through regulation or restrictions. So how big a pollutant is banking? There is a large literature measuring the costs of past financial crises.1 This is typically done by evaluating either the fiscal or the foregone output costs of crisis. On either measure, the costs of past financial crises appear to be large and long-lived, often in excess of 10 per cent of pre-crisis GDP. What about the present crisis? Wealth transfer The narrowest fiscal interpretation of the cost of crisis would be given by the wealth transfer from the government to the banks as a result of the bailout. Plainly, there is a large degree of uncertainty about the eventual loss governments may face. But in the US, this is currently estimated to be around $100 billion, or less than one per cent of US GDP. For US taxpayers, these losses are (almost exactly) a $100 billion question. In the UK, the direct cost may be less than £20 billion, or little more than one per cent of GDP. Assuming a systemic crisis occurs every 20 years, recouping these costs from banks would not place an unbearable strain on their finances. The tax charge on US banks would be less than $5 billion per year, on UK banks less than £1 billion per year.2 Total pretax profits earned by US and UK banks in 2009 alone were around $60 billion and £23 billion respectively. But these direct fiscal costs are almost certainly an underestimate of the damage to the wider economy which has resulted from the crisis – the true social costs of crisis. World output in 2009 is expected to have been around 6.5 per cent lower than 102

its counterfactual path in the absence of crisis. In the UK, the equivalent output loss is around 10 per cent. In money terms, that translates into output losses of $4 trillion and £140 billion respectively. Moreover, some of these GDP losses are expected to persist. Evidence from past crises suggests that crisis-induced output losses are permanent, or at least persistent, in their impact on the level of output if not its growth rate.3 If GDP losses are permanent, the present value cost of crisis will significantly exceed today’s cost. By way of illustration, Table 1 looks at the present value of output losses for the world and the UK assuming different fractions of the 2009 loss are permanent – 100 per cent, 50 per cent and 25 per cent. It also assumes, somewhat arbitrarily, that future GDP is discounted at a rate of five per cent per year and that trend GDP growth is three per cent.4 Present value losses are shown as a fraction of output in 2009. Astronomical figures As Table 1 shows, these losses are multiples of the static costs, lying anywhere between one and five times annual GDP. Put in money terms, that is an output loss equivalent to between $60 trillion and $200 trillion for the world economy and between £1.8 trillion and £7.4 trillion for the UK. As Nobelprize winning physicist Richard Feynman observed, to call these numbers“astronomical” would be to do astronomy a disservice: there are only hundreds of billions of stars in the galaxy.“Economical”might be a better description. It is clear that banks would not have deep enough pockets to foot this bill. Assuming Journal of Regulation & Risk North Asia

Table 1. Present value of output losses (% of 2009 GDP)
Fraction of initial output loss which is permanent 25% uk World
Source: Bank calculations

50% 260 170

100% 520 350

130 90

Table 2. Average ratings difference for a sample of banks and building societies
2007 uk global average 1.56 1.68 1.63 2008 1.94 2.36 2.21 2009 4 2.89 3.24 Average (2007–09) 2.5 2.31 2.36

1. All figures are year-end 2. The UK sample contains 16 banks and building societies in 2007 and 2008 and 13 in 2009. The global sample contains a sample of 26 banks across a range of sizes and countries for 2007 and 28 banks in 2008 and 2009. Source: Moody’s and Bank calculations.

that a crisis occurs every two decades, the systemic levy needed to recoup these crisis costs would be in excess of $1.5 trillion per year. The total market capitalisation of the largest global banks is currently only around $1.2 trillion. Fully internalising the output costs of financial crises would risk putting banks on the same trajectory as the dinosaurs, with the levy playing the role of the meteorite. It could plausibly be argued that these output costs are a significant over-statement of the damage inflicted on the wider economy by the banks. Others are certainly not blameless for the crisis. For every reckless lender there is likely to be a feckless borrower. If a systemic tax is to be levied, a more precise measure may be needed of banks’ distinctive contribution to systemic risk. One such measure is provided by the (often implicit) fiscal subsidy provided to banks by the state to safeguard stability. Those implicit subsidies are easier to describe Journal of Regulation & Risk North Asia

than measure. But one particularly simple proxy is provided by the rating agencies, a number of whom provide both “support” and“standalone”credit ratings for the banks. The difference in these ratings encompasses the agencies’ judgment of the expected government support to banks. Hidden government support Table 2 looks at this average ratings difference for a sample of banks and building societies in the UK, and among a sample of global banks, between 2007 and 2009. Two features are striking. First, standalone ratings are materially below support ratings, by between 1.5 and four notches over the sample for UK and global banks. In other words, rating agencies explicitly factor in material government support to banks. Second, this ratings difference has increased over the sample, averaging over one notch in 2007 but over three notches by 2009. In other words, actions by government 103

Table 3. Average ratings difference for UK banks and building societies(a)
Category 2007 large banks small banks 2008 large banks small banks 2009 large banks small banks average (2007–2009) large banks small banks 3.37 1.48 10 3 2 0 4.67 3.43 7 6 3 0 2.78 0.86 10 2 1 0 2.67 0.14 12 1 1 0 Mean Max difference in sample Min difference in sample

(a) The ‘Large’ category includes HSBC, Barclays, RBS, Lloyds TSB, Alliance & Leicester and Bradford & Bingley (up to 2008), and Nationwide. The ‘Small’ category includes building societies: Chelsea, Coventry, Leeds, Principality, Skipton, West Bromwich and Yorkshire. The ratings are year-end. Source: Moody’s and Bank calculations.

during the crisis have increased the value of government support to the banks. This should come as no surprise, given the scale of intervention. Indeed, there is evidence of an up-only escalator of state support to banks dating back over the past century.5 ‘Too big to fail’ problem Table 3 takes the same data and divides the sample of UK banks and building societies into “large” and “small” institutions. Unsurprisingly, the average rating difference is consistently higher for large than for small banks. The average ratings difference for large banks is up to five notches, for small banks up to three notches. This is pretty tangible evidence of a second recurring phenomenon in the financial system – the “too big to fail”problem. It is possible to go one step further and translate these average ratings differences 104

into a monetary measure of the implied fiscal subsidy to banks. This is done by mapping from ratings to the yields paid on banks’ bonds;6 and by then scaling the yield difference by the value of each banks’ ratingssensitive liabilities.7 The resulting money amount is an estimate of the reduction in banks’ funding costs which arises from the perceived government subsidy. Table 4 shows the estimated value of that subsidy for the same sample of UK and global banks, again between 2007 and 2009. For UK banks, the average annual subsidy for the top five banks over these years was over £50 billion – roughly equal to UK banks’ annual profits prior to the crisis. At the height of the crisis, the subsidy was larger still. For the sample of global banks, the average annual subsidy for the top five banks was just less than $60 billion per year. These are not small sums. Journal of Regulation & Risk North Asia

Table 4. Estimated subsidy for UK banks and building societies (£bn) and global banks ($bn)
2007 Subsidy uk Big 5 Medium small global Big 5 sample total total average total average total average sample total total average 11 9 2 1 0 0 0 37 18 4 0 0 0 0 Subsidy/ Total liabilities 2008 Subsidy 59 52 10 7 3 1 0 220 83 17 1 1 3 1 Subsidy/ Total liabilities 2009 Subsidy 107 103 26 3 3 1 0 250 71 14 1 1 2 2 Subsidy/ Total liabilities Average (2007–09) Subsidy 59 55 13 4 2 1 0 169 57 12 1 1 2 1 Subsidy/ Total liabilities

See footnotes for tables 2 and 3 for details on sample. Source: Moody’s, Bank of America Merrill Lynch, Bankscope published by Bureau van Dijk Electronic Publishing and Bank calculations

Table 4 also splits UK banks and building societies into “Big 5”, “medium” and “small” buckets. As might be expected, the large banks account for more than 90 per cent of the total implied subsidy. On these metrics, the too-big-to-fail problem results in a real and ongoing cost to the taxpayer and a real and ongoing windfall for the banks. If it were ever possible to mint a coin big enough, these would be the two sides of it. These results are no more than illustrative – for example, they make no allowance for subsidies arising on retail deposits. Nonetheless, studies using different methods have found similarly sized subsidies. For example, Baker and McArthur ask whether there is a difference in funding costs for US banks either side of the $100 billion asset threshold – another $100 billion question.8 They find a significant wedge in costs, which Journal of Regulation & Risk North Asia

has widened during the crisis. They calculate an annual subsidy for the 18 largest US banks of over $34 billion per year. Applying the same method in the UK would give an annual subsidy for the five largest banks of around £30 billion. Banking pollution This evidence can provide only a rough guide to systemic scale and cost. But the qualitative picture it paints is clear and consistent. First, measures of the costs of crisis, or the implicit subsidy from the state, suggest banking pollution is a real and large social problem. Second, those entities perceived to be “too big to fail” appear to account for the lion’s share of this risk pollution. The public policy question, then, is how best to tackle these twin evils. To date, the public policy response has 105

largely focussed on the role of prudential regulation in tackling these problems. Higher buffers of capital and liquid assets are being discussed to address the first problem. And add-ons to these capital and liquidity buffers for institutions posing the greatest systemic risk are being discussed to address the second.9 In essence, this is a taxation solution to the systemic risk pollution problem.10 There is a second approach. On January 21, 2010, US President Barack Obama proposed placing formal restrictions on the business activities and scale of US banks. Others have made complementary proposals for structural reform of banking.11 Typically, these involve separation of bank activities, either across business lines or geographies. In essence, this is the prohibition solution to the systemic pollution problem. The great debate This sets the scene for a great debate. It is not a new one. The taxation versus prohibition question crops up repeatedly in public choice economics. For centuries it has been central to the international trade debate on the use of quotas versus subsidies. During this century, it has become central to the debate on appropriate policies to curtail carbon emissions.12 In making these choices, economists have often drawn on Martin Weitzman’s classic public goods framework from the early 1970s.13 Under this framework, the optimal amount of pollution control is found by equating the marginal social benefits of pollution-control and the marginal private costs of this control. With no uncertainty about either costs or benefits, a policy-maker would be indifferent between taxation and 106

restrictions when striking this cost/benefit balance. In the real world, there is considerable uncertainty about both costs and benefits. Weitzman’s framework tells us how to choose between pollution-control instruments in this setting. If the marginal social benefits foregone of the wrong choice are large, relative to the private costs incurred, then quantitative restrictions are optimal. Why? Because fixing quantities to achieve pollution control, while letting prices vary, does not have large private costs. When the marginal social benefit curve is steeper than the marginal private cost curve, restrictions dominate. The results flip when the marginal cost/ benefit trade-offs are reversed. If the private costs of the wrong choice are high, relative to the social benefits foregone, fixing these costs through taxation is likely to deliver the better welfare outcome. When the marginal social benefit curve is flatter than the marginal private cost curve, taxation dominates. So the choice of taxation versus prohibition in controlling pollution is ultimately an empirical issue. To illustrate the framework, consider the path of financial regulation in the US over the past century. The US announcements in January are in many respects redolent of US financial reforms enacted during the late 1920s and early 1930s. Then, restrictions were imposed on both bank size and scope, in the form of the McFadden (1927) and Glass-Steagall (1933) Acts. The history of both, viewed through Weitzman’s lens, is illuminating for today’s debate. The McFadden Act (1927) in the US gave nationally-chartered banks broadly the Journal of Regulation & Risk North Asia

same branching rights as state banks within the state. But it also confirmed the effective prohibition on national banks opening new branches across state lines that had previously been implicit in the US National Banking Act (1864). It covered a wide range of banking functions, including deposit-taking and brokerage. The motivation behind the Act appears to have been in part political, reflecting lobbying by small unit banks under threat from larger competitors. But it also had an economic dimension, as a check on the dangers of “excessive concentration of financial power”.14 The same too-big-to-fail arguments are of course heard today, though the concerns then were competition rather than crisis-related ones. Weitzman’s marginal social benefit curve was perceived to be steep, made so by state-level competition concerns. 1980s watershed McFadden appeared to be fairly effective in limiting the size of US banks from the 1930s right through to the mid-1970s. Over this period, the average asset size of US banks in relation to nominal GDP was roughly flat (Chart 1). As recently as the early 1980s, it was still at around its level at the time of the Great Depression. The 1980s marked a watershed, with interstate branching restrictions progressively lifted. States began to open their borders to out-of-state bank holding companies (BHCs). The 1982 Garn-St Germain Act allowed any BHC to acquire failed banks and thrifts, regardless of the state law. Finally, the Riegle-Neal Act of 1994, which took effect in 1997, largely lifted restrictions on interstate Journal of Regulation & Risk North Asia

branching for both domestic BHCs and foreign banks. The rationale for this change of heart was a mirror-image of the 1920s. Large banks convinced politicians of the high private costs of restrictions, which inhibited the efficiency of their offering to the public. In Weitzman’s framework, private costs trumped social benefits. The effects of the removal of interstate restrictions were dramatic. The average size of US banks, relative to GDP, has risen roughly threefold over the past 20 years (Chart 1). Too-big-to-fail was reborn in a new guise. The US Banking Act (1933) was cosponsored by Senator Carter Glass and Representative Henry Steagall – hence “Glass-Steagall”. It prevented commercial banks from conducting most types of securities business, including principal trading, underwriting and securities lending. It also banned investment banks from taking deposits. The key functions of commercial and investment banking were effectively prised apart. The Act was motivated by stability concerns in the light of the Great Depression. The stock market boom of the 1920s had been fuelled by cheap credit from the banks. The stock market crash of 1929 brought that, and a great many US banks, to a shuddering halt. Among many banks, net losses on securities were as great as losses on loans. These losses transmitted to the real economy through a collapse in lending, whose stock halved between 1929 and 1933. Against this economic backdrop, and amid heated banker-bashing, it is easy to see how the social benefits of segregation were perceived as far outweighing the private 107

Chart 1. Average assets relative to GDP of US commercial banks
0.014 Average Assets per Commercial Bank as a a percentage of Nominal GDP 0.012 0.010 0.008 0.006 0.004 0.002 0.000

Chart 1: Average assets relative to GDP of US commercial banks (a)


(a) Blue vertical line represents the 1982 Garn-St Germain Act, green vertical line represents the 1994 Riegle-Neal Act,red vertical line (a) Blue vertical line represents the 1982 Garn-St Germain Act, green vertical line represents the 1994 Riegle-Neal represents the Riegle-Neal Act coming into effect in 1997. red vertical line represents the Riegle-Neal Act coming into effect in 1997. Source: FDIC and www.measuringworth.org

19 34 19 38 19 42 19 46 19 50 19 54 19 58 19 62 19 66 19 70 19 74 19 78 19 82 19 86 19 90 19 94 19 98 20 02 20 06

Year Average Asset Size of Commercial Banks scaled by Nominal GDP

Source: FDIC and www.measuringworth.org

costs at the time. Kennedy (1973) describes how“Stock dealings which had made bankers rich and respected in the era of affluence now glared as scarlet sins in the age of depression. Embittered public Disillusionment with speculators and securities merchants carried over from investment bankers to commercial bankers; the two were often the same, and an embittered public did not care to make fine distinctions”.

Glass and Steagall made just such a distinction. They underpinned it with legislation, signed by President Roosevelt in June 1933. As with McFadden, Glass-Steagall appears to have been effective from the 1930s right up until the latter part of the 1980s. Measures of concentration in the US banking system remained broadly flat between the 1930s and the late 1980s (Chart 2). But competitive pressures were building from the late 1970s onwards. Strains on US commercial banks intensified from Journal of Regulation & Risk North Asia


(b) Chart 2. Concentration of the US banking system

Chart 2. Concentration of the US banking system(b)
Total assets of top 3 US banks (as % of total com m ercial banking sector assets)

45.00 40.00 35.00 30.00 25.00 20.00 15.00 10.00 5.00 0.00
1935 1939 1943 1947 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007

(a) (a) (b) (b) (c) (c)

Red line represents the Gramm-Leach-Bliley Act (1999) which revoked restrictions revoked restrictions of Glass-Steagall Red line represents the Gramm-Leach-Bliley Act (1999) which of Glass-Steagall Top 3 banks by total assets as a Topincludes only the insured % of total banking sector assets to ensure consistency over time — for example, non-deposit subsidiaries 3 banks by total assets as a % of total of banks sector assets banking Data depository subsidiaries Data includes only the insured depository subsidiaries of banks to ensure consistency over time - for example, are not included. non-deposit subsidiaries are not included. Source: FDIC

Source: FDIC alternative lending vehicles (such as mutual funds and commercial paper markets) and Chart 3. Largest UK company’s assets from overseas banks. The private costs of restrictions were rising. Legislators responded. After 1988, securities affiliates within BHCs were permitted, though were still subject to strict limits. In 1999, the Gramm-Leach-Bliley Act revoked the restrictions of Glass-Steagall, allowing co-mingling of investment and commercial banking. This came as a specific response to the perceived high private costs of restrictions relative to the perceived social benefits – again, in a reversal of the Weitzman calculus from the early 1930s. As with size, the effects of liberalisation on banking concentration were immediate

and dramatic. The share of the top three largest US banks in total assets rose fourfold, in eachper cent to 40 per cent between 1990 from 10 sector relative to GDP and 2007 (Chart 2). A similar trend is discernible internationally: the share of the top Per cent five largest global banks in the assets of160 the largest 1,000 banks has risen from around 140 eight per cent in 1998 to double that in 2009.

120 Massive growth of banks 2000 This degree of concentration, combined with 100 the large size of the banking industry rela80 tive to GDP, has produced a pattern which is not mirrored in other industries. The largest 60 banking firms are far larger, and have grown far faster, than the largest firms in other 40 industries (Chart 3). With the repeal of the 20 . ail gy ia 0 109


Journal of Regulation & Risk North Asia







non-deposit subsidiaries are not included. Source: FDIC

Chart 3. Largest UK company’s assets in each sector relative to GDP
Chart 3. Largest UK company’s assets in each sector relative to GDP

Per cent

160 140

2007 2000

120 100 80 60 40 20









Source: Bureau van Dijk Electronic Publishing, International Monetary Fund and Bank calculations.

Source: Bureau van Dijk Electronic Publishing, International Monetary Fund and Bank calculations.

McFadden and Glass-Steagall Acts, the toobig-to-fail problem has not just returned but flourished. In the light of the Great Recession, and the large apparent costs of too-big-to-fail, does Weitzman’s cost-benefit calculus suggest there is a case for winding back the clock to the reforms of the Great Depression? Determining that requires an assessment of the benefits and costs of restrictions. Benefits of prohibition The potential benefits of restricting activity in any complex adaptive system, whether financial or non-financial, can roughly be grouped under three headings: modularity, 110

robustness and incentives. Each has a potentially important bearing on systemic resilience and hence on the social benefits of restrictions. (a) Modularity In 1973, Nobel-prizing winning economist Robert Merton showed that the value of a portfolio of options is at least as great as the value of an option on the portfolio.15 On the face of it, this seems to fly in the face of modern portfolio theory, of which Merton himself was of course one of the key architects. Whatever happened to the benefits of portfolio diversification? The answer can be found in an unlikely Journal of Regulation & Risk North Asia




non-deposit subsidiaries are not included. Source: FDIC

Chart 3. Largest UK company’s assets in each sector relative to GDP
Chart 3. Largest UK company’s assets in each sector relative to GDP

Per cent

160 140

2007 2000

120 100 80 60 40 20









Source: Bureau van Dijk Electronic Publishing, International Monetary Fund and Bank calculations.

Source: Bureau van Dijk Electronic Publishing, International Monetary Fund and Bank calculations.

source – Al’Qaeda. Although the precise organisational form of Al’Qaeda is not known with certainty, two structural characteristics are clear. First, it operates not as a centralised, integrated organisation but rather as a highly decentralised and loose network of small terrorist cells. Second, as events have shown, Al’Qaeda has exhibited considerable systemic resilience in the face of repeated and ongoing attempts to bring about its collapse. These two characteristics are closely connected. A series of decentralised cells, loosely bonded, make infiltration of the entire Al’Qaeda network extremely unlikely. If any one cell is incapacitated, the likelihood of this Journal of Regulation & Risk North Asia

undermining the operations of other cells is severely reduced. That, of course, is precisely why Al’Qaeda has chosen this organisational form. Al’Qaeda is a prime example of modularity and its effects in strengthening systemic resilience. There are many examples from other industries where modularity in organisational structure has been deployed to enhance systemic resilience. Computer manufacture is one. During the late 1960s, computers were highly integrated systems. Gradually, they evolved into the quintessential modular system of today, with distinct modules (CPU, hard disk, keyboard) which were replaceable if they failed without 111




endangering the functioning of the system as a whole. This improved resilience and reliability. In the computing industry, modularity appears to have had an influence on industry structure. Since the 1970s, the computer hardware industry has moved from a highly concentrated structure to a much more fragmented one. In 1969, IBM had a market share of over 70 per cent. By this century, the market share of the largest hardware firm was around a third of that. Modularity has meant the computer industry has become less prone to“too-big-to-fail”problems. The domino effect Other examples of modularity in organisational structures include: • The management of forest fires, which typically involves the introduction of firebreaks to control the spread of fire;16 • The management of utility services, such as water, gas and electricity, where the network often has built-in latencies and restrictions to avoid overload and contagion; • The management of infectious diseases which these days often involves placing restrictions on travel, either within a country (as in the case of foot-and-mouth disease in the UK) or outside of it (Asia’s H5N1);17 • The control of computer viruses across the world wide web, which is typically achieved by constructing firewalls which restrict access to local domains; • Attempts on the world domino toppling record, which involve arranging the dominos in discrete blocks to minimise the risk of premature cascades. These are all examples where modular structures have been introduced to 112

strengthen system resilience. In all of these cases, policy intervention was required to effect this change in structure. The case for doing so was particularly strong when the risk of viral spread was acute. In some cases, intervention followed specific instances of systemic collapse. The North American electricity outage in August 2003 affected 55 million people in the US and Canada. It had numerous adverse knock-on effects, including to the sewage system, telephone and transport network and fuel supplies. A number of people are believed to have died as a consequence. This event led to a rethinking of the configuration of the North American electricity grid, with built-in latencies and stricter controls on power circulation. Sparrow gets the arrow In the mid-1980s, an attempt on the world domino-toppling record – at that time, 8,000 dominos – had to be abandoned when the pen from one of the TV film crew caused the majority of the dominos to cascade prematurely. Twenty years later a sparrow disturbed an attempt on the world domino-toppling record. Although the sparrow toppled 23,000 dominos, 750 built-in gaps averted systemic disaster and a new world record of over four million dominos was still set. No-one died, except the poor sparrow which (poetically if controversially) was shot by bow and arrow. So to banking. It has many of the same basic ingredients as other network industries, in particular the potential for viral spread and periodic systemic collapse. For financial firms holding asset portfolios, however, there is an additional dimension. Journal of Regulation & Risk North Asia

Chart 4. Bank size and volatility
Income volatility 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 4,000

Chart 5. Bank diversification and volatility
Income volatility 3.0% 2.5% 2.0% R = 0.0857

R2 = 0.013

1.5% 1.0% 0.5% 0.0% 0.7












Average assets ($m)
Notes: Average assets are calculated for 24 banks between 2006 and 2008. Income volatility is measured as the standard deviation of operating income (per asset) over the period 1997-2008. Source: Bankscope, published accounts and Bank calculations.

Notes: Pre-crisis diversification and income volatility for a sample of 25 banks. Diversification index based on revenue concentration, as described in the main text. Source: Bankscope, published accounts and Bank calculations.

Chart 6. Bank size and write downs
Write downs per asset 7% 6% 5% R2 = 0.0009 4% 3% 2% 1% 0% 3,000

Chart 7. Bank diversification and write downs
Write 7% downs per 6% asset 5% R2 = 0.0919 4% 3% 2% 1% 0% 0.7











T otal Assets ($bn)


Notes: Total assets for a sample of 21 banks for 2007. Cumulative write downs over the course of the crisis are shown (from 2007 Q4 to 2009 Q3). Source: Bankscope, published accounts and Bank calculations.

Notes: Sample of 21 banks. Cumulative write downs over the course of the crisis are shown (from 2007 Q4 to 2009 Q3). Source: Bankscope, published accounts and Bank calculations.

This can be seen in the relationship between diversification on the one hand and diversity on the other.18 The two have quite different implications for resilience. In principle, size and scope increase the diversification benefits. Larger portfolios Journal of Regulation & Risk North Asia

ought to make banks less prone to idiosyncratic risk to their asset portfolio. In the limit, banks can completely eradicate idiosyncratic risk by holding the market portfolio. The “only” risk they would face is aggregate or systematic risk. 113

But if all banks are fully diversified and hold the market portfolio, that means they are all, in effect, holding the same portfolio. All are subject to the same systematic risk factors. In other words, the system as a whole lacks diversity. Other things equal, it is then prone to generalised, systemic collapse. Homogeneity breeds fragility. In Merton’s framework, the option to default selectively through modular holdings, rather than comprehensively through the market portfolio, has value to investors. The precise balance between diversification and diversity depends on banks’balance sheet configuration. What does this suggest? Charts 4 and 5 plot the income variability of a set of 24 global banks against their asset size and a measure of the diversity of their business model.19 There is no strong relationship between either size or diversity and income volatility. If anything the relationship is positively sloped, with size and diversity increasing income variability, not smoothing it. Positively sloped Charts 6 and 7 look at banks’ experience during the crisis. Size and diversity are plotted against banks’ write-downs (per unit of assets). Again, if anything, these relationships are positively sloped, with larger, more diversified banks suffering proportionally greater losses. This is consistent with evidence from econometric studies of banking conglomerates which has found that larger banks, if anything, exhibit greater risk due to higher volatility assets and activities.20 This evidence is no more than illustrative. But it suggests that, in the arm wrestle 114

between diversification and diversity, the latter appears to have held the upper hand. Bigger and broader banking does not obviously appear to have been better, at least in a risk sense. In banking, as on many things, Merton may have had it right. (b) Robustness The Merton result holds in a world in which investors form judgments based on knowledge of the distribution of risk. But in complex dynamic systems, the distribution of risk may be lumpy and non-linear, subject to tipping points and discontinuities.21 Faced with this, the distribution of outcomes for the financial system as a whole may well be incalculable. The financial system may operate in an environment of uncertainty, in the Knightian sense, as distinct from risk. There is a literature on how best to regulate systems in the face of such Knightian uncertainty.22 It suggests some guideposts for regulation of financial systems. First, keep it simple. Complex control of a complex system is a recipe for confusion at best, catastrophe at worst. Complex control adds, not subtracts, from the Knightian uncertainty problem. The US Constitution is four pages long. The recently-tabled Dodd Bill on US financial sector reform is 1,336 pages long. Which do you imagine will have the more lasting impact on behaviour. Second, faced with uncertainty, the best approach is often to choose a strategy which avoids the extreme tails of the distribution. Technically, economists call this a“minimax” strategy – minimising the likelihood of the worst outcome. Paranoia can sometimes be an optimal strategy. This is a principle which engineers took to heart a generation ago. It is Journal of Regulation & Risk North Asia

especially evident in the aeronautical industry where air and space disasters acted as beacons for minimax redesign of aircraft and spaceships. Third, simple, loss-minimising strategies are often best achieved through what economists call “mechanism design” and what non-economists call “structural reform”. In essence, this means acting on the underlying organisational form of the system, rather than through the participants operating within it. In the words of economist John Kay, it is about regulating structure not behaviour.23 Taken together, these three features define a “robust” regulatory regime – robust to uncertainties from within and outside the system. Using these robustness criteria, it is possible to assess whether restrictions might be preferable to taxation in tackling banking pollution. To illustrate this, contrast the regulatory experience of Glass-Steagall (a restrictions approach) and Basel II (a taxation approach). Criteria satisfied Glass-Steagall was simple in its objectives and execution. The Act itself was only 17 pages long. Its aims were shaped by an extreme tail event (the Great Depression) and were explicitly minimax (to avoid a repetition). It sought to achieve this by acting directly on the structure of the financial system, quarantining commercial bank and brokering activities through red-line regulation. In other words, Glass-Steagall satisfied all three robustness criteria. And so it proved, lasting well over half a century without a significant systemic event in the US. The contrast with Basel II is striking. This Journal of Regulation & Risk North Asia

was anything but simple, comprising many thousands of pages and taking 15 years to deliver. It was calibrated largely to data drawn from the Great Moderation, a period characterised by an absence of tail events – more minimin than minimax. Basel II was underpinned by a complex menu of capital risk weights. This was fine-line, not red-line, regulation. In short, Basel II satisfied few of the robustness criteria. And so it proved, overwhelmed by the recent crisis scarcely after it had been introduced. (c) Incentives Tail risk within some systems is determined by God – in economist-speak, it is exogenous. Natural disasters, like earthquakes and floods, are examples of such tail risk. Although exogenous, even these events have been shown to occur more frequently than a normal distribution would imply.24 God’s distribution has fat tails. Tail risk within financial systems is not determined by God but by man; it is not exogenous but endogenous. This has important implications for regulatory control. Finance theory tells us that risk brings return. So there are natural incentives within the financial system to generate tail risk and to avoid regulatory control. In the run-up to this crisis, examples of such risk-hunting and regulatory arbitrage were legion. They included escalating leverage, increased trading portfolios and the design of tail-heavy financial instruments.25 The endogeneity of tail risk in banking poses a dilemma for regulation. Putting uncertainties to one side, assume the policymaker could calibrate perfectly tail risk in the system today and the capital necessary 115

to insure against it. In an echo of the 1979 Madness song, banks would then have incentives to position themselves“One Step Beyond” the regulatory buffer to harvest the higher returns that come from assuming tail risk. They do so safe in the knowledge that the state will assume some of this risk if it materialises. Tail risk would expand to exhaust available resources. Countless crises have testified to this dynamic. Radical structural redesign This dynamic means it is hazardous to believe there is a magic number for regulatory ratios sufficient to insure against tail risk in all states of the world. Because tail risk is created not endowed, calibrating a capital ratio for all seasons is likely to be, quite literally, pointless – whatever today’s optimal regulatory point, risk incentives mean that tomorrow’s is sure to be different. In response, some economists have proposed corner solutions to the systemic risk problem – in effect, radical structural redesign. Starting with Irving Fisher in the 1930s, some have proposed narrow banks with a 100 per cent liquid asset ratio to protect the liquidity services banks provide.26 Others have proposed mutual fund banks with a 100 per cent equity ratio to safeguard banks’ solvency.27 These limiting solutions are proof to risk incentives. The one guaranteed safe hiding place for the risk-fearing policymaker is the corner. One criticism of these proposals is that they might raise materially the cost of capital to banks and hence to the real economy. For example, 100 per cent capital ratios could cause the economy-wide cost of capital to sky-rocket given the premium charged for 116

equity over debt finance. This same argument is frequently heard in debates about more modest rises in banks’ capital ratios. But there are good counter-arguments that need also to be weighed. By lowering risk, higher levels of equity ought to lower banks’ cost of debt finance. Indeed, in a frictionless world Modigliani and Miller famously showed that this effect would fully offset the higher cost of equity, thereby leaving the total cost of capital for banks unchanged.28 In other words, the cost of capital for a bank may be unaffected by its capital structure, at least when distortions in the economy are small. Even when they are large, some offset in debt costs is likely. Equity premium puzzle It is possible to go one step further and argue that higher bank capital ratios could potentially lower banks’ cost of capital. The size of the premium demanded by holders of equity is a long-standing puzzle in finance – the equity premium puzzle.29 Robert Barro has suggested this puzzle can be explained by fears of extreme tail events.30 And what historically has been the single biggest cause of those tail events? Banking crises. Boosting banks’ capital would lessen the incidence of crises. If this lowered the equity premium, as Barro suggests, the cost of capital in the economy could actually fall. The costs of prohibition Turning to the other side of the equation, what does existing evidence tell us about the costs to banks of restrictions, whether on the scale or scope of their activities? In Weitzman’s framework, how significant are the private costs of restrictions? Fortunately, Journal of Regulation & Risk North Asia

there is a reasonably rich empirical literature on economies of scale and scope in banking. (a) Economies of scale On economies of scale, the literature tends either to look at the cross-sectional efficiency of banks of different sizes, or the time-series efficiency of banks either side of a merger. As it turns out, both roads reach the same destination. Economies of scale appear to operate among banks with assets less, perhaps much less, than $100 billion. But above that threshold there is evidence, if anything, of diseconomies of scale. The Weitzman marginal private cost curve is U-shaped.31 Experience in the US following the McFadden Act suggests size in banking can bring benefits. Over 9,000 US banks failed during the Great Depression, the majority of which were unit banks. Friedman and Schwarz (1963) blame the absence of bank branching for the high failure rate among US banks. The costs of limited branching were also felt well after the Great Depression in higher-cost provision of banking services, in particular for larger companies using lending syndicates to finance large-scale investment.32 US experience after McFadden chimes with cross-country evidence drawn, in particular, from developing countries. For example, using a dataset of 107 countries, Barth et al (2004) assess the effects of restrictions on the efficiency and stability of the financial system. They find evidence that restrictions are damaging to both, in particular barriers to foreign bank entry. Do those arguments resonate within advanced country banking systems today? Journal of Regulation & Risk North Asia

Two comprehensive studies in the mid1990s found that economies of scale in banking are exhausted at relatively modest levels of assets, perhaps between $5billion-$10 billion.33 A more recent 2004 survey of studies in both the US and Europe finds evidence of a similar asset threshold.34 Even once allowance is made for subsequent balance sheet inflation, this evidence implies that economies of scale in banking may cease at double-digit dollar billions of assets. Striking uniformity Evidence from banking mergers offers little more encouragement. There is no strong evidence of increased bank efficiency after a merger or acquisition.35 And there is little to suggest cross-activity mergers create economic value.36 That rather chimes with recent crisis experience. Of the bank mergers and acquisitions which have taken place recently, the majority have resulted in the merged firm under-performing the market in the subsequent period. Of course, all econometric studies have their limitations so these results do not close the case. Nonetheless, the uniformity of the evidence is striking. (b) Economies of scope Turning from economies of scale to economies of scope, the picture painted is little different. Evidence from US bank holding companies suggests that diversification gains from multiple business lines may be more than counter-balanced by heightened exposures to volatile income generating activities, such as trading.37 This mirrors the evidence from Charts 4 and 5 and from the Great Depression. Internationally, a recent 117

study of over 800 banks in 43 countries found a conglomerate “discount” in their equity prices.38 In other words, the market assigned a lower value to the conglomerate than the sum of its parts, echoing Merton’s 1973 insight. This is evidence of diseconomies of scope in banking. ‘Limited factor’ On the face of it, these findings are a puzzle. The most likely cause was articulated by Austin Robinson back in the 1930s –“Man’s mind and man’s memory is essentially a limited factor . . . Every increase in size beyond a point must involve a lengthening of the chain of authority . . . at some point the increasing costs of co-ordination must exceed the declining economies”.39 Oliver Williamson’s “span of control” theory of organisations made rigorous this intuition 30 years later. The essence of these arguments is that limits on the optimal size and scope of firms may be as much neurological as technological. Numbers of synapses may matter more than numbers of servers. The history of military units provides a good illustration. In Roman times, the optimal size of a military unit was 100 – hence the Roman centurion. This was the maximum number of men a general felt able to know well enough to lead and control. The constraint was neurological. Dunbar’s Law Two millennia have passed. Extraordinary advances have been made in military telecommunications technology. And the optimal size of the military unit in the US army today? Just under 100 people.40 The number of relationships humans are felt able to 118

maintain is believed to lie below 150 – the so-called Dunbar’s Law.41 For most of us, it is single digits. That number has been roughly the same since the dawn of time, despite the extraordinary recent advance of technology and social networks. As Nicholas Christakis has observed, Facebook “friends” are not really your friends. With hindsight, this crisis has provided many examples of failures rooted in an exaggerated sense of knowledge and control. Risks and counterparty relationships outstripped banks’ ability to manage them. Servers outpaced synapses. Large banks grew to comprise several thousand distinct legal entities. When Lehman Brothers failed, it had almost one million open derivatives contracts – the financial equivalent of Facebook friends. Whatever the technology budget, it is questionable whether any man’s mind or memory could cope with such complexity. Sobering conjectures To sum up, the maximum efficient scale of banking could be relatively modest. Perhaps it lies below $100 billion. Experience suggests there is at least a possibility of diseconomies of scale lying in wait beyond that point. Conglomerate banking, while good on paper, appears to be more mixed in practice. If these are not inconvenient truths, they are at least sobering conjectures. They also sit awkwardly with the current configuration of banking. In 2008, 145 banks globally had assets above $100 billion, most of them universal banks combining multiple business activities. Together, these institutions account for 85 per cent of the assets of the world’s top Journal of Regulation & Risk North Asia

1000 banks ranked by Tier 1 capital. If these institutions could be resolved easily, so that the systemic consequences of their failure were limited, efficiency considerations could perhaps be set to one side. Or, put in Weitzman’s terms, the social benefits of cutting banks down to size would be low. But crisis experience has demonstrated that the apparatus does not currently exist to resolve safely these institutions. There are no examples during this crisis of financial institutions beyond $100 billion being resolved without serious systemic spillovers.42 Instead, those in trouble have been bailed out. The same 145 institutions account for over 90 per cent of the support offered by governments during the course of the crisis. A matter of scale In light of the crisis, and in the language of Weitzman, the marginal social benefits of restrictions could be greater than the marginal private costs. The maximum efficient scale of banking may lie below the maximum resolvable scale. A large part of the effort of the international community over the past few years has been directed at increasing the maximum resolvable scale of banks – for example, through improved resolution regimes and living wills.43 If successful, that effort would shift the balance of the Weitzman cost/benefit calculus in the direction of bigger banks; it could help achieve the modularity, robustness and better aligned incentives which restrictions otherwise deliver. But if this effort is unsuccessful, past evidence and present experience pose a big question about existing banking structures. Against that backdrop, it is understandable Journal of Regulation & Risk North Asia

that restrictions on scale and activity are part of today’s debate about solutions to the systemic pollution problem. Thus, $100 billion may not just be the question; it may also be part of the answer. Conclusion We are at the start of a great debate on the future structure of finance, not the end. Some fear that momentum for radical financial reform will be lost. But financial crises leave a scar. This time’s sovereign scar should act as a lasting reminder of the criticality of reform. Today’s crisis has stretched some state’s sinews to the limit. Both literally and metaphorically, global finance cannot afford another. The history of banking is that risk expands to exhaust available resources. Tail risk is bigger in banking because it is created, not endowed. For that reason, it is possible that no amount of capital or liquidity may ever be quite enough. Profit incentives may place risk one step beyond regulation. That means banking reform may need to look beyond regulation to the underlying structure of finance if we are not to risk another sparrow toppling the dominos. Rich but fragile system Today’s financial structure is dense and complex, like a tropical rainforest. Like the rainforests, when it works well it is a source of richness. Yet it is, as events have shown, at the same time fragile. Simpler financial ecosystems offer the promise of greater robustness, at some cost in richness. In the light of a costly financial crisis, both eco-systems should be explored in seeking answers to the $100 billion question. • 119

Editor’s note The publisher and editor of The Journal of Regulation and Risk – North Asia, wish to thank Andrew G. Haldane, Executive Director, Financial Stability, Bank of England, for this weighty contribution to the Journal. Following his speech, delivered at the IRRNA’s March 30, 2010 meeting in Hong Kong, he had this to say: “I am grateful to Dele Adeleye, David Aikman, Marnoch Aston, Richard Davies, Colm Friel, Vaiva Katinaite, Sam Knott, Priya Kothari, Salina Ladha, Colin Miles, Rhiannon Sowerbutts and Aron Toth for their comments and contributions.“ References
1 For example, Reinhart and Rogoff (2009). 2 The levy on US banks announced by the US government in January takes the $100 billion loss and recoups it over 10 years rather than 20. 3 IMF (2009). 4 ibid 5 Haldane (2009a). 6 Using the end-year yield on the financial corporates bond index across the ratings spectrum. 7 For example, banks’ retail deposits are excluded, but unsecured wholesale borrowing is included. 8 Baker and McArthur (2009). 9 Basel Committee on Banking Supervision (2009). 10 For example, Brunnermeier et al (2009), NYU Stern School of Business (2009). 11 For example, Kay (2009), Kotlikoff (2010). 12 Stern (2006). 13 ibid 14 ibid 15 ibid 16 ibid 17 ibid 18 Beale et al (2009).

19 A Herfindahl-Hirschman index of revenue concentration is constructed to measure diversification, with a measure of zero meaning that the HHI = 1, i.e. revenue is concentrated solely on one activity. Revenue concentration is calculated across three buckets for the last pre-crisis year (2006) – Retail and commercial banking; corporate and investment banking; asset and wealth management. 20 De Nicolo (2000). 21 Haldane (2009b). 22 See, for example,Aikman et al (2010). 23 ibid 24 Korup and Clague (2009). 25 Haldane (2009a) discusses some of these strategies in greater detail and the payoffs they generate. 26 Kay (op.cit.) 27 Kotlikoff (2010). 28 Modigliani and Miller (1958). See also Miles (2009). 29 Mehra and Prescott (1985). 30 Barro (2006). 31 Santomero and Eckles (2000). 32 For example, Calomiris and Hubbard (1995). 33 Saunders (1996), Berger and Mester (1997). 34 Amel et al (2004). 35 For example, Berger and Humphrey (1997) based on a survey of more than 100 studies. 36 For example, De Long (2001). 37 Stiroh and Rumble (2006). 38 Laeven and Levine (2007); see also Schmid and Walter (2009) for recent US evidence. 39 Robinson (1934). 40 Christakis and Fowler (2009). 41 Dunbar (1993). 42 Washington Mutual, with assets of around $300 billion, was resolved by FDIC, but perceived by many to have caused systemic spillovers. 43 For example,Tucker (2010).


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Aikman, D, Barrett, P, Kapadia, S, King, M, Proudman, J, Taylor, T, de Weymarn, I, and T Yates (2010), Uncertainty in Macroeconomic Policy Making: Art or Science?, www.bankofengland.co.uk/publications/speeches/2010/speech432.pdf Amel, D, Barnes, C, Panetta, F and C Salleo (2004), ‘‘Consolidation and Efficiency in the Financial Sector: A Review of the International Evidence’’, Journal of Banking & Finance, vol. 28(10). Baker, D and T McArthur (2009), “The Value of the “Too Big to Fail” Big bank Subsidy”, Centre for Economic and Policy Research. Barro, R J (2006),“Rare Disasters and Asset Markets in the Twentieth Century”, Quarterly Journal of Economics, vol. 121(3), p.823-866. Barth, J R, Caprio Jr., and R Levine (2004), “Bank Supervision and Regulation: What Works Best?”, Journal of Financial Intermediation, vol. 13(2), p.205-248. Basel Committee on Banking Supervision (2009), Consultative Document: Strengthening the Resilience of the Banking Sector. Beale, N, Rand, D, Arinaminpathy, N and R M May (2009), Conflicts Between Individual and Systemic Risk in Banking and Other Systems, forthcoming. Berger, A and D Humphrey (1997), “Efficiency of financial institutions: international survey and directions for future research”, European Journal of Operational Research, vol. 98, p.175-212. Berger,A N and L J Mester (1997),“Inside the Black Box:What Explains Differences in the Efficiencies of Financial Institutions?”, Journal of Banking & Finance, vol. 21(7), p.895-947. Brunnermeier, M, Crockett,A, Goodhart, C, Persaud, A and H Shin (2009),“The Fundamental Principles of Financial Regulation”, ICMB-CEPR Geneva Report on the World Economy 11. Calomiris, C and G Hubbard (1995), “Tax Policy,

Internal Finance, and Investment: Evidence from the Undistributed Profits Tax of 1936-1937”, Journal of Business, vol. 68, p.443-482. Carlson, J M and J Doyle (1999), “Highly Optimized Tolerance:A Mechanism for Power Laws in Designed Systems’, Physical Review E, vol. 60(2), p.1412-1427. Chapman, J M and R B Westerfield (1942), Branch Banking, Harper & Brothers. Christakis, N A and J H Fowler (2009), Connected: The Surprising Power of Our Social Networks and How They Shape Our Lives, Little Brown and Company. DeLong, G L (2001), “Stockholder Gains From Focusing Versus Diversifying Bank Mergers”, Journal of Financial Economics, vol. 59, p. 221–252. De Nicolo, G (2000),“Size, CharterValue and Risk in Banking:An International Perspective,” International Finance Discussion Papers No.689, Board of Governors of the Federal Reserve System. Dunbar, R I M (1993), “Coevolution of Neocortical Size, Group Size and Language in Humans”, Behavioral and Brain Sciences, vol. 16(4), p.681-694. Freidman, M and A J Schwartz (1963), A Monetary History of the United States, 1867-1960, Princeton University Press. Haldane, A G (2009a), Banking on the State, www.bankofengland.co.uk/ publications/speeches/2009/speech409.pdf Haldane, A G (2009b), Rethinking the Financial Network, www.bankofengland.co.uk/publications/ speeches/2009/speech386.pdf IMF (2009), World Economic Outlook: Crisis and Recovery, www.imf.org/external/pubs/ft/ weo/2009/01/pdf/text.pdf Kay, J (2009), Narrow Banking: The Reform of Banking Regulation, Centre for the Study of Financial Innovation. Kelling, M J, Woolhouse, M E J, May, R M and B T Grenfell (2003), ‘Modelling Vaccination Strategies Against Foot-and-mouth Disease, Nature, vol. 421, p.136-142. Kennedy, S E (1973), The Banking Crisis of 1933,

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University Press of Kentucky. Korup, O and J J Clague (2009), “Natural Hazards, Extreme Events, and Mountain Topography”, Quaternary Science Reviews, vol. 28(11-12), p.977990. Kotlikoff, L J (2010), Jimmy Stewart is Dead: Ending the World’s Ongoing Financial Plague with Limited Purpose Banking, John Wiley and Sons. Laeven, L and R Levine (2007), “Is There a Diversification Discount in Financial Conglomerates?”, Journal of Financial Economics, vol. 85(2), p.331-367. Mehra, R and E C Prescott (1985), “The Equity Premium: A Puzzle”, Journal of Monetary Economics, vol. 15, p.145-161. Merton, R C (1973), “Theory of Rational Option Pricing”, Bell Journal of Economics and Management Science, vol. 4(1), p.141-183. Miles, D (2009), The Future Financial Landscape, www.bankofengland. co.uk/publications/speeches/2009/speech418.pdf Modigliani, F and M Miller (1958), “The Cost of Capital, Corporation Finance and the Theory of Investment”, American Economic Review, vol. 48(3). NYU Stern School of Business (2009), Restoring Financial Stability: How to Repair a Failed System, John Wiley & Sons. Reinhart, C M and K Rogoff (2009), This Time is Different: Eight Centuries of Financial Folly, Princeton University Press. Robinson, A (1934), “The Problem of Management

and the Size of Firms”, The Economic Journal, vol. 44(174), p/242-257. Santomero, A M and D L Eckles (2000), “The Determinants of Success in the New Financial Services Environment: Now That Firms Can Do Everything, What Should They Do and Why Should Regulators Care?”, Federal Reserve Bank of New York Economic Policy Review (October), vol. 6(4), p.11-23. Saunders,A (1996),Financial Institutions Management: A Modern Perspective, Irwin Professional Publishing. Schmid, M M and I Walter (2009), “Do Financial Conglomerates Create or Destroy Economic Value?”, Journal of Financial Intermediation, vol. 18(2), p.193-216. Stern, N (2006), Stern Review on the Economics of Climate Change, Cabinet Office-HM Treasury, www. hm-treasury.gov.uk/sternreview_index.htm Stiroh, K and A Rumble (2006), “The Dark Side of Diversification: the Case of US Financial Holding Companies”, Journal of Banking and Finance, Vol.80, p.2131-2161. Tucker, P (2010), Resolution of Large and Complex Financial Institutions: The Big Issues, available at – http://www.bankofengland.co.uk/publications/ speeches/2010/speech431.pdf Weitzman, M L (1974),“Prices vs. Quantities”, Review of Economic Studies, vol. 41, p.477-91.

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Journal of Regulation & Risk North Asia

Risk management

Economists’ hubris informed the financial tsunami of 2008
Capco’s Shahin Shojai & Contango’s George Feiger call for a fundamental rethink on attitudes to risk management.
in this paper, the authors look at the shortcomings of academic thinking on financial risk management – a very topical subject. economists have drifted into realms of sterile, quasi-mathematical and a priori theorising instead of coming to grips with the realities of their subject. in this sense, they have stood conventional scientific methodology, which develops theories to explain facts and tests them by their ability to predict, on its head. Not surprisingly this behaviour has carried over to the field of risk management, with an added twist. Like the joke about the man who looks for his dropped keys under the street light because that is where the light is rather than where he dropped the keys, financial economists have focused on things that they can ‘quantify’ rather than on things that actually matter. The latter include the structure of the financial system, the behaviour of its participants, and its actual ability to capture and aggregate information. The recent (and indeed on-going) financial crisis has made it clear that every Journal of Regulation & Risk North Asia participant in the financial system, from the individual investor through banks and brokers up to central banks, needs to think of a three-level analysis of risk: 1. At the level of the individual financial instrument; 2. at the level of a financial institution holding diverse instruments; 3. at the level of the system of financial institutions. A financial instrument might be a credit card or a residential mortgage or a small business loan. In the US, risks in many such instruments have been intensively studied and have proven moderately predictable in large pools. For example, a useful rule of thumb is to equate the default rate on national pools of seasoned credit card balances to the national unemployment rate. A financial institution holding a diverse portfolio of such instruments might be a bank that originates them and retains all or some, or an investing institution like a pension fund or a hedge fund or an insurance company (or, indeed, an individual investor with a personal portfolio). The system of financial institutions is the 123

total of these individual players, in particular, embracing the diverse obligations of each to the others. Academic approach A bank may have loaned unneeded overnight cash to another bank or it may have borrowed to fund its portfolio of tradable securities by overnight repurchase agreements; a hedge fund may have borrowed to leverage a pool of securities; an insurance company may have guaranteed another institution’s debt, backing that guarantee by pledging part of its own holding of securities; and an individual may have guaranteed a bank loan to his small business by pledging a real estate investment, itself leveraged by a mortgage. We would summarise the academic approach to risk management (enthusiastically adopted by the financial institutions themselves) as the sum of the following propositions: 1. The risks of individual financial instruments follow a stationary probability distribution; 2. the enterprise risk of a financial institution is measured by treating the institution as the portfolio of the individual instruments that it holds; 3. as markets price instruments rationally, there are really no systemic risk issues not captured in the pricing of assets. Unfortunately, recent events have shown each of these propositions to be false. Stationarity of instrument risks This is the foundation of all risk management modelling. As anyone who has tried to model instrument risks knows, they are not 124

stationary but depend on the sample period chosen, a simple fact that we will return to again and again. This non-stationarity is not simply an empirical observation; it is endogenous to the way that markets operate. The recent crisis has highlighted one fundamental cause, namely moral hazard in the securitization process, and it is worth examining this in detail. The statistics on mortgage defaults and losses were derived from one particular era in mortgage lending, when lending banks retained on their balance sheets the loans that they made. Because of this, the originators were obliged to work hard to understand the financial prospects of their borrowers at the time of origination and to closely monitor the portfolio thereafter. Enter securitisation The development of securitisation allowed originators to package mortgages and sell them, all risks included, to third-party investors who had no detailed knowledge of the mortgage business or the borrowers. To mitigate this lack of knowledge, a class of “risk evaluation intermediaries,” otherwise known as the rating agencies, stepped in. Their method of risk mitigation was to create diversified pools of loans, basing diversification on loss statistics from the previous world of retained risk. The banks and other originators were transformed from risk-aware lenders to financial engineers of mortgages. Their income no longer came from borrowing spreads less any loss experienced as a result of defaults, but strictly from fees from manufacturing mortgage pools. Is it any wonder that the quality of underwriting deteriorated, Journal of Regulation & Risk North Asia

and in a way that was hard to detect for some time? Ratings agencies blind The rating agencies never had access to the underlying borrowers and so could not assess their true state of health. That information was not even with the originators, who had stopped caring about collecting that kind of information when they started selling the mortgages to other investors [Keys et al. (2010)]. So, the rating agencies had to use history to rate these instruments, or the credit quality of any insurer who had provided credit enhancement to the security [Fabozzi and Kothari (2007)]. Neither the credit enhancer nor the rating agency had any idea about the underlying quality of the borrowers. Add to that the moral hazard of the rating agencies, which supplied ratings for the bond buyers but were paid by the bond originators. Hence the “actual risk statistics” of the resulting mortgage-backed securities systematically deteriorated relative to those of the earlier era. Housing bubble Consequently, all that was needed to bring the house of cards down was a correction in house prices, which is exactly what happened. (The house prices were grossly inflated by the system-wide credit bubble that the risk management modellers did not see, but we will address that below.) The academic approach to modelling enterprise risk is to assume a stationary distribution of the correlations among the instruments and to model the institution as the portfolio of the instruments that it holds. Journal of Regulation & Risk North Asia

As anyone who has attempted to estimate the variance/covariance matrices of financial instruments knows, these distributions vary markedly according to the sample period chosen for estimation. Therefore, the statistically trained have used various weighting schemes to create ‘more relevant’ data; for example, weighting recent data more heavily than older data using some distributed lag scheme. A more productive approach would be to recognise that these correlations are not stationary because, again, of the way that markets evolve. Endogenous causes We can give three examples of these endogenous causes: 1. Real economic‘causation’; 2. ‘convergence of trading behaviour’ in the financial system we have created; 3. adherence to false notions of ‘market efficiency,’which causes neglect of credit-fuelled valuation bubbles. Let us start with causation. Unlike the predictably random movements of electrons in an atom, economic events sometimes have causes that bare rather sharply on the correlation among instruments. It is easy to give a practical illustration. Some time ago, one of the authors had a client with what was, supposedly, a welldiversified portfolio – equities, bonds, real estate, and even some direct business interests. Unfortunately, all the investments were located in or were claims on businesses in Houston, Texas. When the price of oil collapsed, so did the value of the portfolio.There was a common causal factor in the returns of each part of this specific portfolio. 125

It would have been difficult, but not impossible, to have calculated beforehand the variance/covariance matrix of returns in Houston conditional on the price of oil, or of returns in the Midwest conditional on the health of General Motors – let alone to then create the probability distribution of the fate of these causal factors. Certainly this was not done for the loss factors for portfolios of mortgages originating in, say, Las Vegas during the boom. Consider now convergence of trading behaviour. Correlations of returns of assets like European and US and emerging stock indices, various commodities and the like have been highly variable but clearly rising over the past 15 years [Ned Davis Research]. Chasing the same returns A combination of deregulation of global capital flows, development of sophisticated capital market intermediaries operating globally, and data and trading technology have enabled more and more money to be placed on the same bets at the same time. And so it is. Harvard and Yale used to be virtually unique among institutions for investing heavily in timberland and private equity and hedge strategies. Now everyone is doing it and the returns are falling while the volatility and the correlations are rising. And consider finally credit-fuelled valuation bubbles. As we have demonstrated [Feiger and Shojai, 2009], asset markets do not price efficiently, no matter what your professor said in business school. Reinhardt and Rogoff (2009) have demonstrated that for centuries, valuation bubbles funded by excess credit creation have occurred in 126

all economies for which we have decent records. Efficiency of markets Why do investors not simply recognise these and “trade them away,” as the efficient markets hypothesis would imply? It is not so easy, because while the bubbles are‘obvious,’ when they will burst is not. Smithers (2009) explains this in eloquent terms. However, if you think about it, had you started shorting the tech bubble aggressively in 1998 you would have been bankrupt well before the end. As Keynes said, the markets can remain irrational longer than you can remain solvent. Real estate, we might say, is an asset worth what someone will lend you to buy it. When the lenders thought that real estate prices would always go up, they lent freely and the price of real estate was pushed up by the buyers. When credit availability collapsed with the balance sheets of the banks, real estate prices fell along with every other leveraged asset. The correlations went toward one. Modelling systemic risk Once we acknowledge that valuations can undershoot and overshoot, we can explain systemic risk that is, essentially, broad loss of liquidity in most assets. Why pay more for something today than it is likely to be worth tomorrow? Consider the example of the collateralised loan obligation (CLO) market in 2008. Several hundred billion dollars of corporate loans were held in CLOs on the largely invisible books of offshore hedge funds and underwriting institutions (via Journal of Regulation & Risk North Asia

off-balance-sheet vehicles), in structures leveraged 20 times and more. The leverage came from major banks and insurance companies that, we should remember, devoted the bulk of their other business activities to making loans to entities like companies and real estate developers and to each other. They in turn raised their liabilities by issuing bonds and commercial paper to pension funds, insurance companies, mutual funds and individuals. As panic spread about the falling value of collateralised debt obligations (CDOs) backed by mortgages, some of the loans in the CLOs started falling in price in secondary trading (the market making provided by the same banks that were providing the leverage to the CLO holders and the CDO holders). Deleverage spiral This precipitated margin calls on the holders that they could not all meet. With leverage of 20 times, falling loan prices meant that a fund’s equity could quickly disappear so the only recourse was to dump loans and deleverage as quickly as possible. We sat at our Bloomberg screens in amazement as blocks of hundreds of millions or billions of loans were thrown out for whatever bid they could get. Would you have bought at that time, even if you thought that almost all of the loans were ultimately money-good, as we indeed did think? Of course not, because in the panic it was certain that the prices would fall further, which they did. Normally the market makers would buy bargains but they were providing the leverage – and they were holding trading inventories that were tumbling in price. So Journal of Regulation & Risk North Asia

they withdrew the leverage and reduced their inventories and so forced prices down further. Credit losses This killed the hedge funds but also inflicted losses on other holders, including their own balance sheets, and created credit losses on the loans extended to the leveraged CLO holders. Now the banks were in trouble themselves. So they dried up the interbank lending market, essential for liquidity in the world trading system, and their commercial paper appeared risky and fell in price, damaging the money market fund industry that held a large part of liquid assets in the US. We need not elaborate on this history, but you can see why the stationary variance/covariance matrix of the enterprise risk management models did not turn out to be relevant. And, consequently, why the core of academic work on risk management did not turn out to be relevant. And indeed, how insidious the concept of market efficiency has been in blinding market participants to the nature of real risk by implying that it has already been priced in to all assets as well as it can be. Implications for ‘value at risk’ We have not explicitly referred to value at risk (VaR) until now, although it is the universal tool used for enterprise risk management. It is, of course, a product of that view that the enterprise is the portfolio of the instruments it holds and all the issues we have addressed above. Specifically, VaR is an attempt to “represent”the maximum loss that a firm is likely to accept within specified parameters, 127

usually expressed as a confidence interval over a set time horizon. If we use a 95 per cent confidence interval and the firm’s portfolio of investments is estimated to have a one-day five per cent VaR of $100 million, there is said to be a five per cent probability that the portfolio would fall in value by more than $100 million over a one-day period; in other words, a loss of $100 million or more on this portfolio is expected on one day in 20. We have spent the bulk of our effort to this point showing the difficulty in the key clause “is estimated to have”and will dwell on this no further. It is important, however, to explore a number of other problems with concepts likeVaR even if we could do a far better job of estimating conditional probability distributions of outcomes. Role of collateral and incentives These derive primarily from deep problems in the capture and aggregation of information, and we address these below. We wish first to apply our concept of endogenous evolution of market risk to two tools that the same economic theory that gave us VaR tells us can act as risk mitigators: collateralised central clearing and alteration of the incentives of market participants. Collateral, whether in the hands of a central counterparty or put up over the counter against individual transactions (the equity cushion in all those leveraged CLOs), is claimed to allow the system to absorb unanticipated shocks. That may be, but the question is, how much collateral is enough? Here we come back to the stationary joint probability distribution of asset prices, which defines the likely magnitude of these 128

unanticipated shocks, and we can start over with the arguments with which we began this paper. Systemic risk syndrome On reflection, systemic risk renders collateral least helpful when you need it most. Think of something as simple as a mortgage on a house. The collateral is the down payment, which is the lender’s cushion against default. If your house goes on the market in ‘normal times,’say because of a divorce, all will be fine and the lender is likely to recoup his loan. If a real estate bubble has collapsed and every house on your block is for sale, the cushion is non-existent. This is not an easy problem to solve. Smithers (2009) proposes dynamic collateral requirements driven by rules on market value versus ‘true value’ and provides compelling evidence for the existence of techniques for estimating the ‘true value’ well enough for purposes of setting collateral and capital cushions. Incentives conundrum Let us now turn to incentives, particularly the notion that if incentives are paid in deferred common stock of the originators, there will be a much lower likelihood of moral hazard driving endogenous changes in risk. We believe that such attempts will fail the test of practical reality because they are not compatible with the way we have organised our financial markets. They are incompatible with a free market for talent. Institutions that attempt long deferral of incentive payments into restricted vehicles will experience loss of their highest performers to institutions that do not do this. Journal of Regulation & Risk North Asia

You can see this happening right now on Wall Street. The way in which we choose to measure corporate performance encourages the opposite, namely short-term risk taking for near-term results. We measure results quarterly and annually even though the economic cycle takes place over years, not quarters. Who doubts that any financial institution CEO who dropped out of playing in late 2006 would have lost his job and his key staff long before the markets collapsed? Is this not the meaning of the infamous remark by Chuck Prince, former CEO of Citi, that“as long as the music is playing we have to dance.” The proposed holding periods for the restricted incentive payments are always some calendar interval. The economy does not oblige by revealing the implications of systemic risk provoking actions like credit bubbles over short periods. Deep operational problems To this point we have explained the defects of current economic models of risk management in terms of their inability to grasp the endogenous nature of the development of risks and the interconnection of risks across institutions. These are, in essence, issues that arise in asset valuation. The discussion has assumed that individual institutions know their own holdings and cross-obligations and seek to draw inferences about the risks that they are thereby incurring. In fact, for the particular problem of risk management, we need to understand that it is highly unlikely that any institution of significant size is even at this starting position – of knowing where it actually stands at Journal of Regulation & Risk North Asia

any moment. This uncertainty at the foundation derives from limitations likely in both human behaviour and IT. ERM rational The human behaviour issue is easy to understand. There is a lot of employee compensation at stake in the measurement and management of risk, because the entire purpose of enterprise risk management is to attempt to limit the size of the risks that the enterprise takes. And that means limiting the size of the gambles on which the members of the enterprise get paid. While academic literature does account for personal greed, and a number of papers have been written on the subject by Michael Jensen and his many colleagues and students of the subject [Jensen and Meckling (1976)], it is usually overlooked when it comes to subjects that deal with anything other than corporate finance. For some reason, there is an assumption that, just like investors all behave rationally, individuals are also mostly honest when they assess the risks that they take. Financial executives certainly have the motivation to reduce the allocation of risk to their activities if their compensation takes the form of an option on the bank; that is, if they share in the gains and not the losses. Underestimated risk profiles Given the complexity of modelling many of the instruments that financial institutions are dealing with, it is only natural that they will be collecting underestimated risk profiles from the traders and financial engineers. Moreover, their supervisors, the management, know that if the bank gets close 129

to failure, the government will probably bail it out if it is important enough to the local economy or the globe. The IT limitations are a consequence of the organisational and operational structures of all but the smallest financial institutions. Financial institutions of any size and complexity are typically managed in a variety of silos that report what they do in a variety of incompatible ways. As a result, most institutions have major difficulties in aggregating the risks of their credit and market instruments, let alone the firm’s operational or liquidity risks. Data overload For example, many institutions combine credit and foreign exchange instruments within the same divisions, while others keep them separate. Some combine structured instruments with the fixed-income division, others with equities. In some firms foreign exchange, credit, and equities each have their own analytical teams, who compete rather than co-operate, and who are different, in turn, from the analytical team working for the CFO. An even more basic problem is that there is just too much information to deal with. Risk management teams face a hosepipe of data that they have to decipher, and its contents change with every trade. Today, very few financial institutions of any size have not undergone a series of mergers or acquisitions, with the pace increasing over the past decade. Indeed, the current financial crisis has resulted in the forced merger of very large institutions, themselves layers of technically incompatible accounting systems. 130

The result is a spaghetti-like infrastructure of protocols and technologies that are simply unable to communicate with one another [Dizdarevic and Shojai (2004)]. Incompatible systems make the development of viable enterprise-wide risk management close to impossible. Sadly, our practical experience shows that this situation will persist for many years to come. Despite the huge annual investments made by major financial institutions, different systems supporting different instruments are simply unable to share information in any meaningful way. This means that no matter how remarkable insightful conceptual risk models may be, the data that they will be dealing with will remain seriously inadequate. Not to panic! We realise that these are depressing conclusions. The appropriate response is not to despair of doing anything, however, but to recognise that what we need to do must be seen in the light of the very large conceptual and practical limitations to enterprise or systemic risk management that we have explained. For our part, we draw the following conclusions: Quantitative modelling must be seen as research rather an as an actionable management tool. Management judgment and common sense must take the front seat rather than the back seat. The reverse seating arrangement brought us to where we are today. Because the knowledge to second-guess business decisions is hard to acquire, we must make the motivations work for rather than against risk limitation. Subtle ways Journal of Regulation & Risk North Asia

require analysis that we cannot yet undertake. Hence we need to resort to cruder tools such as preventing risk transfer from risk originators via securitisation. Another fundamental tool is limitation of leverage in all forms of transactions, no matter what the models say. Clever deferred compensation and restricted stock schemes are too easy to game. Moreover, non-regulated entities like hedge funds will always escape these nets. The first steps above will reduce the (falsely measured) profitability of risk taking in regulated financial institutions enough to automatically limit compensation. We must recognise that not everything can be regulated and, more important, financial transactions slip away from the regulated sector. By late 2007, more credit was provided to the US economy from securitisation than from the deposit-taking banking sector. Systemic risk will always be able to arise from the unregulated sector, for the reasons we have developed in this paper. So far there don’t appear to be any very effective solutions for this problem. • References
Boudoukh, J., M. Richardson, and R. Stanton, 1997, “Pricing mortgage-backed securities in a multi-factor interest rate environment: a multivariate density estimation approach,” Review of Financial Studies, 10, Dizdarevic, P., and S. Shojai, 2004, “Integrated data architecture – the end game,” Journal of Financial Transformation, 11, 62-65 Fabozzi, F. J., and V. Kothari, 2007, Securitization the tool of financial transformation,” Journal of Financial Transformation, 20, 33-45 Fragnière, E., J. Gondzio, N. S. Tuchschmid, and Q. Zhang, forthcoming 2010, “Non-parametric liquid-

ity-adjusted VaR model: a stochastic programming approach”, Journal of Financial Transformation Hand, D. J., and G. Blunt, 2009, “Estimating the iceberg how much fraud is there in the U.K.,” Journal of Financial Transformation, 25, 19-29 Hand, D. J., and K.Yu, 2009,“Justifying adverse actions with new scorecard technologies,” Journal of Financial Transformation, 26, 13-17 Hunter, G.W., 2009, “Anatomy of the 2008 financial crisis: an economic analysis post-mortem,” Journal of Financial Transformation, 27, 45-48 Jacobs, B. I., 2009, “Tumbling tower of Babel: subprime securitization and the credit crisis,” Financial Analysts Journal, 66:2, 17 – 31 Jensen. M. C., and W. H. Meckling, 1976, “Theory of the firm: managerial behavior, agency costs and ownership structure,” Journal of Financial Economics, 3:4, 305-360 Jorion, P., 2006, Value at Risk: the new benchmark for managing financial risk, 3rd ed. McGraw-Hill Keys, B. J.,T. Mukherjee, A. Seru, and V.Vig, 2010, “Did securitization lead to lax screening? Evidence from subprime loans,” Quarterly Journal of Economics, forthcoming. Kuester, K., S. Mittnik, and M. S. Paolella, 2006,“Valueat-Risk prediction: a comparison of alternative strategies,” Journal of Financial Econometrics, 4:1, 53-89 Markowitz, H., 1952, “Portfolio selection,” Journal of Finance, 7:1, 77-91 Reinhart, C. M., and K. Rogoff, 2009,This time is different: eight centuries of financial folly, Princeton University Press Shojai, S., 2009, “Economists’ hubris - the case of mergers and acquisitions,” Journal of FinancialTransformation, 26, 4-12 Shojai, S., and G. Feiger, 2009,“Economists’ hubris: the case of asset pricing,” Journal of Financial Transformation, 27, 9-13 Smithers, A., 2009, Wall Street revalued: imperfect markets and inept central bank.

Journal of Regulation & Risk North Asia


Risk management

‘Walker Review’ heralds new dawn in risk management
PRMIA’s David Millar enthuses over recent developments in boardroom responsibilities towards new risk culture.
risk management has been the topic on everyone’s lips since late 2007. Why did risk management practices not prevent the “credit crunch”? What could have been done better? The simple answer is that, whilst risk management was being applied at the lower levels of financial institutions, it was being largely ignored at the top level. Tools and techniques could have been better, and are being improved, but there is no point installing an expensive security alarm system, then switching off the bell because it keeps going off; that makes too much noise and spoils your partying! Regulators and governments are now realising this and, worldwide, are formulating rules, restrictions and regulations which are forcing senior individuals in banks, i.e. executive and non-executive board members, to understand the risk messages. Does the current generation of board members have the knowledge, the capacity, the training to both manage the alarm system and to assure the regulator, the visiting policeman that, yes, they fully understand Journal of Regulation & Risk North Asia the messages and are acting accordingly to minimise any risky practices? The ‘Walker Review’ In July last year the UK Treasury released the ‘Walker Review’. This went for preliminary public response and was re-released in November. In January the FSA (the UK regulator), released a discussion paper based on the Walker Review. Comments were closed on April 28 and Prudential Handbook rule changes are expected in Q3 2010. The UK’s Financial Reporting Council (FRC) consulted on whether to include the Walker recommendations in the Combined Code on Corporate Governance (Combined Code) for all UK listed companies. Feedback closed in March and recommendations are expected in Q3. I have approached this article from the point of view of risk in financial institutions. However, the relevant responsibilities of non-executive directors in all organisations – financial or non-financial, commercial or not-for-profit, can be said to revolve around two issues, these being: the risks involved in carrying out their necessary activities; and 133

the risks involved in acquiring and maintaining the necessary funds to perform these activities. I expect that many, if not all, of the recommendations of the Walker Review will be incorporated into the Combined Code and will therefore be applied to all UK listed companies. Firms that are not listed (charities, trusts and private companies) will not be affected by the Combined Code but it would be expected that their directors should abide by its general principles and therefore much of the Walker Review contents. Risk in today’s environment Risk management is also now widely accepted in all areas of business, and is acknowledged as the most creative force in the world’s financial markets. This trend was summed up by Alan Greenspan, chairman of the US Federal Reserve Board: “The development of our paradigms for containing risk has emphasised dispersion of risk to those willing, and presumably able, to bear it. If risk is properly dispersed, shocks to the overall economic system will be better absorbed and less likely to create cascading failures that could threaten financial stability.” However, the past decade has seen many major, significant and embarrassing failures of risk management and risk management has demonstrably not been able to prevent these and their resulting company failures, investor losses and market disruptions. How many of these failures are a result of deficiencies in risk management practices and how many are breakdowns in the corporate governance of the risk management process? 134

“Sophisticated financial engineering, supplied by the banking, securities, and insurance industries, also played a role in covering up the true economic condition of poorly run companies during the equity markets’ millennial boom and bust. Alongside rather simpler accounting mistakes and ruses, this type of financial engineering was one reason that some of these companies violently imploded after years of false success (rather than simply fading away or being taken over at an earlier point).” We live in a world where risk and reward has become the focus of activities and where we have developed ever-improving, and ever more complex, models to maximise the reward and control the risk. We need to make sure that the governance of institutions using these practices is as efficient and effective as the risk models and frameworks claim to be. Organisations can be said to incur many types of risk: strategic risk, market risk, operational risk, etc. However for this paper it is convenient to divide all risks into two groups: financial risk and non-financial risk. Financial risk All organisations require funds (capital) in order to function. Non-financial producers need capital to fund their manufacturing or creative activities; charities will accumulate funds in order to perform their charitable activities. In all cases these funds will need to be protected against market fluctuations (currency and interest rate risks) or invested to protect them against inflation (investment risks including the risks involved in lending to other parties). Financial firms (lenders, traders, brokers, Journal of Regulation & Risk North Asia

etc) have additional transactional risks in their operations as they balance risk against financial return on their capital. The main parameters involved in financial risk management are the probability of loss and the likely amount of loss, together with the financial measurements involved: currency and interest rates, etc. Financial risk differs from non-financial risk as there generally is an up-side (changes in circumstances can increase the value of a portfolio) as well as a down-side (portfolio losses due to market changes). Non-financial risk Non-financial risk rarely has an up-side (although an error is processing can occasionally result in a positive impact, this is not through intention). Here the main parameters in risk management are probability of loss, estimated amount of loss and the cost of mitigation against loss. All organisations can suffer from nonfinancial risks. These will include issues such as the health and safety of employees; losses through theft, fraud, malpractice, etc; incompetence and inadequacy in persons, systems and processes; natural disasters; and many other issues. Board responsibilities The main responsibility of the board of any company is to look after the interests of shareholders. This usually means to balance the risk of any business activity and against the expected returns to the company. The board also needs to take into account the interests of other stakeholders such as holders of corporate debt in the company. Debt holders also have a major interest as the Journal of Regulation & Risk North Asia

company’s activities impact the probability of their debt being repaid. How likely is it that the risk of a particular activity could result in that company becoming insolvent? As part of these activities, the board also needs to monitor the activities and interests of the managers of the company; also stakeholders, to ensure that their activities do not compromise the interests of share and debt holders – for example the taking on of risk for personal benefit, financial or otherwise, of the company’s executive officers and managers. This situation can also be extended to the boards of organisations such as charities and charitable trusts. Do the risks taken increase the ability of the organisation to carry out its charitable remit? Could the risks taken damage the charity so that it is unable to continue effectively? Risk transparency The board must ensure that it sets and governs the business strategy and understands the fundamental risks and rewards that this implies and that, by effective internal and external disclosure, it provides transparency of those risks to managers and stakeholders. The board is not there to manage the business – but it is responsible for overseeing and holding accountable the management. It may not develop the overall strategic plan for the company, but it is responsible for approving it. It must understand how the proposed strategy could impact business opportunities, reputation and partnerships. In this, all risks need to be understood and decisions taken on what is acceptable – this is the“risk appetite”for the company. The board should understand all 135

significant risks, including aggregated risks and classify these under the four basic choices in risk management: 1.) Avoid risk by choosing not to undertake some activities; 2.) Transfer risk to third parties through insurance, hedging and outsourcing; 3.) Mitigate risk, such as operational risk, through preventive and detective control measures; 4.) Accept risk, recognising that undertaking certain risky activities should generate shareholder value. Effective risk culture As part of its risk governance responsibilities, the board must ensure that the company has in place an effective risk management culture that is consistent with the above strategic and risk appetite decisions. Furthermore, the board must ensure that there are effective procedures in place for identifying, assessing and managing all types of risk, i.e. business risk, operational risk, market risk, liquidity risk and credit risk. This includes making sure that all the appropriate policies, methodologies and infrastructure are in place. The infrastructure includes both operating elements (e.g., sophisticated software, hardware, data and operational processes) and personnel. The board needs to ensure that its information on risk management is timely and accurate. It should be sufficiently informed to question risks and to obtain support from external sources to assist in this questioning. Risk committees and officers The above are the overall objectives of risk governance. The best way to put these into action is through supporting bodies to the board, the risk officers and the risk 136

committees. These, the audit and the risk management committees, ratify the key policies and associated procedures of the bank’s risk management activities. The audit committee monitors the risk committee and reports on its effectiveness. My thanks to the authors of the Essentials of Risk Management for much of this section. The risk management committee of the board, not to be confused with the executive risk management committee, is responsible for independently reviewing the identification, measurement, monitoring, and controlling of risks, including the adequacy of policy guidelines and systems. The committee also helps to translate the overall risk appetite, approved by the board, into a set of limits that descend through the executive officers and business divisions. The risk management committee reports back to the board on a variety of items, such as all loans and/or credits over a specified limit that are special, or being made to related parties (e.g., bank officers). The audit committee The risk management committee also monitors credit and securities portfolios, including major trends in credit, market and liquidity risk levels, portfolio composition, and industry breakdowns. This committee also typically provides opportunities for separate, direct and private communication with the chief inspector, the external auditors, and the management committee. The role of the audit committee of the board is critical to the board’s oversight of any organisation. The audit committee is responsible not only for the accuracy of financial and regulatory reporting, but also Journal of Regulation & Risk North Asia

for ensuring that the organisation complies with minimum or best-practice standards in other key activities, such as regulatory, legal, compliance, and risk management activities. To function properly, an audit committee needs members with the right mix of knowledge, judgment, independence, integrity, inquisitiveness, and commitment. In most organisations, a non-executive director leads the audit committee, and most members are non-executives. The audit committee also needs to establish an appropriate interaction with management – independent, but productive, and with all the necessary lines of communication kept open. Risk advisory director The audit committee also needs to be clear about the reporting and risk management elements of governance that it oversees on behalf of the board. For example, these might include financial reporting, operational effectiveness, and efficiency as well as compliance with laws and regulations. It is not likely that all board members will have the skills that will allow them to determine the financial condition of a complex risk-taking corporation such as a bank (or an insurance company, or an energy company). Obfuscation This is especially likely if the selection of non-executives on the board is designed to include non-executives who come from outside the firm’s industry and are truly independent of the corporation. This is a problem because many of the recent corporate governance scandals have shown that it is easy for executives to bamboozle non-executives Journal of Regulation & Risk North Asia

who lack the skills to ask probing questions, or to understand the answers to these questions in a rigorous manner. There are various ways to square this circle, but they all come back to the board’s establishing some kind of support for interpreting information about risk and risk processes that is independent of the senior executive team. Importance of advisory roles One approach is for the board to gain the support of a specialist risk advisory director, that is, a member of the board (not necessarily a voting member) who specialises in risk matters. An advisory director works to improve the overall efficiency and effectiveness of the senior risk committees and the audit committee, as well as the independence and quality of risk oversight by the main board. The concerns of such a director could be: Participate in audit committee meetings to support members; participate periodically in key risk committee meetings to provide independent commentary on executive risk reporting; meet regularly with key members of management; and, observe the conduct of business. A key goal of the advisory director would be an ongoing examination of the interface between corporate governance and risk management in terms of risk policies, methodologies and infrastructure. Chief risk officer The Chief Risk Officer (CRO) is responsible for the management of the risk management infrastructure. He develops the risk appetite of the organisation (working 137

with the executive risk managers and committees) and proposes this to the Board Risk Committee. He then implements this, throughout the organisation, through the risk management infrastructure. He ensures that reporting of risk and governance-related matters is produced in a timely and accurate manner. ‘Approved person’ status The tenure and independence of the CRO should be underpinned by a provision that removal from office would require the prior agreement of the board. In certain countries, for example the UK, the CRO is already an “approved person”and subject to review and approval by the regulator. Risk governance, both financial and non-financial, is a key facet of any organisation, whether it is financial or non-financial, private or share-owned, commercial or notfor-profit. Not only is it key to the success and very continuation of these organisations, it is required by regulation, by investors (or, in the case of a not-for-profit, those donating) and by the public. Failure to demonstrate risk management, at all levels of the organisation, will result in its self-fulfilling failure. Top-down approach Risk management starts at the top of an organisation (the phrase “tone at the top” is now commonly used) and the objective is to create a sound “risk culture” within that organisation (and externally with its partners, suppliers and counterparties). The primary instrument for the creation of that culture is the board of directors, and it is the function of the non-executive directors to ensure that the board is complying with its obligations. 138

To this end, both executive and nonexecutive directors need to have an adequate understanding of both financial and nonfinancial risk management as it pertains to their industry; and a subset of the Board, the Risk Management Committee and the Risk Advisory Director, need to have sufficient knowledge and experience to pro-actively review, comment on, and guide the risk management practices of the organisation. Failure to do so would be an abrogation of the board’s fiduciary duties. Know your ‘risk’ . . . or else Directors of boards will be measured on their ability to ensure that the organisations they supervise have robust risk frameworks, have a pervasive risk culture and that all decisions are taken with risk impacts being considered. Non-executive directors are appointed to ensure that the boards carry out these obligations effectively and conscientiously. The modern non-executive director requires advice on, expertise in and understanding of risk management to ensure that the non-executive function is successfully performed. Without this the business is at risk and the attention of regulators, analysts and shareholders will result in adverse reputational, rating and share price impacts on the company. Executive directors on boards now know that they need both the risk knowledge and risk infrastructure to satisfy the demands of running a risk managed company. Board directors have experienced increasing responsibilities of the past years. Now risk management expertise and involvement has been added to these responsibilities by stint of law. • Journal of Regulation & Risk North Asia

Banking crisis

Ideas have consequences: the importance of ‘narrative’
Peter J. Wallison of the American Enterprise Institute argues that Bear Stearns’ rescue and Lehman’s failure were poison chalices.
there is substantial evidence that the cause of the financial crisis was nothing more complicated than a buildup of weak and high–risk mortgages in the us financial system – mostly the result of us government policy to expand home ownership.[1] too little regulation was not a major factor. under these circumstances, substantial changes in us government housing policy – particularly with respect to fannie Mae and freddie Mac – would have been the most effective way to prevent a recurrence of financial crisis. Yet the debate over financial regulation in Congress became a contest between those who want the government to have more control of the financial system and those who want it to have less. Considering the legislation that came out of both houses, the United States is well on its way to taking down the most innovative and successful financial system the world has ever known. This happened because an erroneous idea – that large, non–bank financial institutions are too “interconnected” to fail – initially adopted by the Bush administration as Journal of Regulation & Risk North Asia the rationale for the rescue of Bear Stearns, evolved into the narrative for explaining the chaos that followed Lehman’s collapse. With this narrative generally accepted, the Obama administration’s regulatory plan inevitably followed. In his bestselling book, The Big Short, Michael Lewis begins his description of the derivatives market with this quote from Leo Tolstoy: “The most difficult subjects can be explained to the most slow– witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him.”[2] Power of narrative Although Lewis did not cite it for this purpose, Tolstoy’s remark is a perfect description of the power of narrative in the modern day. Once a narrative about a public issue becomes accepted, it is virtually impossible to change; facts that support it are reported by the media, but contrary facts are ignored. So it has been with the notion 139

that large, non-bank financial institutions like Bear Stearns, Lehman Brothers, and American International Group (AIG) cannot be allowed to fail – that is, declare ordinary bankruptcy – because their “interconnections” with other financial institutions will drag the others down. Bear Stearns: ‘a narrative’ There is literally no evidence for this notion other than government statements that it is so, yet the claim – first advanced to justify the rescue of Bear Stearns – has evolved into the conceptual foundation for the regulatory regime developed by the Obama Administration, passed by the House of Representatives, and now adopted in the Senate. This Outlook is about how this narrative was formed and how it has influenced policy even though it has no basis in fact. The narrative’s roots are entwined with the rescue of Bear Stearns, which involved a government-assisted sale of the company to JP Morgan Chase in March 2008. In recent public testimony before the Financial Crisis Inquiry Commission (FCIC), Christopher Cox, chairman of the Securities and Exchange Commission (SEC) in 2008, noted that during the week prior to its rescue, Bear – with over 10 per cent capital under the Basel II standards that the SEC applied – was solvent and well capitalised.[3] Not insolvent Bear’s top management testified in the same hearing that while the firm had lost money in the last quarter of 2007, it would have reported a profit in the first quarter of 2008 if it had not been taken over.[4] These claims need not be taken entirely 140

at face value. It is possible that the firm’s capital had been eroded by the time it was rescued on March 14, and the firm certainly would have been worth more as a going concern than as a bankrupt entity. It is also possible that the management’s view about Bear’s profitability in the first quarter was overly optimistic. The FCIC’s own investigation found that Bear was legally solvent – its assets exceeded its liabilities – at the end of its first fiscal quarter in 2008 (which ended in February). But even if we discount these statements, it is unlikely that the market would have suffered a systemic breakdown if Bear Stearns had been allowed to fail. The firm clearly was not a hollow shell; its creditors would have recovered much, if not all, of their advances in the bankruptcy proceeding. Importance of ‘repos’ What is more, most of Bear’s short-term creditors had advanced their funds under repurchase, or “repo,” agreements – a form of collateralised borrowing that the firm had begun to emphasise several years before because it was thought to be more stable than unsecured borrowing. The repo lenders would have been able to recover most, if not all, of their losses by selling the collateral underlying the repos. In testimony before the FCIC, Bear’s management officials said they were baffled by the creditor and counterparty run (withdrawals of funds or refusals to renew even secured financing) that the firm suffered in the week that began on March 10, 2008. The most they could offer was that the firm had simply lost the confidence of the market.[5] This explanation would not justify a rescue Journal of Regulation & Risk North Asia

by the government, and indeed neither the firm’s management nor Cox – speaking as a former member of Congress rather than SEC chair – thought the firm (the smallest of the big five investment banks) should have been considered ‘too big to fail’ or otherwise systemically significant. Rationale for rescue Why, then, did the government rescue Bear Stearns? The unprecedented nature of the action and its implications for moral hazard in the future certainly required a robust rationale. Federal Reserve Board of Governors’ minutes from March 14, 2008 – just before the rescue – record the Board’s agreement that “given the fragile condition of the financial markets at the time, the prominent position of Bear Stearns in those markets, and the expected contagion that would result from the immediate failure of Bear Stearns,” the Fed should extend a loan to JP Morgan, which would eventually be passed along to Bear Stearns.[6] An idea similar to contagion – that Bear was too “interconnected” to fail – first appeared in the media in a Wall Street Journal article on March 17, 2008, and was loosely attributed to unnamed“government officials.” Notion of ‘too interconnected’ According to the article: “Officials have been scrambling to come up with new tools because the old ones aren’t suited for this 21st-century crisis, in which financial innovation has rendered many institutions not ‘too big to fail’ but ‘too interconnected to be allowed to fail suddenly’.”[7] Thereafter, the idea that Bear was too interconnected to fail was used regularly by Journal of Regulation & Risk North Asia

Bush administration and Fed officials to justify their rescue,[8] and it appeared dozens of times in media stories.[9] The most complete statement of the“interconnectedness”theory was contained in Federal Reserve chairman Ben S. Bernanke’s prepared testimony to the Senate Banking Committee on April 3, 2008: Our financial system is extremely complex and interconnected, and Bear Stearns participated extensively in a range of critical markets. The sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence. The company’s failure could also have cast doubt on the financial positions of some of Bear Stearns’ thousands of counterparties and perhaps of companies with similar businesses.[10] Bernanke’s remarks Part of this statement cannot be challenged; there is no question that financial institutions are interconnected. That is how a financial system performs its function; through these interconnections, money is transferred from a place where it is not being used efficiently to a place where it will be. The real question, however, is whether this interconnectedness is so substantial that the failure of one such institution will bring down others – whether, in Bernanke’s words, Bear’s failure could “have cast doubt on the financial positions of some of Bear Stearns’ thousands of counterparties.” If so, then its interconnectedness would have had significant implications for the financial system as a whole. But if Bear was indeed solvent at the time – something the Fed and Treasury must have known from discussions with the SEC – it is 141

highly implausible that its failure would have dragged down its counterparties. If a firm is solvent, all its creditors will be paid in due course. Illiquidity, solvency and bankruptcy Although Bear had become illiquid when many counterparties withdrew their financing, bankruptcy is designed for firms that are solvent but illiquid; it provides temporary protection and allows a creditor panic to subside while the firm marshals its resources and makes arrangements for orderly payment. That is what Bear would have been able to do if it had been allowed to file for bankruptcy. Its rescue short-circuited that process, and thus we will never know whether Bear’s filing would have brought about the systemic event that Bernanke feared by dragging down its counterparties. However, a partial but persuasive answer to whether Bear’s bankruptcy filing would have caused a systemic disruption is provided by the failure of Lehman Brothers that occurred six months later. Unlike Bear, Lehman was likely not solvent, and it had certainly become illiquid by the time it filed for bankruptcy. Lack of ‘interconnected’ contagion Nevertheless, despite all the market turmoil that followed Lehman’s bankruptcy filing, there was only one case of a Lehman counterparty or creditor failing because of Lehman’s inability to meet its financial obligations. That case was the Reserve Fund, a money–market fund that held a substantial amount of Lehman’s commercial paper. The Reserve Fund’s losses caused it to“break the 142

buck” – in other words, it failed to maintain a $1 per share redemption value – and triggered runs at other money-market funds where investors felt they might be at risk of a similar loss. The threat to“thousands of counterparties” that Bernanke envisioned occurring if Bear had not been rescued never materialised after Lehman filed for bankruptcy. Even Lehman’s credit default swap (CDS) obligations, and the CDSs written specifically on Lehman by others, did not cause any substantial disruption in the CDS market when Lehman collapsed. Within a month after the bankruptcy, all of the CDSs specifically written on Lehman were settled through the exchange of approximately $6 billion among hundreds of counterparties, and while Lehman had over 900,000 derivatives contracts outstanding at the time it filed for bankruptcy, these did not give rise to any known insolvency among those of its counterparties that were protected by a Lehman CDS. Bear ‘rationale’ proved erronous In cases where Lehman’s derivatives counter-parties suffered losses, the counterparties filed appropriate claims in the Lehman bankruptcy proceeding, which are being adjudicated in the ordinary course. In other words, Lehman – a larger firm than Bear and one that had more “interconnections” – had no significant effect in dragging down its counterparties. This suggests that the rationale given for Bear’s rescue – its extensive “interconnections” – was erroneous. If Lehman’s interconnections did not drag down its counterparties, Bear’s certainly would not have done so. Journal of Regulation & Risk North Asia

The turmoil and freeze-up in lending that followed Lehman’s bankruptcy was unprecedented and frightening to all observers. Bear amplified ‘moral hazard’ effect However, there is a substantial likelihood that the moral hazard created by the rescue of Bear was the reason Lehman’s bankruptcy precipitated a crisis. A review of the CDS spreads on Lehman shows that they moved within a relatively narrow range as Lehman’s condition continued to weaken through the summer and into the autumn of 2008. It was not until just before the fateful weekend of September 13-14, 2008, that the spreads blew out, indicating that despite Lehman’s deteriorating condition, those seeking to protect themselves against Lehman’s failure were finding ready counterparties in the CDS market. This suggests strongly that the market was expecting a rescue until the very last minute, which would be entirely rational; no sensible person could have imagined that the US government would rescue Bear but not Lehman. Lehman was much larger, more interconnected, and a major player in the CDS market – one of the markets where interconnections were supposed to be most troublesome. If, as government officials were arguing, Bear’s interconnections were really the basis for Bear’s rescue, it would have been completely irresponsible for officials to have allowed Lehman to fail. Indeed, it would not be surprising to learn that the managers of the Reserve Fund decided to hold the fund’s Lehman commercial paper because they expected that Lehman would also be rescued and Journal of Regulation & Risk North Asia

they could then avoid a loss on the paper’s reduced value. This conclusion would be consistent with the CDS market’s judgment about the likelihood of a government rescue for Lehman. Thus, when Lehman filed for bankruptcy, the markets were shocked. The result – hoarding cash and freezing lending – was the rational response to a sudden realisation that the world’s governments were not going to rescue all large firms. Now it was necessary to know the financial condition of all counterparties and to hold cash in case depositors and other funding sources were to withdraw funds or cut off lending. This produced the freeze-up in lending that most people now regard as the financial crisis. In addition, the rescue of Bear probably made it more difficult to find a buyer for Lehman. Lehman and market surprise After Bear, it was rational for Lehman’s management to expect a rescue, and that would have reduced their interest in selling the firm or diluting the stockholders; it would also have kept the firm’s selling price higher than it might otherwise have been. Potential buyers, like the Korean Development Bank or Barclays Bank, would likely have expected some US government support, just as JP Morgan Chase had received in buying Bear. When this was not offered, it is likely that they backed away from the acquisition to put pressure on US officials to come forward with financial assistance. Like other market participants, it was probably difficult for potential acquirers to believe that the US government would have rescued Bear because it was supposedly too interconnected with others in the financial system, 143

but would be willing to allow Lehman to fail. These are all the likely consequences of the moral hazard created by the rescue of Bear, which increasingly – with the passage of time – seems to be the central policy error in the US government’s response to the financial-market weakness that was coming to light in early 2008. Thus, the rescue of Bear – which was probably unnecessary in the first place – reduced Lehman’s incentive to want or to find a buyer, reduced the incentives of potential acquirers to make offers for Lehman without government support, and caused a catastrophic freeze-up in the market when it became clear that the US government would not carry out with Lehman the logical implications of its claim that Bear was too interconnected to be allowed to fail. Evolution of rescue ‘narrative’ Nevertheless, by the time Lehman filed its bankruptcy petition in the autumn of 2008, the idea that Bear had to be rescued because of its “interconnectedness” was the unquestioned explanation for the actions of the Treasury and Fed, regularly used by members of the Bush administration and repeated in virtually every media account of the Bear rescue.[11] Given this acceptance, and recalling the Tolstoy observation, it is not surprising that the turmoil following Lehman’s bankruptcy was not examined for what it showed about the rescue of Bear; nor was Bear’s rescue examined for what it likely contributed to the turmoil that occurred after Lehman’s collapse. Instead, the post-Lehman chaos was interpreted as confirmation that Lehman as well as Bear should have been rescued. 144

This is characteristic of narratives. Once they are established, subsequent events that are thought to confirm the narrative are reported in the media, while those that challenge the narrative are ignored or explained away. Thus, one commentator saw interconnectedness as the cause of the post-Lehman chaos even though it was largely imaginary: Enter a ‘financial super regulator’ For many, the lesson of Lehman Brothers is that a financial firm had to fail in order to demonstrate how interconnected the entire financial system was, often at levels that even top US market players and government officials could not have foreseen. However painful Lehman’s financial and economy effects was on the market [sic] experts said the bankruptcy provided the political will necessary to begin serious discussions about the country’s need for a financial super regulator.[12] Through interpretations like this, the explanation for why Bear was rescued evolved into a conclusion with far greater policy significance; under the new interpretation of Lehman, all large financial firms – because of their purported interconnectedness – were inherently a danger to financialsystem stability. This provided a rationale for extensive government regulation, since regulation was believed (again, without much evidence) to be effective in reducing the likelihood of a financial institution’s failure and thus the chances of another financial crisis. Writing in the Journal of Credit Risk, one commentator made this connection explicit: “This crisis – and the cases of firms like Lehman Brothers and AIG has made clear Journal of Regulation & Risk North Asia

that certain large, interconnected firms and markets need to be under a more consistent and more conservative regulatory regime. It is not enough to address the potential insolvency of individual institutions – we must also ensure the stability of the system itself.”[13] Obama approach That is exactly the approach the Obama administration adopted upon taking office. Through use of the interconnectedness idea, it became possible for the administration to propose a comprehensive system of regulation for the largest non-bank financial firms, going far beyond any regulatory regime ever envisioned in the past. This extensive regulation was justified by arguing that if one of these large firms were to fail it could – like Lehman – cause instability in the financial system, just as Bernanke had argued that the failure of Bear Stearns could have undermined the financial condition of“thousands”of its counterparties. An inconvenient truth The fact that this never occurred when Lehman failed was ignored. For example, in a statement on September 15, 2009, the anniversary of Lehman’s bankruptcy, President Barack Obama stated: “While holding the Federal Reserve fully accountable for regulation of the largest, most interconnected firms . . . we’ll also require these financial firms to meet stronger capital and liquidity requirements and observe greater constraints on their risky behaviour. That’s one of the lessons of the past year. The only way to avoid a crisis of this magnitude is to ensure that large firms can’t take risks that threaten our entire Journal of Regulation & Risk North Asia

financial system, and to make sure they have the resources to weather even the worst of economic storms.”[14] This statement says it all: interconnected financial firms require regulation or they will, by taking risks, bring down the financial system again. Similar declarations – implicating interconnectedness in the financial crisis – were made in the white paper the administration issued in June 2009 as a prelude to the introduction of its regulatory legislation,[15] and thereafter by Treasury Secretary Timothy F. Geithner,[16] presidential adviser Paul Volcker,[17] and many others in the administration and Congress.[18] The beauty of it was that they could make these statements without fear of contradiction because the underlying idea – that large firms were so interconnected that the failure of one would bring down others – had now become not only an explanation for the rescue of Bear, but also, because of the chaos that followed Lehman’s bankruptcy, the accepted narrative for what caused the financial crisis itself. As Tolstoy observed, even intelligent people, once they have accepted an idea, cannot be persuaded to re-examine their position. That is the power of a narrative. • Reference:
1. See Peter J. Wallison, “Deregulation and the Financial Crisis: Another Urban Myth,” AEI Financial Services Outlook (Oct. 2009), available at www.aei.org/outlook/100089; and Peter J. Wallison, “Cause and Effect: Government Policies and the Financial Crisis,” Critical

Review 21, No. 2-3 (June 2009): 365-76, available at www.aei.org/article/101071. 2. Michael Lewis,The Big Short:Inside the Doomsday Machine (New York:W.W. Norton, 2010), ix.


3. Financial Crisis Inquiry Commission, The Shadow Banking System – Day 1, 111th Cong., 2d. sess., May 5, 2010, available at www.fcic.gov/hearings/05–05–2010.php (accessed May 20, 2010). 4. Ibid. 5. Ibid. 6. Minutes of the Board of Governors of the Federal Reserve System, March 14, 2008, quoted in Greg Robb,“Bear Stearns Too Interconnected to Fail, Fed Says,” MarketWatch, June 27, 2008, available at www. marketwatch.com/story/fed-believed-bear-stearnswas-too-interconnected-to-fail (accessed May 19, 2010) (emphasis added). 7. Robin Sidel, Dennis K. Berman, and Kate Kelly,“J.P. Morgan Buys Bear in Fire Sale, as Fed Widens Credit to Avert Crisis,” Wall Street Journal, March 17, 2008 (emphasis added). 8. See Federal Reserve chairman Ben S. Bernanke: “Our financial system is extremely complex and interconnected, and Bear Stearns participated extensively in a range of critical markets,” and Robert Steel, under-secretary of the Treasury for domestic finance: “The failure of a firm at that time that was so connected to so many corners of our markets would have caused financial disruptions beyond Wall Street,” quoted in Associated Press, “Quotes from Bear Stearns Hearing,” FoxNews.com, April 3, 2008, available at www. foxnews.com/wires/2008Apr03/0,4670,Congress BearStearnsQuotes,00.html (accessed May 19, 2010). See also Michael M. Grynbaum, “Paulson Urges Americans to be Patient on the Economy,” New York Times, July 23, 2008;“’Too Big to Fail’ Is Too Expensive by Half,” ChiefExecutive.net, November/ December 2009, available at www.chiefexecutive. net/ ME2/ dirmod.asp?sid=&nm=&type=Publishing &mod=Publications%3A%3AArticle&mid=8F3A70 27421841978F18BE895F87F791&tier=4&id=FA948 EDD2F744208935FAE67A5001184 (accessed May 19, 2010); Jeffrey E. Garten, “Yet Another Domino

Falls,” Newsweek, July 28, 2008; and Gretchen Morgenson,“DoYou Have Any Reforms in Size XL?” NewYork Times, April 23, 2010. 9. See, for example, John Waggoner and David J. Lynch, “Red Flags in Bear Stearns’ Collapse,” USA Today, March 19, 2008; and Matthew Goldstein,“Bear Stearns’ Big Bailout,” Bloomberg Businessweek, March 14, 2008, available at www.businessweek.com/ bwdaily/dnflash/content/mar2008/ db20080314_993131.htm?campaign_id=rss_daily (accessed May 19, 2010). 10. Senate Committee on Banking, Housing, and Urban Affairs, Statement of Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System, 110th Cong., 2d sess., April 3, 2008, 3–4, available at http://banking.senate.gov/ public/index.cfm?FuseAction=Files.View&FileStore_ id=0a0ec016–ad61– 4736–b6e3–7eb61fbc0c69 (accessed May 19, 2010) (emphasis added). 11. See, for example, Mark Gongloff, “Street’s Fate Is in Hands of Uncle Sam,” Wall Street Journal, September 18, 2008; Stephen Labaton, “Trying to Rein in ‘Too Big to Fail’ Institutions,” New York Times, October 26, 2009; Caroline Baum,“Ask Bear Stearns Stockholders about Moral Hazard,” Bloomberg.com, March 18, 2008, available at www.sddt.com/Search/ article. cfm?SourceCode=20080318fm (accessed May 19, 2010); and Irwin Stelzer, “Banking Crisis: It’s Déjà Vu All Over Again,” Sunday Times (London), March 23, 2008. 12. Ken Sweet, “Lehman’s Harsh Lesson to the Global Economy,” FoxBusiness.com, September 14, 2009, available at www.foxbusiness.com/story/markets/industries/finance/lehmans-harsh-lesson-globaleconomy (accessed May 19, 2010). 13. Jeffrey Rosenberg, “Toward a Clear Understanding of the Systemic Risks of Large Institutions,” Journal of Credit Risk 5, No. 2 (Summer 2009). 14. Barack Obama, “Text of Obama’s Speech on


Journal of Regulation & Risk North Asia

Financial Reform,” New York Times, September 15, 2009 [emphasis added]. 15. The white paper says, “All large, interconnected firms whose failure could threaten the stability of the system should be subject to consolidated supervision by the Federal Reserve regardless of whether they own an insured depository institution.” See US Dept of the Treasury, Financial Regulatory Reform:A New Foundation; Rebuilding Financial Supervision & Regulation, 111th Cong., 1st sess. (Washington, DC, June 17, 2009), 6, available at www.financialstability. gov/docs/regs/FinalReport_web.pdf (accessed May 19, 2010). 16. FinancialStability.gov, “Treasury Secretary Tim Geithner Written Testimony House Financial Services Committee Hearing,” news release, March

24, 2009, available at www.financialstability.gov/ latest/tg67.html (accessed May 19, 2010). 17. Paul Volcker, “How to Reform Our Financial System,” NewYork Times, January 30, 2010. 18. Benton Ives, “Kanjorski Unveils Proposal to Break Up Risky Firms,” Congressional Quarterly Today, Nov. 18, 2009.

Editor’s note The Journal of Regulation and Risk – North Asia wish to thank Peter J. Wallison and the American Enterprise Institute for allowing us to publish an amended version of this paper, which was originally hosted on the AEI website. We remind readers that copyright remains with the author and the AEI.


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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 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-regulat ion 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 oth- ‘family’ risk: a The Andreas Kern & Christian cause for concern Fahrholz es amongst ces. among Asian investors compani be one of to offer these servi Global financial change David Smith t impacts complianc will just be able e and risk signs speak abou that will the first The ld rather moni-scramble is on to tackle bribery David Dekker ld ers we saw we shou and corruption banks, or that a year ago the financial wor s These days ns than Who exactly is subject About Penelope Tham & Gerald on in , a name institutio it crisi to the Foreign Corrupt Li sformati providers the cred financial Practices Act? ities. service of a tran ld at months financial future activ Financial markets remunera cial wor the last ed Tham Yuet-Ming tion reform: one and in the finan ge that is tored their current and we have mov step forward rs ly sformed banks Umesh Kumar & Kevin . the chan has tran how rapid n on the Of ‘Black Swans’, stress tests & than cove Marr optimised risk managem Look at in scope osive pace interactio ation) to ent an expl broader that were from physical s of oper Challenging the value of enterprise is much David Samuels and hour banking. risk management occurring expected. banks fall Internet Rockybut s (location to fail or ly Tim Pagett & Ranjit ents then by term original too big Jaswal charge, road ahead for global accountancy convergen ed to be being taken over - electronic paym s were still in ce ing a consider The to ng or Dr Philip Goeth n the bank paradigm is shift Asian regulatory Rubik’s Cube more finan either faili - Agai that are and corthe

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Contact Christopher Rogers Editor in Chief

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ted States. THE autho r of this paper is a academic, leading lawyer and and they implic former bank regulator itly demonstrat speci ing cal failures of e three criticrime. As one alising in ‘white regulation collar’ failure of the unsu and a whole Savings & ng of private mark sale Loans debac heroes of the and et discipline other forms Professor of fraud Black nowa le of the 1980s, Crime of credit risk. days spend The Financial of his time s Enforceme s much researchin nt Network released g why finan markets have (FinCEN) cial Activi a study this week on a tendency functional ty Suspicious . Renowned to become dys- lated Reports (SARs) that federally regufor his theor ‘control fraud financial institu y on with ’, Prof. Black tions (some University the Federal times) file lectures at of Missouri Bureau of the (FBI) Investigatio and Kansas He is the autho when they n find evidence City. r of ‘The Best a Bank is of mortgage Way to Rob fraud. to Own One: Executives How Corpo and Polit icians Loote rate Epidemic warn S&L Indus ing d the The try.’ A prom inent comm FBI tor on the causes of enta- mortg began warning of an the current “epidemic” crisis, Prof. age fraud financial of Black is a mony in Septe in their congressional vocal critic way the US testimber 2004 of the ago. governmen – over five t has hand It also warne banking crisis years led the d that if the and rewar not dealt with epidemic were that have ded institution it would cause clearl a financial duties to inves y failed in their fiduc s sis. Nothing remot criely iary respo tors. nd to the epide adequate was done to mic by regula enforcemen The following tors, t, or private commentary sector “mark law essarily repres does not nec- cipline.” Instead, the epide et disent the view mic produced hyper-infla Regulation of the Journa ted a bubbl and and Risk – l of that e in US housi North Asia. produced a ng prices “The new crisis so severe numbers on that it nearly rals for mortg criminal refer- caused the collapse age fraud in of the globa system the US are l financial just in many and led to unpreceden ted bailouts of the world Journal of of ’s largest banks Regulation . & Risk North Asia

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Minority shareholders blind to threat of expropriation
Dr Fritz Foley et al propose a new understanding of investor structures that allow big stockholders to swallow smaller peers.
Why do minority shareholders continue to hold stock despite the risk of expropriation by controlling shareholders? this paper provides two decades of evidence from Japan suggesting that many investors do not foresee these conflicts of interest, even when there is plenty of disclosure. inefficient stock markets allow majority shareholders – often parent companies – to sell overpriced stock only to buy it back at a later date. One of the major accomplishments of recent corporate governance research has been to expose the risks confronted by minority shareholders in public companies around the globe. Corporate ownership structures such as pyramids, business groups, and dual class shares leave control in the hands of a limited set of block holders – exposing minority investors to potential expropriation. Why, then, do minority shareholders participate in these arrangements? The prevailing academic view since Jensen and Meckling (1976) is that capital markets are efficient in the sense that minority investors Journal of Regulation & Risk North Asia foresee the possibility of expropriation by controlling shareholders. As a result, under this view, the share price that minority investors are willing to pay reflects their rational expectations of expropriation and other agency problems. And because outside equity is expensive, controlling shareholders will only raise equity capital from minority investors if there are commensurate benefits, such as attractive growth opportunities that the firm would not be able to finance otherwise. Agency problems However, recent research raises major issues with the prevailing view of why agency problems persist and thus calls for a new understanding of why these said problems arise to begin with. In recent research (Chernenko et al. 2010), the authors of this paper propose a new and alternative view for the emergence of ownership structures that are prone to severe agency problems. Motivated by the growing literature studying the effects of stock market mispricing on firm behaviour (see for example Stein 1996, Shleifer and Vishny 2003, and Baker 149

2009), we develop a simple framework for thinking about how stock market mis-pricing can offset agency costs and induce controlling shareholders to raise outside equity. Japanese experience Our argument is as follows. Suppose that during some periods, investors are overoptimistic, failing to see the potential for conflicts of interest between themselves and the controlling owner. Under these conditions, equity is overpriced relative to a valuation that fully accounts for the conflicts of interest between minority and majority investors. Stock market mis-pricing induces the controlling shareholder to sell overpriced equity, subsequently diverting resources to his benefit. In order to return to the previous ownership structures with the same agency problems, even greater mis-evaluation is required. Our basic idea is motivated by the stock market performance of minority investors in publicly held subsidiaries in Japan. It is common practice for large companies in Japan to list their subsidiaries on the stock market, while maintaining a controlling stake thereafter. Although subsidiaries are technically independent companies once they are listed, the potential for the expropriation of minority shareholders is immense. NEC expropriation In a case study of NEC Electronics, we document how parent company NEC forced its publicly listed subsidiary NEC Electronics to bear billions of dollars of wasteful R&D and capital expenditures on behalf of the parent company’s mobile phone line. But minority shareholders in NEC Electronics did not seem to have anticipated this kind of activity, 150

and they earned post-listing returns that were well below those of the aggregate stock market, and well below the returns earned by shareholders of the parent company. Using a large sample of subsidiaries listed in Japan between 1980 and 2005, we find that the experience of NEC Electronics is not unique. The evidence is consistent with three predictions that follow from our framework. Predictive framework First, the incentive to divert resources is stronger when a controlling shareholder maintains a smaller ownership stake after listing – so these listings require more mispricing. Consistent with this notion, we find that subsidiaries in which the controlling shareholder sells a larger stake at listing generate low post listing returns. Second, we find that subsidiaries that have product market relationships with their parents also generate low post-listing returns. The scope for agency problems is high for these kinds of subsidiaries, so more mis-pricing is required to support them. Third, prices are likely to revert to fundamental value, and when they do, the controlling shareholder often repurchases the subsidiaries to eliminate agency costs. We find that 25 per cent of the subsidiaries in our sample are repurchased before 2007, and that parent shareholders earn positive returns when these repurchases are announced. The idea that stock mis-pricing supports the creation of ownership structures prone to agency problems has important implications for corporate governance regulations. Many regulatory proposals are aimed at increased Journal of Regulation & Risk North Asia

disclosure and transparency. Our research suggests that, by themselves, more disclosure and transparency may not be enough, as they will not prevent minority shareholders from overpaying for equity. Experimental evidence suggests that decision makers often ignore conflicts of interest, even when such conflicts are prominently disclosed (Cain et al. 2005). And regulators themselves often express concern that investors will not be able to understand conflicts of interest, even when there is plenty of disclosure. Consider for example the recent decision of the Securities and Futures Commission of Hong Kong to allow shares of the United Company RUSAL to be listed on the Hong Kong Stock Exchange. The regulators prevented retail investors from participating, despite the risks being disclosed in a 1,000page prospectus. Role of business groups Our research also contributes to the debate regarding the role of business groups in emerging economies, in particular the extent to which business groups help overcome market inefficiencies or engage in rent seeking behaviour. Without denying their ability to help overcome various market inefficiencies, our research suggests that taking advantage of temporary stock mis-pricing can contribute to the formation of business groups and other ownership structures prone to agency problems. Finally, being able to opportunistically raise outside equity when it is overvalued may reduce entrepreneurs’ incentive to lobby for strong corporate governance regulations. This Journal of Regulation & Risk North Asia

could potentially help explain the persistence of weak protection of minority shareholders in many countries around the world. • Editor’s Note Dr Fritz Foley, Associate Professor, Harvard Business School, would like to extend his gratitude to the co-authors of this research paper – Dr Sergey Chernenko, Assistant Professor, Fisher College of Business, Ohio State University, and Dr Robin Greenwood, Associate Professor at the Harvard Business School. The Journal’s publisher and editors would like to thank VoXEu for allowing us to reprint this paper originally hosted on www. voxeu.org References
Baker, Malcolm (2009), “Capital market-driven corporate finance”, Annual Review of Financial Economics, 1:181-205. Cain, Daylian M, George Loewenstein, and Don A Moore (2005), “The dirt on coming clean: Perverse effects of disclosing conflicts of interest”, Journal of Legal Studies, 34:1-25. Chernenko, Sergey, C Fritz Foley, and Robin Greenwood (2010), “Agency costs, mispricing, and ownership structure”, working paper. Foley, C Fritz, Robin Greenwood and Jim Quinn (2008),“NEC Electronics”, Harvard Business School Case, No. 209001. Jensen, Michael C, and William Meckling (1976), “Theory of the firm: managerial behaviour, agency costs, and ownership structure”, Journal of Financial Economics, 3:305-360. Shleifer, Andrei, and Robert W Vishny (2003), “Stock market driven acquisitions”, Journal of Financial Economics, 70:295-311. Stein, Jeremy C (1996),“Rational capital budgeting in an irrational world”, Journal of Business, 69:429-455.



‘Swap tango’: a regulatory dance in two acts
Author and risk doyen, Satyajit Das, takes a sledgehammer to regulatory proposals to oversee the global derivatives market.
on July 30, 1998, alan greenspan, then chairman of the federal reserve, argued that: “regulation of derivatives transactions that are privately negotiated by professionals is unnecessary.” in october 2008, the now former chairman grudgingly acknowledged that he was “partially” wrong to oppose regulation of credit default swaps (CDs). “Credit default swaps, i think, have serious problems associated with them,” he admitted to a Congressional hearing. his current views on wider derivative regulation remain unknown. Politicians and regulators globally are currently busy drafting laws to regulate derivatives. A common theme underlying the activity is an absence of knowledge of the true operation of the industry and the matters that need to be addressed. As Goethe observed: “There is nothing more frightening than ignorance in action.” The author Thomas Pynchon warned:“If they can get you to ask the wrong questions then the answers don’t matter.” Simplistic causes and solutions may prevent real issues Journal of Regulation & Risk North Asia in relation to derivatives from being debated and dealt with. Based on surveys conducted by the Bank of International Settlements (BIS), the global derivative market as at June 2009 totalled US$605 trillion in notional amount – in June this year it is guesstimated that the figure is between $650 billion to $700 billion depending on which source is utilised, but still below its 2008 high. OTC v. exchange trades This is a large increase in size from less than $10 trillion 20 years ago. The bulk of the activity takes place in the over-the-counter (OTC) market where derivatives are traded privately and on a bilateral basis between banks and clients. The OTC market should be contrasted with the exchange-traded market where relatively standardised products are traded on formalised, regulated exchanges. The outstanding amount compares to global gross domestic product (GDP) of around $60 billion. As author Richard Duncan points out in his 2009 book, The Corruption of Capitalism, the outstandings in 153

the global derivatives market at its peak in June 2008 ($760 trillion) was equal to “everything produced on earth during the previous 20 years.” Or, to put this into another perspective, the value was equal to $190,000 for each person on the planet. Apples and oranges Volume estimates are affected by double and triple counting and other statistical problems. There are also significant disagreements about the significance of the size numbers. Derivative professionals argue that derivative notional amounts (the face value of the contract) are a stock measure (like assets and liabilities). GDP is a flow measure (i.e. income). So strictly speaking they are not directly comparable. Derivative professionals also argue that the outstanding value is irrelevant as it is only the notional face value of contracts. They focus on the current value (around $25 trillion) that can be further reduced after netting between dealers to around $4-5 trillion. If the $4 trillion in collateral (cash and government securities) held to secure the current value is considered, then they argue that the exposure is a negligible amount. In effect, there is no risk. The size of the market doesn’t matter. As Laurence J. Peter author of the famous ‘Peter Principal’ stated: “Facts are stubborn things, but statistics are more pliable.” Current value is a calculation of the worth of the derivative contract if terminated today. It provides a useful measure of current price and risk. The notional amount represents the actual amount of underlying assets that the trader is exposed to. The notional face value is the essential starting point of market size 154

and any measure of leverage. The size of the market is inconsistent with the thesis that derivatives are merely a vehicle for hedging and risk management. Current regulatory proposals do not attempt to deal with the size of the derivatives markets. The current debate about“too big to fail”banks may indirectly affect the size issue. Approached to provide government aid to a company that claimed it was too big to fail, Richard Nixon advised:“get smaller”! Derivative regulators would do well to heed Nixon’s advice. Proponents argue that derivatives are used principally for hedging and arbitrage. In this way, they perform an economically useful function aiding capital formation and reallocating risk to those willing and better able to bear them. While they can be used for this purpose, derivatives are now used extensively for speculation, that is, manufacturing risk and creating leverage. Quantitative hyperbole Stripped of quantitative hyperbole, derivatives enable traders to take the risk of the asset without the need to own and fund it. For example, the purchase of $10 million of shares requires commitment of cash. Instead, the trader can enter a total return swap (TRS) where he receives the return on the share (dividends and increases in price) in return for paying the cost of holding the shares (decreases in price and the funding cost of the dealer).The TRS requires no funding other than any collateral required by the dealer; this is substantially less than the $10 million required to buy the shares. The trader acquires the same exposure as buying the shares but increases its return Journal of Regulation & Risk North Asia

and risk through leverage. Derivative volumes are inconsistent with pure risk transfer. In the CDS market, volumes were in excess of four times outstanding underlying bonds and loans. In the currency and interest rates, the multiples are higher. Seeking alpha Investors searching for return drive speculation. Concerned about stagnant real incomes and inadequate retirement savings, individual investors seek out higher yielding investment structures, often based on derivatives. Pension funds and other institutional investors use derivatives to enhance returns to fully fund and meet their contracted liabilities. In an environment of diminishing returns and fierce competition for attractive investments, fund managers use derivative strategies to enhance returns through readily accessible leverage and capacity to create risk“cocktails”. Facing increased pressure on earnings, corporations have increasingly “financialised”, resorting to speculative derivative trading to meet profit expectations. This pattern affects small companies as well as large ones. It is also evident in emerging as well as developed economies. In China, India and Korea, companies resorted to aggressive derivative strategies to augment earnings as profit margins on products were relentlessly forced down by competition and buyer pressure. Some strategies have led to significant losses. The competitive advantage, if any, enjoyed by investors and corporations in speculative trading, especially in complex derivatives is unclear. Perhaps it is a lack of “horse sense” which, as stated by Raymond Journal of Regulation & Risk North Asia

Nash. is“what keeps horses from betting on what people will do.” Proponents argue that speculators facilitate markets and bring down trading costs, thereby helping capital formation and reducing cost of capital. There is little direct evidence in support of this proposition. Recent experience suggests that in stressful conditions speculators are users rather than providers of scarce liquidity. Given derivatives are second order instruments deriving its value from underlying assets, the argument regarding liquidity is curious. In many cases, the derivative contract is far more liquid than the underlying debt, shares, currency or commodity. This is consistent with trading in derivatives having a significant non-hedging, speculative element. Speculative activity Speculative activity amplifies rather than reduces volatility and systemic risks. Perversely, this may impede capital formation and also increase the cost of capital for companies. A reduction in speculative activity would also arguable free up capital tied up in trading. This capital could be deployed more effectively within the economy. Control of speculative activity in derivatives is feasible. This would require traders to show an underlying risk as a pre-condition to entering into a derivative contract. In the case of investors, it would also require the derivative contract being covered fully with available cash or other securities. The concept is used extensively in the insurance markets. A similar concept is embedded in the hedge accounting standards currently in use. Current regulatory 155

proposals do not attempt to deal with speculative activity directly in the derivatives markets. Some US insurance regulators have proposed controls on speculative activity in certain derivatives, such as CDS, by requiring an underlying position. Amusingly, dealers now argue that the bulk of trading activity is actually for hedging purposes. It may have something to do with a more elastic definition of “hedging”. No evidence was offered. Dealers were probably following Mark Twain’s advice: “Get your facts first, and then distort them as much as you please.” In reality, probably no more than 10-20 per cent of activity in the derivative markets is related to hedging. The Obama Administration’s proposed ‘Volcker Rule’ prohibiting major banks engaging in proprietary trading may, if implemented, affect speculative activity in derivatives. Onerous Section 106 In the surreal theatre of US regulation, the Senate Committee on Agriculture, Nutrition and Forestry, chaired by Blanche Lincoln, has introduced its own version of regulations. The controversial Section 106 prohibits banks using swaps from accessing the Fed’s discount window. The proposal would prevent banks from hedging their own exposures using swaps as well as trading swaps. At a minimum, it would force banks to move their derivatives activities into non-bank entities. Transferring such activities would require additional capital (estimated at $20 billion or more) and also result in higher cost of funding for the derivatives activities. It is not clear how this proposal actually addresses 156

any of the fundamental issues relating to derivative activities. Relatively simple derivative products provide ample scope for risk transfer. Standard forwards or options will generally complete markets and provide the ability to manage risk. The proliferation of complex and opaque products is prima facie puzzling. Arrow-Debreu theorem In the 1950s, two economists, Kenneth Arrow and Gerard Debreu, proposed a theoretically perfect world – known as the Arrow-Debreu theorem. To attain the nirvana of economic equilibrium, the theorem required there to be securities for sale for every possible state of the future –“state securities”. There should be contracts to buy or sell everything at any time period in every place until infinity or the end of the world, whichever was first. This utopian worldview provides the justification for allowing any and every type of derivative markets to be created. Dealers argue that such structures are created in response to customer demand and to provide“financial solutions”. In my experience, clients rarely ask to be shown a US$/ Yen big figure stop with double-barrier conditional accumulator (with or without Elvis Presley pelvic thrusts). Complex structures are designed and sold (often aggressively) by dealers. The major drivers for complex products are increased risk and leverage. Some structures are also designed to circumvent investment restrictions, bank capital rules, and securities and tax legislation. A key issue is the use of“embedded”leverage. These arrangements are used to provide leverage to investors and corporations Journal of Regulation & Risk North Asia

whose internal or statutory rules prevent borrowing to finance increased investments. Derivative technology is deployed to increase gains and losses for a particular event (such as a change in market prices of an asset) in accordance with customer requirements to provide the effects of leverage without transgressing their investment mandates. Proposals to control bank leverage, in broad terms, lack understanding of the issues of embedded leverage and its use in financial markets. Complexity is also related to profitability of derivative trading. On March 19, 1999, Alan Greenspan speaking at the Futures Industry Association Conference at Boca Raton, Florida, remarked:“. . . the profitability of derivative products has been a major factor in the dramatic rise in large banks’ non-interest earning and . . . the significant gain in the overall finance industry’s share of American corporate output . . . the value added of derivatives themselves derives from their ability to enhance the process of wealth creation.” ‘Pharmaceutical’ style warnings The former Fed Chairman’s statement showed an alarming lack of understanding of the real sources of derivative trading profits. Many financial products are opaque and priced inefficiently to produce excessive profits – economic rents – for dealers. efficiency and transparency is not consistent with high profit margins. The majority of derivative transactions are standard and “plain vanilla” earning low margins with dealers relying on volume for profits. The bulk of dealer profitability comes Journal of Regulation & Risk North Asia

from a few complex products. They also feed trading in standard products as dealers manage and re-allocate their risk from more structured transactions. Complexity is also related to mis-selling of derivative products. Arcane structures create significant information asymmetry. Misselling of “unsuitable” derivative products to investors and corporations remains a problem. Expertise of purchasers is sometimes inversely related to the complexity of derivative products. Lawyers’ bonanza Currently, there are numerous disputes concerning derivative transactions between banks and their clients at various stages of litigation and a significant source of earnings to litigation lawyers. It is difficult to identify the causes – client greed or ignorance versus dealer greed or misrepresentation. Current regulatory proposals do not deal with the issue of complexity in derivative products. Regulators could have forced standardisation and listing of derivative contracts, only allowing them to be traded on exchanges. They have favoured, probably correctly, the need to customise products and structures for users and their needs. In relation to product suitability, the BIS have proposed “pharmaceutical-style” warning systems, which do not address the problem. Given significant information and know-ledge asymmetry between sellers and buyers, the possibility of disallowing certain types of transactions altogether or with certain parties should be considered. Such proposals are likely to be unacceptable as inconsistent with “freedom of choice”. Advocates of a “free market” are 157

likely to side with the view of an anonymous commentator: “Nine out of 10 people who change their minds are wrong the second time, too.” Derivative contracts are valued on a mark-to-market (MtM) basis. This requires valuation of the contracts based on the current market price. OTC derivatives trade privately. Market prices for specific transactions are not directly available. This means current valuations rely on pricing models. Level 2 assets In current accounting argot, most derivatives are Level 2 assets (Mark-to-Model). In practice, this means that they cannot be priced based on quoted trade prices (Level 1) but are valued using observable inputs; for example, comparable assets or instruments or using interest rates, volatility, correlation, credit spreads, etc, that can be put through an accepted model to establish values. There are significant differences in the complexity of the models and the ability to verify and calibrate inputs. More complex products used sophisticated financial models, often derived from science or statistical methodology. There are frequently differences in choice, exact factorisation and even numerical implementation of the models. Different dealers may use different models. Some required inputs for the models are available from markets sources. The nature of the OTC market and the limited trading in certain instruments mean that key input parameters must frequently be “estimated” or“bootstrapped”from available data. In certain products, the limited number 158

of active dealers means that “market” prices are sometimes no more than the dealer’s own quote being fed back after being collated and “scrubbed” by an external data provider. This is referred to prosaically as “mark-to-myself”. Model variations and small differences in input can frequently result in large changes in values for some products. The models make numerous assumptions including the ability to borrow at market rates for (theoretically) infinite amounts, unrestricted ability to enter into transactions and abundant trading liquidity. These assumptions are difficult to satisfy in practice. For example, a key assumption of derivative valuation is that a transaction can be hedged with a counterparty or through other means at all times. In late 2008, in the aftermath of the collapse of Lehman Brothers and problems at AIG, market liquidity dried up and made it impossible to source market prices or transact in many instruments. Sage of Omaha Model-based valuations drive pricing of transactions and dealer hedging. They also are used to calculate the risk of the transactions and ultimately to derive the capital required to be held for regulatory and internal purposes. The model-based valuations are also used to determine earnings and ultimately bonus payments for dealer staff. In Warren Buffet’s inimitable words this allows the dealer to see “. . . where the arrow of performance lands and then [paint] the bull’s eye around it”. Non-professional dealers rarely have the required sophisticated pricing and valuation systems. They are dependent upon valuation Journal of Regulation & Risk North Asia

data mainly supplied by dealers or, less frequently, rely on pay-as-you-go pricing services. Investors use the model-based prices to generate values for their fund units. Investors transact at these model-based prices when they invest or redeem investments. Lack of model oversight The accuracy and tractability of derivative valuation, especially for complex products, is questionable. MtM prices may be also prone to manipulation. Recent disclosures about events leading up the government bailout of AIG highlight potential problems. There is limited internal or external (auditors and regulators) oversight of the models. This reflects, in part, the complexity of the models and the scarcity of experienced professionals capable of undertaking such reviews. Widespread reliance on models and MtM methodology is perhaps surprisingly an unquestioned article of faith in financial markets. It allows immediate recognition of gains and losses that will accrue over many years immediately. After his purchase of Gen Re and discovery of the problems surrounding its derivatives operations, Buffett remarked: “I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably they have favoured the trader who was eyeing a multi-million dollar bonus . . . Only much later did shareholders learn that the reported earnings were a sham.” Interestingly, MtM accounting is generally not available outside of financial instruments. An often neglected element of the Enron scandal was the company’s ability to convince its auditors and the US Securities Journal of Regulation & Risk North Asia

and Exchange Commission (SEC) to allow MtM accounting to be used in the natural gas industry. This allowed the company to record current earnings based on the future value of long-term contracts Current regulatory proposals do not attempt to deal with the pricing, valuation and model issues. As Daniel C. Gelman observed: “Where secrecy reigns, carelessness and ignorance delight to hide.” In derivative contracts, each party takes the credit risk of the other side in terms of performing their obligations. This is known as counterparty risk. The failure of Lehman Brothers and a number of banks during the Global Financial Crisis (GFC) highlighted the problems of counterparty risk in derivatives. Counterparty risk in derivatives is different from credit risk generally. In a loan, the lender is exposed to the risk of the borrower failing to pay interest or repay the known face value of the loan. In contrast, in most derivative contracts (other than options), the risk is mutual with both parties being exposed to the risk of non-payment by the other. Counterparty risk is complex because the payment obligations between the parties are contingent. The quantum and the direction of payments depend on market price movements. Democratising risk The potential counterparty risk is not known in advance and is apparent only when actual price movements occur. In practice, this requires parties to estimate the potential exposure using mathematical models based on the expected evolution of the relevant market prices. In the 1980s when derivative 159

markets developed, counterparties were generally of high credit quality. This had the effect of reducing, although not eliminating, counterparty risk. Over the past two decades, the derivatives market has become more democratic. Entities with lower credit ratings have become active users of derivatives. This includes highly leveraged investors, such as hedge funds and private equity funds. Participation of these riskier entities has entailed reliance on credit enhancement techniques. Customised collateral The primary form of credit enhancement is the use of bilateral collateral. This entails counterparties posting collateral in the form of cash or high-quality securities to secure the current value of the contract. The collateral acts as surety against non-performance under the contract. Collateral arrangements are highly customised. For example, AIG’s collateral arrangements required the firm to post collateral only where the exposure under the contracts increased above an agreed level or AIG’s credit rating was reduced below a specified quality. Other credit enhancement techniques used include a right to break that allows either party to terminate the contract under certain credit-related circumstances. Any such termination is at market values triggering an obligation of one party to pay the other party the current value of the contract. Counterparty risk and credit enhancement techniques are predicated on the same models used for pricing and valuation. Use of bilateral collateral relies on the 160

accuracy of valuations and risk models. It also relies on certain and enforceable legal rights in respect of collateral and proper management of the cash and security lodged. The GFC, especially the bankruptcy filing of Lehman Brothers, provided a test of counterparty risk in derivatives.The quantification and management of such risk proved problematic.The quantum of credit risk from derivatives was higher than model based estimates as market volatility increased and correlations between risk factors moved erratically. Legal enforceability, control and management of collateral also experienced problems. Current regulatory proposals focus heavily on counterparty risk issues. The central legislative reform proposed is a central clearinghouse – the central counterparty (CCP). The BIS also proposed changes in capital requirements against counterparty risk in the light of recent experience. Under the CCP arrangements, “standardised” derivative transactions must be transferred to an entity that will guarantee performance. In a curious circularity, standardised means anything that is eligible for and can be “cleared”. Interesting inclusions and exclusions – both in terms of products and parties that must trade through the CCP – are to be found. ‘Too big to fail’ The arrangement centralises contracts in a single entity, the ultimate case of “too big to fail”. The CCP implements risk management systems to manage its exposure under derivative contracts. The CCP will be reliant on risk models and the ability to value contracts. As noted above, there are significant Journal of Regulation & Risk North Asia

issues in pricing and valuing contracts and, for some products, reliance on complex models. The CCP proposal relies heavily on“selfconfidence”, which as Samuel Johnson observed is“the first requisite to great undertakings.” In relation to the CCP, legislators and regulators are basing their approach on Lillian Hellman’s helpful advise: “It is best to act with confidence, no matter how little right you have to it.” One (not very nice) world . . . The GFC, in line with previous derivative crises including the collapse of Long Term Capital Management (LTCM), revealed deep fault lines in financial markets. Derivative markets entail complex chains of risk that link market participants. This is similar to the re-insurance chains that proved problematic in the case of Lloyd’s Insurance market problems. In both markets, the risks are both potentially significant and “long tail”, that is, they do not emerge immediately and may take some time to be fully quantified. As in the re-insurance market, the long chain of derivative contracts can create unknown concentration risks. This is exacerbated by the highly concentrated structure of derivative trading. It is likely that for each product or asset class a few dealers (less than 10-12 and sometimes as few as four or six) account for the bulk of trading. Five entities account for more than 95 per cent of American financial firms’derivative holdings. This means that financial problems or uncertainty about any major dealer could cause the financial system to become gridlocked as uncertainty about Journal of Regulation & Risk North Asia

counterparty risks restrict normal trading activities. Current regulatory proposals have not focused on the issue on inter-connected trading and concentration risk other than as a by-product of the CCP proposal. It is widely believed that the CCP will improve the market structure. In reality, the CCP becomes a node of concentration. In addition, to the extent that products are not routed or counterparties are not obligated to trade through the CCP, the problems remain and may increase. A central problem of the current derivative markets is potential liquidity (cash or funding) risks. Ironically, the problems derive, in substantial part, from the desire to reduce counterparty risk through credit enhancement procedures, such as bilateral collateral. Where derivative contracts are markedto-market daily and any gain or loss covered by collateral to minimise performance risk, movements in market rates can trigger large cash requirements. These requirements may be unanticipated. If there is a failure to meet a margin call then the position must be closed out and the collateral applied against the loss. This may leave the parties unhedged against underlying risks or on offsetting positions creating the risk of additional losses. ACA & AIG not unique For example, ACA Financial Guaranty sold protection totalling $69 billion while having capital resources of around $425 million. When ACA was downgraded below“A” credit rating, it was required to post collateral of around $1.7 billion. ACA was unable to meet this requirement. AIG’s CDS contracts were subject to the 161

provision that if the firm was downgraded below AA- then the firm would have to post collateral. In October 2008, when AIG was downgraded below the nominated threshold, this triggered a collateral call rumoured to be around $14 billion. AIG did not have the cash to meet this call and ultimately required government support. The problems at ACA and AIG are not unique. Current regulatory proposals do not address liquidity risks in derivative markets. Interestingly, the CCP may inadvertently increase liquidity risk as more participants may be subject to margining and unexpected demands on cash resources. The BIS has proposed an extensive regime of liquidity risk management controls that would, in part, cover some liquidity risks. Greenspan’s ‘shock, horror’ The GFC has exposed long standing and significant problems with the infrastructure of derivatives markets. In 2006, Alan Greenspan expressed shock and horror at the state of settlements in the credit derivative market. He expressed surprise that banks trading CDS seemed to document trades on scraps of paper. The ex-chairman, perhaps unfamiliar with the reality of financial markets, had difficulty reconciling a technologically advanced business with this “appalling”operational environment. Derivative systems and trade processing are generally inadequate, with infrastructure lagging well behind innovation. Delays in documenting contracts forced regulators to step in requiring banks to confirm trades more promptly. The accuracy of the mark-to-market values of contracts, particularly of less liquid 162

and infrequently traded reference entities, is not unimpeachable. Where collateral is used, as noted above, monitoring and management of collateral poses significant risks. Current regulatory proposals seek welcome improvements processes and systems for derivative trading. ISDA steps in Derivative contracts are documented under the International Swap and Derivatives Association (ISDA) Master Agreement. The ISDA agreement has been remarkably successful in standardising documentation of trading. The contract has not been tested under stressful conditions such as those of the GFC. A number of issues have emerged The bankruptcy of Lehman Brothers and resulting unwinding of complex derivative arrangements has exposed problems of derivative and bankruptcy law, especially in cross-border, multi-jurisdictional transactions. The GFC also exposed issues relating to the documentation of specific derivative contracts, such as CDS contracts, and the impact on bankruptcy and resolution of financial distressed firms. Current regulatory proposals do not address any of these documentary issues. Regulatory arbitrage Bank regulatory capital has long distinguished between banking (loans or hold-tomaturity assets) and trading books (trading or available-for-sale assets). Differing capital rules between the banking and trading books encouraged regulatory arbitrage, generally using derivative structures to reduce the required level of capital. The BIS Journal of Regulation & Risk North Asia

has addressed some regulatory anomalies, increasing the capital required against derivative positions by the players Regulatory initiatives continue to emphasise improved disclosure of derivative contract. There is already significant disclosure, although much of it is incomprehensible and lacks utility. Additional disclosure will not significantly reduce systemic risks of derivatives. On 25 September 2002, speaking at the UK Society of Business Economist while in London to collect an honorary knighthood for contribution to economic stability, Alan Greenspan outlined the case for less transparency:“. . . paradoxically, the full disclosure of what some participants know can undermine incentives to take risk, a precondition to economic growth . . . to require disclosure of the innovative product either before or after its introduction would eliminate the quasi-monopoly return and discourage future endeavours to innovate . . . market imperfections would remain unaddressed and the allocation of capital to its most productive uses would be thwarted.” Dearth of experts Greenspan argued that even “disclosure on a confidential basis solely to regulatory authorities may well inhibit . . . risk-taking.” Dealers will undoubtedly resist meaningful disclosure prejudicial to their economic interests. Regulatory initiatives do little to address the quality of regulators and the acuity of oversight. The absence of suitably expert and experienced regulators will undermine regulatory and legislative initiatives. Given the shortage of talent in derivatives generally and the pay grades of regulators, Journal of Regulation & Risk North Asia

it will be difficult for regulatory agencies to properly supervise dealers and derivative activity. In terms of an old Spanish proverb “Laws, like the spider’s web, catch the fly and let the hawk go free.” Frenzied tone Debate over regulation of financial services has taken on a frenzied tone. Regulators and think tanks are producing voluminous, overlapping and (sometimes) contradictory proposals. Regulatory agencies are jockeying for position, sometimes forming unlikely coalitions to preserve or expand territory. In the US Congress, multiple bills and several committees are jostling to make sense and harmonise complex and irreconcilable draft legislation. Activity and achievement are confused. Rearguard banking actions Banks and their lobbyists do not believe that there is a case for regulation. In William Davenant’s words: “Had laws not been, we never had been blam’d; For not to know we sinn’d is innocence.” Banks argue that the complex nature of derivative trading dictates that self-regulation is the only feasible approach. If that fails, then banks seek to minimise scrutiny of major issues, such as the size of the market, speculative activity, pricing issues, complexity and mis-selling of derivatives to unsuitable clients. They further argue that existing regulations already adequately cover some issues. Proposed regulations will be masterfully narrowed to minimise impediments to profitable activities. There will be a familiar 163

threat. Lack of international agreement and regulatory uniformity makes compliance impractical. Banks and derivative activity will relocate with losses of jobs and taxes to the host country. Familiar arguments will, of course, be heard regarding the loss of competitive advantage, diminished financial innovation, slower capital formation and higher cost of capital. Each is a well-known step in the familiar“regulatory tango”. Laws v. habits The complexity of the issues means that ultimately no laws may be truly effective. As one famous law maker, Adlai Stevenson, observed “Laws are never as effective as habits.” Groucho Marx famously observed that “[government] is the art of looking for trouble, finding it,

misdiagnosing it and then misapplying the wrong remedies.” Legislators and regulators everywhere are likely to discover the truth of that proposition in their attempts to regulate the derivative market. • Editor’s note The publisher and editor of the Journal of Regulation & Risk – North Asia are grateful to Satyajit Das for allowing the Journal to publish an abridged version of this paper. We remind readers that all copyright on this article is the sole preserve of Mr Das and can only be reproduced with his express authority. Satyajit Das is the author of the newlyreleased Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2010, FT-Prentice Hall).


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Advertising deadline for Vol II Issue IV Winter 2010/11

November 20, 2010
contact Chris Rogers christopher.rogers@irrna.org
164 Journal of Regulation & Risk North Asia

Sovereign debt

Beware Greeks bearing bonds: A tragedy in four acts
Peterson Institute’s Michael Mussa examines some of the policy options Greece can deploy to solve its sovereign debt problems.
in recent months, turbulence has returned to global financial markets due primarily to deepening fears about the ability of greece to service its sovereign debt and widening concerns about the ability of some other advanced european countries with large budget deficits and/ or high ratios of public debt to gDP to meet their obligations. Led by Greece, interest rate spreads for some European sovereigns have shot up, equity markets have sold off in Europe and beyond, and measures of financial stress and volatility have escalated (although they generally remain well be low their crisis peaks in late 2008 and early 2009). The official international community has responded to this new challenge with a very large financial support package for Greece, involving both the European Union (especially the euro area) and the IMF – in conjunction with firm pledges by the Greek government to undertake rigorous fiscal consolidation and other reforms to restore creditworthiness and international competitiveness. Journal of Regulation & Risk North Asia To address remaining concerns about fiscal sustainability in other advanced European countries, the European Union and the IMF have pledged to supply up to US$1 trillion of financial support, and more if needed, to aid euro area members who face critical financial challenges – provided that these countries take appropriately vigorous measures to address their perceived fiscal weaknesses. The European Central Bank (ECB) has also indicated that, under this same proviso, it will purchase in the secondary market debts of euro area sovereigns when these markets appear to have become “dysfunctional.” The Greek situation This paper primarily addresses the current situation in Greece and the challenges to the IMF-EU supported programmeme that is designed to assist Greece. Before turning in-depth to this subject, however, it is important to reflect on the broader financial and economic challenges in Western Europe and the Euro bloc of countries. Then, after discussing Greece in some detail, it will be relevant to reflect on the broader implications that arise from the 165

Greek crisis for Europe and for the rest of the world, including an emphasis on the United States of America. Greece is not alone If Greece were perceived to be essentially alone in its present difficulties, then several different approaches by the international community to assist in dealing with Greece’s problems would be reasonable to contemplate - and quite possibly adopt. But, Greece is not entirely alone in its present predicament. Other countries in the euro area (specifically Portugal, Ireland, Italy, and Spain) are perceived to share, qualitatively if not quantitatively, some of the same concerns about fiscal sustainability and international competitiveness (within the euro area and externally) that now afflict Greece. If Greece were to default upon and/or restructure its sovereign debt in the present environment, this would undoubtedly incite concerns that others might follow – contributing to the possibility of a self-fulfilling prophesy. In the extreme, if Greece were to exit from the eurozone in an effort to gain international competitiveness and spur economic growth, this would undoubtedly escalate concerns about the viability of the European Monetary Union (EMU) for all of its members. This means that exit of Greece from the euro area must be viewed as an extreme step that should be avoided at virtually all costs. Europe’s anaemic recovery More generally, while most of the world economy now appears to be recovering with moderate vigour from the great global recession, recovery in Western Europe is anaemic 166

and uncertain. There are some recent signs that recovery in France, Germany, and several other euro area countries is accelerating. A deepening crisis in Greece that spread to an economically more substantial group of euro area countries could seriously blunt recovery in the rest of Western Europe. Most of the rest of the world (except for Central and Eastern Europe) would be more modestly affected, but the effect would not be positive or trivial. In sum, this is an especially inconvenient time for Greece to blow up into a major financial crisis raising fears of considerably broader problems in Western Europe and beyond. Indeed, an international effort that helps Greece avoid sovereign default – or at least postpones it until generally better times – is desirable not only, and perhaps not primarily, for how it may help Greece but also for its more general benefits. Debt equation significance The notes at the end of this paper detail the basic equation of debt dynamics. Specifically, the rate of increase of a government’s debt to GDP ratio, D/Y, is the sum of two terms: first, the ratio of the primary deficit to GDP, P/Y; and second the product of the difference between the interest rate on government debt minus the growth rate of GDP, i – g, times the debt to GDP ratio, D/Y. The significance of this equation of debt dynamics, especially the importance of the differential between the interest rate on government debt and the growth rate of (nominal) GDP is well illustrated by example of the United States over the past 60 years. The US government has run persistent overall fiscal deficits virtually every year during this period Journal of Regulation & Risk North Asia

and the primary budget balance (excluding interest on the government debt held by the public) has recorded a large cumulative deficit. Nevertheless, the debt to GDP ratio has fallen from 98 per cent of GDP in 1950 to about 60 per cent today. The reason is that, on average, during this period, the growth rate of nominal GDP (g) of 6.7 per cent has exceeded the average interest rate on federal debt by about 2.5 per centage points. Greek nine-year role For the nine years from 1999 through 2008, Greece enjoyed reasonably rapid nominal GDP growth, which generally exceeded the interest rate on Greek government debt. But, growing primary deficits dominated debt dynamics and D/Y grew. With the sharp slowdown in Greek growth in 2008-09 and further rise in P/Y, D/Y shot up to 115 per cent at end 2009. The D/Y ratio now stands at about 120 per cent (see scenario 1 in the notes below). With nominal GDP growth now expected to be significantly negative and with the increase in interest rates on Greek debt, forward-looking debt dynamics indicate rapid rises in D/Y. Greece’s fiscal situation is clearly unsustainable under these conditions. Unsustainable debt level Meanwhile, Greece’s international competitiveness has deteriorated in recent years as wage increases have substantially outpaced productivity increases (in key tradable goods industries and more generally). With the exchange rate pegged within the euro area, Greece requires outright wage deflation to restore competitiveness within the area. Achieving this will not be good for nominal Journal of Regulation & Risk North Asia

GDP growth and for debt dynamics. The adjustment and financing programmeme recently agreed between Greece and the IMF/European Union is supposed to address these problems. The key features of this programme are noted in the notes below. Assuming that this programme works as advertised, the debt dynamics from 2013 onward would plausibly be described by scenario 2, 3, or 4, depending both on how credible and durable the market believed Greece’s policy commitments to be and on how rapidly the Greek economy appeared likely to grow in terms of nominal GDP – both of which affect i – g. In the base reform scenario 2 (IMF Programme A), with i – g = 0, sustainability of debt dynamics is, at best, marginal. D/Y is declining, but the rate of decline is not quite sufficient to allow timely repayment of official assistance (which enjoys preferred creditor status) except by increasing the debt/GDP ratio for private creditors. Keeping debt holders sweet Thus, for this scenario to be viable, private creditors would need to be comfortable with the prospect that the ratio of privately held Greek debt to GDP would be rising for some years as official borrowings were repaid. In the unfavourable (but realistic) reform scenario 3 (IMF Programme B), i – g = + 3 per cent, reflecting likely concerns that debt dynamics may be unsustainable. Here the rate of decline in D/Y, only 0.5 per cent per year, is clearly too slow to reinforce market confidence, especially when it is known that paybacks of official assistance will far more than offset this modest rate of decline in D/Y as far as private creditors are concerned. 167

Good luck, however, is possible as portrayed in scenario 4 (IMF Programme C). Here i – g = – 2 per cent, signifying a high degree of market confidence in debt sustainability and a relatively high growth rate of nominal GDP. In this case, the rate of reduction in D/Y is sufficient to allow for reasonable rapid repayment of official support and a modest pace of reduction in the ratio of private credit to nominal GDP. Critical concerns A number of critics of the present approach have suggested, not without reason, that a debt restructuring for Greece is probably inevitable. More disputably it is argued that it would be best to do this restructuring up front in order (1) to avoid the loss of credibility of subsequently appearing to fail and being forced into a new strategy; (2) to keep the required amount of official financing to more moderate levels; and (3) to lessen concerns about moral hazard and “unfairness” by forcing all existing private creditors to realise up-front losses rather than allowing some creditors (with shorter-maturity Greek debts) to escape losses while holders of longer-maturity debt are later forced to accept even larger losses. Aggressive restructuring Scenario 5 describes the possible debt dynamics subsequent to an immediate restructuring. In this scenario, i – g = 5 per cent, signifying both that growth of nominal GDP is likely to be negative at least during the initial period following an immediate restructuring and that after such a restructuring, creditors may worry that another restructuring may occur relatively soon. 168

To contain this later concern, the initial restructuring needs to be quite aggressive. In scenario 5 it is assumed that all existing debts are immediately written down by 50 per cent with interest rates maintained at established levels on the reduced principals. In the case of such an aggressive restructuring, it is plausibly assumed that Greece would lose access to new private credit for some time. Accordingly, the primary budget position would have to move immediately into moderate surplus in order to make the diminished interest payments on the reduced debt. The need for this primary surplus might be offset by official lending on a much diminished scale from the announced programme. But, under immediate restructuring even with moderate international support, Greece cannot avoid a rapid move at least to primary budget balance and probably beyond. Alternative scenario An alternative scenario for immediate restructuring would involve a one-third write-down in the value of all outstanding debt, holding interest rates constant. This would be combined with a three-year extension of the maturities of all outstanding debts and a three-year moratorium on all interest and principal payments. The effect of such a (compulsory) restructuring would be to reduce the present value of the debt by about 50 per cent – the same as in scenario 5. This form of restructuring would alleviate for three years the need to deal at all with the existing debt, at the cost of leaving a larger amount of private debt on the table to be dealt with later – perhaps with greater doubts about sustainability. Journal of Regulation & Risk North Asia

While there are good arguments to go for an immediate restructuring if it is reasonably certain that a restructuring will ultimately be necessary, there are also at least two good reasons in the present Greek case not to follow this path. Is restructuring necessary now? First, it is not entirely clear that a restructuring will ultimately be necessary (although I would give it better than 50-50 odds). If it occurs, a sovereign debt restructuring will almost surely need to be quite aggressive in order to contain the perceived risk of early recurrence. Understandably, creditors will be irate and the Greek sovereign will not be able to return to normal participation in financial markets for some time. The functioning of the Greek financial system will be seriously impaired for some time. The whole Greek economy will suffer. Thus, looking only at Greece, there is good reason to try to avoid sovereign default and restructuring as long as there is some reasonable chance of being successful. Sovereign default is not a cheap way out. (Exit from the eurozone would be even more disruptive and expensive.) Wider perspectives Second, from a European and global perspective, this is not the best moment for a sovereign Greek debt restructuring. A year or two from now, most Western European economies should be considerably more advanced in their economic recoveries. Countries now perceived to have potential fiscal sustainability problems will have had an opportunity to demonstrate better their Journal of Regulation & Risk North Asia

dedication to fiscal probity. European banks will have been able to strengthen their capital positions and prepare better for the consequences of a sovereign debt restructuring. In December 2008 President Bush decided (with obvious reluctance) that, in the face of continued high stress in United States and global financial markets, it was desirable to delay major corporate bankruptcies by General Motors and Chrysler by extending government loans. In those circumstances, kicking the can down the road to a time when resolution through the bankruptcy process would presumably be less systemically dangerous was clearly the right answer. A similar consideration weighs heavily against immediate sovereign debt restructuring for Greece. IMF-EU bailout package The details of the IMF-EU plan for official financing for Greece is presented in table 4 of the “Memorandum of Economic and Financial Policies” attached to the Greek Government’s request to the European Union for financial support. This plan suggests that the issue of sovereign debt rescheduling for Greece will probably need to be revisited before the end of 2011. The plan, which needs to be understood as a planning scenario subject to revision, envisions the following: First, from now through the end of 2011, the financing need of the Greek state is estimated to be about €94 billion. Most of this need will be met by international financial support disbursements of €78 billion, with €25 billion supplied by an assumed rollover of short-term private credits. No rollover of longer-term private credits is assumed in this period. 169

Second, from the start of 2012 through the middle of 2013, the Greek government’s financing need is estimated to be about €99 billion. Only €32 billion of official financial support is tentatively scheduled in this period. The remaining financing need is assumed to be met by continuing rollover of short-term debts (€26 billion) and successful rollover of 75 per cent of longer-term private credits maturing in 2012, rising to 100 per cent in the first half of 2013 (for €43 billion of assumed financing). Important questions This scenario raises the obvious and important question of whether, by the start of 2012, private creditors will be willing to lend, for the long term, substantial sums to the Greek sovereign at reasonable interest rates. In 2011, the Greek economy is projected to still be contracting. Important fiscal measures scheduled in the programme for 2012 and 2013, amounting to 4.4 per cent of GDP and providing for the move to primary surplus, will not yet have been implemented. Commitments to repay official lenders as preferred creditors will already exceed onethird of Greek GDP and stand in front of obligations to private creditors. In these circumstances it seems implausible to assume that private creditors be confident about extending longer term credits to the Greek sovereign. Effects on yields If the Greek authorities fail to implement the programme to which they are committed, we shall learn relatively quickly that programme is not viable and debt default and/ or restructuring is likely soon to ensue. If the 170

programme is implemented as promised, we shall need to see in the summer and autumn of 2011 what is happening to yields in the secondary market for longer-term Greek debt. If these yields suggest that longer term debt rollover is likely to be feasible at reasonable yields consistent with sustainable debt dynamics, then the programme as envisioned in table 4 can probably proceed successfully. However, if the markets signal that sufficient credibility has not been achieved by autumn of next year, then major decisions about revising the programme will become necessary. One possibility would be to decide that a sovereign debt restructuring has indeed become necessary. The extent of the necessary restructuring would depend on what the Greek authorities had accomplished and reasonably could be expected to deliver in the future. A modest haircut for private creditors would almost surely not be an option. ‘Haircuts’ may be necessary If restructuring is really needed, it will have to involve a substantial write-down in the present value of the private debt in order to provide reasonable assurance that another restructuring will not soon be needed. The result will likely be a costly mess for Greece and its creditors. Hopefully, however, by late 2011 the adverse spillover effects to the rest of Europe and the world economy will be limited. The other alternative is to persevere with the programme, augmenting its official financing and probably insisting on somewhat greater efforts by the Greek authorities. The additional official financing should Journal of Regulation & Risk North Asia

not be a serious problem if, as hoped, other euro area members presently perceived to be at some risk regarding fiscal sustainability do not need to draw on the $1 trillion of already agreed available support. Under this approach private creditors would receive an even larger “bailout,” with increased official financing going to pay down longer maturities of Greek government debt. Unfortunately this would contribute both to the “immoral result” of rewarding past poor lending decisions and to the moral hazard form encouraging more such decisions in the future. Avoiding moral hazard In contrast, the Greek government and people would not be receiving a true “bailout.” Massive fiscal adjustment would be required, sufficient to move the primary budget balance from substantial deficit into considerable surplus. Also, so long as the official support that Greece receives is in the form of loans that must be repaid with interest, then that at least compensates official creditors for their own cost of funds. And there will be no true“bailout”of Greek citizens at the expense of taxpayers in other countries. What about the “moral hazard” of possibly encouraging other countries to follow Greece’s example because the even larger costs of sovereign default have been avoided? Well, watching the experience of Greece in this episode, who would reasonably say:“Let us follow the example of Greece in its great glory”? Broader lessons and implications Looking again beyond Greece, there are at least two important wider lessons to be Journal of Regulation & Risk North Asia

drawn from this episode. First, while Greece is the first of the so-called“advanced economies” to seriously confront the risk of sovereign default and restructuring in half a century, it will not necessarily be the last. Even the United States is not inherently immune. The economic and political power of the United States and the special role of the dollar in world finance provide a degree of protection. More important, the long record of the US government in meeting its financial obligations underlies confidence that this will continue to be the case. US public debt shot up to over 100 per cent of GDP during World War II and was brought back down to about 30 per cent by 1980. It rose again to about 60 per cent by the early 1990s, and it was brought down again to around 30 per cent by 2000. In the past two years, the US debt to GDP ratio has rebounded to about 60 per cent and is surely headed higher. The test ahead will be whether this debt ratio can be contained at 75 to 80 per cent of GDP in the next few years and then be brought down to more reasonable levels. US federal debt In this regard, stabilising the federal debt to GDP ratio at around 80 per cent, which appears to be the current administration’s objective, will not be enough. Containing rising entitlement spending, as well as providing for some structural rise in federal revenues are essential to put the debt-to-GDP ratio clearly on a downward course to somewhere below 50 per cent. If the challenge is not met, there is a clear danger that the next time the United States has to confront a deep recession and/ 171

or major financial crisis, it will not enjoy the unalloyed market confidence that has allowed it to deal so forcefully with the recent crisis. Finally, Greece is a relatively small country and is surely not “too big to fail” in the sense of enduring a sovereign default and debt restructuring. Greater worry The international response to help Greece in its present difficulties, however, is not motivated solely or perhaps primarily by concerns about the costly mess that would engulf Greece in the wake of sovereign default. The greater worry is that in present circumstances a Greek default might trigger a much deeper and wider crisis in Europe and around the world. In a similar way, in September 2008, Lehman Brothers was not by itself“too big to fail,”and, in my view, the sudden bankruptcy of Lehman Brothers was not the cause of the deep crisis that gripped global financial markets in the autumn of 2008. Lehman’s bankruptcy helped to trigger that crisis, but it was the general weakness and perceived fragility of many financial institutions and other businesses that really made the crisis. The lesson from this experience and from the present Greek case is that, whatever Table 1. Scenarios for Greek debt dynamics
Scenario Current, no programme IMF Programme A IMF Programme B IMF Programme C Restructure now Restructure later i–g (per cent) 10 0 3 –2 5 1

might trigger it, when a crisis threatens to go systemic, there is no sensible alternative but massive extensions of official financial support and government guarantees of a wide range of credits. Much can and should be done both to limit the risk of future crises and to contain the moral hazard that inevitably results from expectations of government intervention – especially when potential difficulties do not seriously threaten to reach systemic proportions. But centuries of economic history demonstrate that major crises will happen from time to time. It would be a great tragedy if the very forceful efforts that were deployed to contain the recent systemic crisis were paralysed by too much talk about ending bailouts and “too big to fail,” with the result that we recreated the disastrous situation of the early 1930s. • Editor’s note The Journal of Regulation & Risk – North Asia would like to express its gratitude to Michael Mussa and the Peterson Institute for International Economics for granting us permission to reproduce an amended version of this article. We remind readers that copyright remains with Mr Mussa and the Peterson Institute.

D/Y (per cent) 120 150 150 150 60 100

P/Y (per cent) 8 –5 –5 –5 –3 –5

d(D/Y)/dt (per cent) 20 –5 –0.5 –8 0 –4


Journal of Regulation & Risk North Asia

Notes on Greece and the IMF Debt Dynamics: The rate of change of the stock of public debt, D, is given by dD/dt = P + i D, where P is the primary deficit and i is the average interest rate on government debt. The rate of change of the debt to nominal GDP ratio is d(D/Y)/dt = (P/Y) + (i – g) (D/Y), where g is the growth rate of nominal GDP. 1. The programme envisions declines in real GDP of four per cent in 2010 and 2.5 per cent in 2011, before growth resumes at a moderate pace. The price level is assumed to fall, at least this year and next. Nominal GDP is projected at €231 billion in 2010, €224 billion in 2011, €238 billion in 2012, and €235 billion in 2013. 2. The fiscal adjustment programme includes consolidation measures amounting cumulatively to 11 per cent of GDP by

2013, with 3.9 per cent in revenue measures and 7.1 per cent in expenditure measures. The (additional) effect of these measures is 2.5 per cent of GDP in 2010, 4.1 per cent in 2011, 2.4 per cent in 2012, and 2.0 per cent in 2013. A primary surplus of at least five per cent of GDP is projected to be maintained after 2013. 3. The programme ceiling on the public debt for end 2010 is €342 billion (148 per cent of yearly GDP). The “indicative target” for public debt at end 2011 is €365 billion (163 per cent of GDP). The implied ceiling for public debt at end 2012 is €381 billion. Editor(160 per cent of GDP). Thereafter, the debt to GDP ratio is projected to decline. 4. The programme also includes structural reforms to boost productivity and competitiveness, address problems in the financial sector, and bolster fiscal adjustment.

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Sovereign debt

Global financial crisis and the European Monetary Union
Prof Christian Fahrholz & Dr Cezary Wójcik examine the implications of the global financial crisis for the euro area.
the unprecedented globally co-ordinated stimuli programmes in the aftermath of the 2008 financial crisis averted an economic depression on par with that of the 1930s. however, such huge intervention, much of it with borrowed funds, has led to a secondary crisis, this time focused on sovereign debt as countries begin the onerous task of slashing public expenditure in order to release funds to service national debt repayments. The challenges associated with this process are particularly acute in the Euro-zone bloc of countries, with one of its members, Greece, struggling to avoid defaulting on its debt repayments. This issue has resulted in a domino effect afflicting Portugal, Ireland, Italy, Spain and Greece itself and marks the greatest challenge the European Monetary Union (EMU) has faced since its inception. In this paper, the authors examine the current nature of the Greek debt crisis and how this informs the constitution of the EMU and its future development if the Euro is to survive another 10 years. Governments the world-over reacted Journal of Regulation & Risk North Asia to the financial crisis by sharply increasing public deficits to fund major stimulus packages, with many of these same countries seeing their national deficits rise above six per cent of GDP. In the more advanced western economies whose fiscal stimuli programmes were more aggressive debt levels rose to some nine per cent – compared with an average of four per cent for developing economies (cf. IMF 2010). Concurrent with these massive government interventions, many central backs across the world adopted a near zero interest rate policy, whilst also easing access to their liquidity windows by accepting a much broader class of assets for their open market operations for longer time frames than prior to the crisis. Other unusual methods adopted to stave off catastrophe included the introduction of quantitative easing by the US Federal Reserve and the Bank of England – where by both institutions have engaged directly in purchasing government bonds. As a consequence of all this monetary easing, central bank assets ballooned to all-time record figures as seen in figure 2 overleaf. This monetary policy thus far has not 175

Figure 1. Fiscal balance, 2000-2014 (projected)

Source: World Economic Outlook, IMF, October 2009

Figure 2. Total assets/liabilities of selected central banks (US$ billions), May 2006-April, 2010

Sources: Bank of England, Bank of Japan, European Central Bank, US Federal Reserve


Journal of Regulation & Risk North Asia

Figure 3. Spreads of Greek, Irish, Spanish and Polish government bond yields over German government bond yields, 1998-2009

Source: Bloomberg

created too many inflationary forces due to the fact that a large proportion of the funds have been utilised to restore commercial banks balance sheets in order to prevent a deflationary rout – although it remains to be seen if such actions will result in inflationary pressures. However, fiscal problems have already surfaced in some economies, with many of these adopting austerity measures to prevent a sovereign debt run in the markets and as such, now threaten the nascent global recovery as countries cut back on expenditure. Nowhere is this currently better illustrated than in the European Union, specifically the Euro bloc of nations, with one of its own members, Greece, verging on the brink of a sovereign debt default – this despite massive European Central Bank interventions. Many commentators have even suggested Journal of Regulation & Risk North Asia

that Greece’s current woes could result in the implosion of the Euro and the collapse of the EMU which poses a significant risk not only to Europe, but to the global economy itself as highlighted by Fahrholz and Kern in 2009 and Fell in 2010. The current Euro and Greek crisis thus begs four important questions, namely: What are the roots of the current Greek problems within EMU? What is the shortterm response of EMU countries to such a Greek-type crisis? What does the Greek crisis tell us about the construction of the EMU? What should be done to safeguard the EMU and the euro in the long-run? With regard to the first question, it is important to note that while the global crisis has been a trigger, the Greek problems are primarily home-grown. According to the latest European Statistical Office estimates, 177

Greece’s fiscal deficit reached a whopping 13.6 per cent of GDP last year. As a result, the overall public debt is currently running at some 115 per cent of GDP. At the same time, GDP growth remains in a negative trajectory as the country remains uncompetitive with its major trading partners vis-a-vis the EU. In the past two years alone, its unit labour costs increased by more than 20 per cent relative to its main trading partners, with its current account deficit increasing to some 12 per cent of GDP. EMU shortcomings Greece’s problems, though, cannot entirely be blamed on its own actions, particularly given numerous shortcomings in the EMU framework, specifically with regard to the Stability Pact, which, in theory at least, should work pre-emptively to mitigate against a Greek-style debt problem – this plainly not being not the case in this instance. Moreover, current developments can be partly traced back to a speedy catch-up process, that coupled with EMU membership led to the risk premium in peripheral EU countries, such as Greece, to drop to exceptionally low levels. Again, revert to figure 2. The resultant low costs of funding, in turn, led debtors and creditors to engage in excessive lending and indebtedness. This applies equally to the public and the private sector and is certainly not limited to the European sphere. As a member of the EMU, member countries have limited scope for active policies to correct this problem, specifically by resorting to a currency devaluation to help ease any fiscal adjustments and restore international competitiveness. As such, member countries 178

are forced to adopt a painful internal process of devaluation, such as the lowering of nominal wages. Ratings downgrade As a consequence of this ongoing deflationary process, Greece has been hit by several downgrades of its government debt ratings since the beginning of 2010, with markets showing considerable unease to the extent that the yield spreads of Greek government bonds skyrocketed to above 1,000 basis points relative to German yields – this being considerably higher than spreads on those Eastern European countries who have yet to join the EMU (see figure 2). This leads us to the second question: what is the short-term response of the EMU countries to a Greek-type crisis? Despite the crisis, it took the European Commission, ECB and Euro-bloc member countries a significant period of time to agree on any emergency bail-out efforts, and only then in co-operation with the IMF. The resultant agreed package of emergency assistance extends to funds from both EU members and the IMF, ameliorated with an exceptional credit guarantee line – the Special PurposeVehicle – amounting to €750 billion (approximately US$ 995 billion). Stabalisation plan The three-year stabilisation plan includes €60 billion provided by the European Commission, €440 billion provided in bilateral loans and guarantees by euro area members, as well as €250 billion from the International Monetary Fund (IMF). In addition, the European Central Bank committed to the direct purchase of government bonds Journal of Regulation & Risk North Asia

on the open market. Economists disagree vehemently as to whether this is the correct prescriptive course to follow and question why Greece and other crisis-prone countries should, or should not be bailed out at all, specifically if it relates to a monetisation of public debt? Some commentators (e.g., Frankel 2010, Issing 2010, Wyplosz 2010) have argued that providing any form of financial support would be a policy mistake, as it would undermine the very foundations of the EMU, and jeopardise the stability of the euro in the long-run by creating moral hazard in the future. Default fears In contrast, others argue that letting Greece default could cause a domino effect within the periphery members thereby threatening to break-up the Euro and unleashing “the mother of all financial crises” (Eichengreen 2010). Hence, in their view, Europe needs to create a strong emergency financing mechanism that is eventually backed by a higher degree of political integration. Irrespective of what should or should not be done at the European level, its at least now possible to attempt an evaluation of the root cause of the current crisis on theoretical grounds by means of a game-theoretic, political economy model of default externalities in a monetary union with incomplete political integration – as in the case of a Greek-type crisis. This can be done by reviewing some of the basic features found in this type of analysis (for further details see Fahrholz and Wójcik 2010). As to the general set-up, there are two representative agents involved in the game. We assume that within the EMU there are a Journal of Regulation & Risk North Asia

couple of ‘twin deficit’ countries which suffer from the twin problems of public debt sustainability and external debt sustainability – for example in Greece, as well as in Spain or in Portugal. The second group of countries – for example, Germany – is characterised by current account surpluses within the euro area and more sustainable public debt positions. Lack of integration Furthermore, there is incomplete political integration among the agents, with Eurobloc countries having different incentives to being an EMU member, with each member facing different constituency constraints, combined with the fact there is no automatic emergency financing mechanism for unwinding severe fiscal and macroeconomic imbalances in the EMU. Hence, EMU has been a hotchpotch of compromises since negotiations began in the 1970s, with this informing the direction of fiscal affairs until the present day. EMU advantages Both ‘camps’ are generally interested in preserving the smooth functioning of the EMU. From the viewpoint of a country like Greece, membership in the euro area is advantageous as it helps to provide access to financial markets and to real external resources, whilst paradoxically, leading to a loosening of budgetary constraints for periphery members. At the same time, membership in the euro area is beneficial for a country like Germany, as it supports its export-oriented production and respective economic policy stance. Against the backdrop of these rationales for an EMU membership, ‘EMU 179

stability’is a public good whose deterioration in the course of one member’s default would make both camps worse off. This particularly holds true when a contagion presents itself within the EMU, with the resultant possibility of a disorderly disintegration process in terms of increasing protectionism, reversing production process, growth slack and overall welfare losses. Hence, although individual motivations differ, the interest to preserve the smooth operation of the EMU is shared by all agents. Accordingly, both camps have some willingness-to-pay for preserving EMU stability and their membership within EMU. Reciprocated mutuality The mutual willingness-to-pay for ‘EMU stability’ constitutes the foundations of bargaining for redistribution of actors’ cost shares within EMU. In this context, a country like Greece may resort to brinkmanship, as its potential default would create a negative externality, i.e. a Damocles sword hanging over the rest of the EMU members. This is to say that if a ‘twin deficit’ country experiences a sovereign debt crisis, such a crisis would almost certainly put the smooth operation of EMU at risk. As a consequence of this fragility, such countries are likely to exhibit brinkmanship. Namely, if a ‘twin deficit’ country’s encounters an adverse economic situation, it may ease the burden of adjustment to its constituency, thus, putting the success of the euro area at risk. In doing so, the twin deficit country may elicit other EMU members’ actual willingness to pay for ensuring the provision of the public good,‘EMU stability’, in the long run. Importantly, above all factors 180

there is the risk of an overall worst outcome for such manouvering on the brink – i.e. for example, an EMU break-up – thus constituting a threat, which is not under full control by the actors. As soon as it turns out that the threat is indeed credible brinkmanship ensues. Negative externality By assuming the above structure – which seems to be in line with what one can now observe in Europe – the analysis predicts that a threat of default by one member, creating a negativity externality for the whole monetary union, must result in sharing the costs of economic adjustment by the rest of the members, i.e. a bail-out. Importantly, this is the direct consequence of the current institutional set-up of EMU, of the sui generis nature of EMU that it cannot easily escape. Interestingly, the analysis shows that such a bail-out does not necessarily need to cause an excessive moral hazard problem. The bargaining process is so ‘tight’ that the bailed-out country will abstain from further attempts to promote a hazardous fiscal policy stance and will behave well. Moreover, current account surplus countries’ willingness to pay for contributing to the public good,‘EMU stability’,will be exhausted. EMU construction This brings us to the third question: What does the Greek crisis tell about the construction of the EMU? What’s wrong? The delineated analysis indicates that the current EMU problems do not only ensue from the Greek fiscal problems alone, but from the interactions of these problems with the actual political-economic configuration Journal of Regulation & Risk North Asia

of EMU. To put it differently, the sheer fact that countries share the same currency does not necessarily lead to negative spill-overs between them. If this was the case then fiscal problems in Ecuador, a dollarised country, would produce a threat to the dollar – evidently this is not the case (see more Balcerowicz 2010). In the EMU, however, precisely such spillover – the negative externality – allows twin deficit countries such as Greece to take hostage the whole EMU and thus poising a significant threat to the euro. An analogy Think of the following business analogy – imagine two companies: In the first company, unexpected sick leave of one of the ordinary employees severely disrupts the production process. In the second company, even unexpected sick leave of one of the key managers does not influence day-to-day operations. What makes the difference is that the second company excels at better procedures: in case of an event where all know what to do and who substitutes whom. The EMU is an example of the first economy. It is telling that a problem in one very small country like Greece has a disproportionately greater impact on the stability of the whole area than this is the case in the US monetary union where fiscal woes of even such big states as California do not wreak even a smaller amount of such havoc. Moreover, Europe is a highly integrated economic area in real terms. It goes without saying that allowing for the inter-temporal exchange of goods and services is a prerequisite for reaping welfare benefits stemming from higher productivity (i.e. specialisation in production). At the same time, the current Journal of Regulation & Risk North Asia

macroeconomic imbalances within Europe reflect the concurrent building-up of claims and liabilities regarding future production (usually in the form of holding government bonds within the banking sector). Major pitfall Against this backdrop, one of the major pitfalls of the EMU set-up is that it neither provided incentives for curtailing excessive lending and indebtedness, nor for converting the financing of external resources into real investments, i.e. future production. As a result, pending claims might turn irrecoverable, which, in turn, may severely impair the formation of the real economy, especially within export-oriented economies of the EMU. Apparently, the question is: what are the ‘procedures’that the US monetary union has and the European one does not? Basically, it is greater policy co-ordination through bigger central budget allowing for fiscal transfers and federal bonds helping to finance it at a low cost – it goes without saying that greater labour mobility and flexibility of markets is also conducive to economic adjustments. US comparisons However, here we concentrate on economic management tools. In essence, these tools in the US internalise the cost-sharing mechanism. If economic growth in California goes down, the Federal Government transfers funds to social security expenditure that work as automatic stabilisers. Federal government can also issue federal bonds that can finance these expenditures at lower interest rates that a given state would be able to negotiate at financial markets. Against this background we shall look 181

at the last question: What should be done to make the EMU and the euro more sustainable in the long-run? An ideal solution might be, of course, creating similar tools in Europe as the ones present in the United States. However, it is naïve to think that this can be achieved quickly because it would require a far greater degree of political integration, to which the degree of policy co-ordination is endogenous. Policymakers in Europe know very well that stepping-up political integration takes a frustratingly long time. At present, it may even make some steps backwards, given that the future EMU enlargement will further increase the political and economic heterogeneity of the euro area. A rock and a hard place Being squeezed between the undesirable now and the desirable future, the EMU needs to develop some intermediate solutions that would help to cross the bridge. The sketched analysis above suggests at least possible avenues: If a bail-out is unavoidable in the current state of political-economic configuration of the EMU than it should be made rule-based and explicit. In order to decrease the scope of the negative externality effect, EMU countries should specify the conditions and procedures for leaving the EMU, along the costs and legal requirements of such an operation. The first solution would clearly save all the haggling and uncertainty in the course of such events resulting in lower risk premium which is associated with such uncertainty (see Bini Smaghi 2010 who makes a similar case in context of financial markets). The second solution would also stabilise 182

market reaction, should we experience a next wave of rumours about potential default or exit. Since markets would know exactly what conditions and form it would take, there would be much less room for uncertainty and volatility in financial markets. Importantly, a clear-cut delineation of costs would serve as a deterrent to any form of brinkmanship. Issues of sucession It would be evident to all that no cost sharing will take place should an exit occur. By increasing the perceived costs of leaving relative to the short-term political costs of economic adjustment, it could defuse future threats of leaving and stimulate fiscal discipline and, hence, considerably decrease the scope for the negative externality. The latter solution is not new. It draws on the history of some national states struggling with preserving internal integration. Their experience suggests that when secession is not permitted, pressure for it rises. When secession is openly allowed many would-be secessionists cease to press so hard for it – or for a bail-out as is the case with the Greektype crisis. Concluding remarks As a concluding remark, one can look at the EMU crisis from two perspectives: on the one hand, one can see it as a moment of disaster; on the other hand, one can see it as an opportunity to push ahead with inevitable reforms. For the time being – as the ‘United States of Europe’ seems to be politically unfeasible – one may consider bringing financial markets back in to the arena. Measures of reasserting the monitoring function of financial markets Journal of Regulation & Risk North Asia

may eventually curb the debtors’ ability to demand ‘too much’ debt financing as less investors will flock to ever-riskier government bonds. In this respect, most notably, one has to dampen any ambiguity of lenderof-last-resort facilities to curtail creditors’ moral hazard concerning a disproportionate supply of credit-financing. A rule-based, automatic resolution regime comparable to insolvency proceedings for the private sector – instead of yet another discretionary intervention as has been the case with Greece – would limit debtors’ moral hazard. Any reform steps towards this direction would help stressing market agents’personal liability again, which generally is a prerequisite for smooth operation of markets and may thus guarantee financial stability within the euro area in the long-run. Despite the current bashing of financial market agents and the fractious debates on financial mechanisms for dealing with the debt crisis, Europe may seize the opportunity to preserve the euro and avoid a messy disintegration. It is obvious that the recently implemented credit guarantee line represents only a delay of inevitable economic adjustments. In addition, such emergency financing mechanism rather invites tumbling countries to skirt economic adjustment processes as their constituency pressures build. Notwithstanding, an advantage of European ‘cacophony’ is the potential to develop – slowly but surely – a multitude of possible ways out of its sovereign-debt crisis. We have hence suggested the direction of an intermediate solution in terms of crafting an improved institutional set-up Journal of Regulation & Risk North Asia

of the EMU. As regards global economic recovery, we would be intrigued to see how the issue of the ‘credit hangover’ will be solved on a global scale. It is hard to perceive all economies in the world exhibiting productivity leaps and exporting – and thus paying their due liabilities in real terms – at the same time. • references
Balcerowicz Leszek, 2010,“Sovereign Bankruptcy in the EU in the Comparative Perspective”, paper presented at the XII Travemünde Symposium zur ökonomischen Analyse des Rechts, Travemünde, 24-26 March 2010, http://www. emle-hamburg.de/_data/Balcerowicz.pdf Bini Smaghi, Lorenzo, 2010, “It is better to have explicit rules for bail-outs”, Financial Times, 16 March 2010. Eichengreen Barry, 2010, “Europe’s Trojan Horse”, Project Syndicate, http://www.project-syndicate.org/commentary/ eichengreen14/English, 15 February 2010. Fahrholz, Christian and Cezary Wójcik, 2010,“Modeling Default Externalities in EMU: Understanding the Impact of a Greek-type Crisis on the Euro Area”, mimeo. Fahrholz, Christian and Andreas Kern, 2009, “When Economics is Crushing Big Fat Greek Wedding Plans: A Greek Tale of Full-Blown Drama”. Paper published at Atlantic Community, Berlin, http://www.atlantic-community.org/index/Open_Think_Tank_Article/A_Big_Fat_ Greek_Financial_Wedding, last update: 8 December 2009. Fell, Charlie, 2010,“Euro zone currency crisis is only beginning”, Irish Times, 23 April 2010. Frankel, Jeffrey, 2010, “Let Greece Go to the IMF”, Jeff Frankels Weblog, http://content.ksg.harvard.edu/blog/ jeff_frankels_weblog/2010/02/11/let-greece-go-to-the-imf/, 11 February 2010. IMF, 2010, “World Economic Outlook – Rebalancing Growth”, Washington, D.C., International Monetary Fund, April 2010. Issing, Otmar, 2010, “A Greek bail-out would be a disaster for Europe”, Financial Times, 16 February 2010.



Lehman Bros and Repo 105: a powerful case of addiction
University of Massachusetts, Amherst, Prof Jennifer S. Taub details changes in law that proved a powerful intoxicant for Wall St.
to the uninitiated, ‘repo 105’ evokes the name of a basic finance course or perhaps an expensive perfume. however, the broader implication of lehman’s corrupt accounting strategy is neither simple nor does it pass the smell test. the term repo 105, floated through financial circles in March 2010, with the release of the examiner’s report in the lehman bankruptcy.[1] Volume three of a 2,200 page document, claimed that management used accounting tricks to mask us$50 billion in debt. While hiding $50 billion off balance sheet is nothing to sneeze at, ‘Repo 105’ may be an unfortunate distraction. Instead, we should focus on the perfectly legal, yet dangerous use of repos backed by securitised bonds to grow balance sheets. This practice, expanded by a 2005 legal change, destabilised the financial sector and led to the ultimate credit crisis of 2008. In other words, this enabled what Gary Gorton and Andrew Metrick deemed the “run on repo”[2] and what Jane D’Arista described as a“run on the financial sector by the financial sector.”[3] Journal of Regulation & Risk North Asia A repurchase agreement or “repo” is a twopart arrangement. The seller (borrower of cash) agrees to sell securities at a slight discount to a buyer (lender of cash). Under that same agreement, the borrower agrees to buy them back at a future date at a higher price[4]. The securities are known as “collateral.”The discount is known as the margin or“haircut” and the ratio between the increased price and original price is known as the rate. Oiling Wall St’s wheels Repos have been called the“oil in the industry of Wall Street”[5] because investment banks financed up to 50 per cent of their assets in the repo markets.[.6] One analyst noted that“repo markets are only one channel linking the “shadow banking” sector to the broader economy”.[7] Given its size and importance, the repo market is surprisingly obscure. At its peak, the US market was estimated to be between $7- $10 trillion.[.8] Outstanding US repos today are approximately $4.3 trillion.[9] Lenders in the repo market can be institutional investors like pension funds and mutual funds seeking a liquid but relatively 185

safe place to invest cash for the short term, often overnight. Lenders also include broker-dealers and banks that need securities to cover short positions. Borrowers often are broker-dealers and banks who use repos to finance asset purchases and to leverage. Lehman bankruptcy file Turning to the infamous Lehman bankruptcy examiner’s report of March this year, according to this 2,000 odd page tomb, with ‘Repo 105,’ Lehman, as borrower, accounted for US$50 billion in repos as sales instead of financing transactions. The examiner contended that the appropriate accounting practice was to record these transactions on balance sheet by increasing both cash (assets on the left side) and collateralized financing (liabilities on the right side). Thus a properly recorded repo transaction would have resulted in both a larger balance sheet and also higher leverage ratios. Instead of raising sufficient equity capital to lower leverage ratios, Lehman chose a cosmetic solution. With ‘Repo 105,”near the end of a reporting period, Lehman treated some repos as sales and used the cash proceeds to pay down liabilities. This made the firm appear to have a smaller balance sheet and less leverage than it truly had. The transactions were called ‘Repo 105’ and ‘Repo 108’ in reference to the size of the haircut. For ‘Repo 105’ transactions, Lehman would provide collateral said to be worth 105 per cent of the amount of cash it borrowed. Initially, other firms claimed they did not engage in Repo 105s, yet, footnote 69 in the examiner’s report implied that at least until 186

late 2007, top investment banks were using them to “manage” their balance sheets. By May, some firms admitted improper treatment of repo transactions as sales. [10] Shortly after the report was issued, the SEC announced an investigation of banks using “repurchase agreements, securities lending transactions, or other transactions involving the transfer of financial assets with an obligation to repurchase the transferred assets”.[11] Additionally, another type of misleading repo accounting surfaced. Eighteen banks had “understated the debt levels used to fund securities trades by lowering them an average 42 per cent at the end of each of the past five quarterly periods”.[12] These banks include Goldman Sachs, Morgan Stanley, JP Morgan Chase, Bank of America and Citigroup. 2008 Lehman panic The SEC chief accountant testified that there did not seem to be evidence“that inappropriate practices were widespread”.[13] Yet, given that the larger problem is the legally“appropriate,”but systemically dangerous practices, these words should offer little comfort. Gorton observed:“The [2008] panic centered on the repo market, which suffered a run when lenders [like depositors during Depression-era banking runs] required increasing haircuts, due to concerns about the value and liquidity of the collateral should the‘counterparty bank fail’.” These repo lenders also refused to rollover existing repos. Both actions created “massive deleveraging . . . resulting in the banking system being insolvent”.[14] Yet, the run was not on the whole repo market, but Journal of Regulation & Risk North Asia

rather on repo agreements backed by nongovernment collateral – in particular, repo backed by securitised bonds. Cash-rich lenders still sought opportunities to loan against US Treasuries. They did not trust the valuation of the securitized debt, including mortgage backed securities. Thus, it follows that haircuts got larger for non-government collateral. ‘Haircuts’ at 45 per cent And ultimately, some collateral simply could not be used at all. The average haircut on structured debt went from zero in 2007 to 10 percent by March 2008. In September 2008, the rate shot up from 25 per cent to 45 per cent.[15] How did this happen? Recent legal changes transformed the market, from one backed by largely US Treasury and agency collateral to one backed by securitised bonds. These changes expanded this vital financing market and made it far more unstable. Outstanding repos and reverse repos grew from $4.9 trillion in 2004 to $7 trillion by first quarter 2009. Prior to the bankruptcy law changes, limited types of repos were given special treatment known as a “safe harbour” in bankruptcy. For example, if a repo borrower filed for bankruptcy, a repo lender with special collateral was not subject to the automatic stay and would not need permission before accelerating, closing out the agreement, or selling the collateral.[16] In addition, the interest paid on the repo would not be clawed back as a preference. These collateral types included for example, US Treasury and agency securities, certificates of deposit and certain bankers’ acceptances. However, it was not clear what would Journal of Regulation & Risk North Asia

happen to the repo lender with other types of collateral, in particular mortgage-related securities. While repo lenders depended upon another safe harbor for securities contracts, it was not sufficiently clear. Uncertainty ended in 2005, when Congress expanded the “safe harbour” to additional collateral types, including “mortgage-related securities . . . mortgage loans, interests in mortgage related securities or mortgage loans” and certain foreign sovereign debt. This was affirmed in a subsequent Delaware bankruptcy court decision in early 2008 in the wake of the subprime crisis.[17] Experts have questioned the wisdom of the“safe harbour”. Stephen Lubben argued that “ the rush to close out positions and demand collateral from firms . . . contribute[s] to the failure of an already weakened firm, by fostering a run on the firm [and] also has consequent effects on the markets generally as parties rush to sell trades with the debtor and buy corresponding positions with new counterparties”.[18] ‘Don’t overlook liquidity’ Even bankers concede that repo contributed to the maturity mismatch and interconnectedness at the centre of the crisis. Goldman Sachs CEO, Lloyd Blankfein, noted that: “Certainly, enhanced capital requirements in general will reduce systemic risk. But we should not overlook liquidity. If a significant portion of an institution’s assets are impaired and illiquid and its funding is relying on short-term borrowing, low leverage will not be much comfort.”[19]Yet, little has been done to address this concern. New SEC rules actually may send more cash into repos.This is due to the requirement 187

that taxable money market funds hold 10 per cent of assets in instruments which the fund has the right to receive cash with one day’s notice and all money market funds to hold 30 per cent of assets in instruments that give the fund the right to receive cash in five business days.[20] What of Dodd-Frank? Despite admirable efforts by some members of Congress, the Dodd-Frank Act does not fix the problem. The House version permitted the FDIC as receiver to treat up to 10 per cent of a secured claim (including repos backed by collateral other than safe US government securities) as unsecured. However, this did not survive. Instead the law mandates a study of FDIC liquidation and bankruptcy and to report whether secured creditor haircuts might “improve market discipline and protect taxpayers.” Another forgone opportunity was an amendment that would have rolled back the safe harbour for repos. In the words of former President George W. Bush from the summer of 2008: “Wall Street got drunk.” The bartenders pouring the drinks were repo lenders. We should impose some liability on these bartenders for the leverage and liquidity problems to which they contribute. • References
1. The Lehman Brothers Holdings Inc. Chapter 11 Proceedings Examiner’s Report, March 11, 2010. 2. Gary B. Gorton and Andrew Metrick, “Securitized Banking and the Run on Repo,” Yale ICF Working Paper 09-14, Nov. 13, 2009. 3. Statement of Jane D’Arista Representing Americans for Financial Reform Before the House Committee on Financial

Services Hearing on “Systemic Regulation, Prudential Matters, Resolution Authority and Securitization,” Oct. 29, 2009 4. Michael J. Fleming and Kenneth D. Garbade, “The Repurchase Agreement Refined: GCF Repo,” Current Issues in Economics and Finance, New York Fed.,Vol. 9, No. 6 (2003). 5. Rebecca Christie and Liz Capo McCormick, “Treasury Pledges to Protect Repos as Obama’s Plan Sparks Concern,” Bloomberg, Jan. 28, 2010. 6. Hördahl and King. 7. “Barclays Capital Analyst Ponders Regulatory Status of Repo Market,” Feb. 8, 2010. 8. The Securities Industry and Financial Markets Association, “Financing by U.S. Government Primary Securities Dealers,” (total repurchase and reverse repurchase agreements at $7 trillion for Q1 2008, of which $4.3 trillion repurchase agreements); Peter Hördahl and Michael King, “Developments in Repo Markets During the Financial Turmoil,” Bank for International Settlements Quarterly Review (2008), p. 37 (est. $10 trillion in U.S.). 9. SIFMA, Q1 2010, including both repurchase and reverse repurchase agreements, and only repurchase agreements, $2.48 trillion. 10. Michael Rapoport, “BofA, Citi, Made ‘Repos” Errors,” NewYork Times, May 27, 2010. 11. Available at http://www.sec.gov/divisions/corpfin/guidance/cforepurchase0310.htm 12. Kate Kelly,Tom McGinty & Dan Fitzpatrick,“Big Banks Mask Risk Levels: Quarter-End Loan Figures Sit 42% Below Peak, Then Rise as New Period Progresses; SEC Review,” Wall Street Journal, Apr. 9, 2010. 13. James Kroeker, Chief Accountant, SEC, Testimony Concerning Accounting and Auditing Standards: Pending Proposals and Emerging Issues,” Before the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises of the House Committee on Financial Services,” May 21, 2010. 14. Gary Gorton, “Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007,” Yale and NBER,


Journal of Regulation & Risk North Asia

Prepared for the Federal Reserve Bank of Atlanta’s 2009 Financial Markets Conference: Financial Innovation and Crisis, May 11-13, 2009, p. 4. 15. Gary Gorton, “Questions and Answers about the Financial Crisis: Prepared for the Financial Crisis Inquiry Commission,” February 20, 2010, Gorton, Questions and Answers, Figure on p. 13. 16. Katherine A. Burroughs and Jonathan F.Tross, Dechert LLP, “The Treatment of Mortgage Loan Repurchase Agreements in Chapter 11 Bankruptcy,” Mar. 2008, American Bar Association June 2008 eReport. 17. Phillip Anker, Andrew Goldman & James Millar, “Safe Harbor or Adrift in Bankruptcy: Treatment of Mortgage ‘Repurchase Agreements’ & Servicing Rights in Bankruptcy

Court,” Wilmer Hale, February 22, 2008, re Calyon New York Branch v. Am. Home Mortgage Corp. (In re Am. Home Mortgage Inc.), 379 B.R. 503 (Bankr. D. Del. 2008). 18. Stephen J. Lubben,“The Bankruptcy Code without Safe Harbors,” American Bankruptcy Law Journal,Vol. 84; Seton Hall Public Law Research Paper No. 1569627. 19. Testimony of Lloyd Blankfein, CEO of Goldman Sachs, The Official Transcript of the First Public Hearing of the Financial Crisis Inquiry Commission Hearing, Jan. 13, 2010 (“FCIC Hearing, Day 1”). 20. U.S. Securities and Exchange Commission, Money Market Fund Reform, Release No. IC–29132; File Nos. S7-11- 09, S7-20-09, Federal Register Vol. 75, No. 42, March. 4, 2010, p. 10076 (“Mutual Fund Rule Amendment”)


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Volume I, Issue III,

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Articles & Papers
Issues in resolving Resecuritisation A framework for in banking: major funding liquidity

Autumn Winter 2009-2010

systemically importan t financial institution s challenges ahead

Dr Eric S. Rosengren Dr Fang

Legal &



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

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-regulat ion Black swans, market Professor Lynn A. Stout crises and risk: the human perspectiv e Measuring & managing Joseph Rizzi risk for innovativ e financial instrumen ts Red star spangled Dr Stuart M. Turnbull banner: root causes of the financial crisis The ‘family’ risk: Andreas Kern & Christian a cause for concern Fahrholz among Asian investors Global financial change impacts David Smith compliance and risk The scramble is on David Dekker to tackle bribery and corruption Who exactly is subject Penelope Tham & Gerald to the Foreign Corrupt Li Practices Act? Financial markets Tham Yuet-Ming remuneration reform: one step forward Of ‘Black Swans’, Umesh Kumar & Kevin stress tests & optimised Marr risk management Challenging the David Samuels value of enterprise risk management Rocky road ahead Tim Pagett & Ranjit for global accountan Jaswal cy convergence The Asian regulator Dr Philip Goeth y Rubik’s Cube Alan Ewins and Angus Ross

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

which many of panies – legiss of com es. The US by hundred compani evenPractices were Fortune 500 these scandals by Corrupt d to in the Foreign in 1977. e responde nnings The US cial latur enacting the FCPA provisions to the its begi y A), has ergate Spe two main lo- tuall Act (FCP s, and the n the Wat There are bribery provision and the ntary disc te era, whe Waterga SEC d for volu had made the antior calle s. Both the have jurisFCPA – that ies Prosecut ard J) g provision compan s to Rich accountin ent of Justice (DO y, the SEC sures from contribution n. erall able campaig US Departm the FCPA. Gen s and question idential g provision on over 1972 pres accountin against issuers Nixon’s aled dicti s as es reve ecutes the disclosur ry provision rative proceedings ents pros , these estic paym d the anti-bribe inist However and adm ble dom panies and questiona had been channelle . through civil s ecutes com not just DOJ pros ness ry provision busi reas the funds that anti-bribe to obtain sti- whe but illicit ls for the eedings. rnments equent inve gn gove individua proc to subs to forei Exchange through criminal mation led rities and The infor that the US Secu h revealed es it provision gations by Risk managem s” to ision mak -bribery (SEC) whic “slush fund ical The anti ent mission bribery prov ey or anything kept Com ’s antiissuers and polit nide mon The FCPA many US gn officials offer or prov ials (“foreign”mea or s to forei illegal to gn offic obtain pay bribe a voluntary of value to forei intent to ness to e up with with the parties. ting busi h any cor- ing “non-US”) later cam for direc The SEC e under whic ents ness, or e programm rted illicit paym n retain busi disclosur repo give de sponsoron. which selfcan inclu SEC was any pers of a holiof value poration likely with the Standard & ation, use Anything perated it would ent, lt Poor’s and co-o l and educ outlines the rance that employm for trave n. The resu mal assu of future positive ben David Samuels ent actio e is no an infor $300 ship home, promise enforcem efits of ban meals. Ther than USD - day ks and be safe from osure that more k stress testing on ents (a mas e discounts, drin discl ble paym the bottom was the 147 been mad questiona It is a big line. challenge million in in the 1970s) had for banks a robust appro unt to build sive amo downturn of worst-case ach to managing the th Asia capital adequ risk uncov stress scena & Risk Nor acy programs by definition, rios er risk conce ulation to ntrations and are triggered that, almost encie nal of Reg Jour s, and; apply risk dependunlikely or by apparently unprecede ing these to drive busin nted event improveme s. nts ess selection through perfo – However, solvin rmance analy for example, g the probl adjusted pricin sis and riskfying the risk em of identi g that takes concentrati - into accou stress test result ons and depen cies that give nt. s denrise to worst -case outco vital if the indus mes is Top-l vidual banks try is to thrive – and evel overs ight if indi- Buildi are past two years to turn the lessons ng of the proce a more robust and to competitive comprehen ss for uncov advantage. Banks that sive ering threat tackle the issue s to the enterbe lauded by head-on will prise is clearly, in part, investors and a corporate ance challe coming years regulators governnge.The board in the must of industry and top execu most impo recuperatio have the motiv tives rtantly, will n ation and be able to delive and, scrutinise and tained profit the clout to call a halt to r sus- able ability gains appar . Meanwhile activities if that are well , banks term these are not ently profitplaced to take in the longe consolidatio interests of advantage rthe enterprise of the the n process need intended risk can understand or do not fit to be profile of the the risks embe sure they But contrary organisatio portfolios of dded in the n. potential acqui ing corporate to popular opinion, impro sitions. To improve governance vis not just a tion of puttin and strengthen enterprise risk manageme quesg the ‘right investor confid nt ’ executives banks can take ence, we think board members in and the lead in place and appropriate three relate giving them Better board incentives. d areas: and senior For the bank sight and executive overcontro to make the sions when agement; re-inv l of enterprise risk they are difficu right deciman- busin igorated stress lt, e.g. when ess growth testing and looks good or when risk in the uptur manageme Journal of nt looks expen n, Regulation & Risk Nort sive h Asia

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


Journal of Regulation & Risk North Asia


Credit rating agencies

Regulating the rating agencies: Quick fix or political expedient?
NYU Stern’s Prof Lawrence White advocates a radical fix for the ‘big three’ raters, via the elimination of the ‘force of law’.
the three large us-based credit rating agencies – Moody’s, standard & Poor’s, and fitch – provided excessively optimistic ratings of subprime residential mortgage-backed securities (rMBs) in the middle years of this decade – actions that played a central role in the financial debacle of the past two years. The strong political sentiment for heightened regulation of the rating agencies – as expressed in legislative proposals by the Obama Administration in July 2009, specific provisions in the financial regulatory reform legislation (H.R. 4173) that was passed by the House of Representatives in December, and epitomised by further debate, amendments and resolutions this May and June in the Senate, together with recent regulations that have been promulgated by the Securities and Exchange Commission (SEC) – is understandable, given this context and history. The hope, of course, is to forestall such debacles in future. The advocates of such regulation want to grab the rating agencies by the lapels, shake them, and shout, “Do a better job!” Journal of Regulation & Risk North Asia But while the urge for expanded regulation is well-intentioned, its results are potentially quite harmful. Expanded regulation of the rating agencies is likely to: • Raise barriers to entry into the bond information business; • rigidify a regulation-specified set of structures and procedures for bond rating; • discourage innovation in new ways of gathering and assessing bond information, new technologies, new methodologies, and new models (including new business models). As a result, ironically, the incumbent credit rating agencies will be even more central to the bond markets, but are unlikely to produce better ratings. A better path to stride There is a better policy route, which starts with an understanding of the basic purpose of the rating agencies: to provide information (in the form of judgments, or“ratings”) about the creditworthiness of bonds and their issuers. If the information is accurate, it helps bond investors – primarily financial institutions, such as banks, insurance companies, pension funds, mutual funds, etc. 191

– to make better investment decisions. It also helps the more creditworthy bond issuers stand out from the less creditworthy. If the information is inaccurate, of course, it does the opposite. Centrality mandated As an example of the latter, the major agencies had “investment grade” ratings on Lehman Brothers’ debt on the morning that it filed for bankruptcy. Luckily the large incumbent rating agencies are not – and never have been – the sole sources of creditworthiness information. Many large institutions do their own research; there are also smaller advisory firms; and most large securities firms employ “fixed-income analysts” who provide information and recommendations to their firms’clients. The next step along this better policy route is the recognition that the centrality of only the three major rating agencies for the bond information process is a major part of the problem. This central role of the agencies has been mandated by more than 70 years of “safety-and-soundness” financial regulation of banks and other financial institutions, including insurance companies, pension funds, money market mutual funds, and securities firms. Regulatory reliance In essence, the regulators rely on the ratings to determine the safety of institutional bond portfolios. For example, bank regulators currently forbid (and have done so since 1936) banks from holding “speculative” (i.e., “junk”) bonds, as determined by the rating agencies’ ratings. This kind of regulatory reliance on ratings has imbued these third-party 192

judgments about the creditworthiness of bonds with the force of law! This problem was compounded when the SEC created the category of “nationally recognised statistical rating organisation” (NRSRO) in 1975 and in doing so created a major barrier to entry into the rating business. As of year-end 2000 there were only three NRSROs to whom bond issuers could obtain their all-important ratings: Moody’s, Standard & Poor’s, and Fitch. (Because of subsequent prodding by the Congress, and then the specific barrier-reduction provisions of the Credit Rating Agency Reform Act of 2006, there are now 10 NRSROs. But, because of the inertia of incumbency, the three large rating agencies continue to dominate the business. When this (literal) handful of rating firms stumbled badly in their excessively optimistic ratings of the subprime RMBS, the consequences were disastrous because of their regulationinduced centrality. Elimination of regulatory reliance A better policy prescription would increase competition in the provision of bond information by eliminating regulatory reliance on ratings altogether. Since the bond markets are primarily institutional markets (and not retail securities markets, where retail customers are likely to need more help from regulators), market forces with respect to the provision of information about bonds can be expected to function well, rendering the detailed regulation that has been proposed (and partly embodied already in SEC regulations) unnecessary. Indeed, if regulatory reliance on ratings were eliminated, the entire NRSRO Journal of Regulation & Risk North Asia

superstructure could be dismantled and the NRSRO category could be eliminated, which would bring many new sources of information into the market and, in so doing, also increase the quality of information. Onus on institutions The regulatory requirements that prudentially regulated financial institutions must maintain appropriately safe bond portfolios should remain in force. But the burden should be placed directly on the regulated institutions to demonstrate and justify to their regulators that their bond portfolios are safe and appropriate – either by doing the research themselves, or by relying on thirdparty advisers. Since financial institutions could then call upon a wider array of sources of advice on the safety of their bond portfolios, the bond information market would be opened to innovation and entry in ways that have not been possible since the 1930s. The politically popular proposals for expanding the regulation of the credit rating agencies (as well as the SEC’s recent regulations) are devoted primarily to efforts to increase the transparency of ratings and to address issues of conflicts of interest. The latter arise largely from the major rating agencies’ business model of relying on payments from the bond issuers (an“issuer pays”business model) in return for rating their bonds. Cry for correction Again, the underlying urge to“do something” in the wake of the mistakes of the major credit rating agencies during the middle years of the decade of the 2000s is understandable. Further, the “issuer pays” business model of Journal of Regulation & Risk North Asia

those rating agencies presents obvious potential conflict-of-interest problems that appear to be crying out for correction. But the major credit rating agencies switched to the “issuer pays” model in the early 1970s (they previously sold their ratings directly to investors – an“investor pays” business model); yet the serious problems only arose three decades later. The agencies’ concerns for their long-run reputations and the transparency and multiplicity of issuers prior to the current decade all served to keep the potential conflict-of-interest problems in check during those three intervening decades. Reputational fear subsides In the decade of the 2000s, however, this reputation-based integrity eroded. The profit margins on RMBS instruments were substantially larger than those on ordinary debt issuances, and the issuers of RMBS were far fewer than the thousands of issuers of “plain vanilla”corporate and municipal bonds. This made the threat by a RMBS issuer to take its business elsewhere unless a rating agency provided favourable ratings far more potent. Also, the RMBS instruments were far more complex and opaque than “plain vanilla” corporate and municipal debt, so mistakes and errors (unintentional, or otherwise) were less likely to be noticed quickly by others. And the major credit rating agencies, like so many other participants in the RMBS process, came to believe that housing prices would always increase, so that even subprime mortgages – and the debt securities that were structured from those mortgages – would never be a problem. The result? A 193

tight, protected oligopoly became careless and complacent. In many ways, it was “the perfect storm.” Regulatory culpability Even so, this storm would not have had such devastating consequences if financial regulators had not propelled the three major agencies into the centre of the bond markets, where regulated financial institutions were forced to heed the judgments of just those three. The dangers of expanded regulation of the rating agencies are substantial. They require the SEC to delve ever deeper into the processes and procedures and methodologies of credit judgments. In so doing, such expanded regulation is likely to rigidify the industry along the lines of whatever specific implementing regulations the SEC devises. It is also likely to increase the costs of being a credit rating agency. Expanded regulation will discourage entry and impede innovation in new ways of gathering and assessing information, in new methodologies, in new technologies, and in new models – including new business models. Adverse consequences Even requirements for greater transparency, such as more information about the rating agencies’ methodologies, rating histories, and track records, could have adverse consequences if they force the revelation of proprietary information about the modelling and thereby discourage firms from developing new models. Further, expanded regulation may well fail to achieve the goal of improving ratings. One common complaint about the large agencies is that they are slow to adjust their 194

ratings in response to new information. This criticism surfaced strongly in the wake of the Enron bankruptcy in November 2001, with the revelation that the major rating agencies had maintained “investment grade” ratings on Enron’s debt until five days before that company’s bankruptcy filing. More recently, as mentioned above, the major agencies had “investment grade” ratings on Lehman Brothers’debt on the morning that it filed for bankruptcy. But this sluggishness appears to be a business culture phenomenon for the incumbent rating agencies that long precedes the emergence of the “issuer pays” business model. Herd behaviour As for the disastrous over-optimism about the RMBS in this decade, the rating agencies were far from alone in “drinking the KoolAid”that housing prices could only increase and that even subprime mortgages consequently would not have problems. The kinds of regulations that have been proposed (as well as those already implemented) would not necessarily curb such herd behaviour. The incumbent rating agencies are quite aware of the damage to their reputations that has occurred and have announced measures – including increased transparency and enhanced efforts to address potential conflicts – to repair that damage. The harm to innovation from restrictive regulation is illustrated by the experience in another field: telecommunications regulation and the development of cell phone technology in the US. Although cell phones could have been introduced in the late 1960s, restrictive regulation held them back until the early 1980s. Cell phone usage didn’t Journal of Regulation & Risk North Asia

really flourish until the mid-1990s, when a less restrictive regulatory regime took hold. The way forward The rating agencies’ promises to reform their ways are easy to make and could fall by the wayside after political attention shifts to other issues. Consequently, enforcement mechanisms are necessary. The rating agencies’ concerns about their long-run reputations provide one potential mechanism. But that mechanism proved too weak in the near past, so something stronger is needed. Expanded regulation of the rating agencies (to address the transparency and rating agencies conflict of interest issues) is certainly another potential route – but the dangers, as outlined above, are substantial. Expanded competition among current and potential providers of information about the creditworthiness of bonds and bond issuers is a third – and preferable – route. New competition could come from the smaller bond advisory firms or from advisory firms in other parts of the securities business (e.g., in December 2009 Morningstar, Inc., which is known primarily for its assessments of mutual funds, announced that it would begin rating some companies’bonds). Competition offers a fix Competition could also come from some of the fixed income analysts at large securities firms who might (in a less regulated environment) decide to establish their own advisory companies, or from new entrants that no one has ever heard of before. Since the bond markets are primarily institutional markets, the bond managers of the financial institutions in these markets can be expected Journal of Regulation & Risk North Asia

to have the ability to choose reliable advisers. Expanded competition would be enabled by the elimination of regulatory reliance on ratings, and enhanced by a reduction in (or, ideally, an absence of) regulation of the bond information advisory/rating process. This withdrawal of regulatory reliance on ratings must be accompanied by an enhanced approach by prudential regulators of banks and other financial institutions in how they enforce requirements that their regulated financial institutions maintain appropriately safe bond portfolios. In essence, the regulators must place the burden for safe bonds directly on the financial institutions, thereby replacing the regulators’ current delegation (or, equivalently, outsourcing) of the safety decision to a handful of third-party rating agencies. SEC eliminates some references The financial institutions could do the research themselves, or enlist the help of an advisory firm, which could be one of the incumbent rating agencies or a new competitor. The prudential regulators would have to maintain surveillance of the advisory process; but the primary focus would be on the safety of the bonds themselves. The SEC has taken some recent steps in the direction of this third route by eliminating some regulatory references to ratings; but no other financial regulatory agency has followed the SEC’s lead [1]. The SEC has simultaneously expanded its regulation of the rating agencies. The financial regulatory reform legislation (H.R. 4173) that was passed by the House of Representatives in December would eliminate legislative references to ratings and instruct financial 195

regulators to eliminate reliance on ratings in their regulations; but it would also greatly expand the regulation of the rating agencies. In essence, public policy currently appears to be two-minded about the credit rating agencies: The wisdom of eliminating regulatory reliance on ratings has gained some recognition; but the political pressures to heighten the regulation of the rating agencies are clearly formidable. Elimination of ‘force of law’ There is a better policy route than relying on the incumbent credit rating agencies to police themselves, or on the politically popular route of expanded regulation of the rating agencies. This better alternative would entail: • The elimination of all regulatory reliance on ratings, by the SEC and by all other financial regulators; in essence, elimination of the force of law that has been accorded to these third-party judgments. Instead of relying on a small number of rating agencies for safety judgments about bonds, financial regulators should place the burden directly on their regulated financial institutions to justify the safety of their bond portfolios; • elimination of the special regulatory category for rating agencies, which was created by the SEC 35 years ago; • reduction (or, preferably, the elimination) of the expanded regulation that has recently been applied to those rating agencies. These actions would encourage entry and innovation in the provision of creditworthiness information about bonds. The institutional participants in the bond 196

markets – with appropriate oversight by financial regulators – could then more readily make use of an expanded set of providers of information. As a consequence, the bond information market would be opened wide to new ideas and thus to new entry in a way that has not been possible for more than 70 years. • End notes
1.) Towards the end of 2009 there were two small steps in a favourable direction in fixing the problematic rating agencies: In October the Federal Reserve announced that it would be more selective with respect to which ratings it would accept in connection with the collateral provided by borrowers under the Fed’s “Term Asset-Backed Securities Lending Facility” (TALF) and would also conduct its own risk assessments of proposed collateral. Whilst in November the National Association of Insurance Commissioners (NAIC) announced that it had asked the Pacific Investment Management Company (PIMCO) to provide a separate risk assessment of residential mortgage-backed securities held by insurance companies that are regulated by the 50 state insurance regulators – PIMCO of course not being a nationally recognised statistical rating organisation as promulgated by the SEC in 1975.

Editor’s note The publisher and editor of the Journal of Regulation & Risk – North Asia wishes to thank both Professor White and the Roosevelt Institute for allowing us to publish an edited version of Prof White’s paper which first appeared in their recent publication: Restoring Financial Stability: How to Repair a Failed System. Journal of Regulation & Risk North Asia

Macro-prudential risk

Macro-prudential councils: how to avoid future crises
Amsterdam University’s Prof Enrico Perotti calls for G-20-wide forward looking bank levies to address systemic risk creation.
What should an effective macro-prudential policy framework look like? this column argues that financial stability and macroeconomic stability should be dealt with differently. one requires prompt corrective action; the other requires more gradual policy intervention. systemic levies offer a policy that can tighten financial discipline without the need for a large increase in interest rates across the whole economy. On two occasions this year in – Busan, Korea in April, and Toronto, Canada this June – the G-20 group of countries have gathered and sought to co-ordinate their bank taxation strategies in the wake of the financial crisis of 2008. To-date, no global framework exists to implement such proposals due to divisions between those nations whose banks actually instigated the crisis, and those nations whose banks were relatively unscathed. However, France, Germany and the UK have now adopted a bank levy on bank balace sheets ahead of any EU-wide actions later in the year – this announcement being Journal of Regulation & Risk North Asia made in Canada – that is intended to discourage risky behaviour – a tax on leverage. Whilst under Obama, the US is planning to adopt a scheme similar to that in Sweden with a levy on bank liabilities. Future systemic risk creation The US tax proposal is targeting the stock of uninsured bank liability – citing as justification that these banks were recipients of huge bailouts during the crisis. Yet while this proposal is a reasonable claw-back tax to repay past bailout costs, what the G-20 countries need is a tax that is forward-looking – that will target future systemic risk creation. Any proposed tax should discourage future choices which cause local shocks to propagate across markets, multiplying their impact and disrupting the economy. But what underpins such a macroprudential policy framework? A critical distinction is between aggregate risk creation, which is highly correlated with the business cycle, and systemic risk creation in credit booms. The financial cycle has a higher frequency and potential amplitude, and can exacerbate economic fluctuation unless it 197

is contained in a timely manner. Aggregate risk factors tend to arise on the asset side, so dealing with it is the prime task of financial regulators. Aggregate asset risk factors, such as correlated holdings of long-term assets, can be targeted with counter-cyclical capital requirements and regulation (such as prudential limits, rules on disclosure, and clearing arrangements). Basel II omission With hindsight, the most glaring gap in Basel II was its neglect of unstable short-term funding. Rapid capital withdrawals were the primary source of propagation in the last crisis. This occurred in combination with opaque assets. In previous episodes of opaque asset over-valuation, such as the Internet bubbles, the losses were huge but there was very little propagation across markets. Unlike in the latest global crisis, these investments were funded with equity. Once losses materialised, investors could not escape and took their losses without spreading them. Because of the different nature of asset and liability risks, there is a strong case to separate the tasks of controlling them. Asset risk is the natural remit of micro financial regulators. The control of liquidity risk is already a central bank task. In the event of a crisis, it is the liquidity support function of central banks alone that can contain propagation. It is natural to assign to macro-prudential councils – where central banks are well represented – the task of managing the systemic risk arising from panic withdrawals of short-term funding. A systemic levy which targets unstable funding should focus on uninsured short-term liabilities (including 198

repo’s). Wholesale funding allowed the massive expansion in securitised lending, yet escaped before bearing any losses. A liquidity-risk levy (Perotti and Suarez 2009) charges intermediaries relying on fragile funding for the negative externality they create for others, when they make fire sales to repay rapid withdrawals of funding. Such levies also charge intermediaries ex ante for the de facto insurance of uninsured liabilities, though without creating an explicit insurance promise. Liquidity charges are aimed at future incentives, discouraging rapid asset growth funded by investors bearing no risk. It aims at increasing maturity from the current absurd over-reliance on overnight repo markets, thus increasing financial resilience to shocks. Liquidity-risk charges should be scaled by bank size – to tackle the too-big-to-fail problem – and by inter-connectedness – to control intermediaries which cannot be easily disentangled from others. Liquidity- risk charges Without the need for Glass Steagall restrictions, liquidity charges would discourage intermediaries from scaling up their balance sheet via huge proprietary trading desks. The liquidity charge is essentially an opportunity cost in order to discourage largescale and uninformed carry trade strategies invested in securities that earn on average a risk premium without providing any useful monitoring. This should be distinguished from informed bank lending, which is a useful maturity transformation task by delegated monitors (banks) and which fully deserves public support. The optimal configuration Journal of Regulation & Risk North Asia

probably requires granting rate-setting powers to prudential supervisors, but allocating revenues to the Treasury. It would be inappropriate to store these revenues in a bank stability fund, as a prepayment of future support. Moral hazard The first objection, by itself more than sufficient, is that funds create moral hazard and breed complacency, as previous episodes suggest. But the main argument is purely fiscal. The overwhelming fiscal cost of the crisis has not resulted from direct injections in the financial system – which were, in the end, only modest – but by reduced taxes and increased spending in order to cushion the impact on the economy. A small fraction of revenues may be allocated to a burden sharing fund to resolve cross border failures. Systemic levies are basically taxes, as they need to be levied on all relevant intermediaries, including the shadow banking system [1 ]. Taxes are the domain of finance ministries, not financial supervisors, but systemic charges are a natural macro-prudential tool for financial stability, and need to be adjusted preventively and in a timely manner. Such policy choices are therefore a natural attribute for central banks, in charge of both liquidity insurance and monetary stability, in consultation with micro regulators (the envisioned European Systemic Risk Board combines such policymakers). Delegating general levies to a macroprudential authority does not require a Copernican shift, as central banks play an indirect fiscal role already by the seignorage tax they raise on liquidity holdings. A simple Journal of Regulation & Risk North Asia

solution is to separate a basic tax and timevarying surcharges, the latter to be co-ordinated by a macro-prudential council where central banks play a significant role. As is the case with seignorage, the revenues from surcharges ultimately flow to the Treasury. Ultimately, an optimal policy to control liquidity risk may involve a combination of liquidity charges and reserve requirements, currently assessed in the Basel process.An initial advantage of having liquidity charges as well is that they are less distorting, just as tariffs are less distorting compared with quotas. More critically, charges can be adjusted more smoothly than quantities. They avoid the trigger risk caused when wholesale withdrawals lead all banks to seek to rebuild their buffers at the same time. They are easier to extend to non-banks, which have no monitored reserve obligations. Last but not least, they raise more fiscal revenues with less distorting effects. Public disclosure A critical governance issue is public disclosure of recommendations by macro-prudential authorities. This is indispensable to overcome regulatory delay, as failure to act in a timely manner will be visible. Public announcements support timely intervention and enhance the accountability of macro-prudential policymakers. It enables action at an early stage with small adjustments which signal clear resolve to contain risk creation. Finally, full accountability has the advantage of putting pressure on governments to co-ordinate systemic tax rates across countries. 199

A concern of public announcements is whether they will spook the markets. But if interventions were timely with only small adjustments, the system would not be allowed to become so overexposed, and higher taxes would not trigger a large market response. Conclusions The right combinations of tools and responsibility can finally establish capability and incentives for policymakers to enact a truly preventive macro-prudential policy. Ultimately, new tools must enable us to separate financial stability, which requires prompt corrective action, from macro-economic stabilisation policy, which must steer the slower business cycle. Systemic levies offer a policy that can tighten financial discipline without the need for a large increase in interest rates across the whole economy, thereby avoiding a main cause of reluctance to act on a timely manner to contain systemic risk. • Footnotes 1. Even if liquidity levies were charged only to banks, they would increase the cost of banks’ contingent exposure to the shadow banking intermediaries, removing the critical transmission channel and discouraging liquidity risk creation outside the banking system. References
Acharya,Viral, Lasse Pedersen,Thomas Philippon, and Matthew Richardson (2009), “Regulating Systemic Risk”, in Viral Acharya and Matthew. Richardson (eds.), Restoring Financial Stability: How to Repair a Failed System,Wiley, March. Adrian, Tobias, and Markus Brunnermeier (2009),

“CoVaR”, Federal Reserve Bank of New York Staff Reports, no. 348. Brunnermeier, Markus (2009), “Deciphering the Liquidity and Credit Crunch 2007-08”, Journal of Economic Perspectives 23(1), 77-100. Brunnermeier, Markus, Andrew Crockett, Charles Goodhart, Avi Persaud, and Hyun Shin (2009), “The Fundamental Principles of Financial Regulation”, Geneva Reports on the World Economy 11. Caballero, Ricardo (2009), “A global perspective on the great financial insurance run: Causes, consequences, and solutions (Part 1)”,VoxEU.org, 23 January. Goodhart, Charles (2009), “Liquidity Management”, paper prepared for the Federal Reserve Bank of Kansas City Symposium at Jackson Hole,August. Gorton, Gary (2009), “Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007”, paper prepared for the Federal Reserve Bank of Atlanta’s 2009 Financial Markets Conference, May. Huang, Rocco, and Lev Ratnovski (2008),“The Dark Side of Bank Wholesale Funding”, mimeo, International Monetary Fund. Perotti, Enrico, and Javier Suarez (2009a), “Liquidity Insurance for Systemic Crises”, CEPR Policy Insight 31, February. Perotti, Enrico, and Javier Suarez (2009b), “Liquidity Risk Charges as a Macro prudential Tool”, CEPR Policy Insight 40, November. Perotti, Enrico, (2010), “Tax banks to discourage systemic-risk creation, not to fund bailouts”,VoxEU. org, 19 February. Weder di Mauro Beatrice (2010), “Taxing Systemic Risk”, University of Mainz mimeo.

Editor’s note The Journal of Regulation & Risk – North Asia would like to thank VoxEu and Dr Perotti for their permission to reprint an edited version of this article. Journal of Regulation & Risk North Asia


Solvency II

EC offers last opportunity for insurers to influence Solvency II
The FSA’s Eleanor Beamond-Pepler outlines some key benefits insurers can expect by early adoption of Solvency II provisions.
During 2010, european insurers will be participating in the european Commission’s 5th Quantitative impact study (Qis5). the exercise will feed in to the Commission’s further development of the new regulations and so help to shape the final solvency ii landscape. it will also form a vital part of the preparations by both firms and regulators for the introduction of solvency ii. Qis5 represents the last opportunity for field testing of the current thinking on quantitative aspects of solvency ii. The first four QIS exercises were carried out between 2005 and 2008, and have been instrumental in shaping the direction of Solvency II. These pan-European studies have enabled the Commission to understand the likely impact of the current thinking on Solvency II. QIS5 will be the most important field study yet, coming at a critical point in the development of the final Solvency II framework. Solvency II is being developed according to the Lamfalussy model. This model is structured according to four levels, designed Journal of Regulation & Risk North Asia to provide an efficient way of setting legislation in the context of the complex and fastmoving European financial markets. Level One Level 1 consists of the Solvency II Directive text, which was finalised and adopted by the European Parliament in 2009. This forms the “skeleton” of Solvency II, setting out the high-level framework. Level 1 includes the two key principles of Solvency II: marketconsistency for the balance sheet, coupled with capital requirements at the one-year 99.5 per cent VaR level. Other fundamentals outlined in the Level 1 text include the high-level structure of the standard formula for the calculation of the Solvency Capital Requirement (SCR), considerations for the internal model approach to the SCR, and governance and disclosure requirements. Level Two The Level 2 implementing measures put flesh on the bones of the high-level Directive text. At this stage, more detail is prescribed as to the calculations that underlie the 201

Solvency II balance sheet, the determination of capital requirements and the standards a firm needs to meet in order to gain internal model approval, for example. The Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) was asked by the Commission to provide advice on the content of Level 2 during 2009. This advice covered all aspects of the required implementing measures, on both quantitative and qualitative aspects of Solvency II. Following delivery of CEIOPS’ advice, the Commission has now begun a drafting exercise for its proposed Level 2 measures, leading to finalisation during 2011. Level Three Level 3 then involves the development by CEIOPS of further, more detailed considerations. Some Level 3 guidance has already been issued by CEIOPS, for example in the arena of the internal model pre-application process. However, the bulk of the Level 3 material is expected during 2011/12. QIS5 therefore comes at a time when the basic Level 1 framework is known and the Commission is part-way through drafting the more detailed Level 2 measures. This means the results of QIS5 will be of the utmost importance in this drafting process, and are likely to have a significant bearing on the eventual direction of Solvency II. While the benefits of QIS5 from the Commission’s viewpoint are clear from the positioning within the Solvency II timetable, the exercise will also be of fundamental importance for firms. QIS5 is vital in providing firms with an opportunity to influence the direction of the remaining uncertainties 202

in Solvency II, and especially, as mentioned above, the Level 2 implementing measures. Although the quantitative impact on capital is central here, another important aspect is the practicality of calculations and processes required. Practical burdens of QIS4 For example, QIS4 highlighted various areas where the practical burden of carrying out some calculations was disproportionately great in comparison with the significance for the overall balance sheet. A case in point was the standard formula SCR approach to counterparty risk, which was found to be disproportionately laborious, impractical and cumbersome for what, for most firms, was not their most significant risk. However, QIS5 should also be a cornerstone of firms’ own implementation programmes for Solvency II. QIS5 offers a vital opportunity for firms not only to assess the likely impact of Solvency II on their capital position, but also to take a focused look at their data, systems and processes. QIS5 will provide a chance to examine the kinds of calculations and assessments that will be required; in some areas Solvency II will necessitate the development of new techniques, and an early start on these will be invaluable. QIS5 philosophy The move to the Solvency II philosophy for the best estimate for technical provisions is one such example from the world of nonlife reserving. Furthermore, QIS5 will highlight actions that firms may need to take in preparation for Solvency II implementation, whether in terms of embedding new Journal of Regulation & Risk North Asia

systems, refining the business model or perhaps re-examining their capital base. For firms intending to enter the preapplication process for internal model approval, participation in the most recent QIS exercise will constitute one of the criteria for resource allocation: this reflects the importance of QIS5 for insurers’ thinking about their risk profile and Solvency II readiness. For those insurers that have not yet participated in a QIS exercise, QIS5 will be crucial for their understanding of their likely capital position post-2012 as well as the actions they may need to take to adjust their systems and processes. QIS5 will therefore be a springboard for firms’ preparations in the approach to 2012 as well as being of vital importance for influencing the European policy debate. Scope of QIS5 One of the commonly held myths about QIS5 is that it is limited to testing of the SCR standard formula approach. However, the scope of the exercise is much wider, covering of course the quantitative aspects of Solvency II but also including qualitative issues. The quantitative aspects tested in QIS5 will include the drawing up of the Solvency II balance sheet, incorporating the calculation of technical provisions, valuation of assets and other liabilities, treatment and classification of own funds, standard formula and (optional) internal model approaches to determination of the SCR and testing of the recalibrated approach to the Minimum Capital Requirement (MCR). Firms will also be asked qualitative questions on each of these aspects, and the Journal of Regulation & Risk North Asia

responses to these questions will feed in to the assessment of the practicability of the current proposals for Solvency II. Three pillar approach necessary At first glance, then, it could be assumed that QIS5 is relevant only to the first of the three pillars of Solvency II (see Figure 1). As always, however, all three pillars are needed in order to support the over-arching Solvency II framework: QIS5 is no exception. For example, the thinking that a firm will need to do in order to construct its balance sheet, determine capital requirements and decide on whether to take the standard formula or internal model approach will feed directly to the preparation of the Own Risk and Solvency Assessment (ORSA) required under Pillar 2. Central to the ORSA will be the firm’s appraisal of its risk profile and internal processes, as well as integration of risk and capital management, among other issues. Importance of balance sheet Fundamental to QIS5 will be the construction of the Solvency II balance sheet. The balance sheet forms the bedrock of Pillar 1 as well as underpinning many aspects of Pillars 2 and 3. In Pillar 1, the balance sheet not only incorporates assets, technical provisions and other liabilities, but also lays the foundations for the calculation of the capital requirements (SCR and MCR). The SCR, after all, reflects the impact of stress events on the elements of the balance sheet.The MCR is determined using basic building blocks such as technical provisions and written premiums. If the balance sheet is not correctly set up, then, the capital requirements will not 203

Figure 1. The three pillars of Solvency II

Pillar 1:
Quantitative capital requirements • Technical provisions • Minimum capital requirement • Solvency capital requirement

Pillar 2:
Qualitative supervisory review process • Corporate governance • Principles for internal control and risk management • ORSA • Capital add-ons?

Pillar 3:
Disclosures • Enhance market discipline through public disclosures • Annual FCR and solvency reports • Provide additional (nonpublic) information to the supervisors

Market consistent valuation of assets and liabilities Economic capital validation of internal models

New focus for supervisor Level of harmonisation Group supervision

More pressure from capital markets, investors and shareholders

be appropriate for the undertaking: a robust starting point is needed in order to provide the elements needed for the calculation of the SCR and MCR. This applies to“standard formula”and“internal model”firms alike. All undertakings in scope of the Solvency II Directive will have the opportunity to take part in QIS5, including solo firms as well as groups and EEA sub-groups. The Commission is keen to encourage large-scale participation, with a spectrum of participants that captures all aspects of the insurance industry.This includes a focus on the involvement of smaller and specialist firms: it is important that the proposed measures are tested against small firms as well as large firms and international groups in order to achieve a regime that is suitable for the diversity of the European insurance sector. Draft technical specification Widespread and representative participation, combined with high-quality submissions 204

from firms, will be of central importance for ensuring the Commission has the best possible basis for decision-making. The Technical Specification for QIS5 is owned by the European Commission. A draft of the specification was published on April 15, 2010 and is open for feedback from a specified, limited number of stakeholders for five weeks. Many aspects of the draft Technical Specification are based on the corresponding sections of CEIOPS’ advice on the Level 2 implementing measures. However, there are also several areas where the Commission has made revisions, and some of these are fairly significant. This highlights the importance of QIS5 in informing the remaining“moving parts”of Level 2. The balance sheet The Commission has maintained the fundamental Level 1 principle of market consistency for the valuation of assets, Journal of Regulation & Risk North Asia

technical provisions and other liabilities. This is significant in the context of what some stakeholders have argued has been an erosion of the economic, realistic approach to valuation in some areas of the debate so far. Detailed considerations are set out for the calculation of the best estimate of technical provisions, including deterministic, analytical and simulation methods. The Technical Specification covers the choice of assumptions and methodology, as well as use of expert judgement and validation of data, processes and methods. Some of these aspects will represent a step change from the current regulatory framework: for example, under Solvency II, discounting will be required for all technical provisions, whereas this is not a requirement at present for nonlife business. Risk margin Another new element is the risk margin, designed to ensure that technical provisions for non-hedgeable risks are brought up to a level such that they can be transferred to another willing party in an armslength transaction. This is calculated using “cost of capital “methodology, based on a six per cent cost-of-capital rate applied to the discounted sum of the SCR requirements over the remaining lifetime of the liabilities. The Technical Specification also maintains an emphasis on verification and evidence. The onus is on insurers to be able to demonstrate the suitability of the ingredients, methods and assumptions feeding to the calculation of their technical provisions. In this area, expert judgment will Journal of Regulation & Risk North Asia

prove a point of interest, as the requirements cover aspects such as the scope of use, the extent of adjustments to existing data sets, sensitivity to the assumptions chosen and the skills of the experts themselves. The Technical Specification also includes various simplifications for calculation of technical provisions. These form an important part of the proportionality principle running through Solvency II: firms have the possibility to use simplified approaches where this is commensurate with the nature, scale and complexity of the risks inherent in their business. Hierarchy of simplifications Notable among the simplifications proposed in the QIS5 Technical Specification is the hierarchy of simplifications for determining the risk margin, acknowledging the practical complexity of calculating this part of the technical provisions. Some insurers may be tempted to rely on simplifications for completion of QIS5, for example to minimise the level of resource they expend on the exercise. However, unless they plan to use these simplifications for their actual reporting post implementation, this will not allow them to build up a full picture of their likely position under Solvency II. One of the key developments incorporated in the Commission’s draft of the Technical Specification is the inclusion of an illiquidity premium in the risk discount rate for certain types of contract.This follows work carried out by the joint CEIOPS-industry Illiquidity Premium Task Force during early 2010. Calibrated term structures for the risk 205

discount rate have been proposed by the CFO and CRO Forums and are included with the draft Technical Specification. Discussions on the illiquidity premium have generally focused on contracts whose cash flows are highly predictable; retirement annuities are most frequently quoted as an example. Capital and capital requirements The Commission’s draft Technical Specification proposes a “third bucket”: certain types of retirement annuity can be discounted using the full illiquidity premium; contracts of less than one year are assigned nil illiquidity premium; and all other contracts are treated using 50 per cent of the full illiquidity premium. Although the basic structure of the SCR standard formula is largely prescribed by the Directive text, the draft Technical Specification for QIS5 still includes some structural developments (see Figure 2 below). One such development is the introduction of a new module for the treatment of intangibles in the SCR standard formula. This introduces an 80 per cent stress on such items and corresponds to the developments in thinking on the valuation of such items in the Solvency II balance sheet. CEIOPS level 2 advice Much of the design and structure of the individual risk sub-modules under the standard formula follows CEIOPS’ Level 2 advice on these topics. This advice included some detailed work on the calibration of the various risk modules and submodules. However, the Commission’s draft Technical Specification makes some 206

adjustments to the calibrations of the standard formula stresses in a number of areas; some have regarded these revisions as a response to the feedback from stakeholders on CEIOPS’ original proposals at Level 2. The over-riding requirement for the calibration of the SCR, however, must be the one-year 99.5 per cent VaR standard stipulated by the Solvency II Directive text. Testing of the standard formula calibration as part of QIS5 will be an important step in assessing whether the current proposals achieve this objective. Realistic picture QIS5 participants will also have the opportunity to include the capital requirements arising from their internal model or partial internal model where relevant. This will not only yield useful information to the Commission but will also allow firms to build up a full and realistic picture of their likely position under Solvency II. Firms therefore have the opportunity to make the widest possible use of QIS5 within their Solvency II implementation programmes. In addition to testing the SCR, all firms will be asked to calculate their MCR according to the recently revised calibration set out in the Technical Specification. Taken together with the SCR calculations, this will provide insight into whether these capital requirements constitute a reasonable and workable supervisory ladder of intervention. Firms will then be asked to look at the classification of their own funds, including both on- and off-balance sheet items. The Journal of Regulation & Risk North Asia

classification is based on three“tiers”, with supervisory approval needed for some items. The Commission’s drafting for QIS5 has reversed out some of the more controversial areas of CEIOPS’ advice on classification, such as the relegation of some items (for example the value of inforce cash flows) to Tier 3. Specified limits test Firms will also need to test against specified limits restricting which types of capital are allowable to meet each of the MCR and SCR capital requirements. The emphasis is on the right kind of capital being available for the situations in which it is needed. QIS5 will include testing of group requirements as well as looking at solo firms. This includes the calculation of group own funds and group capital requirements. The same valuation principles and calibrations for capital requirements, per the draft Technical Specification apply to groups as well as to solo firms. Added to this, there is an emphasis on the extent to which capital is available within a group; that is, between entities: the QIS5 calculations are designed to reflect any restrictions that may be in place. Group default approach The default approach for groups under QIS5 will be the accounting-consolidation method, although there is also the possibility to use a deduction-aggregation approach as an alternative. It will be important for groups to examine their structure and consider which of Journal of Regulation & Risk North Asia

their entities will require Solvency II-style balance sheets and SCR calculations, as well as how their calculations may be affected by decisions on equivalence of third country regulatory regimes. The determination of the group solvency position is complex, with considerations specific to each particular group. However, the testing of the current Solvency II proposals for groups will constitute a fundamental part of the QIS5 exercise, both from the Commission’s viewpoint and for groups as they plan their approach to Solvency II. Looking ahead The Commission’s final, post-consultation version of the QIS5 Technical Specification, expected at the beginning of July, will be awaited keenly by stakeholders. Many aspects of the Level 2 measures remain open to further development, and QIS5 will play a vital role in providing evidence to feed in to the Commission’s decision making. Insurers will be submitting their QIS5 results between August and November this year. In the meantime, they have the opportunity to prepare in advance by gathering data and refining the processes and systems needed ahead of time. There will be many synergies here that firms can exploit for their wider Solvency II implementation strategy. Given high-quality results and extensive participation across the insurance sector, QIS5 has the potential to be the most important and influential Solvency II field-study to date. This will be a vital opportunity for the European Commission, regulators and firms alike on the final lap to Solvency II. • 207

Financial reform bill

Did we tame the beast: views on the US Financial Reform Bill
Duke University’s Prof Lawrence Baxter takes a microscope to the ‘Dodd-Frank’ Bill finding a veritable ’Micrographia’ of doubt.
this paper was written in anticipation of the us financial reform Bill’s final passage through Congress prior to being signed into law by President obama on July 5 – obviously this is now not the case. the Bill currently before Congress was devised to address problems associated with the global financial crisis (gfC) of 2007-2009. The Dodd-Frank Wall Street Reform and Consumer Protection Act, which by its very title indicates the complicated nature of the reforms, is actually not yet law. The Bill, which I will refer to as“Dodd-Frank”for the rest of this paper, now hangs in limbo, having been passed by the House of Representatives and the Senate, subsequently reported out of Conference Committee and finally approved by the House, but not quite yet enacted by Congress. Two more votes remain in the Senate. The first will be whether to stop with a cloture vote an attempted filibuster by the Republican minority, which would prevent the bill from coming to a floor vote. If the Senate votes for cloture a second vote will Journal of Regulation & Risk North Asia then approve the legislation by a likely margin of about 59 votes to 40. Only then can the Bill go to the President for signature. These final votes are scheduled for next week when Congress returns from the July Fourth recess. So we will not know until next week whether 12 months of intense effort in Congress and two years of aftershocks from the GFC will actually lead to financial reform in the United States. If, however, DoddFrank is signed into law, the United States will become the first major nation to honour its commitment to the G20 to reform its financial system. Dodd-Frank in general This legislation is neither uncontroversial nor sure to be effective. The Bill has engendered a range of reactions, ranging from savage criticism to effusive self-promotion by Congressional leaders and the President. At the conservative end of the spectrum, a professor at Stanford writes that Dodd-Frank is a “financial fiasco.” The ubiquitous Judge Richard Posner, having recently turned his attention to the subject of banking regulation and become a Keynesian after years in 209

the Milton Friedman camp, has described the bill as “politics in the worst sense.” Liberal commentators have mixed reactions too, with Lynn Parramore declaring the bill to be“both disappointing and inspiring” and Chris Bowers, co-founder of the organisation known as OpenLeft, advocating that despite its shortcomings it is still worth supporting and the last chance to “really take on the banks.” Even Paul Volcker, former chairman of the Fed and after whom one of the major new activity restrictions in DoddFrank is named, is said to be disappointed with how that restriction – the Volcker Rule – was watered down in order to secure Republican votes. There is indeed enough in the massive 2,307-page bill to delight, anger and/or befuddle everybody to some extent. Not a complete bill Dodd-Frank also conspicuously avoids two major areas of greatly needed reform, namely regulatory consolidation among the nation’s illogical morass of financial regulators, and restructuring of the GSE system designed to promote easy access to home mortgages, such as Fannie Mae and Freddy Mac. These dysfunctional organisations, in the view of many, were among the significant contributors to the GFC. Finally, implementation of the Bill awaits over 200 rule-making processes by the implementing agencies! These regulatory elaborations will add considerable depth to the legislative framework and their outcome, far from predictable, will depend on further intense lobbying by all the stakeholders at the less visible level of the administrative process. Yet there is no doubt that Dodd-Frank 210

will profoundly reshape financial services for decades to come. There is much in it that I would praise. What’s hot Consumers have received short shrift in recent years as financial products have become more byzantine, and only a predatory lender, auto dealer, or Washington lobbyist would argue that is it acceptable that ordinary consumers should have to engage professional assistance merely to understand the terms of their mortgages or credit card agreements. As the damage incurred by complex – some would say unnecessary – products sold aggressively to investors has escalated it is also important that the professionals in the business be placed under increasing standards of care in their disclosures and conduct; this, too, is partly addressed in the legislation. The derivatives market is presently rather like the foreign exchange market of a decade ago: money is made as much through the privileged access to information as through actual value added, and in the case of derivatives which can have such massive contingencies the strengthening of the exchange infrastructure and market transparency is an urgent necessity. The introduction of proper supervision is also to be welcomed. Mission accomplished? Given space restrictions, it is impossible to give a wide-ranging summary of the DoddFrank reforms. Instead, one’s intent is to focus on a single important question; namely, does the legislation squarely face and adequately address the problem of financial instability so as to significantly reduce the risk of Journal of Regulation & Risk North Asia

another collapse in the financial system? The threat of destabilisation is the beast that lurks under the gigantic, volatile and labile financial system upon which global prosperity and security depends. Have we in the United States done our part to challenge this beast? My view is that we have not. We have made a partial and reasonably good faith attempt, but we have not truly come to grips with one of the central causes of financial instability, namely the massive global financial institutions now roaming the planet. I will adopt the term in regulatory use for these institutions: large, complex financial institutions, or LCFIs. Just as we saw with the failure of Lehman Brothers and the near collapse of AIG, Citigroup, Merrill Lynch, Royal Bank of Scotland, Lloyds and others in 2008, the failure of any one LCFI would inflict serious disruption on the entire financial system. Issue of ‘too-big-to-fail’ These and many other financial institutions are now more or less openly acknowledged to be“too important to fail,” “too big to fail”or, more euphemistically, “systemically important.” Despite bold declarations and efforts in the legislation to restrict future government assistance, the Dodd-Frank legislation does not do enough to address this problem and, for as long as these LCFIs operate at their current scale and complexity, the financial system will remain fragile and vulnerable to massive sudden shocks. It is true that Dodd-Frank purports to deal with the problem and has been sold as having dealt with it. But in the ultimate analysis it has not. This is because Dodd-Frank assumes that LCFIs can be safely operated, Journal of Regulation & Risk North Asia

regulated and, if necessary, liquidated. However, as long as LCFIs are permitted to operate at their current scale and complexity they will not and cannot in practice be allowed to fail, no matter what the legislation permits or prohibits and no matter what Senator Dodd, Congressman Frank or officials at the Treasury Department declare to the contrary. Financial stability Of all the anxiety stemming from the GFC, perhaps the greatest is fear of widespread domestic and international financial instability. While specific and localised bank failures are surely always painful, they seem to be part of the normal functioning of economic systems – a manifestation of the Schumpeterian “creative destruction” that ensures the very survival of capitalism itself. It is not such specific failures but rather widespread breakdowns of the kind we experienced with the GFC that instil the real fear. Prevalence of financial crises This fear is well founded. The GFC is only the latest in a long line of similar crises. Many earlier crises are well known, including: the Dutch Tulip Mania of 1637; South Sea Bubble of 1720 ; Mississippi Company in 1720; Great Crash of 1929; and, of course, Asian Financial Crisis of 1997. Crashes have occurred in almost every economic region of the globe. It might come as a surprise to learn that there have been more than 112 systemic-scale financial crises in over 90 countries over the past 30 years. Indeed, such crises are now twice as prevalent today than they were a century ago. And we don’t seem to be making much progress 211

in eliminating them. Systemic risk has really only recently attracted much attention. The first glimmers of concern arose in 1974 when a relatively small financial institution in Germany, Bankhaus Herstatt, failed unexpectedly, generating overnight shocks to financial institutions in other countries that were exposed to losses resulting from their inability to settle currency trades with Herstatt in the later time zones. A much more massive version of the systemic phenomenon occurred when Lehman Brothers was allowed to fail on September 15, 2008. Lehman became the largest bankruptcy in US history even though the investment bank was by no means the largest US financial institution. Credit markets froze overnight as financial institutions took defensive action to mitigate their exposures and anticipate potential losses. This was the event that effectively plunged the world into the GFC. Founding of Basel Committee The Herstatt failure prompted the creation by the G10 of a Committee on Banking Regulations and Supervisory Practices, known as the “Basel Committee.” Over the past three decades the Basel Committee and another committee working out of its offices and created by the G20, the Financial Stability Board (FSB) (before 2009 the Financial Stability Forum), have worked on various ways to reduce the vulnerability of the global financial system. Obviously these institutions failed miserably in preventing or even anticipating the current crisis – a story too complicated to investigate here today. Nevertheless, our dim understanding of what leads to such 212

crises, if not our ability to stop them, has actually improved. We have better economic data at both the global and domestic levels and regarding the histories of specific financial institutions. Clear patterns do seem to emerge in the cycle from boom to bust. In recent months governments and markets have been reacting apprehensively to all kinds of signals of possible systemic failure, ranging from the risk of sovereign defaults in Dubai and the Eurozone to possible asset bubbles in Beijing and Shanghai. Financial scale and scope Fluctuating with the ebb and flow of economic globalisation are the fortunes of financial institutions themselves. Their scope and interconnectedness are increasing as fast as the spread of global finance, and their individual sizes have escalated at spectacular rates in recent years. There are now 180 financial institutions with assets greater than $50 billion, with 39 each having more than $500 billion in assets. The largest (currently BNP Paribas) holds just under $3 trillion. Many of these institutions have been kept alive only through massive injections of public funding. Among these financial institutions, many, including some of the biggest, have grown rapidly, more than doubling in size over the past five to 10 years. Bank of England study Despite their assertions of efficiencies of scale, these financial conglomerates have long ceased to be as efficient as their smaller counterparts. So their economic value is questionable. What is worse is that the value of the de facto public subsidies they enjoy is substantial. Journal of Regulation & Risk North Asia

A respected study by the Bank of England recently suggested that the public subsidy of the five largest banks in the United Kingdom has been running at $30 billion per year. A similar study in the United States suggests that the subsidy derived from the US Treasury’s TARP programme for the top 18 banks is approximately $34 billion/ year. In both studies the largest banks take the lion’s share of this public subsidy. Furthermore, both studies look at only one aspect of various state-backed advantages large financial institutions enjoy; there are indeed various other forms of support that generate a broader aggregate subsidy. The international financial system is greatly dependent on the fortunes of these ultra large financial institutions. Difficulties experienced by any one such institution leads to one of two inevitable results: either additional public subsidies are required to keep the institution open, or letting it go into bankruptcy will lead to widespread financial disruption and even general instability – as witnessed during the GFC. This is why such institutions that have become known in the United States as TBTF. Dodd-Frank solution How does the Dodd-Frank Bill address this problem? One obvious way would have been to impose limitations on the size of financial institutions. An amendment proposed by two senators did indeed place such an option squarely before the Senate. Their amendment, however, met fierce opposition from the large banks and the Treasury Department and was eventually defeated. Instead Dodd-Frank delegated the problem to the regulators. The regulatory approach to Journal of Regulation & Risk North Asia

the problem is to: supervise the health of the individual institutions themselves (so-called “microprudential” regulation); monitor the systemic inter-dependence of each financial institution as they interact within the broader financial system (so-called “macroprudential” regulation); and promote, through the medium of the G20, Basle Committee and FSB, greater international co-operation in order to address the transborder interconnections among LCFIs. Regulatory approach Consistent with this regulatory oriented approach, and accepting the position of the US Treasury Secretary that regulators should possess the discretion to act appropriately when dangers arise, Dodd-Frank creates an elaborate and graduated framework for regulatory action. 1.) The Bill creates sophisticated machinery designed to anticipate and react to the buildup of systemic risk. This consists of the new Financial Stability Oversight Council, informed by a new Office of Financial Research in the Treasury Department, which has the responsibility of collecting economic data and producing analysis to identify and monitor emerging systemic risks. DoddFrank also casts a wide net over any financial institution that might contribute to this risk, whether it be a bank or not. 2.) Regulators are empowered to implement progressively tougher standards, ranging from capital requirements to activity restrictions to limits on single counterparty exposures, in order to prevent such systemically significant institutions from becoming more risky. The Bill prohibits certain types of conduct ex ante, though the implementation 213

periods are lengthy and it is far from clear that such activities, for example proprietary trading which will be banned by the socalled Volcker Rule, are really all that important in generating systemic risk, particularly given the exemptions created by the Bill and the lengthy implementation periods. The regulators can also extend this framework of supervision and limitations to financial institutions designated “systemically significant,” even if they are not banks. Such systemically significant institutions will also be required to develop their own “funeral plans” which would provide blueprints for their orderly shutdown when things go wrong. 3.) Dodd-Frank prohibits direct bailouts, either by the lender of last resort or deposit insurer, that benefit an individual bank. The Fed may only provide emergency lending on a broad basis, and not solely for a specific institution, and then only with the approval of the Treasury Secretary. The FDIC, which protects the deposit insurance funds and depositors, has to get special – ultimately Presidential and Congressional – approval in order to guarantee debt in order to prevent a bank run. 4.) New speedy resolution or liquidation procedures, similar to those that already apply to banks, are created for any financial institution deemed systemically significant. The FDIC, which is already the receiver for failed banks, will wind up financial institutions forced into this bankruptcy system. Yet the final iterations of Dodd-Frank have been met with many headlines declaring that the bill will not in fact have killed TBTF. Gretchen Morgenson of the New York Times identified “cutting big and 214

interconnected financial entities down to size”as one of the most important objectives for successful reform. In her assessment“the bill fails completely.” Dodd-Frank failings I believe Morgenson’s evaluation is correct. We will have another crisis soon enough; indeed such crises seem ultimately unavoidable. If Congress, after the kind of crisis we have just been through, cannot itself impose scale limitations on very large financial institutions, I don’t think the regulators will ever be in a position to shut them down. And if financial institutions of current scale and complexity continue to operate, I don’t think that they can be shut down when a crisis occurs. Complexity of LCFIs The primary reason for this gloomy outlook is that financial institutions have evolved to a degree of complexity and size where it is not only more likely that they will fail. It is also practically impossible to let them do so without the cure being worse than the disease.It is more likely that financial Leviathans will run into serious difficulties because: (a) they are now beyond the level of complexity at which risk can safely and reliably be managed; and, (b) it is unrealistic to think that current resources and techniques of regulation can meaningfully monitor them; and, (c) their sheer scale and complexity of operations spawns such deep mutual interconnectedness that the failure of any one creates the serious risk of failure by many others, as well as schools of smaller financial institutions. Such companies, let alone their Journal of Regulation & Risk North Asia

regulators, are still learning the skills of and developing the tools for the complex risk management necessary to operate on a large, global scale in a highly labile global financial market. It is not just credit and market risks that they must master (they have acquired considerable experience at addressing these types of risk); it is also an increasingly complicated level of operational risk, in which the diversity of such companies, coupled with the escalating sources of unexpected dangers – both functional and geographic – creates a situation with which BP would surely now identify: you simply will not see the lightning that hits you. I have yet to see a serious risk management or regulatory plan that adequately or reassuringly addresses such risk complexity. Intervention paradox It is less likely than ever that regulators will use their powers to shut down a large, systemically risky institution because of what one might label the intervention paradox: just when the need to precipitate terminal action to seize a financial institution is greatest, the incentives not to do so, and the ability of the institution itself to resist seizure, are also highest. The result is that such institutions are kept open to the point where they either become zombies – publicly subsidised and ultimately non-productive (i.e. not sustainably profitable) wards of the state – or their collapse creates far greater damage on other institutions than should have been allowed. To elaborate on this paradox, when financial institutions get into difficulty, financial agencies have two main responsibilities. Journal of Regulation & Risk North Asia

If the problem for the institution is essentially one of liquidity then the central bank’s job is to act as a lender of last resort. Paradox elaborated If, on the other hand, there is a risk of a run on the bank, or if there is a danger that the bank’s failure will dissipate more capital than will be sufficient to cover repayment of the deposits, then the deposit insurer’s job is to take “prompt corrective action” to pre-empt the failure or, if this action is already too late, to seize the bank and put it through fasttrack receivership. When the bank is very large and systemically significant, the temptation for both a central bank and deposit insurer is to try to keep the financial institution open in the hope that it will make it through the crisis and be able to rebuild. Small banks are relatively easy to close, and in the US the FDIC regularly closes failing banks with little disruption. But the closure of a complex large bank is both costly to the federal insurance funds and carries the risk of systemic damage to other financial institutions. IMF observations As a recent study by the International Monetary Fund concluded: “The failure of a systemically important institution increases the likelihood of failures among non-systemic institutions. This means that any regulator will be more lenient with a systemically important institution.” Furthermore, the actions of both types of regulators (lender of last resort and prompt corrective actor) become mutually reinforcing and likely to perpetuate the survival of weak but very large institutions. And this is before even 215

taking into account the intense lobbying power that such large institutions possess, which will almost certainly be deployed as a political barricade against any regulatory aspirations to the contrary. The Dodd-Frank system would appear to eliminate the “too big to fail” possibility by prohibiting bailouts in all but the most restricted circumstances. But consider why the possibility of a bailout exists in the first place: the institutions we are talking about would generate all the conditions necessary for both emergency loans from the Fed and debt guarantees by the FDIC, precisely because their failure would have major systemic consequences the world over. Restructuring TBTFs So while the prudential measures developed by Dodd-Frank might in theory help reduce the threat of systemic danger, the continued existence of LCFIs, the failure of which would have major systemic consequences, makes another major disruption to financial stability and another bailout all but inevitable. There is, in my view (and the view of many others) only one way to install systemic blowout preventers so as to mitigate, at least, the scale of damage caused by the next financial crisis. This is to limit the size of, or substantially restructure into safer, more self-sealing subcomponents, the denizens that operate within the system. Limiting bank size will not entirely reduce complexity (which generates operational risk and the possibility of institution failure) or interconnectedness (which generates systemic risk). Indeed an industry paper makes the 216

argument that size is not the problem; rather it is interconnectedness, a feature shared by smaller as well as larger institutions. Big equals unmanageable Interconnectedness is indeed the capillary network of systemic risk. But the argument that size is irrelevant misses the point: interconnectedness increases exponentially with size and above a certain scale risks start to become unmanageable. So limiting financial institution size would be not for the purpose of improving safety. Large scale virtually guarantees the presence of excessively complex risk. More important, the systemic impacts of failure are magnified by size. The managerial culture of banking exacerbates the risks generated by scale. The advocates of large-scale banking, including most of the executives, tend to favour the centralised, branch and integrated model of universal banking because this model is perceived to be more efficient. Over-centralisation risk A unified corporate structure enables the organisation to leverage its capital over all of its operations and avoid the intra-affiliate legal, accounting and operational impediments among subsidiaries. Yet this same operational consolidation also conducts risk more freely across the corporate entitity. Some national regulators require foreign banks to establish local, separately capitalised and operated subsidiaries precisely in order to facilitate more effective domestic supervision. This is part of the attraction of the non-operating holding company (NOHC) structure favoured by the United Journal of Regulation & Risk North Asia

States and some other countries. Affiliate transaction restrictions help to prevent transmission of risk between the operating subsidiaries, and it might be possible to refine structurally separate components further to produce safer conglomerates that can be managed more coherently and that contain stronger internal insulations when risks get out of control. Dodd-Frank indeed uses this technique to address the risks posed by hedge fund activity for banks by requiring that such activities be“pushed out”into separate subsidiaries. Whether the LCFIs would welcome this approach is another matter, since the interaffiliate restrictions would necessarily reduce the “efficiencies” enjoyed by folding diverse operations into more monolithic corporate entities. Rethinking the framework In the absence of sound policy reasons for assuming the greater risks that such institutions add to the system, it is therefore hard to see why it makes sense to continue, like deer in the headlights, to watch financial institutions reach new scales that are beyond the capacity of regulators to supervise properly, at least with techniques currently available, and their own capacity to provide credible guarantees that they can be operated safely. Perhaps a combination of learning and technology will ultimately render very largescale banking safe. Yet even if this were the case, Dodd-Frank ultimately relies upon an outdated framework for matching the new world of finance. This is because, in my opinion, DoddFrank is conceptually misconceived as a vehicle for promoting systemic financial Journal of Regulation & Risk North Asia

safety. The global financial system is evolving so rapidly, is so volatile and so labile that it possesses the characteristics of a complex adaptive system – one that more resembles the weather than a product of intelligent central design. Prof Arner et al If the global financial system is really more accurately understood as a truly complex environment in the scientific sense, then trying to regulate modern global finance will require more nuanced, skilled and rapidly reactive regulation than commands, prohibitions or greater enforcement powers. New techniques of adaptive regulation must be developed to meet the fast-paced world of payments, financial dealing and innovation. Douglas Arner and his co-authors have recently completed major studies directed toward comprehensive redesign of the global financial system and its regulation, so I would direct the audience to that study for a fuller understanding of the overall issues that must be addressed. Closing remarks I will content myself by noting, in closing, that there are some elements of the financial ecosystem that can be controlled upfront. One of them is the size of the participants, so that at least the environmental damage caused by these players does not destroy the habitat for other creatures. In this important respect the DoddFrank Bill has avoided dealing with a central vulnerability to the financial system. This reform will almost certainly be back on the table after the next disaster, the odds of which, if history is any guide, are very high. • 217

Regulatory discretion

Financial supervision and increased powers of discretion
A prescient paper by Steve Randy Waldman questions enhancing regulatory discretion as found in the present Dodd-Frank Act.
in view of the passage, finally, of the Dodd-frank act and the huge discretionary powers it has handed over to the majority of the us’s existing supervisory bodies, it is well worth revisiting an essay hosted by steve randy Waldman on his website – Interfluidity – during the height of the Congressional skirmishes concerning consolidation within america’s multiplicity of regulatory bodies. this is an issue Dodd-frank failed to carry as evidenced in the new regulatory environment contained within the Bill’s 2,319 pages. An enduring truth about financial regulation is this: Given the discretion to do so, financial regulators will always do the wrong thing. It’s easy to explain why. In good times, regulators have every incentive to take banks at their optimistic word on asset valuations, and therefore on bank capitalisation. It is almost impossible for bank regulators to be “tough” in good times, for the same reason it is almost impossible for mutual fund managers to be bearish through a bubble. A “conservative” bank examiner who Journal of Regulation & Risk North Asia lowballs valuation estimates will inevitably face angry push-back from the regulated bank. Moreover, the examiner will be “proven wrong” again and again, until she loses her job. Her fuddy-duddy theories about cash-flow and credit analysis will not withstand empirical scrutiny, as shoddy credits continually perform while asset prices rise. Valuations can remain irrational much longer than a regulator can remain employed. Asset overvaluation Bad times, unfortunately, follow good times, and regulatory incentives are to do the wrong thing yet again. When bad times come, overoptimistic valuations have been widely tolerated. In fact, they will have become very common. Over-valuation of assets leads to overstatement of capital. Overstatement of capital permits banks to increase the scale of their lending, which directly increases reported profitability. Banks that overvalue wildly thrive in good times. Fuddy-duddy banks lag and their CEOs are ousted and The Economist runs uncomplimentary stories about what 219

fools they are. The miracle of competition ensures that many of the most important and successful banks will have balance sheets like helium balloons at the end of a boom. Then, like a pin from outer space, somebody, somewhere fails to repay a loan. When this happens, bankers beg forbearance. They argue that the rain of pins will eventually pass and most of their assets will turn out to be fine. They ask regulators to allow them to write down assets gently, slowly, so that they can let ongoing earnings support or increase their regulatory capital. If that doesn’t work, they suggest that capitalisation thresholds be temporarily lowered, since what good is having a buffer against bad times if you can’t actually use it in bad times? Drawing the line Knowing, and they do know, that their assets are poor and that they are on a glide path to visible insolvency, they use any forbearance they extract to “gamble for redemption,” to make speculative investments that will yield returns high enough to save them, if things work out. If they don’t, the bankers were going to lose their banks anyway. The additional losses that fall to taxpayers and creditors needn’t concern them. Here, wouldn’t regulators draw the line? When the trouble is with just a few small banks, the answer is yes, absolutely. Regulators understand that the costs of closing a troubled bank early are much less than the costs after a delay. If a small bank is in trouble, they swoop in like superheroes and “resolve”it with extreme prejudice. But when very large banks, or a very large number of banks are in trouble, the 220

incentives change. Resolving banks, under this circumstance, will prove very expensive in terms of taxpayer dollars, political ill-will, and operational complexity. It will reveal regulators to have been asleep at the wheel, anger the public, and alienate nice people whom they’ve worked closely with, whom they like, who might otherwise offer them very nice jobs down the line. Systemic crisis When a“systemic”banking crisis occurs, regulators’ incentives are suddenly aligned with bankers: to deny and underplay, to offer forbearance, to allow the troubled banks to try “earn”their way out of the crisis. Regulators, in fact, can go a step further. Bankers can only “gamble for redemption”, but regulators can rig the tables to ensure that banks are likely to win. And they do. A central bank might drop short-term interest rates very low to steepen the yield curve. It might purchase or lend against iffy assets with new money, propping up prices and ratifying balance sheets. It might pay interest to banks on that new money, creating de novo a revenue stream based on no economic activity at all. Discretionary ‘bailouts’ Regulators might bail out prominent creditors and counterparties of the banks, suddenly transforming bad bank assets into government gold. Directly or via those bailed out firms, regulators might engage in “open market transactions” with banks, entering or unwinding positions without driving hard bargains, leaving taxpayer money on the table as charity for the troubled institutions. They might even redefine the meaning of financial contracts in subtle ways that Journal of Regulation & Risk North Asia

increase bank revenues at the expense of consumers. If all that stuff works out, regulators might be able to claim that they didn’t do such a bad job after all, that the crisis was just a “panic”, that their errors prior to the crisis were moderate and manageable and it was only the irrational skittishness of investors and the taunts of mean bloggers that made things seem so awful for a while. Regulators, like bankers, have everything to gain and little to lose by papering things over. And so they do. Besides, things here weren’t nearly as bad as in Europe. There was nothing new or different about the recent financial crisis, other than its scale. Yes, the names of the overvalued financial instruments have changed and new-fangled derivatives made it all confusing about who owed what to whom and what would explode where. But things have always blown up unaccountably during banking crises. Same old story We have seen this movie before, the story I’ve just told you is old hat, and the ending is always the same. We enact“reform”. The last time around, we enacted particularly smart reform – the Federal Deposit Insurance Corporation Act (FDICA) – which was painstakingly mindful of regulators’ incentives, and tried to break the cycle. It mandated in very strong terms that the Federal Deposit Insurance Corporation (FDIC) take “prompt corrective action” with respect to potentially troubled banks. The theory of “prompt corrective action” was and is very sensible. It’s pretty clear that the social costs increase and the likelihood Journal of Regulation & Risk North Asia

of an equitable resolution to problems decreases the longer banks are permitted to downplay weakness, the more regulatory forbearance banks are granted, or the more public capital banks are given. (An “equitable resolution”, in this context, means giving the shaft to bank managers, shareholders, and unsecured creditors to minimise costs to taxpayers and to sharpen the incentives of bank stakeholders to invest well.“Regulatory forbearance”and“public capital injection”are redundant. Existing practice Under current banking practice, regulatory forbearance is economically equivalent to an uncompensated injection of public capital, like TARP but without the messy politics and with no upside for taxpayers. (Make sure you understand why.) So FDICIA tried to short-circuit our woeful tale by telling regulators they should have a twitchy trigger finger. If regulators intervene early and aggressively, the costs of the crisis will be moderate, and since the costs of the crisis are moderate, it should actually be plausible for regulators to intervene early and aggressively rather than playing the world’s most expensive game of “cover your back”. It was a great idea. Except it didn’t work. Importance of capitalisation We’ve already told the story of why it doesn’t work. Bank health and safety is a function of capitalisation, capitalisation is a function of bank asset valuation, and there is no objective measure of asset valuation. During good times “conservative” valuations are demonstrably mistaken and totally unsupportable as grounds for confiscating the property of 221

respected, connected, and wealthy business people. Regulators simply fail to take prompt corrective action until it is far too late. As you read through the roughly 1,400 pages of currently proposed regulatory reform – the initial Bill introduced by Senator Dodd in November 2009 – ask yourself what, if anything, would interfere with the (uncontroversial and long-understood) dynamic that I’ve described. Giving regulators more power doesn’t help, when regulators have repeatedly failed to use the powers they had. Putting more bank-like institutions and activities under a regulatory umbrella seems sensible, as does eliminating opportunities for firms to choose among several regulators and shop for the most permissive. But even our most vigilant and competent regulator – the FDIC – was totally snowed by this and the previous two banking crises. Geithner’s prescience It has become fashionable to suggest that the idea of “systemic risk” is novel, and that just having some sort of high-level, blue ribbon council explicitly charged with worrying about financial catastrophes will change everything. But financial meltdowns are not new, Timothy Geithner was giving smart, widely discussed speeches about systemic risk in 2006, exactly as the current crisis was building. There is, unfortunately, almost no correlation between the degree to which an institution or sector is supervised by regulators and behaviour or misbehaviour during a financial crisis. Commercial banks, Government Sponsored Entities (GSE) and bond insurers were intimately regulated and 222

are now toast. Mortgage originators, boutique securitisers, ratings agencies, and CDS markets were largely unregulated. They also clearly failed. The ‘train wreck’ of AIG The one train wreck that the current round of proposals might have forestalled is AIGFP, whose unhedged, uncollateralised CDS exposure would make even the most lackluster regulator blush. But it is not at all plausible, especially in the US, that AIG was the linchpin without which the late troubles would not have occurred. If we had to re-fight the last war under all the regulations now proposed, we might have won one battle. But we’d very definitely have lost the war. Deregulation won’t solve the problem. But neither will the sort of regulation now proposed by Senator’s Barney Frank or Chris Dodd. But what about the Senator for Vermont, Bernie Sanders? Is“too big to fail”the problem? Yes and no. Unsustainable bankfunded asset price booms can and do occur even among small banks. But systemic crises are more likely in a world with big banks, as only one or two need totter to take down the world. Chopping up banks reduces the frequency of major crises. Also,“prompt corrective action” does sometimes work for small banks. PCA and ‘big banks’ For big banks, PCA is just a joke – Citibank is and always will be perfectly healthy until it is totally a basket case. But regulators do stage early interventions in smaller banks, even during relatively quiet times, and that does help. Crises among small banks can lead to Journal of Regulation & Risk North Asia

large fiscal costs (c.f. the S&L bailout). But even during serious crises, many small banks turn out to have been prudent and small banks tend not to be so inter-connected that a cascade of failures leaves us without a financial system. Small bank-based systems fail gracefully (See Felix Salmon’s website). Crises among small banks are less corrosive to incentives for careful capital allocation, and less offensive to distributive justice, than large bank crises, because regulators are willing to force preferred equity-holders and unsecured creditors of smaller banks to bear losses while they hesitate to do so for big banks. Also managers of smaller banks can be perfunctorily defenestrated, while managers of megabanks somehow survive (and even when they don’t, they are too wealthy to have to care). Again, one hates to be mean, but treating the managers of trouble-causing banks roughly is important both to get the incentives right and out of regard for justice. Degree of inter-connectedness We should insist upon a market structure in which financial institutions are universally small. But smallness cannot be defined by balance-sheet assets alone. We need to manage the degree of inter-connectedness and the scale of total exposures (including off-balance sheet exposures arising from derivative market participation). Further, we need to ensure that no market participants are indispensable by virtue of controlling some essential market infrastructure. Clearing and payments systems, securities and derivatives exchanges, etc should be multiple and redundant if privately owned, or publicly managed if efficiency demands a Journal of Regulation & Risk North Asia

monopoly provider. Essential infrastructure should be held by entities that are bankruptcy remote from firms that bear unrelated risks, although the stakeholders needn’t be bankruptcy remote from the critical infrastructure. (For example, if the owner of a derivative exchange goes under, the exchange must be immune from liability, but if the exchange suffers losses due to insufficient collateral requirements, the owner could still be liable.) Market structure Fundamentally (and a bit radically), for financial reform to be effective, regulators must actively target market structure. Financial systems are public/private partnerships, not purely private enterprises. It is perfectly reasonable for the state as the ultimate provider of funds and bearer of risk to insist on a robust and heterogeneous network of delegates. Regulators need not (and really cannot) architect the breakup of today’s destructive behemoths. All they need to do is identify dimensions along which firms become indispensable or threatening to financial stability as they grow, and tax measures of those attributes at progressively steeper rates. The taxes could be slowly phased in over a few years, to give existing firms time to arrange efficient deconglomerations. Problem of ‘gaming’ Importantly, legislators should characterise the target market structure, and empower regulators to define and alter tax schedules as necessary to achieve that target, rather than specifying them in law, to counter gaming by nimble financiers. (For example, a tax on balance sheet assets would lead to rapturous innovation in tricks to keep stuff 223

off-balance-sheet.) Taxes should always be imposed in a nondiscriminatory way across the industry. (If you are not concerned about the role of political influence and favouritism in regulatory action, you haven’t been paying attention.)“Taxes”could take the form of increased regulatory burdens, such as capitalisation or reserve requirements (though the effectiveness of the latter is diminished if central banks pay interest on reserves). Variations of these ideas were actually in both the Frank-Dodd original proposed legislation. Regulators would have a fair amount of discretion, under the new laws, to do the right thing. They could ignore the terrifying shrieks of our banking overlords and force the monsters to break apart. But we come back to the first and most ancient law of banking regulation. Resolution authority Given discretion, banking regulators will always, always do the wrong thing. Only if Congress defines a verifiable target market structure and periodically audits the regulators for compliance will we eliminate “too-big-and-mean-and-rich-and-scaryand-interconnected-and-sexy-to-fail”. But what about the much vaunted “resolution authority”. Doesn’t that change the deadly dynamic of banking regulation described above? Sure, it will still be true that during booms, banks will make dumb mistakes and regulators will be unable to point out that the Swiss cheese they’re calling assets is chock full of holes. But, you might argue, when the cycle turns, they’ll no longer be helplessly forced to resort to cover your back-and-pray. They’ll have the tools to wind down bad banks ASAP! Maybe. 224

Resolution authority might be helpful. But I’m not optimistic. During the current crisis, there are two accounts of why we guaranteed and bailed existing banks – including creditors, management, preferred shareholders, and financial counterparties – rather than resolving the banks and forcing losses onto the private parties who made bad bets. Legal constraints One account emphasises legal constraints: we had laws that foresaw the orderly resolution of commercial banks, but not investment banks or bank-holding conglomerates. According to this view, regulators’ only options were to permit Lehman like uncontrolled liquidations of financial firms or else make whole every creditor to prevent a formal bankruptcy. If this is what you think then, yes, resolution authority might change everything. But another view – that of the author – suggests that despite the limitations of pre-existing legislation, regulators throughout this crisis have had the capacity to drive much harder bargains, and have chosen not to. Despite having no legal authority to do so, the government “resolved” Bear Stearns over a weekend in almost precisely the same manner that FDIC resolves your average small town bank. Secretary Paulson could at that point have gone to Congress with a proposal for resolution authority to institutionalise the powers he clearly required. Avoidance and TARP Instead, he had Treasury staff prepare the first version of TARP and put it on a shelf until an emergency sufficient to blackmail Congress arose. Whatever the legal prearrangements, Journal of Regulation & Risk North Asia

regulators have always had sufficient leverage, over firms and firm managers, to push through any structural changes they deemed necessary and to create bargaining power for firms to insist on loss sharing. Finally, earlier this year – 2009 – when bank nationalisation was an active debate, opponents did not because they could not claim that authority would not be found if the administration decided nationalisation was the way to go. Harsh measures towards banks would have been extremely popular. What authority the administration did not have by virtue of existing powers and informal leverage they could have achieved by purchasing common shares instead of preferred during “capital injections”, or, in a pinch, by asking Congress for help. In my view, legal niceties were never the issue. Easy option always prevails Regulators opted to guarantee the banking system and bail out creditors because given the terrifying scale of the problem, the operational complexities and investor uncertainty associated with resolutions or nationalisations, the power of the banks and regulators’ personal connections to them – our leaders simply opted not to pursue more hardball resolutions. If we don’t change the structure of the financial industry, there’s no reason to think that next time around regulators won’t use the proposed resolution authority to do exactly what they opted to do this time. They won’t even need to go to Congress for a new TARP, as Frank’s proposal gives the executive branch carte blanche to provide financial firms unlimited guarantees and support. Journal of Regulation & Risk North Asia

(I haven’t read the original text of Senator Dodd’s initial proposal to the Senate). Idea of ‘living wills’ Yes, I know that “living wills” are supposed to diminish the operational complexity and uncertainty associated with taking a harder line and that, in theory, might encourage different choices as identified by British regulators and the Bank of England. I also understand that some sort of industryfunded slush fund is supposed to bear future bail-out costs. My sense is that during a gut-wrenching financial crisis, hypothetical funeral plans will provide little comfort to terrified regulators, prepaid slush funds will prove to be laughably inadequate, and commitments to make firms pay for the mess ex-post will be waived in order to shore up struggling bank balance sheets. These proposals are about providing the political cover necessary to get legislation passed, but they will prove to be utterly without substance when the next crisis occurs. Plus ça change I’ll end where I started. The one rule that you can rely on with respect to banking regulation is that whenever regulators have discretion, they do exactly the wrong thing. For very predictable reasons and despite the best of intentions, they screw up. Besides messing around with intragovernmental organization charts, the main proposals before Congress give regulators more power and more discretion. That just won’t work. • Editor’s Note: This paper has been slightly modified from its original text. 225

Anti-trust regulation

Global anti-trust regulation in the current financial climate
Consultant Gavin Sudhakar critiques trends observed in economic-based US enforcement policy of anti-trust regulation.
is an outdated anti-trust policy hindering economic growth, innovation and entrepreneurial spirit in the current financial crisis? Competition policy works effectively provided free and open markets prevail as an underlining legislative intent. When it comes to global competition, the main focus of anti-trust regulation is targeted towards global firms which are considered “too big to fail”. The US Congress enacted anti-trust laws as a pro-competition tool in promoting free and open trade markets. Applying this 28-yearold anti-trust paradigm, this article argues its effectiveness and US agencies’ aggressive enforcement initiatives in the new digital age and 21st-first century standards. Although the primary focus here is on US anti-trust laws, this is comparable to the anti-trust laws in economically developed countries around the globe.1 Congress enacted anti-trust laws to protect competition and bring about regulatory reform in order to preserve free and open markets and ensure that consumers had access to lower prices and innovative quality Journal of Regulation & Risk North Asia products. It was also the intent to“stimulate businesses to find new, innovative and more efficient methods of production.”2 Enacted in 1890, anti-trust law consists of three main regulations against international cartel activity; namely, the Sherman Anti-trust Act, the Clayton Act and the Federal Trade Commission Act (FTCA). Recently, in 2004, President Geroge W. Bush amended this by empowering anti-trust laws to increase criminal fines and penalties up to US$1 million and 10 years‘ jail for violators. Consumer prophylatic An anti-trust law protects consumers by regulating competitors in setting product prices honestly and independently. When international competitors cheat customers by price fixing, bid rigging, market division or allocation schemes and other forms of collusion, such competitors are subject to criminal prosecution enforced by the Antitrust Division of the US Department of Justice (DOJ). International cartel activity is a form of co-operation among competitors to the material terms of agreement in which competitors enter by price fixing, defining market 227

entry or targeting specific market segment. Such monopolist agreements have no expected business efficiencies or added benefits but rather harm the consumers.3 This article argues the deficiency of this outdated anti-trust regulation in balancing innovation and entrepreneurial spirit, and combating such cartel monopolist agreements with limited agency guidelines in providing the distinction between anti-competitive and pro-competitive activities in the global market place. ‘Immoral and irrational’ During these 28 years of anti-trust paradigm the true intent of legislation is lost between party lines, and the inconsistent approach towards anti-trust laws remains an economic policy issue. Even though renowned economists such as Alan Greenspan and Richard Posner publicly criticised these outdated and inefficient anti-trust regulations, Congress continues to view anticompetitive laws as a means of punishing monopolistic behaviour. In addition, ruling presidential views and opinions play a significant role in shaping anti-trust statutes. For instance, former President Bush’s views on anti-trust laws are merely applicable to clear and convincing price-fixing cases.4 These conflicting views on the statute were sharply criticised by many economists. For example, Dr Gary Hall views anti-trust laws as “immoral and irrational.”5 In his opinion “targets of anti-trust are not criminals but victims of market busters.”On the judicial front, “American anti-trust law took shape only when the Supreme Court began to build the basic framework of antitrust analysis in its decisions.”6 With limited 228

participation, the Supreme Court viewed that anti-trust law standards are to be developed via case-deciding courts“by the light of reason, guided by the principles of law and the duty to apply and enforce the public policy embodied in the statute.” Core principles However it labels cartel activities as “the supreme evil of anti-trust” in deciding the case of Verizon Communications Inc v. Law Offices of Curtis V. Trinko, LLP. It also went on to set the standards of“rule of reasoning” and“doctrine of per se illegality”in anti-trust disputes. The anti-trust division’s criminal enforcement framework developed against cartel activities focuses on seven core principles in punishing violators, namely,“(i) focus prosecutors on “hard core” collusive activity; (ii) treat cartels as serious crimes; (iii) provide an amnesty programme and “amnesty plus”; (iv) vigorously prosecute obstruction of justice; (v) charge cartels in conjunction with other offences; (vi) provide transparency and predictability; and (vii) publicise these enforcement efforts.”7 Corporations and their officials on the other hand view the statute as a“windfall”and“complicated”. Limited guidance With limited guidelines provided by the enforcement agencies, a conglomerate’s innovative activities are viewed as monopolistic and become victims of convoluted agency policies and procedures. In a recent FTC anti-trust case, Intel v. AMD, Intel corporate officials stated that “to the extent the foreign anti-trust regulators have come down harder on the company than American officials, it was a reflection of the Journal of Regulation & Risk North Asia

different approach towards anti-trust law. The American approach towards anti-trust has been historically aimed at protecting competition, while the others use anti-trust often to protect rival companies.”8 With inconsistency in applying anti-trust rule of law, these statutes remain a“lottery”scheme in the name of protecting consumers from monopolistic cartel activities. In addition, corporate views on anti-trust laws provide no leaders or followers, just another political bureaucratic enforcement system targeted towards“too big to fail”global corporations. OECD recommendations Recently, in October 2009, the Organisation for Economic Cooperation and Development (OECD) Council recommended that its member countries “identify existing or proposed public policies that unduly restrict competition and to revise them by adopting more pro-competitive alternatives.”9 It also recommended that its members use its competition assessment tool-kit as a guideline to identify laws and regulations which “unnecessarily restrict competition and developing alternative policies that achieve the same objectives, with lesser harm to competition.”The OECD believes that its “recommendation will encourage further government efforts to reduce unduly restrictive regulations and promote beneficial market activity.”Such OECD proactive initiatives will promote pro-competitive best practices in the global market and take appropriate legal action against hard core cartels. During the past decade, more than 90 countries have developed some form of antitrust laws and the remaining developing countries are working towards implementing Journal of Regulation & Risk North Asia

such statutes. With the co-operation of other OECD member countries, the US DOJ has investigated and prosecuted many international hard core cartels specifically in the merger related cartel activities. Without these co-operative tools among the member countries, such complex and sophisticated investigative proceedings are difficult to resolve in a global competitive network. Case law By protecting competition across selected industries and international borders, the DOJ’s Anti-trust Division claims that it has been a catalyst for economic growth and efficiency in benefiting consumers and businesses. The division also claims it has collected approximately US$5.2 billion in criminal anti-trust fines between fiscal year 1997 to the end of first quarter FY 2009; a significant amount imposed in connection with the prosecution of international cartel activity.10 The following section will set the stage in uncovering the legal standards applied by the enforcement agencies in prosecuting violators in criminal and civil proceedings. Criminal filings In recent years agencies have taken aggressive measures as policy to invoke the Sherman Act under anti-trust criminal enforcement against global corporations and individuals violators. This initiative has created much public and private awareness by showing the importance of the statute as applied against international cartels, as illustrated in the case, U.S.A v. F.Hoffmann-LA Roche Ltd. (Roche).11 From January, 1990 to February, 1999, Roche and co-conspirators 229

entered into a conspiracy to suppress and eliminate competition by price fixing and “allocating the volume of certain vitamins manufactured and sold in the US and elsewhere, and to allocate customers for vitamin premixes sold in the United States. This case also alleges that the companies allocated contracts for vitamin premixes for customers throughout the US and rigged the bids for those contracts.” In addition, the Anti-trust Division of Dallas, Texas, alleged that Roche and its co-conspirators “was in unreasonable restraint of interstate and foreign trade and commerce in violation of Section 1 of the Sherman Act (15 U.S.C. §1).” In return, in a plea agreement, Roche agreed to pay record criminal fines in the amount of $500 million for taking an active part in this international vitamin cartel.12 Applied legal standard The legal standard applied in this case states that, Roche violated the Sherman Act (15 U.S.C. §1), “1) by agreeing to fix and raise prices on Vitamins A, B2, B5, C, E, Beta Carotene and vitamin premixes, 2) agreeing to allocate the volume of sales and market shares of such vitamins, 3) agreeing to divide contracts to supply vitamin premixes to customers in the U.S. by rigging the bids for those contracts; and, 4) participating in meetings and conversations to monitor and enforce adherence to the agreed-upon prices and market shares.” In day-to-day transactions such sophisticated proprietary agreements are extremely hard to prove beyond reasonable doubt. However Roche’s plea bargain demonstrates willingness to fully co-operate with 230

the criminal investigations. One may not uncover the true damage to the competition, consumers and taxpayers without a formal trial proceeding. This landmark case demonstrates the seriousness of anti-trust violations, specifically in international conspiracy cartel agreements targeted at harming American consumers and the pro-competitive market. Difficulties However without establishing a prima facie case of illegality by defendants in this case, the true harm to the American consumers is difficult to prove beyond reasonable doubt. Roche’s plea-bargain clearly demonstrates the quick-and-dirty solution which global corporations opt for as a viable business solution against anti-trust allegations in a global competitive network. With the lack of clear governance between the legislative and judicial due process in anti-trust cases, in the name of few wrongdoers many well established global corporations will continue to opt for a plea-bargain as an element of “business of nexus”in its global operations. Civil side On the civil side of this statute, legal trends show that the US agencies have taken aggressive anti-trust enforcement action by invoking the Sherman Act. The underlying judicial standard developed in civil anti-trust cases is clearly elaborated in the furiously fought case, U.S.A. v. Microsoft Corp.13 In this, US anti-trust agencies filed a civil complaint and claimed that Microsoft Corp (Microsoft) violated anti-trust laws under the Sherman Act, Sections 1 & 2, by engaging in anti-competitive conduct and “attempted to monopolise the Web browser market by tying its Journal of Regulation & Risk North Asia

browser to its operating system.” In this case, 19 states and the District of Columbia (DC) sought to ground liability in addition to antitrust laws.” The DC district court handling this case ruled against Microsoft by applying a four-pronged test, namely: “1) monopolist act must have an anti-competitive effect – it must harm the competitive process and thereby harm consumers; 2) demonstrate that the monopolist’s conduct harmed competition, not just a competitor; 3) monopolist may proffer a pro-competitive justification for its conduct; and, 4) demonstrate that the anti-competitive harm of the conduct outweighs the pro-competitive benefits.” Effects of conduct In addition, the court stressed that “when assessing the balance between the anticompetitive harm and the pro-competitive effect, the courts should focus on the effects of conduct, not the intent behind it.” In response to a settlement, Microsoft agreed to the court’s terms and conditions to comply with the final judgment and swiftly resolved technical disputes.14 This case clearly demonstrates that a“prefect competition”should never be the ultimate goal of anti-trust policy. When it is applied rigidly, it will have profound negative effects on innovation and impede entrepreneurial spirit at the mercy of judicial activism. In recent years, the DOJ Anti-trust Division has dramatically increased the economic-based agency’s enforcement activities against violators. As illustrated in the chart overleaf, the criminal fines imposed on the wrongdoers increased significantly during third quarter 2009 to $990 million. The Obama administration is planning on Journal of Regulation & Risk North Asia

strengthening anti-trust laws by reversing the Bush administration’s policy “which strongly favoured defendants against antitrust claims.”15 Safeguard competition On the individual’s jail sentence front, as illustrated above, the DOJ has continued to prosecute anti-trust violators to the maximum statute limits.16 In addition, the DOJ rejects “the impulse to go easy on anti-trust enforcement during weak economic times.” Such bold government policy actions to promote competition, innovation and entrepreneurial spirit towards market stability in a financial turmoil are arguable initiatives. The DOJ’s recent enforcement actions mainly concentrated on industries such as, “household products and electronics, air transportation, the oil industry, communications technology and supplies and services for military troops.” In addition, the DOJ believes that the anti-competition conspiracies in these industries will have a profound impact in the day-to-day lives of consumers and taxpayers. Inbuilt immunities On the other hand, the anti-trust statute has inbuilt immunities to certain industries, namely: agricultural, the export trade, insurance, labour, fishing, defence, newspaper joint operating arrangements, professional sports, small business joint ventures, and local governments activities.17 Recently, however, such immunities were challenged before the Supreme Court in the sports case, American Needle v. NFL, on the basis of “whether the (National Football League) NFL and the teams functioned as 231

Chart 1. The US DOJ Anti-trust Division — criminal fines obtained in millions of dollars, by fiscal year

a single entity when granting the company an exclusive headwear licence and therefore could not violate Section 1 of the Sherman Act, 15 U.S.C. 1, which requires proof of collective action involving separate entities.”18 The Anti-trust Division’s guidelines provide a very broad brush for its grounds to enforce anti-trust regulation against violators. These guidelines were publicly critiqued by well-known economic pundits, reasoning that the guidelines language is vague and out-of-touch with modern economics, and does not provide any meaningful guidance to the judicial review process. In response to this sharp criticism, during December 2009, enforcement agencies solicited public comments along with the support of Supreme Court Judge, Douglas 232

H. Ginsburg, hoping to clarify its anti-trust regulatory process and identify potential gaps within the guidelines.19 However, the outcome of these public comments has yet to be reflected in its guidelines. Recent trends Recent trends have shown that due to the bureaucratic and time-consuming Antitrust Division’s Business Review process, limited corporations and individuals have taken full advantage of such review requests. In addition, in 2009 only two such business review requests were addressed by anti-trust division.20 Similarly, trends have shown that limited corporations and individuals have taken full advantage of the Anti-trust Division’s Journal of Regulation & Risk North Asia

Chart 2. Average prison terms imposed on foreigners in international cartel cases*
20 18

Average jail sentence in months

15 12 10 6.9 5 3 3 3.3 4.5 3 4.6

0 2000 2001 2002 2003 2004 2005 2006 2007 2008

Fiscal Year
*Includes defendants charged with with USC§1 and/or obstruction offenses
Source: DOJ Antitrust Division

Corporate Leniency Program against criminal convictions. The division has used this leniency programme for many years as an “investigative tool for detecting cartel activity against corporations and individuals.”21 Even though the division claims that its modern leniency programme has dramatically increased amnesty applications in recent years – due to negative publicity and reputation issues – corporations and individuals have considered these programmes as quick-and-dirty operational solutions. Such programmes aid agencies merely as an investigative tool in resolving complicated and sophisticated anti-competitive issues; however they fail to remedy the intent of Journal of Regulation & Risk North Asia

the anti-trust violators in a true competitive business world. In today’s economic market conditions, delivering innovation isn’t an option, it’s a business necessity. In a competitive global market, businesses understand cutting costs might keep them operational in the short term. Lack of consistency However, increasing revenue with an entrepreneurial model should be the ultimate goal. Based on recent trends observed, US legislative intent seems to be out-of-line, outdated and counter-productive to promoting procompetitive markets. Anti-trust regulation 233

is justifiable only if it works towards making the economy work better. With lack of consistent legislative governance and party differences, anti-trust regulation fails to promote economic efficiency and competition. Alan Greenspan recently stated: “Competition effectively works, whatever the strategy, provided free and open markets prevail,” and “anti-trust policy (never in his judgment an effective procompetition tool), is going to find its 20th-century standards far out of date for the new digital age, in which an innovation can turn an 800lb gorilla into a baby chimpanzee overnight.”22 Greenspan wisdom . . . Between regulation, innovation and its connectivity, anti-trust regulation is a very old principle for the new evolving global markets. As such, anti-trust laws are too complex and need to better align with the regulatory reform and innovative economic industries. The trends have also shown that the antitrust regulations process is expensive, cumbersome and not particularly accurate in broader terms. In the end, as Greenspan stated in his anti-trust essay: “No one will ever know what new products, processes, machines, and cost-saving mergers failed to come into existence, killed by the Sherman Act before they were born. No one can ever compute the price that all of us have paid for that Act which, by inducing less effective use of capital, has kept our standard of living lower than would otherwise have been possible.”23 In the evolving global marketplace, legislative policies need to rapidly adapt and recognise the sensitivity between anti-competition and innovative business practices. 234

Along with the recent aggressive legislative “Super Regulation”initiatives, a broader antitrust governmental regulation is needed in line with the new economy global industries and international intellectual property rights. National interest In addition, modern anti-trust laws need to align with the country’s foreign policy and national security. However, in global competition and capitalism, foreign investors should not retaliate against American companies operating abroad as a causation for vague anti-trust laws, similar to the case U.S.A. v. InBev N.V./S.A. et al.24 As such, the current legislative anti-trust policy, in the name of punishing few“too big to fail”market leaders, has driven anti-trust regulations too far in the spectrum of enforcement and shows its counter-productiveness towards American innovation and entrepreneurial spirit. Without any legislative intervention, American businesses will lose their competitive edge in the global market and the radical inefficient legislative anti-trust policies will ruin the economy. Judicial passivity On the judicial front, the Supreme Court has played a passive role in shaping antitrust laws since their enactment. Most of the power is delegated to the lower courts for legal interpretation and setting anti-trust standards. The trends have shown that punishing innovative ideals as monopoly power seems to reflect on the power of judicial activism. The“rule of reason”standards applied in anti-trust cases are difficult to prove beyond reasonable doubt and it depends mainly Journal of Regulation & Risk North Asia

on the judicial subject matter experienced in anti-trust sophisticated business agreements. Similarly the “per se” rule also needs to be clearly defined in its application. Expert opinions on anti-trust cases can be skewed to favour the outcomes, similar to the Microsoft case, and such testimony should not be allowed in jury proceedings. The Supreme Court should also consider overruling several old landmark antitrust cases, similar to U.S.A. v. Eastman Kodak25 case, which misstates the “rationale of monopolistic strategy.”In addition, courts should not price-regulate technology giants such as Apple and GE for owning their proprietary and marketing rights in distribution of products for given markets. It is the judicial responsibility to clearly differentiate between anti-trust and regulation, and consistently apply within the legal framework rather than making corporate policy decisions in a complex global“cutthroat”competitive market. Agency interventions The trends show that the Anti-trust Division’s aggressive enforcement activity, specifically in horizontal merger in globally distributed markets, seems to be the new wave of antitrust regulation. Even though the agency’s concentration is towards regulating industry market leaders, they un-consummated major merger talks as a distributive market protection against unilateral price increases. In addition, trends show that their focus on promoting merger efficiency, merger topics and market definitions, is an economically destructive merger policy. Some of the agency merger interventions have had a spill-over effect in private non-merger cases, such as in Google, Inc. v.Yahoo, Inc. The Journal of Regulation & Risk North Asia

Anti-trust Division’s merger guidelines have become unreliable in complex global market transactions. After 18 years, the Anti-trust Division is considering re-evaluating and reviewing merger guidelines to accommodate the changing market place through several workshop examinations.26 Robin Hood The real benefit and practical application of such guidelines are yet to be appraised in a complex competitive global network. In recommendation, the Anti-trust Division should consider leaving the market alone to fix itself rather than trying to be a Robin Hood, “to save the poor consumer by robbing the underdog.” Given the budget and resource constrains which the Anti-trust Division faces in a complex new digital age, such an aggressive enforcement approach will contribute to economic catastrophe. Dr Gary Hall recently criticised anti-trust laws as immoral and“market busters should not make life impossible for people who make life possible.” As such, typically, corporations do not deliberately seek to violate anti-trust laws, rather they set out to compete aggressively in the market place; and sometimes their actions cross the line and end up being a violation. Anti-trust agencies should reconsider their economic-based enforcement policy and realign their approach in preserving competition and intervention strategy in a global market. Global policy goals Achieving OECD’s competitive best practice framework should be the main antitrust policy goal of member nations. With global anti-trust co-operation, OECD 235

recommended standards are attainable in competing markets. However, it is the responsibility of member world leaders to promote and support initiatives in a collaborative and consistent approach for sustainable global anti-trust governance. An aggressive anti-trust enforcement policy taken by just one of its members will lack the needed collective support and will be counterproductive to OECD’s global procompetitive best practice. To be competitive, market-makers will seize friendlier troughs to promote their products and services, leaving behind many disappointed consumers. In addition to promoting an anti-competitive global framework, the anti-trust policies of member nations should encourage and support businesses to succeed, and be innovative in increasing wealth in a growing economy. Burden of proof The burden of proof remains on corporations and individuals to prove a prima facie case beyond reasonable doubt, which is highly condemned in anti-trust courts. Trends show that legal standard bars applied by anti-trust courts are extremely difficult to attain on reasonable grounds. Hence corporations and individuals opt to comply with the agency and take plea bargain by paying a hefty penalty as a quick solution. Even though the Anti-trust Division’s Corporate Leniency Program has shown positive outcome, on a broader scale such a programme remains a “windfall”. As a recommendation, corporations and individuals must take anti-trust violation as a serious reputational offence and implement antitrust compliance policies and procedures 236

in its day-to-day global transactions. These working compliance plans and policies should be distributed to its member communities, trained and periodically tested for their effectiveness. Proactive risk management A mandatory anti-trust compliance plan implemented as proactive risk management will aid in promoting corporate governance, ethics and fiduciary responsibilities. Periodically these compliance policies must be revised to accommodate regulatory changes. The trends show that the primary anti-trust federal investigation sources are broadly categorised as: employee complaints (including former employees), customer complaints (including third-party), whistleblowers, amnesty applicants, agency web search engines, merger documents review and government proactive efforts. Keeping these sources in hindsight, compliance policies and procedures should remedy the risks with appropriate internal controls. Business review process Finally, when in doubt concerning anticompetitive transactions, corporations and individuals should take full advantage of the Anti-trust Division’s Business Review process to look for any potential anti-trust violation. These proactive measures will aid in making informed business decisions. If the ultimate goal is to protect consumers and their interests at any cost, the moral actions and fiduciary duties of market makers remain an ethical issue. Quick enrichment with a short-sighted monopoly business strategy will lead to Journal of Regulation & Risk North Asia

wrong business judgments in the long run and have a catastrophic brand impact on the consumer society. Innovation and entrepreneurial spirit are the essential elements of a growing economy. However,“it takes two to tango” in achieving sustainable competitiveness in a free market to promote the American brand. Suppressing growing talent and abilities should never take precedence in a competing global market. Innovative and creative minds will remain the burning fuel for building a competitive cutting-edge 21st century. There are many active statutes to protect consumers against wrongdoers. Let us not punish innovators for being innovative. When it comes to US separation-of-power, legislative, executive and judicial governance lacks near- or far-sightedness towards anti-competitive policy in an economic growth. In a competitive business war, chastising the current innovative global economic growth with an outdated anti-trust regulation and broken political abstract beliefs are immoral and unconstitutional. • References
1 DOJ/Anti-trust Division Worldwide Sites, SSRN: www.justice.gov/atr/contact/otheratr.htm 2 DOJ/Anti-trust Division Enforcement and Consumer Definition. SRN: www.justice.gov/atr/public/div_stats/211491.htm 3 DOJ/Anti-trust Division Sanctioning Cartel Activity, SSRN: www.justice.gov/atr/public/articles/240611.htm 4 National Center for Policy Analysis – Bush’sView on Anti-trust, Feb 23, 2000, SSRN: www.ncpa. org/sub/dpd/index.php?Article_ID=10503 5 Ayn Rand Center – Dr Gary Hall speech on May 24, 2005 SSRN: www.aynrand.org/site/

PageServer?pagename=reg_ls_anti-trust 6 DOJ/Anti-trust Division – Anti-trust Law in the U.S. Supreme Court Speech, SSRN: www.justice. gov/atr/public/speeches/204136.htm 7 DOJ/Anti-trust Division - Criminal Enforcement of Anti-trust Laws: The U.S. Model, SSRN: www. justice.gov/atr/public/speeches/218336.htm 8 The NewYork Times – June 7, 2008 SSRN: www. nytimes.com/2008/06/07/technology/07chip. html?_r=2&partner=rssuserland&emc=rss&pag ewanted=all&oref=slogin 9 OECD Recommendation on Competition Assessment. SSRN: www.oecd.org/ document/10/0,3343,en_2649_40381664_ 44080714_1_1_1_1,00.html 10 DOJ/Anti-trust Division – 2010 FY Antitrust Budget, SSRN: www.justice.gov/jmd/ 2010justification/office/fy10-atr-justification.doc 11 U.S.A. v. Roche, SSRN: www.justice.gov/atr/cases/ f2400/2452.htm 12 U.S.A. v. Roche – PR Release May 20, 1999 SSRN: www.justice.gov/atr/public/press_releases/1999/ 2450.htm 13 U.S.A. v. Microsoft SSRN: www.justice.gov/atr/ cases/ms_index.htm 14 U.S.A.v.Microsoft – PR Release Nov 2,2001 SSRN: www.justice.gov/atr/public/press_releases/2001/ 9463.htm 15 The New York Times – May 11, 2009 SSRN: www.nytimes.com/2009/05/11/business/11antitrust.html 16 DOJ/Anti-trust Division – Spring 2009 Newsletter, SSRN: www.justice.gov/atr/public/division_ operations.htm 17 DOJ/Anti-trust Division – Anti-trust Manual, SSRN: www.justice.gov/atr/public/divisionmanual/chapter2.pdf 18 American Needle v. NFL – Football Case, SSRN: onthedocket.org/cases/2009/american-needlev-nfl

Journal of Regulation & Risk North Asia


19 DOJ/FTC Horizontal Merger Guideline Work-shop, Dec 3, 2009, SSRN: htc-01.media. globix.net/COMP008760MOD1/ftc_web/ FTCindex.html#Dec03_09 20 DOJ/Anti-trust Division – Business Reviews, SSRN: www.justice.gov/atr/public/busreview/ index.htm 21 DOJ/Anti-trust Division – Leniency Program, SSRN: www.justice.gov/atr/public/criminal/ leniency.htm 22 Alan Greenspan’s view on anti-trust laws, SSRN: www.scribd.com/doc/4414602/Alan-Greenspan

23 The Political Inquirer – Alan Greenspan’s view on anti-trust, SSRN: politicalinquirer. com/2007/12/12/interrupting-the-electioncoverage-alan-greenspan-on-anti-trustcirca-1961/ 24 U.S.A. v. InBev. et. al., SSRN: www.justice.gov/atr/ cases/inbev.htm 25 U.S.A. v. Eastman Kodak, SSRN: www.justice.gov/ atr/cases/kodak0.htm 26 DOJ/Anti-trust Division – Update review on Horizontal Merger Guidelines, SSRN: www.justice.gov/atr/public/speeches/254577.htm


ournal of regulation & risk north asia

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ournal of regu lation & risk north a sia
Volume I, Issue III,

Articles &
Issues in res olv


Autumn Win ter 2009-20 10

ically imp ortant fina Resecuriti ncial institu sation in ban tions king: major challenges A framewo Dr Eric S. Rose ahead rk for fun ngren ding liquidit y in times Housing, of financi Dr Fang Du monetary al crisis and fiscal policies: fro Derivative m bad to wo Dr Ulrich Bind s: from dis seil rst aster to reregulation Black swa Stephan Scho ns, marke ess, t crises and risk: the hum Measurin Professor Lynn an perspe g & manag A. Stout ctive ing risk for innovative Red star spa financial ins Joseph Rizzi ngled ban truments ner: root cau ses of the The ‘family’ Dr Stuart M. financial cris Turnbull risk: a cau is se for con Andreas Kern cern among Global fina & Christian Asian inv ncial change Fahrholz estors impacts com pliance and The scram David Smith ble is on to risk tackle bri bery and Who exactly corruption David Dekker is subject to the For eign Corru Penelope Tha Financial pt Practic m & Gerald markets rem es Act? Li uneration reform: one Of ‘Black Tham Yuet-Mi step forwa Swans’, stre ng rd ss tests & optimised Umesh Kum Challengi risk manag ar & Kevin ng the val Marr ement ue of enterp rise risk ma Rocky roa nagement David Sam d ahead for uels global acc ountancy Tim Pagett The Asian convergen & Ranjit Jasw regulator ce al y Rubik’s Cube
Alan Ewins Dr Philip Goe th Ross and Angus

ing system

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

Journal of Regulation & Risk North Asia


Asset securitisation in China: Opportunities and challenges
Deutsche Bank’s Claas Becker et al outline the pros and cons of Chinese banks and investors embracing securitisation.
asset securitisation can serve various purposes: generation of funding, economic risk transfer and associated capital release, market arbitrage, regulatory arbitrage (mainly limited to Basel i regulation), or a combination of these. assets to be securitised include corporate loans (unsecured and secured), consumer loans, credit card claims, mortgage loans, non-performing loans, and tranches of existing securitisations (CDo2s). securitisations can either be done in true-sale form, removing the assets from the previous owner’s balance sheet, or in synthetic form involving credit default swaps. Securitisations are fairly complex products: legal, tax, accounting, and regulatory issues had to be solved in each jurisdiction. Meanwhile, securitisation has become a fairly standard procedure in some markets. For standard securitisations, it is not necessary to obtain regulatory approval for each deal, thus facilitating the set-up of new deals. Securitisation is often regarded as the Journal of Regulation & Risk North Asia root cause of the current financial crisis. The author believes that such a view is significantly too simplistic. In general, securitisation deals perform similar to the underlying assets. As an example, the CLOs referencing bank loans exhibit a fairly good performance, similar to the performance of bank loans.1 Put differently, performance was within investors’expectations. Asset performance Another example of an asset class that performed within expectations is the securitisation of UK prime retail mortgaged-backed securities (RMBS).2 The main asset class that did not perform according to expectations was the securitisation of US subprime mortgages. ‘Subprime’ means that origination standards were significantly lower, i.e. loans were granted to borrowers that were not fully able to afford a house. As house prices fell, the degree of collateralisation of such mortgages declined dramatically, resulting in losses for the CLOs. Rating agencies have downgraded a lot of securitisation tranches, often the downgrade comprised multiple notches. In some 239

cases, the downgrade was triggered by asset performance, but in other cases, the downgrade was due to a change in rating methodology. More precisely, rating agencies became cautious about single obligor concentrations, and deals with significant single obligor concentrations were heavily downgraded despite good asset performance. As tranches were downgraded, a lot of institutional investors were forced to sell these, either because the rating fell to below investment grade or because they had to avoid the higher capital charges associated with the downgrade. The desire to sell securitisation tranches fell into a time3 when liquidity in the secondary market broke down almost completely, resulting in fire sales. Subprime lessons The following are some of the lessons hopefully learned from the subprime debacle: The interests of the originator and the investors must be aligned. ‘Originate-to-securitise’ assets show a significantly weaker performance than bank loans. The alignment of interests has been formalised in the regulatory requirement that originators keep a vertical slice of each securitisation; A rating of a structured finance security is an assessment of its credit risk. It does not predict its future price in the secondary market, but just addresses the probability of timely payment of interest and principal;4 Securitisations of securitisation tranches – so-called CDO²s – are rather opaque; and last but not least, transparency is key. Some investors did not fully understand the features of the securities they invested in and relied too much on rating agencies.5 240

The global financial crisis has partly suspended securitisation activity. More precisely, during the crisis assets were mainly securitised in order to generate tranches that could be used for repo deals with central banks. This means that securitisation was used to obtain collateralised funding from central banks. Originator pullback During the crisis, risk premiums rose dramatically, making securitisation uneconomic from an originator’s point of view. As spreads tightened, the market partially reopened, and there were some securitisations that were placed with external investors. It has been discussed controversially whether securitisation requires more regulation. The author believes that these discussions should rather focus on sound lending practices (as opposed to ‘originate-to-securitizs’) and sound investing practices (as opposed to relying solely on rating agencies). There are no risks that are ‘bad’ (e.g. securitised credit risk) or ‘good’ (e.g. corporate loans), but sound risk management practices are essential. Securitisation in China Basel II regulation on securitisation has recently been adopted in China.6 Prior to this, there were some pilot transactions in China relating to the securitisation of bank assets. In March 2005, the State Council approved China Construction Bank (CCB) and China Development Bank (CDB) as the only two banks to execute pilot securitisations. A task force consisting of 10 ministries and regulatory bodies was set up. In April 2005, Peoples’ Journal of Regulation & Risk North Asia

Bank of China (PBOC) – the Chinese central bank – and the China Banking Regulatory Commission (CBRC) set up the Credit Securitisation Provisional Rule. Pilot schemes The two pilot securitisations were China Construction Bank MBS 2005-1 and China Development Bank CLO 2005-1. CCB’s RMBS transaction was a RMB 3.017 bn deal involving a trust structure. Ignoring legal subtleties, this can be regarded as a true-sale deal, in this case with separate interest and principal waterfalls. Credit enhancement is provided through excess spread, a first loss position of three per cent kept by the originator, and subordination of the notes. CDBs CLO 2005-1 transaction was a RMB 7.773
Figure 1. Capital structure of CCB MBS 2005-1

Figure 2. Capital structure of CDB CLO 2005-1

securitisation of corporate assets was governed by the Specific Asset Management Plan (SAMP) that was enacted in May 2005. An example of a SAMP deal is the China Network Communications securitisation. This structure provided significant interest savings compared to traditional bank financing and did not require approval from CBRC or PBOC. The SAMP programme was suspended by the China Security Regulatory Commission (CSRC) in 2006, and subsequent efforts to restart the programme in 2007 failed. In summary, there are two main securitisation markets in China. Securitisations of bank assets are regulated by CBRC, and the tranches are traded in the interbank market. Securitisations of corporate assets are regulated by CSRC, and the tranches are traded in the stock exchange market. What of the future At the beginning of this paper, we stated that the motivations for securitisation can be to obtain funding or to achieve risk transfer 241

bn deal securitising corporate loans. Similar to CCB’s RMBS deal, it also involved a trust structure. As opposed to bank assets, the Journal of Regulation & Risk North Asia

(this is the originator’s perspective). In China, securitisation could achieve the following objectives: 1. Transfer risk from the banking system to other market participants. This may be especially important since there are views that the banking sector may become overheated. 2. Obtain funding especially for small- and medium-sized banks, enabling them to grow their business. 3. Obtaining cheaper funding for corporations that are not able to tap the bond market. For instance, the SAMP programme may be used to finance infrastructure projects like toll roads and power plants. Free up funds Let us detail these thoughts. A healthy supply of loans is the basis for economic growth. Right now, Chinese borrowers have to rely almost entirely on banks to obtain funding. If banks have the opportunity to securitise parts of their balance sheets, they could de-risk their balance sheets, obtain regulatory capital relief, and expand their lending business. As long as lending standards are not lowered and investors’ and originating banks’ interests are aligned, this provides a good opportunity for growth. Foreign investors are looking for opportunities to invest in China.The author expects future Chinese securitisation transactions to be very granular. This is very favourable for investors because granularity implies that there is only ‘macro’ risk and no namespecific (idiosyncratic) risk. Investors usually require that securitisation tranches are rated by at least one of the three big rating agencies, that they are denominated in currencies like US dollar or Euro, and that it is possible 242

to trade these securities. Denomination in a foreign currency would probably require the involvement of the State Administration of Foreign Exchange. Benefits of SAMP Building up infrastructure fosters economic growth and prosperity. However, huge infrastructure projects like power plants or toll roads usually require a lot of capital.This may be difficult to raise via bank loans because it puts a lot of concentration risk on a bank’s balance sheet. Direct issuance of a bond may also be difficult. In such situations, the SAMP programme might be a very attractive opportunity to borrow funds at attractive levels. The China Network Communications securitisation is an example how funding can be achieved in such cases. The author believes that any of the three objectives mentioned above provide strong arguments for promoting securitisation business in China. Issues requiring attention However, there is still some way to go. In particular, the following issues require attention: Regulation – close co-ordination among different regulators is important. Ideally, securitisation should become standardised so that regulatory approval is not necessary for standard deals. This would make structuring of new securitisations easy and efficient; Investors’ requirements–listing of securitisation tranches at one single exchange should be facilitated. OTC trading of tranches should be possible, also among non-banks. Though most investors buy securitisation tranches on a buy-and-hold basis, liquidity Journal of Regulation & Risk North Asia

remains a strong argument. Tranches should be denominated in US dollar or Euro and be rated by one of the three big rating agencies. The author believes that securitisation in China can help foster stable growth and can be beneficial for both originators and investors. Sound practices in underwriting, investment, and risk management remain essential. • References
1 This statement does not apply to Spanish SME loans. Spanish SME CLOs performed below expectations, however performance was in line with Spanish banks’ balance sheets. 2 Residential mortgage-backed securities 3 Q4 2008 and Q1 2009 4 Some ratings address the payment of principal only. 5 As an example, some investors expected senior AAA structured finance securities to exhibit the same char-

acteristics as AAA rated bonds issued by corporates or financial institutions. Actually, some senior AAA tranches were heavily downgraded.Their risk profile is quite different from corporate bonds: For example, low recoveries of corporate bonds can occur whereas low recoveries of senior structured securities are extremely seldom because it would imply a default of almost all of the underlying assets. 6 Guidelines on Regulatory Capital Requirements of Asset Securitisation Exposure of Commercial Banks, published in December 2009.

editor’s note The author would like to thank Gene Guill, managing director in the Loan Exposure Management Group of Deutsche Bank, based in New York; his associate, Terry Tse; and Xiaopu Han from China Development Bank for the many helpful suggestions and assistance offered.


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

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

Articles & Papers

Autumn Winter 2009-2010

Issues in resolving systemically important financial institution s Resecuritisation Dr Eric S. Rosengren in banking: major challenges ahead funding liquidity Dr Fang Du in times of financial crisis Housing, monetary nce Dr Ulrich Bindseil and fiscal policies: Complia from bad to worst Legal & Derivatives: from Stephan Schoess, disaster to re-regulati on Black swans, market Professor Lynn A. Stout crises and risk: the human perspectiv e Measuring & managing Joseph Rizzi risk for innovative financial instrumen ts Red star spangled Dr Stuart M. Turnbull banner: root causes of the financial crisis The ‘family’ risk: Andreas Kern & Christian a cause for concern Fahrholz among Asian investors Global financial change impacts David Smith compliance and risk The scramble is on David Dekker to tackle bribery and corruption Who exactly is subject Penelope Tham & Gerald to the Foreign Corrupt Li Practices Act? Financial markets Tham Yuet-Ming remuneration reform: one step forward h Of ‘Black Swans’, stress Umesh Kumar & Kevin y of whic Marr tests & optimised risk management anies – man US legisChallenging the of comp David Samuels value of enterprise anies. The hundreds risk management tices by Fortune 500 comp scandals by even Rocky road ahead Tim Pagett & Ranjit upt Prac were for global accountanc to these Corr Jaswal in the y convergence Foreign e responded FCPA in 1977. nnings the ial latur The US its begi Dr Philip Goeth ting the isions to The Asian regulatory Rubik’s Cube rgate Spec A), has the tually enac main prov A framework for

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

otwo Act (FCP s, and n the Wate Alan Ewins and Angus era, whe There are bribery provision and the ntary discl e Risk manaRoss Watergate called for volu SEC gement – the antihad mad r Both the Prosecuto companies that ard FCPA nting provisions. J) have juristo Rich accou Justice (DO SEC sures from contributions aign. rally, the rtment of ble US Depa FCPA. Gene isions and questiona presidential camp n over the 1972 nting prov st issuers led dictio Nixon’s the accou again sures revea prosecutes ry provisions as edings these disclo estic payments bribe ative proce and antiHowever, administr d the anies ble dom gh civil and questiona had been channelle cutes comp s Standard & not just ess. throu the DOJ prose that ry provision n busin eas funds Poor’s anti-bribe outlines the ti- wher nts 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 big challe h funds” ion (SEC ing cal The Commiss issuers kept “slus ’s antiaanyth appro nge for banks to money or robust and politi build down The FCPA or provide (“foreign”mean n officials many US of worst-case ach to managing the turn capita l to offer als s to foreig l adequacy risk uncov n or stress scena pay bribe tary illega to foreign offici programs by defini t to obtai tion, rios that, almos er risk conce a volun inten to to are trigge ntrations and of value up with t encies, ) with the parties. business red risk unlikely or and; applyi h any corlater came “non-US” directing unpreceden by apparently to ng these impro dependThe SEC e under whic payments ing business, or for drive busine ted events. vemen programm retain ted illicit disclosure through perfor ss selection – for examp ts de sponsorh self-repor SEC was given any person. can inclu However, solving le, mance analys holition whic of value pora adjusted pricing the problem likely with the is fying of a ation, usethe risk conce Anything perated of identiit would that takes stress and riskent, ntratio t and co-o into account. l and educ cies that ance that employm ns and depen test results The resul for trave give rise to mal assur of future dennt action. e is no worst-case an infor $300 ship home, promise vital if the enforceme outcomes is meals. Ther industry than USD day is to thrive be safe from sure that more Top-level overs drinks and vidual banks (a mas– and if indiunts, ents disclo ight are e disco ble paym was the Buildin 147 past two years to turn the lessons 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 s to the enterbe lauded by head-on will prise is clearly, in part, h Asia investors and a corporate Risk Nort ance challe coming years regulators govern nge.The board lation & in the must of industry of Regu and top execut most impor recuperation have the motiv Journal ives tantly, will ation and be able to delive and, scrutinise and tained profita the clout to call a halt 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 contrary organisation portfolios of ded in the potential acquis ing corporate to popular opinion, impro . itions. To improve governance vis not just a tion of puttin and strengthen enterprise risk manag quesg the ‘right’ ement 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 executive overcontrol of to make the sions when enterprise agement; re-inv they are difficu right deciigorated stress risk man- busine 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

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


Journal of Regulation & Risk North Asia


Exchange rates

Is an undervalued renminbi the source of global imbalances?
Prof Charles Wyplosz of the Geneva Institute dismisses exogenous causes as a factor in the current dollar-RMB debate.
the current debate in the united states over China’s exchange rate policy can be viewed as a rerun of the 1970s and ‘80s, with China taking Japan’s role. this paper argues that while there is a relationship between current account deficits and surpluses, causality is difficult to establish. Politics aside, even if Beijing does not choose to let the renminbi (rMB) appreciate, inflation will eventually finish the job. Back in the 1970s and‘80s, a sure vote-getter in the US and pleasure-getter on Capitol Hill was to complain about Japan manipulating its exchange rate. Every argument that you may hear today about China was made then. In the end, Japan caved in and let its exchange rate appreciate. This is shown in Figure 1 (overleaf), which displays real effective exchange rates, i.e. rates corrected for the evolution of the country’s labour costs relative to those of its trade partners. As can be seen from Figure 2 (overleaf), the US current account deficit improved, but only temporarily, and Japan remained in surplus after a temporary reduction. What Journal of Regulation & Risk North Asia the move has achieved durably was to wreck the Japanese economy, which has not grown one iota since. The Japanese used to call this “the lost decade”; clearly it is now becoming the“lost generation.”As China emulates Japan’s export-led growth strategy, this story is likely to figure prominently in its policymakers’ minds. And rightly so. For further development of this premise, see Park and Wyplosz, 2010. Negative correlation Figure 2 (see overleaf) illustrates the dangers of interpreting co-movements as causality. The striking feature is the opposite movements – or negative correlation – of the US and Japanese current accounts. Equally strikingly, despite these wide fluctuations, for more than 30 years the Japanese account has not been into negative territory while the US has not seen a surplus. US legislators interpreted these opposite yo-yo movements as a proof that the US deficits were caused by the Japanese surpluses and they saw the continuing Japanese surpluses as a proof that the yen was overvalued. They say exactly the same things 245

Figure 1. Real effective exchange rates (2005 = 100)

Figure 2. Current accounts (% of GDP)

Source: IMF. Note: Nominal exchange rates corrected for unit labour costs. An increase represents a real appreciation

Source: IMF.

today, just cut out“Japan”and replace it with “China”. But there is a big problem. The negative correlation between the US and Japanese current accounts is still very much there. So if yesterday’s Congress members were right, then it must still be that the US external deficit continues to be driven by Japan’s surplus. You do not need to bring China into the picture. Alternatively, if you agree with today’s Congress, you didn’t need Japan back then, maybe China was already doing the trick (it wasn’t). The other possibility is that both China and Japan have been colluding all along, which would require an incredible amount of co-ordination between two countries that are barely on speaking terms. China’s reaction China’s authorities naturally see causality running in the other direction. They blame the US current account deficits for the Japanese and Chinese surpluses. They further blame the US budget deficits for their external deficits. The US response has been 246

the “saving glut” hypothesis originally proposed by Bernanke (2005). This view argues that excess savings in China – about 40 per cent of GDP – both depresses imports and creates the need for investment opportunities abroad. Thus politicians look at the current account and competitiveness, therefore the exchange rate, while Fed chairman Ben Bernanke looks at capital flows – the Chinese savings are transformed into US (public sector) borrowing. This removes the exchange rate from centre stage. Heart of the matter Causality lies at the heart of the dispute, as is often the case. As economists, we know how delicate the causality issue is. Theoretically, in general equilibrium few are the truly causal – or exogenous – factors. Empirically, causality is the most vexing issue, which has led to countless techniques, none of which are particularly convincing. The first observation, which is neither clarifying nor hopeful, is that it is impossible to prove which side of the debate is guilty. In particular, no one Journal of Regulation & Risk North Asia

will seriously claim that current accounts are exogenous. Debating whether it is the US deficit that is causing China’s surplus or the other way around is a waste of time. The negative correlation only shows that these variables are related to each other. We must try to understand what is driving both. US budget deficits, Chinese and US savings and a few other variables are good candidates; more on them below. Is the RMB exogenous? Another aspect of the causality problem is the role of the exchange rate. Is the Chinese current-account surplus caused by a renmimbi undervaluation? Put differently, is the renmimbi exchange rate exogenous? The answer is not as easy as it may seem. Of course, the Chinese authorities peg their exchange rate to the dollar and even when they allow for some flexibility (before the crisis and soon again), they still very much keep it under control. Undoubtedly, the nominal exchange rate of the renminbi can be taken as exogenous, but it is the real exchange rate, i.e. the relative price of domestic and foreign goods or relative unit costs as in Figure 1, that affects the current account. Let us start with the object of conflict, i.e. the dollar-renminbi exchange rate. The nominal rate is in the hands of the Chinese authorities, who have opted for a fixed exchange rate regime. This is perfectly compatible with IMF principles. Calling that “manipulation” is not just outside any legal norm, it would also concern the tens of other countries that also peg their currencies to the dollar – and (why not?) those that maintain Journal of Regulation & Risk North Asia

fixed exchange rates vis-à-vis currencies like the euro. But is this peg responsible for the Chinese surplus and the US deficit? Start with the easier part of the question: the link between the Chinese current account and the value of the renminbi. If the exchange rate has any impact on the current account, it is because it affects price competitiveness, which can be approximated by the real exchange rate. The evidence here is not controversial: the nominal exchange rate strongly affects the real exchange rate in the short run, say over one year or two, but not in the long run because real exchange rates eventually are endogenous. The claim that the renmimbi undervaluation is the cause of continuing Chinese surpluses look like a non-starter, unless it can be proven that China also prevents prices from rising in response to undervaluation. Monetary policy Like every country, China tries to stabilise prices. The instrument is monetary policy, which in China is essentially driven by the fixed exchange rate policy. Put differently, the exchange rate is the instrument used to keep inflation low. If the authorities were to peg it at the wrong level, the result would be inflation. This does not fully exonerate China, however. Because they use extensive internal and external financial controls, the Chinese authorities can peg the exchange rate at an undervalued level and combat inflation through credit controls.This is precisely what they do. So, yes, it is possible for China to control its real exchange rate for more than the short run. Put differently, the export-led 247

strategy is still an option. This conclusion, however, does not imply that the renminbi exchange rate can explain the US deficit. The US cannot control its own real exchange rate and, anyway, it does not even attempt to control its nominal rate. Then is the dollar overvalued? That raises the question: what is the dollar equilibrium exchange rate level? The formal definition of equilibrium is complex – the real rate that, if maintained indefinitely would allow the country to run permanent surpluses, respectively deficits, that allows it to serve its external debt, respectively to absorb returns on its net external asset position. A simplified version, inevitably inaccurate, is that the real exchange rate is in equilibrium if it delivers a current account balance when the economy is otherwise in a sustainable position. The problem is that the US quasi-zero private saving rate until 2008 and its budget deficits observed over the past decade are not sustainable. Dollar equilibrium Whether the dollar is in equilibrium or not is highly controversial. A safe conclusion is that a renminbi appreciation, even a large one, will not solve the many disequilibria present in the US economy. US citizens must first start saving again and the federal government must stabilise its own indebtedness. The role of the renminbi is bound to be negligible. A good story must distinguish between short-run co-movements of the US and Chinese current accounts and the longrun trend of larger imbalances visible since the mid-1990s, both of which are negatively correlated. The savings glut story offers an interesting starting point. It takes Chinese 248

savings as exogenous. High savings are seen as the result of Asians’ famed propensity to save combined with income distribution tilted towards large firms and with inexistent social safety nets. It is also a highly desirable feature when the population is quickly ageing, as is indeed the case in China. Fast growth and more resources flowing to high savers explain the trend seen in the left-hand chart in Figure 3. Current account deficit The next step is the trend decline in US net private saving (for the time being, ignore the wide shorter-run fluctuations) also shown in the left-hand chart in Figure 3. This is mirrored in the growing US current account deficit. No need for China and the renminbi to account for this evolution. It just turns out that the current accounts of China and of the US started more or less simultaneously in opposite directions. For the shorter-run movements, we turn to the right-hand chart in Figure 3 which displays the US current account and its two components: the budget balance and net private saving. The striking observation is the near perfect negative correlation between the budget balance and net private saving. This observation suggests – remember, causality is hard to prove – that net private saving fluctuations in the US have been largely driven by the budget balance, in Ricardian fashion (Ricardian equivalence asserts that the private sector saves exactly what the government dissaves because it understands that the public debt must be eventually financed by higher taxes). In a pure Ricardian world, the current account would have remained in balance, which Journal of Regulation & Risk North Asia

Figure 3. The China-US nexus (% of GDP)

Source: IMF and OECD

it approximately did until the early 1990s. This observation came to be known as the Feldstein-Horioka paradox because it meant that the US was not taking advantage of financial markets to borrow or lend internationally. Disappearing paradox The paradox disappeared in the early 1990s when short-run fluctuations of net private savings moved along a declining trend, which was mirrored in the declining current account deficit. This is indeed the time frame when financial deregulation picked up speed around the world. In the US, it led to the development, among other innovations, of the now-infamous subprime mortgage markets. Private saving declined drastically. (The 2008 crisis seems to have brought a reversal, but a couple of years a trend does not make.) Finally, what about the negatively correlated shorter-run current account Journal of Regulation & Risk North Asia

fluctuations in the US and China (and Japan)? The striking message from the lefthand chart in Figure 3 is that the Chinese current account is most directly related to US net private savings and therefore, via the right-hand chart, to the US budget deficits. Assume that Chinese and Japanese (and German) savers would not have responded to rising borrowing needs in the US. In the now-globalised economy, interest rates would have risen worldwide, presumably boosting savings. Conversely, if China’s savings had not been matched by US borrowing, interest rates would have declined worldwide, presumably encouraging borrowing. Depending on which side dominated, interest rates played their balancing role – though this remains to be established. Summary The story can be summarised in a simple, hopefully convincing, way: Financial deregulation in the US led to a 249

drastic decline in US private savings, which translated in a long-run trend decline in the current-account balance; at about the same time, China deregulated its economy and embarked on an export-led strategy. Rapid growth put continuously more income in the hands of large firms that started to save more as they could not invest fast enough to absorb their resources. This translated in a long-run trend rise in China’s current account; in the shorter run, US budget deficit fluctuations led to opposite fluctuations in US net private savings, along the downward trend. US citizens being imperfectly Ricardian, there remains a residual current account imbalance, also along the downward trend, which led to matching saving responses elsewhere in

the world, including China; the renminbi exchange rate is not a necessary ingredient in the story. If China insists on pegging the renminbi to the dollar and on preventing the real appreciation that should accompany fast technological catch-up – the BalassaSamuelson principle – eventually inflation will deliver this appreciation. • References
Bernanke, Ben (2010), ‘Global Saving Glut and the US Current Account Deficit’, Sandridge Lecture, Virginia Association of Economics, Richmond, Fed. Res Brd, March. PARK,Yung Chul Park & CharlesWyplosz (2010), Monetary and Financial Integration in East Asia: The Relevance of European Experience, Oxford University Press.

Journal of regulation & risk north asia
to the subject actly is s Act? Who ex Practice Corrupt Foreign


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 In this pap consultant, exa a. tor on the causes prominent commenta- mortgage fraud warning of an “epidemic” of A in Asi in their congressio of the current financial Kong g FCP nal testicrisis, 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. 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impacts l change financia liance and risk comp


Journal of Regulation & Risk North Asia

Basel liquidity rules

The regulators strike back: Basel and new liquidity rules
The Bundesbank’s Thomas Dietz explains why some banks are opposed to the Basel Committee’s new liquidity requirements.
as history teaches us, painfully, earthquakes in the oceans are often followed by devastating tsunamis. however, the impact of a tsunami will depend on the magnitude of the quake. the worldwide financial crisis triggered by the subprime debacle in the us has surely been the strongest quake in the financial and economic universe since the great Depression. thus, it comes as no surprise that it is now followed by a tsunami – a regulatory one! It is the governments of western industrial countries that are now riding atop this tsunami. Prior to the financial crisis, the Basel Committee on Banking Supervision (BCBS), as the leading international standard-setter in banking oversight, was acting rather independently. Since the first G-20 meeting in Washington in November, 2008 this has changed profoundly. It is now the G-20 governments that are setting the international agenda in this respect. Thus, the fundamental reform of the Basel II framework the BCBS is currently working on, has been guided by Journal of Regulation & Risk North Asia corresponding proposals of the Financial Stability Board and the G-20 summits. Following these guidelines the BCBS’s “Principles for the enhancement of the Basel II framework“ from July, 2009 and its consultative document “Strengthening of the resilience of the banking sector“ from December, 2009 are suggesting a much tighter capital requirements regime that – as a “tax for failure“ during the financial crisis and before – will make banking more costly and less profitable in the future. In parallel, the EU Commission is consulting on respective proposals for the EU level, too. Diverse attitudes With capital attracting so much attention one could easily overlook another fundamental change of paradigm, this time in the field of liquidity regulation. So far the regulatory regime on liquidity risk has been quite diverse. Some supervisors have been working with a qualitative, others with a quantitative approach and some with a mixture of both (like in Germany). A quantitative approach is generally characterised by the supervisory authority 251

prescribing both regulatory ratios the institutions need to comply with and the way the institutions have to calculate them. A qualitative approach goes for ratios, too, but allows the banks to use their own. The supervisor “only” assesses the soundness of these ratios and whether or not he’s satisfied with how they are used to manage the risks they are supposed to measure. Rules-based approach With its “Principles for sound liquidity risk management and supervision” from September, 2008 the BCBS’s answer to the financial crisis concerning liquidity risk management was at first a qualitative one. With the help of 17 principles, four of which being addressed to the supervisors, the obvious shortcomings in liquidity risk management during the crisis were addressed and principles-based guidelines on how to avoid a future crisis were given. Mainly due to the political pressure of the UK government being supported by the US, these principles-based guidelines have now been complemented by a rulesbased approach – the December, 2009 “International framework on liquidity risk management, standards and monitoring” –which the BCBS has been consulting on until mid-April. These liquidity standards – should they be implemented in the current version – do not leave much space for interpretation since they are clearly following a quantitative, rules-based approach. They are designed for internationally active banks, should be regarded as minimum standards (meaning that national supervisors can set higher requirements if deemed necessary), and are 252

covering a stress test not a going-concern scenario. The standards have a dual purpose: • To strengthen the short-term resilience of institutions by prescribing a minimum of high-quality liquid resources enabling the institutions to survive an acute stress scenario lasting for one month; and • promote the long-term resilience of institutions by setting “incentives” to fund their structural activities with more stable (less volatile) sources of funding. To achieve the first objective the consultation paper introduces a so-called Liquidity Coverage Ratio (LCR). The Net Stable Funding Ratio (NSFR) is supposed to capture the structural relationship between assets and their funding. These two ratios are complemented by monitoring tools designed as a set of common metrics to be used by the supervisors for monitoring the liquidity risk profile of the supervised banks. Negative reactions First reactions of the banking industry have been quite negative. Respondants have critisised inter alia that the new rules would: • Oblige the banks to hold large stocks of highly liquid assets, thus significantly reducing their yield P&L; • increase demand for government bonds with prices rising and yields falling further; • decrease demand for non-government bonds forcing, in particular, non-financial companies to attach higher coupons to their bonds, thus increasing their funding costs; • create additional concentration risks in the bank portfolios; and, • increase competition for retail deposits, thus narrowing the margins obtainable from business with private customers. Journal of Regulation & Risk North Asia

In addition, the German banking industry especially pointed out that the prudential ratios of the BCBS would discourage the use of internal liquidity risk measurement and management systems for regulatory purposes (as is currently possible in Germany). Below, we will have a closer look at the proposed framework to understand what exactly makes the industry so sceptical and why the changes are really that profound compared to the current regimes. LCR: short-term resilience With the LCR the supervisors do not only define a ratio above which an institution has to operate at all times but also components in the numerator and the denominator the institution has to use to calculate the ratio. The basic idea of the LCR is to compare the stock of what is defined as high quality liquid assets (HQLAs) to the net cash outflows over a 30-day time period. It is therefore designed as a mixture of a maturity mismatch and a stock approach. In order to comply with the requirements of the consultation paper the high quality assets must exceed the net cash outflows within the next month. This is equivalent to the following condition:
Stock of high quality liquid assets Net cash outflows over a 30-day period >10

number of institutions only survived because their liquidity supply could be maintained by central bank or by other ways of secured funding. All other sources of funding for these institutions had either been reduced significantly or had dried up completely. However, access to central bank funding or secured funding outside the central bank depends on a stock of high quality assets that can be offered as collateral. It is immediately clear that complying with the ratio will become harder the less assets qualify as “high liquid assets”. It will also get harder the stronger the assumptions are on the net cash outflows over the next 30 days. Stocks of HQLAs In order to qualify for a “high-quality liquid asset” (the LCR numerator) assets should (according to the consultation paper) ideally both stay liquid in markets during stress situations and be central bank eligible. In addition, the stock of high-quality liquid assets must be unencumbered and freely available to group entities, also in foreign jurisdictions. The BCBS enumerates a number of fundamental and market-related characteristics of these assets, i.a: • Low credit and market risk; • no (or at least minimum) evaluation uncertainties; • low correlation with risky assets; • tradable on active and sizeable markets with low market concentration. All these characteristics reflect lessons from the financial crisis. For instance, due to the breakdown of certain markets (like the ABCP market) and due to evaluation 253

Economically this means that the institutions need to make sure that all the net cash outflows (cash inflows minus cash outflows) within the next month could be covered completely by repo or selling off their stock of highly liquid assets. This reflects one important experience of the supervisors during the financial crisis. A non-negligible Journal of Regulation & Risk North Asia

problems (like in the ABS and CDO market) the institutions either had to incur losses due to decreasing market values of financial instruments they held as assets or it was not possible any more to get market prices for these assets at all. This was one of the reasons for the crisis of trust on the money markets following the subprime debacle. Limited HQLAs The BCBS interprets the criterion “low correlation with risky assets” in a way that bonds issued by credit institutions would not qualify as HQLAs. This reflects the high (positive) correlation between the return of bank bonds during the crisis. As a result, the number of high-quality liquid assets is extremely limited to: • Central bank reserves (given that they can be drawn down under stress); • marketable securities issued or guaranteed by entities or organisations, as long as: • they are assigned a zero per cent risk weight under the Basel II standardised approach; • deep repo markets exist for these securities; • the securities are not issued by banks or other financial services entities; and, • government debt issued in the currency of the group’s home country. Surprisingly, this means that bonds issued by banks which are state-guaranteed could not be included in the pool of HQLAs. Covered bonds (issued by banks or other companies) would not qualify as HQLAs either. This was one of the most controversial points among the BCBS members when drafting the consultation paper. Whereas the Anglo-Saxon countries, notably the US and 254

UK, were arguing for a narrow definition of a HQLA (basically leaving only government and central bank debt as well as securities of public sector entities like the BIS, the IMF or multilateral development banks), other members preferred a wider definition. The latter would also include covered bonds (such as the German “Pfandbrief”) and high-quality corporate bonds. As a compromise, the BCBS has agreed to collect data via a quantitative impact study (QIS) both on the effects of a narrow and a wider definition of HQLAs. However, the current majority in the BCBS prefers a narrow definition. Even under a wider definition, high haircuts would be applied to the market value of covered and high-quality corporate bonds (between 20-40 per cent) and the total stock of HQLAs would need to be comprised of at least 50 per cent assets falling under the narrow definition. Net cash outflows The net cash outflows (the LCR denominator) have to be calculated by multiplying outstanding balances of liabilities by assumed percentages that are supposed to roll-off or by multiplying various off-balance sheet commitments by specified drawdown ratios. The level of the parameters (the run-off factors) are set by the supervisors according to a combined idiosyncratic and market-wide shock resulting inter alia in: • A three-notch downgrade in the institution’s public credit rating; • a run-off of a proportion of retail deposits; • a loss of unsecured wholesale funding capacity and reductions of potential sources of secured funding on a term basis; Journal of Regulation & Risk North Asia

• a loss of secured, short-term financing transactions for all but HQLAs; • increases in market volatilities that impact the quality of collateral requiring larger collateral haircuts or additional collateral; • unscheduled draws on all of the institution’s committed but unused credit and liquidity facilities. Quite burdensome As a result, the expected cash outflows that are calculated by summing up given run-off percentages under these severe assumptions will be quite burdensome for the institutions. They come from: • Retail deposits; • unsecured/secured wholesale funding; • contingent funding liabilities. Other cash outflows, such as planned derivative payables, should be captured in the LCR, too. The consultation paper distinguishes between the degree of liquidity still available from all these funding sources by attributing different run-off percentages to them. The more stable the funding source is assumed to be the lower this percentage. Most of these percentages are exactly prescribed, i.a. for: • Unsecured wholesale funding (25, 75 or 100 per cent assumed cash outflows from the respective positions, depending on the credit-worthiness of the creditor and/or the economic sector it belongs to – for instance, unsecured wholesale funding provided by non-financial corporate customers, sovereigns, central banks and public sector entities only receive a 25 per cent run-off factor whereas bonds from credit institutions get 100 per cent); Journal of Regulation & Risk North Asia

• drawdowns on committed credit and liquidity facilities (10 per cent for facilities to retail clients and non-corporate customers, 100 per cent for the rest); • funding by ABCPs, Conduits, SIVs and other such financing facilities (100 per cent); • increased liquidity needs related to downgrade triggers embedded in shortterm financing transactions (100 per cent) and to the potential for valuation changes on posted collateral securing derivatives transactions (20 per cent). Other run-off factors are supposed to be minimum percentages, leaving it to the national supervisors to impose higher percentages (if deemed necessary), for instance: • At least 7.5 per cent for “stable deposits” (those covered by a deposit insurance scheme and that have established relationships with the same bank which make deposit withdrawals unlikely) and 15 per cent for “less stable deposits” (e.g. Internet deposits); • increased liquidity needs related to market valuation changes on derivative transactions (where the BCBS does not prescribe a specific minimum ratio but leaves it completely to the national supervisors to set the respective run-off factor). Up to the supervisors Eventually, for some contingent funding liabilities, such as guarantees, letters of credit or unconditionally revocable uncommitted credit and liquidity facilities, the national supervisors alone determine whether or not they should be covered in the LCR at all. Given this and given the possibility for gold-plating when it comes to setting the level of certain run-off factors, it becomes 255

clear that the LCR will be helpful for comparing the liquidity situation of credit institutions in the same jurisdictions, but not necessarily across different jurisdictions. Cash inflows The cash inflow regime in the consultation paper is described quite quickly. It comprises: • Amounts receivable from retail counterparties; • amounts receivable from wholesale counterparties; • receivables from repo and reverse repo transactions backed by illiquid assets; • other cash inflows (such as planned contractual receivables from derivatives). Maturing reverse repurchase or securities lending transactions secured by liquid assets are assumed to be rolled over and will therefore not result in cash inflows within the 30-day period of stress. The same holds true for contingent funding facilities, since no lines of credit, liquidity facilities or other contingent funding facilities the bank holds at other institutions are assumed to be eligible for drawdown. Doubtful assumption The attentative reader will already have realised the contradiction to the cash outflow section in this respect, where a 100 per cent drawdown was assumed in the case where credit institutions have granted committed credit or liquidity facilities to other financial institutions. Another rather doubtful assumption is the run-off of retail depositors. To assume a run-off itself is not unrealistic, but it’s not very credible that all these deposits will not be invested in other credit institutions any more. At the top of the financial 256

crisis a flight to quality could be observed in that respect (in Federal Germany for instance a lot of depositors took money from private banks to the savings and co-operative banks). The parameters set by the supervisors according to the consultation paper are based upon the actual circumstances during the financial crisis that began in mid-2007 and are therefore rather severe. As a result of these very conservative assumptions, banks relying on wholesale funding would be hit the most by the new regime. A bank making use of wholesale funding relies on the financial markets for refinancing their assets, e.g. by issuing bonds, commercial papers, asset-backed securities, etc. Retail funding Banks making use of wholesale funding typically do not or only in a limited way have access to retail deposits (retail funding). These kinds of banks were affected most by the financial crisis whereas banks predominantly using retail funding have coped quite well so far; for instance the German savings and co-operative banks. Thus, “punishing” the wholesale funding business model is supposed to stabilise financial markets. Long-term resilience The consultative paper explicity points out that the stress scenario prescribed by the supervisor does not relieve the institutions from conducting their own stress tests commensurate with the size and complexity of their specific business acitivities. As the consultation paper points out, the NSF ratio is intended to promote Journal of Regulation & Risk North Asia

longer-term structural funding of banks’balance sheets and off-balance sheet exposures and aims to “limit over-reliance on wholesale funding during times of buoyant market liquidity and encourage better assessment of liquidity risk across all on- and off-balance sheet items.’’ In other words, the maturity transformation of banks is supposed to be cut back to a level that has less dramatic consequences for financial stability and (again) wholesale funding should be reduced in favour of the less volatile retail funding. In order to achieve this, the amount of stable funding (the sources of funding) should exceed the required amount of stable funding at all times under a predefined stress scenario (milder than the one assumed for the calculation of the LCR).This is equivalent to the following condition:
Available amount of stable funding Required amount of stable funding >100%

recognised credit rating organisation; • a material event damaging the reputation or credit quality of the institution; • a significant decline in solvency or profitability arising from heightened market risk, credit risk or operational risk exposures. The total available amount of stable funding is calculated in three steps. First the carrying value of an institution’s equity and liabilities is assigned to one of five categories. The ASF factor After that the amount assigned to each category has to be multiplied by a so-called ASF factor applied to the respective category. This factor represents the BCBS’s assumption on the extent up to which this respective source of funding will still be available under the stress scenario described above. For instance, an ASF factor of 85 per cent would mean that 85 per cent of the amount available from a specific funding source under a going-concern scenario would be still available under stress. The less stable the source of funding the lower the ASF factor. Finally, the total ASF is the sum of the weighted amounts in each category. The ASF factors and (some of) the bank’s equity and liability positions in each category are listed below. “Stable” and “less stable” in this respect follow definitions given under the LCR section. The amount of available stable funding must exceed the amount of net stable funding required (NSFR) at all times. Again, there are also three steps to calculating the NSFR. First, all asset categories that need to be funded are assigned to six balance-sheet and two off-balance-sheet related categories. In 257

The BCBS emphasises that such a metric is not new to the institutions since most of them use similar“net liquid asset”and“cash capital” methodologies already to structure their balance sheet, even if the NSF ratio takes a wider perspective by incorporating also the potential liquidity risk of off-balance sheet exposures and“various types of maturity mismatches involved in short-term secured funding of long-dated assets that traditional forms may ignore”. In contrast to the LCR the ssumed NSF stress scenario is only institution-specific with a time horizon of one year. Under this scenario a bank encounters, and investors and customers become aware of: • A potential downgrade by any nationally Journal of Regulation & Risk North Asia

Table 1. The ASF factors of the NSFR24
ASF factor 100% Components of ASF category Tier 1 and Tier 2 capital Secured and secured borrowings and liabilities with effective maturities greater than 1 year (including term deposits) preferred stock (not included in Tier 2) that has an effective maturity of greater than 1 year Retail deposits (stable non-maturity and/or term retail deposits with residual maturity of less than one year) stable unsecured funding by non-financial small business customers (non-maturity or residual maturity of less than one year) Retail deposits (less stable non-maturity and/or term retail deposits with residual maturity of less than one year) less stable unsecured funding by non-financial small business customers (as above) Unsecured wholesale funding provided by non-financial coporate customers (non-maturity or with a residual maturity of less than one year) All other liability and equity categories (including wholesale funding by financial institutions!)


70% 50% 0%

a second step, for each of these eight categories a corresponding RSF factor is set representing the share of stable funding needed (according to the point of view of the supervisors) related to total funding needed or representing the assumed drawdown of the currently undrawn portion of off-balance sheet categories. Liquidity drains The latter was introduced because many off-balance sheet categories need little direct or immediate funding but can lead to substantial liquidity drains in times of stress. This could clearly be observed during the financial crisis when many SPVs used liquidity facilities granted by financial institutions, bringing serious trouble to some. Finally, the total NSFR is the sum of the weighted sums in the respective RSF categories. All in all the NSFR framework leaves much less space for national discretion, since only the SFRs for other contingent funding obligations are subject to the decision of the national supervisors. The NSFR could therefore be a rather robust metric for 258

cross-border comparisons between different credit institutions. The ongoing quantitative impact study previously mentioned will also quantify the impact of the NSFR on the Basel and the EU credit institutions. In addition to the LCR and the NSFR the consultation paper introduces four monitoring tools the supervisors are (as a minimum) supposed to make use of when assessing the liquidity profile of banks: • A contractual maturity mismatch; • concentration of funding; • available unencumbered assets; • market-related monitoring tools. Supervisors are supposed to take action when potential liquidity difficulties would be signalled by the metrics. The contractual maturity mismatch is supposed to identify gaps between contractual on- and off-balance cash in- and outflows for pre-defined time buckets. Such kind of gap analysis is already used on a large scale by the crossborder groups themselves (covering also non-contractual cash flows, however, and under a going-concern perspective) and gives insight into the extent up to which the Journal of Regulation & Risk North Asia

Table 2. The RSF factors of the NSFR24
RSF factor 0% 5% • • • • • Components of RSF category Cash, money market instruments and deposits (at other financial institutions) unsecured debt instruments of financial and sovereign entities outstanding loans to financial entities with effective maturities of less than 1 year Unencumbered marketable securities with residual maturities ≥ one year representing claims on sovereigns, central banks, BIS, IMF, EC noncentral government PSEs or multilateral development banks which are rated AA or higher and are assigned a 0% risk weight under the Basel II standardised approach, provided that active repo-markets exist for these securities




85% 100% National supervisors can specify the RSF factors based on their national circumstances

Conditionally revocable and irrevocable credit and liquidity facilities to retail clients (natural persons) and legal entity customers (non-financial corporates (including small businesses, sole proprietorships and partnerships)) and other legal entity customers such as financial institutions (including banks, securities firms, insurance companies, multilateral development banks etc.), fiduciaries,27 beneficiaries,28 conduits and special purpose vehicles, sovereigns and central banks, public sector entities; affiliated entities of the bank and other entities not included in the categories above) Unencumbered corporate bonds (or covered bonds) rated at least AA with an effective maturity of ≥ one year which are traded in deep, active and liquid markets and which also have a demonstrated history of being a reliable liquidity source in a stressed market environment • Gold • Unencumbered equity securities listed on a major exchange and included in a large capital market index and unencumbered corporate bonds (or covered bonds) rated AA- to A- with an effective maturity of ≥ one year, which are traded in deep, active and liquid markets and which also have a demonstrated history of being a reliable liquidity source in a stressed market environment • Loans to non-financial corporate clients having a residual maturity of less than 1 year Loans to retail clients having a residual maturity of less than one year All other assets Other contingent funding obligations, including products and instruments such as: • Unconditionally revocable "uncommitted" credit and liquidity facilities; • Guarantees; • Letters of credit; • Other trade finance instruments; and • Non-contractual obligations

bank makes use of maturity transformation. Again the assumptions of the BCBS are quite conservative since cash inflows should be reported by the institutions according to their latest and cash outflows, and according to their earliest possible maturity. A concentration of funding ratio is meant to identify sources of funding that, when withdrawn unexpectedly, could trigger liquidity problems. It is an indicator for the diversification (or concentration) of funding. Journal of Regulation & Risk North Asia

This metric would include:
A. Funding liabilities sourced from each significant counterparty The bank’s balance sheet total B. Funding liabilities sourced from each significant product The bank’s balance sheet total C. List of asset and liability amounts by significant currency

A“significant counterparty”is defined as a single counterparty or a group of connected counterparties accounting in total for more than one per cent of the institution’s total 259

liabilities. Similarly, a“significant currency”is defined as liabilities denominated in a single currency accounting for more than one per cent of the bank’s total liabilities and a “significant instrument/product”again accounting for more than one per cent of the bank’s total liabilities. The above metrics should be reported for time buckets from less than one month up to longer than 12 months.

possibly serving as early warning indicators in monitoring potential liquidity strains at banks. This could be market-wide data on asset prices and liquidity but also institutionrelated data on credit default swaps premia and equity prices. In this respect one could think of several indicators, e.g. the index level of the iTraxx (both the main index and the iTraxx Crossover) or the distance between the costs Threshold ‘too low’ for secured and unsecured funding in the It is doubtful whether these metrics would money markets (for instance Euribor and really be helpful for supervisors. Firstly, the Eurepo) which both proved to be quite good consultation paper itself points out that indicators for the development of the finanit is not always possible to identify all the cial crisis. counterparties that hold debt securities, so According to the consultation paper that the degree of concentration could be supervisors should calculate the metrics on underestimated. a monthly basis, if necessary even increasing Secondly, the threshold for “significant” the frequency to weekly or daily under stress seems to be set far too low since it is not really situations. Reporting of the banks would be credible that a client or a product accounting determined correspondingly. The standards for 1.1 per cent of the bank’s total liabilities and monitoring tools in general would be is creating a significant concentration risk for applied to internationally active banks on a an institution. consolidated basis, but may also be used for Similarly, it is doubtful whether reporting any subset of internationally active banks, the available unencumbered assets that are for instance to ensure a level playing field marketable as collateral in secondary mar- between domestic and cross-border banks. kets and/or eligible for central bank’s stand- Information on the metrics should be pubing facilities is helpful for the supervisors, licly disclosed. either. Again the consultation paper itself explains that “the metric does not capture Quantative impact study potential changes in counterparties’ haircuts The BCBS is supposed to agree on the final and lending policies that could occur under version of the liquidity standards until end either a systemic or idiosyncratic event and 2010 with the aim of applying the standards could provide a false comfort that the esti- from end 2012. The overall impact of the mated monetised value of available unen- BCBS rules are currently under examinacumbered collateral is greater than it would tion, not only in Germany. The BCBS (and be when it is most needed.” in parallel the EU) conducts a quantitative The market-related monitoring tools impact study on the effects of the BCBS are referring to high frequency market data standards, the results of which are supposed 260 Journal of Regulation & Risk North Asia

to be published in summer 2010. First estimations, for instance from Bank of America/ Merrill Lynch, are quite pessimistic, meaning that currently only a limited number of banks could comply with the required ratios at all (for instance only four out of 19 large European Banks in the BoA/Merrill Lynch sample would show a NSFR above one). Drastic comments This is also reflected in the more than 200 comments received on the proposed liquidity standards during the consultation period. From a sample of 25 banks (assumed to be representative of the total number of comments) 72 per cent of respondents objected to including a stable funding ratio as a Pillar I requirement and 84 per cent felt treatment of covered bonds in the stable funding ratio too harsh. The most drastic comments state that“it would be impossible for even the most conservative business model to meet the proposed calibration”or that“it is quite possible that the required levels of stable funding do not exist”. This supports the thesis of a real regulatory tsunami being on its way with deep implications for the business models of banks and possibly also for the real economy. As a delicate political side aspect, some people argue that it might be no coincidence that is exactly the two states issuing the largest volumes of government bonds in the coming years pushing for a very narrow definition of HQLAs. Some people involved in the process therefore already expect a second round of consultation after the publication of the QIS results with recalibrated ASFs and Journal of Regulation & Risk North Asia

RSFs and possibly a widened definition of HQLAs. Consistency with EU approach33 In parallel with the BCBS, the EU Commission has launched a consultative process, too. The contents of the two consultation papers referring to the introduction of quantitative minimum standards for liquidity risk are almost completely identical. However, the Commission submits more detailed proposals on: • The scope of application; • the treatment of intra-group transactions and commitments; and • the supervisory responsibility for branch liquidity. According to the Commission, the standards should be applied both to credit institutions on a stand-alone basis and to EU parent credit institutions with the possibility of waiving the application to individual entities under certain conditions. Inconsistencies The proposed LCR introduces certain inconsistencies concerning intra-group transactions. For instance, one group entity would need to assume a liquidity outflow as a result of the drawing of a credit line by another group entity whereas the drawing entity would not be allowed to assume a liquidity inflow (this inconsistency was already mentioned previously). The Commission submits several proposals on how to overcome this shortcoming. It also discusses the possibility of changing the current host-regime in liquidity supervision to a home regime already implemented for solvency supervision. • 261

Basel liquidity rules

Basel Committee’s enhanced framework for liquidity
Dr Michael Wong & Fai Y. Lam of CTRisks detail some of the likely consequences in Asia of the new Basel liquidity proposals.
the Basel-based Committee on Banking supervision last December published a consultative document entitled: International framework for liquidity risk measurement, standards and monitoring”. the target audience, comprising central banks, regulatory bodies and financial institutions covered by the document’s provisional recommendations, have been asked to comment before its provisions are adopted and deployed internationally. The consultative paper aims to strengthen and standardise banks’ liquidity measurement framework by setting out the following requirements: A liquidity coverage ratio (LCR) which aims at measuring banks’ short-term liquidity sufficiency; a net stable fund ratio (NSFR) which aims at measuring banks’ short term liquidity sufficiency; and a set of common monitoring tools to be used by supervisors in their monitoring of banks’ funding liquidity at individual institutions. The new guidelines will have far-reaching implications and consequences for banks and financial institutions, particularly Journal of Regulation & Risk North Asia a number of banks operating in and regulated by those countries constituting the Asia Pacific region. The following discourse will first summarise these new rules before discussing their likely impact on banks across the region. Liquidity coverage ratio (LCR) The Basel Committee defines LCR, under an acute stress situation, as :
High quality liquid assets LCR = ________________________________________ Total cash outflow over 30-day period – total cash inflow over 30-day period

If a bank estimates that the total cash outflow will exceed the total cash inflow over a 30-day period, the bank must hold sufficient high quality liquidity assets to meet the net cash outflow, i.e. LCR greater than 100 per cent. This requirement aims to maintain a buffer of high quality liquid assets for banks to meet with liquidity demand under stress conditions. The Basel Committee defines high quality assets with the following fundamental characteristics: low credit and market risks; ease and certainty of valuation; low correlation with risky assets; and listed on a 263

developed and recognised exchange market. Also, the Basel Committee requires high quality assets to have the following marketrelated characteristics: an active and sizable market; a presence of committed market makers; a low market concentration; and flight to quality. Cash inflows Cash inflows are limited to the following items: amounts receivable from retail counterparties; amounts receivable from wholesale counterparties; receivables in respect of repo and reverse repo transactions backed by illiquid assets and securities lending/borrowing transactions where illiquid assets are borrowed; and other cash inflows, including planned contractual receivables from derivatives. Cash outflows Cash outflows cover a board spectrum of cash consumption activities arising from the following exposures: retail deposits, covering stable deposits and less stable retail deposits; unsecured wholesale funding, covering stable small business customers and less stable small business customers, non-financial corporates, sovereigns, central banks and public sector entities with operational relationships, non-financial corporates with no operational relationship, and other legal entity customers and sovereigns, central banks, and public sector entities (PSEs) without operational relationships. Together with: secured funding, covering funding from repo of illiquid assets and securities lending/borrowing transactions illiquid assets are lent out; liabilities from maturing asset backed commercial paper 264

(ABCP), special investment vehicles (SIVs), special purpose vehicles (SPVs,) and term asset-backed securities including covered bonds; liabilities related to derivative collateral calls subject to a downgrade of up to three-notches; market valuation changes on derivatives transactions; valuation changes on posted non-cash or non-high quality sovereign debt collateral securing derivative transactions; currently undrawn portion of committed credit and liquidity facilities to retail clients, non-financial corporates and other legal entity customers; other contingent funding liabilities, such as guarantees, letters of credit, revocable credit and liquidity facilities, etc; planned outflows related to renewal or extension of new loans; and any other cash outflows. Net stable fund ratio The Basel Committee defines the net stable fund ratio (NSFR) as:
Available amount of stable funding LCR = ________________________________________ Required amount of stable funding

A bank is required to match its available amount of stable funding with a required amount of stable funding over a period of one year, i.e. NSFR greater than 100 per cent. Available amount of stable funding includes: capital; preferred stock with maturity of equal to or greater than one year; liabilities with effective maturities of one year or greater; and the portion of “stable” nonmaturity deposits and/or term deposits with maturities of less than one year that would be expected to stay with the institution for an extended period in an idiosyncratic stress event. Required amount of stable funding Journal of Regulation & Risk North Asia

includes: the value of assets held and funded by the institution, multiplied by a specific required stable funding factor (RSF) assigned to each particular asset type; and the amount of off-balance sheet activity (or potential liquidity exposure) multiplied by the corresponding RSF. The RSF on different asset classes, ranging between five per cent and 100 per cent, are intended to approximate the amount of a particular asset that could not be liquidated through sale or use as collateral in a secured borrowing. Highly marketable assets will thus have low RSF factors and thus require less stable funding. Monitoring tools In addition to the two proposed regulatory ratios, the Basel Committee also recommends four tools for monitoring banks’ liquidity. They are: Contractual maturity mismatch: This tool provides an initial and simple baseline of contractual commitments. Concentration of funding: This tool assesses the extent of liquidity risk caused by excessive reliance on single source or several sources of funds. Available unencumbered assets: This tool help banks to be better aware of their potential capacity to raise additional secured funds. Market-related monitoring tools: This covers market data, such as asset prices, liquidity, credit default swap (CDS) spreads, equity prices, and others that can be easily accessed by banks to monitor their liquidity situations. The new liquidity ratios, together with the new regulatory framework, attempt to supplement the framework to Principles for Sound Liquidity Risk Management and Supervision, published by the Basel Committee in September 2008. These new Journal of Regulation & Risk North Asia

guidelines will have a long-lasting impact and new implications for bank management, especially in Asia. Additional costs, risk The new rules require banks to increase holdings in high quality liquid assets. This will be very costly to all banks because high quality liquid assets generally provide low returns. This will weaken the role of banks in credit rationing. Corporate borrowers, especially those without strong credit ratings, will find it more difficult to raise funds. The definition of high quality assets is biased towards US and European bonds. This is because these bond markets are more actively-traded and their bonds are assigned with better credit ratings. Even though many banks and corporations in emerging economies have demonstrated a high stability during the financial crisis in 2008, their bonds are assigned very unfavourable ratings. It is anticipated that banks from emerging economies will find it more difficult to finance their operation via the issuance of CDs and bonds, thus increasing their funding cost and weakening their profitability. If banks are motivated to hold more US and European bonds to strengthen their liquidity metrics, they will be exposed to US dollar currency risk, EU currency risk, and country risk concentration in the US and Europe. Bancassurance The new liquidity rules will motivate banks to develop or acquire their branch of insurance business because insurance premiums serve as a good source of stable and diversified retail funding. This will drive the occurrence of more bancassurance. By that time, 265

banking risk will be blurred with insurance risk. There will be new capital rules to deal with insurance risk. Pro-cyclical effects Both the new liquidity ratios emphasise liquid assets. In economic downturns, some liquid assets can suddenly become illiquid. The new rules will accelerate the speed of “flight to quality”and may easily drive those banks without strong ratings to serious liquidity problems. The crisis experience in 2008 indicates that liquidity problems can turn serious within a short period of time. Most sizable banks have more than 30 per cent funding from the interbank market and financial institutions. In case of rumours, scandals and economic stress, funding from their peers may disappear in less than 30 days.This issue cannot be easily solved by the new rules on liquidity measures.

Conclusion The new Basel rules may improve the liquidity situation and mitigate bank collapses in the short run. However, they may affect the long-term profitability of banks. More importantly they may make bank risk more concentrated on those high quality liquid assets, which tend to more correlated in their risk profile. Banks in emerging economies may be subject to higher pressure under the new rules. This is because they may find it harder to issue CDs and bonds to solve their liquidity problems. • Reference
Basel Committee, International framework for liquidity risk measurement, standards and monitoring – consultative document, December 2009. Basel Committee, Principles for Sound Liquidity Risk Management and Supervision, September 2008.

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