REGULATORY DEVELOPMENTS INCLUDING THE TURNER REPORT, DE LAROSIÈRE AND BANK CAPITAL

1. REGULATORY DEVELOPMENTS INCLUDING THE TURNER REPORT, DE LAROSIÈRE AND BANK CAPITAL LN2 6414

2. Overview • Changes to the supervisory framework (Chris Bates) • Impact of changes already made and likely to be made to the regulatory framework particularly in relation to capital requirements and liquidity risks (Jeremy Jennings-Mares) • Impact of proposed changes that will impact structured finance and derivative transactions (Peter Green)

3. Changes to supervisory framework • Three levels of change • International: G20 initiatives • EU: de Larosière and Commission proposals • UK and other national changes • US, UK, other • Focus on introducing “macro-prudential” considerations into financial supervision

4. International process • No new institutions • Enhanced role for Financial Stability Board (ex FSF) • FSB and IMF to run Early Warning Exercises • Reliance on existing standard setters (BCBS, IOSCO, IAISB, IASB, etc) • Broader international involvement (China, India, etc.) • Implement regulatory colleges for remaining institutions • Broad agreement on the scope of regulation • Unilateralism vs cooperation

5. Changes to EU framework • Process: • de Larosière report February 2009 • Turner report recommendations March • Commission consultation • Commission Communication (May 2009, consultation ends July) • ECOFIN conclusions (9 June) • Key elements: • European Systemic Risk Board • European System of Financial Supervision (ESFS) • proposed timing: up and running 2010

6. European Systemic Risk Council • Functions: • no legally binding powers • data collection, risk analysis, monitoring • warnings and recommendations • Composition: • steering committee • general board • Issues: • legal basis, role of ECB • role of regulators, non-euro countries

7. ESFS • Elements: • transform Level 3 committees into Authorities • strengthened role for colleges • national supervisors, single rulebook • Powers of Authorities • technical standards, guidelines, review • “supervisor of supervisors” • But remaining issues: • “binding mediation” • supervisory powers over pan-EU institutions • “twin peaks”, integration of authorities

8. UK, US, other • UK: Tripartite system review • US: federal systemic risk regulator, integration of SEC/CFTC • Other: little appetite for change

9. General themes • What are the macro-prudential tools • Separation of investment and utility banking? • Cross-border supervision, control of branches and subsidiaries • Product regulation

10. Capital Adequacy – Quantity and Quality of Capital • Turner and de Larosière – banks had insufficient capital to allow absorption of losses • FSA – banks must have sufficient capital to absorb losses on a “going concern” basis • Current Basel II/CRD requirements (broadly) – total capital of 8% of total risk-weighted assets, including 4% Tier 1 capital and 2% “core” Tier 1 capital (principally ordinary shares and reserves) • “Hybrid” capital must: • have ability to absorb losses (incl. deferring interest) • have permanence (or semi-permanence) • be subordinated to other creditors in a liquidation • FSA – “banks’ losses have been absorbed by core capital, but not by hybrids” • Turner – “insufficient Tier 1 definition led to varied quality of capital held by banks from country to country” • Capital Requirements Directive now clarifies (to some extent) the definition of “hybrid Tier 1 capital” • FSA wants increase in levels of core Tier 1 capital and closer scrutiny of loss absorption capacities of hybrid Tier 1 capital

11. Trading Book Assets • Banking book/trading book • Lower capital requirements for trading book assets • Basel II framework fails to address many risks arising from trading book exposures • Value at Risk (VaR) • FSA/de Larosière recommend a fundamental reassessment of VaR as a risk measure • Basel Committee has proposed: • supplementing VaR – based trading book framework with incremental risk capital charge, which includes default risk • addition of a stressed VaR requirement • increased charges for securitisations, particularly re-securitisations • Changes likely to increase trading book capital requirements at least threefold • Basel/FSA/Turner/de Larosière - fundamental longer term review needed of risk-based capital framework for trading activities – including what assets can qualify for trading book

12. Addressing Procyclicality • Procyclicality – the tendency to encourage or necessitate behaviour on the part of banks which exacerbates the strength of the economic cycle, fuelling the “boom and bust” tendency • Identified by Turner/FSA/de Larosière as major macro-prudential issue. Basel II itself has procyclical effects • Proposals to move to a “through the cycle” approach of measuring risk for banking book exposures • Introduction of system of capital “buffers” or reserves • Capital buffer to be defined on a “supervisor’s discretion” basis or formula-based? • Size of capital buffer – 2-3% of risk weighted assets, on top of minimum capital requirements • In addition, further buffer could be demanded at national supervisor’s discretion • Basel to propose measures to tackle procyclicality in October 2009 • European Commission to propose “counter cyclicality” measures for CRD by end of 2009

13. Credit Ratings within Basel II Framework • FSA/Turner/de Larosière urge a fundamental review of the way credit ratings are “hardwired” into financial sector legislation, particularly the Basel II framework • External credit assessments are integral particularly to the standardised approach of measuring structured finance exposures, but also relevant to the internal ratings based approach • Where credit ratings are available, they must be used. For unrated instruments, banks using IRB approach may use the “supervisory formula approach” • FSA proposes: • requiring firms that use IRB approach to use the supervisory formula approach, and • reviewing risk weights attached to credit ratings, or • a combination of the above • Risk weights should be changed to address “cliff effect” • FSA also addresses issue of implicit government support being reflected in bank’s capital requirements against inter-bank exposures • Proposes that (after stability has returned to the financial system) supervisors should require use of standalone, rather than over-all, bank credit ratings

14. Liquidity Risk • Maturity transformation – banks holding longer term assets than their liabilities, to allow non-banks (eg. corporates and individuals) to hold longer term liabilities than their assets • Broader economy relies on banks to perform maturity transformation, but it exposes banks to liquidity risk • Turner – measuring and managing bank liquidity risk is vital, but did not receive adequate attention (in UK or internationally) • Following need to be taken into account in formulating liquidity risk management policies: • liquidity risk has inherently systemic characteristics • liquidity management has become increasingly complex - more potential liquidity sources and more reliance on liquidity through asset sales • increase of maturity transformation creates greater systemic risks and greater likelihood of government/central bank intervention • FSA consultation in December 2008 to overhaul current UK liquidity regime, focussing on a bank’s ability to survive following a loss of confidence • FSA will require banks to hold longer liquidity buffers • The FSA proposes the introduction of a minimum Core Funding Ratio (“CFR”), to include retail deposits, MTN’s, covered bonds (all stable throughout the economic cycle) but excluding short term money market instruments/short term deposits

15. Liquidity Risk (cont.) • CFR could be used either as backstop rule or a warning indicator to supervisors • FSA consultation in April 2009 for a new liquidity reporting regime, to monitor liquidity at both individual firm level and also at market-wide and sectoral levels • June 2009 consultation on the necessary transitional provisions in respect of the new liquidity regime • Basel Committee developed principles for managing and supervising liquidity risk (revised in September 2008) but FSA and de Larosière both believe the current international prudential framework needs to focus on : • system-wide risks as well as individual bank risk • minimum standards on funding liquidity • new macro-prudential tools to operate alongside Basel II, such as CFR, and effective coordination of macro-prudential policy between central banks and supervisors

16. Leverage • Unrestricted build up of leverage in the financial system caused serious financial instability • Turner: • capital resources have not kept pace with balance sheet growth • assets perceived to be liquid, and therefore low-risk, become high-risk in times of illiquidity • calculating capital requirements based on internal models always entails significant judgment • FSA proposes introduction of maximum Gross Leverage Ratio (“GLR”), to complement Basel II framework • Principal issues in relation to a GLR include: • scope of relevant assets • definition of capital • minimum permissible ratio • FSA is open to whether definition of capital should include all Tier 1 capital or only Core Tier 1, but ratio should not override Basel II requirements • Basel Committee and Financial Stability Forum also consider there is a role for leverage ratios and forms part of their March 2009 recommendations for reducing procyclicality arising from Basel II

17. Securitised Products – Capital Requirements • Concerns have been widely expressed that structured finance products helped contribute to and increase the severity of the financial crisis • “Originate and Distribute” model: • given impetus by Basel I and II • enabled risks to be spread across financial system • many structures were, however, complex and opaque leading to confusion as to risks taken on • created some perverse incentives and blurred relationships between lender and borrower

18. Securitised Products – Capital Requirements (cont.) • Consultation papers to Basel framework published in January 2009 proposed changes to the capital treatment of securitisation exposures including: • imposition of higher risk weights to resecuritisations (including CDOs and liquidity facilities to ABCP programmes) • prevention of using ratings for self guaranteed products • operational requirements on banks requiring them to perform their own due diligence and not rely solely on external credit ratings • increasing the credit conversion factor for all eligible liquidity facilities to 50% under the standardised approach • Amendments to the Capital Requirements Directive include: • 5% “skin in the game” requirements • due diligence and stress testing requirements • penalties if standards are not met • criteria to be applied to origination of loans • Further changes to the CRD are likely

19. Scope of Regulation – shadow banking industry • de Larosière and Turner reports express concerns as to the risks posed by “shadow banks” and other unregulated sectors including: • structured investment vehicles • ABCP conduits • other special purpose vehicles • hedge funds • Particular concerns include: • significant maturity transformation being conducted by such entities in a similar way to banks but not subject to regulatory supervision • vehicles that were supposed to be “off balance sheet” being brought back on balance sheet due to liquidity support or reputational concerns • transfer of credit risk to unregulated entities by use of credit default swaps

20. Scope of Regulation – shadow banking industry (cont.) • Proposals include: • regulation of firms conducting systemically important activities (substance over form) • off balance sheet vehicles which create substantive economic risk should be treated as on-balance sheet for regulatory purposes • increased regulatory reporting and provision of management information to enable supervisors to identify where a group is exposed to an unregulated activity (including reputational risks) • regulated firms exposed to unregulated entities must monitor/assess implications of on and off balance sheet exposures to such entities • de Larosière proposes the introduction of a formal authority to register hedge funds, assess their strategies, their methods and their leverage • Proposed EU Directive on Alternative Investment Fund Managers

21. OTC Derivatives • Concerns include: • concentration of risk by extensive sellers of credit protection (eg AIGFP) • lack of transparency in OTC derivatives market as to where credit risk lies • Significant moves in the US and Europe to establishing CCPs for certain OTC derivatives including credit default swaps • Likely movement towards increased “simplification and standardisation” of most OTC derivatives and measures to increase transparency • US Treasury proposals to establish a comprehensive framework of oversight, protections and disclosure for the OTC derivatives market, including: • moving clearing of standardised OTC derivatives to CCPs • encouraging greater use of exchange-traded derivatives • In Europe, the European Commission is charged with reporting to the European Parliament by end-2009 on measures to enhance transparency of OTC derivatives market and mitigate counterparty risk and other risks

22. Credit Ratings for Structured Finance Instruments • Credit Rating Agencies have attracted much criticism, particularly for ratings of structured finance instruments including: • methodologies and assumptions proving false • failure to adequately monitor ratings leading to delays in downgrades • EU Regulation includes specific provisions relating to structured products including: • CRAs must not make proposals or recommendations in relation to the design of structured finance instruments • differentiation of ratings for structured finance instruments • increased disclosure requirements, including methodologies and assumptions used • EU Regulation does not address conflicts inherent in “issuer-pays” model, but EU Commission to report back on this by 2012 • de Larosière considers “issuer-pays” model and excessive reliance on CRA’s to be the two biggest issues yet to be addressed and recommends: • review of CRAs’ business models • fundamental review of “hardwiring” of ratings with a view to significantly reducing use of ratings in financial regulations over time • FSA’s concerns include: • use of “ratings triggers” in financial instruments • the level of integration of ratings into investment mandates

23. Fair Value Accounting • Fair value v book value • Procyclicality issues • FSA and Turner support continued use of fair value for trading book assets, but don’t favour its use for other assets. de Larosière agrees that “cost less impairment” is appropriate for non-trading book assets • Both FASB and IASB previously released guidance as to when trading book assets can be reclassified as banking book assets • Basel Committee guidance on fair value accounting • Mirrors guidance published by FASB (for US GAAP). In particular “orderly market” does not include a distressed or forced sale • de Larosière report urged IASB to clarify the adaptations that could be applied to fair value accounting in distressed situations, concentrating on trying to achieve convergence with US GAAP • IASB has published draft guidance which achieves much convergence with US GAAP.

24. Remuneration • Financial crisis has given rise to widespread concern as to remuneration policies at financial institutions. This has a particular impact on the structured finance industry. • Concerns highlighted include: • excessive levels of remuneration in the financial sector • rewarding short term revenue and profits gave incentives to pursue excessive risk taking • there is an unequal balance between the risks of employees and the firm • EU Commission recommendations include: • discouraging guaranteed bonuses • differentiating remuneration policies for proprietary traders compared to managers of client assets • assessment of bonuses in a multi-year framework spreading payments over the cycle • FSA has published a draft code of practice and consultation paper

25. Risk Management and Corporate Governance • There have been widespread calls for greater independence of the mutual risk management function within banks including: • having greater responsibility for independent stress testing • risk officers to have high rank in bank’s hierarchy • internal risk assessment and due diligence should not be neglected by our reliance on external credit ratings • In the UK, Sir David Walker has been commissioned to produce a report on corporate governance and risk management expected to be published later this year