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P a g e | 1 Bas e l iii C om p l i a n c e Pr o fe s s iona l s Ass o c i a t i on ( B ii i CPA) 1200 G St r e et N W S u it e 8 0 0 Wa s h i n g t o n , D C 2000 5 - 6705 U S A T el: 20 2 - 449 - 9 750 W e b : w w w.ba s e l - iii - a s soc i a t i o n . com. D ear Mem b er,

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  1. P age |1 BaseliiiComplianceProfessionalsAssociation(BiiiCPA)1200GStreetNWSuite800Washington,DC20005-6705USATel:202-449-9750Web:www.basel-iii-association.com DearMember, Ihadadifficulttimeinthepasttoexplainliquidityriskmanagementandratios. NowIknowwhattodo.Problemsolved! Iwilluseapollution-mitigatingtechnology,likescrubberstoexplainliquidityrisk. Mr.JeremyCStein,MemberoftheBoardofGovernorsoftheFederalReserveSystemexplainedhow: “Supposewehaveapowerplantthatproducesenergyand,asabyproduct,somepollution. Supposefurtherthatregulatorswanttoreducethepollutionandhavetwotoolsattheirdisposal: Theycanmandatetheuseofapollution-mitigatingtechnology,likescrubbers,ortheycanlevyataxontheamountofpollutiongeneratedbytheplant. Inanidealworld,regulationwouldaccomplishtwoobjectives. First,itwouldleadtoanoptimallevelofmitigation–thatis,itwouldinducetheplanttoinstallscrubbersuptothepointwherethecostofan BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  2. P age |2 additionalscrubberisequaltothemarginalsocialbenefit,intermsof reducedpollution. And,second,itwouldalsopromoteconservation: Giventhatthescrubbersdon’tgetridofpollutionentirely,onealsowantstoreduceoverallenergyconsumptionbymakingitmoreexpensive. Asimplecaseisoneinwhichthecostsofinstallingscrubbers,aswellasthesocialbenefitsofreducedpollution,areknowninadvancebytheregulatorandthemanagerofthepowerplant. Inthiscase,theregulatorcanfigureoutwhattherightnumberofscrubbersisandrequirethattheplantinstallthesescrubbers. Themandatecanthereforepreciselytargettheoptimalamountofmitigationperunitofenergyproduced. And,totheextentthatthescrubbersarecostly,themandatewillalsoleadtohigherenergyprices,whichwillencouragesomeconservation,though perhapsnotthesociallyoptimallevel. Thislattereffectistheimplicittaxaspectofthemandate. Amorecomplicatedcaseiswhentheregulatordoesnotknowaheadoftimewhatthecostsofbuildingandinstallingscrubberswillbe. Here,mandatingtheuseofafixednumberofscrubbersispotentiallyproblematic: Ifthescrubbersturnouttobeveryexpensive,theregulationwillendup beingmoreaggressivethansociallydesirable,leadingtooverinvestment inscrubbersandlargecostincreasesforconsumers;however,ifthe scrubbersturnouttobecheaperthanexpected,theregulationwillhavebeentoosoft. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  3. P age |3 Inotherwords,whenthecostofthemitigationtechnologyissignificantlyuncertain,aregulatoryapproachthatfixesthequantityofmitigationisequivalenttoonewheretheimplicittaxratebouncesaroundalot. Bycontrast,aregulatoryapproachthatfixesthepriceofpollutioninsteadofthequantity–say,byimposingapredeterminedproportionaltaxratedirectlyontheamountofpollutionemittedbytheplant–ismoreforgivinginthefaceofthiskindofuncertainty. Thisapproachleavesthescrubber-installationdecisiontothemanageroftheplant,whocanfigureoutwhatthescrubberscostbeforedecidinghowtoproceed. Forexample,ifthescrubbersturnouttobeunexpectedlyexpensive,theplantmanagercaninstallfewerofthem. Thisflexibilitytranslatesintolessvariabilityintheeffectiveregulatoryburdenandhencelessvariabilityinthepriceofenergytoconsumers. Scrubbersandhigh-qualityliquidassets WhatdoesallthisimplyforthedesignoftheLCR?Let’sworkthroughtheanalogyindetail. Theanalogtothepowerplant’senergyoutputisthegrossamountofliquidityservicescreatedbyabank–viaitsdeposits,thecreditlinesitprovidestoitscustomers,theprimebrokerageservicesitoffers,andsoforth. Theanalogtothemitigationtechnology–thescrubbers–isthestockofHQLAthatthebankholds. Andtheanalogtopollutionisthenetliquidityriskassociatedwiththedifferencebetweenthesetwoquantities,somethingakintotheLCRshortfall. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  4. P age |4 Thatis,whenthebankoffersalotofliquidityondemandtoitscustomersbutfailstoholdanadequatebufferofHQLA,thisiswhenitimposesspillovercostsontherestofthefinancialsystem. Inthecaseofthepowerplant,Iarguedthataregulationthatcallsforafixedquantityofmitigation–thatis,forafixednumberofscrubbers–ismoreattractivewhenthereislittleuncertaintyaboutthecostofthesescrubbers.” ThankyouJeremy! Ihavejustopenedmymasterplan.Ihavetolearnmoreaboutscrubbers.InowseeothersimilaritiesbetweentheBISandscrubbers.OnlynowIcanunderstandtheshapeoftheBISbuilding! IthinkIhavejustfoundanotherregulatoryarbitrageopportunity.Arealnationaldiscretion,justified. Scrubbersarecapableofreductionefficienciesintherangeof50%to 98%.WhyshouldtheLiquidityCoverageRatiobe100%? BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  5. P age |5 ALCRfrom50%to98%(meaning50,001%)isgoodenough! ThecalculationsinBaselandscrubbersarealsoalmostthesame! BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  6. P age |6 Liquidityregulationandcentralbanking SpeechbyMrJeremyCStein,MemberoftheBoardofGovernorsoftheFederalReserveSystem,atthe“Findingtherightbalance”2013CreditMarketsSymposium,sponsoredbytheFederalReserveBankofRichmond,Charlotte,NorthCarolina I’dliketotalktodayaboutoneimportantelementoftheinternationalregulatoryreformagenda–namely,liquidityregulation. Liquidityregulationisarelativelynew,post-crisisadditiontothefinancialstabilitytoolkit. KeyelementsincludetheLiquidityCoverageRatio(LCR),whichwasrecentlyfinalizedbytheBaselCommitteeonBankingSupervision,andtheNetStableFundingRatio,whichisstillaworkinprogress. Inwhatfollows,IwillfocusontheLCR. ThestatedgoaloftheLCRisstraightforward,evenifsomeaspectsofitsdesignarelessso. InthewordsoftheBaselCommittee,“TheobjectiveoftheLCRistopromotetheshort-termresilienceoftheliquidityriskprofileofbanks. Itdoesthisbyensuringthatbankshaveanadequatestockofunencumberedhigh-qualityliquidassets(HQLA)thatcanbeconvertedeasilyandimmediatelyinprivatemarketsintocashtomeettheirliquidityneedsfora30calendardayliquiditystressscenario.” Inotherwords,eachbankisrequiredtomodelitstotaloutflowsover30daysinaliquiditystresseventandthentoholdHQLAsufficienttoaccommodatethoseoutflows. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  7. P age |7 Thisrequirementisimplementedwitharatiotest,wheremodeledoutflowsgointhedenominatorandthestockofHQLAgoesinthenumerator;whentheratioequalsorexceeds100percent,therequirementissatisfied. TheBaselCommitteeissuedthefirstversionoftheLCRinDecember2010. InJanuaryofthisyear,thecommitteeissuedarevisedfinalversionoftheLCR,followinganendorsementbyitsgoverningbody,theGroupofGovernorsandHeadsofSupervision(GHOS). TherevisionexpandstherangeofassetsthatcancountasHQLAandalsoadjustssomeoftheassumptionsthatgovernthemodelingofnetoutflowsinastressscenario. Inaddition,thecommitteeagreedinJanuarytoagradualphase-inoftheLCR,sothatitonlybecomesfullyeffectiveonaninternationalbasisinJanuary2019. Onthedomesticfront,theFederalReserveexpectsthattheU.S.bankingagencieswillissueaproposallaterthisyeartoimplementtheLCRforlargeU.S.bankingfirms. Whilethisprogressiswelcome,anumberofquestionsremain. First,towhatextentshouldaccesstoliquidityfromacentralbankbeallowedtocounttowardsatisfyingtheLCR? InJanuary,theGHOSnotedthattheinteractionbetweentheLCRandtheprovisionofcentralbankfacilitiesiscriticallyimportant. AndthegroupinstructedtheBaselCommitteetocontinueworkingonthisissuein2013. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  8. P age |8 Second,whatstepsshouldbetakentoenhancetheusabilityoftheLCRbuffer–thatis,toencouragebankstoactuallydrawdowntheirHQLAbuffers,asopposedtofire-sellingotherlessliquidassets? TheGHOShasalsomadeclearitsviewthat,duringperiodsofstress,itwouldbeappropriateforbankstousetheirHQLA,therebyfallingbelowtheminimum. However,creatingaregimeinwhichbanksvoluntarilychoosetodosoisnotaneasytask. AnumberofobservershaveexpressedtheconcernthatifabankisheldtoanLCRstandardof100percentinnormaltimes,itmaybereluctanttoallowitsratiotodropbelow100percentwhenfacinglargeoutflows,evenifregulatorsweretopermitthistemporarydeviation,forfearthatadeclineintheratiocouldbeinterpretedasasignofweakness. Myaimhereistosketchaframeworkforthinkingabouttheseandrelatedissues. Amongthem,theinterplaybetweentheLCRandcentralbankliquidityprovisionisperhapsthemostfundamentalandanaturalstartingpointfordiscussion. Bywayofmotivation,notethatbeforethefinancialcrisis,wehadahighlydevelopedregimeofcapitalregulationforbanks–albeitonethatlooksinadequateinretrospect–butwedidnothaveformalregulatorystandardsfortheirliquidity. Theintroductionofliquidityregulationafterthecrisiscanbethoughtofasreflectingadesiretoreducedependenceonthecentralbankasalenderoflastresort(LOLR),basedonthelessonslearnedoverthepreviousseveralyears. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  9. P age |9 However,totheextentthatsomerolefortheLOLRstillremains,onenowfacesthequestionofhowitshouldcoexistwitharegimeofliquidityregulation. Toaddressthisquestion,itisusefultotakeastepbackandaskanotherone: Whatunderlyingmarketfailureisliquidityregulationintendedtoaddress,andwhycan’tthismarketfailurebehandledentirelybyanLOLR? Iwillturntothisquestionfirst. Next,Iwillconsiderdifferentmechanismsthatcouldpotentiallyachievethegoalsofliquidityregulation,andhowthesemechanismsrelatetovariousfeaturesoftheLCR. Insodoing,Ihopetoillustratewhy,eventhoughliquidityregulationisaclosecousinofcapitalregulation,itneverthelesspresentsanumberofnovelchallengesforpolicymakersandwhy,asaresult,wearegoingtohavetobeopentolearningandadaptingaswego. Thecaseforliquidityregulation Oneoftheprimaryeconomicfunctionsofbanksandotherfinancialintermediaries,suchasbroker-dealers,istoprovideliquidity–thatis,cashondemand–invariousformstotheircustomers. Someofthisliquidityprovisionhappensontheliabilitysideofthebalancesheet,withbankdemanddepositsbeingaleadingexample. But,importantly,banksalsoprovideliquidityviacommittedlinesof credit. Indeed,itisprobablynotacoincidencethatthesetwoproducts–demand depositsandcreditlines–areofferedundertheroofofthesame BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  10. P age |10 institution;theunderlyingcommonalityisthatbothrequireanabilitytoaccommodateunpredictablerequestsforcashonshortnotice. Anumberofotherfinancialintermediaryservices,suchasprimebrokerage,alsoembodyasignificantelementofliquidityprovision.Withoutquestion,theseliquidity-provisionservicesaresociallyvaluable. Ontheliabilityside,demanddepositsandothershort-termbankliabilitiesaresafe,easy-to-valueclaimsthatarewellsuitedfortransaction purposesandhencecreateaflowofmoney-likebenefitsfortheirholders. Andloancommitmentsaremoreefficientthananarrangementinwhicheachoperatingfirmhedgesitsfutureuncertainneedsby“pre-borrowing”andhoardingtheproceedsonitsownbalancesheet;thislatterapproach doesapoorjobofeconomizingonthescarceaggregatesupplyofliquidassets. Atthesametime,asthefinancialcrisismadepainfullyclear,thebusinessofliquidityprovisioninevitablyexposesfinancialintermediariestovariousformsofrunrisk. Thatis,inresponsetoadverseevents,theirfragilefundingstructures,togetherwiththebindingliquiditycommitmentstheyhavemade,canresultinrapidoutflowsthat,absentcentralbankintervention,leadbankstofire-sellilliquidassetsor,inamoreseverecase,tofailaltogether. Andfiresalesandbankfailures–andtheaccompanyingcontractionsincreditavailability–canhavespillovereffectstootherfinancialinstitutionsandtotheeconomyasawhole. Thus,whilebankswillnaturallyholdbufferstocksofliquidassetstohandleunanticipatedoutflows,theymaynotholdenoughbecause,althoughtheybearallthecostsofthisbufferstocking,theydonotcaptureallofthesocialbenefits,intermsofenhancedfinancialstabilityandlowercoststotaxpayersintheeventoffailure. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  11. P age |11 Itisthisexternalitythatcreatesaroleforpolicy. Therearetwobroadtypesofpolicytoolsavailabletodealwiththissortofliquidity-basedmarketfailure. Thefirstisafter-the-factintervention,eitherbyadepositinsurerguaranteeingsomeofthebank’sliabilitiesorbyacentralbankactingasanLOLR. Thesecondtypeisliquidityregulation. Asanexampleoftheformer,whentheeconomyisinabadstate,assumingthataparticularbankisnotinsolvent,thecentralbankcanlendagainstilliquidassetsthatwouldotherwisebefire-sold,therebydampingoreliminatingtherundynamicsandhelpingreducetheincidenceofbankfailure. Inmuchoftheliteratureonbanking,suchinterventionsareseenasthe primarymethodfordealingwithrun-likeliquidityproblems. Aclassicstatementofthecentralbank’sroleasanLOLRisWalterBagehot’s1873bookLombardStreet. Morerecently,theseminaltheoreticaltreatmentofthisissueisbyDouglasDiamondandPhilipDybvig,whoshowthatundercertaincircumstances,theuseofdepositinsuranceoranLOLRcaneliminaterunriskaltogether,therebyincreasingsocialwelfareatzerocost. Tobeclear,thisworkassumesthatthebankinquestionisfundamentallysolvent,meaningthatwhileitsassetsmaynotbeliquidonshortnotice,thelong-runvalueoftheseassetsisknownwithcertaintytoexceedthevalueofthebank’sliabilities. Onewaytointerpretthemessageofthisresearchisthatcapitalregulationisimportanttoensuresolvency,butonceareliableregimeof BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  12. P age |12 capitalregulationisinplace,liquidityproblemscanbedealtwithafterthefact,viasomecombinationofdepositinsuranceanduseoftheLOLR. ItfollowsthatifoneisgoingtomakeanargumentinfavorofaddingpreventativeliquidityregulationsuchastheLCRontopofcapitalregulation,acentralpremisemustbethattheuseofLOLRcapacityinacrisisscenarioissociallycostly,sothatitisanexplicitobjectiveofpolicytoeconomizeonitsuseinsuchcircumstances. Ithinkthispremiseisasensibleone. Akeypointinthisregard–andonethathasbeenreinforcedbytheexperienceofthepastseveralyears–isthatthelinebetweenilliquidityandinsolvencyisfarblurrierinreallifethanitissometimesassumedtobeintheory. Indeed,onemightarguethatabankorbrokerdealerthatexperiencesaliquiditycrunchmusthavesomeprobabilityofhavingsolvencyproblemsaswell;otherwise,itishardtoseewhyitcouldnotattractshort-termfundingfromtheprivatemarket. ThisreasoningimpliesthatwhenthecentralbankactsasanLOLRinacrisis,itnecessarilytakesonsomeamountofcreditrisk. Andifitexperienceslosses,theselossesultimatelyfallontheshouldersoftaxpayers. Moreover,theuseofanLOLRtosupportbankswhentheygetintotroublecanleadtomoralhazardproblems,inthesensethatbanksmaybelessprudentexante. IfitwerenotforthesecostsofusingLOLRcapacity,theproblemwouldbetrivial,andtherewouldbenoneedforliquidityregulation: BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  13. P age |13 Assumingawell-functioningcapital-regulationregime,thecentralbankcouldalwaysavertallfiresalesandbankfailuresexpost,simplybyactingasanLOLR. Thisobservationcarriesanimmediateimplication: Itmakesnosensetoallowunpricedaccesstothecentralbank’sLOLRcapacitytocounttowardanLCRrequirement. Again,thewholepointofliquidityregulationmustbeeithertoconserveontheuseoftheLOLRorinthelimit,toaddresssituationswheretheLOLRisnotavailableatall–as,forexample,inthecaseof broker-dealersintheUnitedStates. Atthesametime,itisimportanttodrawadistinctionbetweenpricedand unpricedaccesstotheLOLR. Forexample,takethecaseofAustralia,whereprudentfiscalpolicyhasledtoarelativelysmallstockofgovernmentdebtoutstandingandhencetoapotentialshortageofHQLA. TheBaselCommitteehasagreedtotheusebyAustraliaofaCommittedLiquidityFacility(CLF),wherebyanAustralianbankcanpaytheReserveBankofAustraliaanupfrontfeeforwhatiseffectivelyaloancommitment,andthisloancommitmentcanthenbecountedtowarditsHQLA. IncontrasttofreeaccesstotheLOLR,thisapproachisnotatoddswiththegoalsofliquidityregulationbecausetheup-frontfeeiseffectivelyataxthatservestodeterrelianceontheLOLR–which,again,ispreciselytheultimategoal. IwillreturntotheideaofaCLFshortly. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  14. P age |14 Thedesignofregulation Onceithasbeendecidedthatliquidityregulationisdesirable,thenextquestionishowbesttoimplementit. Inthiscontext,notethattheLCRhastwologicallydistinctaspectsasaregulatorytool: Itisamitigator,inthesensethatholdingliquidassetsleadstoabetteroutcomeifthereisabadshock;itisalsoanimplicittaxonliquidityprovisionbybanks,totheextentthatholdingliquidassetsiscostly. Ofcourse,onecansaysomethingbroadlysimilaraboutcapitalrequirements. ButtheimplicittaxassociatedwiththeLCRissubtlerandlesswell understood,soIwillgointosomedetailhere. Ananalogymayhelptoexplain. Supposewehaveapowerplantthatproducesenergyand,asabyproduct,somepollution. Supposefurtherthatregulatorswanttoreducethepollutionandhavetwotoolsattheirdisposal: Theycanmandatetheuseofapollution-mitigatingtechnology,likescrubbers,ortheycanlevyataxontheamountofpollutiongeneratedbytheplant. Inanidealworld,regulationwouldaccomplishtwoobjectives. First,itwouldleadtoanoptimallevelofmitigation–thatis,itwouldinducetheplanttoinstallscrubbersuptothepointwherethecostofanadditionalscrubberisequaltothemarginalsocialbenefit,intermsof reducedpollution. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  15. P age |15 And,second,itwouldalsopromoteconservation: Giventhatthescrubbersdon’tgetridofpollutionentirely,onealsowantstoreduceoverallenergyconsumptionbymakingitmoreexpensive. Asimplecaseisoneinwhichthecostsofinstallingscrubbers,aswellasthesocialbenefitsofreducedpollution,areknowninadvancebytheregulatorandthemanagerofthepowerplant. Inthiscase,theregulatorcanfigureoutwhattherightnumberofscrubbersisandrequirethattheplantinstallthesescrubbers. Themandatecanthereforepreciselytargettheoptimalamountofmitigationperunitofenergyproduced. And,totheextentthatthescrubbersarecostly,themandatewillalsoleadtohigherenergyprices,whichwillencouragesomeconservation,though perhapsnotthesociallyoptimallevel. Thislattereffectistheimplicittaxaspectofthemandate. Amorecomplicatedcaseiswhentheregulatordoesnotknowaheadoftimewhatthecostsofbuildingandinstallingscrubberswillbe. Here,mandatingtheuseofafixednumberofscrubbersispotentiallyproblematic: Ifthescrubbersturnouttobeveryexpensive,theregulationwillendup beingmoreaggressivethansociallydesirable,leadingtooverinvestment inscrubbersandlargecostincreasesforconsumers;however,ifthe scrubbersturnouttobecheaperthanexpected,theregulationwillhavebeentoosoft. Inotherwords,whenthecostofthemitigationtechnologyissignificantlyuncertain,aregulatoryapproachthatfixesthequantityofmitigationis equivalenttoonewheretheimplicittaxratebouncesaroundalot. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  16. P age |16 Bycontrast,aregulatoryapproachthatfixesthepriceofpollutioninsteadofthequantity–say,byimposingapredeterminedproportionaltaxratedirectlyontheamountofpollutionemittedbytheplant–ismoreforgivinginthefaceofthiskindofuncertainty. Thisapproachleavesthescrubber-installationdecisiontothemanageroftheplant,whocanfigureoutwhatthescrubberscostbeforedecidinghowtoproceed. Forexample,ifthescrubbersturnouttobeunexpectedlyexpensive,theplantmanagercaninstallfewerofthem. Thisflexibilitytranslatesintolessvariabilityintheeffectiveregulatoryburdenandhencelessvariabilityinthepriceofenergytoconsumers. Scrubbersandhigh-qualityliquidassets WhatdoesallthisimplyforthedesignoftheLCR?Let’sworkthroughtheanalogyindetail. Theanalogtothepowerplant’senergyoutputisthegrossamountofliquidityservicescreatedbyabank–viaitsdeposits,thecreditlinesitprovidestoitscustomers,theprimebrokerageservicesitoffers,andsoforth. Theanalogtothemitigationtechnology–thescrubbers–isthestockofHQLAthatthebankholds. Andtheanalogtopollutionisthenetliquidityriskassociatedwiththedifferencebetweenthesetwoquantities,somethingakintotheLCRshortfall. Thatis,whenthebankoffersalotofliquidityondemandtoitscustomersbutfailstoholdanadequatebufferofHQLA,thisiswhenitimposesspillovercostsontherestofthefinancialsystem. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  17. P age |17 Inthecaseofthepowerplant,Iarguedthataregulationthatcallsforafixedquantityofmitigation–thatis,forafixednumberofscrubbers–ismoreattractivewhenthereislittleuncertaintyaboutthecostofthese scrubbers. InthecontextoftheLCR,thecostofmitigationisthepremiumthatthebankmustpay–intheformofreducedinterestincome–foritsstockofHQLA. And,crucially,thisHQLApremiumisdeterminedinmarketequilibriumanddependsonthetotalsupplyofsafeassetsinthesystem,relativetothedemandforthoseassets. Ontheonehand,ifsafeHQLA-eligibleassetsareinamplesupply,thepremiumislikelytobelowandstable. Ontheotherhand,ifHQLA-eligibleassetsarescarce,thepremiumwillbebothhigherandmorevolatileovertime. ThislattersituationistheonefacingcountrieslikeAustralia,where,asInotedearlier,thestockofoutstandinggovernmentsecuritiesisrelativelysmall. Anditexplainswhy,forsuchcountries,havingaprice-basedmechanismaspartoftheirimplementationoftheLCRcanbemoreappealingthan purerelianceonaquantitymandate. Whenonesetsanup-frontfeeforaCLF,oneeffectivelycapstheimplicit taxassociatedwithliquidityregulationatthelevelofthecommitmentfeeandtampsdowntheundesirablevolatilitythatwouldotherwisearisefromanentirelyquantity-basedregime. Moreover,itbearsreemphasizingthathavingaCLFwithanup-frontfeeisverydifferentfromsimplyallowingbankstocountcentral-bank-eligiblecollateralasHQLAatnocharge. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  18. P age |18 Rather,theCLFislikethepollutiontax. Foreverydollarofpre-CLFshortfall–thatis,foreverydollarofrequiredliquiditythatabankcan’tobtainontheprivatemarket–thebankhastopaythecommitmentfee. Soevenifthereisnotasmuchmitigation,thereisstillanincentivefor conservation,inthesensethatbanksareencouragedtodolessliquidityprovision,allelsebeingequal. ThiswouldnotbethecaseiftheCLFwereavailableatazeroprice.Whataboutthesituationincountrieswheresafeassetsaremore plentiful? TheanalysisherehasanumberofmovingpartsbecauseinadditiontotheimplementationoftheLCR,substantialincreasesindemandforsafeassetswillarisefromnewmarginrequirementsforbothclearedand nonclearedderivatives. Nevertheless,giventhelargeandgrowingglobalsupplyofsovereigndebtsecurities,aswellasotherHQLA-eligibleassets,mostestimatessuggest thatthescarcityproblemshouldbemanageable,atleastfortheforeseeablefuture. Inparticular,quantitativeimpactstudiesreleasedbytheBaselCommitteeestimatethattheworldwideincrementaldemandforHQLAcomingfromboththeimplementationoftheLCRandswapmarginrequirementsmightbeontheorderof$3trillion. Thisisalargenumber,butitcompareswithaglobalsupplyofHQLA-eligibleassetsofmorethan$40trillion. Moreover,theeligiblecollateralforswapmarginisproposedtobebroaderthantheLCR’sdefinitionofHQLA–including,forexample, certainequitiesandcorporatebondswithoutanycap. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  19. P age |19 IfonefocusesjustonU.S.institutions,theincrementaldemandnumberisontheorderof$1trillion,whilethesumofTreasury,agency,andagencymortgage-backedsecuritiesismorethan$19trillion. Whilethissortofanalysisissuperficiallyreassuring,thefactremainsthat theHQLApremiumwilldependonmarket-equilibriumconsiderationsthatarehardtofullyfathominadvance,andthatarelikelytovaryovertime. Thisuncertaintyneedstobeunderstood,andrespected. Indeed,themarket-equilibriumaspectoftheproblemrepresentsacrucialdistinctionbetweencapitalregulationandliquidityregulation,anditisonereasonwhythelatterisparticularlychallengingtoimplement. Althoughcapitalregulationalsoimposesataxonbanks–totheextent thatequityisamoreexpensiveformoffinancethandebt–thistaxwedgeis,toafirstapproximation,afixedconstantforagivenbank,independentofthescaleofoverallfinancialintermediationactivity. IfBankAdecidestoissuemoreequitysoitcanexpanditslendingbusiness,thisneednotmakeitmoreexpensiveforBankBtosatisfyitscapitalrequirement. Inotherwords,thereisnoscarcityproblemwithrespecttobankequity–bothAandBcanalwaysmakemore. Bycontrast,thetotalsupplyofHQLAisclosertobeingfixedatanypoint intime. Policyimplications Whatdoesallofthisimplyforpolicydesign? First,atabroadphilosophicallevel,therecognitionthatliquidityregulationinvolvesmoreuncertaintyaboutcoststhancapitalregulationsuggeststhatevenapolicymakerwithaverystrictattitudetowardcapital BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  20. P age |20 mightfinditsensibletobesomewhatmoremoderateandflexiblewithrespecttoliquidity. Thispointisreinforcedbytheobservationthatwhenaninstitutionisshortofcapitalandcan’tgetmoreontheprivatemarket,thereisreallynobackupplan,shortofresolution. Bycontrast,asImentionedearlier,whenaninstitutionisshortofliquidity,policymakersdohaveabackupplanintheformoftheLOLRfacility. Onedoesnotwanttorelytoomuchonthatbackupplan,butitspresenceshouldneverthelessfactorintothedesignofliquidityregulation. Second,inthespiritofflexibility,whileaprice-basedmechanismsuchastheCLFmaynotbeimmediatelynecessaryincountriesoutsideofAustraliaandafewothers,itisworthkeepinganopenmindaboutthemorewidespreaduseofCLF-likemechanisms. IfascarcityofHQLA-eligibleassetsturnsouttobemoreofaproblemthanweexpect,somethingalongthoselineshasthepotentialtobeausefulsafetyvalve,asitputsacaponthecostofliquidityregulation. Suchasafetyvalvewouldhaveadirecteconomicbenefit,inthesenseofpreventingtheburdenofregulationfromgettingundulyheavyinanyonecountry. Perhapsjustasimportant,asafetyvalvemightalsohelptoprotecttheintegrityoftheregulationitself,byharmonizingcostsacrosscountriesandtherebyreducingthetemptationofthosemosthard-hitbytherulestotrytochipawayatthem. Withoutsuchasafetyvalve,itispossiblethatsomecountries–thosewithrelativelysmallsuppliesofdomesticHQLA–willfindtheregulationconsiderablymorecostlythanothers. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  21. P age |21 Ifso,itwouldbenaturalforthemtolobbytodilutetherules–for example,byarguingforanexpansioninthetypeofassetsthatcancountasHQLA. Takentoofar,thissortofdilutionwouldunderminetheefficacyoftheregulationasbothamitigatorandatax. Inthisscenario,holdingthelinewithwhatamountstoaproportionaltaxonliquidityprovisionwouldbeabetteroutcome. Onesituationwhereliquidassetscanbecomeunusuallyscarceisduringafinancialcrisis. Consequently,evenifCLFswerenotcountedtowardtheLCRinnormaltimes,itmightbeappropriatetocountthemduringacrisis. Indeed,whiletheLCRrequiresbankstoholdsufficientliquidassetsingoodtimestomeettheiroutflowsinagivenstressscenario,itimplicitlyrecognizesthatifthingsturnoutevenworsethanthatscenario,centralbankliquiditysupportwillbeneeded. AllowingCLFstocounttowardtheLCRinsuchcircumstanceswouldacknowledgetheimportanceofaccesstothecentralbank,andthisaccesscouldbepricedaccordingly. Finally,aprice-basedmechanismmightalsohelppromoteawillingnessofbankstodrawdowntheirsupplyofHQLAinastressscenario. AsInotedattheoutset,oneimportantconcernaboutapurequantity-basedsystemofregulationisthatifabankisheldtoanLCRstandardof100percentinnormaltimes,itmaybereluctanttoallowitsratiotofallbelow100percentwhenfacinglargeoutflowsforfearthatdoingsomightbeseenbymarketparticipantsasasignofweakness. Bycontrast,inasystemwithsomethinglikeaCLF,abankmightin normaltimesmeet95percentofitsrequirementbyholding BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  22. P age |22 private-marketHQLAandtheremaining5percentwithcommittedcreditlinesfromthecentralbank,soitwouldhaveanLCRofexactly100percent. Then,whenhitwithlargeoutflows,itcouldmaintainitsLCRat100percent,butdosobyincreasingitsuseofcentralbankcreditlinesto25percentandselling20percentofitsotherliquidassets. Thisscenariowouldbethesortofliquid-assetdrawdownthatonewouldideallyliketoseeinastresssituation. Moreover,thecentralbankcouldencouragethisdrawdownbyvaryingthepricingofitscreditlines–specifically,byreducingthepriceofthelinesinthemidstofaliquiditycrisis. Suchanapproachwouldamounttotaxingliquidityprovisionmoreingoodtimesthaninbad,whichhasastabilizingmacroprudentialeffect. ThisexamplealsosuggestsadesignthatmayhaveappealinjurisdictionswherethereisarelativelyabundantsupplyofHQLA-eligibleassets. OnecanimaginecalibratingthepricingoftheCLFsoastoensurethatlinesprovidedbycentralbanksmakeuponlyaminimalfractionofbanks’requiredHQLAinnormaltimes–apart,perhaps,fromtheoccasional adjustmentperiodafteranindividualbankishitwithanidiosyncraticliquidityshortfall. Atthesametime,inastressscenario,whenliquidityisscarceandthereisupwardpressureontheHQLApremium,thepricingoftheCLFcouldbeadjustedsoastorelievethispressureandpromoteusabilityoftheHQLAbuffer. SuchanapproachwouldrespectthepolicyobjectiveofreducingexpectedrelianceontheLOLRwhileatthesametimeallowingforasafetyvalveinaperiodofstress. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  23. P age |23 ThelimitcaseofthisapproachisonewheretheCLFcountstowardtheLCRonlyinacrisis. Conclusion Bywayofconclusion,letmejustrestatethatliquidityregulationhasakey roletoplayinimprovingfinancialstability. However,weshouldavoidthinkingaboutitinisolation;rather,wecanbestunderstanditaspartofalargertoolkitthatalsoincludescapitalregulationand,importantly,thecentralbank’sLOLRfunction. Therefore,properdesignandimplementationofliquidityregulationssuchastheLCRshouldtakeaccountoftheseinterdependencies. Inparticular,policymakersshouldaimtostrikeabalancebetweenreducingrelianceontheLOLRontheonehandandmoderatingthecostscreatedbyliquidityshortagesontheotherhand–especiallythoseshortagesthatcropupintimesofseveremarketstrain. And,asalways,weshouldbepreparedtolearnfromexperienceaswego. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  24. P age |24 BaselIIICapital:AWell-IntendedIllusionThomasM.Hoenig ViceChairman,FederalDepositInsuranceCorporation InternationalAssociationofDepositInsurers2013ResearchConference,Basel,Switzerland Introduction Aristotleiscreditedwithbeingthefirstphilosophertosystematicallystudylogicalfallacies,whichhedefinedasargumentsthatappearvalidbut,infact,arenot. Icallthemwell-intendedillusions. OnesuchillusionofprecisionistheBaselcapitalstandardsinwhichworldsupervisoryauthoritiesrelyprincipallyonaTier1capitalratiotojudgetheadequacyofbankcapitalandbalancesheetstrength. Forthelargestofthesefirms,eachdollarofrisk-weightedassetsisfundedwith12to15centsinequitycapital,projectingtheillusionthatthesefirmsarewellcapitalized. Therealityisthateachdollaroftheirtotalassetsisfundedwithfarlessequitycapital,leavingopenthematterofhowwellcapitalizedtheymightbe. Here’showtheillusioniscreated. Basel'sTier1capitalmeasureisabank'sratioofTier1capitalto risk-weightedassets. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  25. P age |25 Eachcategoryofbankassetsisweighedbythesupervisoryauthorityonacomplicatedscaleofprobabilitiesandmodelsthatassignarelativeriskoflosstoeachgroup,includingoffbalancesheetitems. Assetsdeemedlowriskarereportedatloweramountsonthebalancesheet. Thelowertherisk,thelowertheamountreportedonthebalancesheetfor capitalpurposesandthehigherthecalculatedTier1ratio. WeknowfromyearsofexperienceusingtheBaselcapitalstandardsthatoncetheregulatoryauthoritiesfinishtheirweightingscheme,bankmanagersbegintheprocessofallocatingcapitalandassetstomaximizefinancialreturnsaroundtheseconstructedweights. Theobjectiveistomaximizeafirm'sreturnonequity(ROE)bymanagingthebalancesheetinsuchamannerthatforanylevelofequity,therisk-weightedassetsarereportedatlevelsfarlessthanactualtotalassetsundermanagement. Thiscreatestheillusionthatbankingorganizationshaveadequatecapitaltoabsorbunexpectedlosses. Forthelargestglobalfinancialcompanies,risk-weightedassetsareapproximatelyone-halfoftotalassets. This"leveragingup"hasservedworldeconomiespoorly. Incontrast,supervisorsandfinancialfirmscanchoosetorelyonthetangibleleverageratiotojudgetheoveralladequacyofcapitalfortheenterprise. Thisratiocomparesequitycapitaltototalassets,deductinggoodwill,otherintangibles,anddeferredtaxassetsfrombothequityandtotalassets. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  26. P age |26 Inadditiontoincludingonlyloss-absorbingcapital,italsomakesnoattempttopredictorassignrelativeriskweightsamongassetclasses.Usingthisleverageratioasourguide,wefindforthelargestbankingorganizationsthateachdollarofassetshasonly4to6centsfundedwithtangibleequitycapital,afarsmallerbufferthanassertedundertheBasel standards. ComparingMeasures Table1reportstheBaselTier1risk-weightedcapitalratioandthe leverageratiofordifferentclassesofbankingfirms. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  27. P age |27 Column4showsTier1capitalratiosrangingbetween12and15percentforthelargestglobalfirms,givingtheimpressionthatthesebanksarehighlycapitalized. However,itishardtobecertainofthatbylookingatthisratiosince risk-weightedassetsaresomuchlessthantotalassets. Incontrast,Column6showsU.S.firms'averageleverageratiotobe6percentusinggenerallyacceptedaccountingstandards(GAAP),andColumn8showstheiraverageratiotobe3.9percentusinginternationalaccountingstandards(IFRS),whichplacesmoreofthesefirms'derivativesontothebalancesheetthandoesGAAP. ThebottomportionofTable1showsthedegreeofleverageamongdifferentsizegroupsofbankingfirms,whichisstrikingaswell. TheTier1capitalmeasuresuggeststhatallsizegroupsofbanksholdcomparablecapitallevels,whiletheleverageratioreportsadifferentoutcome. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  28. P age |28 Forexample,theleverageratioformostbankinggroupsnotconsideredsystemicallyimportantaveragesnear8percentorhigher. UnderGAAPaccountingstandards,thedifferenceinthisratiobetweenthelargestbankingorganizationsandthesmallerfirmsis175-250basispoints. UnderIFRSstandards,thedifferenceisasmuchas400-475basispoints. Thelargestfirms,whichmostaffecttheeconomy,holdtheleastamountofcapitalintheindustry. Whilethisshowsthemtobemorefragile,italsoidentifiesjusthowsignificantacompetitiveadvantagetheselowercapitallevelsprovidethelargestfirms. ThesecomparisonsillustratehoweasilytheBaselcapitalstandardcanconfuseandmisinformthepublicratherthanmeaningfullyreportabankingcompany’srelativefinancialstrength. Recenthistoryshowsalsojusthowdamagingthiscanbetotheindustryandtheeconomy. In2007,forexample,the10largestandmostcomplexU.S.bankingfirmsreportedTier1capitalratiosthat,onaverage,exceeded7percentof risk-weightedassets. Regulatorsdeemedtheselargesttobewellcapitalized. Thisrisk-weightedcapitalmeasure,however,mappedintoanaverageleverageratioofjust2.8percent. Welearnedalltoolatethathavinglessthan3centsoftangiblecapitalforeverydollarofassetsonthebalancesheetisnotenoughtoabsorbeventhesmallestoffinanciallosses,andcertainlynotamajorshock. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  29. P age |29 Withthecrisis,theillusionofadequatecapitalwasdiscovered,afterhavingmisledshareholders,regulators,andtaxpayers. Thereareother,morerecent,examplesofhowthisarcanemeasurecan bemanipulatedtogivetheillusionofstrengthevenwhenafirmincurslosses. Forexample,inthefourthquarterof2012,DeutscheBankreportedalossof2.5billionEUR. Thatsamequarter,itsTier1risk-basedcapitalratioincreasedfrom14.2percentto15.1percentdue,inpart,to“modelandprocessenhancements”thatresultedinadeclineinrisk-weightedassets,which nowamounttojust16.6percentoftotalassets. OnFeb.1,SNSReaal,thefourthlargestDutchbankwith$5billioninassets,wasnationalizedbytheDutchgovernment. Justsevenmonthsearlier,onJune30,2012,SNSreportedaTier1risk-basedcapitalratioof12.2percent. However,thefirmreportedaTier1leverageratiobaseduponinternationalaccountingstandardsofonly1.47percent. ThisleverageratiowasmuchmoreindicativeoftheSNS’spoorfinancialposition. TheBaselIIIproposalbelatedlyintroducestheconceptofaleverageratiobutcallsforittobeonly3percent,anamountalreadyshowntobeinsufficienttoabsorbsizablefinanciallossesinacrisis. Itiswrongtosuggesttothepublicthat,withsolittlecapital,theselargestfirmscouldsurvivewithoutpublicsupportshouldtheyencounteranysignificanteconomicreversals. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  30. P age |30 MisallocatingResourcesandCreatingAssetImbalances Aninherentproblemwitharisk-weightedcapitalstandardisthattheweightsreflectpastevents,arestatic,andmostlyignorethemarket'scollectivedailyjudgmentabouttherelativeriskofassets. Italsointroducestheelementofpoliticalandspecialinterestsintotheprocess,whichaffectstheassignmentofriskweightstothedifferentassetclasses. Theresultisoftentoartificiallyfavoronegroupofassetsoveranother,therebyredirectinginvestmentsandencouragingover-investmentinthefavoredassets. Theeffectofthismanagedprocessistoincreaseleverage,raisethe overallriskprofileoftheseinstitutions,andincreasethevulnerabilityofindividualcompanies,theindustry,andtheeconomy. Itisnocoincidence,forexample,thatafteraBaselstandardassignedonlya7percentriskweightontripleA,collateralizeddebtobligationsandsimilarlowriskweightsonassetswithinafirm'stradingbook,resourcesshiftedtotheseactivities. Overtime,financialgroupsdramaticallyleveragedtheseassetsontotheirbalancesheetsevenastheriskstothatassetclassincreasedexponentially. Similarly,assigningzeroweightstosovereigndebtencouragedbankingfirmstoinvestmoreheavilyintheseassets,simultaneouslydiscountingtherealrisktheypresentedandplayinganimportantroleinincreasingit. Inplacingalowerriskweightonselectassets,lesscapitalwasallocatedtofundthemandtoabsorbunexpectedlossforthesebanks,underminingtheirsolvency. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  31. P age |31 • AMoreRealisticCapitalStandardIsRequired • Taxpayersaretheultimatebackstoptothesafetynetandhaverealmoneyatstake. • Inchoosingwhichcapitalmeasureismostuseful,itisfairtoaskthefollowingquestions: • DoestheBaselTier1ratioorthetangibleleverageratiobestindicatethecapitalstrengthofthefirm? • Whichoneismostclearlyunderstood? • Whichonebestenablescomparisonofcapitalacrossinstitutions? • Whichoneoffersthemostconfidencethatitcannotbeeasilygamed?Charts1through4comparetherelationshipofthetangibleleverageand • BaselTier1capitalratiostovariousmarketmeasuresforthelargestfirms. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  32. P age |32 BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  33. P age |33 BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  34. P age |34 BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  35. P age |35 BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  36. P age |36 Thesemeasuresinclude:theprice-to-bookratio,estimateddefault frequency,creditdefaultswapspreads,andmarketvalueofequity. Ineachinstance,thecorrelationofthetangibleleverageratiotothesevariablesishigherthanfortherisk-weightedcapitalratio. Whilesuchfindingsarenotconclusive,theysuggeststronglythat investors,whendecidingwheretoplacetheirmoney,relyupontheinformationprovidedbytheleverageratio. Wewoulddowelltodothesame. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  37. P age |37 Despitealloftheadvancementsmadeovertheyearsinriskmeasurementandmodeling,itisimpossibletopredictthefutureortoreliablyanticipatehowandtowhatdegreeriskswillchange. Capitalstandardsshouldservetocushionagainsttheunexpected,nottodivineeventualities. AlloftheBaselcapitalaccords,includingtheproposedBaselIII,lookbackwardandthenattempttoassignriskweightsintothefuture. Itdoesn'twork. Incontrast,thetangibleleverageratioprovidesasimpler,moredirect insightintotheamountofloss-absorbingcapitalthatisavailabletoafirm. AleverageratioasI’vedefineditexplicitlyexcludesintangibleitemsthatcannotabsorblossesinacrisis. Also,usingIFRSaccountingrules,off-balancesheetderivativesarebroughtontothebalancesheet,providingfurtherinsightintoafirm'sleverage. Thus,thetangibleleverageratioissimplertocomputeandmoreeasilyunderstoodbybankmanagers,directors,andthepublic. Importantlyalso,itismorelikelytobeconsistentlyenforcedbybanksupervisors. Amoredifficultchallengemaybetodetermineanappropriateminimumleverageratio. Chart5providesahistoryofbankleverageoverthepast150yearsforthe U.S.bankingsystemandgivesinitialinsightintothisquestion. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  38. P age |38 ItshowsthattheequitycapitaltoassetsratiofortheindustrypriortothefoundingoftheFederalReserveSystemin1913andtheFederalDepositInsuranceCorporationin1933rangedbetween13and16percent,regardlessofbanksize. Withoutanyinternationallydictatedstandardoranyarcaneweightingprocess,marketsrequiredwhattodayseemslikerelativelyhighcapitallevels. Inaddition,thereisanincreasingbodyofresearch(AdmatiandHellwig;Haldane;Miles,Yang,andMarcheggiano)thatsuggeststhatleverageratiosshouldbemuchhigherthantheycurrentlyareandthatBaselIII’sproposed3percentfigureaddslittlesecuritytothesystem. Finally,andimportantly,someformofrisk-weightedcapitalmeasure couldbeusefulasabackstop,orcheck,againstwhichtojudgetheadequacyoftheleverageratioforindividualbanks. Ifabankmeetstheminimumleverageratiobuthasconcentratedassetsinareasthatriskmodelssuggestincreasetheoverallvulnerabilityofthebalancesheet,thebankcouldberequiredtoincreaseitstangiblecapitallevels. Suchasystemprovidesthemostcomprehensivemeasureofcapital adequacybothinabroadcontextofallassetsandaccordingtoabank's allocationofassetsalongadefinedriskprofile. TangibleLeverageRatioandtheMythofUnintendedConsequences Concernsareoftenraisedwithinthefinancialindustryandelsewherethatrequiringthelargestandmostcomplexfirmstoholdhigherlevelsof capitalasdefinedusingatangibleleverageratiowouldhaveseriousadverseeffectsontheindustryandbroadereconomy. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  39. P age |39 Ithasbeensuggested,forexample,thatrequiringmorecapitalfortheselargestbankswouldraisetheirrelativecostofcapitalandmakethemlesscompetitive. Similarly,thereisconcernthatfailingtoassignriskweightstothedifferentcategoriesofassetswouldencouragefirmstoallocatefundstothehighestriskassetstoachievetargetedreturnstoequity. TheseissueshavebeenwelladdressedbyAnatAdmatiandMartinHellwigintheirrecentlypublishedbook,TheBankers’NewClothes. TherequiredROEandtheabilitytoattractcapitalaredeterminedbyahostoffactorsbeyondthelevelofequitycapital. Theseincludeafirm’sbusinessmodel,itsrisk-adjustedreturns,thebenefitsofservicesandinvestments,andtheundistorted,or non-subsidized,costsofcapital. Alevelofcapitalthatlowersriskmayverywellattractinvestorsdrawntothemorereliablereturns. Table1showsmanyofthebankswithstrongerleverageratiosalsohavestockpricestradingatahigherpremiumtobookvaluethanthelargestfirmsthatarelesswell-capitalized. Therealsoisaconcernthatrequiringastronger,simplerleverageratiowouldcausemanagerstoplacemoreriskontheirbalancesheet. Whilepossible,theargumentisunconvincing. Withmorecapitalatriskandwithoutregulatoryweightingschemesaffectingchoice,managerswillallocatecapitalinlinewithmarketriskandreturns. Furthermore,risk-weightedmeasuresandstrongbanksupervisioncanbe availableasaback-upsystemtomonitorsuchactivity. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  40. P age |40 Moreover,giventheexperienceoftherecentcrisisandtheon-going effortstomanagereportedriskassetsdown,nomattertherisk,itringshollowtosuggestthathavingahigherequitybufferforthesameamountoftotalassetsmakesthefinancialsystemlesssafe. Inaddition,thereisaconcernthatdemandingmoreequitycapitaland reducingleverageamongthelargestfirmswouldinhibitthegrowthof creditandtheeconomy. ThisstatementhasanimpliedpresumptionthattheBaselweightingschemeismoregrowthfriendlythanasimpler,strongerleverageratio. However,havingasufficientcapitalbufferallowsbankstoabsorb unexpectedlosses. Thisservestomoderatethebusinesscycleandthedeclineinlendingthatotherwiseoccursduringcontractions. IftheBaselrisk-weightschemesareincorrect,whichtheyoftenhavebeen,thistoocouldinhibitloangrowth,asitencouragesinvestmentsinothermorefavorably,butincorrectly,weightedassets. Baselsystematicallyencouragesinvestmentsinsectorspre-assignedlowerweights--forexample,mortgages,sovereigndebt,andderivatives --anddiscouragesloanstoassetsassignedhigherweights--commercialandindustrialloans. Wemayhaveinadvertentlycreatedasystemthatdiscouragestheveryloangrowthweseek,andinsteadturnedourfinancialsystemintoonethatrewardsitselfmorethanitsupportseconomicactivity. Ifriskweightscouldbeassignedthatanticipateandcalibrateriskswith perfectforesight,adjustedonadailybasis,thenperhapsrisk-weightedcapitalstandardswouldbethepreferredmethodfordetermininghowtodeploycapital. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  41. P age |41 However,theycannot. Tobelievetheycanisafallacythatputstheentireeconomicsystemat risk. ChangingtheDebate Thetangibleleverageratioisasuperioralternativetorisk-weightingschemesthathaveproventobeanillusionofprecisionandinsufficientindefiningadequatecapital. Theeffectofrelyingonsuchmeasureshasbeentoweakenthefinancialsystemandmisallocateresources. Theleverageratiodeservesseriousconsiderationastheprincipaltoolinjudgingthecapitalstrengthoffinancialfirms. TheBaseldiscussionwouldbewellservedtofocusontheappropriatelevelsoftangiblecapitalforbankingfirmstoholdandtherighttransitionperiodtoachievetheselevels. Finally,weshouldnotacceptevencomfortingerrorsoflogicwhichsuggestthatBaselIIIrequirementswillcreatestrongercapitalthanthoseofBaselII,whichfailed. Instead,pastindustryperformanceandmountingacademicandotherevidencesuggestthatwewouldbebestservedtofocusonastrongleverageratiostandardinjudgingafirmandtheindustry'sfinancialstrength. Nobankcapitalprogramisperfect. Ourresponsibilityasregulatorsanddepositinsurersistochoosethebestavailablemeasurethatwillcontributetofinancialstability. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  42. P age |42 Note: ThomasM.HoenigwasconfirmedbytheSenateasViceChairmanoftheFederalDepositInsuranceCorporationonNov.15,2012. HejoinedtheFDIConApril16,2012,asamemberoftheFDICBoardofDirectorsforasix-yearterm. HeisamemberoftheexecutiveboardoftheInternationalAssociationofDepositInsurers. PriortoservingontheFDICboard,Mr.HoenigwasthePresidentoftheFederalReserveBankofKansasCityandamemberoftheFederalReserveSystem'sFederalOpenMarketCommitteefrom1991to2011.Mr.HoenigwaswiththeFederalReservefor38years,beginningasaneconomistandthenasaseniorofficerinbankingsupervisionduringthe U.S.bankingcrisisofthe1980s. In1986,heledtheKansasCityFederalReserveBank'sDivisionofBankSupervisionandStructure,directingtheoversightofmorethan1,000banksandbankholdingcompanieswithassetsrangingfromlessthan $100millionto$20billion. HebecamePresidentoftheKansasCityFederalReserveBankonOctober1,1991. Mr.HoenigisanativeofFortMadison,Iowa.HereceivedadoctorateineconomicsfromIowaStateUniversity. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  43. P age |43 “AcomfortablepositionforGermanbanks” TheBundesbankcurrentlyseesnosignswhatsoeverofacreditshortageoratighteningoflendingstandardsinGermany. “Germanbanksareinaprettycomfortablepositionatthemoment. Byandlarge,neithertheirliquiditynortheircapitalsituationarecausingthemanyproblems,”DeputyPresidentSabineLautenschlägersaidearlierthisweekattheInternationalerClubFrankfurterWirtschaftjournalisten(InternationalclubofFrankfurt-basedbusinessjournalists). Whatismore,bankswerebenefitingfromtheirstrongindustrialandSMEcustomerbase. “Germanbanksfurtherimprovedtheirresiliencein2012,”MsLautenschlägerexplained,referringtotheresultsoftheBaselIIIimpactstudypublishedsometimeago. ThisstudylookedathowthesampleofbankswouldhavefaredifBaselIIIhadalreadybeenfullyphasedinasatthecut-offdate. TheimpactstudyrevealsthatthecapitalshortfalloftheeightlargeGermanbankshasdecreasedby€15billion,or30%,ascomparedwiththelastcut-offdate. Anothergratifyingoutcomeofthestudyisthat,onaverage,the33participatingGermaninstitutionsalreadymeetthefutureminimumratioof4.5%forcoretier1capital. SabineLautenschlägercommentedthatthistrendhadcontinued“withthesameintensity”inthesecondhalfof2012,withbanksraisingcapitalinthetensofbillions. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  44. P age |44 Challengesfacingbanksinthefuture Theabilityofbankstocarryongeneratingsufficientincomeonahighercostbasewasakeyfactorindecidingwhethertheirbusinessmodelsweresustainableoverthelongrun,MsLautenschlägerexplained. Persistentlylowinterestratesandthefiercecompetitionamongbanksweredraggingonearnings. “Theweakearningstrendwillpresentamajorchallengeforbanksandsupervisorsalike,”theDeputyPresidentadded. MsLautenschlägerstruckapositivetoneoverthescheduledglobalimplementationofBaselIIIandsaidsheexpectedtheothermajor financialcentrestofollowsuit. “OnlythenwillBaselIIIbeabletofulfilitsprotectivefunctionandprovideasuitableresponsetothe2008financialcrisis.” Appropriatesupervisionandresolutionmechanismsforbankswithaninternationalfocusnecessitatedgreatercoordinationandimprovedcooperation. Specialarrangementsatthenationallevelwouldbeabreedinggroundforriskstofinancialstability,MsLautenschlägerremarked. Bankingunion–questionsstillunanswered SabineLautenschlägersaidthatmanyquestionsstillremainedunansweredovertheestablishmentofthesingleEuropeansupervisorymechanism. Mostnotably,aclearsetofrulesgoverningthecooperationbetweennationalsupervisorsandtheECBwouldhavetobedrawnup. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  45. P age |45 Developingacommonapproachtosupervision,buildingupappropriatereportingproceduresandrecruitingstaffweretasksthatwouldcertainlykeepsupervisorsbusyoverthenextfewmonths. But,MsLautenschlägeradded,therewasonethingthatsupervisorscouldnotchange,thatbeingthelegalbasis. AlegalframeworkforbanksupervisorsthatallowedmonetarypolicytobestrictlysegregatedfromsupervisorydutieswassomethingthatonlyEUgovernmentsandparliamentscouldcreate. “Thisisaprocessthatwillprobablytakeyears.ButIbelievetheeffortwillbeworthwhile,”shetoldjournalists. MsLautenschlägeralsospokeoutinfavourofasingleEuropeanresolutionmechanism. ItdidnotmakesensetooverseebanksattheEuropeanlevelwhileleavingtheirresolutiontonationalauthorities. Asingleresolutionmechanismshouldallowalargebanktobe restructuredandresolvedwithoutseriouslyjeopardisingfinancialstability,sheadded. Atthesametime,ithadtobeguaranteedthatanyresultinglosseswould befairlydistributedaccordingtosourceandresponsibility. “Ifinvestorsreceiveapremiumforrisk,theyshouldalsobepreparedtobeartheriskitself. Taxpayersshouldbeleftoutoftheequationaltogether,wherepossible.” Legacyrisksshouldnotberedistributed Legacyrisks–thatis,financialrisksthataroseatnationalbanksonthewatchofnationalsupervisors–should,however,bebornebythose BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  46. P age |46 responsibleforthemandnotbemutualised,MsLautenschlägerpointedout. AndtherewasalsothequestionofwhetherthelossesresultingfromfuturerisksshouldbeshoulderedsolelyattheEuropeanlevel.Afterall,banks’balancesheetsalsoreflectedalargenumberofnationalfactorssuchastaxesoreconomicpolicymeasures. “Aslongaseconomicandfiscalpoliciesarenotcoordinated,itmightmakesenseforliabilityriskstobedividedbetweenthenationalandEuropeanlevels,”sheconcluded. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  47. P age |47 RemarksbytheSuperintendentJulieDickson, OfficeoftheSuperintendentofFinancialInstitutionsCanada(OSFI) tothe2013FinancialServicesInvitationalForum,Cambridge,Ontario Introduction OSFIrecentlyreleaseditsPlanandPrioritiesfor2013-2016,andtonightIamgoingtohighlightanddiscussafewofourkeyprioritiesandwhywechosethem:specificallyourfocusontheincreasedthreatofcyberattacks;lowinterestrates(includingrealestatelending);andgovernanceandriskappetite. Cybersecurity AtOSFI,cyberriskhasbecomeoneofourtopconcerns. AgrowingnumberofNorthAmericanbankshavebeenhitwithdenialofserviceattacks,insomecasescausingwebsitestogodown,therebycreatingproblemsforcustomerstryingtodoeverydaytransactions. Denialofserviceattacksarecostlytodefendagainstandaformofharassmentandinconvenience. Butmoreimportantly,theycanbeapreludetomoreserioustypesofcyberattacks. Ourconcernisgrowingduetotherapidevolutionofcyberattacksintermsoffrequency,firepowerandtargets. Thisdriveshometheneedforallfinancialinstitutionstofocusonthisthreat. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  48. P age |48 AtOSFI,wehavesignificantlyincreasedoursupervisoryresourcesintheOp-riskarea,andhavelaunchedanumberofinitiatives,suchasconductingin-depthreviewsofinstitutions’currentcyberprotectionpractices. Therearemanystakeholdersinvolvedinthiseffortandaclearfocusonthisissuebyallwillserveuswell. Lowinterestrates Whenlowinterestratesfirstappeared,theimpactwasmostnoticeableon pensionplansandinsurancecompanies. Butasustainedlowinterestrateenvironment(especiallycombinedwithaflatyieldcurve)affectsthebankingsectoraswell. Banksloseflexibilitytoadjustthecustomerdepositratedown,henceintroducingadepositratefloor. Netinterestmarginsaresqueezed,negativelyaffectingrevenues. Combinedwithtepideconomicgrowth,reduceddemandforloansisfurtheraffectingbanks. Thisenvironmentcanprovideincentivesforbankstogrowtheirearningsassetbasebytryingtogainmarketshare(azerosumgame),increasefeeincomeactivities,reduceexpenses,enternewmarkets,andincreasetheproportionofhigher-yieldingassets(bothinthelendingandinvestmentportfolios). Productsandbusinessesthatareover-reliantonlowfinancingcoststendtogrow. Andborrowersarestronglyincentedtoincreaseleverage. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  49. P age |49 Forallthesereasonsweareveryfocusedonhowbanksarereactingtocurrentconditions. Wearealsocognizantthatthelongerthelowinterestrateenvironmentpersists,themoreinterestrateriskcanbebuiltup. Noonecanpredictwhen,orhowfast,rateswillstarttoclimb(orindeed,whethertheywillfallfurther). Yetdependenceonlowinterestratescanbecomesignificant,meaningthattransitiontohigherratescouldbeverypainful. TherealestatelendingmarkethasbeenabigareaoffocusforOSFI,becauseofthesignificantincentivesforconsumerstoborrowandforbankstomaintainrevenues,thesizeofmortgagelendingportfolios,theconcernsaboutsomemarketsbeingovervalued,andthepossibilitythatcustomers’debtserviceabilitycouldbemaskedbylowinterestrates. Ourworkhasinvolvedmajorreviewsofbanklendingportfolios,whichwasonefactorleadingtotheissuanceofGuidelineB-20. GuidelineB-20includesasetofbestpracticesforprudentresidentialmortgagelending,inalleconomicconditions. Ourguideline,aswellasthestepstakenbytheMinisterofFinancetoplacerestrictionsonmortgageinsurance,haveledtosomewelcomechangesinthemarket:slowergrowthinhouseholdcredit,andamorebalancedpictureoverall. Wearewatchingthisveryclosely,anditistooearlytosaywhetherthejobinthisareaisdone. Oneotherareawhereriskscanhideisinthemodelsthatareusedbysomebankstodeterminetheamountofcapitaltheyhavetoholdformortgageloans. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

  50. P age |50 Accordingly,OSFIhasbeenincreasingscrutinyinthisarea. Investorsarealsofocusedonthis,andanumberofthemhaveaskedquestionsaboutthecalculationofriskweights,giventhelimitedamountofinformationthatthebankspubliclydiscloseinthisregard. InCanada,theaveragemodelriskweightscalculatedbybanksforuninsuredmortgagesareinthemid-teens. Thelackofinformationavailableonriskweightsissomethingwearehopingtoaddress. Therewillbeenhanceddisclosurebydomesticsystemicallyimportantbanksinthecomingyear,pursuanttorecommendationsfromtheEnhancedDisclosureTaskForce,whichwascreatedattherequestoftheFinancialStabilityBoard. Someothercountriesareexperiencingfrothyrealestatemarketsandhaveintroducedfloorsonriskweights—sometimesaround15percent. GiventhatinCanadatheuninsuredmortgageswouldtendtobeofhigherqualitythantheaverageloanportfolioinothercountries(becauseuninsuredloansinCanadahavemaximumloan-to-valueratiosof80percent),wearegenerallycomfortablewiththecapitalbeingheldbybanksusingmodels. OSFIisalsoawarethatfloorscanbecomesafeharboursandleadbanksandsupervisorstopaylessattentiontothe―appropriate‖riskweight,especiallywhenitshouldbewellabovethefloorforaparticularbank. Thus,ourfocuswillcontinuetobeonscrutinizingmodelscurrentlyin use. BaseliiiComplianceProfessionalsAssociation(BiiiCPA) www.basel-iii-association.com

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