global risk regulator september 2012

Global Risk Regulator

International regulators are determined to press ahead with reforms to the structure

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

market funds (MMFs), is being undertaken by the International Organisation of Securities Commissions (IOSCO), the Madrid-based agency comprising securities regulators around the world, including America’s SEC.

The US is very actively involved in this international reform exer-cise. A senior SEC staffer is co-chairing the task force drafting the IOSCO’s final recommenda-tions on money market funds that are being prepared for a critical meeting of G20 finance

ministers in November.But the setback for reforms in the US has sur-prised and perturbed international regulators. In an unusual move, Masamichi

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

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September 2012 Volume 10 Issue 8

US setback on money fund rules threatens global splitWhile Washington regulators struggle to impose reforms on money market funds, parallel international plans are moving rapidly aheadBy Melvyn Westlake

Simplify the rules or drown in a tide of complexity Senior figures say complicated regulation threatens to make things worse for the financial system, not better. Call for return to simplicityBy David Keefe

ContentsBasel III implementationBanks seek EU delay - page 2Regulatory captureIt can be effectively countered, says new book - page 3US Regulatory roundupLatest financial reform developments - page 6

NewsroomStories on: Basel III in Mexico, Singapore, Malaysia, India; Consultation launched on EU conglomerates' capital; Basel II finally comes to Turkey, Russia; Tighter exchange traded fund rules; Forex fears prompt new guidance; Basel sets 2% capital charge on clearing house exposures; Study evaluates US short-selling ban; Consultation on regime for failing financial infrastructure providers- pages 12-18

Insurance regulation(1) Cool response to G20 systemic risk approach- page 19(II) US insurers fear impactof Basel III and Dodd-Frank - page 21OpinionRegulators' lack of vision tests financial system- page 23

ISSN 1741-6620

There is growing concern among past and present regulators that the overwhelming

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

to page 10

to page 8

Mary Schapiro

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September 2012Global Risk Regulator

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The European banking industry is calling for a delay in the implementation of

the tough new Basel III capital require-ments, due to be introduced at the start of 2013. However, there is some disagree-ment over the extent of the delay needed. German bankers would like to see the introduction of the new rules pushed back by a full year, while the British Bankers’ Association (BBA) wants a more nuanced approach, with some elements of the new regime implemented more swiftly than others.In a letter sent in early August to key members of the European Parliament, sen-ior officials in the EU executive and the current leadership of the bloc’s finance ministers, the banking industry’s umbrella body says: “The technical constraints faced by credit institutions cannot be ignored.” Proposed rule changes, it adds, “should be [introduced] to a realistic implementation timetable that recognises the practical dif-ficulties [credit institutions] face.”The letter was sent by the European Banking Industry Committee (EBIC), which comprises trade bodies spanning almost the entire gamut of EU credit institutions – banks, public and private, large and small, as well as building societies, leasing companies and finance houses.It follows the failure of lawmakers and national governments, meeting in so-called

trialogue with European Commission offi-cials, to make sufficient progress towards a deal on the EU version of Basel III, known as the Capital Requirements Directive/ Capital Requirements Regulation (CRD IV/CRR). Negotiations over this legislation have taken much longer than predicted. Many of the thorniest questions remained unre-solved when talks were halted for Europe’s long summer break.

The Council, comprising national govern-ments, suspended its work in this area until September, while the European Parliament decided to vote on the proposals only towards the end of October. EBIC says it is “highly concerned about the considerable delay which the legislative process is expe-riencing. As a consequence of this delay financial institutions will not have sufficient time to prepare for, and adapt to, the new provisions if the implementation date for the new rules remains unchanged from 1 January 2013, onwards.”

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

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

EU banks seek Basel III implementation delayIndustry fears political ruckus over capital rules will not leave sufficient time to prepare for new regime's 2013 introduction

Peter KonesnyIn order to implement new rules, banks “need precise final details, particularly for the IT systems”

3www.globalriskregulator.com


cooperative banks and EBIC vice-chairman, blames the delay on the complexity of the proposals and the difficulties of getting agreement in Brussels on EU legislation. It could be late October or even November before the legislation is finally approved. Implementing the rules in the remaining two or three months before the present start-date is simply not possible, he says. “It is not possible to change the IT systems, educate the staff, prepare internal proce-dures and do everything else necessary to implement this huge package.”Banks have been preparing as much as pos-sible. But it is necessary to have the final legislative text and legal certainty before they can do more, adds Hofmann, a former Bundesbank supervisor. “Banks could incur considerable investment risk.”Precise final details are needed, in par-

ticular, for IT systems, argues Konesny. For instance, he explains, some IT providers in Germany have already said that they can-not provide the systems needed because of the continuing uncertainty over the final provisions of CRD IV/CRR.

Moreover, there is no danger that banks can benefit from any implementation delay by, say, reducing their capital levels, Konesny

opines. All the major banks in the EU are required under the capital adequacy exer-cise conducted in recent months by the European Banking Authority, the supervi-sory watchdog, to maintain a minimum 9% core Tier I capital ratio. The major banks were stress tested to ensure that they met this target ratio. Those that failed were obliged to make up the shortfalls.This 9% ratio is an on-going requirement, and is stricter than demanded under Basel III during the initial transition years, notes Konesny.Meantime, the German cabinet agreed in mid-August to push ahead quickly with the introduction of Basel III rules, approving a Bill that was described as sending a “signal” to institutions including the EU parliament and the European Commission “to share the urgency.”

Gerhard HofmannDelay is caused by the complexity of the proposals and Brussels wrangling

Regulatory capture is not inevitable, as is sometimes claimed. It may be

impossible to eliminate altogether, but much more can be done to effectively counter the phenomenon and mitigate its consequences. This is the central message of a collection of essays by academics, former regulators and representatives of interest groups, published in a new book* by the International Centre for Financial Regulation (ICFR).The London-based ICFR is a research and training organisation that promotes best practice in financial regulation.What makes regulatory capture so difficult to address is the many diverse forms it takes. Definitions vary widely. According to one essay, regulatory capture is “the result or process by which regulation (in law or application) is, at least partially, by intent and action of the industry regulated, consistently or repeatedly directed away from the public inter-est and towards the interests of the regulated industry.”That is the definition employed in the essay jointly authored by Professor Daniel Carpenter, of Harvard University, Professor David Moss of the Harvard Business School and Melanie Wachtell Stinnett, Director of Policy at The Tobin Project, a US research

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

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

ago. Academics, commentators and official enquiries have all pointed to the impact that the undue influence of special inter-ests has played in causing a relaxation in regulatory constraints in the period pre-ceding the crisis.The US financial sector, for example, is reported to have spent $2.7 billion in fed-eral lobbying between 1999 and 2008, and $1.4 million daily lobbying Congress during the crisis.Yet regulatory capture is the one major area that has not received much atten-tion from policymakers as they draw up an extensive array of regulatory reform proposals. Perhaps that is because many studies have suggested that capture is una-voidable. This has even led to calls for fur-ther deregulation, on the grounds that no regulation would be better than regulation captured by industry. But this “inevitability” theory is being challenged. “Regulatory capture is partly – and perhaps largely – preventable,” assert Carpenter, Moss and Wachtell Stinnett.The relationship between policymakers and market participants in the regulation of financial markets does, though, contain a paradox, reckons Pagliari. In a dynamic and technically complex environment such as the financial markets, regulatory authori-ties are required to develop a constant and close interaction with the market par-ticipants under their surveillance in order to stay abreast of rapidly changing financial markets, to monitor the build-up of risks, and to understand the impact of their regulatory policies.However, the same proximity between reg-ulators and market actors that is required

Wrestling the many-headed hydra of regulatory captureFatalism over capture is rejected in a persuasive new book. Reform of decision-making processes can often prevent it By Melvyn Westlake

What makes regulatory capture so difficult to address is the many diverse forms it takes

GRR



for regulators to effectively perform their responsibilities has also been described as opening the regulatory process to the risk of unduly favouring narrow industry inter-ests at the expense of the public. This dis-tortion in the process is commonly defined as “regulatory capture,” says Pagliari.The most important source of disagree-ment, he notes, among the different schol-ars and commentators in this volume of essays concerns the mechanisms through which regulatory policies come to diverge from the public interest and unduly favour narrow interest. Four aspects of the finan-cial policymaking process that make finan-cial regulatory policymaking particularly prone to capture are identified by the vari-ous contributors.

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

strong incentives to constantly monitor and seek to steer the action of regula-tors, other stakeholders face greater chal-lenges in coordinating and mobilising the organisational and informational resources required to compete with the financial industry groups in the marketplace for influencing regulation. Moreover, a survey of respondents to finan-cial consultations conducted by Pagliari and colleague Kevin Young, a Fellow at Princeton University, found that less than 10% of the private actors responding to financial regulatory consultations belong to trade unions, consumer protection groups, non-governmental organisations (NGOs), and research institutions.

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

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

But, there is the clear risk that this revolv-ing door could create incentives for regu-lators to be lenient towards prospective future employers.A third channel for influencing regulatory policies is ‘intellectual capture’ or ‘cognitive capture’ – the ascendency of a particular set of beliefs or ideas, or what FSA chair-man Adair Turner has called the ‘intellectu-al zeitgeist,’ which enabled the influence of bank lobbies to hold sway before the crisis. At that time, the prevailing beliefs empha-sised the efficiency of financial markets at

understanding and allocating risks, their self-stabilising nature, and the benefits of financial innovations for the real economy.The final channel of influence over regu-latory policies identified by regulatory capture theorists is through the political process. Politicians (governments and leg-islative bodies) establish the mandates that independent regulatory agencies need to follow, and grant them the resources and powers to perform these tasks. So, the relationship between regulators and their political masters may create additional avenues for capture, as different stakehold-ers seek to change the course of action of regulators indirectly through the political process. In countries such as the US, the financial industry remains one of the major contributors to politicians’ electoral cam-

Stefano PagliariSees a paradox in the regulatory relationship between policy makers and maket participants

There is the clear risk that this revolving door – as peo-ple move between regulato-ry agencies and the financial sector – could create incen-tives for regulators to be lenient towards prospective future employers

Regulators often find that their best working opportu-nities lie with the firms they regulate



paigns across the political spectrum and it is therefore able to exercise a significant influence over the voting behaviour of Congress on certain regulatory issues. Alternatively, given the significant impact that certain financial regulatory issues may have on the rest of the economy, politicians may interfere in the actions of regulators in order to achieve key political objectives such as economic growth, employment, social and economic stability.With so many channels and mechanisms for influencing regulation, what can be done to prevent capture, or at least miti-gate it? A wide range of strategies are proposed by different contributors to the ICFR book. These are grouped into three broad “agendas” by Pagliari: 1) measures promoting greater balance and diversity in the competition among different stake-holders; 2) reforms of the institutional

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

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

sumer groups, retail investor associations, housing associations, trade unions, founda-tions, think tanks, and NGOs, whose crea-tion has been sponsored by the European Parliament following the crisis with the objective of establishing a more effec-tive counterweight to industry lobbying in regulatory debates.Creating “proxy advocates” within a par-ticular regulatory institution could provide another possible solution. These advo-cates are internal panels given the job of providing regulators with expertise and information from a consumer perspec-tive, challenging regulatory policies, and to represent the public interest at large in the decision making process.This mechanism is common outside of finance, where different utilities regula-tors have established standing panels of consumer representatives. The European Commission has also set up the Financial Services User Group, while Britain’s FSA has a Consumer Panel.

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

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

Additionally, a third set of proposals emphasised by regulatory capture theo-rists concerns the checks and balances needed to ensure that regulatory agencies are constantly held accountable and chal-lenged. These include increasing the trans-parency of the financial regulatory process; granting the right of different stakeholders to appeal some regulatory decisions to the courts; and the creation of external independent watchdogs with the responsi-bility to check the operations of regulatory authorities in order to detect deviation from the public interest.The regulatory agenda that has emerged since the crisis has neglected such “low hanging fruits,” concludes Pagliari, and largely focused on fixing gaps in the regu-lation of specific sectors. Analysis devel-oped in the essays, he says “highlights the fact that paying attention to the pro-cess through which financial regulations are designed and implemented is equally important in order to build a more resil-ient financial regulatory system.”

*The Making of Good Financial Regulation: Towards a Policy Response to Regulatory Capture

David Moss Dan Carpenter Lawrence Baxter

Attempting to define regulatory capture

GRR

“Regulatory capture is preventable”



A selection of news items generated by the American regulatory reform agenda

Washington’s regulatory conveyor belt is spewing out new rules required under the Dodd-Frank Wall Street Reform and Consumer Protection Act, which became law on July 21, 2010. Banks and other market participants are struggling to keep up with the detail. By the law’s second anniversary, some 123 (30.9%) of its 398 total rulemaking requirements had been finalised, according to law firm Davis Polk, and rules had been proposed that would meet 134 (33.7%) more. Around 121 proposed deadlines for rulemakings were estimated to have been missed. Rules had not yet been proposed to meet 141(35.4%) rule-making requirements

Final rule adopted for financial market utilities

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

international standards developed by the Basel-based Committee on Payment and Settlement Systems (CPSS) and the International Organisation of Securities Commissions (IOSCO), in Madrid.In addition, the final rule establishes requirements for advance notice of pro-posed material changes to the rules, procedures, or operations of a designated FMU for which the Fed is the supervisory agency. The advance notice requirements set the threshold above which a proposed change would be considered material and thus require an advance notice to the Fed, and also include provisions on the length of the review period. With two exceptions, the final rule is sub-stantively similar to that initially proposed. It includes a new provision that would allow the Fed Board to waive the applica-tion of certain risk management stand-ards to a particular type of designated FMU, where the risks presented by or the design of that designated FMU would make application of certain standards inappropriate. In addition, the Fed Board has revised the illustrative list of changes that do not require an advance notice, in part to include changes to a designated FMU's fees, prices, or other charges.

Five banks told to make secret recovery plans

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

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

CFTC proposes the first swaps to be cleared

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

US regulatory round-up



considered by the CFTC at a later date. The decision to focus initially on credit default swaps and interest rate swaps is because of their importance in the market and the fact that a significant percentage of these swaps are already being cleared. The proposed rule will not apply to those entities that are exempt from the clearing requirements, notably non-financial firms hedging commercial risk.But regulations are also proposed to prevent evasion of the clearing require-ment and deter abuse of any exemption or exception to the clearing requirement provided under Dodd-Frank Act.Finally, a DCO will be required to post on its website a list of all swaps that it will accept for clearing and clearly indi-cate which of those swaps the CFTC has deemed must be cleared.The deadline for public comment on the proposed rule is 30 days after publication in the Federal Register.

US Basel III developments

Basel III slammed as detrimental to America

Wayne Abernathy, executive vice presi-dent for financial institutions, policy and regulatory affairs at the American Bankers Association (ABA) has described the Basel III international capital requirements as detrimental to the US economy. Noting that Fed experts estimate that US banks will be required to raise capital levels by $60 billion, Abernathy said in early August that this will be a “body blow” to the American economy, according the Bloomberg news service.“That is a lot of money, particularly when you understand that it is to be used to do nothing…” Abernathy is quoted as saying. “Banks would set aside another $60 bil-

lion just to provide the same amount of financial services as they do now. Effectively, those $60 bil-lion would be gathered from the economy and shelved.” Without Basel standards, American banks could receive $60 billion from investors to

support $600 billion in new loans and financial services.“Maybe the Basel standards are needed

to get foreign banks to increase their capital levels,” Abernathy is quoted as saying. “Conceding that point in light of lower capital levels carried by many for-eign banks, that desideratum could surely be achieved with far less complexity and without imposing serious harm on the American economy.”In a separate statement, the ABA said it will “work for capital rules that are countercyclical, that do not worsen a credit crunch, and are appropriately related to reasonable measures of risk.” Policymakers, it added, “must not ignore the contractionary nature of increasing capital standards.”

Extension of comment period granted

Washington bank regulators have extend-ed the comment period on their Basel III proposals by 45 days, to October

22. The extension was announced in early August by the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation.The Basel III capital framework was issued

on June 7 in the form of three notices of proposed rulemaking (NPRs), total-ling 700 pages (see GRRs for June and July). A comment period of three months was originally given, but various banking organisation subsequently clamoured for a further 90 days. Much of the “harmo-nised, comprehensive capital framework” will impact all of America’s 7,300.The first of several letters, requesting a comment-period extension of “at least an additional 90 days,” was sent jointly by the American Bankers Association and the Financial Services Roundtable. “These proposals,” they said, “would be the most material changes to US capital standards since 1989 and will have significant imme-diate and ongoing impact on the nature of financial services” in America.This was followed by a letter from Camden Fine, chief executive of the Independent Community Bankers of America, arguing that the “size, scope and impact of these proposals represent a challenging obsta-cle” for his member banks. “Without an appropriate extension of the proposals to

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

Senators urge larger capital hike for biggest banks

Two Senate Banking Committee lawmak-ers sent a letter to Federal Reserve Chairman Ben Bernanke in early August urging the central bank to require the largest US banks to hold more capital. Senators David Vitter, a Republican from Louisiana, and Sherrod Brown, a Democrat from Ohio, said regulators should demand higher capital for systemically important financial institutions (SIFIs) and that the cur-rent proposed standards are a “baby step in the correct direction.”In their joint letter to Bernanke, the senators say: “You must have the board revisit the pro-posed rule to implement Basel III and modify the rule to include a SIFI surcharge significant enough to change the incentives for the largest banks.” Modifying the proposed rule and requiring the biggest banks to have stronger capital reserves would help preserve the safety and soundness of the American financial system, the senators assert, and will help ensure that megabanks are no longer ‘too-big-to-fail’ or will require another taxpayer bailout. “Your proposed rule on capital standards misses a huge opportunity to address

the too-big-to-fail issue by setting the so-called SIFI surcharge far too low,” say Brown and Vitter. “We urge you to revisit your proposed rule and modify it so that megabanks fund themselves with propor-

tionately more loss-absorbing capital per dollar of assets than smaller regional or community banks.”

David Vitter

Sherrod Brown

Wayne Abernathy

Camden Fine

GRR



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

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

to block Schapiro’s proposals a “national disgrace.” They said it was a victory for an industry lobby that had campaigned ferociously against the reforms.Changing the structure of MMFs has been on regulators’ agenda since the industry was effectively bailed out during the finan-cial crisis. At the height of the turmoil, in 2008, the Reserve Primary Fund became

the second money fund in history to “break the buck” when its shares dropped from $1.00 to $0.97 in the wake of the Lehman Brothers' bankruptcy. That event triggered a wide-spread "flight to quality" as many investors in prime money funds (money funds that invest primarily in short-term bank and corpo-

rate debt) moved their investments out of such funds and into government securities or government money funds. The heavy redemptions contributed to a lack of liquidity in the short-term debt markets, further weakening the financial sector. The growth of MMFs is largely the result of a special exemption granted by the SEC three decades ago, which allows them to seek to maintain a stable $1.00 net asset value by using cost accounting. This means that, unlike all other mutual funds, they

do not have to comply with the mark-to-market valuation standards. As a consequence, they have histori-cally been viewed as a safe, liquid and easily accessible short-term home for the deployment of cash held by municipal and corporate treasurers, cash managers and the like. At the same time, MMFs have become a crucial part of the funding strat-egies of banks in the US, Europe, Japan and elsewhere.But to some regulators, money market funds look suspiciously like banks them-selves. Paul Tucker, a deputy governor of the Bank of England, has described them as “narrow banks in mutual-fund clothing.” That is why they are viewed as manifestly part of the shadow banking sector.

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

US setback on money fund rules threatens global split

From page 1

Masamichi KonoSays “IOSCO will continue its work on the basis of the mandate given to it”

John Rogers

“The industry has won this particular battle, but that does not mean that the war is over”

ChristopherDonahue“The idea that this means total victory is just not true. To us this is a continu-ing effort”



fund assets, adjusted to reflect the risk characteristics of the fund. This capital buffer would be used to absorb the day-to-day variations in the value of a money market fund's holdings. To supplement that buffer in times of stress, it would be com-bined with a 3% so-called “hold-back” of investors’ money for 30-days. The other 97% would be redeemed in the normal way. That holdback would constitute a "first-loss" position and could be used to provide extra capital to a money market fund that suffered losses greater than its capital buffer during that 30-day period. Similar approaches were contained in IOSCO’s April consultation paper, although they were only part of a much wider menu of reform options proposed for the MMF industry worldwide, of which the US accounts for 60%, or $2.7 trillion in assets and Europe some $1.5 trillion. Before the financial crisis, however, US money market funds alone were esti-mated to have reached $4 trillion.In Europe, 90% of the industry is reck-oned to be in three countries – France, Luxembourg and Ireland.Regulators at the Federal Reserve are said to be pretty sore about the failure of the SEC proposals to go forward, although opposition among the Commissioners had been well flagged. The proposed MMF reforms have been urged by US treas-ury secretary Tim Geithner and several top Fed officials, including chairman Ben Bernanke and Bosten Fed president Eric Rosengren. Few people doubt that regula-tors will now be looking for other ways to reduce the perceived risk that the MMF industry poses.Indeed, the Fed and the treasury are believed to have been preparing for the possibility that the financial industry might prevail in stopping the SEC proposed reforms. The whole issue is certain to be kicked back to the Financial Stability Oversight Council (FSOC), the powerful panel of regulatory bosses that Congress charged under 2010 Dodd-Frank reform Act with monitoring the country’s finan-cial threats.In fact, that is exactly what another new body, the Systemic Risk Council, is urging. This Council, an independent, non-partisan body that brings together a galaxy of former regulators, academics

and private sector executives, was set up only in June. Anticipating the defeat of Schapiro’s proposals, the Council said in a statement at the end of July that “if the SEC fails to move forward, we believe the FSOC should use the full range of authori-ties given it under the Dodd-Frank Act to effectuate the proposed reforms.”

John Rogers, chief executive of the CFA Institute, a global association that sets standards for investment professionals, and a member of the Systemic Risk Council (SRC), says “the industry has won this particular battle, but that does not mean that the war is over.”

There are a “lot of raw feelings” both among regulators and within the industry and it is going to take a bit of time for the dust to settle and the situation to become clear, he adds. Certainly the industry expects the regulators to try again. “The idea that this means total victory is just not true. To us this is a continu-ing effort,” Christopher Donahue, chief executive of Federated Investors, a fund management firm that gets nearly half its revenue from money market funds,

is quoted as saying. The 10 big-gest money-fund managers and the Investment Company Institute (ICI), the industry association, are estimated to have spent a com-bined $16 million in the first half of 2012 and $31.6 million last year in trying to scuttle MMF reforms.ICI chief executive Paul Schott Stevens denies that money mar-ket funds accelerated the financial crisis of 2007-08. He told lawmak-ers in June that “some regulators continue to view money market

fund reform through the outdated lens of 2008.” The structural changes being considered by Schapiro “would destroy money market funds, at great cost to investors, state and local governments and the economy,” he argued.

The options nowExactly what powers the treasury-chaired FSOC or Federal Reserve might now consider deploying is still a matter of conjecture. According to Dennis Kelleher, chief executive of Better Markets, a pub-lic interest advocacy organisation, there are three possible avenues open to the FSOC. One avenue would be to direct-ly designate MMFs for supervision and regulation by the Federal Reserve. The statutory authority given to FSOC under the Dodd-Frank Act is broad enough to allow it to designate classes of firms, such as MMFs, for new or heightened stand-ards and safeguards if they pose a threat to US financial stability, Kelleher says in a blog post. Alternatively, FSOC can direct the SEC to impose new or heightened standards and safeguards to MMFs when circum-stances warrant. The Commission can be directed to take systemic risk-mitigating actions regarding money market funds that include risk-based capital require-ments, leverage limits, liquidity require-ments, concentration limits, and other requirements.In addition, under proposals that have not yet been implemented, FSOC may in future have the power to identify, desig-nate and regulate systemically significant non-bank firms, including asset managers.Other approaches have been cited by top officials at the Fed. Governor Daniel Tarullo has suggested that the US central bank, possibly in conjunction with foreign regulators, could curtail banks' reliance

Opponents of SEC proposals

Dan Gallagher Troy Paredes Luis Aguilar

Paul Schott Stevens“Some regula-tors continue to view money fund reform through the outdated lens of 2008”

Dennis Kelleher

There are three possible avenues that FSOC can take now



on money funds for funding. And, Boston Fed president Eric Rosengren has floated the idea that the banks that sponsor money funds could be required to hold additional capital against the risk those funds present, a move that would only apply to about half of the industry.This last idea would involve the inclusion of break-the-buck capital scenarios in the next round of Fed stress test for large bank holding companies. Some of these

companies sponsor large MMFs. And, where the stress tests revealed risks of the buck being broken, those risks would have to be supported by additional capital from the bank holding company.The CFA Institute’s John Rogers is a lit-tle sceptical about some of the indirect routes of trying to regulate MMFs via the banks. And where more specific regula-tions are sought by the FSOC, he notes, the task would have to be remitted back

to the SEC as the agency directly respon-sible for money market funds (unless regulation of the industry or individual funds are imposed under the systemic-threat powers).Ultimately, Rogers thinks the SEC will be asked by FSOC to try again, perhaps looking at a broader range of potential changes to the industry’s practices, with greater chance of winning acceptance.

GRR

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

Provocative HaldaneHaldane, who is executive director for financial stability at the UK central bank, pointed out to fellow central bankers at

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

supporting policy measures: a delayering of the Basel structure; placing leverage on a stronger regulatory footing; strength-ening supervisory discretion and market discipline; regulating complexity explicitly; and structurally re-configuring the financial system. “I think Haldane’s speech was as much an attack on the Basel II advanced approaches [to modelling risk], which he has done before, and I wholeheartedly agree with him,” Bair said.Bair’s remarks reflected her long-standing advocacy of the leverage ratio. As chairman of the FDIC, the federal banking supervi-sory agency that insures customer deposits at America’s banks, she insisted on stricter capital requirements than those proposed by the international accord. Her demands helped stall the introduction of Basel II in the US because she wanted the package to include the leverage ratio that now forms such an important element of Basel III. After she had fought Basel II for so many years because it resulted in precipitous capital declines, Blair said it would be “dis-heartening” to disown Basel III which is designed to correct Basel II’s faults.“The evidence shows that for the larger institutions that got in trouble during the crisis, the leverage ratio was a much better predictor than a risk-based ratio of wheth-er they were going to fail or not. It’s simple, it’s easier for examiners to enforce and it’s easier to understand,” Blair says. Like any simple rule, the leverage ratio is less subject to gaming. And while it’s true the leverage ratio is less risk sensitive, there’s a supervisory process that accom-panies it. However, a good risk-based ratio should capture a bank loading up on risk, Bair says, adding that she had always said that both types of ratio are needed. At present the Basel III rules prescribe a 3% leverage ratio, which Haldane noted means bank equity can in principle be leveraged up to 33 times. Most banks would say a loan-to-value ratio of 97% was imprudent

Simplify the rules or drown in a tide of complexity

From page 1

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



for a borrower, Haldane said, although a 3% leverage ratio means banks are just such a borrower. For the world’s largest banks, the leverage ratio needed to guard against failure in the crisis would have been above 7%, he noted.

Blair said that in terms of complexity, she would focus on Basel II and the use of models in the advanced approaches to measuring risk. “I think we should get rid of the advanced approaches, using the simpler standardised approach for the risk-based capital ratios. We need to put a lot more emphasis on the leverage ratio to constrain risk at insti-tutions.”In respect of Basel III in the US, where regulators have extended the comment period on the implementation proposals to October 22, Bair said there’s still an issue with complexity, despite many analysts believing the US version of Basel III to be simpler than the international accord. “It’s all focused on the risk-based rules and my personal view is those rules need to be simplified. I don’t think models have any place in setting regulatory capital. I think models are fine as part of your risk management tools, but they’re not reliable,” she said. And just how unreliable was seen recently with the so-called “London Whale” fiasco, J P Morgan Chase’s multi-billion dollar derivatives trading blunder.“London Whale shows that if you let banks use models to set their regulatory capital, they will have incentives to have a model that gives lower capital,” she said.Bair believes Basel III will go into effect in America, although meeting the January 2013 implementation deadline may be a tough proposition given the extension of the comment deadline to October 22.Since June Bair, who left the FDIC last year after a five-year stint as chairman, has chaired the SRC. The Council com-prises a diverse group of experts in invest-

ment, capital markets and securities mar-ket regulation, including former Federal Reserve chairman Paul Volcker, sponsor of the Volcker Rule banning banks from pro-prietary trading under the Dodd-Frank Act.

Systemic Risk CouncilConcerns over the slow progress of regu-lators and standard-setters prompted the creation of the SRC. The council has said it will monitor and evaluate the activities of those with the Congressional mandate to develop and implement Dodd-Frank pro-visions related to systemic risk, including the Financial Stability Oversight Council (FSOC), America’s systemic risk watchdog, and the Office of Financial Research, the bureau set up within the US Treasury to improve the quality of financial data avail-able to policymakers. The SRC expects to evaluate and pro-vide commentary on the existing efforts of regulators to design and implement a

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

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

Banning any profits made from hedge transactions would be one way of cur-tailing the use of hedging as a ruse for proprietary trading. Greater transparency and disclosure of the models used for trading would be helpful in determining exactly what banks were up to, Blair said but noted that there’s no provision for that in the rule.

*The dog and the frisbee – paper by Andrew Haldane and Vasileios Madouros, Bank of England, August 2012 .

Andrew Haldane“The length of the Basel rulebook, if anything, under-tates its complexity”

“For the larger institutions that got in trouble during the crisis, the leverage ratio was a much better predic-tor than a risk-based ratio of whether they were going to fail or not. It’s simple, it’s easier for examiners to enforce and it’s easier to understand” – Sheila Bair

Basel III is “all focused on the risk-based rules and my personal view is those rules need to be simplified. I don’t think models have any place in setting regulatory capital. I think models are fine as part of your risk manage-ment tools, but they’re not reliable” – Sheila Bair

GRR



Basel III global monitor – Latin America and Asia

Countries in Latin America and Asia are moving swiftly to adopt the Basel III capi-tal standards, sometimes more quickly and more strictly than the internationally-agreed version requires. Here are some recent developments monitored by GRR. Mexico - The regulatory agency for banks, in Mexico City, announced in mid-August that the country's banks will adopt Basel III rules in September, sooner than previously expected. This would make them the first in the world to adopt the new standards. All have capital lev-els above the minimum required under Basel III, said Guillermo Babatz, head of Mexico's banking and securities commis-sion. Under the Basel III framework, banks are required to maintain top-quality capital equivalent at 7 percent of their risk-bearing assets. According to Reuters, Babatz said at a conference: "The reason for adopting [the rules] ahead of schedule is that the system is really very strong." The commission had previously slated adoption of the rules for the start of 2013, when the transition to Basel III is due to begin globally. Adopting the new rules will encourage Mexican banks to stay disciplined and not rely too much on subordinated debt and other types of capital "that are not so resistant in times of crisis," he said.Singapore – The Basel III capital stand-ards will be implemented early in the island state, Ravi Menon, the managing

director of the Monetary Authority of Singapore (MAS) told journalists when introducing the authority’s annual report in late July. Singapore-incorporated banks will meet Basel III minimum capital adequacy requirements two years ahead of the Basel Committee’s timeline of January 1, 2015 (for banks to reach the minimum core Tier 1 ratio of 4.5%). FRom the beginning of 2015, Singaporean-incorporated banks must meet MAS’ capital adequacy requirements that are 2% higher than the Basel III global capital standards, Menon explained.He also said that MAS will be stepping up consolidated supervision of financial groups. “We are increasingly focusing on areas such as mitigating intra-group con-tagion risk, preventing the multiple use of capital within the group, and limiting group concentration risk exposures.” Malaysia - Basel III capital rules are unlikely to be overly onerous for the major Malaysian banks in light of their satisfactory core capitalisation, according to a report issued by the credit rating agency Fitch in early August.The gradual transition to higher capital standards from Basel II would over time enhance the resilience of the domestic banking sector as a whole, Fitch said. “Compliance does not appear to be a major challenge.”The rating agency estimates the consoli-dated common equity Tier 1 (CET1) capi-tal ratio of the eight Malaysian banks to range between 8% and 11% at end-March 2012 under the Basel III guidelines, which are currently in the consultative stage. The average CET1 ratio is estimated to

be 8.7% on a Basel III basis, slightly lower than 9.3% under the present Basel II framework. The estimated capital ratios are higher than the 7% floor for CET1 under the new framework, which com-prises the 4.5% regulatory minimum and 2.5% capital conservation buffer. India – Banks in India will have to raise between Rs1.5 trillion and Rs1.75 trillion ($31.4 billion) in equity capital, and they further Rs3.25 trillion in subordinated debt, to meet the Basel III standards by the government’s March 2018 dead-line, Duvvuri Subbarao, governor of the Reserve Bank of India (RBI) predicted in early August. And, a big slice of this sum – estimated after allowance for internally-generated earnings – would need to be raised by the public sector banks.The government is constrained from help-ing them raise the necessary capital by its fiscal deficit, the governor said. But, one option, he noted would be for the gov-ernment to reduce its stake in the public sector banks to below 50%. Talking to journalists, Subbarao said he was hopeful that the banks in the private sector would be able to raise their share of the capital that the sector needed. “In the last five years, these banks had raised Rs 500 billion in equity.”The RBI announced in December that Basel III would be implemented more stringently than required under the inter-national framework, both in the level of capital that banks must hold and in the speed of transition to the new regime. Basel III is due to take full effect around the world from the start of 2019.

Newsroom

Consultation launched on EU conglomerates’ capital

The three pan-European supervisory authorities (ESAs) for banking, insur-ance and securities markets have jointly launched a public consultation on methods for calculating the required capital to be held by EU financial conglomerates. The consultation document was issued at the end of August by the European Banking Authority, the European Securities Markets Authority and the European Insurance and Occupational Pensions Authority.It proposes draft regulatory technical standards that will become part of the sin-gle rulebook, and aims to enhance regula-tory harmonisation across the 27-country

bloc. These draft standards are intended to ensure that the entities that comprise the financial conglomerate apply the appropri-ate calculation methods for the determi-nation of the required capital at the con-glomerate level. Financial conglomerates combine banking, insurance and securities and investment businesses in various combinations, which is why all three ESAs are involved in their regulation.The draft standards are based on the European Commission’s proposed leg-islation for implementing the new Basel III capital rules for banks in the EU. This legislation, known in Europe as the Capital Requirements Directive and Capital Requirements Regulation (CRD IV/CRR) is still the subject of negotiation. That means that

the draft conglomerate technical standards might be changed in coming months once the CRD IV/CRR legislation is finalised.The consultation paper frames the draft standards around a number of general principles and three methods of calcula-tion. The principles include: elimination of multiple gearing; elimination of intra-group creation of own funds; transferability and availability of own funds; and coverage of deficit at financial conglomerate level hav-ing regard to definition of cross-sector capital.The three methods of calculation are: the accounting consolidation method; the deduction and aggregation method; and a method that combines the other two. Deadline for public comment on the con-sultation paper is October 5.



Basel II finally comes to Turkey and Russia

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

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

Adoption of international accounts in US years away

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

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Regulators consult on regime for failing FMIs

BASEL/MADRID – International regula-tors are consulting on proposals for dealing with financial market infrastruc-ture (FMI) providers that run into diffi-culties threatening their viability or even fail completely. FMIs, such as systemically important payment systems, central securities depositories, securities settle-ment systems, central counterparties and trade repositories, play an essential role in the global financial system.The disorderly failure of an FMI can lead to severe systemic disruption if it causes markets to cease to operate effectively. Accordingly, regulators have decided that all types of FMIs should generally be sub-ject to regimes and strategies for recov-ery and resolution. Concerns over the potential disruption of an ailing FMI have been heightened by the separate policy of international regulators to reform the vast over-the-counter (OTC) market and ensure that as large a proportion of transactions as possible are cleared through central

counterparties (CCPs).A consultative report, setting out the principles for the recovery and resolu-tion of FMIs was published* at the end of July by the Basel-based Committee on Payment and Settlement Systems (CPSS) and the International Organisation of Securities Commissions (IOSCO), the Madrid body representing securities agencies in over a 100 countries.Principles for FMIs and Key Attributes for the effective resolution of financial institutions in general have been set out in earlier reports. Notably, under the key attributes report, countries are required to establish resolution regimes that allow for the resolution of a financial institu-tion in circumstances where recovery is no longer feasible. An effective resolution regime, regulators say, must enable reso-lution without systemic disruption or exposing the taxpayer to loss. The late-July consultation report focuses on the issues that should be taken into account for different types of FMIs when putting in place effective recovery plans and resolution regimes in accord-ance with the Principles and the Key Attributes. As part of this exercise, the

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

*Recovery and resolution of financial market infrastructures

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Crisis ‘short selling’ ban in US brought no benefit

NEW YORK – The US ban on ‘short selling’ introduced at the height of the financial crisis did more harm than good, according to a study published by the New York Federal Reserve in early August. Restrictions on the short sell-ing of financial stocks were imposed in September 2008, at a time of intense market stress by the US and a number of other countries. They were imposed because regulators feared that short-selling could drive the prices of those stocks to artificially low levels. Short-selling entails borrow-ing shares and then selling them in the expectation that they can be repurchased later at a lower price.But the new analysis of this period sug-gests that the ban did little to slow the decline in the prices of financial stocks; in fact, prices fell more than 12% over the fourteen days in which the ban was in effect. Moreover, the bans produced adverse side effects. According to the

authors’ calculations they increased trad-ing costs in the equity and options mar-kets by more than $1 billion.The study* was carried out by Robert Battalio and Paul Schultz, professors of finance at the University of Notre Dame’s Mendoza College of Business; and Hamid Mehran an assistant vice president in the NY Fed’s research and statistics group. They say that a re-examination of the 2008 restrictions is particularly important in light of the latest wave of bans in Europe, including the restrictions imposed by Spain and Italy in July. To provide additional evidence, the three authors also considered the market effects of short-selling in August 2011, when the debt-rating agency Standard and Poor’s lowered the US sovereign long-term credit rating, prompting the S&P 500 share index to fall 6.66% on the next trading day. At the time, there was no short-selling ban in place. But the authors found no evidence that stock prices declined following the rating downgrade as a result of short-selling. In fact, stocks with large increases in short interest earned higher, not lower,

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

*Market Declines: What Is Accomplished by Banning Short-Selling?



ESMA tightens regime for exchange traded funds

PARIS – New guidelines have been issued by the European Securities and Markets Authority (ESMA), the pan-EU supervi-sory watchdog, aimed at tightening the regulatory regime for Exchange Traded Funds (ETFs) and other types of index-tracker funds authorised to be sold to European retail investors.“These comprehensive guidelines are aimed at strengthening investor protec-tion and harmonising regulatory practices across this important EU fund sector,” said ESMA chairman Steven Maijoor, in comments accompanying the late-July publication of the guidelines. Publication follows a review by the watchdog of current regulatory standards for author-ised funds known as Undertaking for Collective Investment in Transferable Securities (UCITS) and those ETFs that are part of the UCITS universe.This review concluded existing require-ments are not sufficient to take account of the specific features and risks associ-ated with these types of fund and prac-tice. The new guidelines,* which apply to national securities markets regulators and UCITS management companies, are intended to strengthen investor protec-tion and ensure greater harmonisation in regulatory practices across the EU.They set out the information that should be given to investors about index-track-ing UCITS and UCITS ETFs, together with specific rules for these collective undertakings when entering into over-the-counter financial derivative transac-tions and efficient portfolio management techniques. The guidelines also set out the criteria for financial indices in which UCITS may invest, including the provision for investors of the full calculation meth-odology of such indices. And, it will only be permissible to invest in financial indi-ces which respect strict criteria regard-ing the rebalancing frequency and their diversification.In addition to the guidelines, ESMA also launched a specific consultation on the appropriate treatment of repo and reverse repo arrangements when used by ETFs and other UCITS. In particular, the watchdog is proposing a distinct regime for repo and reverse repo arrangements

which, unlike securities lending arrange-ments, would allow a proportion of the assets of the UCITS to be non-recallable at any time at the initiative of the UCITS. The proposed guidelines include safe-

guards to ensure that the counterparty risk arising from these arrangements is limited, and that the collective undertaking entering into such arrange-ments can continue to execute redemption requests. The consulta-

tion period will run until September 25 2012.Once adopted by ESMA, the guidelines on repo and reverse repo arrangements will be integrated into the guidelines on ETFs and other UCITS issues in order to have a single package of rules. The final package, comprising both sets of guide-lines, will become effective two months after publication on the ESMA website of the translations into the official EU languages.*Guidelines on ETFs and other UCITS issues; Consultation on recallability of repo and reverse repo arrangements

Euro crisis spurs need for regulator collaboration

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

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

Forex risk fears prompt new guidance

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

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Stephen Maijoor



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

US strives for level playing field on systemic risk

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

separate Congressional hearings held by the Senate banking committee and the House of Representatives’ financial services committee on the FSOC’s 2012 annual report*.“In this area as in many others, if you end up raising standards in the US and leaving them lower and weaker outside the US, risk will just shift to those [non-US] markets and hurt us too,” Geithner said in the context of global efforts to end the “too-big-to-fail” problem that resulted in taxpayers having to rescue several financial firms during the 2007-09 financial crisis. The Group of Twenty (G20) top economies have backed the listing of 29 big international banks, eight of them American, as global systemically important financial institutions (G-SIFIs)

liable to greater super-visory oversight than less important banks, including the imposition of capital surcharges of up to 2.5%, to increase their capacity to absorb losses. Global regula-tors are working to identify insurers that

might fall into the G-SIFI category. Under Dodd-Frank, US banks with $50 billion or more in assets are subject to addi-tional regulatory requirements. FSOC is in the process of determining which US non-bank institutions such as insur-ers, securities firms and hedge funds, for instance, should be subject similar additional oversight The Congressional lawmakers echoed insurance industry fears in particular that insurers would be unfairly penalised under “bank-centric” regulations and that America’s own efforts would clash with the G20’s.Geithner agreed with the Fed that stand-ards on capital and leverage designed for banks would have to be adapted to rec-ognise the specific differences between the insurance and banking businesses and in a way that mitigates insurance industry concerns. In July FSOC made its first SIFI designa-tions, namely the identification of eight financial market utilities (FMUs) as sys-temically important because of their key “plumbing” role in clearing and settling financial transactions. The eight FMUs are: The Clearing Payments Co; CLS Bank International; Chicago Mercantile

Exchange; the Depository Trust Co; Fixed Income Clearing Corp; ICE Clear Credit; National Securities Clearing Corp; and the Options Clearing Corp. The Treasury Secretary told lawmakers the FSOC chose the eight in a carefully designed process that gave the firms a fair opportunity to contest the Council’s judgments. FSOC will now ensure the firms are run with “conservative cush-ions” against risk. Geithner noted FSOC’s annual report identifies the continuing European sov-ereign debt and banking crisis as the biggest risk to America’s economy. The fact that the financial system still con-fronts a challenging and uncertain overall economic environment is among the most important of potential threats con-fronting the financial system. The threats underscore the need for continued pro-gress in repairing the remaining damage from the global financial crisis and enact-ing reforms to make the system stronger for the long run, Geithner said.

*Financial Stability Oversight Council 2012 Annual Report.

Rebalance Basel’s three pillars, urges UK's Haldane

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

Timothy Geithner



NewsroomBank of the England colleague, Vasileios Madouros.For the Basel accord “simplifying Pillar 1 rules would help rebalance the Basel scales.” That would not only strength-en Pillar 1, but could simultaneously strengthen Pillars 2 and 3, said Haldane, who is executive director for financial stability at the UK central bank. A rebal-ancing away from prescriptive rules pro-vides greater scope for supervisory judg-ment under Pillar 2. In other professions, such as medicine, prescriptive rules have generated the problem of not being able “to see the wood from the trees.” “What is true of doctors is almost cer-tainly true of bank supervisors. In the pre-crisis period being required to moni-tor many small, rule-based risks may have caused supervisors to overlook poten-tially life-threatening ones. This ticked-box approach failed to save the banks, just as in medicine it fails to save lives,” said Haldane. “Supervision suffered the same fate as the autistic savant – penny-wise but pound foolish,” he concluded.Breaking free of that psychological state calls for a fresh approach, one which is less rules-focussed and more judgment based. That alternative approach to finan-cial supervision is beginning to be recog-nised. It’s the approach that will underpin the Bank of England’s new supervi-sory model when it assumes regulatory responsibilities next year, Haldane said. In the paper, Haldane argues that regula-tory responses to financial crises, past and present, have been to increase com-plexity with “a combination of more risk management, more regulation and more regulators”. As the Basel accords have evolved over time, so has the opacity and complexity associated with increas-ingly granular, model-based risk-weighting. Meanwhile, detailed rule-writing in the form of legislation has increased dra-matically, as has the scale and scope of resources dedicated to regulation.He used a set of empirical experiments to measure the performance of regula-tory rules, simple and complex. Haldane found that simple rules such as the lever-age ratio and market-based measures of capital outperform more complex risk-weighted models and multiple-indicator measures in their crisis-predictive perfor-mance.

“The message from these experiments is clear and consistent. Complexity of mod-els or portfolios generates robustness problems when understanding a complex financial system over plausible sample sizes. More than that, simplicity rather than complexity may be better capable of solving these robustness problems.”*The dog and the frisbee – paper by Andrew Haldane and Vasileios Madouros of the Bank of England, August 2012.

ComFrame aim should be local insurance regimes

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

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

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



Legal advice sought on global trade tagging site

BASEL – Global regulators are seek-ing legal advice on where best to locate the key operating elements of their planned system for tagging financial trades. The Group of Twenty (G20)-backed system aims at avoiding the problems, with their associated threat to the financial system as whole, encountered in tracking transactions entered into by Lehman Brothers and other firms stricken in the global finan-cial crisis. America’s futures market regula-tor, the Commodity Futures Trading Commission (CFTC), has meanwhile launched a website – http://www.ciciu-tility.org – for over-the-counter (OTC) derivatives traders to register with the CFTC’s Interim Compliant Identifiers (CICIs) which are intended ultimately to comply with the so-called Legal Entity Identifier (LEI), 20-digit alphanu-meric code tagging system promoted by the G20 grouping of the world’s top economies. The Financial Stability Board (FSB), the body tasked with coordinating the implementation of the global financial reforms agreed by the G20 in the wake of the financial crisis, said in August it’s seeking views on the appropriate jurisdiction for the global oversight body and the Central Operating Unit (COU), the pivotal operating arm of the LEI system. The system will uniquely identify parties to financial trades. G20 regulators plan to have the framework ready by March 2013, although it’s expected to take several years before the system is fully rolled out (see GRR, June 2012). A major consideration for global regu-lators is that the legal framework of the jurisdiction where the global LEI Foundation is set up supports the operation of the global LEI system in terms of intellectual property and data protection laws, tax legislation, dispute settlement arrangements, regulatory framework and judicial system. Legal experts are invited to provide views on a pro bono basis by September 10. A key FSB aim is to develop and imple-ment a detailed plan for the formation of the COU that supports the federat-

ed nature of the LEI system via the set-ting up of the not-for-profit global LEI Foundation, or similar legal equivalent, by private sector participants. The LEI Foundation will be directed by a board under the supervision of a Regulatory Oversight Committee (ROC) which has ultimate authority over the system. Under ROC supervision, the COU will be responsible for ensuring the applica-tion of uniform operational standards and protocols around the world. The COU is expected to be the contract-ing and operational body of the system and will have legal personality. Other key considerations in setting up the LEI Foundation are that it should be shielded from undue influence by capital donors as well as local authori-ties. The legal system of the jurisdiction in which it’s located must ensure that neither can exercise control over the Foundation or the COU. The legal sys-tem must also respect the governance structure of the LEI system. The US CFTC in August designated the Depository Trust and Clearing Corporation (DTCC), which pro-cesses financial trades for thousands of institutions worldwide, and SWIFT – the Society for Worldwide Interbank Financial Telecommunications – as providers of CICIs. SWIFT, the mem-ber-owned communications platform provider connecting 10,000 financial firms in 210 countries, and DTCC will manage and operate the new CFTC website. Meanwhile, DTCC and SWIFT are among the more than 100 institutions from some 25 countries that have joined the Private Sector Preparatory Group (PSPG) that the FSB called for (see GRR, July/August 2012) to sup-port the LEI implementation group in its work in setting up the global LEI system. PSPG members include both financial and non-financial firms, data and technology providers, and academ-ics. The FSB said implementation work on the LEI system will now be taken for-ward in three streams: a government and legal workstream; an operations workstream; and an ownership and relationship data workstream.

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



Global regulators’ proposals for identi-fying systemically important insurers

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

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

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

Working with the FSB, the IAIS proposed in May ways of determining which insur-ance companies, if any, fall into the G-SIFI category. The IAIS didn’t suggest any con-crete policy measures with its proposed methodology and IAIS officials have said in the past that capital surcharges might not be appropriate for G-SIFIs engaged in traditional insurance. Policy measures are expected to be published for comment

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

No evidenceInsurance Europe, the Brussels-based fed-eration of Europe’s national insurance industry trade bodies which was formerly known as the CEA, said the proposed methodology doesn’t reflect the IAIS’s earlier finding that there’s little evidence of traditional insurance generating systemic risk. “We are disappointed that the approach proposed by the IAIS does not adequately reflect the fact that banking and insurance business models can have very different impact on economic and financial stability,” Insurance Europe director general Michael Koller says.The IIF’s Portilla reckons many of the IAIS’s qualitative comments aren’t reflect-ed in the methodical assessment, which seems to have influenced “to an unwar-ranted degree” by the Basel Committee’s approach to bank G-SIFIs. Koller argues the methodology developed by the Basel Committee doesn’t work for insurance. “The limited adjustments that have been made to [the Basel approach] by the IAIS are not sufficient to reflect the existing structural differences between the two sectors,” she adds. And American Insurance Association (AIA) senior vice president Stephen Zielezienski also thinks the IAIS’s methodology, and the process for developing it, may not reflect the IAIS’s conclusion that traditional insur-ance shows little evidence of generating

Insurance regulation

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

Andrés Portilla

Designating firms as SIFIs increases “moral hazard”

Michaela KollerDisappointed that IAIS does not reflect differences between banks and insurers



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

reflecting the particularities of the insur-ance business model. The approach involves three steps – the collection of data, an indicator-based assessment of the data, and a process for supervisory judgment and validation. There are 18 indicators under five categories: size, global activity, interconnectedness to other players in the financial system, non-traditional insurance and non-insurance activities, and substitutability of products and services. The IAIS’s approach is similar to that devised by FSOC for identifying non-bank SIFIs, according to credit rating agency Moody’s Investors Service. Writing in a June report, Moody’s senior credit officer Laura Bazer said both the IAIS and FSOC seek to identify groups whose distress or failure could hurt the financial system based on their size, interconnectedness and lack of substitutability. For determining whether a non-bank finan-cial firm is a SIFI, FSOC has introduced a three-stage framework for evaluating companies across industry sectors. FSOC will evaluate the systemic riskiness of non-bank firms that have more than $50 billion in total consolidated assets and meet at least one of several additional thresholds, including whether a firm has $3.5 billion or more in derivative liabilities, at least $30 billion in CDSs and at least $20 bil-

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

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


No case for capital surchargesThere is no case for subjecting any insurer deemed to be in the global systemical-ly important financial institution (G-SIFI) category to blanket capital surcharges in the manner applying to bank G-SIFIs, the Institute of International Finance (IIF) said in its comments on the proposed methodol-ogy for identifying insurer G-SIFIs. Regulators need to ensure that non-tradi-tional insurance activities attract a capital treatment which is commensurate with the risks they pose and this treatment should form an important part of the regulation of insurance firms or groups which under-take such activities. The emphasis should however remain on the appropriate capital treatment of activities, the IIF said.Regulators won’t disclose their ideas on policy measures for any insurers that might fall into the G-SIFI category until later this year. Meanwhile, the IIF believes the follow-ing should also be borne in mind by regula-tors when developing measures: Great care and attention must be devoted to identifying indicators and other analytical measures providing evidence of insurers having systemic characteristics. Because traditional insurance busi-ness is not a source of systemic risk, it is important that any additional policy meas-ures applied to such firms are specifically designed to focus on non-traditional, non-insurance activities by insurers. General indicators such as size, global activity and interconnectedness are not, in themselves, a reliable guide to sys-temic importance. While these may have some bearing on the nature or intensity of supervision, they should not be the trigger for special regulatory or supervisory treat-ment intended to address systemic risk. Any assessment needs to include a thorough assessment of the adequacy of group-wide risk management, governance and controls. This and a carefully crafted policy response will have the benefit of providing incentives for sound risk manage-ment practices. Enhanced supervision, conducted on a truly global basis through the opera-tion of supervisory colleges and paying due attention to resolution issues, is likely to be a key part of the policy response.

Stephen ZielezienskiThinks G20 should follow the US approach when determin-ing whether insuers are SIFIs

Laura Bazer

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

GRR



America’s central bank must, in formu-lating new capital standards, unequivo-

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

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

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

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

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

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


US insurers fear impact of Basel III and Dodd-FrankFed’s new powers will bring some insurers within the ambit of global banking rules; concerns over unintended consequences

Charles Chamness

“The Fed continues to take a bank-centric approach to regulation”

“Even though insurance was not directly targeted by the Dodd-Frank Act, it has created large amount of potential market turmoil and uncertainty for insur-ers” – Charles Chamness



capital and introduces elements of the ear-lier Basel II accord that have not previously been applied in the US. Chamness said it was imperative the Fed recognised the “striking differences” between the activities of many of the bank holding companies traditionally regu-lated by the Fed and insurance-connected

SLHCs that will be supervised in the future. The distinctions include significantly differ-ent financial reporting, accounting stand-ards, capital requirements and other oper-ational activities, he said. “The information and standards that are critical to supervising an SLHC which is overwhelmingly engaged in insurance activities is fundamentally different than the information and standards critical to regulating traditional bank holding compa-nies. The risk and exposure of insurance companies and the nature and utilisation of their assets and liabilities can be signifi-cantly different from banks.” “Unfortunately, notwithstanding a genuine effort to understand the business of insur-ance, the Federal Reserve continues to take a bank-centric approach to regulation making little allowance for insurance spe-cific standards,” Chamness said. Firms new to the Fed’s regulatory process that are still trying to interpret the mean-ing of bank-centric requirements, there is frequently insufficient time to process and respond to comment periods. The practical result of some regulations may not be immediately apparent and the Congress should urge the Fed to go slow and work closely with insurance compa-nies it now oversees, he said. “Furthermore, rather than working with state regulators and relying on profes-sional expertise of the functional regula-tors, the Federal Reserve is engaging in detailed investigations into insurance com-pany operations. Such activities are duplica-tive, time-consuming and costly for both government and the insurance company, and could lead to conflicting determina-

tions between regulators and inappropri-ate decisions.”The application of the Basel III capital requirements to mutual insurance SLHCs will have many significant consequences, including requiring many firms to adopt new accounting practices. “It will not fully recognise forms of capital that state insurance regulators have recog-nised for more than a century, like surplus notes. It will result in unintended and unwarranted differentiation between [pub-licly listed] and mutual insurers who own banking organisations. And it will result in significant disruption in business functions in advance of the 2013 effective date of the rules. This is obviously not a consequence that Congress intended.”

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

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

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


Robert Hartwig

Provisions in the Dodd-Frank Act could reduce insurers' ability to accumulate capital or mitigate risk

Thomas Quaadman While insurers were intended to be exempt from the Dodd-Frank Act, they will still be affected

GRR



Regulators have bitten off more than they can chew with their efforts to

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

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

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

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

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

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

*The Real Financial Crisis: Why Financial Intermediation is Failing – Oliver Wyman, January 2012

Walter Kielholz is chairman of the Swiss-based global reinsurer Swiss Re. He is also chairman of the European Financial Services Round Table and a board member of the Institute of International Finance.

Opinion

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

What matters most is to ensure that the reform efforts do not distort com-petition, either within or between sectors or financial centres

Regulators are in danger of introducing new risks, such as the moral hazard that could result from signalling which institutions will be more strongly regulated

GRR

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Diary: conferences,meetings and deadlines

SeptemberSept 14 – Deadline for comment on US Commodity Futures Trading Commission’s proposals on margin requirements for uncleared swaps – (www.cftc.gov)Sept 20 – ISDA annual Europe con-ference – London (www2.isda.org) Sept 24-26 – American Bankers Insurance Association annual confer-ence – Phoenix, ArizonaSept 28 – Deadline for comment on Basel Committee’s proposed princi-ples for effective risk data aggregation and risk reporting (www.bis.org).Sept 28 – Deadline for comment on Basel Committee’s consultation on margin requirements for non-central-ly cleared derivatives (www.bis.org).Sept 28 – Deadline for comment on consultation on recovery and resolu-tion of financial market infrastruc-tures – (www.bis.org)

OctoberOctober 10 – Financial markets - serving the real economy and society? Finance Watch conference – Brussels (www.finance-watch.org)October 10-12 – International Association of Insurance Supervisors annual conference – Washington (www.iais2012.org) Oct 11-13 – Institute for International Finance 30th anniversary membership meeting – Tokyo (www.iif.com)Oct 12 – Deadline for comment on Basel Committee’s update of its guid-ance for managing currency market settlement risk – (www.bis.org) Oct 14-16 – American Bankers Association’s annual convention – San Diego, CaliforniaOct 17 – Annual BBA international banking conference – London (www.bba.org)Oct 22 – Deadline for comment on US proposals for implementing Basel III bank rules (extended from

September 7) – www.federalreserve.gov.Oct 28-30 – Risk Management Association annual risk manage-ment conference –Dallas, Texas (www.rmahq.org)Oct 29-Nov 1 – Sibos financial servic-es industry annual conference – Osaka, Japan – (www.sibos.com)

November

November 9-10 – G20 finance minis-ters’ meeting – Mexico. November 20 – Liquidity and Market Regulation conference – London (www.cityandfinancial.com)

December

Dec 3-7 – Riskminds international conference – Amsterdam (www.icbi-riskminds.com)