journal of regulation & risk - north asia, volume v - issue ii - summer, 2013

Articles, Papers & Speeches

On being the right size: Essays in evolution Andrew G. Haldane

Global banking reform five years after the crisis Daniel K. Tarullo

A better alternative to the Basel capital rules Thomas M. Hoenig

Regulation of cross-border OTCs: A middle ground Elisse B. Walter

Lessons from the crisis: The flaws of inflation targeting Otmar Issing

Macroprudential rebalancing in a period of economic stress Jean-Pierre Landau

Dynamics of disintegration: Germany and the Euro Prof. Christian Fahholz and Dr. Gernot Pehnelt

Europe’s interests best served by complying with Basel III Nicolas Veron

The science of fiscal policy & alchemy of monetary policy Prof. Jeffrey Frankel

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

The Brown-Vitter bill: An exposé of lunacy Assoc., Prof. William K. Black

Dodd-Franks extra-territorial reach irks the European Union Mayra Rodríguez Valladares

Macroeconomic stabilisation under modern monetary theory Steve Randy Waldman

Are ineffective AML & CFT laws impeding investor confidence? Gavin Sudhakar

Volume V, Issue II – Summer, 2013

Journal of regulation & risk north asia

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When you have to be right

Journal of Regulation & Risk North Asia 1

Publisher & Editor-in-ChiefChristopher Rogers

Editor EmeritusDr. John C. Pattison

EditorElizabeth DooleyChief Sub Editor

Fiona PlaniEditorial Contributors

Prof. Laurence M. Ball, Assoc., Prof. William K. Black, Rowan Bosworth-Davies, Satyajit Das, Elizabeth Dooley, Dr. Christian Fahrholz, Prof. Jeffrey Frankel,

Andrew G. Haldane, Thomas M. Hoenig, Otmar Issing, Per Kurowski, Jean-Pierre Landau, Dr. Gernot Pehnelt, Christopher Rogers, Judy Shelton,

Prof. Rajiv Sethi, Gavin Sudhakar, Daniel K. Tarullo, Assoc., Prof. Jennifer S. Taub, Mayra Rodríguez Valladares, Prof. Yanis Varoufakis, Nicolas Veron, Steve Randy

Waldman and Elisse B. Walter Design & Layout

Lamma Studio Design Printing

DG3Distribution

Deltec International Express LtdISSN No: 2071-5455

Journal of Regulation and Risk – North Asia5/F, Suite 502, Wing On Building, 71 Des Voeux Road, Central, Hong Kong

Tel (852) 2982 0297Email: [email protected]

Website: www.irrna.org

JRRNA is published quarterly and registered as a Hong Kong journal. It is distributed to governance, risk and compliance professionals in China,

Hong Kong, Japan, Korea, Philippines, Singapore and Taiwan.

© Copyright 2013 Journal of Regulation & Risk - North AsiaMaterial in this publication may not be reproduced in any form or in any way

without the express permission of the Editor or Publisher.

Disclaimer: While every effort is taken to ensure the accuracy of the information herein, the editor cannot accept responsibility for any errors, omissions or those opinions expressed by contributors.

Journal of Regulation & Risk North Asia2

Volume V, Issues II – Summer, 2013

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

Articles, Papers & SpeechesOn being the right size: Essays in evolution 59Andrew G. HaldaneGlobal banking reform five years after the crisis 73Daniel K. TarulloA better alternative to the Basel capital rules 85Thomas M. Hoenig Regulation of cross-border OTCs: A middle ground 91Elisse B. WalterLessons from the crisis: The flaws of inflation targeting 99Otmar IssingMacroprudential rebalancing in a period of economic stress 109Jean-Pierre LandauDynamics of disintegration: Germany and the Euro 115Prof. Christian Fahholz and Dr. Gernot Pehnelt

JOURNAL OF REGULATION & RISK NORTH ASIA


Europe’s interests best served by complying with Basel III 123Nicolas VeronThe science of fiscal policy & alchemy of monetary policy 129Prof. Jeffrey FrankelCentral bank fixation with low inflation prolongs recession 135Prof. Laurence M. BallThe Brown-Vitter bill: An exposé of lunacy 139Assoc., Prof. William K. BlackDodd-Franks extra-territorial reach irks the European Union 149Mayra Rodríguez ValladaresMacroeconomic stabilisation under modern monetary theory 155Steve Randy WaldmanAre ineffective AML & CFT laws impeding investor confidence? 165Gavin Sudhakar

Articles (continued)


ForewordFIRST and foremost, may we offer our readers an apology for the lateness of this publication of the Journal – this delay has been caused by the unexpected death of our Editor, Mr. Ian Watson, who will be greatly missed by our small editorial team and those who dealt with him in the production of the Journal. After an extensive search for a replacement, the Institute of Regulation & Risk - North Asia, is pleased to announce that Ms. Elizabeth Dooley will join the Journal as our new Editor and will build upon the good works of Mr. Watson during his four years at the helm.

This issue of the Journal, as usual, should provide readers with an eclectic mix of papers, opinion and comment on current and future financial management, financial sector policy and macroeconomics gleaned from leading authorities across the World - much of which is informed by the economic events of 2007/8 and efforts to mitigate against another financial shock in future. Obviously, opinion is divided on many of these prescriptions and the likely impact they will have both regionally and worldwide in the coming months and years ahead.

Since the appearance of our last Journal, much has changed - Japan has a new Prime Minister and Governor of the Bank of Japan, the U.S. has made large administration changes, most notably in the Treasury Department with the departure of Timothy Geithner, whilst Mark Carney, the former Governor of the Bank of Canada, replaces Governor Mervyn King at the Bank of England - the first time ever that a non-UK citizen has been charged with running one of the World’s oldest central banks.

Regretfully, in many areas matters remain much the same, epitomised by the con-tinued Euro sovereign debt crisis and outrage at the terms of the bailout of Cyprus and its beleaguered and obese banking and financial services sector. Indeed, since the March shenanigans surrounding the Cypriot bailout, rather than taking fright at the continued weaknesses in the European Union, U.S. and Japan economies, stock indices and mar-kets globally have experienced a further bout of what can only be described as ‘irrational exhuberism’.

Whether, following the Cyprus bailout/bail-in, this is fuelled in part by investor search for high yields and depositor fears that their funds are no more at risk in stocks and bonds than being left in bank accounts that can be seized to bailout failing banks is one question that continues to undermine one of the key notions of a stable economy, namely, bank deposit guarantees.

Christopher Rogers Publisher & Editor-in-Chief


AcknowledgmentsTHE editorial management of the Journal of Regulation and Risk – North Asia could not have published this edition of the Journal without a great deal of assistance and advice from professional associations, international monetary and financial bodies, regulatory institutions, consultants, vendors and, indeed, from the indus-try itself.

A full list of those who kindly assisted with the publication of this issue is not possible, but the Publisher and the Editor would like to thank the following or-ganisations for their generous assistance and support: The Board of Governors of the U.S. Federal Reserve System; the U.S. Securities and Exchange Commission; the U.S. Federal Deposit Insurance Corporation; the U.S. Commodities Futures Trading Commission; the Bank of England; Bruegel; the Peterson Institute for International Economics; Johns Hopkins University; New Economic Perspec-tives; The Cato Institute; the Pareto Commons; VoxEu; the American Banker; MRV Associates; Interfluidity; Wiley Publications and Yanis Varoufakis blog for their kind permission to reproduce material from their respective publications and websites.

Detailed comments and advice on the text and scope of contents from Prof. Laurence M. Ball, Prof. Jeffrey Frankel, Steve Randy Waldham, Assoc., Prof. Wil-liam K. Black, Dr. John C. Pattison, Prof. Rajiv Sethi, Nicolas Veron, Prof. Law-rence Baxter, Per Kurowski and Assoc., Prof. Jennifer Taub were invaluable; we are also grateful to Fiona Plani of Edit24.com for her due diligence in setting out, editing and correcting the text. Further thanks must also go to the China Banking Regulatory Commission, Beijing & Shanghai Chapters of the Professional Risk Managers International As-sociation and the Hong Kong Chapter’s of the Global Association of Risk Profes-sionals and Institute of Operational Risk Management, together with SWIFT and Wolters Kluwer Financial Services, for their kind assistance in helping to distrib-ute this journal to their respective memberships and client-base in Greater China, Japan and Korea, Philippines and Singapore.


Q&A

Global financial system is irredeemably broken down

Robert Pringle, acclaimed author of The Money Trap, crosses foils with the Journals’

new editor, Ms. Elizabeth Dooley.

Elizabeth Dooley: Your recently published book, “The Money Trap - Escaping The Grip of Global Finance” touched upon many sensitive nerves, not least the fact, that in its present unre-constituted trajectory the global financial system is irredeemably not fit for purpose. In your book, you dwell at some length on how national gov-ernments have incentivised the main actors and players in the global financial services sector to behave contrary to their own best interests. Can you expand on this theme a little further?

Robert Pringle: The global financial system (GFS) provides the wrong incentives for two main reasons: first, it is weak, and, second, it is still based mainly on national policies and regulations. Thus, instead of focussing on customer services, clever bankers spend time finding ways round the regulations, for example by moving operations to places with less stringent rules, or to jurisdictions that apply them less strictly. Often, regula-tion has encouraged harmful swings in eco-nomic activity and credit. Because the system is seen to be weak, banks have also invested much time and money in lobbying regulators. They can

influence new rules before they come into effect – as we have seen with the lobbying over Dodd-Frank – and in the process of implementing rules. Also, despite the efforts of the G-20 group of leading economies and the Financial Stability Board (the interna-tional regulatory body), financial regulation remains essentially national.

Protectionist tendenciesIndeed, the entire monetary system – with its characteristic model of independent cen-tral banks following forms of inflation target-ing with flexible exchange rates – is inward looking. It forces policy makers to focus on what is good for their country alone, rather than the international community more widely. This is incompatible with the proper workings of a globalised world economy. It encourages nationalist measures such as protectionism.

ED: You have stressed that in your opinion the financial crisis that engulfed the world in September 2008, and continues to this day, is a symptom of a dysfunctional monetary and banking system. As such, could you explain how


and when the system began to go off the rails in earnest?

RP: We have been through a number of credit and financial cycles over the past 40 years. Each time, the response of the central banks and governments has been similar – to tighten up regulation, to put a floor under the banks, and to try to prevent recessions by expansionary monetary and fiscal policies. Each time central banks and governments alike claimed that these measures would fix the problem; in fact they merely made the next crisis worse. As the managers of private sector financial institutions learned to anticipate such responses, they did not take enough care about their business deci-sions. Together with a bonus-based com-pensation culture, this encouraged excessive risk-taking.

ED: Given the origination of the present crisis is attributed in part to the sub-prime crisis that engulfed the U.S. beginning in March 2007, does it not strike you as odd, given the level of mal-feasance that has been uncovered, that no senior executive of a systemically important financial institution has to date appeared before a court, never mind faced imprisonment over their actions?

RP: Anger is fully justified and an impor-tant pressure for real change. In my book I argue the case for fundamental reform, both of banking and of money. I advocate link-ing finance forever to the real economy, and to establish ways to stop bankers and other financial intermediaries from gambling with our money. Pending such fundamental reforms,

we should return to an ethic of personal responsibility. Top executives should come under stronger pressure to resign as soon as something shameful happens in their organisation, even if they were not directly or personally responsible for it. Only in this way will they make efforts to ensure they know as much as possible about what is going on. At present, the only incentive is to know as little as possible about what is going on so that they can deny any connection with any scandal. Regulation alone cannot fix this problem. At the end of the day it is a last resort, albeit an ethical one.

ED: Turning our attention to the present tra-vails in Europe, specifically regarding Southern European members of the Eurozone, do you believe the Euro is doomed to fail given recent events in Cyprus and growing fears for Slovenia?

RP: The Euro area is confronting problems that all countries living in a global world economy and financial system have yet to face. Having your own currency, like the U.S. dollar or Japanese Yen, does not protect you from these dilemmas and problems.

Having your own currency merely ena-bles local politicians to promise to spend money – the people’s money – and allows governments to more easily postpone taking the hard decisions needed to exist within a global world economy. Whilst I expect the Euro to survive in one shape or other, recent events in both Italy and Cyprus suggests its present member-ship decrease over the coming 12 months. However, despite all the Cassandra’s and recent upheavals that have occurred in


the Eurozone, the Euro presently remains intact. Further, I would go as far to say, that those countries that have the political will to implement needed reforms – and most of the current members have such political determination – will be able to remain in the Eurozone.

Indeed, if current reform plans are fully implemented, the Euro area will emerge stronger in the long run as a result of this crisis.

ED: Despite a raft of regulatory initiatives and increased risk management measures across the U.S., UK and European Union since the finan-cial meltdown of 2008 - not to mention Basel III, recent events such as the failure of MF Global and US$5.8 billion trading loss at JP Morgan’s London operations - large globally active finan-cial institutions have failed to heed previous les-sons. Is this a fair assessment of the present state of play across much of the industry?

RP: It shows that the culture of aggressive, risk-taking investment banking is still preva-lent in the leading institutions. Again, the top people could say they were not aware of such risk-taking. But it is their responsibility to set the tone and to monitor such risk-taking effectively. This underlines the need to split up the big banking groups, and to increase the pressure for such break-ups. Governments should stop pretending that “more regulation” or “better regulation” can ensure a stable and safe banking and finan-cial system. This is not only false but also dangerous, as it takes responsibility further away from the management of individual firms to keep their capital and liquidity strong enough to withstand shocks. It also

fails to encourage firms to make their own assessment of risks.

ED: Would you agree that the Wall Street Reform and Consumer Protection Act, more commonly referred too as the Dodd-Frank Act, has made banking safer in the U.S.?

RP: I welcomed Dodd-Frank when it was passed as a step in the right direction, but banks’ lobbying power is watering it down and will continue to water it down further when it comes to full implementation.

My view now is that this monstrously complex piece of legislation proves that the current banking and finance system should be abolished. It has reached the end of the road. Either we go for a fully nationalised finance system, with extensive state direc-tion, or we need to construct a reformed system where individuals are able to choose what level of risk they are willing to accept for the money they place with financial inter-mediaries and to accept the consequences.

ED: Given the establishment of bilateral trade agreements that have excluded the U.S. dollar as an international settlement currency in recent months, do you believe the dollar will retain its primacy as the international currency for con-ducting business?

RP: The dollar should take its place in a global network of currencies linked to a common benchmark or standard. We need a reference point, or platform, against which currencies, including the dollar, euro and pound, can measure themselves. I suggest one way of defining such an international currency, which I call the Ikon, in my book.•


Debate

Forget “too-big-to-fail”, say hello to “too-big-to-prosecute”

Attorney General Holder’s Freudian slip could prove a “watershed moment” in cutting

banks down to size argues Chris Rogers.

EyEbrows were more than a little raised recently following the public dis-closure by the United states highest rank-ing public prosecutor that banks deemed systemically important were all but immune from being prosecuted for any criminal behaviour. The remarks made by U.s. Attorney General Eric Holder during a senate Judiciary Committee hearing in relation to questions concern-ing the HsbC money laundering scan-dal caused howls of derision across the political spectrum and re-ignited pas-sions concerning too-big-to-fail, a lack of criminal prosecutions in relation to the bank crisis of 2008 and slow progress in the implementation of Dodd-Frank Act.

Holder’s Freudian slip of the tongue was no mere one-off. His well considered remarks to Senators in March echoed similar state-ments made by another luminary of the U.S. Department of Justice (DoJ), Assistant Attorney General Lanny Breuer, who man-aged to transgress not once, but twice in a two month time frame. Breuer, for those who need reminding, was the genius behind last

December’s US$1.92 billion no jail, no pros-ecution settlement with HSBC following the revelation of a litany of money laundering and other criminal transgressions stretch-ing back to the beginning of the millennium. His raison d’être for this dubious decision being that had he pursued criminal charges, “HSBC would almost certainly have lost its banking license in the U.S., the future of the institution would have been under threat and the entire banking system would have been destabilised.”

Breuer, having courted the derision of many for his handling of the HSBC scandal in December, decided to go one step further this January when agreed to participate in an interview for the U.S. public broadcaster PBS’s Frontline current affairs programme titled “The Untouchables.” During this broadcast, Breuer waxed lyrically that U.S. Justice does not apply to the largest active banks on Wall Street – a contention fully backed up by the empirical evidence, or lack thereof since the onset of the financial crisis five years ago. Unsurprisingly, following a wave of outrage over Breuer’s unimpres-sive performance and excuses given for not


upholding his oath of office – he was after all the head of the DoJ’s criminal prosecutions division - he tendered his resignation some 24 hours after the programme aired.

For many bankers on Wall Street and fur-ther afield, 2012 had been an exacting year of which many had hoped to put the “annus horribilis” of mis-selling, money launder-ing, the Libor scandal and “London Whale fiasco” behind them as they embarked on a new year. As such, Breuer’s interjections in January from a PR perspective were unwel-come to say the least, certainly in terms of the negative publicity they engendered, not too mention further reputational risks that all this entailed for many of the world’s larg-est banks – most of which have operations in the U.S.. Hence, the Attorney General’s comments in March came as an utter bomb-shell to the tranquillity many yearned for.

Systemic importanceHaving fought a rear guard action to down-play Assistant Attorney General Breuer’s comments on too-big-to-prosecute, too-big-to-jail during much of January and February, the banking sectors well-oiled PR and lobbying machine was hard at work undermining undesirable elements of the Dodd-Frank Act and U.S. adoption of the more onerous elements of the Basel III inter-national Accord. No doubt, many considered Wednesday, 6 March just a normal day on Capitol Hill, and as such, were unprepared for the tsunami that was to be unleashed by Holder later that afternoon during a routine grilling by the Senate’s Judiciary Committee.

Lulled into what may have been a false sense of security having successfully fielded questions on drone policy and gun control

under questioning from the Republican Senator for Iowa, Charles Grassley, Holder all but admitted what many had believed for many years, namely, that the Justice Department – together with other regula-tory and supervisory bodies - was either unwilling, or unable to press charges or seek criminal prosecutions against large systemi-cally important financial institutions for fear of the damage this could cause, not only to the U.S. economy, but that of the world.

Negative impactsIn reply to the Senator’s enquiry, Holder said: “The size of some of these institutions becomes so large that it does become diffi-cult for us to prosecute them when we are hit with indications that if you do prosecute, if you do bring a criminal charge, it will have a negative impact on the national economy.” He further added that “this is a function of the fact that some of these institutions have become too large.”

Such comments by leading officials within the Obama administration can usu-ally be brushed aside or ignored. However, Holder’s remarks, specifically those relating to too-big-to-fail, pinched a nerve that had been causing trouble to many since the 2008 bank bailouts. Indeed, given that the Obama administration has been trumpeting the fact that the issue of too-big-to fail had been resolved in one passage of the Dodd-Frank Act and that no more public money would be required to bailout failing institutions due to the Resolution authority contained therein, both Holder’s and Breuer’s remarks cast serious doubt on this contention.

Obviously, by straying off message, Holder’s remarks managed to reopen


existing wounds in those both opposed to the Dodd-Frank Act itself, and those who believed that it did not go far enough to strengthen bank regulation, curtail casino-style gambling or prevent outright mal-feasance. Speaking in the aftermath of the Attorney General’s faux pas, Camden Fine, the head of the Independent Community Bankers of America, said that Holder’s more than candid remarks “didn’t just throw fuel on the fire, it threw an entire refinery on the fire.” Meanwhile, whilst The American Bankers Associations’ Wayne Abernathy, suggested that Holder’s comments were “muddled” and certainly not helpful to the dialogue on too-big-to-fail or prosecuting wrongdoer’s within finance, colleagues over at the American Banker magazine called his comments “an amazing admission” and pos-sible turning point in the debate about large financial institutions.

Extraordinary indictmentThe too-big-to-prosecute syndrome, read too-big-to-jail, is not just restricted to the “land of the free and the brave,” for it would seem that the infection has spread to that other citadel of Anglo-American capitalism, namely, the City of London. In a much publi-cised interview given to The Daily Telegraph in December last year in the wake of the Libor scandal, the record fine imposed on HSBC by U.S. authorities and the JPMorgan Chase “London Whale fiasco,” the newly appointed head of the UK’s Prudential Regulation Authority, Andrew Bailey, expressed similar sentiments to those two other fellow travel-lers, namely Breuer and Holder, when he all but confirmed that “some banks had grown too large to prosecute.”

Pushed on the politically sensitive issue of why no criminal charges had been brought in the UK against those involved in rigging interbank lending rates, Bailey had this to say: “It would be a very destabilising issue. It’s another version of too important to fail”, he added, that “because of the con-fidence issue with banks, a major criminal indictment, which we haven’t seen and I’m not saying we are going to see… this is not an ordinary criminal indictment.”

Trouble in the CityAs in the U.S., there has been considerable public and political disquiet in the UK at the fact that no individual or institution has been brought to account over the banking crisis that began with Northern Rock in 2007, gov-ernment bailouts of Royal Bank of Scotland, and Lloyds Banking Group following its merger with Halifax Bank of Scotland in late 2008. So too the insignificant progress made in mitigating against too-big-to-fail and criminality of the City.

The UK government and its regulatory agencies have not only failed to act fully on the recommendations of the Vickers’ Commission’s findings, but have thus far failed to impose sanctions, fines or success-fully prosecute any of those involved with the Libor abuses, not too mention those institutions headquartered in the City which U.S. authorities have issued fines to, among them Barclay’s Bank, Standard Chartered and HSBC. Indeed, the only scalp has been that of Barclay’s former CEO, Robert Diamond, who was forced to resign having lost the trust of the Bank of England. Further, the Conservative-led Coalition government has done all in its power to thwart European


Union legislation on excessive remunera-tion and the introduction of a “Tobin Tax” on securities transactions - this despite inflicting austerity on the economy at a time when the banks themselves are averse to lending.

Whilst Bailey’s comments did little by way of endearing himself to the British pub-lic and certainly could not be construed as a tipping point - they were after all made in the print media - the same cannot be applied to either Breuer’s or Holder’s pub-lic pronouncements. In the aftermath of the HSBC no-prosecution deal, Breuer posi-tively courted the media in relation to the exceptionally large deal he’d managed to strike with the bank - evidently forgetful of the large pile of incriminating evidence that sat on his desk. Having managed to raise a huge media storm in December, he was once more in January playing with media fire and consequently got more than a little singed - obviously having brought too-big-to-fail and too-big-to-prosecute back into the public domain, a matter that both irri-tated and delighted many in equal measure.

The Attorney General’s testimony to the Senate Judiciary Committee was in a different league to that of his junior in the DoJ. Not only did we have the most senior prosecuting counsel in the U.S. underscore the fact that it was all but impossible to seek criminal prosecutions against too-big-to-fail banks, but compounding this admission was the fact that his words were being transmit-ted live via a TV broadcast, recordings of which were soon placed on the Internet and went “viral” within hours. The blogosphere also magnified and dissected Holder’s com-ments to such an extent that a virtual point of “criticality” was reached that very evening.

In light of these two intertwined facts, the issue of too-big-to-prosecute (too-big-to-jail) and too-big-to-fail were once more at the forefront not only of the general publics mind, but also of legislators on Capitol Hill - a dangerous chemical cocktail indeed!

What of the substance of Attorney General Holder’s remarks themselves? It is a question that has been raised by those who sympathise with his dilemma, his detractors and by those either adverse to mega banks or to the Dodd-Frank Act in general for a multitude of reasons, the most significant of course being that it has failed to curtail the banks, and thus failed to fix too-big-to-fail. Most of these issues should not be of inter-est to the Attorney General of the DoJ. They are after all regulatory or legislative issues. That said, out and out criminality should be of primacy concern to Holder. As such, both he and Breuer have contributed to continued recklessness of degenerate banks by failing to uphold the letter of the law, of which no single man or institution should be above.

With regards bringing banks to heal and mitigating against too-big-to-fail, Holder’s comments were a godsend and have shaken up the dialogue on how to prevent another systemic event and taxpayer bailout. Whilst many contend that Holder’s outburst has strengthened the hands of Senator’s Sherrod Brown and David Vitter in their efforts to introduce a legislation to cap bank size, the chances of this effort are close to zero. Rather, what we see is an opportunity for one Elizabeth Warren to elevate her status in the Senate by striking fear into both the sys-temically important banks and those whom are entrusted by the U.S. government to supposedly regulate them.•


Opinion

Thirteen ways of looking at a London whale

Assoc., Prof. Jennifer S. Taub of Ver-mont Law School eviscerates JPMorgan Chase’s “tempest-in-a-teacup” moment.

Wallace Stevens’ Thirteen Ways of Looking at a Blackbird came to mind this March after listening to testimony at the US Senate subcommittee hearings focusing on the activities of the “london Whale” incident at JPMorgan chase’s london operations.

The Senator Levin-led bipartisan Permanent Subcommittee on Investigations’ 301-page report: JPMorgan Chase Whale Trades: A Case History of Derivatives Risks and Abuses, makes for some uneasy reading by those involved in last year’s tempest-in-a-teapot-turned-US$6.2 billion trading loss.

A regulator from the Office of the Comptroller of the Currency (OCC) who tes-tified at the hearings, admitted finding new information in the report that he thought he and his colleagues at the Comptroller’s Office, still needed to “digest.”

In the spirit of the Stevens’ poem, there are at least thirteen facts that can be gleaned from both the report and testimony:

First and foremost, is the fact that JP Morgan saw it coming: A potential US$6.3 billion loss within the synthetic credit portfolio

(SCP) at the Chief Investment Office (CIO) was predicted through the bank’s own com-prehensive internal risk measure. Despite its own internal findings, the bank’s market risk executive, Peter Weiland dismissed the pre-diction as “garbage.”

Second, was the building up of risk: The portfolio did not reduce risk, as was projected by senior management, but actually added risk: The SCP trades violated internal risk limits, yet more risk was added. The OCC saw the risk breach reports but did not act.

Third, this was not a rogue trader or rogue desk – the CEO, Jamie Dimon, was aware of key facts. According to Ina Drew, head of the CIO, who “resigned” last year as a result of the “London Whale” debacle, Dimon was aware of the CIO trading. The report also details he was informed of the risk limit breaches.

Fourth, we have the cover up: The bank CIO unit changed its pricing practices to make losses on portfolio positions look smaller. This phantom pricing continued even after the story of the whale broke and after it was clear another part of the bank priced the same positions as the CIO had in


the past – at the mid-point between the bid/ask spread.

Gambling with depositsFifth, was the potential for fraud: Levin noted that the bank agreed that “books were cooked.” The bank arguably made false statements to the public, policy makers and regulators, whilst Levin focused on the statements made by CFO, Doug Braunstein in April 2012.

Sixth, is the issue of gambling with Federally-Insured Deposits, and not as claimed, hedging positions: The bank could not point to specific assets it was hedging, and appeared to be engaging in proprietary trading, using insured deposits, a practice which would arguably violate the Volcker Rule, set out in Section 619 of the Dodd-Frank Act.

Seventh, the bank’s positions lacked transparency: JP Morgan claimed in April 2012, that it had disclosed trading positions to regulators when it had not. Levin called this and other statements made by Mr. Braunstein an attempt to “calm the seas.”

Regulator ignoranceEighth, denotes minimised losses to regu-lators: The bank may have told regulators losses were just US$580 billion at a time when they had ballooned to US$1.2 billion.

Ninth, the regulator was in the dark: Scott Waterhouse, lead OCC examiner for the bank said he did not find out about the London Whale risky trades until the Wall Street Journal broke the story in April 2012. According to Waterhouse the whale “did not surface to our attention” until that time.

Tenth, is the fact that red flags were

ignored: The OCC failed to investigate the trading activity even after learning of the multiple risk limit breaches. In addition when the bank applied a new value at risk (VaR) model and the VaR dropped by 50 per cent using that model, the OCC did not inquire as to why and failed to look at the portfolio. Levin called this a “pretty bright red flag.”

Eleventh, is that bullying tactics were uti-lised: Chief executive, Jamie Dimon appar-ently yelled at bank examiners and called them “stupid” when he did not agree with their recommendations. Mr. Dimon appar-ently also instructed the bank to withhold daily profit and loss reports from the OCC.

When former CEO, Mr. Braunstein revealed that he had resumed providing reports to the OCC, Mr. Dimon raised his voice and said it was up to him to decide whether or not reports should be resumed. Mr. Dimon had previously told the OCC that they did not require that level of information.

Twelfth, is the fact that JP Morgan skimped on information technology expenses: The bank did not want to pay to automate the new VaR model, so an employee regularly worked late into the night manually entering, sometimes incor-rectly, data into a Excel spreadsheet for the US$350 billion portfolio. The OCC was apparently unaware of this fact.

The Volcker RuleAnd last, but by no means least, is our thir-teenth fact, namely implementation of the Volcker Rule, or lack thereof.

Comptroller Thomas J. Curry of the OCC failed to provide a date by which he thought the Volcker Rule would be implemented. However, he did indicate that the London


Whale experience with the CIO would affect the rule making. Mr. Curry, who was sworn into office just days before the news broke of the affair, seemed to imply that this so-called “portfolio” hedging that JP Morgan Chase claimed to have engaged in would be banned under the rule, as many argue the Dodd-Frank statute already prohibits.

Bruno IksilAfter the first day of the hearings, for some welcome respite, I was reminded of Stevens’ poem, and in particular the third stanza:

“The blackbird whirled in the autumn winds. It was a small part of the pantomime”.

The blackbird connection? Bruno Iksil, former JP Morgan Chase trader dubbed “The London Whale” never appeared at the hearing. Residing in France, outside the reach of the Senate’s subpoena authority, Iksil himself was not in the building. Indeed, if one took a close look, even his trading was a really small part of the investigation, the hearing, and its broader implications.

Tip of the icebergThis is a point made by Josh Rosner, co-author with Gretchen Morgenson of Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Created the Worst Financial Crisis of Our Time. Indeed, on Barry Ritholtz’s Big Picture blog, Rosner contends that inter-nal control problems at JPMorgan Chase “appear to be pervasive.”

The whale problem may just be the tip of the iceberg, so to speak. He also notes that the whale loss itself is less than other related litigation expenses. The bank has already paid out more than US$8.5 billion in settle-ments since 2009 relating to matters covered

in the Levin report. The hearing also raises again the question of whether banks are still “too big to fail.”

Further, Ina Drew did not aid those who argued that nothing was amiss with the sta-tus quo. She headed up the CIO, earning US$14 million in 2011 alone, but claimed that she was unaware they were 1,000 per cent over their risk limit. And, when Levin asked her how big the hedge was and she said she had no idea, she defended this by pointing out that the bank had a US$2.2 tril-lion balance sheet – implying it was either too trivial or perhaps impossible to track.

Levin remarksSenator Levin also attempted to create a larger frame for the hearing, asserting in his opening remarks that:

“The Whale trades exposed problems that reach far beyond one London trading desk or one Wall Street office tower. The American people have already suffered one devastating economic assault, rooted largely in Wall Street excess. They cannot afford another. When Wall Street plays with fire, American families get burned. The task of federal regulators and this Congress is to take away the matches. The Whale trades demon-strated that this task is far from complete”.

Also incomplete is accountability. One can only hope that the next time a banker is cross-examined about arguably materi-ally misleading statements, it is in a court of law, not a Senate hearing room, and that the prosecutor has carefully reviewed at least thirteen ways of looking at a white collar crime. I won’t hold my breath. The statute of limitations will probably run before that happens – “The river is moving. The blackbird must be flying.” •


Opinion

The “Mistake” that dare not speak its name

Per Kurowski, a former World Bank executive director, lambasts the

Basel Committee for castrating banks.

In an Op-Ed I wrote for the Daily Journal of Caracas in november, 1999, I opined that: “The possible Big Bang that scares me the most is the one that could hap-pen the day those genius bank regula-tors in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause its collapse”. Fast forward to June 2004, and that “sys-temic error” I’d railed against was duly introduced by the Basel Committee via the Basel II Accord – which introduced capital requirements for banks based on perceived risks, like those reflected in credit ratings, ignoring the fact, that these risks were already being cleared for by the markets.

Under Basel II, with its emphasis on risk-weighted capital requirements, the Basel Committee had unwittingly laid the foun-dations for the “perfect storm”, which unleashed the North Atlantic financial crisis of 2007-08. Despite causing great damage to the global economy, central bankers and policy-makers have temporarily cushioned us from most of its costs by means of kicking

the can down the road. Today, almost six years after the first rumblings of the financial crisis were heard, our friends in Switzerland seem as blinkered as ever in their inability to recognise their “mistake”, never mind address it. Perhaps it is just too big for the regulatory establishment to acknowledge!

Mark Twain, wrote that: “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain”. And the weatherman could predict sunshine or rain, and he could be right or wrong. If rain was announced and it rained, no problem for the banker, as he had either never lent the umbrella or had already taken it back.

If rain was announced, but the sun shined, the banker may have lost some good tanning opportunities, but that’s about all. If sunshine was announced, and the sun shined, there are of course no problems for the banker. But, if sunshine was announced, and it rained, then the bankers would be in serious trouble. And this could be why Mark Twain also said: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so”.


But our global bank regulators, the Basel Committee, and its sister organisation, the Financial Stability Board, they too loved sun-shine and hated rain. And they felt, perhaps to be on the safe side, that they should also layer on their own preferences and fears on top of those of the bankers themselves.

Hubris dosed wisdomAnd so even though all major bank crises to date have resulted from excessive bank exposures to what was perceived as “abso-lutely safe”, and never ever from excessive exposures to what was perceived as “risky”, the regulators, in their much hubris-dosed wisdom, decided to safeguard our banking system, by requiring the banks to hold much more capital against those assets perceived as “risky” than against those assets perceived as “absolutely safe”.

And this allowed the expected risk and cost of transaction adjusted margins of the banks, when lending to or investing in “safe-sunny” zones, to be leveraged immensely more than the same margins when oper-ating in “risky-rainy” areas. And that of course translated directly into much higher expected risk-and-regulatory adjusted returns on bank equity when bathing in the sun, than when dancing in the rain.

Lower risks - higher returnsIn other words, before the establishment of the present global regulatory environment, banks decided who to lend to, depending on who produced them the highest risk and cost adjusted margin, and of course, as long as that margin could be leveraged to exceed the bank’s cost of capital. Those were the days when one unit of risk and cost adjusted

margins paid to the bank, meant the same, no matter who paid it. But now, because of these capital requirements – more-risk more-capital, less-risk less-capital – banks have come to prefer giving a loan to a bor-rower who provides it with a lower expected risk and cost adjusted margin than what other borrowers offer, only because they are authorised by the regulators to leverage the first many times more than the latter.

In other words, banks have already adjusted for perceived risks in the “numera-tor” in the asset side of the balance sheet, by means of interest rates, the size of the expo-sure and other contractual terms. And so, when regulators forced banks to also adjust for perceived risks in the “denominator”, in the liabilities and equity side of the balance sheet, with capital requirements based on this, they caused the whole risk-adjusting equation to enter a state of chaos.

Wheel of fortuneIn other words, all roulette bets have exactly the same expected pay out. But some bets, such as those made on a number, usually take you out faster from the game than those made, for example, on colour. So what if the regulators decided that playing for a longer time was the equivalent of playing it safe, and that therefore the pay out of any bets on colour should be increased consider-ably? Forget about roulette as a viable bet-ting game.

What about a handicap system that awards good golfers like you more strokes than bad golfers like me? Forget about golf as a viable competition game. First and fore-most the consequence of what was much more mis-regulation than de-regulation; was


that it introduced a huge distortion which makes it impossible for banks to help the economy by assigning economic resources efficiently. The result is that now, more than the markets, the regulator´s hand guides the banks. In turn banks create excessive expo-sures to what is perceived as ‘absolutely safe’, whilst holding very little capital.

Mind-boggling leverageFrom a regulatory point of view, this is as bad as it gets. I repeat, in banking, the really big bangs result from excessive exposures to what was ex-ante perceived as absolutely safe but that, ex-post, turned out to be very risky. And it will cause any perceived safe-haven to become, sooner or later, danger-ously overpopulated, and therefore risky. Just reflect on the fact that Basel II allowed banks to lend to Greece, or to buy AAA-rated secu-rities collateralised with mortgages to the subprime sector, holding only 1.6 per cent in capital. The implication of an authorised leverage of 62.5:1 is indeed mind-boggling.

Favouring the “infallible”, those who are already favoured with lower risk premiums results de-facto in an odious discrimina-tion against the “risky”, i.e., those who are already discriminated with higher risk pre-miums. The “risky” will then have even less access to bank credit, or need to pay more in interest, so as to make up for that com-petitive regulatory disadvantage in order to deliver the same returns on bank equity as the “infallible”.

Castrated lendingThis increased regulatory aversion against perceived risks, figuratively castrates the banks, affecting most those agents who

operate on the fringes of the real economy, those who usually most need access to bank credit, and those who usually find them-selves among “The Risky”, such as medium and small businesses and entrepreneurs. And that is a true disaster for a real economy which, needs “The Risky” risk-takers to help it move forward, as well as for all our young who anxiously wait for a new generation of jobs. We do not sing “God make us daring!” psalms in our churches for nothing.

And some minimalistic capital require-ments also provided the banks with the most potent growth hormone, which helped many of them to grow into “too-big-to-fail” globally active financial institutions. Also, since banks are required to hold the least capital against debts of “infallible sover-eigns”, this translates into a subsidy of the interest rates they pay, which causes the proxies for the risk-free rate, such as U.S. Treasuries, to emit the wrong signals.

Not a laughing matterGiven ones levity thus far, the fact remains that this is no laughing matter - quite the reverse in fact. As such, regulators, elected policy-makers, senior civil servants, central bankers and international financial bodies need to take a deep collective breath in order to address what is to be done to combat this onerous piece of global regulatory oversight. If banks are given specially rewarded access to “absolutely safe” investments, are we the citizens, our pension funds, our widows and orphans, supposed to take care of the needs of funds of the “risky”?

Is it not the banks that are supposed to do this, leaving us others with the option to invest in what is safe? Of course, it can


only help to widen the gap between the haves, the past, the developed, the old, “The Infallible” and the have-nots, the future, the developing, the young, “The Risky”.

A capital “Mistake”Many argue that the problem originates with the credit rating agencies. Not so. The problem resides with regulators using credit ratings excessively. In January 2003, in a let-ter published by Financial Times, I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds”. With Basel II, the regulators bet our banking system on risk models and credit ratings being correct, while in fact their responsibility should be to prepare for when risk models and credit ratings are incorrect, something which will happen, sooner or later. For sure, these capi-tal requirements for banks are not a minor mistake, but rather, a capital “Mistake.” From a regulatory point of view, by just looking at the empirical evidence, one could even make a case for higher bank capital requirements for exposures perceived as “absolutely safe”, over exposures perceived to be “risky”.

Saving faceThis is why someone very close to the regu-lators, on hearing my arguments, told me bluntly that the real problem was how to find a way for regulators to save face. But surely the need is not for regulators to save face, but rather to be held truly accountable, in order to make it less possible for global initiatives, like the Basel Accord, to develop anew with little scrutiny, and within what effectively amounts to small mutual admiration clubs.

Something needs to be done, urgently. It is not the role of the Basel Committee to act as risk manager for the world, which now seems to be digging us even deeper into the hole. With Basel III, where capital require-ments are still based on perceived risk, it wants to add liquidity requirements, which are also based largely on the same perceived risks. Let´s face it: Hollywood would never authorise a Basel III production using the same scriptwriters and directors responsible for a Basel II box office flop.

Single capital requirementIf a certified financial advisor was offering the same advice to a wealthy developed old retiree than to an undeveloped poor young professional, he would have his certifica-tion immediately revoked. And yet the Basel Committee does just that when expecting banks to act in the same way for both con-stituencies, and seemingly favouring more the “après moi le deluge” constituency. By means of a very careful transition we need, with a Basel IV, to move to one single capital requirement for any bank asset, around 8 to 12 per cent, depending on where the differ-ent economies might be in their economic cycle. And I mention this because I can think of few things that are as pro-cyclical as cur-rent capital requirements.

But if bank regulators cannot refrain from meddling, why then not base the capital requirements on job-creation-poten-tial-ratings, or environmental-sustainability-ratings? At least then the banks would have a purpose. As present, the banks are only performing better for those who possess good credit ratings, “The Infallible”, leaving all rest, “The Risky”, out in the cold. •


Opinion

The failings of regulators: Why don’t they do their job?

UK-based Rowan Bosworth-Davies lambasts the UK authorities for their lack

of oversight of the financial services sector.

When, in 1984 as a new Scotland Yard Fraud Detective, I went to study financial regulation as it was then carried out by the Securities and exchange Commission (SeC) and other agencies in Washington D.C., I was introduced to a group of regu-lators that had a culture and an uncom-promising track-record of taking on the biggest financial criminals and bringing them to justice.

I had gone to study with the SEC because I had become only too aware of the tidal wave of new financial crimes we were hav-ing to deal with in London, crimes which were being predicated by the then UK Conservative government’s policy mantra of de-regulation and opening up the City of London up to a far greater degree of finan-cial competition.

Having repealed exchange controls, thus opening up the channels of financial free flows, and having encouraged a policy of enabling foreign financial companies to set up business in London, the then sit-ting Prime Minister - the recently deceased Margaret Thatcher - was determined to put

London firmly in place as the third staging post of a 24/7 trading market, which could facilitate the global dealing in financial prod-ucts, so that when the Tokyo market closed, the UK market would be open, and the US market would open before we closed.

This era of free-flowing financial oper-ability brought with it a whole new range of financial criminals who were willing to hitch a ride on the coat-tails of the major players, and their activities were landing on the few desks of the small specialist squad of detec-tives of which I was a member. It was quickly proved to be useless to seek to involve the civil servant regulators at the Department of Trade and Industry (DTI), very few of whom wanted to dirty their hands or earn the wrath of their political masters.

New types of crimeI quickly became aware that we were deal-ing with crimes, the likes of which we had not hitherto experienced and which would cause British juries difficulties if we, the detectives, were not capable of presenting our cases in ways which a British jury would comprehend. In many cases, these types of


scams were making use of American trad-ing methods and language, about which we knew very little, and I discussed this problem with my boss at the Fraud Squad. An incred-ibly far-sighted man, he asked me to put together a position paper, which he used to lobby for some budget, and then told me to organise a visit to America to go and study with the SEC and the other US regulators, from whose experiences and skills we might learn.

White-collar criminalityThus it was that I ended up studying finan-cial regulation in Washington, Philadelphia, Chicago and New York, a lengthy period of immediate and direct study which I doubt few modern financial regulators have been able to, or indeed, would wish to replicate!

This visit taught me a large number of truths, but chief among them was the reali-sation that those who handle other people’s money, for which they get paid commis-sions, brokerage, bonuses, or any other kind of financial reward, have to be looked upon as potential white collar criminals, and dealt with accordingly!

Draconian penaltiesI say this because that is how the SEC viewed them and dealt with them, and they reserved some very draconian penalties for those who broke the rules. In order to bring order and discipline to their financial markets, the various financial regulatory agencies worked very closely with the Department of Justice, investigating cases in tandem, and shar-ing the evidence so that criminal charges could be brought in step with regulatory wrongdoing.

Yes, it would be nice if we could think that the financial sector was a well-ordered, good-mannered, lawful, transparent and ethical environment, peopled by men and women who paid more than just lip-service to the concepts of integrity and honour. But alas, it isn’t and that is all there is to it! These employees get paid big money to take the big risks, including the risk of getting caught. They are there to insulate their execu-tives and main board directors from direct involvement in the crimes they commit, so that the upper echelons in the manage-ment food chain can always claim they were unaware what was going on when rampant wrong-doing is uncovered.

Deaf, dumb and blind They will always benefit from the outcome of the criminal conduct, but as long as they do not need to be dragged into the day-to-day debate, they can continue to oper-ate on the basis that they were deaf, dumb and blind to what was happening on the floors below. We cannot whinge and whine for something we shall never see, and we should not be surprised when the inhabit-ants of the Square Mile behave in the way we all know they will. If they commit crimes of every financial kind, which they do, then we only have ourselves to blame for allow-ing them to do so.

So we have to recognise them for the kind of animal they are, which is potential organised criminals, because the other les-son of overriding importance that I learned was that the only thing that financial ser-vices practitioners fear is being prosecuted for criminal offences. If they are convicted, then that is the end of their careers, it is the


one-way street to the door marked ‘Exit’, and it means ejection into social and commercial outer darkness.

‘Good Chaps’ syndromeIt is the only way, and I mean the ‘only’ way to regulate financial practitioners, to instil in them such a fear of committing a crime, which they know will be prosecuted, that they will toe the line. It is a draconian, uncompromising penalty, but it works, and that is what I cannot seem to get into the mind-set of the British regulatory galère, who are all imbued with the ‘Good Chaps’ syndrome and oozing with the desire to soft-pedal on the wrong-doings of those whom they regulate.

People who work in the banking and finance industry have one ambition in mind and that is to make as much money for themselves as they possibly can in the most unreasonably short space of time - an issue the eminent economist Jeffrey Sachs has now formally recognised as afflicting much of Wall Street. Therefore, to assume that they will want to do this ethically, honestly, rea-sonably, transparently or honourably, is to ignore all the evidence to the contrary.

Capacity too ireLike the SEC do, they must be assumed to have the capacity to behave like criminals, and the regulatory regime must be geared towards that end-game. You don’t regulate these people by doing nice, you find out what they are doing through intelligence-led detection; you focus on the weak links and turn them; you get the evidence against the top players, and you go in hard and bring them down. It isn’t pretty, it isn’t nice, and it

takes a special kind of professional to carry it out, former properly trained detectives, and Customs and Revenue investigators. All the while we employ these charming young commercial solicitors, chartered accountants, ex-DTI staffers and former financial services sales people in these roles, we are never going to be able to prosecute, never mind gain a successful criminal verdict.

The young regulators who worked at the SEC, and particularly in the Enforcement Division were young, dynamic criminal law-yers, yes, criminal lawyers, who had a good understanding of how regulatory law and criminal law interlinked. They had careers to build, and they wanted to go after the big-gest targets they could and bring them down hard, so there was no shirking of duties, and being nice to the regulated sector. Above all, there was no regulatory capture obvious in their relationships.

Undo influenceRegulatory capture is what happens when regulated industries are able to gain influ-ence over their regulator, so that regulation that ostensibly serves the public interest actually supports the interest of the industry concerned. A summation of this modern day phenomena is detailed on the UK-based website Moneyterms, which states:

“...Some economists argue that regula-tory capture is inevitable, most that it is a significant risk. It occurs because those who are regulated have a high stake in influencing regulation to favour them. Each firm’s profits are heavily influenced by regulation, so they will each put a lot of effort into influencing the regulator, whereas few individual consumers will have a sufficiently large stake to expend


much effort. Another advantage that the regu-lated industry has over consumers, and often over the regulator, is expert knowledge of the industry. This allows the industry to marshal the facts and arguments needed to influence the regulator, far more easily than consumers, and often more easily than regulators.

Conflicts of interest among individuals who run the regulator may also lead to regu-latory capture. It is not uncommon for people to move between working for the regulator and working for the industry: for example working for a financial regulator and then in a compliance role in a bank....”

Carrying a candleLet us consider the case of Hector Sants, the former chief executive of the Financial Services Authority and present executive board member of Barclays Bank, if we need any more proof of the accuracy of this last assertion. Now, I am not saying that Mr. Sants was carrying a candle for Barclays Bank while he was a regulator and was responsible for ensuring that their regulated activity was all it should be. I am advised by friends of mine who worked at Barclays under the benign regime of Roberto ‘The Don’ Diamante, that they were regularly getting hauled in to account for their actions of which the FSA did not approve. They turned up and got their wrists slapped, but nothing ever happened to them. So, what can you say?

Damning reportIt transpires, the UK Parliament’s Treasury Select Committee has said a great deal about the way in which the now defunct Financial Services Agency had handled their role, and

much of what they have had to say has not been pleasant. You have to understand the way in which Government agencies speak publicly about other agencies within their ambit. The normal practice is not to be seen, publicly, to be disparaging of the other’s actions. Carefully worded phrases are usu-ally adopted, which contain vague allusions, recognisable to those familiar with the argot, and which indicate a sense of displeas-ure. It is unusual for a Government agency like the Treasury sub-committee to be very outspoken.

In October 2012, the Treasury Select Committee published a devastating critique entitled: The FSA’s Report into the failure of RBS, which identified serious concerns over the FSA’s oversight of the Royal Bank of Scotland (RBS). The MPs on the committee were unimpressed, concluding that the FSA could and should have intervened in the bank’s takeover of ABN Amro. Its members believe the regulator should have stopped the takeover, and they criticise the FSA for failing to investigate the failure.

Public explanationThe report further states that:

“In December 2010 the FSA initially felt that a 298-word statement about RBS’s fail-ure was explanation enough. This reflects serious flaws in the culture and governance of the regulator. It also reflects a fundamental misunderstanding of its duty to account for its actions to the public and Parliament.

In view of the vast amounts of public money committed to propping up RBS, Lord Turner’s comment that a Report into the demise of RBS “would add little, if anything, to our understanding of what went wrong”


was inadequate. He should have grasped the need for a public explanation of how that situation had arisen, something which he has subsequently acknowledged. We would not expect the new chairmen of the regulators to repeat the error.”

Serious indictmentThe Committee’s report says the FSA’s own report, which describes “failures and inad-equacies in the regulation and supervision of capital, liquidity, asset quality and a failure to appropriately analyse the risks relating to the ABN Amro acquisition’ is a serious indict-ment of ‘both the senior management and leadership... in place at the time”. The FSA report, it adds, not only highlights the over-sight of the Chairman and Chief Executive, but also their predecessors, “regardless of the prevailing assumptions and political pressures”.

New role and dutiesThe Treasury Select Committee has made its displeasure about the FSA felt further in a report published this January titled: Appointment of John Griffith-Jones as Chair-designate of the Financial Conduct Authority. In this, the Treasury Committee’s Sixth Report, the members define clearly the intended new role and duties of Griffiths-Jones in the following statement:

“...He must restore the credibility of the conduct regulator. The FCA is the successor to a body which, failed consumers. Although it devoted a great deal of time and effort to con-duct matters, it left consumers exposed to some of the worst scandals in UK financial history.”

The report goes on to describe the crea-tion of a ‘box-ticking’ culture, “whose benefits

were far from evident and which still failed to pick up major failures in the making”, call-ing for Mr. Griffith-Jones and his board to ensure that the new organisation adopts a “radically different approach”, in the follow-ing statement:

“We note that the PRA, which has assumed responsibility for most prudential aspects of the FSA’s work, has done this, with its adoption of a move to judgement-based regulation.

The board of the FSA also appeared to fail in its oversight of the work of the Authority. He and his new board colleagues will need to demonstrate stronger strategic leadership than their FSA predecessors...”

Evidently, it is clear to see that the Committee have serious reservations over the stewardship of the FSA and its ability to act as an independent arbiter in the lead up to the bank bailouts of 2007/08. Subsequent regulatory mishaps under the FSA’s then leadership, most notably, the Libor scandal and money laundering activities of HSBC and Standard Chartered Bank are also brought into question.

Indeed, Michelle McGagh of the UK-online news publication, Citywire, in a hard-hitting editorial, enquires: “Should the financial regulator be fined for its mis-takes...?” Alas, it is not to be, for despite the stinging rebukes by a Parliamentary watch-dog, Mr. Sants, for all his efforts, or lack thereof, has not only received a Knighthood courtesy of the UK government and the Queen for his somewhat vacuous services, but also walks into a well-remunerated position with one of the banks he was sup-posedly regulating at the Financial Services Authority. •


Book review

Of Bulls and Bair: Fighting to save Main Street from Wall St.

Barnard College Professor Rajiv Sethi applauds Sheila Bair’s account of her time

at the FDIC during a period of crisis.

Sheila Bair’s new book, Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself, is both a crisis narrative and a thought-ful reflection on economic institutions and policy. The crisis narrative, with its revealing first-hand accounts of high-level meetings, high-stakes negotiations, behind-the-scenes jockeying, and clash-ing personalities will attract the most immediate attention. But it’s the eco-nomic analysis that will constitute the more enduring contribution.

Among the many highlights are the follow-ing: a discussion of the linkages between securitisation, credit derivatives and loan modifications, an exploration of the trade-off between regulatory capture and regulatory arbitrage, an intriguing question about the optimal timing of auctions for failing banks, a proposal for ending too big to fail that relies on simplification and asset segregation rather than balance sheet contraction, a full-throated defence of sensible financial regu-lation, and a passionate critique of bailouts for the powerful and politically connected

even when such transactions appear to gen-erate an accounting profit.

Conflict of interestLet’s start with securitisation, derivatives and loan modifications. Under the traditional model of mortgage lending, there are strong incentives for creditors to modify delinquent loans if the costs of doing so are lower than the very substantial deadweight losses that result from foreclosure. But pooling and tranching of mortgage loans creates a con-flict of interest within the group of investors.

As long as foreclosures are not wide-spread enough to affect holders of the over-collateralised senior tranches, all losses are inflicted upon those with junior claims. In contrast, loan modifications lower payments to all tranches, and will thus be resisted by holders of senior claims unless they truly see disaster looming. One consequence of this “tranche warfare” is that servicers, fearing lawsuits, will be inclined to favour foreclo-sure over modification.

But this is not the end of the story. Bair points out that the interests of those using credit derivatives to bet on declines in home


values are aligned with those of holders of senior tranches, as long as the latter continue to believe that foreclosures will not become widespread enough to eat into their pro-tected positions.

This is interesting because these two groups are taking quite different price views: one is long and the other short credit risk. Bair notes that some of the “early resist-ance” to the Financial Deposit Insurance Corporation’s (FDIC) loan modification ini-tiatives came from fund managers who “had purchased credit default swaps protection against losses on mortgage-backed securi-ties they did not own. The irony is that they were joined in this resistance by holders of senior tranches who were relying on the protective buffer provided by the holders of junior claims.

Divided investor interestsThis protective buffer turned out to be insuf-ficiently thick. Vigorous opposition to loan modifications amplified the decline in home values and ended up hurting even hold-ers of the most senior claims. The process of eviction is costly and time consuming for creditors, and debtors have no incentive to maintain properties that they are on the verge of losing. Once the costs of repair and reselling are taken into account, recovery on subprime foreclosures can be as little as a quarter of the outstanding loan amount. Some of these losses could have been avoided if the interests of different groups of investors had not been so divided.

Another interesting discussion in the book concerns the trade-off between regula-tory arbitrage and regulatory capture. A frag-mented regulatory structure with a variety of

norms and standards encourages financial institutions to shop for the weakest regulator. In the lead up to the crisis, such regulatory shopping occurred between banks and non-banks, with mortgage brokers and securities firms operating outside the stronger regula-tions imposed on insured banks.

Diversity of viewsBut Bair also notes that the “three biggest problem institutions among insured banks - Citigroup, Wachovia, and Washington Mutual - had not shopped for charters; they had been with the same regulator for dec-ades. The problem was that their regulators did not have independence from them.” This illustrates the problem of regulatory capture.

Bair argues that while a single mono-lithic regulator would put an end to regula-tory arbitrage, it could worsen the problem of regulatory capture: “A diversity of views and the ability of one agency to look over the shoulder of another is a good check against regulators becoming too close to the entities they regulate.” It’s a point that she has made before, and clearly believes (with consider-able justification) that the FDIC has provided such checks and balances in the past. It was able to do so in part through its power under the law and in part through the power to persuade.

Favoured policyA very different kind of trade-off concerns the timing of auctions for failing banks. One of the policies that Bair favoured at the FDIC was the quick sale of failing banks prior to closure in order to avoid a period of govern-ment stewardship. She recognises, however, that there are some costs to this.


Bids from prospective buyers who have not had time to closely examine the asset pool of the failing institution will tend to be lower than the expected value of these assets, given the need to maintain adequate margins of safety in the face of risk. Waiting until a more precise estimate of the value of the bank’s assets can be obtained can there-fore result in higher bids on average.

But there are also costs to waiting: a “deterioration of franchise value” occurs as large depositors and business customers look elsewhere, and this can offset any gains from a more precise valuation of the asset pool. Bair seems to have concluded that sale before closure was always the best course of action, but I suspect that this need not be the case, especially when the asset pool is char-acterised by high expected value but great uncertainty, and the bulk of deposits are insured. In any case, it’s a question deserving of systematic study.

Political preferenceBair describes herself as a lifelong Republican and was a McCain voter before the 2008 U.S. Presidential election. Yet she seems quite immune to partisan loyalties and pressures. Her description of Barney Frank is positively affectionate. She has kind words for some Democrats (such as Elizabeth Warren and Mark Warner), but offers blistering criticism of others (Robert Rubin, Tim Geithner and Larry Summers in particular).

Among Republicans too, she is discern-ing: Bob Corker’s efforts on financial reform are lauded, but the “deregulatory dogma” overseen by Alan Greenspan comes under forceful attack. She laments the “disdain” for government and its “regulatory function”

and describes as a “delusion” the idea that markets are self-regulating. These are clearly not the views of a political partisan.

Opposition to derivativesOn policy, Bair is opposed to the use of deriv-atives for two-sided speculation (when nei-ther party is hedging) and would require an insurable interest for the purchase of protec-tion against default. She describes synthetic collateralised debt obligations and naked credit default swaps as “a game of fantasy football,” with no limit to the size of wagers that can be placed.

She calls for a “lifetime ban on regulators working for financial institutions they have regulated.” And she argues, as did James Tobin a generation ago, that the attraction of the financial sector for some of the best and brightest of our youth is detrimental to long term economic growth and prosperity.

No review of this book would be com-plete without mention of the bailouts, which troubled Bair from the outset, and which she now feels were excessive:

“To this day, I wonder if we overreacted... Yes, action had to be taken, but the generos-ity of the response still troubles me... Granted, we were dealing with an emergency and had to act quickly. And the actions did stave off a broader financial crisis. But the unfairness of it and the lack of hard analysis showing the necessity of it trouble me to this day. The mere fact that a bunch of large financial institu-tions is going to lose money does not a sys-temic event make... Throughout the crisis and its aftermath, the smaller banks - which didn’t benefit at all from government largesse - did a much better job of lending than the big insti-tutions did.”


What bothers her most of all is the claim that the bailouts were justified because they made an accounting profit:

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

Instinctively repugnantThe ideal policy, according to Bair, would have been to put insolvent institutions into the “bankruptcy-like resolution process” used routinely by the FDIC, but she recog-nises that the legal basis for doing so was not available at the time. She therefore signed on to measures that were instinctively repug-nant to her, and tried to corral and contain them to the largest extent possible.

The argument that the bailouts “made money” is specious for two reasons. First, the funds provided were given well below mar-ket value, and the cost to taxpayers should be computed relative to the value of the service provided. If insurance is provided at a frac-tion of the actuarially fair price, and no claim is made over the period of insurance (so the

insurer makes money), this does not mean that there was no subsidy in the first place.

Furthermore, the cost to taxpayers should take into account any loss of revenues from more sluggish growth. If Bair is right to argue that the bailouts were excessively generous, to the point that growth prospects were damaged for an extended period, the loss of tax revenue must be included in any assess-ment of the cost of the bailout.As noted previously, there are many accounts in the book of meetings and decisions, and a number of speculative inferences about the actions and intentions of others. Some of these will be hotly disputed. But focusing on these details is to miss the larger point.

The crisis offers us an opportunity to think about the flaws in our economic and political system and how some of these might be fixed. It also suggests interest-ing directions in which economic theoris-ing could be advanced. The book helps with both efforts, and it would be a great pity if these substantive contributions were drowned out in a debate over conversations and personalities. •

Editors note: The publisher and editor of the Journal would like to thank Prof. Rajiv Sethi for allowing us to publish an amended version of this book review which first appeared on the authors blog in late 2012. Prof. Sethi’s original review can be accessed at the following address: http://rajivsethi.blogspot.com. We would also like to remind readers that Bull by the Horns - published by the Free Press - is now available to purchase from bookshops across much of the Asia Pacific region in both hardback and paper-back copies.


Book review

The Money Trap: Escaping the Grip of Global Finance

Judy Shelton of the Atlas Economic Research Foundation lauds Robert Pringle’s

call to reform the global monetary system.

To read Robert Pringle’s new book, The Money Trap, is to experience the slow joy of recognising that someone out there in the world of intellectual propriety and academic correctness is willing to state the case that the global financial crisis can be traced in large part to the lack of an orderly international monetary system.

Pringle has done a great service in bring-ing to the debate over the causes of what is now called: “the worst recession since the Great Depression” the notion that the global exchange rate regime matters; we can-not ignore the damaging impact of chaotic exchange rates among leading currencies if we are to identify what brought on the financial meltdown that has since devas-tated real economies around the world.

But even more important, Pringle’s care-ful analysis and assiduous tracing of events leading to the crisis provide the reader with a template for evaluating potential paths to meaningful international monetary reform. In this, he has done a service to mankind – for as Pringle notes repeatedly throughout this work, the achievement of monetary and

financial stability should be pursued as a “global public good.”

It is important to note the unique creden-tials of the author – unique in that one would not normally expect the chairman of Central Banking Publications and the founder of the Central Banking Journal to be making the argument that fundamental reform of inter-national monetary arrangements is needed.

A stinging critiquePringle occupies a prestigious position among those who closely follow develop-ments affecting international money and capital markets, having served in a senior capacity at The Economist and The Banker (as editor) as well as becoming first executive director of the Group of 30, an influential think tank.

His experience in advising leading com-mercial banks and governments on eco-nomic policy issues has brought him into the highest circles of high finance. One wonders whether Pringle will find himself less welcome at the same watering holes as a result of delivering this stinging critique of status quo global monetary and financial


arrangements. Not that he is totally alone in advancing such doubts about the wisdom of our current monetary non-system.

More radical reformA special bonus contained in The Money Trap is the foreword written by Robert Skidelsky – yes, Lord Skidelsky, the eminent biographer of economist John Maynard Keynes – who sets the tone for the book from the outset with his declaration that: “this seemingly never-ending crisis demands a more radical reform of the world monetary and bank-ing systems than anything yet attempted or even imagined by governments.”

Most people consider Keynes as having been the ultimate promoter of economic “stimulus” programmes through govern-ment intervention, both fiscal and mon-etary. Yet it was also Keynes who wrote, in his 1923 work, A Tract on Monetary Reform, that, “what is raised by printing notes is just as much taken from the public as is a beer-duty or an income-tax.” And it was Keynes, too, who noted in the same publication: “The metal gold might not possess all the theo-retical advantages of an artificially regulated standard, but it could not be tampered with and had proved reliable in practice.”

Daring actThe very mention of “gold” and “standard” within the context of a contemporary book addressing the foibles of a global monetary and financial system that has no interna-tional standard – no unit of account to serve as a benchmark for economic value – would be a daring act indeed. But Pringle comes close with his acknowledgment that at the centre of fundamental reform “should be the

construction of a credible world monetary standard.”

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

Tyranny of floating ratesBut one discerns a more than nostalgic appreciation for the views of French econo-mist Jacques Rueff, who championed the classical gold standard in the last century as the key to maintaining a broad liberal order based on democratic values, social cohesion, and the economic welfare of citizens.

Rueff believed floating exchange rates were anathema to monetary discipline; such a lawless regime would encourage protec-tionism and an uncertain trade and invest-ment climate, ultimately leading to recession and unemployment. “If I defended tirelessly for half a century the principle of monetary convertibility,” Rueff is quoted, “it is not by any attachment to an orthodoxy that, in money matters, would make no sense, but because I love liberty and because I am con-vinced it is not a free gift.”

Pringle clearly recognises that the prob-lems caused by the global financial crisis are, to an alarming degree, fulfilling Rueff’s dire prophecy. In Pringle’s view, it makes


no sense to separate the topic of monetary reform from an analysis of banking, finance, and financial markets; they must all be inte-grated if we are to break out of “the money trap” that now threatens economic and political stability around the world.

International currencyPringle considers it a grave sin of omission that a whole generation of economists has failed to build an environment of rules-based monetary relations, or create an inter-national currency, to preserve the benefits of free trade and enhance the productive flow of financial capital.

Instead, in the wake of economic collapse, governments are all too eager to embrace a “back to business as usual” approach that neglects to address the underlying cause of the global financial crisis, namely: the lack of a coherent monetary system. Central banks have been complicit in this derelic-tion of duty, likewise failing to propose radi-cal changes to the existing non-system of exchange rates among currencies.

Boom-and-bustIf we do not create a new monetary regime as a mechanism to hold central banks account-able for maintaining a standard – if we do not “enshrine society’s long-term interest in sound money,” as Pringle states – the world is destined to fall back into another disas-trous boom-and-bust cycle facilitated by overly accommodative monetary policy and exacerbated by the banking and financial industry’s pursuit of profits through arbitrag-ing differential interest rates among major central banks.

It’s a frightening scenario, and one that

comports with my own fears. The next money meltdown is likely to unleash anti-government and anti-banking social pro-tests that will make the “occupy Wall Street” movement appear rather quaint.

How can we avoid such a calamitous future? Herein lies the essential value of Pringle’s book. He dares to explore poten-tial ways to escape “the money trap” – to transcend monetary nationalism in favour of building a truly international monetary order based on a common standard of value. “Let us start by looking at what might be the ideal features of a currency standard,” Pringle suggests, “and then see how close the world could get to such an idea.” He continues:

“It should mimic the classical gold stand-ard in enabling monetary, commercial and economic unification to take place without requiring political integration. It should rest on consent. The supranational element should be kept to a minimum; certainly it should be able to function without a world government or central bank. Countries should be free to remain fully sovereign if they wished, while also being able to share or pool sovereignty through various political institutions as they saw fit. Thus they should be able to opt out of the world currency standard, just as they could (and did) suspend the gold standard in emergencies, though the attractions and pres-tige of being a full member of the club would mean that few would wish to do so (few, if any, countries ever left the gold standard voluntarily, before its collapse in the 1930s). At the international as at the national lev-els, peoples would embrace order to increase practical liberty. It would be a rule of laws and norms rather than of men.”


Pringle has given us a beautiful state-ment of purpose juxtaposed against a back-ground of current failings. For those who have long sensed that the global crash and its damaging effects on the real economy are strongly linked to our dysfunctional mon-etary regime, it will be a most gratifying read.

Four key issuesThe Money Trap provides a superb explana-tion of how we got in this mess (Part I); what we need to understand in order to properly evaluate various potential approaches to finding our way out (Part II); the four key issues that will drive the discussion on future monetary reform (Part III); and how we can apply the genius of past great economic thinkers – from Fisher through Keynes, Rueff to Hayek and Triffin – toward the goal of profoundly changing existing mon-etary arrangements (Part IV). Contemporary economists are invoked as well, with the author’s assessment of different proposals.

Readers will find themselves brought quickly up to speed on recent developments and innovative ideas; they may also be quite intrigued with Pringle’s concept for defining the currency unit as a fraction of the total of tradable equity claims on real assets in the global economy.

Wisdom of BuchananCiting the wisdom of James Buchanan, the Nobel Prize-winning economist and a founder of the public choice school, who has noted that “the market will not work effectively with monetary anarchy,” Pringle concludes The Money Trap with his per-sonal observations on how we can realisti-cally make the leap to a new monetary order

in tandem with his own thoughts on the emerging global financial system.

He stresses the need to bind banking to the real economy and to reduce the ability of the financial industry to exploit its power over regulatory authorities. Pringle also emphasises the importance of turning away from using mountains of foreign reserves as a cushion against future currency shocks, a practice he finds irrational. And he criticises the euro-dollar seesaw, which punishes all those countries that are fixed to either cur-rency, yet trade with both the dollar and euro regions.

Urges a voluntary systemFinally, Pringle adjures the world to put into place a wholly voluntary system wherein the supply of money would be self-regulating. “Such a monetary standard,” he writes, “could be developed using the technol-ogy available as a result of the progressive globalisation of capital markets.” As Pringle elaborates:

“The key step is for major governments to agree not on a common currency but on a common monetary unit of account in which citizens can have confidence. Further steps would be needed to realise the potential of such a reform, but it would open up the pros-pect of bringing the public good of interna-tional monetary stability back to the world economy for the first time in 100 years.”•

Editors note: The publisher and editor would like to thank Ms. Sheldon and the Cato Institute for allowing the Journal to publish an abridged version of this review. Further details on Mr. Pringle can be found at: www.themoneytrap.com


Comment

Cyprus solution will exacerbate the European debt crisis

Irrespective of the fate of Cyprus, the way the problem was solved sets a very

dangerous precedent opines Satyajit Das.

Financial markets have taken cyprus in their stride. But it is important not to underestimate the potential fallout. The impact of relatively small events is unpredictable. The 1931 collapse of the small austrian bank creditanstalt pre-cipitated a major financial panic. Today, one the smallest countries in Europe, with little over one million people repre-senting some 0.2 per cent of the European Union’s combined population and gross domestic product, economically speak-ing, cyprus, may prove a key inflection point in the Euro debt crisis.

The well anticipated European Union (EU)bailout package announced in the middle of March included the controversial provi-sion that ordinary depositors pay a “tax” or “solidarity levy” on Cypriot bank deposits, amounting to a permanent write down in the nominal value of their deposits. The deposit levy was 6.75 per cent on depos-its of less than Euro 100,000 (the ceiling for European Union account insurance) and 9.9 per cent for all deposits above that threshold.

Initially, the Cypriots had pressed for a

Euro 17 billion-rescue package. However, the unprecedented write down of bank deposits was designed to raise around Euro 5.8 billion to reduce the size of the required bailout package to Euro 10 billion, consistent with the requirements of the International Monetary Fund (IMF) and Eurozone mem-bers like Germany. It was also designed to avoid losses to the European Central Bank (ECB) which has major exposures to Cypriot banks via its Emergency Lending Assistance (ELA) Program, estimated at as much as Euro 10 billion.

Other sources of fundingEconomist and commentator Karl Whelan, writing in Forbes magazine, memorably described the EU proposal to allocate part of the burden to depositors as “a stupid idea whose time had come”.

The parliament in Cyprus failed to pass the necessary enabling legislation, instead exploring alternative strategies including confiscation of pensions, additional taxes, and other sources of funding. Unsuccessful discussions were held with Russia for a financing package to secure Cyprus’ position


and protect the interests of the Russian state, its citizens, and banks who have substantial exposures within the small island nation. With no other source of funding avail-able and the ECB threatening withdrawal of emergency funding, Cyprus faced default and rapid economic collapse.

Under duress, the Cypriot government agreed an amended plan on March 25, 2013. Whilst maintaining most of the original elements, the plan appears to amend the deposit levy, with “small” depositors (below Euro 100,000) being protected and exempt from the levy.

Good bank bad bankAs a result a major restructuring of the two largest banks will take place. The troubled Laiki Bank will be divided into a good bank (including small depositors and emergency ECB funding) to be absorbed into the Bank of Cyprus and a bad bank, which will be liq-uidated over time. Shareholders, bondhold-ers, and ultimately larger depositors in Laiki Bank will be forced to absorb losses, the size of which is uncertain. There are some sug-gestions that losses may be capped at 40 per cent. Shareholders, bondholders, and large depositors in Bank of Cyprus will then be written down so that the bank achieves a capital ratio of nine per cent.

Other measures include “temporary, proportionate and non-discriminatory” capi-tal controls to prevent funds being taken out of Cyprus. There will also be a reduction in the size of Cyprus’ financial sector to the EU average by 2018.

Two aspects of the agreed package are noteworthy: the bailout package (Euro 10 billion) cannot be used to re-capitalise banks,

which limits its utility. Second, the plan does not need Cypriot parliamentary approval as it is no longer a “tax.” The transfer of losses on large depositors will take place under recently adopted bank restructuring laws passed at Brussels’ insistence.

The measures stave off the risk of imme-diate collapse and Cyprus having to leave the Euro. But the plan does not address Cyprus’ problem. As in Greece and Portugal, privatisation proceeds and the revenue from increased taxes may not reach targets.

The bank-restructuring plan may not raise sufficient funds. It is likely to encour-age remaining deposits to flee Cyprus when capital controls are eased, compounding the problems. As with Greece, there is a risk that Cyprus will need additional assistance, entailing further write-offs in a depositor’s fund.

The proposed restructuring effectively cripples the Cypriot banking industry, which is a major part of the economy and employs over 50 per cent of workers. The transfer of losses to depositors and imposition of capital controls make it highly likely that activity will shift to other locations.

Dangerous precedentRussian businesses are unlikely to continue to patronise Cyprus. Press reports quoted one Russian business man’s wry observation that the EU had killed Cyprus in one day: “When the Russians leave who is going to stay at the Four Seasons for US$500 a night? Angela Merkel?”

Economic activity in Cyprus is expected to contract by between 15-25 per cent over the next few years. Unemployment will also rise. The slowdown will reduce the Cypriots


capacity to pay back its international credi-tors. Irrespective of the fate of Cyprus, the solution adopted will exacerbate the European debt crisis.

Firstly, the transfer of losses to depositors creates a dangerous precedent. In 147 bank-ing crises since 1970 tracked by the IMF, no depositors, irrespective of the amounts held and the banks with whom the deposits were placed, suffered losses.

Capital flightDepositors in weak banks in weak coun-tries now may consider the risk of loss or confiscation. This may trigger capital flight from banks in Greece, Portugal, Ireland, Italy and Spain. If depositors withdraw funds in significant size and capital flight accelerates, then the ECB, national central banks and governments will have to intervene, fund-ing affected banks and potentially restricting withdrawals, electronic funds transfers and imposing cross-border capital controls.

Bank runs and capital flights are difficult to control once they commence. As outgoing Bank of England Governor Sir Mervyn King argued, it was not rational to start a bank run but rational to participate in one under way.

Secondly, the Cyprus bail-in provi-sion will make it increasingly difficult for European banks, especially in vulnerable countries, to raise new deposits or issue bonds. The ECB, national central banks, and governments will have to cover any funding shortfalls.

Thirdly, the Cyprus arrangements under-mine the credibility of the ECB and EU and measures announced last year to combat the crisis, which have underpinned the recent relative stability.

The ECB’s OMT (Outright Monetary Transactions) facility allows it to purchase sovereign bonds to assist nations to finance and lower their cost of borrowing. The facil-ity, which has not yet been used, requires the affected country to apply for assistance. After Cyprus, it will be politically difficult for coun-tries like Italy and Spain to ask for assistance if required, knowing that if a future debt restructuring is necessary then domestic tax-payers face a loss on their bank deposits.

Cyprus highlights the shortcomings of the EU’s much vaunted “banking union.” The arrangements did not provide sufficient funds to undertake any required re-capitali-sation of banks, an alternative to the levy on deposits. Cyprus also highlights the lack of a Eurozone-wide consistent deposit protec-tion scheme, backed by EU funds.

Popular resistanceFourthly, the Cyprus package highlights the increasing reluctance of countries like Germany, Finland, and the Netherlands as well as the IMF to support weaker Eurozone members. Domestic political consideration and popular resistance to commitment of further taxpayer funds to such bailouts make such assistance increasingly problematic.

Fifthly, the negotiations surrounding the Cyprus bailout revealed policy-maker’s lack of understanding of the problems and the effects of policies. It also revealed significant differences between Eurozone members and also between Europe and the IMF.

Sixthly, by agreeing to potentially indefi-nite capital controls the EU has effectively created a two-tier euro, undermining the single currency in the long term.

The problems in Europe will affect the


U.S. in many ways. Europe is America’s larg-est trading partner and the slowdown in economic activity will not only affect exports but also American businesses operating in Europe. Second order effects will include the effects on China and other emerging mar-kets which trade with Europe, which will flow on to U.S. businesses.

A second channel of transmission will be the currency markets. The weak U.S. dol-lar has assisted the U.S. economy. Concern about the European real economy and also the debt crisis will put upward pressure on the dollar, which will no doubt reduce American export competitiveness.

A final channel of transmission will be the banking system. Problems in European banks, including funding difficulties, will flow through into large U.S. money centre banks, which in turn will pass them on to smaller banks and the U.S. financial system.

In any debt crisis, there are several

possible methods of allocating losses. The borrower bears the losses, either through austerity or bankruptcy. The lenders bear the losses. Some rich relative (in Europe, read Germany) bails out the indebted borrower. Another option is to just ignore such issues, fudge the numbers, and hope that fortunate events will remedy the problems. Europe has now tried all of the above. Unfortunately, in each attempt at resolution, as shown by the proposed Cyprus package, the measures have become the problem rather than the solution, and alas, in the future, Europe’s problems will not be confined to Europe. •

Editors note: The publisher and editor would like to extend their thanks to Satyajit Das for allowing the Journal to publish an amended version of this paper. We also wish to remind our readers that copyright for this particular article remains the sole preserve of Satyajit Das.

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ContactChristopher RogersEditor in chief [email protected]

Articles & PapersIssues in resolving systemically important financial institutions Dr Eric S. RosengrenResecuritisation in banking: major challenges ahead

Dr Fang DuA framework for funding liquidity in times of financial crisis

Dr Ulrich BindseilHousing, monetary and fiscal policies: from bad to worst

Stephan Schoess,Derivatives: from disaster to re-regulation

Professor Lynn A. Stout Black swans, market crises and risk: the human perspective

Joseph RizziMeasuring & managing risk for innovative financial instruments Dr Stuart M. Turnbull Red star spangled banner: root causes of the financial crisis Andreas Kern & Christian FahrholzThe ‘family’ risk: a cause for concern among Asian investors

David SmithGlobal financial change impacts compliance and risk

David DekkerThe scramble is on to tackle bribery and corruption

Penelope Tham & Gerald LiWho exactly is subject to the Foreign Corrupt Practices Act?

Tham Yuet-MingFinancial markets remuneration reform: one step forward Umesh Kumar & Kevin MarrOf ‘Black Swans’, stress tests & optimised risk management

David SamuelsChallenging the value of enterprise risk management

Tim Pagett & Ranjit JaswalRocky road ahead for global accountancy convergence

Dr Philip GoethThe Asian regulatory Rubik’s Cube

Alan Ewins and Angus Ross


Volume I, Issue III, Autumn Winter 2009-2010

Journal of Regulation & Risk North Asia

147

Legal & Compliance

Who exactly is subject to the

Foreign Corrupt Practices Act?

In this paper, Tham Yuet-Ming, DLA

Piper Hong Kong consultant, examines the

pernicious effects of the FCPA in Asia.

The US Foreign Corrupt Practices

Act (FCPA), has its beginnings in the

Watergate era, when the Watergate Special

Prosecutor called for voluntary disclo-

sures from companies that had made

questionable contributions to Richard

Nixon’s 1972 presidential campaign.

However, these disclosures revealed

not just questionable domestic payments

but illicit funds that had been channelled

to foreign governments to obtain business.

The information led to subsequent investi-

gations by the US Securities and Exchange

Commission (SEC) which revealed that

many US issuers kept “slush funds” to

pay bribes to foreign officials and political

parties. The SEC later came up with a voluntary

disclosure programme under which any cor-

poration which self-reported illicit payments

and co-operated with the SEC was given

an informal assurance that it would likely

be safe from enforcement action. The result

was the disclosure that more than USD$300

million in questionable payments (a mas-

sive amount in the 1970s) had been made

by hundreds of companies – many of which

were Fortune 500 companies. The US legis-

lature responded to these scandals by even-

tually enacting the FCPA in 1977.

There are two main provisions to the

FCPA – the anti-bribery provisions, and the

accounting provisions. Both the SEC and the

US Department of Justice (DOJ) have juris-

diction over the FCPA. Generally, the SEC

prosecutes the accounting provisions and

the anti-bribery provisions as against issuers

through civil and administrative proceedings

whereas the DOJ prosecutes companies and

individuals for the anti-bribery provisions

through criminal proceedings.

The anti-bribery provision

The FCPA’s anti-bribery provision makes it

illegal to offer or provide money or anything

of value to foreign officials (“foreign” mean-

ing “non-US”) with the intent to obtain or

retain business, or for directing business to

any person.

Anything of value can include sponsor-

ship for travel and education, use of a holi-

day home, promise of future employment,

discounts, drinks and meals. There is no


163

Risk management

Of ‘Black Swans’, stress tests & optimised risk management Standard & Poor’s David Samuels outlines the positive benefits of bank stress testing on the bottom line.It is a big challenge for banks to build

a robust approach to managing the risk of worst-case stress scenarios that, almost by definition, are triggered by apparently unlikely or unprecedented events.

However, solving the problem of identi-fying the risk concentrations and dependen-cies that give rise to worst-case outcomes is vital if the industry is to thrive – and if indi-vidual banks are to turn the lessons of the past two years to competitive advantage. Banks that tackle the issue head-on will

be lauded by investors and regulators in the coming years of industry recuperation and, most importantly, will be able to deliver sus-tained profitability gains. Meanwhile, banks that are well placed to take advantage of the consolidation process need to be sure they can understand the risks embedded in the portfolios of potential acquisitions. To improve enterprise risk management

and strengthen investor confidence, we think banks can take the lead in three related areas:

Better board and senior executive over-sight and control of enterprise risk man-agement; re-invigorated stress testing and

downturn capital adequacy programs to uncover risk concentrations and risk depend-encies, and; applying these improvements to drive business selection – for example, through performance analysis and risk-adjusted pricing that takes stress test results into account.

Top-level oversightBuilding a more robust and comprehensive process for uncovering threats to the enter-prise is clearly, in part, a corporate govern-ance challenge. The board and top executives must have the motivation and the clout to scrutinise and call a halt to apparently profit-able activities if these are not in the longer-term interests of the enterprise or do not fit the intended risk profile of the organisation.

But contrary to popular opinion, improv-ing corporate governance is not just a ques-tion of putting the ‘right’ executives and board members in place and giving them appropriate incentives. For the bank to make the right deci-

sions when they are difficult, e.g. when business growth looks good in the upturn, or when risk management looks expensive


Comment

Bank Operational Risk: Always a bridesmaid, never a bride!

MRV Associates’ Mayra RodríguezValladares laments lack of global attention

paid to operational risk management

BANKS and the financial regulatory world have changed dramatically since the turn of the millennium and since I started consulting and training on global financial regulations more than a decade ago. Nowhere is this more apparent than with the Basel Accords uniform, inter-national capital standards for banks. Unfortunately, and despite all the Basel Committee’s good intentions, the neglect of operational risk remains the same today as it did on January 1, 2000.

Credit risk may best be equated to the bride at her wedding, upon whom all eyes are fixed. And while one might argue that in the mid-2000s the bride should have received even more attention, since the 2008 global finan-cial crisis, the Basel Committee on Banking and Supervision, together with numerous domestic regulators have once more focused much of their attention on credit risk by means of revamping regulations and issuing numerous consultative papers.

September 2010 saw the release by the Basel Committee of its Basel III guidelines, with substantial enhancements in the area

of credit risk; the new Accord also has pro-visions for leverage, liquidity, capital con-servation and pro-cyclicality buffers, as well as more stringent buffers for systemically important financial institutions. Not con-tent with this, further guidance on credit was issued yet again late last year.

Now that for many the crisis is in the rear-view mirror, market risk has been allowed to play the role of bridesmaid. The Basel Committee recently issued guidelines on market risk-weighted assets and has focused on how to measure the risk of traded assets. Yet, operational risk does not even get an invite to the wedding party, despite the fact that the worst bank losses in the last four decades have been due to operational risk, rather than credit or market risk.

Operational risk is the breach in the day-to-day running of a company due to people, processes, systems/technology and external threats. Think Herstatt Bank, Barings, Allied Irish Banks and, more recently, Société Générale, UBS and JPMorgan Chase. In all of these operational risk cases, failures in people, processes, systems or external threats led to liquidity, credit or reputational


risks. In some of the aforementioned cases, these operational risks led to the demise of the businesses involved.

Failure to agreeDespite the aforementioned cases, and the fact that the Basel Committee itself issued supervisory guidelines in 2011 on this topic, I have heard numerous bankers, and even the odd regulator, relay different definitions for what constitutes operational risk. Fraud and settlement risk are the most typical and yet, operational risk encompasses a lot more than these examples, encompassing eve-rything from human error to vendor selec-tion, model errors, and making provisions for natural disasters and terrorism. If market participants cannot agree on a definition of operational risk is, how can we believe banks have sound practices in place to identify, measure, control and monitor it, or moreo-ver, have sufficient capital to withstand pos-sibly rare, but high impact operational risk events?

Paucity of dataFor any market participant who thinks the three Basel II and III methods for credit risk are complex or leave too much to the dis-cretion of the banks, you really need to take a look at Basel’s guidance for operational risk measurement found under Pillar I. As with credit risk, a bank must be approved by its bank supervisor to use one of three methods starting with the most general, one size fits all, Basic Approach, to the Advanced Measurement Approach where banks get to use their own historical inter-nal loss data. Unlike credit and market risk, the market is clearing lacking in any strong

and cohesive operational risk measurement model. Indeed, operational risk is much harder to measure than other risks because of the paucity of high quality data. Even in instances where operational risk can be measured, most risk managers are reluctant to capitalise on it, since this results in a lower return on equity. Additionally, other than insurance for some operations risk aspects, there are no operational risk derivatives to hedge it. You can try to tell people not to lie, but given human nature that strategy may prove ineffective. You can fire people and try to send them to jail, as many have been clamouring for this year, but so many aspects of operational risk fail to rise to the level of an enforcement action, despite the fact that they can certainly cause banks to lose tre-mendous amounts of money.

Identify, measure, controlEven where one is able to identify, measure and control this type of risk, operational risk officers are left with the challenge of figuring out how to allocate capital for the probability that it may appear, for example, in the form of high impact fraud, insider trading, settle-ment failure or natural disaster. Risk officers often find they can under-allocate capital for operational risk and are not prepared when it materialises. Or they can end up allocat-ing capital to survive the impact of a natural disaster only to find that the impact was a lot less severe than had been anticipated. At the end of the day, capital is not free, and no one wants to over-allocate.

Recently, much of the U.S. media and market participants have been highly focused on salacious and often puer-ile e-mails from alleged professionals at


Standard & Poor’s, JPMorgan Chase and Morgan Stanley about their possible fraudu-lent role in rating or packaging of structured finance collateralised debt obligations com-prised of mortgage-backed securities. The failures at these organisations due to fraud, lack of good controls and misuse of models are all extremely important, because they continue to show the neglect of operational risk at incredibly large and well-known global financial institutions.

Systemic risk?Also noteworthy is the fact that some banks must now pay out high mortgage-related settlements. This includes Bank of America’s unprecedented US$10.3 billion settlement with Fannie Mae in January. Bank of America will survive this loss, just as JPMorgan survived the ‘London Whale,’ but could other U.S. banks survive these losses without causing systemic risk? The market has become so accustomed to bank-ing scandals in the last twelve months, that poor operational risk management and procedures have become widely accepted as the cost of doing business. Shareholders, unfortunately, are not demanding improved operational risk management. It is difficult to believe that banks are very well capitalised given how much they are having to spend regularly on settling fraud, insider trading, and money laundering cases.

Lack of transparencyGiven the lack of transparency, it is practi-cally impossible to establish whether or not a bank is identifying, measuring and control-ling its operational risks effectively. Bringing operational risk out more in the open could

really be helped by the uniform implemen-tation and supervision of Basel Pillar III, that requires more detailed disclosure on banks’ on- and off-balance sheet risks and informa-tion on how credit, market, and operational risk is measured.

Unfortunately, this pillar is implemented differently by banks in Europe and is not implemented at all by American banks. Further, supervisors can use a lot of discre-tion in assessing what inputs and models banks use to measure financial risks; given that the market for operational risk measure-ment models is not as advanced as the those used to measure credit and market risks, it is difficult to know what banks are doing to measure their operational risk. Hence, any market participant wanting to understand how a bank identifies, measures, controls, or monitors risks, especially operational risk, is left with little useful information to go by.

The market should be very concerned whether banks are truly adequately capi-talised for unabated fraud, such as misrep-resentations of securities or insider trading, settlement failures and other operational failures. Banks have failed in the past due to operational risk, and they could certainly do so again. If shareholders and bondholders do fail to demand more accountability and transparency from banks, Basel III opera-tional risk guidelines will never make it to any wedding. •

Editors note: The publisher and editor would like to thank MRV Associates and the American Banker for allowing the Journal to reproduce a modified version of this article which first appeared in late February on the American Banker website.


Opinion

Macroeconomic experiments: Abenomics versus EU austerity

Professor Yanis Varoufakis of the University of Athens contrasts Japan’s new

economic policy with that of Europe’s.

In the long, unending wake of the global financial crisis originating in 2007, des-perate governments and central banks the world over are trying their hand at experimental economic policy mixes epitomised by the United State’s and United Kingdom’s programmes of quan-titative easing. Japan and the Eurozone of 17 member states of the European Union offer a glimpse of how radically different anti-crisis experiments can be in these economically stressed times.

Recently, Japan has been making the news with reports that its new leaders – the new prime minister and the new governor of the Bank of Japan – have joined forces to stop their nation’s so-called ‘lost decade’ from turning into three lost decades.

Prime Minister Shinzo Abe’s govern-ment has committed to a stimulus package (an impressive 2 per cent of national income in 2013 alone) that will attempt to rekindle the real economy. Haruhiko Kuroda – Prime Minister Abe’s new choice of Bank of Japan governor – has audaciously declared that the Bank of Japan will fight deflation by

purchasing financial titles (e.g. government bonds, mortgages) to an extent, and at a pace, never seen before in economic history – in fact doubling the country’s monetary base in two short years.

Boldest Keynesian moveQuite clearly, Prime Minister Abe and Governor Kuroda are aiming their double-barrelled shotgun at the great foe of defla-tionary negative growth, which like a rogue samurai, is slashing into Japan’s capacity to reproduce itself as an advanced, prosperous social economy in the 21st century.

What makes the escapade even more remarkable is not just the size of their com-mitment but also their starting point.

Japan’s national debt is by far the high-est in the civilised world – some 220 per cent debt to gross domestic product ratio, or a staggering JPY 1,178,279.33 billion – mak-ing the decision to allow the budget deficit to rise to more than 11 per cent in 2013 the boldest Keynesian move since U.S. President Ronald Reagan’s expansionary fiscal poli-cies in the early 1980s. Similarly, the Bank of Japan’s decision to spend US$1.5 trillion in


order to accomplish in two years what Ben Bernanke’s U.S. Federal Reserve did during the past six years of ‘quantitative easing’ (and without controlling the world’s reserve cur-rency) is perhaps even more daring.

Idle and neuteredTurning to the Eurozone we are faced with another audacious experiment. In an aggre-gate economy that is in recession, the deep-est austerity is being imposed upon the fastest shrinking national economies that make up the Eurozone.

Meanwhile the European Central Bank is watching idly, too neutered by political and monetary policy considerations in Berlin, and too constrained by its’ Charter, to fol-low the European Central Bank’s president Mario Draghi’s instincts.

Total Eurozone debt is less than 100 per cent of the Eurozone’s annual income (com-pared to Japan’s 230 per cent), the aggre-gate budget deficit is running below 6 per cent (about half that of Japan), while the European Central Bank becomes exposed to a molehill of paper assets (when compared to BoJ’s already mountainous ones).

Diametrically opposed policiesClearly, of the two economies, the Eurozone is the one that has significantly more room within which to accommodate expansion-ary fiscal and monetary policies. And yet, it is Japan that is taking the plunge, firing both its barrels at its stagnation nemesis.

One possible justification of the two diametrically opposed policy settings in Europe and in Japan might be that these two advanced economies are facing very differ-ent challenges.

Europe’s leaders like to imagine that, unlike Japan, Europe is not facing a long-lasting recession, let alone deflation. For them, there is no need for Eurozone gov-ernments to loosen up the purse strings, or for the European Central Bank to flood the financial markets with digital euros.

What matters to them is that the crisis is utilised to force upon the Eurozone’s lag-gards (the Club Mediterranean nations, in particular those of Cyprus, Greece, Portugal, and Spain) the reforms that will help them regain their ‘competitiveness’, both within the European Union and globally.

While the two economies are very dif-ferent, their current predicaments are eerily similar. If I am right, this means that Europe’s leaders may be deluding themselves in thinking that the Eurozone’s crisis is funda-mentally different to that of Japan’s.

Zombification of banksJapan’s and Europe’s crises began when their financial sector imploded following the burst of gigantic bubbles caused by earlier capital inflows into the money and the real estate markets. In both economies, governments tried to keep the banks afloat with injections of capital and liquidity that failed to restore their capacity to borrow and to lend.

Both in Japan and in the Eurozone, the zombification of the banking system was ‘bought’ at the cost of taxpayers and to the detriment of the real economy. The result was a fall in the incomes from which the banking losses and the public debts had to be repaid.

In both realms politicians had too cosy a relationship with bankers and did not dare expropriate them, cleanse the banks and sell


them back to the private sector (as Sweden did in 1992 or South Korea in 1998). The result of these political failures, both in Japan and in the Eurozone, have been a carbon copy of one another.

Put differently, Japan and the Eurozone are in different phases of the same type of crisis, with Japan at a more advanced stage of this common disease, courtesy of having had an earlier start.

The Eurozone is unique in world eco-nomic history in that it comprises of gov-ernments with no central bank to back their economic policies and a European Central Bank with no government to work with. In this sense, the Eurozone is a very different kettle of fish when compared to Japan.

These differences reveal deep weak-nesses that the Eurozone has and Japan is free of. The Eurozone’s complacency in the

face of stagnation means the ‘Japanese dis-ease’, which is now spreading throughout Europe, is going to do even more damage to Europe than it did to Japan over the past two decades.

Moreover, when the time comes for Europeans to reach the same conclusions that both Prime Minster Abe and Governor Kuroda have now turned into policy, the Eurozone will lack the institutions to put them into practice. The most likely result will be the Eurozone’s disintegration; a devel-opment which, ironically, will undoubtedly damage Japan’s recovery – just as it will damage the rest of the global economy. •

Editors note: The publisher and editor of the Journal would like to thank Prof. Yanis Varoufakis for allowing the Journal to publish an amended version of this paper.

JoUrnal of rEgUlatIon & rISK north aSIa

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

November 20, 2013

Contact Chris [email protected]


Regulatory update

European Union finally agrees to limit bankers remuneration

Despite fervent lobbying and UK objec-tions, the EU has finally adopted CRD IV – Chris Rogers details its impact in Asia.

After a protracted legislative journey reaching back to July, 2011, the european Union (eU), following a vote by the european Parliament on 16 April, has agreed to adopt a series of measures to cap bankers’ bonuses to curb speculative risk-taking, step up capital provisions to help banks cope better with crises and stiffen supervision curbing excessive remuneration of bankers. the new rules known collectively as CrD IV extend to most eU-headquartered banks within the 27 member states and their subsidi-ary operations outside of the eU, together with non-eU headquartered banks oper-ating within the eU. the legislation is expected to take full effect next January and will have important implications for Asia Pacific banks with extensive opera-tions within the eU.

Before considering the likely impact of the EU’s CRD IV provisions on Asian banks operating across the 27 member states, a little background is necessary for our under-standing. On 20 July 2011, the European Commission (EC) published its proposals

to implement the international standards on bank capital requirements recommended by the Basel Committee on Banking Supervision – more commonly referred to as the Basel III International Accord. The EC proposals divided its Capital Requirements Directive (CRD) into two legislative instru-ments, namely the Capital Requirements Regulation (CRR) and the CRD IV Directive.

Directive becomes law across EUWithin the EU policy framework a “Directive” essentially means that all member states are obliged to transpose all terms and conditions relating to the “Directive” into national law. A “Regulation” bypasses member state legis-lative scrutiny and is applicable in its entirety as part of the EU’s harmonisation process to facilitate the “Single Market”. Hence, CRD IV will apply directly across the EU ensuring no divergence in prudential standards.

The CRR contains provisions relating to the “single rule book”, including the majority of provisions relating to the Basel III pruden-tial reforms. At the same time, the CRD IV Directive introduces provisions concerning remuneration, enhanced governance and


transparency, together with the introduction of buffers. As with the present CRD, both the CRR and CRD IV Directive will apply to credit institutions and investment firms that fall within the scope of the EU’s Markets in Financial Instruments Directive.

Impact of new provisionsWhilst both the CRR and CRD IV have a wide ranging impact on capital, capital buff-ers, liquidity and leverage, for the benefit of readers, the remainder of this paper will restrict itself to issues of corporate govern-ance and bankers remuneration.

With regards corporate governance, pro-visions are found in both the CRR and the CRD IV Directive. Combined, these new provisions seek to reduce excessive risk tak-ing by firms and ultimately the accumulation of excessive risk within the financial system itself. In essence, the CRD IV Directive con-tains additional requirements on the nature and composition of management bodies and risk management arrangements within firms. At the same time, CRR requires firms to make increased Basel III Pillar 3 disclo-sures about their corporate governance arrangements.

Risk management implicationsFrom a risk management perspective, these new arrangements provide that a banks management body will be responsible for the overall risk strategy and for the adequacy of the risk management system, and that the management body must establish a separate risk committee, composed of non-executive members, to deal specifically with risk issues.

The management body will remain ultimately accountable for the banks risk

strategy, whilst the banks must have a risk management function independent from their operational and management func-tions and with sufficient authority, stature and resources. The principle of proportional-ity, taking into account the size and complex-ity of the activities of the financial institution, as well as different corporate governance models, applies to all of the aforementioned measures.

Effects on remuneration in AsiaPresently, it is expected that the greatest impact that the new EU regulatory envi-ronment will have on Asian institutions is contained within the CRD IV “Directive”. Specifically this relates to those elements dealing with bank executive remuneration, or the so-called “bonus cap.”

A detailed summary is outlined below from documentation issued by the EU fol-lowing the Parliamentary vote to adopt the Commission’s and the Council of the European Union’s recommendations of the February 27 and March 5 respectively, with the added provision of additional transpar-ency and disclosure requirements for certain individuals who earn more than EUR 1 mil-lion per year under the 5th of March guid-ance communiqué. The main details of these provisions are as follows:

• Variable remuneration cannot exceed a maximum of one times fixed remuneration.

• The cap on variable remuneration of one times fixed remuneration can be increased to two times fixed remuneration with shareholder approval.

• For shareholder approval to increase the permitted ratio to two times fixed remu-neration, the approval will need the votes of


at least 66 per cent of shareholders owning half the shares represented, or of 75 per cent of the votes if there is no quorum.

• If a ratio of more than one times fixed remuneration is approved by shareholders, 25 per cent of the variable remuneration must be paid in long-term deferred instru-ments. The deferral period for such instru-ments must be a minimum of five years.

• In calculating the value of these long-term deferred instruments for the purposes of ensuring compliance with the ratio cap, it will be possible to discount the present value of those instruments thereby increas-ing the (effective) ratio cap beyond 1:2. This means, for example, if (i) a ratio cap of 1 (fixed remuneration) to 2 (variable remu-neration) was approved by shareholders, (ii) 25 per cent of the variable remuneration was paid in qualifying long-term deferred instru-ments, and (iii) a 50 per cent discount rate were permitted for those long-term deferred instruments, this would effectively enable a maximum ratio cap between fixed and vari-able remuneration of 1 to 2.5.

• The applicable discount rates that may be applied to qualifying long-term deferred instruments will be determined in due course by the European Banking Authority (EBA), taking into account matters such as inflation, levels of risk and the length of the deferral period. It is expected that, whilst any permitted discounting would enable institu-tions to set an effective ratio of greater than 1 to 2, the effective ratio would be closer to 1 to 2 rather than 1 to 3.

• The long-term deferred instruments will be subject to claw back during the defer-ral period and may also be “bail-in-able” (meaning that they are subject to full or

partial write-down in the event of an insol-vency event of the institution).

• Two years after implementation of the new provisions, the European Commission will lead a review into what practical impact the new limits on variable remuneration have had, and in particular whether they have resulted in restrictions on competitive-ness and any institutions relocating outside of the EU.

Possible implementation delaysWhilst the Commission, Council of the European Union and European Parliament are hopeful that CRD IV can be imple-mented in January, 2013, this is conditional on a detailed review of the legal drafting and translation into other official EU lan-guages, together with a formal adoption by the Council of Ministers. If translation can be completed in time for the legislation to be published in the Official Journal of the European Union before July 1, 2013, then CRD IV implementation will proceed as planned. If this deadline slips, then the “Directive” will be implemented as of July 1, 2014.

For most institutions which operate a bonus payment cycle within the EU where bonuses are paid in the first quarter follow-ing the end of a performance year, there is a strong possibility, if the July deadline is achieved, that this will impact variable remu-neration payable in the first quarter of 2014 in respect of the 2013 performance year. Should however the deadline fails to be met, this will roll over to the next financial year, namely, 2015.

At the time of writing, a detailed legis-lative text concerning these provisions has yet to be published by the EU. Additionally,


further guidance is expected from the European Banking Authority on a variety of issues, among these, permitted discount-ing of long-term deferred instruments. Regulatory and Supervisory bodies in all of the EU’s 27 member states are also required to issue local rules regarding implementa-tion, or to amend existing rules.

Scope of the DirectiveDespite intense industry lobbying and numerous objections raised by the UK, CRD IV, as detailed previously, will be applied to the majority of banks headquartered in the EU, or with extensive operations within the EU regardless of the institutions’ host nation. Further, all EU-based or headquar-tered banks with operations overseas fall under the “Directive”. As such, the scope of application of these rules will therefore be the same as under the current Capital Requirements Directive III (CRD III), which applies to all credit institutions and invest-ment firms that fall within the scope of the Markets in Financial Instruments Directive.

Growing pressure & inconsistenciesHedge funds, private equity houses and investment managers will also be subject to the requirements on remuneration under the Alternative Investment Fund Managers Directive (AIFMD), which in general terms mirrors the current remuneration require-ments under CRD III and does not include any such ratio cap.

There has, however, been growing pres-sure from some elements within the EU for the proposed ratio cap on variable remuner-ation eventually to be incorporated within AIFMD and thereby extended to hedge

funds, private equity houses and investment managers.

A major concern for both employers and employees is which staff - the so-called “identified staff” - will actually be captured by the new rules once fully adopted. At present, it remains unclear under CRD IV what actu-ally constitutes “identified staff,” i.e., under CRD III only those staff who had a material impact on a firm’s risk profile were supposed to be captured, rather than a carte blanche application across all the firms’ employees. However, due to considerable inconsisten-cies in the application of this rule found in institutions across the EU, it was decided that the EBA would issue new guidance later in the year, with the aim strengthening the criteria presently in CRD III.

Shareholder approval issuesGiven the number of foreign banks head-quartered in the EU, or with operations captured by the new rules, a degree of uncertainty remains concerning the share-holder approval requirement for these busi-nesses. As detailed previously, the 1:1 ratio cap on fixed to variable remuneration can be increased to 1:2 with shareholder approval.

One possibility is that the EU may expect that the shareholders of the non-EU parent company would have to vote on the issue at a general meeting. The other possibility is that the non-EU parent company would effectively be deemed as the shareholder for these purposes. Most legal experts are of the opinion that the former of the two is the most likely outcome.

Under the existing remuneration requirements of CRD III, those institutions that are of a smaller size and whose activities


present less systemic risk can, under the so-called “proportionality principles”, choose to dis-apply some of the more restrictive remuneration requirements, including the requirements that a minimum of 40 per cent of variable remuneration be deferred for at least three to five years, and that a mini-mum of 50 per cent of variable remuneration must be paid in shares or other instruments. Further, deferred but uninvested remu-neration must be subject to performance adjustment.

Competitive pressuresIt remains to be seen whether such insti-tutions will also have the opportunity to dis-apply the ratio cap on fixed to variable remuneration under such proportionality principles, particularly given the significant variations across the EU member states as to what actually constitutes a “smaller firm”. Readers are therefore advised to check with each respective country’s regulatory body for a concise definition.

Given the extra-territorial reach of CRD IV in relation to employee remuneration, and its application to staff working within the EU for firms that are domiciled outside of the EU – namely, foreign firms with European headquarters or those whose operations are captured by the new rules – CRD IV will have significant implications, particularly for firms already accustomed to paying variable remuneration, or a multiple of several times fixed remuneration. Indeed, such changes will apply considerable pressure to decrease overall levels of pay.

However, due to competitive pressures or other considerations, institutions may find it unacceptable to reduce total compensation

and may resort to increasing base salaries significantly. That said, it is predicted that many institutions may be reluctant to do so for a number of reasons. The challenge will therefore be to find ways in which payments or benefits can be made to employees, with such payments or benefits being categorised for the purposes of the ratio cap as fixed remuneration rather than variable remuner-ation, whilst conceptually still being seen as separate from and different in nature to base salary.

In anticipating the proposed ratio cap, various approaches have been considered as to how such payments and benefits might be structured. Examples include one-off payments to employees entering into new employment contracts, new contractual restrictions, or the provision of various forms of fixed employment allowances.

Other optionsOther possible mitigation strategies could involve increasing base salaries whilst including contractual provisions to decrease salaries after some time (for example, two years). The use of short fixed-term employ-ment contracts may also be an option. Some institutions have also considered the use of possible new classes of shares for employ-ees with very low initial values, but with the potential for significant growth, which would therefore not result in the value of the variable remuneration exceeding the cap.

Whether any of these approaches will work in practice is uncertain and much will depend greatly on the detail of the forthcom-ing legislative guidance from the European Banking Authority and implementing rules from local regulators themselves. •

On being the right size: Essays in evolution 59Andrew G. Haldane

Global banking reform five years after the crisis 73Daniel K. Tarullo

A better alternative to the Basel capital rules 85Thomas M. Hoenig

Regulation of cross-border OTCs: A middle ground 91Elisse B. Walter

Lessons from the crisis: The flaws of inflation targeting 99Otmar Issing

Macroprudential rebalancing in a period of economic stress 109Jean-Pierre Landau

Dynamics of disintegration: Germany and the Euro 115Prof. Christian Fahholz and Dr. Gernot Pehnelt

Europe’s interests best served by complying with Basel III 123Nicolas Veron

The science of fiscal policy & alchemy of monetary policy 129Prof. Jeffrey Frankel

Central bank fixation with low inflation prolongs recession 135Prof. Laurence M. Ball

The Brown-Vitter bill: An exposé of lunacy 139Assoc., Prof. William K. Black

Dodd-Franks extra-territorial reach irks the European Union 149Mayra Rodríguez Valladares

Macroeconomic stabilisation under modern monetary theory 155Steve Randy Waldman

Are ineffective AML & CFT laws impeding investor confidence? 165Gavin Sudhakar


Articles, Papers & Speeches


Bank regulation

On being the right size: Essays in evolution

The Bank of England’s Andrew Haldane questions the scientific literature supporting

the existence of too-big-too-fail banks.

The title of this paper is drawn from neither finance nor regulation. Instead it is drawn from evolutionary biology. In 1928, evolutionary biologist JBS haldane wrote an important article whose title I have borrowed, On Being the Right Size. his point was simple. The sheer size of an object, institution or animal deter-mined their structure, and as their size rose, their structure needed to strengthen more than proportionately if they were to remain robust and resilient.

This principle is sometimes enshrined in the so-called “square-cubed” law. A proportional rise in an object’s size causes its area to rise by the square, and its volume by the cube, of that rise. At one level, this is simple math-ematical geometry. Yet in the real world, it carries fundamental implications for evolu-tionary structure. Take the animal kingdom for example: the square-cubed law explains why a flea, even if it were the size of a man, would not be capable of jumping to the moon. It explains why a hippopotamus can-not turn somersaults. And it explains why King Kong and Godzilla were physiological

impossibilities – the mere weight transfer associated with a single step would have shattered their thighbones.

Folding under their own weightWhen the world’s biggest banking beasts took a step too far in 2008, they too folded under their own weight. Their physiological structure proved inadequate to make them robust and resilient. That is the essence of the “too big to fail” problem. In the language of Haldane, international policymakers have concluded that many of the world’s largest banks are not the right size given their exist-ing physiological make-up.

Over the past few years, initiatives to solve the too-big-to-fail problem have come thick and fast. The good news is that at their root, each has aimed to strengthen the struc-ture of the world’s biggest banks. However, claims that they have solved the too-big-to-fail problem appear to be premature, and somewhat over-optimistic. Worse, they risk sending a false sense of crisis comfort.

To see why such a cautious conclusion is warranted, we begin by tracking the struc-tural evolution of the financial system over


the past few decades. We then consider the three most prominent policy initiatives aimed at tackling too-big-to-fail systemic surcharges, resolution regimes and structural reform.

Evolution of the financial systemThe past fifty years have seen seismic shifts in the structure, size and composition of the global financial system. These changes gave birth to the too-big-to-fail problem. Chart 1 (see page 71) plots the ratio of banking sector assets-to-GDP, and its cross-country dispersion, for a set of 14 advanced countries over the past 140 years.

For the better part of a century, between 1870 and 1970, financial deepening in these countries followed a modestly upward trend. Over this period, the average bank assets-to-GDP ratio rose from 16 per cent to over 70 per cent, or less than 6 percentage points per decade.

Since 1970, this trend has changed tra-jectory. The ratio of bank assets-to-GDP has more than doubled over the past 40 years, rising from around 70 per cent to over 200 per cent, or over 30 percentage points per decade. In other words, since 1970 financial deepening has occurred five times faster than in the preceding century.

Negative GDP impactFor some individual countries, the rise has been more dramatic still - in the UK for example, the ratio has risen five-fold. In cross-country studies, financial deepening of this type has generally been found to have a positive effect on medium-term growth (Beck and Levine, 2004). Taken literally, this would suggest that the rise in banking scale

over recent decades has provided a signifi-cant tailwind to medium-term growth in advanced countries. Or so it seemed in the pre-crisis period.

Such conventional wisdom however has recently been called into question. IMF research has suggested that financial deep-ening can be growth-positive, at least within limits. Indeed, there is a threshold at which private credit-to-GDP may begin to have a negative impact on GDP growth (Arcand, Berkes and Panizza, 2012).

That threshold is found to lie at a private credit-to-GDP ratio of around 80-100 per cent, consistent with earlier cross-country evidence suggesting that, at credit-to-GDP ratios above unity, output volatility tends to increase (Easterly, Islam and Stiglitz, 2000).

Bank concentration & scaleThis threshold lies significantly below current levels of financial depth in most advanced economies. In other words, taken at face value, this evidence suggests that at its current scale, banking could be acting as a headwind to medium-term growth.

Accompanying this dramatic rise in banking scale has been an equally dramatic rise in banking concentration. The U.S. has undergone the most dramatic upwards shift, with the share of the top three banks ris-ing from around 10 per cent to 40 per cent between 1990 and 2007 - see Chart 2 (page 71).

Other countries saw a less dramatic rise in concentration but from a much higher starting point, driven by financial liber-alisation. The top three banks for instance accounted for between two-thirds and three-quarters of assets in the UK, Switzerland and


Germany. However, it has also spawned an acute problem for society due to escalating expectations of state support for the bank-ing system – usually referred too as “moral hazard.”

Self perpetuating “doom loop”These expectations generate lower fund-ing costs, in particular for the largest banks, which in turn encourages further expan-sion and concentration, worsening the too-big-to-fail dilemma. This illustrates what Allesandri and Haldane (2010) describe as a self-perpetuating “doom loop”.

The size of the resulting “implicit sub-sidy” from the state to the big banks has been the subject of recent study and controversy (Noss and Sowerbutts, 2012). There are a number of possible methods for estimating the subsidy. Perhaps the simplest is found by comparing the “standalone” and “sup-port” ratings assigned to debt issued by large banks. The difference between these rat-ings gives an estimate, used by the market when pricing debt, of the probability of state support.

Implicit subsidiesChart 3 (see page 71) plots the difference between these ratings for the 29 institutions deemed by the Financial Stability Board (FSB) last year to be the world’s most sys-temically important. In the pre-crisis period, this difference averaged a staggering 1.3 notches and suggests that, while non-trivial, too-big-to-fail may not have been a first-order driver of the rising scale and concen-tration in banking.

Yet even small notches of support can translate into bigger implicit subsidies if

balance sheets become too large, as in the case of the world’s largest banks. From 2002 to 2007, the implied annual subsidy to the world’s largest banks averaged US$70 bil-lion per year using a ratings-based measure (Chart 4 page 71). That is roughly 50 per cent of the average post-tax profits of these banks over the same period.

As the crisis struck, this implicit prom-ise became explicit. Financial support was extended to the banking system in the form of capital injections, guarantees and liquid-ity insurance. On some estimates, this sup-port rose to three-quarters of annual GDP in some countries. In response to these interventions, there has predictably been a further ratcheting-up in ratings-implied degrees of state support to banks.

“Pigouvian tax”By 2009, the ratings difference had more than doubled to above three notches, with the implied monetary subsidy rising to over US$700 billion per year, a figure well in excess of average annual pre-crisis profits of these firms. Even if an over-estimate, the scale of the implied subsidy signalled some-thing dramatic was at play. Too-big-to-fail had become hard-wired into the structure and pricing of the financial system.

One way of interpreting these implicit subsidies is as the market’s best guess of how much a policymaker would be willing to pay each year to avoid the failure of the world’s biggest banks. They proxy the expected social costs of big bank failure. In the jargon, they capture a systemic externality.

This notion of a systemic externality has underpinned recent academic and policy efforts to solve the too-big-to-fail problem.


Brunnermeier et al., (2009) use this frame-work to motivate levying a tax – a “Pigouvian tax” – on institutions posing systemic risk externalities. This tax would be set at levels, which offset the effects of the bank’s actions on wider society. A number of academics have since proposed measures along broadly Pigouvian lines (Archarya et al., 2010).

Systemic surchargeRather remarkably, policy reforms in practice have followed closely in the spirit of these proposals. In 2010, the FSB announced its intention to introduce a “systemic surcharge” of additional capital on the world’s largest banks. In July 2011, the Basel Committee published a methodology for measuring systemic importance based on indicators of bank size, connectivity and complexity, with additional capital of up to 2.5 per cent depending on this score.

In November 2011, the FSB endorsed this methodology and announced the 29 systemically important entities to which it would apply. This framework will be final-ised this year, before being phased-in from 2016. Indeed, legislation is already in place, or is being drawn up, to implement the sys-temic surcharge in the United States and Europe.

Step in right directionThese proposals are clearly a practical step in the right direction. By boosting levels of capi-tal in the system, the probability of big bank failure will be reduced. In 2007 you would have got good odds back that something as seemingly elliptical as a Pigouvian tax on systemic risk would have found its way onto the regulatory statute books. Now we have

it. The practical question, however, is how far systemic surcharges take us in tackling the systemic risk externality. In other words, at current levels by how much have systemic surcharges reduced expected losses for the financial system? This is an empirical ques-tion and one, which must, in order to assess it, consider the impact of capital surcharges on the expected losses facing the 29 institu-tions identified by the FSB.

Using each of these banks’ balance sheets, we generate a measure of default probability using the Merton (1974) contin-gent claims model. We assume that the base level of equity for these banks is 7 per cent (the new Basel III minimum) and that, in the event of default, they suffer losses on their assets of around 30 per cent. To keep things simple, banks’ assets are assumed to be nor-mally distributed, in line with Merton (1974), and default occurs only when a bank’s capi-tal has been fully exhausted.

Expected lossesAssume initially that default risks across banks are independent. This is a highly con-servative assumption, as in practice bank default probabilities are highly correlated at times of stress. Indeed, bank correlation coefficients in crisis often head towards one. For that reason, this thought-experiment provides a lower bound on expected losses across the financial system.

Chart 5 (see page 72) shows expected losses across the 29 banks at different levels of the systemic surcharge. In the absence of any surcharge, expected losses across the system are just less than US$200 billion per year. Were every large bank instead to face the maximum capital surcharge of 2.5


per cent, then expected system-wide losses would fall by around 60 per cent relative to their base level. And to remove 90 per cent of the systemic externality – expected losses of around US$5 billion - a surcharge of over 7 per cent would be needed.

Fire sale externalitiesA more plausible experiment would be to assume a non-zero correlation among bank defaults. For example, the failure of a large bank, which caused it to fire-sale assets could impose externalities on other large banks holding these same assets (Wagner, 2009). To place an upper bound on expected losses in the face of these fire-sale externali-ties, assume instead a correlation coefficient of one. Chart 5 (see page 72) illustrates the impact on expected system-wide losses of a high degree of default correlation among the big banks.

The expected system-wide loss increases to around US$750 billion per year – similar in size to the implicit subsidy at its peak. A 2.5 per cent surcharge now only reduces expected system-wide losses to around US$350 billion per year. To lower expected system-wide losses to be around US$5 bil-lion per year would require a surcharge of around 15 per cent – six times its current upper limit.

Gloomy prognosisIf anything, these thought-experiments probably produce conservative estimates of system-wide losses and the necessary sys-temic surcharge. For example, bank asset returns are in practice much fatter-tailed than the log-normal distribution. And in practice, banks are likely to default well before their

capital is fully exhausted. Relaxing either assumption would push up estimates of expected losses and the surcharge necessary to curtail these losses (Schanz et al., 2012).

Nonetheless, if expected system-wide losses are a reasonable proxy for the system-wide externalities large banks pose; this anal-ysis delivers a rather gloomy prognosis. At current levels of the surcharge, a large chunk of the systemic externality would remain untouched. If too-big-to-fail is the problem, then systemic surcharges seem to offer only a partial solution. Capital surcharges lower systemic externalities by lowering default probabilities for the world’s largest banks. An alternative way of lowering those externali-ties would be to reduce the collateral dam-age associated with their failure.

Resolution regimesThis has been a key motivation for a second strand of the reform debate – the design of effective resolution regimes. Few exam-ples better illustrate the costs of getting this wrong than the spiralling queues outside branches of Northern Rock in September 2007. Despite being a medium-sized retail bank, Northern Rock’s failure caused sys-temic disruption and put taxpayers’ money at risk. In response, in 2009 the UK put in place a special resolution regime for banks, providing the Bank of England with tools for winding-down a failed bank.

As the crisis illustrated, financial failure, which causes systemic disruption is not con-fined to banks. And to avoid taxpayer bail-out, losses may need to be imposed on a wide class of bank creditors, including hold-ers of debt as well as equity – for example, by “bail-in”. Over recent years, these resolution


lessons have been enshrined in banking legislation.

For example, in the United States Title II of the Dodd-Frank Act was passed in July 2010. It creates a new regime for the liqui-dation of financial companies, banks and non-banks, which pose a systemic financial stability risk. It enables losses to be imposed on creditors in resolution, while also prohib-iting state bailouts.

Lowering societal costsInternationally, in November 2011 the G-20 endorsed the FSB’s Key Attributes of Effective Resolution Regimes, developed by an international working group chaired by the deputy governor of the Bank of England, Paul Tucker. Efforts are now underway to align national resolution regimes with these principles. As part of that, in Europe a draft directive on bank recovery and resolution was published in June 2012.

Such initiatives are an important practical step in the right direction, lowering the soci-etal costs of bank failure. As with systemic surcharges, it is striking how much progress has been made in so short a space of time on so complex an issue. The practical question is how far this takes us towards removing the too-big-to-fail externality.

Evolutionary trajectoriesDuring a bank resolution, one way of ensur-ing continuity of banking services is by trans-ferring assets and/or liabilities of a failing firm to a third party. But the only entity with sufficient financial and managerial resource to absorb a large asset or liability portfo-lio, without suffering chronic indigestion, is another big bank. So it was during the crisis

for example, that Bear Stearns was swal-lowed by JPMorgan Chase, Merrill Lynch by Bank of America and Washington Mutual by Citigroup.

This makes for a rather uncomfortable evolutionary trajectory, with rising levels of banking concentration and ever-larger too-big-to-fail banks. Levels of banking concen-tration have risen in many countries since 2007, precisely because of such shotgun marriages by over-sized partners. In other words, resolving big banks may have helped yesterday’s too-big-to-fail problem, but at the expense of worsening tomorrow’s.

One way of avoiding this problem is to re-capitalise a bank by bailing-in its creditors, rather than transferring its assets. But resolu-tion rules of this type are not problem-free either. Like all policy rules, they face what economists call a time-consistency prob-lem. Whether a rule is followed in practice depends on the balance of costs and benefits at the time crisis strikes, not at the time the rule is written. That is why policy might in practice lack consistency over time – hence time-inconsistency.

Bailout or bail–in?Consider that trade-off when a big, com-plex bank hits the rocks. On the one side is a simple but certain option - state bailout. On the other side is a complex and less cer-tain option – resolution. Policymakers face a trade-off between placing losses on a narrow set of taxpayers today (bail-in) or spreading that risk across a wider set of taxpayers today and in the future (bailout).

If governments are risk-averse and wish to smooth the pain across taxpayers and across time, then bailout may look attractive


on the day – financial history certainly sug-gests so. The history of big bank failure is a history of the state blinking before pri-vate creditors (Haldane, 2011). Recent cri-sis experience has written another chapter in this history. Next time may be different. For example, the public backlash against future bailouts could reinforce governments’ resolve to impose losses on creditors. And recent U.S. legislation in principle locks the tax-payer cashbox and throws away the key.

Limits of Dodd-FrankLooking forward, the issue is whether this ex-ante rule is ex-post credible. As Chart 6 illus-trates (see page 72), implied levels of support for the U.S.’s biggest banks are much higher than before the crisis. More telling still, is that the passage of Dodd-Frank appears to have had little impact on levels of implied state support. It is early days for this new resolu-tion regime and credibility may take time to be earned.

Nonetheless, at present the market believes that the time-consistency prob-lem for big banks is as acute as ever. Even if it might appear the expedient option on the day of crisis, it is questionable whether bailout is the optimal response over the medium-term.

Sovereign CDS spreadsChart 7 (see page 72) looks at the response of bank and sovereign credit default swap (CDS) spreads around the time of bank bailouts in a selection of crisis countries. While bailouts lowered bank CDS spreads, as might be expected, bailout came at the expense of a rise in sovereign CDS spreads. It is not difficult to see why. The financial

crisis has caused huge damage to the bal-ance sheets of governments in advanced economies. For the G-20 countries, the IMF forecast that the debt-to-GDP ratio will rise by almost 40 percentage points between 2007 and 2016, to almost 120 per cent. At these levels, public sector debt may be a significant drag on medium-term growth (Rogoff and Reinhart, 2010).

For economies with large banking sys-tems and without a credible resolution regime, this leaves policymakers caught between a rock and hard place. When the call comes to ride to the banking rescue, gov-ernments may be unable to afford not to. But nor, at least over the medium term, can they afford to. This is just one of the dilemmas fac-ing advanced countries today.

Structural reformOne way of lessening this dilemma, and at the same making resolution and bail-in more credible, is to act on the scale and structure of banking directly. Perhaps not surprisingly, recent regulatory reforms have sought to do just that. They have taken seri-ously the maxim that if a bank is too big to fail, then it is too big. The result has been detailed proposals for structural reform in a number of advanced countries.

In the United States, the “Volcker rule” has been introduced. This prohibits U.S.-operating banks from undertaking pro-prietary trading and restricts private equity activity. The rule was tabled in October 2011 and became law in July 2012. Banks have two years to comply. In the United Kingdom, the proposals of the “Vickers Commission” include placing a ring-fence around retail banking activities, supported by higher levels


of capital. The final version of these propos-als was tabled in September 2011 and leg-islation to enact them is planned by 2015. Banks will have until 2019 to comply.

Most recently in Europe, the “Liikanen plan” was announced in October 2012. It proposes that the investment banking activities of universal banks be placed in a separate entity from the remainder of the banking group. There are at present no plans to legislate these proposals.

A question of separationAs with other reform strands, it is remark-able how quickly radical structural reform proposals are finding their way onto the statute book. And although different in detail, these proposals share a common motivation: separation of certain investment and commercial banking activities. In theory, such a separation delivers financial stabil-ity benefits of two distinct types (Boot and Ratnovski, 2012).

First, separation reduces the risk of cross-contamination. Riskier investment banking activities, when they go wrong, can pollute and dilute the financial resources of the retail bank. This potentially inflicts losses (or fear of losses) on depositors. It may also constrain banks’ ability to make loans to the real econ-omy when it might most need them. This is a crisis-time benefit of separation.

Cross-subsidisationSecond, separation can secure an improved pre-crisis allocation of financial resources from a societal perspective. High pri-vate return investment banking activities may crowd-out the human and financial resources devoted to high social return

commercial banking activities. Investment banking activities might also piggyback on the cheaper cost of deposit funding. In effect, universal banking allows privately optimal, but socially sub-optimal, cross-subsidisa-tion. This is a benefit of separation in nor-mal times. Both of these costs were evident ahead of, and during, the recent crisis.

Ahead of crisis, resources gravitated to the investment banking side of the fence. Between 2000 and 2007, UK banks’ trading books rose six times as fast as their banking books. Human capital made the same jour-ney, helped by investment banking salaries rising four times as fast as commercial bank salaries since 1980. In the teeth of crisis, risk cross-contamination became a potent factor.

Open questionsBasic banking services in universal banks were often subject to severe disruption from trading book losses, which exceeded by many multiples the capital allocated to them. That is why national deposit insurance schemes were extended and in some cases became temporarily unlimited. It is also why repeated attempts have had to be made to resuscitate weak credit growth over the past few years.

So how far will existing structural pro-posals take us in harnessing these benefits? Volcker, Vickers and Liikanen seek legal, financial and operational separation of activ-ities. So in principle each ought to prevent cross-contamination at crisis time. Whether they do so in practice depends on loop-holes in, or omissions from, the ring-fence. And each of the existing proposals has open questions on this front.

For example, the Volcker rule separates


only a fairly limited range of potentially risky investment bank activities, in the form of proprietary trading. The Vickers proposals mandate only a limited range of basic bank-ing activities to lie within the ring-fence, namely deposit-taking and overdrafts. And the Liikanen plans allow a wide range of derivative activity to lie outside of the invest-ment banking ring-fence.

Ring-fence to string vestIt could be argued that these loopholes are modest. But as the history of the Glass-Steagall Act demonstrates, today’s loophole can become tomorrow’s bolt-hole, and today’s ring-fence tomorrow’s string vest. At a minimum, this suggests the need for full and faithful implementation of the spirit as well as the letter of the Volcker, Vickers and Liikanen plans if risk cross-contamination is to be avoided.

A larger question-mark still hangs over whether these proposals will lead to a sea-change in the allocation of resources to retail and investment banking. The cultures of investment and retail banking are quite distinct. Retail banking relies on forming long-term relationships, while investment banking is inherently shorter-term and transactional. Housing these sub-cultures under one roof makes achieving the neces-sary separation of cultures and capital a sig-nificant operational headache.

Acid testAt a minimum, such a separation of cul-ture and capital is likely to require entirely separate governance, risk and balance sheet management on either side of the ring fence. Without that, human and financial resource

allocation either side of the ring-fence will become blurred. For example, without sepa-rate debt issuance for retail and investment banking, the cost of debt for a big bank will be a blended mix. The implicit subsidy in funding costs would then remain and with it become one of the main distortions associ-ated with too-big-to-fail.

Only time will tell whether cultural sepa-ration can be achieved under the existing structural reform proposals. In the go-go years, will these reforms be sufficient to pre-vent the grass always appearing greener on the riskier side of the (ring-)fence? This is the acid test of the structural reform agenda.

Progress has been made over the past few years towards eliminating too-big-to-fail, with further progress on implementa-tion planned. But today’s task is even more daunting than before the crisis. The big banks are even bigger. The system itself is more concentrated.

Further reforms?Despite reform efforts, the market’s best guess today about tomorrows implicit sub-sidy is far larger than before the crisis struck, at over US$300 billion per year (see Chart 3 on page 71). The market believes that illicit state promise is even more likely to be kept. The wrong conclusion to draw would be that existing reforms have failed or are unneces-sary. On the contrary, these reform initia-tives, while necessary, may be insufficient to eliminate the too-big-to-fail externality. If so, what are the alternatives?

Re-sizing the capital surcharge is one possibility. This would further reduce default probabilities among the biggest banks, thereby lowering the expected system-wide


losses associated with big bank failure. Taking the earlier illustrative example, to reduce materially expected system-wide losses for the world’s largest banks would require a capital surcharge several times larger than its current upper limit. Interestingly, this would take bank capital ratios to levels not dissimi-lar to recent quantitative estimates of their optimal value (Miles et al., 2011; Hellwig et al., 2011).

Limitations on bank sizePlacing limits on bank size is a second option. By reducing balance sheet exposures, this measure would reduce directly system-wide losses in the event of big bank failure. The Dodd-Frank Act includes an explicit limit on the maximum deposit market share of U.S. banks, capping it at 10 per cent. But this does not prevent banks rising to a scale, relative to GDP, at which they could imperil state solvency. For that reason, limiting bank size relative to GDP has recently been pro-posed by a number of commentators and policymakers, among them Fisher (2011), Hoenig (2012), Johnson and Kwak (2010), and Tarullo (2012).

Complete divorceFull structural separation of investment and commercial banking, a modern-day Glass-Steagall Act, has continued to attract sup-port. The main benefit this would bring, relative to structural ring-fencing, is that it would eliminate loopholes from the ring-fence and better ensure that the distinct cul-tures of retail and investment banking were not cross-contaminated.

That would lessen the risk of basic bank-ing activities being starved of human or

financial capital, both ahead of and during crisis. Full separation may also be operation-ally simpler to implement than the existing structural proposals.

Finally, enhanced banking competition would potentially help to reduce some of the problems of too-big-to-fail by reducing the degree of banking concentration. Greater exit from banking, through enhanced reso-lution regimes, could help. But a bigger prob-lem still is bank entry: the UK went 100 years without a new retail bank being set up.

One potential barrier to banking entry is the difficulty of switching deposit accounts and loan contracts. A shared banking plat-form containing customer account details would dramatically reduce the frictions in search and switch for deposit and loan prod-ucts for customers (Leadsom, 2012) and could lower material barriers for new bank-ing entrants.

Counter argumentsA powerful counter-argument to all of these more radical proposals is that they could erode the economies of scale and scope associated with large banks. These econo-mies clearly do exist in banking, as they do in other industries. For example, fixed costs are large in finance, and spreading them widely ought to deliver productivity improvements.

The interesting question is at what point these economies of scale are exhausted. Indeed, informational and managerial dis-economies of scale are likely at some scale, whatever the business line. In his classic the-orem, Ronald Coase tells us that firms will seek a privately-optimal size, which balances the benefits of economies of scale against these diseconomies (Coase, 1937). So how


does all of this apply in banking? The empir-ical evidence on economies of scale and scope in banking is surprisingly patchy.

Early studies, using data from the 1980s, failed to find scale economies much beyond bank asset sizes of around US$100 million (Pulley and Braunstein, 1992). Empirical studies in the 1990s nudged up the optimal bank scale to around US$10 billion (Amel et al., 2004; Mester, 2005).

Questionable dataMost recently, a small number of stud-ies using data from the 2000s have pointed to scale-economies at much higher asset thresholds. For example, Wheelock and Wilson (2012) find scale economies for banks with assets up to US$1 trillion and Feng and Serilitis (2009) for bank with assets up to around US$1.5 trillion.

Using data on banks with assets in excess of US$100 billion, Mester and Hughes (2011) not only find scale-economies, but also argue that these may increase with bank size. At face value, these findings pose a real challenge to policy options which re-size banks. Or do they?

Bank of England research has re-exam-ined the evidence on economies at different banking scales (Davies and Tracey, 2012). As Chart 8 (see page 72) shows, in standard models there is evidence of scale economies for banks with assets above US$100 billion. Indeed, these economies tend to rise with banking scale.

Too-big-to-manageHowever, this finding is based on estimates of banks’ funding costs, which take no account of the implicit subsidy associated

with too-big-to-fail. Removing this subsidy raises banks’ funding costs, lowers estimates of bank value-added and thereby reduces measured economies of scale. As Chart 9 (see page 72) shows, once an allowance is made for the implicit subsidy, the picture changes dramatically.

There is no longer evidence of economies of scale at bank sizes above US$100 billion. If anything, there is now evidence of disecono-mies which rise with bank size, consistent with big banks becoming “too big to man-age”. This evidence reconciles Coase’s theo-rem with the too-big-to-fail phenomenon.

In line with Coase, banks have chosen the size, which maximises their private value. But implicit subsidies may have artificially boosted the privately-optimal bank size. Subtracting this subsidy, removing the state crutch, would suggest a dramatically lower socially-optimal banking scale.

Physiological impossibilitiesWhat about economies of scope? A recent study by Boyd and Heitz (2011) conducts a simple but compelling thought-experiment. They compare the lowest-available estimate of the social cost of the crisis with the high-est-available estimate of the private benefit of scale and scope economies in banking. The social costs of too-big-to-fail exceed the private benefits of scale economies by an order of magnitude.

In his 1928 article, JBS Haldane observed that when “you drop a mouse down a thou-sand-yard mine shaft it walks away, a rat is killed, a man is broken, a horse splashes”. In short, when big banks disappeared down the mineshaft in 2008, their splashes generated a tsunami. To prevent this from happening


again, their physiology needs to change. And whilst existing change initiatives may be occurring in the right direction, it is possi-ble that they are insufficient in degree. There may be a distance to travel before banking is the right size. •

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of Debt,” American Economic Review, AmericanEconomic Association, vol. 100(2), pp. 573-78, May.Segoviano, M and Goodhart, C (2009), “Banking Stabil-ity Measures,” IMF Working Paper 09/04(Washington: International Monetary Fund).Schanz, J, Aikman, D, Collazos, P, Farag, M, Gregory, D and Kapadia, S (2011), “The long-termeconomic impact of higher capital levels”, Bank of Eng-land, MimeoTarullo, D (2012) “Financial Stability Regulation” , Speech At the Distinguished Jurist Lecture,University of Pennsylvania Law School, Philadelphia, PennsylvaniaWagner, Wolf, (2009) “In the Quest of Systemic Exter-nalities: A Review of the Literature ”, mimeoWheelock, D.C., and P.W. Wilson (2012). “Do Large Banks have Lower Costs? New Estimates of Returnsto Scale for U.S. Banks.” Journal of Money, Credit, and Banking, 44(1), 171 – 199.

Chart 1: Bank assets/GDP in selected countries Chart 2: Banking concentration in selected countries

Chart 3: Ratings uplift for systemic institutions Chart 4: Implicit subsidy for systemic institutions

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

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Chart 1: Bank assets/GDP in selected countries Chart 2: Banking concentration in selected countries

Chart 3: Ratings uplift for systemic institutions Chart 4: Implicit subsidy for systemic institutions

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

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

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Chart 7: Sovereign and Bank CDS during bailout announcements

Chart 8: Economies of scale (assuming no implicit subsidy)

Source: Capital IQ, Bank of England calculationsSource: Markit, Bank of England calculations

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Chart 9: Economies of scale (implicit subsidy-adjusted)

Source: Capital IQ, Bank of England calculations

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Chart 5: Expected system-wide loss Chart 6: Bank ratings uplift in the US

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

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Bank regulation

Global banking reform five years after the crisis

Governor Daniel K. Tarullo of the U.S. Federal Reserve System believes its too ear-ly to claim victory in taming global finance.

More than five years after the failure of Bear Stearns marked an escalation of the financial crisis, and nearly three years since the passage of the Dodd-Frank Act, debate continues over the appropriate set of policy responses to protect against financial instability. In recent months, there has been, in particular, a renewal of interest in additional measures to address the too-big-to-fail problem. In some respects, the persistence of debate is unsurprising. After all, the severity of the crisis and ensuing recession, and the frustratingly slow pace of economic recovery, have properly occasioned much thought about the structure of the finan-cial system and the fundamentals of financial regulation.

Continuing discussion of these issues is part of a protracted policy debate over financial regulatory reform. Some argue that little has changed and that the needed reform is a single, dramatic policy change (though that single policy differs considerably among those taking this view). Others argue that reforms already enacted are sufficient to

ensure financial stability. However, many others contend that there has already been too much of a regulatory response, which is suppressing credit extension and faster eco-nomic recovery.

I think most of us would acknowledge, upon reflection, that a good bit has been done, or at least put in motion, to coun-teract the problems of too-big-to-fail and systemic risk more generally. At the same time, I believe that more is needed, particu-larly in addressing the risks posed by short-term wholesale funding markets. I would therefore like to highlight the importance of what has already been accomplished and, at somewhat greater length, to identify what I believe to be the key steps that remain.

Before turning to these subjects, though, I begin with a brief reprise of the origins of the financial crisis, to remind ourselves of the vulnerabilities that led to the crisis and that remain of concern today. It should, but does not always, go without saying that pro-posed solutions should actually help solve the problems at hand, and do so in a man-ner that minimises the costs to otherwise productive activities.


Beginning in the 1970s, the separation of traditional lending and capital market activities established by New Deal finan-cial regulation began to break down under the weight of macroeconomic turbulence, technological and business innovation, and competition.

Growth of shadow bankingDuring the succeeding three decades these activities became progressively more inte-grated, fuelling the expansion of what has become known as the shadow banking system, including the explosive growth of securitisation and derivative instruments in the first decade of this century. This trend entailed two major changes.

First, it diminished the importance of deposits as a source of funding for credit intermediation, in favour of capital market instruments sold to institutional investors. Over time, these markets began to serve some of the same maturity transformation functions as the traditional banking systems, which in turn led to both an expansion and alteration of traditional money markets. Ultimately, there was a vast increase in the creation of so-called cash equivalent instru-ments, which were supposedly safe, short-term, and liquid.

Symbiotic relationshipSecond, this trend altered the structure of the industry, both transforming the activities of broker-dealers and fostering the emergence of large financial conglomerates. There was, in fact, a symbiotic relationship between the growth of large financial conglomerates and the shadow banking system. Large banks sponsored shadow banking entities such

as Structured Investment Vehicles (SIVs), money market funds, asset-backed com-mercial paper conduits, and auction rate securities. These firms also dominated the underwriting of assets purchased by entities within the shadow banking system.

Though motivated in part by regulatory arbitrage, these developments were driven by more than regulatory evasion. The growth and deepening of capital markets lowered financing costs for many companies and, through innovations such as securitisation, helped expand the availability of capital for mortgage lending. Similarly, the rise of insti-tutional investors as guardians of household savings made a wide array of investment and savings products available to a much greater portion of the American public.

Adverse feedback loopBut these changes also helped accelerate the fracturing of the system established in the 1930s. While the increasingly outmoded regulation of earlier decades was eroded, no new regulatory mechanisms were put in place to control new risks. When, in 2007, questions arose about the quality of some of the assets on which the shadow banking system was based – notably, those tied to poorly underwritten sub-prime mortgages – a classic adverse feedback loop ensued.

Investors formerly willing to lend against almost any asset on a short-term, secured basis were suddenly unwilling to lend against a wide range of assets, nota-bly including the structured products that had become central to the shadow bank-ing system. Liquidity-strained institutions found themselves forced to sell positions, which placed additional downward pressure


on asset prices, thereby accelerating margin calls on leveraged actors and amplifying mark-to-market losses for all holders of the assets. The margin calls and booked losses would start another round in the adverse feedback loop.

Highly vulnerable Severe repercussions were felt throughout the financial system, as short-term whole-sale lending against all but the very safest collateral froze up, regardless of the identity of the borrower. Moreover, as demonstrated by the intervention of the government when Bear Stearns and AIG were failing, and by the aftermath of Lehman Brothers’ failure, the universe of financial firms that appeared too-big-to-fail during periods of stress extended beyond the perimeter of traditional safety and soundness regulation.

In short, the financial industry in the years preceding the crisis had been trans-formed into one that was highly vulnerable to runs on the short-term, uninsured cash equivalents that fed the new system’s reli-ance on wholesale funding. The relationship between large firms and shadow banking meant that strains on wholesale funding markets could both reflect and magnify the too-big-to-fail problem.

Fast-moving episodesThese were not the relatively slow-devel-oping problems of the Latin American debt crisis, or even the savings and loan crisis, but fast-moving episodes that risked turning liquidity problems into insolvency problems, almost literally overnight. However, note that while the presence of too-big-to-fail institutions substantially exacerbates the

vulnerability created by the new system, they do not define its limits. Even in the absence of any firm that may individually seem too big or too interconnected to be allowed to fail, the financial system can be vulnerable to contagion.

An external shock to important asset classes can lead to substantial uncertainty as to underlying values, a consequent reluc-tance by investors to provide short-term funding to firms holding those assets, a sub-sequent spate of fire sales and mark-to-mar-ket losses, and the potential for an adverse feedback loop. In short, an effective set of financial reforms must address both these related problems of too-big-to-fail and sys-temic vulnerability.

Extensive reformAs is obvious from the scope of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the amount of activity at the regulatory agencies, reform efforts to date have been extensive. They have also been significant. Without trying to give a full review, let me draw your attention to some of the more notable accomplishments, which can be categorised in three groups.

First, the basic prudential framework for banking organisations is being consid-erably strengthened, both internationally and domestically. Central to this effort are the Basel III changes to capital standards, which create a new requirement for a mini-mum common equity capital ratio. This new standard requires substantial increases in both the quality and quantity of the loss-absorbing capital that allows a firm to remain a viable financial intermediary. Basel III also established for the first time an international


minimum leverage ratio which, unlike the traditional U.S. leverage requirement, takes account of off-balance-sheet items.

Stricter reforms for larger firmsSecond, a series of reforms have been tar-geted at the larger financial firms that are more likely to be of systemic importance. When fully implemented, these measures will have formed a distinct regulatory and supervisory structure on top of generally applicable prudential regulations and super-visory requirements. The governing principle for this new set of rules is that larger institu-tions should be subject to more exacting reg-ulatory and supervisory requirements, which should become progressively stricter as the systemic importance of a firm increases.

This principle has been codified in Section 165 of the Dodd-Frank Act, which requires special regulations applicable with increasing stringency to large banking organ-isations. Under this authority, the Federal Reserve will impose capital surcharges on the eight large U.S. banking organisations identified in the Basel Committee agree-ment for additional capital requirements on banking organisations of global systemic importance.

Move to orderly liquidationThe size of a surcharge will vary depend-ing on the relative systemic importance of the bank. Other rules to be applied under Section 165 – including counterparty credit risk limits, stress testing, and the quantitative short-term liquidity requirements included in the internationally negotiated Liquidity Coverage Ratio (LCR) – will apply only to large institutions, in some cases with stricter

standards for firms of greatest systemic importance.

An important, related reform in Dodd-Frank was the creation of orderly liquidation authority, under which the Federal Deposit Insurance Corporation can impose losses on a failed systemic institution’s shareholders and creditors and replace its management, while avoiding runs and preserving the operations of the sound, functioning parts of the firm. This authority gives the gov-ernment a real alternative to the Hobson’s choice of bailout or disorderly bankruptcy that authorities faced in 2008. Similar resolu-tion mechanisms are under development in other countries, and international consulta-tions are underway to plan for cooperative efforts to resolve multinational financial firms.

Focus on derivativesA third set of reforms has been aimed at strengthening financial markets gener-ally, without regard to the status of relevant market actors deemed as regulated or sys-temically important. The greatest focus, as mandated under Titles VII and VIII of Dodd-Frank, has been on making derivatives mar-kets safer through requiring central clearing for derivatives that can be standardised, and through the creation of margin require-ments for derivatives that continue to be written and traded outside of central clear-ing facilities.

The relevant U.S. agencies are working with their international counterparts to pro-duce an international arrangement that will harmonise these requirements so as to pro-mote both global financial stability and com-petitive parity. In addition, eight financial


market utilities engaged in important pay-ment, clearing, and settlement activities have been designated by the Financial Stability Oversight Council as systemically important and, thus, will now be subject to enhanced supervision.

Significance of changesAs you can tell from my description, many of these reforms are still being refined or are still in the process of implementation. The rather deliberate pace – occasioned as it is by the rather complicated domestic and inter-national decision-making processes – may be obscuring the significance of what will be far-reaching change in the regulation of financial firms and markets.

Indeed, even without full implementa-tion of all such new regulations, the Federal Reserve has already used its stress test and capital-planning exercises to prompt a dou-bling in the last four years of the common equity capital of the nation’s 18 largest bank holding companies, which hold more than 70 per cent of the total assets of all U.S. bank holding companies. The weighted tier one common equity ratio - which compares high-quality capital to risk-weighted assets - of these 18 firms rose from 5.6 per cent at the end of 2008 to 11.3 per cent in the fourth quarter of 2012, reflecting an increase in tier one common equity from US$393 billion to US$792 billion during the same period.

Vulnerabilities remainDespite this considerable progress, we have not yet adequately addressed all the vulner-abilities that developed in our financial sys-tem in the decades preceding the crisis. Most importantly, relatively little has been done to

change the structure of wholesale funding markets so as to make them less suscepti-ble to damaging runs. It is true that some of the clearly risky forms of wholesale funding that existed before the crisis, such as the infa-mous SIVs, have disappeared or substan-tially contracted. But significant continuing vulnerability remains, particularly in those funding channels that can be grouped under the heading of securities financing transac-tions (SFTs).

Repo, reverse repo, securities lending and borrowing, and securities margin lending are part of the healthy functioning of the securi-ties market. But, in the absence of sensible regulation, they are also potentially associ-ated with the dynamic I described earlier of exogenous shocks to asset values leading to an adverse feedback loop of mark-to-mar-ket losses, margin calls, and fire sales.

“Maturity rat race”Indeed, some have argued that this dynamic is exacerbated by a “maturity rat race,” in which each creditor acts to shorten the maturity of its lending so as to facilitate quick and easy flight, in which creditors pay rela-tively little attention to the recovery value of the underlying assets. With respect to the too-big-to-fail problem, actual capital levels are substantially higher than before the crisis, and requirements to extend and maintain higher levels of capital are on the way.

The regularisation and refinement of rigorous stress testing may be the single most important supervisory improvement to strengthen the resilience of large insti-tutions. The creation of orderly liquida-tion authority and the process of resolution planning advance prospects for increasing


market discipline. But questions remain as to whether all this is enough to contain the problem. The enduring potential fragility of a financial system substantially dependent on short-term wholesale funding is espe-cially relevant when considering the impact of severe stress or failure at the very large institutions with very large amounts of such funding.

Implicit funding subsidyConcern about the adequacy of policy responses to date is supported by some recent research that attempts to quantify the implicit funding subsidy enjoyed by certain institutions by looking to such factors as credit ratings uplifts, differentials in interest rates paid on deposits or in risk compensa-tion for bank debt and equity, and premi-ums paid for mergers that would arguably place the merged firm in the too-big-to-fail category.

The calculation of a precise subsidy is dif-ficult, and each such effort will likely occa-sion substantial disagreement. But several measures provide at least directionally con-sistent results. In sketching out the kinds of steps needed to address these remaining vulnerabilities, let me begin with wholesale funding generally, before circling back to the question of too-big-to-fail.

Short-term wholesale fundingAt a conceptual level, the policy goal is fairly easy to state: a regulatory charge or other measure that applies more or less compre-hensively to all uses of short-term whole-sale funding, without regard to the form of the transactions or whether the borrower was a prudentially regulated institution.

The aspiration to comprehensiveness is important for two reasons. First, the risks associated with short-term funding are as much or more macroprudential as they are firm-specific.

From a microprudential perspective, SFTs are low risk, because the borrowing is short-dated, over collateralised, marked-to-market daily, and subject to remargin-ing requirements. The dangers arise in the tail and apply to the entire financial market when the normally safe, short-term lending contracts dramatically in the face of sudden and significant uncertainty about asset val-ues and the condition of counterparties. A regulatory measure should force some inter-nalisation by market actors of the systemic costs of this intermediation.

Equivalent controlsSecond, to the degree that regulatory meas-ures apply only to some types of wholesale funding, or only to that used by prudentially regulated entities, there will be a growing risk of regulatory arbitrage. Ideally, the regu-latory charge should apply whether the bor-rower is a commercial bank, broker-dealer, agency Real Estate Investment Trust (REIT), or hedge fund.

Stating the goal is easy, but executing it is not, precisely because short-term wholesale funding is used in a variety of forms by a vari-ety of market actors. Determining appropri-ately equivalent controls is a challenging task and, with respect to institutions not subject to prudential regulation, there may be ques-tions as to where, if at all, current regulatory authority resides.

And, of course, there is the overarch-ing problem of calibrating the regulation so


as to mitigate the systemic risks associated with these funding markets, while not sup-pressing the mechanisms that have become important parts of the modern financial system in providing liquidity and lowering borrowing costs for both financial and non-financial firms. For all these reasons, it may well be that the abstract desirability of a sin-gle, comprehensive regulatory measure may not be achievable in the near term.

Minimum capitalStill, at least as a starting point, we would do well to consider measures that apply broadly. One option is to change minimum require-ments for capital, liquidity, or both at all regulated firms so as to realise a macropru-dential, as well as microprudential, purpose. In their current form, existing and planned liquidity requirements produced by the Basel Committee aim mostly to encourage matu-rity-matched books.

While maturity mismatch by core inter-mediaries is a key financial stability risk in wholesale funding markets, it is not the only one. Even if an intermediary’s book of securities financing transactions is perfectly matched, a reduction in its access to fund-ing can force the firm to engage in asset fire sales or to abruptly withdraw credit from customers.

Contagion risksThe intermediary’s customers are likely to be highly leveraged and maturity transforming financial firms as well, and, therefore, may then have to engage in fire sales themselves. The direct and indirect contagion risks are high. Thus, the long-term and short-term liquidity ratios might be refashioned so as to

address directly the risks of large SFT books. Similarly, existing bank and broker-dealer risk-based capital rules do not reflect fully the financial stability risks associated with SFTs. Accordingly, higher, generally appli-cable capital charge applied to SFTs might be a useful piece of a complementary set of macroprudential measures, though an indi-rect measure such as a capital charge might have to be quite large to create adequate incentive to temper the use of short-term wholesale funding.

By definition, both liquidity and capital requirements would be limited to bank-ing entities already within the perimeter of prudential regulation. The obvious questions are whether these firms presently occupy enough of the wholesale funding mar-kets that standards applicable only to them would be reasonably effective in addressing systemic risk and, even if that question is answered affirmatively, whether the impo-sition of such standards would soon lead to significant arbitrage through increased participation by those outside the regulatory circle.

Universal minimum marginingIn part for these reasons, a second possibility that has received considerable attention is a universal minimum margining requirement applicable directly to SFTs. The Financial Stability Board has already issued a consul-tative paper, and received public comment, on the idea.

Under such a regime, all repo lenders, for example, could be required to take a minimum amount of over-collateralisation as determined by regulators (the amount varying with the nature of the securities


collateral), regardless of whether the repo lender or repo borrower were otherwise pru-dentially regulated. This kind of requirement could be an effective tool to limit procycli-cality in securities financing and, thereby, to contain the risks of runs and contagion.

Discrete aspectsOf course, it also raises many of the issues that make settling on a single policy instru-ment so hard to achieve, and the decision on calibration would be particularly consequen-tial. Still, the concept has much to be said for it and seems the most promising avenue toward satisfying the principle of compre-hensiveness. It is definitely worth pursuing.

As you can tell, there is not yet a blue-print for addressing the basic vulnerabilities in short-term wholesale funding markets. Accordingly, the risks of runs and contagion remain. For the present, we can continue to work on discrete aspects of these markets, such as through the diminution of reliance on intraday credit in tri-party repo markets that is being achieved by Federal Reserve supervision of clearing banks and through the money market fund reforms that I expect will be pursued by the Securities and Exchange Commission.

Limits on rehypothecationWe might also think about less comprehen-sive measures affecting SFTs, such as limits on rehypothecation, when an institution uses assets that have been posted as collat-eral by its clients for its own purposes. But I do not think that the post-crisis programme of regulatory reform can be judged complete until a more comprehensive set of measures to address this problem is put in place.

Before discussing policies specifically directed at too-big-to-fail, let me say a word about the capital regime that should be applicable to all banks, on top of which any additional requirements for systemi-cally important institutions would be built. The first order of business is to complete the Basel III rulemaking as soon as possible.

The required increases in the quality and quantity of minimum capital, and the intro-duction of an international leverage ratio, represent important steps forward for bank-ing regulation around the world. U.S. banks have increased their capital substantially since the financial crisis began, and the vast majority already have Tier 1 common risk-based ratios greater than the seven per cent requirements dictated by Basel III.

Seek changesThe new requirements, while big improve-ments, are not as high as I would have liked, and the agreement contains some provisions I would have omitted or simplified. In com-ing years we may well seek changes. Indeed, I continue to be a strong advocate of estab-lishing simpler, standardised risk-based capital requirements and am encouraged at the initial work being done on the topic of simplification by the Basel Committee.

And we will certainly simplify the final capital rules here in the United States so as to respond to the concerns expressed by smaller banks. But opposing, or seeking delay, Basel III would simply give an excuse to banks that do not meet Basel III standards to seek delay from their own governments. It would be ironic indeed if those who favour higher or simpler capital requirements were unintentionally to lend assistance to banks


that want to avoid strengthening their capi-tal positions. In turning to specific policies to address too-big-to-fail, the first task is to implement fully the capital surcharge for systemically important institutions, the LCR, resolution plans, and other relevant pro-posed regulations. But, completion of this agenda, significant as it is, would leave more too-big-to-fail risk than I think is prudent.

Further workWhat more, then, should be done? As I have said before, proposals to impose across-the-board size caps or structural limitations on banks – whatever their merits and demerits – embody basic policy decisions that are prop-erly the province of Congress. However, that does not mean there is no role for regulators.

On the contrary, Section 165 of the Dodd-Frank Act gives the Federal Reserve the authority, and the obligation, to apply regulations of increasing stringency to large banking organisations in order to mitigate risks to financial stability. In any event, it is unlikely that the problems associated with too-big-to-fail institutions can be efficiently ameliorated using a single regulatory tool. The explicit expectation in Section 165 that there will be a variety of enhanced standards seems well advised.

Three complimentary endsWe should be considering ways to use this authority in pursuit of three complementary ends: ensuring the loss absorbency needed for a credible and effective resolution pro-cess; augmenting the going-concern capital of the largest firms; and addressing the sys-temic risks associated with the use of whole-sale funding.

There is clear need for a requirement that large financial institutions have minimum amounts of long-term unsecured debt that could be converted to equity and thereby be available to absorb losses in the event of insolvency. Although the details will, as always, be important, there appears to be an emerging consensus among regulators, both here and abroad, in support of the gen-eral idea. Debt subject to this kind of bail-in would supplement the increased regulatory capital in order to provide greater assurance that, should the firm become insolvent, all losses could be borne using resources within the firm.

“Gone” and “Going” concernsThis requirement for additional “gone con-cern” capital would increase the prospects for orderly resolution, and thereby counter-act the moral hazard associated with expec-tations of taxpayer bailouts. Switzerland has already adopted a requirement of this sort, and similar proposals are being actively debated in the European Union. A U.S. requirement, enacted under the Federal Reserve’s Section 165 authority, would both strengthen our domestic resolution mecha-nisms and be consistent with emerging international practice.

With respect to “going concern” capital requirements, there is a good case for addi-tional measures to increase the chances that large financial institutions remain viable financial intermediaries even under stress. To me, at least, the important question is not whether capital requirements for large bank-ing firms need to be stronger than those included in Basel III and the agreement on capital surcharges, but how to make them


so and with what specific risks in mind. In this regard, I would observe that our stress tests and capital-planning requirements have already strengthened capital standards by making them more forward-looking and more responsive to economic developments.

Enhance stress testsAs we gain experience, and as the annual process becomes smoother for both the banks and the Federal Reserve, we have the opportunity to enhance the stress tests by, for example, varying the scenario for stress-ing the trading books of the largest firms, so as to reflect changes in the composition of those books.

As to regulatory measures of capital out-side the customised context of stress testing, one approach is to revisit the calibration of two existing capital measures applicable to the largest firms. The first relates to leverage ratio. U.S. regulatory practice has traditionally maintained a complementary relationship between the greater sensitivity of risk-based capital requirements and the check provided by the leverage ratio on too much leverage arising from low-risk-weighted assets.

Off-balance-sheet assetsThis relationship has obviously been changed by the substantial increase in the risk-based ratio resulting from the new min-imum and conservation buffer requirements of Basel III. The existing U.S. leverage ratio does not take account of off-balance-sheet assets, which are significant for many of the largest firms. The new Basel III leverage ratio does include off-balance-sheet assets, but it may have been set too low. Thus, the tradi-tional complementarity of the capital ratios

might be maintained by using Section 165 to set a higher leverage ratio for the largest firms.

The other capital measure that might be revisited is the risk-based capital surcharge mechanism. The amounts of the surcharges eventually agreed to in Basel were at the lower end of the range needed to achieve the aim of reducing the probability of these firms’ failures, enough to offset fully the greater impact their failure would have on the financial system. At the time these sur-charges were being negotiated, I favoured a somewhat greater requirement for the larg-est, most interconnected firms.

Systemic risksHere, after all, is where the potential for negative externalities is the greatest, while the marginal benefits accruing from scale and scope economies are hardest to discern. While it is clearly preferable at this point to implement what we have agreed, rather than to seek changes that could delay any additional capital requirement, it may be desirable for the Basel Committee to return to this calibration issue sooner rather than later.

The area in which the most work is needed is in addressing the risks arising from the use of short-term wholesale funding by systemically important firms. The systemic risks associated with runs on wholesale funding would, almost by definition, be exacerbated if a very large user of that fund-ing were to come under serious stress.

There could also be greater negative externalities from a disruption of large, matched SFT positions on the books of a major financial firm than if the same total


activity were spread among a greater num-ber of dealers. Thus, in keeping with the principle of differential and increasingly stringent regulation for large firms, there is a strong case to be made for taking steps beyond any generally applicable measures that are eventually applied to SFTs or short-term wholesale funding more generally.

DisadvantagesOne possibility would be to have progres-sively greater minimum liquidity require-ments for larger institutions under the LCR and the still-under-construction Net Stable Funding Ratio (NSFR). There is certainly some appeal to following this route, since it would build on all the work done in fashion-ing these liquidity requirements. The only significant additional task would be calibrat-ing the progressivity structure. However, there are at least two disadvantages to this approach.

First, the LCR and, at least at this stage of its development, the NSFR, both rest on the implicit presumption that a firm with a per-fectly matched book is in a fundamentally stable position. As a microprudential mat-ter, this is probably a reasonable assumption. But under some conditions, the disorderly unwind of a single, large SFT book, even one that was quite well maturity matched, could set off the kind of unfavourable dynamic described earlier.

Better insulatedSecond, creating liquidity levels substantially higher than those contemplated in the LCR and eventual NSFR may not be the most efficient way for some firms to become bet-ter insulated from the run risk that can lead

to the adverse feedback loop and contagion possibilities discussed earlier. A more inter-esting approach would be to tie liquidity and capital standards together by requir-ing higher levels of capital for large firms unless their liquidity position is substantially stronger than minimum requirements.

This approach would reflect the fact that the market perception of a given firm’s posi-tion as counterparty depends upon the com-bination of its funding position and capital levels. It would also supplement the Basel capital surcharge system, which does not include use of short-term wholesale fund-ing among the factors used to calculate the systemic “footprint” of each firm, and thus determine its relative surcharge.

Run susceptibilityWhile there is decidedly a need for solid minimum requirements for both capital and liquidity, the relationship between the two also matters. Where a firm has little need of short-term funding to maintain its on going business, it is less susceptible to runs. Where, on the other hand, a firm is significantly dependent on such funding, it may need considerable common equity capital to con-vince market actors that it is indeed solvent. Similarly, the greater or lesser use of short-term funding helps define a firm’s relative contribution to the systemic risk latent in these markets.

If realised, this approach would allow a firm of systemic importance to choose between holding capital in greater amounts than would otherwise be required, or chang-ing the amount and composition of its lia-bilities in order to reduce the contribution it could make to systemic risk in the event of


a shock to short-term funding channels. The additional capital requirements might be tied, for example, to specified scores under an NSFR that had been reworked signifi-cantly so as to take account of the macropru-dential implications of wholesale funding discussed earlier.

Meaningful counterweightIf one wished to maintain the practice of grounding capital requirements in measures of assets, another possibility would be to add as a capital surcharge a specified percent-age of assets measured so as to weight most heavily those associated with short-term funding.

To provide a meaningful counterweight to the risks associated with wholesale fund-ing runs, the additional capital requirement would have to be material. The highest requirement would be at just the point where a firm had the minimum required level of liquidity.

The requirement then would diminish as the liquidity score of the firm rose suf-ficiently above minimum required levels. If the requirement were significant enough and likely to apply to any large institution with substantial capital market activities, it might also be a substitute for increasing the capital surcharge schedule already agreed to in Basel.

Increasing stringencyI readily acknowledge that calibrating the relationship would not be easy, and that the stakes for both financial stability and finan-cial efficiency in getting it right would be significant. But I think this approach is worth exploring, precisely because it rests upon the

link between too-big-to-fail concerns and the runs and contagion that we experienced five years ago, and to which we remain vul-nerable today. Whether it proves feasible, or whether we would have to fall back on the more straightforward approach of strength-ening liquidity requirements for systemically important firms, the key point is that the principle of increasing stringency be applied.

Of late I find myself in two minds on the question of bringing to a close the major ele-ments of regulatory change following the financial crisis. On the one hand, I strongly believe that all the regulatory agencies should complete as soon as possible the remaining rulemakings generated by Dodd-Frank and Basel III.

No victory yetIt is important that banks and other finan-cial market actors know the rules that will govern capital standards, proprietary trad-ing, mortgage lending, and other activities. In fact, we should monitor whether these rules end up having significant unintended effects on credit availability and, if so, modify them in a manner consistent with the basic aims of safety and soundness and consumer protection.

On the other hand, I equally strongly believe that we would do the American public a fundamental disservice were we to declare victory without tackling the struc-tural weaknesses of short-term wholesale funding markets, both in general and as they affect the too-big-to-fail problem. This is the major problem that remains, and I would suggest that additional reform measures be evaluated by reference to how effective they could be in solving it.•


Bank capital rules

A better alternative to the Basel capital rules

Thomas M. Hoenig, director of the FDIC, urges global regulators to radically rethink

their approach to bank capital standards.

Having been involved in central bank-ing and financial supervision my entire career; i understand the importance of having the right market conditions and regulatory framework for an economic system to thrive. and most certainly i know that the foundation of a strong financial system is strong capital. For these reasons i wish to add a personal perspective on the present global dis-cussions regarding Basel iii. after read-ing the entire 1,000-plus page proposal, i would encourage the Basel Committee on Banking Supervision and the inter-national regulatory community itself to step back and rethink the Basel capital standards.

It may be helpful first to recall how the Basel Accords have evolved since the first agree-ments was reached in 1988. Following the implementation of Basel I, many in econom-ics and finance, together with many of the world’s largest banks, wanted a more sophis-ticated and flexible risk-based capital stand-ard. The U.S. chaired the Basel II Committee then, and with others, agreed that such

change was necessary for the largest firms to remain globally competitive. Basel II and III were also given the task of satisfying various competing national interests, adding fur-ther complexity to the equation. As a result, the number of Basel risk weights evolved from five to thousands under the present framework.

Basel’s poor recordBasel III is intended to be a significant improvement over earlier rules. It does attempt to increase capital, but it does so using highly complex modelling tools that rely on a set of subjective, simplifying assumptions to align a firm’s capital and risk profiles. This promises precision far beyond what can be achieved for a system as com-plex and varied as that of U.S. banking. It relies on central planners’ determination of risks, which creates its own adverse incen-tives for banks making asset choices.

The poor record of Basel I, Basel II and Basel II.5 is that of a system that is funda-mentally flawed. Basel III is a continuation of these efforts, but with more complexity. It also is more prolific since it applies across all


banking firms. Directors and managers will have a steep learning curve as they attempt to implement these expanded rules. They will delegate the task of compliance to tech-nical experts, and the most brazen and con-nected banks with the smartest experts will game the system.

Private unease, public dissentIn private discussions I find a good deal of uneasiness about Basel III’s ability to be more effective than previous Basel efforts; however, there appears to be an impending sense of no return. However, in my opinion we not only can go back, but we must. In my remarks to follow, I will set out my views on the role of capital and the flaws of Basel III, and then will suggest a simpler alternative designed to take us back to the basics.

Capital is the foundation on which a bank’s balance sheet is built. There can be no fortress balance sheet without fortress capi-tal. In a market economy, capital insulates a firm from unexpected shifts in risk and from losses on loans and investments gone bad.

A reliable capital measure facilitates the public’s and the market’s understanding and judgment of the financial condition of a firm and industry. And finally, while essential to the health of a firm, capital has its limits. Even high levels of capital cannot save a firm from bad management or save an industry from the cumulative effects of excessive risk taking.

Prior bank capital levelsIn judging the role of capital, it is useful to look back at bank capital levels in the U.S. before the presence of our modern safety net. Prior to the founding of the Federal Reserve

System in 1913 and the Federal Deposit Insurance Corporation in 1933, bank equity levels were primarily market driven. In this period the U.S. banking industry’s ratio of tangible equity to assets ranged between 13 and 16 per cent, regardless of bank size. Without any internationally dictated stand-ard or any arcane weighting process, mar-kets and the public required what would seem today to be excessively high capital levels.

With the introduction and expansion of the safety net of deposit insurance, central bank loans and ultimately taxpayer sup-port, the market’s capital demands changed. While the safety net protects depositors from loss and promotes stability in the system, its secondary effect has been to erode the mar-ket’s role in disciplining banks. Depositors and other creditors have come to under-stand that the safety net protects them far more importantly than does bank capital or good management.

Pertinent questionsIt is important to ask where these changes have taken us. One of the most significant results has been that bank supervisors, rather than the market, have been left the difficult task of determining adequate capital for the industry.

Unfortunately this has led to a systematic decline in bank capital levels. Between 1999 and 2007, for example, the industry’s tan-gible equity to tangible asset ratio declined from 5.2 per cent to 3.8 per cent, and for the ten largest banking firms it was only 2.8 per cent in 2007.

More incredible still is the fact that these ten largest firms’ total risk-based capital


ratio remained relatively high at around 11 per cent, achieved by shrinking assets using ever more favourable risk weights to adjust the regulatory balance sheet. It is no coin-cidence then that the financial industry in 2008 was unable to withstand the pressures of a declining market, nor bear anywhere near the losses that the taxpayer eventually assumed.

Capital rules failureIt turns out that the Basel capital rules pro-tected no one: not the banks, not the public, and certainly not the FDIC that bore the cost of the failures or the taxpayers who funded the bailouts. The complex Basel rules hurt, rather than helped the process of measure-ment and clarity of information. Basel III introduces a leverage ratio and raises the minimum risk-weighted capital ratios, but it does so using highly arcane formulas, sug-gesting more insight and accuracy than can possibly be achieved.

Where the markets assess, demand and adjust intrinsic risk weights on a daily basis, regulators using Basel look backwards and never catch up. For example, people knew well in advance of the recent financial cri-sis that the risk on home mortgages had increased during the period between 2005 and 2007, yet no changes were made to the risk weights. Basel III still looks backward as demonstrated by the few changes made regarding the weights assigned to sovereign debt.

Time to start overFinally, it is noteworthy to observe how much the industry’s capital level diverges depend-ing on which Basel measure is reported. For

the ten largest U.S. banking organisations as of the second quarter of 2012, total Tier I equity capital was US$1.062 trillion. Total adjusted tangible equity capital was US$606 billion. In a crisis, which number counts?

Given the questionable performance of past Basel capital standards and the com-plexities introduced in Basel III, the supervi-sory authorities need to rethink how capital standards are set. Starting over is difficult when so much has been committed to the current proposal. The FDIC is no different from other U.S. and international regulatory agencies where committed staff has devoted enormous effort to drafting and implement-ing Basel III. However, starting over offers the best opportunity to produce a better outcome.

An alternative to BaselHow might we better assess capital ade-quacy? Experience suggests that to be useful, a capital rule must be simple, understand-able and enforceable. It should reflect the firm’s ability to absorb loss in good times and in crisis. It should be one that the public and shareholders can understand, that directors can monitor, that management cannot easily game, and that bank supervisors can enforce. An effective capital rule should result in a bank having capital that approximates what the market would require without the safety net in place.

The measure that best achieves these goals is what I have been calling the tangible equity to tangible assets ratio. Tangible equity is simply equity without add-ons such as good will, minority interests, deferred taxes or other accounting entries that disappear in a crisis. Tangible assets include all assets


less the intangibles[1]. This tangible capital measure does not remove the complexities from the balance sheet. It does not attempt to differentiate risks among assets. It does not tier the measure into any number of refined levels. There is no governmental ex-ante endorsement of risk assets or capital allocations.

Simpler, stronger measureInstead, this tangible capital measure is a demanding minimum capital requirement within which management must allocate resources within the overall capital con-straint. This simple measure accepts that firms quickly shift their allocation of assets to take advantage of changing risks and rewards. This simpler but fundamentally stronger measure reflects in clear terms the losses that a bank can absorb before it fails and regardless of how risks shift. It provides a consistent and comparable measure across firms.

Since the federal safety net is the current substitute for capital in protecting the depos-itor, it also is reasonable that the supervisor should expect the same minimum capital, as would the market without the safety net. As noted earlier, the equity ratio for the bank-ing industry before the safety net was imple-mented ran between 13 and 16 per cent. Therefore, the starting point for any discus-sion of an acceptable level of tangible equity for all banking firms should be well above the 3.25 per cent level now implied by the Basel III proposal.

Assessing institutional riskFinally, under this simpler approach there remains the challenge of more precisely

assessing individual institutional risk and judging whether this minimum capital is adequate. That judgment should be deter-mined through the periodic examination process, which for the largest banks has become de-emphasised in favour of stress tests. It is the often-ignored Pillar II of the Basel standards.

This is no simple task. However, it is through this process, properly conducted, that supervisors can best assess a financial firm’s fundamental operations, liquidity, asset quality and risk controls. Some disre-gard it perhaps because they claim regulatory capture. My own experience is that commis-sioned examiners as a rule are highly skilled professionals, able to effectively assess bank risk. If the financial supervisors’ record needs improvement, we must hold accountable the leadership of the regulatory agencies. The examination process, effectively con-ducted, holds the best potential to identify firm-specific risks and adjust capital levels as needed.

Too little capitalSome argue that a simple measure with a relatively stronger minimum capital level would reduce liquidity in the market, con-strain loan growth and undermine the econ-omy. I offer a different perspective.

First, experience tells us that economies compete best from a position of strength, and a strong economy will always have banks with strong capital and balance sheets. The recent recession and credit crunch were made worse because banks had too little capital as they entered the crisis.

They were forced to sell assets and shrink their balance sheets in the absence of a


strong capital cushion to absorb losses. The U.S. economy would have been significantly less harmed had the financial industry been holding adequate capital in the run up to the 2008 crisis.

Liquidity & leverageSecond, the term “increased liquidity” is often used when the objective is really “increased leverage.” In the growth phase of an eco-nomic expansion, borrowing is readily avail-able, and firms and individuals easily borrow funds. Some describe this as a liquid market.

A more appropriate description is lev-eraging up. Liquidity is the ability to con-vert assets to cash without loss. Leverage is expanding the balance sheet using debt. It is therefore often the case that greater balance-sheet leverage results in less balance-sheet liquidity. This is especially true in a crisis.

Third, a reasonable capital level does not inhibit economic growth. It sustains it. For example, a ten or higher per cent tangible capital to tangible asset ratio, depending on exam findings, allows a dollar of capital to support as much as ten dollars of loans and other assets. Leverage is permitted, and credit is available and supportive of long-term growth. Sustainable growth is enabled. Excessive growth is impeded.

Equitable treatmentFinally, a simple, understandable and enforceable capital standard when measured consistently, not subject to manipulation, and enforced uniformly across the industry provides for equitable treatment of all firms within the industry, from smallest to largest.

In contrast, the Basel Accord would permit a commercial bank to be judged as

“adequately” capitalised having a Tier I lever-age ratio of 4 per cent, which implies an even lower tangible equity ratio, so long as the total risk weighted capital ratio is above 8 per cent, and the Tier I risk weighted risk capital ratio is above 6 per cent, and the common equity Tier I risk weighted capital ratio is above 4.5 per cent. This is more complicated than simple, more confusing than clear and more easily gamed than not.

In reading the Basel proposal, I am con-vinced that much of its complexity derives from the complexities and conflicts embed-ded in the combination of commercial banking and broker/dealer activities. The safety net’s enormous subsidy encourages ever-greater risk taking as firms attempt to achieve a higher return on equity than would otherwise accrue from operating the payments system and serving as a financial intermediary. In other words, from what they would earn from commercial banking.

Incentive to higher riskThe safety net’s subsidy facilitates the use of leverage and provides an incentive toward higher risks that are hidden in opaque instru-ments, in trading activities and in derivatives. It bestows an advantage to subsidised firms not afforded to others. Solving this problem requires a fundamental restructuring that separates banking from trading activities [2].

Now, in the mistaken belief that the sub-sidy can be neutralised, and that risks and shifting risks can be captured, measured and properly and quickly capitalised using financial models, we get Basel III. It’s time we acknowledge that no Basel model can accomplish this complex objective. Markets move too quickly, and human nature is too


dynamic. Basel III will not improve out-comes for the largest banks since its com-plexity reduces rather than enhances capital transparency. Basel III will not improve the condition of small and medium-sized banks. Applying an international capital standard to a community bank is illogical, particularly when models have not supplanted exami-nations in these banks. To implement Basel III suggests we have solved measurement problems in the global industry that we have not solved. It continues as an experiment that has lasted too long.

Acknowledge limitsWe would be wise to acknowledge our lim-its, to simplify the system, to confine the subsidy, and to reduce the taxpayers’ expo-sure to enormous future liability. It is time for international capital rules to be simple, understandable and enforceable.

I understand where the proposal stands and how much has been invested in drafting Basel III, but I believe the Committee should agree to delay implementation and revisit the proposal. Absent that, the United States should not implement Basel III, but reject the

Basel approach to capital and go back to the basics. By doing so, we can focus on efforts that will create a well-managed, well-capi-talised, well-regulated financial system that actually supports economic growth.•

Endnotes[1] The measure of tangible equity and tangible

assets used here differs from the GAAP meas-ures, which excludes intangible assets such as goodwill, by also excluding deferred tax assets. Deferred tax assets are excluded because they are not available for paying off creditors when a bank fails, that is, they are “going concern” assets but not “gone concern” assets.

[2] My proposal to limit activities supported by the public safety net by restricting commercial bank-ing organizations to traditional banking activities and limited other intermediation activities can be found at http://www.fdic.gov/about/learn/board/Restructuring-the-Banking-System-05-24-11.pdf

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

Journal oF regulation & riSk nortH aSia

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

November 15th 2013


Derivatives

Regulation of cross-border OTCs: A middle ground

SEC Commissioner Elisse B. Walter sees “substituted compliance” as a silver bullet

to regulating the global derivatives market.

Today at the Securities and Exchange Commission and in government agen-cies around the world, regulators are shaping the rules that will govern the way over-the-counter derivatives are transacted. It’s a crucial task given the magnitude and importance of this mar-ket to the international financial sys-tem, presently estimated to be worth in excess of US$639 trillion by the Bank for International Settlements.

In the process, regulatory and supervisory bodies the world over are grappling with the fact that these transactions rarely respect national boundaries. They are complex transactions that routinely cross borders, and are potentially subject to multiple sets of rules. To ensure our regimes work effectively, we need to have a common sense, flexible approach to the cross-border regulation of the derivatives market.

As most are aware, following the finan-cial crisis there was a new focus placed on the regulation of over-the-counter (OTC) derivatives – and for good reason. The expe-riences of companies like AIG highlighted

how the default – or even the threat of a potential default – of a single party involved in a series of derivatives transactions could create widespread instability.

Spill-overWe all witnessed that it didn’t matter whether the counterparty or trading desk was based in the U.S. or overseas, or whether the con-tract was executed in Miami or Milan. What mattered was that the potential spill-over ultimately limited the willingness of market participants worldwide to extend credit.

In the United States, Congress passed the Dodd-Frank Act in August 2010 man-dating the creation of a new regulatory environment to govern this multi-trillion dollar market – a market that U.S. regula-tors previously had been largely barred from regulating.

Split responsibilities The Commodities Futures Trading Comm- ission (CFTC) was given responsibility for “swaps,” and the Securities and Exchange Commission (SEC) for a portion of the OTC derivatives market known as “security-based


swaps” – those which include, for example, swaps based on a security, such as a stock or bond, or credit default swap.

Increased focusBut the increased focus on OTC derivatives regulation was not exclusively restricted to the United States. Other regulators and governments across multiple jurisdic-tions, among them Canada, the European Commission, Hong Kong and Japan, also sought to address the tremendous risks associated with derivatives transactions. And they came to the conclusion that a world-wide comprehensive scheme of regulation would be necessary.

Consistent with this effort, the leaders of the G-20 group of leading economies committed to a global effort to regulate OTC derivatives with the stated goals of mitigating systemic risk, improving market transparency, and protecting against market abuse.

A key element of the policy statement concerns how we intend to apply our rules to cross-border activities. We have commit-ted to issuing this cross-border proposal before fully implementing our regulatory framework. To help ensure we get this right, both the SEC staff and I have spent count-less hours meeting with other regulators in the U.S. and around the globe who are also dealing with these same issues.

Sensible and crucialOf course, trying to get all the various regula-tory pieces to fit together in a sensible way is crucial for a derivatives market that is inter-national in scope. This is because a party to any transaction needs to know which laws it

must abide by when its transaction touches more than one country. This cross-border challenge has not manifested itself in the same way for other securities and financial products as it has for the OTC derivatives markets – in part because of the way in which those markets developed.

Consider securities regulation, which predated the technology that made cross-border transactions feasible on a large scale. For many years’ securities regulation was largely crafted with only domestic markets and domestic market participants in mind.

Over time, as cross-border activities became more common in various parts of the securities arena, regulators began to address questions that arose on an issue-by-issue basis. A holistic approach to con-sidering cross-border securities transactions generally wasn’t considered because, frankly, it wasn’t needed. Now, with derivatives, it is.

Explosive growthIn sharp contrast to the traditional securi-ties markets, the multi-trillion dollar OTC derivatives market became a significant market well after the advent of global trad-ing – exploding in size over the last 20 years, operating relatively seamlessly across juris-dictions, and evolving largely without regu-latory restraints.

Today, cross-border derivatives trans-actions are the norm, not the exception. Therefore, once regulations are implemented across the major derivatives jurisdictions, the majority of derivatives transactions could be subjected to multiple regulatory regimes. The potential for conflicts among those regimes is obvious. Against this backdrop of conflicting or contradictory rules, market


participants have the ability to move – or restructure – their OTC derivatives activity with relative ease, avoiding more regulated markets, in search of less regulated ones. After all, derivatives are contracts between counterparties and need not be anchored to any particular geographic location or spe-cific market.

A “race to the bottom”Some refer to the threat of migration to less regulated jurisdictions as regulatory arbitrage; others a “race to the bottom.” But whatever terminology used, this very real possibility threatens the objectives of all of us who seek to reduce systemic risk, improve transparency, protect against market abuse and ensure the global system functions properly. In a nutshell, both investors and markets deserve better.

That means that getting these cross-border issues right for OTC derivatives is crucial. I know that. And my domestic and international counterparts know that. Yet, as we build this new framework from the ground up and with a common set of goals, we must accept that each jurisdiction neces-sarily is approaching derivatives reform from a slightly different direction.

Differing perspectivesCountries come at the process from differ-ent historical, legal and regulatory perspec-tives, and move forward at different speeds. No amount of effort is going to completely reconcile these differences. After many years of regulatory experience, I have learned that it may not be fruitful to try to convert one another to our own particular regulatory philosophies. Instead, we should continue

to expend our energy on a search for com-patible, rather than identical, approaches to cross-border issues.

Gaps, overlaps, conflictsThis means ensuring that our different reg-ulatory regimes do not produce the gaps, overlaps or conflicts that could disrupt the global derivatives market and lead to regula-tory arbitrage.

Focusing on “compatible” rather than “identical” regulation brings us close to a system that achieves our collective goals of mitigating systemic risk, improving trans-parency, and protecting against market abuse, while also recognising the legitimate and important differences between our regulatory regimes and markets. The impor-tance of a compromise approach becomes evident when we look at the spectrum of approaches available.

The “all-in” approachAt one end of the spectrum is the view that any transaction that touches a jurisdiction – or a person in that jurisdiction – in any way, needs to be subjected to the entire range of regulatory requirements specific to that jurisdiction. This I will define as the “all-in” approach.

Although this approach gives full weight to the unique requirements of local law, I am concerned that subjecting any derivatives transaction – that has any connection to a country – to all of the rules and regulations of that country risks unnecessary duplication and conflict.

Indeed, to the extent that two sets of rules conflict, this approach would place mar-ket participants engaging in a cross-border


transaction in the untenable position of choosing which country’s requirements to violate. Market participants may have to withdraw from one of those markets or incur the costs associated with restructuring their business.

Equivalence and recognitionAt the other end of the spectrum is the view that broad deference should be given to a foreign jurisdiction’s full regulatory regime – in lieu of one’s own regulatory regime – so long as it is comparable in its objective.

Market participants, intermediaries, and infrastructures would be subject to one set of rules for their cross-border activity. The entire regime is recognised as comparable or not comparable. It’s all or nothing, an approach that is often referred to as “equivalence” or “recognition.”

Along these lines, some proponents of this approach also demand reciprocal treatment. In other words, “I will recognise the comparability of your rules only to the extent that you recognise the comparability of mine.”

At first glance, a recognition approach may appear reasonable and consistent with a desire to reduce conflicts, inconsistencies, and duplicative requirements among regu-latory regimes.

Serious concernsHowever, as I have discussed the details with my foreign counterparts, I have developed increasingly serious concerns about the potential consequences of an “all or nothing” approach to cross-border OTC regulation.

Recognition may be an important tool in crafting cross-border regulation in some

contexts, but wholesale recognition cannot be the exclusive tool if it means that critical regulatory requirements in one regime are jettisoned as a result.

Further, I become particularly concerned when such wholesale recognition is com-bined with reciprocity. In other words, “I refuse to recognise your regime unless you recognise mine as equivalent in all respects.”

Quid pro quo consequencesIn my opinion, tying recognition and reci-procity does not move us toward our united goals. This is a because a regulator might feel compelled to recognise a foreign country’s regulations as “equivalent”, solely to avoid the quid pro quo consequences of not hav-ing its own regulations deemed “equivalent” in return.

In turn, the regulator might feel pressure to gloss over major differences and make a sweeping equivalency determination – that is even when a regime imposes a critical policy requirement and the foreign regime does not.

Forced to submitThis type of recognition, driven by the threat of reciprocity could actually create regulatory gaps between these so-called “equivalent” regimes, allowing certain market partici-pants to exploit the differences and escape important requirements by simply choosing to comply with the more permissive regime.

Additionally, a regulator may feel forced to submit to the threat of not being eligible for recognition treatment because its own regulated entities could suffer if the foreign country does not recognise that equivalence exists. This could happen when Country A


chooses not to allow market participants from Country B to do business in Country A unless Country B deems the other country’s regulatory regime to be equivalent.

I am particularly concerned that this forced recognition approach could sub-stantially disrupt an established market and spark a regulatory race to the bottom, as regulators facing such “equivalency” deter-minations realise the apparent futility of maintaining comparatively higher standards in key policy areas.

Sparking a trade warOn the other hand, such a situation could spark a type of trade war in financial ser-vices, and lead to fragmentation of the global marketplace. Given that neither of these are welcome developments, perhaps we require a third way, or middle ground

In short, subjecting every OTC deriva-tives transaction that touches the United States in some way to all aspects of U.S. law – that is, the “all-in” approach - ignores the realities of the global marketplace. And yet, treating clearly different regimes as equiva-lent across all key policy areas risks are set to create regulatory gaps, regulatory arbitrage, and a potential regulatory race to the bottom.

Middle groundGiven the aforementioned issues, it is my contention that a middle ground actually exists to resolve the problems highlighted thus far. That said, the Commission has not yet, as a body, proposed the specifics of this approach. However, I personally support an approach that would permit a foreign market participant to comply with require-ments imposed by its home country that are

comparable with U.S. regulation, so long as it abides by U.S. requirements in areas where the home country’s regulations are not comparable.

I refer to this as approach as “substituted compliance”, one that accepts the inevita-ble differences between regulatory regimes when those differences nevertheless accom-plish similar results. There’s no “my way or the highway.” Instead, parties may substitute compliance with one regulatory regime for another. But we would reserve the right to insist upon compliance with our own regu-lations when necessary. It’s an approach that focuses on what we see as real threats to the Dodd-Frank goals of stability, transparency, and investor protection.

FlexibilityFor example, the SEC could make a deter-mination that would allow market partici-pants based in a foreign jurisdiction to follow their own jurisdiction’s capital requirements. But at the same time, the SEC could require these market participants to follow SEC rules concerning, for instance, public report-ing requirements, if the foreign jurisdiction itself did not have a comparable set of public reporting requirements.

This approach provides flexibility to mar-ket participants and regulators alike, allow-ing us to eliminate duplicative regulation when it is truly duplicative, while recognising that regulatory regimes will necessarily differ in some respects.

While “substituted compliance” does envision looking at different pieces of a juris-diction’s set of rules, I do not believe that the ultimate determination of substituted compliance will be based on a line-by-line


comparison of those rules. Instead, in mak-ing a substituted compliance determina-tion, one would look at key categories of regulation.

Retain focus on outcomesIn addition, one would keep the focus on regulatory outcomes, not the means of achieving those outcomes. Of course, in making these determinations, one would look not just at the way in which a country’s laws and regulations are written, but also, and crucially, at how that country supervises and enforces compliance with its rules.

At this point, I cannot stress how impor-tant this aspect of the “substituted compli-ance” approach is to me. After all, effective regulation does not end with the writing up of rules. Rules must be the starting point and effective supervision and enforcement of those rules is key not only to achieving the G-20 goals, but also to advancing the SEC’s core mission to protect investors, maintain fair, orderly, and efficient markets, and facili-tate capital formation.

For all of these reasons, I believe that the “substituted compliance” approach provides a workable method and a necessary balance within the global market and regulatory environment in which we operate.

Public reporting requirementDuring discussions with the SEC staff, I have learned that the distinction between substi-tuted compliance and what I call recognition and reciprocity is sometimes elusive.

Given this unfortunate fact, the problem can best be summed up in the following illustration. Let’s consider the public report-ing requirements I mentioned earlier in this

paper. As most are aware, the Dodd-Frank Act requires that transaction, volume, and pricing data of all security-based swaps be publicly disseminated in real time, except in the case of block trades.

These requirements are designed to promote transparency and efficiency in the security-based swap market, by providing more accurate information about the pric-ing of security-based swap transactions, and thus about trading activity.

Promoting transparency and efficiency in the security-based swap market is one of the primary goals of the new regulatory framework established by the Dodd-Frank Act. It is not an afterthought.

Bringing sunshineGiven the key role that public transpar-ency requirements play in U.S. efforts to bring sunshine to the largely opaque OTC derivatives markets, I fully expect that public reporting would be one of a number of key categories of requirements that would be the focus of a substituted compliance determi-nation for foreign regulatory regimes.

But the fact that a foreign regulatory regime might not be comparable to ours with respect to public transparency should not be fatal to an SEC substituted compli-ance determination in other areas.

In fact, the SEC could still recognise other areas of a foreign regulatory regime – such as mandatory clearing or capital requirements. Foreign market participants would, how-ever, continue to be subject to the SEC rules regarding public reporting.

This outcome under a substituted com-pliance approach contrasts markedly with what might be described as the “rock and


a hard place” approach that an equivalence determination for an entire foreign regula-tory regime would present.

If the SEC were to adopt such a “recog-nition and reciprocity” approach, we would be faced with the difficult choice: either not make an equivalence determination with respect to the foreign regime, or to deter-mine that a foreign regulatory regime is “equivalent” – even if a key aspect of our regulatory regime were absent.

Much needed stabilityI recognise, of course, that the differences between substituted compliance in specific regulatory areas and an equivalence deter-mination for an entire foreign regulatory regime raise difficult issues and there are many competing interests. And regulators, myself included, can have very strong views about what constitutes the right approach. I nonetheless am committed to resolving these and other difficult issues.

I am also gratified that our regulatory partners are equally determined to fashion arrangements that support investor protec-tion and capital formation, while bringing much needed stability to our global financial system.

Aligning regimesClearly it will be crucial to align the differ-ent regulatory regimes for cross-border transactions in a way that minimises the risk of gaps, conflicts, and inconsisten-cies. But this is not the only consideration in working through effective regulation in the cross-border arena. Also crucial will be for regulators to make sure that their differ-ent regimes work together, for example, to

provide comprehensive data on cross-bor-der transactions.

This is important because the relevant authorities must have an accurate view of the global derivatives market through access to data they need to carry out their mandates. Comprehensive information helps regula-tors identify and address systemic risk and promote stability across markets, as well as monitor, and protect against, market abuse.

However, compiling comprehensive transactional data is challenging enough in a complex domestic market. And, it gets far more complicated in the cross-border world of derivatives, where for example, the vast majority of credit default swaps cross national borders. Fortunately we’re not start-ing from scratch.

Regulation reporting goalsIt is estimated that at least some information on well over 90 per cent of outstanding gross notional amounts in credit derivatives were reported to a trade repository at the end of 2012. However, submission of this informa-tion was largely voluntary, and the result of substantial supervisory encouragement. Further, it did not include all the information regulators need to effectively oversee this market.

One goal of regulation in this area is to increase the quality and quantity of informa-tion reported to trade repositories, so that regulators have the data they need to do their jobs.

There are, however, challenges to getting the data that regulatory authorities require. Certain countries, for example, have pri-vacy laws, blocking statutes, and other laws that restrict or limit the disclosure of certain


information about trade counterparties. Such measures may interfere with global regulatory reporting by prohibiting or lim-iting entities from reporting the identity of their counterparty into trade repositories – thereby undermining the usefulness of these repositories. Regulators internationally, as well as individual jurisdictions, are actively working to develop potential cures.

Interim solutionAs an interim solution, some market partici-pants have received temporary relief to sub-mit reports to certain trade repositories with “masked” data – that is, data that includes some, but not all, of the required relevant information. This is of course a temporary, pragmatic fix to an immediate challenge arising from the new regulatory regime for reporting. However, it is clearly not a long-term solution. Regrettably, potential impedi-ments are not solely the province of foreign law.

Another challenge to getting data comes from the Dodd-Frank Act itself. That Act requires regulators to agree to bear certain potential costs arising from data sharing. In particular, before an SEC-registered trade repository can share information with a domestic or foreign regulator other than the SEC, the regulator must agree, among other things, to indemnify the trade reposi-tory for certain litigation expenses that may be incurred by the repository. The CFTC has a similar provision.

Open-ended indemnificationWe understand that foreign authorities may be prohibited under their laws from satisfy-ing the indemnification requirement. In fact,

even certain U.S. authorities, are not permit-ted to provide an open-ended indemnifica-tion agreement.

Given the limitations of the indemnifica-tion requirements, foreign regulators have expressed concerns about their ability to directly access data held in an SEC or CFTC-registered trade repository. That is why the SEC has publicly advocated for a legislative fix and is considering ways to address this issue in our forthcoming proposal on cross-border issues.

More generally, I can tell you that I per-sonally am committed to doing what I can to make sure that comprehensive data on the global OTC derivatives market are made available to all regulators with a mission-based need for that information. As one of the regulators charged with reforming the OTC derivatives market, I believe the SEC and fellow regulators must strive for no less.

ConclusionIn short, I believe that the regulators of OTC derivatives across the globe working together in good faith and common purpose can bring about a more stable, more trans-parent, and fairer OTC derivatives market, while preserving its global, dynamic char-acter. But I believe we will succeed only if we find the middle ground. There is far too much at stake, in my view, for regulators to do any less. •

Editors note: The publisher and editor of the Journal would like to thank the Securities and Exchange Commission and the office of Commissioner Walter for allowing us to produce an amended version of this speech delivered in April this year.


Central banking

Lessons from the crisis: The flaws of inflation targeting

Former ECB executive board member, Otmar Issing, cautions central banks not to

ignore past lessons on inflation targeting.

There is consensus that not since the Great Depression has the world seen a crisis of the dimension which became obvious after 2007. Fiscal policy became expansionary with exploding public def-icits. Central banks worldwide reduced their interest rates to zero or at least to levels not seen before and on top con-ducted various unorthodox operations. The combination of these measures prevented a repetition of the collapse of production and surge in unemployment, which happened after 1929. At the same time a discussion started about what les-sons should be drawn from this recent experience.

Every crisis also opens an opportunity. The challenge of this crisis for policymakers and researchers is to identify which factors were decisive for all these problems and what could be done to increase our knowledge and improve policy to prevent a repetition of past mistakes and, hopefully, the emergence of new crises.

To be clear, the idea cannot be to avoid any ups and downs of the economy. Cyclical

movements are an unavoidable and even necessary element of any dynamic economy. However, in the future, any financial crisis of the dimension just seen must be prevented.

A flood of studies on “lessons” gives the impression that research has taken up this challenge. On monetary policy, a legion of papers has already been published (e.g., Bean, 2010; Clarida, 2010; Fahr and others, 2010; Mishkin, 2010; and Svensson, 2009), and many more will follow. A number of papers discuss issues in the broader context of general macro and/or macroprudential aspects (Blanchard, Dell’Ariccia, and Mauro, 2010; and IMF, 2010).

Pre-crisis consensusMost approaches start from what is seen as the pre-crisis consensus. Whereas the details may differ, the result boils down to inflation targeting as state-of-the-art monetary policy. And, after reflections on what lessons to take from the crisis – for a thorough analysis see Mishkin (2010) – the conclusion is that this strategy is still optimal. “The case for the basic monetary policy strategy, which for want of a better name, I have called flexible


inflation targeting, is still as strong as ever, and in some ways, more so” (Mishkin, 2010, p. 48). Another prominent advocate comes to this result: “In the end, my main con-clusion so far from the crisis is that flexible inflation targeting, applied the right way and using all the information about financial fac-tors that is relevant for the forecast of infla-tion and resource utilisation at any horizon, remains the best-practice monetary policy before, during, and after the financial crisis.” (Svensson, 2009, p. 7)

Flaws in the strategyWith all respect for highly influential research, this statement immunises the strategy against any critique [1]. And stating that a strategy, which fulfils these demand-ing conditions is best practice comes close to tautology. But beyond that, this defence of inflation targeting implies the pretension that previous versions fulfilled the principle of “using all information.” Looking back to the performance of the strategy, it is hard to accept this as a convincing statement.

Most papers on “lessons”, such as those mentioned, start from the assumption that flaws in the strategy can be corrected by adding factors missing so far but do not put into question the concept as such. Is this not fighting the last war and risking losing the next one, too?

A robust framework Would it not be more promising to start from identifying the principles of a frame-work that is robust under any conditions and challenges that lie in the future? This was at least our ambition at the European Central Bank (ECB) when we designed our strategy

under the motto, “The need for robustness in a world of uncertainty” (ECB, 2000)[2].

It is no exaggeration to say that for many years, “money”– in a very broad sense – was widely ignored in mainstream economics. To a large extent this was also the case in central banks. Overall, the fundamental argument was that for reasons of financial innova-tion, the historical relationships between “money”, nominal GDP growth, and infla-tion had broken down. Velocity had become unpredictably volatile[3].

This verdict on “money” refers, in the first place, to the relation between mon-etary aggregates and inflation. However, the neglect extended to monetary factors in gen-eral, including the composition of monetary aggregates and their counterparts, above all credit.

Monetary factorsNow the tide seems to turn. Interestingly, it is the financial crisis that has triggered the consideration of whether asset price booms caused by credit expansion should not be a matter of concern (Blinder, 2010; Mishkin, 2010). There should have been ample evi-dence before the crisis that money and espe-cially credit can be a driving factor of asset prices. [4] Research by the BIS (e.g., Borio and Lowe, 2002; Borio and Lowe, 2004) and by the ECB (e.g., Detken and Smets, 2004) support the view that nearly all major unsus-tainable booms in asset prices were accom-panied if not preceded by strong increases in credit and/or money.

Monetary factors – I use this term in a broad sense, including credit in all its mani-festations – can be used for the analysis of on-going asset price developments as well


as for forecasting those developments (ECB, 2010a; ECB, 2010b; Gerdesmeier, Reimers, and Roffia, 2009). A central bank that moni-tors the development of money and credit and takes these factors into account when making monetary policy decisions there-fore implicitly applies a “leaning against the wind strategy” without having to identify the emergence of bubbles (or the opposite).

The role of macroprudential toolsIn a world of globalised financial markets, “domestic” money and credit, and therefore asset prices (as well as domestic inflation), might be influenced by global developments. This aspect has been studied by a number of papers (e.g. Sousa and Zaghini, 2004; Borio and Filardo, 2007; Rüffer and Stracca, 2007; Alessi and Detken, 2009; Ciccarelli and Mojon, 2010). This leads to the question of what a central bank can achieve acting alone and what would then be the consequence for the exchange rate.

As already discussed, notwithstanding the fact that macroprudential tools should play a major role, the challenge for mon-etary policy is how to integrate asset price considerations – that is, “leaning against the wind”– into the monetary policy strategy. For inflation targeting this seems very hard to do.

Judging the transmission mechanismInflation targeting, with all its refinement, is based on a forecast for (goods price) inflation using models in which monetary factors do not play an active role. Including “frictions” in such models might be useful as a research strategy, but cannot give practical advice to monetary policymakers (see e.g. Curdia

and Woodford, 2010). Svensson (2009, p. 7) makes a rather sober statement: “Before such extensions of the modelling framework are operational, policymakers and staff have to improvise and apply unusual amounts of judgement on the effects of the financial crisis on the transmission mechanism. Even with much better analytical foundations concerning the role of financial factors in the transmission mechanism, there will be of course, as always, considerable scope for the application of good judgement in monetary policy.”

Anchoring expectationsThis “confession” raises fundamental ques-tions on appropriate communication, on the predictability and credibility of the cen-tral bank, and finally on anchoring inflation expectations. Is it unfair to say that what was once seen, as the “beauty” of an approach connecting monetary policy decisions with the forecast of inflation seems now to be more or less dissolved?

The fundamental problem of inflation targeting becomes obvious in a situation in which the forecast for (goods price) infla-tion signals “no need to change central bank interest rates” or might even indicate down-ward risks, whereas credit (and money) are rising together with asset price increases.

The “risk taking channel” (Borio and Zhu, 2008; Adrian and Shin, 2009) explains how low interest rates foster the emergence of financial imbalances and create the risk of a collapse in asset prices (see also BIS, 2010), a theory which Rajan (2005) had already developed in the “search for yield” approach.

How can the challenge stemming from low interest rates, the development of


money and credit, and risks of asset price imbalances be reconciled with the philoso-phy of inflation targeting? Is the solution as simple as ignoring the fundamentals of this approach and applying “good judgement”?

A two-pillar strategyTaking asset price developments into account is a challenge for any monetary policy strategy. Monetary factors are and will remain an alien element in inflation target-ing. However, they were important in the ECB’s monetary policy strategy. “Money” was given a prominent role from the beginning. In contrast to what is still said to discredit this strategy by calling it monetary target-ing (Clarida, 2010, p. 2), the ECB explicitly rejected that approach from the start [5]. Monetary analysis and economic analysis are the “two pillars” of the ECB’s strategy, connected via crosschecking into an inte-grated approach (see e.g. Beck and Wieland, 2008).

As intended from the beginning, mon-etary analysis was deepened and broad-ened over time (Issing, 2005). Analysing the developments of different monetary aggre-gates, components, and their counterparts by monitoring all aspects of credit is a huge challenge, but serves to deliver important insights (see Papademos and Stark, 2010; ECB, 2010b) [6].

Delivering price stabilityImportant as money and credit are in the context of asset price developments, the fundamental question is which role these factors should play in a monetary policy strategy designed to deliver price stability. Neglect of money and credit was a common

factor not only in academic research (see e.g. Woodford, 2003; Eggertson and Woodford, 2003), but also in a number of central banks (see Meltzer, 2009). That said, being fully aware of all the problems demonstrated over time by a lot of research, I never understood how monetary policy could ignore “money” and how the central bank should not be concerned about “money creation.”

There is of course a complex transmis-sion mechanism from central bank money to the narrow and, even more so, to the broad monetary aggregates and credit – as well as the reverse – to nominal GDP, the real economy, and prices. Even the definition of what is “money” is anything but easy, and measuring “credit” is not simple either. Here is not the place to try even a modest assess-ment of the result of libraries of research. I would however like to make just two points.

Linking monetary growth to inflationThere is hardly any dissent from the view that in the long run, inflation is a monetary phe-nomenon. Lucas (1996) refers to the over-whelming empirical evidence and sees as a consequence that the relationship between monetary growth and inflation “needs to be the central feature of any monetary or macroeconomic theory that claims empiri-cal seriousness.” Or as King (2002) phrased a headline: “No Money, no Inflation.”

So, the question cannot be if, but rather how central banks should take this relation-ship into account when assessing risks to price stability and making monetary policy decisions. With its monetary policy strategy, the ECB has taken up this challenge. It has never claimed that its approach would pro-vide the final answer.


However, it seems strange to me that cri-tiques were directed mainly at giving mon-etary factors a role at all – without presenting an alternative that would meet this chal-lenge in a better way.

Higher inflation target?Admittedly, the strategy could not be formu-lated in an elegant model like (however, only initially) inflation targeting, and from the beginning it included an element of judge-ment. As a consequence, it lacked the “ele-gance” which made it obviously unattractive to academics.

The discussion on the consequences of the crisis for the optimal monetary policy is on-going (see Issing 2010 and Issing 2011). As already mentioned, a number of central banks have reduced their interest rates to zero or close to zero [7].

While the nominal interest rate cannot be reduced below zero, the challenge from the “zero bound” has been discussed for some time. Central banks in the meantime have demonstrated that monetary policy has efficient tools also in such an environment.

A price “too costly”Another approach to deal with this prob-lem is to raise the inflation target in order to achieve more room for manoeuvre to reduce interest rates in case of major shocks. Blanchard, Dell’Ariccia, and Mauro (2010) argue in favour of raising the target, because the zero nominal interest rate bound has proven too costly in the context of the recent crisis.

To avoid the costs of higher inflation, they suggest changes in the tax system and to the issuance of indexed bonds. Evidence

from a large bulk of studies conducted dur-ing times of high inflation does not suggest that this is either easy to implement or effi-cient. However, there is another dimension of economic and social costs, which go far beyond those calculations - the loss of cred-ibility of central banks, having successfully convinced the public and markets that low and stable inflation is essential.

By raising the inflation target, well- guided inflation expectations would lose their anchor. Why should people believe that a target once increased is now the “final” limit? What arguments could be used tomorrow in favour of another increase? It is hard to imagine that central banks could sta-bilise inflation around the new target. And even if they were successful, higher inflation volatility would be unavoidable.

Defining price stabilityIn this context, it has to be mentioned that defining “price stability” as an annual infla-tion rate of not more than 2 per cent is already not easy to explain to the general public. Such a number is already a compro-mise and violates in some respect the prin-ciples of stable money. It is not so long ago that “zero inflation” was debated, and there is still research on the optimal inflation rate that results in rates below 2 per cent [8].

How could a central bank like the ECB with a constitutional mandate of maintain-ing price stability argue that this is consistent even with a target of, for example, 4 per cent inflation?

When the ECB evaluated its monetary policy strategy, it also studied the risk of the zero bound and the appropriate definition of price stability (Issing, 2003). As a result,


strong arguments against an “upper bound” of more than 2 per cent were presented.

Raising the targetA fundamental objection against the con-sideration to raise the target in order to have more room for reducing central bank inter-est rates in case of a major shock is the fact that the “need” for this flexibility is not inde-pendent of the preceding monetary policy. Raising the target, with all the consequences mentioned, would lead to stronger growth of money and credit, thereby contributing to, if not causing, monetary imbalances and asset price booms.

According to the logic of the argument, the subsequent collapse of asset prices might implicitly deliver new arguments for further raising the inflation target [9]. As a conse-quence, it becomes obvious that the idea of raising the inflation target has to be seen in the context and as a consequence of an activist monetary policy with a strong com-mitment to steer output and employment.

A dual mandate?This leads to the question of the mandate of the central bank, which is also discussed as a consequence of the crisis. No central bank will ignore the situation of the real economy and the impact of its policy. A central bank will take those considerations best into account by conducting a medium-term-oriented monetary policy to maintain price stability, anchoring inflation expectations and avoiding fine-tuning.

This is in line with a single mandate to maintain price stability. For a central bank with a dual mandate, it might be very diffi-cult to explain the limits of what it can do – or

rather cannot do – especially in the case of structural unemployment.

The most likely outcome of a dual man-date will be that the central bank is trying to achieve one objective at a time (Meltzer, 2009). This approach can hardly be rec-onciled with a monetary policy in which monitoring money and credit is an essential element of a medium-term orientation.

Allocating responsibilityCentral banks, whether on the basis of a for-mal mandate for financial stability or as an informal obligation as a consequence of the recent crisis, will be confronted with a tre-mendous challenge. For a central bank with a medium-term orientation, taking devel-opments of money and credit into account while focussing on maintaining price sta-bility, implies a strong presumption that monetary policy itself will not cause major financial imbalances but further contribute to financial stability.

This is not at all an argument against macroprudential supervision and regulation. How responsibility in this field should best be allocated is a difficult question.

The independence of the central bank would clearly be hard to defend if it also had the competence and power to deal with individual financial institutions up to the question of whether or not such a firm should be closed.

The crisis management and some forms of unorthodox measures or quantitative eas-ing have also raised concerns about the rela-tion of the central bank to the fiscal authority.

Whatever the outcome, the world of cen-tral banking will undoubtedly never be the same (see e.g. Goodhart, 2010). However,


this is no reason to ignore the principles of sound monetary policy, which were devel-oped over time. Progress in policy comes as a result of crises, and research has to work on the scientific foundation for conduct-ing good policies. Both central banks and research have to take “lessons”– hopefully, the right ones.•

Endnotes [1] In this context it is interesting to follow the head-

lines under which this approach was presented: From “inflation targeting” to “inflation targeting with judgement” to “flexible inflation targeting” (see e.g., Svensson, 2005). To be fair, authors rep-resenting this philosophy acknowledge now that financial factors have to be taken into account. How far is this driving flexibility?

[2] It is worthwhile to quote from this early pub-lication (p. 45): “The ECB’s strategy embodies a ‘full information’ approach in a broad sense, that is, it is a framework that not only encompasses all relevant information, but also takes into account various, possibly different interpretations of this information. Against this background, the strat-egy adopted by the ECB represents a framework that reduces the risks of policy errors caused by overreliance on a single indicator or model. Since it adopts a diversified approach to the interpreta-tion of economic conditions, the ECB’s strategy may be regarded as facilitating the adoption of a robust monetary policy in an uncertain environ-ment.”

[3] However, Meltzer (2009) shows that annual data delivers a stable relationship for the US. See also Lucas (2007).

[4] For an interesting “loop” in research on the relationship between large movements in money and credit and boom-bust cycles in asset prices, see Fisher (1932) or Hayek (1933).

[5] See for example the headline, “Deciding Against a Monetary Target,” in Issing (2008, p. 93) and Iss-ing, and others (2001).

[6] An interesting approach is Shin and Shin (2011), which distinguishes monetary aggregates on the criterion of the money-holding sector and differ-entiates between bank and market-dominated financial systems.

[7] Some suggestions to make this possible are purely hypothetical.

[8] Schmitt-Grohé and Uribe (2010), for example, discuss optimal inflation rates of at most zero per cent a year.

[9] Blanchard et al. (2010) also mention shocks like terrorist attacks. But is this a challenge for the zero bound?

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


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

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


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

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

Call for papers

ContactChristopher [email protected]


33

Opinion

Deregulation, non-regulation and ‘desupervision’

Professor William Black examines the causes of the mortgage fraud epidemic that has swept the United States.THE author of this paper is a leading academic, lawyer and former banking regulator specialising in ‘white collar’ crime. As one of the unsung heroes of the Savings & Loans debacle of the 1980s, Professor Black nowadays spends much of his time researching why financial markets have a tendency to become dys-functional. Renowned for his theory on ‘control fraud’, Prof. Black lectures at the University of Missouri and Kansas City. He is the author of ‘The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry.’ A prominent commenta-tor on the causes of the current financial crisis, Prof. Black is a vocal critic of the way the US government has handled the banking crisis and rewarded institutions that have clearly failed in their fiduciary duties to investors.

The following commentary does not nec-essarily represent the view of the Journal of Regulation and Risk – North Asia. “The new numbers on criminal refer-rals for mortgage fraud in the US are just in

and they implicitly demonstrate three criti-cal failures of regulation and a wholesale failure of private market discipline of fraud and other forms of credit risk. The Financial Crimes Enforcement Network (FinCEN) released a study this week on Suspicious Activity Reports (SARs) that federally regu-lated financial institutions (sometimes) file with the Federal Bureau of Investigation (FBI) when they find evidence of mortgage fraud.

Epidemic warningThe FBI began warning of an “epidemic” of mortgage fraud in their congressional testi-mony in September 2004 – over five years ago. It also warned that if the epidemic were not dealt with it would cause a financial cri-sis. Nothing remotely adequate was done to respond to the epidemic by regulators, law enforcement, or private sector “market dis-cipline.” Instead, the epidemic produced and hyper-inflated a bubble in US housing prices that produced a crisis so severe that it nearly caused the collapse of the global financial system and led to unprecedented bailouts of many of the world’s largest banks.


147

Legal & Compliance

Who exactly is subject to the

Foreign Corrupt Practices Act?

In this paper, Tham Yuet-Ming, DLA

Piper Hong Kong consultant, examines the

pernicious effects of the FCPA in Asia.

The US Foreign Corrupt Practices

Act (FCPA), has its beginnings in the

Watergate era, when the Watergate Special

Prosecutor called for voluntary disclo-

sures from companies that had made

questionable contributions to Richard

Nixon’s 1972 presidential campaign.

However, these disclosures revealed

not just questionable domestic payments

but illicit funds that had been channelled

to foreign governments to obtain business.

The information led to subsequent investi-

gations by the US Securities and Exchange

Commission (SEC) which revealed that

many US issuers kept “slush funds” to

pay bribes to foreign officials and political

parties. The SEC later came up with a voluntary

disclosure programme under which any cor-

poration which self-reported illicit payments

and co-operated with the SEC was given

an informal assurance that it would likely

be safe from enforcement action. The result

was the disclosure that more than USD$300

million in questionable payments (a mas-

sive amount in the 1970s) had been made

by hundreds of companies – many of which

were Fortune 500 companies. The US legis-

lature responded to these scandals by even-

tually enacting the FCPA in 1977.

There are two main provisions to the

FCPA – the anti-bribery provisions, and the

accounting provisions. Both the SEC and the

US Department of Justice (DOJ) have juris-

diction over the FCPA. Generally, the SEC

prosecutes the accounting provisions and

the anti-bribery provisions as against issuers

through civil and administrative proceedings

whereas the DOJ prosecutes companies and

individuals for the anti-bribery provisions

through criminal proceedings.

The anti-bribery provision

The FCPA’s anti-bribery provision makes it

illegal to offer or provide money or anything

of value to foreign officials (“foreign” mean-

ing “non-US”) with the intent to obtain or

retain business, or for directing business to

any person.

Anything of value can include sponsor-

ship for travel and education, use of a holi-

day home, promise of future employment,

discounts, drinks and meals. There is no


163

Risk management

Of ‘Black Swans’, stress tests & optimised risk management Standard & Poor’s David Samuels outlines the positive benefits of bank stress testing on the bottom line.It is a big challenge for banks to build

a robust approach to managing the risk of worst-case stress scenarios that, almost by definition, are triggered by apparently unlikely or unprecedented events.

However, solving the problem of identi-fying the risk concentrations and dependen-cies that give rise to worst-case outcomes is vital if the industry is to thrive – and if indi-vidual banks are to turn the lessons of the past two years to competitive advantage. Banks that tackle the issue head-on will

be lauded by investors and regulators in the coming years of industry recuperation and, most importantly, will be able to deliver sus-tained profitability gains. Meanwhile, banks that are well placed to take advantage of the consolidation process need to be sure they can understand the risks embedded in the portfolios of potential acquisitions. To improve enterprise risk management

and strengthen investor confidence, we think banks can take the lead in three related areas:

Better board and senior executive over-sight and control of enterprise risk man-agement; re-invigorated stress testing and

downturn capital adequacy programs to uncover risk concentrations and risk depend-encies, and; applying these improvements to drive business selection – for example, through performance analysis and risk-adjusted pricing that takes stress test results into account.

Top-level oversightBuilding a more robust and comprehensive process for uncovering threats to the enter-prise is clearly, in part, a corporate govern-ance challenge. The board and top executives must have the motivation and the clout to scrutinise and call a halt to apparently profit-able activities if these are not in the longer-term interests of the enterprise or do not fit the intended risk profile of the organisation.

But contrary to popular opinion, improv-ing corporate governance is not just a ques-tion of putting the ‘right’ executives and board members in place and giving them appropriate incentives. For the bank to make the right deci-

sions when they are difficult, e.g. when business growth looks good in the upturn, or when risk management looks expensive

JournAl oF reGulATion & risk norTh AsiA


Macroprudential policy

Macroprudential rebalancing in a period of economic stress

Jean-Pierre Landau, former deputy governor of the Banque de France, urges

policymakers to get prudential.

Low interest rates and bank deleverag-ing combine to produce slow growth and rising financial risks in advanced econo-mies. This column argues that appro-priate macroprudential policies could contribute to redirecting risk taking, promoting growth and reducing uncer-tainty through more orderly deleverag-ing within the financial sector.

In many advanced economies, policymak-ers try to stabilise and support activity while financial and non-financial agents undergo a process of balance sheet repair and delev-eraging. The task is challenging. Headwinds borne out of deleveraging explain why – to quote Martin Wolf of the Financial Times “economies stagnate, while policy is aggressive.”

Deleveraging is unavoidable and neces-sary. It can be, however, more or less costly depending on how it is conducted. In short, the policy mix matters.

We are used to assessing the policy mix in the fiscal-monetary space. Today, it may be necessary to add a third dimension: prudential policies. Decisions taken in the

prudential field have significant economic consequences. And, therefore, the mix between monetary and prudential policies may prove important and central in achiev-ing the desired economic outcomes.

Accommodative monetary policyMonetary policy is extremely accommoda-tive in all advanced economies. At the same time, prudential standards imposed on banks are being tightened. Those actions are mutually supportive in the long run. In the short term, however, monetary and pruden-tial policies are pulling in opposite directions.

Accelerated deleveraging by banks impairs the monetary transmission mecha-nism. The conjunction of low interest rates and credit constraints distorts portfolio choices and asset prices. Interest rate risk is piling up in balance sheets while bank credit is impaired, especially for small and medium enterprises. Is a better mix is possible?

Most analyses take a deterministic view of deleveraging. Historical experiences and precedents are used as benchmarks and references to conclude that the process has barely started. The overall spirit is well


captured by a column published in the July 2011 of The Economist entitled ‘Deleveraging: You ain’t seen nothing yet’. A similar mes-sage is conveyed in Buiter and Rabati (2012): “There is a lot more private and public debt today in the advanced economies than has been the norm during peacetime periods”.

An endogenous processDeleveraging is not deterministic. In fact, it is an endogenous process with many interac-tions and feedback loops between economic agents. The end point is undetermined as “safe levels of leverage are subject to change over time” (Eggertson and Krugman, 2010). There are many paths that might lead us there and not all of them will have the same effects. Depending on how deleveraging occurs, the total cost is different. The amount of losses to be taken by the economy is endogenous to the deleveraging process itself.

Negative spiralAs emphasised by Buiter, deleveraging is,

first and foremost, a coordination problem. Deleveraging by one agent creates exter-nalities on others. For instance, when house-holds deleverage, firms are worse off and may have to shrink their own balance sheets.

Deleveraging by banks imposes financ-ing constraints on non-financial agents. With those externalities, the distinction between supply and demand constraints in credit distribution seems rather moot. Supply con-straints in one part of the economy translate into weak credit demand in another.

Because the path is indeterminate and the total amount of losses is endogenous, deleveraging generates its own uncertainty.

In turn, uncertainty pushes the banks to deleverage more as it deteriorates the qual-ity of their loans’ portfolios. This circular and reciprocal relationship between deleveraging and uncertainty creates a negative spiral into which many advanced economies, especially in Europe, are currently caught.

To break that spiral, one can think of three possible courses of action:• First, debt can be grouped in a single bal-

ance sheet and centrally managed;This is what ‘bad banks’ do, thereby taking uncertainty and risk away from the rest of the financial system.• Second, liquidity provision may allevi-

ate funding constraints and limit fire sale externalities and spill overs;

Liquidity also eases coordination problems. An anecdote presently circulating econom-ics departments illustrates this particular issue: a German tourist checks into an Irish hotel for the night. While she proceeds to her room, she inadvertently leaves a €100 bank note on the desk. The hotel manager takes it and, while the tourist sleeps, rushes to the grocery store to settle a €100 debt.

Debts extinguishedIn turn the grocery shop owner uses that same bank note to pay back a debt to a transport company, which immediately transfers to a cab driver who sends it to a tour operator to extinguish their own debts. Finally, the tour operator, who owes €100 to the hotelier, sends the note back to the hotel where it originated. When the tourist wakes up for breakfast, she finds the €100 waiting for her at reception. In the meantime debts equivalent to €500 have been extinguished and the leverage in the domestic economy


has been dramatically reduced. Involuntary, but also non-costly liquidity provision by a third party has allowed leverage to be sub-stantially adjusted.

Regulatory uncertaintyThe biggest contribution that policy can make however is to reduce uncertainty in the regulatory field. Financial regulation has been the focus of far reaching reforms since the crisis of 2008. Many of these regulatory changes have been assessed on the basis of their static advantages, with less considera-tion given to the dynamics they may create. Basel III exemplifies this regulatory pro-cess. Studies concur on its significant long-term benefits but diverge on the short run, depending on assumptions made on the transition process.

To avoid unintended effects, it was decided to set ambitious targets and give the banks a long delay to adjust. In fact, that decision opened a period with no precise references to guide markets on the appropri-ate levels of capital requirements and lever-age. It may have created a possible ‘race to the top’ and made the whole process more uncertain and disorderly.

Interest rate riskInterest risk is typical of those that macro-prudential policy is supposed to address. It is global and non-specific to any institution. One example of its systemic consequences can be seen in a bond market crash, one that builds up progressively, hence offering space for preventive measures.

Interest rates on risk free assets (treasur-ies) are at an all-time low. Term premiums on government bonds are heavily negative

in advanced economies, at least once infla-tion and growth expectations have been fac-tored in. Issuance of high yield securities is very high, both in absolute and in proportion of total debt. High yield corporate spreads have narrowed to levels last seen prior to the Eurozone debt crisis (BIS 2013).

Making a judgment is difficult. Risks are by no means certain or one sided: “the upside and downside risks to the level of rates are roughly symmetric as of 2017” (Bernanke 2013). Their distribution is unknown, although one suspects that banks are holding a large chunk (Turner 2013).

Finally, the potential consequences of an increase in long-term rates are difficult to predict. They would be different across institutions, according to their account-ing regimes, their hedging strategies and their investment horizons. They would also depend on whether the adjustment is pro-gressive or abrupt.

Rebalancing bubblesOn the other hand, there is evidence that interest risk has been associated with increased financial fragility with mount-ing leverage, and maturity transformation. Mutual funds and Exchange Traded Funds are accumulating significant exposures to interest rate risk backed by very short-term claims (Tett 2013). “Such financial structures are known to give rise to amplification and non-linear shocks if positions have to be liq-uidated quickly to face redemptions” (Stein 2013).

The current policy mix has therefore produced a very contrasted and unbalanced situation. Market based intermediation is booming. Bubbles may be appearing in


some high yield segments of bond markets. At the same time, deleveraging has brought credit distribution by banks to a halt. This contrast may partly explain the increasing divergence in economic performance on both sides of the Atlantic.

Redirecting riskThe Euro economy, where banks account for more than 80 per cent of credit, is suffer-ing more than the U.S., where markets play a dominant role in financial intermediation. Some rebalancing is necessary. The overall level of risk is not an issue, rather, the prob-lem lies in the nature and the distribution of those risks.

One objective of non-conventional monetary policies is to encourage risk tak-ing. Introducing indiscriminate frictions would contradict that objective. The macro-prudential response should aim at redirect-ing rather than impeding risk taking in the economy by reducing the incentives to take interest rate risk and increasing credit in the banking sector.

Preventative measures Even where the threat is judged to be not immediate or of a great amplitude, there is a case for some preventative action.

The essence of macroprudential policy is to act before imbalances have become so large that they threaten financial stability. In the case of interest risk, prudential action would also free monetary policy from the dangers of “financial dominance”(Hannoun 2012), a situation where so much risk has been piled up in financial intermediaries’ balance sheets that central banks may hesi-tate to raise policy rates where necessary. For

banks, the Federal Reserve has been stress testing some interest rates scenarios and their impact on balance sheets (Bernanke 2013). It is likely that most supervisors are quietly doing the same. Whilst it would be prudent to induce insti-tutions to build up specific buffers, which could be drawn upon in times of stress, the systemic aspect is more difficult. After all, building up leveraged positions and matu-rity mismatches takes place in non-bank-ing institutions, often outside the purview of supervisors. Macroprudential regula-tors should not shy away from formulating explicit warnings and backing them with specific actions (on margin requirements, for instance) when necessary.

Trade-offTo reduce uncertainty, regulators need to express a view (and to give guidance) on the appropriate path and modalities for delever-aging in the financial sector.

In a sense they face a problem identical to the one confronted by central banks when they practice ‘flexible’ inflation targeting, and they need to adopt the same mind-set.

‘Flexible capital targeting’ would involve taking a view on the appropriate path to return to equilibrium after a shock. As cen-tral bankers know, this involves a trade-off. Getting back too fast to target involves important and significant losses of output and costs. On the other hand, waiting too long risks endangering the credibility of the ultimate objective. It is a trade-off that was left unexplored in the regulatory field, and one, which would have brought about huge benefits in terms of making the regulators’ preferences explicit and transparent.


Eliminating uncertainty is clearly neces-sary. However, the very nature of pruden-tial regimes places them in a constant state of flux. Now that the foundations of Basel III have been solidly established, regulators should perhaps consider a moratorium on any changes for a few years. And while the agenda may currently be full (Ingves, 2013), this would not prevent discussions and con-sideration of new measures and improve-ments to be introduced over time.

Basel differentiationAnother solution could be to significantly reduce capital requirements on new bank loans; certainly in the current environment, it makes sense to differentiate between marginal and average capital requirements. Indeed, differentiation of capital require-ments, across time and across asset classes, is surely an integral part of the Basel regime?

Whilst any forbearance should be excluded and capital requirements on past loans should be maintained and strength-ened, by contrast, a favourable regime could be applied to new net exposures, a practice that the UK Financial Services Authority has been implementing since 2012 by “ensur-ing that no bank will be required to hold the additional capital requirements of the increased lending.”

International cooperationClearly, a great deal of international coopera-tion will be necessary to implement such an agenda, and as such, this may be difficult to achieve given the differences various parties may have in judging the reality and serious-ness of risk. At the same time, and in con-clusion, it is clear that current circumstances

offer an opportunity and testing ground for the implementation of efficient macropru-dential policies.•

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

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


Sovereign debt crisis

Dynamics of Disintegration: Germany and the Euro

Christian Fahholz and Gernot Pehnelt contend that politics, and not economics, will be the final arbiter of the Euro’s fate.

The economic situation within the eurozone member states appears increasingly dire. It has turned out that the rush of stabilisation and liquidity actions within the eurozone only pro-vides short-term relief. It seems as if the hesitant crisis management aggravates the european balance-of-payments cri-sis. Nevertheless, there might be a turn-ing point in the eurozone crisis as the dynamics of the eurozone disintegration process may eventually alter the politi-cal-economic conditions. The reason is that both monetary and fiscal assistance will eventually come into conflict with electoral interests (Fahrholz and Pehnelt 2012).

Once the electorate questions and chal-lenges the inconsistencies of (seemingly) futile Eurozone crisis management, policy-makers are likely to change their positions, and exiting from the Eurozone may then become what appears to be a feasible policy option. In this short note, we explain why the Eurozone integration process will most likely be reversed. In doing so, we set forth

that some particular Eurozone members may eventually dispose of adequate financial resources for avoiding a messy disintegration process.

The dynamics of the Eurozone disinte-gration can be illustrated by distinguishing between core and periphery members. In this respect, the Eurozone core – think of Germany, Finland, Luxembourg, and the Netherlands – is characterised by current account surpluses (net capital exporters or net creditors), while the Eurozone periphery is generally characterised by current account deficits (net capital importers or net debtors).

Balance-of-paymentsA hallmark of the European balance-of-pay-ments crisis is that the private financial sector has stopped lending for rolling over accu-mulated debt and for refinancing current account deficits of the Eurozone periphery. Yet, the financial assistance provided to the Eurozone periphery through the provisional European Financial Stability Facility (EFSF), in conjunction with the European Financial Stabilisation Mechanism (EFSM), the per-manent European Stability Mechanism


(ESM), and other bilateral/multilateral arrangements, for instance, the European Central Bank (ECB) and the International Monetary Fund (IMF) have averted a full-fledged balance-of-payment crisis of the Eurozone periphery economies at the time of writing this paper.

TARGET2 imbalancesApart from such forms of fiscal support, the financial assistance has also monetary dimensions. In this respect, particularly the formation of TARGET2 imbalances is a good indicator for the severity of the European balance-of-payments crisis. Basically, the TARGET2 is a prerequisite for turning the Eurozone into a common currency area. Without an automatic clearing of a net transfer of payments a periphery NCB, for example, would have to bid for funds to wire a payment to a core NCB.

This would be akin to the situation of foreign exchange markets, where such a bid – buttressed by pledging adequate collateral – would increase the price of core funds rela-tive to periphery funds. As a result a float-ing exchange rate regime would ensue and jeopardise the idea of a common currency area. In normal times – i.e., if financial inves-tors trust one another – the private financial sector uses the TARGET2 to wire cross-bor-der payments within the Eurozone and any imbalances are only of a temporary nature.

No private sector incentivesUsually, an initial TARGET2 imbalance is offset by private financial sector refinancing activities within the interbank market. In this case, all TARGET2 transactions finally offset each other. However, the TARGET2

still clears cross-border payment flows even in crisis times. Should the interbank market run dry, whereby no further off-setting trans-fer of payments from the core even out the temporary TARGET2 imbalances, as long as commercial banks within the periphery are able to pledge collateral at their NCB in exchange for central bank money, payments can still be wired across borders.

This allows, for instance, for importing tradable’s in times of crisis. There is no settle-ment of ensuing irregular TARGET2-claims and liabilities, as is the case within the U.S. Federal Reserve System.

One may argue that the TARGET2 sys-tem acts like an automatic stabiliser cush-ioning against the adversities of a sharp activation of the periphery current account. However, the problem mainly is that the increasing indebtedness of the Eurozone periphery via the TARGET2 monetary sys-tem does not create incentives for a return of the private financial sector.

Crowding outThe corresponding TARGET2 imbalances represent the Eurozone periphery’s inabil-ity to fund itself via private sector avenues. In doing so, the TARGET2 balances replace withdrawn deposits and foster the crowding out of eligible collateral within the private financial sector of the Eurozone periphery. This is why the formation of TARGET2 is an indicator of the severity of the Eurozone balance-of-payments crisis.

Figure 1 (see opposite page) illustrates that TARGET2 imbalances started to become noticeable at the onset of the subprime crisis during the third quarter of 2007, and highly pronounced in the final months of 2008


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

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

Source: Deutsche Bundesbank


following the ‘Lehman credit event’. For about five years now, the TARGET2-claims recorded at the Deutsche Bundesbank have been sky-rocketing more or less every month (see Figure 1 overleaf). Having gained con-siderable momentum during the Eurozone crisis, the TARGET2 claims of Germany vis-à-vis the Euro-system currently amount to about 715 billion EUR [November 2012].

Stabilisation incentivesAs long as the TARGET2 properly works the Eurozone periphery economies have an incentive to allow for alleged, short-term stabilisation of struggling national financial sectors, so that the TARGET2 imbalances will further increase. Any such debt forma-tion will eventually require restructuring. Whether financial assistance within the cur-rent balance-of-payments crisis is of a fiscal or monetary dimension, it always increases the risk exposure of the Eurozone core, par-ticularly Germany. The financial manoeuvres impact, for instance, the German net inter-national investment position (NIIP), i.e., the ‘wealth’ of Germany (see Figure 2 overleaf).

Run-up to the current crisisIt may turn out that wealth in the form of claims on some future real production becomes irrecoverable. The ‘improving’ NIIP of Germany indicates a protracted Eurozone balance-of-payment crisis. The question arises why such risk exposures have been rather disregarded or underestimated for such a long time in the run-up to the cur-rent crisis.

The following section elaborates why corresponding macro-economic imbal-ances within the Eurozone have emerged

and why such real misalignments have only recently been revealed. Reasons for mount-ing real misalignments between the core and periphery of Eurozone primarily stem from a ‘natural’ inclination towards over-indebtedness in periphery economies. As the Eurozone membership is irrevocable, moral hazard behaviour evolved on the part of both markets and politics.

At the end of markets, financial inves-tors have taken excessive risk by treating Eurozone periphery and core economies’ debt essentially the same for many years. The implicit protection by the irrevocabil-ity of Eurozone membership has reduced market discipline and considerably lowered interest rates for periphery economies with the Eurozone.

Power shiftAt the political end, the irrevocability of Eurozone membership has shifted the political bargaining power to the profligate economy and provided a leeway to passing some portion of their fiscal adjustment costs on to the rest of the Eurozone. Since prob-lems in a single periphery economy may cre-ate a negative externality on other Eurozone members, the latter economies have little choice but to provide financial assistance.

Sovereign members of the Eurozone may thus easily forgo the short-term fiscal adjustment costs necessary for safeguard-ing the Eurozone stability in the long run. Instead, national politics may comfort their electorates and specific interest groups at the expense of the long-term stability of the Eurozone (Fahrholz and Wójcik 2012).

Hence, moral hazard within the Eurozone has led to excessive credit supply,


while there has neither been political incen-tives nor any means of enacting effective countermeasures that help curtail exces-sive credit demand. The resulting external macro-economic imbalances respectively real misalignments are now threatening the stability of the entire Eurozone.

Rational procrastinationFiscal austerity and monetary accommo-dation characterises the current state of play in the EU crisis management. Both policies are apparently the natural order of play. However, the fundamental problem is that this type of EU crisis management has prompted a debt-deflation spiral that crunches its way through the periphery to the core of Eurozone. This section explores the range of possible turning points. In lieu of political forces endogenously changing the dynamics of the Eurozone balance-of-pay-ment crisis, market forces may set in and alter the political-economic configuration of the current Eurozone.

The pattern of EU crisis management consists of averting de facto defaults in the short term at the expense of increasing the overall level of indebtedness within the Eurozone. This strategy comes along with ever-broader ramifications. However, this is the outcome of rational but costly procrasti-nation in the interest of all parties involved.

Institutional drawbacksFrom the viewpoint of the Eurozone periph-ery, fiscal rescue packages and a dysfunctional monetary clearing mechanisms provide the opportunity to postpone necessary eco-nomic adjustments. Institutional drawbacks of the Eurozone set-up undermine structural

reforms needed for returning to sustainable levels of indebtedness.

Such reforms are always costly in the short term. This applies to both the eco-nomic and the political sphere. The resulting delays, however, occur at the expense of fur-ther indebtedness. For periphery Eurozone members there are no incentives for volun-tary opting-out of the Eurozone. The reason is that there is hardly any scope for increasing their export competitiveness by devaluation.

Given a highly import-oriented pro-duction structure of the Eurozone periph-ery, possibly re-starting an economy by introducing a new national legal tender that devalues vis-à-vis the Euro cannot be conducive to export competitiveness in the short-term.

Voter alienationMoreover, cutting off the bypass TARGET2 and other public and private sector assis-tance will represent a plunge into the eco-nomic abyss. It goes without saying that conditionality of fiscal support – the mon-etary bypass TARGET2 is unconditional – creates political hardship for every Eurozone periphery administration in the form of voter alienation. However, these govern-ments weigh these political costs against the short-term severe adversities of exiting the Eurozone. Knowing, furthermore, that a (partial) break-up of the Euro would also leave the Eurozone core with significant losses, the Eurozone periphery has a very high propensity for accepting re-negotiable conditionality of fiscal support in the short term as well.

From the Eurozone core perspective, particularly Germany, these economies are


able to preserve export-oriented production structures. Hence, such Eurozone members have an incentive to ensure that distressed periphery economies continue to repay their debt whilst purchasing tradable’s. In doing so, they forgo the adversities of economic adjustment and re-balancing real misalign-ments. This is to say that the Eurozone core avoids the short-term costs of decreasing production and employment.

The tipping pointMoreover, credit economies (i.e., net export-ers) such as Germany gain from a depreciat-ing Euro vis-à-vis the rest of the world that additionally strengthens its export competi-tiveness. In addition, the flow of funds from the Eurozone periphery to the core is advan-tageous to the liquidity of the German bond markets. Given the incipient redenomina-tion risks within the Eurozone, the according financial safe-haven decisions are very much akin to a free lunch for Germany’s debt roll-overs in the short term (Fahrholz 2012).

The economic wrecking of the Eurozone is a result of rational but costly delay of thor-ough economic reform. Nevertheless, the internal dynamics of the Eurozone crisis, or the political-economic configuration, may adjust to altering financial investor expec-tations. The provision of fiscal rescue pack-ages, for instance, will eventually come into conflict with electoral interests within the Eurozone core.

Debt-deflation spiralAusterity will also force many European economies into recession for a prolonged period, endangering other Eurozone mem-bers’ export-oriented production structure

and starting a debt-deflation spiral sliding from the Eurozone periphery to the core.

Given the political-economic configu-ration of the Eurozone and the prompted debt-deflation spiral, the Eurozone bal-ance-of-payment crisis will not come to a halt at the doorway of the Eurozone core economies. This is true, particularly because as soon as these members directly face the adversities of futile EU crisis management – i.e., the repercussions of the pledged and paid-out fiscal and monetary assistance on its own creditworthiness – public adminis-trations will most probably alter their policy position.

Policy shiftIn particular, largely due to the devaluing of the Euro - and because of core Eurozone investors currently withdrawing from the periphery, and in turn Eurozone periphery savers transferring their assets to the core - such policy shift will take place when the benefits of expected higher export earnings vis-à-vis the rest of the world, as well as the advantages of declining costs of government debt are offset by non-Eurozone investor flight. This is likely to happen only as soon as concerns mount about future Eurozone core economies’ creditworthiness and at a time when a crucial faction of such finan-cial investors realises that the current track of EU crisis management does not effec-tively shield against the crunches of the debt deflation spiral but eventually overburdens the financial capacities of the Eurozone core.

At this stage, going for revaluation will become a politically feasible option for Eurozone core members. If sophistically managed, this may help to craft an economic


rebound and may also protect against linger-ing into the debt-deflation spiral.

Rebalancing incentivesThe correspondingly altered political-eco-nomic configuration of the Eurozone puts an end to procrastination and muddling-through the Eurozone balance-of-payment crisis. At this point, incentives will crop up which will allow, for example, for negotiat-ing a controlled dismantling of the Eurozone and/or a concomitant replacement of the Euro by national legal tenders or other cur-rency arrangements.

In general, real misalignments have to be rebalanced and the according mal-invest-ments have to be worked out. While this applies to all economic centres in the world – e.g. the Americas and Asia – the weakest link in the chain remains the Eurozone. Within the group of sovereign Eurozone members, particularly Germany but also other core members may opt for revaluation as soon as the current benefits of undervaluation are gone.

Boost for businessThe ensuing revaluation, in turn, could be a boost – and not a sting in the tail – to the Eurozone core economies’ export-oriented business sector. The reason is, firstly, that the business sector may also reap windfall prof-its from paying off Euro-denominated loans. Secondly, export earnings would rise as long as these economies gain from reduced import prices and the rather inelastic exter-nal demand for tradable’s in the short and medium-term. Although the Eurozone core would be likely to experience some wel-fare losses, this is not a problem for social

inclusion and political stability in the long run. The Eurozone balance-of-payment cri-sis erodes some of the real value of previous export volumes. However, the public would be unlikely to notice these real losses, as they simply would not have the tradable’s, which they had exported at earlier stages in the equation, at their disposal.

The moderate re-balancing of real mis-alignments will take place only through price-level adjustments. This effect will be outpaced by a full-fledged economic recov-ery after the commencement of a new solid currency arrangement. It is certainly politics that will determine the timing of a U-turn concerning the opt-out of the Eurozone, as well as the scope of a subsequent economic recovery. The assets of the Eurozone core economies, unless not deteriorated in the course of the sliding debt-deflation spiral, are the best precondition for high returns on investment.•

ReferencesFahrholz, Christian. 2012. “The dynamics of Euro-zone disintegration”, EconoMonitor – A Roubini Global Economics Project, New York City, NY, URL: http://www.economonitor.com/blog/2012/10/the-dynamics-of-eurozone-disintegration/, 30 October 2012.Fahrholz, Christian and Gernot Pehnelt. 2012. “Mid- and long-term risks of German Bonds”, Jena, GlobE-con Policy Brief 01-2012. URL: http://www.globecon.org/fileadmin/template/userfiles/-Research/GlobE-con_Policy_Brief_01-2012_Oct_2012.pdf.Fahrholz, Christian and CEurozoneary Wójcik. 2012. “The Eurozone needs exit rules”, Jena and Warsaw, CESifo Working Paper, No. 3845. URL: http://www.cesifo-group.de/portal/pls/portal/docs/1/¬1217000.pdf.


Basel III

Europe’s interests best served by complying with Basel III

Nicolas Véron contends that contrary to popular belief, it is the U.S. and not Europe

that remains true to the intent of Basel III.

On Valentine’s day, February 14, Michel Barnier, the European Commissioner for Internal Market and Services, and Daniel Tarullo, Governor of the U.S. Federal Reserve, and person charged with reg-ulatory and supervisory oversight at the Fed., indicated their agreement to quickly give the Basel III Accord bind-ing force over, respectively, European and American banks. Whilst this news was most welcome, even more important than the exact timing is that the adop-tion should stay true to the international Accord. At this juncture in time, and con-trary to many perceptions within Europe, this is more likely to be the case of the U.S. rather than that of the European Union.

Basel III is the work of the Basel Committee on Banking Supervision, which includes 27 countries as its members (plus EU institu-tions and the International Monetary Fund as observers). The Committee is hosted by the Basel-based Bank for International Settlements, with a small permanent sec-retariat there. It is the crown achievement

of the G-20’s financial regulatory reform agenda in the wake of the Lehman Brothers collapse. Other prominent initiatives have had only partial or mixed results, including the centralised clearing of over-the-counter derivatives, accounting standards conver-gence, the regulation of rating agencies, or restrictions on compensation practices or regulatory havens.

A clear successBy contrast, Basel III has moved ahead quickly and can be labelled a clear success for global financial regulation. It is already making a difference, and a positive one, in the way the global banking system operates. Credit for this goes to the Basel Committee’s members and to its successive chairmen and secretary-generals since 2007.

Without going into all the details of a rather long text, Basel III makes the definition of regulatory capital much more rigorous; increases minimum capital requirements dramatically, from two per cent to seven per cent for the key ratio of common equity to risk-weighted assets; tightens the method-ology to weigh the risk of assets; introduces a


minimum leverage ratio (capital to non-risk-weighted total assets) to mitigate the risk of manipulation of risk weights; introduces additional requirements depending on the financial cycle and the systemic importance of some banks; and introduces regulatory standards and ratios for banks’ liquidity profile.

Dimon attackThe Accord has been criticised from all sides of the financial regulatory debate. Much of the banking community, including the Institute of International Finance, has argued that the increase in capital require-ments would have a large negative impact on growth and that the liquidity ratios would be detrimental to market functioning.

Jamie Dimon, the Chief Executive Officer of the U.S. based banking giant JPMorgan Chase, has lambasted the additional capi-tal requirements for systemically important financial institutions, including his own, as “anti-American.”

However, third-party studies suggest that bankers have been unduly crying wolf, and that the standards’ negative impact on bank business will be more than compen-sated by the resulting additional financial stability.

Inefficient and toothlessConversely, a number of academics and advocates have argued that Basel III is insuf-ficient, or even toothless, be it for the need for even higher capital requirements, the widespread gaming of risk-weighting cal-culations, the excessively long phasing-in period for the standards to take full effect, or the recent announcement that liquidity

standards are likely to be less stringent than initially envisaged.

That said, none of these critiques present an obvious alternative or solution. Pushing minimum capital levels even higher would lead to widespread migration of financial intermediation towards the less-regulated shadow banking system. In essence, risk-weighting is flawed, but the alternatives are worse and Basel III’s leverage ratio at least creates a backstop rule. The phasing in stage now looks rather steep to many banks, particularly in Europe, and in any case was arguably the most acceptable price to pay in the compromise to get the Accord passed in spite of opposition from some Basel Committee members.

ComplacencyThe watering down of liquidity ratios appears justified by the uncertainties surrounding the impact of this new and untested regulatory instrument, and the lessons learned from the Eurozone crisis regarding the possible credit risk and illiquidity of sovereign debt markets. In fairness, Basel III goes remarkably far for a consensus-driven Committee that had been much less bold in the past, especially with the previously considered comprehensive Accord (Basel II), which in the light of the crisis now appears to have been embarrass-ingly complacent.

Beyond the Accord itself, the Basel Committee, in an unprecedented (though arguably long overdue) move, has designed a three-level process to nudge its members to adopt and implement its standards rap-idly and consistently.

Level One checks that each member jurisdiction has adopted rules that legally


mandate the application of Basel III by those for which it was intended, namely large internationally active banks. Level Two checks in detail the consistency of the legis-lation or regulation with all points covered in the text of Basel III. Level Three assesses how the Accord is implemented in practice.

Regular reportsThe Basel Committee has published regular short reports to the G-20 since 2011, scoring countries’ progress on Basel III and the adop-tion of earlier versions of the Accord (Level One). In October 2012 the Committee began to publish detailed reports on the consistency of adopted or proposed legisla-tion/regulation with Basel III, with the first three reports devoted to Japan, the U.S. and the EU (Level Two). More recently, in January 2013, it published its first study on actual implementation, devoted to the consistency of risk-weighting across a sample of banks (Level Three).

The picture that emerges is contrasted but encouraging from a global perspec-tive. Eleven of the Committee’s 27 mem-bers (Australia, Canada, China, Hong Kong, India, Japan, Mexico, Saudi Arabia, Singapore, South Africa and Switzerland) have adopted Basel III, and all but India, who delayed until April 1, began their implemen-tation of Basel III on January 1, 2013.

“Trilogue”In the EU, nine Basel Committee mem-bers are represented, these being Belgium, France, Germany, Italy, Luxembourg, the Netherlands, Spain, Sweden, and the United Kingdom. The implementing legis-lation, known as the Capital Requirements

Regulation (CRR) and Fourth Capital Requirements Directive (CRD IV), was proposed by the European Commission in July 2011 and is in a final phase of discus-sion between the European Commission, European Parliament and European Council - usually referred to as a “Trilogue“ in Brussels terminology.

In the U.S., the three federal agencies jointly in charge – the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) – published a regula-tory proposal in June 2012 and are currently working on a final version. Work is also in progress in the remaining Basel Committee members, namely Argentina, Brazil, Indonesia, South Korea, Russia, and Turkey.

“Funny equity”Among the three jurisdictions reviewed in more detail under the Basel Committee’s Level-Two process, Japan gets high marks for essentially complying with the Accord. Based on its June 2012 proposal, the U.S. is compliant on all areas tested but one: its rejection of any reference to credit rating agencies’ assessments in bank prudential regulation, enshrined in Section 939A of the Dodd-Frank Act of 2010, creates differences with parts of Basel III which keep references to credit ratings. This, despite the fact, that the Basel Committee has also tried to reduce the extent of such references.

The EU is found “materially non-com-pliant” in two areas: its definition of capital, and an exemption that the review found one of the risk-weighting methods too broad. The definition of capital is by far the more important of the two, as it goes to the core


of capital regulation. After all, it is no good having high minimum requirements if the definition includes “funny equity” that is not genuinely loss-absorbing in a crisis.

Such differences are attributable to dif-ferences in financial cycles and local politics. The EU thus finds itself in a state of banking system fragility, which has not been resolved by the recent improvements seen in market conditions. Forbearance is thus a temptation, despite the fact that experience suggests it is a losing crisis-management strategy.

Lessons learnedBy contrast, Japan, Mexico and much of Asia have learned their lessons the hard way dur-ing the financial crises of the 1990s, and their banks have strong enough balance sheets for the early transition to Basel III to be an easy one.

Banks in Canada and Australia have been thriving recently. Switzerland and the U.S., like the EU, have faced severe banking crises in 2007-08, but unlike the EU, have largely resolved them in 2009-10, which makes their implementation of Basel III requirements less challenging than that of several EU member states.

The delay and somewhat spotty com-pliance in the EU stands in stark contrast to Europe’s championing and early adoption of Basel II in the early 2000s. It is not uncom-mon therefore for EU financial policy leaders to offer support for the Basel III process and yet to criticise it at the same time.

Unfair critiqueIn particular, the European Commissioner in charge of financial services has reacted angrily to the Basel Committee’s Level-Two

report on the EU, arguing that some of its findings “do not appear to be supported by rigorous evidence and a well-defined meth-odology,” while simultaneously affirming his “support [for] the Basel Committee’s inten-tion to assess consistent implementation.” The Commissioner implies in his reaction that the EU’s CRR/CRD IV legislative pro-posal was assessed unfairly negatively in comparison with the reviews of Japan and particularly of the U.S.

However, the Basel Committee’s Level-Two assessment process has involved Europeans prominently: they represent no less than half of the respective assessment teams for both Japan (a six-member team led by the Banque de France’s Sylvie Mathérat and including members from the German and Swedish central banks) and the U.S. (a six-member team including members from the French and Italian central banks and the European Commission).

No ‘anti-Europe’ biasAs for the EU, the assessment team was led by Charles Littrell from the Australian Prudential Regulation Authority and included five other members from pru-dential authorities in Japan, New Zealand, Singapore, Switzerland, and the U.S., the teams being formed on the principle of no self-assessment.

The Basel Committee has put a lot of effort into ensuring the quality and consist-ency of its assessment methodology, and there is no convincing evidence of anti-European bias from a detailed reading of the Level-Two reports.

The Committees’ policy so far, has been not to react publicly to the European


Commissioner’s critique, but it is evident from the content of the Level-Two report on the EU, that the same arguments put forward in this critique, have been carefully considered by the assessment team before completion of the report.

U.S. delay denouncedThe reaction from many stakeholders in Europe to the U.S. delay in the adoption of Basel III has been similarly shrill. The joint press release from the Federal Reserve, the FDIC and the OCC does nothing more than announce that the deadline of January 1, 2013 will be missed in the finalisation of the rulemaking process due to the large number of written comments received on the June 2012 proposals that justify more in-depth analysis.

This has been widely denounced in con-tinental Europe as a de facto abandonment of the effort, which in turn would justify signifi-cant delays in the EU’s own decision-making process on grounds of competitive fairness.

As a result, the European Banking Federation sent a letter interpreting the U.S. press release as implying that “our U.S. com-petitors will not have matching obligations imposed on them in parallel [with the EU’s CRR/CRD IV], or in a foreseeable future.”

Further, the President of the Italian Banking Association, Mr. Giuseppe Mussari, argued that “Basel III must be postponed, full stop.”

Concurrent adoptionIn fact, the EU and the U.S. appear likely to adopt Basel III at around the same time, probably in the second quarter of 2013. However, as mentioned above, the

procedures are different. In the EU, CRR and CRD IV proposals are produced by a legis-lative co-decision process, which involves the European Parliament and the Council. Further, while CRR becomes directly appli-cable in all member states once adopted by the European Parliament and Council, CRD IV, as a directive, requires a degree of politi-cisation, as well as further transposition in all member states’ national legislation.

In the U.S., the process is more techno-cratic as it is in the hands of the three fed-eral agencies (the Federal Reserve, FDIC and OCC). However, it is also subject to the scrutiny of Congress, which may still impose further delay.

Sound justificationsFurther, while on both sides, there is no indication that the points of “material non-compliance” found in the Basel Committee Level-Two preliminary assessments will be corrected in the final version, in the U.S., Section 939A of the Dodd-Frank Act prohib-its reference to credit ratings in the pruden-tial regulation of banks and this is unlikely to be abrogated by Congress any time soon.In this respect, the EU is ill placed to criticise the U.S., as it has itself put much blame on credit rating agencies in the crisis context and submitted them to increasingly strin-gent regulation.

In the EU, there is no indication that the revision of the non-compliant parts of CRR are among the points that the co-legislators in the European Parliament and Council envisage to revise in the current final phase of legislative “Trilogue”.

There would be sound justifications, however, for a second look in the EU that


would enable the adoption of a Capital Requirements Regulation that would be fully compliant with the Basel III Accord, as summarised in the following observations:

First, is that the direct economic impact of the necessary changes would be lim-ited, especially if the changes only apply to the large internationally active banks for which the Basel Committee’s standards are intended. Indeed, in his response to the Basel Committee’s Level-Two report on the EU Commissioner, Mr. Barnier argues in particular that the report’s reservations on the definition of capital of non-joint stock companies (presumably referring to so-called “silent participations” at some of Germany’s public banks) “concerns a single internationally active bank,” adding that the other material issue about the treatment of insurance subsidiaries “can arise only in very few banks.”

Enhanced trustSuch points are made to argue that the non-compliance with Basel III is not material, but that the argument can be reversed in the sense that correcting the non-compliance would not have a systemically detrimental effect on the EU economy.

Second, full compliance with Basel III would enhance trust in European banks. The EU’s deviations from the international Accord feeds widespread presumptions in the investor community that at least some supervisory authorities in the EU tend to apply a high degree of forbearance to banks within their remit and are reluctant to force them to apply high and consistent capital standards. Such market sentiment is clearly detrimental to all EU banks (and

the European economy as a whole), includ-ing those (presumably many) among them, which are sufficiently capitalised. The cost-benefit balance is without a doubt favour-able to bringing CRR to full compliance with Basel III.

Finally, the EU’s incomplete adoption of Basel III undermines the global author-ity of the Basel Committee, encourages other jurisdictions to introduce exceptions of their own, and diminishes the EU’s own moral stature in the global financial regula-tory debate. In the past two decades, the EU has been a champion of global financial regulatory convergence, in particular with its endorsement of International Financial Reporting Standards in the early 2000s and support of Basel II and Basel 2.5 throughout the 2000s. The calculation was that global financial convergence and integration would support an agenda of harmonisation and integration within the EU itself.

This calculation remains relevant, even after the shift from a G-7 to a G-20 global framework in which the EU member states’ relative influence is less than it used to be. The European Union’s co-legislators should revisit their stance and make the Capital Requirements Regulation fully compli-ant with Basel III before they put their final stamp on it.•

Editor’s note: The publisher and editor would like to thank Mr. Nicolas Véron of the of the Brussels-based think tank, Bruegel, and the Peterson Institute for International Economics in Washington DC for allowing the Journal to publish a reformatted version of this paper. The original online copy of this paper can be viewed at www.bruegel.org.


Macroeconomics

The science of fiscal policy & alchemy of monetary policy

Harvard’s Prof. Jeffrey Frankel asserts that fiscal, not monetary policy, offers the best way out of the current economic malaise.

2013 marks the 100th anniversary of US federal income tax and the establishment of the Federal Reserve. What lessons have we learnt about macroeconomic policy since then? This column assesses the lessons learned and argues that under the conditions that have held in recent years, as in the 1930s, fis cal expansion is more likely to be effective in the short term than mon etary stimulus. Indeed, compared with fiscal policy, monetary policy seems more alchemy than science.

This year represents the centenary of two significant institutional innovations in U.S. economic policy, namely: The Constitutional Amendment enacting federal income tax (February 1913); and, the law estab-lishing the U.S. Federal Reserve System (December 1913). It took some time before the two new institutions became associated with the explicit concepts of fiscal policy and monetary policy respectively. It wasn’t until after the experience of the 1930s that they came to be viewed as potential instru-ments for managing the macroeconomy. John Maynard Keynes, of course, pointed

out the advantages of expansionary fis-cal policy in circumstances like the Great Depression, while Milton Friedman blamed the Depression on the Federal Reserve because it allowed the money supply to fall. In subsequent debates:• Keynes was associated with support for

activist or discretionary policy. The aim was a countercyclical response to eco-nomic fluctuations: expansion in reces-sions, discipline in booms (1).

• Friedman opposed activist or discretion-ary policy, believing that government institutions – whether monetary or fiscal – were unable to time their interventions effectively.

However, what the great economists were both opposed to were procyclical policy moves such as the misguided U.S. tighten-ing in 1937, at a time when the economy had not yet fully recovered.

Post-war lessonsAfter the Second World War, the lessons of the 1930s (see Eichengreen et al. 2009) were incorporated into all macroeconomic textbooks and, to some extent, permeated


the beliefs and actions of policymakers. But many of these lessons have been forgot-ten in recent decades, crowded out of pub-lic consciousness by other major economic phenomena, such as the high-inflation in the 1970s.

Austerity-versus-stimulusMany politicians in advanced countries are repeating the mistakes of 1937 today. This is happening despite conditions (see Almunia et al. 2010) qualitatively similar to those that determined Keynes’ policy recom-mendations in the 1930s (Eichengreen and O’Rourke 2010): high unemployment, low inflation, and rock bottom interest rates.

The austerity-versus-stimulus debate (see Frankel 2012a, Corsetti 2012) has been thoroughly hashed out. On the one hand, proponents of austerity correctly point out that the long-term consequences of perma-nent expansionary macroeconomic policy – both fiscal and monetary – are unsustainable deficits, debts, and inflation.

ProcyclicalistsOn the other hand, proponents of stimulus correctly point out that in the aftermath of a recession, when unemployment is high and inflation low, the immediate conse-quences of contractionary macroeconomic policy are continued unemployment, slow growth, and debt-to-GDP ratios that go up rather than down. With conditions of excess supply in goods and labour markets, as opposed to full capacity and full employ-ment, demand expansion goes into output and employment.

Procyclicalists (see Frankel 2012b) both in the U.S. and Europe represent the worst

of both worlds. They push in the direction of expansion during booms (such as that of 2003-07 ) and in the direction of contrac-tion during recessions (such as that of 2008-2012), thereby exacerbating both upswings and downswings. Counter-cyclicalists have it right: working in the direction of fiscal and monetary discipline during booms and fiscal and monetary ease during recessions.

Less thoroughly aired recently is the question of whether, given recent condi-tions, monetary or fiscal expansion is the more effective instrument. This question was addressed clearly in 1937 by Sir John Hicks in a once-famous article entitled: “Mr. Keynes and the Classics: A Suggested Interpretation” (Hicks 1937). The graphical model is known to many generations of undergraduate stu-dents in macroeconomics under the label ‘IS-LM’.

Which policy is more effective?Under circumstances that held true in the 1930s and do so again today – conditions not just of high unemployment and low inflation but also of near-zero interest rates – stimulus in the specific form of fiscal expan-sion is much more likely to be effective in the short term than stimulus in the form of monetary expansion.

Monetary expansion is rendered rela-tively less effective because interest rates can’t be pushed below zero. This situation, labelled by Keynes as a liquidity trap, is today known as the ‘Zero Lower Bound’. Indeed, firms are less likely to react to easy money by investing in new factories and equipment if they cannot sell the goods produced in already existing factories. The hoary but still evocative metaphor is ‘pushing on a string’


(that is, it is easier to stop an expansion than to end a severe contraction). Meanwhile, fiscal expansion is rendered relatively more effective, in that it doesn’t push up rock-bottom interest rates and thereby crowd out private-sector demand.

Hamstrung politicsDespite the inability of central banks to push short-term nominal interest rates much lower, one should not give up completely on monetary policy, especially because fis-cal policy is so thoroughly hamstrung by politics in most countries. Whilst quantita-tive easing, forward guidance and nominal targets may be worth trying, the effects of each are highly uncertain. That monetary policy is less effective than fiscal policy under conditions of high unemployment and zero interest rates should not be a novel position. However, many economists appear to have forgotten much of what they knew, and poli-ticians may well have never even heard of the proposition.

Multiplier effectIntroductory economics textbooks have long talked about the Keynesian multiplier effect: the recipients of federal spending – or of consumer spending stimulated by tax cuts or transfers – respond to the increase in their incomes by spending more, as do the recipi-ents of that spending, and so on.

Again, the multiplier is much more rel-evant under current conditions than in more normal situations where the expansion goes partly into inflation and interest rates, and thus crowds out private spending. By the time of the 2008-09 global recession, even those who believed in fiscal stimulus, had

marked down their estimates of the fiscal multiplier (intimidated, perhaps, by newer theories of policy ineffectiveness). The sub-sequent continuing severity of recessions in the UK and other countries pursuing con-tractionary fiscal policies, apparently to the surprise of the politicians enacting them, suggested that multipliers are not just posi-tive, but greater than one. The International Monetary Fund’s own research department (Blanchard and Leigh 2013) has reacted to this recent evidence and bravely confessed that official forecasts, including its own, had been operating with underestimates of mul-tiplier magnitudes.

New wave of researchA new wave of econometric research esti-mates fiscal multipliers using methods that allow them to be higher in some cir-cumstances than others. Baum, Poplawski-Ribeiro and Weber (2012) allow the estimate to change when crossing a threshold meas-ure of the output gap. Batini, Callegari and Melina (2012) allow regime switching across recessions versus booms.

Others that similarly distinguish between multipliers in periods of excess capacity ver-sus normal times (see Ramey 2012), include Auerbach and Gorodnichenko (2012a, 2012b), Baum and Koester (2011), and Fazzari, Morley and Panovska (2012). Most of this research finds high multipliers – above 1.0 – under conditions of excess capacity and low interest rates, though few have the cour-age to mention that this is what one would have expected from elementary textbooks dating back 50 years. Related studies confirm other conditions that matter for the size of the fiscal multiplier in precisely the way the


traditional textbooks say, for example (see Ilzetzki, Mendoza and Vegh 2011) that they are lower in small open economies because of the crowding out of net exports.

Substantial uncertaintyNeedless to say, the effects of fiscal policy are subject to substantial uncertainty. One never knows, for example, when rising debt levels might suddenly alarm global investors who then abruptly start demanding higher interest rates, as happened to countries on the European periphery in 2010. For this rea-son alone, the U.S. would be well advised to lock in a long-term path towards debt sus-tainability, even while undertaking a little short-term stimulus. In the case of stimulus in the form of tax cuts, one never knows how much of the boost to disposable income will be saved by households rather than spent. We are also uncertain as to the magnitude of the negative effects of high tax rates, via incentives, on long-term growth. Indeed, it is true that monetary policy is much better understood than it was in the past.

Monetary alchemy & fiscal scienceNevertheless, if the question is whether monetary policy or fiscal policy can more reliably deliver demand expansion under current conditions, the answer has to be the latter. One might even dramatize the contrast by speaking of ‘monetary alchemy and fiscal science’. A much-admired paper by Eric Leeper (2010) had it the other way around, characterising monetary policy as science and fiscal policy as alchemy. It is true that the state of knowledge and prac-tice at central banks, which actually set the instruments of monetary policy, is close to

the best that modern society has to offer. It is likewise true that the instruments of fiscal policy are set in a very political process that is poorly informed by the state contemporary economic knowledge and largely motivated by politicians’ desire to be re-elected. These political realities may be what Leeper had in mind.

Modern chemistryAlchemists were neither stupid nor selfish. Nor did their wisdom fall on deaf ears. Rather, alchemy fell far short of modern chemistry. The term alchemy could be applied to pre-Keynesians such as US Treasury Secretary Andrew Mellon, whose Depression pre-scription was that President Herbert Hoover should “liquidate labour, liquidate stocks, liquidate farmers, liquidate real estate ... it will purge the rottenness out of the system”. It could also be applied to the UK ‘Treasury view’ circa 1929, defined by Churchill as the Treasury believing that “when Government borrow[s] in the money market it becomes a new competitor with industry and engrosses to itself resources which would otherwise have been employed by private enterprise, and in the process raises the rent of money to all who have need of it”. But in light of all that was learned in the 1930s, it would be misleading to characterise the current state of fiscal policy knowledge as ‘alchemy’.•

ReferencesAlmunia, Miguel, Agustín Bénétrix, Barry Eichen-green, Kevin O’Rourke, and Gisela Rua (2010), “From Great Depression to Great Credit Crisis: Similarities, Differences and Lessons”, Economic Policy 25,62, 219-265.Auerbach, Alan and Yuriy Gorodnichenko (2012a),


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

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

Authors notes1.) It is a myth that he favoured big govern-ment more generally. Indeed, he said “the boom is the time for austerity”2.) For an alternative perspective, see Romer and Romer (2013) for a discussion of ‘why monetary policy doesn’t matter’.

Editors note: The publisher and editor of the Journal would like to thank both VoxEU and Harvard Kennedy School’s Prof. Jeffrey Frankel for allowing the Journal to reproduce a slightly amended version of this paper that was first published on the authors blog in January, 2013.


Interest rate risk

Central bank fixation with low inflation prolongs recession

Prof. Laurence Ball of Johns Hopkins University questions the wisdom of a “low inflation” target to generate global growth.

Since the double-digit inflation of the 1970s, central banks have sought to reduce inflation and keep it low. This col-umn argues that recent history teaches us that inflation has fallen too low. Raising inflation targets to 4 per cent would have little cost, and it would make it easier for central banks to end future recessions.

Many central banks have adopted a com-mon policy – an inflation target near 2 per cent. These central banks include the Fed (which calls it a ‘long run goal’), the ECB (which targets inflation ‘below, but close to 2 per cent’) and the central banks of most other advanced economies. A number of econo-mists, such as Blanchard et al. (2010), have suggested a higher inflation target – typically 4 per cent. Yet this idea is anathema to central bankers. According to Ben Bernanke (2010a), the Federal Open Market Committee unan-imously opposes an increase in its inflation goal, which ‘would likely entail much greater costs than benefits’.

I examine the case for a 4 per cent infla-tion target in a recent essay (Ball, 2013) and reach the opposite conclusions to those

of Chairman Bernanke: A 4 per cent tar-get would ease the constraints on mon-etary policy arising from the zero bound on interest rates, with the result that economic downturns would be less severe. This impor-tant benefit would come at minimal cost, because 4 per cent inflation does not harm an economy significantly.

Recent history has demonstrated the problem of the zero bound. In response to the US financial crisis and recession, the Fed reduced its target for the federal funds rate from 5.25 per cent in August 2007 to a range of 0 to 0.25 per cent in December 2008. The target remains in that range today. Yet this sharp monetary easing has not restored full employment. The unemployment rate peaked at 10 per cent in 2009 and then stayed high; in April 2013, it was 7.6 per cent. Unemployment of 5 per cent – widely con-sidered the natural rate just a few years ago – is nowhere in sight.

During past recessions, the Fed has reduced interest rates and kept reducing them until unemployment fell to an accept-able level. But cutting interest rates has not been feasible since 2008. With nominal rates


already near zero, they cannot fall farther. Nobody would lend at a negative interest rate because one can do better by holding cash. As the US recession spread around the world, many other central banks reduced interest rates to 1 per cent or less. Like the US, their economies are stuck in the ‘liquidity trap’ described by Keynes (1936).

The Fisher effectIn general, a higher inflation target reduces the zero-bound problem. In long run equi-librium, a higher inflation rate implies that nominal-interest rates are also higher – the Fisher effect. When a recession occurs, rates can fall by more before hitting zero, making it more likely that policymakers can restore full employment.

Suppose that central banks had been targeting 4 per cent inflation in the early 2000s rather than 2 per cent. Nominal-interest rates would have been two per-centage points higher, allowing rates to fall by an extra two points before hitting zero. I estimate that this extra stimulus would have reduced average unemployment over 2010-2013 by two percentage points (Ball 2013).

Risk of the zero boundLooking forward, the case for a higher infla-tion target depends on the risk that inter-est rates will hit zero in future recessions. Some economists believe that this risk is low. Mishkin (2011), for example, argues: “Although [the zero bound] has surely been a major problem in this recent episode, it must be remembered that episodes like this do not come very often. Indeed, we have not experienced a negative shock to the economy of this magnitude for over seventy

years. If shocks of this magnitude are rare, then the benefits to a higher inflation target will not be very large because the benefits will only be available infrequently.”

In my view, Mishkin understates the risk of the zero bound. If we look beyond the US, the crisis of 2007-2009 is not unique in recent history. A completely separate financial cri-sis pushed Japanese interest rates to zero in 1997. It was only around 1990 that central banks began to target inflation rates of 2 per cent or less. The two largest economies that adopted this policy both hit the zero bound within 20 years. More generally, history sug-gests that the zero bound is dangerous if central banks target 2 per cent inflation. In my paper, I make this point by examining the eight US recessions since 1960.

Looking at recessionWe can divide these recessions into two groups: First, recessions with low initial inflation. Three of the eight recessions began with inflation rates between 2 and 3 per cent. These episodes provide the most direct evi-dence on the zero-bound problem at low inflation rates. One of the three is the Great Recession of 2008-09, when the zero bound constrained monetary policy severely. Based on the Taylor rule that fits policy before 2008, Rudebusch (2009) finds that the optimal federal funds rate, ignoring the zero bound, fell to -5 per cent in 2009.

The other two recessions that began with 2-3 per cent inflation are the first one in the sample, which occurred in 1960-61, and the last one before the Great Recession, in 2001. These two recessions were milder than most: their peak levels of unemployment were only 7.1 per cent and 6.3 per cent. In both


cases, the federal funds rate did not hit zero, but it came close. The funds rate fell to 1.2 per cent following the 1960-61 recession and 1.0 per cent following the 2001 recession.

Low versus high inflationWe have seen that, with low inflation, a severe recession reduces the optimal federal funds rate to -5 per cent and mild recessions reduce it to about +1 per cent. Comparing these cases, it seems likely that a recession of average severity would push the optimal rate below zero.

Second, recessions with high initial infla-tion. In five of the eight recessions since 1960, inflation began above 4 per cent. With high inflation, nominal-interest rates were also high, so the Fed could cut them sharply without approaching zero. But what would have happened if inflation had started at 2 per cent? We can get an idea by examining real interest rates. If the nominal-interest rate, ‘i,’ cannot fall below zero, then the real rate, r=i-π , cannot fall below -π . One way to interpret the danger of low inflation is that it raises the lower bound on the real interest rate.

Interpreting the dangersIf inflation is 2 per cent when a recession begins, the bound on the real rate is -2 per cent at that point. However, the recession is likely to push inflation down somewhat. In the three recessions that actually started with 2-3 per cent inflation, the inflation rate fell to about 1 per cent before the economy recov-ered. History suggests, therefore, that initial inflation of 2 per cent will produce a bound of -1 per cent on the real interest rate. For the recessions that started with inflation above

4 per cent, we can gauge the relevance of a real-interest-rate bound by examining the lowest value reached by the real rate dur-ing the recession and subsequent recovery. In two of the five cases – the recessions of 1973-75 and 1980 – the real rate fell below -4 per cent. In these episodes, a lower bound of -1 per cent would have severely distorted monetary policy.

During the recession of 1969-70, the real rate fell to a minimum of -2.3 per cent. In the recession of 1990-91, the minimum was -0.6 per cent; this episode would have been a near miss with a lower bound of -1 per cent. Only in one case, the recession of 1981-82, was the minimum real rate above zero. To summarise, history suggests that, with a 2 per cent inflation target, the lower bound on interest rates is likely to bind in a large frac-tion of recessions.

The scourge of inflationWould 4 per cent inflation hurt the econ-omy? Economists have suggested various costs of inflation, such as variability in relative prices and distortions of the tax system. But research has not shown that these effects are quantitatively important for moderate infla-tion. As Krugman (1997) puts it: “one of the dirty little secrets of economic analysis is that even though inflation is universally regarded as a terrible scourge, efforts to measure its costs come up with embarrassingly small numbers”.

Some central bankers acknowledge that 4 per cent inflation does not greatly harm the economy. Nonetheless, they oppose adoption of a 4 per cent target because they think this action may actually cause inflation to rise above 4 per cent, or at


least create expectations of that outcome. Bernanke (2010a), for example, asserts that “inflation would be higher and probably more volatile” with a 4 per cent target and “inflation expectations would also likely become significantly less stable”.

Maintaining credibilityAccording to Bernanke (2010b): “The Fed, over a long period of time, has established a great deal of credibility in terms of keep-ing inflation low, around 2 per cent... If we were to go to 4 per cent and say we’re going to 4 per cent, we would risk a lot of that hard-won credibility, because folks would say, well, if we go to 4 per cent, why not go to 6 per cent? It’d be very difficult to tie down expectations at 4 per cent.”

Mishkin (2011) makes a similar argu-ment, asserting that “when inflation rises above the 3 per cent level, it tends to keep on rising”. We might call this view ‘the addictive theory of inflation’. Like an alcoholic’s first drink, 4 per cent inflation may not do great harm by itself, but it is the first step in a dan-gerous process.

Inflation expectationsThe rationale for this view is not clear. In other contexts, Bernanke and Mishkin argue that a central bank should determine its optimal policy, explain this policy to the pub-lic, and carry it out.

Why can’t policymakers explain that the zero-bound problem makes 4 per cent infla-tion desirable, raise inflation to 4 per cent, and keep it there? Mishkin points to the 1960s, when inflation increased to 4 per cent and the Fed let it keep rising, but why must policymakers repeat that mistake?

History does not suggest that it would be “difficult to tie down expectations” if infla-tion rises modestly. Inflation expectations, as measured by surveys, have generally fol-lowed actual inflation with a lag. They fol-lowed inflation up during the 1960s and ‘70s, and after that they followed inflation down. If inflation rises to 4 per cent, it seems unlikely that expectations will overshoot this level. Since the double-digit inflation of the 1970s, central banks have sought to reduce inflation and keep it low. Recent history teaches us that inflation has fallen too low. Raising inflation targets to 4 per cent would have little cost, and would make it easier for central banks to end future recessions.•

ReferencesBall, Laurence (2013), “The Case for 4 per cent Infla-tion”, Central Bank Review (Central Bank of the Republic of Turkey), May.Bernanke, Ben S (2010a), “The Economic Outlook and Monetary Policy”, Jackson Hole Symposium, 27 August.Bernanke, Ben S (2010b), “Testimony before the Joint Economic Committee of Congress”, 14 April.Blanchard, Olivier, Giovanni Dell’Ariccia and Paolo Mauro (2010), “Rethinking Macroeconomic Policy”, IMF Staff Position Note SPN/10/03.Keynes, John M (1936), The General Theory of Employment, Interest and Money, Macmillan.Krugman, Paul R (1997), The Age of Diminished Expectations: US Economic Policy in the 1990s, MIT Press.Mishkin, Frederic S (2011), “Monetary Policy Strat-egy: Lessons from the Crisis”, NBER Working Paper #16755.Rudebusch, Glenn D (2009), “The Fed’s Monetary Policy Response to the Current Crisis”, FRBSF Eco-nomic Letter 2009-17.


Legislation

The Brown-Vitter bill: An exposé of lunacy

Former bank regulator and prosecutor, William K. Black, pulls no punches in his

denunciation of proposed Senate bill.

U.S. Senators Sherrod Brown and David Vitter have introduced a legislative bill to the Senate entitled “Terminating Bailouts for Taxpayer Fairness Act of 2013.” Under President Obama, biparti-san bills to date have had a dismal effect on Capitol Hill. As the Democrats nego-tiate away the very elements necessary to create a good bill and add provisions that make parts of the bill harmful, seemingly in a bid to pick up a few token co-spon-sors, the Republicans react by doing their bit to kill off any positive parts of the bill in their effort to enact the negative.

The Brown-Vitter bill (BV) seems to exem-plify all these problems. Not only would it fail to achieve its desirable outcomes, even if it was to become law, but it would also allow the largest fraudulent banks to continue to cripple any effective examination. The result is an enactment of a bill by the Republicans that is so bad it can only be described as criminogenic.

One of the most essential actions we need to take is to eliminate systemically dan-gerous institutions (SDIs), a rough example

of this being any bank with liabilities greater than US$50 billion. The Dodd-Frank Act passed in 2010 did nothing effective to end SDIs. Whilst BV could be a sensible, even vital reform, if only it were drafted with the aim of ending SDIs, its harmful provisions will likely be made worse by its possible amendments.

Bill enshrines SDI problemThe bill, in its current draft format, enshrines, rather than resolves, the problem of SDIs. The concept of SDIs is that their failures are likely to cause a global, systemic crisis. This is why the “too big to fail” (TBTF) concept developed. TBTF, however, was historically a misnomer. TBTF banks did indeed fail in America.

The Federal Deposit Insurance Corporation (FDIC), however, ensured that when TBTF banks did fail, their general cred-itors did not suffer losses. The equity holders and subordinated debt holders would nor-mally have been wiped out, if and when, a TBTF bank did fail.

However, the regulatory concern was that if general creditors of an SDI suffered


losses when the SDI failed, it could cause a “cascade” of bank failures as their largest general creditors were typically other banks. The effect is the creation of three disastrous problems; any one of which should have been sufficient decades ago to convince Congress to get abolish SDIs.

Woes of SDIsFirst, SDIs make a mockery of the phrase “free markets.” The metaphor used by a group of conservative New York University scholars to describe the competitive advan-tage to SDIs of the implicit subsidy that arises from bailing out the general creditors is akin to “bringing a gun to a knife fight.”

Second, SDI failures risk causing global financial crises. And third, SDIs create so much economic power that inherently translates into dominant political power, thus crippling any democracy or democratic oversight by creating what amounts to crony capitalism.

SDIs also fail to create any desirable advantages as they are so large that they are impossible to manage or regulate effectively. They are inefficient as well as dangerous. The only win-win situation on the horizon is to make banks more efficient and far less dan-gerous by getting rid of SDIs.

Protect the taxpayerHowever, the focus of the BV bill was never on the abolishment of SDIs. Brown and Vitter’s comments make it clear that they agree with the first two problems caused by SDIs. “The truth, according to the markets, is that ‘too-big to-fail’ is alive and well with the Wall Street megabanks,” Vitter said. “Our number one goal is to protect the taxpayers

from financial risks and the best way to do this is by implementing a systemic solution, increasing the minimum amount of capital the mega banks are required to have.”

The first problem with BV is so obvious that the fact that it is ignored by the media (and by Brown and Vitter) tells us that SDIs have so insinuated themselves into our psy-ches that even reformers cannot conceive of a world free of what Brown and Vitter describe as their scourge. If their “number one goal” is to protect us from SDIs, why don’t Brown and Vitter seek to rid the mar-ket of them?

BV fails bailout testBrown and Vitter began the press release announcing their co-sponsored bill as fol-lows: “Washington, D.C.– U.S. Sens. Sherrod Brown (D-OH) and David Vitter (R-LA) announced a new plan that would prevent any one financial institution from becoming so large and over leveraged that it could put our economy on the brink of collapse or trig-ger the need for a federal bailout.”

BV does not do any of the things the sponsors claim in this sentence. The SDIs are already large enough that they pose a global systemic risk when they fail. BV does not limit the size of the SDIs or prevent them from growing. Fraudulent SDIs can be mas-sively overleveraged under BV. As such, BV fails to eliminate the need for federal bailouts.

Our second problem is the fact that higher capital requirements cannot, and do not, make SDIs safe. Higher capital require-ments cannot protect us from the three dis-asters that SDIs cause. Brown and Vitter’s explanation for their bill contains this telling fact. “Prior to the crisis, Lehman Brothers


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

Misunderstand capitalAnother major issue is that neither Brown nor Vitter seem to understand “capital,” accounting, or fraud. Brown and Vitter do not understand the import of the facts of the Lehman’s failure in September 2008. “Capital” is merely an accounting residual: assets – liabilities = capital. Accounting con-trol frauds such as Lehman (see my House testimony for details) massively overstate asset values.

Frauds also use many scams to dramati-cally understate liabilities. Indeed, Lehman used an accounting scam to substantially understate its debt levels. There are also scams that directly create fictional capital. See my description in earlier articles of the Icelandic banks’ scams in which they lent money to their shareholders to buy their shares.

Dangerous delusionsFurther, Brown and Vitter do not understand the ephemeral nature of capital. “Capital requirements will focus on common equity and other pure, loss-absorbing forms of capital.” Brown and Vitter’s conception that capital can be something that is “pure” and can be counted on to be there when the bank fails to “absorb loss” is a dangerous delusion that demonstrates that Brown and Vitter do not understand the most basic and critical concepts of finance, accounting, and regulation.

They seem to believe that there is some vault in a bank that holds “capital” and that

there is “pure” capital that will remain in the “pure capital” vault even after the bank is looted. It is dangerous to believe in such absurd myths.

Brown and Vitter also appear to have for-gotten recent history, when Congress suc-cessfully extorted the Financial Accounting Standards Board (FASB), demanding that they change generally accepted accounting principles (GAAP) so that the largest banks would not have to recognise their mas-sive losses on their loans and toxic deriva-tives - the so called Mark-To-Market. This accounting travesty remains the rule today, which means that we have systematically overstated bank asset values – which means in turn that we systematically overstate bank capital. Brown and Vitter propose no change to end this travesty. Instead they do little but spread fantasies about “pure” capital.

Fraud, what fraud?In a nutshell, our two erstwhile Senators ignore the real problem, namely, accounting control fraud. Lehman provides a chilling example of how much fictional capital and accounting control fraud can create – and how much damage the controlling offic-ers can do by looting “their” firms. George Akerlof and Paul Romer described these frauds in their 1993 article: Looting: The Economic Underworld of Bankruptcy for Profit.

I assume for the purposes of analysis the accuracy of Vitter’s claim that Lehman’s asset valuations were overstated by 91 cents on the dollar. At the same time it was reporting an 11 per cent (positive) capital level, its real capital level was in the range of a (negative) 85 per cent. Lehman could, easily, have reported that it met the 15 per


cent capital requirement that BV proposes for “megabanks.” It would have required a few more scam deals, and that would have increased Lehman’s losses. Brown and Vitter however show no signs of understanding the basics of accounting control fraud.

Fraud is a “sure thing”The fraud “recipe” for officers controlling a lender reads something like this: Grow like crazy by making really crappy loans at a pre-mium yield, while employing extreme lever-age, and providing only grossly inadequate allowances for loan and lease losses (ALLL)!

Akerlof and Romer agreed with the con-clusion of regulators and criminologists that this recipe produces a series of “sure things.” The lender is guaranteed to report record (albeit fictional) profits in the short-run, the controlling officers will promptly be made wealthy by modern executive compensa-tion, and the lender will eventually suffer catastrophic losses.

Fictional profitsThe officers who control a bank and use it as a “weapon” to defraud can easily produce vast amounts of fictional profits that can (partially) be retained so that they produce very high levels of reported capital. A higher capital requirement can slow down a fraud by reducing growth and leverage, but it will not prevent catastrophic losses and, if many controlling officers follow the same strategy, a hyper-inflated bubble that can produce a systemic crisis.

Accounting control frauds are excep-tionally adept at suborning the “independ-ent professionals” who value assets and liabilities. The fraudulent controlling officers

deliberately create a “Gresham’s dynamic” that drives good ethics out of key positions in the professions. Lehman had no difficulty getting a subset of appraisers to overstate home prices and auditors to “bless” even their massively over-valued assets and its preposterously inadequate ALLL. Again, anyone who thinks there is “pure” capital has to believe in “pure” asset and liability valuations.

I had not thought, after this crisis, that anyone still believed in such a myth, but then came BV. The bottom line is that BV will fail the banks precisely where success is most essential – within the arena of accounting control frauds.

Fraud is “pervasive”As a group of conservative finance profes-sors were recently forced to conclude as a result of their study, during the recent crisis fraud was “pervasive” at our “most reputable” banks – see Asset Quality Misrepresentation by Financial Intermediaries: Evidence from RMBS Market, by Tomasz Piskorski, Amit Seru & James Witkin (February 2013) (“PSW 2013”).

The national commission that inves-tigated the causes of the S&L debacle reported that at the “typical large failure” “fraud was invariably present.” The S&L frauds were control frauds. No one doubts that the Enron-era scandals were control frauds. Even conservative scholars that have investigated the most recent crisis have con-cluded that the SDIs engaged in “pervasive” fraud.

The key persons who have not got-ten the message about the need to deal with accounting control fraud if we wish to avoid future financial crises are Brown and


Vitter. This passage, from their description of the BV bill reveals that they have implicitly assumed fraud out of existence: “Requiring the largest banks to fund themselves with more equity will provide them with a sim-ple choice: they can either ensure they can weather the next crisis without a bailout or they become smaller.”

Accounting control fraudNo, there is another choice – a choice that the officers controlling the SDIs have often decided was their superior option – account-ing control fraud. Fraud is a “sure thing,” and the C– suites are filled with officers who love sure things.

Again, notice that Brown and Vitter do not understand the import of Lehman’s massive overstatement of assets (and, there-fore, capital) that they used as purportedly supporting the desirability of their bill. No capital requirement can “ensure” that a bank will not fail and will not be bailed out.

Dream stateOur bill sponsors though go one better in what can only be described as a dream state in trying to temper some form of regulatory fusion with private market discipline, which is best summed up in the following section: “Regulators may increase capital ratios as banks increase in size.

Setting capital levels for the largest megabanks at levels required by the private market, absent government support, will ensure that they have an adequate cushion of equity in the event that the FDIC must put a megabank through orderly liquidation under Title II of Dodd-Frank.”

This passage is another demonstration

that Brown and Vitter do not comprehend the importance of the Lehman fraud and the resultant catastrophic losses. Once more, they claim that their bill will “ensure” that we will never again have any expense when a “megabank” fails. How can they conceivably say that after Lehman’s failure? We need to go back to basic facts about finance.

Lehman was an investment bank so it had no FDIC deposit insurance. Lehman was not treated as TBTF by the markets or the government. It was allowed to fail and its general creditors were not bailed out by the government. Lehman was not treated by the markets as immune to failure.

The lie of Lehman’sAs a result, it purported to maintain a higher capital level (11 per cent) than did most FDIC insured banks. But that higher reported capital level was a lie – an enormous lie by a grotesquely insolvent investment bank. Its reported capital level was chosen by its man-agement “at levels required by the private market, absent government support.”

Not only was the reported capital level a work of fiction but “the private market” also failed to spot for years the fact that Lehman was actually deeply insolvent. Lehman proves that one has to be delusional to believe that they can “ensure that they have an adequate cushion of equity” by setting a higher capital requirement. Congress’ role in successfully extorting FASB to hide real losses in order to overstate reported assets and capital also explains one of the several reasons BV cannot “ensure” the attainment of any of its stated goals.

Another contention I have with BV is the fact, that contrary to their intent, the bill


does not eliminate the implicit Federal sub-sidy megabanks enjoy, and they the authors decry. I explained why the acronym TBTF was a misnomer. TBTF banks have failed. It actually refers to bailing out the general creditors. Brown and Vitter explicitly criticise the “implicit federal subsidy” enjoyed by the SDIs because they can borrow more cheaply than their competitors.

No higher capital requirementsBut a close reading of their press release reveals that Brown and Vitter appear to believe that the SDIs can borrow more cheaply because the government never permits them to fail. Brown and Vitter do not understand that the implicit subsidy arises because the government ensures that when an SDI fails that its general creditors are bailed out. This explains why BV does not ban bailing out an SDI’s general credi-tors. BV, therefore, fails to remove the implicit federal subsidy that SDIs enjoy.

A further issue with BV is the fact, as the bill is presently drafted, is that it does not significantly increase capital requirements for most SDIs. Vitter did not promise sig-nificantly higher capital requirements for SDIs. Further, he has conflated TBTF with “megabanks.” Megabanks are an important subset of SDIs because their assets are so massive, but most SDIs do not meet the BV definition of a “megabank”, namely, assets greater than US$50 billion.

Media failureAgain, the media has largely ignored this incredible failure by BV to require most SDIs to have substantially greater capital. Even if we were to assume, contrary to fact, that

higher capital requirements removed the three disastrous consequences of SDIs, BV leaves a massive loophole. BV only begins to increase a SDIs capital requirement substan-tially when it attains a size roughly 10 times larger than the US$50 billion threshold to become an SDI.

BV redefines most SDI’s as “mid-size” and “regional” banks, but calling them that is a pure fig leaf. They are so large that they pose a systemic risk when they fail. BV’s eight per cent capital requirement is essen-tially a return to the status quo before Basel II. If our co-sponsors of this Bill were serious about SDIs they would be calling out for the reintroduction of the only effective means to make reported capital real, this being vigor-ous independent examination.

Gresham’s dynamicsAs I have noted, officers running account-ing control frauds find it easy to create Gresham’s dynamics that allow them to suborn appraisers and auditors who will bless massively inflated asset values while hiding real losses. A lender that follows the fraud recipe will produce record (fictional) income and can produce very large amounts of (fictional) capital. These results are “sure things” under the fraud recipe. Creditors do not “disci-pline” accounting control frauds – they fund their growth. Creditors love to loan to firms reporting record profits.

Regulators are the only controls that the fraudulent CEO cannot hire and fire. Only skilled, vigorous examiners backed by tough supervisors have any hope of ensuring that reported bank capital bears any relationship to reality. Brown and Vitter do not appear to


understand the import of the Financial Crisis Inquiry Commission’s (FCIC) key finding that the regulators failed to act because of the competition in regulatory laxity, the creation of regulatory black holes, and the regulators’ experience that it was impossible to get the political appointees running their agen-cies to take action against banks that were reporting high profits (FCIC 2011: 307).

Shock wavesThe key is for examiners to order banks to recognise losses on bad assets as soon as those assets are impaired – not when the default happens (which can be years later). In the S&L debacle, we sent shock waves through the frauds when we targeted the S&Ls reporting the highest profits and growth as our top priority for investigation because they were the most likely to be fraudulent. It is essential that we return to that strategy by appointing real regulators.

Regrettably for me, the industry itself, and the general public, far from achiev-ing this examiners nirvana, BV would have the opposite effect, as such, it is BV is criminogenic, and would eviscerate what one considers vigorous examination. Many influential officials try to impair vigorous regulation, which always starts with vigor-ous examinations.

Keating sagaIn the S&L debacle, the Reagan administra-tion tried to give the most notorious S&L CEO, Charles Keating (who ran Lincoln Savings), control of the federal agency regu-lating S&Ls. I blew the whistle on this effort, which led to the resignation in disgrace of one of our three presidential appointees

running our agency. A majority of the House co-sponsored a resolution calling on us not to go forward with reregulating the industry. Speaker Wright held the bill to recapitalise the FSLIC insurance fund (so that we would have the funds to close more control frauds) hostage to extort favours for Texas control frauds.

Senator Cranston put a secret hold on the same bill at Keating’s behest. Keating used Alan Greenspan as a lobbyist to help recruit the five U.S. Senators who would become known as the “Keating Five” when my notes of the meeting were made public.

Threat of legal proceedingsThe Office of Management and Budget threatened to make a criminal referral against the head of our agency, Edwin Gray, on the grounds that he was closing too many insol-vent S&Ls. Yes, you read that sentence cor-rectly. The top guy in Treasury for S&L policy testified against our agency in the challenge to the appointment of a receiver of an insol-vent S&L. He opined that it was “arbitrary and capricious” to close S&Ls because they were insolvent.

He also testified to Congress that we should simply run a Ponzi scheme by encouraging insolvent S&Ls to grow so that they could use the cash they obtained from deposit growth from new depositors to pay interest to existing depositors. The Reagan administration and Speaker Wright made a cynical secret deal not to reappoint Gray to a new term.

The administration appointed Danny Wall as Gray’s successor. Wall proceeded to meet Wright’s demand that we force out our top supervisor in Texas. Wright’s complaint


was that he was homosexual, but everyone knew that Wright’s real complaint was that he was effective. Wall immediately ordered an end to our examination and the enforce-ment investigation of Lincoln Savings.

Largest S&L failureThis was Keating’s primary demand because he knew that our examination and enforce-ment investigation had already discovered a number of his frauds and that his control over Lincoln Savings could not survive our continued examination and enforcement investigation.

Wall then removed the jurisdiction of the agency’s San Francisco office over Lincoln Savings because we persisted in recom-mending a takeover of Lincoln Savings after the Keating Five tried to intervene to pre-vent us from taking action against Lincoln Savings’ massive violation of the law. This led to a disaster. Lincoln Savings became the most expensive S&L failure and defrauded thousands of widows.

The Texas state S&L commissioner was consorting with so called “ladies of the night” provided by the Nation’s second worst financial fraud, Vernon Savings (known as “Vermin” to its regulators). The California state S&L commissioner was secretly in business with Keating. The Texas Attorney General announced he was investigating us for discrimination against Texas S&Ls, par-ticularly in our examination process.

“Get Black … Kill Him Dead.”A couple of days later he announced we were guilty without any cumbersome inves-tigation to slow him down. The COO of one the S&L our San Francisco office regulated

threatened our examiner-in-charge. The FBI informed us that organised crime controlled the S&L. Keating hired private counsel who had recently left a senior position at the Department of Justice (DOJ). They contacted William Weld, one of the most senior DOJ officials. Within days, the FBI was investigat-ing us (the San Francisco office of the federal regulatory agency), rather than Keating.

Keating twice hired private investigators to investigate me. He sued me and a number of regulators, for US$400 million in our indi-vidual capacities (in a Bivens suit). Keating boasted of spending US$50 million to attack our examination report of Lincoln Savings. Keating infamously put in writing his direc-tive to his chief political fixer that his “highest priority” should be to “Get Black … Kill Him Dead.”

“The secret file”Keating also created what became known as “the secret file” that supposedly had deroga-tory information on me and gave it to senior officials of our agency. They refused allow me to read and respond to the file. When I persisted, they gave the file back to Keating to prevent me from getting access to the file.

I note these personal occurrences to explain several points that are essential to our understanding of BV. First, regulation can succeed. It is only now, with the expe-rience of the current crisis where effective regulation and regulators were deliberately targeted for removal that we can see that Chairman Gray’s actions in promptly re-regulating the industry saved many trillions of dollars by containing a surging epidemic of accounting control fraud in the 1980s.

We can also see that our actions in


driving liar’s loans out of the S&L industry in 1990-1991 prevented a crisis that also would have cost trillions of dollars to resolve absent effective regulation.

Second, the key is regulatory profes-sionalism, knowledge of accounting control fraud techniques, vigour, and resoluteness. Pushback is inevitable and violent. The accounting control frauds cultivate powerful political allies.

Akerlof & Romer insightThird, the examination process is the key value that a financial regulatory agency adds. Good examiners do not wait for the assets to blow up in massive defaults. They spot impaired loans early and they spot account-ing control fraud schemes early. It is then incumbent on the agency’s leadership to back up the examiners with prompt, vigor-ous supervision, enforcement, receiverships, and criminal referrals.

Akerlof and Romer examined a large amount of materials from our examiners and came to this key insight: “Neither the public nor economists foresaw that [S&L deregu-lation was] bound to produce looting. Nor, unaware of the concept, could they have known how serious it would be. Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from expe-rience, history need not repeat itself” (George Akerlof & Paul Romer.1993: 60).

Provision of regulatory reliefFourth, the frauds recognise that the exami-nations are the key and their effort is always to impair the examination and the ability

of supervisors to require prompt corrective action on the basis of the examinations. I mentioned Speaker Wright holding the FSLIC recapitalisation bill hostage. The broader story is that the Texas control frauds hijacked the bill and festooned it with “for-bearance” provisions designed to allow the frauds to stall the exams and vital supervi-sory actions.

Fifth, the destruction of effective exami-nation as a result of some of these forbear-ance provisions and the regulatory race to the bottom proved disastrous during the most recent crisis. Restoring effective financial examination and supervision (and criminal prosecutions) should be a national priority.

Impaired examinationSixth, instead, BV, as introduced, is designed to further impair examination. The Senators’ description of this portion of the bill is dis-turbingly disingenuous:

“Provide regulatory relief for community banks. By reducing regulatory burdens upon community banks, they can better compete with mega institutions. Because community institutions do not have large compliance departments like Wall Street institutions, this legislation provides common sense meas-ures to lessen the load on our local banks. Creates an independent bank examiner ombudsman that institutions can appeal to if they feel that they have been treated unfairly by their examiner.”

This provision, however, is not limited to “community” (very small) banks. Creating an ombudsman for examination will be a godsend to fraudulent SDIs. Keating ran a US$6 billion S&L – and spent US$50 million


attacking a single examination (roughly our entire budget for a region regulating hun-dreds of S&Ls). Wait till JP Morgan decides to fight an examination. It will be able to stall the examiners and supervisors for years.

Hostile OmbudsmenThe SDIs will hire away the Ombudsman, assuming he sides with the industry, and give him a wonderful sinecure (“revolving door”). The SDIs will lobby to try to ensure that the person selected as Ombudsman is hostile to effective regulation. Incredibly, BV recreates the worst of Keating’s abuses.

‘‘(e) Confidentiality – The Ombudsman shall keep confidential all meetings, discus-sions, and information provided by financial institutions.’’

Yes, Keating’s secret files will now become National policy. The bank gets to make ex parte presentations in person and writing with the Ombudsman – who is for-bidden by statute from informing the regu-latory agency of the charges and giving the examiner and the agency an opportunity to respond. Then, on the basis of ex parte smears, the Ombudsman can issue a report condemning the examiner or the agency.

Institutionalised grave diggerThe grave danger is that one portion of BV will become law – the provisions that will be drafted by the fraudulent SDIs’ lawyer/lobbyists that will expand the assault on any effort to restore what is already a crippled examination process.

This is what happened when Speaker Wright was extorting us in 1986-1987. It was only a bit of clever amending by us with the invaluable aid of Representatives Jim

Leach and Henry B. Gonzalez that saved the Nation from disaster.

I mentioned the cynical deal that the Reagan administration reached with Speaker Wright. The administration prom-ised two things as part of the deal. It would not reappoint Ed Gray as chairman of the regulatory agency and it would not opposed the “forbearance” provisions that the control frauds’ lawyers had drafted to make effective examination and supervision impossible.

Obama questionsWill the Obama administration oppose this travesty of a bill posing as a reform aimed at the SDIs that would actually be a great boon to the SDIs because they could use it to assure that examination remains impotent?

Will the Obama administration support a clean bill with the three provisions: No SDI may grow; All SDIs must shrink within five years to below US$50 billion (US$ 2013 equivalent) in assets: All SDIs will be subject to stringent examination and supervision during that five year divestment period.

And will the Obama administration appoint regulatory leaders who will actually vigorously enforce the laws? •

Editors note: The publisher and editor of the Journal would like to express their grati-tude to Associate Prof. William K. Black of the University Missouri-Kansas City for allowing the Journal to republish an abridged version of this paper that first appeared on the authors website, New Economic Perspectives - www.neweconomicperspec-tive.org - this May. Please also note that the original title has been altered to benefit our readership here in the Asia Pacific region.


Derivatives

Dodd-Franks extra-territorial reach irks European Union

MRV Associates’ Mayra Rodríguez Valladares details growing global concerns over the CFTC’s interpretation of Title VII.

Summer tends to be a quiet time for europeans as many head out for nice holidays. This summer may be quite different; as european bankers, govern-ments, and regulators are increasing their pressure on Commodity Futures Trading Commission Chairman Gary Gensler to curb what they deem is the CFTC’s extraterritorial reach with Dodd-Frank’s Title VII. Gensler and his supporters, however, are not satisfied that relying on foreign regulators to monitor u.S. deriva-tives activities abroad would protect the u.S. taxpayer if a breach in Dodd-Frank rules or a derivatives transactions fail-ure were significant enough to disrupt markets.

Due to the role of unregulated over-the-counter (OTC) financial derivatives in the 2008 financial crisis which began in the U.S. but whose influence was felt globally, the G-20 agreed in its Pittsburgh meeting in 2009 that “all standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms where appropriate, and cleared through central

counterparties by end-2012, at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”

Failure of 2009 communiquéIt is important to note that unlike Basel III, the international uniform capital standards for banks, the 2009 communiqué did not lead to international uniform financial deriv-atives standards.

The members of the G-20, in vary-ing degrees and at different speeds, have embarked in their own jurisdictions to reform the OTC derivatives market. Given the interconnected nature of these markets, international cooperation has very much been part of crafting derivatives financial regulation.

Nonetheless, as noted by Gensler “due to different cultures, political systems and legislative mandates, some differences are inevitable.” Unlike with the Basel III bank capital standards, the U.S. has been faster at finalising and implementing derivatives rules as part of Dodd-Frank’s Title VII.


In July 2012, for example, the CFTC released guidance for financial institutions to address extraterritorial concerns raised both in the U.S. and abroad. Reporting exemp-tions were granted to numerous participants, but these are due to be revisited on July 12.

Extraterritorial regulationsBefore highlighting the differences between the CFTC’s and others’ view on whether Dodd-Frank’s treatment of derivatives regulations is extraterritorial, it is extremely important to understand the size of the derivatives markets and the role of U.S. par-ticipants therein. According to the Bank for International Settlements, at the end of 2012, total global derivatives markets accounted for around US$633 trillion in notional amounts – more than ten times the size of the actual global economy itself.

U.S. participants, with about US$223 trillion in notional exposure, account for over a third of the aforementioned global amount, representing a 270 per cent rise in just one decade. The data goes a long way to explain the desire of U.S. regulators such as the CFTC and the Securities and Exchange Commission, along with bank regulators, the Federal Reserve, the Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency, to see that derivatives markets are not only better regu-lated but also well supervised.

U.S. derivatives transactionsThe disproportionate amount of derivatives transactions are between dealers; end-users such as commodity companies are incred-ibly small in comparison. In the U.S., 80 per cent of financial derivatives are interest rate

derivatives, 12 per cent are foreign exchange derivatives, about six per cent are credit derivatives, with the remainder being equity and commodity derivatives.

The majority of U.S. players, to no one’s surprise, are banks. According to the OCC, while over 1,350 insured U.S. commercial banks and savings associations reported derivatives activities at the end of the fourth quarter 2012, derivatives activity in the U.S. banking system continues to be overwhelm-ingly dominated by a small group of large financial institutions.

Specifically, JPMorgan Chase, Citibank, Goldman Sachs, and Bank of America rep-resent 93 per cent of the total banking indus-try derivatives notional amounts and 81 per cent of industry net current credit exposure.

Changes in management cultureWhat many may not know, however, is that the top U.S. banks’ derivatives portfolios are about 96 per cent OTC, which until 2010 were unregulated, and only 3-4 per cent are exchange traded.

For the banks to transition from OTC to clearable derivatives is requiring a massive change in risk management culture, not to mention business strategy and significant overhaul of how data is collected, verified, and reported to comply with Dodd-Frank.

Moreover, U.S. regulators like CFTC and SEC, which had minimal exposure to OTC derivatives, have had to upgrade signifi-cantly their knowledge not only about these instruments, but how international banks such as JPMorgan and Bank of America con-duct their derivatives business across multi-ple legal entities and geographies.

Also extremely important, these entities


often book their derivatives not only in mul-tiple legal entities in the U.S. but also abroad. Just because financial book trades are booked offshore does not mean that risk stays off-shore, as has been seen with JP Morgan’s “London Whale” scandal, Citibank, AIG, Lehman, Long Term Capital Management and Bear Stearns.

Complex supervisory tacticsTo illustrate the challenge of supervising derivatives activities, one need only look at one of the largest players, Bank of America, to gauge how complex matters presently are. Taking the publicly available living will executive summary that Bank of America published in 2012, which of course has very limited information, was nonetheless a reminder of how complex and opaque these institutions are.

Bank of America has 2,000 subsidiaries globally formed in over 95 different jurisdic-tions. Over 38 per cent of the subsidiaries were formed in a foreign legal jurisdiction. The public executive summary of Bank of America’s living will highlights two key enti-ties where most derivatives are probably booked.

High-level but inadequate dataFirst, there is Merrill Lynch International (MLI), a UK-based and regulated interna-tional broker-dealer that provides a wide range of financial services globally for busi-ness originated in Europe/Middle East/Africa (EMEA), Asia/Pacific Region and the Americas.

This entity amongst other things engages in equity and foreign exchange derivatives; there is also Merrill Lynch International Bank

Limited (MLIB) the primary non-U.S. bank-ing entity of Bank of America Corp., which is incorporated in Ireland and regulated by the Central Bank of Ireland. However, MLIB operates globally for business origi-nated in EMEA, Asia/Pacific Region and the Americas.

MLIB engages in “debt derivatives trades. It trades flow rates, for example swaps, and over-the-counter derivatives principally with third-party institutions and affiliate compa-nies.” In the living will executive summary, one can get high-level data on derivatives transactions and information about differ-ent legal entities but not the exact number and type of derivative per legal entity and per geography.

Geographical issuesGiven the descriptions of MLI and MLIB, one can make an educated guess that this is where most Bank of America derivatives are booked, but as for where they are geo-graphically, one would have to guess that the major geographies are probably the UK and Ireland.

Complicating matters further, since U.S. banks are not fully compliant with Basel II, they are not abiding by Pillar III, which has uniform transparency guidelines.

Hence, further sleuthing is necessary. Since UK and continental European regu-lators have required banks in their jurisdic-tions to be compliant with Basel II, Pillar III disclosures are available for some of Bank of America’s foreign legal entities such as MLI, but Pillar III is not implemented uniformly even where it is being required by European regulators.

Not only does the aforementioned


represent a challenge to the CFTC, the Fed and the OCC from a supervisory perspective of these banks and their derivatives activities, if any large, interconnected firm were to fail, the process of resolving would truly test the FDIC in terms of Dodd- Frank’s Title I and II.

CFTC guidanceGensler has argued that Dodd-Frank should apply to transactions entered into by “branches of U.S. institutions offshore, between guaranteed affiliates offshore, and for hedge funds that are incorporated off-shore but operate in the United States.”

His concern has been that although it’s possible that some U.S. jobs and markets may move offshore, that in a time of stress, “risk would come crashing back to the U.S. economy.” The guidance released by the CFTC in 2012 included a “commitment to permitting foreign firms and, in certain cir-cumstances, overseas branches and guaran-teed affiliates of U.S. swap dealers, to meet Dodd-Frank requirements through compli-ance with comparable and comprehensive foreign rules.”

The CFTC calls this “substituted compli-ance.” This regulatory concept means that if other regulators have similar derivatives rules as we do, our derivatives participants’ offshore entities can comply with those rules rather than Dodd-Frank.

International cooperationThe CFTC proposed granting time-limited relief until July for non-U.S. swap dealers (and foreign branches of U.S. swap dealers) from certain Dodd-Frank swap requirements. In July, when the relief expires, various Dodd-Frank requirements will apply to non-U.S.

swap dealers. According to Gary Gensler “under this time-limited relief, foreign swap dealers may phase in compliance with cer-tain entity-level requirements.” In addition, it provides relief for foreign dealers from speci-fied transaction-level requirements when they transact with overseas affiliates guaran-teed by U.S. entities, as well as with foreign branches of U.S. swap dealers.

During my studies of Russian and Soviet politics, both in the U.S. and in the Former Soviet Union, the phrase often repeated was “trust but verify.” Unfortunately, this phrase again applies to international financial regu-latory cooperation.

International cooperation is critical, but each country must make sure that its regula-tions are being followed. In the U.S., because of the size and complexity of our derivatives participants, it is critical that their foreign subsidiaries are not given exemptions.

OTC transactions abroadThe list of firms’ whose derivatives implo-sions began in an offshore division but came back to U.S. shores is too long!

Gensler’s concerns are very valid given the influence of U.S. market participants in U.S. and global derivatives markets and especially since large U.S. banks in particu-lar often book a significant portion of their OTC derivatives transactions in legal entities abroad.

Gensler is trying to manage an incredibly delicate position. On the one hand, he can-not be seen as the U.S. pushing its will onto others, and the CFTC has engaged in sig-nificant discussions with foreign regulators. On the other hand, the CFTC must protect U.S. taxpayers from being impacted by failed


derivatives transactions at U.S. institutions, whether the trades are booked in the U.S. or abroad.

Much emphasis has been given in the media about regulations, but equally impor-tant if not more so is supervision. The CFTC is not only responsible for writing the rules and enforcing them when they are broken, they must also supervise market participants based on a risk based supervision approach.

Compliance & risk management Not all supervisors utilise that framework; some bank and derivatives supervisors are more compliance-based, that is, they are more focused on whether market par-ticipants’ are complying with rules rather than really looking to see how participants conduct risk management – that is, the identification, measurement, control and monitoring of risks.

Importantly, given austerity programs throughout Europe and our sequester in the U.S., bank and derivatives regulators have not been given the necessary budgets to increase the number of and capacity of existing regulators so that they can supervise and examine derivatives, something that for many is a completely new responsibility.

It is precisely because of the intercon-nectedness of derivatives markets that the CFTC cannot afford to assume that other supervisors are properly monitoring the derivatives of U.S. participants offshore or foreign entities in the U.S.. Substituted com-pliance is an invitation for significant regula-tory arbitrage. When our institutions import their derivatives implosions abroad back to the U.S., no foreign taxpayer will come to substitute our taxes for theirs.

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


Economic theory

Macroeconomic stabilisation under modern monetary theory

Interfluidity’s Steve Waldham casts a not-too-uncritical eye over an economic theory that’s gaining widespread support online.

Over the past year or so, a macroeco-nomic perspective known as “modern monetary theory” (MMT) has grown surprisingly prominent in economic policy debates. As the result of collabo-ration between hedge fund manager, Warren Mosler and a number of academ-ics associated with the post-Keynesian tradition, among them L. randall Wray, Bill Mitchell, Pavlina Tchernova, and eric Tymoigne, it draws heavily on the insights of Hyman Minsky, and Abba Lerner’s theory of “functional finance”.

Mainstream unorthodox?Although both camps may be loathe to admit it, MMT bears a very strong resem-blance to the more mainstream, though still unorthodox, “fiscal theory of the price level,” as developed by, among others, Eric Leeper, Christopher Sims, Michael Woodford, and John Cochrane.

A summary of MMT’s view of stabilisa-tion policy would suggest that the central macroeconomic policy instrument available to governments is in place to regulate the flow of “net financial assets” to and from the

private sector. In short, governments create private sector assets by issuing money or bonds in exchange for current goods or ser-vices, or via simple transfers, only to destroy private sector financial assets via taxation.

Benefits and costsWhilst advocates of MMT tend to view financial asset swaps or “conventional mon-etary policy”, as second order and less effec-tive, they might acknowledge some impact. That said, I would argue that although the flow of net private sector financial assets is undoubtedly a powerful tool in macroeco-nomic policy, it is not one that is uniquely effective.

Indeed, changes in the relative price of financial assets, the object of conventional monetary policy, and in their distribution can also have a powerful effect on behav-iour, for which there are associated benefits and costs. My first question, therefore, is to consider the justification for MMT focusing almost exclusively on managing the level of “net financial assets”.

Secondly, MMT proposes that a gov-ernment that borrows in its own currency


cannot be insolvent in the same way as private businesses. The theory holds that as such, a government will never face a sharp threshold where it cannot meet promised payments, leading to a socially unanimous or even legal declaration of insolvency and an almost certain run on its liabilities.

Flow of obligationsThat said, I would argue that while it is true that a government cannot be forced into insolvency for want of its capacity to pay in its own currency, that it is possible for it to find itself politically or institutionally unable to meet an obligation despite access to the printing press. It strikes me therefore as an open question the degree to which protec-tion from formal insolvency protects govern-ment obligations from disruptive races to redeem.

However, I think that few people would argue with the point made by MMT advo-cates that the value of money and govern-ment claims in real terms is absolutely variable. Governments do and properly should manage their flow of obligations with an eye to supporting that value, among other competing objectives, particularly, for example, full employment.

Government obligations irrelevantA further point in the theory relates to the notion that the real value of money and gov-ernment debt is not reliably related to any theory of government balance sheets. In par-ticular, the stock of outstanding government obligations is largely irrelevant. The value of government obligations, according to MMT, is a function of financial flows. Government claims will retain their value so long as the

private and foreign sectors wish to expand their holdings of those claims at the current price level, that is so long as agents are will-ing to sacrifice real goods and services today to reduce their indebtedness, improve their financial position, or stimulate their export sectors. The value of government claims will come under pressure only when agents, on net, seek to increase indebtedness or redeem existing claims for real goods and services.

Such a scenario is where supporters of MMT, quite rightly I believe, call out conven-tional economists on adherence to dogma that is ill supported by the data. Empirically, the relationship between government bal-ance sheet quantities and either the price level or private/foreign willingness to absorb government claims is weak.

Cause and effectIndeed, theories of the public balance sheet that have proven unreliable continue to be endorsed to avoid inconsistency in the edi-fice of neoclassical finance. It is true, after all, that in extreme cases, governments that experience hyperinflations go through peri-ods of high indebtedness relative to GDP, but the barrier between cause and effect is murky to say the least.

Indeed, common models of macroeco-nomic theory impose a “no Ponzi condition” that is absurd not only for governments, but also for private firms. All firms and govern-ments do eventually end, and when they do, they usually leave substantial claims unsatisfied.

Agents lend to corporations and gov-ernments not because they believe the debt will be paid down, but because they believe the almost certain eventual default


or debasement of claims is unlikely to hap-pen within their investment time horizon. In the real world, governments and corpora-tions balance actual gains from the transfer component of increased borrowing against increased hazard that the end will come quickly and potentially “distress costs”.

Liquidity constraintsTypically, governments and firms find these costs easy to manage as long as indebted-ness grows no faster than “size”, whether measured in terms of revenue or asset val-ues. And while may be risky to “lever up” – to increase debt faster than size – many firms and governments do so successfully. We have no reliable criteria of maximum leverage even for firms, let alone for govern-ments. Governments are special. Their core asset is their taxing power.

Their liabilities, whether notionally bonds or money, are best understood as preferred equity rather than debt. Governments, at the end of the day, face very diffuse liquidity con-straints. This aside, I think MMT sometimes errs in the opposite direction. Its supporters, I believe are right that ultimately it is flow (actual or desired) between private agents in aggregate and governments that determine the value of government obligations. But the whole purpose of balance sheet analysis, in the private sector and the public sector, is to predict future flows.

Taxation or inflation?That conventional theories of public bal-ance sheets are foundationally stupid and overstate the hazards associated with large stocks of outstanding debt doesn’t invali-date the intuition that flow volatility is likely

to be proportional to the outstanding stock of government claims. Suppose, because of a sunspot, private holders of government claims get nervous and try to redeem them for current goods. If the net stock of claims in private sector hands is small, it takes very little taxation to offset that flow. If the net stock of government claims is large, than the desired flows might be massive, and govern-ments might be faced with an unappetising choice between taxation, or accommodating inflation.

There is little evidence that increasing the stock of government obligations can, by itself, increase the likelihood that the private sector will seek (impossibly but disruptively) to divest itself of those claims. But there are undoubtedly fluctuations in the private sector’s enthusiasm for holding money and government debt, and it strikes me as implausible that the difficulty of managing those fluctuations is entirely unrelated to outstanding stock of those claims.

Private sector demandWhilst advocates of MMT are typically regarded as “left” economists, I believe the theory somewhat underplays the distribu-tional costs involved in expanding the stock of government obligations. Government obligations, like all financial assets, are dis-proportionately held by the wealthy.

If the government did not accommodate the private sector’s demand for net financial assets, preferring different policy levers to stabilise the economy, wealthy people might be forced to store wealth in the form of claims on real resources, and would have to oversee the organisation of those resources into value-sustaining projects. A large stock


of “risk-free” financial assets allows people wishing to carry wealth forward to shirk their duty to steward resources carefully and bear the consequences of investment failure. Thus, the availability of government obliga-tions simultaneously degrades the quality of real investment (by disincentivising super-vision) and magnifies the distributional injustice that attends failures of aggregate investment by shifting the burden of those shocks onto risk investors and workers.

Mitigating injusticeIn theory, governments can mitigate this injustice by careful transfers and expendi-tures ex post. In practice however, those who disproportionately hold existing government obligations disproportionately hold political power, and resist the issue of new obliga-tions that might dilute the value of existing claims. Further, a large stock of government claims serves as the lifeboat through which prior wealth inequality carries itself into the future.

Absent an accommodative stock of government obligations, recessions would be crucibles that separate the deserving from the undeserving rich, and would thin the ranks of the rich generally. Recessions should be periods that decrease inequality, but the availability of default-risk free claims whose purchasing power is politically pro-tected inverts the dynamic.

Sustainable fiscal manoeuvresSupporters of MMT are right, I think, to argue that, for fiat-money issuers who bor-row in their own currency, conventional gov-ernment solvency criteria are false. They are right to argue that such governments have a

great deal more latitude to issue money and debt than conventional theories suggest. But such arguments shouldn’t be taken as license to defend carelessness in the distri-bution of new claims, or to treat expansions of money or debt as entirely cost-free.

Serious advocates of MMT also consider distributional issues and quality of expendi-ture, and do not claim that deficits should be “carelessly” expanded. But in the heat of current policy debates, rhetoric about “deficit terrorists” and money being nothing more than spreadsheet entries is unhelpful.

At its best, one of the major arguments of MMT is that the absence of short-term fiscal constraints creates space for government to craft policy that focuses on the productivity of the real economy. If the mobilisation of real resources is wise, fiscal manoeuvres will be rendered sustainable ex post.

Government solvencyIf the real economy is mismanaged or left to languish and decay, no amount of “fiscal discipline” will save us. Indeed, the version of MMT that I like best is, oddly perhaps, wed-ded to an almost Austrian sensibility con-cerning real investment.

Another argument put forward by MMT, and one that I agree with entirely, is that the “solvency” of a government is best understood as its capacity over time to man-age the economy in a manner that avoids net outflows, where “net outflows” relates to attempts by non-government actors in aggregate to redeem government paper for current goods and services.

Whilst some MMT enthusiasts object to any use at all of the word “solvency” when describing a currency-issuing government, I


believe this theory offers the best definition of government solvency. After all, what such a government must concern itself with is not the dictionary definition of insolvency per se, as in an inability to pay debts, but some-thing quite different: a decay in the value of its claims in terms of real goods and services.

Avoiding net outflowsI also adhere to MMT’s claim that avoid-ing net outflows is easy in times like the present, when i) low quality and difficult to service debt in the private sector leaves many agents eager to reduce indebtedness and increase their holdings of financial assets; ii) there has been little inflation or devaluation in the recent past; and iii) resource utilisa-tion is slack, as evidenced especially by high unemployment.

It is incontestable that the avoidance of net outflows is more difficult when private sector agents’ balance sheets are healthy, or when agents come to expect inflation or devaluation, or when real resources (espe-cially humans) are fully employed.

Creating demandHowever, MMT also points to the fact that a sovereign government can always cre-ate demand for its money and debt via its coercive ability to tax. That is, if optimistic agents with strong balance sheets start up a spending spree, or if gold bugs fearful of devaluation ditch government paper for commodities, a government can reverse those flows by forcing private agents to sur-render real goods and services for the money they will owe in taxes.

Indeed, on the one hand, I consider this point is one of MMT’s deepest insights, and

its secret weapon. So long as a government’s taxing power is strong, so long as it is capa-ble of persuading individuals to surrender highly valued real goods and services for the ability to escape liabilities imposed by fiat, exercise of that taxing power creates a floor beneath which the value of a currency, in real goods and services, cannot fall.

However, relying too overtly on taxation to give value to a currency strikes me as dan-gerous and potentially counterproductive. A government’s taxing power is limited and socially costly. Governments must maintain a patina of legitimacy so that people pay taxes “voluntarily” or else they must intru-sively or even brutally force compliance. In a decent society, it’s perfectly possible that governments will find it politically impos-sible to tax at the level consistent with price stability goals.

Stabilising price levelsAfter all, a wise, MMT-savvy government would try very hard to regulate the issue of government obligations over time in a way that avoids the need for sharp fiscal shifts in order to stabilise the price level. Avoiding the need for sharp contractions later on might imply slower issue of obligations than would be short-term optimal during recessions. However, once you acknowledge this kind of forward-looking dynamic, MMT starts to sound quite conventional as we start having to trade off the short-term benefits of fiscal demand stimulation with long-term “exit costs”.

Whilst I am interested in and sympa-thetic to the idea of designing a govern-ment-guaranteed full employment policy that would be complementary to a vibrant


private sector and that would anchor rather than disrupt macroeconomic stability goals, however richly advocates of MMT have out-lined such an institution in theory, we are very far from implementing such a thing in practice.

Sustaining valueI do agree that MMT offers a deep and pow-erful way to think about public finance, that a government’s “solvency constraint” is not a function of any accounting relationship or theories about the present value of future surpluses and ultimately lies in its politi-cal capacity to levy and enforce payment of taxes. However, this depends first and fore-most on the quality of the real economy it superintends.

The value that a government is capable of taxing is necessary to sustain the value of its obligations increases with the value pro-duced overall. A government that wishes to be solvent should interact with the polity in a manner that promotes productivity. I would also point out that the political capacity to levy taxes depends upon either the legiti-macy of, or the coercive power of the state.

Legitimacy is best betAfter all, a government that wishes to sustain the value of its obligations must either gain the consent of those it would tax or maintain an infrastructure of compulsion. In theory, either choice could be effective, although along with the libertarians, I like to imagine excessively coercive regimes are inconsistent with overall productivity, so that legitimacy is a government’s best bet.

The two strategies are not mutually exclusive: a government could be sufficiently

legitimate as to be capable of taxing some fraction of the population without resistance and sufficiently coercive as to force the other fraction to pay up. That probably describes the best we can hope for in real governments.

Whilst offering a perspective more pow-erful than many observers give it credit, MMT is not one to which I fully subscribe. The critiques offered are neither intended to discredit or dismiss MMT. Indeed, I maintain my stance that MMT offers a coherent and important perspective on fiscal and mon-etary issues that ought to be understood, on its own terms rather than in dismissive cari-cature, by anyone serious about macroeco-nomics. MMT should ultimately be judged, just as any other theory, by how useful it is, in terms of making sense of what we already know and in offering guidance for policy going forward.

Inflationary deficitIn response to Paul Krugman’s understand-ing of the MMT position as one where the only consideration is whether or not the def-icit creates excess demand to such an extent to be inflationary, and where the perceived future of solvency of the government is not an issue, I disagree. In my humble opinion, a six per cent deficit would, under normal con-ditions, be quite expansionary; but it could be offset with tight monetary policy, so that it need not be inflationary.

However, if the U.S. government has lost access to the bond market, the Fed is not in a position to pursue a tight-money policy. On the contrary, it has to increase the monetary base fast enough to finance the hole in rev-enue. The result is that a deficit that would be manageable with capital-market access


becomes disastrous without. The real ques-tion is why a deficit that would be inconsist-ent with price stability with “loose money” would be transformed into something sus-tainable with “tight money”.

Public to private sector flowFrom an MMT-perspective, it is the flow of net financial assets from public sector to pri-vate, relative to the private sector’s willing-ness to absorb, that matters. Whether those net financial assets take the form of liquid cash or liquid treasury securities is second order. As Krugman himself has pointed out, conventional monetary policy is nothing more than a shift in the maturity of govern-ment obligations.

If the private sector is unwilling to hold the expanding stock of dollar-denominated obligations at, in terms of real goods and services, prices consistent with our definition of price stability, MMT suggests the private sector will be unwilling to hold those obli-gations whether in the form of bonds or money.

Tight money, loose fiscalAn obvious objection is that bonds pay yields that might induce private sector agents to hold government paper at current prices, while money historically does not. Krugman’s sustainable “tight money, loose fiscal” scenario basically amounts to pointing out that the private sector can be induced to hold more paper if the public sector prom-ises to make large on going transfers to those who hold its paper.

Whilst advocates of MMT may have mixed feelings about using interest pay-ments to increase the willingness of the

private sector to hold government paper, since most central banks now pay interest on reserves, these payments no longer serve to demarcate the “fiscal” obligations of the treasury, nor the “monetary” obligations of the central bank.

Rather than being divided into “fiscal” and “monetary” policy, we end up with a “flow” and “yield” policy, where in order to stabilise the price level and real spending in the face of changes in private sector demand for government paper, the public sector can either modulate supply by adjusting the size of the deficit or surplus, or modulate demand via the yield by altering the inter-est paid on reserves or by selling term bonds. As Bill Mitchell puts it: “Our preferred posi-tion is a natural rate of zero and no bond sales. Then allow fiscal policy to make all the adjustments. It is much cleaner that way.”

Accommodating net demandMMT views the size of the flow itself – that “six per cent deficit” – as the primary instru-ment of stabilisation policy. By holding the deficit constant in his thought experiment, Krugman deprives MMT of the means by which it would manage demand. MMT does not claim that fiscal policy can ignore private willingness to hold government assets.

On the contrary, they take from Wynne Godley’s sectorial balance analysis that fiscal policy should accommodate the changing net demand of the private and external sec-tors for financial assets.

Whilst MMT supports the theory that it is important not to lose access to the bond market, it suggests that the government’s power to tax is sufficient to maintain the private sector’s appetite to hold government


paper, whether in the form of bonds or of money. Therefore, there is little need to fret about “confidence” and unread theories of government solvency. The government can issue paper when the private and external sectors are willing to buy, and reduce deficits or even run a surplus when those appetites have been sated.

Quality of expenditureI’ll end with a few miscellaneous comments: I’d like to see more attention paid to quality-of-expenditure concerns. That is, if a stable economy requires continuing government deficits to accommodate growing private sector’s demand for financial surplus, then the government must actually make choices about how to spend or transfer money into the economy.

These choices will undoubtedly shape the evolution of the real economy, for better or for worse. Should we rely on legislators to make direct public investment choices? Should we put funds in the hands of indi-viduals and then allow consumer prefer-ences and private capital markets to shape the economy? How? Via tax cuts? A job guarantee? Direct transfers? Perhaps the government should delegate management of public funds to financial intermediaries, and rely upon banking professionals to find high value investments?

Private/household distinctionsWhile MMT focuses mostly on the liability side of the public balance sheet, many crit-ics fear that ever-increasing public outlays imply increased centralisation of economic decision making that will lead to low qual-ity choices. Whether that is true depends

entirely on institutional and political choices. These concerns can be and should be spe-cifically addressed.

MMT-ers sometimes blur the distinction between “private sector net savings”, which is necessarily backed by public sector deficits or an external surplus, and household sav-ings, which need not be. In doing so, MMT-ers rhetorically attach the positive normative valence associated with “saving” to deficit spending by government. This is dirty pool, and counterproductive. The vast majority of household savings is and ought to be backed by claims on real investment, mediated by the liabilities (debt and equity) of firms.

Household savings or real investment?There is no need whatsoever for govern-ments to run deficits to support household saving. When household savings increases, an offsetting negative financial position among firms represents increase in the amount or value of invested assets, and is usually a good thing.

Household savings is mostly a proxy for real investment, while “private sector net financial assets” refers to a mutual insurance program arranged by the state. It is a cate-gory error to confuse the two.

Yet in online debates, the confusion is frequent. Saving backed by new investment requires no accommodation by the state. It discredits MMT when enthusiasts claim otherwise, sometimes quite aggressively and inevitably punctuated by the phrase “to the penny”. In general, the MMT community would be well served by adopting a more civil and patient tone when communicating its ideas. I’ve had several conversations with economists who have proved quite open to


the substance, but who cringe at the name MMT, having been attacked and ridiculed by MMT proponents after making some ordi-nary and conventional point.

Much of what is great about MMT is that it persuasively challenges a lot of ordinary and conventional views. But people who cling to those views, even famous econo-mists who perhaps “ought to” know better, are mostly smart people who simply have not yet been persuaded. Neither ridicule nor patronizing lectures are likely to help.

My complaint is a bit unfair. The MMT community has been sinned against far more than it has sinned, especially within the economics profession. Whether you ultimately agree with them or not, the MMT-ers have developed a compelling perspective and have done a lot of quality work that has pretty much been ignored by

the high-prestige mainstream. But a sense of grievance may be legitimate and still be counterproductive.

The Internet is a fractious place. Many MMT-ers are civil and patient, and devote enormous energy to carefully and respect-fully explaining their views. There’s no way to police other peoples’ manners. Still, even by the standards of the online debate, MMT-ers have a reputation as an unusually prickly bunch. That might not be helpful in terms of gaining broader acceptance of the ideas.

Despite my complaints and critiques, learning about MMT has added enormously to my thinking about economics. In practi-cal terms, I think that MMT offers the most promising toolkit for crafting a desperately needed replacement of status quo central banking as our core means of stabilising the macroeconomy. •

JOurnAL Of reguLATiOn & risK nOrTH AsiA

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

November 20, 2013

Contact Chris [email protected]


Compliance

Are ineffective AML & CFT laws impeding investor confidence?

Gavin Sudhaker of Sapling Solutions casts a critical gaze over recent trends in

U.S. Securities law enforcement.

Money laundering techniques have evolved alongside technological inno-vations in the securities sector in recent years. Speedy and sophisticated trade execution, interconnected global reach, complex product offerings and adapt-ability have made the security industry an easy target for money laundering and terrorist financing. In turn, recent finan-cial turmoil and a dramatic increase in insider trading, market manipulation and fraudulent securities activities, has begun to impede shareholder confidence in the securities regulatory regime.

In the aftermath of 9/11 terrorist attacks upon New York and Washington D.C., the U.S. authorities enacted stringent legislation to counter terrorist financing (CTF), namely, the Patriot Act. Such legislation sought to strengthen existing laws, including the Bank Secrecy Act’s provisions on anti-money laundering (AML), whilst casting its net further to include financial institutions not previously covered by its provisions. Chief among these are investment advisers, bro-ker-dealers and investment bankers.

Under the expanded AML/CFT legisla-tion, those covered by the Act have had to adopt minimum standards in four key areas, namely: a written code of AML policies and procedures; a designated AML compliance officer; on-going employee AML train-ing; and finally, execution of an independ-ent audit testing of the AML Compliance programme. Further, under this enhanced due diligence framework, those captured by the Act are required to maintain a strong Customer Identification Programme (CIP) and Suspicious Activity Reporting (SAR) procedures.

Broker-dealersThis brief overview aside, the remainder of this paper will focus on this enhanced leg-islative environment as it applies specifically to broker-dealers. Within the context of the U.S., all active broker-dealers fall under the governance of a self-regulating industry body - the Financial Industry Regulatory Authority (FINRA).

The Authority’s Rule 3310 reiterates the importance of establishing and implement-ing sound AML compliance programmes to


all its members. However, many observers, including this author, question the effec-tiveness of this generic approach to AML/CTF legislation, particularly in relation to the FINRA’s implementation guidelines as they apply to complex multi- layered global secu-rities transactions.

Congressional failingsIn the age-old worldwide money-launder-ing scheme, the securities industry, unlike other financial sectors, “risk lies mainly not in respect to the placement stage but rather in the layering and integration stages”, accord-ing to an FATF report on money laundering.

Despite a strong linkage between the security and banking sectors, applying the current AML/CFT generic statute across broker-dealers fails to recognise the com-plexity involved in trading operations. Hence the burden of monitoring, remediating and reporting AML suspicious activity in a timely manner is shifted to the broker-dealers, who in practice are given limited guidance.

Originally, the main intent of the Congress bid to expand its AML statute to include registered broker-dealers was to provide a consistent AML regulation across all financial institutions and to combat the threat of terrorist financing. However, due perhaps to lack of industry knowledge, Congress failed to consider the trading com-plexity involved in globally interconnected Over-the-Counter (OTC) globally markets.

Grappling to complyBy delegating its rule making and guide-line drafting responsibilities to the FINRA, Congress failed to recognise the importance of the AML statute. In addition, the FINRA,

as a regulating agency, failed to tailor their rule-making and guidelines specifically towards the securities industry. As a result, with limited judicial branch intervention, broker-dealers are grappling to comply with this expanded AML statute, despite their best efforts.

Specific guidance neededHence, voluntary broker-dealer suspicious transaction reporting “remains relatively low in the securities sector in comparison to other sectors,” according to a private sector survey report by the Financial Action Task Force (FATF). Further, “due to lack of awareness and insufficient securities-specific indicators, broker-dealers are looking for enhanced specific guidance from international organi-sations and national authorities” in order to fully comply with AML statute.

As an “inter-governmental body whose purpose is the development and promo-tion of policies, both at national and inter-national levels,” the FATF works to combat money laundering and terrorist financing. The Task Force is therefore a “policy-making body” which works to generate the necessary political will to bring about national legisla-tive and regulatory reforms in these areas.”

Illicit tradingThe FATF report, published in October 2009 and submitted to the Organisation for Economic Co-operation and Development (OECD), suggests that “the securities indus-try provides money laundering with a dou-ble advantage – the ability to launder illicit assets generated outside the industry and the ability to use these illicit assets to gen-erate additional illicit assets within the


securities industry, such as insider trading, market manipulation and securities fraud in the layering and integration stages.”

In addition the study shows that “the securities industry evolves rapidly and is global in nature and provides opportuni-ties to quickly carry out transactions across borders with a relative degree of anonymity.” Given the strong linkage between securi-ties broker-dealers and the banking and insurance industries, “illicit trading in secu-rities is often not limited to the securities broker-dealers.”

Multiple jurisdictionsAn October 2008 Asia Pacific Group (APG) typology workshop report on money laun-dering within the securities industry states that a limited number of APG countries require that all suspicious transactions be reported. “Where such requirements do exist, securities related SAR reporting levels are low, hence potentially impeding the abil-ity of these jurisdictions to investigate money laundering. The overall experience of some APG countries is that the securities industry is a method of generating illicit assets instead of a conduit for laundering illicit assets gen-erated outside of the industry”, the report adds.

Given the global nature of the securities industry, the expanded AML/CFT regula-tions fail to consider the imbalance found in policy enforcement across multiple country jurisdictions. The FATF’s report also elabo-rates on risk controls and the vulnerabilities of money laundering specific to the securi-ties industry and includes recommenda-tions to implement enhanced due diligence in Customer Due Diligence (CDD)/Know

Your Customer (KYC) detection points and AML regulatory information sharing policy changes to its member countries.

Main goalsThe main goals of the expanded AML/CFT act were initially to: “1) detect and prevent money laundering; 2) comply with the BSA’s record keeping and reporting requirements; 3) comply with the U.S. PATRIOT act; 4) identify suspicious activities; 5) comply with the requirements of Office of Foreign Assets Control (OFAC) and other anti-money laun-dering regulations; 6) identify suspected/actual money laundering; 7) identify sus-pected/actual terrorist financing; 8) identify suspected/actual proceeds of corruptions; 9) identify and isolate PEP’s (Politically Exposed Persons) and Senior Foreign Political Figures; and 10) minimise violations of the Foreign Corrupt Practices Act (FCPA).”

A work in progressToday, in their efforts to combat “financial terrorism”, OECD member countries have taken several initiatives to improve AML and FCPA regulative information through shar-ing across member jurisdictions. By imple-menting monitoring software tools against OFAC database entries, member country regulators are able to intercept perpetrators of illicit money laundering and impose on them hefty sanctions and penalties.

However, the fight against global money laundering remains a work in progress and appears to be directly correlated to the effectiveness of the foreign policy govern-ing member countries’. As such, in order to promote global cooperation, the Securities AML regulatory framework requires better


alignment across its member countries. After all, a chain is only as strong as its weakest link.

Similarly, a sovereign country must rely on all countries to establish effective AML/CFT regimes to prevent, detect, prosecute and impose sanctions on criminal activ-ity. Lack of adequate controls due to vary-ing AML policies and controls across some under-developed jurisdictions can only be detrimental to the global fight against money laundering.

Fitting the business modelIn recent years, the FINRA has introduced aggressive enforcement policies to invoke AML/CFT statutes against global broker-dealers and individual violators. Such ini-tiatives have enhanced public and private awareness by highlighting the importance of this statute against the broker-dealer. This is illustrated in the case of U.S. vs. E*Trade, where worldwide broker-dealer E*Trade was fined US$1 million for its “inadequate AML program.”

The case details show that “from January 1, 2003 to May 31, 2007, E*Trade did not have an adequate AML programme based upon its business model.”

In addition the FINRA claims that “E*Trade did not have separate and dis-tinct monitoring procedures for suspicious trading activity in the absence of money movement, therefore its AML policies and procedures could not reasonably be expected to detect the reporting of suspicious securi-ties transactions.”

This case also alleges that E*Trade “relied on its analysts and other employees to manually monitor and detect suspicious

trading activity without providing them with sufficient automated tools to do so.”

Responding to this case settlement, Susan L. Merrill, the FINRA’s chief of enforcement, remarked that “brokerage firms’ AML programmes must be tailored to their business model.” Whilst the FINRA determined that E*Trade’s “approach to suspicious activity detection was unreason-able given its business model”, in settling this case, E*Trade “neither admitted to nor denied the charges, but consented to the entry of the FINRA’s findings.”

Similarly, in the case of U.S. vs. Scottrade, Scottrade was “fined US$600,000 for its inadequate AML program.” Here, the FINRA claims that from the period April 2003 to April 2008, Scottrade “failed to establish and implement an adequate AML program tai-lored to its business model.” In addition, case details show that “Scottrade did not have any systematic or automated programmes designed to detect potentially suspicious money movement or securities transactions.” Once again, in settling this case, Scottrade “neither admitted to nor denied the charges, but consented to the entry of the FINRA’s findings.”

Quick and dirty solutionsThese administrative proceedings case set-tlements clearly demonstrate the quick-and-dirty solution which global broker-dealers opt for as a viable business solution against AML allegations within a global competitive network.

With a lack of clear governance between the legislative and judicial due process in AML securities cases, many well-established global broker-dealers will no doubt continue


to opt for plea bargains as a “business nexus” element of their global operations.

Given the speed and volume of trad-ing involved, the complexity of day-to-day monitoring of global trading operations and settlements remains at the forefront of a growing range of challenges faced by broker-dealers in their efforts to comply with AML statutes.

Under the generic guidelines provided by the FINRA, broker-dealers are compelled to implement state-of-the-art AML pro-grams which tend to have a profound impact on its bottom-line. In short, any illicit insider trading, market manipulation and fraudu-lent activity within the securities industry is overshadowed by the FINRA’s requirements for broker-dealers to tailor their AML pro-grammes to their own business model.

Enforcement trendsAn AML survey report on the securities industry conducted by the U.S. General Accounting Office (GAO) in October 2001, noted that personal cheques were the most common form of acceptable payment received by broker-dealers.

The report added that many broker-dealers “viewed the payment received with less AML concern, since they can usually be traced to accounts at depository institutions that have their own AML requirements.”

However, more than a decade on, com-pliance with AML due diligence remains a growing challenge for broker-dealers in an ever-increasingly global and interconnected market.

Indeed, case law trends show that the burden remains on the broker-dealers to implement sound AML detection points

to protect their reputation and survival in a global and highly competitive market.

“Other” field most prevalentIn recent years the FINRA has dramatically increased SAR-based AML enforcement activities against broker-dealers. In light of this development, the number of volun-tary SAR filed by the securities and futures industries increased significantly from January 2003 to December 2008, from a total of 6,267 to 53,022 respectively. Further, when asked to define the type of suspicious activity observed, the field marked “Other” was the most prevalent characterisation of suspicious activity, followed by “Money Laundering/Structuring.”

Statistics show that the securities indus-try accounted for only five per cent of the 1,461 AML SAR inquires made between July 2009 and June 2010. The majority of these enquiries related to how to file a report correctly; whether or not it was necessary to file an SAR report; and advice on SAR sharing and disclosure to law enforcement agencies.

Whilst the Obama administration has made plans to strengthen AML laws through the introduction of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Title IV - commonly known as the “Registration Act” and requiring pri-vate equity funds with AUM over US$150 million to register with the SEC - only time will tell how effective this will be.

Impractical languageThe FINRA presently oversees around 4,560 brokerage firms. However, the FINRA’s guidelines are at best generic when it comes


to enforcing AML regulation against broker-dealers and have been publicly criticised for failing to provide any meaningful guidance to promote AML awareness, transparency and accountability.

One recent development can be seen in a statement made to the Securities and Exchange Commission (SEC) by the FINRA “to approve a rule change to establish a new registration category and qualification exam requirement for certain operations person-nel.” As a result most executives in senior level positions in Wall Street will now have to register with the FINRA and pass a licens-ing exam. The requirement was classified by the FINRA as a “regulatory element”, with which all broker-dealer trade approving executives must comply.

Heavily reliant However, such bold policy moves by the FINRA have yet to be measured against a complex global trading platform. Indeed, if this is yet another attempt by the FINRA to chase dirty money, it will take time to qualify its effectiveness in what has become a highly competitive commission fee-based industry. The fact that recent trends show that broker-dealers have come to rely heavily on other financial institutions, for example banks and clearing house brokers, to comply with AML/CFT statutes, remains nothing more than a secondary concern.

Broad-brush policyWhilst broker-dealers do appear to be forth-coming in their voluntary AML inquiries, SAR and enhanced CDD/KYC due dili-gence measures, trends also show that the hefty price to pay for non-AML compliance

sends a clear signal to players in the securi-ties industry that AML has become an inte-gral part of the business model and trade lifecycle process.

However, in today’s turbulent financial market, the current AML/CFT statute, as an extension of President Bush’s Patriot Act, appears to be nothing more than a broad brush policy approach aimed at financial sectors across the board. Such policy legis-lative initiatives are, in their very essence, a narrow interpretation of a generic intent to combat “global terroristic financing.”

Out-of-line and unnecessaryCongress surely needs to re-evaluate the costs and benefits of such policy in the secu-rities industry, and to acknowledge industry risk. The challenge for the securities indus-try is surely to detect and report illicit AML activities at the layering and integration stages. Indeed, FATF and APG research cites that within the securities industry, money laundering is “a method of generating illicit assets” through activities such as insider trading, market manipulation and securi-ties fraud, rather than as “a conduit for laun-dering illicit assets generated outside of the industry.”

In an evolving global landscape, impos-ing such aggressive legislative AML regula-tory policy is somewhat unnecessary within a non-cash based securities business model. Further, in a “trade anywhere” state of nir-vana, surely the focus of Congress legis-lative intent should be the promotion of global wealth management that successfully enhances shareholder confidence and value. Given the strong linkage between the secu-rities, banks and insurance sectors, Congress


needs to reconsider the long-term policy implications to the securities sector by cir-cumventing “political anger” against a hand-ful of wrongdoers.

Rebuilding investor trustIn terms of enforcement, the SEC has failed to establish any effective governance of the securities industry. Rather than identify-ing market wrongdoers in the war against financial terrorism, the SEC seems to oper-ate within a vacuum as it enters into an even bigger battle armed with ineffective fire-power. As disjointed as they are, the SEC, FINRA and FinCEN, have failed to establish a systematic process for soliciting and shar-ing input from law enforcement agencies across the globe.

In a recent statement the FINRA’s CEO, Richard Ketchum, stated that “it is impera-tive that the FINRA deal aggressively with wrongdoing in the industry to help rebuild investor trust and confidence in the markets.”

Call for legislative interventionSuch wishful policy statements do not pro-vide meaningful guidelines and frameworks for the industry. Imposing additional rules to enforce security executive offices and back-offices to register with the FINRA will not prohibit wrongdoers from carrying out their illicit actions. Without legislative interven-tion, the American securities industry not only looks set to lose its competitive edge in the global market, but with its radically inefficient legislative AML policies will ulti-mately do little but destroy investor trust and confidence.

There is clearly a need for the FINRA to promote clear AML guidelines specific

to the securities industry. Only by defining SAR reporting requirements through for-eign policy will the industry have a chance of filling the gaps between developed and underdeveloped countries’ SAR require-ments. Without establishing any clear secu-rities AML enforcement policy, the FINRA’s move to implement an aggressive approach appears to be nothing more than excessive.

A recent 2011 case study conducted by Sutherland Asbill & Brennan (Sutherland), a global law firm with a practice in finan-cial services, notes that “while broker-dealer firms and individuals often think that set-tling with the SEC and the FINRA makes the most sense, this study continues to show that in some circumstances, respondents will be better off if they try their cases and tell their stories in front of judges or hearing panels, especially where fraud is charged.”

Fight for justiceOver the course of 2009 and 2010 Sutherland’s 2011 study of cases brought against the SEC and FINRA shows that “SEC staff failed to prove fraud charges approximately 57 per cent of the time in FY 2009-2010 and 13 per cent of respondents got charges dismissed in the 237 charges liti-gated by the SEC and FINRA which resulted in SEC Administrative Law Judge (ALJ) or FINRA Hearing Panel decisions.”

The results suggest that broker-dealers should fight for justice rather than settling cases by neither admitting nor denying the charges and consenting to the entry of SEC and FINRA findings. Broker-dealers should lobby for the FINRA to introduce more spe-cific AML guidelines, rather than opting for plea bargains.


In terms of money laundering prevention and detection, broker-dealers have a signifi-cant role to play in rebuilding shareholder confidence and value in the global securities markets. This is particularly relevant given that spending on surveillance programs by U.S. and European broker-dealers has been estimated to be around US$206 million in 2011 alone.

Certainly in light of such massive finan-cial regulatory overhaul, it is imperative for broker-dealers and governance alike that these back-office trading programs are developed and implemented as Enterprise Risk Management (ERM) solutions and are geared towards meeting AML requirements designed specifically for broker-dealers.

Building robust programsSuch an approach to ERM requires clear due diligence policies and procedures and should be managed over the long term. The devel-opment of policies and procedures must also ensure work to ensure that the firm and its employees consistently comply with policy requirements.

Dedicated and on-going support from senior management and the board of direc-tors are critical in the implementation of robust AML compliance programs. AML compliance officers must be empowered, and be designated clear roles and responsi-bilities if an effective global compliance pro-gram is to be maintained.

The practical challenge for broker-deal-ers then lies in maintaining an effective SAR program whilst actively working to ensure “that the AML officer or the unit coordinates sufficiently with all points in its organisation that might require an SAR filing.”

In an increasingly complex global arena, access to a rigorous and flexible electronic surveillance program and the capability to report illicit activities proactively to law enforcement officials, is key to identifying potential wrongdoers.

In addition, automated programs must be designed in accordance with SAR com-pliance rules. They should also have the capability to identify and isolate PEPs and Senior Foreign Political Figures, and to cross check the OFAC database for known terror-ist organisations.

Monitoring and validationProactive SAR measures need to focus on the promotion and protection of a firm’s rep-utation, brand equity and goodwill within the global securities market. Indeed, despite industry risk in the layering and integration stages, customer due diligence is pivotal to the broker-dealer business operating model. Responsibility must lie with the broker-deal-ers themselves to account for and to imple-ment enhanced due diligence CDD/KYC detection points, policies and procedures.

Account types (trust, nominee and omnibus accounts, charity, non-profit organisation, shell companies etc.) need to be specified, and compliance programs independently tested periodically for effi-ciency. In addition, CIP policies and proce-dures must be able to validate and monitor secondary account holders and third-party vendors for AML compliance.

In-house independenceWhat is clear is that broker-dealers should not be reliant on other financial institutions, such as banks and clearing houses, as a


means of complying with due diligence and internal control within the AML/CFT statute.

Having a consistent independent AML detection and validation policy across the organisation will enhance the effectiveness of internal controls. An effective new Client On-boarding (COB) Program is also a criti-cal aspect of AML compliance.

According to regulations, broker-deal-ers should also be able to identify and take appropriate actions against any “rogue employees” and to report illicit trading activi-ties to law enforcement officials “in a timely manner. “ Being able to follow the code of business ethics in all aspects of the trading life cycle process, including trading, clearing, settlement and custody, will give broker-dealers the advantage when it comes to establishing sound business practice.

Importance of training and guidelinesIn terms of AML training, the FINRA – AML Boot Camp and its educational series are a starting point for broker-dealers to train its employees in implementing the AML compliance program. The CCOutreach Broker-Dealer Program, the FINRA Annual Conference and Webinar are just some of the other resources available for industry practitioners to participate, network and share information with other AML compli-ance officers in the industry.

The burden however remains on broker-dealers to implement effective working AML compliance governance programs. Such programs should include adequate tools and techniques to allow dealer-brokers to promptly report any suspicious activities to relevant law enforcement agencies. Training in the detection and mitigation of money

laundering within the process of wealth cre-ation should also be made an integral part of any broker-dealer corporate governance practice.

When it comes meeting wealth man-agement considerations, the world is a flat market. In the new global regulatory regime, insider trading, market manipulation and securities fraud have come to the forefront of the securities industry. For broker-dealers, adapting to the growing demands imposed by the regulatory regime, despite a clear lack of guidelines, seems to have become a harsh reality.

Greed a main motiveThe recent Global Financial Centres Index indicates that London remains the top financial hub city for broker-dealers and other financial services, followed by New York, Hong Kong and Singapore.

Whether or not the recent aggressive tactics utilised in U.S. risk management enforcement policy against broker-dealers will result in the reduction or increase of risk is yet to be seen.

As technology evolves, the AML regu-latory regime needs to catch up with the increase in business demands. As long as greed remains the main motive, money laundering and other illicit activities will find ways to erode the fabric of the global enterprise markets. In any financial crisis, shareholder confidence and wealth creation will remain nothing more than a figure-of-speech. At the end of the day, a regulatory environment lacking in any clear guidelines appears doomed to derail the market poten-tial of a securities industry it set out to nur-ture and protect. •

Standard & Poor’s Fixed Income Risk Management Services group is analytically and editorially independent from any other analytical group at Standard & Poor’s, including Standard & Poor’s Ratings. This material is not intended as an offer or solicitation for the purchase or sale of any security or other fi nancial instrument. Copyright © 2009 Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. All rights reserved. STANDARD & POOR’S and S&P are registered trademarks of The McGraw-Hill Companies, Inc.

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journal of regulation & risk - north asia, volume v - issue ii - summer, 2013

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