International Association of Risk and Compliance Professionals (IARCP)

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International Association of Risk and Compliance Professionals (IARCP)1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 202-449-9750 www.risk-compliance-association.comTop 10 risk and compliance management related news stories and world events that (for better or for worse) shaped the week's agenda, and what is next

Dear Member,

I had a difficult time in the past to explain liquidity risk management and ratios.

Now I know what to do. Problem solved!

I will use a pollution-mitigating technology, like scrubbers to explain liquidity risk.

Mr. Jeremy C Stein, Member of the Board of Governors of the Federal Reserve System explained how:

Suppose we have a power plant that produces energy and, as a byproduct, some pollution.

Suppose further that regulators want to reduce the pollution and have two tools at their disposal:

They can mandate the use of a pollution-mitigating technology, like scrubbers, or they can levy a tax on the amount of pollution generated by the plant.

In an ideal world, regulation would accomplish two objectives.

First, it would lead to an optimal level of mitigation that is, it would induce the plant to install scrubbers up to the point where the cost of anInternational Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 2

additional scrubber is equal to the marginal social benefit, in terms of reduced pollution.

And, second, it would also promote conservation:

Given that the scrubbers dont get rid of pollution entirely, one also wants to reduce overall energy consumption by making it more expensive.

A simple case is one in which the costs of installing scrubbers, as well as the social benefits of reduced pollution, are known in advance by the regulator and the manager of the power plant.

In this case, the regulator can figure out what the right number of scrubbers is and require that the plant install these scrubbers.

The mandate can therefore precisely target the optimal amount of mitigation per unit of energy produced.

And, to the extent that the scrubbers are costly, the mandate will also lead to higher energy prices, which will encourage some conservation, though perhaps not the socially optimal level.

This latter effect is the implicit tax aspect of the mandate.

A more complicated case is when the regulator does not know ahead of time what the costs of building and installing scrubbers will be.

Here, mandating the use of a fixed number of scrubbers is potentially problematic:

If the scrubbers turn out to be very expensive, the regulation will end up being more aggressive than socially desirable, leading to overinvestment in scrubbers and large cost increases for consumers; however, if the scrubbers turn out to be cheaper than expected, the regulation will have been too soft.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 3

In other words, when the cost of the mitigation technology is significantly uncertain, a regulatory approach that fixes the quantity of mitigation is equivalent to one where the implicit tax rate bounces around a lot.

By contrast, a regulatory approach that fixes the price of pollution instead of the quantity say, by imposing a predetermined proportional tax rate directly on the amount of pollution emitted by the plant is more forgiving in the face of this kind of uncertainty.

This approach leaves the scrubber-installation decision to the manager of the plant, who can figure out what the scrubbers cost before deciding how to proceed.

For example, if the scrubbers turn out to be unexpectedly expensive, the plant manager can install fewer of them.

This flexibility translates into less variability in the effective regulatory burden and hence less variability in the price of energy to consumers.

Scrubbers and high-quality liquid assetsWhat does all this imply for the design of the LCR? Lets work through the analogy in detail.

The analog to the power plants energy output is the gross amount of liquidity services created by a bank via its deposits, the credit lines it provides to its customers, the prime brokerage services it offers, and so forth.

The analog to the mitigation technology the scrubbers is the stock of HQLA that the bank holds.

And the analog to pollution is the net liquidity risk associated with the difference between these two quantities, something akin to the LCR shortfall.

That is, when the bank offers a lot of liquidity on demand to its customersInternational Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 4

but fails to hold an adequate buffer of HQLA, this is when it imposes spillover costs on the rest of the financial system.

In the case of the power plant, I argued that a regulation that calls for a fixed quantity of mitigation that is, for a fixed number of scrubbers is more attractive when there is little uncertainty about the cost of these scrubbers.

Thank you Jeremy!

I have just opened my master plan. I have to learn more about scrubbers. I now see other similarities between the BIS and scrubbers. Only now I can understand the shape of the BIS building!I think I have just found another regulatory arbitrage opportunity. A real national discretion, justified.

Scrubbers are capable of reduction efficiencies in the range of 50% to 98%. Why should the Liquidity Coverage Ratio be 100%?

A LCR from 50% to 98% (meaning 50,001%) is good enough!International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 5

The calculations in Basel and scrubbers are also almost the same!Read more at Number 1 below.Welcome to the Top 10 list.

Best Regards,George Lekatis President of the IARCPGeneral Manager, Compliance LLC1200 G Street NW Suite 800, Washington DC 20005, USA Tel: (202) 449-9750Email: lekatis@risk-compliance-association.comWeb: www.risk-compliance-association.com HQ: 1220 N. Market Street Suite 804, Wilmington DE 19801, USATel: (302) 342-8828International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 6Liquidity regulation and central banking

Speech by Mr Jeremy C Stein, Member of the Board of Governors of the Federal Reserve System, at the Finding the right balance 2013 Credit Markets Symposium, sponsored by the Federal Reserve Bank of Richmond, Charlotte, North CarolinaBasel III Capital: A Well-Intended Illusion

Thomas M. Hoenig, Vice Chairman, Federal Deposit Insurance Corporation, International Association of Deposit Insurers, 2013 Research Conference, Basel,Switzerland

Aristotle is credited with being the first philosopher to systematically study logical fallacies, which he defined as arguments that appear valid but, in fact, are not.

I call them well-intended illusions.

One such illusion of precision is the Basel capital standards in which world supervisory authorities rely principally on a Tier 1 capital ratio to judge the adequacy of bank capital and balance sheet strength.PCAOB Issues Policy Statement on Extraordinary Cooperation in Connection with Board Investigations Washington, DCInternational Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 7

The Public Company Accounting Oversight Board today published a formal statement concerning the benefits that may be available to registered public accounting firms and individuals who provide extraordinary cooperation in PCAOB investigations.Solvency II: where are we now?

Although there is no certainty on the Solvency II implementation date, EU policymakers are continuing to finalise key aspects of the framework.Policy Statement Conducting statutory investigations

The Prudential Regulation Authority (PRA) is required, under the Financial Services Act 2012 (the Act), to investigate and report to HM Treasury on possible regulatory failure and matters of public interest.Commission report underlines importance and urgency of financial sector reforms as a basis to restore long-term growthThe European Commission is publishing today the European Financial Stability and Integration Report (EFSIR), which is being presented at a joint conference with the European Central Bank (ECB) in Brussels.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 8Statement on the 2013 PCAOB Academic ConferenceJeanette M. Franzel, Board Member 2013 PCAOB Academic Conference Washington, D.C.The importance of culture in driving behaviours of firms and how the FCA will assess this

Speech by Clive Adamson, Director of Supervision at the CFA Society - UK Professionalism Conference 19 April 2013, London.Lessons for South Africa from Germany in a challenging global environment

Address by Ms Gill Marcus, Governor of the South African Reserve Bank, at the SouthernAfrican-German Chamber of Commerce and Industry luncheon, JohannesburgThe journey of financial reform

Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to theAustralian Chamber of Commerce in Shanghai.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 9Liquidity regulation and central banking

Speech by Mr Jeremy C Stein, Member of the Board of Governors of the Federal Reserve System, at the Finding the right balance 2013 Credit Markets Symposium, sponsored by the Federal Reserve Bank of Richmond, Charlotte, North Carolina

Id like to talk today about one important element of the international regulatory reform agenda namely, liquidity regulation.

Liquidity regulation is a relatively new, post-crisis addition to the financial stability toolkit.

Key elements include the Liquidity Coverage Ratio (LCR), which was recently finalized by the Basel Committee on Banking Supervision, and the Net Stable Funding Ratio, which is still a work in progress.

In what follows, I will focus on the LCR.

The stated goal of the LCR is straightforward, even if some aspects of its design are less so.

In the words of the Basel Committee, The objective of the LCR is to promote the short-term resilience of the liquidity risk profile of banks.

It does this by ensuring that banks have an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be converted easily and immediately in private markets into cash to meet their liquidity needs for a 30 calendar day liquidity stress scenario.

In other words, each bank is required to model its total outflows over 30 days in a liquidity stress event and then to hold HQLA sufficient toInternational Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 10

accommodate those outflows.

This requirement is implemented with a ratio test, where modeled outflows go in the denominator and the stock of HQLA goes in the numerator; when the ratio equals or exceeds 100 percent, the requirement is satisfied.

The Basel Committee issued the first version of the LCR in December 2010.

In January of this year, the committee issued a revised final version of the LCR, following an endorsement by its governing body, the Group of Governors and Heads of Supervision (GHOS).

The revision expands the range of assets that can count as HQLA and also adjusts some of the assumptions that govern the modeling of net outflows in a stress scenario.

In addition, the committee agreed in January to a gradual phase-in of the LCR, so that it only becomes fully effective on an international basis in January 2019.

On the domestic front, the Federal Reserve expects that the U.S. banking agencies will issue a proposal later this year to implement the LCR for large U.S. banking firms.

While this progress is welcome, a number of questions remain.

First, to what extent should access to liquidity from a central bank be allowed to count toward satisfying the LCR?

In January, the GHOS noted that the interaction between the LCR and the provision of central bank facilities is critically important.

And the group instructed the Basel Committee to continue working on this issue in 2013.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 11

Second, what steps should be taken to enhance the usability of the LCR buffer that is, to encourage banks to actually draw down their HQLA buffers, as opposed to fire-selling other less liquid assets?

The GHOS has also made clear its view that, during periods of stress, it would be appropriate for banks to use their HQLA, thereby falling below the minimum.

However, creating a regime in which banks voluntarily choose to do so is not an easy task.

A number of observers have expressed the concern that if a bank is held to an LCR standard of 100 percent in normal times, it may be reluctant to allow its ratio to drop below 100 percent when facing large outflows, even if regulators were to permit this temporary deviation, for fear that a decline in the ratio could be interpreted as a sign of weakness.

My aim here is to sketch a framework for thinking about these and related issues.

Among them, the interplay between the LCR and central bank liquidity provision is perhaps the most fundamental and a natural starting point for discussion.

By way of motivation, note that before the financial crisis, we had a highly developed regime of capital regulation for banks albeit one that looks inadequate in retrospect but we did not have formal regulatory standards for their liquidity.

The introduction of liquidity regulation after the crisis can be thought of as reflecting a desire to reduce dependence on the central bank as a lender of last resort (LOLR), based on the lessons learned over the previous several years.

However, to the extent that some role for the LOLR still remains, one now faces the question of how it should coexist with a regime of liquidity regulation.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 12

To address this question, it is useful to take a step back and ask another one:

What underlying market failure is liquidity regulation intended to address, and why cant this market failure be handled entirely by an LOLR?

I will turn to this question first.

Next, I will consider different mechanisms that could potentially achieve the goals of liquidity regulation, and how these mechanisms relate to various features of the LCR.

In so doing, I hope to illustrate why, even though liquidity regulation is a close cousin of capital regulation, it nevertheless presents a number of novel challenges for policymakers and why, as a result, we are going to have to be open to learning and adapting as we go.

The case for liquidity regulation

One of the primary economic functions of banks and other financial intermediaries, such as broker-dealers, is to provide liquidity that is, cash on demand in various forms to their customers.

Some of this liquidity provision happens on the liability side of the balance sheet, with bank demand deposits being a leading example.

But, importantly, banks also provide liquidity via committed lines of credit.

Indeed, it is probably not a coincidence that these two products demand deposits and credit lines are offered under the roof of the same institution; the underlying commonality is that both require an ability to accommodate unpredictable requests for cash on short notice.

A number of other financial intermediary services, such as prime brokerage, also embody a significant element of liquidity provision. Without question, these liquidity-provision services are socially valuable.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 13On the liability side, demand deposits and other short-term bank liabilities are safe, easy-to-value claims that are well suited for transaction purposes and hence create a flow of money-like benefits for their holders.

And loan commitments are more efficient than an arrangement in which each operating firm hedges its future uncertain needs by pre-borrowing and hoarding the proceeds on its own balance sheet; this latter approach does a poor job of economizing on the scarce aggregate supply of liquid assets.

At the same time, as the financial crisis made painfully clear, the business of liquidity provision inevitably exposes financial intermediaries to various forms of run risk.

That is, in response to adverse events, their fragile funding structures, together with the binding liquidity commitments they have made, can result in rapid outflows that, absent central bank intervention, lead banks to fire-sell illiquid assets or, in a more severe case, to fail altogether.

And fire sales and bank failures and the accompanying contractions in credit availability can have spillover effects to other financial institutions and to the economy as a whole.

Thus, while banks will naturally hold buffer stocks of liquid assets to handle unanticipated outflows, they may not hold enough because, although they bear all the costs of this buffer stocking, they do not capture all of the social benefits, in terms of enhanced financial stability and lower costs to taxpayers in the event of failure.

It is this externality that creates a role for policy.

There are two broad types of policy tools available to deal with this sort of liquidity-based market failure.

The first is after-the-fact intervention, either by a deposit insurer guaranteeing some of the banks liabilities or by a central bank acting as an LOLR.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 14The second type is liquidity regulation.

As an example of the former, when the economy is in a bad state, assuming that a particular bank is not insolvent, the central bank can lend against illiquid assets that would otherwise be fire-sold, thereby damping or eliminating the run dynamics and helping reduce the incidence of bank failure.

In much of the literature on banking, such interventions are seen as the primary method for dealing with run-like liquidity problems.

A classic statement of the central banks role as an LOLR is Walter Bagehots 1873 book Lombard Street.

More recently, the seminal theoretical treatment of this issue is by Douglas Diamond and Philip Dybvig, who show that under certain circumstances, the use of deposit insurance or an LOLR can eliminate run risk altogether, thereby increasing social welfare at zero cost.

To be clear, this work assumes that the bank in question is fundamentally solvent, meaning that while its assets may not be liquid on short notice, the long-run value of these assets is known with certainty to exceed the value of the banks liabilities.

One way to interpret the message of this research is that capital regulation is important to ensure solvency, but once a reliable regime of capital regulation is in place, liquidity problems can be dealt with after the fact, via some combination of deposit insurance and use of the LOLR.

It follows that if one is going to make an argument in favor of adding preventative liquidity regulation such as the LCR on top of capital regulation, a central premise must be that the use of LOLR capacity in a crisis scenario is socially costly, so that it is an explicit objective of policy to economize on its use in such circumstances.I think this premise is a sensible one.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 15

A key point in this regard and one that has been reinforced by the experience of the past several years is that the line between illiquidity and insolvency is far blurrier in real life than it is sometimes assumed to be in theory.

Indeed, one might argue that a bank or broker dealer that experiences a liquidity crunch must have some probability of having solvency problems as well; otherwise, it is hard to see why it could not attract short-term funding from the private market.

This reasoning implies that when the central bank acts as an LOLR in a crisis, it necessarily takes on some amount of credit risk.

And if it experiences losses, these losses ultimately fall on the shoulders of taxpayers.

Moreover, the use of an LOLR to support banks when they get into trouble can lead to moral hazard problems, in the sense that banks may be less prudent ex ante.

If it were not for these costs of using LOLR capacity, the problem would be trivial, and there would be no need for liquidity regulation:

Assuming a well-functioning capital-regulation regime, the central bank could always avert all fire sales and bank failures ex post, simply by acting as an LOLR.

This observation carries an immediate implication:

It makes no sense to allow unpriced access to the central banks LOLR capacity to count toward an LCR requirement.

Again, the whole point of liquidity regulation must be either to conserve on the use of the LOLR or in the limit, to address situations where the LOLR is not available at all as, for example, in the case ofbroker-dealers in the United States.At the same time, it is important to draw a distinction between priced and unpriced access to the LOLR.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 16For example, take the case of Australia, where prudent fiscal policy has led to a relatively small stock of government debt outstanding and hence to a potential shortage of HQLA.

The Basel Committee has agreed to the use by Australia of a Committed Liquidity Facility (CLF), whereby an Australian bank can pay the Reserve Bank of Australia an upfront fee for what is effectively a loan commitment, and this loan commitment can then be counted toward its HQLA.

In contrast to free access to the LOLR, this approach is not at odds with the goals of liquidity regulation because the up-front fee is effectively a tax that serves to deter reliance on the LOLR which, again, is precisely the ultimate goal.

I will return to the idea of a CLF shortly.

The design of regulation

Once it has been decided that liquidity regulation is desirable, the next question is how best to implement it.

In this context, note that the LCR has two logically distinct aspects as a regulatory tool:

It is a mitigator, in the sense that holding liquid assets leads to a better outcome if there is a bad shock; it is also an implicit tax on liquidity provision by banks, to the extent that holding liquid assets is costly.

Of course, one can say something broadly similar about capital requirements.

But the implicit tax associated with the LCR is subtler and less well understood, so I will go into some detail here.

An analogy may help to explain.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 17

Suppose we have a power plant that produces energy and, as a byproduct, some pollution.

Suppose further that regulators want to reduce the pollution and have two tools at their disposal:

They can mandate the use of a pollution-mitigating technology, like scrubbers, or they can levy a tax on the amount of pollution generated by the plant.

In an ideal world, regulation would accomplish two objectives.

First, it would lead to an optimal level of mitigation that is, it would induce the plant to install scrubbers up to the point where the cost of an additional scrubber is equal to the marginal social benefit, in terms of reduced pollution.

And, second, it would also promote conservation:

Given that the scrubbers dont get rid of pollution entirely, one also wants to reduce overall energy consumption by making it more expensive.

A simple case is one in which the costs of installing scrubbers, as well as the social benefits of reduced pollution, are known in advance by the regulator and the manager of the power plant.

In this case, the regulator can figure out what the right number of scrubbers is and require that the plant install these scrubbers.

The mandate can therefore precisely target the optimal amount of mitigation per unit of energy produced.

And, to the extent that the scrubbers are costly, the mandate will also lead to higher energy prices, which will encourage some conservation, though perhaps not the socially optimal level.

This latter effect is the implicit tax aspect of the mandate.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 18

A more complicated case is when the regulator does not know ahead of time what the costs of building and installing scrubbers will be.

Here, mandating the use of a fixed number of scrubbers is potentially problematic:

If the scrubbers turn out to be very expensive, the regulation will end up being more aggressive than socially desirable, leading to overinvestment in scrubbers and large cost increases for consumers; however, if the scrubbers turn out to be cheaper than expected, the regulation will have been too soft.

In other words, when the cost of the mitigation technology is significantly uncertain, a regulatory approach that fixes the quantity of mitigation is equivalent to one where the implicit tax rate bounces around a lot.

By contrast, a regulatory approach that fixes the price of pollution instead of the quantity say, by imposing a predetermined proportional tax rate directly on the amount of pollution emitted by the plant is more forgiving in the face of this kind of uncertainty.

This approach leaves the scrubber-installation decision to the manager of the plant, who can figure out what the scrubbers cost before deciding how to proceed.

For example, if the scrubbers turn out to be unexpectedly expensive, the plant manager can install fewer of them.

This flexibility translates into less variability in the effective regulatory burden and hence less variability in the price of energy to consumers.

Scrubbers and high-quality liquid assetsWhat does all this imply for the design of the LCR? Lets work through the analogy in detail.The analog to the power plants energy output is the gross amount of liquidity services created by a bank via its deposits, the credit lines itInternational Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 19

provides to its customers, the prime brokerage services it offers, and so forth.

The analog to the mitigation technology the scrubbers is the stock of HQLA that the bank holds.

And the analog to pollution is the net liquidity risk associated with the difference between these two quantities, something akin to the LCR shortfall.

That is, when the bank offers a lot of liquidity on demand to its customers but fails to hold an adequate buffer of HQLA, this is when it imposes spillover costs on the rest of the financial system.

In the case of the power plant, I argued that a regulation that calls for a fixed quantity of mitigation that is, for a fixed number of scrubbers is more attractive when there is little uncertainty about the cost of these scrubbers.

In the context of the LCR, the cost of mitigation is the premium that the bank must pay in the form of reduced interest income for its stock of HQLA.

And, crucially, this HQLA premium is determined in market equilibrium and depends on the total supply of safe assets in the system, relative to the demand for those assets.

On the one hand, if safe HQLA-eligible assets are in ample supply, the premium is likely to be low and stable.

On the other hand, if HQLA-eligible assets are scarce, the premium will be both higher and more volatile over time.

This latter situation is the one facing countries like Australia, where, as I noted earlier, the stock of outstanding government securities is relatively small.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 20

And it explains why, for such countries, having a price-based mechanism as part of their implementation of the LCR can be more appealing than pure reliance on a quantity mandate.

When one sets an up-front fee for a CLF, one effectively caps the implicit tax associated with liquidity regulation at the level of the commitment fee and tamps down the undesirable volatility that would otherwise arise from an entirely quantity-based regime.

Moreover, it bears reemphasizing that having a CLF with an up-front fee is very different from simply allowing banks to count central - bank - eligible collateral as HQLA at no charge.

Rather, the CLF is like the pollution tax.

For every dollar of pre-CLF shortfall that is, for every dollar of required liquidity that a bank cant obtain on the private market the bank has to pay the commitment fee.

So even if there is not as much mitigation, there is still an incentive for conservation, in the sense that banks are encouraged to do less liquidity provision, all else being equal.

This would not be the case if the CLF were available at a zero price.

What about the situation in countries where safe assets are more plentiful?

The analysis here has a number of moving parts because in addition to the implementation of the LCR, substantial increases in demand for safe assets will arise from new margin requirements for both cleared and noncleared derivatives.

Nevertheless, given the large and growing global supply of sovereign debt securities, as well as other HQLA-eligible assets, most estimates suggest that the scarcity problem should be manageable, at least for the foreseeable future.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 21

In particular, quantitative impact studies released by the Basel Committee estimate that the worldwide incremental demand for HQLA coming from both the implementation of the LCR and swap margin requirements might be on the order of $3 trillion.

This is a large number, but it compares with a global supply of HQLA-eligible assets of more than $40 trillion.

Moreover, the eligible collateral for swap margin is proposed to be broader than the LCRs definition of HQLA including, for example, certain equities and corporate bonds without any cap.

If one focuses just on U.S. institutions, the incremental demand number is on the order of $1 trillion, while the sum of Treasury, agency, and agency mortgage-backed securities is more than $19 trillion.

While this sort of analysis is superficially reassuring, the fact remains that the HQLA premium will depend on market-equilibrium considerations that are hard to fully fathom in advance, and that are likely to vary over time.

This uncertainty needs to be understood, and respected.

Indeed, the market-equilibrium aspect of the problem represents a crucial distinction between capital regulation and liquidity regulation, and it is one reason why the latter is particularly challenging to implement.

Although capital regulation also imposes a tax on banks to the extent that equity is a more expensive form of finance than debt this tax wedge is, to a first approximation, a fixed constant for a given bank, independent of the scale of overall financial intermediation activity.

If Bank A decides to issue more equity so it can expand its lending business, this need not make it more expensive for Bank B to satisfy its capital requirement.

In other words, there is no scarcity problem with respect to bank equity both A and B can always make more.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 22

By contrast, the total supply of HQLA is closer to being fixed at any point in time.

Policy implications

What does all of this imply for policy design?

First, at a broad philosophical level, the recognition that liquidity regulation involves more uncertainty about costs than capital regulation suggests that even a policymaker with a very strict attitude toward capital might find it sensible to be somewhat more moderate and flexible with respect to liquidity.

This point is reinforced by the observation that when an institution is short of capital and cant get more on the private market, there is really no backup plan, short of resolution.

By contrast, as I mentioned earlier, when an institution is short of liquidity, policymakers do have a backup plan in the form of the LOLR facility.

One does not want to rely too much on that backup plan, but its presence should nevertheless factor into the design of liquidity regulation.

Second, in the spirit of flexibility, while a price-based mechanism such as the CLF may not be immediately necessary in countries outside of Australia and a few others, it is worth keeping an open mind about the more widespread use of CLF-like mechanisms.

If a scarcity of HQLA-eligible assets turns out to be more of a problem than we expect, something along those lines has the potential to be a useful safety valve, as it puts a cap on the cost of liquidity regulation.

Such a safety valve would have a direct economic benefit, in the sense of preventing the burden of regulation from getting unduly heavy in any one country.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 23

Perhaps just as important, a safety valve might also help to protect the integrity of the regulation itself, by harmonizing costs across countries and thereby reducing the temptation of those most hard-hit by the rules to try to chip away at them.

Without such a safety valve, it is possible that some countries those with relatively small supplies of domestic HQLA will find the regulation considerably more costly than others.

If so, it would be natural for them to lobby to dilute the rules for example, by arguing for an expansion in the type of assets that can count as HQLA.

Taken too far, this sort of dilution would undermine the efficacy of the regulation as both a mitigator and a tax.

In this scenario, holding the line with what amounts to a proportional tax on liquidity provision would be a better outcome.

One situation where liquid assets can become unusually scarce is during a financial crisis.

Consequently, even if CLFs were not counted toward the LCR in normal times, it might be appropriate to count them during a crisis.

Indeed, while the LCR requires banks to hold sufficient liquid assets in good times to meet their outflows in a given stress scenario, it implicitly recognizes that if things turn out even worse than that scenario, central bank liquidity support will be needed.

Allowing CLFs to count toward the LCR in such circumstances would acknowledge the importance of access to the central bank, and this access could be priced accordingly.

Finally, a price-based mechanism might also help promote a willingness of banks to draw down their supply of HQLA in a stress scenario.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 24

As I noted at the outset, one important concern about a pure quantity - based system of regulation is that if a bank is held to an LCR standard of 100 percent in normal times, it may be reluctant to allow its ratio to fall below 100 percent when facing large outflows for fear that doing so might be seen by market participants as a sign of weakness.

By contrast, in a system with something like a CLF, a bank might in normal times meet 95 percent of its requirement by holdingprivate-market HQLA and the remaining 5 percent with committed credit lines from the central bank, so it would have an LCR of exactly 100percent.

Then, when hit with large outflows, it could maintain its LCR at 100 percent, but do so by increasing its use of central bank credit lines to 25 percent and selling 20 percent of its other liquid assets.

This scenario would be the sort of liquid-asset drawdown that one would ideally like to see in a stress situation.

Moreover, the central bank could encourage this drawdown by varying the pricing of its credit lines specifically, by reducing the price of the lines in the midst of a liquidity crisis.

Such an approach would amount to taxing liquidity provision more in good times than in bad, which has a stabilizing macroprudential effect.

This example also suggests a design that may have appeal in jurisdictions where there is a relatively abundant supply of HQLA-eligible assets.

One can imagine calibrating the pricing of the CLF so as to ensure that lines provided by central banks make up only a minimal fraction of banks required HQLA in normal times apart, perhaps, from the occasional adjustment period after an individual bank is hit with an idiosyncratic liquidity shortfall.

At the same time, in a stress scenario, when liquidity is scarce and there is upward pressure on the HQLA premium, the pricing of the CLF could beInternational Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 25

adjusted so as to relieve this pressure and promote usability of the HQLA buffer.

Such an approach would respect the policy objective of reducing expected reliance on the LOLR while at the same time allowing for a safety valve in a period of stress.

The limit case of this approach is one where the CLF counts toward the LCR only in a crisis.

Conclusion

By way of conclusion, let me just restate that liquidity regulation has a key role to play in improving financial stability.

However, we should avoid thinking about it in isolation; rather, we can best understand it as part of a larger toolkit that also includes capital regulation and, importantly, the central banks LOLR function.

Therefore, proper design and implementation of liquidity regulations such as the LCR should take account of these interdependencies.

In particular, policymakers should aim to strike a balance between reducing reliance on the LOLR on the one hand and moderating the costs created by liquidity shortages on the other hand especially those shortages that crop up in times of severe market strain.

And, as always, we should be prepared to learn from experience as we go.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 26Basel III Capital: A Well-Intended Illusion Thomas M. Hoenig

Vice Chairman, Federal Deposit Insurance CorporationInternational Association of Deposit Insurers 2013 Research Conference, Basel, SwitzerlandIntroduction

Aristotle is credited with being the first philosopher to systematically study logicalfallacies, which he defined as arguments that appear valid but, in fact, arenot.

I call them well-intended illusions.

One such illusion of precision is the Basel capital standards in which world supervisory authorities rely principally on a Tier 1 capital ratio to judge the adequacy of bank capital and balance sheet strength.

For the largest of these firms, each dollar of risk-weighted assets is funded with 12 to 15 cents in equity capital, projecting the illusion that these firms are well capitalized.

The reality is that each dollar of their total assets is funded with far less equity capital, leaving open the matter of how well capitalized they might be.

Heres how the illusion is created.

Basel's Tier 1 capital measure is a bank's ratio of Tier 1 capital to risk-weighted assets.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 27

Each category of bank assets is weighed by the supervisory authority on a complicated scale of probabilities and models that assign a relative risk of loss to each group, including off balance sheet items.

Assets deemed low risk are reported at lower amounts on the balance sheet.

The lower the risk, the lower the amount reported on the balance sheet for capital purposes and the higher the calculated Tier 1 ratio.

We know from years of experience using the Basel capital standards that once the regulatory authorities finish their weighting scheme, bank managers begin the process of allocating capital and assets to maximize financial returns around these constructed weights.

The objective is to maximize a firm's return on equity (ROE) by managing the balance sheet in such a manner that for any level of equity, the risk-weighted assets are reported at levels far less than actual total assets under management.

This creates the illusion that banking organizations have adequate capital to absorb unexpected losses.

For the largest global financial companies, risk-weighted assets are approximately one-half of total assets.

This "leveraging up" has served world economies poorly.

In contrast, supervisors and financial firms can choose to rely on the tangible leverage ratio to judge the overall adequacy of capital for the enterprise.

This ratio compares equity capital to total assets, deducting goodwill, other intangibles, and deferred tax assets from both equity and total assets.

In addition to including only loss-absorbing capital, it also makes no attempt to predict or assign relative risk weights among asset classes.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 28

Using this leverage ratio as our guide, we find for the largest banking organizations that each dollar of assets has only 4 to 6 cents funded with tangible equity capital, a far smaller buffer than asserted under the Basel standards.

Comparing Measures

Table 1 reports the Basel Tier 1 risk-weighted capital ratio and the leverage ratio for different classes of banking firms.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 29Column 4 shows Tier 1 capital ratios ranging between 12 and 15 percent for the largest global firms, giving the impression that these banks are highly capitalized.

However, it is hard to be certain of that by looking at this ratio since risk-weighted assets are so much less than total assets.

In contrast, Column 6 shows U.S. firms' average leverage ratio to be 6 percent using generally accepted accounting standards (GAAP), and Column 8 shows their average ratio to be 3.9 percent using international accounting standards (IFRS), which places more of these firms' derivatives onto the balance sheet than does GAAP.

The bottom portion of Table 1 shows the degree of leverage among different size groups of banking firms, which is striking as well.

The Tier 1 capital measure suggests that all size groups of banks hold comparable capital levels, while the leverage ratio reports a different outcome.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 30

For example, the leverage ratio for most banking groups not considered systemically important averages near 8 percent or higher.

Under GAAP accounting standards, the difference in this ratio between the largest banking organizations and the smaller firms is 175-250 basis points.

Under IFRS standards, the difference is as much as 400-475 basis points.

The largest firms, which most affect the economy, hold the least amount of capital in the industry.

While this shows them to be more fragile, it also identifies just how significant a competitive advantage these lower capital levels provide the largest firms.

These comparisons illustrate how easily the Basel capital standard can confuse and misinform the public rather than meaningfully report a banking companys relative financial strength.

Recent history shows also just how damaging this can be to the industry and the economy.

In 2007, for example, the 10 largest and most complex U.S. banking firms reported Tier 1 capital ratios that, on average, exceeded 7 percent ofrisk-weighted assets.

Regulators deemed these largest to be well capitalized.

This risk-weighted capital measure, however, mapped into an average leverage ratio of just 2.8 percent.

We learned all too late that having less than 3 cents of tangible capital for every dollar of assets on the balance sheet is not enough to absorb even the smallest of financial losses, and certainly not a major shock.

With the crisis, the illusion of adequate capital was discovered, after having misled shareholders, regulators, and taxpayers.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 31

There are other, more recent, examples of how this arcane measure can be manipulated to give the illusion of strength even when a firm incurs losses.

For example, in the fourth quarter of 2012, Deutsche Bank reported a loss of 2.5 billion EUR.

That same quarter, its Tier 1 risk-based capital ratio increased from 14.2 percent to 15.1 percent due, in part, to model and process enhancements that resulted in a decline in risk-weighted assets, which now amount to just 16.6 percent of total assets.

On Feb. 1, SNS Reaal, the fourth largest Dutch bank with $5 billion in assets, was nationalized by the Dutch government.

Just seven months earlier, on June 30, 2012, SNS reported a Tier 1 risk-based capital ratio of 12.2 percent.

However, the firm reported a Tier 1 leverage ratio based upon international accounting standards of only 1.47 percent.

This leverage ratio was much more indicative of the SNSs poor financial position.

The Basel III proposal belatedly introduces the concept of a leverage ratio but calls for it to be only 3 percent, an amount already shown to be insufficient to absorb sizable financial losses in a crisis.

It is wrong to suggest to the public that, with so little capital, these largest firms could survive without public support should they encounter any significant economic reversals.

Misallocating Resources and Creating Asset Imbalances

An inherent problem with a risk-weighted capital standard is that the weights reflect past events, are static, and mostly ignore the market's collective daily judgment about the relative risk of assets.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 32

It also introduces the element of political and special interests into the process, which affects the assignment of risk weights to the different asset classes.

The result is often to artificially favor one group of assets over another, thereby redirecting investments and encouraging over-investment in the favored assets.

The effect of this managed process is to increase leverage, raise the overall risk profile of these institutions, and increase the vulnerability of individual companies, the industry, and the economy.

It is no coincidence, for example, that after a Basel standard assigned only a 7 percent risk weight on triple A, collateralized debt obligations and similar low risk weights on assets within a firm's trading book, resources shifted to these activities.

Over time, financial groups dramatically leveraged these assets onto their balance sheets even as the risks to that asset class increased exponentially.

Similarly, assigning zero weights to sovereign debt encouraged banking firms to invest more heavily in these assets, simultaneously discounting the real risk they presented and playing an important role in increasing it.

In placing a lower risk weight on select assets, less capital was allocated to fund them and to absorb unexpected loss for these banks, undermining their solvency.

A More Realistic Capital Standard Is Required

Taxpayers are the ultimate backstop to the safety net and have real money at stake.

In choosing which capital measure is most useful, it is fair to ask the following questions:International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 33

Does the Basel Tier 1 ratio or the tangible leverage ratio best indicate the capital strength of the firm?

Which one is most clearly understood?

Which one best enables comparison of capital across institutions?

Which one offers the most confidence that it cannot be easily gamed?

Charts 1 through 4 compare the relationship of the tangible leverage and Basel Tier 1 capital ratios to various market measures for the largest firms.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 34International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 35International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 36International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 37These measures include: the price-to-book ratio, estimated default frequency, credit default swap spreads, and market value of equity.

In each instance, the correlation of the tangible leverage ratio to these variables is higher than for the risk-weighted capital ratio.

While such findings are not conclusive, they suggest strongly that investors, when deciding where to place their money, rely upon the information provided by the leverage ratio.

We would do well to do the same.

Despite all of the advancements made over the years in risk measurement and modeling, it is impossible to predict the future or to reliably anticipate how and to what degree risks will change.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 38

Capital standards should serve to cushion against the unexpected, not to divine eventualities.

All of the Basel capital accords, including the proposed Basel III, look backward and then attempt to assign risk weights into the future.

It doesn't work.

In contrast, the tangible leverage ratio provides a simpler, more direct insight into the amount of loss-absorbing capital that is available to a firm.

A leverage ratio as Ive defined it explicitly excludes intangible items that cannot absorb losses in a crisis.

Also, using IFRS accounting rules, off-balance sheet derivatives are brought onto the balance sheet, providing further insight into a firm's leverage.

Thus, the tangible leverage ratio is simpler to compute and more easily understood by bank managers, directors, and the public.

Importantly also, it is more likely to be consistently enforced by bank supervisors.

A more difficult challenge may be to determine an appropriate minimum leverage ratio.

Chart 5 provides a history of bank leverage over the past 150 years for theU.S. banking system and gives initial insight into this question.

It shows that the equity capital to assets ratio for the industry prior to the founding of the Federal Reserve System in 1913 and the Federal Deposit Insurance Corporation in 1933 ranged between 13 and 16 percent, regardless of bank size.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 39

Without any internationally dictated standard or any arcane weighting process, markets required what today seems like relatively high capital levels.

In addition, there is an increasing body of research (Admati and Hellwig; Haldane; Miles, Yang, and Marcheggiano) that suggests that leverage ratios should be much higher than they currently are and that Basel IIIs proposed 3 percent figure adds little security to the system.

Finally, and importantly, some form of risk-weighted capital measure could be useful as a backstop, or check, against which to judge the adequacy of the leverage ratio for individual banks.

If a bank meets the minimum leverage ratio but has concentrated assets in areas that risk models suggest increase the overall vulnerability of the balance sheet, the bank could be required to increase its tangible capital levels.

Such a system provides the most comprehensive measure of capital adequacy both in a broad context of all assets and according to a bank's allocation of assets along a defined risk profile.

Tangible Leverage Ratio and the Myth of Unintended Consequences

Concerns are often raised within the financial industry and elsewhere that requiring the largest and most complex firms to hold higher levels of capital as defined using a tangible leverage ratio would have serious adverse effects on the industry and broader economy.

It has been suggested, for example, that requiring more capital for these largest banks would raise their relative cost of capital and make them less competitive.

Similarly, there is concern that failing to assign risk weights to the different categories of assets would encourage firms to allocate funds to the highest risk assets to achieve targeted returns to equity.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 40

These issues have been well addressed by Anat Admati and Martin Hellwig in their recently published book, The Bankers New Clothes.

The required ROE and the ability to attract capital are determined by a host of factors beyond the level of equity capital.

These include a firms business model, its risk-adjusted returns, the benefits of services and investments, and the undistorted, ornon-subsidized, costs of capital.

A level of capital that lowers risk may very well attract investors drawn to the more reliable returns.

Table 1 shows many of the banks with stronger leverage ratios also have stock prices trading at a higher premium to book value than the largest firms that are less well-capitalized.

There also is a concern that requiring a stronger, simpler leverage ratio would cause managers to place more risk on their balance sheet.

While possible, the argument is unconvincing.

With more capital at risk and without regulatory weighting schemes affecting choice, managers will allocate capital in line with market risk and returns.

Furthermore, risk-weighted measures and strong bank supervision can be available as a back-up system to monitor such activity.

Moreover, given the experience of the recent crisis and the on-going efforts to manage reported risk assets down, no matter the risk, it rings hollow to suggest that having a higher equity buffer for the same amount of total assets makes the financial system less safe.

In addition, there is a concern that demanding more equity capital and reducing leverage among the largest firms would inhibit the growth of credit and the economy.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 41

This statement has an implied presumption that the Basel weighting scheme is more growth friendly than a simpler, stronger leverage ratio.

However, having a sufficient capital buffer allows banks to absorb unexpected losses.

This serves to moderate the business cycle and the decline in lending that otherwise occurs during contractions.

If the Basel risk-weight schemes are incorrect, which they often have been, this too could inhibit loan growth, as it encourages investments in other more favorably, but incorrectly, weighted assets.

Basel systematically encourages investments in sectors pre-assigned lower weights -- for example, mortgages, sovereign debt, and derivatives-- and discourages loans to assets assigned higher weights -- commercialand industrial loans.

We may have inadvertently created a system that discourages the very loan growth we seek, and instead turned our financial system into one that rewards itself more than it supports economic activity.

If risk weights could be assigned that anticipate and calibrate risks with perfect foresight, adjusted on a daily basis, then perhaps risk-weighted capital standards would be the preferred method for determining how to deploy capital.

However, they cannot.

To believe they can is a fallacy that puts the entire economic system at risk.

Changing the Debate

The tangible leverage ratio is a superior alternative to risk-weighting schemes that have proven to be an illusion of precision and insufficient in defining adequate capital.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 42

The effect of relying on such measures has been to weaken the financial system and misallocate resources.

The leverage ratio deserves serious consideration as the principal tool in judging the capital strength of financial firms.

The Basel discussion would be well served to focus on the appropriate levels of tangible capital for banking firms to hold and the right transition period to achieve these levels.

Finally, we should not accept even comforting errors of logic which suggest that Basel III requirements will create stronger capital than those of Basel II, which failed.

Instead, past industry performance and mounting academic and other evidence suggest that we would be best served to focus on a strong leverage ratio standard in judging a firm and the industry's financial strength.

No bank capital program is perfect.

Our responsibility as regulators and deposit insurers is to choose the best available measure that will contribute to financial stability.Note:

Thomas M. Hoenig was confirmed by the Senate as Vice Chairman of the Federal Deposit Insurance Corporation on Nov. 15, 2012.

He joined the FDIC on April 16, 2012, as a member of the FDIC Board of Directors for a six-year term.

He is a member of the executive board of the International Association of Deposit Insurers.

Prior to serving on the FDIC board, Mr. Hoenig was the President of the Federal Reserve Bank of Kansas City and a member of the Federal Reserve System's Federal Open Market Committee from 1991 to 2011.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 43

Mr. Hoenig was with the Federal Reserve for 38 years, beginning as an economist and then as a senior officer in banking supervision during theU.S. banking crisis of the 1980s.

In 1986, he led the Kansas City Federal Reserve Bank's Division of Bank Supervision and Structure, directing the oversight of more than 1,000 banks and bank holding companies with assets ranging from less than$100 million to $20 billion.

He became President of the Kansas City Federal Reserve Bank on October 1, 1991.

Mr. Hoenig is a native of Fort Madison, Iowa. He received a doctorate in economics from Iowa State University.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 44PCAOB Issues Policy Statement on Extraordinary Cooperation in Connection with Board Investigations Washington, DC

The Public Company Accounting Oversight Board today published a formal statement concerning the benefits that may be available to registered public accounting firms and individuals who provide extraordinary cooperation in PCAOB investigations.

The policy statement describes what the PCAOB may consider to be extraordinary cooperation and how credit might be reflected for such cooperation.

The policy is generally consistent with the Board's existing practices.

"This policy provides benefits to investors and real, tangible incentives to cooperate to firms and persons associated with firms," said James R. Doty, PCAOB Chairman. "

Extraordinary cooperation permits the Board to more quickly and efficiently address wrongdoing for the protection of investors, and may earn parties credit in connection with the Board's disciplinary processes."

According to the policy statement, extraordinary cooperation is voluntary and timely action beyond compliance with legal or regulatory obligations.

Cooperation that could result in credit includes self-reporting violations before the conduct comes to the attention of the Board or another regulator.

Self-reporting is more valuable the earlier it is provided.

The other types of extraordinary cooperation that could result in credit are taking remedial or corrective action to reduce the risk of similarInternational Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 45

violations recurring, and providing substantial assistance in the PCAOB's investigative processes.

Credit for cooperation may result in reduced charges or sanctions in a disciplinary proceeding.

In some cases, extraordinary cooperation may lead to language in settlement documents noting the cooperation and its effect.

In exceptional cases, extraordinary cooperation could lead to no disciplinary action at all.

"Extraordinary cooperation can help streamline and expedite PCAOB investigations, which allows the Board to turn its attention and resources to other potential auditor misconduct," said Claudius B. Modesti, Director of the PCAOB Division of Enforcement and Investigations.

"This policy statement is an important step in encouraging auditors to go above and beyond what is required by law," he said.

Members of the public who wish to report potential violations of law or PCAOB rules may contact the Board through the Tip and Referral Center on the PCAOB website.

Summary

The Public Company Accounting Oversight Board ("PCAOB" or "Board") is issuing this policy statement to provide guidance to registered public accounting firms ("firms") and persons associated with firms ("associated persons") concerning how extraordinary cooperation may be considered in determining the outcome of a PCAOB investigation.

This policy statement does not bind and is not intended to influence any PCAOB hearing officer or the Board in the adjudication of litigated matters.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 46

Further, please note that the Board is not adopting any rule or making any commitment or promise about any specific case, or conferring any rights on any person or entity.

Further, the Board is not in any way limiting its discretion to evaluate every case individually, on its own particular facts and circumstances.

The types of cooperation that could result in credit are: voluntary and timely self-reporting; voluntary and timely remedial or corrective action; and voluntary and timely substantial assistance to the Boards investigative processes or to other law enforcement authorities.

These actions, alone or taken together, can be viewed as extraordinary cooperation for purposes of this policy statement and, depending on the facts and circumstances, may influence the PCAOBs enforcement decisions.

By publishing this policy statement on cooperation, the Board seeks:

to encourage firms and associated persons to voluntarily and timely self-report, correct and remediate violative behavior, and provide substantial assistance to the Boards investigative processes; and

to increase transparency into how the Board may credit cooperation.

Moreover, the Board will, in appropriate cases and in its discretion, note in settlement documents or other public statements that it has credited the extraordinary cooperation of a firm or associated person.

Doing so will enhance the Boards enforcement program by publicizing the benefits of cooperation and informing firms and associated persons of the types of cooperation that may merit credit.I. Introduction

The Sarbanes-Oxley Act (the "Act") and Board Rules require firms and associated persons to cooperate in connection with PCAOB inspections and investigations.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 47

Section 102(b)(3) of the Act requires every firm applying for PCAOB registration to supply

a consent to cooperate in and comply with any request for testimony or the production of documents made by the PCAOB in the furtherance of its authority and responsibilities under the Act,

an agreement to secure and enforce similar consents from each associated person of the firm, and

a statement that the firm understands and agrees, among other things, that its cooperation and compliance shall be a condition to the continuing effectiveness of the firms registration with the Board.

Even if a firm fails to provide those items with its application, it is not relieved of the obligations to cooperate in and comply with Board requests made in furtherance of the Boards authority and responsibilities under the Act.

Moreover, two Board Rules address cooperation by registered firms and associated persons.

Board Rule 4006, Duty to Cooperate with Inspectors, applies to inspections, and requires a registered firm and any associated person of that firm to cooperate with any Board inspection by providing information requested in Board inspections and providing access to the firms records.

Rule 4006 also requires that information provided to the Board be truthful and not misleading.

Sections 105(c)(4) and (5) of the Act and Board Rule 5300(a) govern sanctions for noncooperation with an inspection.

Section 105(b)(3) of the Act and Board Rule 5110, Noncooperation with an Investigation, apply to investigations, and provide that the Board may sanction a firm or associated person for failing to cooperate with a Board investigation.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 48

The forms of cooperation covered by Rule 5110 are enumerated in paragraphs (1)-(3), with paragraph (4) providing a catch-all provision for failure to cooperate generally. Section 105(b)(3) of the Act and Board Rule 5300(b) govern sanctions for failure to cooperate with an investigation.

In certain situations, a firm or associated person might cooperate with PCAOB investigations beyond compliance with those obligations.

Cooperation beyond what is required to comply with legal and regulatory obligations can contribute significantly to the success of the Boards mission of protecting investors and furthering the public interest in the preparation of informative, accurate and independent audit reports.

Such extraordinary cooperation might help the Boards staff to discover potential violations earlier and allow the Board to conclude investigations in a more efficient and timely manner, thus reducing the risk that such violative conduct will be repeated and result in more significant harm to investors, and assisting the Board in identifying audit reports that may be inaccurate.

For that reason, extraordinary cooperation in connection with Board investigations may be considered by the Boards Division of Enforcement and Investigations (the "Division") in its disciplinary recommendations to the Board, and by the Board in determining whether to accept settlement offers.

II. What is extraordinary cooperation?

Extraordinary cooperation is voluntary and timely action beyond compliance with legal or regulatory obligations that contributes to the mission of the Board.

There are three broad types of cooperation that (alone or taken together) might merit cooperation credit: self-reporting; remedial or corrective action; and substantial assistance to the Boards investigative processes or to other law enforcement authorities.

Self-Reporting relates to conduct upon learning of violations.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 49

A firm or associated person may earn credit for self-reporting by making voluntary, timely and full disclosure of the facts relating to violations before the conduct comes to the attention of the Board or another regulator.

If self-reporting is required by legal or regulatory obligations, it is not voluntary and is not eligible for cooperation credit.

Thus, for example, self-reporting is not voluntary if made after receipt of a regulatory inquiry (e.g., any request, demand or subpoena for the same information or documents from the Board, the U.S. Securities and Exchange Commission, Congress, any other federal, state, local or foreign authority, or any self-regulatory organization).

Likewise, self-reporting is not voluntary if required by Section 10A(b) of the Securities Exchange Act of 1934 [15 U.S.C. 78j-1(b)], Audit requirements- Required response to audit discoveries (which addresses an auditors obligation to report the illegal acts of the audit client) and Rule 10A-1 thereunder.

As a result, if the auditor discovers or detects an illegal act during either a quarterly review or annual audit, and is required to report it pursuant to Section 10A, the auditor would not be eligible to earn credit forself-reporting.

Self-reporting is more valuable the earlier it is provided.

When firms or associated persons self-report to the PCAOB, the Board encourages them to self-report by directly contacting the Division of Enforcement and Investigations, or by providing information and documents via the Boards tips hotline: http://pcaobus.org/Enforcement/Tips/Pages/default.aspx

Remedial or Corrective Actions are voluntary, timely and meaningful actions designed to reduce the likelihood and risk that similar violations will recur, as well as actions to correct violative conduct.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 50

For example, a firm might earn credit by promptly and voluntarily modifying and improving its quality controls or other internal policies and procedures to prevent recurrence of the violative conduct.

A firm might take remedial or corrective action by re-assigning or limiting the activities of those individuals responsible for violations (which might include members of the audit team, as well as persons outside the audit team, including persons in firm management), and in appropriate cases by terminating or imposing discipline upon the responsible individuals.

A firms remedial or corrective action might also include promptly notifying its audit client or its audit committee (as appropriate) of the violative conduct and cooperating with the client, so that the client can (if necessary) take steps to comply with the federal securities laws and regulations (e.g., by engaging an auditor to re-audit the financial statements affected by an auditors independence violations).

A firms remedial or corrective action also might include appropriately compensating those adversely affected by the firms violations.

Substantial Assistance to the Boards investigative processes or to other law enforcement authorities includes timely and voluntarily providing information or documents that might not have been discovered absent that cooperation, or beyond that sought by the Boards staff via accounting board demands and requests, and beyond what is required pursuant to legal and regulatory reporting requirements.

For example, a firm might substantially assist the Board by conducting a timely, thorough, objective and competent internal investigation into the violative conduct when it was discovered, and informing the Divisions staff of the pertinent facts discovered in the internal investigation.

A firm or associated person might substantially assist another law enforcement authoritys investigative processes by self-reporting to that authority, or providing it with the facts discovered in an internal investigation.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 51

How might extraordinary cooperation be credited?

Credit for extraordinary cooperation in PCAOB matters may be reflected in a variety of ways.

Credit may be reflected by reducing charges and sanctions imposed in settlement against the cooperating firm or associated person.

Extraordinary cooperation could, in some cases, lead to language in settlement documents noting the cooperation and its positive effect on the final settlement by the firm or associated person.

In exceptional cases, depending on the facts and circumstances involved, the level of extraordinary cooperation could lead to no disciplinary action at all against a firm or associated person.

Other Factors

There exists some tension between the Boards interest in encouraging (and crediting) extraordinary cooperation and its interest in holding firms and associated persons fully accountable for their violative conduct.

The Boards cooperation policy is intended to balance that tension, encouraging cooperation with the Board and its staff while maintaining accountability for violative conduct.

Thus, whether a firm or associated person provided extraordinary cooperation is only one factor that will be considered in determining the appropriate disciplinary response to violative conduct.

Other factors also may impact the appropriate regulatory response to any particular violative conduct, including the nature of the misconduct and its root causes (including whether it was deliberate, the result of recklessness, negligence, or honest mistake), whether there were repeated violations or a pattern of misconduct, the duration of the misconduct, and the existence of prior disciplinary history.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 52

For firms, whether supervisors or firm management directed, tolerated or remained willfully blind to the violative conduct may impact the appropriate regulatory response.

Also for firms, self-policing and the implementation of quality controls prior to the discovery of the violative conduct, including the establishment of effective compliance procedures, an effective internal whistleblower and complaint system, and an appropriate tone at the top, may impact the appropriate regulatory response.

For associated persons, their role in the violative conduct and their knowledge, education, training, experience in auditing, and position of responsibility at the time the violations occurred may impact the appropriate regulatory response.

The specific facts and circumstances of each case will be considered to determine whether (and how) the firm or associated person should receive credit for extraordinary cooperation.

V. Conclusion

The PCAOB was established by Congress to oversee the audits of public companies (and broker-dealers) in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports.

Extraordinary cooperation can contribute significantly to those interests by, among other things, allowing the Board to address possible audit or other violations sooner, reducing the risk that such violative conduct will be repeated and result in more significant harm to investors, and assisting the Board in identifying audit reports that may be inaccurate.

Also, crediting extraordinary cooperation may shorten investigations and reduce the burdens on the Boards resources, thus allowing the Board to focus on other potential auditor misconduct for the protection of investors.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 53

Providing this guidance and publicly acknowledging extraordinary cooperation may encourage firms and associated persons to provide extraordinary cooperation, and may provide insights into how extraordinary cooperation is credited.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 54Solvency II: where are we now?

Although there is no certainty on the Solvency II implementation date, EU policymakers are continuing to finalise key aspects of the framework.

Recent developments include EIOPAs consultation on interim measures, the impact assessment of the long-term guarantee package and a debate on whether new legislation is needed formally to delay Solvency IIs application.

Solvency II implementation date

The legal position is that Member States must transpose the Solvency II Directive into national laws by 30 June 2013 and apply it to firms from 1 January 2014.

It is clear, however, that this Solvency II timetable is not feasible.

EU Member States cannot implement theSolvency II framework by the set dates, for the simple reason that it is not finalised.

A Member States failure to meet the legal implementation deadlines for Solvency II would mean that it was not complying with EU law and could have legal implications.

As a result, Member States are keen to ensure that further legislation amends the Solvency II Directive to postpone deadlines for Solvency II implementation on a formal basis.

This can be done by means of another quick-fix Directive, similar to the one adopted last summer, which established current transposition and implementation dates.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 55

Many people expect implementation to be put back to January 2016.

The European Commission, however, is resisting pressure to introduce another quick-fix, so as to encourage others in the EUs legislative process to agree the Omnibus II Directive as a priority.

Instead, the Commission proposes to produce a letter of comfort to Member States confirming that it will not commence proceedings against them for failure to implement Solvency II.

The discussion is ongoing and we are monitoring it.

EIOPAs consultation on Solvency II interim measures

Although the Solvency II legislative process is delayed, EIOPA believes that the insurance industry should build on preparatory work already undertaken.

In addition the IMFs Financial Sector Assessment Programme (FSAP) review of the EU concluded that early harmonised implementation of Solvency II would reduce risks arising from the current regime.

EIOPA has therefore published a set of consultation documents proposing to introduce some core Solvency II provisions in advance of the formal deadline (still to be confirmed).

EIOPAs guidelines are addressed to national supervisors and cover the following areas:

System of governance

A forward looking assessment of the undertakings own risks (based on the ORSA)

Submission of information to national supervisors (reporting requirements)

Pre-application for internal modelsInternational Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 56

Lloyds is reviewing the guidelines and contributing to the debate at UK and EU levels.

Many insurers are most concerned about EIOPAs proposed reporting requirements, which look very onerous.In a related development, the European Central Bank (ECB) plans to pass a Regulation enabling it to collect information from insurers for financial stability and statistical purposes.The ECB is working with EIOPA and, so far as possible, will rely on data collected through the Solvency II reporting templates.In the interim period, before Solvency II is implemented, it probably will not require insurers to report any additional data.Longer-term, however, its requirements may become more extensive.Legally, this Regulation will apply to Eurozone Member States only, although central banks in other Member States may decide to impose similar reporting requirements.It is unclear what position the Bank of England will take.Impact assessment of the long-term guarantee package

Last years debates on the long-term guarantee package proved inconclusive and the Commission decided to conduct an impact assessment to inform Omnibus IIs development.EIOPA launched the assessment in January 2013: insurers had until the end of March 2013 to submit information.

Lloyds did not participate due to the issues limited relevance to most of Lloyds business.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 57

EIOPA is expected to publish a report with its findings in June this year, followed by a communication from the Commission.

Parliament has scheduled a vote on the Omnibus II Directive for 22 October 2013.

This is indicative only, but suggests the deadline by which agreement on the long-term guarantee package should be reached.Compromises over the long-term guarantee package and subsequent adoption of the Omnibus II Directive are important to the Solvency II implementation timeline.If agreement is not reached and the Directive is not finalised in 2013, this is likely to delay Solvency II implementation beyond the expected deadline of January 2016.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 58Policy Statement Conducting statutory investigations

Introduction

The Prudential Regulation Authority (PRA) is required, under the Financial Services Act 2012 (the Act), to investigate and report to HM Treasury on possible regulatory failure and matters of public interest.

This statement fulfils the requirement, under section 80 of the Act, for the PRA to describe how it will discharge its functions in carrying out investigations and for identifying where regulatory failure has occurred.

It has been approved for publication by the PRA and HM Treasury.

Statutory provisions The PRAs objectives

The PRA has two statutory objectives:

to promote the safety and soundness of PRA-authorised firms, primarily by seeking to minimise the adverse effect their failure could have on the stability of the UK financial system, and by seeking to ensure that they carry on their business in a way that avoids any adverse effect on the stability of the UK financial system; and

for insurers, to contribute to the securing of an appropriate degree of protection for those who are or may become policyholders.

4. Consistent with those objectives, it is not the PRAs role to ensure that no PRA-authorised firm fails, as made clear in section 2G of the Financial Services and Markets Act 2000 (FSMA).International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 59

As described in the PRAs policy documents on its approach to prudential supervision, the PRAs supervision will be driven by its statutory objectives. The objectives will also act as guiding principles for the PRA in identifying regulatory failure.

The PRAs duty to undertake statutory investigations

There are three broad circumstances in which the PRA is required under the Act to conduct a statutory investigation:

where it appears to the PRA that a serious regulatory failure has occurred; or

where it appears to HM Treasury that a serious regulatory failure has occurred; or

where HM Treasury considers an investigation to be in the public interest.

As required by the Act, this paper sets out how the PRA will identify whether the conditions for an investigation into regulatory failure are met, and how it will carry out investigations both into regulatory failure and matters of public interest.

Identifying regulatory failure

Reflecting the PRAs statutory objectives, the Act sets out three conditions which trigger the requirement for an investigation into regulatory failure by the PRA:

Public expenditure where relevant public expenditure has been incurred in respect of a PRA-authorised firm and might not have been incurred but for a serious failure in the scope or design of the system of regulation or the operation of that system; or

Safety or soundness where events have occurred which had, or could have had, a significant adverse effect on the safety or soundness ofInternational Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 60

one or more PRA-authorised firms, which might not have occurred, or the effect of which might have been reduced, but for a serious failure in the scope or design of the system of regulation or the operation of that system; or

(c) Policyholder protection where events have occurred, relating to the effecting and carrying out of contracts of insurance by a PRA-authorised firm, which indicate a significant failure to secure an appropriate degree of protection for policyholders, which might not have occurred, or the effect of which might have been reduced, but for a serious failure in the scope or design of the system of regulation or the operation of that system.

Should it appear to the PRA that any of these three conditions have been met, the PRA will be required to investigate the events in question and the circumstances surrounding them.

The PRA must report to HM Treasury on its findings and, subject to some restrictions as described below, this report must be published.

An investigation into regulatory failure may also be required in connection with the Lloyds insurance market, in which case the requirements will be the same as the above save that they will refer respectively to:

relevant public expenditure that has been incurred in respect of a member of the Society of Lloyds;

events which had, or could have had, a significant adverse effect on the safety or soundness of the Society of Lloyds and its members, taken together; and

events relating to the effecting and carrying out of contracts of insurance by the Society of Lloyds or any other person who carries on PRA-regulated activities in relation to anything done at Lloyds, which indicate a significant failure to secure an appropriate degree of protection to policyholders.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 61

How the PRA will identify regulatory failure

11. In order to determine whether the conditions for an investigation into regulatory failure have been met, the PRA must:

assess whether relevant public expenditure, significant adverse effects on safety or soundness, or significant failure to secure an appropriate degree of policyholder protection have occurred; and

assess whether those events were the result of a serious failure of the regulatory system or its operation.

If the PRA determines that both (i) and (ii) are satisfied, an investigation into regulatory failure will be required.

The fact that investigations will not be triggered automatically by relevant events reflects the important principle, rooted in the PRAs objectives, that it is not the PRAs role to prevent all firm failures, nor to protect all policyholders in full in all circumstances.

The matters which the PRA will take into account in its assessment of whether an investigation into regulatory failure is required are outlined below.

Relevant public expenditure

Relevant public expenditure is defined by the Act, as being in broad terms:

financial assistance provided, or expenditure incurred, by HM Treasury in respect of a PRA-authorised firm, for the purpose of resolving or reducing a threat to the stability of the UK financial system.

This may include, for example, an injection of capital or funding into, or the provision of a guarantee to, a major insurer to prevent it