1. P a g e | 1International Association of Risk and
ComplianceProfessionals (IARCP)1200 G Street NW Suite 800
Washington, DC 20005-6705 USATel: 202-449-9750
www.risk-compliance-association.comTop 10 risk and compliance
management related news storiesand world events that (for better or
for worse) shaped theweeks agenda, and what is nextDear Member,I
had a difficult time in thepast to explainliquidityrisk management
and ratios.Now I know what todo. Problem solved!I will use a
pollution-mitigatingtechnology, likescrubberstoexplain
liquidityrisk.Mr. JeremyC Stein, Memberof the Board of Governorsof
the Federal Reserve System explainedhow:Supposewehave a powerplant
that producesenergyand, asa byproduct, somepollution.Supposefurther
that regulatorswant toreducethepollutionand have twotoolsat their
disposal:Theycan mandatethe useof a pollution-mitigatingtechnology,
like scrubbers, or theycanlevyatax ontheamount of pollution
generatedby theplant.In an ideal world, regulation
wouldaccomplishtwoobjectives.First, it wouldlead toan optimal level
of mitigation that is, it wouldinducethe plant toinstall scrubbers
up tothe point wherethecostof anInternational Association of Risk
and Compliance Professionals
(IARCP)www.risk-compliance-association.com
2. P a g e | 2additional scrubber isequal to themarginal
socialbenefit, in terms ofreducedpollution.And, second, it
wouldalsopromote conservation:Giventhat thescrubbersdont get rid of
pollutionentirely, onealsowantstoreduceoverall energyconsumption
bymaking it more expensive.Asimplecaseis onein whichthe costsof
installingscrubbers,aswellasthesocial benefits of reducedpollution,
are knownin advanceby theregulator and themanager of the
powerplant.In this case, the regulatorcan figure out what theright
number ofscrubbersis and require that theplant install
thesescrubbers.Themandate can thereforepreciselytarget the optimal
amount ofmitigation per unit of energy produced.And, to the extent
that the scrubbers are costly, the mandate will alsoleadto higher
energy prices, which will encourage some conservation,
thoughperhapsnot the sociallyoptimal level.This latter effect isthe
implicit tax aspect of themandate.Amore complicatedcaseis when the
regulator doesnot know ahead oftimewhat the costsof building and
installingscrubberswill be.Here, mandatingtheuse of a fixednumber
of scrubbersispotentiallyproblematic:If the scrubbersturn out tobe
very expensive, the regulation will end upbeingmore
aggressivethansociallydesirable,leadingto overinvestmentin
scrubbersand largecostincreasesfor consumers;however, if
thescrubbersturn out tobe cheaper than expected, theregulation will
havebeen too soft.International Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
3. P a g e | 3In otherwords,
whenthecostofthemitigationtechnologyissignificantlyuncertain, a
regulatory approachthat fixesthe quantityof mitigationisequivalent
toone wherethe implicit tax rate bouncesaround a lot.Bycontrast,
aregulatoryapproachthat fixesthepriceof pollutioninsteadof the
quantity say, by imposing a predeterminedproportional tax
ratedirectlyon the amount of pollution emittedby the plant is
moreforgivingin the faceof this kind of uncertainty.This approach
leaves the scrubber-installation decision to the manager ofthe
plant, who can figure out what the scrubbers cost before deciding
howtoproceed.For example, if thescrubbers turn out to be
unexpectedlyexpensive, theplant manager can install fewer of
them.This flexibilitytranslatesintolessvariabilityin
theeffectiveregulatoryburden and hence lessvariabilityin the price
of energy toconsumers.Scrubbers and high-quality liquid assetsWhat
doesall thisimplyfor the designof the LCR?Lets workthrough
theanalogyin detail.Theanalog to the powerplants energyoutput is
the grossamount ofliquidityservicescreatedby a bank via its
deposits,thecredit linesitprovidesto itscustomers, the prime
brokerage servicesit offers,and soforth.Theanalog to
themitigationtechnology the scrubbers is the stock ofHQLA that the
bank holds.And the analogto pollution is thenet
liquidityriskassociated with
thedifferencebetweenthesetwoquantities, somethingakin to the
LCRshortfall.That is,whenthebank offersalot of liquidityondemand
toitscustomersInternational Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
4. P a g e | 4but fails tohold an adequatebuffer of HQLA, this
is whenit imposesspillover costson the rest of thefinancial
system.In the caseof thepowerplant, I argued that a regulation that
callsfor afixed quantityof mitigation that is, for a fixednumber of
scrubbers ismore attractivewhenthere is littleuncertainty about
thecost of thesescrubbers.Thank you Jeremy!I have justopenedmy
master plan. I have to learn more about scrubbers.I now see other
similaritiesbetweentheBISand scrubbers. Onlynow Ican understand
theshapeof the BISbuilding!I think I have just found another
regulatoryarbitrageopportunity. Arealnational discretion,
justified.Scrubbersarecapableof reduction efficienciesin the
rangeof 50% to98%. Why should theLiquidityCoverageRatiobe 100%?ALCR
from 50% to98% (meaning50,001%) is good enough!International
Association of Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
5. P a g e | 5Thecalculationsin Basel and scrubbersare
alsoalmost thesame!Read moreat Number 1below.Welcometo the Top
10list.BestRegards,GeorgeLekatisPresident of the IARCPGeneral
Manager, ComplianceLLC1200G Street NW Suite800,Washington
DC20005,USATel: (202) 449-9750Email:
[email protected]:
www.risk-compliance-association.comHQ: 1220N. Market Street
Suite804,Wilmington DE 19801,USATel: (302) 342-8828International
Association of Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
6. P a g e | 6Liquidity regulation and central bankingSpeechby
Mr Jeremy C Stein, Member of the Boardof Governorsof theFederal
Reserve System, at theFinding theright balance 2013Credit
MarketsSymposium, sponsored by theFederal Reserve Bankof Richmond,
Charlotte, North CarolinaBasel III Capital: AWell-Intended
IllusionThomasM. Hoenig, Vice Chairman, Federal
DepositInsuranceCorporation, InternationalAssociation ofDeposit
Insurers, 2013ResearchConference, Basel,SwitzerlandAristotleis
creditedwithbeingthe first philosophertosystematicallystudylogical
fallacies, whichhedefinedasargumentsthat appearvalid but, in fact,
arenot.I call them well-intendedillusions.Onesuch illusion of
precision is the Basel capital standardsin whichworldsupervisory
authoritiesrely principallyon a Tier 1capital ratiotojudgethe
adequacyof bank capital and balance sheet strength.PCAOB
IssuesPolicy Statement onExtraordinary Cooperation in
Connectionwith Board InvestigationsWashington, DCInternational
Association of Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
7. P a g e | 7ThePublic CompanyAccounting Oversight Boardtoday
publishedaformal statement concerningthebenefitsthat may be
availabletoregisteredpublic accounting firms and
individualswhoprovideextraordinarycooperation in PCAOB
investigations.Solvency II: whereare we now?Although there is
nocertaintyon theSolvencyII implementationdate, EU policymakers are
continuingtofinalisekey aspectsof theframework.Policy
StatementConducting statutoryinvestigationsThePrudential
RegulationAuthority (PRA) is required, under theFinancial
ServicesAct 2012(theAct), to investigateand report to HMTreasuryon
possibleregulatory failureand mattersof public interest.Commission
report underlines importanceand urgency of financial sector reforms
asabasis to restore long-term growthThe European Commission is
publishing today the European FinancialStability and Integration
Report (EFSIR), which is being presented at ajoint conferencewith
the European Central Bank (ECB) in Brussels.International
Association of Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
8. P a g e | 8Statement on the 2013PCAOB
AcademicConferenceJeanette M. Franzel, Board Member2013 PCAOB
Academic ConferenceWashington, D.C.The importance of culture in
drivingbehavioursof firms and how the FCA willassessthisSpeechby
CliveAdamson, Director of Supervisionat theCFA Society -UK
ProfessionalismConference19April 2013,London.Lessons for South
Africa from Germany in achallenging global environmentAddress by
MsGill Marcus,Governor of theSouthAfrican Reserve Bank, at
theSouthernAfrican-German Chamber of Commerceand Industryluncheon,
JohannesburgThe journey of financial reformAddress by Mr Philip
Lowe,DeputyGovernor of theReserveBank ofAustralia, totheAustralian
Chamber of Commercein Shanghai.International Association of Risk
and Compliance Professionals
(IARCP)www.risk-compliance-association.com
9. P a g e | 9Liquidity regulation and centralbankingSpeechby
Mr Jeremy C Stein, Member oftheBoard of Governorsof
theFederalReserveSystem, at the Finding the rightbalance 2013Credit
MarketsSymposium, sponsored by theFederalReserve Bank ofRichmond,
Charlotte, North CarolinaId like to talk todayabout one important
element of the internationalregulatoryreform agenda namely,
liquidityregulation.Liquidityregulation is a relativelynew,
post-crisisaddition tothefinancial stabilitytoolkit.Key
elementsincludethe LiquidityCoverage Ratio (LCR),
whichwasrecentlyfinalizedbythe Basel Committeeon Banking
Supervision, andthe Net StableFundingRatio, whichis still a workin
progress.In what follows, I will focuson the LCR.Thestated goal of
the LCR is straightforward, even if some aspectsof itsdesignare
lessso.In the wordsof theBasel Committee, Theobjectiveof theLCR is
topromotetheshort-term resilienceof theliquidityrisk profile of
banks.It doesthis by ensuringthat bankshavean adequatestock
ofunencumberedhigh-qualityliquid assets(HQLA) that can be
convertedeasilyandimmediatelyin privatemarketsintocashtomeettheir
liquidityneedsfor a 30 calendar day liquiditystressscenario.In
other words,each bank isrequired to model its total outflowsover
30days in a liquiditystressevent and then tohold HQLA sufficient
toInternational Association of Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
10. P a g e | 10accommodatethoseoutflows.This requirement
isimplemented witha ratio test, wheremodeledoutflowsgo in
thedenominator and the stock of HQLA goesin
thenumerator;whentheratio equalsor exceeds100percent,
therequirementis satisfied.TheBasel Committeeissued the first
versionof the LCR in December2010.In January of thisyear,
thecommitteeissueda revisedfinal version of theLCR, followingan
endorsement byitsgoverningbody, theGroup ofGovernorsand Headsof
Supervision (GHOS).Therevision expandsthe rangeof assetsthat can
count asHQLA andalsoadjustssomeof the assumptionsthat govern
themodeling of netoutflowsin a stressscenario.In addition,
thecommitteeagreed in January toa gradual phase-in of theLCR,
sothat it only becomesfullyeffectiveon an international
basisinJanuary 2019.On thedomesticfront, theFederal Reserve
expectsthat theU.S. bankingagencieswill issuea proposal later this
year to implement theLCR forlargeU.S.bankingfirms.While
thisprogressiswelcome, a number of questionsremain.First, towhat
extent should accesstoliquidityfrom a central bank beallowedto
count towardsatisfying theLCR?In January, the GHOS noted that
theinteraction betweentheLCR andtheprovision of central bank
facilitiesiscriticallyimportant.And the group instructedthe Basel
Committeeto continueworkingonthisissuein 2013.International
Association of Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
11. P a g e | 11Second, what stepsshould be taken to enhancethe
usability of the LCRbuffer that is, toencouragebanksto actuallydraw
down their HQLAbuffers,asopposed tofire-sellingother lessliquid
assets?TheGHOShasalsomadeclear itsview that, during periodsof
stress,itwouldbe appropriatefor banksto usetheir HQLA,
therebyfallingbelowtheminimum.However,creatinga regimein whichbanks
voluntarilychooseto dosoisnot an
easytask.Anumberofobservershaveexpressedtheconcernthat if abank
isheldtoan LCR standard of 100percent in normal times,it may be
reluctant toallowitsratioto drop below 100percent whenfacing
largeoutflows, evenif regulatorswereto permit this temporary
deviation, for fear that adeclinein the ratiocould be
interpretedasa sign of weakness.My aim
hereistosketchaframeworkforthinkingabout
theseandrelatedissues.Among them, theinterplay betweentheLCR and
central bank
liquidityprovisionisperhapsthemostfundamentalandanatural
startingpoint fordiscussion.Bywayofmotivation, notethat
beforethefinancialcrisis, wehadahighlydeveloped regime of capital
regulationfor banks albeit onethat looksinadequatein retrospect but
wedid not have formal regulatorystandardsfor their
liquidity.Theintroduction of liquidityregulation after the
crisiscan be thought ofasreflectinga desire to reducedependenceon
the central bank asalender of last resort (LOLR), basedon
thelessonslearned over thepreviousseveral years.However,to the
extent that some role for the LOLR still remains,onenow facesthe
questionof how it should coexistwith a regime of
liquidityregulation.International Association of Risk and
Compliance Professionals
(IARCP)www.risk-compliance-association.com
12. P a g e | 12Toaddressthis question, it is useful to take a
step back and ask anotherone:What underlying market failure is
liquidityregulation intendedtoaddress, and whycant this market
failurebe handledentirelyby anLOLR?I will turn to this
questionfirst.Next, I will considerdifferent mechanismsthat could
potentiallyachievethegoalsof liquidityregulation, and how
thesemechanismsrelate tovariousfeaturesof theLCR.In sodoing, I hope
toillustratewhy, even though liquidityregulation is aclosecousin of
capital regulation, it neverthelesspresentsa number ofnovel
challengesfor policymakers and why, asa result, weare going
tohaveto be opentolearningand adaptingaswego.The case for liquidity
regulationOneof theprimary economic functionsof banksand other
financialintermediaries,suchasbroker-dealers,is to provideliquidity
thatis,cash on demand in variousforms totheir customers.Someof
thisliquidityprovisionhappenson the liability sideof
thebalancesheet, withbank demand depositsbeinga leadingexample.But,
importantly, banks alsoprovide liquidityvia committed
linesofcredit.Indeed, it isprobablynot
acoincidencethatthesetwoproducts demanddepositsand credit lines are
offered under the roof of the sameinstitution;theunderlying
commonalityis that both require an
abilitytoaccommodateunpredictablerequestsfor cash on short
notice.Anumber of other financial intermediaryservices,such
asprimebrokerage, alsoembodya significant element of
liquidityprovision.Without question,
theseliquidity-provisionservicesare sociallyvaluable.International
Association of Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
13. P a g e | 13On the liabilityside, demand depositsand other
short-term bankliabilitiesaresafe,easy-to-valueclaimsthat
arewellsuitedfor transactionpurposesand hencecreatea flowof
money-like benefitsfor their holders.And loancommitmentsare more
efficient than an arrangement in whicheachoperatingfirm
hedgesitsfutureuncertainneedsbypre-borrowingandhoarding
theproceedson itsown balancesheet;this latterapproachdoesa poor job
of economizingon the scarceaggregate supplyof liquidassets.At
thesametime, asthefinancial crisismadepainfullyclear, thebusinessof
liquidityprovision inevitablyexposesfinancial
intermediariestovariousforms of run risk.That is, in
responsetoadverse events,their fragile fundingstructures, together
withthe binding liquiditycommitmentstheyhavemade, can result in
rapid outflowsthat, absent central bankintervention, lead
bankstofire-sellilliquid assetsor, in a more severecase,to fail
altogether.And fire salesand bank failures and theaccompanying
contractionsincredit availability can have spillover effectstoother
financialinstitutionsand to the economy asa whole.Thus, while
bankswill naturallyhold buffer stocksof liquid
assetstohandleunanticipatedoutflows, theymay not hold
enoughbecause,although theybear all the costsof this buffer
stocking, they donot capture all of thesocial benefits, in termsof
enhancedfinancialstabilityand lowercoststotaxpayers in theevent of
failure.It is this externalitythat createsa role for
policy.Therearetwobroadtypesof policytoolsavailabletodeal
withthissortofliquidity-basedmarket failure.Thefirst
isafter-the-fact intervention, either by a deposit
insurerguaranteeingsome of thebanksliabilitiesor by a central bank
actingasan LOLR.International Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
14. P a g e | 14Thesecond type isliquidityregulation.As an
exampleof theformer, whenthe economy isin a badstate, assumingthat
aparticularbank isnot insolvent, thecentralbank canlendagainst
illiquidassetsthat wouldotherwisebefire-sold,therebydampingor
eliminatingthe run dynamics and helpingreducetheincidenceof bank
failure.In much of theliteratureon banking, such interventionsare
seen astheprimarymethod for dealing
withrun-likeliquidityproblems.Aclassicstatement of the central
banksrole asan LOLR is WalterBagehots1873book Lombard
Street.Morerecently, the seminal theoretical treatment of this
issueis byDouglasDiamond and Philip Dybvig, whoshow that under
certaincircumstances, the useof deposit insuranceor an LOLR can
eliminaterun risk altogether, therebyincreasingsocial welfareat
zero cost.Tobeclear, thisworkassumesthat thebank in
questionisfundamentallysolvent, meaning that whileitsassetsmay not
be liquid on shortnotice,the long-run valueof these
assetsisknownwith certaintytoexceed thevalue of
thebanksliabilities.Onewaytointerpret themessageof this research is
that capital regulationis important toensuresolvency, but oncea
reliableregime ofcapitalregulation is in place,
liquidityproblemscan bedealt with after thefact, via
somecombinationofdepositinsuranceanduseof theLOLR.It followsthat if
one is goingtomake an argument in favor of
addingpreventativeliquidityregulation such asthe LCR on top of
capitalregulation, a central premisemust be that the use of LOLR
capacityin acrisisscenario is sociallycostly, sothat it is an
explicit objectiveof policytoeconomize on itsusein such
circumstances.I think this premiseis a sensibleone.International
Association of Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
15. P a g e | 15Akey point in this regard and one that hasbeen
reinforcedby theexperienceof thepast several years is that the
linebetweenilliquidityand insolvencyisfar blurrier in real life
than it is sometimesassumed tobein theory.Indeed, one might argue
that a bank or broker dealer that experiencesaliquiditycrunch must
havesomeprobability of havingsolvencyproblemsaswell;otherwise,it is
hard toseewhyit could not attract short-termfundingfrom the private
market.This reasoningimplies that when thecentral bank actsasan
LOLR in acrisis, it necessarilytakeson some amount of credit
risk.And if it experienceslosses,theselossesultimatelyfall
ontheshouldersoftaxpayers.Moreover,theuseof an LOLR to support
banks whenthey get intotroublecan lead tomoral hazard problems, in
thesensethat banksmaybelessprudent ex ante.If it werenot for
thesecostsof usingLOLR capacity, the problem wouldbe trivial, and
there wouldbenoneed for liquidityregulation:Assuming a
well-functioningcapital-regulationregime, the central
bankcouldalwaysavert all firesalesand bank failuresexpost,
simplybyactingasan LOLR.This observationcarries an immediate
implication:It makes no senseto allowunpriced accessto thecentral
banksLOLRcapacityto count toward an LCR requirement.Again, the
wholepoint of liquidityregulation must be either toconserveon
theuseof theLOLR or in the limit, to addresssituationswheretheLOLR
is not availableat all as, for example, in the
caseofbroker-dealersin theUnitedStates.At thesametime, it
isimportant todraw adistinctionbetweenpriced andunpriced accessto
the LOLR.International Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
16. P a g e | 16For example, takethecaseofAustralia,
whereprudent fiscal policy hasledto a relatively small stock of
government debt outstandingand hencetoa potential shortageof
HQLA.TheBasel Committeehasagreed totheusebyAustralia of a
CommittedLiquidityFacility (CLF), wherebyanAustralianbank
canpaytheReserveBank ofAustralia an upfront fee for what is
effectivelya loancommitment, and this loan commitment can then be
countedtowarditsHQLA.In contrast to free accesstotheLOLR, this
approachisnot at oddswiththegoalsof
liquidityregulationbecausetheup-front feeis effectively atax that
servestodeter relianceon the LOLR which, again, is
preciselytheultimategoal.I will return tothe ideaof a CLF
shortly.The design of regulationOnceit hasbeen decided that
liquidityregulationis desirable, thenextquestion ishow best
toimplement it.In this context, notethat the LCR
hastwologicallydistinct aspectsasaregulatorytool:It is a mitigator,
in thesense that holdingliquid assetsleadstoa betteroutcome if
there is a bad shock; it is alsoan implicit tax on
liquidityprovision by banks, tothe extent that
holdingliquidassetsiscostly.Of course,one can say
somethingbroadlysimilar about capitalrequirements.But the implicit
tax associated withtheLCR is subtler and lesswellunderstood, soI
will go intosome detail here.An analogymay help to
explain.International Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
17. P a g e | 17Supposewehaveapowerplant that
producesenergyand, asabyproduct, some pollution.Supposefurtherthat
regulatorswant toreducethepollutionandhavetwotoolsat their
disposal:Theycan mandatethe useof a pollution-mitigatingtechnology,
likescrubbers,or theycan levya tax on theamount of pollution
generatedbythe plant.In an ideal world, regulation
wouldaccomplishtwoobjectives.First, it wouldlead toan optimal level
of mitigation that is, it wouldinducethe plant toinstall scrubbers
up tothe point wherethecostof anadditional scrubber isequal to
themarginal socialbenefit, in terms ofreducedpollution.And, second,
it wouldalsopromote conservation:Giventhat thescrubbersdont get rid
of pollutionentirely, onealsowantstoreduceoverall energyconsumption
bymaking it more expensive.Asimplecaseis onein whichthe costsof
installingscrubbers,aswellasthesocial benefits of reducedpollution,
are knownin advanceby theregulator and themanager of the
powerplant.In this case, the regulatorcan figure out what theright
number ofscrubbersis and require that theplant install
thesescrubbers.Themandate can thereforepreciselytarget the optimal
amount ofmitigation per unit of energy produced.And, to the extent
that the scrubbers are costly, the mandate will alsoleadto higher
energy prices, which will encourage some conservation,
thoughperhapsnot the sociallyoptimal level.This latter effect isthe
implicit tax aspect of themandate.International Association of Risk
and Compliance Professionals
(IARCP)www.risk-compliance-association.com
18. P a g e | 18Amore complicatedcaseis when the regulator
doesnot know ahead oftimewhat the costsof building and
installingscrubberswill be.Here, mandatingtheuse of a fixednumber
of scrubbers ispotentiallyproblematic:If the scrubbersturn out tobe
very expensive, the regulation will end upbeingmore
aggressivethansociallydesirable,leadingto overinvestmentin
scrubbersand largecostincreasesfor consumers;however, if
thescrubbersturn out tobe cheaper than expected, the regulationwill
havebeen too soft.In otherwords,
whenthecostofthemitigationtechnologyissignificantlyuncertain, a
regulatory approachthat fixesthe quantityof mitigationisequivalent
toone wherethe implicit tax rate bouncesaround a lot.Bycontrast,
aregulatoryapproachthat fixesthepriceof pollutioninsteadof the
quantity say, by imposing a predeterminedproportional tax
ratedirectlyon the amount of pollution emittedby the plant is
moreforgivingin the faceof this kind of uncertainty.This approach
leaves the scrubber-installation decision to the manager ofthe
plant, who can figure out what the scrubbers cost before deciding
howtoproceed.For example, if thescrubbers turn out to be
unexpectedlyexpensive, theplant manager can install fewer of
them.This flexibilitytranslatesintolessvariabilityin
theeffectiveregulatoryburden and hence lessvariabilityin the price
of energy toconsumers.Scrubbers and high-quality liquid assetsWhat
doesall thisimplyfor the designof the LCR?Lets workthrough
theanalogyin detail.Theanalog to the powerplants energyoutput is
the grossamount ofliquidityservicescreatedby a bank via its
deposits,thecredit linesitInternational Association of Risk and
Compliance Professionals
(IARCP)www.risk-compliance-association.com
19. P a g e | 19providesto itscustomers, the prime brokerage
servicesit offers,and soforth.Theanalog to themitigationtechnology
the scrubbers is the stock ofHQLA that the bank holds.And the
analogto pollution is thenet liquidityriskassociated with
thedifferencebetweenthesetwoquantities, somethingakin to the
LCRshortfall.That is,whenthebank offersalot of liquidityondemand
toitscustomersbut fails tohold an adequatebuffer of HQLA, this is
whenit imposesspillover costson the rest of thefinancial system.In
the caseof thepowerplant, I argued that a regulation that callsfor
afixed quantity of mitigation that is, for a fixednumber of
scrubbers ismore attractivewhenthere is littleuncertainty about the
costof thesescrubbers.In the context of the LCR, the cost of
mitigation is the premium that thebank must pay in the form of
reduced interest income for itsstock ofHQLA.And, crucially, this
HQLA premium is determined in market equilibriumand dependson the
total supplyof safe assetsin the system, relative tothedemand for
thoseassets.On the onehand, if safeHQLA-eligibleassetsare in ample
supply, thepremium is likelytobe low and stable.On the other hand,
if HQLA-eligible assetsare scarce, thepremium willbeboth higher and
more volatile over time.This latter situation is the one facing
countrieslike Australia, where, as Inoted earlier, the stock of
outstanding government securities is relativelysmall.International
Association of Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
20. P a g e | 20And it explainswhy, for such countries,havinga
price-basedmechanismaspart of their implementationof the LCR can be
more appealingthanpure relianceon a quantitymandate.When one sets
an up-front fee for a CLF, one effectively caps the implicittax
associated with liquidity regulation at the level of the commitment
feeand tamps down the undesirable volatility that would otherwise
arise froman entirelyquantity-based regime.Moreover,it
bearsreemphasizingthat havinga CLF withanup-front feeis very
different from simplyallowingbankstocount central - bank
-eligiblecollateral asHQLA at no charge.Rather, the CLF is like the
pollution tax.For every dollar of pre-CLF shortfall that is, for
every dollar of requiredliquidity that a bank cant obtain on the
private market the bank has topaythe commitment fee.Soeven if there
isnot asmuch mitigation, thereis still an incentiveforconservation,
in thesensethat banks areencouragedto dolessliquidityprovision, all
elsebeingequal.This wouldnot be thecaseif the CLF wereavailableat a
zeroprice.What about the situation in
countrieswheresafeassetsaremoreplentiful?Theanalysis here hasa
number of moving parts becausein addition totheimplementationof the
LCR, substantial increasesin demand for safeassetswill arise from
new margin requirementsfor both
clearedandnonclearedderivatives.Nevertheless,giventhelargeandgrowingglobalsupplyofsovereigndebtsecurities,aswellasother
HQLA-eligibleassets,most estimatessuggestthat the scarcityproblem
should be manageable, at least for
theforeseeablefuture.International Association of Risk and
Compliance Professionals
(IARCP)www.risk-compliance-association.com
21. P a g e | 21In particular, quantitativeimpact
studiesreleasedby the BaselCommitteeestimatethat the worldwide
incremental demand for HQLAcomingfrom both the implementationof the
LCR and swapmarginrequirementsmight be on the order of $3
trillion.This is a largenumber, but it compareswith a global
supplyofHQLA-eligibleassetsof more than $40trillion.Moreover,the
eligiblecollateral for swapmargin is proposedtobebroader than
theLCRs definition of HQLA including, forexample,certain
equitiesand corporatebondswithout any cap.If one focusesjust on
U.S.institutions,theincremental demand numberis on the order of
$1trillion, while the sum of Treasury, agency,
andagencymortgage-backedsecuritiesis more than $19trillion.While
this sort of analysisissuperficiallyreassuring, thefact
remainsthattheHQLA premium will depend on market-equilibrium
considerationsthat are hard to fullyfathom in advance, and that are
likely tovary overtime.This uncertaintyneedsto beunderstood, and
respected.Indeed, themarket-equilibriumaspect of
theproblemrepresentsacrucialdistinctionbetweencapital regulationand
liquidityregulation, and it isonereasonwhythelatter isparticularly
challengingtoimplement.Although capital regulationalsoimposesa tax
on banks tothe extentthat equityisamore expensiveform of
financethandebt thistax wedgeis,toafirstapproximation, afixed
constant foragivenbank, independentof the scaleof overall financial
intermediation activity.If Bank Adecidestoissuemore equitysoit can
expand itslendingbusiness,this need not make it more expensivefor
Bank B tosatisfyitscapital requirement.In other words,thereis
noscarcityproblem withrespect to bank equity bothAand B can always
make more.International Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
22. P a g e | 22Bycontrast, thetotal supplyof HQLA
isclosertobeingfixedat anypointin time.Policy implicationsWhat
doesall of this implyfor policydesign?First, at a
broadphilosophical level, the recognitionthat liquidityregulation
involvesmore uncertaintyabout coststhancapital
regulationsuggeststhat even apolicymaker witha very strict
attitudetowardcapitalmight find it sensibleto besomewhat more
moderate and flexiblewithrespect toliquidity.This point is
reinforced by the observationthat whenan institutionisshort of
capitalandcant get moreontheprivatemarket, thereisreallynobackup
plan, short of resolution.By contrast, asI mentioned earlier,
whenan institution isshort ofliquidity, policymakers do have a
backup plan in the form of theLOLRfacility.Onedoesnot want
torelytoomuch on that backup plan, but itspresenceshould
neverthelessfactor intothedesign of liquidityregulation.Second, in
thespirit of flexibility, while aprice-basedmechanism such astheCLF
may not beimmediatelynecessaryin countriesoutsideofAustralia and a
few others,it is worthkeepingan open mind about themore
widespreaduse of CLF-like mechanisms.If a scarcityof HQLA-eligible
assetsturnsout tobe more of a problemthan weexpect, somethingalong
thoselineshasthepotential to be auseful safetyvalve, asit putsa cap
on thecostof liquidityregulation.Such a safety valvewouldhave a
direct economicbenefit, in thesenseofpreventingtheburdenof
regulationfrom gettingundulyheavyin anyonecountry.International
Association of Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
23. P a g e | 23Perhapsjust asimportant, a safetyvalvemight
alsohelp to protect theintegrityof the regulation itself, by
harmonizingcostsacrosscountriesandtherebyreducingthetemptationofthosemosthard-hit
bytherulestotry tochip awayat them.Without suchasafetyvalve, it
ispossiblethat somecountries thosewithrelativelysmall suppliesof
domestic HQLA will find the regulationconsiderably more costlythan
others.If so, it wouldbenatural for them to lobbyto dilutetherules
forexample, by arguingfor an expansion in thetype of assetsthat can
countasHQLA.Taken toofar, this sort of dilution wouldunderminethe
efficacyof theregulation asboth amitigatorand a tax.In this
scenario, holdingthe linewithwhat amountstoa proportional taxon
liquidityprovision wouldbe a better outcome.Onesituation
whereliquid assetscan becomeunusuallyscarceis duringa financial
crisis.Consequently, evenif CLFs werenot counted towardtheLCR in
normaltimes,it might be appropriatetocount them during a
crisis.Indeed, while theLCR requires banks tohold sufficient liquid
assetsingood timestomeet their outflowsin a givenstressscenario, it
implicitlyrecognizesthat if thingsturn out even worsethanthat
scenario, centralbank liquiditysupport will be needed.AllowingCLFs
tocount toward theLCR in such circumstanceswouldacknowledgethe
importanceof accesstothecentral bank, and thisaccesscould be priced
accordingly.Finally, a price-based mechanism might alsohelp promote
a willingnessof banksto draw down their supplyof HQLA in a
stressscenario.International Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
24. P a g e | 24As I noted at the outset, one important concern
about a pure quantity-based system of regulation isthat if a bank
is held toan LCR standard of100percent in normal times,it may be
reluctant toallowitsratio tofallbelow 100percent
whenfacinglargeoutflowsfor fear that doing somightbeseenby market
participantsasa sign of weakness.By contrast, in a system
withsomethinglike a CLF, a bank might innormal timesmeet 95 percent
of itsrequirement by holdingprivate-market
HQLAandtheremaining5percent withcommittedcreditlinesfrom thecentral
bank, soit wouldhavean LCR of exactly100percent.Then, when hit
withlargeoutflows, it could maintain its LCR at 100percent, but
dosoby increasingits useof central bank credit linesto25percent and
selling20 percent of itsother liquid assets.This scenariowouldbe
the sort of liquid-asset drawdownthat one wouldideallylike to seein
a stresssituation.Moreover, the central bank could encourage this
drawdown by varyingthe pricing of its credit lines specifically, by
reducing the price of thelinesin the midst of a
liquiditycrisis.Such an approach wouldamount
totaxingliquidityprovision more ingood timesthan in bad, whichhasa
stabilizing macroprudential
effect.Thisexamplealsosuggestsadesignthat
mayhaveappealinjurisdictionswherethere is a relatively abundant
supplyof HQLA-eligible assets.Onecan imagine calibratingthe
pricingof the CLF soasto ensure
thatlinesprovidedbycentralbanksmakeuponlyaminimal
fractionofbanksrequiredHQLA in normal times apart, perhaps,from the
occasionaladjustment periodafter an individual bank is hit withan
idiosyncraticliquidityshortfall.At thesametime,in
astressscenario,whenliquidityisscarceandthereisupwardpressure
ontheHQLA premium, thepricingof theCLF couldbeInternational
Association of Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
25. P a g e | 25adjustedsoastorelievethispressureand
promoteusabilityof theHQLAbuffer.Such an approach would respect the
policyobjective of reducing expectedreliance on the LOLR while at
the same time allowing for a safety valve ina period of
stress.Thelimit caseof thisapproach is one wheretheCLF
countstowardtheLCR onlyin a crisis.ConclusionBywayofconclusion,
letmejustrestatethat liquidityregulationhasakeyroleto playin
improving financial stability.However,weshould avoid thinkingabout
it in isolation;rather, wecanbest understand it aspart of a larger
toolkit that alsoincludescapitalregulation and, importantly,
thecentral banksLOLR function.Therefore, proper design and
implementation of liquidityregulationssuch asthe LCR should
takeaccount of theseinterdependencies.In particular, policymakers
should aim tostrike a balancebetweenreducingrelianceontheLOLR
ontheonehandandmoderatingthecostscreated by liquidityshortageson
the other hand especiallythoseshortagesthat crop up in timesof
severe market strain.And, asalways, weshould bepreparedtolearnfrom
experienceaswego.International Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
26. P a g e | 26Basel III Capital:AWell-Intended
IllusionThomasM. HoenigVice Chairman, Federal Deposit
InsuranceCorporationInternationalAssociation of Deposit
Insurers2013Research Conference, Basel,
SwitzerlandIntroductionAristotle is creditedwith being the
firstphilosophertosystematically study logicalfallacies,
whichhedefinedasargumentsthat appearvalid but, in fact, arenot.I
call them well-intendedillusions.Onesuch illusion of precision is
the Basel capital standardsin whichworldsupervisory authoritiesrely
principallyon a Tier 1capital ratiotojudgethe adequacyof bank
capital and balance sheet strength.For the largest of thesefirms,
each dollar of risk-weighted assetsis fundedwith 12to15cents in
equitycapital, projecting the illusion that thesefirmsare
wellcapitalized.Thereality isthat each dollar of their total
assetsis funded withfar lessequitycapital, leavingopenthematter of
howwell capitalizedtheymightbe.Hereshow theillusionis
created.BaselsTier 1capital measure is a banks ratio of Tier
1capital torisk-weightedassets.International Association of Risk
and Compliance Professionals
(IARCP)www.risk-compliance-association.com
27. P a g e | 27Each category of bank assets is weighed by the
supervisory authority on acomplicated scale of probabilitiesand
models that assign a relative risk oflossto each group,
includingoff balancesheet items.Assetsdeemed lowrisk are reported
at loweramountson thebalancesheet.Thelowertherisk,thelowertheamount
reportedonthebalancesheet forcapital purposesand thehigher the
calculatedTier 1ratio.We know from years of experience using the
Baselcapital standardsthatoncethe regulatory authorities finish
their weightingscheme, bankmanagersbegin theprocessof
allocatingcapital and assetstomaximizefinancial returns around
these constructedweights.Theobjectiveis tomaximize a firmsreturn on
equity(ROE) bymanagingthe balancesheet in such a manner that for
anylevel ofequity, the risk-weightedassetsare reported at levelsfar
lessthan actualtotal assetsunder
management.Thiscreatestheillusionthatbankingorganizationshaveadequatecapitaltoabsorbunexpected
losses.For thelargest global financial
companies,risk-weightedassetsareapproximatelyone-half of total
assets.This "leveragingup" hasserved worldeconomiespoorly.In
contrast, supervisorsand financial firmscan choosetorely on
thetangibleleverageratio tojudgethe overall adequacyof capital for
theenterprise.This ratiocomparesequitycapital to total
assets,deductinggoodwill, other intangibles,and deferred tax
assetsfrom both equityand total assets.In additiontoincludingonly
loss-absorbingcapital, it alsomakesnoattempt to predict or assign
relativerisk weightsamong asset classes.International Association
of Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
28. P a g e | 28Usingthisleverageratioasour guide, wefind for
thelargest bankingorganizationsthat each dollar of assetshasonly4
to 6centsfundedwithtangibleequitycapital, a far smaller buffer than
asserted under the Baselstandards.Comparing
MeasuresTable1reportstheBasel Tier 1risk-weightedcapital ratio and
theleverageratiofor different classesof banking firms.International
Association of Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
29. P a g e | 29Column 4 showsTier 1capital
ratiosrangingbetween12 and 15percentfor the largest global firms,
giving theimpression that thesebanksarehighly
capitalized.However,it is hard tobe certain of that by lookingat
thisratiosincerisk-weightedassetsaresomuch lessthan total assets.In
contrast, Column 6 showsU.S.firms averageleverageratiotobe 6percent
using generallyacceptedaccountingstandards(GAAP), andColumn 8
showstheir averageratioto be3.9percent using
internationalaccountingstandards(IFRS), whichplacesmore of
thesefirmsderivativesonto thebalancesheet than doesGAAP.Thebottom
portionof Table1showsthe degreeof leverageamongdifferent size
groupsof banking firms, whichis striking aswell.TheTier 1capital
measuresuggeststhat all size groupsof banks holdcomparable capital
levels,while the leverageratioreports a
differentoutcome.International Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
30. P a g e | 30For example, the leverageratiofor most
bankinggroupsnot consideredsystemicallyimportant averagesnear 8
percent or higher.Under GAAP accounting standards, the difference
in this ratio betweenthe largest banking organizations and the
smaller firms is 175-250 basispoints.Under IFRSstandards,
thedifferenceisasmuch as400-475basispoints.Thelargest firms,
whichmost affect theeconomy, hold the least amountof capital in the
industry.While thisshowsthem tobe more fragile, it alsoidentifies
just howsignificant a competitiveadvantagethese lowercapital
levelsprovidethelargestfirms.Thesecomparisonsillustratehow easily
the Baselcapital standard canconfuseand misinform the public rather
than meaningfullyreport abankingcompanysrelativefinancial
strength.Recent history showsalsojusthow damagingthiscan be
totheindustryandtheeconomy.In 2007, for example, the10 largest and
most complex U.S.bankingfirmsreported Tier 1capital ratiosthat, on
average, exceeded 7percent ofrisk-weightedassets.Regulatorsdeemed
theselargest to be well capitalized.This risk-weightedcapital
measure, however,mapped intoan averageleverageratioof just
2.8percent.We learned all too latethat having lessthan 3centsof
tangiblecapital forevery dollar of assetson thebalancesheet is not
enough to absorbeventhesmallest of financial losses,and
certainlynot a major shock.With the crisis, the illusion of
adequate capital wasdiscovered, afterhavingmisled
shareholders,regulators,and taxpayers.International Association of
Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
31. P a g e | 31There are other, more recent, examples of how
this arcane measure canbe manipulated to give the illusion of
strength even when a firm incurslosses.For example,in
thefourthquarter of 2012, Deutsche Bank reported a lossof 2.5
billion EUR.That same quarter, its Tier 1risk-basedcapital
ratioincreasedfrom 14.2percent to15.1percent due, in part, to model
and processenhancements that resultedin a declinein
risk-weightedassets, whichnowamount to just16.6 percent of total
assets.On Feb. 1, SNSReaal, the fourth largest Dutch bank
with$5billion inassets,wasnationalized by the Dutch government.Just
seven monthsearlier, on June 30, 2012,SNS reported a Tier
1risk-basedcapital ratio of 12.2 percent.However,the firm reported
a Tier 1leverageratiobased uponinternational accountingstandardsof
only1.47percent.This leverageratiowasmuch more indicativeof the
SNSspoor financialposition.TheBasel III proposal
belatedlyintroducestheconcept of a leverageratio but callsfor it
tobe only 3 percent, an amount alreadyshown to beinsufficient
toabsorb sizablefinancial lossesin a crisis.It iswrongtosuggest
tothepublic that, withsolittlecapital, theselargestfirmscould
survive without public support should theyencounter anysignificant
economicreversals.Misallocating Resourcesand CreatingAsset
ImbalancesAn inherent problem with a risk-weighted capital standard
is that theweights reflect past events, are static, and mostly
ignore the marketscollectivedaily judgment about the relativerisk
of assets.International Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
32. P a g e | 32It alsointroducestheelement of political and
special interestsintotheprocess, whichaffectstheassignment
ofriskweightstothedifferent assetclasses.Theresult is
oftentoartificiallyfavor onegroup of
assetsoveranother,therebyredirectinginvestmentsand
encouragingover-investment in thefavored assets.Theeffect of
thismanagedprocessisto increaseleverage, raisetheoverall risk
profile of theseinstitutions,and
increasethevulnerabilityofindividual companies, the industry, and
the economy.It is no coincidence,for example, that after a Basel
standard assignedonlya 7 percent risk weight ontripleA,
collateralizeddebt obligationsand similar lowrisk weightson
assetswithina firmstradingbook,
resourcesshiftedtotheseactivities.Overtime, financial
groupsdramaticallyleveragedtheseassetsontotheirbalancesheetsevenasthe
risksto that asset classincreasedexponentially.Similarly,
assigningzero weightstosovereign debt encouragedbankingfirmsto
invest more heavily in theseassets,
simultaneouslydiscountingtherealrisk theypresentedand playing
animportant rolein increasingit.In placing a lowerrisk weight on
select assets,lesscapital
wasallocatedtofundthemandtoabsorbunexpectedlossforthesebanks,underminingtheir
solvency.AMore Realistic Capital Standard Is
RequiredTaxpayersaretheultimatebackstoptothesafetynetandhaverealmoneyat
stake.In choosingwhichcapital measure is most useful, it is fair
toaskthefollowingquestions:International Association of Risk and
Compliance Professionals
(IARCP)www.risk-compliance-association.com
33. P a g e | 33- Doesthe BaselTier 1ratio or the
tangibleleverageratiobest indicatethecapital strengthof the firm?-
Whichone is most clearlyunderstood?- Whichone best
enablescomparison of capital acrossinstitutions?-Whichone
offersthemost confidencethat it cannot be easily gamed?Charts
1through 4compare the relationship of the
tangibleleverageandBaselTier1capitalratiostovariousmarketmeasuresforthelargestfirms.International
Association of Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
34. P a g e | 34International Association of Risk and
Compliance Professionals
(IARCP)www.risk-compliance-association.com
35. P a g e | 35International Association of Risk and
Compliance Professionals
(IARCP)www.risk-compliance-association.com
36. P a g e | 36International Association of Risk and
Compliance Professionals
(IARCP)www.risk-compliance-association.com
37. P a g e | 37Thesemeasuresinclude:theprice-to-book ratio,
estimated defaultfrequency, credit default swapspreads, and market
value of equity.In each instance, thecorrelationof
thetangibleleverageratioto thesevariablesis higher than for the
risk-weightedcapital ratio.While such findingsare not conclusive,
theysuggest stronglythatinvestors,whendecidingwhereto placetheir
money, rely upon theinformation provided by the leverageratio.We
woulddowellto do thesame.Despiteall of theadvancementsmadeover
theyearsin riskmeasurementandmodeling, it isimpossibleto predict
thefuture or to reliablyanticipatehow and towhat degreeriskswill
change.International Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
38. P a g e | 38Capital standardsshould serve to cushion
against theunexpected, not todivineeventualities.All of the
Baselcapital accords, includingtheproposedBasel III,
lookbackwardand then attempt to assign risk weightsintothe
future.It doesnt work.In contrast, the tangible leverage ratio
provides a simpler, more directinsight into the amount of
loss-absorbing capital that is available to afirm.Aleverageratio
asIve definedit explicitlyexcludesintangibleitemsthatcannot absorb
lossesin a crisis.Also, using IFRSaccounting rules,
off-balancesheet derivativesarebrought ontothe balancesheet,
providingfurtherinsight intoa firmsleverage.Thus,
thetangibleleverageratiois simpler tocompute and more
easilyunderstood by bank managers,directors, and
thepublic.Importantlyalso,it ismore likely tobe
consistentlyenforcedby banksupervisors.Amore difficult challengemay
be todetermine an appropriateminimumleverageratio.Chart 5providesa
historyof bank leverageover thepast 150years for theU.S. banking
system and givesinitial insight intothisquestion.It showsthat the
equitycapital to assetsratiofor the industryprior to thefounding of
the Federal Reserve System in 1913and theFederal
DepositInsuranceCorporation in 1933ranged between13 and 16percent,
regardless of bank size.International Association of Risk and
Compliance Professionals
(IARCP)www.risk-compliance-association.com
39. P a g e | 39Without any internationally dictated standard
or any arcane weightingprocess, markets required what today seems
like relatively high capitallevels.In addition, thereis an
increasingbodyof research(Admati and Hellwig;Haldane;Miles,Yang,
and Marcheggiano) that suggeststhat leverageratios should be much
higher than theycurrentlyare and that Basel IIIsproposed 3 percent
figure addslittlesecurity to thesystem.Finally, and importantly,
some form of risk-weightedcapital measurecouldbe useful
asabackstop, or check, against whichto judgetheadequacyof
theleverageratiofor individual banks.If a bank meets the minimum
leverage ratio but has concentrated assetsin areas that risk models
suggest increase the overall vulnerability of thebalance sheet, the
bank could be required to increase its tangible capitallevels.Such
a system providesthemost comprehensivemeasure of
capitaladequacyboth in a broad context of all assetsand accordingto
a banksallocationof assetsalonga definedrisk profile.Tangible
Leverage Ratio and the Myth of
UnintendedConsequencesConcernsareoften
raisedwithinthefinancialindustryandelsewherethatrequiringthelargest
and most complex firms tohold higher levelsofcapital asdefined
usinga tangibleleverageratiowouldhaveseriousadverseeffectson
theindustry and broader economy.It hasbeen suggested, for example,
that requiringmore capital for theselargestbankswouldraisetheir
relativecost of capital and make them lesscompetitive.Similarly,
there is concern that failingto assign riskweightstothedifferent
categoriesof assetswouldencourage firms toallocatefundstothehighest
riskassetsto achievetargeted returnstoequity.International
Association of Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
40. P a g e | 40Theseissueshave been well addressed byAnat
Admati and MartinHellwig in their recentlypublishedbook, The
BankersNew Clothes.Therequired ROE and the abilityto attract
capital are determinedby ahost of factorsbeyond the level of
equitycapital.Theseinclude a firmsbusinessmodel,
itsrisk-adjustedreturns, thebenefitsof servicesand investments, and
theundistorted, ornon-subsidized, costsof capital.Alevel of capital
that lowersrisk may very well attract investorsdrawn tothemore
reliablereturns.Table1showsmany of the bankswithstronger
leverageratiosalsohavestockpricestradingat a higher premium to book
valuethan thelargestfirmsthat are lesswell-capitalized.There alsois
a concern that requiringa stronger, simpler
leverageratiowouldcausemanagers to placemore risk on their
balancesheet.While possible, the argument isunconvincing.With more
capital at risk and without regulatory
weightingschemesaffectingchoice, managers will allocatecapital in
linewithmarket riskand
returns.Furthermore,risk-weightedmeasuresandstrongbank
supervisioncanbeavailableasa back-up system tomonitor such
activity.Moreover,given theexperienceof therecent crisisand the
on-goingeffortsto manage reported risk assetsdown, no matter the
risk, it ringshollowto suggest that having a higher equitybuffer
for the same amountof total assetsmakesthe financial system
lesssafe.In addition, there isa concern that demanding more
equitycapital andreducingleverageamong thelargest firms
wouldinhibit thegrowthofcredit and the economy.International
Association of Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
41. P a g e | 41This statement hasan implied presumption that
the Basel weightingschemeismore growthfriendlythan a simpler,
stronger leverageratio.However,having a sufficient capital buffer
allowsbanks to absorbunexpected losses.Thisservestomoderate
thebusinesscycleandthedeclineinlendingthatotherwiseoccursduring
contractions.If the Basel risk-weight schemesare incorrect,
whichthey oftenhavebeen, this toocould inhibit loangrowth, asit
encouragesinvestmentsinother more favorably, but incorrectly,
weightedassets.Basel systematically encouragesinvestmentsin
sectorspre-assignedlowerweights-- for example, mortgages, sovereign
debt, and derivatives-- and discouragesloanstoassetsassignedhigher
weights-- commercialand industrial loans.We may have inadvertently
created a system that discourages the veryloan growth we seek, and
instead turned our financial system into onethat rewardsitselfmore
than it supportseconomicactivity.If risk weightscould be assigned
that anticipateand calibraterisks withperfect foresight, adjusted
on a daily basis,then perhapsrisk-weightedcapital standardswouldbe
the preferred method for determininghow
todeploycapital.However,they cannot.Tobelieve theycan isa
fallacythat putsthe entire economic system atrisk.Changing the
DebateThetangibleleverageratiois a superior alternativeto
risk-weightingschemesthat haveproven tobean illusionof precisionand
insufficient indefiningadequatecapital.International Association of
Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
42. P a g e | 42Theeffect of relying on suchmeasureshasbeen
toweakenthe financialsystem and misallocate
resources.Theleverageratio deservesseriousconsiderationasthe
principal tool injudgingthe capital strength of financial
firms.TheBasel discussion wouldbe well served to focuson the
appropriatelevelsof tangiblecapitalfor bankingfirmstohold and
theright transitionperiod to achievetheselevels.Finally, weshould
not accept even comfortingerrorsof logic whichsuggest that BaselIII
requirementswill createstronger capital than thoseof Basel II,
whichfailed.Instead, past industryperformanceand
mountingacademicand otherevidencesuggest that wewouldbebest served
to focuson a strongleverageratiostandard in judginga firm and
theindustrys financialstrength.No bank capital program is
perfect.Our responsibility asregulatorsand deposit insurersis
tochoosethebestavailablemeasure that will contributeto financial
stability.Note:ThomasM. Hoenig
wasconfirmedbytheSenateasViceChairman oftheFederal Deposit
InsuranceCorporation on Nov. 15, 2012.He joinedtheFDIC onApril 16,
2012,asa member of the FDIC Board ofDirectorsfor a six-year term.He
isamember of theexecutiveboard of
theInternationalAssociationofDeposit Insurers.Prior toservingon the
FDIC board, Mr. Hoenig wasthe President of theFederal Reserve Bank
of KansasCity and a member of the FederalReserveSystems Federal
Open MarketCommittee from 1991to2011.International Association of
Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
43. P a g e | 43Mr. Hoenig waswiththe Federal Reserve for
38years, beginningasaneconomistand then asa senior officer in
banking supervision during theU.S. banking crisisof the 1980s.In
1986, he led theKansasCity Federal Reserve BanksDivision of
BankSupervisionand Structure, directingtheoversight of more than
1,000banksand bank holdingcompanies withassetsranging from
lessthan$100million to $20billion.He became President of
theKansasCityFederal Reserve Bank onOctober 1,1991.Mr. Hoenig is a
nativeof Fort Madison, Iowa. He receiveda doctorateineconomicsfrom
IowaStateUniversity.International Association of Risk and
Compliance Professionals
(IARCP)www.risk-compliance-association.com
44. P a g e | 44PCAOB IssuesPolicy Statement onExtraordinary
Cooperation in Connectionwith Board InvestigationsWashington,
DCThePublic CompanyAccounting Oversight Boardtoday publishedaformal
statement concerningthebenefitsthat may be
availabletoregisteredpublic accounting firms and
individualswhoprovideextraordinarycooperation in PCAOB
investigations.The policy statement describes what the PCAOB may
consider to beextraordinary cooperation and how credit might be
reflected for suchcooperation.Thepolicyis generallyconsistent with
theBoards
existingpractices."Thispolicyprovidesbenefitstoinvestorsand real,
tangibleincentivestocooperatetofirms and personsassociatedwith
firms," said JamesR.Doty, PCAOB Chairman.
"Extraordinarycooperationpermitsthe Board to more
quicklyandefficientlyaddresswrongdoing for the protection of
investors, and mayearnpartiescredit inconnectionwiththeBoards
disciplinaryprocesses."According to the policy statement,
extraordinarycooperationis voluntaryandtimelyactionbeyond
compliancewithlegalorregulatoryobligations.Cooperation that could
result in credit includesself-reportingviolationsbeforetheconduct
comestothe attentionof the Board or
anotherregulator.Self-reportingismore valuabletheearlier it is
provided.Theother typesof extraordinarycooperation that could
result in creditare taking remedial or corrective action
toreducethe risk of similarInternational Association of Risk and
Compliance Professionals
(IARCP)www.risk-compliance-association.com
45. P a g e | 45violationsrecurring,
andprovidingsubstantialassistanceinthePCAOBsinvestigativeprocesses.Credit
for cooperationmay result in reduced chargesor sanctionsin
adisciplinaryproceeding.In some cases,extraordinarycooperationmay
lead tolanguageinsettlement documentsnoting the cooperation and
itseffect.In exceptional cases, extraordinarycooperation could lead
tonodisciplinaryaction at all."Extraordinarycooperationcan help
streamline and expeditePCAOBinvestigations,whichallowstheBoard
toturn its attention and resourcestoother potential auditor
misconduct," said ClaudiusB.Modesti, Director of the PCAOB Division
of Enforcement andInvestigations."Thispolicystatement isanimportant
stepinencouragingauditorstogoaboveand beyond what isrequired by
law," he said.Membersof the public whowishto report potential
violationsof law orPCAOB rulesmay contact theBoard through theTip
and Referral Centeron thePCAOB website.SummaryThePublic
CompanyAccounting Oversight Board ("PCAOB" or"Board") is
issuingthispolicy statement to provideguidancetoregisteredpublic
accounting firms("firms") and personsassociated
withfirms("associatedpersons") concerninghow
extraordinarycooperationmay be consideredin determining the outcome
of a PCAOBinvestigation.This policy statement doesnot bind and is
not intended toinfluenceanyPCAOB hearingofficer or theBoard in the
adjudication of litigatedmatters.International Association of Risk
and Compliance Professionals
(IARCP)www.risk-compliance-association.com
46. P a g e | 46Further, please note that the Board is not
adopting anyrule or making anycommitment or promise about any
specific case, or conferring any rightson anypersonor
entity.Further, the Board isnot in any waylimitingitsdiscretionto
evaluateevery caseindividually, on its own particularfactsand
circumstances.Thetypes of cooperation that could result in credit
are: voluntary andtimely self-reporting;voluntary and
timelyremedial or correctiveaction;andvoluntary and
timelysubstantial assistancetothe Boardsinvestigativeprocessesor
toother law enforcement authorities.Theseactions,aloneor taken
together, can be viewedasextraordinarycooperation for purposesof
this policy statement and, dependingon thefactsand
circumstances,may influencethe PCAOBs enforcementdecisions.By
publishingthispolicy statement on cooperation, the Board
seeks:(a)to encourage firms and associatedpersonstovoluntarilyand
timelyself-report, correct and remediateviolativebehavior, and
providesubstantial assistanceto the Boards
investigativeprocesses;and(b)to increasetransparency intohowthe
Board may credit cooperation.Moreover,the Board will, in
appropriatecasesand in itsdiscretion, notein settlement documentsor
other public statementsthat it hascreditedtheextraordinary
cooperation of a firm or associated person.Doingsowill enhancethe
Boardsenforcement program bypublicizingthebenefitsof
cooperationandinformingfirmsandassociatedpersonsofthetypes of
cooperation that may merit credit.I. IntroductionThe Sarbanes-Oxley
Act (the "Act") and Board Rules require firms andassociated persons
to cooperate in connection with PCAOB inspectionsand
investigations.International Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
47. P a g e | 47Section 102(b)(3) of theAct requireseveryfirm
applying for
PCAOBregistrationtosupply(1)aconsenttocooperateinandcomplywithanyrequest
fortestimonyortheproduction of documentsmadeby thePCAOB in
thefurtheranceofitsauthorityand responsibilitiesunder theAct,(2)an
agreement tosecure and enforce similar consentsfrom eachassociated
person of thefirm, and(3)a statement that the firm understands and
agrees, among otherthings, that its cooperation and compliance
shall be a condition to thecontinuingeffectivenessof the firms
registration withthe Board.Even if a firm fails
toprovidethoseitemswithitsapplication, it is notrelieved of
theobligationsto cooperatein and complywithBoard
requestsmadeinfurtheranceof theBoardsauthority
andresponsibilitiesunder theAct.Moreover,twoBoard
Rulesaddresscooperation by registered firms andassociated
persons.Board Rule 4006, Duty to Cooperate
withInspectors,appliestoinspections,and requires a registered firm
and any associatedpersonofthat firm to cooperatewithany Board
inspection by providinginformation requestedin Board inspectionsand
providing accessto thefirms records.Rule4006alsorequiresthat
informationprovidedtotheBoard betruthfulandnot
misleading.Sections105(c)(4) and (5) of theAct and Board Rule
5300(a) governsanctionsfor noncooperationwith an
inspection.Section105(b)(3) oftheAct and
BoardRule5110,NoncooperationwithanInvestigation,
applytoinvestigations,and provide that the Board maysanctiona firm
or associatedperson for failing tocooperate with a
Boardinvestigation.International Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
48. P a g e | 48Theforms of cooperation covered by Rule5110are
enumerated inparagraphs(1)-(3), with paragraph (4) providing a
catch-all provision forfailuretocooperategenerally. Section
105(b)(3) oftheAct andBoardRule5300(b) govern sanctionsfor failure
tocooperatewithan investigation.In certain situations,a firm or
associatedperson might cooperate withPCAOB investigationsbeyond
compliancewith thoseobligations.Cooperation beyond what isrequired
to comply with legal and regulatoryobligationscan contribute
significantlytothesuccessof theBoardsmission of
protectinginvestorsand furtheringthepublic interestin
thepreparation of informative,accurateand independent audit
reports.Such extraordinarycooperation might help the Boards staff
todiscoverpotential violationsearlier andallowtheBoard
toconcludeinvestigationsin a more efficient and timely manner,
thusreducingthe risk that suchviolativeconduct will be repeated and
result in more significant harm toinvestors,andassistingtheBoard in
identifyingaudit reportsthat may beinaccurate.For that reason,
extraordinary cooperation in connection
withBoardinvestigationsmaybeconsideredbytheBoardsDivisionofEnforcementand
Investigations(the "Division") in itsdisciplinary
recommendationstothe Board, and bythe Board in determiningwhether
toacceptsettlement offers.II. What is extraordinary
cooperation?Extraordinarycooperationis voluntary and timely action
beyondcompliancewithlegal or regulatory obligations that
contributestothemission of the Board.There are three broad types of
cooperationthat (aloneor takentogether)might merit cooperation
credit:self-reporting;remedial or correctiveaction;and substantial
assistancetothe Boardsinvestigativeprocessesortoother law
enforcement authorities.Self-Reportingrelatesto conduct upon
learningof violations.International Association of Risk and
Compliance Professionals
(IARCP)www.risk-compliance-association.com
49. P a g e | 49Afirm or associatedperson may earn credit for
self-reportingby makingvoluntary, timely and full disclosureof the
factsrelatingto violationsbeforetheconduct comestothe attention of
theBoard or anotherregulator.If self-reportingis required by legal
or regulatory obligations,it is notvoluntary and is not eligiblefor
cooperationcredit.Thus,forexample,self-reportingisnot voluntaryif
madeafterreceipt ofaregulatoryinquiry (e.g., any request, demand or
subpoena for the sameinformation or documentsfrom the Board,
theU.S. SecuritiesandExchangeCommission, Congress, anyother
federal, state, localor foreignauthority, or
anyself-regulatoryorganization).Likewise,self-reportingis not
voluntary if required by Section 10A(b) ofthe Securities
ExchangeAct of 1934 [15 U.S.C. 78j-1(b)], Auditrequirements-
Required responsetoaudit
discoveries(whichaddressesanauditorsobligationto report
theillegalacts of the audit client) andRule10A-1thereunder.As a
result, if theauditordiscoversor detectsan illegalact during either
aquarterlyreview or annual audit, and isrequired toreport it
pursuant toSection 10A, the auditor wouldnot be eligibleto earn
credit forself-reporting.Self-reportingismore valuabletheearlier it
is provided.When firms or associated personsself-report tothePCAOB,
the Boardencouragesthem toself-report by directlycontacting
theDivision ofEnforcement and Investigations,or by providing
information anddocumentsvia the Boards tipshotline:http:/ /
pcaobus.org/ Enforcement/ Tips/ Pages/ default.aspxRemedial or
CorrectiveActionsare voluntary, timely and
meaningfulactionsdesigned to reducethe likelihood and risk that
similar violationswill recur, aswell asactionstocorrect violative
conduct.International Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
50. P a g e | 50For example, a firm might earn credit by
promptly and voluntarilymodifying and improvingits
qualitycontrolsor other internal policiesandprocedurestoprevent
recurrenceof theviolativeconduct.Afirm might takeremedial
orcorrectiveactionbyre-assigningorlimitingtheactivitiesof those
individualsresponsiblefor violations(whichmightincludemembersof the
audit team, aswell aspersonsoutsidetheauditteam, includingpersonsin
firm management), and in appropriate casesbyterminatingor
imposingdisciplineupon the responsible individuals.Afirms remedial
or correctiveaction might alsoincludepromptlynotifying itsaudit
client or itsaudit committee(asappropriate) of theviolativeconduct
andcooperatingwiththeclient, sothat theclient can(ifnecessary) take
stepsto comply withthefederal securities lawsandregulations(e.g.,
by engagingan auditorto re-audit the financialstatementsaffectedby
an auditorsindependenceviolations).Afirms remedial or
correctiveaction alsomight
includeappropriatelycompensatingthoseadverselyaffectedby thefirms
violations.Substantial Assistance tothe
Boardsinvestigativeprocessesor tootherlawenforcement authorities
includestimely and voluntarily providinginformation or
documentsthat might not have been discoveredabsentthat cooperation,
or beyond that sought by the Boardsstaff viaaccountingboard
demandsand requests,and beyond what is requiredpursuant to legal
and regulatory reportingrequirements.For example, a firm might
substantiallyassist the Board by conductingatimely, thorough,
objectiveand competent internal investigation
intotheviolativeconduct whenit wasdiscovered, and informing
theDivisionsstaff of thepertinent factsdiscovered in the internal
investigation.Afirm or associatedperson might substantiallyassist
another lawenforcement authoritys investigativeprocessesby
self-reportingto thatauthority, or providingit withthe
factsdiscoveredin an internalinvestigation.International
Association of Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
51. P a g e | 51III. How might extraordinary cooperation be
credited?Credit for extraordinarycooperationin PCAOB mattersmaybe
reflectedin a varietyof ways.Credit may be reflectedby
reducingchargesand sanctionsimposed insettlement against the
cooperatingfirm or associated person.Extraordinarycooperationcould,
in somecases, lead to languageinsettlement documentsnoting the
cooperation and itspositive effect onthefinal settlement by the
firm or associatedperson.In exceptional cases, depending on the
facts and circumstancesinvolved, the level of extraordinary
cooperation could lead to nodisciplinaryaction at all againsta firm
or associated person.IV. Other FactorsThere existssome tension
betweenthe Boards interest in encouraging(andcrediting)
extraordinarycooperationanditsinterestin holdingfirmsand
associatedpersonsfullyaccountablefor their
violativeconduct.TheBoardscooperation policyis intendedto
balancethattension, encouraging cooperation withthe Board and
itsstaff whilemaintainingaccountabilityfor violativeconduct.Thus,
whethera firm or associatedperson provided extraordinarycooperation
is onlyone factor that will be consideredin determining
theappropriatedisciplinaryresponsetoviolative conduct.Other
factorsalsomay impact the appropriate regulatory
responsetoanyparticular violativeconduct, includingthenature of the
misconduct anditsroot causes(includingwhetherit wasdeliberate,the
result ofrecklessness,negligence, or honest mistake), whetherthere
wererepeatedviolationsor a pattern of misconduct, the duration of
themisconduct, andtheexistenceof prior
disciplinaryhistory.International Association of Risk and
Compliance Professionals
(IARCP)www.risk-compliance-association.com
52. P a g e | 52For firms, whethersupervisorsor firm management
directed, toleratedorremainedwillfullyblindtotheviolative conduct
may impact theappropriateregulatory response.Also for firms,
self-policingand the implementation of qualitycontrolsprior
tothediscoveryof theviolativeconduct, includingtheestablishment of
effectivecomplianceprocedures, an effectiveinternalwhistleblowerand
complaint system, and an appropriatetoneat thetop, may impact the
appropriate regulatoryresponse.For associatedpersons, their role in
the violative conduct and theirknowledge, education, training,
experiencein auditing, and positionofresponsibilityat the timethe
violationsoccurred may impact theappropriateregulatory
response.Thespecific factsand circumstancesof each casewill be
consideredtodeterminewhether(and how) thefirm or associatedperson
shouldreceivecredit for extraordinarycooperation.V.
ConclusionThePCAOB wasestablishedby Congressto oversee the auditsof
publiccompanies (and broker-dealers)in order toprotect the
interestsofinvestorsand further thepublic interest in the
preparation ofinformative, accurateand independent audit
reports.Extraordinary cooperation can contribute significantly to
those interestsby, among other things, allowing the Board to
address possible audit orother violations sooner, reducing the risk
that such violative conduct willbe repeated and result in more
significant harm to investors, and assistingtheBoard in identifying
audit reportsthat may be inaccurate.Also,
creditingextraordinarycooperation may shorten
investigationsandreducetheburdenson theBoards resources,
thusallowingthe Board tofocus on other potential auditor misconduct
for theprotection ofinvestors.International Association of Risk and
Compliance Professionals
(IARCP)www.risk-compliance-association.com
53. P a g e | 53Providingthisguidanceand publicly
acknowledgingextraordinarycooperation may encouragefirmsand
associatedpersonsto provideextraordinarycooperation, and may
provide insightsintohowextraordinarycooperationis
credited.International Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
54. P a g e | 54Solvency II: whereare we now?Although there is
nocertaintyon theSolvencyII implementationdate, EU policymakers are
continuingtofinalisekey aspectsof theframework.Recent
developmentsincludeEIOPAs consultationon interimmeasures,theimpact
assessment ofthelong-termguaranteepackageanda debateon whethernew
legislation is needed formally to
delaySolvencyIIsapplication.Solvency II implementation dateThelegal
positionis that Member Statesmust transposetheSolvencyII
Directiveintonational lawsby30 June2013and applyit to firmsfrom
1January 2014.It is clear, however,that this Solvency IItimetableis
not feasible.EU Member Statescannot implement theSolvencyII
framework bytheset dates,for thesimplereasonthat it
isnotfinalised.AMember Statesfailure to meet the legal
implementation deadlinesforSolvencyII wouldmeanthat it wasnot
complying withEU lawand couldhavelegal implications.As a result,
MemberStatesare keentoensure that further
legislationamendstheSolvencyII Directiveto postpone deadlinesfor
SolvencyIIimplementationon a formal basis.This can be done
bymeansof another quick-fix Directive, similar totheone adopted
last summer, whichestablishedcurrent transpositionand
implementationdates.International Association of Risk and
Compliance Professionals
(IARCP)www.risk-compliance-association.com
55. P a g e | 55Many peopleexpect implementation to beput back
to January2016.TheEuropean Commission, however, is
resistingpressure tointroduceanother quick-fix, soasto encourage
othersin theEUs legislativeprocessto agree theOmnibusII
Directiveasa priority.Instead, the Commission proposestoproducea
letter of comfort toMemberStatesconfirmingthat it will not
commenceproceedingsagainstthem for failure to implement
SolvencyII.Thediscussionisongoingand wearemonitoring it.EIOPAs
consultation on Solvency II interim measuresAlthough the SolvencyII
legislativeprocessis delayed, EIOPAbelievesthat the
insuranceindustryshould build on preparatory work
alreadyundertaken.In additionthe IMFsFinancial SectorAssessment
Programme (FSAP)review of the EU concluded that earlyharmonised
implementationofSolvencyII wouldreduce risksarisingfrom thecurrent
regime.EIOPA hasthereforepublisheda set of consultation
documentsproposingtointroducesomecoreSolvencyII
provisionsinadvanceoftheformal deadline(still to be
confirmed).EIOPAsguidelinesare addressed tonational supervisorsand
cover thefollowingareas:- System of governance- Aforward
lookingassessment of theundertakingsown risks(basedon theORSA)-
Submissionof informationto national
supervisors(reportingrequirements)- Pre-applicationfor internal
modelsInternational Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
56. P a g e | 56Lloydsis reviewingthe guidelinesand
contributingto thedebate at UKandEU levels.Many insurersare most
concerned about EIOPAsproposed reportingrequirements,whichlook very
onerous.In arelated development, theEuropeanCentral Bank (ECB)
plans topassaRegulation enablingit tocollect information from
insurersforfinancial stabilityand statistical purposes.TheECB is
workingwithEIOPAand, sofar aspossible,will relyon
datacollectedthrough theSolvencyII reportingtemplates.In the
interim period, before Solvency II is implemented, it
probablywillnot require insurerstoreport any additional
data.Longer-term, however, its requirementsmay become more
extensive.Legally, this Regulation will applyto EurozoneMember
Statesonly,although central banks in other MemberStatesmay
decidetoimposesimilar reporting requirements.It is unclear what
position the Bank of England will take.Impact assessment of the
long-termguarantee packageLast years debateson
thelong-termguaranteepackageproved
inconclusiveandtheCommissiondecidedtoconduct animpact assessment
toinform OmnibusIIsdevelopment.EIOPA launched theassessment
inJanuary 2013:insurershad until the end ofMarch2013tosubmit
information.Lloyds did not participatedueto the issueslimited
relevanceto most ofLloyds business.International Association of
Risk and Compliance Professionals
(IARCP)www.risk-compliance-association.com
57. P a g e | 57EIOPA is expectedtopublish a report
withitsfindingsin June thisyear, followedby a communication from
theCommission.Parliament hasscheduled a vote on theOmnibusII
Directive for 22October 2013.This is indicativeonly, but
suggeststhedeadlineby whichagreement onthelong-term guarantee
packageshould be reached.Compromisesover the long-term
guaranteepackageand subsequentadoption of the OmnibusII Directive
areimportant totheSolvency IIimplementationtimeline.If agreement is
not reachedand the Directiveis not finalisedin 2013,thisis likelyto
delaySolvencyII implementationbeyond theexpecteddeadlineof
January2016.International Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
58. P a g e | 58PolicyStatementConducting
statutoryinvestigationsIntroduction1.ThePrudential
RegulationAuthority (PRA) is required, under theFinancial
ServicesAct 2012(theAct), to investigateand report to HMTreasuryon
possibleregulatory failureand mattersof public interest.2.This
statement fulfilstherequirement, under section 80of theAct,
forthePRA to describehow it will dischargeits functionsin carrying
outinvestigationsand for identifying whereregulatory failure
hasoccurred.It hasbeen approved for publication by the PRA and HM
Treasury.Statutory provisionsThe PRAsobjectives3.ThePRA
hastwostatutoryobjectives:topromotethesafety andsoundnessof
PRA-authorised firms, primarilybyseekingtominimise the
adverseeffect their failurecould have on thestability of theUK
financial system, and by seekingtoensurethat theycarryon their
businessin a waythat avoidsany adverse effect on thestability of
theUK financial system; andfor insurers,tocontributetothe
securingof an appropriate degreeofprotectionfor thosewhoare or may
become policyholders.4. Consistent with those objectives, it is not
the PRAs role to ensure thatno PRA-authorised firm fails, as made
clear in section 2G of the FinancialServicesand MarketsAct
2000(FSMA).International Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
59. P a g e | 595.As describedin thePRAspolicydocumentson
itsapproach toprudential supervision, the PRAs supervisionwill be
driven by itsstatutoryobjectives.The objectiveswill alsoact
asguidingprinciplesforthePRA in identifying regulatory failure.The
PRAsduty to undertake statutory investigations6.There arethree
broadcircumstancesin whichthe PRAis requiredunder theAct toconduct
a statutoryinvestigation:(i)whereit appearstothe PRAthat a
seriousregulatory failurehasoccurred; or(ii)whereit appearstoHM
Treasurythat a seriousregulatoryfailure hasoccurred; or(iii)whereHM
Treasuryconsidersan investigationtobe in the publicinterest.7.As
required by theAct, this paper setsout howthe PRAwill
identifywhethertheconditionsforaninvestigationintoregulatoryfailurearemet,
and how it will carry out investigationsboth intoregulatory
failureand mattersof public interest.Identifying regulatory
failure8.Reflecting the PRAs statutory objectives, the Act sets out
threeconditions which trigger the requirement for an investigation
intoregulatoryfailure bythe PRA:(a)Public expenditure whererelevant
public expenditure hasbeenincurredin respect of a PRA-authorised
firm and might not have beenincurredbut for a serious failurein
thescope or design of thesystem ofregulationor the operationof that
system; or(b)Safetyor soundness whereeventshave occurredwhichhad,
orcouldhave had, a significant adverseeffect on the safety or
soundnessofInternational Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
60. P a g e | 60oneormorePRA-authorised firms,whichmight
nothaveoccurred, ortheeffect of whichmight have been reduced, but
for a seriousfailure in thescopeor design of the system of
regulationor the operation of thatsystem; or(c) Policyholder
protection whereeventshaveoccurred, relatingtotheeffectingand
carrying out of contractsof insurancebya PRA-authorisedfirm, which
indicatea significant failure tosecure an appropriate degreeof
protection for policyholders, whichmight not haveoccurred, or
theeffect of whichmight have been reduced, but for a seriousfailure
in thescopeor design of the system of regulationor the operation of
thatsystem.9.Should it appeartothe PRAthat any of these three
conditionshavebeen met, the PRAwill be required to investigatethe
eventsin questionandthecircumstancessurroundingthem.ThePRAmust
report to HM Treasury on its findingsand, subject tosome
restrictionsasdescribedbelow, thisreport must be published.10.An
investigationinto regulatory failuremay alsobe required
inconnectionwiththe Lloyds insurancemarket, in
whichcasetherequirementswill be thesame asthe above savethat
theywill referrespectivelyto:(a)relevant public expenditure that
hasbeen incurred in respect of amember of theSociety of
Lloyds;(b)eventswhichhad, or could have had, a significant adverse
effect onthesafetyor soundnessof theSociety of Lloyds and
itsmembers, takentogether;and(c)eventsrelatingto theeffectingand
carrying out of contractsofinsuranceby the Societyof Lloyds or any
other person whocarriesonPRA-regulated activitiesin relation
toanything done at Lloyds, whichindicateasignificant failure
tosecure anappropriatedegreeof
protectiontopolicyholders.International Association of Risk and
Compliance Professionals
(IARCP)www.risk-compliance-association.com
61. P a g e | 61How the PRAwill identify regulatory failure11.
In order todeterminewhetherthe conditionsfor an
investigationintoregulatoryfailure have been met, the PRA
must:(i)assesswhetherrelevant public expenditure, significant
adverseeffectson safetyor soundness, or significant failure
tosecure an appropriatedegreeof policyholder protectionhave
occurred;and(ii)assesswhetherthoseeventsweretheresult of a
seriousfailure of theregulatorysystem or its operation.If the
PRAdeterminesthat both (i) and (ii) are satisfied, an
investigationintoregulatory failurewill be required.12.Thefact that
investigationswill not be triggered automaticallybyrelevant
eventsreflectsthe important principle, rooted in
thePRAsobjectives,that it is not the PRAs roletoprevent all firm
failures, nor toprotect all policyholders in full in all
circumstances.13.ThematterswhichthePRAwill take intoaccount in
itsassessment ofwhetheran investigationintoregulatoryfailure is
required areoutlinedbelow.Relevant public expenditure14.Relevant
public expenditureisdefinedby theAct, asbeing in
broadterms:financial assistanceprovided, or expenditure incurred,
by HM Treasuryin respect of a PRA-authorised firm, for the
purposeof resolving orreducing a threat to thestabilityof the UK
financial system.This may include,for example, an injectionof
capital or fundinginto, ortheprovision of a guarantee to, a major
insurer to prevent its failure;International Association of Risk
and Compliance Professionals
(IARCP)www.risk-compliance-association.com
62. P a g e | 62expenditureincurred by HM Treasuryin the
exerciseof resolution andvariousother powersunder the BankingAct
2009.This may include, for example, a lossincurredby HM Treasuryin
takinga bank intotemporarypublic ownershipand onward saletoa
privatesectorpurchaser;financial assistanceprovided, or expenditure
incurred, by HM Treasuryin respect of the Financial
ServicesCompensation Scheme(FSCS) inrelationtoa PRA-authorised
firm.This may include,for example, a temporary loanto the
FSCSallowingitswiftly tocompensatethedepositorsof afailing
bank.15.FinancialassistancetoaPRA-authorised firm
includesguaranteesorindemnitiesand anyother kind of financial
assistance(actual orcontingent), but not indemnitiesor
guaranteesgivenby HM Treasuryinrespect of theprovision of financial
assistanceby theBank of England.Safety or soundnessand policyholder
protection16.ThePRA must assesswhether there hasbeen a significant
adverseeffect on thesafety or soundnessof one or more
PRA-authorised firmsora significant failure tosecure an appropriate
degreeof policyholderprotection.Safetyand soundnessis assessedin
thecontext of thePRAsgeneralobjective,whichisadvanced
primarilyby:(a)seekingtoensurethat thebusinessof PRA-authorised
firmsis carriedon in a waywhichavoidsany adverse effect on the
stabilityof the UKfinancial system; and(b) seeking to minimisethe
adverseeffect that the failure of aPRA-authorised firm could be
expectedto haveon the stabilityof theUKfinancial
system.International Association of Risk and Compliance
Professionals (IARCP)www.risk-compliance-association.com
63. P a g e | 63Thefailure of a PRA-authorisedfirm wouldnot
necessarilysatisfytheconditionsfor an investigationif there hasnot
been a significant adverseeffect on safetyand soundnessin
thissense.17.Subject to this, thePRA may judgethat sucheventshave
occurred if:(a)a firm is in resolution or actively beingwoundup;
or(b)solvencyconstraintshavepreventedaninsurancefirm from
deliveringon contractual obligationsto policyholders, or from
providinga level ofpayout topolicyholdersthat the Financial
ConductAuthority(FCA)consideredfair; or(c)there wasan imminent risk
totheviabilityof the firm such that eventsasdescribed in (a) or (b)
wouldhaveoccurredbut for theinterventionsorforbearanceof a third
party(for example, an acquisition or capitalinjectionby a
third-party institution).18.In addition, even wherea firm doesnot
itselffail, if its behaviourhashada significant adverseeffect on
thestability of