Journal of Regulation & Risk - North Asia, Volume VI, Issue I, Spring 2014

Articles, Papers & Speeches
Regulating foreign banking organisations in the USA Daniel K. Tarullo

Lessons from the panic of 2008: Are we better prepared? Elizabeth Warren
US super-ve too big to fails antithetical to capitalism Thomas M. Hoenig
Monetary policy capture in the US treasuries sphere Jeremy C. Stein
Building renewed trust in nancial markets Hans Hoogervorst
Historic ties between ethics, responsibility and protability Martin Wheatley
Asian tigers securities regulator bares its fangs Mark Steward
Global ambitions for OTC derivatives regulation Michael S. Pinowar
Market-based bank capital regulation Jeremy Bulow, Jacob Goldeld and Paul Klemperer
Unconventional monetary policies revisited - Part one Biagio Bossone
Unconventional monetary policies revisited - Part two Biagio Bossone
EU banking union: Outlook and short-term choices Nicolas Vron
Central clearing for OTCs: Schlieffen Plan redux Thomas Krantz
Basel III odyssey across the Asia Pacics larger economies Selwyn Blair-Ford
Foreign banks rmly in the crosshairs of Feds nal rules Christopher Rogers
Social media regulation in the global securities industry Gavin Sudhaker
Has Chinas ascent been mirrored on the legal front? Michael Thomas
Emerging political realities expose central bank tradition Philip Pilkington and Thomas Dwyer
Volume VI, Issue I Spring, 2014
JOURNAL OF REGULATION & RISK
NORTH ASIA
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When you have to be right
Journal of Regulation & Risk North Asia
1
Publisher & Editor-in-Chief
Christopher Rogers
Editor
Elizabeth Dooley
Associate Editor - UK
Philip Pilkington
Chief Sub-Editor
Fiona Plani
Editorial Contributors
Fred Andrews, William K. Black, Mehrsa Baradaran, Selwyn Blair-Ford, Biagio
Bossone, Jeremy Bulow, Elizabeth Dooley, Thomas Dwyer, Ian Fraser, Jacob
Goldfeld, Thomas M. Hoenig, Hans Hoogervorst, Sara Hsu, Paul Klemperer,
Thomas Krantz, Allan Meltzer, David Millar, Philip Pilkington, Michael S.
Pinowar, Alex J. Pollock, Robert Pringle, Christopher Rogers, Rajiv Sethi, Mark
Steward, Jeremy C. Stein, Gavin Sudhaker, Daniel K. Tarullo, Michael Thomas,
Mayra Rodrguez Valladares, Nicolas Vron, Elizabeth Warren, Martin Wheatley
Design & Layout
Lamma Studio Design
Printing
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Deltec International Express Ltd
ISSN No: 2071-5455
Journal of Regulation and Risk North Asia
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Tel (852) 2982 0297
Email: christopher.rogers@irrna.org
Website: www.irrna.org
JRRNA is published quarterly and registered as a Hong Kong journal. It is
distributed to governance, risk and compliance professionals in China,
Hong Kong, Japan, Korea, Philippines, Singapore and Taiwan.
Copyright 2014 Journal of Regulation & Risk - North Asia
Material in this publication may not be reproduced in any form or in any way
without the express permission of the Editor or Publisher.
Disclaimer: While every effort is taken to ensure the accuracy of the information herein, the editor
cannot accept responsibility for any errors, omissions or those opinions expressed by contributors.
A
t its zenith, the Royal Bank of
Scotland was the worlds biggest bank.
It had assets of $3 trillion, employed over
200,000 people, had branches on every
high street and was admired and trusted
by millions of savers and investors. Now
the mere mention of its name causes anger
and resentment, and its former CEO
Fred Goodwin is reviled as one of the
architects of the worst fnancial crisis
since 1929.
In Shredded, award-winning fnancial
journalist Ian Fraser lifs the lid on the
catastrophic mistakes that led the bank
to the brink of collapse, and those who
were responsible for them the colleagues
who were overawed by Goodwins despotic
style of leadership, the investors who
egged him on, the politicians who created
the light touch, limited touch regulatory
framework, and the RBS directors who, in
failing to check his hubris, allowed him to
lead the bank to destruction.
As more and more toxic details
emerge about the banks pre- and post-
bailout misconduct, including its deliberate
ruination of numerous small businesses
in the UK and Ireland, its alleged
manipulation of global foreign-exchange
markets, its fddling of Libor and other
benchmark interest rates, and its pivotal
role in the mis-selling of US mortgage
bonds, Ian Fraser examines what the future
holds for RBS and weighs up its chances of
ever regaining the publics trust.

IAN FRASER is an award-winning
journalist, commentator and broadcaster
whose work has been published by among
others The Economist, Financial Times,
The Sunday Times, Independent on Sunday,
Guardian, Observer, Mail on Sunday,
Herald, Sunday Herald, Thomson Reuters,
Hufngton Post, economia and qfinance.
He has taught at the University of Stirling
and his BBC documentary, RBS: The Bank
That Ran Out of Money, was short-listed
for a Bafa.
www.ianfraser.org
www.birlinn.co.uk
25
9 7 8 1 7 8 0 2 7 1 3 8 5
ISBN 978-1-78027-138-5
I
A
N

F
R
A
S
E
R
Cover design by James Hutcheson
Photographs by Victor Albrow and James Hutcheson
The defnitive account of the Royal Bank of Scotland fasco. Its an
engaging, if in some ways infuriating, tale of how self-serving bank
executives systematically broke the rules, lent with astonishing recklessness,
abused customers and got suckered by Wall Street before ultimately
dumping their mess on taxpayers. Fraser doesnt just point the fnger at
Royals clueless bankers. He also expertly chronicles the role of misguided
regulations, captured supervisors, and deluded politicians in fuelling
this catastrophe.
Yves Smith, founder of Naked Capitalism and author of
econned: How Unenlightened Self Interest Undermined Democracy
and Corrupted Capitalism
This book should be posted through the letterbox of every
taxpayer in Britain.
David Mellor, former chief secretary to the Treasury and
secretary of state for National Heritage
Ian Fraser has spotted stories, uncovered scandals and written about
them in a detailed and accessible way that leaves many other fnancial
journalists in the dust.
Eamonn ONeill, director of the MSc course in investigative
journalism at the University of Strathclyde
INSIDE RBS
S
H
R
E
D
D
E
D
IAN FRASER
THE BANK THAT BROKE BRITAIN
INSIDE RBS
THE BANK
THAT BROKE
BRITAIN
3
A
t its zenith, the Royal Bank of
Scotland was the worlds biggest bank.
It had assets of $3 trillion, employed over
200,000 people, had branches on every
high street and was admired and trusted
by millions of savers and investors. Now
the mere mention of its name causes anger
and resentment, and its former CEO
Fred Goodwin is reviled as one of the
architects of the worst fnancial crisis
since 1929.
In Shredded, award-winning fnancial
journalist Ian Fraser lifs the lid on the
catastrophic mistakes that led the bank
to the brink of collapse, and those who
were responsible for them the colleagues
who were overawed by Goodwins despotic
style of leadership, the investors who
egged him on, the politicians who created
the light touch, limited touch regulatory
framework, and the RBS directors who, in
failing to check his hubris, allowed him to
lead the bank to destruction.
As more and more toxic details
emerge about the banks pre- and post-
bailout misconduct, including its deliberate
ruination of numerous small businesses
in the UK and Ireland, its alleged
manipulation of global foreign-exchange
markets, its fddling of Libor and other
benchmark interest rates, and its pivotal
role in the mis-selling of US mortgage
bonds, Ian Fraser examines what the future
holds for RBS and weighs up its chances of
ever regaining the publics trust.

IAN FRASER is an award-winning
journalist, commentator and broadcaster
whose work has been published by among
others The Economist, Financial Times,
The Sunday Times, Independent on Sunday,
Guardian, Observer, Mail on Sunday,
Herald, Sunday Herald, Thomson Reuters,
Hufngton Post, economia and qfinance.
He has taught at the University of Stirling
and his BBC documentary, RBS: The Bank
That Ran Out of Money, was short-listed
for a Bafa.
www.ianfraser.org
www.birlinn.co.uk
25
9 7 8 1 7 8 0 2 7 1 3 8 5
ISBN 978-1-78027-138-5
I
A
N

F
R
A
S
E
R
Cover design by James Hutcheson
Photographs by Victor Albrow and James Hutcheson
The defnitive account of the Royal Bank of Scotland fasco. Its an
engaging, if in some ways infuriating, tale of how self-serving bank
executives systematically broke the rules, lent with astonishing recklessness,
abused customers and got suckered by Wall Street before ultimately
dumping their mess on taxpayers. Fraser doesnt just point the fnger at
Royals clueless bankers. He also expertly chronicles the role of misguided
regulations, captured supervisors, and deluded politicians in fuelling
this catastrophe.
Yves Smith, founder of Naked Capitalism and author of
econned: How Unenlightened Self Interest Undermined Democracy
and Corrupted Capitalism
This book should be posted through the letterbox of every
taxpayer in Britain.
David Mellor, former chief secretary to the Treasury and
secretary of state for National Heritage
Ian Fraser has spotted stories, uncovered scandals and written about
them in a detailed and accessible way that leaves many other fnancial
journalists in the dust.
Eamonn ONeill, director of the MSc course in investigative
journalism at the University of Strathclyde
INSIDE RBS
S
H
R
E
D
D
E
D
IAN FRASER
THE BANK THAT BROKE BRITAIN
INSIDE RBS
THE BANK
THAT BROKE
BRITAIN
Volume VI, Issue I Spring 2014
Contents
Foreword Christopher Rogers 7
Acknowledgements 9
Dialogue Allan Meltzer and Robert Pringle 13
Opinion Dr. Sara Hsu 19
Opinion Mayra Rodrguez Valladares 23
Opinion Christopher Rogers 25
Opinion Dr. Mehrsa Baradaran 29
Book review Prof. Rajiv Sethi 33
Book review Fred Andrews 35
Book review Alex J. Pollock 39
Book prcis Ian Fraser 43
Book prcis Christopher Rogers 47
Comment William K. Black 51
Comment David Millar 55
Comment Philip Pilkington 59
Regulatory update Elizabeth Dooley 63
Regulating foreign banking organisations in the USA 71
Daniel K. Tarullo
Lessons from the panic of 2008: Are we better prepared? 85
Elizabeth Warren
US super-ve too big to fails antithetical to capitalism 89
Thomas Hoenig
Monetary policy capture in the US treasuries sphere 95
Jeremy C. Stein
Building renewed trust in nancial markets 101
Hans Hoogervorst
NORTH ASIA
5
Historic ties between ethics, responsibility and protability 107
Martin Wheatley
Asian tigers securities regulator bares its fangs 111
Mark Steward
Global ambitions for OTC derivatives regulation 117
Michael S. Pinowar
Market-based bank capital regulation 123
Jeremy Bulow, Jacob Goldeld and Paul Klemperer
Unconventional monetary policies revisited - Part one 129
Biagio Bossone
Unconventional monetary policies revisited - Part two 137
Biagio Bossone
EU banking union: Outlook and short-term choices 141
Nicolas Vron
Central clearing for OTCs: Schlieffen Plan redux 161
Thomas Krantz.
Basel III odyssey across the Asia Pacics larger economies 169
Selwyn Blair-Ford
Foreign banks rmly in the crosshairs of Feds nal rules 177
Chris Rogers
Social media regulation in the global securities industry 183
Gavin Sudhaker
Has Chinas ascent been mirrored on the legal front? 189
Michael Thomas
Emerging political realities expose central bank tradition 195
Philip Pilkington and Thomas Dwyer
Articles (continued)
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Our dedicated team of compliance officers has years of professional experience equipped with in-depth
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By partnering with CompliancePlus, our clients gain access to compliance solutions that they can trust and
the latest knowledge of regulatory policies and procedures. Through building up strong relationships with our
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7
Foreword
WELCOME to the Spring 2014 edition of the Journal - now in its sixth year of publica-
tion following its founding at the height of the Great Financial Crisis (GFC) in September
2008. A few house announcements frst before moving on to highlighting some of the
key topics contained in this edition, together with some genufection on whats been
happening in the frst quarter of 2014 in the governance, risk management and compli-
ance space within the fnancial services sector.
First and foremost, our editorial team and the Secretariat of the Institute of Regulation
& Risk - North Asia would like extend a note of welcome to our latest staff member,
Philip Pilkington, who is heading our enhanced research capabilities, whilst keeping an
eye on whats happening in London and Europe. Wed also like to instruct readers that
the Institute has widened its footprint and now has capabilities in Singapore and a new
registered offce in London, thus we are becoming somewhat international shall we say!
This issue of the Journal, as usual, provides readers with an eclectic mix of papers,
book reviews, opinion and comment on issues pertinent to governance, risk manage-
ment and compliance across the region, much of which is international given the pleth-
ora of signifcant changes and policy statements emenating out of the United States and
Europe. Suffce to say that many in the industry here believe we have not only regula-
tory overload, this despite the fact that the GFC originated thousands of miles away,
but that we are suffering a dose of economic and regulatory nationalism, this despite
protestations from leading G20 nations that this is not the case - see Daniel Tarullos pro-
nouncements in the back section of the Journal for a taste of this.
Despite offcial statements suggesting the global downturn is at an end and all is rosy
in a new economic paradigm, here at the Journal we remain sceptical, this despite the
Dow Jones Industrial Average being at record levels. We remain cautious about bub-
bles inspired by quantitative easing, be it in the United States, UK or mainland China.
Indeed, as we have made clear often, policy-makers in the US and the EU have not
grasped the nettle, nor made the necessary adjustments that many nations in Asia were
forced to adopt in the wake of the Asian Crisis. It would seem a case of whats good for
the goose is certainly not good for the gander, this despite the fact Asia weathered the
storm of 2007/08 signifcantly better than peers in the West, courtesy of changes made in
the late 90s, radical changes that many western nations seem averse to adopt!
Christopher Rogers
Publisher & Editor-in-Chief
CompliancePlus Consulting

Compliance Consulting Funds Consulting
Regulatory Consulting Compliance Training
CompliancePlus Consulting Limited
801, Exchange Square Two, 8 Connaught Place, Central, Hong Kong
Tel: (852) 3487 6903 www.complianceplus.hk
Navigating a Changing Regulatory Environment

CompliancePlus is an independent consulting firm focused on providing a complete range of proven and
reliable compliance solutions to licensed firms, fund management companies and hedge fund managers in Asia.

Our dedicated team of compliance officers has years of professional experience equipped with in-depth
knowledge of both functional and compliance experience in managing and minimizing regulatory, operational and
reputational risks.

We have been providing real time compliance support and proactive recommendations to licensed firms and
licensed individuals, start-up hedge funds, fund of hedge funds and multi-strategies hedge funds with our solid
compliance knowledge.

By partnering with CompliancePlus, our clients gain access to compliance solutions that they can trust and
the latest knowledge of regulatory policies and procedures. Through building up strong relationships with our
clients and by ensuring our availability to them, we are trusted advisors helping clients to navigate a challenging
and changing regulatory environment.

To book an introductory meeting and to meet with our consultants, please contact our Hong Kong Office:

Josephine Chung, Director jchung@complianceplus.hk Tel: 852-3487 6903

The Institute of Regulation & Risk North Asia
is proud to present:
An Evening Dinner Dialogue with
Vitor Constancio & Christine Cumming
Vice President, ECB & First Vice President
Federal Reserve Bank of New York*
5:00 PM 9:30 PM
Thursday, February 12 2015
Gibson Hall - Main Hall, 13 Bishopsgate, City of London
5:00 PM Registration - Cocktails & Canaps
5:45 PM Welcoming Remarks
Nermat Shak, Deputy Governor, Markets & Banking, Bank of England
6:15 PM Will adverturism in the single European banking area impact Euro Zone
monetary policy moving forward?
Vitor Constancio
6:45 PM Does nancial intergration impact monetary policy: A US perspective
Christine Cumming
7:15 PM Evening Dinner & Beverages
8:15 PM Coffee Table Discussion and Audience Q&A
Moderator
Gillian Tett, Assistant Editor and Columnist, Financial Times
Panelists:
Erik Berglf, Chief Economist, European Bank for Reconstruction & Dev.
Vitor Constancio
Christine Cumming
Nermat Shak
9.30 PM End of Dinner Dialogue - Private Drinks & Conversation
* Agenda is correct as of 19th May 2014 , but may be subject to change
9
Acknowledgments
THE editorial management of the Journal of Regulation and Risk North Asia could
not have published this edition of the Journal without a great deal of assistance
and advice from professional associations, international monetary and fnancial
bodies, regulatory institutions, consultants, vendors and, indeed, from the indus-
try itself.
A full list of those who kindly assisted with the publication of this issue of the
Journal is not possible, but the Publisher and the Editor would like extend a spe-
cial thank you to Alex J. Pollock for allowing us to print his review of Fragile by
Design prior to its formal appearance on the website: Law and Liberty. Further
thanks must also be extended to the following organisations and institutions for
their generous assistance and support: The Board of Governors of the US Federal
Reserve System; the US Securities and Exchange Commission; the US Federal
Deposit Insurance Corporation; the offce of Senator Elizabeth Warren; the UKs
Financial Conduct Authority; the International Accounting Standards Board; the
Hong Kong Securities and Futures Commission; New Economic Perspectives;
Triple Crisis; the American Enterprise Institute; VoxEu; the American Banker;
MRV Associates; the Money Trap and TABB Forums for their kind permission to
reproduce material from their respective publications and websites.
Detailed comments and advice on the text and scope of contents from Alex J.
Pollock; Assoc., Prof. William K. Black; Dr. John C. Pattison, Prof. Rajiv Sethi;
Nicolas Veron; Stephen Roach; Mark Steward; Fanny W.Y. Fong; Ian Fraser;
Thomas Krantz; David Millar; Thomas Dwyer and Robert Pringle. We are also
indebted to Fiona Plani of Edit24.com for her due diligence in setting out, editing
and correcting the text.
Further thanks must also go to the China Banking Regulatory Commission,
Beijing & Shanghai Chapters of the Professional Risk Managers International As-
sociation and the Hong Kong Chapters of the Global Association of Risk Profes-
sionals and Institute of Operational Risk Management, together with SWIFT and
Wolters Kluwer Financial Services, for their kind assistance in helping to distrib-
ute this journal to their respective memberships and client-base in Greater China,
Japan and Korea, Philippines and Singapore.
11
Dialogue
Monetary policy Grandees
castigate younger peers
Prof. Allan Meltzer and Money Trap
author Robert Pringle pour cold water on
international monetary and scal policies.
FROM time to time, the Journal of
Regulation & Risk - North Asia, pub-
lishes important exchanges between
notable academics, monetary policy deci-
sion makers, key regulators and infu-
encers of fscal policy. In this, our Spring
edition of the Journal, we print an edited
email exchange between two renowned
experts, whose careers have focused on
international monetary and fscal poli-
cies. The email dialogue took place this
March between Prof. Allan Meltzer of
the Carnigie Mellon Universitys Tepper
School of Business and the former exec-
utive director of the Group of Thirty
economists and founder & chairman
of Central Banking publications, Mr.
Robert Pringle (captured photo).
Robert Pringle: Thinking further about the
international monetary system, I now nd it
difcult to conceive monetary stability being
established in one country alone even if
that country is the US. This is to me the main
lesson of the crisis and why I have changed
my mind. I would welcome your view.
Allan Meltzer: Yes, international stability
would be a big improvement. But it isnt pos-
sible without better domestic policy limits on
budget decits and money growth. If forced
to choose, I would choose limits on decits.
Notice, please, that Germany chugs along
year after year without world currency sta-
bility and Japan has for decades gone its own
way, remaining stable while growing very
slowly.
Need for international stability
Robert Pringle: Glad we agree on need for
international stability. I feel it is a prior con-
dition of domestic stability in any country.
Interestingly, Paul Volcker (former chairman
of the US Federal Reserve) and Jacques de
Larosire (former managing director of the
International Monetary Fund, president of
the European Bank for Reconstruction and
Development and Bank of France Governor)
understand this in these past two weeks
both of them have endorsed the thesis of
my book in public (The Money Trap), yet few
economists do.
I would say Germany and Japan have
been among the chief victims of the inter-
national monetary anti-system having been
12
repeatedly destabilised by huge swings in
exchange rates, political pressure from a
proigate US, and inability to impose disci-
pline on decit countries, leading to accu-
mulation of depreciating US dollars.
PRIOR scal agreement
Allan Meltzer: You know that I favour an
international agreement. But no agree-
ment can work without scal restrictions.
That should be obvious from the European
Central Bank experience, where the coun-
tries had an international agreement the
Stability and Growth Pact that failed to
enforce scal discipline on the participants.
Unlike the gold standard, the European
Central Bank treaty did not permit suspen-
sion of euro area members in a crisis. It may
survive, but it has not worked satisfactorily.
The only major question now is how much
additional funding Germany will agree to
pay in order to make the system survive.
A common currency works in the US
because we have scal transfers. The gold
standard worked for a long time because it
permitted suspension during troubled times.
No international agreement on curren-
cies can work satisfactorily if there is not a
PRIOR scal agreement.
Ex-post efforts useless
Robert Pringle: Yes, scal rules plus I
would add a credible no bail-out rule. My
argument is that scal rules may be easier to
impose and adhere to if part of an interna-
tional agreement to preserve free trade and
free capital ows and captures the gains from
globalisation. Fixed exchange rates can be
again part of the mechanism to enforce scal
discipline. It is hopeless to try to coordinate
national policies ex-post there has to be
something in place that governments know
they will have to defend/adhere to ex-ante.
Countries lack the political capacity/incen-
tive to observe scal discipline on their own.
This is an area we have discussed at great
length previously.
Further, the US would get a good deal if
it negotiated a deal now. If it waits 20 years, it
will be (I expect) in a weaker position.
On European Monetary Union, remem-
ber the poor experience many had with
oating exchange rates there was a strong
desire for more stability.
Allan Meltzer: We agree on many things.
Recall that I have had a proposal for increased
exchange rate stability since the mid 1980s.
It depends on markets to enforce the agree-
ment, as the gold standard did.
Electorate wants full employment
The big change from the gold standard, as
Bretton Woods demonstrated, is that voters
have learned that monetary authorities can
increase employment. I see much evidence
that most publics will trade off exchange rate
stability for more employment, even if the
latter proves to be only temporary. That is
the hard fact that you or I or any proposal has
to overcome.
In your words governments lack the
capacity. I say the voters want governments
to put full employmentahead of any other
objective. Alas, that remains true even when
governments do a poor job of providing full
employment.
My proposal would be voluntary for
each government. The markets could pun-
ish them by devaluing if the government
expands too much to maintain the exchange
13
rate. Do you think governments would
choose to restore the exchange rate? Or
do you agree with me that they would wel-
come devaluation as a way of increasing
employment?
Stupid, or politically driven
Your proposal ignores the publics demand
for more jobs. Thats why Bretton Woods
failed. Thats why the European Central Bank
failed. People can see that Sweden, Britain
and others outside the xed exchange rate
system can do better at increasing employ-
ment than those in France, Italy, et al. inside
the system.
I, too, would like greater international
stability. But I can see that central banks
seem determined to respond to very short
period data. Any program emphasising
stability requires them to act according to
medium or long-term objectives. They are
unwilling to do that. They may assert their
independence, but an independent central
bank does not nance a large part of the
government decit.
Everyone who knows anything about
data knows that the monthly unemploy-
ment rate is a noisy number subject to very
large revisions. Yet, the Federal Reserve
responds to it almost slavishly. Are they stu-
pid? Or politically driven?
What we agree on
Robert Pringle: It is necessary to agree on
many things to have a useful discussion, and
it is not surprising we do as my thinking has
been much inuenced by yours for many
years. In a sense I am trying to reconcile
my understanding with what I have learnt
from Mundell (Robert Alexander Mundell,
noted Canadian economist and professor
at Columbia University) which is difcult as
you have different underlying assumptions
and ways of viewing the economy. Never
mind, we can cut through the treacherous
theoretical mineeld to get at practical policy
issues we face.
It would be useful to list sometime the
big issues on which we agree and why.
I too agree on the need to have a largely
voluntary system, with a safety valve as in
the gold standard. And market enforcement.
But you would need a core of countries to get
it going. I do not believe in F. A. Hayeks cur-
rency competition the State has to agree on
the denition of the monetary standard, but
you can have free competition among pro-
ducers of money to that standard.
Zero sum game
I think you should have the minimal state
in fact tolerate quite a lot of anarchy
politically. But you need a unied currency.
Money should not form part of the struggle
because it is a zero sum game and because
any central bank or money creating centre
is always controlled by powerful groups,
as today I fear crony capitalism is a mor-
tal threat to democracy, especially in the US;
see Luigi Zingalesbook A Capitalism for the
People: Recapturing the Lost Genius of American
Prosperity.
The trouble is Republicans in the US
tend to have a knee-jerk reaction whenever
banks are criticised. Breaking up the banks
and defending the US constitution against
crony capitalists should be central to the
Republican agenda. (You probably deal with
that in your book , Why Capitalism?, which I
must re-read).
14
Of course, history informs us that there
will always be competition and ghts over
resources, territory, positional goods, gold,
intellectual property. But as in the Roman
Empire you can have this take place within
a common monetary area where the de-
nition of money does not form part of the
struggle.
IF we had a plan
The public learnt in 1950-75 that pre-elec-
tion booms were likely to end in busts and
to accept the attempt to make central banks
independent. This was a step in the right
direction. I know it is likely to fail as central
banks abandon rule-based policies in favour
of policies that suit powerful groups, but it
shows progress in this direction is possible.
People can likewise learn that the power
to devalue brings short-term gains to
employment but has bigger long-term costs.
European Monetary Union has been a set-
back, so far, and a public relations disaster for
currency areas/monetary unions of all sorts.
We know the reasons. They can be xed,
especially if applied at the world level.
Of course it is true by denition that (as
Larosire says) nations are not ready to
abandon the pretence of national auton-
omy if they were it would already have
happened.
Portents of doom
But suppose that the next crisis brings
unemployment to 20 per cent, further nan-
cial chaos, leading to nationalisation of the
nance industry, extreme controls on per-
sonal freedom, state-directed investment,
restrictions on travel and capital ows.
And imagine that there is a plan to jump
to a world money where we could have free-
dom in all these respects and restore capital-
ism IF governments accepted limitations of
national sovereignty and if there is a good
plan ready we would have a chance of sell-
ing it to a desperate world. And I think there
WILL BE another worse crisis!
My reading of the Bretton Woods agree-
ment is that it was pushed through by a few
determined people who grasped a unique
opportunity there was nothing inevitable
about it.
Allan Meltzer: The point of the Jacques de
Larosire paper, with which I agree most
is on page four where he writes: This is a
world composed of states determined to pre-
serve their own interest without having to
accept external constraints. In sum a world
of national objectives.(See speech given at
Oesterreichische Nationalbank gathering on
Bretton Woods in February this year.)
I read that as saying that international
coordination is a good idea, but it wont work
without PRIOR agreement on scal policy.
International agreed rules
Robert Pringle: Indeed, yet 18 developed
countries have opted to enter into a cur-
rency union in Europe and are sticking
with it, including 12 of the Organisation for
Economic Co-operation and Developments
member countries and several others who
have been heavily managing exchange
rates. In fact which are oating? UK,
Canada, Australia, Japan? Korea? Mexico?
Turkey?And how much effective
autonomy does this give them?
I think international coordination is the
wrong idea unworkable; bringing national
monetary policies into line with each other
15
as outlined in the rst part of the Jacques
de Larosire paper and disciplining scal
policies is not a matter of co-ordination but
following international agreed rules ex-
ante. As you say, PRIOR.
Agree to disagree
Allan Meltzer, closing summation: Robert
Pringle and I have discussed the problem of
achieving greater international nancial sta-
bility. Although we started from very differ-
ent origins we converged to a small number
of principles.
We agreed that the current non-system
reduces growth and productive opportuni-
ties and that no international system can
last without a major change everywhere but
especially in the United States to less expan-
sive, and less variable budget policies accom-
panied by more stable monetary policies.
We agreed also that countries should
seek a voluntary system that, like the old gold
standard, depends on market enforcement.
A remaining disagreement is over the
ability of a single country, particularly a large
country like the United States, to achieve
stability acting alone.
In his very good book, The Money Trap,
Mr. Pringle makes a strong case for his
system, one that is multi-national in a-
vour. I agree that a multi-national system
has great merit. I differ by believing that
Germany, Japan and some others have
achieved stability by following relatively
independent policies. I hope our exchange
will stimulate others to discuss the requi-
sites of much greater nancial stability.
Editors note: This email exchange
between Mr. Pringle and Mr. Meltzer in
its original unexpurgated format can be
accessed at: www.themoneytrap.com
Subscribe
today
Contact:
Christopher Rogers
Editor-in-Chief
christopher.rogers@irrna.org
Articles & Papers
Issues in resolving systemically important nancial institutions
Dr Eric S. Rosengren
Resecuritisation in banking: major challenges ahead
Dr Fang Du
A framework for funding liquidity in times of nancial crisis
Dr Ulrich Bindseil
Housing, monetary and scal policies: from bad to worst
Stephan Schoess,
Derivatives: from disaster to re-regulation
Professor Lynn A. Stout
Black swans, market crises and risk: the human perspective
Joseph Rizzi
Measuring & managing risk for innovative nancial instruments Dr Stuart M. Turnbull
Red star spangled banner: root causes of the nancial crisis Andreas Kern & Christian Fahrholz
The family risk: a cause for concern among Asian investors
David Smith
Global nancial change impacts compliance and risk
David Dekker
The scramble is on to tackle bribery and corruption
Penelope Tham & Gerald Li
Who exactly is subject to the Foreign Corrupt Practices Act?
Tham Yuet-Ming
Financial markets remuneration reform: one step forward Umesh Kumar & Kevin Marr
Of Black Swans, stress tests & optimised risk management
David Samuels
Challenging the value of enterprise risk management
Tim Pagett & Ranjit Jaswal
Rocky road ahead for global accountancy convergence
Dr Philip Goeth
The Asian regulatory Rubiks Cube
Alan Ewins and Angus Ross
NORTH ASIA
Volume I, Issue III, Autumn Winter 2009-2010
147
Legal & Compliance
Who exactly is subject to the
Foreign Corrupt Practices Act?
In this paper, Tham Yuet-Ming, DLA
Piper Hong Kong consultant, examines the
pernicious effects of the FCPA in Asia.
THE US Foreign Corrupt Practices
Act (FCPA), has its beginnings in the
Watergate era, when the Watergate Special
Prosecutor called for voluntary disclo-
sures from companies that had made
questionable contributions to Richard
Nixons 1972 presidential campaign.
However, these disclosures revealed
not just questionable domestic payments
but illicit funds that had been channelled
to foreign governments to obtain business.
The information led to subsequent investi-
gations by the US Securities and Exchange
Commission (SEC) which revealed that
many US issuers kept slush funds to
pay bribes to foreign ofcials and political
parties.
The SEC later came up with a voluntary
disclosure programme under which any cor-
poration which self-reported illicit payments
and co-operated with the SEC was given
an informal assurance that it would likely
be safe from enforcement action. The result
was the disclosure that more than USD$300
million in questionable payments (a mas-
sive amount in the 1970s) had been made
by hundreds of companies many of which
were Fortune 500 companies. The US legis-
lature responded to these scandals by even-
tually enacting the FCPA in 1977.
There are two main provisions to the
FCPA the anti-bribery provisions, and the
accounting provisions. Both the SEC and the
US Department of Justice (DOJ) have juris-
diction over the FCPA. Generally, the SEC
prosecutes the accounting provisions and
the anti-bribery provisions as against issuers
through civil and administrative proceedings
whereas the DOJ prosecutes companies and
individuals for the anti-bribery provisions
through criminal proceedings.
The anti-bribery provision
The FCPAs anti-bribery provision makes it
illegal to offer or provide money or anything
of value to foreign ofcials (foreign mean-
ing non-US) with the intent to obtain or
retain business, or for directing business to
any person.
Anything of value can include sponsor-
ship for travel and education, use of a holi-
day home, promise of future employment,
discounts, drinks and meals. There is no
163
Risk management
Of Black Swans, stress tests &
optimised risk management Standard & Poors David Samuels
outlines the positive benets of bank stress testing on the bottom line.
IT is a big challenge for banks to build
a robust approach to managing the risk
of worst-case stress scenarios that, almost
by defnition, are triggered by apparently
unlikely or unprecedented events.
However, solving the problem of identi-
fying the risk concentrations and dependen-
cies that give rise to worst-case outcomes is
vital if the industry is to thrive and if indi-
vidual banks are to turn the lessons of the
past two years to competitive advantage.
Banks that tackle the issue head-on will
be lauded by investors and regulators in the
coming years of industry recuperation and,
most importantly, will be able to deliver sus-
tained protability gains. Meanwhile, banks
that are well placed to take advantage of the
consolidation process need to be sure they
can understand the risks embedded in the
portfolios of potential acquisitions. To improve enterprise risk management
and strengthen investor condence, we think
banks can take the lead in three related areas:
Better board and senior executive over-
sight and control of enterprise risk man-
agement; re-invigorated stress testing and
downturn capital adequacy programs to
uncover risk concentrations and risk depend-
encies, and; applying these improvements
to drive business selection for example,
through performance analysis and risk-
adjusted pricing that takes stress test results
into account.
Top-level oversight Building a more robust and comprehensive
process for uncovering threats to the enter-
prise is clearly, in part, a corporate govern-
ance challenge. The board and top executives
must have the motivation and the clout to
scrutinise and call a halt to apparently prot-
able activities if these are not in the longer-
term interests of the enterprise or do not t
the intended risk prole of the organisation.
But contrary to popular opinion, improv-
ing corporate governance is not just a ques-
tion of putting the right executives and
board members in place and giving them
appropriate incentives. For the bank to make the right deci-
sions when they are difcult, e.g. when
business growth looks good in the upturn,
or when risk management looks expensive
17
Is Chinas shadow banking
sector about to go critical?
State University of New Yorks Dr. Sara
Hsu questions belief that Middle Kingdoms
shadow banking sector is ripe for a fall.
Opinion
A vague panic has overcome many ana-
lysts when discussing Chinas shadow
banking sector. The sector has even been
referred to as a ticking time bomb by
some. Other analysts say there is noth-
ing to fear in the shadow banking sector.
So which is it? Is the risk so high that
a shock in this sector might result in a
fnancial crisis? Or is the risk so low that
growth will be entirely unaffected?
Looking at the sector from several angles, we
try to rate the level of risk in various shadow
banking sectors to determine whether this
fear is justied. We look at liquidity risk, or
whether shadow banking institutions have
sufcient cash to repay asset holders in the
short run; solvency risk, whether shadow
banking institutions can muster up repay-
ments in the long run; and market risk,
whether shadow banking institutions are
exposed to an overall decline in asset prices
First, we start with trust products, which
have of late earned some notoriety. Trust
products have faced high levels of liquid-
ity risk, with some facing on-time repay-
ment issues. Some trust products became
insolvent and had to be bailed out, whilst
others were eventually repaid. Trust expo-
sure to the real estate sector may result in
further delinquencies as real estate prices
decline, so that market risk may be a factor
of concern. Taken altogether, we can say that
the trust sector, which comprises the largest
percentage of all shadow banking activity in
China, at 11 trillion RMB, presents a medium
to high level of risk. Low levels of regulation
in this sector compound our concern; many
trust companies themselves often do not
include risk control departments.
Second, although wealth management
products sold by banks are better regulated
than trust products, some of these products
contain trust products, which increases their
overall level of risk. Wealth management
products (WMPs) have faced liquidity and
solvency issues where trust products have
broached failure, and may face market risk
when underlying real estate loans (part of
the non-standard asset portfolio of WMPs)
encounter problems as the real estate mar-
ket turns downward. Overall, the 9 trillion
RMB WMP market presents a medium level
of risk.
18
Third, corporate bonds did not default for
some time until this year, when two bonds,
Chaori Solar and Xuzhou Zhongsen, failed.
The 9 trillion RMB corporate bond mar-
ket has generally been comprised of highly
rated debt, but with the coming roll out of
debt by local government nancing vehicles,
the market will likely increase in risk. The
presence of a burgeoning junk bond market
and the recent corporate bond failures have
revealed that there are problems in the bond
market.
As corporate bond yields are directly
affected by the market, market risk plays a
role in these types of instruments. Hence
the corporate bond market is moving slowly
in the direction of medium level risk, and an
increase in regulation by the Chinas regula-
tory bodies may be necessary to ensure that
the bond market appropriately prices in risk.
Fourth, bankers acceptance bills, which
have traditionally been extended to rms
involved in trade transactions, of which those
outstanding measure in at about 9 trillion
RMB. Banks back these instruments and will
repay if necessary. Despite the fact that some
of these bills have been used to nance risky
ventures of late, the bank guarantee renders
liquidity and solvency problems a non-issue.
Market risk is generally judged to be low, as
the bills are diversied in their funding. Risk
is low to medium on balance, although this
sector is little regulated.
Fifth, credit guarantee companies, which
are regulated by local governments and
the National Development and Reform
Commission, guarantee loans to banks
and have faced both liquidity and solvency
issues. Although rst promoted by the state
to enhance access to funds among SMEs,
credit guarantee companies have grown in
risk and have become increasingly intercon-
nected to other rms. Market risk is low, but
in an economic downturn, the interconnect-
edness of these rms may lead to local sol-
vency crises. The relatively small size of this
shadow banking sector, at 1-2 trillion RMB,
is of some consolation, but the nancial fra-
gility posed by this sector induces us to rate
the overall level of risk as medium.
Finally, the entrusted loans sector is a 2
trillion RMB shadow banking channel that
analysts rarely discuss. Although we lack
specic information about these transac-
tions that are usually made from a larger
corporation to a smaller one, though a bank,
we do not believe the liquidity, solvency, and
market risks are high since the borrowers
are diversied. These larger corporations
lend extra funds that they hold in the form
of cash, and it may be fair to say that these
loans do not threaten their nancial security.
The overall risk in this sector is low.
In sum, the riskiest shadow banking
sectors are the trust and wealth manage-
ment product markets. These are mainly
risky based on the integrity of the underlying
loans. Many of these loans were extended
through a process of adverse selection, with
high risk borrowers like local government
nancing vehicles showing a willingness to
pay high interest rates because they have no
other choice. The adverse selection issue will
play out in the trust and WMP industries,
while shadow banking sectors that have lent
to more creditworthy customers (as in the
entrusted loan sector) or priced in risk (as in
the corporate bond sector) will be shielded
to some extent from this fallout. All of this
will soon unfold.
19
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Sabine Lautenschlger & Sarah Dahlgren
Member of the Executive Board, ECB &
Executive Vice President of the FRBNY
5:30 PM 9:15 PM
Thursday, November 13 2014
Jerwood Hall, LSO St Lukes, 161 Old Street, London
6:15 PM Welcoming Remarks
Andrew Bailey. Deputy Governor for Prudential Regulation, & CEO
of the Prudential Regulation Authority, Bank of England (Pending
conrmation)
6:30 PM Europes nascent single supervisory environement: A boon or
unnecessary expansion of Europes maligned monetary union
experiement?
Sabine Lautenschlger
6:45 PM Federalism and Banking Supervision: Views from across the Pond
Sarah J. Dahlgren, EVP, Financial Institution Supervision Group, FRBNY
7:00 PM Prudential regulation and supervision within Europe: An insiders view
Andrea Enria, Chairman, European Banking Authority
7:45 PM Coffee Table Discussion and Audience Q&A
Moderator
Prof. William K. Black, University of Missouri Kansas City
Panelists:
Sabine Lautenschlger
Sarah J. Dahlgren
Andrea Enria
9: 15 PM End of evening dialogue, Thank you drinks
21
Opinion
Political ignorance threatens
Volcker Rules deployment
Mayra Rodrguez Valladares of MRV Associ-
ates in a recent American Banker post is critical
of timelines associated with Volcker Rules.
POLITICIANS have given a lot of atten-
tion to the Volcker Rule in testimonies to
the House and Senate in early February
and even in Fed Chair Janet Yellens frst
semi-annual monetary policy report to
Congress. Not a single politician, how-
ever, has asked recently whether any
bank is ready in the near future to imple-
ment the Volcker Rule and whether the
regulators, each with their distinct man-
date, will be able to adequately supervise
and enforce it.
For banks, the Volcker Rule represents prob-
ably the most challenging rule of any regula-
tion from the perspective of data collection,
aggregation and reporting. Part of the chal-
lenge is just guring out how the Volcker
Rule interacts with other elements of Dodd-
Frank and Basel III.
It is very unlikely that global systemically
important banks, not to mention smaller
banks, will be able to revamp their IT infra-
structure, compliance processes and report-
ing mechanisms to comply with the Volcker
Rule on time, even though the compliance
deadline is not until 2015.
Although it has been over ve years since
the global nancial crisis, banks are over-
whelmed with a wide range of data chal-
lenges. Key Basel Committee and Senior
Supervisory Group reports in December and
January highlighted how banks are strug-
gling with establishing strong data aggrega-
tion governance, architecture and processes,
and are even challenged by timely and accu-
rate reporting of data related to their top
counterparty exposures.
In order to have any hopes of imple-
menting the Volcker Rule, banks will seri-
ously have to rethink their strategy of what
types of businesses they want to be involved
in, and what types of securities and deriva-
tives they want to trade. A number of banks
have been deleveraging in the last few years
in order to bolster their capital levels and
avoid contravening the Volcker Rule. Of
course, by deleveraging, they may be lower-
ing their risks, but they are also risking being
less protable.
Importantly, banks will need to ensure
they have a strong board of directors and
senior management who truly understand
the Volcker Rule, since the rule imposes
22
signicant responsibility and accountability
on them. One of the elements of the Volcker
Rule is for a banks CEO to attest annually
in writing to regulators that the bank has
in place the processes needed to establish,
maintain, enforce, review, test and modify its
compliance program. If regulators enforce
this provision, CEOs will nally have to
make compliance a priority.
Undeniably, banks need to create a well-
thought out Volcker Rule implementation
and monitoring plan, since numerous busi-
ness units are affected by the rule. Finding
the appropriate personnel to be involved
in creating and implementing the plan will
hardly be easy, since the people who usu-
ally should be involved are already stretched
working on other elements of Dodd-Frank,
not to mention Basel III.
Banks will also need to develop a very
strong compliance program and evaluate the
personnel available to do so. As part of the
compliance program, banks have to create
compliance manuals specic to the Volcker
Rule, where they should provide details of
the type of trading conducted, identication
of customers, risks and risk management
processes, hedging policies, and how they
resolve problems when the Volcker Rule is
breached.
Banks will also need to pay special atten-
tion to the information that they will need
to comply with market-making and under-
writing exemptions granted by the Volcker
Rule. Just preparing the compliance manual
should force banks to think of what type of
IT architecture they have in place to capture,
store and maintain relevant data.
For all regulatory agencies, supervising
and especially examining banks to see if
they are properly implementing the Volcker
Rule will be far from easy. Whilst all regu-
lators now have even more responsibilities,
thanks to new Dodd-Frank and Basel rules,
even before the Volcker Rule was nalised,
all the agencies, especially the Securities and
Exchange Commission and Commodity
Futures Trading Commission, already oper-
ate with insufcient human and technol-
ogy resources to help them do their work
adequately.
The bank regulatory agencies have had
to hire additional people. Fortunately, many
are coming in with industry experience, but
they have the challenge of learning to work
as regulators. Existing staff at these agen-
cies often seriously need training in capital
markets and derivatives products and in
understanding the nuances of all the new
regulations being put in place.
Unfortunately, rather than receiving
more support, staff at these regulatory enti-
ties are all too often used as punching bags
and derided by politicians and journalists
who rarely have ever worked in a regulatory
agency to understand the challenges.
If the goal really is to reform the nancial
sector, the Volcker Rule should never have
been the focus for politicians or regulators.
Moreover, since the UK and continental
Europe lag in implementing similar rules to
Volcker, US banks may be able to nd regu-
latory arbitrage opportunities abroad.
That said, now that the Volcker Rule
is regulation, I do not expect that it will be
implemented or enforced satisfactorily any
time soon. Moreover, continued focus on it
will distract bank managers and regulators
from nding ways to make the global nan-
cial system healthier.
23
Opinion
FDIC sues Libor miscreants:
Beware the Ides of March
Decision to act against banks involved in
the Libor scandal has strains of a Shake-
spearian tragedy, writes Chris Rogers.
IF miscreant banks, supine regulators
and colluding cheerleaders in politics
and academia were under the illusion
that they had successfully managed the
global fallout from the Libor scandal,
they were in for a rude awakening. For
this March, following a shock decision by
the US-based Federal Deposit Insurance
Corporation (FDIC), legal proceedings
were put in place to prosecute 17 institu-
tions believed to be directly involved in
what one former regulator, William K.
Black, calls the largest rigging of prices in
the world by many orders of magnitude
in a securities market with an estimated
worth of up to US$500 trillion during the
period the scandal run for.
Not wishing to infer too much from William
Shakespeares Julius Caesar [Act 1, scene 2],
portents of doom have often coincided with
the 15th of March clasically known as the
Ides of March. The juxtaposition of this date
and the FDICs belated decision to go after
a Whos Whoof leading nancial institu-
tions involved in manipulating the London
interbank offered rate resonate. Law suits
have been led at the Federal District Court
in New York against 17 globally active banks
accused of involvement in a widespread
conspiracy that rst came to light in 2007
and continued through to 2011.
Familiar spectre
Acting as reciever for 38 failed institutions
insured by the agency among them,
Washington Mutual, Indy Mac, and Colonial
Bank the FDIC claims that a cartel com-
prising sitting members of the US dollar
Libor panel (the body that sets the bench-
mark lending rate), fraudulently and col-
lusively suppressedthe rate for their own
benet.
Chief among those named and shamed
in the court documents are the UKs Barclays
Bank, Royal Bank of Scotland, HSBC
and Lloyds Banking Group; US-based
JPMorganChase, Bank of America and
Citigroup; Canadas Royal Bank of Canada,
Swiss Leviathans Credit Suisse and UBS,
Frances Socit Gnrale, Germanys
Deutsche Bank, the NetherlandsRabobank,
together with Japans Bank of Tokyo
Mitsubishi UFJ and Norinchukin Bank.
24
But the FDIC has another and no-less
dynamic target in its crosshairs the British
Bankers Association (BBA). The name of this
once most-venerable of British institutions
also appears in the lawsuit led on March 14
in Manhatten.
Citys crown jewel
The BBA was the industry body which, up
until January this year, was charged with
overseeing the setting and conduct of the
Libor panel during the period in ques-
tion, 2007-2011. Ironically, its redoubtable
former CEO throughout that period, one-
time Conservative Member of Parliament
and darling of the City of London, Angela
Knight, famously claimed in 2008 that Libor
could be trusted as a most reliable bench-
mark. Indeed, such was the importance
of this industry-sponsosored benchmark to
Londons prestige that many considered it
the jewel in the Citys crown - now regreta-
bly tarnished and no longer self-regulated.
But in the background of this sudden liti-
gious urry stands an all too familiar spectre:
a majority of those named in the FDIC law-
suit are considered systemically important
nancial institutions, and therefore deemed
not only too big to fail, but according to our
friend, the US Attorney General, Eric Holder
too big to prosecute for fear of undermin-
ing the global economy.
Foam the runway
Evidently, senior FDIC management g-
ures among them its chairman Martin J.
Gruenberg and its vice chairman, former
president of the US Federal Reserve Bank
of Kansas, Thomas H. Hoenig following in
the footsteps of their illustrious predecessors,
Sheila Bair and William Seidman, had
seemed incapable of reading from the same
script. Written by the Obama administra-
tion and made esh by then US Treasury
Secretary, Timothy Geithner, the scripts
objective, according to Neil Barofsky, former
special inspector general for the Troubled
Assets Relief Programme (TARP), was to
foam the runwayfor a plethora of abuses
by those deemed above and beyond the
reach of the law.
The pending litigation breaks with
what appeared to have been an ofcially
sanctioned international policy of treading
lightly in handling the nancial abuses and
criminality which came to light following the
Global Financial Crisis of 2007/08. To date
there have been no serious prosecutions of
senior executives whom many observers
believe were at the heart of the malfeasance
which brought about the crisis.
Hornets nest
The FDIC, by launching its legal salvo
against senior members of the global bank-
ing cartel on the eve of the Ides of March,
has stirred up a hornets nest. It has drawn
unwanted scrutiny on previous and con-
tinued abuses perptuated by leading global
nancial institutions, most of whom receive
generous nancial support and backstops
from their respective governments at least
thats the opinion of Andrew Haldane, exec-
utive director of nancial stability at the Bank
of England.
Despite all this government largesse,
leading global nancial institutions seem
incapable of abating rampant recidivism
within their hallowed ranks; to date, those
institutions accussed of colluding to x US
25
dollar Libor rates have paid nes and pen-
alties worth some US$6 billion to settle civil
and criminal charges in the US and Europe,
notwithstanding record payouts recorded
for a litiny of charges related to the selling
of mortgage-backed securities, rampant
mis-selling of collateralised debt obliga-
tions, colossal money laundering and ump-
teen breaches of auditing and compliance
regulations.
Et tu, Brute?
Returning to the meme of Julius Caesar, and
reminiscent of Act 3 of Shakespeares tragedy,
having ignored warnings of the soothsayer
and Artemidorus - roles played by industry
watchers and compliance ofcers - our pro-
tagonists in the alleged Libor cartel are set to
suffer another dagger blow, one wielded by
Brutus, in the guise of the acclaimed thes-
pian, the European Commissions director-
general of Competition, Joaquin Almunia,
whos expected to launch further antitrust
proceedings against all those involved in
manipulating Libor sometime in the next
month or two - Et tu, Brute.
Cry Havoc!
Despite the sudden interjection of the FDIC
this March, and anticipated legal proceed-
ings emanating from the European Union,
there has been a shocking lack of action
in bringing forward criminal proceedings
against those deemed complicit in these
gigantian account frauds, manipulation
of markets and outright malfeasance by a
handful of institutions, which are deemed
untouchables.
Instead of a chorus of outrage and action
on par with Cry Havoc!, and let slip the
dogs of war, [Act 3, scene 1] from those
agencies responsible for oversight, chief
among them, the Federal Reserve Bank of
New York, the UKs now defunked Financial
Services Authority, the US Securities and
Exchanges Commission and highest judicial
authorities in leading nancial centres, what
has been witnessed is a wringing of hands
comparable with that of Pontius Pilates
handling of Jesus at the behest of an elite
unwilling to face up to its own shortcomings.
Maybe, just maybe, the FDICs decision
to launch legal proceedings against 17 global
banks, together with the agent ultimately at
the time responsible for overseeing the Libor
panel, the BBA, represents a sea change in
how regulators and the judiciary deal with
outright malfeasance within the ranks of the
global banking elite.
Cassius
However, many remain unconvinced, for
despite the howls of protestations that fol-
lowed Attorney General Holders remarks
in early 2013 that senior criminal elements
within Wall Street banks could not be pros-
ecuted for their crimes for fear of setting off
a Lehman event, little has changed, despite
interventions from leading political g-
ures, including US Senators Carl Levin and
Elizabeth Warren, and the UKs Labour
Party leader, Edward Miliband. Unlike
Shakespeares protagonists, those implicated
in the Libor scandal did not do so for the
glory of Rome, their actions comparable with
Cassius in soiling the act of regicide by prof-
iting directly from their crimes [Act 4, scene
1]. Indeed, senior management have denied
any responsibility whatsoever, and unlike
Brutus, remain to fall upon their swords.
Stefan Gannon and Mark Steward
General Counsel, Hong Kong Monetary Authority &
Head of Enforcement, HKSFC
5:30 PM 9:15 PM
Tuesday, 21 October, 2014
JW Marriott Hotel, Pacic Place, Hong Kong
6.15 PM Welcoming Remarks
Ashley Alder, Chief Executive Ofcer, HKSFC
6:30 PM Basel III, Resolution & Supervision: Views from the HKMA
Stefan Gannon
6.45 PM Does regional competition impact supervision in Hong Kong?
Mark Steward
7.00 PM Supervision & Prudential Regulation in Asia and the rest of the World
Jeffrey Carmichael, former Chairman, Australian Prudential Regulatory
Authority & CEO, Promontory Group, Australasia, LLP
7.45 PM Panel Discussion and Audience Q&A
Moderator:
Anthony Neoh, former Chairman, HKSEC & Barrister SC
Panelists:
Mark Steward
Stefan Gannon
David Webb, Corporate governance advocate
Jeffrey Carmichael
9: 15 PM End of evening dialogue, Thank you drinks
27
Opinion
Federal Reserve introduces
regulation by hypothetical
The US Federal Reserve needs to abandon
two pillars of the Dodd-Frank Act argues
University of Georgias Mehrsa Baradaran.
BANKING regulation presently in the
US resembles a cat-and-mouse game of
industry change and regulatory response.
Often, a crisis or industry innovation will
lead to a new regulatory regime. Past
regulatory regimes have included geo-
graphic restrictions, activity restrictions,
disclosure mandates, risk management
rules, and capital requirements. But the
recently enacted Dodd-Frank Act intro-
duced a new strain of banking-industry
supervision: regulation by hypothetical.
Regulation by hypothetical refers to rules
that require banks to predict future crises
and weaknesses. Those predictions which
by denition are speculative become the
basis for regulatory intervention.
Two illustrative instances of this regula-
tion were codied in Dodd-Frank: stress
tests and living wills. They are two pillars on
which Dodd-Frank builds to manage risk in
systemically important nancial institutions
(SIFIs).
As I argue in my forthcoming article
for the October edition of the 67 Vanderbilt
Law Review, regulation by hypothetical in
Dodd-Frank should be abandoned for three
reasons: it relies on a faulty premise, tasks an
agency with a conicted mission, and likely
exacerbates the moral hazards involved
with governmental sponsorship of private
institutions.
Because of these weaknesses, the
regulation-by-hypothetical regime must
be either abandoned (my rst choice) or
strengthened. One way to strengthen these
hypothetical scenarios would be to conduct
nancial war games.
Reverse intentions
First, regulation by hypothetical is an exten-
sion of the risk-management regime, which
most scholars believe was either a failure or
of limited efcacy. If the risk-management
framework failed, as some say, because
rms did not consider risks that were severe
enough, then hypothetical regulation could
provide an antidote by compelling banks to
consider more severe scenarios of economic
failure.
However, if the risk-management
regime failed because it was based on a
faulty premise that it is possible to imagine
28
and prepare for every scenario that might
affect a rm in the future then any regula-
tions designed on hypotheticals are of lim-
ited use, too.
Conict of interest
The Federal Reserve Bank uses historical
modeling in designing its hypotheticals, and
therefore these models are inherently unable
to account for unprecedented events, often
referred to as black swans, which are often
the triggers for nancial crises.
Second, the Federal Reserve, the creator
and administrator of mandated hypothetical
testing, comes to the project with a conict
of interest. The Federal Reserve has always
been a systemic risk regulator, and Dodd-
Frank emphasises and strengthens that
function of the Federal Reserve.
But the Federal Reserve is also tasked
with ensuring calm markets. Therefore, if
the Federal Reserve creates a stress test that
is too difcult and rms are not able to with-
stand the pressure, markets may panic.
On the other hand, if the Federal Reserve
creates a softstress test to reassure markets
about bank safety, systemic risks may well go
unaddressed.
Mandated moral hazard
This is not only a theoretical problem. It was
apparent during the rst round of stress
testing that the Federal Reserve was more
interested in calming markets. The Federal
Reserve publicised the results, predictably
causing a boost in the stock prices of the
tested banks and a general surge of market
condence.
Third and relatedly, when the govern-
ment conducts what it claims to be the
rigorous stress test of a bank and then gives
it a clean bill of health, the market receives a
signal not only that the banks risks are well
managed, but that the government itself will
stand behind the bank in case that assess-
ment proves incorrect or another example
of mandated moral hazard.
In other words, whereas faulty risk man-
agement modelling before Dodd-Frank
was used by individual rms to inform their
investment strategies, regulation by hypo-
thetical has a game-changing quality.
Regulators are now using models to
reassure markets of rm strength, thereby
providing a stamp of approval that could
well lead to unjustiable reliance by markets.
Another implicit subsidy
The Federal government has already been
accused of over-subsidising large banks by
providing below-market funding, Federal
Deposit Insurance Corporation insur-
ance, and too-big-to-fail implicit bailout
protection.
This new regime creates another Federal
Reserve subsidy to the largest banks a mar-
ket signal that certies the health of these
rms. If the hypotheticals were accurate and
the stress testing rigorous, this might not
be that troublesome, but these hypothetical
tests are not accurate barometers of bank
health because of the two failings mentioned
above.
In fact, the regulatory stamp of approval
more likely has the effect of lulling mar-
kets into complacency and suppressing
more rigorous analysis of the largest rms.
It may also make it more likely that these
rms would be bailed out again (another
subsidy) in the event of a disaster, because
29
counterparties can claim reliance on Federal
Reserve pronouncements that led them to
invest in unsafe banks.
There are two ways to deal with these
shortcomings: rstly to recognise them and
abandon the hypothetical regime based
on the conclusion that unreliable data and
indicators are worse than none at all; or sec-
ondly, to attempt to remedy them by taking
account of human behaviour in the hypo-
thetical scenarios.
Although I think that the rst option is
better, I recognise that regulation by hypo-
thetical may be here to stay. If regulators
continue to mandate hypothetical regula-
tion, they must both understand the limits
and problems with these models and also
strengthen the regime by increasing its diag-
nostic value.
One tool for improving regulation by
hypothetical would involve borrowing from
military war game modelling to better pre-
dict crisis responses.
The current hypotheticals only look at
balance sheets at a static point in time and
do not attempt to predict how rm manage-
ment might react to specic market events.
For example, it would be relevant to
know in predicting systemic risk, whether
a fund manager faced with a stock market
loss would try to prevent further loss, double
down on risk to try to recuperate, or attempt
to hedge to account for the loss.
All of these responses would implicate
different parts of the nancial market as
well as different counterparties. An accurate
war game scenario could provide regula-
tors better information about rm response
and systemic vulnerabilities. Even so, these
nancial war games would still rely on
hypotheticals created by regulators and
would suffer from the same limitations and
problematic market signals.
Editors note: The publisher and editors
would like to thank Associate Professor
Mehsra Baradaran of the University of
Georgias School of Law for allowing the
Journal to publish an advance prcis of a
forthcoming paper that will appear in the
October 2014 edition of 67 Vanderbilt Law
Review. Please be advised that copyright
remains the sole perogative of the author
and that the original paper can be accessed
from:http://papers.ssrn.com/sol3/papers.
cfm?abstract_id=2402201
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email: fona@edit24.com
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writers, editors, press & public relations practitioners
AT YOUR SERVICE AROUND THE CLOCK
31
Book review
Superuous Financial
Intermediation
Barnard Colleges Prof. Rajiv Sethi nds much
to like and dislike in Micheal Lewiss latest ex-
pos of the underbelly of Wall St., Flash Boys.
MICHAEL Lewis has a gift for mak-
ing complex phenomena intelligible
through simple anecdotes. In his latest
book, Flash Boys, he uses this device to
illustrate what might be labelled super-
fuous fnancial intermediation.
This is the practice of inserting oneself
between a buyer and a seller of an asset,
when both parties have already commu-
nicated to the market their willingness to
trade at a mutually acceptable price. If the
intermediary were simply absent from the
marketplace, a trade would occur virtually
instantaneously at a single price acceptable
to both parties. Instead, both parties trade
against the intermediary, at different prices.
The intermediary captures the spread at the
expense of the parties who wish to transact,
adds nothing to liquidity in the market for
the asset, and doubles the notional volume
of trade.
One example from the book is where
a hundred thousand shares in a company
have been offered for sale at a specied price
across multiple exchanges. A single buyer
wishes to purchase the whole lot and is
willing to pay the asking price. He places a
single buy order to this effect. The order rst
reaches BATS, where it is partially lled for
ten thousand shares; it is then routed to the
other exchanges for completion. An inter-
mediary, having seen the original buy order
on arrival at BATS, places orders to buy the
remaining ninety thousand shares on the
other exchanges. This latter order travels
faster and trades rst, so the original buyer
receives only partial fulllment. The interme-
diary immediately posts offers to sell ninety
thousand shares at a slightly higher price,
which the original buyer is likely to accept.
All this occurs in a matter of milliseconds.
The intermediary here is serving no use-
ful economic function. Volume is signi-
cantly higher than it otherwise would have
been, but there has been no increase in mar-
ket liquidity. Had there been no intermedi-
ary present, the buyer and sellers would have
transacted without any discernible delay, at
a price that would have been better for the
buyer and no worse for the seller. Further, an
order is allowed to trade ahead of one that
made its rst contact with the market at an
earlier point in time.
32
Another example given involves inter-
actions between a dark pool and the public
markets. The highest bid price for a stock in
the public exchanges is US$100.00, and the
lowest ask is US$100.10. An individual sub-
mits a bid for a thousand shares at US$100.05
to a dark pool, where it remains invisible and
awaits a matching order. Shortly thereafter, a
sell order for a thousand shares at US$100.01
is placed at a public exchange. These orders
are compatible and should trade against
each other at a single price. Instead, both
trade against an intermediary, which buys at
the lower price, sells at the higher price, and
captures the spread.
As in the rst example, the intermedi-
ary is not providing any benet to either
transacting party, and is not adding liquidity
to the market for the asset. Volume is dou-
bled but no economic purpose is served.
Transactions that were about to occur any-
way are preempted by a fraction of a second,
and a net transfer of resources from inves-
tors to intermediaries is the only lasting
consequence.
The most damning claim in Flash Boys
concerns the behaviour of brokers who direct
trades to their own dark pools at the expense
of their customers. Brokers with less than a
ten percent market share in equities trading
mysteriously manage to execute more than
half of their customers orders in their own
dark pools rather than in the wider market.
This is peculiar because for any given
order, the likelihood that the best matching
bid or offer is found in a brokers internal
dark pool should roughly match the bro-
kers market share in equities trading. Lewis
presents evidence that a small portion of
the order is traded at external venues in a
manner that allows the information content
of the order to leak out. This results in a price
response on other exchanges, allowing the
internal dark pool to then provide the best
match.
Michael Lewis has focused on such prac-
tices because their social wastefulness and
fundamental unfairness is transparent. But
it is important to recognise that most of the
strategies implemented by high frequency
traders and broker-dealers may not be quite
so easy to classify or condemn. For instance,
how is one to evaluate trading on short-term
price forecasts built from genuinely public
information?
I have argued elsewhere that the prolif-
eration of such information extracting strat-
egies can give rise to greater price volatility.
Furthermore, an arms race among interme-
diaries willing to sink signicant resources
into securing the slightest of speed advan-
tages must ultimately be paid for by inves-
tors. This is a consequence of Jack Bogles
dictum: Gross return in the market, less
the costs of nancial intermediation, equals
the net return actually delivered to market
participants.
Flash Boys has its share of minor factual
errors, but these do not detract from the
books main message, or derail the impor-
tant and overdue debate that it has stirred.
By focusing on the most egregious practices,
Lewis has already picked the low-hanging
fruit. What remains to be determined is how
typical such practices are. Taking full account
of the range of strategies used by high fre-
quency traders and Wall Street banks, to
what extent are our asset markets charac-
terised by superuous nancial intermedia-
tion?
33
Book review
Trading places in America:
Chinas faustian bargain
Renowned Sinophile Stephen Roach calls
for a change of roles in US-Sino economic
relations in his latest book Fred Andrews.
STEPHEN Roach (pictured above) pro-
poses to remake the two largest econo-
mies on the globe, that of the United
States and Chinas. For decades, he
writes, the United States and China relied
too much on a marriage of convenience
that guaranteed China a huge market
for its exports. In exchange, China gave
American consumers a cornucopia of
inexpensive products, while creating a
willing buyer of the United States gov-
ernments swollen debt. But that mar-
riage has played out, Mr. Roach says; it
has warped the two economies, leaving
them ill-equipped for further growth.
In Unbalanced: The Codependency of America
and China, Mr. Roach asserts that its time
for the two nations to switch identities: that
the United States should change its empha-
sis from consuming to producing, and that
China should do the opposite.
Mr. Roach suggests that the way for the
two nations to prosper is jointly. If China is
to build a consumer society and nd jobs for
millions of peasants ooding into cities look-
ing for work, it must create a robust services
sector. The trick for the United States is to
build its exports by helping China meet that
need, exploiting American expertise in eve-
rything from running retail chains to over-
night delivery to professional services.
A US$4 trillion market
China is already the third-largest importer
of American products. It has gobbled up
American producer goods, so prospects for
broader American exports are good. Mr.
Roach calculates that a US$4 trillion market
is opening up for foreign providers.
None of that will come easily, Mr. Roach
concedes. He says China can probably pull
it off its consumerist goals are already
built into its Five-Year Plan. But he won-
ders, without offering much of a blueprint,
whether the American people and their
elected leaders can stomach the sacrices of
saving rather than consuming.
Anti-Chinese whispers
The alternative, he worries, might be more
st-shaking toward China and, conceivably,
a devastating trade war that nobody wants.
Strident anti-Chinese voices in Congress
34
arent entirely bad, Mr. Roach says a Senate
bill proposing trade sanctions, sponsored by
US Democrat Senators Charles Schumer of
New York State and Sherrod Brown of Ohio
in late 2011 spooked China into lifting the
value of its currency, thus raising the price of
Chinese imported products.
Illusions of Don Quixote
But if the United States economy doesnt
revive and Washington actually enacts trade
sanctions, a tit-for-tat exchange of curbs
could career out of hand as Beijing replies in
kind.
Mr. Roach offers an evenhanded,
thorough response to the anti-China
rhetoric emanating from Democrats and
Republicans in both Congressional houses
alike. It is surprising, though, how matter-
of-factly he seems to accept that America is
on a downhill slope. In the fresh relationship
that he sketches for the two world pow-
ers and reminiscent of the hero-servant
interplay found in Don Miguel de Cervantes
Saavedras 1605 literary classic, Don Quixote
- China is the mature senior partner (Sancho
Panza) and America its problematic, less reli-
able junior (Don Quixote).
China addiction
Mr. Roach is a global affairs senior fellow at
Yale who once led Morgan Stanley Asia. A
top Wall Street global economist, he was
struck by how adroitly China dodged being
drawn into the Asian nancial crisis in the
1990s (by pushing cheap exports to nance
huge dollar reserves). It didnt take long for
me to get hooked on the Chinese develop-
ment miracle,he writes.
And hooked he remains. Much of his
book is devoted to defusing hostility toward
China. He notes, for instance, that though
Chinese exports ravaged American manu-
facturing, their low prices reduced consumer
ination in the United States by way of
example, some 70 per cent of what giant US
retailer Walmart sells within its stores comes
from China.
And though China gets a black eye for
excessive exports to the United States, Mr.
Roach sees it as wrongly blamed. China
is often just the nal link in a long supply
chain, assembling parts made elsewhere.
Yet under international accounting rules,
the entire value of such products is recorded
as Chinese exports, though much of their
value was produced in other countries
among these, the United States itself via
such tech titans as AMD, Broadcom, Intel,
Nvidea and Qualcomm.
The root problem
Chinas enormous holdings of United States
Treasury debt are a grave worry, he acknowl-
edges. If China were abruptly to stop buy-
ing US Treasury debt, Uncle Sam would be
hard-put to nd buyers for so much volume
and almost certainly would have to pay
higher interest.
The root problem, Mr. Roach says repeat-
edly, is Americas inability to save enough at
home to nance its growth a situation that
is hardly Chinas fault. And a day of reckon-
ing is coming. If China devotes more of its
surplus savings to funding a decent pension
plan or health care for its citizens, it will spend
that much less at US Treasury auctions.
Mr. Roach walks a line between explain-
ing China and excusing it. He stresses that
its modern economy, barely three decades
35
old, is still learning the game. He notes that
though China has a terrible record on intel-
lectual property rights, the West has dealt
with intellectual-property issues since the
1400s; Chinas patent law dates only to 1985.
And, yes, the Internet is censored, often
heavy-handedly, but it does exist and even
thrives in China; it has by far the worlds larg-
est Internet community, which plays a vital
role in creating the new consumer economy.
Mr. Roach understands that China, in
many ways still a poor country, differs vastly
from the United States. He acknowledges
the Chinese Communist Partys many aws.
He knows that it cracks down proactively on
any dissent that threatens its rule.
He is aware that dealings between
Washington and Beijing can sour for innu-
merable reasons. And he is terribly pessi-
mistic about political myopia and paralysis in
Washington.
But the endgame provides enormous
opportunity for each, he writes. The
challenge is for both to see it.
Editors note: The publisher and editors of
the Journal would like to extend their thanks
to both Professor Stephen Roach and Fred
Andrews, together with the New York
Times, for allowing the Journal to publish
an amended version of this review, which
originally appeared under the headline:
The case for swapping roles with China,in
the business section of the New York Times
on January 16, 2014. We kindly remind
our readers that copyright of this review
remains the sole preserve of its author, Mr.
Fred Andrews, and the New York Times.
Professor Roachs book - Unbalanced: The
Codependency of America and China, is now
available across Asia Pacic from leading
bookstores and online retailers.
NORTH ASIA
Editorial deadline for
Vol VI Issue II Summer 2014
July 15th 2014

Unbalanced
The Codependency of America and China

Stephen Roach

The Chinese and U.S. economies have been locked in an
uncomfortable embrace since the late 1970s. Although the
relationship arose out of mutual benefits, in recent years it has
taken on the trappings of an unstable codependence, with the two
largest economies in the world losing their sense of self, increasing
the risk of their turning on one another in a destructive fashion.
In Unbalanced: The Codependency of America and China
Stephen Roach lays bare the pitfalls of the current China-U.S.
economic relationship. He highlights the conflicts at the center of
current tensions, including disputes over trade policies and
intellectual property rights, sharp contrasts in leadership styles,
macroeconomic strategy, the role of the Internet, the recent
dispute over cyberhacking, and more. He concludes with an
assessment of the opportunities that await both nations if they
rebalance their growth models.

Stephen Roach combines scholarly expertise and long practical
experience in this thought-provoking critique of economic policy.
His insights and arguments will influence the debate on both sides
of the Pacific.
Henry A. Kissinger

[An] eye-opening look at a condition that wanders from the
boardroom to the psychiatrists couch: financial codependency,
which enables the worst qualities of two powerful economies
Full of implication, well written and of much interest.
Kirkus Reviews

Unbalanced is an education in growth, stability and postwar
globalization, full of deep insights and colorful personalities on
both sides, and wonderfully well written. Very few people have the
breadth of knowledge and experience to write such a book.
A. Michael Spence, Nobel Laureate in Economics

How the U.S. and China will transit from precarious
codependency to stable coexistence is one of the most crucial
questions for the 21
st
century. This is a timely and must-read book.
Justin Yifu Lin, former chief economist, the World Bank

An evenhanded, thorough response to the anti-China potshots
from Democrats and Republicans alike"
Fred Andrews, New York Times

New from
Yale University Press

Stephen Roach is senior fellow,
Jackson Institute for Global Affairs and
School of Management, Yale University.
Prior to that he was Chairman of Morgan
Stanley Asia, and for the bulk of his
career on Wall Street was Chief
Economist of Morgan Stanley. He holds a
Ph.D. in economics from New York
University. Roach has written extensively
for the international media and appears
regularly on television around the
world. He lives in New Canaan, CT.

ISBN 978-0-300-18717-5
$32.50

Available at bookstores,
through online booksellers,
at yalebooks.com, or by
calling Triliteral Customer
Service at 1-800-405-1619.

New from Yale University Press
37
Book review
Marriage of government and
banks: For better or for worse!
Alex J. Pollock of the American Enterprise
Institute waxes lyrically about Charles
Calomiris and Stephen Habers latest study.
Fragile by Design: The Political Origins
of Banking Crises and Scarce Credit, by
Charles Calomiris and Stephen Haber,
combining their scholarship of banking
and political institutions, is a book full of
fertile ideas, instructive histories of the
evolution of a number of banking sys-
tems, and provocative interpretations of
the co-dependency between banks and
governments.
Three main tenets inform the bulk of
Calomiriss and Habers joint study of the
banking sector, namely that each bank-
ing system needs to be understood as a
mutually protable deal between the politi-
cians who control the government and the
bankers who receive government charters
for their banks. These deals vary among
countries in historically contingent or path
dependentways, resulting in quite different
banking systems in some countries, robust;
in others, systems prone to collapse. The
governments of modern states absolutely
need banks, not least to lend money to the
government itself. In exchange, they grant
banks various charter privileges, including
restricted competition and government sup-
port. Likewise, the banks need the govern-
ment for their chartered existence. Working
out the specics of these deals the authors
call the game of bank bargains.
Thinking of banking systems in this
fashion, as deals between governments and
banks, is without question a deep and pow-
erful perspective.
As a perfect current example of such a
deal, consider that European banks are now
full of credit to European sovereign bor-
rowers,i.e. governments. In two particular
cases, as economist Brendan Brown recently
observed, Spanish and Italian banks have
been loading up on their domestic govern-
ment bonds, as part of their deal in the over-
all rescuing of those respective sovereigns
from insolvency.
Meanwhile, paradoxically, the credit of
the banks themselves is dependent on the
support of these governments.
As Brown continues, Yes, the banks get
regulatory forbearance on their holding of
government bonds of course! since the
regulators work for the government and
can treat the carry trade prot on these as
38
full earnings with no loss reserves. And yes,
there are barriers to entry of new banks who
would not own legacy bad assets and who
might refuse to take part in government
nancing. Yet would-be equity shareholders
are deeply anxious about this faade.
The Grand Bargain
In one sense it is indeed a faade. But in
another, it is a classic government-bank bar-
gain more appropriately termed a Grand
Bargain. The European situation has been
referred to as the perverse nexus of govern-
ments and banks. Calomiris and Habers
argument is that a nexus between these two
is always there, though it may or may not be
perverse.
In this perspective, banks include the
central banks, which are an essential part of
the banking system and an essential part of
the government-bank deal. This is exempli-
ed by the European Central Banks what-
ever it takessupport of government debts,
and even more explicitly in the Federal
Reserves monetisation of US Treasury debt
and government mortgage securities to the
combined tune of US$4 trillion.
Old Lady of Threedneedle St.
This pattern is nothing new. Central banks
are always available to lend money to the
government when needed, and get in
exchange monopoly powers. This is seen in
archetypical form in the history of the Bank
of England often referred to as the Old
Lady of Threadneedle Street.
As the book discusses, the foundation
of the Bank of England in 1694 was a bank-
government deal in pure form: The Bank
committed to lend the government money
to nance King Williams wars against
France, and in return got a monopoly in lim-
ited liability banking and in currency issu-
ance in London.
The long-term history of banking cannot
be considered apart from the history of wars,
which have generated the biggest govern-
ment needs for borrowing and for ination-
ary depreciation of debts.
A notable example of a bank bargain
(Grand Bargain) in the context of war, as
instructively explored in the book, is the US
National Banking Act, originally called the
National Currency Act, of 1863-64, devel-
oped under the auspices of the Abraham
Lincoln Administration.
Demands of war
This key banking deal was to help nance
the vast American Civil War, by creating
national banks which could issue paper cur-
rency for a prot, but which in order to do
so, had to buy an equivalent amount of US
government bonds a clever idea. It was
also intended to create a uniform national
currency, and drive the currency previously
issued by hundreds of state-chartered banks
out of circulation.
It was thus a nationalist idea, and yet, as
Calomiris and Haber convincingly argue,
it left intact an older bank deal, that guar-
anteed a state-centered banking system of
mostly small, undiversied, local unit banks.
This was, they further argue, the result of a
robust political coalition between rural pop-
ulists and unit bankers to fend off any con-
centration of nancial power in the form of
nationwide banks. The success of this coali-
tion for 150 years meant that US banks were
limited to single states, and often to single
39
ofces as they were when I myself was a
young banking ofcer.
Catalogue of crisis
The result of this government-bank deal,
the authors conclude, was to give the United
States a fragmented, risky banking system
prone to periodic panics and collapses. The
country (USA) witnessed banking crises, by
the authorscount, in 1837, 1839, 1857, 1861,
1873, 1884, 1890, 1893, 1896, 1907, the 1920s,
1930-33, 1980-92, and 2007-09. We should
add the crisis of 1974-76 to this long list of
episodic banking events.
In time, Calomiris and Haber relate that
the rural populist-small bank coalition was
replaced by a new one: urban populists and
big banks. This reected the shift from a
predominantly rural to an urban population,
but also in the political dynamics of the rapid
banking consolidation which has marked
the past three decades.
US Federal legislation of the 1970s put
urban populist community groups in a
position to object to, delay and possibly stop
mergers which the big banks wanted to do,
as the long-delayed natural consolidation of
American banking got rolling.
New populist alliances
It was cheaper and more efcient for the big
banks to promise money and lower credit
quality loans to the constituencies of the
urban populist organisations, than to have
their mergers held up, thus launching a new
political alliance.
This shift of US bank bargains Grand
Bargain over time is strikingly symbol-
ised by the names of the Congressional
committees with jurisdiction over banks.
Traditionally, in both the Senate and the
House of Representatives, the name was
The Committee on Banking and Currency.
A sensible title.
But in the 1970s, the Senate committee
changed its name to The Committee on
Banking, Housing and Urban Affairs,while
the House changed to The Committee on
Banking, Finance and Urban Affairs. The
new names represent very different ideas
from the old one! As a former Senate
Committee staffer told me, It seemed like
the committee was more about housing
than banking.
Canada: A paragon of virtue?
After the Republican Party took control
of the House in the 1990s, they changed
the Committees name again, to The
Committee on Financial Services. The dif-
ferent names in the two houses now nicely
summarise two very different approaches:
whether the government should be the
guarantor of housing nance and the pro-
moter of low quality mortgage loans and
higher leverage or not!
A banking system with a different bank
bargain, and the banking system most
admired by Calomiris and Haber, is that of
Canada. Indeed the Canadian system has
much to say for itself, especially its long-term
stability as contrasted with the US propensity
for cyclical collapses. Since 1839, the authors
write, some Canadian banks have failed,
but the country has experienced no systemic
banking crises. The Canadian system has
been extraordinarily stablethere has been
little need for government intervention in
support of the banks since Canada became
an independent country in 1867.
40
How this historically came about is
described in interesting detail, with Canadas
notable banking stability provides a convinc-
ing refutation of the theory of the proponents
of the Glass-Steagall Act, or more recently
of the Volcker Rule, since Canadas prin-
cipal banks are all universal banks, which
combine commercial, investment, and retail
banking, as well as other nancial services.
Stability and competition?
Canada is similar to the US in many ways,
though economically on a smaller scale. Its
population is about 11 per cent of the United
States, and its GDP is likewise about 11 per
cent. But its banking assets are proportion-
ately much bigger, about 23 per cent of the
US. And in contrast to the 7,000 US banks,
only ve nationwide banks entirely domi-
nate the Canadian banking sector.
An oligopoly of ve nationwide banks
has evidently provided stability. But is
Canadian banking competitive, with the
advantages for customers only competition
can bring? Calomiris and Haber consider
the evidence and conclude that it is quite
competitive. So whats not to like?
Canadian housing bubble
Maybe real estate lending? Interestingly
enough, US national banks and Canadian
chartered banks were both originally pro-
hibited from making real estate loans, since
these were considered too risky for banks.
In both countries that prohibition is long
gone. In the US, even the central bank is
now a US$1.7 trillion investor in real estate
loans, and the ve big Canadian banks own
most of the real estate mortgages in their
nation.
Furthermore, Canada did not share in
the extremes of the 2007-09 banking crisis,
but ve years later, does now seem to have
its own housing bubble. At least housing
prices there are at historic highs, having
increased far more than US house prices
did at the peak of its bubble. What happens
to the Canadian banking system then, if or
when their housing bubble deates? Will it
retain its historical record of banking stabil-
ity? This may be a good stress test for the
Canadian bank bargain.
Omissions
Speaking of the future, I wish the authors
had more to say in the way of explicit pre-
scriptions, especially for the US government-
bank deal, to add to their admirable history.
Would we in the US, for example, want ve
nationwide, universal banks with 90 per cent
of the market among them, in exchange for
the stability of the Canadian system? If ve
is too few oligopolistic, nationwide banks for
a country as big as the US, how many such
banks would we like?
Should we try to move to a non-populist
bank bargain like Canadas? Even though
the books theory suggests that given our
historical path, we cant get there, should we
try? How many banks should the US have in
total? If 7,000 is too fragmented and unsta-
ble, what is the perfect number?
How can we undo the housing part of
the US bank bargain and defeat the coali-
tion which promotes hyper-leveraged real
estate risk, as symbolised in the name of the
Senate committee? Is some other coalition
possible? Perhaps the sequel to Fragile by
Design will address these and other pressing
questions.
41
Book prcis
Halcyon era of British retail
banking largely a sham
Ian Fraser offers a prcis of his upcoming
book on the demise of both the Royal Bank
of Scotland and the UKs retail bank sector.
IN the UK popular imagination the
pre-1980s bank manager is a Captain
Mainwaring type fgure a pompous,
bumbling, offcious, well meaning char-
acter epitomised by the actor Arthur
Lowe in the long running British com-
edy series, Dads Army. He and it was
always a he was middle class, kindly,
and always had customers best interests
at heart. He was pastoral as opposed to
predatory in that his focus was ensur-
ing lending was done responsibly and
that bad debts were minimised.
His mission was to ensure that credit ended
up in the right hands, underpinned by a
deep knowledge and understanding of his
local community. In this way, he instilled
sufcient trust for consumers to entrust
their savings to him. While the stereotype
is appealing I began to realise it was wide
of the mark when researching my book
Shredded: Inside RBS The Bank That Broke
Britain. The retired NatWest, Royal Bank of
Scotland and National Commercial Bank
of Scotland managers I interviewed for the
book soon disabused me of any notion that
the bank managers of the 1950s to 1970s
were saintly, or that this was a halcyon era
for British banking.
The British banking sector was a pro-
tected and highly protable oligopoly. The
Bank of England favoured muted competi-
tion, as it made supervision easier. There was
a gentlemens agreement between English
and Scottish banks that they would not
encroach on each others territories. British
banks liked these cozy arrangements, as they
enabled them to over-charge for what was,
at times, lousy service without the need for
much investment or innovation.
Institutional investors welcomed the
situation, as a lack of competition kept
banks margins high and the prots rolling
in. The priorities of the late Charlie Winter,
RBSs group chief executive from 1985 to
1992, were: staff rst, customers second, and
shareholders third (if at all).
That was turned on its head by the 1980s.
In the wake of President Nixons decision
to tear up the Bretton Woods agreement in
1971, the government of Margaret Thatcher
had little choice other than to end exchange
controls. Her radical pro-free -market
42
agenda saw the removal of the corsetand
other constraints on consumer credit and
enabled the building societies to compete
on a level playing-eld with banks. Big
Bang not only ended xed commissions
in the City of London but also brought an
unprecedented degree of deregulation, liber-
alisation and scope for agglomeration in the
nance sector.
Policy goal
The policy goals were to enable the City to
regain its crown as the worlds pre-eminent
international nancial centre from New York;
to increase competition in the hope that UK
customers might obtain a better deal; and
free up the credit market so as to stimulate
economic growth, and to entrench a prop-
erty-owning democracy.
By the early 1990s, RBS was licking its
wounds after the property crash of 1990-91
and was being comprehensively trounced by
its main rival the Bank of Scotland in its main
markets. Board members became convinced
the only way the bank could survive was
to reinvent itself from the bottom up and
to turbocharge its growth with signicant
acquisitions south of the border now that the
gentlemens agreement had lapsed.
Project Columbus
The person they hired to implement such
changes was George Mathewson, an engi-
neer and former university lecturer who
had led a regional development agency
and worked in both aerospace and private
equity. Mathewson, the rst non-banker to
have led the institution in its recent history,
was regarded with deep suspicion by many
of RBSs old school bankers.
They were right to be fretful. Mathewson
led what has been described as a Chairman
Mao-style revolution at the bank that com-
menced with a bloodbath. Within a few
months the golf courses of Edinburgh had
lled up, as he effectively ousted two-thirds
of the banks top 300 managers.
With input from consultancy McKinsey
he devised a strategy, Project Columbus,
that saw the segmentation of the customer
base. Business and corporate banking were
removed from the branches and transferred
to new dedicated regional hubs and deci-
sion-makers stripped out of the branches.
All credit decisions, even for the tiniest loan
to a retail customer, were transferred to a
small elite specialist credit team based at a
new building in Edinburghs South Gyle,
which used new-fangled computerised pro-
cesses to assess peoples tness for a loan.
Hollowed out branches
Under Mathewson the bank also intro-
duced a rank and yankperformance meas-
urement system, and incentive pay for all
22,500 retail banking staff they were given
extra pay and perks, including all-expenses-
paid foreign holidays if they met specic
sales targets. Cross-selling trying to sell
additional nancial services and products,
notably high-commission insurance prod-
ucts, to existing customers became the holy
grail.
Any surviving Captain Mainwaring
types either left in disgust or were cleared
out. They were replaced by bright young
things in shiny suits whose number one pri-
ority was to sell. Mathewson had hollowed
out the branches and transformed them into
the front line in a sales war. Mathewson sold
43
off the investment bank Charterhouse, asset
managers Capital House and investor ser-
vices division RBS Trust Bank, but expanded
the insurer Direct Line, enlarged the banks
footprint in the US, entered a strategic alli-
ance with Santander, formed a banking
joint venture with Tesco and tried and failed
to acquire numerous building societies.
NatWest takeover
Under Iain Robertson he also built up the
banks presence and product offering in the
corporate banking market. The banks focus
was now rmly on shareholders, not staff
or customers. And for them, Mathewson
delivered. He drove it so hard that in 1998, it
became the rst Scottish company to achieve
prots of more than 1bn.
After a prolonged battle with its erce
rival the Bank of Scotland, RBS secured an
audacious 21bn takeover of the much larger
NatWest in February 2000. Mathewson and
his boardroom colleagues almost imme-
diately appointed Fred Goodwin, a former
Touche Ross accountant who had spent a
year running the National Australia Bank-
owned Clydesdale Bank, as RBSs next chief
executive.
Enter Fred the Shred
Goodwin is regarded as having excelled
himself during the arduous takeover battle,
convincing sceptical institutional investors
that he had a much better chance of suc-
cessfully crunching NatWest together with
his own bank than his counterparts at Bank
of Scotland.
Goodwin, who colleagues believed suf-
fered from a form of Aspergers Syndrome,
was nicknamed Fred The Shred because
of his proclivity for verbally dismantling col-
leagues and sacking people. He proceeded
to institute an expanded version of Project
Columbus, stripping out back ofce func-
tions from NatWest and transferring these
to a dedicated manufacturing division,
amalgamating data centres, and making
nearly one third of NatWests 65,000 staff
redundant.
What astonished the banks new head of
retail banking, Gordon Pell, the most was the
lack of any sales processes at NatWest. Pell
said: They had lost track of the fact that they
were really managing a sales force and not a
load of bank clerks and they were about nine
or ten years out of date, actually.
Goodwin loses his head
The revolution worked. Goodwin exceeded
cost-saving and revenue synergy targets,
successfully growing RBSs prots from
1.21bn in 1999 to 6.45bn in 2002. This bol-
stered the enlarged banks share price and
caused City of London investors to virtu-
ally hero worship the Paisley-born chartered
accountant. Between the years 2000 and
2004, in a collective swoon they gave him
carte blanche to pursue further deals.
However, success went to Fred
Goodwins head, especially after he was
named Forbes global business man of the
year in December 2002 and knighted by the
Queen in June 2004.
After that he spurned advice from
respected advisers and generally took a
higher-handed approach to running the
bank and to its investors. Goodwin went
on to signicantly overpay for a string of
acquisitions, including Charter One in the
US, Churchill Insurance in the UK and
44
the mortgage bank First Active in Ireland.
Between 2000 and 2007, he bought a total of
27 nancial institutions, including a 5.16 per
cent stake in Bank of China. Analysts say he
came to believe his own hype.
Lack of IT investment
His regime took retail and business cus-
tomers for granted, using the retail bank as
a cash cowto fund international growth.
Customers were alienated through the wide-
spread mis-selling of products, including
personal protection insurance, and a great
many business customers were destroyed
through the mis-sale of interest rate hedging
products.
Goodwins failure to invest in the banks
IT backbone, meant that when markets
became volatile the bank became more or
less incapable of assessing risk, and there-
fore effectively unmanageable. It also meant
that, after it was rescued, many retail cus-
tomers would repeatedly be deprived of
access to their money as a result of IT system
meltdowns.
ABN Amro takeover
Another cardinal error made by Goodwin
was that he failed to adequately supervise or
control RBSs burgeoning investment bank-
ing arm, which got heavily into esoteric areas
of the nancial markets which were beyond
Freds ken. It also got up to its neck in all sorts
of nefariousness, including rigging Libor, the
bill for which has not yet been fully paid,
despite nes to the US Commodities and
Futures Trading Commission, Department
of Justice and the UKs Financial Services
Authority.
It also became a suckerfor savvier Wall
Street rms as they de-risked their balance
sheets in 2006-07. Risk managers who
warned of fantastical valuations on securi-
tised products and awed models were rou-
tinely dismissed, or walked after the bank
ignored their advice.
To compound these errors RBS pro-
ceeded to make a 72 billion takeover of
Dutch global banking ABN Amro four
months after the credit crisis erupted in July
2007. Driven by ego, conceit and the lust
for power, Goodwin and his two amigos
Fortis CEO Jean Paul Votron, and Santander
chairman Emilio Botin seemed oblivious
to the risks that were building up in the
global nancial system as they carved up the
wounded Dutch bank between them from
October 2007.
From boom to bust
For Goodwin it meant that by assets, which
totaled 1.9 trillion in December 2007, RBS
was briey the largest bank in the world.
However, the deal turned out to be one of
the worst in nancial history, and put RBS
in an even more perilous position due to
being funded using short-term borrowings.
Exactly a year after the deal ABN completed,
RBS was bust and only avoided extinction
thanks to massive state intervention total-
ling a collosal 1.3 trillion by some estimates.
The real tragedy of this shocking saga is
that so few lessons have been learnt. RBSs
bankers continue to help themselves to
up to 1bn a year in annual bonuses, even
though the bank has declared cumulative
losses of 46bn over the past six years. The
bank still treats its customers with contempt,
regulation has been skin deep and it remains
unlikely to turn a prot any time soon.
45
Book prcis
The suspicions of Mr. Whicher:
A mysterious case of AML
Chris Rogers wades through 650 pages
of Nigel Morris-Cotterills latest musings
on anti-money laudering in Asia Pacic.
NIGEL Morris-Cotterill, an expert in
money laundering, begins his 650-page
analysis of how and when we do and
dont form suspicion with a joke: the
dedication takes a different direction to
the usual list of thanks, then points out
that the reader was expecting something
different, uses that to demonstrate that
the reader is therefore, right from start-
ing out on something, constrained by his
expectations and by convention.
So, after a brief, traditional, dedication he
says, Happy now? Good. Now lets go and
ignore those traditions, set aside those con-
ventions and break open that box. Because
suspicion is never where you expect to nd
it. If it was, it would be knowledge.
The book contains many examples of
where the author, in addition to explaining
how people are misled, actively misleads or
at least misdirects his readers, then explains
why the trick worked.
The introduction denes the problem
that the book sets out to solve: When con-
fronted with the realities of money laun-
dering risk management, the rst question
most people ask is Do I really have to do
this stuff? The answer in a nutshell, is yes.
The second question they ask is how do
I know if I am suspicious? This is a sim-
ple question and deserves a simple answer.
And that answer, unsurprisingly, is: There
is no simple answer. What we do know is
that there is a state where there is no sus-
picion; and we know that there is a state of
suspicion.
What we need to know now is how one
moves from one to the other and at what
point no suspicion turns into suspicion.
There is no balancing point where there is
neither one nor the other. There is only black
and white, no room for grey. It is a switch
not a lever. In the marketing for the book, it
says six months, 650 pages, 130,000 words.
It is important that readers do not feel the
time they invest in reading and understand-
ing it is wasted.
So Nigel Morris-Cotterill attempts to
make every sentence carry a punch - a series
of short jabs followed to a cross to the jaw to
make the point forcefully. The plan was sim-
ple: lots of words, none of them to be wasted.
The book is set out in phasesto emphasise
46
that it is not linear: each phase, although
sometimes linked to another, develops a
specic topic while the book as a whole sets
out to resolve a specic issue.
Linear thought
The simple question how do I know if I
am suspicious?has hidden depth. First is
the question of what is suspicion?Despite
examining laws and regulations from around
the world, relating to nancial services and
much wider topics, Morris-Cotterill con-
cludes that there is no one single denition.
Courts say that suspicion must be based on
facts, but Morris-Cotterill shows how facts
are variable, and what is fact for one person
is not fact for another.
The rst major theme that is developed,
and which permeates the book, is that we, as
people, tend to think literally, in straight lines,
to trap ourselves in boxes dened by our
culture, expectations and even habit. These
militate against effective risk management,
especially nancial crime risk management.
He emphasises that unthinking compli-
ance with internal systems can increase, not
decrease, risk.
Undesirable rigid systems
Morris-Cotterill differentiates his analysis by
rarely using examples from within the nan-
cial sector. His objective is that his readers
begin to break down the barriers between
the knowledge they gain for their working
life and the knowledge they gain in their
personal lives. And so, when demonstrating
that unthinking compliance causes prob-
lems his examples include the operation of
trafc lights and pedestrian crossings at road
junctions in Singapore.
He does not simply say that the fact that
drivers and pedestrians are both shown
green lights at the same time creates a con-
ict in which the risk of collision is gener-
ated; he shows exactly why and how the
drivers decision making process is affected.
Having said that rigid systems are unde-
sirable, he turns to one of the most rigid sys-
tems ordinary people know: a baking recipe.
Then he shows how important it is to target
the systems to the audience: recognising that
almost all children love to help with home
baking, he points out that one recipe from a
highly respected TV cook says to heat milk
until just hand hot, i.e. so that you can hold
your little nger in without it burning.
24 phases
That, he points out, is an invitation to some-
one to say to a child,put your nger in this
and tell me when it starts to hurt. He says A
recipe for baking is, in effect, a management
process and to get the right results, you need
compliance.
These two examples show that processes
must be thought through, that options for
failure must be considered and that design-
ers must approach the design of systems
not from a policing standpoint but starting
with risk management (who might use this
system?) and then re-assess the completed
process from a risk management standpoint
(who might use this system and how could
someone intentionally or stupidly make it
fall over?).
A recurring theme that comes into sev-
eral of the 24 phases is that of people like
us. We tend to trust people with whom we
have something in common. In an exam-
ple based in a coffee shop, he demonstrates
47
that we might criticise people for a form of
conduct but, without thinking of the conse-
quences, we might do exactly the same. In
this way he demonstrates that people like
usdoes include criminals, and so one of the
primary lters for identifying suspicion is
open to question.
Helter-skelter ride
Next, the reader is taken on a helter-skelter
ride through his own feelings and emo-
tions, through how his mind works when
gathering information, how information is
accepted or rejected even before it is ana-
lysed, what things inuence where we look
for information and what factors inuence
how we view that information.
Using all manner of cultures from foot-
ball hooligans to religions, the way our back-
ground affects the way we view the conduct
of others, and therefore form suspicion, is
demonstrated in a raft of accessible ways.
A large painting, a smaller and more del-
icate one, a Wordsworth poem and a trans-
lationinto prose, black holes, a pebble in a
pond are all used to help the reader under-
stand how how we identify information,
how we think, how we react, and ultimately
how we draw conclusions.
Facts are not constant
Even hormonal changes and nutrition are
used to demonstrate that there are constant
variables in the ways that individuals make
decisions. As the reader works through the
phases, the complex question of how we
form suspicion gradually make sense.
Morris-Cotterill examines and explains
pattern analysis using the same tools as are
used in developing transaction monitoring
software, explaining at least some of that
which hides in the black boxes that the
HKMA recently told Authorised Institutions
(banks) that they should understand.
There are times when the book seems
to ramble, to be somewhat verbose, then
comes the point: in one case the point is that
the verbosity led to a loss of concentration, to
a reduction in the quality of decision mak-
ing, a practical example of how a person can
be led away from a point a money launderer
wishes to minimise the importance of.
Questions of what is true and what
is false, what is honest and what is a lie
are examined alongside the grey area in
between. For example, are delusions lies?
The example of US General Patten is a star-
tling example of how someone who, in other
times, would be regarded as delusional, was
considered an expert in a time of war.
The primary thesis of the book is that
whether or not a person is suspicious is
a feeling, an emotional reaction to facts.
However, as Morris-Cotterill sets out, it is
much more complicated than that.
At the beginning of the book, he says
there is no simple answer to the question
how do I know if I am suspicious?and at
the time that statement was made, when
the rst pages of the book were written, it
was true. But, as all the disparate informa-
tion, from many different sources and many
different disciplines come together, it turns
out that that there is a simple, single sen-
tence answer. The book itself demonstrates
that facts do change, that what is true today
might be untrue tomorrow. That is why
forming suspicion is so difcult. But at least,
now, readers will be able to give an effective
answer when they are asked that question.
49
Comment
The most dishonest number
in the world: Libor benchmark
William K. Black lambasts the Obama
administrations failure to tackle endemic
bank fraud epitomised by the Libor scandal.
THE US-based Federal Deposit
Insurance Corporation (FDIC), together
with the British Bankers Association
(BBA), has recently fled suit against 16 of
the largest banks in the world, alleging
that all named parties engaged in fraud
and collusion to manipulate the London
Inter-bank Offered Rate (Libor) which
the BBA once referred to as the most
important number in the world.
Libor is actually composed of many gures
that depend on the currency involved and
the term or maturity of the loan itself. The
collusion the FDIC suit refers to involved
manipulating most of these rates. A sig-
nicant number of loans and derivatives are
priced off of these numbers.
Estimates of the notional dollar amount
of deals affected by the collusion range from
US$300-US$550 trillion in deals manipu-
lated on any given date. The Libor frauds
began in earnest no later than 2005 and con-
tinued through to 2011.
The BBA, the industry body in which
the Libor panel was based, and the panels
member banks claimed to the world that
Libor was simply the price or interest rate
set by the market for what it cost the worlds
largest banks to borrow from each other. The
banks would report to the BBA those interest
rates and, after excluding outliers, the aver-
age reported cost to borrow for X days in
Y currency would be reported as the Libor
numberfor that particular day or deal.
The system itself was not formally regu-
lated. Instead, the theory promoted was that
the banks self-regulated. Libor was the City
of Londons crown jeweland theo-classical
economics predicted that the elite banks
self-interest in their reputation and the
value they gained from having Libor as the
global standard would ensure that the banks
would report honestly. Regrettably, as many
knowledgable folk can attest to, any discus-
sion of the banksinterests is dangerously
misleading.
The key question is the interest of the
banks ofcers, particularly those who con-
trol the banks. The unfaithful agent(bank
ofcer) is the leading threat to the banks.
Theo-classical economists assumed away
the agency problem, with disasterous
effects for innocent third parties caught up in
50
this scandal. The fact that the FDIC is only
suing 16 of the largest banks in the world
does not indicate that the other elite banks
were run honestly.
Twin emergencies
Quite the reverse in fact, for the other elite
banks were not part of the group that set
Libor so they could not join in the cartel.
The Libor conspiracy could only succeed and
persist if none of the 16 elite banks were con-
trolled by honest ofcers and no regulator
acted to end the collusion once they became
aware of it, which happened no later than
April 16, 2008. A real world test of the ethics
of the leaders of 16 of the worlds most elite
banks revealed that the scorecard according
to the U.S. government agency that inves-
tigated the matter (the FDIC) reports that
each of the leaders failed. Our twin emer-
gencies are therefore not only both nancial
and ethical but global.
Assets
According to the FDIC investigation, the
three largest banks in the US (including the
worlds two largest banks), the four larg-
est banks in the U.K, the largest bank in
Germany, the largest bank in Japan (plus one
of the handful of surviving main banks),
the third largest bank in France, the two larg-
est Swiss banks, the second largest bank in
Canada, and the second largest bank in the
Netherlands conspired together to manipu-
late Libor and not only lied about it but also
covered up the cartel and the fraudulent
scheme it used.
Of the institutions presently being sued,
one of which is now defunked, the 15 sur-
viving banks total assets were nearly twice
as large as the United States gross domes-
tic product as of September 30, 2013. The
list of banks on the lawsuit led by the
FDIC and their respective asset net worths
as of September 30, 2013 is as follows:
Bank of America Corp - US$3063 billion;
Barclays PLC - US$2275 billion; Citigroup
Inc - US$2693 billion; Credit Suisse Group
AG - US$1643 billion; Deutsche Bank
AG - US$2420 billion; HSBC Holdings
PLC - US$2723 billion; JPMorgan Chase
& Co - US$3678 billion; The Royal Bank of
Scotland Group PLC - US$1829 billion; UBS
AG - US$1160 billion; Rabobank - US$908
billion; Lloyds Banking Group -US$1409
billion; Societe Generale - US$1698 billion;
Norinchukin Bank - US$846 billion; Royal
Bank of Canada - US$825 billion; Bank of
Tokyo-Mitsubishi UFJ - US$2469 billion.
Ethics
Tallied together, the 16 banks sued by
the FDIC have assets in excess of some
US$29,639 billion. Excluded from this list of
banks being sued by the FDIC is Germanys
WestLB, the now infamous Landesbank,
which was sold off as part of that countrys
bailout efforts. At the time of its collapse,
WestLB had assets of approximately US$400
billion.
Considering the ethical and political
implications of what the FDIC investigation
has conrmed, the entire barrel of apples
is rotten. Every CEO failed the ethical test,
with the ethical bar set exceptionally low.
That can only happen when a Greshams
dynamic has been allowed to persist for
years because of deregulation, desupervi-
sion, and de facto decriminalisation. Such a
dynamic can cause bad ethics to drive good
51
ethics out of the markets. No one should be
able to view the facts the FDIC cites without
a sense of horror, combined with an urgent
commitment to transform the industry that
has done so much nancial and ethical harm
to our nations.
Reprehensible and harmful
There are two distinct possibilities at play,
which the Libor scandal, and consequen-
tial FDIC decision to sue exposes. The rst
is that the Obama administration knew for
six years that the worlds largest banks were
endemically led by fraud. Alternatively, the
Obama administration learned of that fact
recently when it was nally acquainted with
the results of the FDIC investigation into
manipulation of Libor. Given that the Libor
scandal became public knowledge with the
Wall Street Journals April 16, 2008 expose,
the second Bush administration also knew it
was dealing with elite frauds. Ultimately, if
the Obama administration has long known
that fraud was endemic among the leaders
of the worlds largest nancial institutions,
then its policies toward those CEOs and the
banks they control have been reprehensible
and harmful to say the least.
Control frauds
That said, if the Obama administration has
just learned from the FDIC investigation
about the true nature of the banks CEOs,
which the administration has refused to
hold accountable, whilst at the same time
allowing them to retain and even massively
increase their wealth through leading con-
trol frauds, then we can doubtless expect a
series of emergency actions transforming the
administrations nance industry policies.
The FDIC lawsuit provides a natural
experimentthat allows us to test which of
the above hypothoses is correct. The US
government, through the FDIC, has found
after a lengthy investigation of nearly three
years that the leaders of 16 of the worlds
largest banks conspired together to form a
cartel to manipulate the Libor numbers
and to defraud the public about the scam.
This should have led the criminal justice
authorities to prosecute large numbers of
senior ofcers of these banks. However, to
date none have been prosecuted or brought
to account.
Pervasive failure
The Obama administrations unwillingness
to act poses a grave threat to the safety and
soundness of the entire nancial system.
The endemic frauds led by elite CEOs dem-
onstrate such a pervasive failure of integ-
rity and ethics by the leaders of the nance
industry that can only be described as a
moral crisis of tragic proportions. Detailed
below is a list of questions (along with the
usual who, when, where details) the general
public should request that the media for-
mally ask the administration, or even their
Senators or Crogressmen.
Did the FDIC brief the administration
before it brought its Libor suit? Why didnt
Attorney General Holder and the FDIC
leadership conduct a news conference
announcing the suit and emphasising its
implications? Why did the FDICs website
fail to even note the suit? Did the suit cause
the administration to transform its nance
industry policies? When will the President
address the Nation about xing the twin
emergencies?
53
Opinion
So you think you can manage
operational risk: Think again?
David Millar of DXL Partners calls for a
proper system of training and professional
qualications for nancial risk managers.
CAN you prove your competence as a
risk manager? We live in a world where
risk managers are unprofessional and
unqualifed. Yes, there are good practices
and good managers out there but how do
we, investors and customers of banks,
know this? Mr Lee has been managing
risk at the bank for a number of years
and the systems havent crashed yet, we
have not gone bankrupt, and no one has
stolen too much money, so he must be
doing a good job. Is that enough?
Surely we need some proof that he is not
just lucky. If I go to a lawyer or a doctor, I
will probably look for recommendations
from people I know, but I will also check out
where he qualied and that he is a member
of a professional association. Indeed, he
will not be allowed to practise unless he is a
member of his professional association.
A professional body expects its members
to have an initial level of expertise, demon-
strated usually through a relevant university
degree; that they take and pass the associa-
tionsexaminations; that they undergo regu-
lar training updates; and that they abide by a
professional code of conduct. Failure in this
last requirement means they can be ned or
expelled from the association, whereupon
they may no longer practise.
But for some reason we do not expect
this of risk managers, despite the fact that
bank failures can destroy our economy, our
savings and, if we lose the ability to pay for
medical care, our lives.
Professional standards
There are some attempts to remedy this
situation and the risk management profes-
sion is moving, albeit frustratingly slowly, to
becoming a profession on a par with medi-
cine, law and other disciplines.
The global risk management asso-
ciations, such as the Global Association of
Risk Managers (GARP), the Professional
Risk Managers International Association
(PRMIA) and a few others, are promoting
certication and professional standards.
The regulators expect risk managers
both to demonstrate expertise and to prove
their skills, although they rarely go as far
as demanding qualications. After a few
more crashes, scandals and bail-outs, we
54
can expect the G12 to lose patience with
nancial risk failures and to instruct the
Financial Stability Board to enforce these
developments.
Secure route
Professionalism is not an impossible target.
All the professions started out on an infor-
mal basis. Accountancy only became profes-
sional in the 1920s, and law, depending on
the country, in the 1600s.
Even medical doctors, many years ago,
could set up a practice by simply putting a
sign on the door. They had no qualications,
although they may have had a lot of practical
experience, and there was no professional
body overseeing them.
Today no one is allowed to practise
medicine or law without being a member
of a professional body with its underlying
exams and codes of conduct. It is technically
possible to practise as an accountant with-
out being a member of a recognised profes-
sional association but who would employ
such an accountant? Professionalism is the
secure route to best practice and to control of
malfeasance.
Operational risk
True professional status also means that the
practitioner has two masters: his employer,
but also his association. A nance director
is less likely to falsify a companys account-
ing results if he knows that such an act could
lead him to be expelled from his professional
body and so remove his ability for work as
an accountant.
On the risk management certica-
tion front, there are qualications that
cover general risk management skills, the
Global Association of Risk Professionals
Financial Risk Manager and Professional
Risk Managers International Associations
Professional Risk Managerbeing the lead-
ers here, and there are Universities offering
risk management MScs and, in some cases,
full degrees.
However all these focus on credit and
market risk, the quantitative disciplines, and
none give much exposure to the procedural,
as well as quantitative aspects, of operational
risk. This is probably because operational risk
is more about regulations, best practices and
operational procedures and less about quan-
titative analysis, statistics and probabilities.
Prot wins
This is less attractive to mathematical aca-
demics and quantitative traders. Perhaps this
is due to credit and market risk being about
generating secure prots whereas opera-
tional risk is more about avoiding unidenti-
ed losses. Prots always win over budgets
and enthusiasm.
Basel compounds this prejudice as typi-
cally, the operational risk component of a
rms capital requirements is only 10-12
per cent of the total requirement with most
of the rest being attributed to credit risk,
this despite the fact that an operational
risk derived failure can close a bank down
overnight.
I have looked at a number of risk man-
agement certicate and MSc syllabi and I
would put their operational risk component
at no more than 10 per cent and poorly rep-
resented in the study of principles (although
it gets a lot of coverage in the case studies).
Whilst this may match Basels view of the
signicance of operational risk, it is poor
55
return for the operational risk manager
seeking to improve skills and demonstrate
expertise.
Risk prevention
I fully understand the argument that says
that a risk manager must not concentrate
solely on his own risk categories and that a
broad understanding of all risks that impact
your organisation is essential.
However the certication that supports
operational risk must be comprehensive and
of the highest quality, and that is not the case
in the currently available generic risk man-
agement qualications.
Operational risk is different. It is defen-
sive and cost-saving rather than aggressive
and prot-seeking and it attracts a different
type of manager, one who focuses on pre-
vention rather than the balanced risk taking
that is part of the quantitative risks involving
credit, prices and rates.
For that matter, operational risk is less
quantitative and nancially specic and
more procedural and qualitative than other
types of risk, and has more commonality
with other industries. We need to facilitate
the movement of professional operational
risk managers across industries.
Simple good practice
I believe there is a strong argument for hav-
ing operational risk as a separate qualica-
tion from other types of risk. The currently
available qualications continue to give
credit and market risk managers the neces-
sary broad understanding of operational risk.
But I believe that those who wish to
become professional operational risk man-
agers should have their skills developed
beyond what is currently available and
should have their education expanded to
cover all regulations as well as issues such as
reputational and model risk.
Operational risk suffers from being seen
as simple good practice. But it is more than
that and failures can outweigh the impact
of market and credit risk failures. A rogue
trader, or department, is the classic exam-
ple where an operational failing can bring
a bank to its knees, with Barings being the
prime example.
The impact of procedural failings or
malpractice has nancial, reputation and
regulatory implications. The managers of
these risks need a formal benchmark of their
abilities.
Gap in the market
The London-based Institute of Operational
Risk had early ambitions to create a full qual-
ication for operational risk but this does not
seem to have progressed. It has created a
professional institute with membership and
promotion of standards but there is nothing
on certication. Nor is it truly a global body.
However it is, as far as I know, the only
multi-country body that represents profes-
sional standards for operational risk manag-
ers and, as such, needs to be supported.
An independent professional bench-
mark for operational risk skills is needed.
Operational risk, badly managed, has a far
greater ability to close down a bank than the
other risks. There is also demand from those
entering the risk management profession for
such a benchmark.
Seeing this gap in the market, a number
of training companies have stepped in and
are offering three to ve-day training courses,
56
followed by a short test which result in what
they call an internationally accepted cer-
ticate, validated by some obscure academic
body.
Extensive study; rigorous testing
This is dangerous, as students, particularly
in developing countries, can believe the
hype and expecting that, after less than a
weeks training, they will nd themselves
recognised as risk managers. This is blatantly
untrue.
I am guilty as some of my operational
risk training courses have provided a cer-
ticate to those who pass the end-of-course
test, but I stress the validity of the certicate
is simply that the holder has attended and,
hopefully, understood a short course given
by an operational risk practitioner. In no
way does it certify the holder as having the
comprehensive capability and experience to
practice as an operational risk manager.
What we need is a proper demonstra-
tion of operational risk management capa-
bility based on extensive study; one which is
rigorously tested. We need something that is
globally recognised and of sufcient reputa-
tion that aspiring operational risk manag-
ers will want to take it as part of their career
progression.
Start-up profession
The exam should not be seen as the only
requirement of the qualication and should
be coupled with a formal apprenticeship
working in the industry and mentored by a
senior operational risk manager.
The need for the start-up of the profes-
sion could be facilitated by current experi-
ence in the industry being a replacement for
the apprenticeship. This has been common,
I believe, in the case of industries such as
accountancy when they started on the pro-
fessional path.
Based on formal exams, with the knowl-
edge developed during an apprenticeship,
and supported by an enforced code of con-
duct, we will have a professional qualica-
tion that experienced managers will want
to have as a formal demonstration of their
capability.
It will conrm the professional status
that allows regulators and bank boards to
feel condent that those that carry the asso-
ciated title have the knowledge to fall back
on when extreme events occur.
I believe that the risk management
community in general, and operational risk
managers specically, should work towards
achieving professional status and not wait
for this to be enforced by governments or
regulators.
I believe such a move would improve
standards, mitigate against catastrophic
failures and reduce malpractice. I think the
future is in our own hands.
Editors note: The publisher and editors of
the Journal would like to extend their thanks
to Mr. David Miller presently an opera-
tional risk trainer with DXL partners and
the former chief operating ofcer of PRMIA
and the Journal of Risk Management in
Financial Institutions for allowing the Journal
of Regulation & Risk - North Asia to publish
an extended version of this paper, which rst
appeared in March, 2014. We also wish to
remind our readers that copyright for this
article remains the sole preserve of Mr. David
Millar.
57
Comment
Bank of England overturns
decades old shibboleth
Associate Editor, Philip Pilkington, cele-
brates the Old Lady of Threadneedle Streets
decision to break with convention.
THE frst quarter of 2014 was an historic
one for the practice of central banking.
Why? Because the Bank of England pub-
lished a quarterly report that fnally laid
out the truth about how money is cre-
ated (Money Creation in the Modern
Economy, BoE Quarterly Report Q1
2014). The report overturned a number
of myths about the money creation pro-
cess. Contrary to what many economists
believe, private banks create money ex
nihilo; the central bank does not exer-
cise control over the growth of monetary
aggregate directly; and the money mul-
tiplier theory taught in almost every
economics classroom in the world has
the causality backwards and is grossly
misleading.
Much of the above has been known by those
working in alternative economic traditions
specically, those who subscribe to het-
erodox or non-conformist economic doc-
trines for a long time. During the debates
surrounding monetarism in the 1970s and
1980s the famous British Post-Keynesian
economist Lord Nicholas Kaldor was at
pains to debunk the myths on which the
theories of Milton Friedman were based (see
The Scourge of Monetarism, Oxford University
Press). Kaldor drew on the work of the
UKs Radcliffe Commission, set up in 1957
to independently evaluate how monetary
policy functioned in the British economy.
Drawing on the ndings of the
Committees report, Kaldor was able to
show that the central bank exercises no
direct control over monetary supply. Rather
it set the rate of interest and let the sup-
ply of money adjust. Shortly after Kaldor
broke this new ground, the Canadian Post-
Keynesian economist, Basil Moore outlined
an alternative theory that has since become
known as endogenous money theory(see
Horizontalists and Verticalists, Cambridge
University Press).
Through its report the Bank of England
has steered central banks on a clear course:
no longer must they pretend that they exer-
cise control over money supply directly this
was tried in the late-1970s and early-1980s
and was a dismal failure. Rather they set the
overnight interest rate and let the quantity of
money demanded at this price oat. Those
58
working within central banks may say to
this: So what? We know this is how it works
already. And whilst this is true to some
extent, many leading economic commenta-
tors continue to occupy their minds with the
old shibboleths of traditional thought.
Krugman Keen bust up
This became abundantly clear in the debates
between Nobel Prize winning economist
Paul Krugman and the Australian Post-
Keynesian economist Steve Keen over the
nature of money creation that took place on
the blogosphere in March, 2013. Krugman,
who is only the most visible example in this
regard, made it abundantly clear that he
was completely ignorant about the nature
of money creation (see Banking Mysticism,
Continued: Conscience of a Liberal blog,
the New York Times).
This continued confusion is visible across
the whole spectrum of economists and com-
mentators. Most commentators assumed,
for example, that the Quantitative Easing
(QE) programs enacted after the crisis would
lead to an increase in broad money aggre-
gates. They thought that by pumping the
banks full of money the central bank could
push this money into the economy and this
would lead to growth and a healthy uptick in
ination. How wrong they were!
Wicksellian theory
While QE programs have had some impact
on asset prices and interest rates, they have
not led to a substantial increase in broad
money aggregates or ination. Those
working in the endogenous money tradi-
tion, like Australian economist Bill Mitchell,
were long aware that this would be the case
(see Quantitative Easing 101, Bill Mitchells
Billy Blog.) There are, however, mainstream
economists who have come to appreci-
ate that central banks set the interest rate
and that the money supply is determined
endogenously by the demand for money at
that price.
Working within the framework of the
Taylor Rule, economists like David Romer
have proposed that we view the manner
in which central banks operate in precisely
this way (see Keynesian Macroeconomics
Without the LM-Curve, Journal of Economic
Perspectives). This has led to a prolifera-
tion of enthusiasm among central bankers
in the old Wicksellian theory of the natural
rate of interest, a theory rst proposed by
the Swedish economist Knut Wicksell at the
beginning of the 20th century (see Interest
and Prices, Sentry Press).
The Holy Grail
The theory assumes that there are two rates
of interest in the economy: the money rate of
interestand the natural rate of interest. The
natural rate of interest is the rate of interest
at which there would be full employment
of resources and a zero rate of ination.
The money rate of interest meanwhile, is
the rate at which banks charge for loans.
If the money rate of interest diverges from
the natural rate, prices will rise or fall. In
short, too high a money rate of interest will
cause deation and too low a rate will cause
ination.
The Holy Grail for macroeconomic policy
will then be to have the central bank line up
the money rate of interest with the natural
rate of interest so that the economy will set-
tle on an optimum growth path equilibrium.
59
The recent Bank of England report made it
clear that their interest rate policies were
aimed at just this and even hinted that mon-
etary policy alone was an adequate means to
achieve this.
Taylor Rule
This view is in keeping with much contem-
porary macroeconomic theory, most speci-
cally the theories associated with the New
Keynesian School. As already mentioned,
this theory has crystallised out as what is
known as the Taylor Rule and, indeed, many
central bank economists see themselves as
operating under the constrains of this rule,
even if, for practical reasons, they often nd
themselves in violation of it.
Allow me, however, to make a rather
radical statement: there is no such thing as a
natural rate of interest and thus any attempts
by central banks to generate macroeconomic
stability using monetary policy alone will
only result in failure. Now allow me to make
another perhaps even more radical state-
ment: provided that the reader will approach
my argument with an open mind, I can
prove this quite quickly and simply.
Open Market Operations
Let us start at the basics: when referring to
the actually existing economy, what is the
money rate of interest? Presumably this
would be the overnight interest rate that is
set by the central bank through its Open
Market Operations (OMOs). This is the rate
that central banks around the world use to
try to inuence the level of economic activ-
ity. But is this the only rate of interest in the
economy? Of course not.
There are so many rates of interest in the
economy that we can barely keep track of
them all: there are rates of interest on mort-
gages; rates of interest on AAA-rated cor-
porate bonds; rates of interest on low-rated
junk bonds; the list is endless. What the
central bank tries to do is to inuence these
interest rates by manipulating the overnight
interest rate.
Thus the overnight interest rate becomes
something of a force of gravity. When the
central bank lowers the overnight rate of
interest by injecting money into the bank-
ing system this money increases the value of
all the other types of debt and thus lowers
their interest rates. The opposite happens
when the central bank raises the interest
rate by removing money from the banking
system. So, modifying our original formula
we might consider that these interest rates
in the aggregate make up the money rate of
interest.
Animal spirits
This is precisely where we run into problems.
Even if we admit that there is an optimal rate
of interest a natural rate at which the cen-
tral bank can set the overnight rate, it does
not follow that all the other rates will then
nd their optimal position automatically.
This is because these rates are only partly
inuenced by the overnight interest rate.
The other key component that inuences
these rates are the expectations or animal
spiritsof investors. If investors are overly
optimistic they will bid these rates down too
low, while if they are overly pessimistic they
will bid them up to high.
This has long been recognised by eco-
nomic theorists like John Maynard Keynes
and Hyman Minsky, both of whom denied
60
the existence of a natural rate of interest. Add
to this the fact that the demand for money is
also driven by the animal spiritsof investors
and consumers, it quickly becomes clear that
while the idea of a natural rate of interest is
nice in theory, it relies on assumptions that
are quite simply at odds with the reality of
how the economic system functions.
Mortgage-Backed Securities
Consider the response of mortgage rates
to the rise in the overnight rate in the U.S.
during the housing bubble years. Between
mid-2004 and mid-2006 the Federal Reserve
raised the overnight interest rate from one
per cent to just over ve per cent. In theory
this should have increased the rate of inter-
est on mortgages and stymied demand for
credit, thus deating any potential bubble
emerging in the property market. However,
the mortgage interest rate did not respond
at all.
In mid-2004, when the overnight rate
was set at one per cent, the 30-year con-
ventional mortgage rate was around six per
cent, while in mid-2006, when the overnight
rate was over ve per cent the mortgage
rate remained at around six per cent. This
reected, as we now know, innovations in
the market for mortgage securities, most
notably, the now notorious Mortgage-
Backed Securities (MBS). These low interest
rates were part of the reason for the housing
bubble that led to the nancial crisis in 2008.
Dog and the Frisbee
The fact of the matter is that central banks
have no control over what we might refer
to as the money rate of interest. If we take
this money rate to encompass all the lending
rates in the economy these are inherently
tied up with nancial assets and nancial
asset pricing, then the process of nan-
cial asset pricing is by no means rational,
but rather based rmly on the mood of the
markets. This is because, as Keynes always
insisted, asset markets operate in a world
of uncertainty and those making decisions
cannot assign probabilities to the future and
thus cannot make decisions based on some
mathematical notion of rationality.
The BoEs executive director for nan-
cial stability, Andrew Haldane summarises
this as such: In an uncertain environment,
where statistical probabilities are unknown,
approaches to decision-making [based
on probability weighting] may no longer
be suitable. Probabilistic weights from the
past may be a fragile guide to the future.
Weighting may be in vain (see The Dog
and the Frisbeespeech given at the Federal
Reserve Bank of Kansas City pp5-6, 2012).
In such a world there is, unfortunately, no
such thing as a naturalrate of interest or at
least, no such rate that the central bank can
hit by manipulating the overnight or money
rate of interest.
Now that the Bank of England has paved
the way for a better understanding of how
money is created the question becomes
whether or not central banks can accept that
their monetary policy tools are inherently
limited? Can macroeconomists making
decisions about interest rate policy integrate
the wisdom that is coming from those who
are examining nancial stability? Those
are questions to which only posterity has
the answer. That said, our economic future
depends on them all being answered in the
positive rather than the negative.
61
Regulatory update
Asian nations call for more
regulatory cooperation
Elizabeth Dooley details some of the most
signicant regulatory and supervisory
changes in Asia during the rst quarter.
THE frst quarter of 2014 proved a busy
time for regulators across the region,
amplifed particularly by concerns illus-
trated by a warning by the governor of
Indias central bank, Raghuram Rajan
that a prolonged period of ultra-loose
monetary policy in developed countries
would lead emerging markets to build
defence reserves that would hinder
global growth. Criticising US Federal
Reserve offcials for not expressing
more public concern about the fnan-
cial turmoil their low-interest rate poli-
cies had unleashed in emerging market
economies, he highlighted the threat of a
breakdown in global cooperation.
With such global risks reaching breaking
point, we take a tour of the region and some
of the regulatory developments being put
into place in the aftermath of the nancial
crisis and in the wake of strategic regulatory
moves by the US and Europe.
We begin our ride by entering Chinas
Middle Kingdom, where the year started
with the countrys central bank looking set
to risk another cash crunch at the end of
January, barely a month after the last market
squeeze.
As policymakers pressed ahead with a
crackdown on shadow nancing and other
risky bank lending, the Central Banking
Regulatory Commission (CBRC), along-
side the Peoples Bank of China (PBC),
announced its new years resolutions to fur-
ther regulate the risk retention behaviour of
the originators of credit asset securitisation.
Protection of the legitimate rights and
interests of investors and promotion of a
sustainable and sound development of asset
securitisation business in the country, also
remained high on the agenda.
Meanwhile, mid-January saw the
issuance of the CBRCs Guidelines for
Commercial Banks of Global Systematical
Importance Evaluation Index Disclosure,
targeted at banks which had achieved over
RMB1.6 trillion of adjusted on-and-off
balance-sheet assets by the end of last year,
and/or those recognised as globally and sys-
tematically important in the previous year.
Disclosure would be based upon 12 indi-
cators, namely on-and-off balance-sheet
asset balance; inter-nancial institution asset
62
and liabilities; securities and other instru-
ments; payment made though payment
systems or settled by correspondence banks;
assets under custody; securities underwriting
amount; OTC derivatives notional amount;
tradable and available-for-sale securities;
tier 3 assets; cross-border claims; and cross-
border debt.
Key risks
Essentially, the CBRC entered the year
resolving to protect its economy against
seven major risks relating to the mitigation
of nancing platform loans, real estate loans,
production overcapacity, wealth manage-
ment, trust, nancing guarantees and micro-
nance businesses.
Liquidity risk, information technology
risk, and market and operational risk also
remained key issues during quarter one. As
Chinas banking regulator pressed banks
for more disclosure in an effort to align its
regulations with international practices, the
Shanghai Stock Exchange set Basel bond
rules for listed banks to issue bonds on the
bourse for the rst time.
Meanwhile, foreign banks that had been
lobbied by the Chinese government to open
branches in the mainlands rst free trade
zone in Shanghai, were left in limbo over
regulation delay.
Confusion and reform
Confusion coincided with in-ghting
between the central bank and the nations
banking regulator, particularly in relation to
shadow banking. Reports implied frustra-
tion on the part of the PBC on the appar-
ent unwillingness of the CBRC to toughen
regulation of banks dealings with shadow
lenders. However, at a January G20 meet-
ing, PBC Governor Zhou Xiaochuan played
down risks associated with shadow banking,
noting that reforms to rebalance the econ-
omy would continue.
As the nations nancial regulators
reported that it would continue to pur-
sue market-oriented reform for new share
listings, the China Securities Regulatory
Commission (CSRC) revised its Compilation
Rules for Information Disclosure by
Companies Publicly Offering Securities to
the Public (No. 26).
Indeed, after foreign banks that had been
lobbied by the Chinese government to open
branches in the mainlands rst free trade
zone in Shanghai were left in limbo over reg-
ulation delay and ambiguous guidelines and
regulations still to come into force, the citys
mayor pledged that the Year of the Horse
would see progress in nancial reforms in
the citys new free-trade zone (FTZ), includ-
ing those relating to the full convertibility of
Chinas currency.
FX changes
The beginning of March saw the PBCs
issuance of its Notice on Implementation
Rules for Foreign Exchange Management
Shanghai Pilot Free Trade Zone, set to sim-
plify FX sale and purchase documents and FX
registration procedures for direct investment.
The move would permit foreign-invested
enterprises to settle non-RMB capital funds
at will, and remove administrative approval
for external guarantee and guarantee fees
paid to oversees businesses.
The new regulation also lifted the ceil-
ing on overseas foreign exchange loans by
enterprises within the FTZ, abolished debt
63
approval for overseas nancial leasing and
set in place reforms to allow domestic nan-
cial leasing businesses to receive rents in for-
eign currency.
Call for better management
Better management of liquidity and asset
liabilities by commercial banks remained a
major theme for Chinas central bank, with
analysts warning of continued liquidity
shortage without major policy adjustment,
despite the injection of fresh funds into the
market.
This was followed by the announcement
by the central bank of new rules to limit risk
in the interbank market, one of the fastest
growing debt markets. Banks were effec-
tively banned from using funds raised from
the sale of high-yield investment products
for proprietary trading or trading for its own
prot. The CBRC meanwhile, in a new
liquidity management regulation put into
effect on March 1, 2014, announced that
Chinese commercial banks liquidity cover-
age ratios must reach 100 per cent by 2018 to
strengthen them against the risk of further
credit crunches.
In line with Basel III
The target ratio was set at 60 per cent for
2014, rising ten percentage points annually
until 2018, the same transitional period spec-
ied in the Basel III accord. The move coin-
cided with Bank of China (BOC), Chinas
most internationalised bank, rolling out its
rst offshore RMB index (ORI), the launch
of direct trading between the RMB and the
New Zealand dollar (NZD), and the sign-
ing of memorandum of understandings
between PBC and Deutsche Bundesbank
regarding the clearing and settlement
arrangements of RMB payments Frankfurt,
and The Bank of England on RMB clearing
and settlement in London.
Across the border and into Hong Kong,
Asias World City entered 2014 with the
notion that the United States and Europe
would continue to lead economic recovery,
as stated by several corporations and devel-
opment agencies at the seventh annual
Asian Financial Forum.
In an effort to establish an effective
resolution regime for nancial institutions
in Hong Kong, the Hong Kong Monetary
Authority (HKMA) launched the rst stage
of a three-month public consultation.
Virtual currency concerns
The HKMA also issued a circular to remind
all authorised institutions of the need to
exercise prudent risk management regard-
ing money laundering and terrorist nanc-
ing risks associated with virtual commodities
such as Bitcoin.
The Securities and Futures Commission
(SFC) followed suit, with a reminder to
licensed corporations and associated entities
to take all reasonable measures to ensure
that proper safeguards were put in place to
mitigate such risks. Meanwhile, nancial
rms and some lawmakers expressed con-
cern that a government-proposed law for
2015 may give too much power to regulators.
A proposal was thus aimed at ensur-
ing that the barren rock complies with
new international rules brought in by the
Financial Stability Board, formed by the
leaders of the Group of 20 developing econ-
omies, of which Hong Kong is a member.
In response to guidance on sound capital
64
planning issued by the Basel Committee on
Banking Supervision (BCBS) on 23 January,
the HKMA issued a circular noting the neces-
sity for sound capital planning by banks to
ensure a robust regulatory framework that is
critical for determining the amount, type and
composition of capital that should prudently
be held by banks to allow them to continue
to pursue their business objectives, whilst
withstanding stressful situations.
IMF remarks
This was followed by a notice to author-
ised institutions to provide guidance and
clarication on the regulatory requirements
governing the sale of foreign exchange accu-
mulators and non-leveraged RMB-linked
deposits.
Into the nal month of the rst quar-
ter the mood remains positive, with an
International Monetary Fund (IMF) Staff
Mission to Hong Kong endorsing the
Governments proactive policies to rein-
force the resilience of the economy and the
nancial system, and reiterating the Linked
Exchange Rate System as the best arrange-
ment for the territory.
Uncertainty over deregulation
Over on Japans Chrysanthemum Throne,
member of a government council on special
economic zones, Heizo Takenaka, saw in the
year with the view that deregulation could
push the Nikkei past 18,000, with Japanese
stocks potentially surpassing a level not seen
since 2007 if the government pushes through
its drive to loosen business regulations.
However, uncertainty loomed as Bank
of Japan (BOJ) board member Sayuri Shirai
repeated her warning during a speech on
central bankschallenges in a rapidly chang-
ing global economic environment.
Speaking of the unlikeliness of the bank
hitting its two per cent ination target over
two years, she noted that it could take time
for aggressive easing to have full effect on the
economy and for quantitative and qualitative
monetary easing measures to materialise.
Entering the second month of the quar-
ter, Japan posted its smallest current account
surplus on record last year, throwing spot-
light on Tokyos ability to service its huge
debt and exposing a danger point in an
economy starting to nd its feet after years of
underperformance.
BOJ bullish
That said, BOJ Deputy Governor Kikuo
Iwata remained bullish, suggesting that
downside risks to the economy were small,
despite concerns over the US and develop-
ing economies causing a rebound of the yen
after falling exports and plummeting Tokyo
share prices.
Into February, the BOJ boosted lend-
ing programs while sticking with a plan
for unprecedented asset purchases, as the
central bank attempted to support a recov-
ery and stamp out 15 years of deation by
doubling a funding tool to 7 trillion yen ($68
billion) and announcing its permission for
individual banks to borrow twice as much
low-interest money as previously stated
under a second facility.
Meanwhile, fellow Deputy Governor
Hiroshi Nakso told lawmakers that the BOJ
board agreed that downside risks to global
economic growth had decreased, rejecting
the idea that he had appeared more cau-
tious about aggressive easing than some of
65
his peers and going on to tell the House of
Representatives Financial Affairs Committee
that Japans economy is indeed on track
towards modest recovery and stable two per
cent ination.
New special economic zones
After being urged by Japans biggest lend-
ers to extend a low-interest loan program,
BOJ Governor Haruhiko Kuroda said he
was ready to carry out additional monetary
easing measures, even before all data were
made available on the effects of a consump-
tion tax rise in April.
At the end of March, as part of its efforts
towards better regulation, Japans Finanical
Service Agency (FSA) published an English
translation of Comprehensive Guidelines
for Supervision of Financial Market
Infrastrucutres.
Heading into the second quarter of 2014,
reports suggest that in order to keep up
momentum, Japan would need to introduce
fundamental reforms aimed at boosting the
anemic long-term growth rate. Japans new
special economic zones, revealed as Tokyo
and Osaka, are being heralded as the next
opportunity.
Singapore takes stock
Into the Lion City, Singapore began the year
resolving to consider tougher stock market
rules for companies looking to list in the
city-state.
Just months after its penny stock scan-
dal, the Monetary Authority of Singapore
(MAS), alongside the Singapore Exchange
(SGX), set out to explore various propos-
als that included an independent listing
committee to vet certain IPO applications,
stronger enforcement of powers for SGX,
and tighter rules on stocks that fall below a
certain price.
Into February and SGX continued to
revise its fee structure for its securities mar-
ket as a way to improve liquidity by facilitat-
ing market making and improve the cost
efciency of trading. SGXs enhancement of
regulatory tools to encourage on-exchange
trading through rening of its query pro-
cess and the addition of new requirements
in line with international standards became
effective in March. Revisions to clearing and
depository fees are due to be rolled out at the
beginning of the second quarter.
Gradual appreciation
Internationally, German exchange opera-
tor Deutsche Borse entered into talks about
opening a clearing house in Singapore, a
move which was said to deepen its strategic
push into Asia to take on its US rivals. Chief
executive Reto Francioni announced plans
to spend 30 million in the coming year on
growth projects. He noted that Asia would
be a key focus, with Singapore becoming
the hub for Deutsche Borses growth in the
region.
Further, MAS announced plans in
March to develop a real-time gross settle-
ment system for the RMB. In its Monetary
Policy Statement published in mid-April, it
announced that given that core ination is
expected to stay elevated, it would maintain
its policy of a modest and gradual apprecia-
tion of the S$NEER policy band:
The policy stance is assessed to be
appropriate for containing domestic and
imported sources of ination, and ensuring
medium-term price stability as a basis for
66
sustainable growth. MAS will continue to be
vigilant over developments in the external
environment, including in nancial markets,
and stands ready to curb excessive volatility
in the S$NEER,the statement concluded.
Offshore RMB
On the island once known as Formosa,
Taiwan started the year with talks centred
around its cooperation with Hong Kong
and London and the development of off-
shore RMB business. At a press conference
in Taipei, the Lord Mayor of London, Fiona
Woolf noted Taiwans potential to develop
into a large offshore yuan business centre
if the government proceeds in the direction
of further loosening regulations on nancial
products and services.
Whilst a possible delay in the US imple-
mentation of tax information exchange with
nancial institutions across the world could
help Taiwan to gain leverage in follow up
negotiations, Chinese companies continued
to turn to the islands banks, long the ush
lenders in Asia, in search of cheap money,
sending borrowing costs surging to their
highest levels in three years.
Hermit Kingdom
Into the Hermit Kingdom of South Korea
and into 2014, the governor of the Bank of
Korea (BOK), Kim Choong-soo, announced
in a press conference held after the regu-
lar Monetary Policy Committee meeting
on January 9 that there would be no more
downside risk from tapering.
Referring to quantitative easing policies
by US monetary authorities, he noted that
recovery of the US economy was not a bad
thing for the country. Demonstrating his
optimism he added: Although we consid-
ered the tapering a downside risk in our pre-
vious monetary policy statements, this time
around it has become more positive.
In February, as part of an effort to
strengthen nancial consumer protection,
the South Koreas Financial Supervisory
Service (FSS) announced that the preven-
tion of nancial products mis-selling would
be a top priority for 2014. Indeed, a study
of banks selling of nancial investments
showed that many investors chose invest-
ments with greater risk than they are will-
ing to take. Accordingly, the FSS set out to
improve the way high-risk investments are
being promoted, effectively setting its goal
to protect nancial consumers by helping to
choose investments appropriate for their risk
tolerance level.
Following the Basel Committee on
Banking Supervisions set of disclosure
requirements on the composition of banks
capital, published in June 2012, in April the
FSS published the ndings of its examina-
tion of domestic banks rst capital disclo-
sures under Basel III standards.
The end of the quarter also saw Taiwans
Financial Services Commissions (FSC)
announcement of the approval of the
Enforcement Decree of the Covered Bond
Act by the Cabinet, following the passing
of the Covered Bond Act by the National
Assembly on December 19, 2013.
Designed to provide a statutory founda-
tion for nancial companies to issue covered
bonds, the Enforcement Decree, which took
effect on April 15, 2014, stipulates details
mandated by the Covered Bond Act, includ-
ing qualications for cover assets, evaluation
basis and issuance cap.
Regulating foreign banking organisations in the USA 71
Daniel K. Tarullo
Lessons from the panic of 2008: Are we better prepared? 85
Elizabeth Warren
US super-ve too big to failsantithetical to capitalism 89
Thomas Hoenig
Monetary policy capture in the US treasuries sphere 95
Jeremy C. Stein
Building renewed trust in nancial markets 101
Hans Hoogervorst
Historic ties between ethics, responsibility and protability 107
Martin Wheatley
Asian tigers securities regulator bares its fangs 111
Mark Steward
Global ambitions for OTC derivatives regulation 117
Michael S. Pinowar
Market-based bank capital regulation 123
Jeremy Bulow, Jacob Goldeld and Paul Klemperer
Unconventional monetary policies revisited - Part one 129
Biagio Bossone
Unconventional monetary policies revisited - Part two 135
Biagio Bossone
EU banking union: Outlook and short-term choices 141
Nicolas Vron
Central clearing for OTCs: Schlieffen Plan redux 161
Thomas Krantz.
Basel III odyssey across the Asia Pacics larger economies 169
Selwyn Blair-Ford
Foreign banks rmly in the crosshairs of Feds nal rules 177
Chris Rogers
Social media regulation in the global securities industry 183
Gavin Sudhaker
Has Chinas ascent been mirrored on the legal front? 189
Michael Thomas
Emerging political realities expose central bank tradition 195
Philip Pilkington and Thomas Dwyer
NORTH ASIA
69
Bank regulation
Regulating foreign banking
organisations in the USA
Feds head of regulatory affairs, Governor
Daniel K. Tarullo, assuages overseas banks
concerns over nal rules at Harvard chat.
THE fnancial crisis exposed, in painful
and dramatic fashion, the shortcomings
of existing regulatory and supervisory
regimes. In both the United States and the
European Union, the crisis also revealed
some particular vulnerabilities created
by foreign banking operations. In this
paper, Ill focus on these vulnerabilities
and on how best we should address
them.
Let me note at the outset the now com-
monplace observation that we have a quite
integrated international nancial system,
with many large, globally active rms oper-
ating within a system of national govern-
ment and regulation or, in the case of the
European Union (EU), a hybrid of regional
and national regulation.
I add the equally commonplace obser-
vation that there is no realistic prospect for
having a global banking regulator and con-
sequently, the responsibility and authority
for nancial stability will continue to rest
with national or regional authorities.
1
The question then is how responsibility
for oversight of these large rms can be most
effectively shared among regulators. This, of
course, is the important issue underlying the
perennial challenge of home-host supervi-
sory relations.
Another introductory observation is that
at least in a world of nations with substan-
tially different economic circumstances, dif-
ferent currencies, and banking and capital
markets of quite different levels of depth and
development there will be good reason to
vary at least some forms of regulation across
countries.
Legitimate differences
Presumptively, at least, nations should be
able to adjust their regulatory systems based
on local circumstances and their relative level
of risk aversion as it pertains to the potential
for nancial instability. Although the nan-
cial systems and economies of the United
States and the EU are more similar to one
another than they are to those of many other
jurisdictions, they are hardly identical.
Even between these two, for example,
there may be legitimate differences within
the broader convergence around mini-
mum regulatory and supervisory standards
70
developed at the Basel Committee, the
International Organisation of Securities
Commissions, the Financial Stability Board,
and other forums.
Balkanisation charges
These opening observations are impor-
tant in responding to the curious charge of
Balkanisationthat has been levelled at the
US and, to a lesser extent, some other juris-
dictions, as a result of actions taken or pro-
posed in response to problems presented by
foreign banks during the crisis.
I say curiousfor several reasons. One is
that the charge reects a misunderstanding
of the allocation of responsibility between
home and host supervisors that has evolved
in the Basel Committee over the past several
decades.
Another is that the charge seems implic-
itly, and oddly, premised on the notion that
what we had in 2007 was a well-function-
ing, integrated global nancial system with
effective consolidated supervision of global
banks. A third is that the charge overlooks
the fact that much of what the US is now
doing is matching what the EU has quite
sensibly been doing for years.
Question of questions
In the rest of my remarks I will elaborate
on these points, though not in the spirit of
a debaters arguments, but in an effort to
answer the question I posed previously:
How can we successfully reduce the risks
to nancial stability posed by large, interna-
tionally active banks?
As I hope will become apparent, a
theme I wish to emphasise is that we need
to redouble efforts of genuine supervisory
cooperation if we are to manage effectively
the vulnerabilities and challenges posed by
the perennial home-host issue.
While the circumstances and risks may
have changed, the issue of the appropriate
roles of home and host countries is not a
new one. Indeed, it was a key motivation for
the creation of the Basel Committee in 1975
following the failures of the Herstatt and
Franklin National banks.
Many of the Basel Committees early
activities were focused on the challenges
created by gaps in the supervision of inter-
nationally active banks, as evidenced by the
fact that Basel Concordatson supervision
preceded Basel Accordsand Frameworks
on capital and other subjects. This task has,
through necessity, been ongoing, as experi-
ence revealed gaps in supervisory coverage
and as the scale and scope of internationally
active banks grew.
Consolidated supervision
The principle of consolidated supervision
emerged in the early 1980s to ensure that
some specic banking authority generally
the home-country regulator had a com-
plete view of the assets and liabilities of the
bank.
2
This principle was reinforced and
elaborated following the Bank of Credit and
Commerce International episode in the early
1990s.
3

It is important to note that each Basel
Committee declaration on the importance
of home-country consolidated oversight has
also included a statement of the obligations
and prerogatives of host states, in which sig-
nicant foreign bank operations are located.
This feature of the Basel Committees
approach makes sense as a reection both of
71
the host authoritys responsibility for stabil-
ity of its nancial system and of the practi-
cal point that a host authority will be more
familiar with the characteristics and risks in
its market.
Essential criteria
In accordance with this history, the current
version of the Core Principles for Effective
Banking Supervisionsets out as one of its
essential criteria for home-host relation-
ships that [t]he host supervisors national
laws or regulations require that the cross-
border operations of foreign banks are sub-
ject to prudential, inspection and regulatory
reporting requirements similar to those for
domestic banks.
4

It is clear then, that consolidated supervi-
sion is not intended to displace host-country
supervision. Instead, as the Basel Committee
has regularly noted, the two are intended to
be complementary, so as to assure effec-
tive oversight of large, internationally active
banks.
Similarly, the stated purpose of the Basel
Committee in requiring consolidated capi-
tal requirements is not to remove from host
countries any responsibility or discretion to
apply regulatory capital requirements, but
to preserve the integrity of capital in banks
with subsidiaries by eliminating double
gearing.
5

Minimum regulation requirements
Likewise, and contrary to suggestions that
are sometimes made, the capital accords
and frameworks developed by the Basel
Committee have always been explicitly
minimum requirements. They are oors, not
ceilings.
Finally, it is worth noting that, in estab-
lishing a post-crisis framework for domestic
systemically important banks (D-SIBs), the
Basel Committee made clear that a host
country may, in appropriate circumstances,
designate domestic operations of a foreign
bank as systemically important for that
country, even if the parent foreign bank has
already been designated a global systemi-
cally important bank (G-SIB).
6

The idea informing the newly created
concept of a D-SIB is that an entity whose
stress or failure could destabilise a domes-
tic nancial system might thereby indirectly
destabilise the international nancial system.
Thus, the D-SIB category carries along
with it higher loss-absorbency requirements
than are generally applicable to domes-
tic banks, although perhaps not as high as
requirements for G-SIBs.
Complimentary responsibilities
Of course, our regulation for foreign bank-
ing organisations (FBOs) does not entail
D-SIB designation or require higher than
generally applicable loss absorbency. But I
cite this feature of the D-SIB framework that
permits designation of the domestic opera-
tions of foreign G-SIBs because it reects
rather clearly the principle that the specic
characteristics of domestic markets may call
for regulation of foreign banks in the host
country, not just at a consolidated level.
In short, over the years, the work of the
Basel Committee has not been directed at
restraining host-country authorities from
supervising and regulating foreign banking
operations in their country.
On the contrary, the committee has
repeatedly asserted the complementary
72
responsibilities of both home and host coun-
tries to oversee large, internationally active
banking groups, in the interests of both
national and international nancial stability.
Failure to respond
Further, the committee has frequently
returned to this set of issues in responding
to developments that pose a threat to the
safety and soundness of the international
nancial system. Unfortunately, neither the
Basel Committee nor national regulators
responded in a timely fashion to the mag-
nitude of the expansion in scale and scope
of the worlds largest banking organisations
in the roughly 15 years before the nancial
crisis.
Consider this, at the end of 1974, just
before the Basel Committee was created,
the assets of the worlds ten largest banking
organisations together equaled about 8 per
cent of global GDP. The three largest were
all American Bank of America, Citicorp,
and Chase Manhattan. But their combined
assets were equal to less than 3.5 per cent of
world GDP, or about 10 per cent of the GDP
of their home country, the United States.
Explosive growth
By 1988, the combined assets of the worlds
ten largest banking organisations as a pro-
portion of world GDP had nearly doubled to
about 15 per cent, a ratio that held constant
during the succeeding decade, at the begin-
ning of the emerging market nancial crisis
in 1997.
Then the explosive growth began. In
the next decade that is, up to the onset of
the nancial crisis in 2007 the combined
assets of the worlds ten largest banks as a
share of global GDP nearly tripled, to about
43 per cent. The largest bank in the world
at that time, Royal Bank of Scotland (RBS),
had assets equivalent to about 6.8 per cent
of global GDP, nearly twice the comparable
gure for the three largest banks combined
in 1974.
Adding the assets of Deutsche Bank and
BNP Paribas the second and third largest
banks in 2007 to those of RBS, the three
had combined assets equal to about 17 per
cent of global GDP. And each of the three
had assets nearly equal to, or in one instance
substantially more than, the GDP of its home
country. Even the eighth-ranked bank, UBS,
had assets well over four times the GDP of
its home country, Switzerland.
Accelerating trends
Not only did the size of the largest banks
change dramatically, but so too did their
scope, reecting the overall integration of
capital market and traditional lending activi-
ties that accelerated in the decade and a half
preceding the crisis. This trend was particu-
larly apparent in the United States and the
United Kingdom, homes to the worlds two
largest nancial centres.
In the United States, the proportion of
foreign banking assets to total US banking
assets has remained constant at approxi-
mately one-fth since the late 1990s. But the
concentration and character of those assets
have changed noticeably.
Today there are as many foreign banks
as there are US-owned banks with at least
US$50 billion in US assets, the threshold
established by the Dodd-Frank Wall Street
Reform and Consumer Protection Act for
banks for which more stringent prudential
73
measures must be established.
7
Perhaps
even more important was the shift in com-
position of foreign bank assets in the 15
years before the crisis, with the proportion of
assets held in the US broker-dealers of the
ten largest FBOs rising from approximately
15 per cent to roughly 50 per cent.
8

Increased reliance
Today, four of the top ten broker-dealers in
the United States, and 12 of the top 20, are
owned by foreign banks. Meanwhile, even
the traditional branching model of large for-
eign commercial banks in the United States
has changed.
Reliance on less stable, short-term
wholesale funding has increased signi-
cantly. Many foreign banks have shifted
from the lending branchmodel to a fund-
ing branchmodel, in which US branches of
foreign banks are borrowing large amounts
of US dollars to upstream to their parents.
These funding branches went from
holding 40 per cent of foreign bank branch
assets in the mid-1990s to holding 75 per
cent of foreign bank branch assets by 2009.
As a group, foreign banks moved from a
position of receiving funding from their par-
ents on a net basis in 1999, to providing sig-
nicant funding to non-US afliates by the
mid-2000s more than US$600 billion on a
net basis by 2008.
9

Short-term funding
A good bit of this short-term funding was
used to nance long-term, US dollar-
denominated project and trade nance
around the world. There is also evidence
that a signicant portion of the dollars raised
by European banks in the pre-crisis period
ultimately returned to the United States in
the form of investments in US securities.
Indeed, the amount of US dollar-denom-
inated asset-backed securities and other
securities held by Europeans increased sig-
nicantly between 2003 and 2007, much of it
nanced by the short-term, dollar-denomi-
nated liabilities of European banks.
10

Just as regulatory systems did not, in
the years preceding the crisis, address vul-
nerabilities such as reliance on short-term
wholesale funding that were created by the
integration of capital markets and traditional
lending, so did they not respond to the trans-
formation of foreign banking operations.
Accordingly, just as home countries of
systemically important banks have been
playing catch-up on capital, liquidity, and
other requirements, so host countries of very
large foreign banking operations are play-
ing catch-up in dealing with the very differ-
ent character of many internationally active
banks from that of 20 or 30 years ago.
The regulatory response
In a sense, the major strengthening dur-
ing the past few years of capital and liquid-
ity requirements for internationally active
banks including the capital surcharge for
banks of global systemic importance has to
date been the most important international
regulatory response to the revealed vulner-
abilities associated with large foreign bank-
ing operations.
Building capital and improving the
liquidity positions of banks on a consolidated
basis is surely a key step toward assuring the
stability of major FBOs in host countries. Of
course, these agreed changes have not yet
been fully implemented. It is critical not just
74
that all jurisdictions adopt appropriate regu-
lations that fully incorporate the new Basel
standards, but also that we ensure our banks
will be substantively, and not just formally,
compliant as the various transition target
dates are reached.
Vulnerabilities and responsibilities
It is also the case that there is more to be
done in addressing the risks posed by large
global banking organisations, including
additional measures to deal with the run
risks associated with short-term wholesale
funding and ensuring that even the largest
rms can be successfully resolved without
either creating major systemic problems or
requiring an infusion of public capital.
I will return to these subjects a bit later, in
discussing the cooperative agenda that lies
ahead for the US, Europe, and our partners
throughout the world.
First, though, I want to describe how
Europe, the UK, and the US are dealing with
the vulnerabilities associated with large for-
eign banking operations, and thus are ful-
lling their responsibilities as host-country
supervisors.
I discuss the UK separately from the
EU both because it is outside the euro zone
and because, as a host jurisdiction, it is more
similar to the United States than to other EU
member states or, indeed, to any other coun-
try in the world.
New EU capital requirements
The EU has not, since the crisis, specically
adjusted the structure of regulation of for-
eign banks by its member states in their role
as host supervisors. Indeed, for more than a
decade before the crisis, EU member states
had prudently required that not only com-
mercial banking, but also investment bank-
ing subsidiaries of foreign (non-EU-based)
banking organisations, be subject to Basel
capital requirements in the same way as
EU-based rms.
With the adoption of CRD IV,
11
the
directive implementing the new EU capital
requirements, Basel III will now be applied
to all EU rms, including EU bank and
investment bank subsidiaries of non-EU
banking organisations. Branches of non-
EU banks are generally not subject to local
requirements.
Before the crisis and the subsequent
development of Basel III, there was no lev-
erage ratio requirement in EU capital direc-
tives. Insofar as a new leverage ratio is part
of the Basel III package agreed upon interna-
tionally, one would anticipate that it will be
applied to commercial banking and invest-
ment banking rms in the EU, again includ-
ing local subsidiaries of non-EU rms.
Supervisory challenges
Likewise, one would anticipate that the
Basel III liquidity requirements will be imple-
mented in the EU in accordance with the
internationally agreed time-line and, again,
that it will apply to EU subsidiaries of FBOs.
A greater challenge for the EU has been
dealing with banks headquartered in one
EU country but doing business in other EU
countries under the single passport,which
basically allows for full access in the rest of
the EU, with supervision provided only by
the home country.
During the crisis, there were some nota-
ble instances of banking stresses and failures
involving such institutions, with consequent
75
negative effects on depositors, counterpar-
ties, and economies in other parts of the
EU. Much of the ongoing post-crisis reform
agenda in Europe seems directed at ensur-
ing the safety and soundness of EU-based
institutions.
Post-crisis reforms
The most important of these changes may
be the assumption by the European Central
Bank of supervisory responsibility for larger
euro area banks. And, as we saw just last
week, work continues on the long process of
creating a credible resolution mechanism for
those banks.
As a member state of the EU, the UK of
course implements the EU policies I have
just described. But that country has applied
an additional set of requirements on the
local operations of foreign banks, particularly
with respect to liquidity.
The Prudential Regulation Authority of
the Bank of England applies local liquidity
requirements to commercial and investment
banking subsidiaries of non-UK banks,
requiring them to hold local buffers as deter-
mined by internal stress tests with both 14-
and 90-day components.
Stricter stress tests
The assumptions on which the stress tests
are premised are quite strict. For example,
the UK subsidiary generally must assume
zero inows from non-UK afliates even
for claims on non-UK afliates with short
terms that mature within the stress test
period and 100 per cent outows to non-
UK afliates.
The requirements generated by the
test are subject to a supervisory review and
add-on that for some rms has resulted in
a signicant increase in the buffer require-
ment. Branches of foreign commercial
banks may in some circumstances be subject
to local liquidity requirements as well.
The UK initiative in applying local liquid-
ity requirements is wholly understandable in
light of the difculties encountered because
of stress on foreign institutions, including the
Lehman bankruptcy, during the crisis.
Because London is one of the worlds
two largest nancial centre hosts, the UK is
the only country other than the US hosting
numerous, very large broker-dealers that are
owned by foreign banks and also a broad
array of commercial bank subsidiaries and
branches that are owned by foreign banks.
Respect for UK banking authorities
In fact, the six institutions headquartered
outside the US and the UK that are in the
top three tiers of G-SIBs hold roughly 40 per
cent of their worldwide assets in those two
jurisdictions.
12

Thus the UK initiative on liquidity and its
internal debates on matters such as struc-
tural supervision, the Vickers proposals, and
stress testing have all been very instructive
for the Federal Reserve Board.
Even where we have eventually adopted
somewhat different approaches, we respect
the motivation and scrupulousness of the
UK banking authorities in addressing the
systemic vulnerabilities posed by FBOs and
in fullling their responsibility to the rest of
the world to assure the stability of one of the
worlds two most important nancial centres.
Unlike the EU, the US did not prior to the
nancial crisis require that all broker-deal-
ers and investment banks meet Basel capital
76
standards. The legacy of the Glass-Steagall
Act, which had separated investment bank-
ing from commercial banking, meant that
only commercial banks were subject to the
prudential regulation of the federal banking
agencies.
Market uncertainties
In Europe, the dominance of universal bank-
ing, or variants thereon, led more naturally
to application of capital and other prudential
standards to all forms of banking activity.
Even after the Gramm-Leach-Bliley Act
removed the remaining barriers to afliation
between investment banks and commer-
cial banks in the United States, Basel capital
requirements applied at a consolidated level
to the activities of an investment bank or
broker-dealer only if it afliated with a com-
mercial bank.
Thus, the ve large free-standing US
investment banks were generally not subject
to full application of Basel capital standards.
During the crisis, the ill-advised nature of
this regulatory state of affairs became appar-
ent. The decline in value of many mortgage-
backed securities and the consequent market
uncertainty as to the true value of that entire
class of securities raised questions about the
solvency of major broker-dealers.
Liquidity issues
Because the dealers were so highly leveraged
and dependent on short-term nancing,
the uncertainty also led to serious liquid-
ity strains, rst at Bear Stearns and Lehman
Brothers and eventually at most dealers
domestic and foreign owned.
Bear Stearns and Merrill Lynch were
acquired by existing bank holding companies
after coming close to failure. Lehman
Brothers went bankrupt. Goldman Sachs
and Morgan Stanley became bank holding
companies.
Through its Primary Dealer Credit
Facility, the Federal Reserve provided sub-
stantial liquidity to the broker-dealer afli-
ates of the bank holding companies, as well
as to the primary dealer subsidiaries of for-
eign banks.
At the same time, the shift in strategy of
many foreign banks toward using their US
branches to raise dollars in short-term mar-
kets for lending around the world created
another set of vulnerabilities that resulted in
substantial and, relative to total assets, dis-
proportionate use of the Federal Reserves
discount window by foreign bank branches.
Consolidated prudential regulation
The experience of the crisis made clear, rst,
that the perimeter of prudential regulation
around US nancial institutions needed to
be expanded. As noted a moment ago, this
had occurred de facto during the crisis.
The Dodd-Frank Act has given a legal
foundation for this change, rst by man-
dating that Goldman Sachs and Morgan
Stanley will remain subject to consolidated
prudential regulation, even were they to
divest their insured depository institutions
and, second, by giving the Financial Stability
Oversight Council the authority to designate
other nancial rms as systemically impor-
tant, a step that would place them under
Federal Reserve regulation and supervision.
Dodd-Frank further required the Federal
Reserve to apply progressively more strin-
gent prudential regulation to bank hold-
ing companies with more than US$50
77
billion in assets. Congress also required the
Federal Reserve to apply special prudential
standards to large FBOs. As I have already
implied, much of what we have done is sim-
ply to catch up with EU and UK practice.
Enhanced regulation
Under our recently nalised Section 165
enhanced prudential standards regula-
tion, an FBO with US non-branch assets
of US$50 billion or more must hold its US
subsidiaries under an intermediate holding
company (IHC), which must meet the risk-
based and leverage capital standards gener-
ally applicable to bank holding companies
under US law.
13

Such an FBO must also certify that
it meets consolidated capital adequacy
standards established by its home-country
supervisor that are consistent with the Basel
Capital Framework. FBOs with combined
US assets of US$50 billion or more must also
meet liquidity risk-management standards
and conduct internal liquidity stress tests.
The IHC must maintain a liquidity buffer
in the United States for a 30-day liquidity
stress test. The US branches and agencies of
an FBO must maintain a liquidity buffer in
the United States equal to the liquidity needs
for 14 days, as determined by a 30-day liquid-
ity stress test.
14
The IHCs of FBOs must also
conform to certain risk-management and
supervisory requirements at the IHC level.
New US rules
Structurally, the US capital requirements
for FBOs are similar to those that apply to
foreign banks in the EU. That is, generally
applicable Basel capital requirements are
applied to the US operations of FBOs that
own local banking subsidiaries, investment
banks, and broker-dealers. In fact, the new
US rules are somewhat more favourable to
foreign institutions, in that they only apply
once the non-branch US assets of an FBO
exceed US$50 billion.
That dollar amount, incidentally, is the
same as the Dodd-Frank threshold for more
stringent prudential measures, though note
that this statutory threshold applies if the
total assets of any US banking organisation
foreign, as well as domestic exceed that
level.
As in the EU, the capital requirements do
not apply to US branches of foreign banks,
even though the crisis experience provides
some credible arguments for doing so. The
leverage ratio requirement has received par-
ticular attention.
Leverage ratio standards
One complaint is that the foreign operations
of US banks are not subject to leverage ratios
for their local operations. It is true that many
foreign countries including the EU mem-
ber states do not currently have leverage
ratio standards for their banks.
As noted earlier, however, one may rea-
sonably expect that those countries will be
implementing the Basel III leverage ratio in a
timely fashion. Also, I would note in passing
that the US leverage ratio requirement for
foreign rms will be phased in more slowly
than originally proposed, so as to align it
more closely with the effective date of the
Basel III leverage ratio requirement.
A second complaint is that there is
something unfair about the United States
requiring an FBO to meet the international
leverage ratio in its US operations, because
78
its operations may be heavily weighted
toward broker-dealer activities, which gen-
erally have higher leverage, whereas the
leverage ratio for US rms is based on their
global operations.
Basel III commitments
Again, one suspects that the foreign opera-
tions of US rms could be subject to a similar
ratio requirement abroad as countries imple-
ment their Basel III commitments.
However, quite apart from what may
happen in the future, there are two US-based
rms Goldman Sachs and Morgan Stanley
whose global business mix resembles that
of the US subsidiaries of FBOs that are pre-
dominantly engaged in broker-dealer activi-
ties in the United States.
In fact, under the enhanced supple-
mentary leverage ratio the Board proposed
during the summer, these and other US
G-SIBs would be subject to a higher Basel III
leverage ratio requirement (5 per cent) than
would apply to FBO IHCs (3 per cent).
The applicable liquidity requirements,
while somewhat differently dened, are
roughly comparable to those already appli-
cable to FBOs in the United Kingdom.
The similar positions of our two nations
as host countries for foreign bank operations
heavily involved in trading and signicantly
reliant on potentially runnable short-term
wholesale funding explain this rough
parallelism.
IHC requirements
The most notable departure of the new US
FBO standards from existing EU and UK
practice lies in the IHC requirement for for-
eign banks with large domestic operations.
Given the structure of US nancial regula-
tion that is a legacy of Glass-Steagall, as
well as the efforts by a small number of
very large foreign banks to evade the intent
of Congress that capital standards apply to
their US operations, we needed to create this
structural requirement.
It is unclear how much difference this
makes for the capital requirements of FBOs
in the US as opposed to those of US opera-
tions in the EU. That would depend on
the existence and size of nancial afliates
owned by the US rm that are not subject to
Basel standards directly.
In any case, it seems sound prudential
practice and consistent with the various
Basel Committee principles to which I earlier
referred that large domestic operations of
foreign banks meet capital standards on the
basis of all exposures in the host jurisdiction
and, indeed, that they manage their risks in
that country across all their afliates.
Scope for integration
To return to the issue of Balkanisation, three
things should now be apparent. First, in its
new capital regulations applicable to FBOs,
the United States is more a follower of the
pattern set by the EU than it is an initiator of
new kinds of requirements.
Of course, a few foreign banks would
prefer the old system under which they held
relatively little capital in their very extensive
US operations.
But that was neither safe for the nancial
system nor particularly fair to their competi-
tors US and foreign that hold signicant
amounts of capital here. Indeed, a rm
that is genuinely well capitalised, including
holding the G-SIB surcharge at its global
79
consolidated level, should require only mod-
erate adjustment efforts during the transition
period established in the FBO rule.
Second, there is considerable scope for a
foreign bank to integrate its US operations
with its global activities within the rule the
Federal Reserve adopted last month.
Freedom to lend
For example, while foreign rms with more
than US$10 billion in non-branch assets
have some additional reporting require-
ments, only when US non-branch assets
rise above US$50 billion do the quantitative
Basel capital requirements become applica-
ble to the US subsidiaries.
Moreover, no capital requirements apply
to branches so long as their parent is subject
to home-country consolidated capital rules
consistent with Basel standards. The US
operations of FBO branches and subsidiaries
will not be subject to due fromrestrictions.
They remain free to lend money to their
worldwide afliates; they must simply do so
with a more stable funding base. Finally, I
note that many FBOs, like many US-based
banks, have made considerable progress in
reducing dependence on short-term whole-
sale funding and in building capital. To some
extent, the new requirements are intended
to preserve this progress.
Effective supervision
Third, the capital and liquidity requirements
that do apply are wholly consistent with
the responsibility of host-country supervi-
sors to assure nancial stability in their own
markets.
Collectively, foreign banks with a large
presence in the United States conduct
activities of a scope, and at a scale, that could
lead to problems for the US nancial system
should they come under stress. Realistically,
exposures and vulnerabilities in a large host-
country market are much more difcult for
home-country supervisors to assess.
Indeed, US regulators count on the
expertise and proximity of UK regulators in
overseeing the London operations of large
US nancial institutions to enhance the
effective consolidated supervision and regu-
lation for which we are responsible.
On the issue of home-host-country
coordination in regulating large, globally
active banking organisations, I would make
three additional points. First, our FBO capi-
tal requirements, like those of the EU for for-
eign commercial and investment banks, are
based on the capital rules agreed to in the
Basel Committee.
15

Supervisory expectations
Thus, there is an overall compatibility
between national and international rules
with respect to applicable denitions, stand-
ards, and required ratios. Second, home
countries must implement and enforce
faithfully at a consolidated level these same
capital rules.
More broadly, home-country supervi-
sory expectations for strong consolidated
capital levels, liquidity positions, and risk-
management practices, are likely to facilitate
compliance with domestic requirements
for large FBOs of the sort applicable in the
United States and the EU.
It is also important that home countries
assure the credibility of resolution mecha-
nisms for their large banking organisations.
This task entails the implementation of the
80
Financial Stability Boards principles for
effective resolution regimes, including estab-
lishing a resolution authority with adequate
legal powers to manage the process in an
orderly fashion, without injection of public
capital.
16

Strain reduction
It also includes requiring each such institu-
tion to have total loss absorption capacity
sufcient to re-capitalise the rm even if its
substantial equity buffer is lost in an extreme
tail event.
Home and host countries should work
together toward international standards
that will ensure that an appropriate amount
of this capacity would be available to host
authorities faced with the potential insol-
vency of large FBOs in their jurisdiction or
with the consequences for their market of
the failure of parent banks.
In this regard, I think that capital require-
ments for FBOs of the sort now required by
the EU and the United States are very likely
to reduce the considerable strains that have
traditionally accompanied nancial dis-
tress at global banking rms. In most cases,
including both internationally and within the
EU itself in recent years, stress has resulted in
the demand by host authorities for ex post
ring fencing of capital, liquidity, or both, often
in the absence of any ex ante requirements.
International standards
The existence of FBO capital and liquid-
ity standards, particularly if supplemented
with the total loss absorbency measures to
which I just referred, should mitigate the
need for such demands, which of course
come at the worst possible time for the rm
trying to meet them. Third, we by which
I mean both home and major host banking
regulators need to nd better ways of fos-
tering genuine regulatory and supervisory
cooperation.
Particularly at the most senior levels of
the agencies that actually supervise globally
active banks, our interactions with our coun-
terparts from other countries have become
almost exclusively focused on developing
international standards or reviewing compli-
ance with existing ones.
These discussions are usually conducted
with numerous colleagues who are not
themselves responsible for banking regula-
tion in their own jurisdictions.
Shared interests
As important as these efforts have been and
continue to be, following the crisis, there is a
risk that by not having opportunities for sen-
ior ofcials of the various national agencies
that have direct supervisory responsibility for
banking organisations to meet and discuss
shared challenges, we give short shrift to the
collective interest of bank regulators in effec-
tive supervision of all globally active rms.
Proposals to include prudential require-
ments or, more precisely, to include limita-
tions on prudential requirements in trade
agreements would lead us further away
from the aforementioned goal of empha-
sising shared nancial stability interests, in
favour of an approach to prudential matters
informed principally by considerations of
commercial advantage.
The job of regulating and supervising
large, globally active banking organisa-
tions is a tough one. Issues of moral haz-
ard, negative externalities, and asymmetric
81
information are, if not pervasive, then at least
signicant and recurring. The job is made
only harder by the fact that these rms cross
borders in ways their regulators do not.
International responsibility
But we cannot ignore this fact and pretend
that we have global oversight. International
standards for prudential regulation are not
the same as global regulations, and consoli-
dated supervision is not the same as com-
prehensive supervision.
The jurisdictions represented on the
Basel Committee not only have the right to
regulate their nancial markets including
large FBOs participating in those markets
they have a responsibility to their home
jurisdictions, and to the rest of the world, to
do so.
The most important contribution the
US can make to global nancial stability is
to ensure the stability of our own system.
There must be some assurance beyond mere
words from parent banks or home-country
supervisors that a large FBO will remain
strong or supported in periods of stress.
Genuine cooperation
After all, as we saw in the crisis, while a par-
ent bank or home-country authorities may
have offered those words with total good
faith in calm times, they may be unable to
carry through on them in more nancially
turbulent periods. None of this means that
we need be at odds with one another. On
the contrary, these very circumstances call
not only for more tangible safeguards in host
countries, but also for more genuine coop-
eration among supervisory authorities.
Indeed, as I hope will continue to be the
case with the international agenda on reso-
lution, total loss absorbency, and related mat-
ters, we should aspire to converge around
the kinds of protections that we can expect
at both consolidated and local levels.
Endnotes
1. I would add, in passing, the observation that I am not
at all sure it would be desirable to have a single global bank
regulator even if it were remotely within the realm of
political possibility.
2. Basel Committee on Banking Supervision (1983), Prin-
ciples for the Supervision of Banks Foreign Establishments
(PDF) (Basel: Bank for International Settlements, May).
3. Basel Committee on Banking Supervision (1992), Min-
imum Standards for Supervision of International Banking
Groups and Their Cross-Border Establishments (PDF)
(Basel: Bank for International Settlements, July). Return to
text
4. Basel Committee on Banking Supervision (2012),
Core Principles for Effective Banking Supervision (PDF)
(Basel: BIS, September), p. 38.
International Convergence of Capital Measures and Capi-
tal Standards (PDF) (Basel: Bank for International Settle-
ments, June), p. 7.
A Framework for Dealing with Domestic Systemically
Important Banks (PDF) (Basel: BIS October).
7. As of September 30, 2013, there were 24 such for-
eign banks, compared with 24 US frms. Source: For US
bank holding companies: FR Y-9C; for foreign banks: FR
Y-9C, FFIEC 002, FR 2886b, FFIEC 031/041, FR Y-7N/NS,
X-17A-5 Part II, and X-17A-5 Part IIA, and X-17A-5 Part
II CSE.
8. Source: FR Y-9C, FFIEC 002, FR 2886b, FFIEC 031/041,
FR Y-7N/NS, X-17A-5 Part II, and X-17A-5 Part IIA, and
X-17A-5 Part II CSE.
9. Source: FFIEC 002, various years.
10. Ben S. Bernanke, Carol Bertaut, Laurie Pounder
82
DeMarco, and Steven Kamin (2011), International Capital
Flows and the Returns to Safe Assets in the United States,
2003-2007, International Finance Discussion Papers
Number 1014 (Washington: Board of Governors of the
Federal Reserve System, February).
11. The European CRD IV package, which implemented
the global Basel III capital standards into European
Union law, entered into force on July 17, 2013. See http://
ec.europa.eu/internal_market/bank/regcapital/legislation_
in_force_en.htm . R
12. Staff estimates, using data from the Federal Reserve and
the Bank of England. The UK data include only UK resident
banking entities of each banking group. The US data include
all entities of each banking group. Both UK and US assets
include intragroup claims on related affliates. Worldwide
assets are calculated using the accounting standards of
home country jurisdictions. The list of G-SIBs is available at
www.fnancialstabilityboard.org/publications/r_131111.pdf.
13. Actually, Foreign bank organisations need not meet
advanced approach risk-based capital requirements in the
United States, unless they specifcally opt in to that treat-
ment. See www.federalreserve.gov/newsevents/press/
bcreg/20140218a.htm.
14. An Foreign bank organisation with total consolidated
assets of US$50 billion or more but with combined US
assets of less than US$50 billion must report the results
of an internal liquidity stress test (either on a consolidated
basis or for its combined US operations) to the Board on
an annual basis. Return to text
15. As a technical matter, the relevant Foreign bank organi-
sations are subject to the traditional 4 per cent US lever-
age ratio, but it is very likely that this requirement will be
less binding than the 3 per cent international leverage ratio
because of the inclusion in the denominator of the latter of
off-balance-sheet activities and exposures.
16. Financial Stability Board (2011), Key Attributes of
Effective Resolution Regimes for Financial Institutions
(Basel: Financial Stability Board, November 4).
NORTH ASIA
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Editor-in-Chief
Articles & Papers
Issues in resolving systemically important nancial institutions Dr Eric S. Rosengren
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135
Compliance
Global nancial change impacts
compliance and risk
EastNets head of products management
compliance, David Dekker, details a potent
chemical reaction in nancial markets.
ABOUT a year ago we saw the frst signs
of a transformation in the fnancial world
and in the last months the credit crisis
has transformed the fnancial world at
an explosive pace. The change that is
occurring is much broader in scope than
originally expected. Banks that were
considered to be too big to fail or fall
are either failing or being taken over by
fnancial institutions that are more fnan-
cially sound, resulting in a huge para-
digm shift in how banks are regarded by
the public and other banks.
Since banking largely revolves around
trust and the ability to service customers, los-
ing a customer and determining the impact
of it, should be part of the ongoing risk
management of the organisation, as well as
monitoring the riskiness of existing and new
products and the customers using/buying
these products. But there are more changes
and challenges in the banking world that are
threatening banking as we have known it.
The banks will, in the future, not be the
default vehicles by which to move our funds,
maintain our balances and portfolios; they
will just be one of companies amongst oth-
ers that will be able to offer these services.
These days we should rather speak about
nancial institutions than banks, or moni-
tored nancial service providers, a name that
covers their current and future activities.
Look at how rapidly we have moved
from physical interaction on the banks
terms (location and hours of operation) to
electronic payments then Internet banking.
Again the banks were still in charge, but
as mentioned the paradigm is shifting to a
world where we (physical persons and cor-
porations) pay each other without the banks
involvement with new technologies such as
mobile payments.
Network providers
In the future the banks and organisations
such as SWIFT, NACHA and other pay-
ment networks become network providers
that allow you to send money from A to B
and will charge you for the network traf-
c that you generate. This brings similari-
ties with industries such as telecom, energy
suppliers and cable companies. The nancial
world is clearly undergoing an important
33
Opinion
Deregulation, non-regulation and desupervision
Professor William Black examines the
causes of the mortgage fraud epidemic that has swept the United States.
THE author of this paper is a leading
academic, lawyer and former banking
regulator specialising in white collar
crime. As one of the unsung heroes of the
Savings & Loans debacle of the 1980s,
Professor Black nowadays spends much
of his time researching why fnancial
markets have a tendency to become dys-
functional. Renowned for his theory on
control fraud, Prof. Black lectures at the
University of Missouri and Kansas City.
He is the author of The Best Way to Rob
a Bank is to Own One: How Corporate
Executives and Politicians Looted the
S&L Industry. A prominent commenta-
tor on the causes of the current fnancial
crisis, Prof. Black is a vocal critic of the
way the US government has handled the
banking crisis and rewarded institutions
that have clearly failed in their fduciary
duties to investors.
The following commentary does not nec-
essarily represent the view of the Journal of
Regulation and Risk North Asia. The new numbers on criminal refer-
rals for mortgage fraud in the US are just in
and they implicitly demonstrate three criti-
cal failures of regulation and a wholesale
failure of private market discipline of fraud
and other forms of credit risk. The Financial
Crimes Enforcement Network (FinCEN)
released a study this week on Suspicious
Activity Reports (SARs) that federally regu-
lated nancial institutions (sometimes) le
with the Federal Bureau of Investigation
(FBI) when they nd evidence of mortgage
fraud.
Epidemic warning The FBI began warning of an epidemic of
mortgage fraud in their congressional testi-
mony in September 2004 over ve years
ago. It also warned that if the epidemic were
not dealt with it would cause a nancial cri-
sis. Nothing remotely adequate was done to
respond to the epidemic by regulators, law
enforcement, or private sector market dis-
cipline. Instead, the epidemic produced and
hyper-inated a bubble in US housing prices
that produced a crisis so severe that it nearly
caused the collapse of the global nancial
system and led to unprecedented bailouts of
many of the worlds largest banks.
83
Bank regulation
Lessons from the panic of
2008: Are we better prepared?
United States Senator Elizabeth Warren
calls for a new 21st Century Glass-Steagal
Act to end Too Big to Fail once and for all.
IT has been more than fve years since
the fnancial crisis, but we all remember
its darkest days. Credit dried up. The
stock market cratered. Historic institu-
tions like Lehman Brothers and Merrill
Lynch were wiped out. There were legit-
imate fears that the dominos of our fnan-
cial system would never stop falling and
that we were heading into another Great
Depression.
We averted that grim outcome, but the dam-
age was staggering. A recent report by the
Federal Reserve Bank of Dallas estimated
that the nancial crisis cost us upward of
14 trillion dollars trillion, with a t. Thats
US$120,000 for every American household -
more than two yearsworth of income for the
average family. Billions of dollars in retire-
ment savings disappeared.
Millions of workers lost their jobs and
their sense of nancial security. Entire
communities were devastated. Indeed, an
August US Census Bureau study shows that
home ownership rates declined by 15 per
cent for families with young children. The
Crash of 2008 changed lives forever.
In April 2011, after a two-year bipar-
tisan enquiry, the US Senate Permanent
Subcommittee on Investigations released a
635-page report that identied the primary
factors that led to the crisis - Wall Street and
the Financial Crisis: Anatomy of a Financial
Collapse. The list included high-risk mort-
gage lending, inaccurate credit ratings, exotic
nancial products, and to top it all off, the
repeated failure of regulators to stop the
madness.
Blame is everywhere
As Senator Tom Coburn, the Subcommittees
ranking member, said: Blame for this mess
lies everywhere from federal regulators who
cast a blind eye, Wall Street bankers who let
greed run wild, and members of Congress
who failed to provide oversight.
Even Jamie Dimon, the CEO of
JPMorgan Chase, has emphasised inade-
quate regulation as a source of the crisis. He
wrote to his shareholders: Had there been
stronger standards in the mortgage markets,
one huge cause of the recent crisis might
have been avoided. The crash happened
quickly and dramatically, and it caught our
84
nation and apparently even our regulators
by surprise. But dont let that fool you. The
causes of the crisis were years in the making,
and the warning signs were everywhere.
Hidden fees and charges
As many of you know, I spent most of my
career studying the growing economic pres-
sures on middle class families families that
worked hard and played by the rules but
still cant get ahead. And Ive also studied
the nancial services industry and how it
has developed over time. A generation ago,
the price of nancial services credit cards,
checking accounts, mortgages, and signa-
ture loans was pretty easy to see. Both
borrowers and lenders understood the basic
terms of the deal.
But by the time the nancial crisis hit,
a different form of pricing had emerged.
Lenders began to use a low advertised
price on the front-end to entice customers,
and then made their real money with fees,
charges and penalties and re-pricing in the
ne print. Buyers became less and less able
to evaluate the risks of a nancial prod-
uct, comparison shopping became almost
impossible, and the market became less
efcient.
Dodd-Frank
Credit card companies took the lead, with
their contracts ballooning from a page and
a half back in 1980 to more than 30 pages
by the beginning of the 2000s. Teaser-rate
credit cards which advertised deceptively
low interest rates paved the way for teaser-
rate mortgages.
When I worked to set up the Consumer
Financial Protection Bureau (CFPB), I pushed
hard for steps that would increase transpar-
ency in the marketplace. The crisis began
one lousy mortgage at a time, and thanks to
CFPBs work, I think there will never again
be so many lousy mortgages. On this front,
I think were a lot safer than we were. But
what about the other causes of the crisis?
There is no question that Dodd-Frank
was a strong bill the strongest in three gen-
erations. Ididnt have a chance to vote for
it because I wasnt yet in the Senate, but if
I could have, I would have voted for it twice.
Even so, the law is not perfect. And so its
important to ask: Where are we now, ve
years after the crisis hit and three years after
Dodd-Frank?
Too big to fail problem
There are many issues to discuss and Im
sure you will get to them in the panel that
follows this speech see pages xxx-xxx. But
Id like to focus on one in particular. Where
are we now on the Too Big to Failproblem?
Where are we on making sure that the behe-
moth institutions on Wall Street cant bring
down the economy with a wild gamble?
Where are we in ending a system that lets
investors and CEOs scoop up all the prots
in good times, but forces taxpayers to cover
the losses in bad times?
After the crisis, there was a lot of discus-
sion about how Too Big to Fail distorted the
marketplace, creating lower borrowing costs
for the largest institutions and competitive
disadvantages for smaller ones. There was
talk about moral hazard and the dangers of
big banks getting a free, unwritten, govern-
ment-guaranteed insurance policy.
Sure, there was talk, but look at what
happened: Today, the four biggest banks are
85
30 per cent larger than they were ve years
ago. And the ve largest banks now hold
more than half of the total banking assets
in the country. One study earlier this year
showed that the Too Big to Fail status is giv-
ing the ten biggest US banks an annual tax-
payer subsidy of US$83 billion.
Logic of Congress
Who would have thought ve years ago,
after we witnessed rst hand the dangers of
an overly concentrated nancial system that
the Too Big to Fail problem would only have
gotten worse?
There are many who say, Sure, Too Big
to Fail isnt over yet, but Congress should
wait to act further because the agencies
still have to issue a bunch of Dodd-Franks
required rules. True, there are rules left to
be written, but thats because the agencies
have missed more than 60 per cent of Dodd-
Franks rulemaking deadlines.
I dont understand the logic. Since when
does Congress set deadlines, watch regula-
tors miss most of them, and then take that
failure as a reason not to act? I thought
that if the regulators failed, it was time for
Congress to step in. Thats what oversight
means. And thats certainly a principle that
would have served our country well prior to
the crisis.
Time to act
So lets put the pieces together: It has been
three years since Dodd-Frank was passed;
the biggest banks are bigger than ever, the
risk to the system has grown, and market
distortions have continued. While the CFPB
has met every single statutory deadline so
we know its possible to get the job done
the other regulators have missed their
deadlines and havent given us much reason
for condence. The result is that the Too Big
to Fail problem remains. I add that up, and
its clear to me that its time to act. The last
thing we should do is wait for more crises
for another London Whale before we take
action!
For that reason, I partnered with Senator
John McCain, Senator Maria Cantwell, and
Senator Angus King to offer up one potential
way to address the Too Big to Fail problem
this being the 21st Century Glass- Steagall
Act. By separating traditional depository
banks from riskier nancial institutions,
the 1933 version of Glass-Steagall laid the
groundwork for half a century of nancial
stability.
Gramm-Leach-Bliley Act
During that time, we built a robust and thriv-
ing middle class. But throughout the 1980s
and 1990s, Congress and regulators chipped
away at Glass-Steagalls protections, encour-
aging growth of the megabanks and a sharp
increase in systemic risk. They nally n-
ished the task in 1999 with the passage of the
Gramm-Leach-Bliley Act, which eliminated
Glass-Steagalls protections altogether.
The 21st Century Glass-Steagall Act
would reinstate many of the protections
found in the original Glass-Steagall Act. It
would ward off depository institutions from
riskier activities like investment banking,
swaps dealing, and private equity activities.
It would encourage nancial institutions to
shrink, and eliminate their ability to rely on
federal depository insurance as a backstop
for high-risk activities. In other words, the
new Glass-Steagall Act would attack both
86
too bigand to fail. It would reduce the
failures of the big banks by making bank-
ing boring, protecting deposits and provid-
ing stability to the system even in bad times.
And it would reduce too bigby dismantling
the behemoths, so that big banks would still
be big but not too big to fail or, for that mat-
ter, too big to manage, too big to regulate, too
big for trial, or too big for jail.
Wrong in the 1930s - wrong today
Big banks would once again have under-
standable balance sheets, and with that
would come greater market discipline. Sure,
the lobbyists for Wall Street say the sky will
fall if they cant use deposits in checking
accounts to fund their high-risk activities.
But they said that in the 1930s too. They
were wrong then, and they are wrong now.
The Glass-Steagall Act would restore the
stability to the nancial system that began to
disappear in the 1980s and the 1990s.
This is one way to deal with Too Big to
Fail, and I think it would work. But there
are other approaches too. So what I want
to know is this: how much longer should
Congress wait for regulators to x this prob-
lem? Another three months? Another three
years? Until the next big bank comes crash-
ing down?
Congress must act
US Treasury Secretary Jack Lew recently said
that if Too Big to Failis still a problem at the
end of the year, it might be time to consider
other options. I applaud Secretary Lew for
laying out a timeline, and Id like to see other
Administration ofcials and regulators fol-
low suit.
If Dodd- Frank gives the regulators the
tools to end Too Big to Fail, great end Too
Big to Fail.
But if the regulators wont end Too Big to
Fail, then Congress must act to protect our
economy and prevent future crises.
We should not accept a nancial system
that allows the biggest banks to emerge
from a crisis in record-setting shape while
ordinary Americans continue to struggle.
And we should not accept a regulatory sys-
tem that is so besieged by lobbyists for the
big banks that it takes years to deliver rules
and then the rules that are delivered are
often watered-down and ineffective.
What we need is a system that puts an
end to the boom and bust cycle. A system
that recognises we dont grow this country
from the nancial sector; we grow this coun-
try from the middle class.
David and Goliath battle
Powerful interest groups will ght to hang
on to every benet and subsidy they now
enjoy. Even after exploiting consumers,
larding their books with excessive risk, and
making bad bets that brought down the
economy and forced taxpayer bailouts, the
big Wall Street banks are not chastened.
They have fought to delay and hamstring
the implementation of nancial reform, and
they will continue to ght every inch of the
way.
Thats the battleeld. Thats what were
up against. But David beat Goliath with the
establishment of CFPB and, just a couple
months ago, with the conrmation of Rich
Cordray. David beat Goliath with the pas-
sage of Dodd-Frank. And I am condent
David can beat Goliath on Too Big to Fail.
We just have to pick up the slingshot again.
87
Bank regulation
US super-ve too big to
fails antithetical to capitalism
Thomas Hoenig, vice chair of the Federal
Deposit Insurance Corp., is sanguine in face
of banking opposition to further reform.
THE United States is in its sixth year fol-
lowing the fnancial and economic crisis
of 2008, and we are just about to start our
fourth year since the enactment of the
Dodd-Frank Act. Enormous energy has
been expended in an attempt to imple-
ment a host of required reforms. The
Volcker Rule has been implemented, and
more recently a rule requiring foreign
bank operations to establish US holding
companies has been adopted under the
auspices of Section 165 of Dodd Franks
by the US Federal Reserve.
While these are important milestones, much
remains undone and I suspect that 2014 will
prove to be a critical juncture for determining
the future of the banking industry and the
role of regulators within that industry. The
inertia around the status quo is a powerful
force, and with the passage of time and fad-
ing memories, change becomes ever more
difcult. There are any number of unre-
solved matters that require attention, some
of which are as follows:
This past July 2013 the regula-
tory authorities proposed a sensible
supplemental capital requirement that
is yet to be adopted. This single step
would do much to strengthen the resil-
iency of the largest banks, since even
today they hold proportionately as little
as half the capital of the regional banks.
The Global Capital Index points out
that tangible capital to asset levels of the
largest rms average only 4 per cent.
The largest banking rms carry an enor-
mous volume of derivatives. The law
directs that such activities be conducted
away from the safety net, and we are
still in the process of completing what is
referred to as the push-out rules.
Bankruptcy laws have not been
amended to address the use of long-
term assets to secure highly volatile
short-term wholesale funding. This
contributes to a sizeable moral hazard
risk among banks and shadow banks,
as these instruments give the impres-
sion of being a source of liquidity
when, in fact, they are highly unstable.
The response so far has required that
we develop ever more complicated
bank liquidity rules, which are costly
88
to implement and enforce, and leave
other rms free to rely on such volatile
funding.
Fannie Mae and Freddie Mac continue
to operate under government conser-
vatorship, and as such they dominant
home mortgage nancing in the United
States.
Finally, among the more notable and
difcult pieces of the unnished busi-
ness is the assignment to assure that
the largest, most complicated banks
can be resolved through bankruptcy in
an orderly fashion and without public
aid. Congress gave the Federal Reserve
and the FDIC, and the relevant banking
companies, a tough assignment under
the Title 1 provisions of the Dodd-Frank
Act to solve this problem. It requires
making difcult decisions now, or the
die will be cast and the largest bank-
ing rms will be assured an advantage
that few competitors will successfully
overcome.
1
Persistence of too big to fail
I want to spend a few more minutes on
this last topic, as it remains a critical step to
a more sound nancial system. The chart
titled Consolidation of the Credit Channel
(see page 90) shows the trend in concentra-
tion of nancial assets since 1984.
The graph (see page 90) shows the dis-
tribution of assets for four groups of banks,
ranging in size from less than US$100 mil-
lion to more than US$10 billion. The chart
shows that in 1984, the control of assets
among the different bank groups was almost
proportional.
Also, within each group, if a single bank
failed, even the largest, it might shock the
economy, but most likely would not bring it
down.
Today this distribution of assets is dra-
matically different. Banks controlling assets
of more than US$10 billion have come to
compose an overwhelming proportion of
the economy, and those with more than a
trillion dollars in assets have come to domi-
nate this group. If even one of the largest ve
banks were to fail, it would devastate mar-
kets and the economy.
Title I of the Dodd-Frank Act is intended
to address this issue by requiring these larg-
est rms to map out a bankruptcy strategy.
This is referred to as the Living Will. If bank-
ruptcy fails to work, Title II of Dodd-Frank
would have the government nationalise and
ultimately liquidate a failing systemic rm.
Issues with liquidation
While these mechanisms outline a path for
resolution, success will be determined by
how manageable large and complex rms
are under bankruptcy and whether under
any circumstance they can be resolved with-
out major disruption to the economy.
This is a daunting task, and increasing
numbers of experts question whether it can
be done given current industry structure.
2

Two impediments are most often high-
lighted to organising an orderly bankruptcy
or liquidation for these rms.
First, it is not possible for the private sec-
tor to provide the necessary liquidity through
debtor in possessionnancing due to the
size and complexity of the institutions and
due to the speed at which crises occur.
There simply would be too little con-
dence in bank assets and the lenders ability
89
to be repaid, and too little time to unwind
these rms in an orderly fashion in a bank-
ruptcy. Under the current system, it would
have to be the government that provides
the needed liquidity, it is argued, even in
bankruptcy, to avoid a broader nancial
meltdown.
Panic equals nationalism
Second, when a mega banking rm goes
into bankruptcy, capital markets and cross-
border ows of money and capital most
likely would seize up, intensifying the crisis,
as happened following the failure of Lehman
Brothers, for example.
International cooperation is critical in
such circumstances, and it would be ideal if
creditors, bankers and governments acted
calmly and rationally in a crisis. It would be
ideal also if all contracts were honoured and
if collateral and capital were free to move
across borders. But, experience suggests
otherwise.
Panic is about panic, and people and
nations generally protect themselves and
their wealth ahead of others. Moreover,
there are no international bankruptcy laws
to govern such matters and prevent the
grabbing of assets, sometimes known as
ring-fencing.
One systemic failure
This raises the important question of whether
rms must simplify themselves if we hope to
place them into bankruptcy. This is no small
question, and it must be addressed.
A further sense of the importance of
these unresolved issues can be gained by
working through the annual report of any
one of these largest rms. These reports
show that individual rms control assets
close to the equivalent of nearly a quarter
of US GDP, and the ve largest US nancial
rms together have assets representing just
over half of GDP.
The reported composition of rm assets
represents a further challenge in judging
their resolvability, as it is opaque and the
relationship among afliate rms is some-
times unclear.
A host of assets and risks are disclosed
only in footnotes, although they often
involve trillions of dollars of derivatives that
are not shown on the balance sheet. Inter-
company liabilities are in the hundreds of
billions of dollars and if any one link fails, it
can initiate a chain reaction of losses, failure
and panic.
And should crisis emerge, liquidity
is sought through the insured bank, not
through the provisions of bankruptcy. One
failure means systemic consequences.
Antithetical to capitalism
These conditions mean too big to fail
remains a threat to economic stability. They
necessarily put the economic system at risk
should even one mega bank fail.
And they allow these mega banks to
operate beyond the constraints of econo-
mies of scale and scope, and provide the
rms an enormous competitive advantage
all of which is antithetical to capitalism.
These observations are not new to the
nancial system, and they have sparked a
broadening debate on what action might
be taken to better assure that bankruptcy
is the rst option for resolution. Potential
actions include the following: First, simplify
the corporate structure of the mega banks
90
Chart 2. Consolidation of the Credit Channel Change in Assets by Bank Size
Groups (1984-2012)
Chart 1. Global Capital Index Capitalisation Ratios for Global Systemically
Important Banks (GSIBs)
91
that now dominate the nancial system.
There is mounting evidence of the benets
that would ow from such an action. Market
analysts and economists have pointed to
increased value and greater economic stabil-
ity that would ow from such restructuring.
Subsidisation
Commercial banking is different than bro-
ker-dealer activities, and studies show that
requiring banks and broker-dealers to oper-
ate independently would serve potentially to
improve the pricing and allocation of capital,
and to increase value.
Second, as the Federal Reserve recently
required for foreign banks operating in the
United States, governments should require
global banking companies to establish
separate operating subsidiaries within each
country.
This subsidarisation would give greater
clarity to where capital is lodged globally,
and it would serve to assure that banks
within each country have capital available at
foreign afliates to absorb losses on a basis
comparable to that jurisdictions domestic
banks.
Subsidarisation also would lead to
greater recognition of the risks on rmsbal-
ance sheets, causing more capital to be held
globally and thus contributing to greater
overall nancial stability and availability of
credit.
Ending the charade
Those who object to this concept suggest
that such a requirement interferes with capi-
tal ows and would actually reduce avail-
able credit. However, subsidarisation would
require that capital be aligned with where
assets reside, and it would identify for mar-
kets and authorities the capital available to
absorb losses should it be needed. It pro-
vides far more transparency than the current
structure.
Such transparency would encourage a
more responsible use and allocation of capi-
tal and resources. It ends the charade that
markets are open and safe, only to see them
suddenly shut down and ring-fenced, with
devastating effect, when the inevitable crisis
occurs.
Conclusion
It is fundamental to capitalism that markets
be allowed to clear in an open, fair manner
and that all participants play by the same
rules.
A situation whereby oligopolies that
evolve into institutions that are too big to
fail, and are so signicant and complex that
should they fail the economy fails, is not
market economics. To ignore these circum-
stances is to invite crisis.
Bibliography
1. Literature review of the too-big-to-fail subsidy. http://
www.fdic.gov/news/news/speeches/literature-review.pdf.
2. December 11, 2013 meeting of the FDIC Systemic
Risk Advisory Committee. http://www.fdic.gov/about/srac/
3. Organisation of Economic Cooperation and Devel-
opment research by Adrian Blundell-Wignall, Paul Atkin-
son and Caroline Roulet http://www.oecd.org/daf/fn/
fnancial-markets/Bank-Separation-2013.pdf http:/www.
oecd.org/daf/fn/fnancial-markets/Bank-Business-Models-
Basel-2013.pdf Break Up Banks: Show Me My Money,
Credit Agricole Securities - Mike Mayo. January 2013. Hoe-
nig and Morris: http://www.fdic.gov/about/learn/board/hoe-
nig/Restructuring-the-Banking System, Hoenig & Morris,,
November.2013.pdf
93
Asset fund management
Monetary policy capture in
the US treasuries sphere
Fed. Governor Jeremy C. Stein applauds
authors of Market Tantrums and Monetary
Policy for their sterling research effort.
I am delighted to have the opportu-
nity to discuss here today (February 28,
2014) the paper Market Tantrums and
Monetary Policy by Michael Feroli, Anil
K. Kashyap, Kermit Schoenholtz, and
Hyun Song Shin. It is timely, provoca-
tive, and extremely insightful. Let me
start by summarising what I take to be
the papers main messages.
1

First, the authors argue that policymakers
should pay careful attention not just to meas-
ures of leverage in the banking and shadow
banking sectors, but also to the nancial sta-
bility risks that may arise from the behaviour
of unlevered asset managers, such as those
running various types of bond funds.
Notably, assets under management in
xed-income funds have grown dramati-
cally in the years since the onset of the nan-
cial crisis, even while various measures of
nancial-sector leverage have either contin-
ued to decline or remained subdued.
Second, the authors develop a model of
agency problems in delegated asset manage-
ment, according to which an environment of
low short-term rates can encourage asset
managers concerned with their relative per-
formance rankings to reach for yield,which
in turn acts to compress risk premiums.
Moreover, the model has the feature that
this reach for yield can end badly, with a sud-
den and sharp correction in risk premiums
that arises endogenously in response to a
small tightening of monetary policy. The
events of the spring and summer of 2013,
which saw a rapid rise in bond market term
premiums, are cited as a leading example of
what the model sets out to capture.
Liquidity risks
Third, the authors assert that the conven-
tional regulatory toolkit, which is largely
designed to contain intermediary leverage,
is not well suited to dealing with the asset-
management sector. Given this limitation of
regulation, and because monetary policy has
a direct inuence on the behavior of asset
managers, the nancial stability risks that
these managers create should be factored
into the design and conduct of monetary
policy.
Presumably, this consideration would
imply that monetary policy should be
94
somewhat less easy in a weak economy, all
else being equal, to reduce the probability
of an undesirable upward spike in rates and
credit spreads down the road.
Monetary policy design
The authors are careful to note that our
analysis neither invalidates nor validates
the course the Federal Reserve has actually
taken.
2
Rather, they are highlighting a set
of considerations that they believe should
ultimately be incorporated into the design of
a monetary policy framework.
This is the spirit in which I will discuss
the paper not as a comment on the cur-
rent stance of policy, but as an exploration of
the factors that should be taken into account
when thinking about the trade-offs associ-
ated with monetary policy more generally.
The model in the paper is a simple one,
and it does a nice job of framing the issues.
In particular, regarding the value of the the-
ory, on the one hand I believe that an emerg-
ing body of empirical work documents that
an easing of monetary policy - even via
conventional policy tools in normal times
tends to reduce both the term premiums on
long-term US Treasury bonds and the credit
spreads on corporate bonds.
3

What is the problem?
In other words, monetary policy tends to
work in part through its effect on capital
market risk premiums, perhaps through
some sort of risk-taking or reaching-for-
yield mechanism.
On the other hand, while this empiri-
cal observation sheds some interesting light
on how monetary policy inuences the real
economy, it does not by itself suggest that
there is any nancial stability dark side to the
lowered risk premiums that go with mon-
etary accommodation.
For there to be any meaningful trade-off,
there would have to be some sort of asym-
metry in the unwinding of these risk premi-
ums, whereby the eventual reversal either
occurs more abruptly, or causes larger eco-
nomic effects, than the initial compression.
Said a little differently, if an easing of
Federal Reserve policy puts downward pres-
sure on term premiums and credit spreads,
and if this downward pressure is only gradu-
ally reversed as policy begins to tighten, then
what is the problem?
The nice feature of the model is that it
speaks to this asymmetry in that it features
a gradual compression of risk spreads dur-
ing a period of monetary ease. Later, when
policy begins to tighten, it delivers a sharp
and abrupt correction, driven by a particular
form of market dynamics. Of course, this is
just a theoretical prediction.
Conditional volatility
One thing that the paper does not do, but
which would be very helpful in assessing the
real-world relevance of the model, would
be to see if this sort of asymmetry in bond
returns is present in the data. In particular,
if I am interpreting the model correctly, it
implies a specic form of conditional volatil-
ity and skewness in bond returns. For exam-
ple, when term premiums are unusually
low relative to historical norms, the model
suggests an elevated probability of a sharp
upward spike in rates. I dont know of any
evidence that bears on this hypothesis in the
bond market, though an analogous pattern
does appear in stock market returns.
4

95
It is worth saying a little about the musical
chairsmechanism that leads to the sharp
spike in rates.
Financial fragility
The fund managers in the model care about
their relative performance in that they are
averse to posting lower returns than their
peers, holding xed absolute performance.
These relative-performance concerns induce
a form of strategic complementarity of fund
manager actions. Specically, as short-term
rates begin to rise and fund manager x con-
templates whether she should bail out of
long-term bonds and move into short-term
bills, she is more apt to do so if she thinks
that some other manager, y, is also going to
bail because she is worried that otherwise,
she may wind up underperforming manager
y and nishing last in the relative-perfor-
mance tournament.
While appearing in a different guise here,
this strategic-complementarity effect, or the
idea that any one agent is in more of a rush
to get out when he or she thinks that oth-
ers may also want to get out, is essentially
the same mechanism that drives bank runs
in the classic work of Diamond and Dybvig,
and that, in one manifestation or another,
creates nancial fragility in many other
settings.
5

Run-like risk
However, one thing that is distinctive about
the variant presented in the current paper is
that there is a clear prediction of exactly what
sets off the run for the exits on the part of
money managers namely, a small increase
in short rates beyond a certain threshold
level.
6
The model focuses on one particular
source of run-like fragility that might ema-
nate from the asset-management sector, but
there are others.
One that the paper briey mentions,
and that is worth a fuller treatment, has to
do with the potential for outows of assets
under management (AUM) from open-end
funds. Note that the model is effectively one
of a closed-end fund, since the manager is
assumed to have a xed amount of AUM;
the fragility, in this case, comes entirely from
the managers portfolio allocation decision
and from the strategic interaction among
fund managers.
But another source of run-like risk comes
from the strategic interaction among fund
investors and the incentives that each of
them may have to get out before others do
when asset values are at risk of declining.
Dynamics and incentives
These AUM-driven run dynamics are more
likely to arise in those open-end funds that
hold relatively illiquid assets. The key ques-
tion in determining whether there is a stra-
tegic complementarity in the withdrawal
decisions of fund investors is whether,
when investor i exits on day t, does the net
asset value (NAV) at the end of the day that
denes investor is exit price fully reect the
ultimate price effect of the sales created by
his exit?
If not, those investors who stay behind
are hurt, which is what creates run incen-
tives. And, if the run incentives are strong
enough, then a credit-oriented bond fund
starts looking pretty bank-like.
The fact that its liabilities are not techni-
cally debt claims is not all that helpful in this
case they are still demandable, and hence
96
investors can pull out very rapidly if the
terms of exit create a penalty for being last
out the door.
Illiquid assets
A funds stated NAV is less likely to keep
pace with the ultimate price impact of inves-
tor withdrawals if the underlying assets are
illiquid, for two distinct reasons.
First, some of the assets are likely to
have stale prices that is, not to have been
recently marked to market.
And, second, if most of a funds assets are
illiquid securities, its manager will be inclined
to accommodate early exits by drawing
down on the funds cash reserve while plan-
ning to sell securities and replenish the cash
stock later.
Why, at the end of the day, should one
care if run-like incentives come predomi-
nantly from the strategic behaviour of fund
investors, as opposed to that of fund man-
agers? Isnt there the same worrisome fra-
gility in either case? Perhaps, but the policy
response may differ depending on the exact
diagnosis. In the former case, when the
primary worry is AUM runs on the part of
investors, there is at least in principle a natu-
ral regulatory x.
Regulatory response?
One could impose exit fees on open-end
funds that are related to the illiquidity of the
funds assets, in an effort to make departing
investors more fully internalise the costs that
they impose on those who stay behind.
In the latter case, when the problem
is driven more by the portfolio choices of
fund managers, it is harder for me to see an
obvious regulatory response, so I am more
inclined to share the authors view that if
there is, indeed, a signicant nancial stabil-
ity problem, monetary policy would be left to
take up some of the slack.
To be clear, I am not advocating for exit
fees of the sort I just described; I do not think
we know enough about the empirical rel-
evance of the AUM-run mechanism, to say
nothing of its quantitative importance, to be
making such recommendations at this point.
But, given the detailed nature of the
microdata that are available on individual
fund holdings and returns, there is clearly
room to make signicant further progress on
this front.
Indeed, recent work by Chen, Goldstein,
and Jiang is very much in this spirit, although
it restricts its analysis to equity funds and
doesnt consider the xed-income categories
that are the focus of the current paper.
7
Testing mechanisms
With this framing in mind, let me comment
briey on the empirical work in the paper.
There is a lot of it, and I will just touch on a
couple of points. A rst observation is that
the heavy focus on ows in and out of funds
is a bit at odds with the theoretical model.
As I mentioned earlier, the model, taken
literally, is one of closed-end funds with
xed AUM. If one were interested in testing
the specic mechanism in the model most
directly, it seems to me that one would want
to look not at fund ows but rather at the
portfolio allocations within each fund.
For example, the model suggests that
during the unfolding of an episode of bond
market volatility like the one in the spring
and summer of last year, we should see a
coordinated shift among bond managers out
97
of long-term bonds and into bills, so that the
average durations of their portfolios would
co-move strongly together.
The forecasting effect
There is a well-developed empirical literature
on herding among fund managers in their
portfolio allocations, but as far as I know, this
work has not looked at how such herding
responds to changes in the monetary policy
environment.
8
So this avenue seems like a
potentially promising one to pursue.
The papers focus on ows in and out
of funds is, however, well suited to think-
ing about mechanisms related to AUM-run
dynamics. In this regard, a particularly inter-
esting set of ndings has to do with the abil-
ity of ows to forecast future asset returns,
even controlling for past returns.
Most notably, this forecasting effect is
much stronger in the less liquid high-yield
and emerging market categories than it is in
US Treasury securities; indeed, it is essentially
non-existent in the latter category.
While not a decisive test, this pattern is
consistent with one of the necessary precon-
ditions for the existence of strategic comple-
mentarities and run-like dynamics.
Predictable downward pressure
Again, the key idea is that, when a funds
assets are illiquid, outows today are met
in part with drawdowns from cash reserves,
with the other assets being sold off more
gradually over time hence, the predictable
downward pressure on prices going forward.
This predictability is what creates the
incentive for any given investor to pull out
quickly if he or she sees a large number of
co-investors pulling out.
9
Let me summarise
by noting the areas in which I agree most
closely with the authors and by adding one
key qualication.
First, I think they are absolutely on tar-
get in emphasising that the rapid growth
of xed-income funds as well as other,
similar vehicles bears careful watching. As
they point out, it would be a mistake to be
complacent about this phenomenon simply
because such funds are unlevered.
Other economic mechanisms can mimic
the run-like incentives associated with
short-term debt nancing, and one or more
of these mechanisms may well be present in
xed-income funds.
Second, I also agree that there is no gen-
eral separation principle for monetary policy
and nancial stability. Monetary policy is
fundamentally in the business of altering
risk premiums such as term premiums and
credit spreads.
Call for case by case analysis
Monetary policymakers cannot wash their
hands of what happens when these spreads
revert sharply. If these abrupt reversions also
turn out to have non-trivial economic con-
sequences, then they are clearly of potential
relevance to policymakers.
My one qualication is as follows: In the
absence of a general separation principle,
when one might consider addressing nan-
cial stability issues either with regulation
or with monetary policy, it becomes all the
more critical to get the case-by-case analysis
right that is, to really dig into the microeco-
nomic details of the presumed market failure
and to ask when a regulatory intervention is
comparatively more efcient than a mon-
etary one, or vice versa.
98
So while I think it is important to remain
heterodox and to be open to taking either
approach, I would not want to rule out the
possibility that some of the risks identied
by the authors could be mitigated, at least in
part, via a regulatory approach. I look for-
ward to seeing more work that helps us sort
through these challenging issues.
Endnotes
1. The views expressed here are my own and are not
necessarily shared by other members of the Federal
Reserve Board and the Federal Open Market Committee.
I am grateful to Nellie Liang for helpful conversations.
2. See Feroli and others (2014), p. 6.
3. See, for example, Hanson and Stein (2012); Gertler and
Karadi (2013); and Gilchrist, Lopez-Salido, and Zakrajsek
(2013).
4. See Chen, Hong, and Stein (2001). They document
that, consistent with a bubble popping view, stock returns
are more negatively skewed when past returns have been
positive and when valuation ratios (for example, market-to-
book ratios) are high. Alternatively, the ratio of downside
to upside volatility is unusually high in such circumstances.
5. See Diamond and Dybvig (1983).
6. This feature is in contrast to many other models in
the Diamond-Dybvig (1983) tradition, which have multiple
equilibria and hence convey a sense of fragility, but have
less to say about what underlying variable tips the scales
toward a run-like equilibrium. The more pinned-down
nature of the model in this paper comes from an applica-
tion of the global-games methodology described in Morris
and Shin (2003).
7. See Chen, Goldstein, and Jiang (2010).
8. Chevalier and Ellison (1999) is a classic reference.
9. Indeed, the results in the paper closely parallel those in
Chen, Goldstein, and Jiang (2010), who fnd that fund fows
forecast future returns more strongly among those equity
funds that hold relatively illiquid stocks (for example, small-
cap stocks). Moreover, Chen, Goldstein, and Jiang cast their
regressions as being an explicit test of the strategic-com-
plementarity hypothesis.
References
Chen, Joseph, Harrison Hong, and Jeremy C. Stein (2001).
Forecasting Crashes: Trading Volume, Past Returns, and
Conditional Skewness in Stock Prices (PDF), Leaving the
Board Journal of Financial Economics, Vol. 61, pp. 345-81
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99
Audit
Building renewed trust in
nancial markets
Hans Hoogervorst, chairman of the IFRS,
delivers a memorial lecture in honour of the
ten-year passing away of Ken Spencer.
I am greatly honoured to provide the
2014 lecture in memory of Ken Spencer.
Over the years there have been a few
accounting innovators - visionaries who
also possess the necessary gumption to
turn their ideas into reality. Their work
endures long after they leave the stage.
Ken Spencer was one of those people.
Although I never had the privilege of
meeting Ken, he is one of the reasons
why the organisation that I chair exists
today. He had an intense commitment to
the improvement of fnancial reporting,
both nationally and internationally.
As well as being Chairman of the Australian
Accounting Standards Board, Ken played a
pivotal role in the creation of the International
Financial Reporting Standards Foundation
and the International Accounting Standards
Board (IASB). Alongside fellow Trustee Paul
Volcker, he created the institution, arranging
funding from around the world and appoint-
ing the original members of the IASB.
I have been told that Ken Spencer was a
straight shooter. He chose his words carefully,
but never minced them. Ken passed away in
2004, but his legacy lives on. Ten years later,
the mission of the IFRS Foundation that he
helped to shape is shared by almost every
country in the world. Today, more than 100
countries require the use of IFRS. Most other
jurisdictions permit the use of IFRS in some
shape or form. We are not yet at the point
where IFRS adoption is total and complete,
but it is an impressive achievement in such a
short period of time.
Thanks to the efforts of Ken Spencer
and those other pioneers in international
accounting, today we are much closer to
achieving that objective. This brings me on
to the topic of my address to you this morn-
ing, and that is the relationship between
accounting and moral hazard.
As you may know, I have spent a big part
of my professional life in politics. I was a
minister in several governments that had to
bring the bloated Dutch welfare state under
control. It was very difcult and sensitive
work. We continually had to challenge the
unrealistic expectations of the Dutch popu-
lation of what the state could deliver.
So when I left politics in early 2007 to
become Chairman of the Authority for the
100
Financial Markets (AFM), the Dutch nan-
cial markets regulator, I thought I had seen it
all. I was happy to leave the hectic world of
politics behind me. Cheerfully, I entered into
what I thought to be the relatively rational
world of nance. And then the nancial cri-
sis hit.
Market failure
I must admit to having been largely nave
about the depth of market failures that I was
about to discover in the nancial industry.
During the nancial crisis, it became clear
that the banking industry had become just
as dependent on the state as the clients of
the Dutch welfare state! The bonuses were
many times higher than unemployment
benets, but in many cases they too turned
out to be underwritten by the state.
The AFM also uncovered malpractices
that were not directly linked to the nancial
crisis: Massive mis-selling of complicated
investment products to unwitting consum-
ers by respectable insurance companies; lack
of quality control in accounting rms; severe
cases of incomplete or misleading informa-
tion to shareholders.
Potential for moral hazard
So the former minister who thought he had
seen it all was profoundly shocked. And
I must admit that I am still shocked as we
continue to stagger from scandal to scan-
dal in the nancial markets. At the root of
all these problems lies the enormous extent
of moral hazard in the nancial markets.
The capital and credit markets are rife with
agent-principal conicts.
There is a high potential for conicts of
interest wherever people work with other
peoples money. Moral hazard becomes
even bigger when there is an asymmetry of
information, when the agent has more infor-
mation than the principal. Lack of transpar-
ency is the scourge of nancial markets. It
is not just an inevitable by-product of the
inherent complexity of products and mar-
kets. Opacity is sometimes actively sought
to create opportunities for rent seeking.
In the post-war period, the potential for
moral hazard has exploded as more people
have started working with more of other
peoples money. The leverage in the credit
markets has increased exponentially. The
nancial crisis has exposed the risks of a his-
torically unprecedented credit boom, which
led to banks being leveraged 30 to 50 times.
Short-term incentives
Secondly, the global capital markets have in
the last 30 or so years nearly quadrupled in
size relative to GDP.
1
A lot more money has
become available for investment through
institutionalised savings by pension funds,
mutual funds and insurance companies.
With the increasing complexity of the
economy, the distance between investor
and investee has increased dramatically as
well. Not many investors are capable of
keeping a close eye on the managers they
have entrusted their money to. All this is an
ideal backdrop for short-termism. Money
managers have huge incentives for making
momentum-driven investment decisions.
In the short run, going with the ow is often
the safest bet, no matter how irrational this
ow may be. As long as the going is good,
the money manager does not face criticism;
when the music stops, he can blame it on the
markets.
101
Third, performance-related pay has
increased tremendously in listed companies.
While this serves to align the interests of
management with those of investors, it also
provides an increased incentive for earnings
management.
Role of accounting standards
According to a 2005 survey, more than 75 per
cent of the 400 business executives surveyed
said that they would give up economic value
in order to smooth earnings. These execu-
tives said this is mainly driven by a desire
to satisfy investors.
2
But could it be that
performance-related pay is also a powerful
incentive for short-termism? Against this
backdrop of moral hazard, what is the role of
accounting standards?
According to our Constitution, the objec-
tive of the IFRS Foundation is to develop, in
the public interest, a single set of high qual-
ity, understandable, enforceable and globally
accepted nancial reporting standards based
upon clearly articulated principles.
These standards should require high
quality, transparent and comparable infor-
mation in nancial statements and other
nancial reporting to help investors, other
participants in the worlds capital markets
and other users of nancial information
make economic decisions.
Honest capitalism?
Personally, I prefer David Tweedies much
snappier version of this denition of the
role of accounting being to keep capitalism
honest. Indeed, if I had to summarise the
essence of our mission in ve words, I would
say it is building trust in nancial markets.
The public interest in our work goes beyond
serving the information needs of investors.
We protect and strengthen the very fabric
of trust in our market economies. People
sometimes tell us that we should not set our
standards from an anti-abuse perspective.
I do not agree with this view. I believe
combating moral hazard is at the core of
what we do. That is why our standards are
all about discipline and rigour. Eliminating
information asymmetry is the key to mini-
mising moral hazard. We should be com-
pletely unapologetic about it. Over the years,
the IASB has built up an impressive track
record in its efforts to combat moral hazard.
I will give just a few examples.
Questioning the logic
Some years ago, the IASB and the FASB had
the mother of all battles against vested inter-
ests to record the granting of stock options
as an expense. There was a hugely expen-
sive lobbying campaign to keep it that way.
But there was one question that this lobby
could never answer: if these stock options
really cost nothing, why not give them to
everybody?
Almost ten years later and very few peo-
ple question the logic of recording stock
options as an expense. It is simply regarded
as good business practice. The same is true
with pensions. In the past, companies were
able to keep pension liabilities off the bal-
ance sheet. As is often the case, what is not
measured is not managed. As a result, the
management of some companies were able
to literally give away the value of the com-
pany without shareholders knowing any-
thing about it.
At the time, bringing pensions liabili-
ties onto the balance sheet was hugely
102
controversial. Today, these liabilities are rou-
tinely discussed in the boardroom and with
investors. Today, we have a similar battle
with leasing, with the vast majority of lease
contracts not recorded on the balance sheet,
even though they usually contain a heavy
element of nancing.
Off-balance sheet numbers
For many companies, such as airlines and
retail chains, the off-balance sheet nancing
numbers can be quite substantial. Stripped
bare, the leasing project is all about prevent-
ing the understatement of liabilities. Some
might want to say it is about bringing pru-
dence to lease accounting. Again, there is
huge resistance against our bringing these
liabilities to the balance sheet.
I have no doubt that ve years from now,
many will wonder what all the fuss was
about. Sometimes we did not get it quite
right. A good example is the incurred loss
model for impaired nancial assets. The
incurred loss model was developed to pre-
vent earnings management by banks.
Our predecessors wanted to prevent
big bath provisioningas they feared these
provisions could be used to atter earnings
in bad economic times. During the nancial
crisis, it became apparent that the incurred
loss model could be used for another type of
earnings management.
Legitimising models
The model provided legitimacy for delaying
the recognition of losses when they had all
but become inevitable. Our new expected
loss model should put an end to this practice,
while it still contains sufcient safeguards
against earnings management.
Given our track record on instilling disci-
pline and rigour, I am amazed by the some-
times virulent nature of the public debate
on Prudence. As you may know, until 2010,
our Conceptual Framework contained the
concept of Prudence. It was dened as the
inclusion of a degree of caution in the exer-
cise of the judgements needed in making
the estimates required under conditions of
uncertainty, such that assets or income are
not overstated and liabilities or expenses are
not understated.
The IASB removed this concept, as some
were worried that it was misunderstood and
that it could conict with the goal of neu-
trality. Ever since, Prudence has become an
issue of controversy. Some have even gone
as far as to claim that the act of removing the
word Prudencefrom the framework in 2010
partly caused the 2007 global nancial crisis.
Go gure that one out!
The concept of Prudence
I have said before that I believe the concept
of Prudence still to be very much alive in
our Standards. In our deliberations on the
Conceptual Framework, the IASB will seri-
ously look at the question whether to rein-
state Prudence, and if so, how to go about it.
But I also want to be clear about what
Prudence as a concept cannot mean. It can-
not mean a return to old-fashioned account-
ing with hidden reserves. It cannot lead to a
systemic bias toward conservatism that is at
odds with neutrality.
And as Warren McGregor recently
pointed out
3
, the concept of Prudence
should be used to override our Standards. If
a standard is not prudent enough, the stand-
ard should be changed. Finally, Prudence
103
should not be invoked to create a taboo on
using current measurements.
There is nothing more imprudent than
to measure derivatives at cost or to measure
an insurance liability at historic interest rates.
If Prudence, on the other hand, is seen as
congruous with our quest for limiting moral
hazard and harmful earnings management,
we have no issue with it and we should be
able to give it its proper place.
Private interests
Now I would like to make some observa-
tions about the implications of the issue of
moral hazard to the governance and work-
ing methods of the IASB. Some nd it dif-
cult to understand why an organisation
whose work has such a clear public interest
function should be a privately organised.
Given its public mission, would it not be
logical if the IFRS Foundation and the IASB
were public sector organisations?
Does the fact that the IASB is privately
organised not make it vulnerable to pressure
from private interests? These are legitimate
questions that deserve a serious answer.
First, I would like to point out that a public
governance structure of standard setting is in
itself no guarantee for avoiding moral hazard.
Take for example public sector accounting.
Inconvenient truth
In most jurisdictions public accounting
standards are set by public authorities.
Whether these standards always lead to
a complete picture of a countrys nan-
cial position is in doubt. The most obvious
shortcoming in public sector accounting is
the treatment of pension liabilities.
There are only a few countries such
as Australia and New Zealand that fully
consolidate public sector pension obliga-
tions in the public accounts. Tellingly, these
countries have made great progress in mak-
ing their pension systems realistic and sus-
tainable. Most countries around the world,
however, keep their pension liabilities off
balance sheet. Several studies have found
these liabilities in many countries to be more
than twice as big as the ofcial public debt.
4

Full consolidation of these enormous
amounts would make it immediately clear
that these pension obligations cannot pos-
sibly be met without deep reform. As a for-
mer minister of nance I can assure you that
the political incentives for keeping an incon-
venient truth off the books are very strong
indeed!
Finding the right balance
So, standard-setting in a politicised environ-
ment is very likely to lead to sub-optimal
results. The IPSASB Governance review
group, chaired by the IMF and the OECD,
recently noted that national standard-set-
ters for the public sector are often inherently
conicted by the fact that they are working
under the auspices of ministries of nance
that are subject to these standards.
5
Around the world, accounting standard-
setters are organised in different ways. Some
are private, others are public. I strongly
believe that the key to the success of a stand-
ard-setter is not so much the public or pri-
vate nature of its governance.
The key to being able to serve the pub-
lic interest is its ability to fend off capture
by special interests. The key to preventing
moral hazard in standard-setting is to nd
the right balance between independence
104
and accountability. The governance of the
IFRS Foundation has evolved throughout
its 13-year history. We started in a purely
private setting, but since the creation of the
Monitoring Board our governance has a mix
of private and public elements.
Transparent accountability
Moreover, a large number of jurisdictions
have public endorsement procedures in
place for the adoption of our Standards. I am
sure our governance will continue to evolve
in the years to come. But I am equally sure
that the IASB already has rst-class proce-
dures in place to ensure our accountability.
Never before in my public life have I
worked in an environment that is as trans-
parent as ours. Our due process is rst-rate
and is monitored continually. All of our
standard-setting activities and papers are
open to the public.
The recent creation of the Accounting
Standards Advisory Forum has further
enhanced the inclusiveness of our work. But
in order to fend off special interests, we also
need our independence. We are not asking
for unfettered independence, but we need to
be shielded from politicised processes domi-
nated by special interests.
Building trust
We need to be able to draw a line between
listening to our constituents and being
overly pressurised by specic interest. Our
independence is not there to protect the
IASB, but to protect the quality of our work.
The central theme of my speech was moral
hazard and what to do about it.
Moral hazard was the root cause of the
global nancial crisis. The global nancial
crisis has shaken trust in our market econo-
mies and its institutions to the core. The eco-
nomic and political repercussions of this loss
of trust will be felt for many years to come.
The mission of the IASB is to build trust
in nancial markets. With the spread of IFRS
around the world, we have come a long way
in fullling this mission. But our mission is
not complete. Some very signicant juris-
dictions still have not adopted or completely
adopted IFRS. That is why we need the con-
tinued support of the G20 for a single set of
global accounting standards.
As the current President of the G20,
Australia is very well placed to help us bring-
ing our mission forward. It is not a goal that
can be fully accomplished during your presi-
dency. But you can do a lot to keep this long-
term project going.
As Theodore Roosevelt once famously
said, nothing in the world is worth having
or worth doing unless it involves effort, pain
and difculty. We are happy to share our
pain with the Australian government and
count on your support!
References
1. McKinsey & Company, Global Capital Markets: Enter-
ing a New Era, Insights and Publications,
2. Graham, J R, Harvey, C R and Rajgopal, S (2005), The
Economic Implications of Corporate Financial Reporting,
Journal of Accounting and Economics, 2005
3. Jan McCahey, Warren J. McGregor: Prudence in fnan-
cial reporting: virtue or vice? Commentaries on fnancial
reporting
4. E.g. see: Reimund Mink (ECB), General government
pension obligations in Europe. IFC Bulletin no. 28, 2008
5. The Future Governance of the International Public
Sector Accounting Standards Board (IPSASB). Public Con-
sultation, January 2014
105
Supervision
Historic ties between ethics,
responsibility and protability
The head of the UKs Financial Conduct
Authority, Martin Wheatley, invokes a new
Protestant work ethic from his pulpit.
I want to start with a thank you note to the
Worshipful Company of International
Bankers for the important community
work it undertakes, particularly in areas
like fnancial education and inclusion.
As we look to understand and rectify all
that went wrong pre-crisis, it is easy to
forget that pre-pre-crisis, the growth of
fnancial services was inextricably con-
nected to social responsibility of this
kind.
At the start of the 20th century, German soci-
ologist, philosopher, and political economist,
Max Weber, in his most inuential study: The
Protestant Ethic and the Spirit of Capitalism,
famously linked the expansion of Western
European capitalism to the Protestant work
ethic, Calvinism and a belief in predestina-
tion - the idea that we all have our calling in
life.
Two of the UKs largest domestic rms,
Lloyds Banking Group and Barclays Bank,
were given to us by the Quaker movement.
And this focus on ethics and integrity con-
tinued, largely untroubled, well into the 20th
century. For a long time few questioned the
social utility of nance. Today of course, the
world is very different. The string of post-cri-
sis crises has fashioned a new, Wolf of Wall
Street public narrative. London Inter-Bank
Offered Rate (Libor) emails, angry traders
ripping their own shirts off their backs, mis-
selling, opacity, casino-banking, and so on
and so forth.
So, we are now essentially in a position
where the nancial sector is confronting a
world with fewer advocates than it would
like, but also perhaps fewer advocates than
it deserves.
Ethical sea change
Over the last 18 months or so, weve seen
a mini-cultural revolution taking place. The
majority of big banks and rms now have
change programmes in position.
Ross McEwan, chief executive ofcer of
majority state-owned bank, RBS, last week
openly talked about the bank scrapping the
likes of teaser savings, cashback offers and
zero per cent offers on credit transfers. He
also challenged RBS high street rivals to
follow suit. At the same time, were see-
ing the rise of new models of banking
106
and nance from entrants like Aldermore,
Handelsbanken and Crowdfunder on the
one hand complementing existing players
in the market, and on the other, confronting
them.
A priority challenge for leaders in regula-
tion, in politics and industry, is how we keep
this emphasis on culture as we enter the next
phase of the UK nancial cycle.
Issues of sustainability
My serious concern is that if were not care-
ful, economic recovery will bring so much
investor pressure for growth stock that ques-
tions of culture will become second or even
third order issues.
Weve already seen annual, global divi-
dend pay-outs total more than US$1 trillion
for the rst time. What are the odds that in
ve, ten or fteen years, expansion becomes
an irrepressible force for short-termism, with
chief executives pushed and pushed for year-
on-year, quarter-by-quarter growth?
Will we then see more interest only neg-
ative-amortising adjustable-rate sub-prime
mortgages - a form of enchanted wealth, as
Thomas Carlyle described it after the indus-
trial revolution?
Or will we instead see growth and prof-
itability based on productivity, high quality
products and high quality client service?
FCA responsibility
For all of us today, these are questions of the
greatest societal importance. We have the
narrowest of windows here to make cultural
change stick before memories of nancial
crisis fade. We also have the narrowest of
windows to restore the long link between
ethics and growth that dominated nancial
services for most of their history. The key
challenge is how we take advantage of this
opportunity. There are two key areas of
focus that I want to touch on tonight. The
rst is the importance of creating effective,
future-proofed regulation. And second, the
importance of effective self-regulation.
On the rst, our priority issue at the
Financial Conduct Authority has been, and
will continue to be, moving the regulator
away from a low value culture of reacting to
events.
Warren Buffett, commonly referred to
as the Sage of Omaha, and the only man
alive with his name in more book titles than
the Dalai Lama, famously remarked that in
the business world, the rear view mirror is
always clearer than the windshield.
Proactive agency
For the ofcial sector, this problem has been
particularly acute. Around the world there
has been a culture of reacting to conduct
issues, whether mini-bonds in Hong Kong,
currency swaps in Korea, structured agricul-
tural products in Australia or of course per-
sonal protection insurance in the UK.
So the rst Financial Conduct Authority
priority is simply to anticipate better and be
more forward looking, in other words, to
prevent culture from going south as prof-
its head north. Key examples so far include
the positive work the Financial Conduct
Authority has done with banks on areas like
interest only mortgage. This included writ-
ing to some 2.6m homeowners and alerting
them to the importance of having capital
repayment plans in place.
And, in June last year, the new retry sys-
tem, effectively an agreement by lenders that
107
if an account payment is unsuccessful in the
morning, it will be attempted again later in
the day saving retail consumers an esti-
mated 200m a year. The second Financial
Conduct Authority priority has been to re-
assess the regulatory balance between ethics
and rules. Should one dominate the other?
Rules subordinating ethics
In his excellent book, Ethicability: How to
Decide Whats Right and Find the Courage to
Do it, Roger Steare argues for a more sophis-
ticated interpretation of integrity in business.
One that is not simply dened by the eth-
ics of obedience, so what is legally right or
wrong, but actually looks towards the ethics
of care and the ethics of reason.
Steare talks about rules subordinating
ethics, suggesting that, at their worst, laws,
regulations and red tape have a tendency to
multiply because they remove our responsi-
bility for deciding whats right.
His chief concern here is the fact that
governments tend to respond to scandal
with regulations, without considering that
it is this obedience culturethat often fails in
the rst place.
So, if we take the Financial Services
Authority the predecessor to the Financial
Conduct Authority as just one example of
this culture, you see its guidance increas-
ing by some 27 per cent during 2005-08, a
period that coincides with many of the most
explosive crises we are dealing with today.
Stricter ethical standards
Now, clearly regulators and rms still require
rules to function effectively. But experience
tells us red tape is more easily hurdled than
principles. So as we move forward, rms
will begin to see themselves held up against
stricter ethical standards.
And this brings me onto my nal point
today: the importance of good self-regula-
tion by rms. The key issue here being how
do rms create cultures that are genuinely
different from those pre-crisis, and, cru-
cially, how do we encourage change that
keeps pace with economic growth? In other
words, how do we create a culture strong
enough to resist short-termism. One of the
most important issues here is incentives.
Michael Lewis in his autopsy of the Great
Financial Crisis, The Big Short, famously uses
the example of some US hospitals removing
more appendixes than others because they
get paid more for doing so, to underline the
point that: if you want to predict how people
will behave, you look at their incentives.
Within the nance community, rewards
are clearly an ongoing matter of national
debate - not just within corporate or invest-
ment banking, but on the frontline as well,
and the relationship between how we
reward staff on the one hand, and how they
sell products, like personal protection instur-
ance, on the other.
Encouraging portents
The Financial Conduct Authority pub-
lished its own analysis of sales incentives on
Tuesday, March 3 this year. The broad story
is extremely encouraging. All the major
banks have either replaced, or substantially
reformed their incentive schemes. And I
do want to applaud businesses for taking
these steps. Clearly, these reforms mirror
European Union efforts to revisit incentives
in the City as well, with the introduction of
deferred awards, clawbacks and the like.
108
But there is a wider issue here around
how boards ensure these positive signals
are not corrupted as they move down the
line. One of the more worrying statistics to
emerge last year was a survey of senior exec-
utives in UK nancial services undertaken by
the Economist Intelligence Unit.
Troubling trends
In a far reaching poll that should set alarm
bells ringing, some 53 per cent of nancial
service executives reported that career pro-
gression at their rm would be tricky without
exibilityover ethical standards rising to
some 71 per cent of the investment bankers
questioned in the same questionaire.
There are serious questions within
these statistics for senior executives sitting
on boards to consider as we move forward.
There are also serious future risks to manage.
Fairly or otherwise, nancial service lead-
ers have not always been held up as great
communicators. Former Chairman of the
US Federal Reserve, Alan Greenspans wife
notoriously failed to understand what he
was saying the rst time he proposed mar-
riage to her.
Getting the message across
These Economist Intelligence Unit gures
suggest some business leaders are still strug-
gling to get their message across. The fact
that not all cultural reform proposals have
been understood or accepted makes it all the
more imperative that they are.
But I do want to nish with a thank you
to those boards and executives sitting on
them, for at least beginning this difcult con-
versation around culture in their businesses.
Will we look back in 25 years and see this as
a turning point? Only time will tell. Perhaps
our best hope for the future, alongside struc-
tural changes in the ofcial sector, remains
the fact that the promotion of strong ethics
in rms is not a zero-sum game where for
one side to win the other has to lose, like a
game of football or tennis.
A non-zero sum game
This is, at its heart, a non-zero sum game
in which we rise, or fall, in lock step. In his
inaugural presidential address in 1937, the
then 32nd President of the United States of
America, Franklin Roosevelt, famously said:
Weve always known heedless self-interest
was bad morals; we now know that it is bad
economics.
In other words, a crisis does not generally
affect only one rms share value or reputa-
tion. It affects the whole world that society
and business depends on for growth: per
capita GDP, employment, political impera-
tives, regulation and so on.
We cannot hope to avoid all future crises,
or anticipate every issue that bubbles up, but
we can safely say that it is in all our interests
to choose long term, sustainable growth
over short term enchanted wealth.
would like to thank Martin Wheatley and
the UKs Financial Conduct Authority for
allowing the Journal of Regulation & Risk -
North Asia to publish an amended version
of this speech delivered to the London-
based charity, the Worshipful Company of
International Bankers, in March this year.
Readers are reminded that copyright for
this article remains the sole preserve of the
Financial Conduct Authority.
Enforcement
Asian tigers securities
regulator bares its fangs
Mark Steward, enforcement head at the
HKSFC, lays out his supervisory stall for
market participants in Hong Kong.
IN this presentation, I would like to talk
about compliance challenges from a
number of different perspectives: frstly,
the challenge set by regulators and the
need for prudent compliance; secondly,
the challenges of an increasingly com-
plex set of laws in multi-jurisdictional
businesses; and thirdly, the need for,
but also the limits of, governance sys-
tems and controls in fostering a com-
pliant environment. I also want to say
something about our litigation practice
because the need for precedent and case
law is an essential aid to all of these chal-
lenges. And our litigation practice is also
always topical, if not controversial!
Hong Kong, as a global nancial centre, has
a constant and ready supply of capital and
capital markets expertise. But what about
condence and integrity in our market?
Where does that come from? The Hong
Kong Securities and Futures Commissions
(HKSFC) overall objective, in general, is to
raise and maintain the highest standards of
conduct within our market.
The challenge for us as regulators and for
nancial services participants and compli-
ance professionals in particular is whether
that objective is a shared one or not. This is,
in essence, the rst part of the challenge set
by regulators. The second part relates to the
content of that challenge. For example, the
Hong Kong style avoids overly prescriptive
rules. Our rule book prescribes broad stand-
ards of conduct that assume intelligent, pru-
dent behaviour.
Road map
Nonetheless, we have experts in their eld
who continue to lobby us saying, We want
more prescriptive rules. Tell us exactly what
you want us to do and we will do it. It is too
hard for us to work out how and what it is
we should be doing. In other words, a road
map. But life is full of situations in which you
know where you want to end up but you
dont necessarily know straight away how to
get there.
This is where expertise, experience, judg-
ment, the ingredients of tness and prop-
erness, perhaps summed up by that most
Roman of virtues, prudence needs to be
applied. It is hard to sympathise with the
110
argument that prescriptive rules are required
so that expert professionals will know what
to do when the argument is put forward by
those same highly trained professionals and
experts who are meant to possess the requi-
site expertise and judgment.
Prudence
The notion of prudence is a useful one
here. It is now commonly used to refer to
thoughtful cautiousness before action. But
in Roman times, it had a more formal and
pointed meaning: the ability to govern and
discipline oneself with practical wisdom and
good sense - in other words, the ability to act
in a situation you may not have faced before.
An expert doesnt necessarily have a map
or guide for every situation. If there was such
a map, arguably there would be no need for
regulated persons at all, certainly no need for
them to have qualities of expertise and expe-
rience as well as tness and properness. All
that would be needed would be a big book
we could consult that would tell us exactly
what to do in any situation.
Prudence also imports the action, not just
expertise. It is sometimes said the prudent
person is someone who not only knows
or senses what is right and what should be
done but is also compelled to do it. There is
no doubt a moral core at the heart of both
prudent action and prudent compliance.
Recent examples
We have seen some examples of the right
thing being perceived and acted upon
recently. On January 1, 2014, our new stand-
ards on electronic trading will come into
effect. They introduce profound change in
this important and growing eld. The new
standards deal with: measures that make it
clearer how existing trading requirements
apply to electronic trading; introduce new
standards for the design, development, test-
ing and use of algorithms; indicate what
kinds of control over in-use software is
required; dene what is meant by pre-trade
and post-trade controls; and dene the
extent to which Direct Market Access (DMA)
devices can be delegated and sub-delegated.
The challenges set by these new stand-
ards are real ones. And the reaction, I am
glad to report from most market participants,
has been prudent in the true Roman sense.
Qualitative value
The Electronic Trading Information Template
(ETIT) that was developed by a number
of industry associations, including my fel-
low panelist this morning, Mark Austens
ASIFMA (Asian Securities Industry and
Financial Markets Association), is an exam-
ple of proactive prudence and is a notable
case in point.
The template is a tool that will help rms
develop compliant practices in a relatively
new and uncharted area of regulation. It
is not meant or intended to be any kind of
guarantee of compliance but I think it is a
sensible, mature and relevant starting point.
That is its virtue. I commend ASIFMA and
the other industry bodies involved in devel-
oping the template.
The challenge for compliance profession-
als and expert advisers is that they will help
nancial services rms not only comply with
the bottom line, but they will add qualitative
value to the prudential culture of the organi-
sation, adding some of that Roman virtue of
prudence to the business operations of their
111
rms and, in turn, the market. Another chal-
lenge arises from the longer arms of many
regulators, especially those in global mar-
kets, including the HKSFCs, extending well
beyond territorial boundaries.
Multi-lateral compliance
We are used to the notion of parallel systems
in Hong Kong through one country, two
systems. But for many nancial services
rms operating here, it is more complicated
than that: one rm, multiple, or perhaps
multilateral, systems. The HKSFC too must
operate in a multilateral legal environment.
The HKSFC has recently taken suc-
cessful insider dealing proceedings against
a Fidelity fund manager based in Boston
who traded in Hong Kong on behalf of his
employer as well as proceedings against a
number of Mainland traders for market mis-
conduct here in Hong Kong.
More recently we have initiated market
misconduct proceedings against New York-
based hedge fund Tiger Asia for trading in
Hong Kong; we have ongoing proceedings
before the Court of First Instance against
two Hong Kong solicitors whom we allege
committed securities contraventions in
relation to trading in both Hong Kong and
Taiwan using condential information from
within the law rms that employed them;
and insider dealing proceedings against a
Singaporean in relation to trading in shares
of Titan Petrochemicals Group Ltd.
Cross-border enforcement
There are many other examples where pro-
ceedings are on foot or investigations are
in motion. Our Hontex litigation last year
involved proceedings in Hong Kong against
a company that was incorporated in the
Cayman Islands with no operative presence
in Hong Kong, a business in Fujian province
and directors residing in Taiwan. In obtain-
ing remediation orders of over US$1billion
for investors who were mostly in Hong
Kong but also scattered around the world,
the solution too had to be multi-jurisdic-
tional and multi-legal.
We all know ignorance of the law is no
excuse. The maxim pre-supposes we are
only referring to the law of this jurisdiction
but the challenge is far greater and no one
can afford to be ignorant of any law of any
jurisdiction that may apply from time to time.
Cross-border enforcement action is
likely to be a permanent and growing phe-
nomenon, especially in global markets like
Hong Kongs, if the increasing volume of
incoming requests to the HKSFC from for-
eign regulators seeking assistance is a guide.
Roman virtue
There are several challenges in this space
for regulators too, including how regulators
should determine priority and precedence of
enforcement action when conduct violates
laws in multiple jurisdictions. Regulators too
need the Roman virtue close to hand. This is
a subject for another day.
A third compliance challenge is, in a
sense, a paradox. One of the important
achievements of modern nancial markets is
the attention paid now to systems and con-
trols in governing conduct within nancial
services rms.
The paradox is that while systems and
controls are necessary, their existence can
lull senior management into a false sense
of comfort. The assumption underlying any
112
system is that it works. But testing whether
a system works, or is t for purpose, is inher-
ently difcult. The question of whether it is
in fact t for purpose only arises when it fails,
and by then it is too late.
Prudent questions
Fraudsters, for example, love systems
because senior management focuses on
what the system delivers, which means the
eye is rarely trained on the gaps or ways in
which the system can be evaded or exploited.
For example, the investment banker who
is placed on a deal team but knows the tim-
ing gap between the team being assembled
and the control room being notied of the
relevant addition to the restricted trading
lists, which gives rise to a trading opportu-
nity prudence might indicate that the team
be assembled after rather than before the
control room notications were in place.
There is no solution to this paradox other
than the administration of any control sys-
tem needs counter-intuitive auditing from
a risk perspective. How would a fraudster
view this system? What are the key safety
measures that need to be in place? How do
we test and measure the reliability of the sys-
tem? What data are we not capturing in this
system? What are the gaps?
These are all prudent questions that
ought to be asked of every control system on
a regular basis.
Benets of litigation
This brings me to the other challenge for
compliance: when the regulator takes
enforcement action. This is an opportunity
to restate our commitment to litigation as
a means of tackling problems that arise in
our market. Litigation achieves highly valu-
able and desirable outcomes that cannot be
achieved by any other means. First, it is self-
evidently important that public controversies
caused by misconduct are resolved through
a public and judicial process.
Public judgments aid future decision-
making by market participants. Their
absence creates greater uncertainty for com-
pliance professionals and advisers in guiding
the behaviour of market participants and
fosters inconsistent or perverse outcomes.
This is one of the reasons the HKSFC is keen
to litigate in courts of record, so that a pub-
lic decision with reasons is available to the
wider community of market participants
and professionals.
This is a necessary development in
our market that will improve the quality of
advice and decision-making by all market
participants, which in turn will help to foster
condence and integrity in our market.
Ongoing cases
As at the end of October, 2013 we have
caused to be issued and served over 70
charges with over two thirds of the charges
dealing with insider dealing or market mis-
conduct. This represents an increase of 17
per cent on the same time last year; we have
initiated civil proceedings seeking remedial
orders against 64 people, representing an
increase of 23 per cent on the same time last
year; and we have issued 32 decision notices
in disciplinary proceedings under Part IX of
the Securities and Futures Ordinance, rep-
resenting an increase of 100 per cent on the
same time last year.
All of these cases have been commenced
on the basis that we believe their prospects
113
are strong based on competent and expe-
rienced legal advice. We will not win all of
these cases, (although our track record is that
we win over 90 per cent of our cases), and
this is a profoundly healthy reality.
Checks and balances
Of course that doesnt give us a licence to
bring cases on imsy or suspect grounds or
where there is insufcient legal merit to the
case. It simply means that in a two horse
race, it is unrealistic to think we will or ought
to win every race.
At the same time, the fear or anxi-
ety of losing a case should never trump
the inherent merits of a case that ought to
be prosecuted. Recently, there have been
some sectoral voices seeking to challenge
the HKSFCs litigation practice, complain-
ing about a perceived absence of check or
balance on the HKSFCs litigation decisions.
The best check and balance on the HKSFCs
litigation practice is the court room: it is the
ultimate test of whether we are making reli-
able decisions. And, of course, the best check
and balance on sectoral interests is an inde-
pendent regulator like the HKSFC.
of the Journal would like to thank Mark
Steward and the Hong Kong Securities
and Futures Commission and Fanny W.Y.
Fung for allowing the Journal to publish an
amended version of a speech delivered at the
Second Annual Compliance Summit Asia,
hosted in Hong Kong during November,
2013. Readers are reminded that copyright
for this article remains the sole preserve of
Mr. Steward and the Hong Kong Securities
and Futures Commission.
Hong Kong: +852 9144 5549
Australia: +61 (41) 271 8715
South Africa: +27 (82) 449 6333
writers, editors, press &
public relations practitioners
www.edit24.com
115
Regulation derivatives
Global ambitions for OTC
derivatives regulation
SEC Commissioner Michael S. Pinowar
sets forth his principles for regulating OTC
derivatives in a globalised economy.
INTERNATIONAL engagement has
long been a fundamental aspect of effec-
tive capital markets regulation. As one of
my predecessors, Commissioner Kathy
Casey, noted in a speech she gave while
Commissioner in 2007: If we, as regula-
tors, are to remain effective and relevant
in meeting our mission of protecting
investors, fostering capital formation
and maintaining competitive, fair and
orderly markets, we will need to be more
nimble and responsive to market devel-
opments and rely more on cooperation
and collaboration with our international
counterparts.
1
It has become clear to me over these past few
months that at no time in the Commissions
history have we been more engaged with the
international community or more involved
in collaborative work-streams with our fel-
low regulators from around the globe.
Much of this international work stems
from the 2009 G-20 initiatives regard-
ing over-the-counter (OTC) derivatives
reforms.
2
It thus came as little surprise to me
that, from the very beginning of my tenure as
Commissioner, I have seen a steady stream
of visitors eager to discuss the Commissions
approach to the regulation of cross-border
OTC derivatives.
In addition to sharing their own views
and observations on these issues, visitors
frequently ask me my personal views on the
topic. I believe I can condense them into a
single, concise theory that should provide
you with clarity on where I stand on every
cross-border issue facing the Commission:
I am a proponent of the rationalisation of
the global regulatory framework by seek-
ing convergence and harmonisation of rules
through bilateral and multilateral dialogue
and the mutual recognition of comparable
regimes based on principles of international
comity.
I am sure that clears things up. I have
been struck by two observations regarding
international nancial regulatory issues, par-
ticularly with respect to OTC derivatives.
First, this is an incredibly complex area
where actual details matter more than
abstract concepts. Second, much of the con-
versation involves buzzwords and terms
of art that may mean different things to
116
different people. I recognise that labelling
regulatory approaches is sometimes con-
structive and frequently necessary in order to
foster dialogue between regulators.
Cross-border interpretation
However, the two observations I just men-
tioned often collide with eachother as regu-
lators and market participants alike seek
to understand how jurisdictions around
the world intend to regulate cross-border
activities.
Broad concepts and terms of art not only
fail to provide the specicity required by the
nancial markets, but also lend themselves
to being misconstrued, as individuals read
into the terms what they seek to get out
of them. We saw a recent example with
regard to the so-called Path Forwardagree-
ment on derivatives regulation negotiated
between the Commodity Futures Trading
Commission (CFTC) and the European
Commission.
3

Not long after the agreement was pub-
lished, it became clear that the regulators had
differing interpretations of the understand-
ings in that document. Surely, neither side
intended to mislead the other by agreeing to
a set of broad concepts that left signicant
room for interpretation rather than specic
requirements that would have bound both
parties.
Call for clarity
However, the fact remains that the docu-
ment failed to resolve any of the crippling
uncertainty in the market. At this point you
may be questioning how I can critique the
reliance on international buzzwords and
broad concepts, and yet give a speech in
which I share with you some of the broad
principles that guide my decision-making in
this area.
I raise these issues only to express my
view that the use of such terms, while at
times helpful, must be met with a healthy
dose of skepticism, and cannot serve as a
substitute for detailed guidelines. The prin-
ciples I share with you should be treated the
same way. However, my hope is that they
will provide you with insight into my think-
ing as the Commission tackles these com-
plex issues in the near future.
The rst principle guiding my thoughts
in this area is respect for my international
counterparts. My education has given me a
broad perspective of, and a healthy respect
for, the international community.
Shaping nancial development
My respect for the international nancial
regulatory community has only grown as I
have worked with regulators from around
the globe during my professional career at
both the Senate Banking Committee and
the Securities and Exchange Commission.
Approaches to regulating the same activ-
ity often differ across jurisdictions. This is not
surprising given the role that legal traditions
and cultural norms play in shaping nancial
development and regulation. However, we
must not let these differences get in the way
of cooperation, and lead to unnecessary bur-
dens for market participants or duplicative or
conicting regulations.
Therefore, I reject any notion that we
must pull the whole world into the US
regulatory sphere, or that other jurisdic-
tions should simply adopt US regulations.
This would be neither appropriate given
117
our mission, nor necessary given applicable
regulations in other jurisdictions.
I believe that market participants that
comply with the regulatory requirements
in the jurisdiction in which they are based
should, under certain circumstances, be
deemed to comply with our requirements in
the Dodd-Frank Act Title VII space.
Effective global regulation
This is probably the area where the most ink
is spilled on creating terms of art for use by
the international nancial regulatory com-
munity. It is little wonder that this occurs,
however, because allowing for compliance
with home country requirements in this
manner is vital to creating an effective global
regulatory environment.
As a result, I believe we should apply this
principle broadly, and expect that regula-
tors in other jurisdictions will do the same.
Determinations about which jurisdictions
qualify for this type of treatment should be
based on a minimum level of acceptable reg-
ulation, and focused on regulatory outcomes
rather than a rule-by-rule comparison.
In addition, where differences in the tim-
ing of compliance dates among jurisdictions
arise, we should provide reasonable relief to
market participants in the interim period.
Long-term goals
The implementation of enhanced regulation
for OTC derivatives represents the creation
of a long-term system of oversight, and must
not be used as a short-term power grab
between regulators or jurisdictions. Market
participants should not pay the price either
directly through increased compliance and
restructuring costs or indirectly through
market uncertainty or differences in their
regulatorscompliance dates.
The second principle that guides
my thoughts on cross-border applica-
tions of Commission regulations is that
the Commission should take a territorial
approach. The territorial approach to regula-
tion has a long history at the Commission,
4

and there is no reason to abandon it as we
develop the new framework for OTC deriv-
atives regulation. Of course, a territorial
approach to regulation may itself be viewed
as a term of artwork.
In using this term in the context of OTC
derivatives, I mean that the Commissions
regulation of cross-border OTC derivatives
activity should generally apply to transac-
tions involving activity within the US. An
activity may be deemed to occur within the
US either because a transaction is entered
into with a US person, or because it is con-
ducted within the US.
US person
These concepts are only given meaning
through the denitions applied to them. I
could spend this entire speech talking about
the denition of the term US person,but
for now I will simply convey the two essen-
tial aspects of this denition.
First, the denition of the term must be
clearly dened and easily applied. Market
participants will inevitably be required
to build out their compliance systems to
account for how this term is dened. It is our
job as regulators to give them clear guide-
lines to follow.
Second, the denition must be lim-
ited in scope. We should not attempt to
expand the reach of our rules by creating an
118
unreasonably broad denition. The deni-
tion of what constitutes a transaction con-
ducted within the United Statesis also an
important aspect of the territorial approach
to regulation.
Changes in behaviour
It ensures that all market participants oper-
ating within the United States are subject to
the same rules and that everyone entering
into transactions in the US market receives
the same protection.
However, it is important to note that not
all activities that touch the United States
should be drawn into its regulatory sphere.
For example, a phone call from abroad made
to someone in the United States seeking
OTC derivatives market colour is not the
type of activity that should trigger applica-
tion of our regulations.
Another key principle in this area is
that we should consider the predictable
changes in behaviour by market partici-
pants in response to regulation. Markets are
dynamic and constantly changing and as a
result, market participants must be creative
and able to adapt.
Regulatory arbitrage
It would be nave and foolish for regulators
to think that we can completely control mar-
kets and prevent market participants from
pursuing their economic interests. If we
adopt unnecessarily harsh regulations in the
US, we must expect that market participants
will adapt.
This could involve structuring busi-
ness activities away from our jurisdictional
reach, which some call regulatory arbitrage.
We should not be surprised by this activity,
nor should we condemn it. It would not
be nefarious. Rather, it would simply be
a rational response to overly burdensome
regulation.
It would also be nave and foolish for
regulators to downplay the impact of our
decisions on markets and the burdens they
place on market participants. We know that
increased regulation is not costless. Market
regulators must always strive to implement
effective regulation that adequately protects
investors.
However, we must do so in full recogni-
tion of the trade-offs and costs associated
with our rules. These costs can burden our
economy and ultimately hurt investors. It is
not just the potential increased costs asso-
ciated with our regulations that we must
consider.
Regulatory process matters
We must also recognise that, with truly
global capital markets, our actions have the
power to shift the markets themselves. If our
rules are unnecessarily harsh and we reject
international cooperation, market partici-
pants may rationally seek other jurisdictions
in which to operate.
If this happens, we must own up to the
fact that our own actions even ones under-
taken with the best of intentions can result
in less regulatory transparency, less effective
regulation, fewer protections for investors,
higher prices, fewer productive jobs, and
slower economic growth.
This leads me to my nal point regu-
latory process matters. Just as we cant
ignore the impacts associated with our
rules, we must not ignore the appropriate
process for developing them. That process
119
includes a rigorous economic analysis that
includes identifying and evaluating reason-
able alternatives to the proposed regulatory
approach.
5
Dodd-Frank Title VII
The regulation of cross-border OTC deriva-
tives activity involves many decision points,
each with a number of viable alternatives.
In developing our nal rules in this area, we
must engage in a thoughtful economic anal-
ysis to guide our decision-making process.
The importance of the rulemaking process
is highlighted by the current state of OTC
derivatives regulation in the United States.
As I am sure all of you are aware, both
the SEC and CFTC have been tasked with
implementing portions of Title VII, includ-
ing application of the statute to cross-
border activities. The SEC has undertaken
a methodical, deliberative process that
included the publication of a comprehen-
sive document in May 2013 containing pro-
posed rules developed with the insight of a
thoughtful economic analysis.
6
Proposal review
Our SEC staff are currently reviewing the
public comments on that proposal, and I
expect that in the near future we will adopt
nal rules in this area that reect the com-
ments received and that are based on sound
analysis of the economic consequences of
the rules.
The CFTC, on the other hand, chose not
to engage in a disciplined rulemaking pro-
cess, and instead attempted to address these
same issues by publishing interpretive guid-
ancein July 2012.
7
This interpretive guidance did not
contain clear rules, and was not based on
any economic analysis. It is therefore not
surprising that the guidance received wide-
spread condemnation by foreign regulators.
In December 2012, the CFTC responded
with further interpretive guidance
8
that
received so much criticism from foreign
governments and regulators that the House
Committee on Agriculture held a hearing a
few weeks later.
9

In July 2013, the CFTC issued its nal
interpretive guidance on the cross-border
application of the swap provisions added
by the Dodd-Frank Act.
10
Lacking the clar-
ity and nality achievable through the rule-
making process, the CFTCs nal guidance
has now been called into question through
litigation, injecting further uncertainty into
the markets.
11
Cross-border collaboration
While the CFTCs guidance is currently tied
up in the courts for an indeterminate period
of time, I can envision the SECs methodi-
cal approach to these issues bearing fruit in
the form of a robust nal rule in the coming
months.
Aesop, the ancient Greek storyteller,
would be quite happy looking at the state
of Title VII regulation right now. His fabled
story of the tortoise and the hare seems quite
appropriate, with its overarching message
that slow and steady wins the race.
In closing, it bears repeating that the
application of Dodd-Frank Act Title VII
provisions to cross-border OTC derivatives
activities is an incredibly complex area that
does not lend itself to mere generalities. That
is precisely why many of the common terms
of art used in international dialogue are not
120
always helpful. Market participants do not
need to know whether their regulators sup-
port abstract notions of mutual recognition,
comparability assessments, or international
comity. They do need to know whether their
transactions must be reported, cleared, or
traded on an exchange, and where they can
undertake those activities.
I trust that my remarks give you a better
sense of how I intend to approach interna-
tional nancial regulatory issues, including
the nal cross-border OTC derivatives
rulemaking.
I further hope that the Commission, as
a whole, will follow the old adage the lit-
tle things you do matter more than the big
things you say, and rely more on coopera-
tion and collaboration with our international
counterparts as we work together to develop
an effective global nancial regulatory
framework that is consistent with our mis-
sion of protecting investors, maintaining fair,
orderly and efcient markets, and promot-
ing capital formation.
Endnotes
1. Remarks at the Institute of International Bankers Fall
Membership Luncheon by Commissioner Kathleen L.
Casey (Oct. 9, 2007), available at http://www.sec.gov/news/
speech/2007/spch100907klc.htm.
2. See Leaders Statement at the Pittsburgh Summit, G-20
Meeting (Sept. 25, 2009), available at http://www.treasury.
gov/resource-center/international/g7-g20/Documents/
pittsburgh_summit_leaders_statement_250909.pdf.
3. Cross-Border Regulation of Swaps/Derivatives Discus-
sions between the Commodity Futures Trading Commis-
sion and the European UnionA Path Forward (July 11,
2013), available at http://www.cftc.gov/PressRoom/Press-
Releases/pr664013.
4. See, e.g., Registration Requirements for Foreign Bro-
ker-Dealers, Securities Exchange Act Release No. 27017, 54
F.R. 30013, 30016 (July 18, 1989).
5. See, e.g., Current Guidance on Economic Analysis in
SEC Rulemakings (Mar. 6, 2012), available at http://www.sec.
gov/divisions/riskfn/rsf_guidance_econ_analy_secrule-
making.pdf.
6. Cross-Border Security-Based Swap Activities; Re-
Proposal of Regulation SBSR and Certain Rules and Forms
Relating to the Registration of Security-Based Swap Deal-
ers and Major Security-Based Swap Participants; Proposed
Rule, Securities Exchange Act Release No. 69490, 78 F.R.
30967 (May 23, 2013), available at http://www.gpo.gov/
fdsys/pkg/FR-2013-05-23/pdf/2013-10835.pdf.
7. See Cross-Border Application of Swaps Provisions, US
Commodity Futures Trading Commission website, avail-
able at http://www.cftc.gov/LawRegulation/DoddFrankAct/
Rulemakings/Cross- BorderApplicationofSwapsProvisions/
index.htm.
8. id.
9. See Dodd-Frank Derivatives Reform: Challenges Fac-
ing US and International Markets Before the Subcommit-
tee On General Farm Commodities and Risk Management
of the House Committee on Agriculture (Dec. 13, 2012).
Hearing transcript, testimonies, and other documents
are available at http://agriculture.house.gov/hearing/dodd-
frank-derivatives-reform-challenges-facing-us-andinterna-
tional- markets.
10. See Cross-Border Application of Swaps Provisions, US
Commodity Futures Trading Commission website, avail-
able at http://www.cftc.gov/LawRegulation/DoddFrankAct/
Rulemakings/Cross-BorderApplicationofSwapsprovisions/
index.htm. See also Statement of Dissent by Commis-
sioner Scott D. OMalia, Interpretive Guidance and Policy
Statement Regarding Compliance With Certain Swap
Regulations and Related Exemptive Order (July 12, 2013),
available at http://www.cftc.gov/PressRoom/SpeechesTesti-
mony/omaliastatement071213b.
11. SIFMA, ISDA, and International Institute of Bankers v.
United States CFTC, No. 13-CV-1916 (D.D.C. fled Dec.
4, 2013).
121
Monetary policy
Market-based bank capital
regulation
Bulow, Goldeld and Klemperer propose
a new regulatory bank capital system that
mitigates against taxpayer bailouts.
TODAYS regulatory rules especially
the ineffective capital requirements
have led to costly bank failures. This
paper proposes a new, robust approach
that uses market information but does
not depend upon markets being right.
Under this proposed regulatory system,
bank losses will be credibly borne by
the private sector; systemically important
institutions would be unable to collapse
suddenly; bank investment would be
counter-cyclical; and regulatory actions
would be dependent upon market
signals.
One key innovation to this new approach
is Equity Recourse Notes(ERNs) that
gradually bail inequity as needed. These
are supercially similar to, but fundamen-
tally different from, Contingent Convertible
bonds usually referred to as CoCos.
Current bank regulatory capital systems
fail in three important respects. First, regula-
tory capital measures bear little relation to a
rmsnancial health. Financial institutions
ranging from Lehman Brothers, Wachovia
Corp, and Citigroup in the US, to Bankia and
Dexia in Europe, were rated as well capital-
ised on the day they failed, got bailed out, or
were acquired.
Just two months before it requested a
90 billion bailout guarantee, Belgium-based
Dexia passed the 2011 European stress tests
with ying colours (EBA 2011). Its core
equity projected to fall no lower than 15.3
billion (about 10 per cent) in the adverse
scenario. As such, the present regulatory
rules distort both investment decisions and
risk-management.
Property rights
Second, the continuing existance of too big
to failinstitutions globally means the prop-
erty rights in bank losses are not clearly
and credibly allocated. Many observers,
among them the authors of this paper, do
not know which debt holders will be asked
to contribute how much to rescue insolvent
institutions.
While efforts are being made to make
bankruptcy less costly and so more plausi-
ble, such as living wills and bail-in, it is hard
to know whether politicians both sides of
the Atlantic will allow these mechanisms to
122
operate as planned. It will always be more
expedient to push off a default, and some-
times it might even be the right policy. But
the consequence is that tail-risk gets shifted,
both explicitly and implicitly, to citizens who
are ill-equipped to bear it.
Easy solutions dont work
And because regulatory capital rules allow
banks to overstate assets, and encourage
them to gamble on mean reversionin asset
prices, taxpayerslosses can be enormous.
Thirdly, the current system is pro-cyclical.
Distressed banks those with little market
capital relative to their regulatory capital and
liabilities nd it unappealing or impossi-
ble to raise the new equity required to make
new risky loans, because so much of any
equity raised will simply go to reducing the
expected losses of creditors, including the
government who is insuring the deposits.
That is, the current regulatory system
creates a severe debt overhangproblem
that in bad times acts just like a tax on new
investment.
1
As a result, as we have seen in
Europe from 2008 onwards, troubled banks
contract.
Towards a more robust system
Simply doubling or trebling capital require-
ments is insufcient to say the least. For
example, from 2008-11 the US Federal
Deposit Insurance Corporation lost money
on 413 bank failures.
If we consider that those banks which
required 6 per cent core tier one regulatory
equity to be classied as well capitalised
each held an extra 14 per cent of assets in
cash, but no extra debt on the day they failed,
this infusion would have been insufcient
to cover losses in 372 (90 per cent) of these
cases.
2
Of course most of these banks were
relatively simple; more complex large banks
the so called Systemically Important
Financial Institutions(SIFIs) such as Bank
of America, Deutsche Bank and Barclays
might have better risk management, but also
more scope for complication.
Furthermore, high capital requirements
have costs too, creating incentives to move
assets to shadow banksand other differ-
ently regulated institutions.
Moreover, merely changing capital
requirements would do nothing about the
problems of pro-cyclicality, or the pressures
on regulators to relax requirements in a
recession. As such, many believe it necessary
among them the authors of this paper to
transition to a fundamentally more robust
system at a juncture in time when banks
are temporarily less reliant on government
support.
Two simple rules
This more robust bank capital requirement
system as envisaged by the authors of this
paper would be underpinned by two rules.
First off, any SIFI that cannot be quickly
wound down must limit the recourse of
non-guaranteed creditors to assets posted
as collateral plus equity plus unsecured debt
that can itself be converted into equity - so
these creditors have some recourse but can-
not force the institution into re-organisation.
Secondly, any debt guaranteed by the gov-
ernment, such as deposit accounts, must,
in the long run, be backed by government-
guaranteed securities.
The second leg of the proposed
reforms is but a pipe-dream for now, so
123
the interim primary objective would be
toringfencegovernment-guaranteed
deposits separate from all other liabilities
in a manner broadly along the lines of cur-
rent policy proposals, such as those of the
UK Independent Commission on Banking
(2011).
3
Replace unsecured debt
This would however, require institutions
collateralisation by assets that are haircut
by percentages similar to those applied by
lenders (including central banks and com-
mercial banks themselves) to secured bor-
rowers.
4
Under the envisaged plan, it would
rst be necessary to have banks replace all
(non-deposit) existing unsecured debt with
Equity Recourse Notes.
Whilst Equity Recourse Notes are super-
cially similar to CoCos, in essence, they are
fundamentally different. Equity Recourse
Notes would be long-term bonds with the
feature that any interest or principal payable
on a date when the stock price is lower than
a pre-specied price would be paid in stock
at that pre-specied price.
Why ERNs?
The pre-specied price would be required
to be no less than perhaps 25 per cent of
the share price on the date the bond was
issued. For example, if the stock were sell-
ing at US$100 per share on the day a bond
was issued, and then fell below US$25 by
the time a payment of US$1000 was due,
the rm would be required to pay the credi-
tor 1000 25 = 40 shares of stock in lieu
of the payment. If the stock rebounded in
price, future payments could again be made
in cash.
Unlike CoCos, Equity Recourse Notes
would afford the following advantages: First,
any payments in shares are at a pre-set share
price, so Equity Recourse Notess are stabilis-
ing because that price will always be at a pre-
mium to the market; that is, Equity Recourse
Notes have the opposite effect to so-called
death-spiralbonds that convert at a dis-
count to the current price.
Because Equity Recourse Notes con-
versions are always for a xed number of
shares at prices above the then current share
price, every conversion transfers wealth to
current shareholders, and so shores up the
share-price.
Subtle transformation
In effect, banks buy puts from lenders every
time they sell an Equity Recourse Note, which
transfers risk from shareholders to Equity
Recourse Notes holders, and so reduces
share price volatility. Secondly, conversion
is triggered by market prices, not regulatory
values removing incentives to manipulate
regulatory measures, and making it harder
for regulators to relax requirements.
Thirdly, conversion is payment-at-a-
time, not the entire bond at once (because
Equity Recourse Notes become equity in
the states that matter to taxpayers, they are,
for regulatory purposes, like equity from
their date of issuance, so there is no reason
for faster conversion). The effect to further
reduce pressures for regulatory forbear-
anceand also largely solve a multiple equi-
libria problem raised in various academic
literature.
Fourthly, institutions would be required
to replace all existing unsecured debt with
Equity Recourse Notes, not merely a fraction
124
of it. These distinctions eliminate the aws
of standard contingent convertible debt.
Importantly, this design also ensures, as
is eplained in greater detail overleaf, that
Equity Recourse Notes become cheaper
to issue when the stock price falls, creating
counter-cyclical investment incentives when
they are most needed.
Limiting creditor recourse
This proposed plan for a more robust bank
capital requirement would also require a
subtle, but crucial transformation of secured
(i.e. collateralised) borrowing by banks.
Currently a secured creditor has a claim
against the posted assets plus an unsecured
claim against the bank for any shortfall, if
things go wrong.
If there is a good chance that the govern-
ment will bail out a failing bank, the terms of
the loan will be based partially on the gov-
ernments credit rather than on the quality
of the banks. The solution in this case is to
limit the recourse that a creditor would have,
beyond the posted collateral, to either shares
of stock or Equity Recourse Notes.
The second part of this envisaged plan,
which at this juncture in time is but a pipe
dream, would require, in an idealworld,
deposit accounts following a money mar-
ket fund model. Government guaranteed
accounts would be like existing money mar-
ket funds that invest in government-guar-
anteed debts, along the lines of 100 per cent
reserve proposals.
Eliminating the middle man
Currently, in effect, depositors in receive
short-term government-guaranteed debt,
acquired from banks that obtain it in
return for unsecured bank debt plus mis-
priced, cheap, deposit insurance. As such,
this would eliminate the middle man, so
that depositors directly hold loans from the
government.
5
Creditors could still acquire short-term
unsecured (i.e. non-collateralised) bank
debt, in much the way they can acquire
short-term debt from, for example, mortgage
securities. Investment trusts could purchase
Equity Recourse Notes and pool and tranche
them, issuing more senior and shorter-term
claims to those who want them.
The major difference is that in a panic,
which might cause an investment vehicle
to sell some of its bonds to pay short-term
claims, losses would be borne by those who
took levered, junior claims in the trust with-
out any short-term repercussions for the
underlying banksnancial condition.
Counter-cyclical benets
Furthermore, investors who wanted to
reduce or eliminate the tail risk of their
Equity Recourse Notes could do so by buy-
ing equity puts. They could transfer the risk
to any willing buyer just not to the taxpayer.
Some of the senior unsecured claims
generated by such trusts might be held in
non-guaranteed money market accounts,
operated under rules akin to those pro-
posed by the US Securities and Exchanges
Commission in 2012, with oating net asset
values so that it would quickly become clear
to investors that the accounts had some risk,
like that of a very short-term bond fund.
Similar principles could be applied to the
funding of derivatives and other potential
liabilities.
One of the key benets of this envisaged
125
approach to market-based bank capital reg-
ulation is that it generates strong countercy-
clical pressures, that can be best summarised
as in the rst instance as debt payments
that are automatically converted to equity
in times of stress, so automatically repair the
capital structure.
Debt overhang reversed
Secondly, Equity Recourse Notes become
cheaper to issue when the stock price falls.
If, for instance, the stock price declines from
100 to 40, new Equity Recourse Notes can be
issued with a conversion price of 10 instead
of 25 so the new bonds will only suffer
losses after the old bonds have already taken
a 60 per cent haircut.
The more the stock price declines, the
more senior new issues can be; if a stock hits
a low new, Equity Recourse Notes will be
senior to all other unsecured capital and so
especially cheap to issue.
Thirdly, issuing new senior debt (Equity
Recourse Notes) can send a better signal
about the companys prospects than sell-
ing assets, because issuing Equity Recourse
Notes is relatively cheap; by contrast, raising
new funds in the existing system is a worse
signal than selling off assets, because of the
need to raise equity to maintain its regula-
tory-capital ratio.
Finally, the existing systems debt-over-
hangproblem that acts like an investment
tax in bad times is reversed.
Whimpers, rather than bangs
Because all creditors nal recourse is to
Equity Recourse Notes which become
equity in bad world-states the proposed
system alleviates liquidity as well as solvency
problems. Further, it also mitigates down-
ward spirals and liquidity crises, while
allowing poorly-run rms to gradually
decline and fail or recover.
The envisaged plan also respects an
important time-consistency constraint
whereby regulators and politicians cannot
be counted on to permit sudden failures
and, also importantly, institutions know this:
hence, the new system allows banks and
systemically important institutions to fail, but
with a whimper rather than a bang.
Many proposals add ever-more elabo-
rate regulations to an already baroque
regulatory system one that is already
unmanageable. The plan envisaged in this
paper makes things much simpler, that is,
Equity Recourse Notes are a counterweight
to pro-cyclicality. They make capital raising
and therefore lending easier rather than
harder in recessions.
Assigning losses to investors
Counter-cyclicality also increases the cred-
ibility of the plan, because there will be no
incentive to scrap it in bad times. Jettisoning
complex capital rules, and simply transfer-
ring tail risk back where it belongs (with
private investors) takes taxpayers off the
hook and ensures that banks with protable
opportunities can use them.
Equity Recourse Notes also reduce
share-price volatility relative to conventional
debt. In short, the new system envisaged in
this paper eliminates distortionary incen-
tives for regulatory arbitrage and forbear-
ance, facilitates counter-cyclical raising of
unsecured capital, and clearly and credibly
assigns losses to private investors where they
belong.
126
While the proposals rely on markets to
determine banks risk capital requirements,
this envisaged system is robust to the mar-
ket being wrong, or less accurate on average
than regulators or banks internal models.
By contrast, current regulatory models will
often lose money, and perhaps cause a crisis,
if markets are right.
This paper is a signicantly slimmed
down version of the authors proposals, a
more detailed version of their plan is avail-
able online from the Social Science Research
Network.
The authors acknowledge that their pro-
posals, as radical as they are, need not (and
will not!) be implemented all at once. In
the short run, some of the features of their
proposed Equity Recourse Notes could
improve the existing design of Contingent
Convertible bonds; in the medium-term,
a full transition to Equity Recourse Notes,
ideally in conjunction with ring-fencing,
would substantially stabilise the nancial
system.
Endnotes
1. By debt overhang problem, we mean a requirement
that new investments be funded with securities that are
on average suffciently junior that wealth is transferred
from existing shareholders to creditors (by transferring
expected costs of default). In particular, regulatory capi-
tal requirements may force a bank wishing to make a new
investment to increase its share capital by a suffciently
greater fraction than that by which it increases its debt that
the total value of its deposit insurance falls, even though
its guaranteed outstanding debt increasessee Bulow and
Klemperer (2013).
2. Source: Federal Deposit Insurance Corporation His-
torical Statistics on Banking, as of December 10, 2012.
3. In our system, ring-fencing is not so much a way of lim-
iting the activities of commercial banks as a way of reduc-
ing banks reliance on deposit insurance, and ensuring that
newly-issued Equity Recourse Notes will be senior securi-
ties in bad times.
4. See for example the Federal Reserve Discount Win-
dow and Payment System Risk Collateral Margins Table
and the Bank of England Summary of haircuts eligible for
the Banks lending operations.
5. Our interim objective of tight ring-fencing would not
achieve this, but would theoretically require banks to
secure deposits with a pool of assets against which other
lenders would be willing to provide enough cash to fully
back deposits. There would be inevitable pressure to
relax regulatory haircuts to below-market levels. In the
longer run we would prefer to see the government out of
the secured lending business as well, except in acting as a
lender of last resort.
References
Bulow, J, and P Klemperer (2013), Market-Based Bank Capi-
tal Regulation, mimeograph.
EBA (2011). European banking authority 2011 EU-wide
stress test aggregate report, The European Banking
Authority.
Independent Commission on Banking, Final Report: Rec-
ommendations, September 2011.
of the Journal would like to thank Jeremy
Bulow, Professor of Economics, Graduate
School of Business, Stanford University,
Jacob Goldeld of JG Fund and Paul
Klemperer (captioned photo), Edgeworth
Professor of Economics at Oxford University
and CEPR Research Fellow, together with
VoxEU www.voxeu.org for allowing us
to publish an abridged version of this paper.
We also wish to remind readers that copy-
right for this article remains the sole preserve
of the authors and VoxEU.
127
Monetary policy
Unconventional monetary
policies revisited - Part one
Biagio Bossone of Group of Lecce reviews
the range of unconventional monetary
policy responses to the great nancial crisis.
THE 2007 fnancial crisis and the follow-
ing economic slump led central banks
in advanced economies to undertake
unconventional monetary policies.
1
The
crisis evolution, especially in debt-rid-
den European nations, and the limits of
the unconventional approaches adopted,
triggered proposals for new heterodox
responses. This paper details some of the
unconventional measures implemented
and the major proposals submitted. Key
pointers will be discussed in part two of
this commentary in the next article on
page 133.
As the crisis erupted, major central banks
intervened to x the broken nancial mar-
kets by starting quantitative easing (QE).
They committed to issuing liquidity by pur-
chasing assets (including toxic) from banks
and non-banks, at a time when banks
stopped lending to each other, households
and rms were credit squeezed, and policy
rates were running against the zero lower
bound.
2
When the crisis spilled over to the real
sector, the objective of QE in some countries
shifted from nancial markets repair to
revamping economic activity (a step into
the dark, as Rajan (2013) dubbed it). In the
United States, United Kingdom, and Japan,
QE turned at stimulating demand by lower-
ing the cost of money and by raising ination
expectations (Bank of England 2011).
QE has been crucial to avert nancial
meltdown, and has had some effects on the
macroeconomy (see, for instance, Joice et al.
2011, Gambacorta et al. 2012, and Crdia
and Ferrero 2013). Yet there are reasons to
be critical about its effectiveness for macroe-
conomic stabilisation relative to its costs and
risks. QE has dramatically increased base
money, but not the money supply that drives
aggregate demand.
QE injects money to owners of assets
(e.g. traders, hedge funds, investors, banks,
high-wealth individuals, and speculators)
who benet from QE-stirred bond and
asset-price rises, but represent a tiny minor-
ity with a low propensity to consume.
Conversely, QE does not reach common
people (with higher propensity to consume)
and deprives them of interest incomes: with
given or falling incomes, and prices expected
128
to rise, they may even reduce consumption.
3

Although research on this issue is warranted,
indications are that QE has signicant distri-
butional effects.
4
Bubbles
Under QE, share prices rise and business
cash holdings grow. Larger businesses
have utilised QE money to buy their own
assets through share buy-backs and debt-
equity swaps, with little effect on output and
employment. Smaller companies, with lim-
ited access to capital markets, have still had a
hard time borrowing from banks.
Where QE attens the yield curve, risk
pricing becomes distorted. Capital gets
directed to otherwise unproductive and
unprotable uses. Money growth feeds
bond and asset-price bubbles, and high-risk
structured nancial instruments re-emerge
(Stein 2013 and IMF 2013). Voices of exit
from QE increase interest rates and uncer-
tainty (Grenville 2013 and Rajan 2013).
A major factor conditioning the macro-
economic effects of QE is its interaction with
scal policy. Pulling QE alongside a restric-
tive scal policy is like pushing on the cars
accelerator and brake pedals at the same
time, which is what has happened in the US
and UK.
Abenomics
The alternative is what Japan is doing under
Abenomics, providing for a simultaneous
expansionary use of the monetary and s-
cal levers. But how is such a mix eventu-
ally going to play in an economy that is
already plagued by a huge public debt? And
what are the implications for central-bank
independence?
Although conceived earlier than QE, at
least in its original understanding, what has
recently come to be known as forward guid-
ance has evolved as a natural complement
to QE, and has gained prominence among
central banks as a way to inuence market
expectations on future interest-rate levels.
5
When the central bank is constrained
by the zero lower bound in its capacity to
reduce the short-term rate, it can use for-
ward guidance to communicate its intention
to keep the policy rate at the current level for
some time in the future, even beyond the
point when normalising it would be in order.
Thus, forward guidance implies a will-
ingness to tolerate higher future ination,
6

and helps engineer an easing of credit con-
ditions even at a constant short-term interest
rate (Praet 2011).
Forward guidance puzzle
Importantly, forward guidance marks the
heightened attention from the monetary
authorities to the level of economic activity
and resource employment. It is expected
that forward guidance will help central
banks better explore the scope for economic
expansion without jeopardising price and
nancial stability.
On the critical side: rst, research has
found only partial evidence that forward
guidance improves market participantsabil-
ity to forecast short-term rates, and shows
no evidence that it has increased monetary-
policy efcacy in New Zealand, the country
with the longest history of forward guidance
(see Kool and Thornton 2012).
Second, it appears that standard cen-
tral banks macroeconomic models tend to
grossly overestimate the impact of forward
129
guidance on the macroeconomy a phe-
nomenon called the orward guidance
puzzle.
7
Negative rates
Third, it is not clear what makes forward
guidance credible and what ensures the
commitment underpinning it: will central-
bank governors stick to the explicit prom-
ise or will they renege on it, when the time
comes, by saying that long-term expecta-
tions have become less well anchored? (See
Rajan 2013, and Clarida 2012).
Finally, while preserving central-bank
independence, forward guidance does not
resolve monetary-policy impotency at the
zero lower bound.
When the economy is in deep recession,
liquidity preference keeps interest rates high,
policy rates run proximate to zero, and the
lower bound could be removed by allow-
ing interest rates to go negative. Negative
interest rates would apply to central-bank
reserves, and possibly to bank deposits and
other saving instruments.
Objections
Cash would have to be suppressed or taxed
(stamped), or a new currency would have
to replace the one in circulation at a depre-
ciated exchange rate vis--vis the unit of
account, say, the dollar, which would remain
the numraire. Negative interest rates aims
to make money such a hot potatothat banks
and people want to get rid of it: the former by
lending it, the latter by spending it.
Mankiw (2009) resurrected the idea
publicly, and Buiter (2009a,b) identied the
above conditions for effective removal of
the zero lower bound.
8
The objections to
negative rates are many - see for instance
discussions by Coppola 2012, 2013, and the
more analytical contributions by Garbade
and McAndrews 2012, and by Van Suntum
et al. 2011.
Besides the odious idea of taxing money
or of seemingly subsidising banks with nega-
tive rates on reserve lending, critics hold that
negative rates would push people toward
cash hoarding and safe asset accumulation,
rather than spending.
They argue that banks would still hold up
lending if they perceived risks to be too high,
and that their margins compression would
lead them to charge higher, not lower, lend-
ing rates. Critics either ignore Buiters con-
ditions or emphasise their practical hurdles.
Kimball (2013b) meanwhile points that the
problem can be addressed by transferring
legal tender from cash to electronic money,
and proposes a detailed plan to do so.
Scandinavian expamples
While unconventional, negative rates do
not involve central banks balance-sheet
alterations, and do not infringe central-bank
independence, it is not clear, however, if
and what legal issues would be raised by its
implementation.
Experience with negative rates is very
limited. The central bank of Sweden charged
a negative rate on its deposit facility as a
response to the 2008 crisis, but without shift-
ing the monetary-policy regime (Mankiw
2009), whilst the central bank of Denmark
introduced a negative rate on deposit cer-
ticates in 2012, only to lessen exchange rate
pressures.
9

In early 2013 the Bank of England has
considered the possibility of a negative rate
130
for macro stabilisation, and last June the ECB
indicated it was technically ready for it. Both
central banks, however, have refrained from
making commitments.
10
Overt money
The idea was revived by Bernanke (2003).
He recommended that Japan ght deation
through public decits explicitly nanced
with incremental and permanent central
bank purchases of government debt. The
money created would nance tax cuts or
new spending programmes.
If the money had gone to nance tax cuts,
Bernanke argues, consumers and businesses
would likely spend their tax-cut receipts,
since no current or future debt-service bur-
den would be created to imply future taxes.
11
But what about the debt implications of
overt money nancing? The key element is
the permanency of the purchases of public
debt, which rules out that the new debt will
ever be placed on the market.
12
Permanency
eliminates Ricardian equivalence effects,
and prevents new debt accumulation,
13
but
raises government-central bank relationship
issues, to be discussed in Part Two.
Complimentary money
Overt money nancing comes as close as
possible to putting money into the publics
hands for spending: helicopter money.
More extreme forms are proposed by Wood,
and by Cattaneo and Zibordi.
14

They submit that in highly leveraged
and depressed economies the minister of
nance should be granted the power to
issue a form of complementary money, with
legal tender, to be used to nance scal de-
cits large enough to stimulate demand. The
government would have full sovereignty on
the issuance of the complementary money.
15
Considering the public debts of some
Eurozone countries as unsutainable, Pris
and Wyplosz (2013) propose that the ECB
purchase and subsequently eliminate these
debts through debt monetisation.
In practice, the ECB would purchase
the outstanding debt of a euro member in
exchange for a zero-interest loan of an equal
amount. The loan would stay indenitely on
the ECB books, and never be repaid.
One-off measure
Notice that, like in the case of overt mon-
etary nancing, the monetisation would be
permanent. The counterpart of the opera-
tion would be an equal supply of euro mon-
etary base, which would represent the cost of
monetisation.
The monetisation would be a one-off
measure, and would not be intended directly
at supporting economic activity; yet it would
regain scal space to the government and
spending capacity to the economy.
The ination risk would be remote,
according to the monetisation proponents,
due to the weak economic conditions of
the countries considered, but if necessary,
the ECB could sterilise the money issued.
The proposal does not deal with the institu-
tional issues underpinning monetisation in
a context of a multi-national setting with a
strongly independent central bank.
Endnotes
1. IMF (2009). Although several taxonomies have been
employed in the literature to discuss unconventional mon-
etary policies (Stone et al 2011), all of them refer to their
characterisation as balance sheet policies, introduced by
131
Borio and Disyatat (2009) in the frst systematic review of
the issue, whereby the central bank actively uses its bal-
ance sheet to affect directly market prices and conditions
beyond a short-term, typically overnight, interest rate. In
contrast to the traditional interest rate policy, unconven-
tional monetary policies result in substantial changes in the
central-bank balance sheet, in terms of size, composition
and risk profle, as they target market segments that go
beyond that for bank reserves and over which the central
bank has far less control.
2. Still in early 2000, referring to the complex of uncon-
ventional monetary policy tools that had been introduced
in the US, Federal Reserve chairman Ben Bernanke spoke
of credit easing, to distinguish the approach followed by
the Fed from thequantitative easing adopted by the Bank
of Japan from 2001-2006. Whereas the latter had aimed
at increasing the quantity of money to support prices and
improve economic activity, the former aimed at changing
the asset composition of the central banks balance sheet in
order to facilitate credit access to fnancial and non-fnan-
cial institutions under stress (Carlson et al 2009). In Europe,
the European Central Bank initially focused on meaures
to enhance interbank and non bank credit market condi-
tions; subsequently, it introduced instruments to purchase
government debts in the secondary markets with a view
to addressing the malfunctioning of securities markets, and
to restoring an appropriate monetary policy transmission
mechanism. For a detailed recounting of QE operations
in Europe, Japan, UK, and the US, see Fawley and Neely
(2013). Central banks in emerging market economies have
not engaged in unconventional policy since they were not
confronted with defationary trends. Exceptions were the
central bank of Turkey, where monetary policy has aimed
at managing capital fows and credit controls used to
check infation, and the central bank of Brazil, which has
intervened in FX futures markets to counteract specula-
tive activity on exchange rates. I am grateful to Otaviano
Canuto for sharing information on monetary policies on
emerging-market countries.
3. See, for instance, the result of the Bank of Japans public
expectations survey http://www.boj.or.jp/en/research/o_
survey/ishiki1308.pdf, and the comment by Binder, 2013.
4. The Bank of England (2012) points that the overall
impact of QE on household wealth by pushing up asset
prices is likely to be substantial, but notes that the ben-
efts from wealth effects accrue to those households hold-
ing most fnancial assets, and that fnancial asset holdings
are heavily skewed with the top fve per cent of households
holding 40 per cent of the assets and with the median
household holding only around 1,500 of gross assets.
5. Krugman (1998) and Woodford originated the line of
thinking underpinning forward guidance, which was later
further developed by Eggertsson and Woodford (2003). As
was the case with infation targeting, the Reserve Bank of
New Zealand was the frst central bank to adopt Forward
guidance. In 1997 it started announcing a path for the
three-month bank bill rate.
6. This stands out quite clearly in the illustration of for-
ward guidance in the United Kingdom, by Dale and Talbot
(2013).
7. Del Negro et al. (2013), who have coined this expres-
sion, show that, as long as forward guidance extends far
into the future, the modelled impulse response to the
extended peg will lift the short-term rate in the previous
period, thus requiring a cascade of shocks over that period
in order to push the interest rate back down. As a result of
this feedback-loop mechanism built into the models, even
a modest amount of forward guidance is predicted to pro-
duce unrealistically large real effects.
8. Buiter and Panigirtzoglou had already discussed NIR in
the early 2000s (see http://ideas.repec.org/e/pbu137.html).
The idea goes back to the original proposal by the (unduly
neglected) German businessman and economist Silvio
Gesell (see DeLong (2009), and Kimball (2013a)). The
idea was successfully experimented with in the Austrian
city of Woergl in the 1930s. It is to be noticed, however,
that negative rates were applied only after a new comple-
mentary currency was issued by the city authorities and
used to fnance public spending programmes (see http://
www.reinventingmoney.com/documents/worgl.html). The
132
Woergl experiment resembles closely the overt monetary
fnancing of fscal defcits discussed below.
9. See Negative interest rates: the Danish experience,
Nordea Research, April 2013 (http://research.nordeamar-
kets.com/en/fles/negative-rates-April13.pdf)
10. See offcial communications, respectively, at http://
www.bankofengland.co.uk/publications/Documents/other/
treasurycomm..., and http://www.ecb.europa.eu/press/
pressconf/2013/html/is130606.en.html). On the European
Central Banks thinking about negative rates, see Nowa-
kowski (2012).
11. McCulley and Pozsar (2013) and Adair Turner (2013)
review the combined use of monetary and fscal policies
in a deleveraging context, and conclude that OMF provide
the most effective way to address defationary conditions.
12. In studying an economy with a consolidated fscal
and monetary authorities, Buiter (2004) indicates that the
increase in the nominal stock of money must be perma-
nent for it to have positive real effects. In the case of OMF,
as these are run by separate and independent authorities,
the condition of permanency must be extended to cover
the central banks purchases of public debt.
13. In fact, with no repayment obligation, defcits fnanced
with OMF do not even constitute debt, but fat money
allocation from the State to itself. Bossone and Wood
(2013) discuss this issue and its implication for central bank
fnances.
14. See Wood (2012a,b,c), and Wood (2013). In a forth-
coming book, Cattaneo and Zibordi (2013) submit a
proposal for Italy, which could well be adopted by other
eurozone countries currently in deep recession; see also
http://bastaconleurocrisi.blogspot.it/2013/09/tax-credit-
certifcates-ce.... All these proposals can be theoretically
situated within the Neo Chartalist school (see Wray
(2000), and Tcherneva (2007)).
15. Interestingly, these proposals have an historical ante-
cedent in the special government bonds that Germany
issued in the 1930s, under central banker and fnance min-
ister Hjalmar Schacht, to survive the Great Depression as
the country was heavily indebted and fnally vexed by the
winning power of the First World War. The operation suc-
ceeded in pushing the German economy through a speedy
recovery.
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purchases, 12 July.
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titative Ease, August 19.
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policies: an appraisal, Bank for International Settlements
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ments, Nov.
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of fscal defcits: navigating Article 123 of the Lisbon Treaty,
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fat Money and the liquidity trap, CEPR Discussion Papers
4202, January.
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coming to a central bank near you?, Financial Times, Willem
Buiters Maverecon, 7 May.
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nal interest rates, again, VoxEU.org, 4 June.
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nomic Trends, Federal Reserve Bank of Cleveland, 11 Feb-
ruary.
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leuro: gli strumenti per rimettere in moto leconomia itali-
ana, Hoepli Editore, forthcoming
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learned about monetary policy in a low-infation environ-
133
ment? A review of the 2000s, Journal of Money, Credit
and Banking, February, pp. 123 -140
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rates. Coppola Comment, 12 December.
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Comment, 12 January.
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large-scale asset purchases?, FRBSF Economic Letter 2013-
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titative Easing, Federal Reserve Bank of St. Louis Review,
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of the Journal would like to thank Biagio
Bossone, chairman of the Group of Lecce,
and VoxEU www.voxeu.org for allow-
ing us to publish an abridged version of this
paper. We also wish to remind readers that
copyright for this article remains the sole
preserve of the author and VoxEU.
JOURNAL OF REGULATION
& RISK NORTH ASIA
Editorial deadline for
Vol VI Issue II Summer 2014
July 15th 2014
135
Monetary policy
Unconventional monetary
policies revisited - Part two
Biagio Bossone of Group of Lecce follows
on from his previous paper with key
pointers inuencing future monetary policy.
SO-CALLED helicopter money poli-
cies those in which government spend-
ing or transfers to households are paid
for by printing money involve both
monetary and fscal policy. This means
they require extraordinary cooperation
between the government and the cen-
tral bank, which potentially undermines
central-bank independence.
However, emergency policies of this type
may be justied during extreme systemic
crises. Injections of helicopter money can
increase net wealth and thus stimulate
spending, a mechanism that is particularly
important when conventional monetary
policy is stuck at the zero lower bound.
The rst column in this two-part series
(Bossone 2013) reviewed the unconventional
monetary measures adopted by a number of
central banks following the nancial crisis
of 2007, and the major policy proposals that
were submitted as the crisis evolved into a
deep economic recession or depression.
The policies were: quantitative easing
(QE); forward guidance; negative inter-
est rates; overt monetary nancing of scal
decits, including in extreme neo-chartalist
forms; and debt monetisation. Although
debt monetisation is primarily intended to
avert default by highly indebted countries,
once implemented it would increase public
and private spending thus helping to stabi-
lise output and employment.
Main features
Table 1 (see end of paper, page 138) offers a
snapshot of what I consider to be the main
features of each policy type. In the table, pol-
icies are reported from left to right in ascend-
ing order of the directness of their impact on
spending, from those that rely on changes in
prices and expectations to those that affect
spending by adding money balances to the
economy.
The policies that have greater direct
impact on spending (overt monetary nanc-
ing, neo-chartalism) are those that com-
bine expansionary scal impulses with
permanent monetary nancing helicopter
money. This combination requires a degree
of cooperation between the government
and the central bank, with implications for
central-bank independence. Government
136
(and political) involvement, as well as the
necessary coordination with the central
bank, entail longer policy gestation periods
than for policies involving the central bank
exclusively (forward guidance, negative
interest rates, and QE).
Key pointers
On the other hand, the transmission from
the scal-plus-monetary policy impulse to
the spending response which is inherent
in helicopter money options is more direct,
quicker and stronger.
The features of the different uncon-
ventional monetary policies discussed in
Part One suggest a number of interrelated
considerations, as outlined below: Firstly,
monetary effectiveness. In a highly-lever-
aged economy in a deep recession under
deationary expectations with policy rates
already at the zero lower bound economic
activity is constrained by aggregate demand
rather than by the cost of money.
Liquidity preference is high, lenders dont
lend, borrowers dont borrow, and investors
response to interest rates is weak. Under
such conditions, the money issued by the
central bank typically against purchases of
assets or through lending to banks fails to
yield enough economic stimulus.
Helicopter money
Interest rates lose their power to affect spend-
ing unless the large premium on liquidity is
offset by a negative interest rate. Instead,
money should be given out or granted for
it to be effective, as occurs under helicopter
money policies. Giving out money belongs
to the realm of scal policy, not monetary
policy.
1
However, scal policy alone cannot
implement helicopter money options, unless
the government and the (independent)
central bank cooperate (overt monetary
nancing) or if the government takes on full
monetary sovereignty and nances decits
with money issuance (neo-chartalism).
Secondly, central bankgovernment
cooperation. Monetising scal decits (or
indeed scal debts, as under debt monetisa-
tion) constitutes a joint monetary and scal
policy decision. With the exception of neo-
chartalist operations (where money is issued
by the government, or by the central bank
as a government department), cooperation
between the government and the central
bank is necessary to engineer helicopter
money policies, and such policies require a
specic framework for assigning duties and
responsibilities to the two institutions.
2
Rules suspended
Obviously, this impairs or calls into question
central-bank independence, but in times of
crisis this kind of cooperation may be neces-
sary for the collective good.
3
It is critical in
such times to have an appropriate frame-
work in place for emergency policy action.
This framework should specify which
institutions do what under which circum-
stances, and under which accountability
rules. It should also be clear who is responsi-
ble for activating the emergency framework.
In other words, just as in wars or national
emergencies ordinary rules may be sus-
pended and decisions delegated to a chief
commanding body, so might economic pol-
icy decisions be delegated during particularly
severe systemic crises.
Thirdly, money in central-bank mod-
els. In the macroeconomic models typically
137
adopted by the central banks, there is no role
for helicopter money. In these models, mon-
etary policy operates through an interest-
rate feedback rule in which the interest rate
is set in response to deviations from an ina-
tion target and some measure of economic
activity and scal policy is usually restricted
to a Ricardian setting (Tovar, 2008).
Money injections
There is no role in these models for money to
be added directly into the publics hands, or
for the channels through which this money
is spent. As a result, these models are not
capable of gauging the real effects of such
monetary-scal policies. At least for critical
economic circumstances, there should be a
way of introducing this type of money into
the models in a meaningful way. This issued
is discussed next.
As argued by Buiter (2004), at money
is not a liability of its issuer (the monetary
authority), but it is an asset for its holder (the
private sector). It is thus an integral part of
the systems net wealth. More generally, if
the state is able to nance its own liabilities
with permanent at money issuances, the
latter given current prices add to the sys-
tems net wealth.
Rational expectations
In a dynamic stochastic general equilibrium
model with rational agents maximising
utility over an innite time horizon sub-
ject to inter-temporal budget constraints
an increase in net wealth through heli-
copter money issuance would lead agents
to increase their current and future con-
sumption a monetary wealth effect. This
means they plan to consume more than the
income they earn by selling their labour for
production.
However, due to rational expectations, they
realise that if they all behave this way then
either output in each period grows by enough
to satisfy planned consumption (which is pos-
sible only if there are unemployed resources),
or the price level or the real interest rate rise
so as to bring planned consumption back into
equilibrium with output.
Vindication
It follows that the Euler equation (which
determines the solution to the agents opti-
mal consumption programmes) reects the
monetary wealth effect, consistent with the
current and expected resource-employment
conditions.
The same real effect would surely obtain
in a model with an agent (the monetary sov-
ereign state) that can spend and nance its
own spending with helicopter money.
This result vindicates the proposed meas-
ures to expand the money supply via overt
monetary nancing or neo-chartalism, which
aim to inject new money independently of
central banksinterest-rate policies especially
if these are limited by the zero lower bound.
Endnotes
1. Grenville (2013). For an economy based on noncredit
money, see Bossone (2002) and Bossone and Sarr (2003).
2. Bossone (2013) identifes some essential elements of
an operational cooperative framework.
3. Nothing makes the point more authoritatively than
quoting the words spoken on this subject by the US Federal
Reserves Board of Governors member, Governor Ber-
nanke (2003): It is important to recognise that the role of
an independent central bank is different in infationary and
defationary environments. In the face of infation, which is
138
often associated with excessive monetization of govern-
ment debt, the virtue of an independent central bank is its
ability to say no to the government. With protracted defa-
tion, however, excessive money creation is unlikely to be
the problem, and a more cooperative stance on the part
of the central bank may be called for. Under [these] cir-
cumstances, greater cooperation for a time between [cen-
tral banks] and fscal authorities is in no way inconsistent
with the independence of the central banks, any more than
cooperation between two independent nations in pursuit
of a common objective is inconsistent with the principle of
national sovereignty.
References
Bernanke, B (2003), Some thoughts on monetary policy
in Japan, Remarks before the Japan Society of Monetary
Economics, Tokyo, 31 May.
Bossone, B (2013a) Time for the Eurozone to shift gear:
Issuing euros to fnance new spending, VoxEU.org, 8 April.
Bossone, B (2013b), Unconventional monetary policies
revisited (Part I), VoxEU.org, 4 October.
Bossone, B and A Sarr (2002), A new fnancial system for
poverty reduction and growth, IMF Working Paper No.
02/178, October.
Bossone, B and A Sarr (2003), Thinking the economy as
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fat Money and the liquidity trap, Centre for Economic
and Policy Research Discussion Paper 4202.
McCulley, P and Z Pozsar (2013), Helicopter money: or
how I stopped worrying and love fscal-monetary coop-
eration, Global Society of Fellows, 7 January.
Tovar, C E (2008), DSGE models and central banks, Bank for
International Settlements Working Paper No. 258, September.
Editors note: The publisher would like to
thank Dr. Bossone, chairman of the Group of
Lecce, and VoxEU www.voxeu.org for
allowing the Journal to publish an abridged
version of this paper. We also wish to remind
readers that copyright for this article remains
the sole preserve of the authors and VoxEU.
Table1. Unconventional monetary policies: A synopsis
139
EU banking policy
EU banking union: Outlook
and short-term choices
Nicolas Vron of the Peterson Institute
gives testimony on Europes push for bank-
ing union at the Portuguese Parliament.
THE launch of Europes banking union
on 29 June 2012 is arguably the European
Unions most consequential policy ini-
tiative since the start of its fnancial cri-
sis in mid-2007. Banking union, defned
as the transfer of banking sector policy
from the national to the European level,
is a highly ambitious project. Its com-
pletion will take many more years, but
it is already changing the structures of
the European fnancial system and has
wide-ranging political implications. Its
implementation to date, while protracted
and far from straightforward, is broadly
in line with the initial commitment.
As decided in June 2012, the rst steps
are the formation of a Single Supervisory
Mechanism (SSM) within the European
Central Bank (ECB) and its corollary, a com-
prehensive assessment of the euro areas
largest banks, generally referred to as its
most critical component, the Asset Quality
Review (AQR).
1

At this juncture, the prospects for the
AQR and the establishment of the SSM
to be successfully implemented before the
end of 2014 are encouraging, even though
the most difcult phase of the plan still lies
ahead of us.
If this success is conrmed, it can be
expected to improve the functioning of
Europes banking system and its contribu-
tion to the broader economy.
Institutional mismatches
However, it cannot be expected to resolve
the current European crisis entirely, as fur-
ther efforts will be needed to address the
EUs severe institutional mismatches.
Specically, the bank-sovereign vicious
circle, which has been correctly identied as
a key factor of instability, cannot be elimi-
nated without further progress towards scal
and political union.
In the short term, the most critical policy
choices are those that relate to the conduct of
the AQR and its likely consequences in terms
of bank restructuring in 2014 and early 2015,
even though the legislative discussion on a
future Single Resolution Mechanism (SRM)
currently attracts more media attention.
While analysts had advocated various
forms of EU banking policy integration for
140
years and even decades, the catalyst for the
June 2012 decision was the deterioration of
market conditions for euro area sovereign
debt that started in 2010 and accelerated in
mid-2011, with the contagion then extend-
ing to large countries such as Spain and Italy
(as well as French banks for a brief time in
August 2011) and creating doubts about the
sustainability of the euro itself.
Breaking the vicious circle
From an analytical standpoint, the character-
isation of the bank-sovereign vicious circle
as a driver of instability became increasingly
accepted in the course of 2011. This in turn
led to an acceleration of the policy debate on
banking union in the spring of 2012,
2
culmi-
nating in the landmark euro area summit
statement of 29 June.
This starts with the words We afrm
that it is imperative to break the vicious circle
between banks and sovereigns,and goes on
to establish the basis for the creation of the
SSM.
The signicance of this decision was not
immediately clear and remains debated to
a signicant extent. An inuential narra-
tive is that banking union was decided as a
default solution in the absence of a political
consensus for scal union, including some
form of pooled bond issuance without the
hard size limits of the European Financial
Stabilisation Facility (EFSF) and its successor
the European Stability Mechanism (ESM).
Fiscal union
Fiscal union was much discussed in the sec-
ond half of 2011, but with limited results.
In this narrative, banking union was a kind
of Potemkin reform, erected to mask EU
leaders inability to make progress towards
scal union.
It may be an improvement in the long-
term policy architecture of the EU, but had
no impact on the current crisis as it was not
designed as a crisis management mecha-
nism.
3
In a starker version of this argument,
the decisions made towards banking union
so far are dismissed as insubstantial and
inconsequential, and may even be harmful
as a botched system may impair the credibil-
ity of the ECB.
4
This dismissive narrative of banking
union, however, underplays the centrality of
banking system fragility in the unfolding of
the European crisis.
5
The European bank-
ing sector has been in a continued state of
weakness since mid-2007, well before the
rst concerns about Greek debt sustainabil-
ity in late 2009.
Policy drivers
Doubts about bank strength, including in
so-called core member states such as France
and Germany, were a prominent driver of
policy reactions to adverse market develop-
ments in the early phase of the sovereign
debt crisis in 2010.
Moreover, this very banking fragil-
ity, which was complacently blamed on an
exogenous trigger (the US subprime crisis)
by most policymakers for a number of years,
was actually caused by the uncontrolled bal-
ance sheet expansion and risk accumulation
by European banks in the decade preceding
the crisis, itself enabled by weak supervi-
sion under the guise of favouring the emer-
gence of national banking champions in an
increasingly integrated European nancial
system.
141
In this alternative narrative, banking
union is less a sideways manoeuvre to avoid
the impasse on scal union than a logical
consequence of the bankruptcy of banking
nationalism as a driver of member states
nancial sector policies.

Policy integration
Banking nationalism enabled the build-up of
systemic risk when market conditions were
supportive; prevented an early resolution
of the banking crisis when it erupted; and
resulted in excessive use of public money
in successive bank bailouts whenever a
banks weakness had become impossible
to dissimulate. Particularly since the late
1990s, banking nationalism was incentiv-
ised by the coexistence of national banking
policy frameworks with EU nancial market
integration.
When failure became too evident to
deny, the choice was a stark one: banking
policy integration, or bidding farewell to
market integration. In June 2012 European
leaders chose banking policy integration.
After that, there was no way back.
A parallel question relates to the role of
the decision to initiate banking union in the
reversal of the deterioration of market con-
ditions during the second half of 2012. This
trend reversal was followed by a remarkable
normalisation of sovereign debt markets
that has continued until now, in spite of sig-
nicant policy shocks, such as the botched
treatment of the Cypriot crisis in March 2013.
Banking union effects
Two other major developments happened
shortly afterwards: the announcement
by the ECB that it would be willing to buy
sovereign bonds of a euro area country
under stress if certain conditions are met,
signalled by ECB President Mario Draghi in
late July 2012 and formalised with the pres-
entation of the ECBs Outright Monetary
Transactions (OMT) program in September;
and a determination by German Chancellor
Angela Merkel that Greece would not be
forced to exit the euro area, which appears to
have been formed during the summer and
had become evident at the time of her visit
to Athens in early October 2012.
It is difcult to disentangle the respective
effects of banking union, OMT, and reassur-
ance against Greek exit on the reversal of
market trend and positive contagionthat
ensued.
Outright Money Transactions
However, even if the succession in time does
not imply causality, there are strong indica-
tions that the commitment of political lead-
ers on banking union was a key factor in the
ECBs decision to announce OMT.
If such is the case, and even as the OMT
announcement clearly had the most direct
inuence on market participants percep-
tions and behaviour, then the decision to
embark on banking union in late June can
be seen as the true turning point of at least
this phase of the European crisis.
This role of banking union in enabling
OMT would be enough to dismiss the cri-
tique that it has not contributed effectively to
managing the current crisis. However, there
is a separate and perhaps equally impor-
tant impact, which many observers did not
immediately identify. The creation of the
SSM made it inevitable that all banks would
be submitted to a simultaneous balance
142
sheet assessment, before the actual transfer
of supervisory authority to the ECB.
AQR and its implications
This would resetthe supervisory evaluation
of their capital strength, as the ECB should
not take over supervision of banks that it
would consider insolvent. This is the process
generally referred to as AQR, even though in
addition to the asset quality review itself, it
also includes what the ECB calls a supervi-
sory risk assessment, and a stress test coor-
dinated by the European Banking Authority
(EBA) and covering banks from all EU mem-
ber states.
The comprehensive assessment is
dened by Article 33(4) of the EU legisla-
tive text establishing the SSM, or SSM
Regulation.
7
This article on transitional
provisions was present from the rst version
published by the European Commission in
September 2012, but its true importance was
acknowledged by most analysts only gradu-
ally over the course of 2013.
Article 33 also implies that the AQR and
stress test should be completed before the
assumption of direct supervisory authority
by the ECB on 4 November 2014, unless the
ECB itself decides to delay this deadline.
Forcing the process
The AQR thus can be expected to force
a process of triage, recapitalisation and
restructuring that has been proved by past
experience to be the surest way to resolve a
systemic banking crisis, especially in a devel-
oped-economy environment.
8

The context of this review is fundamen-
tally different from the stress tests of 2009
and 2010, coordinated by the Committee of
European Banking Supervisors (CEBS), and
of 2011, coordinated by its newly formed
successor, the EBA.
These earlier stress tests are widely seen
as policy failures, as they gave a clean bill of
health to banks that collapsed shortly after-
wards. But none of them included an AQR,
which is the core of this years assessment.
By contrast to the CEBS and EBA,
the ECB has direct relationships with the
reviewed banks, direct access to all super-
visory information, wide legal authority to
request information from both the banks
and national supervisory authorities, and
the ultimate ability to revoke a banks license
after the handover on 4 November 2014.
Moreover, all euro area member states
have a stake in the credibility of the ECB as
a monetary authority, which had no equiva-
lent with the CEBS and EBA.
Problem bank restructuring
The AQR process, of course, implies subse-
quent restructuring of problem banksthat
would be exposed as severely undercapital-
ised in its aftermath, a set of decisions which
belongs to individual member states within
the EU legal framework (including state aid
rules), a crucial point which is discussed more
at length in the last section of this statement.
This explains why the AQRs robustness
cannot yet fully be taken for granted. But in
any event, it will be signicantly more robust
than the European stress tests of 2009, 2010
and 2011.
If credible, the AQR and subsequent
restructuring of problem banks could have
a transformative and highly positive (if not
painless) impact on the European banking
system. It holds the promise of a gradual
143
return of trust, as legacylosses, related to
past risk management mistakes and supervi-
sory forbearance, would be crystallised, pub-
licly disclosed, and adequately addressed.
Fragmentation reversed
Following this, banks would be under much
less suspicion of keeping skeletons in the
closet than has ever been the case since
2007, both from the investor community and
from each other.
This would allow for a return of bank
funding markets to more normal condi-
tions, and for a gradual removal of the ECBs
extraordinary intervention policy, known as
xed-rate full allotment and in place since
mid-October 2008.
9

This in turn may put an end to the cur-
rent dysfunctional credit allocation in the
euro area, in which credit conditions, espe-
cially to households and smaller companies,
remain adverse in so-called periphery coun-
tries, even as sovereign spreads have sharply
declined.
In other words, a successful AQR is a key
condition for a reversal of the fragmentation
of the euro area nancial system, which cur-
rently acts as a major drag on growth and
employment in the periphery and beyond.
The AQR process is still in its early phase,
and it is too early to form a rm judgement
of its future success.
Accountability and governance
However, the banking union process is
already having an impact. As argued above,
it is likely to have played a major role in
the dramatic reversal of market perception
about the sustainability of the euro area in
the second half of 2012, initiating a trend
that has been sustained until now. The SSM
Regulation establishes a robust and unam-
biguous legal basis for the ECBs supervi-
sory authority. Its nal version, adopted in
October 2013, is not a complex compromise
that leaves ultimate responsibilities unclear,
in sharp contrast to current discussions
about the SRM as further elaborated in the
next section.
On the contrary, it provides clear lines of
accountability and a governance framework
which is likely to be effective.
This is despite the awkwardness of mak-
ing it open to non-euro area member states
of the EU while subordinating it to the
statutory bodies of the ECB, especially the
Governing Council, as dened by the Treaty
on the Functioning of the European Union
which grants exclusive governance rights to
euro area countries.
Unexpected roadblocks
The ECBs supervisory authority extends to
all banks headquartered in the correspond-
ing geographical scope (or banking union
area), namely all euro area countries plus
other EU member states that may volun-
tarily join the SSM, as could be the case of
Denmark and/or some Central European
countries.
10

There are initial exemptions for smaller
banks with a balance sheet total under EUR
30bn, a category that includes most German
saving banks and cooperative banks, but
the ECB can later choose to supervise them
directly as well.
Because of unexpected roadblocks in the
legislative process in 2013, the date of trans-
fer of supervisory authority to the ECB was
delayed in comparison to the one initially
144
contemplated, from March to November
2014, but this delay may have been inevita-
ble anyway given the logistical and opera-
tional complexity of the AQR.
Anticipated backstop
On one important aspect, however, some
initial expectations about the implementa-
tion of banking union have not been met.
The summit statement of 29 June 2012
included a convoluted sentence that read:
When an effective single supervisory mech-
anism is established, involving the ECB, for
banks in the euro area the ESM could, fol-
lowing a regular decision, have the possibil-
ity to recapitalise banks directly.
This led many observers to anticipate
that ESM direct recapitalisationcould pro-
vide a form of European-level backstopin
the period covering the AQR and its imme-
diate aftermath.
But subsequent developments have
proved that this sentence had to be read lit-
erally, implying that no direct recapitalisation
by the ESM would be possible before the
SSM is established and effective,i.e. some
time after the AQR and subsequent bank
restructuring, if at all.
Restructuring challenges
This is a direct consequence of the political
potency of the legacyargument in several
Northern European countries including
Germany, according to which there should
be no European-level mutualisation of the
public cost of past supervisory failures that
have occurred at the national level.
As a consequence of this argument,
breaking the bank-sovereign vicious circle
is made more difcult; and the restructuring
of problem banks following the AQR, as
it cannot rely on direct resources from the
European level, is made more politically
painful.
Nevertheless and contrary to some
claims, the absence of a European backstop
does not make such restructuring impossi-
ble, or even necessarily disruptive in terms of
sovereign debt markets stability.
Whatever bank restructuring may be
needed as a consequence of the AQR will be
nanced by three tiers of resources.
First, nancial losses will be taken by
junior creditors, according to European
Commission state aid rules in force since
August 2013, and possibly by senior credi-
tors as well, depending on individual mem-
ber statesdecisions as elaborated in the last
section of this statement.
Banking system repair
Second, relevant member states may inter-
vene nancially, providing what the current
jargon refers to as national backstops.
Third, if this intervention puts a member
state at risk of losing market access, it may
rely on nancial assistance from the ESM
along the lines of the Spanish programme
in 2012, which was specically designed for
the purpose of banking system repair and
appears to have been broadly successful.
Even under pessimistic assumptions
about capital gaps that may be uncovered
in problem banks and could not be met
from market investors on a going-concern
basis, most member states should be able to
provide adequate backstops if market con-
ditions remain broadly benign, as they cur-
rently are.
Under the same assumptions, those
145
member states that may require ESM assis-
tance, if any, are likely to be few in number
and rather small in size, with the implica-
tion that current ESM resources should be
sufcient.
Shifting market sentiment
Of course, things would be different if sov-
ereign debt market conditions were to dete-
riorate dramatically in the next months, a
scenario that cannot be entirely ruled out.
But if this were to be the case, the experi-
ence of 2012 suggests that euro area member
states would be willing to collectively adapt
their policy stance to the changed environ-
ment, and to introduce further assistance
mechanisms.
As a consequence, the absence so far of
a European backstop for bank restructuring
does not condemn the AQR process to com-
placency. Indeed, market sentiment about
the AQR has shifted signicantly in the past
few months.
In September 2013, the prevailing senti-
ment among investors was widespread cyn-
icism, with the anticipation that the obstacles
to a robust process that were observed in
2010 and 2011 would again prevent the
results from being credible.
Reduction trends
By contrast, more recent indications of
investor perceptions suggest a much higher
degree of expected toughness of the review,
partly in reaction to the ECBs own commu-
nication about the AQR since October.
This is mirrored in the behaviour of a
number of banks that have raised additional
capital in recent months, or appear to plan
capital-raising in the near future.
11

In addition, there are recent indications that
some banks which had high portfolios of
home-country sovereign debt have started
to reduce these.
If conrmed, this trend would suggest
a weakening of a critical component of the
bank-sovereign vicious circle, namely the
disproportionate accumulation of home-
country sovereign risk in the balance sheet
of many banks.
12
A standard, if simplied, depiction of
developed-economy banking policy frame-
works identies four core building blocks:
regulation; supervision; resolution and
deposit insurance. For Europes banking
union to be complete, all four should be
essentially shifted from the national to the
European level.
13
The current status is of a
work in progress.
14
Prudential requirements
A signicant part, but far from all, of the
applicable regulation is now set at the EU
level, building on a history of single mar-
ket initiatives that long predates the start of
banking union.
15

The Capital Requirement Regulation of
2013
16
for the rst time sets out core pru-
dential requirements in a fully harmonised
manner, and thus marks a major advance
towards the stated aim of a single rulebook.
However, member states continue to
take solo initiatives as the UK, France and
Germany recently did as regards the separa-
tion of functions within banking groups.
The Bank Resolution and Recovery
Directive (BRRD), which is almost nal-
ised but has not yet been adopted, is a step
towards harmonisation of resolution frame-
works (or creation thereof in countries which
146
do not yet have one), but leaves signicant
scope for divergence between national legis-
lative arrangements.
Supervisory infrastructure
Tax, insolvency and corporate governance
frameworks remain almost entirely national,
and thus differ widely from one country to
another.
The implementation of the SSM in
November 2014 will represent an almost
complete integration of supervision of the
larger banks in the banking union area (euro
area, plus member states which may join
voluntarily).
Member states outside this scope,
including the UK, will retain separate super-
visory frameworks, while the EBA provides
some EU-wide coordination of supervisory
standards and practices.
National supervisory authorities will
retain a role within the supervision of larger
banks, under the authority of the ECB, and
with much more autonomy as supervisors of
smaller banks.
How this role evolves over time, and the
related question of how much the ECB may
build up its own on-the-ground supervisory
infrastructure in individual member states,
remains almost entirely to be determined.
Integration at the European level of the
authority to resolve failing banks remains a
distant prospect, for a number of reasons, as
detailed in the following few sentences.
Long-term resolutions
There is no harmonised or EU-wide insol-
vency framework, and its creation would be
a long-term effort; absent a treaty change,
there is no obvious legal basis for a European
resolution authority that could make quick,
discretionary and independent decisions
on bank crisis management while being
embedded in the accountability framework
of EU institutions.
The absence of a genuine European scal
union makes resolution funding problematic
at the European level; and the pooling of res-
olution authority meets considerable resist-
ance from national political environments.
The current discussion on creating a
so-called Single Resolution Mechanism is
shaped by these constraints. Despite the
name, all currently considered options,
including the proposal published in July
2013 by the European Commission, make
the SRM a much less centralised, let alone
singleframework than is the case of the
SSM.
Unclear timing
At this point, it is unclear when SRM legisla-
tion may be adopted, if at all, even though
most negotiating parties state the aim of
nalising it before the end of the current
European Parliamentary term.
A European deposit insurance system,
which would go beyond the currently con-
sidered harmonisation of national systems,
is not being discussed at all, given its direct
link with the issue of European scal union.
This is because a deposit insurance sys-
tem, even if pre-funded, needs a clear and
unlimited scal backstop to be credible, and
is essentially useless if it lacks credibility.
It is self-evident that the bank-sovereign
vicious circle will remain an instability factor
as long as deposit insurance systems remain
national, as was graphically illustrated by the
developments in Cyprus in March 2013.
147
Some European policymakers have
acknowledged that European deposit insur-
ance would be needed in the long term. But
there is no prospect of progress on this front
in the near future, unless forced by disruptive
market developments.
Supervision rst
As this summary review suggests, the choice
made by European policymakers has been
one of phased deployment of banking
union, rather than a big bangapproach in
which all building blocks would be assem-
bled simultaneously.
It can be summarised as supervision
rst,accompanied by an acceleration of reg-
ulatory harmonisation and the convergence
towards a single rulebook.
The SRM is in all scenarios a hybrid
structure, and will have no practical impact
until well after the completion of the phase
of bank restructuring that may immediately
follow the AQR.
Supranational deposit insurance is not
even on the horizon. This phased approach
is frustrating to observers of the important
policy interdependencies between the four
building blocks listed above.
Phased approach
It should be noted, however, that it is in line
with the letter of the euro area summit state-
ment of 29 June 2012, which explicitly put
supervision rst and did not even mention
the SRM, which the European Council rst
introduced (without clearly specifying its
aims) in December 2012.
While several individual policymakers
have expressed concerns about the policy
mismatches that may be created by the
phased approach, a big bang approach has
never been ofcial EU policy. The underly-
ing logic of the phased approach is twofold.
First, it acknowledges the multiplicity of
links between banks and sovereigns, both
implicit and explicit, and infers that severing
all these links cannot realistically be achieved
in one single go. Second, it identies super-
visory integration as a necessary rst step.
The reason is that without a single super-
visor, there can be no common trust about
the true condition of individual banks in
all participating countries, and therefore
no effective management of nancial risks
inherent in any European-level banking
policy initiative.
Removal of legacy risks
In this approach, the policy mismatches
that result from the phased rollout of bank-
ing union are accepted as a necessary price
to pay for the sake of operational, legal and
political practicality.
Specically, any nancial risk mutualisa-
tion must be preceded by a credible removal
of legacyrisks resulting from past national
banking policy choices, a vision now materi-
alised by the fact that the restructuring trig-
gered by the AQR may rely only on national
backstops.
This approach was exposed most clearly
so far by Germanys Federal Finance Minister
in an important newspaper comment in
May 2013, concluding: A banking union of
sorts can thus be had without revising the
treaties, including a single supervisor; har-
monised rules on capital requirements, reso-
lution and deposit guarantees; a resolution
mechanism based on effective co-ordination
between national authorities; and effective
148
scal backstops, also including the European
Stability Mechanism as last resort.
Long-term vision
This would be a timber-framed, not a steel-
framed, banking union. However, it would
serve its purpose and buy time for the crea-
tion of a legal base for our long-term goal:
a truly European and supranational bank-
ing union, with strong, central authorities,
and potentially covering the entire single
market.
20
This vision has been essentially adhered
to in subsequent policy developments. It
remains crucially predicated on orderly mar-
ket conditions. It does not involve perma-
nent hostility to nancial risk mutualisation,
which may become possible once the cen-
tralised supervisory practice has established
sufcient common trust.
But the protracted pace of trust-building
also means that the benets of banking
union can only be reaped gradually, with
signicant economic pain associated with
adjustment in the meantime. As previously
mentioned and given the logic of the super-
vision-rst approach, there is a gap between
what the SRMs name promises and what
the single resolution mechanism can realis-
tically deliver.
18

Limited potential
The absence of a European insolvency
framework implies that, for the near future
at least, the SRM has to work in practice
through national resolution regimes as
established or harmonised in accordance
with the BRRD.
Moreover, the Meroni doctrine of the
European Court of Justice, not to mention
political resistance, limits the potential for
the Single Resolution Board (SRB) to make
autonomous, discretionary decisions that
could be enforced directly in a resolution
process, leading to excessive complexity and
unpredictability of the SRM decision-mak-
ing procedures.
Meanwhile, in the absence of progress
towards scal union, the single resolution
fund (SRF) can only be of limited size, which
restricts its potential effectiveness as a crisis
management tool irrespective of how rap-
idly its initially separate compartmentsare
mutualised.
It should be noted that these limita-
tions apply similarly to the European
Commissions proposal for the SRM pub-
lished in July 2013, the Council version nego-
tiated by ECOFIN in December 2013, and
the European Parliaments negotiating posi-
tions which are currently being discussed.
Call for compromise
It remains to be seen whether a compromise
will be found in the current negotiation, in
which case the nal SRM Regulation could
be published around mid-2014; or whether
it will be left pending and rolled over to the
next European Parliamentary term, in which
case one might expect a nal text in the rst
half of 2015.
If no compromise is found this spring, it
will surely lead to many comments charac-
terising the impasse as a major setback for
banking union. Ironically, however, a delay
may actually improve the conditions for
forming the SRM, without having a signi-
cant adverse practical impact. In any event,
the most important provisions of the SRM
are not expected to kick in before 2016 event.
149
The key point is that if the AQR is broadly
robust and successful in addressing the leg-
acyissue, as appears currently more likely
than not, then a discussion on the SRM in
early 2015 might include policy options that
are currently considered a no-go area at this
point, including in Germany.
19

Policy steps beyond AQR
As a consequence, the conclusion of the
SRM negotiation in the next two months
should by no means be seen as a make-or-
break test of the future of European bank-
ing union. The make-or-break test is and
remains the AQR, including subsequent
bank restructuring.
Again under the assumption of a broadly
successful AQR and subsequent wave of
bank restructuring, 2015 would open a new
phase that would correspond to what the
above-cited article called the timber-framed
banking union an improvement on the
pre-2012 situation that makes the mon-
etary union more robust and the banking
market more integrated, but with lingering
risks associated with an incomplete banking
union.
New initiatives
The nalisation of the SRM, expected to be
reached in 2015 if not before, will probably
not mark the beginning of a steady-state
in banking policy. To the contrary, a num-
ber of tensions are likely to appear rapidly
or gradually between the newly established
European framework (in supervision and to
a lesser extent in resolution) and remaining
arrangements at the national level. This is
likely to open a new sequence of banking
policy initiatives.
In terms of EU legislation, the next
Commissioner for nancial services will
need to take a position on the proposal for
structural separation of activities within
banking groups published by the European
Commission in January 2014, in echo to the
so-called Volcker Rule in the US, the Vickers
Report in the UK, and legislation adopted in
individual euro area countries such as France
and Germany.
Beyond this, a number of additional leg-
islative adjustments to the respective roles
and responsibilities of the ECB and national
supervisors in supervising banks may need
to be considered, depending on the type of
operational and governance relationships
that are established over time within the
SSM.
20

Cross-border consolidation
A broader agenda might involve the gradual
formation of a more integrated framework
for corporate governance, insolvency proce-
dures and tax treatments of banks in Europe,
at least as an option that banks that would
opt for a European banking charter.
21
The ECBs supervisory decisions will be
consequential for the future reshaping of
the European nancial system. Signicant
developments of privatisation, consolidation
and restructuring can be expected among
European banks well beyond the immedi-
ate aftermath of the AQR, as this is often the
case following the resolution of major sys-
temic banking crises.
The ECB has been fairly explicit in call-
ing for more cross-border consolidation
among European banks, and also in calling
for a larger role for non-bank nancial inter-
mediation in Europe, especially as banks are
150
likely to keep deleveraging for at least some
time.
22
The ECB may also be expected to
encourage European banks to diversify their
portfolios of sovereign debt away from their
current home-country bias, which creates an
unnecessary concentration of risk in a bank-
ing union context, and there are early indi-
cations that it might gradually impose limits
on banks credit exposure to their respective
home-country sovereigns.
23

Scope of supervision
The ECB can also be expected to strengthen
and harmonise accounting, risk-weighting
and provisioning practices of banks across
the banking union area; to streamline cross-
border regulatory processes in order to
deliver on its promise to reduce cross border
banks regulatory compliance costs; and to
impose more consistent public disclosures
by banks and market discipline, not least by
itself publishing more granular data about
European banks than is currently done by
national regulators.
24
The ECB may also gradually expand its
scope of direct supervision to smaller banks
within the SSM, as it gradually builds up its
supervisory resources.
This is likely to be especially sensitive in
Germany, where savings banks and coop-
erative banks are subject to highly specic
oversight regimes.
Governance reform
But leaving these banks permanently out-
side of the ECBs direct authority may also
give rise to perverse incentives and regula-
tory arbitrage, which in turn could generate
potential instability over the longer term.
A new balance will need to be found
between the ECB and fellow bank supervi-
sors outside of the banking union area. This
is of course crucially dependent on the future
evolution of the relationship between the
UK and the EU.
In the immediate future, the review
of the EBA, scheduled in 2014 together
with that of other European Supervisory
Authorities (for securities markets and insur-
ance companies), provides an opportunity
to strengthen the EBAs capacity to act as a
neutral actor that can credibly mediate dif-
ferences between the ECB and other bank
supervisors in the EU.
This would require signicant reform
of the EBAs governance, well beyond the
changes brought by the regulation adopted
together with the SSM in 2013.
Legislative adjustments
The practice of bank resolution, both by
national resolution authorities and by the
SRM, will need to address major questions
raised by the adoption of the BRRD and the
stated aim to avoid recourse to government
budgets in resolution funding.
This track record will necessarily be
shaped by successive crises, and it may take
time to be able to form a clear judgment on
the practicality and sustainability of the leg-
islative choices made in the BRRD and SRM.
This in turn may lead to future legislative
adjustments.
One major question, itself dependent on
other institutional developments within the
EU, is whether the SRB will be able to estab-
lish itself as a credible resolution authority, or
whether another institutional overhaul will
be needed in this area, including the option
to transfer its resolution mandate directly
151
to the European Commission. Similarly,
only time will tell if the current hosting of
the SSM by the ECB is sustainable over
the longer term, or if a tighter separation of
supervision from monetary policy might be
necessary. Last but not least, the stability of
the EU institutional framework itself cannot
be taken for granted.
Policy framework changes
There could be major changes in the next
decade in terms of EU Membership (the
possible UK referendum, not to mention
separatism in Catalonia and Scotland); the
internal boundary between the euro area,
the banking union area (assuming some
non-euro area countries opt to join it), and
the rest of the EU; the role of the European
Parliament in legislative initiative, budgetary
oversight, and executive scrutiny, as well as
its internal political dynamics; and the evolv-
ing functions of the Commission, of the
Presidency of the Council, and of present
and future institutions that may be speci-
cally tailored for subsets of countries such as
the euro area.
Depending on future political, economic,
nancial and legal developments, what is
now often referred to as scal union and
political union will continue to be discussed,
with possible changes in policy framework,
including perhaps the European treaties.
25
Difcult choices
These may in turn open up new possibilities
to address the unnished agenda of banking
union, especially as regards bank crisis reso-
lution and deposit insurance. It is impossi-
ble to predict when such developments may
unfold, if at all.
On the one hand, it is far from clear that a
timber-framedbanking union is capable to
deliver long-term stability in the European
nancial system.
On the other hand, it may be argued that
the previous state of affairs created by the
Maastricht Treaty, with monetary union but
no banking union at all, was inherently even
more instable than an incomplete banking
union and it lasted more than a decade.
Developments exogenous to the EU may
also possibly affect the timetable.
While many difcult choices lie ahead
over the medium term, the above analysis
suggests that by far the most crucial issue in
the short term is the AQR a much more
critical hurdle than the legislative tussle over
the SRM.
Possible outcomes
An unsuccessful AQR may compromise any
further future steps towards banking union,
with material negative consequences for the
future prospects of the ECB, the euro area,
and the EU.
Conversely, a robust AQR and aftermath
that would convincingly address the legacy
issue would help restore normal credit con-
ditions throughout the EU, and would open
up new policy space and enable progress
in signicant areas that appear presently
deadlocked.
Now that the SSM Regulation has been
adopted, the key players in the remain-
ing AQR sequence are the ECB, individual
national governments (which would have
to steer the restructuring of banks that may
be found unviable, or problem banks), and
the European Commission competition-
policy arm (DG COMP) as the EU authority
152
that controls state aid. Of these, in principle
at least, DG COMP has the simplest task,
as it relies on signicant experience and
precedents through its review of past bank
restructuring cases, especially in the last
seven years of crisis.
DG COMP revisions
It has issued a revision of its rules early in the
AQR sequence, in force since August 2013.
These enhance DG COMPs ability to block
state aid that it deems in breach of EU law.
As previously mentioned, they also spe-
cically mandate that junior creditors should
take losses before any state aid is envisaged
(unless market conditions were to dete-
riorate sharply, in which case a systemic risk
exemption could apply).
However, their application stops at the
boundary between junior and senior debt,
and it seems that DG COMP will leave any
choice of bail-inor imposition of losses to
senior creditors to the individual member
states.
The interplay between the ECB and
member states is less predictable. On the
one hand, no member state wants the ECBs
reputation to be impaired, and in this respect,
the incentives for cooperation are stronger
than with the EBA in 2011.
ECB incentives
On the other hand, bank restructuring is
always politically painful, and has often led
to the fall of governments or of individual
senior policymakers. Thus, member states
may be tempted to resist calls from the ECB
to restructure problem banks in their remit.
Conversely, the ECB is rmly com-
mitted to defending its reputation and
independence, but it cannot be entirely
insensitive to the potential systemic risk
implications of its prudential decisions.
Where problem banks may be located, and
how serious their problems are, is a matter
of guesswork at this point. Current levels of
transparency vary enormously across coun-
tries and bank models.
Among the 124 banks in the AQR sam-
ple,
26
less than half (representing about 60
percent of total assets) are publicly listed or
part of listed groups, and thus subject to the
disciplines of listed-company disclosure.
There is arguably more predictability on
banks of countries that are or have recently
been subjected to an assistance programme
(i.e. Greece, Ireland, Portugal, Spain and
Cyprus), as these have had to undergo
stringent examination and stress testing
under the auspices of the so-called Troika.
However, these represent only one-quarter
of the samples banks and less than one-fth
of the total assets.
Identication of problem banks
The banks on which there is generally least
visibility at this point, i.e. unlisted banks in
non-programme countries, represent 43 per
cent of the banks in the sample, and almost
a third of the total assets.
In aggregate asset terms, these banks
are concentrated in France (EUR 3.5trn),
Germany (EUR 3.2trn), the Netherlands
(EUR 1.9trn), Belgium (EUR 0.7trn), and
Italy (EUR 0.6trn).
These banks are not necessarily those
where most problems lie, but, if all things
were equal, they should arguably be con-
sidered those with the highest potential for
surprises springing out of the AQR.
153
In fairness, however, all things are by no
means equal, including as regards the reli-
ability of public disclosures by listed banks
in different member states. Ultimately, only
the AQR itself can answer the question of
which banks are problem banks which is
precisely why the AQR is so critical.
Rapid ECB advances
The ECB has incentives to be rigorous, and
its communication so far, while understand-
ably sparing, gives no reason to suspect a
lack of resolve.
Even though some preparations have
suffered delays, it is advancing rapidly in the
early phase of the AQR, which represents a
massive operational, logistical and technical
challenge.
Key choices, on which no nal decisions
have been publicly announced yet, include
the scoring methodology and tools for the
supervisory risk assessment; the details of
the process and methodology to review and
evaluate assets; and the respective consid-
eration of the AQR and of the stress test in
determining each banks capital needs at the
end of the exercise.
Communication challenge
Communication itself is a uniquely delicate
challenge, given the potentially long time
span between the nalisation of the asset
quality review itself, perhaps in the late
spring or early summer, and that of the stress
test, currently planned in October 2014. It
appears implausible that the ECB would not
communicate the AQR results to the respec-
tive banks.
But among those that are listed or
otherwise subject to public disclosure
requirements, some may have to disclose at
least part of the relevant information pub-
licly, especially if it is not aligned with prior
nancial communication which may in
turn give rise to challenging potential liabil-
ity issues.
This could lead to an acceleration of the
timetable, at least for some banks, unless the
nalisation of the AQR itself is delayed com-
pared to initial plans.
The choices to be made by member
states that may have to restructure banks as
a consequence of the AQR, both individually
and collectively, are at least as challenging as
those faced by the ECB.
European issues
Some have endeavoured to minimise the
potential capital gaps by relieving banks
of part of their future tax liabilities, which
can then be included in capital calculations
as so-called deferred tax assets, through
non-sector-specic tax decisions that may
therefore not be considered for state aid by
DG COMP (and give rise to limited politi-
cal opposition compared to other forms of
public nancial assistance). But this channel
of assistance may not apply to all member
states, or be sufcient to x all problems.
The discussion of specic challenges in
individual member states goes beyond the
scope of this statement, and is made particu-
larly problematic by the difculty to locate
the problem banks as described above.
From a European perspective, however,
at least two specic questions stand out, in
both cases because of signicant potential
benets from collective action.
The rst question is whether to impose
losses on problem banks senior creditors,
154
assuming the bailing inof junior ones is not
sufcient to absorb the identied nancial
gap. As previously mentioned, the European
Commissions state aid framework does not
prescribe a stance in this respect.
Forced bail-in?
Neither does EU legislation: the bail-in pro-
visions of the BRRD and SRM will not in any
scenario enter into force before 2016. As a
consequence, member states have discretion
to decide on whether to bail in the senior
creditors of their problem banks.
This creates a potential for damaging
policy inconsistency, for two main reasons:
First, and as in previous phases of the crisis,
banking nationalism concerns may result
in a race to the bottom, as no member state
may want to impose bail-in decisions that
could put its domestic banking sector at a
disadvantage compared to the neighbours
in terms of future funding conditions.
Second, there is a risk of exacerbation of
the bank-sovereign vicious circle, in a sce-
nario in which scally weaker member states
would have less policy autonomy than s-
cally stronger ones, and may thus be forced
by their peers to go further in the direction of
senior creditor bail-in.
Statement of intent
Such a scenario would defeat the whole
purpose of banking union, by entrenching
the perception that banks headquartered in
scally fragile countries are intrinsically less
likely to reimburse their creditors.
As a consequence, there is a strong case
for an ex ante commitment mechanism that
would prevent divergent attitudes to senior
creditor bail-in in different member states,
at least within the banking union area. It is
not clear that this should or could include a
pre-commitment on what the approach to
bail-in will be, as this may be dependent on
future market conditions and on the magni-
tude of problems uncovered by the AQR.
But it should at least include a statement
of intent from the highest political level,
i.e. a joint declaration of euro area heads of
state and government, that they will adopt
an identical stance as regards senior credi-
tor bail-in in all cases of bank restructuring
associated with the AQR; and probably also,
an indication of process on how this intent
would be fullled in practice, under the
short-term pressure that bank restructuring
decisions typically entail.
Potential costs
Whether existing national legislation in some
member states may need to be amended in
order to allow such cross-border consist-
ency would also need to be checked. The
second question concerns the management
of restructured banks and assets by member
states as a consequence of the AQR. On the
one hand, this will understandably be seen
as a matter of national sovereignty, not least
because of potential scal implications.
On the other hand, and from a more
technical standpoint, there is a powerful case
for joint management (not implying joint
liability), because of the enormous cross-
border synergies that could be involved.
Practitioners of past and present bad
banks
27
know that there are considerable
nancial benets of experience in this mat-
ter, or conversely, that starting such a practice
from scratch and in isolation entails a poten-
tially very costly learning curve.
155
There would thus be a considerable pub-
lic interest in envisaging a European Asset
Management Company (AMC) which could
manage assets on behalf of the individual
member states, with separate accounts
implying no mutualisation of nancial risk,
but which would reap the operational syner-
gies from the critical mass of portfolios under
management.
Build-up and retention
This would allow for the build-up and reten-
tion of adequate investment management
skills, especially in assets held outside of the
home country.
To give an example, both Dexia and
WestLB had assets in the United States. The
resolution of these two banks would have
gained from a joint management of these
portfolios. Multiplied across the euro area,
the potential savings from such a joint oper-
ational approach could involve very large
sums for the respective countriestaxpayers.
Importantly, it would also prevent a not
unthinkable scenario in which different
national bad banks would compete against
each other to sell similar distressed assets in
the same period, thus reducing the proceeds
for national budgets.
28

Financial advantages
Even though such an initiative would surely
elicit political resistance, its nancial advan-
tages justify its joint consideration by euro
area member states well in anticipation of
the delivery of the AQR results.
The creation of an effective European
AMC would require at least a few weeks
of preparation. Enabling national legisla-
tion may also be needed, at least in some
countries. The mere enunciation of these
choices underlines how difcult it could be
to make the AQR and subsequent bank
restructuring a policy success, even as the ini-
tial phases of the exercise have been encour-
aging (based on what can be observed from
an outside position).
The European elections in May give
extra weight to short-term political consid-
erations, and their results may also add to
the constraints on policymakers later in the
year, at least in some member states. But
decision-makers must keep in mind that the
AQR is, in practical terms, the key to eco-
nomic recovery in the euro area.
Conversely, allowing zombie banks
to continue their operations while hoping
for the best would be even more costly to
Europes taxpayers and citizens than have
been all the excessive publicly-funded bail-
outs of the past few years.
Endnotes
1. Following widespread practice, the acronym AQR is
used here to designate the entire process which is formally
referred to by the ECB as the Comprehensive Assessment.
2. To the authors best knowledge, the expression bank-
ing union was frst introduced by an unidentifed analyst in
the fall of 2011. The author started using it in December
2011, and it became part of the mainstream EU policy lan-
guage in April 2012. It was offcialised in a formal European
Council statement in June 2013.
3. This view has been articulated, among others, by Angel
Ubide, How to Form a More Perfect European Banking
Union, Peterson Institute for International Economics
Policy Brief PB13-23, October 2013; and Thorsten Beck,
Banking union for Europe where do we stand? in
VoxEU.org, 23 October 2013
4. See e.g. Gene Frieda, A weak European Union banking
union risks defation, Financial Times, 10 December 2013
156
5. On the role of banks in the unfolding of the euro area
crisis, see also Vitor Constncio, The European crisis and
the role of the fnancial system, Speech at the Bank of
Greece in Athens, 23 May 2013.
6. This alternative narrative is elaborated in Nicolas
Vron, Banking Nationalism and the European Crisis, key-
note address at the European Private Equity and Venture
Capital Association (EVCA)s 30th Anniversary Symposium
in Istanbul, 27 June 2013, available at http://piie.com/publica-
tions/papers/veron20130627.pdf.
7. Council Regulation (EU) No. 1024/2013 of 15 October
2013, conferring specifc tasks on the European Central
Bank concerning policies relating to the prudential supervi-
sion of credit institutions.
8. This point is developed in Adam Posen and Nicolas
Vron, A Solution for Europes Banking Problem, Peter-
son Institute for International Economics Policy Brief PB09-
13, June 2009.
9. Several months will be needed after the announce-
ment of AQR results for the ECB to be reassured that it
can remove this protective policy, which may be why the
ECB announced last November that it would keep the
fxed-rate full allotment policy until at least mid-2015.
10. On the corresponding choices see Zsolt Darvas and
Guntram Wolff, Should non-euro area countries join the
single supervisory mechanism? Bruegel Policy Contribu-
tion 2013/06, March 2013.
11. See e.g. Boris Groendahl and Sonia Sirletti, Draghi
Throwing Light on Bank Assets Spurs Fundraising Flurry,
Bloomberg News, 29 January 2014
12. Contrary to an often-heard argument, this home bias
cannot be attributed to the much-criticised EU interpre-
tation of successive Basel accords, under which sovereign
debt is considered free of credit risk in regulatory capital
calculations. While such zero-risk weighting does create
an incentive for banks to hold EU sovereign-debt securities,
it does not specifcally encourage the purchase of home-
country debt. The domestic home bias may result from
various causes, including the banks national supervisory
context and corporate governance, but not from applica-
ble regulations as framed by international standards and EU
prudential legislation.
13. See e.g. Jean Pisani-Ferry, Andr Sapir, Nicolas Vron &
Guntram Wolff, What Kind of European Banking Union?
Bruegel Policy Contribution 2012/12, June 2012; Thorsten
Beck (ed.), Banking Union for Europe: Risks and Chal-
lenges, VoxEU.org e-book, October 2012; Rishi Goyal &
co-authors, A Banking Union for the Euro Area, Interna-
tional Monetary Fund Staff Discussion Note SDN/13/01,
February 2013
14. See also Nicolas Vron, A Realistic Bridge Towards
European Banking Union, Peterson Institute for Interna-
tional Economics Policy Brief PB13-17, June 2013.
15. These include a series of banking directives since 1977;
the Financial Services Action Plan, published in 1999 and
implemented in the following years; and the Larosire
Report of February 2009, which led to the creation of the
EBA and the emphasis on a single rulebook.
16. Regulation (EU) No. 575/2013 of the European Parlia-
ment and of the Council of 26 June 2013, on prudential
requirements for credit institutions and investment frms
and amending Regulation (EU) No. 648/2012.
17. Wolfgang Schuble, Banking Union must be built on
frm foundations, Financial Times, 13 May 2013.
18. An early exposition of this analysis is in Nicolas Vron
& Guntram Wolff, From Supervision to Resolution: Next
Steps on the Road to European Banking Union, Bruegel
Policy Contribution 2013/04, February 2013.
19. That being said, it is to be hoped that the BRRD will
be adopted in fnal form before the end of the current
European Parliamentary term. Its policy parameters have
been agreed by all EU institutions since December 2013.
Taking it hostage to a delayed conclusion of the SRM dis-
cussion, as some members of the European Parliament
seem tempted to do, would add more signifcantly to the
uncertainty about future bank restructurings than a delay
of the SRM legislation itself, and thus be detrimental to the
prospects for resolving the current banking fragility during
the AQR phase.
20. On 7 February 2014, the ECB launched a public con-
157
sultation on a draft Regulation establishing its framework
for cooperation with national authorities within the SSM.
This however is unlikely to frame a permanent arrange-
ment, and is probably best seen as a frst step in what may
be a long sequence of adjustments.
21. See e.g. Martin Cihak and Jrg Decressin, The Case
for a European Banking Charter, International Monetary
Fund Working Paper WP/07/173, July 2007; Vitor Constn-
cio, Banking union and the future of banking, speech at
the IIEA in Dublin, 2 December 2013.
22. See e.g. the speech by ECB Vice President Vitor Con-
stncio referenced in the previous note; and Mario Draghi,
Financial Integration and Banking Union, speech for the
20th anniversary of the establishment of the European
Monetary Institute in Brussels, 12 February 2014. See also
Andr Sapir and Guntram Wolff, The Neglected Side of
Banking Union: Reshaping Europes Financial System, note
presented at the informal ECOFIN meeting in Vilnius, 14
September 2013, published by Bruegel.
23. Interview with Danile Nouy, Chair of the SSM Super-
visory Board, Financial Times, 10 February 2014
24. See Christopher Gandrud and Mark Hallerberg,
Supervisory Transparency in the European Banking
Union, Bruegel Policy Contribution 2014/01, January 2014.
25. For further elaboration, see Nicolas Vron, Challenges
of Europes Fourfold Union, testimony before the Sub-
committee on European Affairs of the US Senate Commit-
tee on Foreign Relations, 1 August 2012.
26. Not counting four banks in Malta and Slovakia which
are subsidiaries of banks otherwise included. For the list,
see Decision of the European Central Bank of 4 February
2014 identifying the credit institutions that are subject to
the comprehensive assessment (ECB/2014/3). The num-
bers that follow are from the authors calculations based on
The Banker database, with reference to 2012 assets.
27. The term bad bank is highly imprecise and has been
used in different fnancial contexts that are not at all com-
parable with each other. It is used here in a generic sense
of a vehicle to manage distressed assets, with no indication
of the specifc fnancial engineering that might be involved.
28. An early proposal along these lines is in Adam Posen &
Nicolas Vron, A Solution for Europes Banking Problem,
Peterson Institute for International Economics Policy Brief
PB09-13, June 2009. The author is also grateful to Hans-
Jrgen Walter at Deloitte for sharing his thought-provoking
presentation Do We Need a European Bad Bank? at the
Euro Finance Week in Frankfurt, 19 November 2013.
Editors note: Wed like to thank Mr.
Nicolas Vron of the Brussels-based think
tank, Bruegel, and the Peterson Institute
for International Economics for allowing
the Journal to publish a re-formatted ver-
sion of this paper, which was delivered at
the joint conference of the Committee on
European Affairs, the Committee on Budget,
Finance and Public Administration, and the
Committee on Economics and Public Works
of the Portuguese Parliament (Assembleia da
Republica), Lisbon, on February 26, 2014.
Hong Kong: +852 9144 5549
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159
OTC clearing
Central clearing for OTCs:
Schlieffen Plan redux
The global headlong rush towards CCPs,
far from reducing systemic risk, may actu-
ally accentuate it, argues Thomas Krantz.
CENTRAL counterparty (CCP) clear-
ing of fnancial instruments is hardly a
matter of war and peace. But given the
calamitous socioeconomic role played
by OTC derivatives in the fnancial cri-
ses that began to unfold across the world
in 2007, the G20s central strategic pro-
posal based upon the September 2009
Pittsburg declaration
1
to mitigate these
risks deserves careful review.
2
To do so,
a comparison with one of historys most
rigorous military plans might not be out
of line perhaps it is refecting on World
War I as the centenary of its outbreak
approaches that leads our minds in this
direction.
Before turning to nancial matters, the
Schlieffen Plan
3
merits explanation. The
authorities charged with German defence
had to respond to the countrys historic geo-
graphical dilemma of being in the middle of
Europe: at almost all costs, a successful strat-
egy would require the militarys resources
not being split between east and west.
And so in the years before World War I, the
nations best thinkers put their minds to it.
The plan assumed thatFrance was weakand
could be beaten quickly, and that Russiawas
much stronger, but would take longer to
mobiliseits army.
At the outbreak of World War I, the plan
was put to the test. It began to go wrong
almost immediately. On 30 July 1914, Russia
mobilised its army, but France did not.
Germany was forced to invent a pretext to
declare war on France four days later.
Execute regardless
Matters deteriorated further when Britain
declared war on Germany the following day
because, in a Treaty signed in 1839, Britain
was committed to defend Belgium. German
men and materiel were mostly east of the
Rhine and were readied for movement to
the west, famously with a massive concen-
tration set to cross the river at Cologne over
a single railroad bridge at a time when few
crossings existed. Despite the unexpected
opening of the war, the Schlieffen Plan had
to be executed because, well, that was the
plan.
We cite Schlieffen in the context of the
G20s strategic defence of the global nancial
160
system not to criticise the G20; we simply
state that strategy will only be effective when
it can be properly executed, and the logistics
and resources mobilised for the operation
suit the needs.
We will now turn to over-the-counter
(OTC) derivatives and consider the G20s
three-pronged plan, especially as it affects
CCPs, the market infrastructures we know
so well.
Profound change
A little over two years ago, UK advisory busi-
ness Thomas Murray was approached by six
global banks to review the changing land-
scape for central counterparties to nancial
transactions. Following the G20 instruction
in Pittsburgh, by late 2011 laws and regula-
tions were already written, or at least well
outlined, and one could see that central
clearing like much else in nancial services
was about to undergo profound change.
The concernedbanks asked us to learn
what we could about where the CCP seg-
ment might be going, and what the regu-
latory changes might mean for business
planning as well as for these rms capital
requirements.
Apprehension
Our team of experts set about doing just
that. With ourselves at the helm, the con-
cernedbanks formed into a working party
and were quickly joined by SWIFT, and the
public documents and opinions of key global
and national authorities were sought and
included.
The research addressed six broad risk
components: counterparty; treasury and
liquidity; asset safety; nancial; operational
and governance; and transparency. The nal
result of this enquiry and market coopera-
tion is an exceptionally comprehensive and
detailed set of data and analyses.
What we gleaned from this research
makes us apprehensive about the new
responsibilities CCPs are being asked to
assume in order to accommodate privately
traded nancial contracts. It is unclear that
these small institutions are t for this pur-
pose. Most have worked well, indeed very
well, for assuming counterparty risk in cash
securities, options, and futures, that are
listed and traded on exchanges but OTC is
something else.
Is there an echo in this of Schlieffen? Is
channelling so much of the OTC contract
counterparty risk into regulated CCPs the
nancial equivalent of that single railroad
crossing over the Rhine, where men and
materiel had to be clearedand sent west
100 years ago?
Default risk
During the course of the research some 85
CCPs have been identied. Our coverage for
now is 27 institutions and includes nearly
all of the largest clearing houses around the
world the ones most likely to cause a dis-
ruption to the nancial system if a default
were to occur.
The default risk is real: The International
Organisation of Securities Commissions
(IOSCO) global risk assessment released
in October 2013 cited CCPs as one of four
central concerns for potential disruption
of the worlds nancial system in the year
ahead, and declared CCPs another category
of nancial institutions which are too big to
fail.
161
Given their modest size, an alternative
way to state this is that CCPs are too central
to capital markets operations to be allowed
to fail. Whilst our efforts, and those of the
concerned banks, together with SWIFT,
have resulted in a great deal of information
on central clearing in a standardised format.
Depth of eld
It remains to be said that there is much of
fundamental importance about this seg-
ment which we and our research partners do
not know. To the best of our knowledge, no
one else has put together answers to these
questions in a world-wide, systematic way,
either.
4
To start, we do not know how many
employees work in the worlds CCPs. Many
of them are legal structures for which the
work is done by employees on contract else-
where in the business group for example,
in a dedicated business department. Those
CCPs that do have staff are often small,
sometimes only a few dozen employees.
That is all that has been required.
Like the exchanges they complement,
CCPs are skewed and the few largest have
hundreds of employees. In terms of the
number of persons honed in the complexi-
ties of clearing risk management as the asset
mix changes, well, we do not have a gure
for that, either.
Solidity or fragility
There cannot be many of them perhaps
a few in each clearing house. We therefore
suppose that there is expertise concentration
in the hands of a few dozen persons at most.
Similarly, we do not know what the clearing
segments capital base is.
However, we do know that two very
large institutions, the Chicago Mercantile
Exchange and Korea Exchange, have their
clearing business contained within the trad-
ing company. There is no separate balance
sheet.
Without a gure for capital set aside
for central clearing, we cannot know what
resources are available to withstand shocks
although clearing houses usually (but not
invariably) are set up with guarantee funds
and waterfallsof additional funding to run
through as the lines of rst defence in case of
default, notably the margin posted by clear-
ing members.
Diversity
Without that overall capital base for the seg-
ment, we do not know how protable this
business might be. From our individual
analyses, we note that this is entirely vari-
able. Some CCPs have been set up as prot
centres; others merely to clear trades at mini-
mal fees that might not be in proportion to
the business risks being run.
There is no consistency. That should
not be surprising, given that clearing houses
were founded and grew up in the specic
circumstances of agricultural futures trading,
were found to be useful for nancial deriva-
tives as from the 1970s, and of general utility
to the exchange sector in the decades that
followed.
Each is local in spirit, built for the circum-
stances in which it was established; when
the analyses are set out side-by-side, they
are a disparate community.
Little is written by clearing houses on
the investment policy of their equity or the
margin held to secure clearing member
162
positions. CCPs are at all times vulnerable to
liquidity problems: Can the assets deposited
be turned to cash immediately; or, if not, over
what period of time?
It is well and good for regulation to man-
date levels of available liquidity, but over the
past six to seven years we have witnessed
even the most actively traded asset classes
freezing, notwithstanding central banks
epochal distributions of cash.
Margin unknowns
The research has not been able to unearth
consistent information on margin method-
ology, the formulation of requests to trading
counterparties for assets to offset the risk
inherent in the trading position the CCP is
assuming.
How much margin is to be handed over
to the clearing house? What is the quality of
those assets? What are the open positions
in the market for the asset classes the clear-
ing house has taken on its books? We can-
not calculate on an industry-wide basis the
ratio of default fund to initial margin, yet that
information is central to understanding the
level of risk mutualisation.
Pricing problems
The difference between centrally clearing an
exchange-listed and traded product and an
OTC instrument is how the price is formed,
the transparency of the process, and the
breadth and depth of participation. It is a dif-
ferent matter for a CCP to try to nd prices
in OTC, because by denition there is no
organised market for those contracts.
When it clears OTC, it must take the
price from the participants only, with inher-
ently less certainty, in particular when it
comes to stress testing the effects of potential
adverse market movement. We would think
it is especially important to understand the
hypotheses underlying those tests for this
category of assets. Finally, among the critical
pieces of information missing, we must cite
the question of resolution and recovery of a
failed CCP. We have gathered some pieces
of information, but not found more.
Where does this leave the G20 plan for
OTC derivatives? Is the forceful channel-
ling of standardisedOTC instruments into
central clearing the right way to solve OTC
risks? The Pittsburgh Declaration could not
have been clearer in its description of OTCs
being pushed in various ways toward forms
of regulation.
Why CCPs?
But why CCPs, which are structured for the
public exchange environment? How did this
come about anyway? Who gave heads of
government the idea of reshufing the risks
in this manner? CCPs have never especially
been on the public radar screen, though
they were being followed episodically by the
Group of Thirty, and later by the Committee
on Payment and Settlement Systems at
the Bank for International Settlements and
IOSCO.
In the autumn of 2009, to the best of our
recollection and knowledge, CCPs in their
majority were not volunteering to take this
work on. Nor was it considered a coup to
have this new ow of business coming
through.
Is there a back-up? Returning to the
Schlieffen Plan example and the abrupt dis-
covery that the military needed to reverse the
direction of trains going over that bridge in
163
the face of unexpected circumstances, is the
nancial sphere about to be confronted with
an analogous situation?
Is OTC risk being massed for trans-
fer into CCPs, as those troops and materiel
were in Cologne one century ago? Clearing
standardisedOTC contracts has and will
continue to lead to risk reduction, supposing
there can be a common global understand-
ing of what standardisedis.
5

Why not on exchange?
We wonder about the extent to which stand-
ardisation is even the issue. This seems to be
a distraction from the difculties of pricing
risk, which to us is the key factor and it is
harder to do so without the interaction that
comes from broad public involvement on
an exchange, not easier. If products can be
standardised,then why are they not listed
and traded on an exchange anyway?
Concentrating risk in CCPs may make
them fragile. Clearing houses can protect
themselves in normal trading conditions,
but only if the OTC trade price reported to
the CCP is valid and the corresponding mar-
gin remains liquid.
Then there is the problem of rapid-re
trading, meaning that risk positions are being
modied at high speed throughout the trad-
ing day. How is one to request and receive
margin, that essential asset that secures
the system, when microsecond changes in
counterparty positions are occurring? This
affects all CCPs.
Fragmentation of data
As to the other parts of the G20 strategy,
if these contracts come to be traded on
exchanges as well as other platforms, the
liquidity required to nd prices gets split.
Also, trade reporting looks set to scatter
massive data in varying formats across many
repositories, making it hard if not virtually
impossible to see how they can be reas-
sembled into a coherent picture of counter-
party positions, at least for the foreseeable
future.
Regarding additional capital require-
ments for OTC contracts that are not cen-
trally cleared, this might be an invitation to
transfer as much trading as possible to juris-
dictions able to be less costly. We wish this
were not the case.
From the words of the Pittsburgh
Declaration and the public discourse that
followed, the expectation is one of near
elimination of OTC risk, to be accomplished
by sending some trades to CCPs, reporting
everything, and adding capital requirements
for non-cleared OTC instruments.
We are not sanguine that these
approaches will work.
Right goals, but....
The strategic goal of reining in OTC deriva-
tives is laudable and necessary for protecting
the worlds nancial system. G20 has got
that right.
Yet the G20s request to use CCPs as part
of the solution strikes us as odd. It prods
the worlds CCPs, regulated institutions that
have worked well to date, to remake them-
selves in order to accommodate risks being
generated outside the regulatory perimeter.
This is not a comfortable t. In our view,
if two parties have a commercial justication
to go outside the thousands of available pub-
licly traded contracts, with their associated
central clearing, and wish to take a position
164
or cover a risk by dealing off-exchange, this
should be perfectly acceptable, provided that
they alone assume the risks of doing so.
These positions should then be notied
to capital markets and bank authorities in a
way that the home country supervisors can
summarise the counterparties global net
exposures.
6
Incomprehensible results
This G20 strategic response to the OTC
problem, by pushing it part-way into the
regulated perimeter of capital markets,
looks like a poor match for doing more than
netting out a portion of the OTC risk, the
standardisedparts, while scattering most
of the price information across a multitude
of differing platforms for some trading and
diverse forms of reporting.
In 2007-2008, the essential problem was
information about what was out thereand
what it was worth the G20 approach does
not seem to us to advance in getting a com-
prehensive overview of over-the-counter
derivatives.
Adapt to ourish
As 2014 progresses, we are no longer theo-
rising about what to do. The G20 plan was
put forward several years ago. Legislation
and regulation have been drawn up, and the
nancial services industry is advancing into
plan execution.
We trust that the authorities and market
participants will remain adaptable. Let us
remember Schlieffen and the many other
superbly crafted plans, all of which always
needed to be adapted to circumstances.
Let us also watch over CCP risk proles
as central market infrastructure institutions.
They must be kept robust for the work they
have performed well historically for regu-
lated marketplaces. We strongly request that
the clearing house risk managers themselves
be the persons who choose what trades to
take on, and how. They must be condent
of the quality of the assets being introduced
onto their balance sheets, their ready liquid-
ity and their pricing.
Endnotes
1. Pittsburgh G20 Summit Declaration, September 2009:
Improving over-the-counter derivatives markets: All
standardised OTC derivative contracts should be traded
on exchanges or electronic trading platforms, where
appropriate, and cleared through central counterparties by
end-2012 at the latest. OTC derivative contracts should be
reported to trade repositories. Non-centrally cleared con-
tracts should be subject to higher capital requirements.
G20 Communique.
2. The Bank for International Settlements Triennial Cen-
tral Bank Survey on Foreign exchange and derivatives
markets, published in December 2010, cites on page 2
extreme growth in OTC derivatives in the period 2007-
2010. And it continued, Despite the Crisis-related
declines [in asset values], positions in the OTC deriva-
tives market went up in the three years since the last sur-
vey. Notional amounts outstanding of such instruments
reached US$$ 583 trillion at end-June 2010, 15 per cent
higher than the level recorded in the 2007 survey. This
corresponds to an annualised compound rate of growth of
only 5 per cent, however, compared to 32 per cent annu-
ally in the period 2004-2007, and it is also clearly below
the roughly 20 per cent average annual rate of increase
between 1995, when position in OTC derivatives were
frst surveyed by the BIS, and 2007. In the December
2013 BIS triennial survey, growth resulted in an outstand-
ing notional fgure of US$693 trillion, the efforts of G20
to restrain these markets notwithstanding. To give some
perspective, the CIA World Factbook shows estimated
165
world Gross Domestic Product in 2012 at US$72 trillion
in current dollars.
3. Schlieffen Plan, 1914: A plan intended to ensure Ger-
man victory over a Franco-Russian alliance by holding off
Russia with minimal strength and swiftly defeating France
by a massive fanking movement through the Low Coun-
tries, devised by Alfred, Count von Schlieffen (1833--1913)
in 1905. Collins Dictionary.
4. The Financial Stability Boards OTC Derivatives Mar-
ket Reform, Third Progress Report on Implementation,
15 June 2012 states that Nevertheless, incomplete cur-
rently available data means the level of standardisation in
the market, and the extent to which it is increasing, can
only be roughly estimated. The more recent report in this
series, dated 2 September 2013, did not address this point.
But it was clear by September 2013 that the deadline of
end-2012 for implementation of reforms as set in the Pitts-
burgh meeting had been missed.
5. A commonly accepted defnition of standardised
remains to be developed. That is not so different from
other frequently used terms in the capital markets, most
notably the concepts liquidity and market depth. That
would not be problematic, but for the point that under
the new rules of trading what is standardised is meant to
be centrally cleared. It seems to us that this will remain a
matter for the observer to judge.
6. Such a reporting obligation may appear to be onerous,
but then one must recall that many fnancial institutions
heading into these crises were unable to understand, man-
age, or communicate their risk positions, either.
of the Journal would like to thank Thomas
Krantz, former secretary general of the World
Federation of Exchanges, together with UK
capital markets advisory business Thomas
Murray, for allowing us to publish this arti-
cle. It appeared in abbreviated form in the
Financial Times, and in an amended form in
TABB Forums.
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Risk management
into account.
167
Basel III
Basel III odyssey across the
Asia Pacics larger economies
Wolters Kluwers Selwyn Blair-Ford sum-
marises the current state of play in Asias
progression towards Basel III compliance.
THE great fnancial crisis of 2007 through
2008 did not impact all regions equally.
While the United States and Europe
saw a number of large and small institu-
tions fail or require massive state inter-
ventions, banks across the rest of world
particularly here in the Asia Pacifc
were far less impacted than their peers in
the West. This is mostly ascribed to the
less complex business models the major-
ity of Asias banks adhered too, specif-
cally a higher proportion of traditional
on balance sheet banking activities than
that found in the US or Europe.
Their relatively low exposure to over-the-
counter (OTC) derivatives and securitisa-
tions protected the bulk of the regions
nancial services sector from the harmful
effects of contagion witnessed by many of
their Western peers at the height of the crisis
in the nal quarter of 2008.
In addition to the far simpler business
models deployed across the region, valuable
lessons had been gleaned from the Asian-
currency crisis of the late 1990s, resulting in
tighter regulations on capital, liquidity and
certain forms of leverage than their counter-
parts in Europe and the US.
As a result, in the aftermath of the 2008
crisis the Asia Pacic nancial sector was
far stronger in terms of measurable capi-
tal and liquidity than their Western peers.
This strength was further bolstered by the
fact that the majority of Asian nations have
economies that are export-driven, rather
than being net importers of goods.
Behind the curve
The relatively light damage experienced in
the immediate aftermath of the nancial
crisis has meant that many observers in the
region are far more likely to assume that
banking will eventually return to its previous,
less complex model.
This may well be true for many Asia
Pacic banks from a capital and liquidity
standpoint, as many have not had to dra-
matically increase these in order to comply
with the enhanced Basel III requirements
emanating out of Switzerland.
One area where the region has been
relatively behind the curve in relation to
their US and European-based nancial
168
institutions is the area related to risk appetite,
risk control and the governance and control
of infrastructure.
Increased investment
Being aware of many of the business risks,
European and North American banks have
embraced new techniques and controls sur-
rounding the controls of those risks, which
to-date have not been taken up by their
Asian peers to such an extent.
As a result of this fact, many nan-
cial rms across Asia Pacic are presently
investing in key areas relating to rm-wide
stress-testing, quantication of risk appetite,
internal management information processes
and operational risk.
However, improvements in the control
infrastructure of the banking sector are a
key and necessary part of Basel III, as is the
increased intrusiveness of regulators and the
increased transparency required of this inter-
nationally agreed process.
In this regard the environment that the
nancial sector operates in has changed for
the foreseeable future and is not likely to
revert back to its previous model any time
soon.
Land Down Under
For the remainder of this article, we shall
focus on the way Basel III has been, and is
being, implemented in the big six Asia Pacic
countries, namely: Australia; China; Hong
Kong; India; Japan and Singapore, with the
aim of drawing out the similarities and dif-
ferences between each of them in their turn.
Our rst port of call on our Asia Pacic
jouney is that land from Down Under,
Australia. On September 28, 2012, the
Australian Prudential Regulatory Authority
(APRA) published its nal Basel III capital
reform package, which outlines the countrys
new minimum capital requirements, which
commencedantion-wide on January 1, 2013.
APRA also published its revised Liquidity
Coverage Ratio (LCR) standards in May of
that year, which should be implemented in
full from the beginning of 2015, barring any
last minute hiccups.
These new capital standards will require
Australian Authorised Deposit Institutions
(ADIs) not only to adhere to the enhanced-
capital liquidity and leverage requirements
demanded by APRA, but also to have in
place an internal capital adequacy assess-
ment process; a mechanism to operate con-
servation and countercyclical capital buffers;
the ability to inform APRA of any adverse
changes in actual or anticipated capital ade-
quacy; and to seek regulatory approval for
any planned capital reductions.
Earlier deployment schedule
APRA will stick with the international Basel
norms with regards to capital and liquidity.
However, it will be implementing Basel III
earlier than the agreed international sched-
ule. As a result, Australian banks have been
required to have a Common Equity Tier 1
(CET1) ratio of 4.5 per cent, a Tier 1 ratio of
6 per cent from January 1, 2013 rather than
January 2015.
Australian banks will also implement the
full conservation and counter-cyclical buffers
(2.5 percent each) in 2016, a timeframe three
years ahead of the international agreements.
There will also be no transitional measures
applied to the Liquidity Coverage Ratio, with
ADIs having to have a 100 per cent ratio from
169
January 2015. In addition to this accelerated
implementation, the concessional treatment
for certain capital items - most notably the
threshold treatment for deduction of invest-
ment in other nancial institutions, mort-
gage service rights and deferred tax assets
- have not been adopted by APRA.
Liquidity concerns
The result is estimated to have increased the
CET1 capital position by between 1 to 1.5
per cent, or to put it another way, the capital
ratios given by the Australian institutions are
not comparable to the rest of the world and
are likely to understate the amount of capital
held by up to 1.5 per cent.
It will not be difcult for the Australian
banks to comply with the capital, leverage
and liquidity requirement, with most institu-
tions having reached or having been close to
reaching the required metrics early in 2012.
There is a concern regarding liquidity,
which may mean the interest rates on cus-
tomer deposits will increase as ADIs attempt
to comply with the LCR measures.
Overall the rise in capital standards could
mean that high risk borrowers need to pay
more for nancing, but the adverse impact
of this is offset by the improvement in overall
nancial stability.
The Middle Kingdom
Our next port of call popularised by the tall
stories of one Marco Polo and often referred
to as the Middle Kingdom, is the Peoples
Republic of China. China began adopt-
ing internationally agreed banking norms
prior to the turn of the millenium when
Basel I Capital Adequacy Ratio (CAR) and
the associated regulation were imposed
on the countrys domestic banks in 1994.
From 2003, the China Banking Regulatory
Commission (CBRC) has been responsible
for banking regulation and supervision.
The core of the CBRC regulations was
issued in June 2012, in documentation which
adopted much of the Basel III capital frame-
work. In October and November 2012, sup-
plementary documents were also published
detailing CAR reporting requirements and
the transition to the Basel III process.
These capital rules apply to 511 commer-
cial banks across this vast territory, including
small and medium sized banks that are not
internationally active. Chinas banking sec-
tor is dominated by its ve largest banks,
which between them account for 60 per cent
of the countrys banking assets.
Higher capital standards
The CBRCs capital rules include: CAR cal-
culations; regulatory capital make-up and
deductions; a capital conservation buffer;
a countercyclical buffer; and leverage ratio.
Final rules regarding the Liquidity Coverage
Ratio, at the time of writing, have not yet
been announced.
Like some other Asia Pacic jurisdictions,
among them India and Singapore, the capi-
tal requirements imposed by the CBRC are
higher than what the international stand-
ards call for.
For domestic banks deemed non-
systemically important, Common Equity
Tier 1 (CET1) ratio and Tier 1 ratio is set at
a minimum of 5.5 per cent (4.5 per cent
under Basel III), Tier 1 ratio at 6.5 per cent (6
per cent under Basel III) and CAR of 8.5 per
cent (8 per cent under Basel III). For those
institutions deemed systemically important
170
by the Chinese regulator, an extra 1 per
cent charge is added to CET1 which carries
through to Tier 1 and CAR. The CBRC have
also imposed a leverage ratio of 4 per cent (3
per cent under Basel III).
Compliant, or largely compliant
Applying the new Basel III rules, the average
total capital ratio of Chinese banks stood at
13 per cent in 2012. This compares favoura-
bly with the Basel III minimum of 8 per cent.
The 2012 CET1 ratio and Tier 1 ratio
were 10 per cent, again comparing favora-
bly against the 7 per cent required under
the internationally agreed Basel III critria.
Clearly Chinese banks do not have great
difculty in reaching the new capital require-
ments demanded by their regulator.
An assessment of Basel III regula-
tions for the Basel Committee for Banking
Supervision (BCBS), as part of the Regulatory
Consistency Assessment Programme
(September 2013), found that the Chinese
framework was compliant or largely compli-
ant in all key components.
Some omissions
There were two areas considered largely
compliant relating to a credit risk standard-
ised approach and the disclosure require-
ments. The credit risk standard approach
does not use the Basel risk weights for
domestic sovereign, bank and public entity
exposure, but are instead assigned xed risk
weights.
These risk weights at present are higher
than the ones that would be selected by
Basel. However, if there were a severe
enough sovereign credit downgrade this
may not be the case.
The assessment team also felt that
although most of Pillar 3 had been imple-
mented, certain requirements for regarding
detailed disclosure of credit quality were not
present in the domestic regulation.
There were also comments regard-
ing market risk calculations, with many of
the more sophisticated risk measurement
practices under standard and advanced
approaches not being available.
It was argued by the Chinese authorities
and their bank regulator that this approach
was appropriate as it reected the business
models present in the Chinese banking sec-
tor today.
However with more rms wanting to
participate in areas like option trading and
other derivatives, this approach may need to
be reviewed from time to time to maintain
stability and compliance with international
obligations under Basel III.
Growth concerns
Overall the concern for Chinese banks relates
to economic growth. The new requirements
have reduced the amount the banking sector
can grow its asset base for any given amount
of capital. With the Chinese economy being
among the worlds fastest growing, the pres-
sure to grow balance sheets is large. The
Basel III reforms may, in the short term, act
as a drag on growth.
Continuing our Asia Pacic odyssey, our
next port of call is the Hong Kong Special
Administrative Region, usually referred to
as Asias World City. In February 2012, the
Hong Kong Legislative Council passed the
Banking (Amendment) Ordinance that
established the legal framework used to
implement the Basel III capital and liquidity
171
standards. The Ordinance amended the
current rules to include measures regarding
composition of capital, credit risk, market
risk and the other Basel III measures. The
sophisticated and more advanced modeling
approaches are available under the Hong
Kong Monetary Authority (HKMA) rules.
Hong Kong excels
Basel III rules took effect from January 1,
2013, and disclosure requirements from
June 30, 2013. Rules regarding the capital
buffers and the LCR were issued in the nal
quarter of 2013. Hong Kong has opted to
implement the full Basel III accord with capi-
tal ratios CET1, Tier 1 and total capital ratios
being set at the international standards.
It should be noted however that the
average capital ratio of Hong Kong incor-
porated banks was 16.1 per cent (8 per cent
Basel III), with the Tier 1 ratio of 13.3 per cent
(6 per cent Basel III) and over 90 per cent of
capital being held as common equity. These
banks are not expected to have any difculty
reaching the required Basel III standards.
The strategy Hong Kong has adopted
has been to ensure that the banking sector
abides by the international standards, while
ensuring that the domestic entities exceed
them.
Business-friendly approach
This is similar to the approach adopted by
other international nancial centres, includ-
ing London, and is designed to make sure
regulation is not a barrier to business.
There are concerns however, that many
Hong Kong banks are branches of interna-
tional rms. The new Basel rules are likely
to restrict the movement of liquidity and
discourage the idea of universal banking.
Both these changes may adversely impact
markets such as Hong Kong.
Departing Asias World City, our journey
continues as we reach one of the regions
most exotic and populous of countrries,
namely, India. Although ofter seen as quite
erronously behind the curve as far as the
Basel accords have been concerned, sur-
prisingly India was one of the rst nations
to implement Basel I way back in 1992 and
has gone on to implement Basel II unlike
its more supposedly advanced brethren, the
United States, which prior to the nancial
crisis of 2007 and 2008, had failed to deploy
Basel II across much of its banking sector.
Indian Master circular
On July 1, 2013 the Reserve Bank of India
(RBI) published its Master Circular - Basel
III Capital Regulations, which includes
rules and provisions regarding the follow-
ing: composition of regulatory capital; capital
charge for credit risk; external credit assess-
ments; credit risk mitigation; capital charge
for market risk; capital charge for operational
risk; Pillar 2 the supervisory review process;
Pillar 3 market disclosure; the capital con-
servation buffer; and the leverage ratio
Basel III has been implemented as of
April 1, 2013 in India, albeit with a phased-
in approach to its national deployment. The
RBI circular represents methodologies that
came into force from 2013 under this phased
approach. India has chosen to imple-
ment requirements in excess of the Basel III
requirements.
As a result, where the Basel Accord
stipulates that banks should have a mini-
mum common equity tier 1 ratio of 4.5 per
172
cent, the RBI is requiring a 5.5 per cent ratio.
Also the Basel leverage ratio has a maximum
leverage of three per cent. However the RBI
will be requiring a 4.5 per cent threshold for
its banks. These two measures represent a
signicant tightening of the rules over and
above the international standards agreed at
Basel, Switzerland.
Well capitalised
The Indian banking sector is well capital-
ised, with a CAR set at approximately 13.4
per cent, with many of its numerous banks
already operating at the higher levels of capi-
tal required under the guise of the RBI.
One danger however, is the level of eco-
nomic growth hence the requirement for
banks to grow their risk weighted assets
which means that additional capital will
have to be raised. Indeed the raising of
banking capital standards may be seen in the
short term as having a negative effect on vital
economic activity.
Indian nancial institutions have also
been strengthening their risk management
processes and systems, but this will need to
continue. As the larger rms adopt the more
advanced approaches, the capital adequacy
framework will be more tightly associated
with keeping it protable, sound and stable.
Therefore the need for skilled risk
personnel, up-to-date and appropriate
management information, will increase dra-
matically of the course of the next few years.
Chrysanthemum seal
Our journey takes a considerable detour
as we venture to the land of the chry-
santhemum seal, better known to non-
travellers as Japan. In March 2012, Japans
nancial services regulatory body, the
Financial Services Agency, published the
countrys rules and guidance in relation to
the roll out of Basel across the nation, with a
tight deadline for for the implementation of
Basel III set for the end of March, 2013.
As with many of its peers across Asia
Pacic, the rules cover most of the key com-
ponents of Basel III, including Pillar 2 and
Pillar 3 disclosure requirements.
It is interesting to note the areas that
were not included within the regulatory
guidance and framework. Rules relating to
the countercyclical and capital conservation
buffers, at the time of writing, have not yet
been published and are not expected to be
until late 2014 or even 2015.
Slipping deadlines
Neither has Japan issued rules in relation
to Global Systemically Important Banks
(G-SIBs), which have a start date of January
1, 2016, although authorities are required to
issue rules by the beginning of 2014, a dead-
line, which into the rst quarter of the year,
seems to be slipping by.
This should be a pressing issue, as Japan
currently has three nancial institutions
deemed a threat to global nancial stability,
among them Mitsubishi UFJ FG, Mizuho FG
and Sumitomo Mitsui FG. Japan also has to
issue liquidity standards which are due to
start as of January 2015, together with the
leverage ratio.
Given the exceptions however, it has
been found during the BCBSs regulatory
consistency assessment, that Japan was
either compliant, or largely compliant in all
components.
Furthermore, the CAR for Japanese
173
banks was 16.3 per cent at the end of 2011
based on the current Basel II rules. The
potential difculty for Japanese banks relates
to the increase in the quality of capital instru-
ments required under Basel III.
Journeys end - Singapore
More specically, replacement of large
amounts of hybrid capital and the higher
proportion of common shareholders funds
are needed. Increasing this class of capital
will require banks to increase the proportion
of retained earnings and to pay less away in
the form of dividends.
As with all journeys, ours eventually
must reach its last destination point, so
heading back towards the Indian Ocean, we
venture upon the tip of the Malay Peninsula,
namely the City State of Singapore.
As one of several Asia Pacic countries
now represented on the expanded Basel
Committee, Singapores central bank and
regulatory body, the Monetary Authority of
Singapore (MAS), rst published guidance
on the countrys Basel III implementation
process way back in 2011, with the issuance
of Notice 637.
Adherence to Notice 637
Under Notice 637 the MAS set out detailed
Basel risk-based capital adequacy require-
ment for banks operating in Singapore
which has been updated on a regular basis
taking into account changes emanating
from the Basel Committee itself, and the City
States intepretation of said changes as they
impact its nancial services sector.
The banking sector itself covers a total of
123 banks, of which seven are locally incor-
porated, the rest being branches of foreign
banks headquartered outside Singapore. It
is the locally incorporated entities that need
to adhere to the Notice 637.
Three banking groups control six of the
seven incorporated entities and are respon-
sible for 96 per cent of all assets of locally
incorporated banks and 39 per cent of the
nancial systems total assets as of June 2012.
MAS Notice 637 included sections on capital
adequacy and leverage ratios; denition of
capital; credit risk; market risk; operational
risk; the supervisory review process; pub-
lic disclosure requirements; and reporting
schedules.
As of the third quarter of 2012 the aver-
age Tier 1 ratio was 14.3 per cent (6 per cent
Basel III) and with CAR standing at 17.4 per
cent (8 per cent Basel III). Singapores bank-
ing sector will not appear to have difculty
reaching the Basel minimum requirements.
Head of the Basel pack
The last BCBS Regulatory Consistency
Assessment undertaken was in March last
year. At that time, it found that Singapore
was compliant or largely compliant in all 14
key Basel III components, with only Credit
Risk Standard Approach and Credit Risk
Internal Ratings Approach being rated as
largely compliant.
The reasons given for the former related
to the fact that structured deposits could be
used collateral and for the latter because
exposures to individuals ineligible for retail
treatment were being weighted at 100 per
cent rather than considered as corporates.
However, Singapore does have the
highest ratings of all the assessments that
have been undertaken to date. The MAS
have decided to implement higher capital
174
standards than the Basel III minimum. CET1
will be set at 6.5 per cent (4.5 per cent Basel
III); Tier 1 capital adequacy will be set at 8
per cent (6 per cent Basel III); and the total
CAR will be 10 per cent (8 per cent Basel III),
which is unchanged for Singapore.
Recap of itinerary
The challenge for banks in this jurisdic-
tion will be less from the amount of capital
leverage and liquidity required, but more
from ensuring the correct risk, control and
information.
Our Basel III odyssey across six Asia
Pacic jurisdiction suggests that the capital
and leverage positions of banks in the region
are strong, and that the majority of those
banks in the countries covered will not nd
it very difcult to reach the minimum Basel
III standards.
There are no areas to date where the
regimes that are emerging have been found
materially non-compliant with the key Basel
III components.
However looking more closely we nd
that each jurisdiction displays its own char-
acteristics. The faster growing economies
have concerns about the effect of Basel III
on economic growth, which is due to todays
levels of capital not being expected to be
enough to support the required amount of
future lending.
Made-to-measure tailoring
Each jurisdiction has tailored their imple-
mentation according to the sophistication of
the businesses in their jurisdiction.
We nd in China, that the sections of
Basel III representing the more advance
techniques are not included. Singapore
however includes all of Basel III. Australia,
with its strong growth, low public debt levels
and conservative approach to banking has
opted for the earliest full implementation
and chosen not to include many of the con-
cessional treatments for capital items.
There are also the concerns surround-
ing capital, so we see Japan and to a certain
extent India concerned about the replace-
ment growth of rmsown funds. In Japans
case this is driven by the replacement of
hybrid instruments, while in India it reects
the capital demands of economic growth.
Postcard remarks
What is clear is that because many of the
business models used in Asia-Pacic have
been relatively simple in terms of banking,
the need for the most sophisticated risk and
control infrastructures has not been present.
The result is that although many will have
more than adequate capital, leverage and
liquidity, the processes controlling and mon-
itoring the related business risks will not be
as developed.
Consequently banks in Asia-Pacic will
need to continue to invest in their infrastruc-
ture in order to meet the highest standards
of risk and business management. The
ongoing costs of running a risk sensitive
framework should not be underestimated. It
should also be noted that these costs grow
signicantly if the framework is imple-
mented poorly.
To conlude, overall we can see that Asia-
Pacic is in a generally healthy position
relative to Basel III. The key to the regions
success will be to use this strength to effec-
tively take advantage of the new opportuni-
ties that arise.
175
Prudential standards
Foreign banks rmly in the
crosshairs of Feds nal rules
Enhanced Dodd-Frank prudential standards
serve notice on overseas banks operating
within the United States, writes Chris Rogers.
THIS February, the US Federal Reserve
fnally got around to issuing its not-so-
fnal Final Rule on enhanced pruden-
tial requirements for banks operating in
the US as mandated by Congress under
Section 165 of the Wall Street Reform
and the Consumer Protection Act - bet-
ter known as Dodd-Frank. The revised
rules bolstering prudential standards
apply to both US-based institutions and
foreign banking organisations with a
presence on US sovereign territory.
In the wake of the furore following the
nancial crisis and implosion of Lehman
Brothers, the US has set out to strengthen
the resiliance of its domestic banking sector,
with most attention paid to those institu-
tions deeemed signicantly important or
in laymans terms, those banks considered
too big to fail by US federal agencies and the
US government.
As such, the Federal Reserves prudential
standards nal rules governing large com-
plex nancial institions are both detailed
and highly prescriptive for the largest of its
banking fraternity those with assets greater
than US$50 billion together with a greater
emphasis on overseas banks operating
within the USA (FBOs) with US assets in
excess of US$50 billion or overseas branch
assets again over the US$50 billion mark.
Having on the whole previously dealt
with its own banking house for instance
in relation to its obligations towards Basel III
and more specically, those rules governing
risk-based and leveraged capital, together
with capital planning, and supervised stress
testing - US institutions were spared any sig-
nicant revisions.
Apart from the following changes to
Section 165 of Dodd-Frank, as detailed in
the Federal Reserves February 18, 2014
release focusing on risk management
including duties and qualications for a
risk management committee and chief risk
ofcer, together with liquidity stress testing
and buffer requirements, and the poten-
tial application of a 15-to-1 debt-to-equity
limit to US-based banks deemed by the
US Financial Stability Oversight Council
(FSOC) - as being systemically important
nancial institions, and as such, a threat to
the US nancial sector.
176
Given these facts, Februarys nal rules
announcement by the Fed is of more impor-
tance to overseas players with operations in
the US, rather than US-based banks them-
selves, chiey based on the fact that the Fed
has changed the goalposts as far as regulat-
ing overseas entities in the US in concerned.
Adoption of ICHs
Most signicantly perhaps, is the Feds deci-
sion that foreign banks with non-branch
assets of US$50 billion or more a ve fold
increase from its initial US$10 billion g-
ure are required to set up an intermediate
holding company (ICH) for any subsidiaries
under US law, and with few exceptions, will
be subject to the same regulatory require-
ments as their US-based brethren found
under Section 165.
Further, foreign banks with global assets
of at least US$10 billion will be subject to a
layered and escalating set of capital, stress
testing and liquidity and risk management
requirements, depending on the size of their
worldwide assets, together with their US
assets. The following are examples of these
changes detailed in the Feds nal rules
guidance:
FBOs with worldwide consolidated assets of US$10 billion
or more but less than US$50 billion must be subject to a
home-country capital adequacy stress testing regime that
meets certain FRB-defned standards or else face asset
maintenance requirements at its US branch;
Publicly traded FBOs with total consolidated assets of
US$10 billion or more and FBOs with total consolidated
assets of US$50 billion or more, whether or not publicly
traded, are also required to maintain a committee of its
global board of directors on a stand-alone basis or as part
of its enterprise-wide risk committee that oversees risk
management policies of its US operations;
FBOs with worldwide consolidated assets of US$50 billion
or more but combined US assets of less than US$50
billion must also (i) certify to the FRB that they are sub-
ject to and in compliance with risk-based and leverage
capital requirements in their respective home jurisdictions
that are substantially equivalent to those promulgated by
the Basel Committee on Banking Supervision (the Basel
Committee) or face various restrictions on their US oper-
ations if they are unable to do so and (ii) report to the FRB
the results of internal liquidity stress tests for either their
consolidated operations or the combined US operations
or else be subject to limits on the net amount owed by
their non-US offces to their US offces; and
FBOs with worldwide consolidated assets of US$50 bil-
lion or more and combined US assets of US$50 billion
or more that also are required to form an IHC must (i)
maintain a US risk committee either at the IHC board
level or at the FBO parent board level to approve and
oversee the risk management framework and policies of
the combined US operations, including as to liquidity risk,
(ii) appoint a US chief risk offcer having certain defned
qualifcations, and (iii) be subject to various liquidity stress
testing and buffers, contingency funding plans, and cash-
fow projection requirements.
Whilst in its February announcement per-
taining to its nal rules governing pruden-
tial standards, the Fed postponed some of
its most important compliance deadlines
for overseas banks, the planning and imple-
mentation process, especially for those
banks with a larger non-banking presence
in the US, will be a signicant and complex
undertaking , which will require a signicant
amount of effort by staff and senior manage-
ment even before the enhanced prudential
standards become madatory.
Non-US banks operating within the
US and subject to the intermediate hold-
ing company provisions need also be aware
of any tax implications that may apply in
177
incorporating the holding company into its
existing organisational structure, or to reor-
ganise existing structures under the new
holding company requiremets.
Omissions
Februarys Fed announcement also omits
nal rules establishing single counterparty
credit limits or the early remediation frame-
works which have been applied to US banks
and overseas banks under the Feds previ-
ous pronouncements - these rules remain
under development and will be addressed at
a future, as yet, unspecied date.
The Fed also failed to address enhanced
prudential standards for non-bank nancial
companies, which have been pinpointed
by the FSOC for supervision by the Fed.
In its February preambledetailing its nal
enhanced prudential requirements, the
Fed stated it would focus on the so-called
shadow banking entities at a later date,
either by rules-based regulation, or through
an order.
The Fed also announced that the new
enhanced prudential standards (the nal
rules) would take effect from June 1, 2014,
and expect institutions captured by Dodd-
Franks Section 165, both foreign and
domestic, to be compliant in phased stages
beginning 2015 through to 2018.
Treatment of overseas banks
Earlier, on December 28, 2012, the Fed
issued a separate set of proposed rules to
implement the provisions of Sections 165
and 166 for foreign banks with total assets
of US$10 billion or more and foreign non-
bank nancial companies designated by the
FSOC. After this announcement, the Fed
received more than 100 public comments
on the proposed US ruleand more than 60
public comments on the proposed overseas
bank rule.
As we are now aware, the most sig-
nicant changes made in the nal rule,as
opposed to the proposed rule, relate primar-
ily to the treatment of overseas banks, whilst
deferrng implementation of certain parts of
the proposals as they relate to overseas-
owned entities. These include:
The size threshold for forming an IHC: The Proposed FBO
Rule would have required an FBO with global consoli-
dated assets of US$50 billion or more and combined US
non-branch assets of US$10 billion or more to establish
an IHC. The preamble notes that many commenters
argued that the proposed threshold was too low and that
the US operations of entities with US$10 billion of US
non-branch assets do not present risks to US fnancial
stability. After taking these comments into consideration
and reviewing the statutory considerations in Section 165,
tht FRB raised the threshold for imposition of the IHC
requirement from US$10 billion in US non-branch assets
to US$50 billion. If this threshold is met, the creation of
an IHC is required whether or not an FBO controls an
insured depository institution subsidiary in the US.
Implementation deadlines extended for FBOs: The fnal
rule extends the initial compliance date for FBOs that
currently meet the asset threshold by one year to July 1,
2016. By July 1, 2016, an FBO must transfer to the IHC
its entire ownership interest in any US BHC subsidiary,
any insured depository institution subsidiary, and US sub-
sidiaries holding at least 90 per cent of the FBOs US non-
branch assets not owned by such US BHC subsidiaries
or insured depository institution subsidiaries. Ownership
interest, however, is not specifcally defned in the fnal
rule. An FBO must hold its ownership interests in all US
subsidiaries, other than so-called 2(h)(2) subsidiaries
and DPC branch subsidiaries, through its IHC by July
1, 2017.
178
An FBO with US non-branch assets of US$50 billion or
more as of June 30, 2014 must submit an implemen-
tation plan by January 1, 2015, outlining its proposed
process for establishing an IHC. The fnal rule includes
the possibility of limited case-by-case relief for ownership
interests in US subsidiaries that cannot be transferred
to the IHC, including a timeline and description of all
planned capital actions and strategies for capital accre-
tion for the IHC to achieve the applicable risk-based and
leverage capital requirements. The fnal rule includes
the possibility of limited case-by-case relief for ownership
interests in US subsidiaries that cannot be transferred to
the IHC, which may be conditioned on to-be-determined
supervisory requirements and/or FBO commitments as
to these subsidiaries.
Generally speaking, FBOs currently are not subject to
leverage capital requirements in their home countries.
To address concerns regarding compliance with lever-
age capital requirements proposed for IHCs, the fnal
rule delays application of leverage capital requirements
to IHCs until January 1, 2018, consistent with the FRBs
approach to the timing of the effectiveness of the sup-
plementary leverage ratio in the revised US capital rules
adopted in July 2013 and the Basel Committees Basel
III international leverage ratio implementation. However,
each bank holding company or insured depository institu-
tion that is controlled by an FBO is otherwise required to
comply with existing capital and capital planning require-
ments, and a bank holding company controlled by an FBO
must comply with the enhanced prudential standards
applicable to it because it is also a US BHC beginning on
January 1, 2015 and until the IHC becomes subject to
the new parallel requirements applicable to IHCs
The fnal rule also generally delays the application to
IHCs of the capital plan and Dodd-Frank Act company-
run and supervisory stress test requirements. The frst
capital plan fling appears to be required to be made,
according to the preamble, in January 2017
4
and the
frst Dodd-Frank company-run stress test fling must be
made, according to the fnal rule, in January 2018 and
subject to the FRBs supervisory stress test thereafter.
However, each existing subsidiary bank holding company
and insured depository institution otherwise subject to the
capital plan rule and stress test requirements and con-
trolled by an FBO prior to October 1, 2017 must comply
with the stress test requirements through September 30,
2017.
The FRB may accelerate the application of the leverage
and stress test requirements to an IHC if it determines
that an FBO has taken actions to evade the application
of the fnal rule, for example, by transferring assets from
an existing US BHC to the IHC.
An FBO with US non-branch assets that equal or exceed
US$50 billion after July 1, 2014 has two years to establish
an IHC under the fnal rule, instead of the 12 months
provided by the Proposed FBO Rule.
Liquidity buffer: The Proposed FBO Rule would have
established a 30-day liquidity buffer requirement and
required US branches and agencies of FBOs to maintain
the frst 14 days of their 30-day liquidity buffer in the
US while permitting the US branches and agencies to
meet the remainder of this requirement at the parent
consolidated level. The fnal rule, however, requires US
branches and agencies of FBOs to maintain a liquidity
buffer only for days one through fourteen of a 30-day
stress scenario (which must be held in the US as initially
proposed). The fnal rule still requires the IHC to main-
tain its entire 30-day buffer in the US.
In addition to the aforementioned, the nal
ruleincludes changes that are applicable to
both US banks and overseas banks alike. It
also provides for the establishment of sepa-
rate enhanced prudential standards for non-
Financial Stability Oversight Council to be
developed by rule or order at a later date, and
leaves several provisions applicable to US
BHCs and FBOs to be addressed by future
rulemakings:
Capital requirements: The fnal rule references the
179
previously adopted Basel III-based fnal capital rules,
capital plan (CCAR) and stress test requirements
(DFAST), as meeting the Section 165 enhanced pru-
dential requirements for US BHCs.
Liquidity requirements: Overall, the fnal rules liquidity
stress testing and 30-day liquidity buffer provisions remain
substantively more fexible than the proposed liquidity
coverage ratio (LCR) rules,

particularly with respect to
the calculation of net cash outfows. However, the FRB did
not expand (as some commenters requested) the scope
of qualifying assets. The liquidity provisions of the fnal
rule (including stress testing) and contingency funding
plan provisions are stated to be complementary to the
LCR rules and are supposed to refect institutions specifc
risks (conceptually similar to the company-run stress tests
and the supervisory stress testing exercise).
Other important changes and/or clarica-
tions made to the liquidity requirements
include:
The preamble that clarifes that a US BHC may include
Federal Home Loan Bank advances in its contingency
funding plan.
Assets used as hedges for other positions and those
pledged to an FHLB can still count in the calculation of
the liquidity buffer.
Highly liquid assets (HLA) pledged to a company cov-
ered by the enhanced prudential standards as collateral
can be used as HLA for the liquidity buffer (and not
treated as encumbered) if the covered company is able to
rehypothecate the HLA.
Diversifcation requirements do not apply to US Treasury
and agency securities. Assets that qualify as good high
quality liquid assets for LCR purposes generally qualify
for the liquidity buffer, but are still subject to other require-
ments of the fnal rule for example, diversifcation and
appropriateness of assets for the liquidity risk profle of
the institution.
Failure to meet the 100 per cent LCR requirement is a
trigger for the contingency funding plan.
The preamble to the fnal rule leaves open the
question of how the LCR proposal, once fnalised, will be
applied to IHCs and how and whether it will be applied
to US branches.
On the risk management and risk commit-
tee requirements-side, the nal ruleadopts
most aspects of the proposalswith respect
to risk management and risk committee
requirements.
However, in response to comments
recieved, the nal rulemakes revisions to
certain elements of the proposals involv-
ing the duties of boards of directors, risk
committees and CROs to more closely align
them with the traditional oversight respon-
sibilities of a board of directors and commit-
tees thereof, as well as senior management.
Non-bank entities
Turning our attention to non-bank nancial
companies supervised by the Fed, the pro-
posals provided that the standards appli-
cable to US BHCs and FBOs would serve
as the baseline for enhanced prudential
standards applicable to US and foreign non-
FSOC.
The preambleacknowledges, however,
that companies designated by the FSOC
may have a range of businesses, structures,
and activities, that the types of risks to nan-
cial stability posed by non-bank nancial
companies will likely vary, and that the
enhanced prudential standards applicable to
US BHCs and FBOs may not be appropriate
for all non-bank nancial companies and, in
particular, those predominantly involved in
insurance activities.
Accordingly, the Fed has opted to
postpone the development and applica-
tion of enhanced prudential standards for
180
FSOC-designated non-bank nancial com-
panies. Instead, the Fed intends to separately
issue an order or rule imposing standards
tailored to each non-bank nancial com-
pany or category of non-bank nancial com-
panies designated by the FSOC taking into
account the business model, capital structure
and risk prole of the designated company
or companies.
Remediation
In relation to single counterparty credit lim-
its (SCCL), the nal ruledoes not imple-
ment the single counterparty credit limits
mandated by Section 165 of Dodd-Frank.
According to the preamble, the Fed is con-
tinuing its development of SCCLs for US
BHCs and FBOs based on the results of a
previously conducted quantitative impact
study and the Basel Committees initiative to
develop a regulatory framework governing
large credit exposures, which is intended to
apply to all global banks.
On the early remediation requirements
front, the nal ruledoes not implement the
proposed early remediation requirements
of Section 166 of Dodd-Frank. The Federal
Reserve has indicated that it is working on
integrating the various remediation levels
with the new Basel III-based US nal capital
rules adopted in July 2013, and that it con-
tinues to review comments received on the
proposals with respect to early remedia-
tion requirements.
Opinion
Turning to limits on short-term debt, the
nal rule does not implement limits on
short-term debt, although the Fed indicated
that it is continuing to study and evaluate
the benets to systemic stability from impos-
ing limits on short-term debt.
Although the Feds February 18 memo-
randum contained but a brief overview of
the nal rules, it is clear for all to see that
the changes anounced concerning foreign
bank operations in the US are going to have
a huge impact as far as compliance costs
are concerned moving forward, particularly
with regards to overseas banks with assets in
excess of US$50 billion.
Some solace can be taken from the fact
that the Fed decided not to proceed with
its original plan to impose these stringent
new requirements on all overseas banks
with assets above US$10 billion. That said,
what the Fed giveth, it also taketh away, for
in lessening the prudential requirements for
smaller banks, it has impossed even tougher
requirements on those captured in its US$50
billion criteria.
Perhaps most disturbingly, despite pro-
testations claiming otherwise, the Fed has
driven a coach and horses through any
notion of complying itself with decades old
principles of fair national treatment, equality
of cross-border competition, and deference
to home country regulatory standards for
overseas banks operating in the US. And to
top it all, as detailed in our narrative, these
are not the nal nal rules, as Governor
Tarullo made clear this February.
To conclude, this is a reminder to the Fed
that the nancial crisis originated out of the
US - not Europe or Asia - specically via the
actions of mortgage facilitators, and at the
time, the six bulge bracketbanks operat-
ing out of Wall Street, together with AIGs
London subsidiary selling worthless coun-
terparty insurance.
181
Regulation - social media
Social media regulation in
the global securities industry
Gavin Sudhaker of Sapling Solutions
bemoans the fact that regulators have failed
to keep pace with technical innovation.
SOCIAL media has unleashed a global
digital revolution that threatens to
change our daily lives and the way busi-
ness is conducted. Social medias market
penetration has given the business com-
munity, particularly within the consumer
products and services sectors, the ability
to reach millions of subscribers globally
at the press of a button. However many
in the fnancial services industry are still
holding back from using social media,
largely due to ambiguous compliance
and regulatory constraints.
Towards the end of 2010 the US Securities
Exchange Commission (SEC) dispatched an
advisory request to investment advisers (IAs)
to provide documents focusing on advis-
ers record keeping, training, supervisory
and other policies in relation to social media
use. The effect of this caused trepidation
among the IA community regarding the use
of social media tools in the emerging digital
consumer-orientated business world.
This paper argues that such tactics and
their effectiveness against the IA sector,
is a direct result of decient social media
regulation and weak guidelines by gov-
ernment, regulatory agencies and securities
business interest bodies. Whilst the primary
focus of this article is related to deciencies
in the US Investment Advisers Act of 1940
(Advisers Act), securities laws and recent
FINRA guidelines on the Social Media
Regulatory Notice 11-39, the rules and regu-
lations themselves are similar to those found
in other nancial centres globally in relation
to limiting the usage of social media within
the securities industries.
Section 206(4)-1
In 1940, the US Congress passed the Advisers
Act, with the intent of eliminating abuse in
the securities industry that many believed
had contributed to the Great Crash of 1929
and the subsequent Great Depression. In the
wake of the 2008 crisis, this act was amended
by Title IV of the Dodd Frank Act to expand
registration requirements to hedge fund and
private fund advisers. However, Congress
left the Adviser Advertising Rule under sub-
section 206(4)-1 of the Advisers Act intact for
the SEC and FINRA to enforce and moni-
tor, an action which, in turn, served to limit
182
the use of social media by IAs. In essence,
subsection 206(4)-1 deems various online
advertising practices as fraudulent, decep-
tive or manipulative, effectively prohibiting
registered IAs from publishing, circulating or
distributing any advertisement directly or
indirectly to its clients without appropriate
approval.
Not t for purpose
Specically, this rule prohibits the use of
client testimonials, recommendations or
endorsements, as well as graphs, charts,
formulas or other devices used directly or
indirectly for securities offering, that do not
adhere to certain harsh criteria and disclo-
sure requirement standards.
What is clear is that in our digital era,
the existing Advisers Act statute is not only
outdated but also not t for purpose. So too,
in the current social media revolution, is its
application by FINRA under its Notice 11-39
guidelines on adviser advertising rules spe-
cically in relation to social media websites
and the use of personal devices used for
business communications.
Whilst numerous studies indicate con-
sumers globally are obsessed with social
media tools that have become the norm in
many cultures, the majority of IAs in the
US are unenthusiastic about using such
tools, largely due to antiquated advisory
statute rules and impractically weak FINRA
guidelines.
Missed opportunities
This is mainly due to the fact that IAs are
dependent on internal legal and compli-
ance departments for clearance to use and
promote business products and services. To
illustrate, Fidelity Investments Hadley Stern
sums up the present dilemma of IAs in the
US when he said recently that, without social
media your business will go elsewhere. He
went on to explain that the fastest growing
demographic on Facebook are women aged
55-65, a group that represents a large pro-
portion of the IA client-base.
Further, Hadley contends that presently
there is a large wealth transfer from the older
to the younger generation, a factor which
presents a huge opportunity for IAs to dem-
onstrate their attributes to potential new
clients and to connect with them online, spe-
cically on social media sites such as Twitter,
Facebook and Linkedin. He expresses his
frustration of social media IA enforcement
policies when he states that it takes ve
minutes to sign up for Facebook, but three
to four months to make a social media plan
that satises the requirements of legal and
compliance departments.
Fear factor
Clearly the actions of the SEC in its 2010
advisory request has had a detrimental
impact on IAs use of social media tools for
fear of breaching existing rules and regu-
lations. In short, in an era where social
media plays such a huge role in relationship
building and participatory culture, IAs are
unable to utilise social medias full potential
in their marketing strategies to service the
investment requirements of the younger
generation.
A survey conducted by Aite Group illus-
trates the strong dependency between social
media usage, the serving generation, rev-
enue potential and navigation of the practi-
calities of existing compliance requirements.
183
The survey also indicated that 48 per cent
of registered IAs are refraining from using
social media tools, preferring to lose revenue,
rather than adopt modern marketing tech-
niques riddled with potential compliance
issues.
Record keeping requirements
In another survey of 223 individuals with
compliance-related responsibilities at bro-
ker-dealers, registered IA rms and other
regulated rms, it was found that social
media imposes an array of challenges due
to the Advisers Act statutes built-in fear
factor. Further, within IA rms, usage con-
dence levels are at their lowest specically
when using mobile devices such as smart
phones and tablets versus traditional com-
pany-based e-mail systems.
The recent FINRA Notice 11-39 guide-
lines for using social media has created
further confusion among the IA user com-
munity. The president of Andree Media
& Consulting, Kristin Andree, stated that,
although FINRAs advice laid the ground-
work, the notice itself raised more questions
than it answered.
Ambiguous guidelines
Further, she explained that the notice failed
to provide any specic guidance, adding that
based on the key points broadly outlined
in the guidelines, namely, record keeping,
supervision, third-party posts, links and
websites, and personal devices, IA rms need
a clear operational strategy in implementing
social media policies and procedures.
In addition, the record keeping
requirement under FINRAs guidelines for
social media are considered as business
communication, and as such, IA rms are
required by law to keep these books and
records for a minimum of three years, result-
ing in increased costs for IA rms needing
to upgrade operational systems to acquire
social media tools to capture and retain such
communication.
Whilst FINRA guidelines reiterate that
IA rms must establish and maintain oper-
ating systems to supervise all social media
activities, it is noted that participation in
interactive electronic forums falls under the
denition of public appearance and there-
fore does not require prior approval. On
the other hand, static postings are deemed
advertisementsand therefore require prior
approval by a registered principal.
Unanswered questions
Supervision of interactive and static social
media activities and education of IA staff
therefore remains a daunting and time-
consuming compliance task. In terms of
third-party postings, links and websites, the
guidelines note that IA rms should not
entangle themselves with the content of
third-party websites and should rather rely
on emails and face-to-face communication,
creating further challenges for the busy IA
professional.
The use of personal devices is another
grey area, with guidelines permitting IAs to
use smart phones and tablets, provided the
member rms are able to retain, retrieve
and supervise business communications.
Despite the guidelines addressing ques-
tions raised by IAs, several pertinent ques-
tions remain unanswered. Chief among
these is what, if any, disclosure language
should be included on social-media proles?
184
Does, for example, a like on Facebook, a
comment left on a blog, or a LinkedIn rec-
ommendation constitute an endorsement?
These, and many more unanswered ques-
tions surely make the guidelines impractical
to enforce and impossible for IA businesses
to reap the benets of social media.
Court cases
Such lack of clarity has created a compliance
nightmare for IAs and an air of apprehen-
sion that regulators are monitoring and
scrutinising their online marketing strategy
an issue given further credence by the recent
Snowden revelations concerning the US
National Security Agency and government
sanctioned spying on all forms of digital
communication.
Given that the regulators social media
enforcement policies are farcical to say the
least, would the industry and regulators be
better served by the demotion of its force in
the securities industry?
In recent years, numerous court cases
based on social media usage have been con-
sidered around the globe. Broadly speak-
ing, social media court cases are mainly
categorised as defamation; civil action; and
employment related. That said, IA-specic
court cases are still in their infancy, mainly
due to the fear factorinvolved in the use of
social media across the industry.
Non-media defamation standard
The number of reported defamation cases
in which the subject is allegedly defamed on
blogs or on social media sites has dramati-
cally increased over the past few years. The
case of the Superior Court of the State of
Californias Simorangkir v. Courtney Love,
where the female musician and actress
agreed to pay US$430,000 plus interest as
part of a legal settlement to fashion designer
Dawn Simorangkir for posting defamatory
remarks on Twitter in March 2009 which
were said to have ruined Simorangkirs
reputation and business, became the rst
known lawsuit focusing on defamation via
the social media network.
In the rst amendment complaint by
Simorangkir, the court determined that
Loves case was actionable and recovery
should be granted based on defamation legal
standards, even for a non-media defendant
such as Simorangkir.
Class action lawsuits
In short, this case made it clear that IA busi-
nesses require clear legal guidelines and
training to meet this non-media defama-
tion standard if they are to avoid the fate of
Ms. Love, particularly given that it appears
that IAs are held to a higher standard due
to obligations of condentiality and poli-
cies relating to acting in the best interestof
their clients, particularly in light of the recent
nancial crisis, where the IA community
may be held accountable to higher standards
in a court of law.
Social media has also generated several
class action lawsuits as illustrated in the on-
going Swift v. Zynga et al. case, where plain-
tiff Rebecca Swift alleged that defendants
Zynga Game Network Inc. and Facebook,
Inc. utilised social networking sites such as
Facebook and MySpace to lure unsuspecting
consumers into signing up for services and
goods that they did not want or need.
In this class action case, the plaintiff
sought a nationwide class consisting of
185
individuals from fty states, with an aggre-
gate exceeding US$5 million dollars. If this
landmark case prevails to the plaintiff, social
media sites and their third-party providers
such as Zynga will be forced to meet the
legal standards set forth by the courts and
deploy further additional internal controls.
Practical regulatory challenges
With a lack of clear social media regula-
tory guidelines, it is apparent that IA rms
need to rely on such class action case laws
to meet legal standards when putting into
place additional rm-wide compliance con-
trols. Further, when it comes to employer-
employee relationships, social media has
generated additional practical regulatory
challenges for global organisations to abide
by.
As discussed in the case of NLRB v. AMR,
commonly known as the Facebook Firing,
the National Labor Relations Board (Board)
alleged that the American Medical Response
of Connecticut, Inc (AMR) maintained an
overly broad handbook policy regarding
blogging, internet posting and communica-
tions between employees, and had unlaw-
fully terminated an employee pursuant to
that policy after she had posted critical com-
ments about her supervisor and responded
to further comments from her co-workers.
Legal standard for free speech
In this case employee Dawnmarie Souza
was red for posting negative comments
about her boss on Facebook. AMR settled
with a no judge-ruled holding, saying it
would reinstate Ms. Souza and update its
social media policy, thereby setting the legal
standard that employees free speechrights
are limited, especially when it comes to mak-
ing comments about their employers, their
business, and other employees, both inside
and outside of the workplace. The case set
the precedence on the importance of having
clear social media policies and procedures in
place.
However, at the time of writing, IA
rms have a long way to go in terms of set-
ting social media policies and procedures
tailored to their business needs. With no
clarity around social media regulation and
guidelines, IA rms are grappling to nd a
common ground as to the AMR case and
the implementation of a robust social media
policy to mitigate against such instances.
Close monitoring
Heightened regulatory awareness that social
media websites such as Facebook, Twitter,
LinkedIn and blogs are increasingly being
used by IAs to connect with clients and
that use of these sites may present regula-
tory issues under the advertising rules of the
Advisers Act, is also a major concern to IAs
and regulators alike.
On the enforcement front, the recent
Jenny Quyen Ta case illustrates that the SEC
and FINRA are closely monitoring registered
IAs activities in social media. In this case
Jenny Quyen Ta (Ta) was using posts on
Twitter to pump up a stock failing to disclose
a conict of interest and evading the rms
posting approval procedure.
Ta consented to FINRA ndings with-
out admitting or denying them. As a result
she was ned US$10,000 and suspended
from association with any FINRA mem-
ber for a full year, adding further fuel to the
re regarding social media policy among IA
186
member rms. Clearly, the actions of a few
rogue registered IAs has diminished the true
potential of social media in the securities
market and induced fear amongst member
rms.
Poster child approach
To protect the online brand, many IA rms
have forbidden the use of social media sites,
with some having put into place non-robust
policies and procedures in order to maintain
their online presence.
In turn, trends show that the regulators
have taken a poster childapproach to this
revolution, with current FINRA guidelines
being limited to Q&A documents setting
forth particular facts and circumstances
which apply current FINRA regulations to
social media. SEC and FINRA enforcement
trends appear to be far removed from the
reality of the social media revolution.
The result is that innovative IAs are tak-
ing baby steps to evolve their social media
strategies to adapt their marketing strategies
to offer clients more online functionality.
Anything but a fad
Meanwhile, as the social media industry
attempts to spearhead this movement by
providing rich applications to support the
needs of the online generation, what is clear
is that regardless of whether the US chooses
to embrace the use of social media in the
multi-trillion dollar securities fully or not, the
rest of the world will continue to evolve in
this area.
Indeed, in a globally interconnected
world, social media has proven to be any-
thing but a fad. Congress needs to recognise
the global prominence of this revolution
and reconsider the policies against IA social
media activities. Until clear FINRA guide-
lines are fully developed, IA rms need to
consider putting into place internal compli-
ance and legal ofcials with the appropriate
authority to supervise, train and approve
all social media communications and static
public proles.
In addition to retaining real-time data
from social media according to the books
and records communication rules they
need to benchmark policies and procedures
against industry best practices, and to sepa-
rate and segregate personal and professional
social networks.
Further, IA rms should also have a clear
disclaimer to avoid entanglement by custom-
ers or other third party content. Alongside
maintaining clear and non-ambiguous
guidlines, all third party posting should be
screened for policy violation. IAs would also
benet from training in their use of personal
devices for business communication.
It is clearly in the member rms best
interest to monitor employees use of social
media, to actively maintain policies and
procedures, and to periodically review
and update these to meet with growing
demands and technological advances. With
adequate employee training, compliance
oversight and internal controls, social media
tools could be pivotal to IAs business value
creation using rich media applications.
Threats and weak guidelines should not
impede the IAs use of social media in this
era of information sharing and relationship
building. The social media world will no
doubt continue to grow through technology
advancement and the US securities industry
should be able to embrace its full potential.
187
China - legal & regulation China - legal & regulation
Has Chinas ascent been
mirrored on the legal front?
Michael Thomas of Wolters Kluwers Asia
places Chinese regulatory and legal reforms
under the lens of his astute microscope.
REGULATORS across the globe have
enacted a continuing succession of new
rules and regulations in an attempt to
help fnancial frms manage and reduce
risk in all sections of the fnancial mar-
kets. Starting from the technology bub-
ble of the late 1990s we can see how a
mixture of excessive enthusiasm about
market opportunities and fraud has
resulted in major shocks to the fnancial
system and to the global economy.
We have also seen how regulatory responses
have closed one door after another but left
many more unnoticed waiting for the next
nascent major nancial issue to emerge.
The globalisation of markets means that
all signicant economies must reach a high
level of trust and compliance for the global
economy to remain viable and stable. China
is now the worlds second largest economy
and so it must learn from the recent nancial
crisis and resulting recession in the West.
Many trace the roots of both all the way
back to the so-called dotcom boom of the
1990s. Driven by a new global phenomena,
the Internet, the boom opened up business
opportunities for companies to suddenly be
able to reach a potential world market of six
billion (now more than seven billion) people
with minimum investment in infrastructure.
In short, the Internet had revolutionised
business.
Milking the markets
However, the enthusiasm of dreams, the
aspirational hype of young, inexperienced
businesses and their managements, drove
stock prices to astronomical multiples, often
based upon miniscule, even zero, revenues.
But as more and more investment poured
into these companies, very few delivered on
their promises and good times had to come
to an end.
And so they did. As with other stock
market booms, the desire to make a fast
return drove people to make irrational
investments and for corrupt individuals
to milk the markets through fraudulent
accounting and reporting.
Enron, quickly followed by Worldcom,
were two of the biggest examples, with the
former destroying the reputation, and ulti-
mately the business, of global accountants
188
Arthur Anderson. The United States legis-
lative response to this nancial meltdown
was the introduction of the Sarbanes-Oxley
Act, which increased penalties for destroy-
ing, altering or fabricating records or for
attempting to defraud shareholders. The act
also increased the accountability of auditing
rms to remain unbiased and independent
of their clients.
International standards
The International Standards Accounting
Board (IASB) was established in 2001 with
fresh impetus caused by the technology bub-
ble and massive accounting frauds, to dene
quality and consistent accounting standards
that would allow investors to compare busi-
nesses operating across different interna-
tional boundaries on a like-for-like basis.
International Financial Reporting
Standards (IFRS), emerged in 2005, and with
continuing renements and revisions, have
been adopted by many countries as the basis
for the nancial reporting of all companies.
Whilst they cannot eliminate fraud and
misreporting, they do provide a solid basis
for comparison of company performance
and assist investors in their investment deci-
sions, which has historically been especially
difcult in international business.
Increased regulation
Of course this only applies to companies
operating in countries that have adopted the
IFRS or to any business that has unilater-
ally applied it. Only if all countries adopt a
consistent standard can full comparability be
achieved.
At the same time as Sarbanes-Oxley,
the tragic events of 9/11 caused a further
increase in regulation, with the rapid passing
of the USA Patriot Act, increasing the focus
on anti-money laundering (AML) controls.
The new rules added requirements to moni-
tor for potential signs of terrorist funding and
increased risks involved with the nancial
transactions of politically exposed persons.
This has steadily developed into a uni-
ed approach to tackling nancial crime as
a whole, bringing fraud, corruption, money-
laundering and terrorist funding under
increased scrutiny through the monitoring
of money ows driven through the Financial
Action Task Force (FATF), of which China is
a full member.
Meanwhile, the nancial markets have
been forced to comply with much more rig-
orous requirements to manage risk on their
balance sheets with the progressive intro-
duction of Basel I, II and III. However, even
these efforts have been found wanting.
Failure to predict
The implementation of Basel II failed to pre-
dict or prevent the nancial crisis of 2008, the
ramications and costs of which will remain
a drag on the global economy for many
more years to come. It is hoped the latest
revisions under Basel III will help prevent the
systemic collapse of the global markets and
that close management of liquidity risk will
lessen the chances of another major nan-
cial crisis moving forward.
So where is China in all of this? Financial
crimes, which consist of fraud, money laun-
dering and terrorist nancing, are not issues
limited to the West. It is in human nature
that some individuals will give in to such
temptations when the opportunities arise,
quite irrespective of nationality.
189
The risks increase as economies grow
more rapidly. The vast majority of people
grow their businesses honestly and continue
to respect others at all times, but a minority
will see the chance to seize an opportunity
to get rich quickly through some dishonest
means or by playing the system.
Market manipulation
The pressure of having an increasing num-
ber of peers becoming successful can lead
to jealousy and a rise in nancial criminality.
The lessons of how fraud has been commit-
ted in the West have been learned by crimi-
nals in the emerging economies of the BRIC
countries Brazil, Russia, India and China.
This can be seen with the downfall of a
number of Chinese companies. The invest-
ment world has welcomed many Chinese
companies to their global markets but has
seen some fail quickly as accounting fraud
and market manipulation has come to light.
According to an analysis by McKinsey,
the aggregate market capitalisation of
US-listed Chinese companies fell in 2011
and 2012 by 72 per cent and around one in
ve companies were delisted. After some of
the major Western frauds of the past, mar-
kets have become to be increasingly nerv-
ous of new market entrants and the losses
they have suffered from companies such as
Longtop and Rino International.
Obvious fraud
Accounting fraud, lax regulation and the use
of variable interest entities, a corporate struc-
ture previously used by Alibaba group, have
been behind many of the losses. The fraud
in many cases has been obvious, with inven-
tories and revenues being inated to achieve
high listing valuations and to attract investor
funds. A major issue though has come from
the lack of international trust in the quality
of information provided during the listing
processes.
Chinese laws forbid international audit
rms to release information from their audits
performed in China. In some cases the list-
ing exchanges in New York and now also in
Hong Kong have taken action against the
audit rms, but are prevented from send-
ing their own teams to China to perform
independent reviews, due to infringement of
sovereignty concerns.
Such impositions should not be nec-
essary if China can adopt international
accounting standards, such as IFRS and rel-
evant elements of Sarbanes-Oxley, and is
seen to rigorously investigate and prosecute
both auditors and business managements
responsible for committing fraud.
Inating gures
There are growing signs of future coop-
eration with US and Hong Kong authori-
ties and also the likely introduction of IFRS
accounting standards, with the Ministry
of Finance and China Banking Regulatory
Commission (CBRC) issuing a draft report-
ing taxonomy earlier this year based upon
the IFRS standards, although they have not
as yet issued a timeline for its introduction.
The case of China Metal Recycling, for
example, appears to be a clear case of fraud
from information provided by the Hong
Kong Securities & Futures Commission,
with the company accused of inating
nancial gures contained in its prospectus
with falsied transactions.
This is the twelfth mainland company
190
to be suspended and delisted by the Hong
Kong Securities and Futures Commission
since 2009 and further damages the reputa-
tion of Chinese companies seeking interna-
tional investment.
Turning to Nasdaq
Alibaba has encountered issues of its own,
but for very different reasons. It has now
withdrawn its plans for an IPO in the imme-
diate future to allow time for further dis-
cussions to be held with the Hong Kong
Securities and Futures Commission.
Alibaba wants to introduce two classes
of shares, a practice illegal under Chinese
mainland law, with the intention of retain-
ing control by the founders of the business
and limiting that of the directors and private
shareholders.
This practice is not uncommon in the US
and other international markets. If Alibaba
continues to be rebuffed by the Hong Kong
Securities and Futures Commission, it may
turn to Nasdaq in the US.
In 2011, Alibaba surprised its two major
international investors, Yahoo and Softbank,
when it spun its Alipay subsidiary out of a
Variable Interest Entity (VIE), set up speci-
cally to allow for international investments.
This removed the control and effective,
though not direct, ownership the foreign
companies believed they had over Alipay.
Ownership concerns
VIEs have been used by many Chinese
Internet-based companies as a means of
raising overseas investment without break-
ing Chinese law, which prohibits foreign
ownership of Chinese Internet companies
and some other categories of company that
have followed this same, or similar practice
of raising overseas fund.
However, the VIE companies only con-
trol their subsidiaries through contracts
between the companies and not through
legal ownership, and hence it was possible
for Alibaba group to cancel all contracts to
Alipay and remove it from the VIE altogether.
The dispute between the three rms
occurred because the foreign companies
claimed that they were not informed in
advance of these actions.
They later resolved the dispute but it
has undoubtedly raised ongoing concerns
over the management and ownership of
the entire Alibaba group and made foreign
securities exchanges more hesitant to man-
age the Alibaba listing.
Global standards in China?
Ironically, VIEs were created in response to
the practices used by Enron in its fraudu-
lent actions. However, their use by Chinese
companies is for different reasons and the
structures have been abused by some to
raise capital but then remove control and
value from those investors.
So how is China now progressing
in addressing its issues and implement-
ing global standards? And where must it
increase its focus in terms of doing so?
On the bank regulation front, and more
specically in relation to Basel III, China
is now leading the way in implementing
nancial controls across the nancial sector.
Provided the China Banking Regulatory
Commission continues to pressure all levels
of nancial institutions to fully implement
the requirements then China will be at the
leading edge of nancial regulation and
191
able to continue to open its markets to more
sophisticated trading instruments.
In terms of anti-money laundering, the
Peoples Bank of China is now introducing
global standards across all nancial rms to
control the placement and integration of the
proceeds of crime into the nancial system.
New rules
The new rules will be fully active from 2016
and should lead to much greater control
and opacity. Responsibility will lie with the
nancial rms to implement processes and
controls to ensure their compliance so the
regulators need to ensure that those are in
place and being rigorously applied. These
controls do not prevent fraud from occurring
but will make it more difcult for individu-
als and companies from abusing markets by
moving funds illicitly.
Turning to accounting standards,
Chinas Ministry of Finance and the China
Banking Regulatory Commission are mov-
ing towards the application of international
nancial reporting standards. This needs to
be enforced on all companies and not just
nancial rms. No timeline has been set;
this needs to be urgently addressed by the
Chinese authorities
The application of the standards does not
prevent fraud but it provides markets a valu-
able and consistent way to value businesses
from China that wish to list on international
markets, including Chinese exchanges as
they open to international investors.
Auditing provisions
This includes proper supervision and more
transparency of auditing of rms operating in
global markets through the implementation
of the auditing provisions of Sarbanes-Oxley
or similar laws.
Returning once more to VIEs, on this
front structures have been used as a means of
getting around China restrictions over own-
ership of businesses operating in sensitive
industries. However, they have left foreign
investors with heavy losses due to the non-
ownership of the underlying assets that they
are investing in. It does not benet investors
to continue with VIE structures at all.
China lawmakers need to review the
restriction of foreign ownership of some
business areas, such as internet companies
and training/educational businesses.
There is still potential to control and
limit such access to the most sensitive areas
of these broad denitions by using busi-
ness licenses to rene the controls with-
out prohibiting or complicating ownership
structures.
Need for foreign investment
Chinese companies need foreign investment
and it is best that China allows this more
broadly whilst it remains the Lion King of
growth on the global stage. To delay this to
when China emerges as a mature economy
with globally average growth will be too late.
In summary, China is making big strides
toward managing fraud and money laun-
dering activity, but in some respects is strug-
gling to implement adequate controls and
international business laws into its internal
structures.
Just as its growth outstrips almost all
other countries, it must catch up rapidly in
areas of law and supervision to enhance and
maintain the trust of the global investment
community.
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193
Central banking
Emerging political realities
expose central bank tradition
Notions of central bank neutrality becom-
ing unsustainable in the new reality argue
Philip Pilkington and Thomas Dwyer.
WE habitually think of the diffculties
faced by central banks in primarily eco-
nomic terms. However, recent develop-
ments themselves the culmination of
long-standing, even ancient, structural
problems in many of the worlds devel-
oped economies point to an increase in
challenges of a strictly political nature
to central banks. This is because central
banks, particularly in Europe, are increas-
ingly being expected to intervene in
political affairs, or are faced with issues
that have strong political origins or rami-
fcations. This, in turn, has the potential
to drastically affect the form and scope of
central bank duties and operations.
Cognisant readers will recognise the alleged
role of the European Central Bank (ECB)
in the European sovereign debt crisis in
the foregoing abstract. There were and
still are allegations that the ECB is essen-
tially a bloated and enlarged version of the
Bundesbank and as such, looks after par-
ticular German economic interests rather
than general European economic growth
(Mitchell 2014).
Additionally, it is frequently alleged that
the ECB functions as an institution that
serves as a monetary surrogate for German
political aspirations (Millman 2011). While
the Eurozone crisis is a complex situation
that cannot be boiled down to simple des-
ignations of villainy, it should be noted that
the ECB has a particular political imprint that
extends beyond its economic remit and that
this imprint is the result of the recent history
of the institution.
The axiomatic duty
This is also increasingly characteristic of the
experience of central banks elsewhere. In
short, central banks face increasing purely
political pressures from a variety of actors.
Yet this is not surprising. Central banks
are, after all, public institutions famously
dened by the Federal Reserve as independ-
ent within the government, rather than
independent of the government(Federal
Reserve 2013).
But central banks have always aspired
to preserve an independent and neutral role
divorced from matters of state and party
politics. This has become an axiomatic duty
194
of central banks and even though practise
often departs from theory, it should never-
theless be noted that this separation of scal
and monetary powers is carefully guarded.
This neutrality is being jeopardised, however,
by partisan attacks within the United States
and by political developments, combined
with sluggish economic growth in Europe.
Blurring of boundaries
This stems from, among other things, the
tensions inherent between the obligation
to perform their function independent from
political interference and the ongoing eco-
nomic problems created by the economic
recession of 2008. However, there are other
problems that have increasingly caused a
blurring of boundaries between central bank
independence and political preoccupations.
We wish to focus on one particular
phenomenon among many that is increas-
ingly drawing central banks into political
debates. One effect of this has been on the
thoroughly analysed, but still imperfectly
understood, impact on economies classed as
peripheral.
Peripheral nationalism
These are considered to be the derogatively
labelled PIIGS namely, Portugal, Ireland,
Italy, Greece and Spain. We shall cursorily
analyse the political instability engendered
in these, but our main focus will be on the
economic crisis and the ECBs transnational
central banking which have given rise to
other problems of a peripheralnature.
Foremost among these is the increase
in so-called peripheral nationalismin the
established states of Western Europe. This
label is not intended pejoratively but is
comprehended as meaning cultural or lin-
guistic ethnic groups in long-established
states that do not currently enjoy a separate
sovereign existence.
These movements which are increas-
ingly gaining support among their respective
populations not only threaten the dissolu-
tion of previously cohesive states, but hold
out interesting possibilities for the future of
central banking.
Tied up with the same dynamic is the rise
of left-wing parties within these countries
that are increasingly Eurosceptic. While eth-
nic nationalist parties tend to appeal to vot-
ers on the basis of ethnic sovereignty, these
new left-wing parties increasingly appeal to
voterssense of economic sovereignty.
Global phenomena
These dynamics are not conned to Western
Europe and can also be seen in the blend-
ing of ethnic and economic nationalism in
places like Scotland and Quebec. Separatist
nationalisms have now become an estab-
lished feature of political life in most Western
European states.
While separatist, regionalist and nation-
alist parties are the rule rather than the
exception, in most states the world over in
specic countries their popularity and prole
are far more prominent. Foremost among
these are Belgium, Spain, Canada and the
UK states that represent the twenty-fth,
thirteenth, eleventh and sixth-largest econo-
mies in the world respectively.
The peripheral nations in question are,
of course, Scotland in the UK, Quebec in
Canada, Flanders in Belgium and Catalonia
in Spain. This rise in popularity of politi-
cal parties espousing separatist sentiment
195
should not be underestimated. In Belgium,
the Vlaams Belang and the Nieuw-Vlaamse
Alliantie attained 7.8 per cent and 17.4 per
cent of the popular vote respectively in
the 2010 Belgian elections. Furthermore,
so acute have Flemish-Walloon tensions
become in Belgium that there was a dead-
lock between 2007 and 2011 over the forma-
tion of a federal Belgian government.
Spain and Scotland
In Spain, Arthur Mas, the leader of
the Catalonian nationalist movement
Convergncia i Uni and who is also the
current President of Catalonia announced
his intention to hold a referendum on
Catalonian independence. This has been
greeted with characteristic hostility from the
Spanish government, with one army ofcer
even alluding to the possibility of military
force being used to protect the Spanish
constitution.
In the UK, a majority government was
formed by the Scottish National Party (SNP)
after the elections for the Scottish Parliament
in 2011. This has prompted the SNP to pro-
pose a plebiscite on Scottish independence,
effectively dissolving the Act of Union of
1707. In a concordat with the Westminster
government known as the Edinburgh
Agreement such a plebiscite will be held
in September 2014.
Canadian woes
Lastly, Francophone Quebec has long
chafed within a majority Anglophone
Canada. Referenda on Quebecois sover-
eignty were held in 1980 and 1995. While
the Parti Quebecois government formed in
Quebec in 2012 was defeated in the April
2014 elections, parties that espouse inde-
pendence or increased autonomy accounted
for 56 per cent of the popular vote.
From the perspective of central bank-
ing these movements are divisible into two
camps. In the rst, the ECB and the EU have
created the conditions - through the estab-
lishment of a very large trade bloc, a currency
union and a transnational central bank - for
independence in these peripheral nations to
be economically viable.
The second group is more interest-
ing for our purposes. This group, like the
rst, are subject to the jurisdictional super-
vision of long-established central banks,
with Scotland being subject to the Bank of
England and Quebec to the Bank of Canada.
What is absent in their cases is membership
of a transnational banking union of the type
pertaining to Catalonia/Spain and Flanders/
Belgium.
Transnational banking unions
More interesting still, the plans for independ-
ence of both the SNP and the PQ propose
the creation of such transnational banking
unions in their respective jurisdictions after
secession. That is, independent Quebec will
use the Canadian dollar and have a seat on
the board of the Bank of Canada. Similarly,
the SNPs manifesto for independent
Scotland proposes to keep the pound ster-
ling and have a seat on the Monetary Policy
Committee of the Bank of England.
Like the examples of Catalonia/Spain
and Flanders/Belgium, the existence of
large trade-blocs has diluted the incentives
for Scots and Quebecois to cleave to their
respective states. In the case of Scotland this
is, again, the European common market.
196
In the case of Quebec, the North American
Free Trade Agreement has diminished the
economic rationale to remain within a
majority Anglophone Canadian state.
Economic nationalisms
The proposals of both representative par-
ties are best understood as aspiring toward
attaining optimal economic performance
through increased domestic sovereignty
combined with the membership of exter-
nal structures that can increase growth and
social provision for these nationalities.
Their primary concerns are gaining scal
sovereignty, access to markets and most
importantly for our purposes creating or
retaining transnational currency unions in
which control of monetary policy remains
with central banks located in separate
jurisdictions and subject to all the political
pressures and control exercisable by the gov-
ernments of these areas.
First, it might be worthwhile looking
at how transnational central banks (in this
case the ECB) have facilitated the growth of
peripheral nationalism. While doing so we
will also point out how ECB policies cannot
be seen as truly political neutral and have
given rise to what we have termed eco-
nomic nationalisms.
Genesis of the ECB
Then we will look at how peripheral nation-
alist groups that are not currently subject
to such transnational central banks have
embraced it as a potential enabler of their
post-secession economic plans. Lastly, we
will explore the potential effect this might
have on the traditional form and functions of
central banks in the future, particularly as it
promises to entangle these purportedly neu-
tral and technocratic institutions in political
or even geopolitical problems of the rst
order.
The European Central Bank (ECB) was
established in 1998 and obtained its full
powers as central bank of the Eurozone
when the euro came into existence in 1999,
Since its establishment, the ECB has insisted
that it is, like other central banks, an inde-
pendent entity. The full extent of what such
independence means is laid out in Article
127(1) of the Treaty on the functioning of the
European Union (TFEU).
Primacy of price stability
The Treaty states that: the primary objective
of the European System of Central Banks
(hereinafter referred to as the ESCB) shall
be to maintain price stability. Without preju-
dice to the objective of price stability, the
ESCB shall support the general economic
policies in the Union with a view to con-
tributing to the achievement of the objec-
tives of the Union as laid down in Article 3
of the Treaty on European Union. The ESCB
shall act in accordance with the principle of
an open market economy with free com-
petition, favouring an efcient allocation of
resources, and in compliance with the prin-
ciples set out in Article 119.
The two main characteristics of inde-
pendence are thus: (i) a focus on maintaining
price stability; and (ii) acting in accordance
within a framework of an open market
economy with free competition which pro-
motes the efcient allocation of resources.
As we can see, even in this early formula-
tion the denition of independenceis open
to extensive interpretation. Interpreting this
197
article, for example, the ECB could use a host
of tools to maintain its primary goal of price
stability. Tied to this denition of independ-
ence, however, is another provision in the
TFEU that disallowed the ECB from directly
funding sovereign governments in the
Eurozone through direct bond purchases.
Article 123(1)
This is laid out in Article 123(1) which,
though somewhat dense, is worth quoting
at length: Overdraft facilities or any other
type of credit facility with the European
Central Bank or with the central banks of
the Member States (hereinafter referred
to as national central banks) in favour of
Union institutions, bodies, ofces or agen-
cies, central governments, regional, local or
other public authorities, other bodies gov-
erned by public law, or public undertakings
of Member States shall be prohibited, as
shall the purchase directly from them by the
European Central Bank or national central
banks of debt instruments.
This adds a third key component to the
ECBs claim to independence: namely, that
it is not allowed to come to the assistance
of Eurozone countries that are experiencing
problems with their sovereign debt burden.
Crisis catalyst
This, of course, has been the main catalyst
for the Eurozone crisis that played out after
2008. While central banks in countries like
Japan, the US and the UK were standing
by to purchase the sovereign debt of their
nation-states in potentially unlimited quan-
tities, the ECB was not similarly mandated to
do so.
Many economists noted very early on
that this meant if there was a macroeco-
nomic shock of a substantial enough magni-
tude and government scal decits grew to
a large enough level this would precipitate a
sovereign debt crisis.
In 1992, for example, the British econo-
mist Wynne Godley wrote that the design
of the ECB and other European institutions
was based on the view one which, as we
have seen, is contained in Article 127(1) of
the TFEU that economies are self-righting
organisms which never under any circum-
stances need management at all, and that
following from this general principle all that
can legitimately be done is to control the
money supply and balance the budget.
Dangerously mistaken
This view, of course, proved dangerously
mistaken in light of what happened in 2008.
The key problem that Godley noted was
that when faced with such a scenario there
is every chance that individual nation-states
might sooner or later exercise their sover-
eign right to declare the entire movement
towards integration a disaster (Godley
1992).
What economists like Godley were hint-
ing at is that the dominant view of inde-
pendence within the ECB and formalised in
the TFEU might not actually be as neutral as
its proponents had thought.
Because these views contained within
them implicit assumptions about how the
macroeconomy functions and what tools
are required for maintaining stability if these
views were proved wrong, they could give
rise to macroeconomic dynamics that not
only destabilised the economies of many
countries, but also their political structures.
198
The ECB has come to recognise this and
in doing so has invoked its mandate for price
stability in order to override its inability to
purchase sovereign debt.
No contradiction!
ECB ofcials have effectively argued that the
two mandates are in contradiction with one
another because a nation in depression with
rising interest rates on its government bonds
will be at risk of substantial deation. Thus
the ECB must be in a position to stabilise
such a nations nances in order to allow it
to avoid deationary collapse.
Unfortunately, the ECB has not yet been
able to ofcially recognise that even with
stable interest rates, if a country is engaged
in austerity, it will likely exacerbate deation-
ary pressures (Coeur 2013). By tying the
purchase of sovereign debt deemed Open
Market Transactions (OMT) to austerity
measures the ECB has not been able to ade-
quately contain deationary pressures.
In the face of this, many countries in the
Eurozone have faced substantial political
upheaval. Previously marginalised far-left
parties have risen to national prominence,
with Syriza becoming one of the most
popular political parties in Greece, and Sinn
Fin effectively replacing the Labour Party in
Ireland.
Dubious nationalistic claims
Peripheral nationalist groups have used the
economic environment created by austerity
measures to further their causes. Catalonian
nationalists have been quick to seize on the
poor economic conditions in Spain to blame
the mainstream political parties.
These nationalist groups make dubious
claims that Catalonia is the richest region
in Spain and were it an independent state
it would not be suffering economically
because the Catalans would have managed
public nances properly.
Flemish nationalists too have reacted to
the poor economic climate. Dominant fac-
tions within this movement have used the
crisis as a means to attack what they see as
collectivist tendencies in the EU. Something
similar can be seen in Finland too, with the
True Finns party gaining major shares of
the electorate by blaming the current crisis
on dysfunctional collectivistEU structures.
These latter movements blame the crisis
on the European project and they view the
ECB as facilitating bailouts that redistribute
income from rich countries to poor.
Mistaken ideology
What we are seeing today is that the ECBs
mandate for independence is based on eco-
nomic ideologies and theories which serve
to promote rather than alleviate macroeco-
nomic instability. This instability then leads
to political fractures in various countries.
Sometimes these fractures are impelled
by a rejection of the ECBs vision, such as in
Ireland and Greece, while on occasion they
are impelled by domestic nationalist groups
using the crisis to further their political goals.
Despite the dissimilarities, what these ten-
dencies have in common is that they reject
the structure of the Eurozone as being
dysfunctional.
The left-wing economic nationalists
have identied the ECB as having a right-
wing agenda that serves to impoverish
peripheral states, while the generally right-
wing ethnic nationalists have identied the
199
EU project with a left-wing collectivist vision
and the bailouts presided over by the ECB
as part of a scheme to redistribute income
from the rich countries to the poor countries
within the Eurozone.
Fallacy of hands off
Thus the ECB vision, while aiming at neu-
trality, has actually created an economic situ-
ation in which peripheral groups can further
their own power base by criticising domi-
nant institutions.
Far be it from having effectively taken a
hands-offapproach to European politics,
the ECBs independence mandate has actu-
ally given rise to an objective situation in
which the rules that the ECB is laying down
for various member countries are actually
serving to ignite political tensions within
those countries.
In countries in which austerity is being
undertaken this policy has not been viewed
as neutral at all by the new economic nation-
alists. Rather it is seen as being highly politi-
cised and part of an overarching right-wing
vision for Europe.
Independence undermined
Similarly in countries where factional groups
have sought to blame the peripheral regions
for the problems within the Eurozone, the
ECBs bond purchases and bailout programs
are viewed as being highly politicised and
part of an overarching left-wing program
to redistribute resources from the wealthier
areas of Europe to the poorer areas of Europe.
The ECB is thus in a very difcult posi-
tion where in trying to take a neutral posi-
tion it is nding its role increasingly viewed
by both sides of the political divide as being
part of an overarching political project. In
the coming years, as austerity and bond pur-
chases roll on we can only expect that these
views will metastasize further and become
ever more dominant within the political dis-
courses of the European nation-states. From
this point-of-view it will be extraordinarily
difcult for the ECB to continue to maintain
its perceived status as an independent entity.
In summary we can say that the pursuit
of these policies by the ECB that purported
to be neutral have had the objective effect of
being politically disruptive in terms of politi-
cal challenges to established parties within
the extant nation-states that belong to the
Eurozone. They are also, as we have seen,
disruptive to multi-national states with exist-
ing ethno-cultural frictions.
Unintended consequences
One unintended consequence of the ECBs
political engagement is to inadvertently cre-
ate conditions in which peripheral nation-
alism can ourish. There is resentment at
interference in peripheral economies which
are believed to be detrimental to the opti-
mum performance of these economies.
The fact that central governments in
these states are the ultimate enforcers for
unpopular restructuring and rebalancing
efforts has had the result of alienating poten-
tial peripheral nations from the centre. This
is most apparent in the Spanish/Catalonian
case and, to a lesser extent, in the Flemish/
Belgian case. In the latter case the dysfunc-
tion is sought at the more abstract level of
the European political project itself.
Similarly, the existence of the European
Union as a trade-bloc has drastically dimin-
ished the incentives for national entities like
200
Scotland to remain in the existing politi-
cal union represented by the UK. Indeed,
Scotland affords an interesting example
of both the potential for muscular trans-
national central banking and the fact
that central banks are nding themselves
increasingly engaged in situations of serious
political import.
Problamatic nature
The UK is the largest economy to face this
peripheral nationalist problem as well as
being one of the worlds major nancial
centres and is along with Canada one of
the G8 states. Interestingly, one of the main
planks of the SNPs plans for independent
Scotland is to retain the pound sterling.
The reasons for this are both economic
and political. Electorates are wary of dra-
matic upheavals in familiar economic and
monetary totems not least their perceived
effect on wages and pensions.
As Pauline Marois, the former leader of
the PQ (whose post-independence plans
contain similar provisions) acknowledged,
such alterations invariably sparks wide-
spread panic among people. Scotland
should serve as an adequate instance of both
the appeal of transnational central banking
and the problematic nature of this appeal for
central banks.
Constitutional conundrum
The current debate on Scottish independ-
ence, though far from quiet, has gotten
louder as the nal nine months before the
referendum date of 18th September 2014
approach.
This constitutional conundrum is better
understood as the untimely coincidence of
two specic contexts that combine to pro-
mote already latent ssiparous tendencies,
rather than being solely a British issue. These
two contexts are the European context and
the economic context the convergence of
which has created the conditions for previ-
ously content historic nations to attempt the
separatist plunge.
Essentially, this originates in the com-
bination of economic ideology and political
reality that has prevailed in Europe since the
nancial crisis of 2008 that is, as we said
earlier, the convergence between economic
and ethnic nationalisms.
Regarding this political reality, the most
obvious contributing factor is the almost
Byzantine levels of continental, national,
regional and local government that has
become Europes political structure over the
past half-century.
Transmogrication
From once unied nation-states, with strong
local and civic government, Europe has
transmogried into a trade-bloc, an incom-
plete monetary union and a patch-work
political entity. This state of affairs mirrors
the haphazard and disjointed evolution of
Europe over the past half-century.
With free movements of labour, capital
and limited currency controls in a unied
trade-bloc under the Schengen Accord, there
is little motivation for peripheral regions to
remain within the previous nation-state
unions they joined centuries before.
The deleterious economic context refers
to the current ideological quagmire in
the Euro and Sterling zones that endorse
short-sighted austerity programmes. This
adherence is grounded in vaguely-dened
201
economic theory, but generally couched
in terms of immediate personal morality;
state budgets are directly (and erroneously)
approximated to household or personal
budgets.
Inuence of Carney speech
This has the understandable effect of scar-
ing people but also promotes separatism
in peripheries with strong social democratic
tendencies. Scotland is one such periphery.
While the Eurozone crisis has forced the
SNP to reconsider its previous commitment
to joining the Euro, it has instead proposed
an alternate monetary union with the Bank
of England acting as a transnational central
bank.
How this has involved this particular
central bank in political controversy was
illustrated by Mark Carneys speech in late
January 2014 outlining the difculties this
might create.
Carneys talk, entitled The Economics of
Currency Unions given the time, timing,
place and audience was intended to be a
technocratic assessment of the pros and
cons of the proposed currency union that is
integral to the SNPs plans for an independ-
ent Scotland. Rarely has a lunch lecture
to business dignitaries on such a topic set
pulses racing.
Disasterous intervention?
Yet the world of media, punditry and the
commentariat couldnt help noticing the
topicality of what was viewed as techno-
cratic intervention in a matter of primar-
ily political concern. Most of the coverage
presented this as a disastrous intervention
that boded ill for the Scottish nationalist
road-map. More measured analysts painted
Carneys approach as a calculated effort to
remain above the fray. But what precisely
did Carney state?
Very few pundits have attempted to
paint this as a positive endorsement of post-
independent Scotlands monetary structures.
Most have, instead, narrowed in on Carneys
concluding remarks that a durable, success-
ful currency union requires some ceding of
national sovereignty. Carneys conclusion
had unavoidably politicalramications and
was widely recognised as such.
Carney is generally viewed by the press
as a rather conservative central banker and
was undoubtedly viewed by the British gov-
ernment that appointed him as a proverbial
safe pair of hands. When this fact trans-
lates into his position on any given policy, it
is typical to conclude that his stance would
be antipathetic to drastic alterations in the
political or economic structures of the UK.
Pros and cons
It is therefore unsurprising that news outlets
concluded that this was a pounding(as
The Sun newspaper, in a front-page splash,
reported) of pro-independence aspirations.
If this is an operating assumption and it
is understandable to suppose so then it
might be worth applying this presumption
of Carneys conservatism to the structure
and statements of his Edinburgh luncheon.
Firstly, the speech was structured in
particular way. Roughly, it was a speech of
two parts that was clearer in its intentions
in the rst part and slightly vaguer in the
second. After some brief attery addressed
to his Scottish audience - Adam Smith and
David Hume were mentioned - Carney
202
commenced with a brief description of the
benets of currency union. Low transaction
costs, mitigation of foreign exchange risk,
access to liquidity, the maintenance of liq-
uid markets, reduced borrowing costs (both
personal and sovereign), increased trade
and easier mobility for labour and capital
were adumbrated. This was followed by the
drawbacks of currency union in relation to
independent monetary policy.
Reservations
The second half of the speech was more
interesting, prominently featuring terms
like credibility, prudence and stability.
There Carney indicated that a successful cur-
rency union would have to maintain a cen-
tral bank (the Bank of England) as a lender of
the last resort, a shared supervisory structure
(the Prudential Regulatory Authority and the
Financial Conduct Authority) and a com-
mon nancial deposit guarantee and com-
pensation structure (the Financial Services
Compensation Scheme).
It is worth noting that this does not
depart from SNP plans for independence
these will all be maintained, with only a
Financial Ombudsman Servicebecoming
part of a super, all-inclusive consumer dis-
pute resolution service in Scotland. So, this
banking unionis uncontroversial it exists
now and would continue to exist if the SNP
had their way.
Eurozone lessons
But Carneys next point best illustrates
the reservations of the Bank of England
regarding transnational central banking.
The lessons Mr. Carney attained from the
Eurozone crisis seem rmly derived from
the peripheral irresponsibility school of
thought. There is not room here to point out
how awed this argument is, but applied to
this debate, Carney indicated that scal poli-
cies in an independent Scotland would have
to be limited and monitored from London
in case a departure from prudent behav-
iourcaused contagion in the wider currency
zone.
Furthermore, an argument based on
moral hazard was put forward. Put bluntly,
Carney stated that a currency union would
incentivise reckless spending by smaller
countries with weaker economies because
they were aware that they would be bailed
out by the stronger country that had run
their nances prudently in the rst place.
Tight scal rules
That is, that they would engage in reckless
spending because the safety of the wider
currency union would be jeopardised if they
were not bailed out from the effects of their
spending. Carney derived from this conclu-
sion that a need for tight scal ruleswould
be needed namely, the control of national
budgets that would render the intended
results of Scottish independence negligible.
Obviously, this invokes an ingrained idea
of Scottish public-spending proclivity that
is gaining increasing purchase in England.
Carneys essential argument is that currency
union (without tight scal rules) would
cause an independent Scottish government
to spend too much due to their awareness
that the UK would bail them outeventually.
However, governments or states rarely
behave like this despite frequent assertions
in popular and academic media to the con-
trary. Most bailouts occur due to unforeseen
203
systemic shocks or market shifts that reduce
revenue, cause bank-runs and thereby
increase bond-yields. They very rarely occur
because a government consciously over-
spends due to the mercenary calculation
that they will be bailed-out. Of course, this
is meat for many opposed to Scottish inde-
pendence. Yet there is something incredibly
heartening about Carneys intervention.
No currency union
Firstly, it was innitely more measured than
many other interventions. Carney doesnt
seem to have any personal emotional invest-
ment in Scottish independence and was
attempting to edge debate toward consider-
ing a separate currency altogether. Carney
may also have been attempting a qualied
endorsement of a currency union with
the tacit caveat that it would be difcult to
operate.
But it also indicates an increasing incli-
nation of central bankers to intervene in
political affairs even if the intervention is
designed to ward off the possibility of further
entanglement in political affairs that would
be engendered by a period of transnational
central banking. The effects were immediate.
In the aftermath of the Governors inter-
vention, all the major political parties in the
UK endorsed his ndings and coalesced to
detail that they refuse a currency union in the
event of Scottish independence.
Fantasy from the past
Mark Carney may have gone to Edinburgh
intending to scupper the economic vision of
the Scottish nationalists that of a transna-
tional Central Bank in the British Isles. That
he did contribute to this is heartening. As
he pointed out, a limited array of modied
nancial instruments and decent policies
could, and should, be able to overcome the
stiing limitations placed on Scottish eco-
nomic policy before and after independence.
But by choosing the lesser of two politi-
cal evils Carney risks refusing to engage in a
process that will progress whether the Bank
of Englands advice is heeded or not. In
other words, this refusal to engage might not
even be a choice any more.
Even though Carney attempted to take
a light touch to the question of Scottish
nationalism, the political parties and the
press leapt on his comments. This just goes
to show how in the world that is emerging
after 2008, central bank independence may
well be a fantasy from a now distant past.
The reality
Many central banks are the offspring of poli-
tics and political upheaval. Most famously,
the Bank of England was created in 1694
for William IIIs England to ght effectively
in the Nine Years War. Using the credit that
the Bank provided, the way was paved for
the Act of Unions of 1706 and 1707 which
allowed England and Scotland to join
together in order to become a powerful and
expansionary state that cornered imperial
markets.
In recent times, however, central banks
have come to be viewed as independent
institutions. In 1998, the Bank of England,
for example, tried to leave the past behind
and moved to become an independent
entity. The movement toward this view has
a political history all of its own.
Philip Mirowskis forthcoming work,
for example, seeks to show how the Nobel
204
Prize in Economics itself was the product of a
political struggle within Sweden in the 1960s
over whether the central bank of Sweden,
the Sveriges Riksbank, should or should not
be independent of the Swedish government
(Mirowski 2011). Today, however, this illu-
sion may be in the process of being shattered.
Back to the future
With the rise of peripheral nationalisms in
Quebec, Scotland and across Europe, central
banks simply cannot turn a blind eye to the
fact that their actions indeed, even their
very existence are highly politicised.
The very existence of the ECB, for exam-
ple, has led many regional nationalisms to
propose economic alternatives. At the same
time its austerity policies have led to a politi-
cisation of the discourse surrounding both its
existence and its mandate.
The Bank of England, in a rather ironic
reversal of its role in the run-up to the 1707
Act of Union, has also been forced to weigh
in on the issue of whether Scotland would
be allowed to use sterling if it secedes from
the union and establishes independence.
Whats more, if central banks continue
to maintain that they are independent enti-
ties existing on a plane of existence outside
of political struggles they risk being circum-
vented entirely. Indeed, proposals already
exist that would allow nation-states within
Europe to circumvent the ECB in maintain-
ing their access to the bond markets while
continuing to use the euro (Pilkington 2014).
Hobbled central bank
If political parties that view the ECB as hav-
ing taken an expressly political line such
as Sinn Fin in Ireland or Syriza in Greece
ever rise to power they may decide to take
actions that could greatly diminish the ECBs
role in these respective countries. What may
emerge out of such a scenario is a hobbled
central bank that has been superseded by
policy measures implemented at a national
level. So, how then should we view the
future of central banking if it is to remain as
valid an institution as it is today?
First and foremost those working within
these institutions need to start to recognise
that the very existence of these institutions is
inherently political and the actions that they
undertake especially in the face of ques-
tions of nationalism are a key component
of the political history that is being written
today.
Whether or not economic policy can
be determined in a wholly scientic man-
ner and the nancial crisis has certainly
called that proposition into question the
existence of peripheral nationalisms means
that central banks cannot make policy in a
vacuum.
Moving forward
And even if the ECB and the Bank of
Englands policies can be justied with an
appeal to economic science, the very fact
that they are being interpreted politically by
all and sundry means that they are already,
wittingly or unwittingly, seeping into the
politics of the day.
If those working within central banks
can come to appreciate that they are part
of an inherently political institution of great
importance we can then begin to have a
debate over what policies are best pursued.
This does not mean that discourse within
central banks must necessarily descend into
205
unproductive, factionalised political inght-
ing; central banks can continue to try to
make policy with reference to the overall
prosperity over those they govern. However,
if they try to have these debates without ref-
erence to the existing political situations of
the day it seems doubtful that they will be
able to meaningfully carry out this goal.
Political awareness
When those working in central banks simply
ignore, for example, the effect their actions
are having on the political discourses in the
countries over which they govern, they are
quite literally walking blind into an alto-
gether dark future.
If they continue to pursue this politically
appealing strategy they may well quickly
nd themselves in a very difcult position
when events take a turn outside of their con-
trol. It is far better that they should instead
open their eyes to the political realities and
confront them directly and out in the open.
By engaging directly with the politi-
cal issues, those working in central banks
can ensure that critical parties do not get to
entirely set the terms of the debate. Thus it is
in the interest of rational political debate that
central banks should tackle these questions
head on. This is illustrated most typically in
the rise of peripheral nationalisms.
More assertiveness
Thus, regardless of their traditional circum-
spection, central bankers might be forced
to become increasingly involved in matters
of a purely political nature. This might not
be through a determination to resolve eco-
nomic matters such as ination, low growth
or perpetually stagnant economies.
Rather, it might be because political
structures might alter independently of their
actions and force them to come to terms with
circumstances that involve advice to sover-
eign governments to which they maintain
primary loyalty. The alternative is to control
the economic destiny of post-secessionist
states whose monetary policy they control
through no choice of their own.
Or it may be because political structures
have reacted endogenously, as the econ-
omists say to the supposedly neutral policy
mandates of the central bank, as we have
seen extensively in the case of Europe.
Either way, it seems highly likely that
the current situation could give rise to more
assertive central banks. Rather ironically,
in giving up the pretence to independence,
central bankers may usher in a new era of
muscular central banking.
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Editors note: The publisher and editor
would like to thank Mr. Philip Pilkington, the
Journals recently appointed research head
and associate UK editor (captioned photo),
together with Dr. Thomas Dwyer, a recent
postgraduate researcher from Londons
Kings College, for agreeing at short notice
to draft a paper pertinent to the ensuing
debate surrounding Scottish independence,
monetary union with the rump-UK and
central banking politicisation. We remind
readers that copyright for this article is
shared between the Journal and above men-
tioned two authors, but welcome requests
to reproduce this article and quote from it at
length, be this online or in print.
Call for papers
Contact:
Christopher Rogers
Editor-in-Chief
33
Opinion
Deregulation, non-regulation
and desupervision
Professor William Black examines the causes of the mortgage fraud epidemic that
has swept the United States.
THE author of this paper is a leading academic, lawyer and former banking regulator specialising in white collar crime. As one of the unsung heroes of the Savings & Loans debacle of the 1980s, Professor Black nowadays spends much of his time researching why fnancial markets have a tendency to become dysfunctional. Renowned for his theory on control fraud, Prof. Black lectures at the University of Missouri and Kansas City. He is the author of The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry. A prominent commentator on the causes of the current fnancial crisis, Prof. Black is a vocal critic of the way the US government has handled the banking crisis and rewarded institutions that have clearly failed in their fduciary duties to investors.
The following commentary does not necessarily represent the view of the Journal of Regulation and Risk North Asia.
The new numbers on criminal refer- rals for mortgage fraud in the US are just in
and they implicitly demonstrate three critical failures of regulation and a wholesale failure of private market discipline of fraud and other forms of credit risk. The Financial Crimes Enforcement Network (FinCEN) released a study this week on Suspicious Activity Reports (SARs) that federally regulated nancial institutions (sometimes) le with the Federal Bureau of Investigation (FBI) when they nd evidence of mortgage fraud.
Epidemic warning
The FBI began warning of an epidemic of mortgage fraud in their congressional testimony in September 2004 over ve years ago. It also warned that if the epidemic were not dealt with it would cause a nancial crisis. Nothing remotely adequate was done to respond to the epidemic by regulators, law enforcement, or private sector market discipline. Instead, the epidemic produced and hyper-inated a bubble in US housing prices that produced a crisis so severe that it nearly caused the collapse of the global nancial system and led to unprecedented bailouts of many of the worlds largest banks.
147
Legal & Compliance
parties.
any person.
163
Risk management
into account.
NORTH ASIA
135
Compliance
Global nancial change impacts
compliance and risk
EastNets head of products management
compliance, David Dekker, details a potent
chemical reaction in nancial markets.
ABOUT a year ago we saw the frst signs
of a transformation in the fnancial world
and in the last months the credit crisis
has transformed the fnancial world at
an explosive pace. The change that is
occurring is much broader in scope than
originally expected. Banks that were
considered to be too big to fail or fall
are either failing or being taken over by
fnancial institutions that are more fnan-
cially sound, resulting in a huge para-
digm shift in how banks are regarded by
the public and other banks.
Since banking largely revolves around
trust and the ability to service customers, los-
ing a customer and determining the impact
of it, should be part of the ongoing risk
management of the organisation, as well as
monitoring the riskiness of existing and new
products and the customers using/buying
these products. But there are more changes
and challenges in the banking world that are
threatening banking as we have known it.
The banks will, in the future, not be the
default vehicles by which to move our funds,
maintain our balances and portfolios; they
will just be one of companies amongst oth-
ers that will be able to offer these services.
These days we should rather speak about
nancial institutions than banks, or moni-
tored nancial service providers, a name that
covers their current and future activities.
Look at how rapidly we have moved
from physical interaction on the banks
terms (location and hours of operation) to
electronic payments then Internet banking.
Again the banks were still in charge, but
as mentioned the paradigm is shifting to a
world where we (physical persons and cor-
porations) pay each other without the banks
involvement with new technologies such as
mobile payments.
Network providers
In the future the banks and organisations
such as SWIFT, NACHA and other pay-
ment networks become network providers
that allow you to send money from A to B
and will charge you for the network traf-
c that you generate. This brings similari-
ties with industries such as telecom, energy
suppliers and cable companies. The nancial
world is clearly undergoing an important
When you have to be right
One wrong
move is
one too
many.
Navigating difcult terrain has its share
of risks and rewards. But when the
stakes are high, the consequences of
even one wrong step can be severe.
Your world is a dynamic, changing
environment with new regulations,
renewed regulator vigilance and high
stakeholder expectations. When changes
demand action, you have to be ready,
and you have to be right. Wolters
Kluwer Financial Services empowers
compliance, risk management and audit
professionals with the information and
technology and services needed to adapt
quickly and appropriately to meet these
challenges with condence.
When a single wrong step is one too
many, always enlist the partner you can
count on to ensure youre right.
To learn more go to
WoltersKluwerFS.com.

Journal of Regulation & Risk - North Asia, Volume VI, Issue I, Spring 2014

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Journal of Regulation &amp; Risk - North Asia, Volume VI, Issue I, Spring 2014

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Regulating foreign banking organisations in the USA Daniel K. Tarullo

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Journal of Regulation & Risk - North Asia, Volume VI, Issue I, Spring 2014

Journal of Regulation & Risk - North Asia, Volume VI, Issue I, Spring 2014