Monday April 30 2012 - Top 10 risk and compliance management related news stories and world events

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_____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)

www.risk-compliance-association.com

International Association of Risk and Compliance Professionals (IARCP)

1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 202-449-9750 www.risk-compliance-association.com

Top 10 risk and compliance management related news stories and world events that (for better or for worse) shaped the week's

agenda, and what is next

George Lekatis President of the IARCP

Dear Member,

Do you know that investor in London are betting on when a particular set

of US citizens will die and, if these people live longer than anticipated, the investment may not function as expected …

… and that the UK Financial Services Authority (FSA) has confirmed

guidance that this is a high risk product that should not be promoted to

the vast majority of retail investors in the UK?

We live in (mad) financial times. These “high risk products” are called

Traded Life Policy Investments (TLPIs). Yes, risk management is very

important. The risk is that policyholders will not die the day we want

them to die.

Investors hope to benefit by buying the right to the insurance payouts

upon the death of the original policyholder.

Well, we speak about London, let’s see the interesting definition of the shadow banking sector from Mr Paul Tucker, Deputy Governor for Financial Stability at the Bank of England, (speaking at the European Commission High Level Conference, Brussels, 27 April 2012). He said that “shadow banking” is not the same as the non-bank financial sector.

http://www.risk-compliance-association.com/

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For example, the vast majority of hedge funds are not shadow banks, and don’t trade in the credit markets or especially illiquid markets. Also, non-bank intermediation of credit is not a bad thing in itself. Indeed, it can be a very good thing, helping to make financial services more efficient and effective and the system as a whole more resilient. But, as we know from this crisis and from previous ones, true shadow banking can weaken the system. Regulatory arbitrage, which is always with us, can distort and disguise channels of intermediation. Shadow banking comes in lots of shapes and colours. There are degrees to which any particular instance of shadow banking replicates banking. The liquidity offered by some shadow banks relies pretty well entirely, and more or less openly, on committed lines of credit from commercial banks. In these cases, the liquidity insurance offered by the shadow bank is “derivative”; there is a real bank in the shadows. But for other shadow banks, liquidity services are offered without such back-up lines. In those cases, claims on the shadow bank have, in effect, become a monetary asset. Examples probably include money market mutual funds and an element of the prime brokerage services offered by securities dealers to levered funds. Interesting! Welcome to the Top 10 list.

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Developing a Single Rulebook in banking Andrea Enria, Chairperson European Banking Authority, Central Bank of Ireland – Stakeholder Conference ‘Financial Regulation, Thinking about the future, 27 April 2012

FSA confirms traded life policy investments should not generally be promoted to UK investors 25 Apr 2012 The Financial Services Authority (FSA) has confirmed guidance that traded life policy investments (TLPIs) are high risk products that should not be promoted to the vast majority of retail investors in the UK

Federal Deposit Insurance Corporation U. S. Small Business Administration April 24, 2012 FDIC and SBA Team Up to Offer Financial Education Support for New and Aspiring Entrepreneurs

FSA Japan Press Conference by Shozaburo Jimi, Minister for Financial Services (Excerpt)

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Securities Lending and Repos: Market Overview and Financial Stability Issues Interim Report of the FSB Workstream on Securities Lending and Repos, 27 April 2012

Shareholder value and stability in banking: Is there a conflict? Speech by Jaime Caruana, General Manager, Bank for International Settlements

Jens Weidmann: Global economic outlook – what is the best policy mix? Speech by Dr Jens Weidmann, President of the Deutsche Bundesbank, Economic Club of New York, New York, 23 April 2012

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Energy ≠ Heat: DARPA seeks non-thermal approaches to thin-film deposition

Federal Open Market Committee Information received since the Federal Open Market Committee met in March suggests that the economy has been expanding moderately.

FSB Principles for Sound Residential Mortgage Underwriting Practices April 2012

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Developing a Single Rulebook in banking Andrea Enria, Chairperson European Banking Authority, Central Bank of Ireland – Stakeholder Conference ‘FINANCIAL REGULATION - THINKING ABOUT THE FUTURE’ 27 April 2012

Ladies and Gentlemen, My main topic today will be the Single Rulebook, the main path ahead of us to achieve the objectives of the new European institutional framework established with the endorsement of the recommendations of the de Larosière report. I will primarily focus on owns funds, as this is a key issue for re-establishing the regulatory framework on a sound footing and the EBA is currently running a public consultation on this. I will also briefly touch on another important component of the Single Rulebook: the liquidity requirements. However, before tackling these issues, I would like to give you an overview of the first year of existence of the EBA and especially of the work done to face the challenges posed by the current crisis.

1. The efforts of the EBA in tackling the financial crisis

In the first year of its life, the priorities of the EBA had to be focused on the challenges raised by the deterioration of the financial market

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environment. The stress test exercise we conducted in the first part of 2011 focused on credit and market risks but also, in recognition of the risks that subsequently crystallised, incorporated sensitivity to movements in funding costs. Banks were also required to assess the credit risk in their sovereign portfolios. In many respects, I believe the exercise was successful: in order to achieve the tougher capital threshold, anticipating many aspects of the new Basel standards, banks raised € 50 bn in fresh capital in the first four months of the year; we set up a comprehensive peer review exercise, which ensured consistency of the exercise across the Single Market, notwithstanding the many differences in national regulatory frameworks; the exercise included an unprecedented disclosure of data (more than 3200 data points for each bank), including amongst other things detailed information on sovereign holdings. However, the progress of the stress test was tracked by a significant further deterioration in the external environment. The main objective of restoring confidence in the European banking sector was not achieved, as the sovereign debt crisis extended to more countries, thus reinforcing the pernicious linkage between sovereigns and banks. Most EU banks, especially in countries under stress, experienced significant funding challenges. In this context, the IMF and the European Systemic Risk Board (ESRB) called for coordinated supervisory actions to strengthen the banks’ capital positions. The EBA assessment was that without policy responses, the freeze in bank funding would have led to an abrupt deleveraging process, which

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would have hurt growth prospects and fuelled further concerns on the fiscal position of some sovereigns, in a negative feedback loop. We then called for coordinated action on both the funding and the capitalisation side. While advising the establishment of an EU-wide funding guarantee scheme, the EBA focused its own efforts on those areas where it had control, primarily bank capitalisation. To this end, the Board of Supervisors, comprising the heads of all 27 national supervisory authorities, discussed and agreed that a further recapitalisation effort was required as part of a suite of coordinated EU policy measures. Our Recommendation identified a temporary buffer to address potential concerns over EU sovereign debt holdings and required banks to reach 9% CT1. The total shortfall identified was € 115 bn. The measure was agreed in October and enacted in December 2012. It was swiftly followed by the ECB’s long term refinancing operations (LTROs), arguably the key “game changer” in this context. But the recapitalisation was a necessary complementary measure: while banks needed unlimited liquidity support, to avoid a credit crunch, they had to be asked to accelerate their action to repair balance sheets and strengthen capital positions. These measures have bought time but should not bring complacency. The recapitalisation plan has seen banks make significant efforts to strengthen their capital position without disrupting lending into the real economy.

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The EBA’s intensive monitoring of the process shows that 96% of the shortfall identified was met by direct capital actions. Moreover, there has been a strong spirit of cooperation between home and host supervisors in discussing and taking forward these plans through colleges of supervisors, which has acted as a meaningful counterweight to the trend for national concerns to come to the fore in the current environment. Going forward, heightened attention to addressing residual credit risk, making efforts to meet the new CRD IV requirements, setting in place plans to gradually restore access to private funding and exit the extraordinary support of the ECB will be key.

2. The Single Rulebook in banking

As the finalisation of the new legislative framework for capital and liquidity requirements was coming closer, the focus of the EBA work has been increasingly moving to our tasks in the rule-making process. The key task that the reform proposed by the de Larosière report assigns to the EBA is the establishment of a Single Rulebook, ensuring a more robust and uniform regulatory framework in the Single Market and preventing a downward spiral of competitive relaxation of prudential rules. The EBA is asked to draft technical standards that, once endorsed by the Commission, will be adopted as EU Regulations. The standards will therefore be directly applicable to all financial institutions operating in the Single Market, without any need for national implementation or possibility for additional layers of local rules. I see that at the moment, while the negotiations on the capital requirement directive and regulation (CRD4-CRR) are entering the final stages, there is a call for more national flexibility. It is often argued that minimum harmonisation is all that is needed, as the

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decision of a national authority to apply stricter requirements would only penalise financial institutions chartered in that jurisdiction. This argument neglects the fact that we have lived in a world of minimum harmonisation until now, and this has delivered an extremely diverse regulatory environment, prone to regulatory competition. It is a fact that the flexibility left by EU Directives has been a key ingredient in the run-up to the crisis. The Directives left significant flexibility to national authorities in the definition of key prudential elements (e.g., definition of capital, prudential filters for unrealised gains and losses), the determination of risk weights (e.g., for real estate exposures), the approaches to ensure that all the risks are captured by the requirements (e.g., effectiveness of risk transfers). All these elements of flexibility have been used by banks to put pressure on their supervisors, triggering a process that led to excessive leverage and fuelled credit and real estate bubbles. The heterogeneity of the regulatory environment also complicated significantly the effective supervision of cross-border groups, which were at the epicentre of the crisis: supervisors had serious difficulties both building up a firm-wide view of risks and acting in a timely and coordinated fashion. Furthermore, regulatory arbitrage drove business decision. This problem has not been fixed yet. In its first year of activity, the EBA identified a number of differences in regulatory treatment that lead to very material discrepancies in key requirements. For instance, the EBA staff conducted a simple exercise on the data collected for the recapitalisation exercise. The capital requirement for the same bank were calculated using the less

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stringent and the most restrictive approaches in four areas where national rules present important differences – the calculation of the Basel I floors, the application of the prudential filters, the treatment (deduction from capital or inclusion in assets with a 1250% weight) of IRB shortfalls and of securitisations. As a result, the ratio was 300 bps lower when the stricter methodologies were applied, showing that differences can be very material and difficult to spot. In integrated financial markets, these differences can have very disruptive effects. Once risks generated under the curtain of minimum harmonisation materialise, the impact is surely not contained within the jurisdictions that adopted less conservative approaches. Without using exactly the same definition of regulatory aggregates and the same methodologies for the calculation of key requirements, the problem will not be fixed. At the same time, it is absolutely true that the new regulatory framework has to be shaped in such a way to leave a certain degree of national flexibility in the activation of macroprudential tools, as credit and economic cycles are not synchronised across the EU. Also, there could be structural features of financial sectors, or components thereof, which might require tweaking prudential requirements to prevent systemic risk. But the same source of systemic risk should be treated in a broadly consistent manner in different jurisdictions across the Single Market, to avoid an unlevel playing field and less stringent approaches that might subsequently generate spillovers in other countries. The ideal long-term solution for avoiding conflicts between the flexibility needed for macroprudential supervision and the degree of regulatory harmonisation called for by the Single Rulebook is constructing a suite of

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macroprudential instruments along the blueprint of the countercyclical buffer. This provides a significant leeway for tightening standards while the European Systemic Risk Board (ESRB) is entrusted with the task of drafting guidance on the activation of the tool and of conducting ex post reviews. At the same time, reciprocity in the application of the tool allows for cross-border consistency and reduces the room for regulatory arbitrage. So, we may well have a single rule, adopted through an EU Regulation, while this rule provides for flexibility in its application, with a framework that the Basel Committee has labelled as “constrained discretion”.

3. Giving life to the Single Rulebook: the new regulatory framework of bank capital and liquidity

In giving life to the Single Rulebook in banking, the EBA is facing a major challenge. The CRD4-CRR proposal envisages around 200 tasks, more than 100 technical standards - 40 of which will have to be finalised by the end of this year. We will have to ensure standards of high legal quality as they will be immediately binding in all 27 Member States when endorsed by the European Commission. We will have to respect due process, with wide and open consultations and adequate impact assessments. As to the substance of the new regulatory framework, I will focus today on the definition of capital and the quality of own funds, which I consider as one of the cornerstones of the Single Rulebook in banking.

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3.1. Own funds The definition of capital has been a major loophole in the run-up to the crisis. As financial innovation brought about increasingly complex hybrid instruments, national authorities have been played against each other by the industry, with the result that the standards for the quality of capital were continuously relaxed. As a consequence, once the crisis hit, a significant amount of capital instruments proved to be of inadequate quality to absorb losses. In several cases, taxpayers’ money was injected while the holders of capital instruments continue to receive regular payments. The Basel Committee has done an outstanding job in significantly strengthening the definition of capital and we must make sure that this is not lost in the implementation of the standards. The EBA already achieved some progress in the use of stringent uniform standards when imposing the use of a common definition of capital for the purpose of the stress test and the recapitalisation exercise. This proves that collective enhancements can be reached when necessary. But what can be done in periods of stress must be perpetuated in normal times. For this purpose, on 4 April, the EBA published a consultation on a first set of regulatory technical standards on own funds. These cover most areas of own funds, fleshing out the features of instruments of different quality (from CET1 to Tier 2 instruments). The consultation will provide appropriate input from interested parties and regular contacts with banks and market participants are already under way.

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The standards elaborate on the characteristics of the instruments themselves, as well as on deductions to be operated from own funds. It is indeed crucial to ensure that there is a uniform approach regarding the deduction from own funds of certain items like losses for the current financial year, deferred tax assets that rely on future profitability, defined benefit pension fund assets. It is also necessary to ensure that, where exemptions from and alternatives to deductions are provided, sufficiently prudent requirements are applied. The standards cover also several areas affecting more directly cooperative banks and mutuals, whose particular features have to be taken into adequate account. At the same time, it is necessary to define appropriate limitations to the redemption of the capital instruments by these institutions. The standards will also contribute to increase the permanence of capital instruments more generally by strengthening the features of the latter and by specifying the need for supervisory consent when reducing own funds. Finally, the standards will also increase the loss absorbency features of eligible hybrid instruments, in line with the objective to bring investors closer to shareholders and share losses on a pari passu basis. In order to complete its current work on own funds, the EBA will soon publish a technical standard on disclosure by institutions. The work of the EBA on own funds will not be concluded with the endorsement of the new technical standards. Indeed, although technical standards, like EU Regulations, should not leave room for interpretation, it cannot be excluded that some provisions will not work as they are meant to.

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This is the reason why a close review of the application of the standards is necessary to detect potential loopholes and propose changes when needed. A framework should be developed, probably in the form of a Q&A platform, in order to address technical issues that may well emerge in the practical application of the standards. Furthermore, an important task that has been attributed to the EBA is the publication of a list of instruments included in Common Equity Tier 1 (CET1) as well as the monitoring of the quality of capital instruments. I believe the current text of the CRD4-CRR does not go far enough in ensuring a strong control on the instruments that will be included in the capital of higher quality. I understand the decision of the EU institutions to follow an approach that privileges substance over form: the definition of Common Equity Tier 1 will not be restricted to ordinary shares, as there is no harmonised EU-wide definition that could be relied upon. Instead, the legislation will require that only instruments that are in line with all the principles defined by the Basel Committee will qualify. In order for this to ensure a strict control on the quality of these instruments, strong mechanisms should be put in place to make sure that there is no room for watering down the requirements. The “substance” needs to be checked and has to be the same across the Single Market. From my perspective, the list that the EBA will keep should be legally binding. There should be an in-depth scrutiny of the instruments conducted at the EU level by the EBA, in cooperation with national supervisors, to confirm the inclusion in the list.

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If an instrument is included in the list, it should be accepted throughout the Single Market. If it is not included in the list, no authority should have the possibility to consider it eligible as CET1. The present text limits the role of the EBA to the publication of an aggregated list only based on the assessment done at national level. This would not bring any added value compared to a situation where Member States would be required to publish by themselves a list of instruments recognised in their jurisdictions. On the contrary, this could be misleading, as it could convey the impression that the instruments have received an EU-wide recognition. In any case, even if the legislative framework does not provide the EBA with the necessary legal tools, we are committed to fully exploiting the draft Regulation’s provisions that require the EBA to monitor the quality of own funds across the Single Market and to notify the Commission in case of evidence of material deterioration in the quality of those instruments. If we consider that some instruments that are not of sufficient quality have been accepted, we also have the possibility to open formal procedures for breach of European law. Having strong enforcement tools is essential: supervisors have lost control of the definition of capital once and we should not allow this to happen again. We are acutely aware that the new rules will trigger a new wave of financial innovation, aimed at limiting the restrictive impact of the reform. Indeed, this is already under way. We already hear that new ways are being devised to smooth the impact of permanent write-downs or to circumvent the prohibition of dividend stoppers for hybrid instruments.

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Our monitoring of capital issuances is ongoing. The EBA recently decided to develop a set of benchmarks for hybrid instruments to give more clarity on what are the terms and conditions – in terms of permanence, flexibility of payments, loss absorbency – that make an instrument compliant with applicable rules. The work in this area will begin when the final legislation is in place and a sufficient number of new issuances are available, in order to have a meaningful sample of instruments to assess. In the future, hopefully, this work could move a step further, towards providing common templates, which could lead to the harmonisation of the main contractual provisions of hybrid capital instruments, in line with the objectives of a Single Rulebook. A concrete illustration of these common templates has already been given by the EBA when publishing a common term sheet for the convertible instruments accepted for the purpose of the recapitalisation exercise.

3.2. Liquidity

The new liquidity standards represent a second important area of work for the EBA. The first deliverable is due at the end of 2012, when we will have to provide for uniform reporting formats. The framework is currently under development and is expected to be released for public consultation over the summer. However, we can already foresee that the reporting is likely to be fairly similar to that used by the Basel Committee for the quantitative impact study, which many European banks are already familiar with. But the most important and delicate area of work is the definition of liquid assets and, more generally, the calibration of the new requirements.

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We are aware that the banking industry has raised serious concerns on the two liquidity standards defined by the Basel Committee, the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). The Basel Committee itself is reviewing the calibration of the ratios, recognising that some underlying assumptions are excessively conservative, even if confronted with the toughest moments of the financial crisis. The key principles underlying the LCR and the NSFR are sound and cannot be given up by regulators: banks need to have sufficient buffers of liquid assets to withstand a shock for some time without the need for public support; maturity transformation needs to be constrained to some extent, so as to prevent banks from adopting fragile business models relying excessively on volatile, short term wholesale funding to support longer term lending. But it is essential to get the calibration right, as funding is and will increasingly be the main driver of the deleveraging process at EU banks. Time is needed to do a proper job: we have to ensure that data of adequate quality is available – hence the need for a uniform reporting provided at the end of 2012 – and to allow for in-depth analyses. The first impact assessments on LCR and the NSFR are due in 2013 and 2015 respectively. The EU has taken the decision to use the monitoring period until 2015 for the LCR and 2018 for the NSFR, before proposing legislation for a final calibration of the liquidity ratios. This monitoring phase exactly mirrors the Basel Committee’s timeline. It is in my view the right choice to allow for this extensive observation period. I would strongly argue that we should avoid making any policy choice before proper evidence on the potential impact of the two ratios.

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Conclusions Ladies and gentlemen, Today I tried to convey to you a bird’s eye picture on the difficult challenges the EBA is facing. In the first year of activity we have already done a huge effort to strengthen the capital position of EU banks and to restore confidence in their resilience. The work is not over in this area. The liquidity support provided by the ECB avoided an abrupt deleveraging process, but banks are still in the process of repairing and downsizing their balance sheets and of refocusing their core business. We, as supervisors, need to accompany this process and do our utmost to ensure that it occurs in an ordered fashion, without adverse consequences on the financing of the real economy. One way to support the process is the introduction of the reforms on capital and liquidity standards endorsed by the G20. I strongly believe that we need to exploit this opportunity to move to a truly harmonised regulatory framework, a Single Rulebook that ensures that high quality standards are enforced throughout the Single Market. We have to be particularly rigorous on the definition of capital, as this is the basis for most prudential requirements. We cannot afford anymore financial innovation that allows instruments to be accepted as capital, while not respecting the key principles of permanence, flexibility of payments and loss absorbency. The control on eligible capital instruments needs to be very strict and should be performed at the EU level. Ideally, the co-legislators should give the EBA the legal basis to perform this difficult task.

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But in any case we will conduct a close monitoring of capital issuances, as we consider our duty to ensure that only the instruments of the best quality are accepted as regulatory capital. As to liquidity standards, I believe that while the principles embodied in the Basel text are absolutely shared, we need to do more work on the calibration of the requirements. We understand the concerns expressed by the industry, but it is important that we collect solid empirical evidence before taking any decision in this delicate area, which will provide a major driver for the needed changes in banks’ business models. Thank you for your attention.

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FSA confirms traded life policy investments should not generally be promoted to UK investors 25 Apr 2012

The Financial Services Authority (FSA) has confirmed guidance that

traded life policy investments (TLPIs) are high risk products that should

not be promoted to the vast majority of retail investors in the UK.

The guidance is an interim measure – the FSA will shortly be consulting

on new rules imposing significant restrictions on the promotion of

non-mainstream investments, including TLPIs, to retail investors.

TLPIs invest in life insurance policies, typically of US citizens.

Investors hope to benefit by buying the right to the insurance payouts

upon the death of the original policyholder.

Basically, a TLPI investor is betting on when a particular set of US

citizens will die and, if these people live longer than anticipated, the

investment may not function as expected.

The FSA has found evidence of significant problems with the way in

which TLPIs are designed, marketed and sold to UK retail investors.

Many of these products have failed, causing loss for UK retail investors.

Many TLPIs take the form of unregulated collective investment schemes,

which cannot lawfully be promoted to retail investors in most cases, but

have often been marketed inappropriately to retail customers.

Peter Smith, the FSA’s head of investment policy said:

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“The TLPI retail market is worth £1 billion in the UK and we were very

concerned that it was likely to grow even more.

At the time that we published our guidance over half of existing retail

investments were in financial difficulty – even so, we were hearing about

the development of new products intended to be sold to UK retail

customers.

“The threat to new customers was significant and growing: the potential

for substantial future detriment was clear.

There was a concern that we were witnessing a repeating cycle of

unsuitable sales followed by significant customer detriment in the TLPI

market.

Following publication of the guidance for consultation, this threat has

receded.

“This is an interim measure – we believe that TLPIs and all unregulated

collective investment schemes should not generally be marketed to retail

investors in the UK and will be publishing proposals soon to prevent them

being promoted except in rare circumstances.”

Traded Life Policy Investments (TLPIs), Key risks associated with TLPIs

Longevity risk

An accurate estimation of life expectancy is the most important factor in assessing the price of each underlying life insurance policy in a TLPI. Based on this, the primary risk is that the underlying policies’ lives assured live longer than expected (for example, because of medical advances and the incompatibility of life assurance actuarial models as the basis for investment purposes) so the TLPI needs to continue to fund premiums on the policies for longer than expected.

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This could negatively affect the return on investment and liquidity on an ongoing basis.

Liquidity risk

The underlying investments are illiquid due to their specialised nature and there is only a limited secondary market for them. This may mean they are sold at a significantly reduced value if the TLPI needs to raise funds at short notice, which has an impact on the value of the portfolio. Investors may therefore suffer financial loss at the point of redemption.

Parties involved in the TLPI may become insolvent

This risk factor, though not unique to TLPIs, is often overlooked. For example, if an insurance company becomes insolvent and is unable to meet claims upon the deaths of the original policyholders the TLPI could find itself in difficulties given the often large value of the policies it holds.

Governance issues

TLPI product governance has often proven problematic and led to product difficulties. Some common issues are as follows:

Conflicts of interest

Conflicts exist among different participants in the product value chain that lead to high fees being charged and may lead to detriment for investors.

TLPI models/structure

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In some models, yields are promised to previous investors, which can only be sustained by using new investors’ money, so the model in effect ‘borrows’ from itself.

The underlying assets are located offshore

This means there is an exchange rate risk, both in terms of the costs of meeting ongoing premiums and the final payout for the underlying insurance contracts. Currency hedging instruments may be used by TLPI providers, but these may pose additional risks and involve extra costs.

Many TLPIs sold in the UK are operated by firms based offshore

This means investors may have limited or no recourse to the Financial Services Compensation Scheme (FSCS) if things go wrong and the product fails. They may also not be covered by the Financial Ombudsman Service (FOS) if they have a complaint about the operation of the TLPI. Customers would be able to complain to the FOS if, for example, the advice they have received from UK distributors was unsuitable or if a promotion from a UK provider or distributor was unfair, unclear or misleading.

Awareness of authorisation/compensation arrangements

Many TLPIs are operated by firms based abroad and outside of the FSA’s jurisdiction. There is evidence that providers and advisers have not fully understood or conveyed to investors the risks involved in how or whether the client’s product will be authorised and what compensation arrangements apply.

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These factors could result in a significant risk of loss of capital (and any income provided) for customers.

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Federal Deposit Insurance Corporation U. S. Small Business Administration April 24, 2012

FDIC and SBA Team Up to Offer Financial Education Support for New and Aspiring Entrepreneurs

The Federal Deposit Insurance Corporation (FDIC) and U.S. Small Business Administration (SBA) announced new resources to support small businesses.

FDIC Director for Depositor and Consumer Protection Mark Pearce and SBA’s Deputy Associate Administrator for Entrepreneurial Development Michael Chodos released Money Smart for Small Business, a training curriculum for new and aspiring business owners.

Developed in partnership between both agencies, this curriculum is the latest offering in the FDIC’s 10 year old award-winning Money Smart program.

Money Smart for Small Business provides an introduction to day-to-day business organization and planning and is written for entrepreneurs with limited or no prior formal business training.

It offers practical information that can be applied immediately, while also preparing participants for more advanced training.

The curriculum is designed to be delivered to new and aspiring business owners by financial institutions, small business development centers (SBDCs), among others.

Director Pearce and SBA Associate Administrator Chodos were joined by Training Alliance partners at the launch of Money Smart for Small

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Business, hosted by the District of Columbia’s Affinity Lab, a small business incubator.

“We are proud to launch Money Smart for Small Business,” said Acting Chairman Gruenberg.

“Since 2001, Money Smart has helped individuals build a secure financial future for themselves.

I am very pleased that small businesses, which play a vital role in supporting our national economy, will now have access to this resource.

The FDIC looks forward to working with the SBA and the Money Smart Alliance, to promote financial literacy among small business owners.”

“We are excited to join the FDIC in its expansion of the Money Smart curriculum for small business,” said SBA Administrator Karen Mills.

“The FDIC is a vital ally in our efforts to help small business owners start, grow and create jobs.

Money Smart for Small Business will help to put more information on the business basics of financial management at entrepreneurs’ fingertips and make it easier for them to build their knowledge and skill set.”

Each of the ten instructor-led modules in Money Smart for Small Business provides financial and business management for business owners and includes a scripted instructor guide, participant guide and overhead slides.

Organizations that use the curriculum to support small businesses through training, technical assistance or mentoring are invited to join the FDIC and SBA’s Training Alliance.

The FDIC will host an online “town hall” for potential Training Alliance partners in the months ahead.

More than ten years after the original release of the award - winning Money Smart adult curriculum, Money Smart for Small

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Business builds on the proven results in financial management for those who complete the curriculum.

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FSA Japan - Press Conference by Shozaburo Jimi, Minister for Financial Services (Excerpt) [Opening Remarks by Minister Jimi] This morning, the Minister of Economic and Fiscal Policy, the Minister of Economy, Trade and Industry and the Minister for Financial Services held a meeting, and I will make a statement regarding the policy package for management support for small and medium-size enterprises (SMEs) based on the final extension of the SME Financing Facilitation Act. Recently, the Diet passed and enacted an amendment bill to extend the period of the SME Financing Facilitation Act for one year for the last time and an amendment bill to extend the deadline for the determination of support by the Enterprise Turnaround Initiative Corporation of Japan, over which Minister of Economic and Fiscal Policy Furukawa has jurisdiction, for one year, and the new laws were promulgated and put into force.

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I believe that this year will be very important for creating an environment for vigorously implementing support that truly improves the management of SMEs, namely an exit strategy. From this perspective, the ministers who represent the Cabinet Office, the Financial Services Agency (FSA) and the Small and Medium Enterprise Agency held a meeting and adopted the policy for management support for SMEs. The FSA will seek to facilitate financing for SMEs through measures related to the final extension of the period of the SME Financing Facilitation Act, including this policy package, and will also create an environment favorable for management support for SMEs while maintaining cooperation with relevant ministries and agencies. For details, the FSA staff will later hold a press briefing, so please ask your questions then.

[Questions & Answers]

Q. The G-20 meeting started on April 19.

I hear that the expansion of the International Monetary Fund's lending facility, which has been the focus of attention, may be put off, and the market could fall into turmoil again, with the yield on Spanish government bonds rising in Europe. Could you tell me how you view the recent financial market developments?

A. As for the current situation surrounding the European debt problem

that you mentioned now, individual countries' financial and capital markets have generally been recovering for the past several months as a result of efforts made by euro-zone countries and the European Central Bank, as you know.

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On the other hand, concern over the European fiscal problem has not been dispelled, as indicated by unstable market movements caused by concern over Spain's fiscal condition. The euro zone has set forth the path to fiscal consolidation and President Draghi of the European Central Bank (ECB) has taken bold measures, as you know well. Such measures as the ECB's long-term refinancing operation and the strengthening of the firewall have been taken. To ensure that the market will be stabilized and the European debt problem will come to an end, it is important not only that the series of measures adopted by the euro zone is carried out but also that the IMF's financial base is strengthened. From this perspective, Minister of Finance Azumi recently expressed an intention to announce Japanese financial support worth 60 billion dollars for the IMF at the G-20 meeting. I hope that this Japanese action, combined with Europe's own efforts, will help to resolve the European debt problem. As you know, it is unusual for Japan to exercise initiative and announce support for the IMF. Although Japan has various domestic problems, it is the world's third-largest country in terms of GDP. In addition, as I have sometimes mentioned, Japan is the only Asian country that has maintained a liberal economy and a free market since the latter half of the 19th century. Even though Japan lost 65% of its wealth because of World War II, it went on to recover from the loss.

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In that sense, it is very important for Japan to exercise initiative, on which the United States eventually showed an understanding from what I have heard informally.

Q. It has been decided that Kazuhiko Shimokobe of the Nuclear Damage

Liability Facility Fund will be appointed as Tokyo Electric Power Company's new chairman. Tokyo Electric Power's management problem has had some effects on the corporate bond market and also has affecteds SMEs through a hike in electricity rates. What do you think of this appointment?

A. I am aware that Mr. Shimokobe, who is chairman of the Nuclear

Damage Liability Facility Fund's management committee, has accepted the request to serve as Tokyo Electric Power's chairman, but the FSA would like to refrain from commenting on personnel affairs. Formerly, I, together with Mr. Yosano, joined the cabinet task force, which was responsible for determining the scheme for rehabilitating Tokyo Electric Power, in response to the economic damage caused by the nuclear station accident, as additional members, and our efforts led to the enactment of the Act on the Nuclear Damage Liability Facility Fund. I understand that Tokyo Electric Power and the Nuclear Damage Liability Facility Fund are drawing up a comprehensive special business plan. What kind of support Tokyo Electric Power will ask stakeholders to provide and how stakeholders including financial institutions will respond are matters to be discussed at the private-sector level, as I have been saying, so the FSA would like to refrain from making comments for the moment. In any case, regarding Tokyo Electric Power's damage compensation, making damage compensation payments quickly and appropriately and ensuring stable electricity supply are important duties that electric power companies must fulfill.

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Therefore, with the fulfillment of those duties as the underlying premise, it is important to prevent unnecessary, unpredictable adverse effects - you mentioned the effects on the corporate bond market earlier - so I will continue to carefully monitor market developments.

Q. On April 19, the Democratic Party of Japan's working team on the

examination of the future status of pension asset management and the AIJ problem adopted an interim report. Could you tell me about the status of the FSA's deliberation on measures to prevent the recurrence of the problem, including when the measures will be worked out?

A. I read about that in a newspaper article.

Regarding problems identified in this case, it is necessary to ensure the effectiveness of countermeasures while taking account of practical financial practices. That report is an interim one, so it stated that various measures will be worked out in the future. I have my own thoughts as the person in charge of the FSA. However, I think that the FSA needs to conduct a study on measures such as strengthening punishment against false reporting and fraudulent solicitation - as you know, false reports were made in this case - establishing a mechanism that ensures effective checks by third-parties like companies entrusted with funds, auditing firms and trust banks - the checking function did not work at all in this case - and including in investment reports additional information useful for pension fund associations to judge the reliability of companies managing customers' assets under discretionary investment contracts and the investment performance. In any case, regarding measures to prevent the recurrence of this case, we will quickly conduct deliberation while taking into consideration the results of the Securities and Exchange Surveillance Commission's

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additional investigation and the survey on all companies managing customers' assets under discretionary investment contracts - the second-round survey is underway - as well as the various opinions expressed in the Diet, including the arguments made in the interim report, which was written under Ms. Renho's leadership. We will implement measures one by one after each has been finalized.

Q. Regarding the policy package announced today, several people said in

the Diet that more efforts should be devoted to measures to support SMEs in relation to the extension of the period of support by the Enterprise Turnaround Initiative Corporation of Japan. In relation to the policy package, do you see any problems with the collaboration that has so far been made with regard to management support for SMEs?

A. Twenty-two years ago, in 1990, I became parliamentary secretary for

international trade and industry, and served in the No. 2 post of the former Ministry of International Trade and Industry for one year and three months under then Minister of International Trade and Industry Eiichi Nakao. At that time, I was in charge of financing for SMEs, such as financing provided by Shoko Chukin Bank, the Japan Finance Corporation for Small and Medium Enterprise, the National Life Finance Corporation and the Small Business Corporation, for one year and three months. Many departments and divisions are involved in the affairs of SMEs. While diversity and nimbleness are important for SMEs, I know from my experiences that they lack human resources and that unlike large companies, it is difficult for them to change business policies quickly in response to tax system changes. The FSA will continue to cooperate with relevant ministries and agencies and relevant organizations, such as the Enterprise Turnaround Initiative

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Corporation of Japan, liaison councils on support for the rehabilitation of SMEs, financial institutions and related organizations, including the Japanese Bankers Association, and commerce and industry groups - there are four traditional associations of SMEs - as well as prefectural credit guarantee associations, which play an important role for the government's policy for SMEs. In addition, the FSA will cooperate with government-affiliated financial institutions and take concrete actions, and I hope that recovery and revitalization of local economies based on the rehabilitation of regional SMEs will lead to the development of the Japanese economy. However, between the three ministers who held a meeting today, the policy toward SMEs tends to lack coordination. In Tokyo, Minister of Economy, Trade and Industry Edano and Minister of Economic and Fiscal Policy Furukawa and I worked together to adopt the policy package. In Japan's 47 prefectures, there are liaison councils on support for rehabilitation of SMEs and there are commerce and industry departments in prefectural and municipal governments, and these organizations will also be involved, so the policy for SMEs is wide-ranging and involves various organizations. Therefore, while we provide management support, these various organizations tend to act without coordination. Today, the three of us held a meeting to exercise central government control, and we will keep close watch on minute details so as to ensure coordination. As I have often mentioned, there are 4.3 million SMEs, which account for 99.7% of all Japanese corporations in Japan, and 28 million people, which translates into one in four Japanese people, are employed by SMEs, so SMEs have large influence on employment. We will maintain close cooperation with relevant organizations.

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Q. In relation to the previous question, I understand that the Enterprise

Turnaround Initiative Corporation of Japan has mostly handled cases involving SMEs. At a board meeting yesterday, it was decided that a former official of a regional bank will be appointed to head the corporation. How do you feel about that?

A. I read a newspaper article about the decision to appoint a former

president of Toho Bank. Toho Bank is the largest regional bank in Fukushima Prefecture, and personally, I am pleased that a very suitable person will be appointed as a new president. Fukushima Prefecture has been stressing that the revival of Japan would be impossible without the revival of Fukushima in relation to the nuclear station accident. In that sense, the selection of the former president of Toho Bank, a fairly large regional bank, who also served as chairman of the Regional Banks Association of Japan, is appropriate. This morning, Minister of Economic and Fiscal Policy Furukawa reported on the selection. I think that a very suitable person has been selected.

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Securities Lending and Repos: Market Overview and Financial Stability Issues, Interim Report of the FSB Workstream on Securities Lending and Repos, 27 April 2012 Introduction At the Cannes Summit in November 2011, the G20 Leaders agreed to strengthen the regulation and oversight of the shadow banking system, and endorsed the Financial Stability Board (FSB)’s initial recommendations with a work plan to further develop them in the course of 2012.

Five workstreams have been launched under the FSB to develop policy recommendations to strengthen regulation of the shadow banking system, including securities lending and repos (repurchase agreements).

The FSB Workstream on Securities Lending and Repos (WS5) under the FSB Shadow Banking Task Force is developing policy recommendations, where necessary, by the end of 2012 to strengthen regulation of securities lending and repos.

In order to inform its decision on proposed policy recommendations, the Workstream has reviewed current market practices through discussions with market participants, and existing regulatory frameworks through a survey of regulatory authorities.

The Workstream has identified a number of issues that might pose risks to financial stability.

These financial stability issues will form the basis for the next stage of its work in developing appropriate policy measures to address risks where necessary.

This report documents the Workstream’s progress so far.

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Sections 1 and 2 provide an overview of securities lending and repos markets globally, including the main drivers of the markets.

Section 3 places securities lending and repo markets in the wider context of the shadow banking system.

Section 4 provides an overview of existing regulatory frameworks for securities lending and repos, and section 5 lists a number of financial stability issues posed by these markets.

Additional detailed information on the market segments and a survey of relevant literature survey can be found in the annexes.

1. Market Overview: Four market segments The securities financing markets can be divided into four main, inter-linked segments: (i) a securities lending segment; (ii) a leveraged investment fund financing and securities borrowing segment; (iii) an inter-dealer repo segment; and (iv) a repo financing segment, as described below. The securities lending segment (Exhibit 1) comprises lending of securities by institutional investors (e.g. insurance companies, pension funds, investment funds) to banks and broker-dealers against the collateral of cash (typical in the US and Japanese markets, and comprising a minority share of the European market) or securities. According to one industry estimate, the total securities on loan globally, as of April 2012, are estimated to be about US$1.8 trillion. In general, borrowers may borrow specific securities for covering short positions in their own activities – for example arising from market - making activities – or those of their customers; or for use as collateral in repo financing and other transactions.

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Lenders (or beneficial owners) may reinvest cash collateral through separate accounts or commingled funds managed by their agent lender or a third party investment manager. Cash collateral is also reinvested through the repo financing segment described later

The leveraged investment fund financing and securities borrowing segment (Exhibit 2) comprises financing of leveraged investment funds’ long positions by banks and broker-dealers using both reverse repo and margin lending secured against assets held with prime brokers, as well as securities lending to hedge funds by prime brokers to cover short positions. This segment is closely linked to the securities lending segment, which is used by prime brokers to borrow securities to on-lend to hedge funds. The cash proceeds of short sales by hedge funds, in turn, may be used by prime brokers as cash collateral for securities borrowing. Hedge funds may give prime brokers permission to re-hypothecate assets, usually up to a proportion of their current net indebtedness to the prime broker (e.g. 140% in the US).

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Re-hypothecated assets may then be given as collateral to borrow cash or securities by prime brokers in the repo financing or securities borrowing segments.

The inter-dealer repo segment (Exhibit 3) comprises primarily government bond repo transactions amongst banks and broker-dealers. These may be used to finance long positions via general collateral (GC) repos (primarily against government securities), or to borrow specific securities via special repos. In the US, Europe and Japan, the inter-dealer repo segment is typically cleared by central counterparties (CCPs). Transactions are predominantly at an overnight maturity. Total repos and reverse repos outstanding (including both the inter-dealer repo segment and the repo financing segment) are estimated around US$2.1-2.6 trillion in the US, US$8 trillion in Europe, and US$2.4 trillion in Japan

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The repo financing segment (Exhibit 4) comprises repo transactions primarily by banks and broker-dealers to borrow cash from “cash-rich” entities, including central banks, retail banks, money market funds (MMFs), securities lenders and increasingly non-financial corporations. As described in the next section, the drivers of this market segment are primarily the short-term financing needs of banks and broker-dealers, as well as the desire of institutional cash managers to hold collateralised, “money-like” investments. Increasingly in the US and Europe, collateral movements and valuation are outsourced to tri-party agents (the so-called “tri-party repo”). Collateral includes government bonds, corporate bonds, structured products, money market instruments and equities. The share of asset-backed securities (ABSs) used as repo collateral has declined sharply since the crisis. Transactions are predominantly short-term but the European market also includes a growing, longer-term element.

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The above 4 market segments can be combined to form a complex network of securities lending and repos as shown in Exhibit 5.

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2. Five key drivers of the securities lending and repo markets The Workstream has identified the following five key drivers of the securities lending and repo markets that contribute to better understanding of the characteristics and developments of the four market segments described in section 1. These drivers are not ranked in order of importance and may overlap.

2.1 Demand for repo as a near-substitute for central bank and insured bank deposit money The first key driver, particularly for the repo financing segment, is demand by certain risk-averse institutions for “money-like” instruments to support their primary investment objectives of preserving principal and liquidity. Such institutions may not have access to central bank reserves; may be ineligible for deposit insurance or have cash holdings that exceed deposit insurance limits; and/or find that Treasury bill markets do not have an adequate supply or depth, or do not match their maturity requirements. These repo investors include: (i) MMFs; (ii) entities seeking to reinvest cash collateral from securities lending activities; (iii) official reserves managers; (iv) commercial banks that are required to hold a regulatory liquidity buffer; (v) pension funds, investment funds and insurance companies; (vi) non-financial corporations;

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(vii) other specialist entities, e.g. CCPs and the US Federal Home Loans Banks; (viii) structured finance (e.g. securitisation) vehicles. A key attribute of repo is that it allows banks, broker-dealers and other intermediaries to create “collateralised” short-term liabilities provided they can access underlying collateral securities meeting the credit and regulatory requirements of the cash lenders. The institutional demand for money-like assets has grown significantly over the last twenty years. Pozsar (2011) estimates that the total size of MMFs, cash collateral reinvestment programmes and corporate cash holdings in the US rose from $100 billion in 1990 to a peak of over $2.2 trillion in 2007 and stood at $1.9 trillion in Q4 2010.

2.2 Securities-based financing needs

The second key driver is the financing needs of leveraged intermediaries.

Regulated banks and broker-dealers dominate, using these markets both as part of their wider wholesale funding and more particularly for securities dealing.

But some unregulated non-bank intermediaries, such as ABCP conduits and CDOs, did make use of repo financing alongside other sources of money market funding such as ABCP issuance before the crisis as part of the shadow banking system.

For most large global banks, the inter-dealer repo market has almost replaced unsecured money markets as the marginal source and use of overnight funds.

In particular, repo financing markets have become an increasingly important source of borrowing at maturities from overnight to twelve months or even longer.

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With access to liquid repo and securities lending markets, broker-dealers can:

(i) quote continuous two-way prices in the cash market (i.e. market-making) in a reasonable size without carrying inventory in every security;

(ii) prevent a chain of settlement delivery failures from developing; (iii) finance long positions and cover short positions more effectively; and (iv) hedge against their credit or market risk exposures arising from other activities, e.g. government auctions, corporate bond underwriting, and trading in cash instruments and derivatives. Liquid securities financing markets are therefore critical to the functioning of underlying cash, bond, securitisation and derivatives markets. For instance, before the crisis, the acceptability of senior tranches of ABSs as repo collateral contributed significantly to the growth of the securitisation leg of the shadow banking system.

2.3 Leveraged investment fund financing and short-covering needs The third key driver, primarily of the leveraged investment fund financing and securities borrowing market segment, is facilitation of hedge fund and other investment strategies involving leverage and short selling.

Some hedge funds are insufficiently creditworthy to borrow cash unsecured or to borrow securities directly from institutional investors.

They therefore rely on prime brokers for financing as well as to locate and borrow the securities they want to sell short.

By pooling the supply of lendable securities in the market, prime brokers can also provide hedge funds with stable securities loans allowing them to maintain short positions while providing securities lenders with the

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liquidity to recall securities loans if they wish: for example, in order to sell the underlying holdings (securities on loan) or exercise shareholder voting rights.

Short-sale proceeds may be used by hedge funds as cash collateral against borrowed securities.

That cash is in turn used by prime brokers to collateralise securities borrowing from securities lenders that reinvest the cash in the separate accounts or commingled funds (e.g., registered MMFs or unregistered cash reinvestment funds), which vehicles may invest in repo.

In this way, short selling may have the effect of temporarily re-directing cash intended for investment in equity or bond markets into the money markets, creating additional demand for wholesale “money-like” assets (the first driver described above).

In addition, market participants told the Workstream that some pension funds use repos to finance part of their bond holdings.

This is notably the case of funds running liability-driven investment (LDI) strategies, with one such strategy consisting of repo-ing out holdings of high-quality long-term assets, usually for term, to raise cash for liquidity management or return enhancement purposes, and by doing so to achieve some degree of leverage.

2.4 Demand for associated “collateral mining” from banks and broker-dealers The fourth driver of the markets is the increasing need for banks and broker-dealers to gain access to securities for the purpose of optimising the collateralisation of repos, securities loans and derivatives. As mentioned earlier, the creation of money-like repo liabilities requires collateral, and therefore the borrowing capacity of banks and broker-dealers depends on the total amount of non-cash collateral available to them. “Collateral mining” refers to the practice whereby banks and broker-dealers obtain and exchange securities in order to collateralise their other activities.

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Increasingly, banks and broker-dealers are seeking to centralise collateral management in order to use collateral in the most efficient and cost-effective way across the firm’s activities. That may include: (i) Ensuring that repo, securities lending and derivatives counterparties are delivered the cheapest collateral acceptable to them, for example, by using tri-party services;

(ii) Using the securities lending and collateral swap markets to upgrade lower quality collateral into higher quality collateral that is more acceptable to other counterparties, for example, in the repo financing markets or at CCPs, or which is eligible for regulatory liquidity requirements; (iii) Re-using collateral delivered by other counterparties in repo, securities lending or OTC derivatives transactions; (iv) Taking advantage of opportunities to re-hypothecate client assets from prime brokerage activities; and (v) Taking advantage of the option to deliver from a range of eligible collateral in bilateral agreements (e.g. credit support annexes supporting ISDA derivatives agreements) in order to deliver collateral securities at the lowest cost to the firm, which is typically the securities with the lowest credit quality or highest yielding.

2.5 Demand for return enhancement by securities lenders and agent lenders

The fifth driver, particularly of the securities lending market segment, is seeking of additional returns by institutional investors, such as pension funds, insurance companies, and investment funds.

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Most lend out securities in order to generate additional income on their portfolio holdings at minimal risk, to help offset the cost of maintaining the portfolio, or to generate incremental returns.

Agent lenders may take a share of their clients’ lending income (net of borrower rebates paid out) arising from lending fees or cash collateral reinvestment.

In general, the loan fees paid by borrowers to the lenders represent what borrowers are prepared to pay for “renting” ownership/use of particular securities, for example, in order to create a short position.

Some securities lenders, however, also treat lending against cash collateral as a source of financing for leveraged investment in search of additional returns, making market activity “supply-led”.

For example, government bonds can usually be lent to raise cash collateral, which can be reinvested with proceeds split between the securities lender and its agent, net of the fixed "rebate" percentage paid to the party borrowing the securities and posting cash.

Securities lenders may thereby run a cash reinvestment business through which they seek higher returns by taking credit and liquidity risk.

One major asset manager also told the Workstream that it intended to use securities lending as a means of raising cash collateral for treasury purposes, in particular, to collateralise OTC derivative positions where bank counterparties are no longer willing to take uncollateralised counterparty risk following regulatory changes.

3. Location within the shadow banking system It is important to note that banks play important roles in these markets and many of the policy issues concern their use of collateral. Arguably, our main focus from a shadow banking perspective should be on four areas:

(i) Borrowing through repo financing markets, including against securitised collateral, which creates leverage and facilitates maturity and liquidity transformation.

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Repo allows banks as well as non-banks – such as securities broker-dealers, pension funds, and (to a greater extent before the crisis) conduits and investment vehicles – to create short-term, collateralised liabilities. Because repo financing is typically short-term but collateralised with longer-maturity assets, it often has embedded risks associated with maturity transformation. It can also involve liquidity transformation depending on the type of securities used as repo collateral. (ii) The extent to which leveraged investment fund financing leads to maturity transformation and leverage; (iii) The chain of transactions through which the cash proceeds from short sales are used to collateralise securities borrowing and then reinvested by securities lenders, into longer-term assets, including repo financing. This activity can mutate from conservative reinvestment of cash in “safe” collateral into more risky reinvestment of cash collateral in search of greater investment returns (prior to the crisis, AIG was an extreme example of such behaviour). (iv) Collateral swaps (also known as collateral downgrades/upgrades) involving lending of high-quality securities (e.g. government bonds) against the collateral of lower- quality securities (e.g. equities, ABSs), often at longer maturities and with wide collateral haircuts. Banks then use the borrowed securities to obtain repo financing, which can further lengthen transaction chains, or hold them to meet regulatory liquidity requirements.

4. Overview of regulations for securities lending and repos

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The major participants in securities lending and repo markets are generally regulated institutions.

By comparison with “financial market intermediaries” such as banks and broker-dealers (securities firms), regulations and activity restrictions on lenders such as investment firms, pension funds and insurance companies vary considerably by jurisdiction and type of entity.

In general, these regulations are focused more on investor/policyholder protection than financial stability considerations.

As for the channels for disclosure (transparency) related to securities lending and repo activities, they are not significantly different from the general requirements for public disclosures through financial reporting and regulatory reporting.

The FSB Workstream on Securities Lending and Repos (WS5), in cooperation with the IOSCO Standing Committee on Risk and Research (SCRR), conducted a survey exercise in autumn 2011 to map the current regulatory frameworks in member jurisdictions. This section provides a high-level summary of the results of the regulatory mapping exercise based on the survey responses from 12 jurisdictions (Australia, Brazil, Canada, France, Germany, Japan, Mexico, the Netherlands, Switzerland, Turkey, UK and US), the European Commission, and the European Central Bank (ECB).

4.1 Requirements for financial intermediaries: banks and broker-dealers

Risk exposures (including counterparty credit risk) arising from securities lending and repo transactions are typically taken into account in the regulatory capital regimes for banks and broker-dealers.

Under the Basel capital regime, for example, banks are required to hold capital against any counterparty exposures net of the collateral received on the repo or securities loan, together with an add-on for potential future exposure.

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But netting of the collateral is only permitted if the legal agreement is enforceable under applicable laws. Capital requirements must also continue to be held against lent or repo-ed securities.

In addition, banks and securities broker-dealers are subject to other requirements that are designed to enhance investor protection and improve risk management.

Unlike regulatory capital requirements that apply consistently across jurisdictions (e.g. Basel III for banks), there is diversity in the tools and the details each jurisdiction has adopted for risks that need to be addressed.

For example, a number of jurisdictions have established regulations for the use (re-hypothecation) of customer assets by banks and broker-dealers but the details differ:

In Australia and the UK, a bank or broker-dealer is permitted to re-hypothecate (i.e. use for its own account) customer assets transferred for the purpose of securing the client’s obligations where permitted under the terms of the relevant legal agreement (e.g. a prime brokerage agreement with a hedge fund).

Once the assets have been re-hypothecated, title transfers to the bank or broker-dealer, and the client’s proprietary interest in the securities is replaced with a contractual claim to redelivery of equivalent securities.

In France, re-hypothecation is subject to several caps. The use of re-hypothecation is authorised in a specific framework for a maximum amount of 100% of the contracted loan (from the prime broker to the hedge fund) for ARIA funds and 140% for ARIA EL funds. There is no regulatory cap for contractual funds. In the US, re-hypothecation by a broker-dealer is subject to a 140% cap as proportion of client indebtedness. In the UK, no similar regulatory cap exists but re-hypothecation is only permitted where securities are transferred for the purpose of securing or

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otherwise covering present or future, actual or contingent or prospective obligations. Under UK regulations, prime brokers are required to set out for the client a summary of the key provisions permitting re-hypothecation in the agreement, including the contractual limit (if any) and key risks to the client’s assets, and report to the client daily on the amount of re-hypothecated assets.

4.2 Requirements for investors: investment funds and insurance companies

For institutional investors (e.g. MMFs, other mutual funds, ETFs, pension funds, college endowments, and insurance companies) that act as “investors” in the securities lending and repo markets, risk exposures arising from their involvement in the markets tend to be regulated by the relevant regulatory requirements and/or activity restrictions designed to protect investors.

4.2.1 Counterparty credit risk

Counterparty credit risk arising from securities lending and repo transactions can be mitigated by restrictions on eligible counterparties (e.g. based on credit ratings or domicile) and counterparty concentration limits (e.g. percentage of total capital or net asset value).

Some jurisdictions measure counterparty risk on a gross (no collateral benefit) basis; while others measure on a net basis (adjusted by collateral).

4.2.1.1 Restrictions on eligible counterparties

There is a divergence across jurisdictions in the entities that are eligible as counterparties for securities lending and repo transactions.

In France, for MMF and UCITS, the eligible counterparties for securities lending transactions are limited to UCITS depositaries; credit institutions headquartered in an OECD country; and investment companies headquartered in an EU member state or in another state in the European

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Economic Area (EEA) Agreement, with minimum capital funds of 3.8 million euros.

In Mexico, for mutual funds and pension funds, their counterparties can only be banks and brokerage firms.

In the UK, counterparties of regulated funds are generally restricted to European banks, investment firms and insurers, US banks and US broker-dealers.

In the US, registered investment company (RIC) lenders are generally required to approve counterparties, and may not lend securities to affiliated counterparties except with express approval of the SEC.

4.2.1.2 Counterparty concentration limits In addition to restriction on eligible counterparties, some jurisdictions set counterparty concentration limits to mitigate the impact of a large counterparty’s default. A number of jurisdictions measure counterparty risk on a gross (no collateral benefit) basis while others measure it on a net basis (adjusted for the value of the collateral). For example: In the EU, the UCITS Directive allows securities lending (securities borrowing is not allowed) by UCITS funds but limits net counterparty exposure of a fund (i.e. adjusted for collateral received) to 10% of NAV. The directive also includes a reference to repo and securities lending transactions in the context of calculating global exposure, requiring these to be taken into account when they are used to generate additional leverage or exposure to market risk. Future changes to the UCITS Directive are likely to include a range of issues relating to securities lending such as rules on collateralisation and gross limits.

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In the US, for MMFs, no counterparty can be greater than 5% of the fund’s total assets unless the repo is fully collateralised by cash or US government securities, in which case the MMF may look to the issuer of the collateral for the purposes of the 5% limit on exposure to a single issuer.

4.2.2 Liquidity risk

Restrictions on the term or maturity of securities loans and repos are used in a few jurisdictions to mitigate liquidity risk arising from securities lending and repo transactions for insurance companies (Australia, Brazil, Mexico, US) and MMFs (Brazil, Canada, Germany, Japan, Mexico, US).

The maturity limits range from 30 days to around one year.

The requirement to allow securities lending transactions to be terminable at will is relatively common.

4.2.3 Collateral guidelines

Some jurisdictions have introduced collateral guidelines that apply either generally or specifically to securities lending and repos.

Such guidelines may include various regulatory tools such as: minimum margins and haircuts; eligibility criteria for collateral; restrictions on re-use of collateral and re-hypothecation; and restrictions on cash collateral reinvestment.

4.2.3.1 Minimum levels of margins and haircuts

A few jurisdictions have imposed minimum levels of haircuts/margins.

For example:

In Canada, haircut requirements for repos are applied to mutual funds and require collateral with a market value of at least 102% of cash delivered.

In the UK, exposures of regulated funds arising from securities financing transactions must be 100% collateralised at all times.

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In the US, RICs must maintain at least 100% collateral at all times, regardless of the type of collateral received (but RICs may only accept as collateral cash, securities issued or guaranteed by the US government and its agencies, and eligible bank letters of credit).

4.2.3.2 Eligibility criteria on acceptable collateral (eligible collateral) Some jurisdictions set criteria for eligible collateral for certain financial institutions to restrict assets acceptable as collateral so as to ensure the quality of collateral. Such criteria are usually based on credit ratings, currency-denomination, market liquidity, instrument types and correlation risk.

4.2.3.3 Restrictions on the re-use of collateral / re-hypothecation

Restrictions on re-use of collateral/re-hypothecation by investment funds and insurance companies have been imposed in a few jurisdictions.

These usually take the form of simple ban on such activities, a quantitative cap (based on client indebtedness), or are based on considerations of ownership.

For example, in France, pursuant to Article 411-82-1 of the AMF General Regulation28 non-cash collateral cannot be sold, re-invested or pledged.

4.2.3.4 Cash collateral reinvestment

Canada, Germany, the UK and the US have restrictions on cash collateral reinvestment for UCITS and RICs (including MMFs).

These restrictions usually take the form of limits on the maturity or currency-denomination of the investments, or are based on asset liquidity considerations.

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In Canada, mutual funds can use cash received in a securities lending transaction to purchase qualified securities with a maturity no longer than 90 days, or purchase securities under a reverse repurchase agreement.

During the term of a securities lending transaction, a mutual fund must hold all non-cash collateral delivered under the transaction, without reinvesting or disposing of it.

For cash received under a repo transaction, the maximum term to maturity of securities in which the cash can be reinvested is 30 days.

In Germany, for MMFs and UCITS, deposits may be (re)invested in money market instruments denominated in the respective currency of the deposits; or (re)invested in money market instruments by way of repurchase agreements. In the UK, regulations on UCITS restrict the types of cash collateral reinvestment to a certain set of financial instruments, and require that cash collateral reinvestment be consistent with the fund’s investment objectives and risk profile. In the US, for RICs (including MMFs), cash collateral reinvestment is generally limited to short-term investments which give maximum liquidity to pay back the borrower when the securities are returned.

4.2.4 Transparency (Disclosures) Disclosure requirements for securities lending and repo activities are not significantly different from the general requirements for public disclosures and regulatory reporting, e.g. disclosure as appropriate in registration statements, financial statements, and other periodic SEC filings for US RICs, and reporting of outstanding positions for banks. One exception is in the case of US regulated insurers involved in securities lending program. They are required to file added disclosure regarding reinvested collateral by specific asset categories and stress testing.

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Such disclosures will highlight the duration mismatch and require a statement from the company on how they would deal with an unexpected liquidity demands.

5. Financial stability issues Based on the results from the market practices survey and regulatory mapping exercise, the Workstream has preliminarily identified the following seven issues that could be considered from a financial stability perspective.

These issues are not equally relevant to all market segments.

For example, securities financing markets for high-quality government bonds tend to have higher levels of transparency and contribute less to procyclicality of system leverage.

5.1 Lack of transparency Securities financing markets are complex, rapidly evolving and can be opaque for some market participants and policymakers.

Market transparency may also be lacking due to the usually bilateral nature of securities financing transactions.

It may be appropriate to consider, from a financial stability perspective, whether transparency could be improved at the following levels:

(i) Macro-level market data - Prior to the crisis, some jurisdictions faced difficulties in assessing and monitoring the risks in certain aspects of those markets. Some data is available based on surveys carried out by the authorities or trade associations and from data vendors that collect information from intermediaries for commercial purposes.

The lack of transparency is serious especially for bilateral transactions (i.e. not involving tri-party agents, who may publish aggregated data on the transactions they process, or agent lenders, who may report transactions to commercial data vendors) and synthetic transactions, where currently no market data is readily available and authorities have to rely on market intelligence.

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(ii) Micro-level market data (transaction data) – Since securities lending and repo are structured in a variety of ways, it can be difficult to understand the real risks individual market participants entail or pose to the system without detailed transaction-level information/data.

This is especially so for bilateral transactions.

(iii) Corporate disclosure by market participants – In most jurisdictions, cash-versus-securities transactions (e.g. repo, reverse repo, cash-collateralised securities loans) are usually reported on-balance sheet.

However,

(i) in some limited cases (e.g. repo to maturity or over-collateralised repos), repos can be off-balance sheet depending on the accounting standards used; and

(ii) limited disclosure is provided in financial accounts of securities-versus-securities transactions (e.g. securities loans collateralised by other securities), that are typically “looked through” for the purposes of financial reporting.

The ability of financial institutions to engage in off-balance sheet transactions without adequate disclosure may contribute to their risk-taking incentives and hence the fragility of the financial system.

(iv) Risk reporting by intermediaries to their clients – Prior to the crisis, many prime brokers did not provide sufficient disclosure on re-hypothecation activities to their hedge fund clients.

For example, following the collapse of Lehman Brothers International, many hedge funds unexpectedly became unsecured general creditors because they had not realised the extent to which it had been re-hypothecating client securities.

In addition, some securities lenders, in particular some less sophisticated ones, have alleged that they were not adequately informed of the counterparty risk and cash collateral reinvestment risk of their securities lending programmes by the agent lenders.

5.2 Procyclicality of system leverage/interconnectedness

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Securities financing markets may allow financial institutions (including some non-banks) to obtain leverage in a way that is sensitive to the value of the collateral as well as their own perceived creditworthiness.

As a result, these markets can influence the leverage and level of risk-taking within the financial system in a procyclical and potentially destabilising way.

This procyclical behaviour of securities financing markets depends, in addition to changes in counterparty credit limits, on three underlying factors:

(i) the value of collateral securities available and accepted by market participants;

(ii) the haircuts applied on those collateral securities; and

(iii) collateral velocity (the rate at which collateral is reused).

5.2.1 The value of collateral securities available and accepted by market participants

The value of collateral that repo counterparties and securities lenders are willing to accept as collateral will fluctuate over time with market values, market volatility and changes in credit ratings.

Sudden shifts, however, have tended to follow unexpected common shocks to a large section of the collateral pool, such as the deterioration in the US housing market affecting ABS markets, and doubts about the creditworthiness of some European government issuers affecting government bond and repo markets.

These can cause market participants to exclude entire classes of collateral from their transactions, creating a vicious circle as contraction in the securities financing markets damage underlying cash market liquidity, reducing the availability of reliable prices for collateral valuation.

Changes in the market value of lent securities (e.g. equities) feed directly into changes in the value of cash collateral required against securities lending and then reinvested in the money market.

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This creates a procyclical link between securities market valuations and the availability of funding in the money markets.

For example, the value of securities lending cash collateral reinvestment declined sharply in the autumn of 2008, as equity markets fell, according to data from the Risk Management Association (RMA).

5.2.2 Haircuts Most securities financing transactions are subject to “haircuts” which may further contribute to procyclicality. The importance of changes in haircuts since the crisis seems to have varied across different market segments. Securities lenders and providers of short-term repo financing appear to have kept haircuts relatively stable and mainly adjusted counterparty limits and/or collateral eligibility restrictions. In the bilateral inter-dealer repo market against G7 government bond collateral, market practice often does not require haircuts and CCPs in those markets have also kept haircuts stable. But haircuts on lower quality assets (e.g. ABS) did increase sharply in the inter-dealer repo and leveraged investment fund financing segments. And in the European government bond market, CCPs increased haircuts significantly on repo of government bonds issued by peripheral euro area government as yield differentials between bonds issued by different euro area governments widened. Procyclical variation in haircuts may not simply be driven by over- and under-exuberance. For example, haircuts should reflect the potential decline in the price of the collateral between the final variation margin call prior to a counterparty’s default and the point at which the non-defaulting party can sell the collateral.

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That will vary with the volatility and correlation of asset prices and market liquidity, both of which are likely to be procyclical. Nonetheless, some element of the procyclicality of haircuts observed in certain segments of the markets may have reflected over-optimistic haircuts before the crisis that could have been corrected, at least in part, by setting of more conservative haircuts in good times.

5.2.3 Collateral velocity Collateral re-use (re-hypothecation) and collateral velocity, or the length of collateral re-use chains, can also be procyclical. According to Singh (2011), the length of “re-pledging chains” has shortened significantly since the crisis. Immediately after the failure of Lehman Brothers, some securities lenders withdrew from the market entirely. Market participants told the Workstream that most securities lenders are now lending again. However, many will only accept high-quality government bonds as collateral or cash collateral that they will reinvest at short maturities in high quality government bond repo, Treasury bills and/or in MMFs.

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5.3 Other potential financial stability issues associated with collateral re-use

In addition to the potential for heightened procyclicality, there are other financial stability risks associated with collateral re-use, whether arising from repo, securities lending, re-hypothecation of customer assets or margining of OTC derivatives.

These include the potential for increased interconnectedness amongst firms and for higher leverage; and whether problems could arise following the default of multiple firms if they had provided the same securities as collateral to their secured creditors as a consequence of collateral re-use.

5.4 Potential risks arising from fire-sale of collateral assets

Securities lending and repo transactions are typically undertaken on the basis that non-defaulting counterparties will sell collateral securities immediately following a default in order to be able to realise cash or buy back lent securities in the market.

As seen during the financial crisis, collateral fire sales may lead to market turmoil, and as discussed by Acharya and Öncü (2012), especially when a defaulting party's collateral assets pool is large relative to the market and concentrated in less liquid asset classes.

If markets are already under stress, further selling would put downward pressure on the already stressed price of the collateral assets, with contagion to other financial institutions that have used those securities as collateral or hold them in trading portfolios.

Individual market participants that establish appropriate risk management requirements or operate under regulatory exposure limitations (e.g. collateral credit quality, counterparty limitations, diversification, and haircuts) can mitigate exposure on their own secured transactions with a particular counterparty, but lack the visibility to assess that counterparty's aggregate transactions and collateral pool across the market and assess the overall market impact of its default.

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5.5 Potential risks arising from agent lender practices

Securities lending practices may entail risks for the market participants involved.

One of the most important is the risk of shortfall of assets held by financial intermediaries in their capacity as custodians.

For example, the EU adopted in 2011 the Alternative Investment Fund Managers Directive which makes the depositary of a hedge fund strictly liable for any loss of assets held in custody bar force majeure.

Many agent lenders offer indemnities to their customers against the risk of borrower default.

The terms of these indemnities, their scope and any caps applicable vary.

There is a need to consider what consequences different market practices in relation to indemnities have for incentives to manage risks and whether this has any implications for market stability.

For example, if an agent lender indemnifies a loan against borrower default, this could lead to the lender looking to the agent lender as its effective counterparty, and no longer screen and monitor the borrower.

5.6 Shadow banking through cash collateral reinvestment

By reinvesting cash collateral received from securities lending transactions, any entity with portfolio holdings can effectively perform “bank-like” activities, such as credit and maturity transformation, thereby subjecting its portfolio to credit and liquidity risks.

As illustrated by AIG’s behaviour as a securities lender prior to the recent financial crisis, lenders can use securities lending as a means of short term funding for financing leveraged investment in instruments that, while highly rated when purchased, can become illiquid, risky, and lose value quickly.

That may give rise to the risk of a “run” if securities borrowers start terminating the securities lending transactions and ask for their cash collateral to be returned.

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Discussions with market participants indicate that AIG’s pre-crisis behaviour was quite atypical of broader activity at that time.

We have been told by some agent lenders that most cash reinvestment programmes are currently more focused on preservation of capital than they were pre-crisis.

But the majority of cash collateral reinvestment programmes are managed by agent lenders, who, like most agents, share in the reinvestment profits but not the losses.

Some have argued that this can create potential conflicts of interest.

Others have argued that this is not the case because securities lending clients that are part of an agent lender’s programme approve the cash reinvestment guidelines and are responsible for monitoring the agent lender’s compliance with their guidelines.

In addition, cash collateral may be reinvested by agent lenders into commingled funds, which offer less control and transparency than separate accounts and may create an incentive for clients to “run” first in the event of any problems.

Market participants told the Workstream that an increasing number of clients are moving towards separate accounts and the number of commingled funds has decreased significantly since the crisis.

However, many clients still seem to use commingled funds for cash collateral reinvestment.

5.7 Insufficient rigor in collateral valuation and management practices When the prices of mortgage-backed-securities (MBS) fell during the early stage of the financial crisis, a number of financial institutions did not mark-to-market their holdings of MBS or based decisions on prices generated by overly-optimistic models, and later suffered significant losses when they eventually had to do so. Arguably, the decline in the prices of MBS would have caused less of a major disruption in financial markets should such price changes have

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been reflected in financial institutions’ balance sheets earlier and more gradually through continuous marking-to-market.

Annex 1: Details of the Four Market Segments 1. Securities lending segment 1.1 Market structure

This market segment involves lenders of assets lending their securities to broker-dealers/banks.

Lenders typically engage an agent or several agents to manage their securities lending business.

In the past, the securities lending agents were custodian banks and they remain the largest players, but today a number of non-custodial agents also act as intermediaries in this business.

Securities lending transactions involve the following key steps:

(i) The terms for the loan are agreed between the beneficial owner and the borrower.

The agent lender, if one is used, usually negotiates the terms on behalf of the beneficial owner.

Terms may include issuer and amount of securities to be lent/borrowed, duration of the loan, basis of compensation, eligible collateral, amount of collateral and collateral margins.

(ii) The beneficial owner delivers the securities to the borrower and the borrower delivers the collateral, either in the form of cash or securities, as agreed upon, to the beneficial owner. (iii) During the life of the loan, the collateral and the lent securities are valued daily to maintain sufficient levels of collateralisation and the margin required is increased or decreased accordingly. The beneficial owner’s agent lender usually manages this process.

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(iv) If the collateral is in the form of cash, it is often reinvested in money market assets, usually through a separate account, or a commingled fund, managed by the agent lender, in which cash collateral of several of the agent lender’s securities lending clients will be commingled and reinvested. Collateral in the form of securities may also be kept in separate or commingled accounts. (v) When the loan is terminated, equivalent securities are returned to the beneficial owner and equivalent collateral is returned to the borrower. In return for lending its securities, the beneficial owner receives a fee from the borrower if the collateral is non-cash. Lending fees can vary greatly depending on the nature, size and duration of the transaction, the demand to borrow the securities, and other factors. Agent lenders are typically compensated for their services through an agreed split of the revenue generated by the lending programme. The size of such splits may vary depending on a number of factors such as the services and protection (i.e. loan indemnification) provided by the agent lender and the type and size of the beneficial owner’s portfolio of assets. In case of cash collateral, the securities lender, typically through its agent lender, will pay the borrower interest on the cash collateral (the “rebate”), usually expressed as a spread below overnight market interest rates unless the lent securities are in very high demand, in which case the borrower will pay the lender a fee (known as a “negative rebate”).

The remainder of the cash reinvestment income is typically shared between the beneficial owner and its agent lender, with the beneficial owner typically receiving the lion’s share.

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The lending agent may also receive a separate asset-based fee for managing the cash collateral, and in some cases a fixed administrative fee.

Securities are usually lent on an open basis with no fixed maturity date.

This gives lenders the flexibility to recall their securities at any day (subject to normal settlement timetables) if, for example: they are dissatisfied with the terms of the loan, no longer like the credit risk of the borrower; want to sell the securities; want to exercise voting rights on equities that have been lent out; or for any other reason.

Borrowers may also return the security at any time, if, for example, they decide to terminate a short position that utilises the borrowed security.

Most securities lending occurs under industry-standard master agreements. Securities lending agreements used outside the US involve transfer of legal title, with the borrower becoming legal owner of the securities on loan and the lender becoming legal owner of the collateral.

Except in the US, both the borrower and lender can therefore sell or use assets received under securities lending transactions as collateral in other transactions.

The agreement between the parties is designed to return all the economic benefits and risks associated with ownership, such as dividends and coupons, to the original owners.

For example, the lender remains exposed to any change in the market value of the lent securities and the borrower is required to make payments to the lender equal to any dividends or coupons received on the lent securities, net of tax at the lender’s tax rate.

But the lender’s economic exposure to the lent securities is entirely synthetic arising from its contract with the borrower.

1.2 Key participants

Lenders are typically institutional investors such as public and private pension funds, ERISA plans, insurance companies, registered investment companies (e.g. mutual funds, MMFs, and ETFs), and college endowment funds.

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Agent lenders, including custodian banks and third-party specialists, are employed by lenders to lend their securities for them. If the collateral received on the securities loan is cash, the agent lenders often also reinvest the cash on behalf of the lenders through their asset management businesses. Cash reinvestment may either be through separate accounts or through commingled funds that pool the cash collateral received by the agent lender’s clients. Benefits of employing an agent lender include economies of scale, securities lending expertise and systems that the beneficial owner may not have, specialised market knowledge, and better access to borrowers.

Most agent lenders also provide indemnification to lenders against the default of the securities’ borrower, but usually not against losses incurred on the reinvestment of cash collateral.

Borrowers of securities include market makers and cash/derivatives traders who borrow securities for their own purposes, e.g. market making, hedging, facilitation of trade settlement or short-covering, and principal intermediaries (e.g. prime brokers) that borrow securities in order to lend to client institutions, such as hedge funds.

1.3 Market characteristics

Lenders typically have minimum eligibility requirements for non-cash collateral, for instance only accepting collateral with a credit rating of AA- or better.

In addition, lenders define their own collateral eligibility schedules, even when they conduct securities lending through an agent lender.

Since the crisis, the Workstream understands that the trend has generally been to move away from ratings-based schedules and towards asset class-based schedules.

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In addition to cash, many lenders will accept government bonds as collateral but equities are also becoming increasingly accepted in some jurisdictions.

Agent lenders told the Workstream that they would only accept non-cash collateral for which current market prices are available, with a number of them referring to a “3-day stale-price policy”, whereby securities for which a market price cannot be obtained after 3 days automatically becomes ineligible.

Agent lenders also told the Workstream that generally they and the lenders agree on a list of approved borrowers for their securities, and sometimes tailor acceptable collateral to the borrower in question.

Some securities borrowers, such as banks/broker-dealers, may give haircuts/margins, which are privately agreed and in some cases are based on minimum regulations.

Margins tended to follow market norms before the crisis (e.g. 102-105%), but have now become more differentiated with respect to asset type and maturity.

VaR models and stress tests are increasingly used to test adequacy of haircuts/margins.

However, agent lenders said that haircuts tended to be adjusted infrequently, with reductions in the value of outstanding loans being the main tool used in response to any counterparty credit concerns.

CCPs are attempting to move into the securities lending market but penetration has been very limited so far.

A key problem is the increased financial costs for lenders to use a CCP; market participants are currently considering viable solutions to overcome this problem.

1.4 Collateral swaps

There has been increased demand from banks in the past year to undertake collateral swap transactions (also known as liquidity swaps and “collateral upgrade/downgrade” trades), a type of securities lending transaction that involves borrowing high-quality and liquid securities,

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such as government bonds, in return for pledging relatively less liquid securities, such as RMBS. Banks may use the high-quality securities to meet regulatory liquidity buffer requirements, raise cash in the repo market or as collateral for CCPs or bilateral derivatives transactions.

1.5 Regional variations

Institutional investors in most countries lend securities globally. But typically, lending programmes are run by agent banks located in London, New York, Tokyo or Hong Kong.

According to the Risk Management Association (RMA), the total value of US securities on loan globally was around $0.7 trillion as of Q3 2011, of which 26% was against non-cash collateral, 74% was against US$ cash collateral, and less than 0.1% was against euro cash collateral.

In comparison, the total value of European securities on loan globally was around $0.2 trillion, of which 59% was against non-cash collateral, 24% was against US$ cash collateral, and 17% was against euro cash collateral.

Cash collateral reinvestment had been largely seen as a market centred around US and Japanese lenders.

However, non-US institutions lending US securities may also be receiving cash collateral and hence subject to cash collateral reinvestment risk.

In Europe, some securities lending programmes are also run by post-trade market infrastructures (International Central Securities Depositories) for the purpose of enhancing securities settlement efficiency.

In Japan, the proportion of cash collateral for bond lending was around 97% in 2011 according to JSDA.

1.6 Recent history

During the 2007-2008 financial crisis, AIG experienced substantial losses on the securities lending programme operated by some of its life insurance subsidiaries.

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AIG ran the programme primarily as a source of financing for leveraged investment. Cash was pooled and reinvested in relatively long maturity instruments, including ABS, to maximize returns. Meanwhile, the cash reinvestment programmes of a number of large agent lenders suffered from the illiquidity of US money markets, with the estimated secondary market value of reinvestment assets falling below the lender’s obligation to return cash collateral.

Where the cash collateral was reinvested in commingled pools, some lending agents restricted the ability of clients to completely redeem their assets from the pools, offered repayment in kind rather than in cash, and/or permitted limited cash redemption, in small monthly percentages (“gates”) or in the case of “ordinary course” redemptions only.

These measures were taken in part to address the illiquidity of the reinvestment pools, and to address the incentive of some clients might have to withdraw their cash collateral, which could have further eroded the liquidity of the cash reinvestment pools to the detriment of those remaining in the pools.

Agent lenders also provided incentives for borrowers to maintain loans in order to avoid the need to liquidate cash collateral pools, including by raising rebate rates and offering to reinvest new cash in term repo with borrowers.

A number of reinvestment programmes also experienced investment losses following defaults of Lehman Brothers and some SIV investments.

Some legal actions have been commenced by lenders against agent lenders in relation to losses on cash reinvestment programmes (generally these suits allege breach of contract as to the investment guidelines and breach of fiduciary duties).

The Workstream understands generally that, notwithstanding the losses in the value of the securities in which the cash was invested, the securities continued to generate income and during this period lenders continued to receive income, in some cases substantial, from their cash collateral reinvestments.

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In 2008, the size of the securities lending market shrank significantly.

This was due in large part to sharp falls in the market value of lent securities but also to a lesser extent because some lenders and borrowers withdrew from the market, reflecting a combination of concerns about counterparty creditworthiness and illiquidity in cash reinvestment portfolios, reputational concerns following regulatory bans on short selling, and realisation that they did not sufficiently understand the risks inherent in their securities lending activities.

Lehman Brothers had been a significant securities borrower prior to its collapse but its default was managed relatively smoothly by securities lenders, with collateral in most cases being sufficient to avoid losses according to market participants.

Since 2008, agent lenders report that the majority of lenders have returned to the market. But the Workstream has been told that lenders have generally tightened their non-cash collateral schedules, moved to less risky cash reinvestment mandates, and required more frequent and detailed reporting from agent lenders. The Workstream has also been told that lenders with larger programmes have also shifted away from pooled reinvestment vehicles towards separate accounts in order to reduce the risk of liquidity runs (which are a risk when using commingled pools for cash collateral reinvestment). In the US, lenders may reinvest cash collateral in rule 2a-7 funds (registered MMFs), or unregistered funds that may follow some but not all of the requirements of rule 2a-7 funds (and/or separate accounts). Lenders reinvesting the cash in commingled funds, and looking to the cash reinvestment as a profit centre may invest the cash in non-2a-7 funds. Meanwhile, lenders reinvesting the cash in commingled funds with capital preservation as the primary goal, are more likely to invest in 2a-7 funds, or short-term repo, or similarly conservative investments.

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2. Leveraged investment fund financing and securities borrowing segment 2.1 Market structure

This market segment covers banks and broker-dealers lending securities and providing financing to leveraged investment funds (most of which are hedge funds) via market-based securities lending and repo transactions, and through margin lending as part of the prime broker relationship.

Prime brokers are typically large banks and securities firms that offer a range of services to their clients, most of which are hedge funds.

The prime brokerage agreement is based on a pledge over the hedge funds’ total in-custody assets, and is thus very much relationship-based. Hedge funds are able to borrow cash or securities up to this value less a margin, with margins typically calculated on a portfolio basis, drawing on VaR type calculations and stress testing.

Financing of long positions can be collateralised with the underlying securities purchased, while securities borrowing to cover short positions can be collateralised with the cash proceeds.

Margin requirements are met from net assets.

Prime broker margin lending occurs alongside repo and securities lending transactions that the hedge fund may enter into with other banks and broker-dealers.

Typically, equity funds rely more on prime broker margin lending whereas larger fixed income funds transact directly across multiple banks/broker-dealers using repo.

A key role of a prime broker is to locate securities that hedge funds wish to sell short through the securities lending and other markets and on-lend them to hedge funds. These loans are typically “at call” so that the prime broker is not exposed to a contractual maturity mismatch. The prime broker’s reputation, however, rests on never needing to recall securities from a hedge fund client.

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A good prime broker will protect its hedge fund clients from a “short squeeze” in the market to a certain extent through access to multiple securities lenders and other sources of securities. In some cases, prime brokers will pay securities lenders for exclusive access to “hard-to-borrow” portfolios (e.g. emerging market equities) over a defined period. Some lenders have a business model of periodically auctioning these exclusive portfolios to the prime broker prepared to pay the highest fee. Index funds and ETFs are valued by prime brokers because they have stable portfolios and are less subject to the risk of recall because of investment decisions by asset managers. They may therefore command higher lending fees. Prime brokerage agreements usually give the prime broker the right to re-use pledged assets it holds on behalf of the hedge fund up to a proportion of its net indebtedness, a practice known as “re-hypothecation”.

This is often separate from securities lending and repo transactions, which typically take place under industry-standard master agreements and involve full temporary transfer of title of the underlying securities and collateral.

In the US, the extent to which prime brokers can re-hypothecate client assets is limited by SEC regulations to 140% of the client’s net indebtedness towards the prime broker.

No such regulatory cap exists in the UK, another market where prime brokerage is active, but hedge funds typically have contractual limits on re-hypothecation with their prime brokers, which have been converging towards 140% of client indebtedness since the crisis.

UK regulation does require regular reporting of re-hypothecation by prime brokers to hedge funds.

Prime brokers can sell assets within agreed limits on re-hypothecation or use them as collateral for securities borrowing or repo financing transactions.

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Outside these limits, assets must be held in custody for the hedge fund client.

Similar to securities lending and repo transactions, the obligation of the prime broker in relation to re-hypothecated assets is to return “equivalent securities” rather than the “exact same” securities.

For liquid securities, prime brokers may be confident that they can buy or borrow the securities in the market to return to the hedge fund client without necessarily going back to the counterparty of the original transaction.

In the case of illiquid, hard to source securities, prime brokers however told the Workstream that they are careful to ensure that they can return the exact securities re-hypothecated.

For example, they said it was not common practice to lend re-hypothecated assets to other hedge funds for short covering.

Prime brokers also told the Workstream that re-hypothecation is critical to their business model because it makes the business more “self financing”. Hedge fund cash balances are used to collateralise borrowing from securities lenders for on-lending to hedge funds and, likewise, re-hypothecated securities are used to collateralise repo financing and securities borrowing for on-lending to hedge funds. Before the crisis, prime brokerage activities could generate excess cash and collateral for use elsewhere in a bank’s business. But now prime brokers said that lower limits on re-hypothecation negotiated by hedge funds, higher haircuts by securities lenders and, importantly, additional liquidity buffers required by regulators such as the UK FSA against possible withdrawal of hedge fund cash balances mean that prime brokerage is a net consumer of liquidity from the rest of the bank, rather than a net generator of liquidity.


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The global prime brokerage industry is mainly concentrated in New York and London, and activities elsewhere, if any, are usually dominated by major US and European investment banks, with some exceptions where domestic prime brokers are also active (e.g. Toronto).

Prime brokers told the Workstream that most London-based hedge funds now set a limit on re-hypothecation of 140% of client indebtedness, the same as the US regulatory limit, but some are still prepared to allow higher limits up to 200%.

2.3 Recent history

In 2008, after a run from hedge funds, Bear Stearns, a large prime broker, became illiquid and was bought by JP Morgan.

Another prime broker, Lehman Brothers, declared bankruptcy later in the year due to large losses on its exposures to subprime mortgages.

As a result, haircuts on hedge fund financing increased sharply during the crisis, particularly against ABS collateral, forcing many hedge funds to reduce leverage.

Following Lehman Brothers’ collapse, clients of Lehman Brothers’ prime brokerage business experienced delays in recovering client assets and client money held with the firm.

In particular, many clients had granted Lehman Brothers unlimited rights to re-hypothecate assets to obtain funding and were therefore unsecured creditors when Lehman Brothers declared bankruptcy.

This exposed the risks run by hedge funds in allowing their prime brokers to re-hypothecate assets beyond their net indebtedness position.

Since the crisis, hedge funds have responded by diversifying their financing sources via multiple prime brokers, becoming more sensitive to the creditworthiness of their prime brokers, improving collateral monitoring and modifying their contracts to limit re-hypothecation.

Some have also made arrangements to transfer any “excess” assets on a regular basis to custody accounts with third party custodian banks or custodian sister companies of the prime broker (e.g. ring-fenced from the prime broker’s lien).

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3. Inter-dealer repo segment 3.1 Market structure

This segment consists primarily of repo transactions between banks and broker-dealers. At the beginning of a repo transaction, the cash borrower sells securities with a simultaneous agreement to repurchase equivalent securities at a future date for the original value plus a repo rate. During the term of the repo, any divergence between the market value of the securities sold (collateral) and the cash received should be eliminated by margin maintenance, usually on a daily basis, i.e. if the market value of collateral falls, the buyer calls for extra collateral or requests the difference be refunded in cash and vice versa. If, on the contrary, the market value of a collateral rises and exceeds the price at the time of agreeing the repo by an agreed percentage, the difference is called either an initial margin if the collateral is calculated as a premium over the cash value, or a haircut if the cash is calculated as a discount under the collateral value. Transactions are either against “general collateral (GC)”52 or specific securities.

GC trades dominate the inter-dealer repo market and are driven by the cash leg of the transaction, with banks looking to lend and borrow cash in a secured way for financing purposes or to take yield curve positions.

Repo transactions to borrow specific securities may be to cover short positions for market making, settlement or hedging purposes.


Participants in this market segments are major banks and broker-dealers with an international trend towards central clearing of repo transactions through CCPs. Inter-dealer GC repo trading in US dollar, euro and sterling government bond repo markets is primarily conducted through anonymous electronic trading systems linked to CCPs.

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The inter-dealer government bond repo market is of key importance to banks for squaring their positions in the overnight money markets and for hedging short-term interest rate risk.

This market is also central to the ability of broker-dealers to manage inventories as well as make markets and provide liquidity to government bond cash markets.

Volumes are greatest for overnight transactions.

However, unlike the unsecured interbank market, transactions also take place at longer maturities, reflecting the lower credit risk and capital requirements for repos.

Bilateral transactions in the short-term inter-dealer government bond repo market do not usually involve haircuts, reflecting the equal credit standing of the two parties, the perception of zero credit risk on the collateral, and the collection of variation margin usually on a daily basis to reflect any change in the value of the underlying collateral.

However, this is not necessarily the case in bilateral repo transactions in the US, or for repos conducted against lower quality collateral (e.g. low quality corporate bonds) or with other types of counterparties (e.g. hedge funds).

A CCP, acting as the counterparty to both parties, takes margin/haircut from both sides of the trade.

The benefits of trading through a CCP rather than bilaterally include

(i) reduced counterparty credit risk (and more favourable treatment for regulatory capital purposes) and

(ii) balance sheet netting.

Unlike the repo financing market – which overwhelmingly involves a one-way flow of cash from “cash-rich entities” to banks and broker-dealers in exchange for securities collateral – the inter-dealer repo market is a two-way market amongst banks and broker-dealers.

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Moreover, banks and broker-dealers will often re-use collateral received, so the velocity of collateral in the inter-dealer repo market is relatively high.


Government bond inter-dealer repo markets exist in most developed countries and are closely linked to debt management and central bank monetary policy operations.

This market segment is also usually viewed as a core funding market given its centrality to banks’ funding and its important role in supporting the liquidity in the government cash bond markets.

While a considerable proportion of inter-dealer government bond repo trading is already centrally cleared in the US, UK, euro area and Japan, the Australian and the Canadian repo markets are exclusively bilateral, although a CCP has recently been introduced in Canada to clear repo transactions on specific Canadian government securities and is expected to expand over time.

The US has the largest inter-dealer market in repos backed by non-government bonds, primarily now in US Agency MBS and debentures.

3.5 Recent history

According to the ICMA repo survey, the size of the European repo market (sum of repo and reverse repos outstanding) fell from a peak of 6.7trillion euros in June 2006 to a bottom of 4.6trillion euros in December 2008, before rebounding back to 6.2trillion euros in December 2011.

The European sovereign bond crisis has led to a flight to quality in the euro government bond repo market, with a significant widening of spreads between repo rates on core and periphery sovereign bonds between August and early December 2011, although the spreads narrowed markedly following the ECB’s 3-year long term refinancing operations (LTRO).

CCPs initially raised margin requirements on repos of Italian, Irish, Portuguese and Spanish government debt, but subsequently reduced the

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margins as market conditions improved. Repo market participants told the Workstream that the inter-dealer repo market for some periphery sovereign bonds had almost disappeared beyond overnight maturities, although there has been some significant improvement following the ECB 3-year LTROs.

In the US, the inter-dealer repo market for private label ABS and CDOs that existed before the crisis largely dried up after 2008.

Gorton and Metrick show data on how haircuts in this market widened rapidly from zero before the crisis to up to 100%.

4. Repo financing segment 4.1 Market structure

This segment of the market is used primarily by banks and broker-dealers, and by some other market participants, to finance holdings of securities or for short-term financing. It also provides risk-averse cash investors with a “money-like”, short-term means of lending and investing excess cash in wholesale markets.


The main cash borrowers are investment banks and broker-dealers.

Lenders include retail/private banks but also a wide range of non-bank entities, including MMFs (up to one third of the US tri-party repo market), securities lending cash collateral reinvestment funds (up to one quarter of the US tri-party repo market), official reserves managers, non-financial corporations and other bodies such as the US Federal Home Loan Banks and CCPs.

In Europe, the Euro Money Market Survey (among credit institutions only) published by the ECB on 30 September 2011 indicates that the repo market is concentrated among a few dominant players with the top 20 reporting institutions from an overall panel of 170 accounting for 81.1% of secured financing market activity in 2011.

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With regard to non-bank intermediaries, available data is rather scarce but market intelligence suggests that MMFs and large insurance companies are large lenders. Some large companies have also reportedly begun to use reverse repos instead of bank deposits.


Trades can either be conducted on a bilateral or on a tri-party basis. Tri-party agents provide services including: trade matching; collateral allocation and optimisation; settlement; collateral valuation and margining; as well as custody and reporting on behalf of the parties.

They are remunerated by the cash borrowers.

The main tri-party service providers globally are global custodian banks, with CCPs and CSDs/ICSDs competing in Europe.

Cash borrowers usually give haircuts, but there is no market standard and a wide degree of dispersion exists, even for a given category of assets.

Tri-party repo developed predominantly as means for broker-dealers to finance their inventory on an ongoing basis (akin to sequential overnight trades), and as a facility to optimise collateral mapping across institutional cash providers.

Some repo lenders insist on receiving government bonds only as collateral. Tri-party repos, however, facilitate the acceptance of a wider range of collateral and investment banks are prepared to pay a higher rate and higher haircuts on broader collateral that can be less easily (or more expensively) financed elsewhere, corresponding to the securities they carry on their balance sheets.

Prior to the crisis, collateral eligibility was typically defined by credit rating, with ABS commonly used.

Now, lenders tend to focus more on asset types, market liquidity and availability of prices for valuation.

The proportion of collateral consisting of ABS has declined markedly since the crisis, while equities have become more widely accepted.

Unlike the inter-dealer repo market, cash lenders in the repo financing market do not typically re-use collateral as most are not leveraged entities with a need to collateralise borrowing.

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This may change in the future however with, for example, demand for collateral against derivatives positions with CCPs.

The 2011 ECB survey includes data on activity in the secured market cleared through CCPs (as a subset of the repo market). The share of these transactions in the secured market was revised upward to 51% for the second quarter of 2010 and remained stable at 50% for the second quarter of 2011. The share of tri-party repos reached 12% of the segment, at the expense of the non-CCP cleared bilateral repos which accounted for 38 %


Repo financing markets are most developed in the US and Europe where tri-party arrangements have a significant and growing market share.

Tri-party is less or not at all used in Australia, Canada and Japan where bilateral trading remains typical.

Overnight tri-party repo financing remains predominant in the US but in Europe longer-term transactions have grown recently alongside overnight and open maturities.

Tri-party collateral in the US market comprises mostly Agency MBS and debentures, and US Treasury bonds, with a smaller share of corporate bonds and equities.

In Europe, government bonds also comprise the largest share of tri-party collateral with corporate bonds, equities and covered bonds also comprising material components of the acceptable collateral universe.

In Japan, Japanese government bonds account for most of the repo financing segment where broker-dealers borrow cash from trust banks and other institutional investors, with a very small portion of corporate bonds and equities.

4.5 Recent history

Unlike the inter-dealer market, Copeland et al (2011) show that haircuts in the US tri-party repo financing market were generally stable during the

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crisis, with the response to counterparty credit concerns largely taking the form of reduction in lending volumes. In Europe, market participants told the Workstream that tri-party haircuts had been increased during the crisis but in a measured way. Collateral eligibility had also changed, with lenders excluding ABS and adopting criteria based on asset type and liquidity rather than purely ratings.

Annex 2: Data on securities lending and repos Securities lending segment Data Explorers, SunGard’s Astec Analytics, and the Risk Management Association (RMA), among others, collect, aggregate, and provide data on securities lending to their clients/members. No data is currently available to the public. All collect data on a global basis rather than by geographical location. RMA data below is based on survey returns from 15 large agent lenders. Data Explorers collects data from lenders, agent lenders and broker-dealers. It claims its dataset encompasses more than 90% of global transactions. Table 1 shows “lendable assets” (i.e. securities held within lending programmes) and assets on loan (i.e. securities actually lent at the time of the survey) as a proportion of total outstanding assets by market value. It also shows the proportion lent against cash collateral (based on the RMA survey data). The remainder are lent against the collateral of securities.

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Leveraged investment fund financing and securities borrowing segment Estimates from public databases show the size of hedge fund assets under management (AUM) globally to be between $1.7 and $2.5 trillion. The UK Financial Services Authority (UK FSA) has been collecting exposure and risk data on a small sample of hedge fund managers based in the UK through its Hedge Fund Survey (HFS), which started in October 2009. The latest HFS for September 2011 captured around 50 hedge fund managers and 100 hedge funds, representing approximately $400bn in assets under management.

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For hedge funds in this sample, repos account for roughly 55% of aggregate hedge fund borrowing, followed by synthetic borrowing (29%) and collateralised borrowing under prime brokerage agreements (15%). Since the first survey in October 2009, collateralised borrowing via prime brokers has declined as a proportion of total borrowing, from 24% to 14%, driven mostly by increases in other forms of borrowing. In addition, the UK FSA collects data on UK-based banks and prime brokers’ exposures to hedge funds through its Hedge Fund as Counterparty Survey (HFACS). The latest data for the HFACS for October 2011 estimated total “cash-out” reverse repo financing provided to hedge funds was $390 billion. This survey also showed that over 74% of repo financing between surveyed banks and their hedge fund counterparties comprised G10 government bonds as collateral, which has remained relatively unchanged across recent surveys.

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3 and 4. Interdealer repo segment and repo financing segment

Separate estimates for the interdealer repo segment and the repo financing segment are available only in the US.

Therefore only aggregate statistics are presented in this section.

Moreover, when calculating the size of the repo market, many studies simply sum up the total amount of repos and reverse repos outstanding on financial institutions’ balance sheets, leading to significant double counting (since one bank’s reverse repo asset may be another bank’s repo liability).

The US and euro area have by far the largest repo markets in the world.

The Federal Reserve Bank of New York (FRBNY) facilitates the industry’s publication of detailed data on tri-party repos on a monthly basis, whereas the most comprehensive statistics available on the European repo markets (including Sterling and Swiss franc) are the semi-annual surveys conducted by the International Capital Markets Association (ICMA).

The total size of the US tri-party repo market was roughly US$1.8 trillion as of March 2012, having reached a peak of over $2.8 trillion in April 2007.

Note that statistics on the size of the US repo market are measured by the total amount of collateral held through two tri-party agents (JP Morgan and Bank of New York Mellon) and are not subject to double counting.

The distribution of collateral between Treasuries/Agencies/Agency MBS and other assets was 84.5% and 15.5% respectively as of March 2012.

In addition, the Fixed Income Clearing Corporation (FICC) also publishes data on GCF (General Collateral Financing) repos, a blind-brokered interdealer market centrally cleared by FICC.

Total volume on the GCF platform on 18 April, 2012 was $357 billion (these statistics do not include the interdealer broker trades, which always net to zero by virtue of the broker’s role in the transaction).

The US tri-party repo market is predominantly part of the repo-financing segment.

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Bilateral (Delivery-versus-Payment, DVP) repos span both the interdealer and repo financing segments.

Anecdotal evidence suggests that tri-party repo activity may account for between 65% and 80% of the total US repo market.

The total size of the US repo market might therefore be roughly $2.1-2.6 trillion (excluding the interdealer repos that have been netted through a CCP).

The latest ICMA survey (December 2011) covers 59 financial institutions involved in the European repo market, as well as automatic repo trading systems (ATS), tri-party repo agents in Europe, and the London-based Wholesale Market Brokers’ Association (WMBA).

The total value of repo contracts (sum of repos and reverse repos) outstanding on the books of the surveyed institutions was 6.2 trillion euros ($8.3 trillion).

However this number included double counting of repo transactions between those institutions.

Moreover, the time-series trend was affected by changes in the survey participants.

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Nonetheless, the survey results provide interesting statistics on the characteristics of the European repo market. For example, the overall share of repos traded on ATS and centrally cleared through a CCP was 32%, up 1.5% from June 2011, comprising predominantly overnight inter-dealer transactions. The share of tri-party repo was 11%, unchanged from June 2011, comprising primarily open trades but with a growing share of long-term (>12 months) transactions. Repos negotiated through voice brokers included a large share of forward-starting transactions. Finally, the top 10 banks accounted for 64% of the total European repo market.

Apart from the US and Europe, other significant repo markets include those against Canadian and Japanese government bonds. According to data from the Office of the Superintendent of Financial Institutions (OSFI), the size of the Canadian repo market was C$213

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billion ($ 218 billion) as of August 31, 2011, measured by the sum of reserve repo assets and repo liabilities of the six largest Canadian banks. The size of the Japanese repo market was estimated to be JPY 182 trillion ($ 2.4 trillion) as of December 2011 according to the Japan Securities Dealers Association (JSDA), measured by the sum of reverse repos and repos of the members of JSDA. In addition to JSDA’s statistics, the Bank of Japan conducts Tokyo Money Market Survey which covers stocks as well as credit terms (e.g. counterparties, collaterals, maturities and haircuts) of securities lending/repos.

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There are many risk management experts that discuss this interesting speech

Shareholder value and stability in banking: Is there a conflict? Speech by Jaime Caruana, General Manager, Bank for International Settlements

Understandably, the global regulatory response to the global financial crisis has stirred controversy.

That response, with Basel III at its core, seeks to strengthen the resilience of the banking system.

In doing so, it asks shareholders to give up high leverage as a source of high returns on equity.

And it asks bondholders, especially those of systemically important institutions, to take more of a hit in the event of failure.

In this light, it is easy enough to imagine that investors would have little reason to hail the new framework.

This view, however, tells only part of the story.

It assumes that, on balance, bank investors were well served by the pre-crisis system.

It also posits a conflict between value for shareholders on the one hand and the public interest in safer banking on the other.

In my remarks today I would like to suggest that this supposed conflict of interests is overstated.

Yes, tensions may arise over a short investment horizon.

But over long horizons, they tend to disappear – because, in the long term, the focus necessarily shifts to sustainable profits and returns.

This is not just theorising: we’ll take a look at the statistical evidence in a moment.

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And unless one believes that markets can be consistently timed – a rare gift at best – it is long horizons that should matter for investors.

Let me first outline what we in Basel mean by safer banking and take stock of where we stand in the development and implementation of new standards.

This is an issue in which, I am sure, you will have a keen interest.

I shall then argue that the concerns of investors and bank supervisors are remarkably well aligned in the long term.

Basel’s vision of safe banking In the past few years, the Basel Committee on Banking Supervision has conducted a sweeping review of regulatory standards and it has put in place a strengthened framework that incorporates new macroprudential elements.

This framework is in several ways a great improvement over the pre-crisis regulatory approach.

First of all, it sets a much more conservative minimum ratio for capital that is of far better quality.

When the whole Basel III package is implemented, banks’ common equity will need to be at least 7% of risk-weighted assets.

This compares to a Basel II level of 2% – and that is before taking account of the changes to definitions and risk weights that make the effective increase in capital all the greater.

Among the improvements in capturing risk on the assets side, I would especially point to the improved treatment of risks arising from securitisation and contingent credit lines.

Moreover, these risk-based capital requirement measures will be supplemented by a non-risk-based leverage ratio, which will serve as a backstop and limit model risk.

This new framework responds to the main lessons from the crisis: banks had leveraged excessively, had understated the riskiness of certain assets (particularly those considered practically risk-free), and had made

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innovations that reduced the loss-absorbing capacity of headline capital ratios.

Second, Basel III takes the notion of a “buffer” much more seriously.

The 7% figure includes a 2.5% capital conservation buffer, which banks can draw upon in difficult times.

Dividends and remuneration will be restricted at times when banks are attempting to conserve capital.

Supervisors will have the discretion to apply an additional, countercyclical buffer when risks show signs of building up in good times, most notably in the form of unusually strong credit growth.

The goal is to build up buffers in good times that banks can draw down in bad times.

Third, the package contains elements to address systemic risk head-on, both by mitigating procyclicality and by cushioning the impact of failures on the entire system.

I have already mentioned the countercyclical buffer, which aims to address the procyclical build-up of risk, and the leverage ratio, which will help contain the build-up of excessive leverage in good times.

The framework now also recognises explicitly that stresses at the largest, most complex financial institutions can threaten the rest of the system.

The Financial Stability Board (FSB) and the Basel Committee envisage that these systemically important financial institutions, or SIFIs, will have greater loss absorbency, more intense supervision, stronger resolution and more robust infrastructure.

These aims complement each other, and share a common rationale.

Greater loss absorbency – including capital surcharges that range from 1 to 2.5% for those institutions designated as SIFIs – and better supervision should reduce the probability that problems at these big market players disrupt activity throughout the wider financial system.

Stronger resolution and better infrastructure should reduce the systemic impact of a SIFI’s closure or restructuring and thereby strengthen market discipline.

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In addition, methods to identify globally systemically important insurers are being developed and should be ready for public consultation by the G20 Leaders’ Summit in June 2012.

And, work is under way to address the issue of banks that are systemic on a national rather than a global level, as well as to identify other globally systemic non-bank financial institutions.

Fourth, liquidity standards have been introduced.

These comprise a liquidity coverage ratio, or LCR, and a net stable funding ratio, or NSFR.

The standards will ensure that banks have a stable funding structure and a stock of high-quality liquid assets to meet liquidity needs in times of stress.

Importantly, the group of governors and heads of supervision that oversees the Basel Committee has confirmed that this liquidity buffer is there to be used.

Specifically, banks will be required to meet the 100% LCR threshold in normal times.

But, during a period of stress, supervisors would allow banks to draw down their pools of liquid assets and temporarily to fall below the minimum, subject to specific guidance.

The Committee will clarify its rules to state this explicitly, and will define the circumstances that would justify use of the pool.

Since this is the first time that detailed global liquidity rules have been formulated, we do not have the same experience and high-quality data as we do for capital.

A number of areas will require careful potential impact assessment as we implement these rules.

The Basel Committee has therefore taken a gradual approach in adopting the standards between 2015 and 2018, and will meanwhile assess the impact during an observation period.

At the same time, in order to reduce uncertainty and to allow banks to plan, key aspects of liquidity regulation, such as the pool of high-quality liquid assets, are being reviewed on an accelerated basis.

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But any changes will not materially affect the framework’s underlying approach, which is to induce banks to lengthen the term of their funding and to improve their risk profiles, instead of simply holding more liquid assets.

Finally, it is time for these new rules and frameworks to be implemented.

The Basel Committee is already engaged in the full, consistent and timely implementation of the framework by national jurisdictions.

To this end, the Committee has started to conduct both peer and thematic reviews through its Standards Implementation Group.

Last October, the Committee published the first regular progress reports on members’ implementation of what they have agreed.

Each member will also undergo a more detailed peer review, starting with the EU, Japan and the United States.

And the Committee is currently reviewing the measurement of risk-weighted assets in banking and trading books, with an eye to consistency across jurisdictions.

The goal of these measures is clear: to have a stronger and safer financial system.

This should benefit everyone – the banking industry, users of financial services and taxpayers.

But some may question whether shareholders will benefit as well.

Has the leveraged business model of the past really served them well?

The record, to which I turn next, suggests that it has not.

Shareholder returns and the leveraged business model

Over the long term, banks have turned in a sub-par performance, whether assessed on accounting measures or by return on equity.

Historically, the average return on equity in banking has matched that of other sectors (see Table).

But unlike in other sectors, these returns have involved the generous use of leverage, either on the balance sheet or, frequently, off it.

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We know that banking involves leverage and maturity transformation, but the question is how much is appropriate?

There may be no clear answer, but let’s look at the data. Bank equity was on average leveraged more than 18 times in 1995–2010. Equity in non-financial firms was leveraged only three times (see Table).

This implies that, compared with other firms, banks have succeeded in delivering only average return on equity over the long term but at the cost of higher volatility and losses in bad times (Graph 1).

Turn now to stock returns and the message does not change much.

Anyone who at the start of 1990 had invested in a portfolio that was long global banking equities and equally short the broad market indices would today be sitting on a loss (Graph 2, right-hand panel).

And, over the long term, risk-adjusted returns have been sub-par.

The main exception is Canada, where banks have barely suffered in the recent crisis (Graph 2, left-hand panel).

It is high leverage that has contributed to the volatility of bank profits. And it is high leverage that makes banks perform so badly on a rainy day.

During periods that comprise the worst 20% of stock market performance, banks do worse than most other sectors (Graph 3, left-hand panel).

Clearly, the flip side is that they do very nicely on sunny days (Graph 3, right-hand panel).

For investors, this is not a compelling value proposition.

To be sure, some may be agile enough to profit from the downside in bank stocks.

But most investors inevitably entered the global financial crisis fully invested or overweight in bank stocks.

And, historically, market timing has proved an elusive strategy.

Not only is the performance of banks over time inconsistent with the notion that shareholders can benefit from high leverage and state support; the evidence across banks actually suggests that the banks that were more strongly capitalised at the outset weathered the crisis better.

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The left-hand panel of Graph 4 suggests that no particular relationship existed between Tier 1 capital and the pre-crisis return on equity.

Indeed, banks with stronger Tier 1 equity could and did match the returns of less well capitalised peers.

When the crisis hit, however, the less well capitalised banks scrambled to raise funds in difficult market conditions, while their stronger competitors could avoid fire sales and distressed fund-raising (centre panel).

And it was the banks that had reported high-flying returns before the crisis that were the most likely to resort to fire sales and distressed fund-raising (right-hand panel).

The conclusion is that stronger capital makes a difference.

A further consideration is that it is easier and probably cheaper to raise capital in good times.

Together, these observations suggest that leverage is not the only way to generate returns – and that, when returns don’t depend on leverage, they are more sustainable.

What investors can expect from banks

All this indicates that investors could reach a better understanding with bank managements.

The key is sustained profitability through both good and bad times.

Recent work at the BIS suggests that, when economic activity moves from peak to trough, the betas on bank stocks, relating percentage changes in their value to that of broad market indices, increase by well over 150 basis points.

In effect, banks are generating good returns in good times by writing out-of-the-money puts that come back to haunt them when the market falls.

How did we get here?

The story of a major UK bank is symptomatic.

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Twenty years ago, the head of the bank promised investors that the institution would beat its cost of equity, which he took to be 19%.

For a while, the bank was able to achieve this return by closing branches.

But ultimately such promises led bank managers to invest their liquidity reserve in asset-backed securities, boosting earnings in effect by writing puts on both credit and liquidity.

When it came to the crunch, the bank could not keep its return on equity above 20% during the global financial crisis and had to seek help from the state.

Given the trend decline in inflation and government bond yields, 20% in the early 1990s translates to something more like 15% today.

Still, bank managements that continue to promise such returns may find themselves again writing puts, effectively making themselves hostage to bad times in order to pump up returns in good times.

Accounting norms that treat risk premia in good times as distributable profits do not help.

In any case, managements who promise sustained 15% returns in a low-inflation, deleveraging economy may be leading investors astray.

Over time, sustained profitability at more reasonable levels should bring bank share prices back to a premium over book values.

Past behaviour supports this conclusion. In particular, my colleagues estimate that if leverage decreases from 40 to 20, the required return – the return investors demand – drops by 80 basis points.

The intuition is that, when banks increase their equity base (or reduce leverage), they work each unit of equity less – that is, the risk borne by each unit of equity falls—and so does the return investors require.

This prospect would characterise a new long-run understanding between shareholders and bank managements that produce sustained profits. But how should banks get there?

Here I do not refer to the immediate problem banks face in bringing their assets into line with their capital, leading to considerable deleveraging. Instead, I refer to the longer-term problem.

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How should banks generate returns in order to be sustainable?

I would argue that such returns can arise from a reconsideration of banks’ business models.

In line with the lessons drawn from the crisis by banks, investors and prudential authorities, these models would recognise that our knowledge of systemic risk is incomplete.

As a result, bank managers would seek sustainable profit less in risk-taking and maturity transformation and more in operational and cost efficiency.

Cost efficiency can powerfully contribute to bank earnings.

As a rule of thumb, on average across countries, a 4% reduction in operating expenses translates into roughly a 2 percentage point increase in return on equity.

Moreover, experience strongly suggests that determined attempts to clean up balance sheets and cut costs can go hand in hand with a sustained recovery in profits on the back of a stronger capital base.

This is precisely the experience of Nordic countries, which suffered serious banking crises in the early 1990s (Graph 5).

With costs under control, banks can achieve higher profitability with stronger capital.

Conclusions

Let me pull together the threads of the argument.

The banks that fared better in the crisis were those that were more prudently capitalised.

Investors as well as regulators want to ensure that this wisdom is written into the rules of the game.

The financial reforms that have been agreed will increase the quality and amount of bank capital in the system; they will also promote increases of capital buffers in good times that can be drawn down in bad times.

Big, interconnected and hard-to-replace banks will carry extra capital. The authorities are working to ensure that no bank is too complex to be wound down. They are refining new liquidity standards.

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And they are taking unprecedented steps to make sure that the new regulations are implemented effectively across countries.

The outcome should be a stronger financial system. But regulation is only part of the answer and stronger market discipline will also be necessary to ensure resilience.

I have presented the case that, over the long term, there is no conflict between shareholder value and the public interest in safer banking.

This proposition is supported by the record of return on equity and bank share price performance – a record that refutes the argument that banks have used leverage to produce sustained shareholder value – and the key word here is “sustained”.

Bank returns may have been comparatively high in good times.

But those returns have melted away in bad times.

And they have come at the cost of greater risk.

In the long run, bank business models have produced middling returns with substantial downside risk.

This means that in good times banks have overpromised and overestimated their underlying profitability.

They have written put options on their liquidity and credit and reported the premia as current income.

In effect, they have made distributions out of what should have been treated as expected losses.

How can investors help banks move in the right direction?

They could encourage sustainable business models based less on risk-taking and more on a careful analysis of competitive advantage and operational efficiencies.

And they should be wary of entertaining unrealistic expectations about sustainable rates of return.

Only when solid business models and realistic commitments to sustainable returns are rewarded can shareholder value be reconciled with safe banking.

Indeed, there is no other way.

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*****

As a postscript, and for the sake of completeness, let me outline three other regulatory initiatives.

First, the FSB, with the involvement of the IMF, the World Bank and standard-setting bodies, will draft an assessment methodology that provides greater technical detail on the Key Attributes of Effective Resolution Regimes for Financial Institutions.

The FSB will use the draft methodology to begin, in the second half of 2012, a peer review evaluating member jurisdictions’ legal and institutional frameworks for resolution regimes (and of any planned changes).

And supervisors plan to put in place resolution plans and institution-specific cooperation agreements for all 29 G-SIFIs by end-2012.

Second, work continues towards strengthening OTC derivatives markets.

This includes meeting the commitments by G20 Leaders to move trading in standardised contracts to exchanges and central counterparties by end-2012.

Market supervisors and settlement system experts are close to finalising standards for strengthening CCPs and other financial market infrastructures.

Meanwhile, banking supervisors are reviewing the incentives for banks to trade and clear derivatives centrally.

Another important initiative here is the establishment of a global, uniform legal entity identifier, for which the FSB, with the support of an industry advisory panel, is developing recommendations to be presented to the next G20 Summit in Mexico in June.

Third, potential risks related to the shadow banking system are being addressed. Banking supervisors are examining banks’ interactions with shadow banking, including issues related to consolidation, large exposure limits, risk weights and implicit support, and will propose any needed changes by July 2012.

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Market supervisors are looking at the regulation of money market funds and at issues relating to securitisation on the same schedule. Multidisciplinary FSB task forces are examining other shadow banking entities and, separately, securities lending and repo markets, with a view to making policy recommendations later this year

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Jens Weidmann: Global economic outlook – what is the best policy mix?

Speech by Dr Jens Weidmann, President of the Deutsche Bundesbank, at the Economic Club of New York, New York, 23 April 2012.

1. Introduction Ladies and Gentlemen George Bernard Shaw is said to have made an interesting remark about apples – “If you have an apple and I have an apple and we exchange these apples then you and I will still each have one apple. But if you have an idea and I have an idea and we exchange these ideas, then each of us will have two ideas.” I think those words perfectly encapsulate the intention of the Economic Club of New York and of today’s event. Ideas multiply when you share them and they become better when you discuss them. I am therefore pleased and honoured to be able to share some ideas with such a distinguished audience today. And I look forward to discussing them with you. In a long list of speakers, I am the third Bundesbank President to speak at the Economic Club. The first was Karl Otto Pöhl in 1991, followed by Hans Tietmeyer in 1996. Although only a few years have passed since then, the global economic landscape has completely transformed in the meantime – just think of the spread of globalisation, think of the introduction of the euro, think of the Asian crisis or the dotcom bubble.

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All these events and others have constantly shaped and reshaped our world. Most recently, we have experienced a crisis that, once again, will change the world as we know it – economically, politically and intellectually. It is this new unfolding landscape that provides the backdrop to my speech. I shall address two questions: “Where do we stand?” and “Where do we go from here?” Of course, it is the second question that is the tricky one. In answering it, we should be aware that every small step we take now will determine where we stand in the future. Specifically, I shall argue that measures to ward off immediate risks to the recovery are closely interconnected with efforts to overcome the causes of the crisis. They are interconnected much more closely and vitally than proponents of more forceful stabilization efforts usually assume. But, first, let us see where we stand at the present juncture.

2. Where do we stand?

When we look back from where we are standing right now, we see a crisis that has left deep scars. The International Labour Organisation estimates that up to 56 million people lost their jobs in the wake of the crisis. This number equals the combined populations of California and the state of New York.

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Or look at government debt: Between 2007 and 2011, gross government debt as a share of GDP increased by more than 20 percentage points in the euro area and by about 35 percentage points in the United States. I think we all agree that the crisis was unprecedented in scale and scope. And the first thing to do was to prevent the recession turning into a depression. Thanks to the efforts of policymakers and central banks across the globe, this has been achieved. Following a slight setback in 2011, the world economy now seems to be recovering. In its latest World Economic Outlook, the IMF confirms that global prospects are gradually strengthening and that the threat of sharp slowdown has receded. Looking ahead, the IMF projects global growth to reach 3.5% in 2012 and 4.1% in 2013. For the same years, inflation in advanced economies is expected to reach 1.9% and 1.7%. Basically, I share the IMF’s view. However, we all are aware that these estimates have to be taken with a grain of salt – probably a large one. Being a central banker, I am not quite as calm about inflation. Taking into account rising energy prices and robust core inflation, prices could rise faster than the IMF expects. We have to be careful that inflation expectations remain well anchored and consistent with price stability. Expectations getting out of line might very well turn out to be a non-linear process.

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If this were to happen, it would be difficult and expensive to rein in expectations again. Even though the outlook for growth has improved over the past months, some risks remain – the European sovereign debt crisis being one of them. And this seems to be the one risk that is weighing most heavily on peoples’ minds – not just in Europe but here in the United States, too. The euro-area member states have responded by committing to undertake ambitious reforms and by substantially enlarging their firewalls. This notwithstanding, the sovereign debt crisis has not yet been resolved. The renewed tensions over the past two weeks are a case in point. Thus, we have to keep moving, but each step we take has to be considered very carefully. As I have already said: each small step we take now will determine where we stand in the future.

3. Where do we go from here? Eventually, three things will have to happen in the euro area. First, structural reforms have to be implemented so that countries such as Greece, Portugal and Spain become more competitive. Second, public debt has to be reduced – a challenge that is not confined to the euro area. Third, the institutional framework of monetary union has to be strengthened or overhauled, and we need more clarity about which direction monetary union is going to take. I think we all agree on this – including the IMF in its latest World Economic Outlook.

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However, there is much less agreement on the correct timing. Since the crisis began, the imperatives I have just mentioned have tended to be obscured by short-term considerations. And surprisingly, this tendency seems to be becoming stronger now that the world economy is getting back on track. This view is reflected by something Lawrence Summers wrote in the Financial Times about four weeks ago. Referring to the US, he said that “… the most serious risk to recovery over the next few years […] is that policy will shift too quickly away from its emphasis on maintaining adequate demand, towards a concern with traditional fiscal and monetary prudence.” It is in this spirit that some observers are pushing for policies that eventually boil down to “more of the same”: firewalls and ex ante risk sharing in the euro area should be extended, consolidation of public debt should be postponed or, at least, stretched over time, and monetary policy should play an even bigger role in crisis management. I explicitly do not wish to deny the necessity of containing the crisis. But all that can be gained is the time to address the root problems. The proposed measures would buy us time, but they would not buy us a lasting solution. And five years after the bursting of the subprime bubble and three years after the turmoil in the wake of the Lehman insolvency, we have to ask ourselves: Where will it take us if we apply these measures over and over again – measures which are obviously geared towards alleviating the symptoms of the crisis but which fail to address its underlying causes? In my view, this would take us nowhere. There are two reasons for this.

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First, the longer such a strategy is applied, the harder it becomes to change track. More and more people will realise this and they will start to lose confidence. They will lose confidence in policymakers’ ability to bring about a lasting solution to our problems. And we should bear in mind that the crisis is primarily a crisis of confidence: of confidence in the sustainability of public finances, in competitiveness and, to some extent, in the workings of EMU. But there is a second reason why the “more of the same” will not take us anywhere. The analgesic we administer comes with side effects. And the longer we apply it, the greater these side effects will be, and they will come back to haunt us in the future. In the end, it is just not possible to separate the short and the long term. You will be tomorrow what you do today. With these two caveats in mind, let us take a closer look at the suggested policy mix. For the sake of brevity, I shall focus on monetary and fiscal policies.

3.1 An even bigger role for monetary policy? To contain the crisis, the EMU member states have built a wall of money that recently reached the staggering height of 700 billion euros. As I have already said, ring-fencing is certainly necessary, but again: it is not a lasting solution.

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And it is not the sky that’s the limit – the limits are financial and political. In the face of such limits, the Eurosystem is now seen as the “last man standing”. Consequently, some observers are demanding that it play an even bigger role in crisis management. More specifically, such demands include lower interest rates, more liquidity and larger purchases of assets. But does the assumption on which these demands are based hold true when we take a closer look at it? In the end, monetary policy is not a panacea and central bank “firepower” is not unlimited, especially not in monetary union. True, this crisis is exceptional in scale and scope, and extraordinary times do call for extraordinary measures. But the central banks of the Eurosystem have already done a lot to contain crisis. Now we have to make sure that by solving one crisis, we are not preparing the ground for the next one. Take, for example, the side effects of low interest rates. Research has found that risk-taking becomes more aggressive when central banks apply unconditional monetary accommodation in order to counter a correction of financial exaggeration, especially if monetary policy does not react symmetrically to the build-up of financial imbalances. In the end, putting too much weight on countering immediate risks to financial stability will create even greater risks to financial stability and price stability in the future.

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The Eurosystem has applied a number of unconventional measures to maintain financial stability. These measures helped to prevent an escalation of the financial turmoil and constitute a virtually unlimited supply of liquidity to banks. But monetary policy cannot substitute for other policies and must not compensate for policy inaction in other areas. If the Eurosystem funds banks that are not financially sound, and does so against inadequate collateral, it redistributes risks among national taxpayers. Such implicit transfers are beyond the mandate of the euro area’s central banks. Rescuing banks using taxpayers’ money is something that should only be decided by national parliaments. Otherwise, monetary policy would nurture the deficit bias that is inherent to a monetary union of sovereign states. In this regard, the situation of the Eurosystem is fundamentally different from that of the Federal Reserve or that of the Bank of England. Moreover, extensive and protracted funding of banks by the Eurosystem replaces or displaces private investors. This breeds the risk that some banks will not reform unviable business models. So far, progress in this regard has been very limited in a number of euroarea countries. And the Eurosystem has also relieved stress in the sovereign bond market.

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However, we should not forget that market interest rates are an important signal for governments regarding the state of their finances and that they are an important incentive for reforms. Of course, markets do not always get it right. They may have underestimated sovereign risks for a long time and now they are overestimating it. But past experience taught us that their signal is still the most powerful incentive we have. At any rate, I would not rely on political insight or political rules alone. After all, monetary policy must not lose sight of its primary objective: to maintain price stability in the euro area as a whole. What does this mean? Let us say that monetary policy becomes too expansionary for Germany, for instance. If this happens, Germany has to deal with this using other, national instruments. But by the same token, we could say this: even if we are concerned about the impact on the peripheral countries, monetary policymakers must do what is necessary once upside risks for euro-area inflation increase. Delivering on its primary goal of maintaining price stability is essential for safeguarding the most precious resource a central bank can command: credibility. To sum up: what we do in the short-term has to be consistent with what we are trying to achieve in the long-term – price stability, financial stability and sound public finances.

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This implies a delicate balancing act – a balancing act we shall upset if we overburden monetary policy with crisis management.

3.2 Rethinking consolidation and structural reforms? Now, what about consolidation and structural reforms? Here, too, we have to strike the right balance between the short and the long run. Those who propose putting off consolidation and reforms argue that embarking on ambitious consolidation efforts or far-reaching structural reforms at the present moment would place too great a burden on recovery. They do not deny the necessity of such steps over the medium term, but in the short-run they consider it more important to maintain adequate demand, avoid unsettling people and nurture the recovery. But in the end, the current crisis is, to a large degree, a crisis of confidence. And if already announced consolidation and reforms were to be delayed, would people not lose even more confidence in policymakers’ ability to get to the root of the crisis? We can only win back confidence if we bring down excessive deficits and boost competitiveness. And it is precisely because these things are unpopular that makes it so tempting for politicians to rely instead on monetary accommodation. It is true that consolidation, in particular, might, under normal circumstances, dampen aggregate demand and economic growth. But the question is: are these normal circumstances?

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It is quite obvious that everybody sees public debt as a major threat. The markets do, politicians do, and people on Main Street do. A widespread lack of trust in public finances weighs heavily on growth: there is uncertainty regarding potential future tax increases, while funding costs are rising for private and public creditors alike. In such a situation, consolidation might inspire confidence and actually help the economy to grow. In my view, the risks of frontloading consolidation are being exaggerated. In any case, there is little alternative. In the end, you cannot borrow your way out of debt; cut your way out is the only promising approach.

4. Conclusion Allow me to conclude by going back to the beginning of my speech where I mentioned the benefits of sharing and discussing ideas. I have stressed that we have to embark on reforms that make the crisis countries more competitive; that we have to reduce public debt and that we have to further improve the institutional framework of monetary union. But the spirit of my argument was expressed succinctly some 20 years ago by Karl Otto Pöhl. In his speech at the Economic Club he said: “The true function of a central bank must be, however, to take a longer-term view.” And after five years of crisis, the long term might catch up with us faster than we expect. We therefore have to think about the future now – and we have to act accordingly as well. Thank you for your attention.

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Andreas Dombret: Towards a more sustainable Europe Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank, at the Euromoney Germany Conference, Berlin, 25 April 2012. * * *

1 Introduction

Ladies and Gentlemen I am delighted to have the opportunity to speak to you today at the Euromoney Germany conference. Now in its 8th year, the conference has established itself as a first-class opportunity for policymakers and financial practitioners to exchange views. I firmly believe that this free flow of ideas is of benefit to us all, and I am looking forward to sharing my views with you in the next 20 minutes. We are facing a crisis that is no longer confined to individual countries. Throughout and beyond Europe, it weighs heavily on people’s minds. Some believe, it even challenges the viability of monetary union in its current form. Given the exceptional scale and scope of the crisis, it is hardly surprising that views diverge on how to overcome it. But it is worth recalling that despite intense debates on the best way forward, we share a common vision for the future of our monetary union: a sound currency, sound public finances, competitive economies, and a stable financial system. These are the principles enshrined in the Maastricht Treaty.

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With the adoption of the treaty, all euro-area member states committed to a European stability culture. Among those most eager to join were the countries with first-hand experience of the painful consequences of deficits spiralling out of control and of a monetary policy not always fully committed to maintaining price stability. The unholy “marriage” between Banca d’Italia and the Italian treasury in 1975 is a perfect example. Banca d’Italia vowed to act as buyer of last resort for government bonds. Up to the “divorce” in 1981, Italian government debt more than tripled while average inflation stood at 17%. After Banca d’Italia was granted greater independence, inflation rates began to fall significantly. The principles of a sound currency, sound public finances and a competitive economy thus remain the cornerstones of a strong and sustainable monetary union. Far from being a specifically German conviction, they serve the well-being of citizens throughout the euro area. And the ongoing validity of these principles is a prerequisite for the public acceptance of monetary union. Thus, any approach that does not respect and comply with these principles will not bring about a lasting solution to the crisis. The current crisis is not a crisis of the euro as our common currency. Since the start of the euro, inflation has been in line with the Eurosystem’s definition of price stability, and the euro continues to be a strong currency – to some, it actually appears to be too strong.

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But it is generally accepted that the two central elements of the crisis are large macroeconomic imbalances stemming from diverging competitiveness levels, and unsustainable levels of public debt.

2 The root causes of the crisis: macroeconomic imbalances and over-indebtedness No lasting solution to the crisis will be achieved unless these root causes are tackled. Firewalls can help some countries to cope better with the effects of sudden shifts in investor sentiment, but, ultimately, all it can do is buy time. As the IMF points out in its recent World Economic Outlook , firewalls by themselves cannot solve the difficult fiscal, competitiveness and growth issues that some countries are now facing.

2.1 Macroeconomic imbalances There is broad consensus that macroeconomic imbalances, which have built up in recent years, lie at the heart of the crisis. But the best way to correct these imbalances has been the subject of intense debate. Exchange rate movements are usually an important channel through which unsustainable current account positions are corrected – deficit countries eventually see a devaluation, while surplus tend to revalue their currencies. The reactions that this triggers in imports, exports and corresponding capital flows then help to bring the current account back closer to balance. In a monetary union, however, this is obviously no longer an option.

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Spain no longer has a peseta to devalue; Germany no longer has a deutsche mark to revalue. Other things must therefore give instead: prices, wages, employment and output. The question now is which countries have to shoulder the adjustment burden. Naturally, this is where opinions start to differ. The German position could be described as follows: the deficit countries must adjust. They must address their structural problems, reduce domestic demand, become more competitive and increase their exports. But this position has not gone uncontested. Indeed, well-known commentators suggest that surplus countries should bear part of the adjustment burden in order to avoid deflation in deficit countries. They also point out that not all countries can act like Germany, in other words, not all countries can run a current account surplus. Hence, they suggest that surplus countries should shoulder at least part of the burden. But this criticism misses the point of what the correction of domestic imbalances actually means: As regards the lingering threat of a protracted deflation, it is rather a one-off reduction of prices and wages that is required, not a lasting deflationary process.

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In fact, frontloading reforms and necessary adjustment has proven to be more successful than protracted adjustment, as experience in the Baltic states and Ireland shows. And while not all countries can run a current account surplus, all can become more competitive – higher competitiveness due to productivity increases or lower monopoly rents in, up to now, overregulated sectors is not a zero sum game. Structural reforms can unlock the potential to increase productivity and thus improve competitiveness without inducing deflation. There is no way around the fact that Europe is part of a globalised world. And, at the global level, we are competing with economies such as the United States or China. To succeed, Europe as a whole has to become more dynamic, more inventive and more productive. Once the deficit countries start to become more competitive, surplus countries will adjust automatically. They will become less competitive in relative terms, exporting less and importing more. And we should acknowledge that this process has already been set in motion. Exports of a number of peripheral countries have started to grow, bringing down current account deficits in the process. Correspondingly, German imports from the euro area have grown strongly over the last two years, almost halving the current account surplus between 2007 and 2011. To facilitate the adjustment process, euro area members have committed significant funds within the framework of the EFSF and the ESM.

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Germany is contributing the biggest share. This support is based on the high reputation Germany enjoys among investors. We would put this trust in jeopardy if we were to give in to calls for fiscal stimulus in Germany in order to raise demand for imports from the peripheral euro area. But weakening Germany’s fiscal position would lead to higher refinancing costs and, therefore, either reduce the capacity of the firewalls or raise the borrowing costs for programme countries. Moreover, studies by the IMF suggest that positive spill-over effects from an increase in German demand to partner countries in the euro area would be minimal. So, instead of stimulating exports in peripheral euro-area countries, additional fiscal stimulus at a time when Germany’s economy is already running at normal capacity would be of detriment to all parties.

2.2 Fiscal consolidation Turning to fiscal consolidation, it is often stressed that such measures, together with structural reforms, would be too much of a burden. They would create a vicious circle of decreasing demand and further budget pressure that would eventually bring the economy down. But to the extent that the current output level was fuelled by an unsustainable ballooning of private and public debt, correction as such is unavoidable, and the only question that remains is that of the best timing. However, this crisis is a crisis of confidence. While, under normal circumstances, consolidation might dampen the economy, the lack of trust in public finances and in policymakers” willingness to act is a huge burden for growth.

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Thus, frontloaded, and therefore credible, consolidation would instead strengthen confidence, actually help the economy to grow and reduce the danger of the crisis spreading to the financial system. In addition, urgently needed structural reforms and consolidation are often hard to disentangle. For example, a bloated public sector or very generous pension system are both a drag on growth and a burden on the budget. The same applies to inefficient companies that are state-owned or operate in highly regulated sectors. The risks to growth emanating from immediate fiscal consolidation therefore have to be put into perspective. Negative short-term effects cannot be ruled out. But to the extent that consolidation constitutes necessary corrections of an unsustainable development and brings about greater efficiency, the long-term gains do not only vastly exceed potential short-term pain, they also help to alleviate it now by restoring the lost credibility in the ability to tackle the root causes of the crisis.

3 The role of monetary policy Up to now, the picture has been mixed in this regard. We have seen substantial progress, often initiated by new, more reform-minded governments, but also some setbacks. A much clearer pattern has emerged with respect to the expectations placed on monetary policy. Whenever a new intensification of the crisis looms, the first question seems to be “What can the central banks do about this?”

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To me, this is a worrisome development. Monetary policy has already gone a very long way towards containing the crisis. But we have to be aware that the medicine of a very low interest rate policy, ample provision of liquidity at very favourable conditions and large-scale financial market intervention does not come without side effects – which are all the more severe, the longer the drug is administered. In the course of this crisis, the role of central banks has changed fundamentally. Before the crisis, they provided scarce liquidity; now they increasing serve as a regular source of funding for banks, and this threatens to replace or displace private investors. This may give rise to new financial instability if, as a result of the measures, banks and investors behave carelessly or embark on unsustainable business models, for instance, due to substantial carry trades. But emergency measures will not become the “new normal”. Banks, investors and governments have to be fully aware of this, and central banks cannot tolerate that their well-intentioned emergency measures result in a delay in necessary adjustments in the financial sector or protracted consolidation and reform efforts among governments.

4 Conclusion Ladies and Gentlemen, In my remarks, I have focused on necessary reforms in the euro area member states. This is not to say that changes to the institutional set-up of monetary union are not important.

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If member states want to retain autonomy with regard to fiscal policy, we need stricter rules to account for the incentives to accumulate debt that exist in a monetary union. The fiscal compact is a promising step forward. Now, it is essential that the rules are applied rigorously. Referring to the motto of this conference “A German Europe or a European Germany”, how should one label the recipe to overcome the crisis that I have just presented? Well, it is, quite obviously, a European solution. And that is because it fully reflects and respects the letter as well as the spirit of the European Treaty and therefore of the principles that I stressed at the beginning. The current crisis is most certainly a defining moment for monetary union. But the crisis and the measures taken to overcome it should not be allowed to redefine implicitly what monetary union actually is. This time we really cannot “let this crisis go to waste”, as the former White House chief of staff, Rahm Emanuel, put it. The crisis has laid bare structural flaws at many levels. It has questioned the way we adhered to the principles of EMU, but did not invalidate the principles themselves, quite the contrary. I am confident that having stared into the abyss, Europe will make the right choices and pave the way for a more prosperous and sustainable future – to the benefit of Germany as well as of the euro area as a whole.

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ENERGY ≠ HEAT: DARPA SEEKS NON-THERMAL

APPROACHES TO THIN-FILM DEPOSITION April 26, 2012 Chemistry and physics researchers wanted to develop new approaches to reactant flux, surface mobility, reaction energy, by-product removal, nucleation and other components of thin-film deposition When the Department of Defense (DoD) wants to build a jet engine, it doesn’t put a team of engineers in a hangar with a block of metal and some chisels. Jet engines are made up of individual components that are carefully assembled into a finished product that possesses the desired performance capabilities. In the case of thin-film deposition—a process in which coatings with special properties are bonded to materials and parts to enhance performance—current science addresses the process as though it is attempting to build a jet engine from a block of metal, focusing on the whole and ignoring the parts. Like a jet engine, the thin-film deposition process could work better if it was addressed at the component level. Thin-film deposition requires high levels of energy to achieve the

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individual chemical steps to deposit a coating on a substrate. Under the current state of practice, that necessary energy is generated by applying very high temperatures—more than 900 degrees Celsius in some cases—at the surface of the substrate as part of a chemical vapor deposition process. The problem with using the thermal energy hammer is that the minimum required processing temperatures exceed the maximum temperatures that many substrates of interest to DoD can withstand. As a result, a wide range of capabilities remain out of reach. DARPA created the Local Control of Materials Synthesis (LoCo) program to overcome the reliance on high thermal energy input by addressing the process of thin-film deposition at the component level in areas such as reactant flux, surface mobility, reaction energy, nucleation and by-product removal, among others. In so doing, LoCo will attempt to create new, low-temperature deposition processes and a new range of coating-substrate pairings for use in DoD technologies. “What really matters in thin-film deposition is energy, not heat,” said Brian Holloway, DARPA program manager. “If we break down the thin-film deposition process into components, we should be able to achieve better results by looking at each piece individually and then merging those solutions into a new low - temperature process. It’s going to be researchers in specialties like plasma chemistry, photophysics, surface acoustic spectroscopy and solid-state physics who make it possible. DARPA seeks scientists who can contribute pieces of the puzzle so that the LoCo team can put them together.”

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Breakthroughs in thin-film deposition could enhance performance and enable new capabilities across a range of DoD technologies, impacting areas as diverse as artificial arteries, corrosion-resistant paint and steel combinations, erosion-resistant rotor blades, photovoltaics and long-wavelength infrared missile domes, among others. As a second focus area, the LoCo program seeks performers to evaluate the cost and performance impacts of coating application to existing DoD parts and systems. Through these assessments, DARPA hopes to identify a specific piece of equipment that would benefit from a novel coating to use as a test bed for any new thin-film deposition process. Through this parallel effort, LoCo intends to move from initial research to practical application within three years. To answer questions regarding the LoCo program, DARPA will hold a Proposers’ Day workshop on May 9, 2012. This live workshop and simultaneous webcast will introduce interested communities to the effort, explain the mechanics of a DARPA program and address questions about proposals, participation and eligibility. The meeting is in support of the forthcoming Local Control of Materials Synthesis Broad Agency Announcement (BAA) that will formally solicit proposals. More information on the Proposers’ Day is available at: http://go.usa.gov/y6M. The BAA will be announced on the Federal Business Opportunities website (www.fbo.gov).

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Note: DARPA’s – or ARPA’s, as it was called at the time – involvement in the creation of the Internet began with a memo.

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Dated April 23, 1963, the memo was dictated as its author, Joseph Carl Robnett Licklider, was rushing to catch an airplane. No surprise there: Licklider was spending a lot of his time on airplanes in those days. The previous fall, he had come to the Pentagon to organize the Information Processing Techniques Office (IPTO), ARPA’s first effort to fund research into “command and control” – that is, computing. And he had been crisscrossing the country ever since, energetically assembling a network of principal investigators scattered from the Rand Corporation in Santa Monica, Calif., to MIT in Cambridge, Mass. Licklider’s task might have been easier if he had been pursuing a more conventional line of computing research – improvements in database management, say, or fast-turnaround batch-processing systems. He could have just commissioned work from mainstream companies like IBM, who would have been more than happy to participate. But in fact, with his bosses’ approval, Licklider was pushing a radically different vision of computing . His inspiration had come from Project Lincoln, which had begun back in 1951 when the Air Force commissioned MIT to design a state-of-the- art, early-warning network to guard against a Soviet nuclear bomber attack. The idea – radical at the time – was to create a system in which all the radar surveillance, target tracking, and other operations would be coordinated by computers, which in turn would be based on a highly experimental MIT machine known as Whirlwind: the first “real-time” computer capable of responding to events as fast as they occurred. Project Lincoln would eventually result in a continent-spanning system of 23 centers that each housed up to 50 human radar operators, plus two

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redundant real-time computers capable of tracking up to 400 airplanes at once. This Semi-Automatic Ground Environment (SAGE) system would also include the world’s first long-distance network, which allowed the computers to transfer data among the 23 centers over telephone lines. Licklider, who was then a professor of experimental psychology at MIT, had led a team of young psychologists working on the human factors aspects of the SAGE radar operator’s console. And something about it had obviously stirred his imagination. By 1957, he was giving talks about a “Truly SAGE System” that would be focused not on national security, but enhancing the power of the mind. In place of the 23 air-defense centers, he imagined a nationwide network of “thinking centers,” with responsive, real time computers that contained vast libraries covering every subject imaginable. And in place of the radar consoles, he imagined a multitude of interactive terminals, each capable of displaying text, equations, pictures, diagrams, or any other form of information. By 1958, Licklider had begun to talk about this vision as a “symbiosis” of men and machines, each preeminent in its own sphere – rote algorithms for computers, creative heuristics for humans – but together far more powerful than either could be separately. By 1960, in his classic article “Man-Computer Symbiosis,” he had written down these ideas in detail – in effect, laying out a research agenda for how to make his vision a reality. And now, at ARPA, he was using the Pentagon’s money to implement that agenda.

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Press Release Federal Open Market Committee Information received since the Federal Open Market Committee met in March suggests that the economy has been expanding moderately. Labor market conditions have improved in recent months; the unemployment rate has declined but remains elevated. Household spending and business fixed investment have continued to advance. Despite some signs of improvement, the housing sector remains depressed. Inflation has picked up somewhat, mainly reflecting higher prices of crude oil and gasoline. However, longer-term inflation expectations have remained stable.

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Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects economic growth to remain moderate over coming quarters and then to pick up gradually. Consequently, the Committee anticipates that the unemployment rate will decline gradually toward levels that it judges to be consistent with its dual mandate. Strains in global financial markets continue to pose significant downside risks to the economic outlook. The increase in oil and gasoline prices earlier this year is expected to affect inflation only temporarily, and the Committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate. To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014. The Committee also decided to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.

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The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability. Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Dennis P. Lockhart; Sandra Pianalto; Sarah Bloom Raskin; Daniel K. Tarullo; John C. Williams; and Janet L. Yellen. Voting against the action was Jeffrey M. Lacker, who does not anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate through late 2014.

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Press Release April 25, 2012 The Federal Reserve Board and the Federal Open Market Committee on Wednesday released the attached table and charts summarizing the economic projections and the target federal funds rate projections made by Federal Reserve Board members and Federal Reserve Bank presidents for the April 24-25 meeting of the Committee. The table will be incorporated into a summary of economic projections released with the minutes of the April 24-25 meeting.

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Explanation of Economic Projections Charts The charts show actual values and projections for three economic variables, based on FOMC participants’ individual assessments of appropriate monetary policy: Change in Real Gross Domestic Product (GDP)—as measured from the fourth quarter of the previous year to the fourth quarter of the year indicated, with values plotted at the end of each year. Unemployment Rate—the average civilian unemployment rate in the fourth quarter of each year, with values plotted at the end of each year. PCE Inflation—as measured by the change in the personal consumption expenditures (PCE) price index from the fourth quarter of the previous year to the fourth quarter of the year indicated, with values plotted at the end of each year. Information for these variables is shown for each year from 2007 to 2014, and for the longer run. The solid line, labeled “Actual,” shows the historical values for each variable. The lightly shaded areas represent the ranges of the projections of policymakers. The bottom of the range for each variable is the lowest of all of the projections for that year or period. Likewise, the top of the range is the highest of all of the projections for that year or period. The dark shaded areas represent the central tendency, which is a narrower version of the range that excludes the three highest and three lowest projections for each variable in each year or period.

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The longer-run projections, which are shown on the far right side of the charts, are the rates of growth, unemployment, and inflation to which a policymaker expects the economy to converge over time—maybe in five or six years—in the absence of further shocks and under appropriate monetary policy. Because appropriate monetary policy, by definition, is aimed at achieving the Federal Reserve’s dual mandate of maximum employment and price stability in the longer run, policymakers’ longer-run projections for economic growth and unemployment may be interpreted, respectively, as estimates of the economy’s normal or trend rate of growth and its normal unemployment rate over the longer run. The longer-run projection shown for inflation is the rate of inflation judged to be most consistent with the Federal Reserve’s dual mandate.

Explanation of Policy Path Charts These charts are based on policymakers’ assessments of the appropriate path for the FOMC’s target federal funds rate. The target funds rate is measured as the level of the target rate at the end of the calendar year or in the longer run. Appropriate monetary policy, by definition, is the future path of policy that each participant deems most likely to foster outcomes for economic activity and inflation that best satisfy his or her interpretation of the Federal Reserve’s dual objectives of maximum employment and stable prices. In the upper panel, the shaded bars represent the number of FOMC participants who judge that the initial increase in the target federal funds rate (from its current range of 0 to ¼ percent) would appropriately occur in the specified calendar year.

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In the lower panel, the dots represent individual policymakers’ assessments of the appropriate federal funds rate target at the end of each of the next several years and in the longer run. Each dot in that chart represents one policymaker’s projection. Please note that for purposes of this chart the responses are rounded to the nearest ¼ percent, with the exception that all values below 37.5 basis points are rounded to ¼ percent. These assessments of the timing of the initial increase of the target federal funds rate and the path of the target federal funds rate are the ones that policymakers view as compatible with their individual economic projections.

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FSB Principles for Sound Residential Mortgage Underwriting Practices April 2012

Definitions Definitions often differ across jurisdictions. For the purposes of these Principles, the following definitions are used: Appraisal: A comprehensive assessment of the property characteristics, which will include determining an opinion of the collateral’s value. In some countries the same process is known as a “valuation” or the terms are used interchangeably. Balloon payment: The remaining amount of principal that becomes due and payable on the final instalment payment for a loan that is not fully amortised. Collateral: The property or property rights upon which the residential mortgage loan is secured. Collateral management: For purposes of these Principles, collateral management concerns all tasks and processes within the mortgage underwriting process where collateral is involved, e.g. appraisal of collateral, the constitution of collateral, review of its legal existence and enforceability and entry of collateral-related data in the lender’s information technology systems.

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Debt-to-income (DTI): Annual or monthly total debt servicing requirements, including principal, interest, taxes and insurance, as a percentage of annual or monthly income that is available to repay the debt. Down payment: Up-front payment from the buyer for a portion of the purchase price, which reduces the balance of the loan against the property. Equity: Difference between the appraised value of the property and the total claims held against the property. Loan-to-income (LTI): Annual or monthly mortgage loan servicing requirements as a percentage of annual or monthly income that is available to repay the loan. Loan-to-value (LTV): The ratio of the amount of the loan outstanding to the appraised value of the residential property. Mortgage loan: A loan that is collateralised against a residential property, including purchase, home equity loans, home equity lines of credit (HELOCs) and refinancings. Mortgage insurance: A type of insurance where the lender receives compensation against loss from default on the part of a borrower on a mortgage loan (also known as mortgage default insurance or mortgage guaranty insurance). Variable rate mortgage: A loan in which the interest rate rises and falls possibly based on the movement on an underlying index. The term variable rate mortgage is used interchangeably with adjustable rate mortgage.

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I. Introduction In March 2011 the Financial Stability Board (FSB) published a thematic review of residential mortgage underwriting and origination practices. Based on the findings of the review, six recommendations were set out, one of which asked the FSB to develop an international principles-based framework for sound underwriting practices. After providing sufficient time for implementation, the FSB will conduct a follow-up review to assess progress made in implementing the framework. Given that the underlying risks can differ across jurisdictions, the Principles are high-level rather than aimed at detailed international standards. As the global crisis demonstrated, the consequences of weak residential mortgage underwriting practices in one country can be transferred globally through securitisation of mortgages underwritten to weak standards. As such, it is important to have sound underwriting practices at the point at which a mortgage loan is originally made. In response to the crisis, a number of FSB members have encouraged stricter underwriting practices so as to limit the risks that mortgage markets pose to financial stability and to better safeguard borrowers and investors. Internationally agreed Principles will help to strengthen residential mortgage underwriting practices and enable supervisors to more effectively monitor and detect the erosion of underwriting practices particularly when the housing market is booming. The FSB Principles are intended to apply to loans to individuals (consumers) that are

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(i) secured either by residential mortgage or by another comparable security commonly used in some jurisdictions on immovable residential property; (ii) secured by a right related to immovable residential property; and (iii) loans for which the purpose is to acquire or retain rights in immovable residential property. However, some or all of the Principles may not necessarily be appropriate or applicable for certain niche forms of finance. Jurisdictions should nonetheless seek to apply all Principles that are relevant. In all instances, a robust and effective assessment of individual affordability must underpin any sustainable lending model. It is important to note that the Principles focus on the credit granting decision rather than wider issues of credit risk management. Jurisdictions should ensure that entities that originate a mortgage, or own the resulting risk, adhere to these FSB Principles, including any entities involved in outsourcing of mortgage underwriting. The Principles span the following areas, some of which proved to be particularly weak during the global financial crisis that started in 2007: (i) effective verification of income and other financial information; (ii) reasonable debt service coverage; (iii) appropriate loan-to-value ratios; (iv) effective collateral management; and (v) prudent use of mortgage insurance.

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The report also sets out an implementation framework to promote minimum residential mortgage underwriting standards, and describes tools that could be used to monitor and supervise these standards. In general, the range of residential mortgage underwriting practices reflects the distinct real estate markets, cultural differences and socioeconomic policies that shape each jurisdiction’s mortgage market.

Hence, these Principles should be implemented according to national circumstances, and as appropriate to national institutional arrangements, whether through legislative, regulatory or supervisory measures, or through industry practices.

II. Principles The FSB Principles for Sound Residential Mortgage Underwriting Practices aim to provide a framework for jurisdictions to set minimum acceptable underwriting standards.

Jurisdictions should ensure that lenders adopt sound mortgage underwriting standards against which supervisors can monitor and supervise.

Lenders may choose to outsource aspects of the activities covered by these Principles, for example to credit intermediaries, credit bureaus and appraisers, but jurisdictions should ensure that lenders retain responsibility for all such tasks.

The examples presented in italics provided throughout the Principles should be interpreted as such, and jurisdictions should implement the Principles accordingly.

The Principles will assist FSB members in their efforts to improve financial stability and prudential standards.

They also refer to consumer protection issues that contribute to these objectives, but the Principles are not intended to be a statement of consumer protection standards.

Jurisdictions will want to adopt the consumer protection standards that are appropriate to them.

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1. Effective verification of income and other financial information A borrower’s underlying income capacity is a key input into effective mortgage underwriting.

Jurisdictions should ensure that lenders verify and document each applicant’s current employment status, relevant income history, and other financial information (e.g. credit scores, credit registers) submitted for mortgage qualification.

While income verification can help to measure a borrower’s “ability to repay”, other financial information can help to measure or to infer a borrower’s historical “propensity to repay”.

1.1 Jurisdictions should ensure that lenders make reasonable inquiries and take reasonable steps to verify a borrower’s underlying income capacity.

Lenders should obtain sufficient income history on the borrower and make appropriate efforts to capture any variability in the borrower’s income by collecting and analysing sufficient income history. These income reports should be based on authoritative sources. Lenders may require even more extensive history or third-party verification to document income and profit capacity for borrowers who are self-employed, entrepreneurs, or have seasonal or irregular sources of income.

1.2 Jurisdictions should ensure that lenders maintain complete documentation of the information that leads to mortgage approval.

Lenders should document the income history collected for each applicant, including the steps taken to verify income, and maintain this documentation for a number of years after origination of the loan. A proper record with an adequate explanation of the steps taken to verify income capacity should be readily available for supervisors.

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For example, the documentation could contain income information disaggregated into wage/salary and the more volatile components such as overtime, commissions, bonuses, equity pay, seasonal and irregular income, where variable pay is a significant part of the total income. In case a lender uses internal scoring methods, information about data and algorithm requirements for scoring borrowers should also be available.

1.3 Jurisdictions should ensure that incentives are aligned with accurate representation of borrowers’ income and other financial information.

The loan documentation requirements should be designed to help identify misrepresentation of information either by the borrower, the lender or the credit intermediary. When fraud is detected, it should be possible to have recourse as appropriate to the jurisdiction’s legal system.

2. Reasonable debt service coverage One of the most fundamental components of prudent underwriting is an accurate assessment of the borrower’s ability to repay the mortgage. This is important to help ensure prudent mortgage underwriting standards minimise defaults and losses, and thus, promote stability of the financial system. Furthermore, it is an important factor in reducing the likelihood of consumer over-indebtedness and the negative social and economic impact of forced sales. 2.1 Jurisdictions should ensure that lenders, while taking into account data protection rules in their jurisdiction, appropriately assess borrowers’ ability to service and fully repay their loans without causing the borrower undue hardship and over-indebtedness.

Jurisdictions should ensure that lenders

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(i) establish appropriate processes to assess the borrower’s ability to repay the loan;

(ii) review these processes at regular intervals; and

(iii) maintain up-to-date records of those processes.

Jurisdictions should ensure that lenders take into account all relevant factors that could influence the prospect for the loan to be repaid according to its terms and conditions over its lifetime. This should include an appropriate consideration of other servicing obligations, such as the level of other debt (secured and unsecured), the interest rate and outstanding principal on such debt, and evidence of delinquency. Lenders should also include an assessment of whether the loan can be expected to be repaid, including principal, interest, taxes and insurance, within the specified loan amortisation period from the borrowers’ own resources (income and assets) without inducing undue hardship and over-indebtedness. Temporarily high incomes should be suitably discounted. If the loan term extends past normal retirement age, lenders should take appropriate account of the adequacy of the borrower’s likely income and repayment capacity in retirement. The assessment of the borrower’s ability to repay should neither be based on the assumption that the property will appreciate in value (unless the purpose of the loan is to construct or renovate the immovable residential property) nor on an expected significant increase of the borrower’s repayment capacity. 2.2 Jurisdictions should ensure that lenders make reasonable allowances for committed and other non-discretionary expenditures in the assessment of repayment capacity.

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This could include establishing the borrowers’ actual obligations, including appropriate substantiation and consideration of normal living expenses.

Lenders should also include risk limits in their internal loan policies, such as specifying minimum levels of residual net income after meeting obligations or fixed ratios of repayment to some measure of gross or net income (e.g. debt-to-income ratio, loan-to-income ratio). 2.3 Jurisdictions should ensure lenders make prudent allowances for future negative outcomes. Lenders should include an increase in benchmark interest rates in the case of variable rate mortgages or an unfavourable change (for a borrower) in the exchange rate in the case of mortgages granted in foreign currencies. As such, repayment capacity calculations should take into account the highest payment currently scheduled to apply during the term of the loan rather than solely utilising the first few payments at the prevailing interest rate or foreign exchange rate. Lenders also should consider the increase in future payments due to negative amortisation, balloon payment, or deferred payments of principal or interest. 2.4 Jurisdictions should ensure that lenders provide borrowers with sufficient information to clearly understand the main elements which are taken into account in order to determine a borrower’s repayment capacity, the main characteristics of the loan including the costs, and risks associated with the loan in order to enable borrowers to assess whether the loan is appropriate to their needs and financial circumstances.

It is important that customer information be clear, concise, reliable, comparable, easily accessible, timely, and comprehensive (i.e. the information should also take into account the effect of variation in interest rates and the combined effect of the loan and any other product linked to

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it). This information should be provided to borrowers without charge and effectively present the total cost of the mortgage during its lifetime, taking into account the loan terms.

3. Appropriate loan-to-value (LTV) ratios Collateralisation is an important dimension of mortgage underwriting standards. From an historical perspective, high-LTV ratio loans consistently perform worse than those with a high proportion of initial equity. While it is common for individual lenders to apply a cap on LTV ratios, it is not necessary for regulators and supervisors to mandate such a cap if they satisfy themselves that the underwriting standards are sufficiently prudent and are unlikely to be eroded under competitive pressure. However, jurisdictions may consider imposing or incentivising limits on LTV ratios according to specific national circumstances. 3.1 Jurisdictions should ensure that their regulatory and supervisory frameworks appropriately incentivise prudent approaches to the collateralisation of mortgage loans.

However, the LTV ratio should not be relied upon as an alternative to assessing repayment capacity (see Principle 2 for more details). 3.2 Jurisdictions should ensure that lenders adopt prudent LTV ratios with an appropriate level of down payment that is substantially drawn from the borrower’s own resources, not from, for example another provider of finance, to ensure the borrower has an appropriate financial interest in the collateral.

3.3 Where national frameworks specify controls, standards or incentives on LTV ratios, these jurisdictions should ensure that lenders satisfy themselves that the LTV ratio takes into consideration the "real value" of the available equity, which could be calculated on the basis of:

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- a robust and prudent approach to property appraisals (see Principle 4); - all loans that are collateralised against the same property or for

financing part of the cost of the property. This should include loans provided alongside the main mortgage (e.g. top-up loans, renovation or decoration loans); and

- any increase in loan authorisation being subject to a full assessment of

the borrower’s repayment capacity and to an appropriate LTV ratio at the point of the new mortgage underwriting, and not rely on the excess equity.

Any subsequent refinancing utilising a second charge or lien should lead to the calculation of a new LTV ratio where possible. Particular caution should be exercised about drawing down on the equity in the property if that would raise the current LTV ratio above the level originally agreed. 3.4 Jurisdictions should ensure that lenders refrain from relaxing LTV ratios at the time of a boom in the property market.

4. Effective collateral management Collateral management and sound appraisal processes are essential to the mortgage business. The property and the appraised property value are of utmost importance for risk limitation and mitigation. 4.1 Jurisdictions should ensure that lenders adopt and adhere to adequate internal risk management and collateral management processes, which include sound appraisal processes.

Proper collateral management should include onsite inspections by lenders or appraisers; but onsite inspections could be exempted if the

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lender or appraiser is able to demonstrate that the risk posed has been adequately assessed through the overall collateral management process. For example, a flat or an apartment in a multi-family building which had recently undergone an on-site inspection could be exempted. 4.2 Jurisdictions should ensure that lenders adopt appraisal standards and methods that lead to realistic and substantiated property appraisals. Property appraisal reports should be supportable and therefore reflect the current price level and the property’s function as collateral over the entire life of the mortgage. Property appraisal reports should not reflect expected future house price appreciation. 4.3 Jurisdictions should ensure that lenders require all appraisal reports to be prepared with appropriate professional skill and diligence, and that appraisers (whether internal or external) meet certain qualification requirements.

Appraisers, and providers of appraisal systems, should be independent from the lender’s respective mortgage acquisition, loan processing and loan decision process. In addition, they should not have an interest in the result of the appraisal. Coercion, improper compensation schemes and other inappropriate influence on appraisers should be sanctioned.

4.4 Jurisdictions should recognise the importance of sound regulation and oversight of appraisers, either through self-regulation or statutory means.

4.5 Jurisdictions should ensure that lenders maintain adequate appraisal documentation for collateral that is comprehensive and plausible.

It should include an examination of all aspects relevant to the property value.

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The scope and extent of the appraisal report should be commensurate with the property value and inherent risks.

4.6 Jurisdictions should ensure that lenders satisfy themselves that the claim on collateral is legally enforceable and can be realised in a reasonable period of time.

This includes that borrowers should have or will have clear title to the property and the characteristics are as they have been represented. The types of property accepted as collateral and the related mortgage underwriting policies should be clearly documented. The property serving as collateral should be appropriately insured against damage.

4.7 Jurisdictions should ensure that lenders deduct significant incentives or benefits offered in the context of buying the property (e.g. vendor financing of down payments, sales and financing concessions) that may inflate the price of the property in the course of the appraisal process.

5. Prudent use of mortgage insurance Mortgage insurance is used in some jurisdictions as a form of credit support for mortgage loans, and a way to provide additional financing flexibility for lenders and borrowers. 5.1 Jurisdictions should ensure that where mortgage insurance is used, it does not substitute for sound underwriting practices by lenders.

Lenders should conduct their own due diligence including comprehensive and independent assessment of the borrower’s capacity to repay, verification minimum initial equity by borrowers, reasonable debt service coverage, and assessment of the value of the property. In addition, mortgage insurers should have their own prudent underwriting practices consistent with the Principles in this framework.

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In summary, mortgage insurance should not be considered as an alternative for due diligence. 5.2 Jurisdictions should ensure that lenders carry out prudent and independent assessments of the risks related to the use of mortgage insurance, such as counterparty risk and the extent and details of the coverage of the mortgage insurance policies.

The effectiveness of mortgage insurance depends on the financial strength of the provider and a clear understanding of the policy coverage, which should be frequently monitored and assessed by the lender. 5.3 Jurisdictions should ensure that all mortgage insurers be subject to appropriate prudential and regulatory oversight and, where used, represent an effective transfer of risks from lenders to insurers.

However, in the case of government entities, comprehensive regulatory oversight may suffice. Through the use of mortgage insurance, credit risks, particularly those for high LTV loans, are transferred from lenders to insurers. Given that credit risks are often concentrated within a smaller number of institutions, jurisdictions should carefully monitor mortgage insurers’ exposure to such risk concentrations.

6. Implementation framework Underlying the FSB Principles set out above is an understanding that mortgage underwriting standards are multi-dimensional and interrelated. Lending standards should be applied in a coordinated way, leading to a balanced approach that can vary with the national or economic context. Such an approach aims at preventing excessive build-up of risks (e.g. “risk layering”), avoiding one-dimensional policies that could exclude some creditworthy categories from housing finance, and dampening cycles that could arise from neglecting important dimensions, both in overheating phases (undue relaxation) or downturns (procyclical standard tightening).

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The following actions form a basis for addressing underwriting risk, although jurisdictions may employ alternative means to counter the build-up of excessive risk. 6.1 Jurisdictions should ensure that there is an effective framework of mortgage underwriting standards against which regulators and supervisors can monitor and supervise.

This framework could be set centrally by regulators or supervisors, in addition to requiring lenders to have board-approved mortgage underwriting policies. In either case, the framework should meet Principles 1 to 5 and have regard to the interconnectedness of these aspects and the opportunities for arbitrage. 6.2 Jurisdictions should ensure that lenders consider more conservative underwriting criteria to compensate for situations where the underlying risks are higher.

For example, more conservative underwriting standards (e.g. LTV ratios or servicing requirements) could be considered where: - there are considerable risks that an asset price bubble is building up

in the property market as a whole or in specific segments or geographical areas;

- the loan is in a market segment that, compared with other mortgage loans in that jurisdiction, tends to perform worse than average in a property downturn (depending on the jurisdiction, examples of such a market segment might include luxury apartments, buy-to-let investors, second homes, cash-out refinancers, etc.);

- there is a lack of full recourse against borrowers; or

- other aspects of the underwriting standards are looser than the typical

setting in the jurisdiction.

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6.3 Jurisdictions may want to impose absolute minimum levels of particular dimensions of mortgage underwriting standards below which no mortgage would be deemed acceptable, irrespective of the settings across the other dimensions.

One consideration could be whether a particular product or contract feature is harmful to the borrower’s interests. For example, the supervisor could specify that initial LTV ratios above 100 percent are not acceptable under any circumstances or that stated income, i.e. on a pure declarative basis (see Principle 1) is not acceptable and lenders should always conduct due verification.

6.4 Jurisdictions may want to require appropriate compensatory tightening in one or more dimensions to offset an easing in other dimensions.

For example, prolonged processes to foreclose delinquent loans could be offset by lower LTV ratios or foreign currency denominated loans could be offset by tighter serviceability requirements.

6.5 Jurisdictions may want to articulate the circumstances under which the supervisor would expect a material tightening of mortgage underwriting standards, either at an individual institution or across the whole industry.

For example, a supervisor could articulate that it reserves the right to demand tighter standards at a particular institution that has material weaknesses in its management controls.

7. Effective supervisory tools and powers Jurisdictions should provide for appropriate monitoring and supervision of mortgage underwriting practices. Supervisors should consider the optionality embedded in the relevant loan terms and conditions, and the information used to verify that the loan meets the standard.

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7.1 Jurisdictions should give supervisors and regulators the authority to monitor, and where applicable to supervise, mortgage standards and practices.

These powers could include: - collecting data on mortgage underwriting standards and other

matters necessary to carry out their regulatory functions and ensure compliance with the framework they have articulated as set out in Principle 6, or (subject to necessary confidentiality restrictions) requiring other agencies to collect data for this purpose on their behalf;

- specifying the data they will collect to fulfill this requirement;

- requiring entities under their prudential and regulatory framework to be capable of tracking portfolios and originations according to the mortgage underwriting standards observed;

- aligning other parts of the supervisory framework (e.g. stress-testing,

compensation regulations or guidance) with the objective of ensuring prudent lending practices in the mortgage market.

7.2 Jurisdictions should consider subjecting the framework of mortgage underwriting standards described in Principle 6.1 to periodic review.

A forward-looking approach should be developed as much as possible, taking into account the fact that significant delinquencies generally appear some years into the life of a loan. The framework should also be mindful of the phase of the cycle in each jurisdiction, and thus avoid adjustments that enhance the procyclical nature of mortgage markets. 7.3 Jurisdictions may want to give supervisors and regulators the authority to require lenders to identify groups of loans with a higher risk profile and that these loans be underwritten to a set of norms specific to them within the overall framework described in Principle 6.

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For example, they could require lenders not to process solely through automated systems loans extended to borrowers whose situations make risk assessment complex.

7.4 Jurisdictions should ensure that supervisors or other authorities disclose an assessment of mortgage underwriting practices in their jurisdiction, including the set of entities that are not prudentially regulated, whenever significant changes have been detected.

The authority or authorities responsible for publishing such an assessment should have the powers to collect such data as are required to make that assessment, or to receive those data from the agency that is authorised to collect it. Jurisdictions should specify the relative level of oversight of different types of lenders according to their importance in the financial system and the risks they pose.

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