The State of the Banking Industry

BANKING & F INANCE

The State of the Banking IndustryBanking and Investment Banking & Securities

Winter 2005

SOBI Winter 2005

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The State of the Banking Industry is published by KPMG LLP’s Banking & Finance

Industry Sector for members of the Banking and Investment Banking & Securities

Industries. Information and statistics contained in this document were obtained

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BANKING & FINANCE

The State of the Banking Industry Banking and Investment Banking & Securities

Winter 2005

SOBI Winter 2005

© 2004 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registeredtrademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. 23680NYGR


Contents Page

Changes & Trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

General Highlights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Regulatory and Legislative Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Accounting Standards and Developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6

Market Forces . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Broker/Dealers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11

Consolidation and Convergence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

International Focus and Globalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

e-Business and Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

KPMG Banking Insider . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Analysis and Commentary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

KPMG Contacts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

SOBI Winter 2005 1


General Highlights• According to the Securities Industry

Association’s “Key Trends in the

Securities Industry,” the U.S. securities

industry continued to raise trillions of

dollars for new and expanding

businesses as individuals, both U.S.-

and foreign-based investors, increased

their ownership of equities. Other key

trends, based on nine-months’

annualized data, include:

– The securities industry raised an

estimated $2.9 trillion of capital for

U.S. business in 2004 through

corporate underwriting activity in the

United States, the second straight

year at this level.

– IPOs are projected to raise $42 billion

in 2004, a strong rebound from the

$16 billion achieved in 2003.

– Average daily share volume on the

NYSE and NASDAQ remains strong.

Average daily volume on the NYSE

was 1.44 billion shares. NASDAQ’s

average daily volume was 1.78 billion

shares. These figures are roughly

twice the daily average traded five

years ago.

– International trading and investments

in foreign securities are booming. The

total value of U.S. holdings of foreign

securities was $1.9 trillion in mid-

2003, and by mid-2004 the value had

grown to $2.5 trillion (peak value was

$2.5 trillion in 1999).

– The net purchases of U.S. securities

by foreigners has brought the total

value of their U.S. portfolios to $5.8

trillion in mid-2004 — a new high.

– Seventy-three percent of Americans’

liquid financial assets are invested in

securities-related products, such as

stocks, bonds, and mutual funds.

This represents a large shift in

investments over the past 30 years

— in 1975, 55 percent of the

American public’s assets were in

bank deposits.

– Pre-tax profits for all broker-dealers

doing a public business in the United

States are forecast to reach

$18.9 billion in 2004, representing the

fourth most profitable year ever for

the industry. Total revenues are

forecast to reach $216.3 billion (up

1.7 percent from 2003).

– The M&A market remains stagnant,

but will show a modest improvement

over 2003. The value of announced

deals is expected to reach

$757 billion in 2004, still far from the

$1.741 trillion in 2000.

– The securities industry’s employment

levels apparently bottomed-out in

May 2003. Since then the industry

has gained 35,800 jobs through

September 2004. (Securities Industry

Association Press Release,

November 4, 2004)

• Commercial banks and savings

institutions insured by the Federal

Deposit Insurance Corporation (FDIC)

reported net income of $32.5 billion for

the third quarter of 2004, surpassing

the first quarter high of $31.8 billion.

According to the FDIC, the profits were

fueled in part by increased lending to

consumers and businesses and higher

gains on sales of securities and other

assets. Profits for the third quarter

surpassed the total for the same period

in 2003 by 6.9 percent. The numbers

are from the FDIC’s “Quarterly Banking

Profile,” released on November 23,

2004. Major findings in the third quarter

report include: net interest income grew

strongly while noninterest income

declined; the $198 billion increase in

loans and leases was the second

largest quarterly increase ever reported

by the industry; growth in consumer

loans remained robust, while

commercial and industrial loan demand

showed signs of picking up

momentum. Also according to the

FDIC, should interest rates increase, the

industry’s ability to realize gains on

securities sales would be limited. (FDIC

Press Release, November 23, 2004)

• The Federal Open Market Committee,

on December 14, 2004, raised its target

for the federal funds rate by 25 basis

points to 24 percent. Despite this

increase, the Committee believes that

the stance of monetary policy remains

accommodative and, coupled with

robust underlying growth in productivity,

Changes & Trends

2 SOBI Winter 2005

is providing ongoing support to

economic activity. The Committee said

the upside and downside risks to the

attainment of both sustainable growth

and price stability for the next few

quarters are roughly equal. With

underlying inflation expected to be

relatively low, the Committee believes

that policy accommodation can be

removed at a pace that is likely to be

measured. In a related action, the Board

of Governors unanimously approved a

25 basis point increase in the discount

rate to 3-1/4 percent. (Federal Reserve

Press Release, December 14, 2004)

• Business Roundtable’s December 2004

CEO Economic Outlook Survey shows

that America’s leading CEOs expect the

U.S. economy to continue to grow at a

healthy pace in the first half of 2005,

with a slight easing from the strong

growth of 2004. The responses led to a

CEO Economic Outlook Index of 98.9,

the second-highest index level for the

survey. A majority of the respondents

expect sales to continue to increase,

and half of the CEOs expect to increase

capital expenditures. In the annual

question about challenges to growth,

CEOs cited health care costs as the

greatest cost pressure to corporate

America, followed by litigation costs and

energy prices. The percentage of CEOs

who cited energy cost pressures is

nearly three times higher than a year

ago. A separate manufacturing sector

“CFO Outlook” survey, released on

December 6, 2004 by Bank of America,

saw almost the same results. CFOs

surveyed also were bullish about the

economy in 2005 and expect to

increase their capital expenditures. Also,

almost a quarter of CFOs expect to

participate in a merger or acquisition in

2005, up substantially from last year.

Almost half of the respondents said that

credit availability from their current

lender has increased during the year,

and the majority of the companies

surveyed purchased at least one

financial product in addition to the credit

facility. (Press Releases: Business

Roundtable, December 1; Bank of

America, December 6, 2004)

• Average U.S. home prices increased

12.97 percent from the third quarter of

2003 through the third quarter of 2004.

Appreciation was 4.62 percent, or an

annualized rate of 18.48 percent. The

figures were released on December 1

by the Office of Federal Housing

Enterprise Oversight (OFHEO), as part

of OFHEO’s House Price Index (HPI).

Several factors could be playing a role in

the large house price increases in the

third quarter, OFHEO notes. With the

slight decrease in long-term interest

rates, purchasing a house has been less

expensive. Also, refinancing volume fell

last quarter substantially below levels in

recent quarters. During the previous

period of intense refinancing, HPI

increases may have been held down as

appraised values used for refinancing

mortgages with low loan-to-value ratios

may not have kept up with recent

market price increase. According to the

Mortgage Bankers Association’s (MBA)

long-term forecasts for the housing

finance market for 2005 and 2006,

purchase mortgage originations should

remain near the record levels of 2004.

MBA predicts that purchase originations

will decline from an expected

$1.48 trillion in 2004 to $1.45 trillion in

2005 and $1.44 trillion in 2006. The

refinance market is expected to decline

from $1.19 trillion in 2004 to

$0.68 trillion in 2005 and $0.46 trillion in

2006. As a result, according to MBA,


refinance mortgages will account for

only 32 percent of the mortgage market

in 2005 and 26 percent in 2006. (Press

Releases: OFHEO, December 1;

Mortgage Bankers Association,

October 27, 2004)

• The Bank Administration Institute’s

Check 21 readiness survey revealed

that many bankers believe their financial

institutions have a long way to go

before they will be able to maximize the

potential of Check 21, but a majority are

expected to be able to meet the

minimum requirements by October 28,

2004. Sixty-four percent of those

responding place their institutions in

one of the top two overall readiness

categories, but fewer than one in 20

expressed doubt that their companies

would be able to receive and process

substitute checks, make consumers

aware of the law and their rights under

it, and provide expedited recredit as

required by the Check Clearing for the

21st Century Act. In a separate report,

Celent estimates that paper check

processing should nearly disappear by

the end of the decade. According to its

report, “The Future of Check

Processing in the US,” image exchange

of transit checks will grow from more

than 14 percent in 2005 to 61 percent

by 2007. By 2010, more than 93 per-

cent of transit items will be image-

exchanged. (Press Releases: Bank

Administration Institute, October 2004;

Celent, October 27, 2004)

Regulatory andLegislative Issues Important actions during recent months

by federal agencies, including the

Securities and Exchange Commission

(SEC) and other regulatory bodies and

industry groups such as NASD (formerly

SOBI Winter 2005 3


known as the National Association of

Securities Dealers, Inc.), the New York

Stock Exchange, Inc. (NYSE), and the

Municipal Securities Rulemaking Board

(MSRB) are referenced below. All dates

refer to the year 2004, unless otherwise

noted. For more information on select

topics, please see the publications

referenced including KPMG’s The

Washington Report (WR) and KPMG’s

Compliance & Regulatory Focus (CRF)

available at www.us.kpmg.com.

Rulemaking Initiatives• In a series of related rulemaking

initiatives, the SEC approved

complementary NASD and NYSE rules

and amendments that form a

comprehensive regulatory scheme

designed to strengthen the supervisory

procedures and internal controls of

broker-dealers. New NASD Rule 3013

and related interpretive material require

the designation of a chief compliance

officer by December 1, and annual

certifications by the chief executive

officer relative to the state of a firm’s

internal compliance systems, among

other things. Effective January 31,

2005, amendments to NASD Rule 3010

and new NASD Rule 3012 will require

firms to establish procedures to test

their supervisory internal controls,

among other things. The NYSE has

promulgated requirements under Rule

342, effective December 17, 2004, that

are substantially similar to the NASD

regulations. Further, there are certain

additional new requirements relating to

the transmission of customer funds and

securities, customer changes in

addresses, changes in customer

investment objectives, time and price

discretionary limits, and recordkeeping

under NASD Rule 3110 and NYSE Rules

401, 408(d), 410. NASD has set forth

elements of its new rules, amendments

and expectations under related inter-

pretive material in Notice to Members

04-71 and Notice to Members 04-79.

The NYSE has communicated the

same information to its members via

Information Memo 04-38. (CRF, October

and December; WR, November 8,

2004; and RPL 04-06)

• The SEC adopted rule amendments

under Regulation S-P to require financial

institutions to adopt policies and

procedures regarding the safeguarding

and disposal of certain customer

information as per section 216 of the

Fair and Accurate Credit Transactions

Act of 2003. The rules apply to most

broker-dealers, investment companies,

and investment advisers, among others.

(CRF, January 2005; WR, December 6,

2004)

• The SEC voted to propose new rules

and rule and form amendments that

would impact the current structure

and function of the self-regulatory

organization (SRO) paradigm. The

proposals address the areas of

governance, transparency, SRO

reporting, SRO ownership, and SRO

self-listing activities. In a related action,

the SEC issued a concept release to

explore issues relating to the efficacy

of the self-regulatory system. (CRF,

December; WR, November 15, 2004)

• The SEC voted to propose new and

amended rules and form changes to

modify the registration, communi-

cations, and offering processes under

the Securities Act of 1933 that would

facilitate the ability of a company that

plans to issue shares of its stock in an

initial public offering to communicate

accurate information to investors and

potential investors in the weeks before

the sale. (CRF, November; WR,

November 1, 2004)

• The SEC voted to propose amendments

to Regulation M under the Securities

Exchange Act of 1934, the anti-

manipulation rule concerning securities

offerings, which applies to broker-

dealers and their activities relative to

the promotion of sales of initial public

offerings. The changes would curtail

certain market activities that undermine

the integrity and fairness of this

process, as well as enhance the

transparency of underwriters’

aftermarket activities. (CRF, November;

WR, October 11 and 18, 2004)

• The SEC approved an order to delay the

Regulation SHO (Short Sales) pilot

period to suspend the operation of short

sale price provisions. (CRF, January

2005; WR, December 6, 2004)

Enforcement Actions• The NYSE announced that it reached an

agreement in principle with a broker-

dealer to settle an action that resulted in

a censure and $19 million fine, among

other things, for allegedly failing to

deliver prospectuses to customers in

registered offerings. (CRF, October; WR,

October 4, 2004)

• NASD censured and fined 29 broker-

dealers over $9.2 million in connection

with widespread late disclosures of

reportable information about firm

registered representatives, including

customer complaints, regulatory actions

and criminal charges and convictions.

Two of the firms were also prohibited

from registering new brokers for a

period of time, due to the number of

violations and their previous disciplinary

histories. (CRF, December; WR,

December 6, 2004)

• The SEC announced a $2 million

settlement with a broker-dealer that

allegedly made undisclosed cash

4 SOBI Winter 2005


payments to three investment advisers

in return for encouraging the advisers to

direct their clients’ brokerage business

to the firm. The SEC initiated and

subsequently settled related fraud

actions against the advisers. (CRF,

October; WR, October 4, 2004)

• NASD censured and fined 18 broker-

dealers over $1.2 million in connection

with findings of widespread trade

reporting violations to NASD’s Order

Audit Trail System. Multiple firms

were also cited for related supervisory

deficiencies. (CRF, November; WR,

October 11, 2004)

• In a NASD action, a broker-dealer was

fined $156,000, ordered to disburse

over $1 million in restitution to

customers, and required to retain an

independent consultant and pre-file

advertising material with NASD for

one year. The allegations related to

advertising, markup/down, and

supervisory and other deficiencies.

(CRF, November 2004)

• NASD fined a broker-dealer $1 million

for allegedly providing misleading

information as to the nature of the

variable life insurance products at

sales seminars for its agents. (CRF,

December 2004)

• NASD censured and fined a broker-

dealer $700,000 in connection with

allegations that it failed to prevent

market timing in three mutual funds

offered by an affiliate. The firm was

also cited for related supervisory

failures. (CRF, November; WR,

October 18, 2004)

• In the largest enforcement action to

date involving hedge fund sales by

broker-dealers, NASD fined a firm

$250,000 for allegedly disseminating

inappropriate sales literature that

included unsubstantiated claims and

inadequate risk disclosure. (CRF,

December 2004)

• NASD announced that it exercised, for

the first time, its temporary cease and

desist authority. (CRF, October; WR,

September 13, 2004)

SEC Agenda• At the Securities Industry Association’s

annual meeting, SEC Chairman William

H. Donaldson discussed well-publicized

industry events of the last year,

initiatives undertaken by his agency and

the industry to meet the related

challenges of the current business

climate, and the corresponding progress

made in many areas to date. (CRF,

December; WR, November 29, 2004)

• SEC Chairman Donaldson delivered

remarks before the Annual Conference

of Independent Sector regarding the

issue of the erosion of investor

confidence in the non-profit sector of

U.S. business and the corresponding

opportunity for independent sector

institutions to work to restore the trust

of donors, the public, and Congress.

(CRF, December; WR, November 29,

2004)

• Remarks by Lori A. Richards, Director of

the SEC’s Office of Compliance

Inspections and Examinations, at the

Financial Services Institute’s First

Annual Public Policy Day, centered on a

discussion of developments in the

SEC’s examination program. (CRF,

November; WR, October 25, 2004)

• SEC Commissioner Cynthia A.

Glassman spoke before the Council of

Institutional Investors on proposed new

Regulation National Market System

(NMS) governing market structure, and

discussed its reception by the public.

(CRF, November; WR, October 11,

2004)

• Before the Investment Company

Institute’s 2004 Equity Markets

Conference, Annette L. Nazareth,

Director of the SEC’s Division of Market

Regulation, spoke primarily about

proposed Regulation NMS and the

substance of comments received

relative to this rulemaking initiative.

(CRF, October; WR, September 27,

2004)

• Stephen M. Cutler, Director of the

SEC’s Division of Enforcement,

delivered a speech entitled “The

Themes of Sarbanes-Oxley as Reflected

in the Commission’s Enforcement

Program” at the UCLA School of Law.

(CRF, October; WR, September 27,

2004)

Regulatory Issues• NASD’s Mutual Fund Task Force

submitted a report to the SEC con-

taining its first set of recommendations

regarding soft dollars and portfolio

transaction costs. (CRF, December; WR,

November 22, 2004)

• The SEC recently published interpretive

guidance relative to issues regarding

Addendum A of the Global Research

Analyst Settlement. (CRF, December;

WR, November 15, 2004)

• NASD issued Notice to Members 04-66

to remind member firms of their

obligations under NASD supervisory

regulations to ensure that their

supervisory systems and written

supervisory procedures are adequate to

ensure the proper entry of orders into

trading systems. (CRF, October; WR,

September 20, 2004)

SOBI Winter 2005 5

Issues Relevant to theFinancial Services Industry• The SEC adopted new rules that require

certain hedge funds to register as

investment advisers under the

Investment Advisers Act of 1940. The

new rules will also subject these

entities to inspection and examination

by the SEC, require that registered

hedge funds adopt basic compliance

controls, and mandate certain

disclosures, among other things.

Compliance with the new regulations

is expected by February 1, 2006. (CRF,

October and November; WR,

December 12, November 11, and

October 25)

• The Government Accountability Office

issued a report recommending that

Congress consider improvements to the

current U.S. financial services regulatory

structure, particularly with respect to

the oversight of complex, internationally

active firms. (CRF, December; WR,

November 15, 2004)

• The SEC extended, until March 31,

2005, the compliance dates for banks

relative to the temporary exemption

from the definition of “broker” under

the Gramm-Leach-Bliley Act of 1999.

(CRF, December; WR, November 8,

2004)

• On December 17, President Bush

signed the “National Intelligence

Reform Act of 2004” into law. The new

law is intended to: disrupt the financing

of terrorism; strengthen the country’s

anti-money laundering laws; and

improve the tools with which the

government can stop the flow of

terrorist funds. (WR, December 20,

2004)

(Sources: The Federal Register and Web sites of the issuingagencies including: www.sec.gov, www.nasd.com,www.nyse.com, www.msrb.org, www.federalreserve.gov,www.occ.treas.gov, www.fdic.gov, www.gao.gov,www.financialservices.house.gov, and www.ots.treas.gov.)

To receive KPMG’s regulatory and legislativereports electronically, please send an e-mailmessage to [email protected] for any ofthe following:

– The Washington Report

– Regulatory Practice Letters

– Legislative Practice Letters

– Compliance & Regulatory Focus

These reports can also be accessed throughKPMG’s Web site at www.us.kpmg.com(Financial Services industry).

KPMG hosts Regulatory Perspectives, aquarterly teleconference briefing for clients on important legislative and regulatoryactivities specific to the financial servicesindustry. For more information aboutRegulatory Perspectives, or to register forfuture teleconferences, please send an e-mailmessage to [email protected], and include your name, title, company name, and e-mail address. You will be notified via e-mailregarding future teleconferences.

Accounting Standardsand Developments• FASB Statement No. 123(R), Share-

Based Payment, issued in December

2004, sets accounting requirements

for “share-based” compensation to

employees, including employee stock

purchase plans. It does not affect the

accounting for awards to non-

employees nor does it affect the

accounting for employee stock

ownership plan transactions, which

will still follow SOP 93-6, Employers’

Accounting for Employee Stock

Ownership Plans. Awards to non-

employee directors, however, do fall

under the scope of the newly revised

statement. The statement requires

companies to recognize as income the

grant-date fair value of stock options

and other equity-based compensation

issued to employees. Previously,

Statement 123 allowed companies a

choice between the fair value method

and the intrinsic value method. The

revised statement does not specify

what type of valuation model should

be used to determine fair value. The

classification of a share-based award

will affect compensation cost

recognized. Liability-classified awards

are remeasured to fair value at each

balance-sheet date until the award is

settled. Equity-classified awards are

measured at grant-date fair value and

are not subsequently remeasured. The

statement is effective for most public

companies’ interim or annual periods

beginning after June 15, 2005 and is

effective for nonpublic companies for

annual periods beginning after

December 15, 2005.

• Following the issuance of Statement

123(R), Share-Based Payment, as

noted above, the FASB approved the

resulting revisions to Statement 133

(Accounting for Derivative Instruments

and Hedging Activities) Implementation

Issues. The FASB amended Statement

133 Implementation Issue No. C3

(Exception Related to Stock-Based

Compensation Arrangements) to clarify

that equity-based compensation

instruments issued to non-employees

only receive the scope exception

provided in paragraph 11(b) of

Statement 133 while the instrument

is subject to the requirements of

Statement 123(R). The FASB also

noted that Statement 133

Implementation Issue No. G1 (Hedging

an SAR Obligation) was updated to

reflect the changes in the underlying

accounting for non-vested stock

appreciation rights (SARs) under

Statement 123(R), and noted that they

© 2004 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registeredtrademarks of KPMG International, a Swiss cooperative. Printed in the U.S.A. 23680NYGR


6 SOBI Winter 2005

are still considering the need for

specific transition guidance or whether

the current guidance in Statement 133,

paragraph 31 is sufficient. Additionally,

the FASB noted that there were no

substantive changes to Statement 133

Implementation Issue No. E19,

Methods of Assessing Hedge

Effectiveness When Options Are

Designated as the Hedging

Instruments.

• The FASB is reconsidering in its

entirety Emerging Issues Task Force

(EITF) and all other guidance on

disclosing, measuring, and recognizing

other-than-temporary impairments of

debt and equity securities. Until new

guidance is issued, companies must

continue to comply with the disclosure

requirements of EITF Issue No. 03-1,

“The Meaning of Other-Than-

Temporary Impairment and Its

Application to Certain Investments,”

and all relevant measurement and

recognition requirements in other

accounting literature. In September,

the FASB delayed the guidance on

impairment losses under EITF 03-1, but

the delay did not include the disclosure

provisions, which will remain in effect

until the full reconsideration of the

EITF 03-1 guidance is completed.

New measurement and recognition

guidance had been expected to be in

place by the end of 2004. However,

the FASB is expected to present

recommendations on its full

reconsideration of EITF 03-1 and the

related literature in early 2005.

• The effective date has been adjusted

for EITF Issue No. 04-8, “The Effect of

Contingently Convertible Instruments

on Diluted Earnings per Share.”

Originally, the effective date of the

consensus in EITF 04-8 would have

coincided with the effective date of a

proposed amendment to FASB

Statement No. 128, Earnings per

Share. However, at the November

2004 meeting, due to an anticipated

delay in the issuance of that

amendment, the Task Force de-linked

the effective date of EITF 04-8 from

the effective date of the proposed

amendment to Statement 128 and

specified that the consensus in EITF

04-8 should be applied for reporting

periods ending after December 15,

2004.

• Corporate accounting for income taxes

will be affected by the American Jobs

Creation Act of 2004, signed into law

during October 2004. The new law

allows domestic entities to repatriate

foreign earnings at a reduced rate,

subject to certain limitations. The law’s

incentive to repatriate foreign earnings

will affect evaluations of whether

some or all of those earnings qualify

for Statement 109’s exception from

recognizing deferred tax liabilities. In

December 2004, the FASB issued two

Staff Positions on the accounting

treatment of the tax change. FSP FAS

109-1, “Application of FASB Statement

No. 109, Accounting for Income Taxes,

to the Tax Deduction on Qualified

Production Activities Provided by the

American Jobs Creation Act of 2004,”

requires companies that qualify for

the recent tax law’s deduction for

domestic production activities to

account for the deduction as a special

deduction under Statement 109 and

reduce their tax expense in the period

or periods the amounts are deductible

on the tax return. FSP FAS 109-2,

“Accounting and Disclosure Guidance

for the Foreign Earnings Repatriation

Provision within the American Jobs

Creation Act of 2004,” allows

companies additional time to evaluate

whether foreign earnings will be

repatriated under the repatriation

provisions of the new tax law and

requires specified disclosures for

companies needing the additional time

to complete the evaluation.

(Source: KPMG’s Defining Issues; FASB Web site)

KPMG's Audit Committee Institute

Recognizing the challenge that auditcommittees face in meeting their demandingresponsibilities, KPMG created the AuditCommittee Institute (ACI) in 1999 to serve as aresource for audit committee members andsenior management. Our primary mission is tocommunicate with audit committee membersand enhance their awareness, commitment, andability to implement effective audit committeeprocesses. ACI's initiatives include semiannualroundtables, publication of Audit CommitteeQuarterly, conference and board presentations,a toll-free hotline, periodic distribution of time-sensitive information, and our Web site. Duringthe past five years, ACI has conducted activeoutreach among thousands of audit committeemembers and we have sponsored hundreds ofworkshops, presentations, and issue-orientedmeetings.

ACI's Web site address ishttp://www.kpmg.com/aci/. ACI can be reachedtoll-free at 877-576-4224 or via e-mail [email protected].

Taxation• Withholding Taxes Under Internal

Revenue Code Section 1441

In September of 2004, the IRS

announced a new Section 1441

Voluntary Compliance Program (VCP)

under which eligible withholding

agents may essentially be able to

perform a self-evaluation of their

documentation, withholding and

reporting obligations, identify areas of

noncompliance, and pay any

underwithholding. This VCP is not an

amnesty, but a temporary opportunity


SOBI Winter 2005 7

for withholding agents to avail

themselves of an attractive alternative

to an IRS audit. Taxpayers have until

December 31, 2005 to file their VCP

application with the IRS.

To encourage withholding agents to

come in under VCP, the IRS has

announced that it intends to achieve

100 percent coverage, whether by

traditional IRS audit or voluntary

disclosures under VCP, for the top 500

Form 1042 filers. The IRS has further

indicated that it does not intend to

impose penalties on those withholding

agents that come in voluntarily. More-

over, it has also agreed to entertain

individual proposals for the allowance

of lower documentation standards

(i.e., faxed forms, and forms with

inconsequential errors permissible to

support reduced rates of withholding)

as long as the withholding agent

proposes and implements a remedial

plan to correct the problem(s) in the

future. The IRS has indicated that it will

not afford either benefit to withholding

agents that opt for the traditional IRS

audit. (IRS Web site, September and

October 2004)

• The American Jobs Creation Act of

2004

The American Jobs Creation Act of

2004 (Pub. L. No. 108-357, hereinafter

the Act) that was signed into law by

the president on October 22, 2004, is

the culmination of a multiyear effort to

resolve a number of controversial tax

and international trade issues. Its

primary objective, which has been

accomplished, was the repeal of the

foreign sales corporation regime and

the repeal of its replacement, the

exclusion for extraterritorial income,

which the World Trade Organization

had found to be an “illegal trade

subsidy.” The key provisions of the

legislation are highlighted below.

– International Tax Reform

The Act contains significant changes

to the international tax law regime.

o Repatriation of Foreign Earnings

Under section 965 of the Act,

certain actual and deemed

dividends received by a U.S.

corporation from controlled foreign

corporations in which it is a U.S.

shareholder, are eligible for an

85 percent dividends-received

deduction (DRD). At the taxpayer’s

election, this deduction is available

for dividends received either:

» During the taxpayer’s last tax

year beginning before

October 22, 2004 (the date of

enactment); or

» During the taxpayer’s first tax

year, which begins during the

one-year period beginning on

the date of enactment.

The DRD applies only to certain

extraordinary repatriations in

excess of the taxpayer’s “average

repatriation level” in recent tax

years. Special rules apply for the

computation of the repatriated

amount eligible for the DRD.

Section 965 contains several

limitations on the repatriated

dividends that are eligible for the

reduced tax rate. One key require-

ment is that the repatriated funds

must be invested by the company

in the United States pursuant to a

domestic reinvestment plan

(“Plan”) approved by company

management before the funds are

repatriated.

On January 13, 2005, the Treasury

Department and IRS released an

advance copy of Notice 2005-10

and a Fact Sheet providing

guidance on repatriation of foreign

earnings under the Act. According

to a related Treasury Department

release, Notice 2005-10 and the

Fact Sheet are the first in a series

of notices that will provide

guidance for U.S. companies

planning to repatriate earnings

from overseas subsidiaries subject

to the temporary reduced tax rate

available under the Act.

Notice 2005-10 provides detailed

guidance regarding the para-

meters for a Plan and the types of

investments in the United States

for which repatriated funds may

be used under this provision. The

notice also provides guidance on

the requirement that the repatri-

ation be in the form of a cash

dividend. In addition, Notice 2005-

10 provides guidance on electing

application of the provision and on

required information reporting

regarding repatriated dividends

and associated U.S. investments,

and provides a safe harbor

mechanism for taxpayers to use

in establishing that the Plan

requirement is satisfied. (KPMG’s

TaxNewsFlash-United States Nos.

2005-12 and 2005-13)


8 SOBI Winter 2005

o Foreign Tax Credits

The Act makes a number of

changes to the foreign tax credit

regime, including:

» Reducing from nine to two

the number of categories

(“baskets”) by which income

must be classified

» Extending the period of time

over which foreign tax credits

may be carried forward (from 5

years to 10 years), but reducing

the carryback period (from 2

years to 1 year)

» Modifying the calculation of the

foreign tax credit by permitting

deductible interest to be

determined on a worldwide

basis and providing a rule that

redresses an inequity with

regard to how domestic income

following a domestic loss may

be allocated to enhance the

foreign tax credit.

o Deferral of Taxation of Foreign-

Sourced Income

The Act makes a number of

specific, but relatively limited,

changes to the regime governing

the extent to which the foreign

earnings of a controlled foreign

corporation are taxed currently in

the United States.

o Inversions

The Act imposes a new tax

regime on companies that

“invert” — i.e., become the sub-

sidiary of a foreign-incorporated

entity — after March 4, 2003. If

the former shareholders of the


U.S. corporation hold 80 percent

or more of the stock of the

foreign-incorporated entity, the

foreign entity is deemed to be

a domestic U.S. corporation for

tax purposes. If the entity is

60 percent owned, the top-tier

corporation is respected as a

foreign corporation, but a number

of corporate-level “toll charges”

are imposed upon the

establishment of the structure.

– Deferred Compensation Rules

Effective in 2005

As a result of changes to the tax

characterization of unfunded

deferred compensation under the

Act, virtually all such plans will need

to be examined — and most will

need to be changed — to conform

to the new rules. When these rules

become effective in 2005, any

attempt to defer compensation will

be deemed “ineffective” — and

the deferred element of the

compensation will be immediately

taxable and subject to significant

additional penalties — unless the

following conditions are met:

o Distributions are payable only

upon an employee’s separation

from service, death, or disability; a

change in control of the company;

an “unforeseeable emergency”;

or a specific date in the future.

o The timing and schedule of

payments cannot be accelerated

(unless in accordance with certain

regulatory exceptions). Thus,

“haircut” provisions and “board

discretion” distributions are

prohibited.

o Financial “triggers” based on the

health of the company are not

allowed. (Under the Act, plan

triggers are treated as property

transfers.)

Elections of “initial deferral” must be

made in the preceding tax year (with

a performance-based compensation

deferral election possible later).

“Subsequent deferral” elections

cannot be made less than 12 months

prior to the first scheduled payment,

cannot take effect for 12 months,

and must result in a deferral of at

least five additional years.

These rules also may apply to stock

appreciation rights or discounted

stock options.

In addition, deferred compensation

assets in foreign trusts (rabbi trusts)

are taxed upon vesting, with the

exception of assets in foreign

jurisdictions where “substantially all”

services were performed. Many U.S.

taxpayers working overseas and

covered under foreign deferred

compensation arrangements (even if

unfunded) may not be in compliance

with these rules.

In a taxpayer-friendly provision, the

Act specifies that the “spread” upon

the exercise of rights under an

incentive stock option or employee

stock ownership plan will not

constitute wages for employment

tax purposes.

– New Disclosure and Penalty

Regimes for Reportable

Transactions (Tax Shelters)

Taxpayers should take particular note

of new disclosure and penalty

SOBI Winter 2005 9

regimes that the Act establishes

with respect to reportable

transactions. These provisions —

which are generally applicable to all

companies — include the following:

o Disclosure of Reportable

Transactions

The Act imposes a strict liability

penalty for the failure to disclose

“listed transactions.” It also

imposes a penalty on nonlisted

reportable transactions. Nonlisted

reportable transactions include

those that:

» Result in certain large losses or

book/tax differences in excess

of $10 million per year;

» Are offered under conditions of

confidentiality;

» Are subject to contingent fee

arrangements or refunds if the

intended tax results are not

achieved;

» Result in tax credits (including

foreign tax credits) in excess of

$250,000 when the taxpayer

has held the underlying asset

for less than 45 days.

The penalty is $50,000 ($10,000

for a natural person) with respect

to nonlisted reportable trans-

actions, and $200,000 ($100,000

for a natural person) with respect

to listed transactions. This penalty

regime, which affects tax returns

and statements due after

October 22, 2004, applies solely

to the issue of nondisclosure; it is

not in lieu of other penalties and is

applicable even if the taxpayer

prevails on the underlying merits

of the position. However, the

Commissioner can rescind the

penalty for failing to disclose a

nonlisted reportable transaction

but must submit an annual report

to Congress describing each

penalty and explaining why it was

rescinded.

SEC reporting companies must

inform shareholders, via their SEC

filing, in the event that this penalty

is imposed on the company for

failure to disclose a listed

transaction.

o Understatements

The Act created a new accuracy-

related penalty for listed trans-

actions, and other reportable

transactions if a significant

purpose of the other reportable

transaction is the avoidance or

evasion of federal income tax

(reportable avoidance transaction).

This penalty affects returns for tax

years ending after October 22,

2004.

The understatement penalty is

20 percent in the case of

disclosed listed or reportable

avoidance transactions and 30 per-

cent if the transaction was not

disclosed. The 20 percent penalty

may be mitigated in the case of

disclosed transactions by

“reasonable cause” (although an

opinion from a disqualified tax

adviser cannot be used to

establish reasonable cause).

Companies that are penalized at

the 30 percent rate under this

provision must disclose the action

in their SEC filing. An additional

$200,000 penalty may be imposed

for failure to do so.

– Conclusion

The American Jobs Creation Act

of 2004 provides significant

opportunities for U.S. businesses

to improve their tax positions. At

the same time, however, it presents

a host of new hurdles and risks,

including stricter reporting require-

ments, increased penalties, and,

potentially, new tax costs. In addition

to the provisions highlighted in this

executive brief, the Act affects a

broad spectrum of business

activities, transactions, and entities.

Businesses, tax professionals, regu-

lators, lawmakers, and third parties

will have to devote significant time

and resources to analyzing this new

law to gain a better understanding

of the implications of the Act and

provisions that are pertinent to their

interests. (The American Jobs

Creation Act of 2004 unless

otherwise stated above)

• IRS Administrative Procedures for

Automatic Consent to Change

Method of Accounting Under

"INDOPCO Regulations" for Second

Tax Year Ending After 2003

On December 13, 2004, the IRS

released an advance copy of Rev. Proc.

2005-9, that sets forth the exclusive

administrative procedures that a

taxpayer must use to obtain automatic

consent to change its method of

accounting for the second tax year

ending on or after 2003, under the

final section 263(a) regulations on

capitalizing costs incurred in acquiring

or creating intangible assets. (KPMG’s

TaxNewsFlash-United States, No.

2004-303)


10 SOBI Winter 2005


• Final Instructions for New Schedule

M-3 Are Released

On December 2, 2004, the Treasury

Department and IRS released the final

instructions for Schedule M-3, Net

Income (Loss) Reconciliation for

Corporations With Total Assets of

$10 Million or More.

Schedule M-3 generally expands

certain reporting made on Schedule

M-1, and is intended to make

differences between financial

accounting net income (book income)

and taxable income more transparent.

Schedule M-3 is to be used by certain

corporate taxpayers filing Form 1120,

U.S. Corporation Income Tax Return.

The final draft version of Schedule M-3

was issued in October 2004, in

advance of the final Schedule M-3

instructions to provide affected

taxpayers, tax software vendors, and

other stakeholders immediate access

to the form as they prepare to imple-

ment and comply with Schedule M-3.

Schedule M-3 is effective for any tax

year ending on or after December 31,

2004. In general, Schedule M-3 must

be filed by a corporation required to file

Form 1120 and that reports on Form

1120 at the end of the corporation’s

tax year total assets that equal or

exceed $10 million. However, a

corporation is only required to com-

plete certain sections of Schedule M-3

in the first tax year for which the

corporation is required to file the

schedule.

According to a related Treasury

Department release, the final

instructions to Schedule M-3 provide

additional guidance to those corpo-

rations required to file the schedule,

including detailed instructions for

almost every line and many illustrative

examples. The additional guidance and

examples are expected to assist

taxpayers in completing the schedule.

(KPMG’s TaxNewsFlash No. 2004-298)

• Rev. Proc. 2004-73 – IRS Provides

Accuracy-Related Penalty Guidance

On December 20, 2004, the IRS

released Rev. Proc. 2004-73, 2004-51

IRB 999, which updates Rev. Proc.

2003-77, 2003-44 IRB 964. Rev. Proc.

2004-73 identifies circumstances under

which the disclosure on a taxpayer’s

return with respect to an item or a

position is adequate for purposes of

reducing the understatement of

income tax under IRC section 6662(d),

relating to the substantial understate-

ment aspect of the accuracy-related

penalty, and for purposes of avoiding

the preparer penalty under IRC section

6694(a), relating to understatements

due to unrealistic positions. (Rev. Proc.

2004-73, 2004-51 IRB 999)

• Final Circular 230 Regulations

On December 17, 2004, the IRS issued

final Circular 230 regulations on tax

opinion standards. “The [regulations]

set best practice standards only for

those practicing before the IRS and

provide mandatory rules for

practitioners who provide covered

opinions. The [regulations] define

covered opinions and explain the

requirements for covered opinions,

disclosures, and other written advice.

They do not, however, reflect changes

made to the practice standards by the

American Jobs Creation Act of 2004

(P.L. 108-357).” (IRS Issues Long-

Awaited Circular 230 Regs, Proposes

Bond Opinion Regs, 2004 TNT 244-1,

December 20, 2004)

SOBI Winter 2005 11


Broker/Dealers• Global prime broker revenues for the

five years ending 2004 reached

$5 billion, but this number is expected

to more than double over the next five

years to $11.5 billion, according to

Celent’s report “The Burgeoning

Business of Prime Brokerage.” The

report indicates that although currently

top three leading prime brokers

represent 55 to 65 percent of the

market, this will change with the

explosive growth of the hedge fund

industry. Celent predicts that global

hedge fund assets will grow at an

average annual rate of 16.5 percent

over the next five years, reaching

$2.1 trillion by 2009. This growth,

according to the company, will

perpetuate demand for prime broker-

age services at all points of the hedge

fund life cycle. Other changes in the

industry, including new technology,

market structure changes, growth in a

derivatives market that is increasingly

complex, and bank consolidations, will

modernize firms, enable cross-asset

class servicing, and spur innovation in

prime brokerage, according to the

report. (Celent Press Release,

October 20, 2004)

• According to Merrill Lynch’s “Survey of

Global Fund Managers” for December,

global asset allocators expect 2005 to

be another year in which equities

outperform bonds. The survey shows

that a net 49 percent of asset

allocators expect equities to be the

best performing asset class while a net

38 percent believe bonds will be the

worst. Regionally, asset allocators

prefer Eurozone and Global Emerging

Market assets and dislike U.S. assets.

By global sector, fund managers see

the most value in pharmaceuticals and

the least value in technology. For

those who need to maintain a bond

allocation, managers expect govern-

ment bonds to outperform corporate

bonds in 2005 and inflation-linked

bonds to perform better than

conventional bonds, according to the

survey. (Merrill Lynch Press Release,

December 14, 2004)

• Client satisfaction with the

performance of their brokers was the

topic the annual Securities Industry

Association Investor Survey released

on November 4, 2004. The results

indicate that the majority of

respondents felt that they are satisfied

with the quality of service they receive

from their broker. Respondents believe

that recent reforms of securities

regulations are working and that these

recently adopted regulations will curb

abuses in the securities industry.

Additionally, the study found that the

vast majority of respondents continue

to look to the securities industry to do

more to educate them about how to

make good investments. (Securities

Industry Association, November 4,

2004)

Consolidation andConvergence• According to SNL Financial, M&A deal

value decreased in the financial

services sector in the third quarter

while volume was mixed, with bank

and specialty finance deals up but

insurance and specialty finance deal

volume on the decline. The total

number of banking M&A deals

announced during the quarter totaled

71, about the same as the year ago

quarter’s 68, but well above the

second quarter’s 59. Volume by total

deal value declined 74 percent to

$9.6 billion from $36.5 billion in the

previous quarter, but more than

doubled the year ago period’s

$4.2 billion. Securities and investments

M&A deals slowed during the third

quarter with 27 deals announced,

compared to second quarter’s 38

deals, but up slightly from the year ago

quarter’s 23 deals. Securities and

Investments deal value fell more than

60 percent to $984.5 million from last

quarter’s $2.6 billion and decreased

76 percent from the year ago quarter’s

$4.1 billion. (SNL Financial Press

Release, October 8, 2004)

• On December 2, ING Group

announced that it finalized an

agreement to sell most of its German

banking unit, ING BHF-Bank, to Sal.

Oppenheim for EUR 600 million. The

deal included ING BHF-Bank’s asset

management, private banking, financial

markets, and core corporate banking

businesses, with a total of EUR

6 billion in risk-weighted assets and

EUR 600 million in capital at the time

of the announcement. ING Group also

announced that it had reached

agreements in principle to sell the

London branch of ING BHF-Bank to

Deutsche Postbank and to sell part of

the bank’s corporate lending portfolio

Market Forces

12 SOBI Winter 2005


to HVB Group. All three transactions

were expected to close by the end

of 2004. (ING Press Release,

December 2, 2004).

• Bank of America announced on

October 20, the merger of the

broker/dealers of Banc of America

Investment Services, Inc. and Quick &

Reilly. The newly formed brokerage

organization will operate under the

name Banc of America Investment

Services, Inc. (BAI) and will represent

the nation’s third-largest bank-owned

brokerage firm and ninth-largest

brokerage organization, according to

Bank of America. BAI is part of the

company’s Wealth & Investment

Management division, which has over

$690 billion in client assets under

administration and generates more

than $6 billion in annual revenue,

according to Bank of America. (Bank of

America Press Release, October 20,

2004)

• Northern Trust Corporation and ING

Group N.V. announced on

November 22 that they reached an

agreement for Northern Trust to

acquire Baring Asset Management’s

Financial Services Group (FSG) for

approximately GBP 260 million

(approximately USD 480 million),

subject to adjustments. FSG is the

institutional fund administration,

custody, and trust services arm of

Baring Asset Management, a unit in

ING Group. (Press Releases: Northern

Trust Corporation and ING Group,

November 22, 2004)

• MetLife, Inc. and Citigroup Inc.

announced on January 31, 2005 an

agreement for the sale of Citigroup’s

Travelers Life & Annuity, and

substantially all of Citigroup’s

international insurance businesses, to

MetLife for $11.5 billion, subject to

closing adjustments. As a result of this

combination, MetLife will become the

largest individual life insurer in North

America based on sales, and MetLife’s

Retirement and Savings general

account assets will increase by almost

60 percent, according to MetLife.

(MetLife, Inc. Press Release,

January 31, 2005)

International Focus andGlobalization• The Eastern European markets have

performed strongly over the past two

years and are expected to continue

to do well over the coming 6 to 12

months, according to Credit Suisse

European Frontiers Fund co-managers’

analysis. Many of the positive factors

that have driven markets historically

should remain in place and thus spur

investment in the region going

forward. Economic growth was strong

in the region when compared to the

global economy. The fund co-managers

continue to prefer Hungary to Poland

in Central Europe as Hungarian stocks

continue to trade at lower multiples

and generally have excellent manage-

ment track records, while even though

the Polish economy seems to be in a

slow recovery, it is difficult to find

compelling ideas at a stock level.

(Credit Suisse Press Release,

September 27, 2004)

• European fixed income trading is facing

a challenging environment. According

to a new report from Greenwich

Associates, with interest rates at

historic lows, institutional investors are

turning to more complex instruments

that may boost returns while hopefully

mitigating some risks. The attraction

toward more speculative products is

occurring at a time when regulators in

several countries are stepping-up

oversight of these strategies. There is

some uncertainty surrounding the role

the regulatory environment will play,

and for now, concerns about regulatory

ambiguity appear to be taking a back

seat to the pressure for higher invest-

ment returns. Greenwich Associates

notes that in the past year European

institutional investors doubled their

investment in below-investment grade

credit bonds and credit derivatives. The

ambiguity caused by the potential for

regulatory agency actions has also

slowed the expansion of electronic

trading of fixed income vehicles

throughout Europe. A recently released

Celent analysis demonstrates how

widespread electronic trading is also

hampered by the lack of uniformity

among national markets and the lack

of European settlement and payment

institutions apart from banks. (Press

Releases, Greenwich Associates,

December 1; Celent, October 6, 2004)

• Standard & Poor’s announced on

December 2 that it has signed a

Memorandum of Understanding

(MOU) with RTS Stock Exchange

(RTS), the Moscow-based stock

exchange, to create a new generation

of Russian equity indices. Under the

MOU, Standard & Poor’s and RTS will

develop, calculate, license, and

promote Russian equity indices

worldwide, and will revamp the indices

by applying to them internationally

recognized Standard & Poor’s indexing

principals. Launch of the new RTS/S&P

indices is expected in the first half of

2005. (Standard & Poor’s Press

Release, December 2, 2005)

SOBI Winter 2005 13

• Merrill Lynch announced on October

14 that a number of changes in the

selection criteria used to construct the

Merrill Lynch global bond indices

would take effect on December 31,

2004. Some of the more significant

changes include: (1) the algorithm

underlying the composite rating,

currently based on Moody’s and S&P,

will add Fitch ratings as well (except in

Canada, which will use DBRS), and (2)

minimum size filters for the EMU

Broad Market Index will be increased,

eliminating 1,992 securities currently

in the Index. (Merrill Lynch Press

Release, October 14, 2004)

• Household debt in Canada has been

rising twice as fast as disposable

income over the past 15 years, and

faster than growth in household assets

since the beginning of the decade,

according to CIBC World Markets’

January Consumer Watch. A CIBC

spokesperson indicates that with low

and declining interest rates, borrowers

have a false sense of confidence that

they are able to control their debt.

However, should interest rates

increase substantially or in the event

of an economic slowdown, borrowers

may find themselves unable to keep

pace. According to the release,

Canadians are now 7 percent more

indebted than they were a year ago.

CIBC points to the lack of income

growth, with wages remaining virtually

flat since the beginning of the decade,

as the key cause for the excess

borrowing. (CIBC Press Release,

January 20, 2005)

Risk Management• Attempted check fraud at U.S. banks

rose to $5.5 billion in 2003, according

to the American Bankers Association’s

(ABA) biennial “Deposit Account Fraud

Survey Report,” released on

November 22, 2004. Although check

fraud continued to grow (increasing

3 percent to 616,469 cases in 2003),

actual dollar losses remained stable

at $677 million, down from the

$698 million that banks lost in 2001.

Regardless of bank size, the most

common type of check fraud in 2003

was forgery. Survey participants

credited check fraud prevention

systems with keeping actual losses

significantly lower, citing the use of

account screening software during

account opening as the most effective

prevention method. (American

Bankers Association Press Release,

November 22, 2004)

• According to TowerGroup projections

released in December 2004, fraud

losses due to “phishing” scams on

consumers will reach $137 million

globally in 2004. “Phishing” scams, or

using e-mail to convince individuals to

reveal confidential information, could

become one of the most urgent

threats to the growth of online financial

services. TowerGroup expected the

incidence of phishing to rise to 86,000

incidents globally in 2005, from 31,000

incidents in 2004, as the phenomena

spread to smaller institutions and grow

more sophisticated. The greatest

threat is the negative impact that the

scams could have on consumer

confidence in the Internet as a viable

commerce channel. According to

TowerGroup the cost of managing the

risk could be greater than the cost of

the direct fraud itself. (TowerGroup

Press Release, December 1, 2004)

• In a recent presentation to the Bank

Administration Institute’s “Roundtable

for CFOs,” Acting Comptroller of the

Currency Julie L. Williams said that

although the industry remains in

excellent health, there is danger of

complacency. Focusing on emerging

risks, including a net slippage in credit

underwriting standards, rising interest

rate risk, expansion in home equity

lending, and certain credit card account

management and disclosure practices,

Ms. Williams said that when the OCC

sees risk issues emerging, it will work

with banks to prevent those issues

from developing into damaging

problems. (Office of the Comptroller

of the Currency Press Release,

December 3, 2004)

• PeopleSoft on December 8, announced

a software alliance with Algorithmics

that will deliver an enterprise risk and

profitability management solution for

the banking and capital markets

industry. The combination of

PeopleSoft’s profitability management

applications and Algorithmic’s

enterprise risk management products

will deliver a comprehensive solution

that will enable financial institutions to

better analyze risk, allocate investment

capital, and comply with Basel II

regulatory requirements, according to

PeopleSoft. (PeopleSoft Press Release,

December 8, 2004)

e-Business andTechnology• According to a survey conducted by

Federal Reserve, electronic payment

transactions (credit cards, debit cards,

and automated clearinghouse trans-

actions) in the United States have

exceeded check payments for the

first time. The number of electronic

payment transactions totaled

44.5 billion in 2003, while the number

of checks paid totaled 36.7 billion.


14 SOBI Winter 2005


According to the survey, this trend is

expected to continue. Another

indication that checks are losing

ground are the findings of a Visa study

that indicate about half of financial

executives responding plan to reduce

their organization’s reliance on checks

as a form of commercial payment.

Instead, 40 percent plan to increase

use of commercial payment cards.

(Press Releases: Federal Reserve,

December 6; Visa Press, November 8,

2004)

• Since the Check 21 Act became

effective, several banks in the U.S.

have begun to offer business

customers remote deposit capture,

creating a “virtual” bank branch that

can provide significant convenience

and flexibility to those corporate

customers, according to the

TowerGroup research report “Check 21

and Remote Deposit Capture: Creating

the Virtual Branch,” released

November 16. Key findings of the

TowerGroup report include:

– In addition to offering remote deposit

capture, banks see an opportunity of

helping consolidate the banking

business of clients that maintain

accounts at multiple banks.

– Business environments that are well

suited for remote deposit products

include corporations using deposit

concentration services, businesses

receiving high-value checks,

companies receiving checks at

nonpayment locations, and

businesses using Internet banks.

– Banks will succeed in their efforts to

sell remote deposit products.

Although the initial focus of these

initiatives should be on clients with

low-volume check deposits, the

product has future application for

higher-volume depositors as banks

ultimately implement electronic

check presentment.

– Banks will need to address several

issues related to remote deposit

capture before widespread roll-out of

the technology can occur (including

the defining of legal liability between

the bank and corporate depositor,

quality of the check images, and

new controls to detect fraudulent

check deposits). (TowerGroup Press

Release, November 16, 2004)

• Use of online banking surged in

Canada’s largest cities, according to

BMO Financial’s survey released on

November 29, which found that almost

half of the respondents who are

residents of five of Canada’s six largest

cities are using online banking. These

usage numbers represent a significant

change in how customers are

conducting their banking business

from previous years. A study looking at

similar measures conducted in 2000

found that 75 percent of customers

were visiting a bank branch and only

18 percent were using online services

to conduct their transactions. (BMO

Press Release, November 30, 2004)

• TowerGroup believes that enterprise

mobility in financial services is at the

beginning of a significant, long-term

upswing as deployment costs continue

to fall and the available device,

network, application, and other tech-

nology options improve considerably.

Adoption of mobile data devices by

financial services executives stands at

approximately 10 percent of total

industry employment. TowerGroup

forecasts this to rise to 35 percent by

2009. In its new research, “Mobilizing

the Financial Services Enterprise:

Business Mobility Gets Unwired,”

TowerGroup indicates that financial

institutions are exploring mobile

opportunities with enterprise

applications tailored to a number of

vertical sectors. Executive alerts,

insurance claims and quotes, mortgage

information, and institutional mutual

fund sales are examples of applications

being prepared for wireless

deployment. (TowerGroup Press

Release, September 27, 2004)

SOBI Winter 2005 15


Analysis and CommentaryIn this section we offer KPMG’s analysis

and commentary reprinted from KPMG

Banking Insider.

Banks Power Up Energy TradingNovember 11, 2004By Christopher Westfall, Managing Editor, Banking Insider

The unprecedented spike in oil and gas

price volatility has motivated several

banks to create or expand energy-trading

operations.

But industry watchers caution that banks

will need to juggle their expertise with the

unique risks that power trading entails.

“There are many different risks involved in

physical energy trading that banks are just

now beginning to understand,” says Julie

Luecht, a principal in KPMG’s Financial

Risk Management practice in Chicago.

Several banks have built their energy

trading business over the past year.

Barclays, UBS, Wachovia Corp., and

JPMorgan Chase have created new

energy trading desks, according to

published reports. Established players,

including Goldman Sachs and Morgan

Stanley, have expanded their energy

trading capabilities, including ownership of

power generation facilities.

Trading of energy is conducted primarily

through two-party, or bilateral, contracts,

as well as on over the counter (OTC)

stock markets. There are few statistics on

bilateral energy trading. However, several

energy OTC markets have seen increased

trading; the New York Mercantile

Exchange has reported that the amount of

contracts on its most liquid market, open

natural gas, has risen 11 percent since the

beginning of 2004.

A couple of trends are driving the

increased trading. The first has been the

large swings in power prices. Banks will

trade against the market on a proprietary

basis, in the same manner that banks

trade against swings in currency, equity,

and bond prices.

The other element is that many bank

customers — namely hedge funds —

want banks to act as counterparties to

their own trading activity. As many as 200

hedge funds have begun energy trading

activity over the past year, according to

energy consultants Global Change

Associates.

Working with hedge funds is perhaps the

key reason that banks are interested in

energy, says KPMG’s Luecht. She

explains that after the collapse of energy

trading giant Enron, many power

companies that had been acting as a

counterparty and source of liquidity for

traders in the energy market pulled out.

“Power generators [utility companies] are

still trading, but only around their own

assets rather than acting as market

makers,” Luecht says. She adds that

utilities are making mostly trades that

hedge their own risk, rather than acting as

a major force in the markets. Luecht says

that banks have the opportunity to provide

the market large amounts of liquidity,

adding to their credibility as traders.

On the whole, banks’ nascent entrance in

the wholesale energy market is positive,

according to Denise Furey, an analyst with

Fitch Ratings Service in New York. She

says that banks’ high credit ratings will

allow the wholesale energy market to

grow: “The average utility has about a

Triple-B rating, while most banks are

graded above ‘A.’” As the increased credit

stability helps attract investors, “the entire

market’s credit profile is being enhanced,”

Furey says.

Also, she explains, banks’ expertise in

financial structures will help expand

power trading beyond the current bilateral

trades to more complex derivative

structures, such as swaps.

But as banks and hedge funds ramp up

energy trading, they also need to ramp up

their risk management. That’s because as

first-time market participants, they have

little experience in the perils of the power

market, especially the concept of physical

delivery risk, says Peter Fusaro, CEO of

Global Change.

“There is a lack of knowledge in the

physical energy space,” Fusaro says, as

many new participants are simply applying

their previous trading models without

taking into account the unique risks of the

power market.

“This is not the foreign exchange market,

and black box traders are going to have

their heads handed to them,” Fusaro

says.

By physical delivery risk, energy traders

take into account the possibility that the

underlying commodity — oil, gas or

KPMG Banking Insiderwww.kpmginsiders.com

16 SOBI Winter 2005


electricity — is not delivered on time or at

all. For instance, a pipeline blowing up,

foreign unrest, or a truckers’ strike

represent physical delivery risk.

As a result, banks have been on a hiring

binge for experienced energy traders,

says Adam Josephson, an analyst with

Celent Communications.

“A few banks have wanted to get into this

and bought a trading desk on the quick,”

Josephson says. Although banks can

quantify a financial risk for most

industries, they need the expertise in

quantifying and modeling physical risk in

energy market trades.

“[Banks] were obvious candidates [to

enter energy trading] given their large

balance sheets, trading expertise, and risk

management expertise and the only piece

that was missing was experienced energy

professionals.”

The Enemy WithinDecember 6, 2004By Christopher Westfall, Managing Editor, Banking Insider

With reports that terrorist groups are

targeting the American financial system,

many argue the industry needs to actively

prepare for attacks that would target or

affect their information technology

systems through cyberterrorism.

But security professionals caution that the

greatest threat could come not from an Al

Qaida operative with a laptop, but rather

from a terrorist sitting quietly in a nearby

cubicle.

“Access is the key, and the insider is the

most likely threat vector,” said Byron

Collie, a Goldman Sachs vice president,

at the Securities Industry Association

Business Continuity Conference.

“With the fourth generation of Al Qaida

being fielded — and many being highly

educated with technical expertise — the

issue for [financial services] has become

[the quality of] background checks,” Collie

said.

Collie, who is also chairman of the

Financial Services Information Sharing and

Analysis Center Threat and Intelligence

Committee, said that while the common

perception of cyberttacks — hackers

using their home computers to assault IT

systems from the outside — is true, the

threat is often exaggerated.

“Usually, [remote] attacks against

systems or networks are transient and

don’t have a long-term impact,” Collie

said. Remote cyberattacks usually lack the

widespread network access rights needed

to cause serious damage. “Without

access, no amount of technology will

help,” Collie added.

In the past, terrorists have used external

computers as their method of attack in a

few less-than-successful campaigns.

Collie pointed to “cyberwar” between

Israelis and Palestinians between October

of 2000 through January of 2001. During

that period, attackers from 23 countries

hit eight governments, mostly with denial-

of-service attacks and Web site deface-

ments touting pro-Israeli or pro-Palestinian

causes.

“There was a lot of hype in the media, so

a lot of things that followed came under

the definition of cyberterrorism,” he said.

Last summer, several banks and other

financial industry firms were put on higher

alert after detailed information identified

several buildings as terrorism targets.

But an employee with even the lowest

security clearance into a financial services

firm’s network can do enormous damage.

Many of the costliest debacles against

banks or securities firms have come from

employees who were able to manipulate

IT systems, according to a study

conducted by Carnegie Mellon

University’s Computer Emergency

Readiness Team (CERT) Coordination

Center. The study reveals 23 “illicit cyber

activity” incidents carried out by 26

insiders in the banking and finance sectors

between 1996 and 2002.

Some of the activity resulted in major

losses, including a foreign currency trader

who hacked a bank’s systems to cover

over $600 million in losses; and two

employees that cost a credit union

$215,000 by altering credit reports for

kickbacks.

One attack had nothing to do with

personal gain: a disgruntled employee let

loose a “logic bomb” (illicit code that

launches an attack after a triggering event)

on an international bank system that

deleted over 10 billion files on 1,300

servers in the United States. The cost to

repair the damage from that attack was

more than $3 million.

None of the events listed in the study

were thought to have a political impetus,

but they point to the vulnerability of

financial institutions to insiders, says

Dawn Cappelli, a senior member of the

technology staff of CERT.

“A majority of the cases we looked at

were done for financial gain, or by

disgruntled workers looking to inflict harm

on the employer,” Cappelli says. “There

was also sabotage to extort payment. But,

it does point to the vulnerability of the

security systems.”

In the context of a terrorist strike, Cappelli

says one major danger is that financial

system networks may be targeted in

tandem with a physical attack. For

example, after a car bomb is used against

a bank’s critical infrastructure, the

terrorists may seek to cause additional

confusion by cyberattacking the equity

market’s computer systems. “[Cyber-

terrorism] could be used to enable or

magnify the impact of a physical attack,”

she says.

Part of a good defensive measure is a

background check system that reviews

anyone who has access to systems,

including employees and contractors,

says Scott Moritz, director of corporate

intelligence in KPMG Forensics.

“The image of the corporate hacker for

many is sort of a ‘War Games’ mentality,”

Moritz says, referring to the 1983 film

that depicted a teenager unwittingly

breaking into U.S. defense systems and

nearly causing World War III. “But it's

really people in a position of trust who are

in the best position to hurt you.”

Many banks don’t know just how deep

into a potential employee’s background

they should delve. They are building

programs that have different “tiers” of

background checks corresponding to a

job’s level of access and responsibility.

“You need to look at everyone, not solely

based on their salary and title,” Moritz

says, adding that checking credit and

criminal records are not enough for

some employees. “They need to ask

themselves, ‘If this is a malicious person,

how could they hurt us?’”

Privacy to Dominate Bank OutsourcingPlansDecember 15, 2004By Christopher Westfall, Managing Editor,Banking Insider

Privacy considerations related to the ways

customer information is managed,

transmitted and stored among banks and

their third-party service providers is

expected to receive considerable attention

from regulators and examiners in the

coming months, according to speakers at

the BITS/American Banker Financial

Services Outsourcing Conference.

And as government officials point out, any

consequences for privacy failures are not

expected to end with the third-party

provider. “If your outsourcer screws up,

it’s the bank that is going to pay,” said

Mark O’Dell, deputy comptroller in the

operational risk office of the Office of the

Comptroller of Currency (OCC).

The outsourcing of bank functions such as

call centers, data management and direct

marketing programs has become a

common practice in recent years.

According to research firm TowerGroup,

one-third of financial institutions’

information technology spending is

currently dedicated to third-party

providers. And total spending on

outsourcing by financial institutions is

expected to move from $30.9 billion this

year to $38.2 billion by 2006, a rise of

11.2 percent.

For many banks, the appeal of outsourcing

stems in part from the merger and

acquisition craze of the 1990s. As banks

gobbled up smaller competitors, they took

on disparate systems and technologies

that were often unwieldy and expensive

to manage in-house, said Lawrence

Baxter, executive vice president and chief

eCommerce Officer for Wachovia

Corporation.

“Wachovia did 150 merger and acquisition

deals in the last three years, and there

were a number of different platforms from

the mergers for bill payment and online

banking,” Baxter said.

But with an increasing amount of

customer data being managed by third

parties, regulators are expected to pay

closer attention in 2005 to how that

information is being protected.

“Privacy will not only be a [regulatory]

imperative, but it is something we see

Congress getting involved in,” said

Stephen Malphrus, staff director for

management at the Federal Reserve

Board of Governors.

Many agencies involved in bank oversight

argue they want to ensure that

compliance keeps up with industry

practice. “We, as regulators, are not

against outsourcing,” said OCC’s O'Dell.

“But we expect a bank to adopt appropri-

ate policies and procedures to deal with

the risks.”

O’Dell said several agencies have issued

regulations that deal with privacy. These

rules typically revolve around four main

issues: compliance, information security,

business recovery, and personnel

controls. A bank’s vendor-management

process, including due diligence, contract

management and performance of third

party providers, will also be part of the

regulators’ common exam process.

“There are also reputational and strategic

risks that banks need to follow,” O’Dell

added.

O’Dell cited three OCC Bulletins — 2001-

47 (Risk Management Principals of Third

Party Relationships), 2002-16 (Bank Use

of Foreign-Based Third Party Service

Providers) and 2004-20 (Risk Management

of New, Expanded or Modified Bank

Services) — that deal with regulators’

supervisory guidance when it comes to

outsourcing arrangements.

SOBI Winter 2005 17


18 SOBI Winter 2005


Bankers were also told to follow an

examination handbook called Outsourcing

Technology, which was published last year

by the Federal Financial Institutions

Examination Council.

Bank controls can become more

complicated if the bank has outsourced

operations to a third party located outside

the United States. Banks’ “offshoring”

practices, or using third-party providers in

popular domiciles like India, Vietnam or

the Philippines, is becoming more

common as the financial services industry

looks to take advantage of a less

expensive international labor force.

“U.S. companies need to have an

understanding of local laws and customs,

especially if [problems] lead to a delay in

certain projects,” said Michael L. Jackson,

associate director of e-banking for the

Federal Deposit Insurance Corporation.

Jackson cited the example of a U.S. firm

that did not take local bank holidays into

account and wound up having several

projects delayed.

Offshoring will likely also be a focus of

regulators as it becomes a common

practice throughout the financial services

industry, O’Dell added. “We do see an

increase in foreign bank service providers,

and that’s moving down to mid-sized

institutions,” O’Dell said.

Credit Derivatives Platform: Build it andThey Will TradeJanuary 4, 2005By Christopher Westfall, Managing Editor, Banking Insider

The race is on to develop a successful

electronic credit derivatives trading

platform, which could introduce new

players and transform the market.

Industry observers say that eventually

only one credit derivatives platform will be

used universally. And the emergence of a

single, reliable trading platform may turn

credit derivatives trading from a fast-

growing market into an explosive one.

“A lot of people who want to use [credit

derivatives] find it difficult to do so, but

getting [derivatives] on a trading screen

will make [trading] them essential,” said

Michael Bagguley, managing director of

Barclays Capital in London.

Credit derivatives use has skyrocketed

over the past several years. Banks,

insurers, and hedge funds use the

instruments to mitigate risk in the face

of declining credit quality. According to

the International Swaps and Deals

Association, credit derivative use grew

67 percent in 2003 to $3.6 trillion in

notional outstanding. The most basic form

of credit derivatives is a credit default

swap (CDS), in which one party sells

protection to the holder of a bond in case

of default.

The credit derivative market has grown

despite the product’s opaque structure.

Like most other derivatives, credit

derivatives are contractual agreements

between two firms, making it difficult to

convert them into units that can be valued

and traded over an electronic system,

according to speakers at the recent Fixed

Income Summit & Expo on Technology

and Electronic Trading sponsored by the

Bond Market Association.

Realizing the potential market, several

companies have built trading platforms

they hope will make credit trading quick

and transparent. Creditex has launched a

system for trading credit derivatives, and

UK-based firms Markit and Icap plan to

offer platforms, as well as New York-

based Axiom Global Partners.

The first electronic platforms for credit

derivatives trading will focus on trading

index-based products, such as iTraxx,

which are baskets of individual CDS

issues.

The brass ring for the exchanges? The

platform that gets out of the gate first

with the most users is likely to be the one

that sticks; a successful platform will also

help increase use outside of traditional

markets in Europe and into the U.S.

The only question for many is when CDS

trading will become widespread, and

which firms will succeed after spending

the time and money on a successful

platform. “For many, it is ‘if you build it,

they will come’ issue,” said Michael

Lustig, managing director of BlackRock

Investment Management.

And although the U.S. is developing into a

major CDS market, not everyone is

excited by the prospect of an electronic

trading platform. Large investment banks

may not benefit from the price

transparency that electronic trading

platform may bring, Lustig said.

“The buy-side likes it, but the dealers in

the U.S. have a good thing going,” Lustig

said. American dealers would rather see

CDS traded at a higher price on their

individual desks than more cheaply on a

single electronic platform. “They have

their spreads and they don’t want to see

profits hit again.”

But European firms are already latching

onto the idea of trading CDS electronically,

making it likely that the rest of the world

will follow.

“Companies in Europe are much bigger

users, and the investment space [for CDS]

is much more diversified,” said Lisa

Watkinson, product manager for flow CDS

and credit indexation with Morgan Stanley.

“[An electronic trading platform’s] ability to

capitalize quickly and gain market share is

much more certain in Europe.”

There’s a huge incentive for banks to push

electronic trading: quantifying risk,

according to Jim Toffey, CEO of Thomson

TradeWeb. Currently most CDSs are

settled in cash, lending to the uncertainty

whether the counterparty will make good

on the trade. However, an electronic

trading platform backed by highly liquid

dealers that guarantee banks would make

banks more apt to participate.

“It’s clear to me that the market is ripe

and everyone is looking for a workflow

solution,” Toffey said. “Operational risk is

a big driver to have the market go

electronic.”

In addition, much of the settlement

process is already automated, which will

help foster CDS trading, said Chip Carver,

CEO of SwapsWire. “We have been in a

market where the volume [of traders] was

doubling every six months,“ said Carver.

“The back office aspect is already there,

so the next step is the execution side.”

The information provided in the precedingarticles is of a general nature and is notintended to address the specific circumstancesof any individual or entity. In specificcircumstances, the services of a professionalshould be sought. The views and opinions arethose of the authors and do not necessarilyrepresent the views and opinions of KPMG LLP.

To receive a complimentary subscription toKPMG Banking Insider, go towww.kpmginsiders.com.

SOBI Winter 2005 19


20 SOBI Winter 2005


ContactsChristopher S. Lynch

National Sector Leader

Financial Services and Banking

San Francisco, CA

[email protected]

Robert T. McCahill

Tax Sector Leader – Banking

New York, NY

[email protected]

Editorial Production

Mary Ann Bramer

Special Projects, Industries

Marketing & Communication

Montvale, NJ

(201) 505-3570

[email protected]

Contributing Authors:Legislation and Regulation

Laura H. Leigh

Financial Risk Management

Washington, D.C.

[email protected]

Karen Staines

National Regulatory Advisory

Services Group

Washington, D.C.

[email protected]

Accounting

T. J. Scallon

Audit & Risk Advisory Services

New York, NY

[email protected]

Taxation

Denise Schwieger

Tax

New York, NY

[email protected]

For additional information on KPMG,

please visit our Web site at

www.kpmg.com.

To submit changes to our mailing list,

please contact Erika Arroyo at

[email protected].

Documents

The State of the Banking Industry