Journal of Regulation & Risk

J ournal of Regulation & Risk
North Asia
Volume II, Issues II & III, Summer/Autumn 2010
Articles & Papers

Perspectives on regulatory reform after the 2008 crash Charles L. Evans
Regulation or prohibition: the $100 billion question Andrew G. Haldane
Economists’ hubris informed the financial tsunami of 2008 Shahin Shojai & George Feiger
‘Walker Review’ heralds new dawn in risk management David Millar
Ideas have consequences: the importance of ‘narrative’ Peter J. Wallison
Minority shareholders blind to threat of expropriation Fritz Foley et al
‘Swap tango’: a regulatory dance in two acts Satyajit Das
Beware Greeks bearing bonds: A tragedy in four acts Michael Mussa
Global financial crisis and the European Monetary Union Christian Fahrholz & Cezary Wójcik
Lehman Bros and Repo 105: a powerful case of addiction Jennifer S. Taub
Regulating the rating agencies: Quick fix or political expedient? Lawrence White
Macro-prudential councils: how to avoid future crises Enrico Perotti
EC offers last opportunity for insurers to influence Solvency II Eleanor Beamond-Pepler
Did we tame the beast: views on the US Financial Reform Bill Lawrence Baxter
Financial supervision and increased powers of discretion Steve Randy Waldman
Global anti-trust regulation in the current financial climate Gavin Sudhakar
Asset securitisation in China: Opportunities and challenges Claas Becker et al
Is an undervalued renminbi the source of global imbalances? Charles Wyplosz
The regulators strike back: Basel and new liquidity rules Thomas Dietz
Basel Committee’s enhanced framework for liquidity Michael Wong & Fai Y. Lam
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Publisher & Editor-in-Chief
Christopher Rogers
Editor Emeritus
Dr. John C. Pattison
Editor
Ian Watson
Sub Editor
Fiona Pani
Editorial Contributors
Prof. Lawrence Baxter, Toby Baxendale, Eleanor Beamond-Pepler, Prof. Lucian
Bebchuk, Prof. Thorsten Beck, Claas Becker, Dr. Sergey Chernenko, Satyajit Das,
Thomas Dietz, Charles L. Evans, Dr. Christian Fahrholz, Dr. George Feiger, Dr.
Fritz Foley, Dr. Robin Greenwood, Andrew G Haldane, Fai Y. Lam, William M.
Isaac, Prof. Laurence Kotlikoff, David Millar, Michael Mussa, Prof. Enrico Per-
otti, Jonathan Pickworth, Prof. Carmen M. Reinhart, Christopher Rogers, Shahin
Shojai, Dr. V. Shunmugam, Gavin Sudhakar, Kavaljit Singh, Prof. Jennifer S.
Taub, Steve Randy Waldman, Peter J. Wallison, Prof. Lawrence White,
Prof.Cezary Wójcik Dr. Michael Wong, Prof. Charles Wyplosz
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© Copyright 2010 Journal of Regulation & Risk - North Asia
Material in this publication may not be reproduced in any form or in any way
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Disclaimer: While every effort is taken to ensure the accuracy of the information herein, the editor
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Journal of Regulation & Risk North Asia 1

Volume II, Issues II & III – Summer/Autumn 2010
JOURNAL OF REGULATION & RISK

NORTH ASIA
Contents
Foreword – Christopher Rogers 5
Acknowledgments – 7
Profile – Stephen S. Roach 9
Debate – Prof Brad DeLong 19
Opinion – Chris Rogers 29
Opinion – Lucian Bebchuk 39
Opinion – Laurence Kotlikoff 41
Book overview – William M. Isaac 45
Book review – Toby Baxendale 49
Book review – Satyajit Das 53
Comment – Dr V. Shunmugam 59
Comment – Prof Thorsten Beck 65
Historical analysis – Prof Carmen M. Reinhart 71
Legal update – Jonathan Pickworth 77
Regulatory update – Kavaljit Singh 83
Articles
Perspectives on regulatory reform after the 2008 crash 91
Charles L. Evans
Regulation or prohibition: the $100 billion question 101
Andrew G. Haldane
Economists’ hubris informed the financial tsunami of 2008 123
Shahin Shojai & George Feiger
‘Walker Review’ heralds new dawn in risk management 133
David Millar
Ideas have consequences: the importance of ‘narrative’ 139
Peter J. Wallison
Minority shareholders blind to threat of expropriation 149
Dr Fritz Foley et al
2 Journal of Regulation & Risk North Asia

Articles (continued)
‘Swap tango’: a regulatory dance in two acts 153
Satyajit Das
Beware Greeks bearing bonds: A tragedy in four acts 165
Michael Mussa
Global financial crisis and the European Monetary Union 175
Prof Christian Fahrholz & Dr Cezary Wójcik
Lehman Bros and Repo 105: a powerful case of addiction 185
Prof Jennifer S. Taub
Regulating the rating agencies: Quick fix or political expedient? 191
Prof Lawrence White
Macro-prudential councils: how to avoid future crises 197
Prof Enrico Perotti
EC offers last opportunity for insurers to influence Solvency II 201
Eleanor Beamond-Pepler
Did we tame the beast: views on the US Financial Reform Bill 209
Prof Lawrence Baxter
Financial supervision and increased powers of discretion 219
Steve Randy Waldman
Global anti-trust regulation in the current financial climate 227
Gavin Sudhakar
Asset securitisation in China: Opportunities and challenges 239
Claas Becker et al
Is an undervalued renminbi the source of global imbalances? 245
Prof Charles Wyplosz
The regulators strike back: Basel and new liquidity rules 251
Thomas Dietz
Basel Committee’s enhanced framework for liquidity 263
Dr Michael Wong & Fai Y. Lam

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could be realized—or an uncertain regulatory environment
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The world’s leading risk practitioners and thought leaders

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To learn more and register, visit www.garp.org
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© 2010 Global Association of Risk Professionals.
All rights reserved.
Foreword
First and foremost, may we offer our readers an apology for the lateness of this
Journal appearing – the delay has been caused by a change of ownership and man-
agement structure which we trust will contribute greatly to our future efforts in
raising issues of importance within the governance, risk management and compli-
ance space here in Northeast Asia, together with the Asia region in general. These
changes will be finalised by year’s end, at which juncture the Journal will become
a standalone entity with a revised publication calendar and enhanced local cover-
age, supplementing our already extensive international coverage.
This double issue of the Journal should provide readers with considerable food for
thought on current and future financial management and financial sector policy. This
edition of the Journal also appears exactly two years after events at Lehman Brothers
in August and early September 2008 precipitated the largest financial crisis since the
Great Depression of the 1930s, one which threatened to spill over into the general global
economy unless massive and co-ordinated action was undertaken by the G-20 group of
nations to mitigate against the worst effects of the crisis – the implosion of the banking
system, large-scale economic dislocation and huge unemployment.
Having stabilised the global banking system, many nations are now threatened by
a sovereign debt tsunami as they adjust economic policy to the post-crisis environment
in an effort to contain spiralling debt levels caused, in part, by bailing out the banking
sector and issuing unlimited public guarantees over much of the debt many of the global
“too-big-to-fail” banks hold on their balance sheets – the Greek crisis epitomising this
current problem.
Further, as a result of the trillions of dollars lost from the global GDP, hope was
unleashed that stringent regulatory reforms would be embraced the world over to pre-
vent a repeat of the 2008 crisis by reining in the worst excesses of the financial services
sector. As promised, the US has been the first to enact legislation to regulate more effec-
tively its banking sector, the outcome of which, the Dodd-Frank Act, informs much of the
content of this current Journal.
Suffice to say, many of our renowned contributors have mixed feelings over
Dodd-Frank and are now focusing their attention on discussions within the Basel
Committee, as it too tries to implement an international framework in an effort
to make banking more robust and less of a threat to the global economy – more
about which we shall hear in our next edition of the Journal towards the end of
November.
Christopher Rogers
Publisher & Editor-in-Chief

Acknowledgments
THE editorial management of the Journal of Regulation and Risk – North Asia could
not have published this edition of the Journal without a great deal of assistance
and advice from professional associations, international monetary and financial
bodies, regulatory institutions, consultants, vendors and, indeed, from the indus-
try itself.
A full list of those who kindly assisted with the publication of this issue is not
possible, but the Publisher and the Editor would like to thank the following or-
ganisations for their generous assistance and support: The Federal Reserve Bank
of Chicago; the Bank of England; the Bundesbank; the Financial Services Author-
ity, the Peterson Institute for International Economics, the American Enterprise
Institute, the Roosevelt Institute, Harvard Legal Blog; the Pareto Commons; Vox-
eu; Interfluidity and DLA Piper for their kind permission to reproduce material
from their respective publications and websites.
Detailed comments and advice on the text and scope of contents from Wil-
liam Isaac, Prof William Black, Dr John C. Pattison, Prof Lawrence Baxter Prof
Laurence Kotlikoff and Prof Jennifer Taub were invaluable; we are also grateful
to Ian Watson and Fiona Plani of Edit24.com for their due diligence in setting out,
editing and correcting the text.

Further thanks must also go to the China Banking Regulatory Commission,
Beijing & Shanghai Chapters of the Professional Risk Managers International
Association and the Hong Kong Chapter of the Global Association of Risk Pro-
fessionals for their kind assistance in helping to distribute this journal to their
respective memberships in Greater China, Japan and Korea.

Profile
Morgan Stanley stalwart Roach

bids farewell to Asia Pacific
Chris Rogers profiles some of the highs and
lows in Stephen S. Roach’s distinguished
40-year career as an economist.
AFTER a career spanning almost three the Brookings Institute as a research fellow.
decades with Wall Street leviathan This at a time of rising political tensions and
Morgan Stanley, and three years of that economic problems within the US as a result
time most recently spent heading up of the country’s involvement in Vietnam and
Morgan’s operations in Asia Pacific as huge costs associated with funding both
chairman, Stephen Roach announced the US military-industrial complex and
recently that he would be hanging up his President Lyndon B. Johnson’s push for a
spurs in the region. He said he would be “Great Society”.
heading back to the US for a well-earned The pull of public service being great,
rest and teaching assignments at Yale Roach joined the staff of the economics divi-
University’s Jackson Institute for Global sion of the Federal Reserve Board in 1972
Affairs. Roach will, however, remain a and remained there until 1979 before mov-
thought leader with Morgan Stanley in ing on to his first position within the pres-
the guise of non-executive chairman, a tigious confines of Wall Street at Morgan
position that will allow him to keep tabs Guaranty Trust Company – better known
on Asia on a monthly basis. today as JP Morgan Chase.
One of Wall Street’s most respected and oft Days at the Fed
quoted economists, Roach has had a long Roach’s time at the Fed coincided with one
and distinguished career since graduating of the more interesting periods of politics
from the University of Wisconsin – Madison and monetary policy within DC spanning
with a bachelor’s degree in economics; this two Fed chairmen and three US presidents
followed by a period of research undertaken – Arthur Frank Burns and George William
at New York University for which he was Miller, and Richard Nixon, Gerald Ford and
awarded his doctorate. Jimmy Carter respectively. Notwithstanding
With Ph.D in hand, Roach journeyed to the politicisation of the Fed under Nixon, his
Washington, DC, where he joined the staff of tenure also occasioned that of the“oil shock”

of 1973 and onset of stagflation under the Congress rejected and overturned prevail-
Carter administration. Although not directly ing Fed orthodoxy by modifying its mandate
involved in monetary policymaking deci- to focus on both full employment and price
sions while at the Fed – and indeed Roach stability. Roach speaks highly of Paul Volcker
is on record years later as being highly critical – whom he terms a “hero” of his in central
of policy as conducted by the Fed during his banking circles – during this episode in US
six-year tenure – he has made it clear that his history.
time spent in Washington influenced him Roach states that Volcker “dispelled any
greatly as an economist. doubts over the ability of the Fed to contain
inflation and used the Humphrey-Hawkins
Insidious inflation Act as political cover by pushing up the fed-
Pressed further, Roach had this to say:“Under eral funds rate to 19 per cent in mid-1981, an
Arthur Burns and then G. William Miller, the experience that was critical in forming me as
Fed failed to contain an insidious inflation. It an economist; it showed me what monetary
did not appreciate the need to focus on real policy could do and shouldn’t do in manag-
short-term interest rates, instead choosing to ing the broader macro economy.“
view its target largely in nominal terms. As
such, monetary policy was highly stimulative Off to Wall Street
as US inflation surged toward double-digit After working for three years as a senior
rates.” economic analyst at Morgan Guaranty,
Roach’s views on Burns and Miller are in Roach, now a seasoned and well-respected
stark contrast to those of Paul Volcker who economist and analyst, picked up his boots
took over as Fed chairman not long after and decamped to Morgan Stanley – this in
his own departure in 1979. Again, discuss- a period when brokerage and investment
ing the pre-Volcker years, he explained that banking was still considered boring and
the “Burnsian” view was to regard inflation Wall Street’s offices were adorned with such
as being driven by a series of exogenous distinguished nameplates as Dean Witter
and institutional factors that could not be Reynolds, Salomon Brothers, Smith Barney,
controlled through monetary policy. As will Brown Brothers Harriman and, of course,
become clear later, this is something Roach Lehman Brothers.
vehemently opposes, and indeed is an issue Whilst Roach’s 28 years at Morgan
over which he took the president and CEO Stanley cannot really be said to have been
of the Federal Reserve Bank of Chicago to “meteoritic” – Roach being more of a jour-
task while visiting Hong Kong in March. neyman rather than one of the “masters
of the universe’”– by the early years of this
Volcker and the H-H Act new century, his stature as an indepen-
Roach beleives that the passing of the dently minded economist not afraid to fire
Humphrey–Hawkins Act of 1978 was a off missives in all directions, had become
“watershed moment” in the Fed’s almost well known and, indeed, appreciated by
100-year history. By passing this Act, the US many outside the small world of investment

banking. As such, and given his known aver- some 1.2 million miles during his three-year
sion to much of the “irrational exuberance” stint as chairman of Morgan’s in Asia, and
apparent within the greater investment who is well known for hob-nobbing with
community – including sections within the great and the good across the region,
Morgan Stanley itself – it came as a surprise Roach’s sympathies lie with the more liberal
to this author and many others when it was elements of the Democratic Party – as befit-
announced Roach would leave New York to ting someone with a wife and six daughters
take up the reins of leadership of Morgan and family home in that “liberal” bastion of
Stanley’s operations in Asia, based in Hong Connecticut. Donating to John Kerry’s failed
Kong, but within a stone’s throw of that presidential campaign in 2004 and Hillary
emerging Colossus, China. Clinton’s run for the Democratic nomination
in 2008, as Roach himself would observe, he
Top of the greasy pole has “placed a few wrong bets in his time.”
Questioned on his appointment, Roach One of the more interesting periods in
somewhat self-deprecatingly had this to say: Roach’s long career was during the 1990s, a
“It was purely a reflection of senior manage- period which saw him receive some unwel-
ment’s appreciation of my potential value – come flak from sections of the media for his
added to our Asian franchise – very much an supposed initial support of policies associ-
outgrowth of the expertise I had developed ated with libertarian traditions, a matter he
on Asia in the decade prior to my appoint- disputes and is at pains to dispel – at least to
ment as chairman. He added: “It had little this author.
or nothing to do with my macro critique of
markets, policies, or the financial services NAFTA and Gramm Leech Bliley
industry. Nor did I alter my negative view of Roach looked back over the Bush (Snr)
macro and market risks once I became chair- and Clinton years, ones that are associated
man, as my published commentary over the with the wholesale movement towards lib-
past three years clearly indicates.” eralisation and deregulation, epitomised
by the passage of the North America Free
Political leanings Trade Agreement (NAFTA) which came
A “conservative” at heart – that’s conserva- into force in January 1994, and the Financial
tive with a small‘c’– Roach has always stood Modernisation Act – better known as the
out as an urbane thinker not prone to hyper- Gramm Leech Bliley Act – which came into
bole or as a follower of the latest fads. Such force in 1999 and overturned many of the
qualities are most rare, but of great value in provisions found in the Banking Act of 1933
an economist, particularly if they happen (better known today as the Glass-Steagall
to belong to the global chief economist for Act).
one of the largest“bulge bracket”investment On the issue of NAFTA, Roach said that
banks in both Wall Street and the world. it was not too much of a focal point for him
As for political affiliations, for a person in the early 1990s. However, he did wish to
who has travelled the world notching up elucidate further on the distinction between

trade liberalisation and financial deregula- counter-party risk.” Turning to some unwel-
tion, stating: “I supported the former and come media attention in the 1990s, Roach
very much objected to the latter. ”Touching made it clear he is a firm believer in trade
upon home ownership, he was quick to point liberalisation and, if used correctly by policy-
out that he “strongly objected”to the politi- makers and business alike, has many virtues.
cal economy of excessive home ownership – However, the framework or matrix for this
arguing that the Community Reinvestment policy must not be used for wanton destruc-
Act of 1977 (Carter administration) tilted the tion, particularly if people’s jobs are on the
US body politic toward condoning anything line. So it was quite surprising to learn that
and everything that promoted ever-higher Roach himself, initially, had been caught up
rates of home ownership. in the belief, or fad, that after the downturn
of the early 1990s, the US economy was
Financial innovation charging ahead by embracing a new faster
He continued: “This was the political cover productive paradigm – this period coinciding
that successive administrations, Republicans with NAFTA and a huge upswing in finan-
and Democrats alike, used to validate the cial services.
push toward “creative” subprime lending
and so-called financial innovations such as Ever-increasing revenues
CDOs that were billed as facilitating such Indeed, it should be made clear here that the
lending. “ As Journal readers are no doubt recovery of the early 1990s was not based on
aware, it was the growth of these products a manufacturing recovery but rather on ever-
that subsequently led to the subprime crisis increasing revenues from finance fuelled in
that overwhelmed Bear Stearns in March part by Greenspan’s monetary policy at the
2008 and paved the way for the financial cri- Fed – which Roach has stated was “far too
sis some six months later. accommodative”for his liking.
While Roach may have initially been
Greenspan’s failings supportive of the movement towards out-
Turning his guns on Alan Greenspan’s sourcing and costing, it did not take him
nearly 20-year reign as boss of the Fed, long to recognise that something was
Roach had this to say on its role in extend- amiss and that even in the midst of a sup-
ing home ownership and loose monetary posed economic recovery, unemployment
policy: “The Greenspan Fed was too accom- remained sticky. His scepticism gave way to
modative of this development in two ways outright opposition once it became apparent
– it kept the cost of credit far too low and to him that many in the US and other devel-
it extolled the “virtues” of financial innova- oped economies – notably the UK – were
tions that allowed home ownership to rise approaching this productivity enhancement
to new highs. And it incorrectly viewed these in completely the wrong way and with many
innovations as self-cushioning in the event unintended consequences.
of a disruption in the housing market – fail- Roach’s initial support for the new pro-
ing to appreciate the perils of concentrated ductive paradigm soon came back to haunt

him when certain sections of the media of International Settlements and Raghuram
began vilifying Roach as the guru of cost cut- Rajan of the IMF to name but three) correct
ting and the outsourcing of jobs to cheaper following the subprime implosion beginning
locations such as China and India. Indeed, early 2007 and resultant 2008 banking crisis.
not only did the Wall Street Journal pick up on In an interview with Howard Winn,
this story, the BBC became involved when which appeared recently in the South China
Newsnight anchorman Jeremy Paxman had Morning Post, Roach expanded on his phi-
the temerity, live on air, to invite interviewee losophy and reasons for making his now
Roach to issue an apology to all those who famous call on the US economy, well before
had lost their jobs. Roach was not amused, other peers in investment banking and cen-
to say the least. tral banks – not surprising given Greenspan’s
inability to notice an asset bubble, be it hous-
Paul Krugman ing or stocks.
Again, and more recently Roach, who often
appears on numerous financial news chan- The ‘big call’
nels, was asked about Paul Krugman’s Roach explained:“When you’re on a big call,
advice to US policymakers, urging them to there’s a lot of pressure on you to explain
put pressure on China to revalue its currency. yourself. When you walk down the hall of a
Roach’s riposte was blunt and to the point: major securities firm and you are known for
“We should take out the baseball bat on Paul your call, there is a lack of eye contact during
Krugman . . . I mean, I think that the advice is this period when you are wrong. Eventually,
completely wrong.” Roach, of course, having if the world does not conform to your fore-
a completely different view on the reasons cast, then self-doubt creeps in and there is
for the trade imbalance between the US and pressure to change the view.”
China. Roach, however, stuck to his guns, even
though his own senior management at
Wall St ‘permabear’ Morgan Stanley were betting on the fact that
Having earned the moniker of“permabear“ the ever-upward spiral of wealth generation
for his downbeat assessments of the US and would continue, a matter he fundamentally
global economy during periods of seem- did not agree with. Whilst he tried to influ-
ingly unending economic exuberance – dur- ence opinion internally, few would listen,
ing 2003-2004 to be precise when he began even though, as Roach willingly admits, “I
to doubt the vitality of the US economy had a framework that led me to these con-
and chairman of the Federal Reserve Alan clusions and the conclusions and the frame-
Greenspan’s loose money and low interest work still seemed to me to have rigour. It
rates strategy to cement sustainable growth turned out I was right.”
– which subsequent events proved Roach, Having already noted that Roach is
and other members of the Cassandra fra- nether infallible – a fact he himself agrees
ternity (Professor Nouriel Roubini of New with – nor easily persuaded if the facts sup-
York University, William White of the Bank porting his position remain true, perhaps

a quote from John Maynard Keynes best nor a Cassandra when it comes to pro-
sums up his moral rectitude and philoso- nouncements on China or India. He takes a
phy:“Looking again today at the statements more balanced and circumspect approach to
of these fundamental truths which I then his research.
gave, I do not find myself disputing them. That said, having studied China’s rise
Yet the orientation of my mind is changed; from impoverishment since the reforming
and I share this change of mind with many zeal of the visionary Deng Xiaoping in 1978,
others.” Roach, following many visits and meetings
with China’s business and ruling elite, has
Asia and beyond learned to respect what he sees as one of the
Shifting focus to Roach’s three-year chair- main strengths of the Chinese leadership
man’s tenure in Asia, the man is part of a – its pragmatism and willingness to adapt
pantheon of economists and investment to changing circumstances to safeguard its
gurus whose every pronouncement is care- continued economic progress and that of its
fully scrutinised by investors and media alike one billion-plus inhabitants.
– his fellow soothsayers being Dr James (Jim)
Walker, Jim Rogers, Jim O’Neil, Dr Marc Paradigm shift needed
Faber and Mark Mobius. While he aban- One matter Roach is emphatic about when
doned the cloak of chief economist in 2007 it comes to China, and a major concern to
with his elevation to heading up Morgan leading Chinese economists such as Dr Ha
Stanley’s operations in Asia, Roach has Jiming of the mainland’s sole investment
maintained a prolific output of papers and bank, China International Investment Corp
articles concentrating on both the region’s (an institution which Morgan Stanley was
emerging economies and it’s developed closely associated with) is the over-reliance
nations. Indeed, unable to cease putting quill on what had originally formed the bedrock
to paper, he has managed to shoot off some of its economy – its export-orientated eco-
150 pieces, many of which formed the main nomic model. This Roach believes, given
body of a book published in late 2009: The China’s current aspirations, is unsuitable for
Next Asia – opportunities and challenges for a the next phase of the country’s development.
new globalization. A paradigm shift from its external demand
model to an internal demand model is now
Twin powerhouses called for, he says.
Understandably, Roach, like many of his This was an issue brought clearly home
peers, has been mesmerised by the mete- to China in 2008 when its exports were
oritic rise of both China and India as inter- crushed in the wake of the financial crisis,
national economic powerhouses. Unlike leading to widespread unemployment and
certain contemporaries – those über bulls social unrest. Around 20 million people in
Jim Rogers and Goldman Sachs’stalwart Jim Guangdong province alone lost their liveli-
O’Neil, or even that perennial China bear, hoods in the first six months of the down-
Jim Walker – Roach is neither a cheerleader turn. In Roach’s opinion, the Five Year Plan

leadership gathering in China next year “will from the US, Japan and the UK.Among them
be a watershed period for China and the rest were the president and CEO of the Federal
of the China-centric region.” Reserve Bank of Chicago, Charles Evans;
Except for the brightest of analysts, a the Bank of England’s executive director for
summation of Roach’s economic philosophy financial stability, Andrew Haldane; and for-
and the underpinnings of his beliefs is diffi- mer Bank of Japan monetary policymaker,
cult to impart. This is particularly so concern- Professor Kazuo Ueda. (Presentations and
ing the strong moral and ethical convictions points of view Roach referred/alluded to are
informing many of his pronouncements, and published in full in the latter half of this quar-
the vitriol and contempt he holds towards ter’s Journal.).
some, but not all, of those who command
the reins of monetary policy, partcilarly when Views on regulation
the tools and instruments they control are Following keynote presentations by Evans,
deployed incorrectly or contrary to the pre- Haldane and Ueda and opening remarks by
vailing economic winds. the chairman and editor-in-chief of Central
Our final paragraphs detail in depth Banking Publications, Robert Pringle, Roach
some of these views and much of what took to the podium and instructed everyone
Roach holds dear via an examination of that he wished to deal with four areas central
his thoughts relating to the causes of the to the current crisis and its aftermath. These
financial crisis of 2008 and central banking were: regulation, monetary policy, central
responses in its wake. This was a crisis he banking mandates, and the indefinite period
alluded to as“the greatest threat to the global of near-zero interest rates.
economy since the Great Depression of the On the matter of regulation, Roach
1930s.” opined that Evans had “not made any new
Not wishing to do an injustice to Roach, revelations” about current Fed policy, with
this author hopes to reveal the full gamut of his (Evans’) comments in line with those of
his views by affording him the opportunity Fed chairman Ben Bernanke and his prede-
to convey that which he finds important by cessor, Alan Greenspan. That is to say, the
publishing in full an account of off-the-cuff current principal focus of post-crisis policy
remarks he made at a recent central banking adjustments should be in, and are indeed in,
gathering in Hong Kong. the regulatory arena. Principally, by shifting
from a micro- to macroprudential regulation
Responses to the crisis and focusing extensively on the establish-
This high-powered meeting was con- ment of a resolution authority as the answer
cerned with regulatory and monetary policy to the problem of the“too-big-to-fail”moral
responses to the banking crisis and how such hazard conundrum that the US faces – a
crises could be mitigated against in future. matter Roach readily admits is insufficient in
Roach’s remarks were made in front of an itself to prove of any real value.
audience consisting of some 300 bankers, On the systemic risk front and despite
financiers and senior central banking figures Haldane’s warning about the skill set, or lack

thereof, of the omniscient proposed systemic high quality monetary policy in the US”and
risk regulator – a very important warning in that he found it “not a comforting compari-
Roach’s opinion – he countered:“We talk the son that the Fed had reverted to past form.”
talk of systemic risk, but I challenge anyone He continued: “I think there is a monetary
to clearly define the metrics that we use to policy problem, and I think the regulatory
measure it,”adding,“nevertheless, I take the issues are important, but I think there’s an
point which the Fed makes, that we do need equally important challenge for monetary
a new approach to regulatory policy. But I policy.”
argue that’s a necessary, but hardly sufficient More critically, he said the Fed had been
condition to avoid the mess we are currently quick to be critical about using monetary
experiencing occurring in future.” policy to deal with these types of financial
instability issues – asset and credit bubbles –
Monetary policy and continually citing that the federal funds
Regarding monetary policy, Roach turned his rate is a blunt instrument that can do a lot of
gaze and full might of his analysis towards damage to areas of the economy that do not
his fellow guest speakers and exclaimed, deserve to be impacted.
rather contemptuously, that they had either
failed to address, or only obliquely referred Shouting match
to what he called the“big gorilla”in the room While there may well be some truth to this,
– namely monetary policy. In passing, he he said he found it “rather ironic” when the
pointed out a few areas that concerned him. President of the Chicago Fed (Evans) said
He explained that since 2000 the infla- we don’t want to be seen as being too sub-
tion-adjusted federal funds rate – that is to tle when we have these financial problems.
say the nominal fund rate less the Consumer We need to shout. To which Roach riposted
Price Index headline inflation – had been that he considered the Federal funds rate a
less than its long-term average of 1.9 per “pretty good way of shouting!”
cent for all but one year and, that over the Continuing this train of thought, Roach
same period, the real Fed fund rate had been added: “And I would say this idea of using
less than zero for about half the period in a blunt instrument is important.” Looking
question. As measured by this calculation, back at the unfolding crisis, he said: “At its
this has been the most “accommodative peak, the bubble distorted housing and, yes,
monetary policy” the Fed had run since the consumer spending sectors in the economy
1970s. amounted to some 80 per cent of US GDP. If
that’s not deserving of a blunt instrument, I
Uncomfortable comparisons don’t know what is?”
Referring to the time he spent working Moving to his third major area of con-
for the board of governors at the Federal cern, namely monetary policy mandates,
Reserve (1973-79) and the accommodative Roach said he believed this required serious
monetary policy it conducted, he said that consideration and concurred with a point of
this was “not one of the great periods of view raised by Robert Pringle that financial

stability may need to be mandated and sanc- and the distortions they can impart on the
tioned by the state. He said: “I think we need real economy.” Roach’s concluding remarks
to get serious about things, about the policy and final area of concern were, in his opin-
mandate that shapes and guides the con- ion, those that get right to the heart of the
duct of US monetary policy.“ current policy debate and focus on the near
record low interest rates policies central
Historical precedents banks are deploying to allegedly safeguard
He then detailed some important histori- a nascent economic recovery in many of the
cal precedents in the US that had informed world’s leading economies . . . with particular
monetary policy since the end of World War scorn heaped on the Fed.
II, referring to this as “a bit of a history lesson He began by praising Evans and other
here”. In 1946 post-Depression America, he Fed officials for their deft handling of the
said, Congress was adamant that never again media when journalists asked about the
would we have unemployment rates peak Fed’s policy of maintaining interest rates at
out at 25 per cent, as was the case in the 1930s. near zero for an indefinite period and ques-
And so the Full Employment Act, set- tioning when this strategy was likely to end.
ting the Fed’s target at just that, was enacted Roach said:“Its a big question!”
and added to its mandate. It worked for 30
years and then along came the “great infla- Lousy recovery, appropriate rates
tion”and the same Congress said,“you guys He continued with this line of exploration
made a mistake.” by enquiring: “Is it really appropriate right
Thus in 1978 the Full Employment and now for central banks [to be] globally main-
Balanced Growth Act (known informally as taining interest rates set at the depths of the
the Humphrey-Hawkins Act) was passed, crisis.”He acknowledged, however, that cen-
a move that added price stability to the Fed tral banks did the right thing in slashing rates
mandate. This was the“great dual mandate” to zero – as any emergency would suggest.
and the Fed again did a terrific job courtesy Roach then queried the wisdom of this
of a courageous central banker, Paul Volcker, continued approach in light of the fact that,
who went after the country’s rampant infla- “Central banks themselves around the
tion. Roach added . . .“and again, I’d say, for world are telling us the emergency is over.”
30 years that worked.” And then he enquired of his fellow speakers:
“Is it appropriate, given this fact, to maintain
‘Hard–wiring’ financial stability monetary policy at emergency levels now
“And now we have another crisis, a crisis that the said emergency is allegedly over?”
driven by a combination of asset and credit Continuing on this theme, he said:“Yes,
bubbles, and I’d say there is a good case to be we’ve heard the recovery is lousy, so why not
made for rethinking the mandate again and have your policy setting at a lousy recovery
adding financial stability to the central banks’ setting given the leads and lags of monetary
mandate – “hard-wiring” the accountability policy. This does not mean that the funds
of central banks to deal with asset bubbles rate has to go from night to day, from zero

to a probable funds rate. Given this infla- critically, he opined:“The Fed has a view that
tion rate, and the long-term average of the the main lesson to be drawn from Japan is all
federal funds rate (1.9 per cent), a normal you have to do when you have a crisis – the
fund rate would be four per cent. Why not bursting of bubbles – is to move quickly after
split the difference and deploy a progressive the crisis and leave cleaning up the mess
normalisation that takes you half-way there until afterwards.”
– two per cent – and then if the recovery Roach then launched into the Fed and
turns out to be disappointing, you certainly its current interest rate policy strategy and its
have the opportunity to revert back to your inability to learn from previous mistakes and
emergency setting.” policy blunders. “The mess we have lived
through after this crisis (2008), is testament
Rate policies peril to the fact that this clearly is the wrong con-
Roach then warned audience and speakers clusion.“
alike:“But, if you leave the fund rate on hold Somewhat deprecatingly, he added:“The
at its emergency setting, you run the risk of correct conclusion, in my opinion, is that in
taking us right back to the same movie that future policymakers need to be more pre-
we all watched in the aftermath of the burst- emptive in avoiding the types of problems
ing of the equity bubble.” This was when we have just witnessed.“
“the Fed stayed too easy, for too long set-
ting us up for a period of excessive monetary Praise for William White
accommodation that played a critical role Roach then paid homage to one of those
in leading to the credit and property bub- who had been most prescient in raising
bles that nearly brought the global economy alarm bells to the excesses of Fed policy some
to a very, very difficult place in the closing five years prior to the 2008 crisis – none other
months of 2008.” than William White, former chief economist
and adviser to the Bank of International
Lessons learned Settlements, about whom he stated:
In his concluding remarks, Roach observed “In the words of Bill White, monetary
that, “having listened carefully to the views policy should not be aimed at cleaning up
expressed by our central banking colleagues messes afterwards; rather, central bank-
from Japan, the UK and the US, I believe the ers need to lean against the wind to avoid
lessons to be drawn from the experience of messes in future.”
Japan over the past two decades are abso- Roach ended with this line: “While the
lutely critical in informing the current policy current regulatory agenda is critical, impor-
debate.” tant and necessary, it is not sufficient on its
Roach detailed the pointers that he con- own to prevent crises. Central bankers glob-
sidered the Fed had gleaned from Japan’s ally need to be held accountable for mone-
own experiences in their home-grown eco- tary policy over the past decade and the very
nomic downturn and period of low growth serious mistakes many made that led to the
since the late 1980s. Again, and rather subprime crisis.” •

Debate
The blogosphere strikes back

against Richmond Fed assault
U.C. Berkeley Professor Brad DeLong leads
an armchair economic bloggers’ offensive
against Richmond Fed’s Kartik Athreya.
FOLLOWING publication of a critical Athreya’s reasoning, this episode highlights

paper against online economic bloggers once again the unintended consequences
by the Richmond Fed’s Kartik Athreya, of one’s actions or policy prescriptions
a number of leading bloggers named by within the polity, be this the blogosphere or
Athreya in his article: ‘Economics is hard: the nation-state itself. This is a matter that
Don’t let bloggers tell you otherwise,’ William Isaac, former head of the Federal
responded in kind with their own mis- Deposit Insurance Corp (FDIC), is often at
sives against the errant Fed employee. pains to highlight in his numerous papers
Among those manning their keyboards and columns – not to mention his latest
were leading luminaries Brad DeLong, book, Senseless Panic.
Mark Thoma, Scott Sumner, Arnold
Kling, Ryan Avent, Mathew Yglesias, Voices from the blogosphere
Tyler Cowen and Nick Rowe. The JRRNA begins it trawl through the
blogosphere and its reactions to Athreya’s
While the publisher and editorial staff at paper – mostly negative – by visiting some
the Journal of Regulation & Risk – North Asia of our favoured depositories of common
(JRRNA) endeavour on all occasions to sense. First off the starting blocks in con-
encourage open debate and dialogue, the demning Athreya’s take was leading online
Journal is only able to do so with the express blogger Scott Sumner who penned the fol-
authority of the parties themselves. Having lowing riposte: “In a recent essay, Kartik
made a formal request to publish in full Athreya suggests that almost all economics
Kartik Athreya’s article, the author, although bloggers are basically quacks, hardly worth
honoured by such a request, humbly paying attention to. OK, take a deep breath
declined, no doubt wishing to avoid drawing and don’t get defensive Sumner; construc-
further attention to himself from irate online tive criticism is always welcome: To quote
bloggers. Athreya: “In summary, what I’d like to con-
Though the Journal fully understands Mr vince the public [about] is that economics is

far, far, more complicated than most com- to deliver an ipinion on important public
mentators seem to recognise. Because if they policy issues? I don’t recall ever reading a
did, they could not honestly write the way Greg Mankiw post that I didn’t feel knowl-
they now do. Everything“depends”and this edgeable enough to write. On the other
is just the way it is. And learning what “it” hand, I’ve read lots of Mankiw posts that I
depends on, exactly, takes enormous effort. didn’t feel clever enough to write.
That’s an important distinction. Mankiw
Chatter, blogs and op-eds is a great economist in the “scientific” tradi-
Moreover, just below the surface of all the tion, and he’s a great blogger – but for com-
chatter that appears in blogs and op-ed pletely different reasons. He’s a great blogger
pages, there is a vibrant, highly competitive, for the same reason he is a great textbook
and transparent scientific enterprise hard writer. I don’t know if Krugman has done
at work. At this point, the public remains a lot of recent research on macro, but he
largely unaware of this work. In part, this is knows enough about the literature to offer
because few of the economists engaged in an informed opinion.
serious science spend any time connecting
to the outer world (Greg Mankiw and Steve Difference of opinion
Williamson are two counter-examples that I often disagree with the views of Krugman,
essentially prove the rule), leaving that to a DeLong, Thoma, et al, on fiscal policy, but
group almost defined by its willingness to they can cite highly “scientific” papers by
make exaggerated claims about economics people like Woodford and Eggertsson for all
and over-represent its ability to determine their fiscal policy views. There must be doz-
clear answers.” ens of economics bloggers who either teach
That’s right; there’s no need to pay at elite schools, or have a Ph.D from elite
attention to Gary Becker, John Taylor, Paul schools, and who are qualified to comment
Krugman, and all the other quacks who on current policy issues.
lack Athreya’s sophisticated understand- Athreya also takes on those who (he
ing of the “science” of economics. BTW, any claims) lack formal qualifications in eco-
time someone wields the term ’science’ as a nomics. Here’s how he opens his essay:
weapon, you pretty much know they are an “The following is a letter to open-minded
intellectual philistine. Am I being defensive consumers of the economics blogosphere.
yet? In the wake of the recent financial crisis,
bloggers seem unable to resist commentat-
Getting serious ing routinely about economic events. It may
To get serious for a moment, in this essay always have been thus, but in recent times,
Athreya is confusing a bunch of unrelated the manifold dimensions of the financial cri-
issues, among them the following: The style sis and associated recession have given fillip
of bloggers – are they polite or not? The ide- to something bigger than a cottage industry.
ology of bloggers – their views on methodo- Examples include MattYglesias, John Stossel,
logical issues; And, are bloggers competent Robert Samuelson, and Robert Reich.

In what follows, I will argue that it is crisis: Athreya continues:“I find the compar-
exceedingly unlikely that these authors have ison between the response of writers to the
anything interesting to say about economic financial crisis and the silence that followed
policy. This sounds mean-spirited, but it’s two cataclysmic events in another sphere of
not meant to be, and I’ll explain why. Before human life telling.
I continue, here’s who I am: The relevant fact These are, of course, the tsunami in East
is that I work as a rank-and-file Ph.D econo- Asia, and the recent earthquake in Haiti.
mist operating within a central banking sys- These two events collectively took the lives
tem. I have contributed no earth-shaking of approximately half a million people, and
ideas to Economics and work fundamentally disrupted many more. Each of these events
as a worker bee chipping away with known alone, and certainly when combined, had
tools at portions of larger problems.“ larger consequences for human wellbeing
than a crisis whose most palpable effect has
Where to begin been to lower employment to a rate that, at
Where do I begin?Yes, bloggers who address worst, still employs fully 85 per cent of the
important public policy issues sometimes total workforce of most developed nations.
“seem unable to resist” commenting on
the biggest economic crisis since the 1930s. Seismic qualifcations
Unlike Athreya, I don’t judge people by their However, neither of these events was met by
credentials, but rather by the quality of their (i) a widespread condemnation of seismol-
arguments.Yglesias is the only person listed ogy, the organised scientific endeavour most
above that I read routinely. Although he is closely “responsible” for our understanding
much more liberal than I, and we differ on of these events or (ii) a flurry of auto-didacts
many public policy issues, I find his reason- rushing to offer their own diagnosis for what
ing ability on economic issues to be superior had happened, and advice on how to avoid
to the majority of professional economists the next big one.
that I have met or read. Everyone understands that seismology
I guess no one will accuse me of being is probably hard enough that one probably
one of those “worker bees” who churns out has little useful to say without first getting a
ever more macro studies that follow accepted Ph.D in it.
scientific methods. I notice that those econ- The key is that macroeconomics, which
omists had little or no useful advice to offer involves aggregating the actions of millions
the Fed when the current crisis hit in 2008. to generate outcomes, where the constituents
pieces are human beings, is probably every bit
Pragmatic suggestions as hard.This is a message that would-be com-
I may be incorrect in my policy views, but mentators just have to learn to accept. For my
at least I am trying to offer pragmatic policy part, 17 years after my first Ph.D coursework,
suggestions. But maybe it’s not the fault I still feel ill at ease with my grasp of many
of economists. Maybe there is nothing issues, and I am fairly confident that this is not
that could have been done to prevent this just a question of limited intellect.”

This confuses two unrelated issues, the on the fringes, like George Warren and Irving
ability to predict a crisis and the ability to Fisher, and that most“respected”economists
prevent a crisis. In 1932 no one could have were peddling snake oil.
predicted the rapid inflation that occurred Today it is bloggers who are offer-
during 1933. But we know exactly what pol- ing ideas on how to boost AD, the sort of
icy choices caused that inflation, the sharp ideas that almost everyone now agrees
depreciation of the dollar that began in April should have been tried in the 1930s, and it
1933. We could have easily prevented the is respected economists who are often rec-
inflation (Thank God we didn’t). ommending that no further effort be made
to boost aggregate demand. One example in
Fed monopoly the latter category is Athreya’s boss, the pres-
We knew how to prevent the sharp fall in ident of the Richmond Fed. According to
NGDP after mid-2008; we simply chose not press reports he is pressing for tighter money
to do so. In contrast, we do not know how to (as if money isn’t already tight.) Perhaps he’s
prevent earthquakes and tsunamis. Athreya not convinced that models linking nominal
ignores the role of the medium of account, GDP growth with unemployment are suf-
and the importance of nominal shocks. ficiently“scientific.”
Yes, the economy is incredibly complex, but
nominal aggregates are relatively simple. Disinflation
The Fed has a monopoly on the supply In the 1930s many “respected” economists
of the medium of account. It’s their job to tar- warned that inflation was just around the
get some sort of variable linked to aggregate corner, even as prices kept falling. Today,
demand (prices, NGDP, etc). The tsunami of many of the more conservative respected
falling aggregate demand (AD) all around economists are issuing the same warning,
the world that occurred in late 2008 was not despite the fact that the markets are signal-
some sort of mysterious event, but rather ling lower-that-target inflation and despite
reflected the loss of monetary policy credibil- the fact that conservative economists (claim
ity. The Fed has the tools to prevent some- to) believe that markets are efficient. It seems
thing like that from occurring. Bernanke to me that it is mostly bloggers (on both the
explained to the Japanese how to use those left and the right) who insist that the real
tools in 2003. problem is disinflation.
So who’s right Mr Scientific Economist,
Snake oil peddlers the bloggers with their market signals, or
The fact that he refused to use them in the scientists with their abstract models that
2008, and never explained why, is certainly were completely unable to predict the cur-
grounds for criticism. A lot of the more scien- rent crisis, are unable to explain 16 years of
tific economists have a very limited under- deflation in Japan, but are somehow able
standing of economic history. Many do not to tell us that inflation is the real long-term
realise that in the Great Depression some of threat?
the most promising ideas came from those I don’t think the real problem is that

bloggers oversimplify. If you disagree with Those were genuine improvements over
someone, their views will always seems Friedman’s macro theory. But that is all.
simplistic. Lucas’s insistence that good macro can
only be done by carefully embedding all the
The punch line assumptions in general equilibrium models
No, the real problem here is that Athreya with micro foundations turned out to be an
likes some simplistic models more than oth- intellectual dead end.
ers: “The punch line to all this is that when There is not a single idea in monetary eco-
a professional research economist thinks or nomics of use to policy makers that can’t be
talks about social insurance, unemployment, explained in partial equilibrium terms on
taxes, budget deficits, or sovereign debt, the back of an envelope. If blogs had been
among other things, they almost always around in the 1960s and 1970s, Friedman
have a very precisely articulated model would have been the world’s best econom-
that has been vetted repeatedly for internal ics blogger.
coherence.
Critically, it is one whose constituent Bank of Japan example
assumptions and parts is visible to all pre- Here’s what Friedman said about the1998
sent, and can be fought over. And what I Japanese crisis:
certainly know is that to even begin to talk “The governor of the Bank of Japan, in
about the effects of unemployment, debt, a speech on June 27, 1997, referred to the
deficits, or taxes, one has to think very hard “drastic monetary measures” that the bank
about many, many things. Examples of this took in 1995 as evidence of“the easy stance
approach done right in the context of some of monetary policy.” He, too, did not men-
of the topics mentioned above are recent tion the quantity of money. Judged by the
papers by Robert Lucas of the University discount rate, which was reduced from 1.75
of Chicago, Jonathan Heathcote of the per cent to 0.5 per cent, the measures were
Minneapolis Fed, or Dirk Kreuger and his drastic.
co-authors.” Judged by monetary growth, they were
When you combine this passage with too little too late, raising monetary growth
his previous praise for Steve Williamson’s from 1.5 per cent a year in the prior 3½ years
blog, it becomes pretty clear what sort of to only 3.25 per cent in the next 2½ years.
research Athreya considers scientific. After the US experience during the
Great Depression, and after inflation and
Friedman’s approach rising interest rates in the 1970s and disinfla-
What would be an example of non-scientific tion and falling interest rates in the 1980s, I
research? How about Milton Friedman’s thought the fallacy of identifying tight money
partial equilibrium approach to monetary with high interest rates and easy money with
economics and business cycle theory? I low interest rates was dead. Apparently, old
am a big fan of Lucas’ work on rational fallacies never die.”
expectations, especially the Lucas Critique. The same point is made in Mishkin’s

textbook. And Mishkin is a respected “sci- Hot on the heels of Sumner’s acrid riposte
entific economist”by anyone’s standards. So to the Fed’s Athreya, the Associate Editor
why is it that 90 per cent of the respected sci- of the Atlantic Monthly and prolific multiple
entific macroeconomists don’t understand blogger himself, Mathew Yglesias, was quick
this? Why do most keep insisting that the to launch a broadside against the miscreant
Fed has conducted an “accommodative” or who voiced concerns over armchair pundits
“easy”money policy since 2008? and their acolytes on the worldwide web.
Quoting in full from Yglesias’s website, our
Lack of intuition supposed ill-informed commentator had
Maybe they think that doubling the base is this to say:
easy money, and are unaware that the Fed ‘Kartik Athreya, a self-described “rank-
started paying interest on base money in and-file Ph.D economist operating within
October 2008. As Cochrane pointed out, a central banking system” who by his own
this means that reserves are now effectively admission has “contributed no earth-shak-
bonds, not money. ing ideas to Economics and works funda-
My claim is that despite all these fancy mentally as a worker bee chipping away
mathematical models, most scientific econo- with known tools at portions of larger prob-
mists lack Milton Friedman’s intuitive grasp lems” has published an essay condemning
on what is really important, what is really writ large bloggers and op-ed writers who’ve
going on below the swirling mass of data tried to explicate macroeconomic policy con-
with which we are constantly bombarded. troversies in the wake of the financial panic
And I don’t pick Friedman merely of 2007-2008.
because I happen to agree with his politics,
Krugman is also very good at looking below Original sinner
the surface (when he doesn’t let ideology get He names me by name as one of the sin-
in the way.) I’m afraid that we won’t get the ners, and argues: “It is exceedingly unlikely
answers we need from “worker bees.” Matt that these authors [i.e. people like me] have
Yglesias may not have an economics Ph.D, anything interesting to say about economic
but he has a sure grasp of the importance of policy. I think there’s a lot that’s wrong about
preventing a sharp break in NGDP growth, Athreya’s essay, much of it explained by Scott
something that some much more distin- Sumner, but most of all I think his argument
guished economists seemed to overlook in hinges on two category errors, one about what
the turmoil of the recent financial crisis. I’m doing and one about what he’s doing.
First me. Do I have anything interesting
Yglesias in the pulpit to say about economics? Well, “interesting”
If Athreya really thinks we are so shallow, is relevant to audience. I should hope that
then I encourage him to enter the fray, start Ph.D economists working in central bank-
his own blog. I’d love to debate monetary ing systems aren’t learning about economics
policy with him. He might find out that from my blog! That’s what grad school, con-
bloggers know a bit more than he imagined.’ ferences, the circulation of academic papers,

etc, is for. But perhaps you’re a citizen of a the Fed could reduce unemployment by
liberal democracy who speaks English and raising its inflation target but this would be
tries to keep abreast of political controversies. a bad idea because it runs the risk of caus-
ing inflation expectations to become un-
It’s the economy, stupid anchored. That’s a judgment that contains
Well you’ve probably heard politicians talk- some “economics” content but it’s largely a
ing a lot about jobs and the economy.You’ve political judgment. It’s part of his job to make
probably noticed that voters keep telling those judgments, but it’s the job of citizens to
pollsters that jobs and the economy matter question them.
to them. Jobs and the economy may mat- At any rate, the next time anyone finds
ter to you! You may have seen that political me claiming to have broken original ground
scientists have found that presidential rein macroeconomic theory I hope someone
election is closely linked to economic perfor- will call the expertise police. But you don’t
mance, and thus deduced that the fate of a need a Ph.D in sociology to see how it might
whole range of national policy issues hinges be the case that the Federal Reserve Board
on economic growth. of Governors would be unduly attuned to
Well then I bet you are probably inter- the interests of college-educated Americans
ested in the fact that a wide range of cred- to the exclusion of the working class, or that
ible experts (with Ph.Ds, even) believe the the European Central Bank might be unduly
world’s central banks could be doing more attuned to the needs of Germans to the
to boost employment. Is Athreya inter- exclusion of Spaniards and Italians. [END]
ested in this? Well, I hope he would know
it whether or not he reads my blog – he’s King’s fusillade
working at a central bank somewhere and With temperature’s rising on the blogo-
probably knows a lot more about this than sphere as news of Katrik’s literary assault fil-
most people. tered through the digital ether, Cato Institute
Scholar and EconLog co-editor, not to men-
Conceit of policymakers tion a former economist himself for the
But now to Athreya. His essay seems to par- Federal Reserve System, had this put-down
take of the conceit that what economic poli- for the young Athreya and the audacity of his
cymakers do is just economics and that for claim: ‘Kartik Athreya writes, “Why should
political pundits to second-guess their deci- anyone accept uncritically that Economics,
sions would be on a par with me trying to or any field of human endeavour, for that
second-guess someone doing particle phys- matter, should be easy to process and con-
ics. Completely apart from the fact that the tribute to?”He suggests that bloggers supply
“science” of economics is a good deal less more noise than signal on economic topics.
developed than what you see in real sci- I understand his point, but I disagree with it.
ences, the fact is that economic policy is eco- It is a fair point that it is tempting when
nomics plus politics. writing for an audience that includes non-
For example, according to Ben Bernanke, professionals to try to oversimplify, to make

your views sound more well-grounded than what happened. He may be forgetting the
they are, and to make others’ views sound “God’s revenge” explanation proposed for
sillier than they are. If you read just one eco- the Haiti earthquake, but his point is well
nomics blogger, you will get that blogger’s taken. My pushback would be that econo-
prejudices and blind spots along with what- mists have claimed to know more about
ever insights might be on offer. the process of recessions than seismologists
have claimed to know about earthquakes
Collective efforts and tsunamis. No seismologist I know of has
It is possible, however, for the collective ever said or had the temerity to claim that
efforts of many bloggers to produce more we have “conquered” such events the way
signal and less noise. That would be the case that economists have in the past claimed to
if the competitive market serves as a check have conquered the business cycle. I agree
on the more unsound ideas. I am not saying with Athreya that non-economists should
that it works that way, but it might. express opinions about macroeconomics
Athreya takes the view that the aca- only with great humility. Where I disagree
demic process of refereed journals is more is that I think that economists, too, need to
rigorous and works well. I do not fully share show humility.
that view. The peer-reviewed journal process
may be better than anything else someone Levels of proficiency
has come up with, but it is a deeply flawed In fact, I have thought about opening my
process. It rewards ritual over substance, and hypothetical book on macroeconomics
trend following over originality. The process something along these lines: If a textbook
failed badly in the area of macroeconomics covers a body of knowledge in order to raise
over the past 30 years, an era which I believe the reader’s level of proficiency, then what
Paul Krugman is justified in describing as a should one call a book that covers a body of
Dark Age. knowledge in order to raise the reader’s level
Athreya draws an interesting contrast of doubt? A doubt book, perhaps. Above all,
between reactions to the economic crisis and what you are about to read (or discard, as the
reactions to natural disasters. He points out case may be) is a doubt book.
that the tsunami in East Asia and the earth- Herbert Stein, in his memoir Economic
quake in Haiti combined to kill hundreds Washington Bedtime Stories said that he had
of thousands and to impose hardships on learned two things from experience about
many others that are far worse than what economic matters: 1.) Economists know
has been inflicted by the recession. very little. 2.) Non-economists know even
less. Athreya is repeating the second point,
Economists’ hubris and I agree However, I would also place
He continues by stating that neither of those stress on the first point. [END]
‘disasters’ was met by a denunciation of seis- Tyler Cowen of the Marginal Revolution
mology for failing to predict them nor an made short work of Athreya with the fol-
outpouring of ill-informed speculation about lowing quip: ‘‘I would say that economics is

really, really, really, really, really, really, really advice to offer our errant Federal Reserve
hard. And that’s leaving out a few of the employee by pointing him in the direction
‘reallys’.” of the Federal Reserve Bank of Minneapolis
It’s so hard that experts don’t always do president, Narayana Kocherlakota. DeLong
it well. The experts are constantly prone to suggested that Kotcherlokota could best
correction by non-experts, by practitioners, emphasise to Kartik Athreya that,“someone
by people who are self-educated economic who has taken a year of Ph.D coursework in
experts but not professional economists, and a decent economics department (and passed
by people who know some economics and a their Ph.D qualifying exams) is unlikely to be
lot about some other field(s). It is very often able to say anything coherent about our cur-
that we – at least some of us – are wrong and rent macroeconomic policy dilemmas.”
at least some of those other people are right.
Furthermore those other people are often Kocherlakota advice
more meta-rational than a lot of professional As Kocherlakota himself observes: “Why
economists. do we have business cycles? Why do asset
Even very simple problems can be quite prices move around so much? At this stage,
hard, such as why nominal wages are some- macroeconomics has little to offer by way of
times sticky or why particular markets don’t answer to these questions. The difficulty in
always clear, in the absence of legal impedi- macroeconomics is that virtually every vari-
ment. Why doesn’t the restaurant charge able is endogenous – but the macroeconomy
more on a Saturday night? You can imagine has to be hit by some kind of exogenously
how hard the hard problems are, such as specified shocks if the endogenous variables
what level of public expenditure is consistent are to move.
with an ongoing and workable democratic The sources of disturbances in macro-
equilibrium. economic models are (to my taste) patently
unrealistic. Perhaps most famously, most
Argument aside models in macroeconomics rely on some
Putting aside agreement and ideology, and form of large quarterly movements in the
just focusing on how one understands an technological frontier. Some have collec-
issue, I’ll take my favourite non-Ph.D blog- tive shocks to the marginal utility of leisure.
gers over most professional economists, six Other models have large quarterly shocks to
out of seven days a week. Not to estimate a the depreciation rate in the capital stock (in
coefficient, but to judge public policy, thereby order to generate high asset price volatilities).
integrating and evaluating broad bodies of None of these disturbances seem compel-
knowledge? It’s not even close. ling, to put it mildly. Macroeconomists use
Not wishing to be left out of the general them only as convenient shortcuts to gener-
mêlée, University of California Berkeley pro- ate the requisite levels of volatility in endog-
fessor and a former USTreasury under- secre- enous variables …”
tary to boot, Bradford DeLong: while ducking If Narayana is right, Kartik is wrong. I’m
out of a long response to Athreya, had this betting on Narayana. •

Opinion: Dodd-Frank Act
Much Ado About Nothing:

Dodd-Frank and all that . . .
After nine months’ gestation and with a cast
of thousands, Chris Rogers is none too
impressed by Congress’s latest production.
The financial reform bill that had preoc- US in what was promised as the most wide-
cupied numerous parties in Washington ranging reform undertaken since the days of
since November last year finally gar- Roosevelt and the Great Depression.
nered enough support to become law
this month once President Obama gives Asian concerns
it his official seal of office. Following Should our readers, many of whom work for
much intense and often bitter debate in the US and European-based too-big-too-
Congress between proponents of the bill, fail financial institutions in question – with
its opponents, and those that sought more many others working for more regional and
far reaching reform, the US becomes the local financial services businesses – actually
first leading economy to honour its G-20 care what legislation and reforms have been
obligations and overhaul its financial ser- passed in Washington this summer?
vices sector in the wake of the 2008 bank- The answer must be an unequivocal
ing meltdown. “yes”. Yes, not only should we care, but we
need to take stock of the Dodd-Frank Act
As the dust settles and the bill’s two lead- and ask ourselves whether US lawmakers
ing sponsors, Senator Chris Dodd (pictured have enabled legislation which will make the
above) and Representative Barney Frank global financial system safer or whether, to
prepare for Washington’s long summer the contrary, have they enacted a bill which,
recess, a plethora of bankers, lawyers, aca- for all its fine words and original intent, has
demics and industry specialists now begin failed in its stated ambition of reining in
the onerous task of reviewing what has been the worst aspects of Wall Street and casino
officially termed the Wall Street Reform capitalism.
and Consumer Protection Act – otherwise It is our view that each of us who reads
referred to as the Dodd-Frank Act – to this Journal should be highly concerned at
determine the full extent of the legislation’s what has transpired in Congress, particu-
impact on the financial services sector in the larly in the light of events from March to

November 2008, not only on Wall Street, many instances by the very same financial
but in financial services centres across the institutions that were the recipients of all this
world as the banking sector teetered on government largesse less than 20 months
the brink of disaster. Obviously, we should previously.
be concerned that the two leading epicen-
tres of casino capitalism, namely Wall Street The Dodd-Frank Act
and the City of London – whose banks like So yes, in a nutshell, we who work and run
mighty Leviathans bestrode the world – businesses in Asia need to be very con-
forced their governments between them to cerned at what has transpired in Congress
spend and issue guarantees totalling some and whether the “Wall Street Reform and
US$15 trillion (nearly 25 per cent of annual Consumer Protection Act” actually protects
global GDP) to bail out their financial ser- us from the effects of a possible collapse in
vices sectors. And this astronomical figure one of the too-big-too-fail (TBTF) institu-
does not even include the cost of bailouts, be tions, and the many knock-on effects and
they private or public knowledge, within the permutations such a calamity can, and
Euro area or other G-20 nations. indeed has had on our neck of the woods in
the immediate past.
Fear of a ‘double-dip’ But what of the Dodd-Frank Act itself,
Again, we should be concerned that in the a bill that when jointly introduced into the
wake of the 2008 financial tsunami that Senate and House of Representatives on a
swept all before it and threatened to pitch windswept winter’s day in November last
the world into a global depression, many of year offered hope that finally, following the
our governments here in Asia were forced to disaster that engulfed all in 2008, US legisla-
embark on massive stimulus programmes tors would address the multiple causes that
to mitigate the worst effects of the global contributed to the demise of Bear Stearns,
downturn as export-orientated economies Lehman Brothers and nationalisation of
felt the full weight of a collapse in interna- Fannie Mae, Freddie Mac and AIG at great
tional confidence and orders, where friends cost to the American body politic, whilst
and family members lost their jobs and their introducing the term“moral hazard’ into the
livelihoods – many within Asia’s own finan- lexicon of the English language as the world
cial services businesses or those that service faces up to the complex issues surrounding
the financial sector. the global TBTF institutions, many of which
And now, when it seemed the crisis are housed in both Europe and Asia.
had passed, we have been confronted by
the threat of a ‘double-dip’ depression, as Radical overhaul
those nations which borrowed huge sums The original Dodd bill – Restoring American
to finance their emergency stimulus pro- Financial Stability Act of 2009 – as intro-
grammes, are forced to embark on tough duced to the Senate, weighed in at a mighty
austerity measures to satisfy the demands 1,136 pages and within its vast volume of
of the sovereign debt markets, operated in text contained detailed and radical proposals

to overhaul financial regulation, the most Unfortunately, much that was good
radical element of which was the call for a within Dodd’s original draft proposals,
consolidated regulatory body outside of the after months of debate, amendments and
authority of the Federal Reserve System. Congressional skirmishes never saw the
Further provisions included the establish- actual light of day.
ment of a consumer financial protection
agency, a systemic risk body, oversight of Dodd undermined
credit rating agencies, enhanced derivatives The reasons for this are manifold and wor-
oversight, hedge fund and private equity thy of a book. But due to space constraints,
reforms, bringing insurance under a federal we can but highlight a few of the factors that
regulatory umbrella, curtail government and undermined Dodd’s original intent. First
the Fed propping up individual institutions and foremost, the Dodd bill was far more
at taxpayer expense, executive compensation wide-reaching and radical in its scope than
limits/curtailments and, finally, new legisla- what the Obama administration – heavily
tion to end too-big-too-fail. influenced by Larry Summers and Treasury
Secretary Timothy Geithner – had originally
Dealing with TBTFs intended.
The TBTF provisions would force large com- The Dodd bill also deviated greatly from
plex interconnected institutions to issue a similar bill simultaneously introduced into
hybrid debt securities for use in an emer- the House by Barney Frank. Specifically,
gency, provide for the establishment of Frank’s bill was more in line with the views
“living wills” to be used if a company faced of the Obama administration in that it did
collapse and most importantly, empowering not call for a sweeping overhaul of the regu-
the Federal Deposit Insurance Corp (FDIC) latory environment. Rather, it suggested the
to unwind failing institutions via receiver- Office of the Comptroller of the Currency
ship to be funded by a levy on institutions (OCC) be merged with that of the Office of
with assets over US$10 billion. Thrift Supervision (OTS); differences in how
Had Senator Dodd’s original propos- to approach TBTFs were also apparent.
als, as presented to the Senate, been passed
into law, it is the opinion of this writer and No GOP support
many of the leading authorities with whom As if matters were not sufficiently detrimen-
the Journal of Regulation & Risk – North Asia tal to Dodd as far as the Obama administra-
communicates, that the resultant legislation and sections of the Democratic party
tion would have gone a long way towards were concerned, his efforts were certainly
addressing many of the problems high- undermined by the fact that the Republican
lighted by the banking crisis of September leadership in Congress was opposed to any
and October 2008 – for which the Journal bill recommended by the Democrats lest it
commends Senator Dodd and all those upset their business interest constituency.
associated with drawing up his original The Federal Reserve itself was also opposed
proposals. to losing many of its supervisory powers

to an independent body and, as such, was together, could have had a serious impact
more supportive of Frank’s proposals. on the final bill in their original form. It also
Further, much of the financial services needs stating that many other notable addi-
sector itself – and those businesses that uti- tions to the bill/bills were proposed but ulti-
lised FX derivatives to hedge against cur- mately voted down and, as such, failed to
rency movements – was opposed to much gain mention in any form in the final act.
of the sweeping proposed reforms and
fought a highly successful lobbying cam- Volcker amendment
paign to curtail the more onerous sections of First, as though few readers need reminding,
the bill making the statute books. The lob- was the introduction of the ‘Volcker Rules’,
byists, many engaged by Wall Street firms, drawn up by former chairman of the Federal
the American Banker’s Association and Reserve Paul Volcker and initially champi-
International Institute of Bankers, to name oned by none other than President Obama
but a few, placed considerable pressure on in January this year. Apart from the fact that
legislators during the nine-month passage by introducing the Volcker Rules into the
of the final Act, with sums in excess of US$1 equation so late in the day, Obama threat-
million being spent each day at the height ened to upset leading Senate Democrats by
of the struggle. This was a disgrace by any changing the scope of the original Dodd bill.
perspective given the huge sums swiftly That said, the proposal were radical,
expended by the US public to bail the sector calling not only for limits on the size of the
out at the height of the banking panic. largest banks, but also by divorcing their
proprietary trading arms from the rest of
Reconciliation process the business – effectively by banning casino
A comprehensive review and analysis of gambling by deposit-taking institutions, or
the battle for supremacy within Congress institutions covered by the FDIC. Effectively,
between opponents and proponents of the the Volcker Rules threatened to overturn 30
bill’s passage is beyond the scope of this years of deregulation by emulating key ele-
paper and the author can offer limited back- ments of Glass-Steagall.
ground detail to inform our analysis of the
actual bill which appeared for final confir- Brown-Kaufman amendment
mation in late June, 2010. In April, Senators Sherrod Brown and Ted
That said, even after both the House Kaufman, tried, but ultimately failed in their
and the Senate finalised and passed their attempts to introduce the Safe Banking
own versions of a financial reform bill, both Act into Dodd’s original bill, which like the
had to be reconciled within the Conference Volcker Rules threatened to place leverage
Committee, thus requiring further debate and market capitalisation caps on America’s
and compromise before a final Act could be TBTF banks – effectively the proposals,
presented to President Obama. if passed, would have meant a number
An exception to the above must be made of America’s largest financial institutions
regarding several late proposals, which being broken up into smaller constituent

parts – much in the way President Teddy side of the sector or, to put it bluntly, those
Roosevelt dealt with Standard Oil at the activities that currently fall off the radar
beginning of the 20th century. Such a pro- screens of regulators.
vision ultimately would simplify any resolu- Despite Dodd’s original intent in
tion of a failing institution while militating November, and the interjections of many
against serious knock-on effects to numer- members of Congress to contribute to a
ous counter-parties. bill that actually dealt fully with many of
The Brown-Kaufman amendment was the causes and activities that resulted in the
complimented by a proposal by Represen- banking crisis of 2008, the final Dodd-Frank
tative Paul Kanjorski, and adopted by the bill as it was presented to the Senate at the
House, that would significantly enhance end of June was a far cry from what many
the authority of federal regulators to pre- had expected or hoped for.
emptively break up large financial institu-
tions that – for any reason – posed a threat to Half-baked, half-hearted
financial or economic stability in the United Under fire from all directions, and full of
States. Again, this amendment dealt with compromise, opt-outs, exceptions, outright
resolving the issue of TBTF and was seen as contradictions and with glaring omissions,
addressing several weaknesses with Dodd’s the bill to be presented to the President
own proposals of only allowing regulators is half-baked, half-hearted and lacking in
to intervene as a“last resort,”which in many teeth to deal with the very real issue at hand,
instances could be far too late to prevent a namely, preventing a rerun of that movie
national or global crisis. which was the great financial crisis of 2008.
The bill in its final guise weighs in at a
Blanche Lincoln massive 2,319 pages of complex rules and
Special reference must also be made to the procedures covering some 16 Titles with
Hon. Senator for Arkansas, Blanche Lincoln multiple sub-sections. Notwithstanding the
– perhaps under instruction by the indomi- fact that the final package is more than dou-
table former chair of the Commodity Futures ble its original length – some 250,000 words
Trading Commission, Ms Brooksley Born – – no one can accuse the Dodd-Frank Act of
in her desire to make derivatives transac- not being wide-reaching or less than ambi-
tions more transparent by mandating that tious in its remit.
all transactions be exchange traded, that FX
swaps be regulated and that large financial Anti-climax
institution swaps desks be spun off into sep- It is something of an anticlimax, therefore,
arate entities. Again, this measure was seen when it comes to specifics and actualities,
as an effort to deal with issues of TBTF and preferring instead to add numerous discre-
interconnectedness – smaller institutions tionary powers to the existing regulatory
being easier to unwind than large complex bodies, or establish new bodies composed of
ones. It was also part of a concerted effort to the heads of existing bodies, such as the SEC,
deal with the so-called “shadow banking” Fed and FDIC. It is thus a far cry from what

Glass-Steagall achieved in 1933 with a piece banking meltdown of 2008, with the one
of legislation weighing in at a puny 45 pages, glaring omission of any mention of govern-
accessible by all and, ultimately, significantly ment-sponsored entities. A closer examina-
more radical in scope than that which stands tion of the actual text itself, though, paints a
before us today. less complimentary picture and brings into
A detailed analysis of the Dodd-Frank question whether the bill has adequately
bill is beyond us in this paper, therefore let dealt with the moral hazard of TBTF, those
us concentrate on some of the key elements riskier elements of casino capitalism –
of the legislation as passed by the Senate on derivatives, structured products and credit
July 15, some 10 days later than anticipated default swaps – excessive compensation,
following the death of Senator Robert Byrd transparency, increased capital requirements
and after extortionate demands costing the and enhanced powers to prosecute acts
US taxpayer a further US$19 billion to fund malfeasance.
the enhanced regulation by Senator Scott
Brown (Rep) – charged with responsibility More agencies
for the funds management heavy state of To begin with, far from streamlining the US
Massachusetts – who objected to large com- regulatory environment, Dodd-Frank actu-
plex financial institutions themselves hav- ally increases the number of state and federal
ing to cover the additional cost of regulating agencies from its current 115 agencies to a
them. Frank duly relented and removed the staggering 126 – the OTS being an excep-
offending provision from the final bill, thus tion to this rule via its consolidation into the
leaving a rather large black hole to be filled. OCC. Among the new agencies is the much
fêted consumer protection agency – housed
Living up to the hype within the Federal Reserve and an over-
Last-minute political shenanigans aside, we arching systemic risk agency, the Financial
must ask ourselves if the bill has lived up Stability Oversight Council, comprising the
to its original remit of removing risk from heads of the Fed, Treasury Secretary, SEC
the financial system by constraining indi- and FDIC. Unfortunately, it is first necessary
vidual organisations’ risk-taking activities to determine which financial institutions are
and capturing a broader set of organisations actually systemically important – Bloomberg
– including the so-called “shadow” bank- estimates that there are 184 banks world-
ing system – in the revised regulatory envi- wide each with assets exceeding US$50 bil-
ronment, whilst enhancing consumer and lion. That’s just banks and not other complex
investor protection . . . thus making the US financial institutions.
financial services sector a safer place.
A first glance at a summary of the leg- Increased discretionary powers
islation on both the Senate and House of This brings us to our second observation, that
Representative’s websites indicates, on the while the bill has added significant powers to
whole, that the bill addresses many of the the existing regulatory agencies, as detailed
problems and issues that resulted in the in Title I, many of these are discretionary,

rather than mandatory. Indeed, a true picture institutions and those deemed of systemic
of the regulatory environment established importance to the financial services sector
by Dodd-Frank will not become clear until – it’s just not clear which financial services
next 2012 following an estimated 520 rule businesses currently cross this threshold.
makings, 81 studies and 93 reports – a fig-
ure that varies significantly from one report Nuclear option
to another. However, putting this in to per- Further, to invoke its new winding-up
spective, Sarbanes-Oxley only required 16 authority, the FDIC will have to go through
new regulations and six studies – thus mak- a convoluted process involving the Fed,
ing Dodd-Frank some 30 times larger and Treasury and get three senior judiciary
more energy intensive than SOX. So much judges to sign-off on any winding-up res-
for ending uncertainty or a sense of urgency olution before it can be deployed. Indeed,
– meanwhile, if another crisis emerges, the as one critic noted, it is doubtful if this
miscreants can always count on the US tax- authority will ever be used, much like the
payer and Fed to bail them out. authority to launch a nuclear weapon was
Much of the dialogue in Congress and never used. Lets think of this as a deter-
consequential details in the Dodd-Frank Act rent then, one which it is hoped will curtail
centres on the vexed issue of“moral hazard,” risky behaviour by management and force
currently associated with TBTF and the reso- shareholders to make sure these institu-
lution of a TBTF in case of crisis that does not tions have stringent risk management pro-
add to the burden of the US taxpayer, nor cedures in place.
systemically threaten the rest of the financial Enhanced capital requirements or
services sector. cushions are called for in Dodd-Frank and
are dealt with in detail under the Collins
Title II and ‘orderly resolution’ Amendment as drawn up by the FDIC and
The Federal Reserve for its bank stress tests found in section 171 of the Act. This states
in 2009 identified 19 institutions which were that Federal banking agencies are required to
deemed systemically important to the US establish minimum leverage and risk-based
financial system – and this figure did not capital requirements to apply to insured
include other complex financial institutions depository institutions, bank and thrift hold-
operating outside of banking – think AIG, ing companies and systemically important
Freddie or Fannie here or any institution non-bank financial companies. and that
with assets in excess of US$50 billion. these minimums must not be lower than
Title II of Dodd-Frank and several other that found today in FDIC insured banks.
of theTitles in one way or another address the Notwithstanding the fact that Basel III is
problem of TBTF, interconnectedness and also currently considering these levels, this
an orderly resolution of a failing institution. process, again discretionary, will not be fully
Most of the resolution powers contained implemented until 2012 at levels yet to be
within the bill are handed over to Sheila determined.
Bair’s FDIC and cover all deposit-taking Given how leverage played a crucial

role in the demise of Bear Stearns, Lehman horribly wrong. It was decided, at the behest
Brothers and AIG, its seems at odds with of our good friend Scott Brown, that this
Dodd-Frank’s stated ambition of making was inappropriate. So he drove a coach and
Wall Street safer that reference to lever- horses through the proposal; as such banks
age within the Act is oblique, to say the are allowed to utilise three per cent of their
least, unless we refer back to Section 171. capital to gamble and own three per cent
Regardless of capital cushions or require- of outside entities such as hedge funds and
ments, many financial institutions up until private equity vehicles. So much for reduc-
September 2008 were leveraged up to 40 ing systemic risk or mitigating against casino
times their actual capital reserves. capitalism.
It’s the same old story on executive com-
Greater leverage pensation; risk-taking and short-termism
Provisions already existed prior to the implo- rules whilst the Fed and SEC take another
sion, for the Fed and SEC to monitor debt- look at the issue. The same applies to mal-
to-asset ratios and equity-to-asset-rations; feasance, up for a little judicial review and
however, under the SEC’s Christopher Cox, nothing concrete. Again, let’s visit Blanche
Greenspan and Bernanke at the Fed, such Lincoln and bring derivatives on to the radar
powers were never utilised. Capital require- screen via central clearing of all trades. The
ments were also applied in Basel II – which rules here will be exceedingly complicated.
many now blame for an excess of leverage Banks will be allowed to play in some of
once the US signed up to this agreement – these markets and will be banned from oth-
this due to the fact that supposed enhanced ers – at least, though, they bought the idea of
risk management procedures allowed for a central clearing exchange.
greater leverage, which many of the ‘bulge
bracket’ banks duly embraced . . . with tragic Electorate opts for change
consequences for Lehman Brothers. By fail- In November 2008, the US electorate voted
ing to mandate or make reference to such for change and the election of President
issues, Dodd-Frank effectively fails to miti- Obama promised a new era and a new
gate against this problem and thus leaves the start. By focusing on healthcare issues first
door open for a rerun of 2008. Obama expended nearly all his dry powder,
leaving little left to deal with the real problem
Limits, checks and balances at hand – a wayward Wall Street and failing
What about the Volcker Rules, derivatives economy. The world was looking for leader-
and compensation? Well, the Volcker Rule ship on bank reform, as was the US elec-
remains in name only, rather than divorce torate, and believed the US would deliver
the banks from their huge risk-taking prop leadership in a time of international crisis.
desks that use depositors’money to gamble Two years down the line, it is clear nei-
on behalf of the bank itself – with the trad- ther team Obama or Dodd-Frank have
ers earning huge bonuses if they win and grasped the nettle and placed the genie back
the taxpayer picking up the tab if it goes in its bottle. Instead of concise meaningful

reform that addresses both TBTF and the financial services sector in the short term
causes of the crisis, we get opt-outs, omis- by way of increased compliance costs
sions and delegation of powers to the same and some curtailed profit-making activi-
said agencies that failed to police Wall Street ties by around five-10 per cent, accord-
to begin with. ing to some researchers’ recent reports.
Yes, there is good in the bill’s 2,319 pages,
but much of this good is overwhelmed by Much Ado About Nothing
ill- judged compromise in order to pass leg- In the long run, should Wall Street dis-
islation that ought to have had more beef like what it sees, nothing can stop it from
and teeth. Instead of mandating powers to decamping overseas and utilising regulatory
the Fed and the Federal Deposit Insurance arbitrage, and this includes those venerable
Commission – financial stability and similar institutions, the Basel Committee and G-20.
powers to Chapter 11 respectively – Dodd- In a nutshell, Dodd-Frank is like that
Frank actually increases uncertainty, for the Shakespearian favourite, Much Ado About
time being at least or until the regulatory Nothing; frivolous to say the least, some-
agencies finish their rule-makings, studies what obscure, but entertaining all the same.
and reports – all of which are open to intense Unfortunately, it does not live up to the radi-
lobbying and further change. calism Dodd proposed in November, 2009
The best that can be said for the Dodd- and, as such, fails in its ambition to radically
Frank Act is that it is still very much a overhaul finance . . . and make America a
work in progress, one which could hit the safer place to boot. •

North Asia
Editorial deadline for

Vol II Issue IV Winter 2010/11
November 15th 2010

Opinion
Credit rating agencies shocked

at investor performance clause
Harvard Law School’s Lucian Bebchuk
details proposals tabled by the US Senate
to rate the rating agencies themselves.
IN the new financial order being put in vehicles to maintain portfolios of assets that
place by regulators around the world, have received sufficiently high grades from
reform of credit rating agencies should the recognised agencies.
be a key element. Credit rating agencies, Disappointment about the raters’ per-
which play an important role in modern formance, and scepticism about the effec-
capital markets, completely failed in the tiveness of regulation, has led to calls to
years preceding the financial crisis. What eliminate any regulatory reliance on ratings.
is needed is an effective mechanism for If ratings are not backed by the force of law,
rating the raters. so the argument goes, regulators need not
worry about rating quality and can leave the
There is widespread recognition that rat- monitoring of raters to the market.
ing agencies have let down investors. Many
financial products related to real estate lend- Failure to perform
ing that Standard & Poor, Moody’s, and Fitch Proponents of this course of action such
rated as safe in the boom years turned out as Senators George LeMieux and Maria
to be lethally dangerous. And the problem Cantwell, would remove references to the
isn’t limited to such financial products: with credit agencies in all major financial services
issuers of other debt securities choosing and laws. LeMieux stated: “We know that one
compensating the firms that rate them, the of the main reasons why we had our finan-
agencies still have strong incentives to recip- cial debacle in 2008 was that credit agencies
rocate with good ratings. failed to do their jobs, they put AAA stamps
What should be done? One proposed of approval on products that deserve no such
approach would reduce the significance stamp, and the investing world relied upon
of the raters’ opinions. In many cases, the the fact that these rating agencies were sup-
importance of ratings comes partly from posed to do their job and they failed.”
legal requirements that oblige or encour- Even if ratings were no longer required
age institutional investors and investment or encouraged by law, however, demand for

ratings – and the need to improve their reli- performance. For such a mechanism to work
ability – would remain. Many investors are well, it must link the number of assignments
unable to examine the extent to which a won by raters, and thus their compensa-
bond fund’s high yield is due to risk-taking, tion, to appropriate measures of their per-
and would thus benefit from a rating of the formance. Such measures should focus on
fund’s holdings. Given past experience, we what makes ratings valuable to investors
cannot rely on market reputation to ensure who use them – their accuracy in forecast-
that such ratings will be reliable. ing financial health. Once developed, such a
mechanism should not be limited (as, unfor-
Judicial threat tunately, it is in the Senate bill) to ratings of
Another approach would be to unleash structured financial products. It should apply
the liability system. On this view, if inves- to all products that rating agencies evalu-
tors were able to take raters to court, raters’ ate. All ratings of financial products raise the
incentives would improve. But while such same incentive problems and could benefit
judicial scrutiny may be effective in eliminat- from reform.
ing some egregious cases, it cannot ensure
that raters do the right thing when courts are Stiff raters’ resistance
not expected to be able to tell after the fact Predictably, the Senate’s bill encountered
what the right thing was. As such, there no stiff resistance from the dominant ‘big three’
substitute for providing raters with incen- global rating agencies. Standard & Poor
tives to provide as accurate a rating as they argued that such a mechanism would pro-
can. This can be done by making raters’ vide credit rating agencies with “less incen-
profits depend not on satisfying the issuers tive to compete with one another, pursue
that select them, but on performing well for innovation, and improve their models, crite-
investors. If raters’ profits depend on such ria, and methodologies.”
performance – on the accuracy of their rat- Well, such a mechanism would indeed
ings – the profit motive would turn from a reduce raters’ negative incentives to com-
source of perverse incentives to a provider of pete with one another to please issuers of
beneficial incentives. securities, and to pursue innovations and
improvements that enable raters to serve
Senate approval issuers better. But it would strengthen raters’
The US Senate voted in May to incorpo- positive incentives to compete with one
rate such a mechanism into the financial another to produce accurate ratings, and to
reform bill that will now have to be recon- pursue innovations and improvements that
ciled by the bill passed by the US House enable raters to achieve that far more socially
of Representatives. Under the Senate’s beneficial goal.
approach, regulators would create rules Rating agencies have been and should
under which an independent regulatory remain an important aspect of modern capi-
board would choose raters. The board would tal markets. But to make ratings work, the
be allowed to base its choices on raters’ past raters themselves need to be rated. •

Opinion
Endemic fraud at heart of the

bank crisis, so ‘let’s get radical’
Put paid to financial crises permanently
via ‘limited purpose banking’, says Boston
University economist Laurence Kotlikoff.
THE Obama Administration as well as issue liar mortgages, rate triple-C assets as
Congress continue to ignore the primary triple A, insure the uninsurable, pay yourself
cause of our financial debacle and to pro- massive and fully undeserved bonuses, shop
pose reforms that badly miss the mark. for compliant regulators, and bribe politi-
cians to change rules – that’s theft, plain and
The cause was first and foremost finan- simple.
cial fraud, of which the US Securities and
Exchange Commission’s fraud-based law- Proprietary info key
suit of Goldman Sachs is just the latest Proprietary information, not proprietary
evidence. The financial industry, aided and trading, was the key to the crime.
abetted by credit rating companies on the “We’ll make you a mint. But no ques-
take, politicians on the make, and regulations. If we disclose, others will learn and
tors on a break, systematically manufactured we’ll no longer beat the market.”
trillions of dollars of securities, which we Would that everyone could beat the mar-
now call toxic. And we call them toxic, not ket. And would that Wall Street’s wizards, as
because they were risky, but because they a group, actually had proprietary information
were, phony. of social value. But the information they were
keeping private was their sale of snake oil.
Fraud in vogue When the fraud surfaced, so did the
The fraud didn’t arise because banks were questions. Was every asset toxic? Was every
too large, too leveraged, and too intercon- loan overvalued? Were any financial state-
nected, although these factors greatly exac- ments to be trusted? These questions were
erbated the financial fallout and need to be asked about every bank, no matter its pedi-
fixed. gree, the tenure of its“top”management, or
The fraud arose because large parts of its regulator. And this new information, that
the industry decided to make money the old there was no information, laid waste to one
fashioned way – by stealing it. When you financial company after another. Today, two

plus years into the crisis, full non-disclosure plague. It’s called Limited Purpose Banking
prevails. No one can drill down on the web (LPB). LPB implements what Bank of
to the individual holdings and liabilities of England Governor Mervyn King and for-
any major financial institution, least of all our mer US Treasury Secretary and Secretary
central bank – the Federal Reserve, which of State George Shultz, strongly advocate
has printed $1.5 trillion to buy up . . . who – namely transforming financial companies
knows precisely what? into financial piping (utility) companies who
stick to their legitimate purchase, financial
Bank paper death intermediation, rather than gambling with
No one will swap something real for bank taxpayers’money.
paper, which they suddenly suspect is Unlike the Volcker Rule, which draws a
worthless and aren’t permitted to inspect. line in the sand between commercial (good
Hence, financial plague, whether spread by boy) and investment (bad boy) banks – a line
truth or rumour, can strike any part of our easily crossed, LPB erects a concrete barrier
financial system at any time. between financial intermediaries with and
And if the plague hits our central bank, without limited liability.
its paper, the “almighty” buck, will find few
takers. The Fed has already laid the basis for LBP at a glance
such hyperinflation, having printed more Under LPB, all financial corporations
money in two years than in the entire history (banks, insurance companies, hedge funds,
of the republic. etc) would operate strictly as pass-through
Were prices to skyrocket, we’d see a run mutual fund companies. Investment
on the banks, with people desperate to buy banking would become a pure consult-
something real before their money becomes ing service, and trading operations would
worthless. Federal Deposit Insurance simply match buyers and sellers, with no
Corporation (FDIC) insurance, guaranteeing exposure.
that our dollars, as opposed to our purchas- Mutual funds are, effectively, small banks
ing power, are safe, would be no assurance. with zero leverage. Their investments can
lose value, but the funds themselves can
Bank run printing blitz never fail. Hence, LPB puts an end to finan-
And such a run would force Uncle Sam cial collapse.
to douse the fire with a gas tanker. He’d LPB also replaces some 115 federal and
be legally bound to meet his gargantuan state financial regulatory bodies with the
explicit and implicit FDIC, money market Federal Financial Authority (FFA) – effec-
fund, commercial paper, and other financial- tively an FDA for securities held by the LPB
sector guarantees, which means printing tril- mutual funds. The FFA would use federal tax
lions more. returns to verify income and employment
Could ‘Do Cry for Me Argentina’ really statements on mortgage and commercial
become top draw on iTunes?Yes. loan applications as well as on new tenders
But there’s a simple cure for our financial of stock.

It would hire multiple, non-conflicted for centuries. The New York Stock Exchange
private firms to appraise collateral and pro- first met inside the Tontine Coffee House.
vide ratings. And it would oversee third- Tontines don’t pretend to insure the unin-
party custody of all mutual fund securities. surable – aggregate risk. But all idiosyncratic
Most important, it would disclose all details risks – longevity, property losses, early death,
about individual mutual fund securities in disability, medical costs, accidents, etc – can
real time. be insured by paying out the mutual fund’s
assets (the pot) to those shareholders expe-
FFA transparency riencing losses.
Markets don’t work when people can’t tell
what they are buying. The FFA makes finan- Parimutual bets
cial products transparent, but it doesn’t say Parimutual betting dates to 1867 and is used
which products can or can’t be sold. in racetracks around the world. The horses
Once a new security is processed by the here can be IBM defaults or not, Intel’s stock
FFA, and fully disclosed on the web, it would passing $120 or not, inflation exceeding five
be put up for auction to the mutual funds. per cent or not, etc.
This would ensure that households and In all cases, the fund’s pot is given, held
firms receive financing at the lowest cost by a third party custodian, and paid out to
available. the winners. There is no liability left for the
In addition to the 8,000 or so mutual taxpayer. Mutual fun pots are natural finan-
funds now being marketed, LPB would cial firewalls – something desperately miss-
feature cash mutual funds and insurance ing in our current system.
mutual funds. It’s time to really fix our financial system.
Cash mutual funds hold only cash and, If we don’t, we should stop planning the
consequently never break the buck (apart flowers for the next Wall Street funeral and
from the service fee). All other mutual funds start digging a massive grave – one large
would proclaim: this fund is risky and can enough to hold Uncle Sam. •
break the buck. Cash mutual funds replace
today’s checking accounts. We’d write checks Editor’s note
against them and draw on our balances The editor and publisher of this Journal wish
with debit cards and via automated teller to thank Professor Kotlikoff for allowing us
machines (ATMs). to publish an amended version of this paper
that originally appeared on Bloomberg’s
Tontine mutual funds news service. For those with an interest in
Insurance companies would sell tontine- Limited Purpose Banking, as proposed by
type mutual funds, in which sharehold- Prof Kotlikoff in this paper, please proceed to
ers bet on things that can happen to them, page 49 and read a review of his new book,
like dying, and parimutuel funds, in which Jimmy Stewart is Dead, by Toby Baxendale.
shareholders bet on impersonal events. The book further details his ideas on LPB
The tontine dates to 1653 and survived and the 2008 banking meltdown.

Book overview
Capitol Hill ‘complicit’ in

lead-up to banking crisis
In a patriotic call to arms, former FDIC
chief, William M. Isaac, pulls no punches
in his new book, ‘Senseless Panic’.
THE financial panic of 2008 and the ensu- trying to deflect blame to “greedy bankers,”
ing deep recession did not have to hap- and offering slogans rather than solutions to
pen and I am appalled by the enormous real and present dangers.
financial, human and political cost of it Among other things, they are telling us
all. Taxpayers, rightly so, are extremely the Troubled Asset Relief Program (TARP)
angry about the events of 2008 and 2009 was essential to calming the markets when,
– they know instinctively that something in fact, the TARP did far more harm than
does not smell right. good. This book exposes the TARP for what
it was – an ill-conceived programme hastily
I wrote this book – Senseless Panic: How slapped together by a panicked government
Washington Failed America – to get out the working too close for my comfort with a
truth about what happened and why and handful of Wall Street firms. It set off an eco-
how we can prevent future crises. We, and I nomic and political firestorm from which we
mean all of us and our great country, are in have yet to recover.
enormous trouble! If we do not take the time
to learn what went wrong and how to fix it, Carter appointee
we, our children, and their children, will pay I had the privilege of leading the Federal
a big price. Deposit Insurance Corporation (FDIC) dur-
If we let them, our political leaders will ing the bank and thrift crises of the 1980s,
do everything in their power to hide their having been appointed to the FDIC board of
culpability for the mess in which our nation directors by President Carter in 1978 at the
finds itself, and they will enact “politically age of 34. Little did I know when I took the
easy” legislation that will not address the post that the country was about to experi-
fundamental causes of the crisis and will ence the worst economic and banking crisis
in fact make things worse. Our leaders are since the Great Depression – a crisis that
already covering up their role in creating would result in larger and more severe bank
what I call the senseless panic of 2008, are failures than in the 1930s.

Inflation had been high throughout the different outcomes in the financial mar-
1970s and it was getting worse. President kets this time around?
Carter appointed PaulVolcker as chairman of It is impossible to listen to or read a news
the Federal Reserve in 1979 with the charge report about the crisis of 2008 and beyond
of getting inflation under control. Volcker without being told that the problems in
raised interest rates rapidly and the prime this latest crisis are much worse than in any
rate soared to an incredible 21.5 per cent. period since the Great Depression of the
Few financial institutions or borrowers could 1930s. When people do talk about the 1980s,
absorb that kind of rate increase. most refer only to the S&L crisis and seem
Following Ronald Reagan’s election in not to be aware how serious the banking and
1980, I was named chairman of the FDIC. economic problems were during that period.
The entire banking and thrift sector was Most people – members of Congress
in dire straits. A short recession occurred included – would be surprised to learn that
in 1980 followed by a deep and prolonged we were so concerned about the condition
recession in 1981-82, with unemployment of our major banks during the 1980s that we
soaring to 11 per cent. developed a contingency plan to nationalise
all of them. As late as the Presidential Debate
Decade of failures of 1992, candidate Ross Perot asserted that
From 1980 through 1991 some 3,000 banks the FDIC fund was horribly inadequate to
and thrifts failed, including many of the larg- cope with what he believed was the massive
est in the country (nine of the 10 largest Texas insolvency of our major banks.
banks, for example). The failed banks and
thrifts had $650 billion of assets and cost the Navigating the storm
FDIC fund more than $100 billion (multiply In this book, I discuss how we were able
those numbers by six to put them into rela- to navigate the treacherous economic and
tive terms to today’s banking system). banking waters in the 1980s without creat-
It was an extremely difficult period, but ing a financial panic and why we failed to
the public’s confidence in the banking sys- contain the less serious problems in 2008
tem held and financial panic was averted. that nearly sank the financial system.
Even as we handled thousands of bank and Having lived 24/7 the banking and S&L
thrift failures, the economy improved and crises of the 1980s, I examine the lessons we
we enjoyed the longest peacetime economic learned and failed to learn from that period
expansion in history. and identify the mistakes that led to the
Contrast this result in the 1980s with the senseless panic of 2008. It was a panic that
worldwide financial panic that hit in the fall would not have happened had our political
of 2008 and threatened to push the world leaders acquired even passing knowledge of
into an economic depression. what happened during the 1980s and how
The economy was actually quite strong we dealt with the enormous problems.
in pre-financial crisis 2007 unlike 1980- Many historians believe that World War
1982, so why did we experience such II was a continuation of World War I. They

believe that the issues that led to the first war Though it eventually passed, Isaac presents
were not resolved and the Treaty of Versailles a clear-eyed critique of TARP as unnecessary
was terribly flawed, so after a 20-year hiatus and a waste of taxpayers’money.
the fight resumed. Similarly, I believe the
banking and S&L crises of the 1980s were Poor agency responses
misunderstood by our political leaders, the Isaac first gives readers a succinct and
wrong“fixes”were put into place during the straightforward look at how in the 1980s
1990s, and those actions led us directly into the FDIC and Paul Volker’s Fed managed to
the banking crisis of 2008. stave off a brewing bank panic with unpopu-
Based on what I have seen thus far from lar but necessary steps. He provides a road-
the Obama Administration and the legisla- map on how later the lack of political will,
tive efforts on Capitol Hill, we have not got- agency turf wars and boneheaded policy
ten any smarter this time around and I fear responses to the bank and S&L crises of the
for the future of our great nation. 1980s led to the current debacle.
Isaac explains how banking regula-
Prof Hurley’s thoughts tors need to have the courage to promote
This is what Prof. Cornelius Hurley of Boston unpopular counter-cyclical strategies to pro-
University and former assistant general tect the financial markets. Isaac shows how
counsel in the Federal Reserve Board had the regulators botched the job, calling out a
to say after reviewing Bill Isaac’s latest mis- bipartisan collection of economic and politi-
sive against Washington: Before “too big cal leaders including treasury secretaries, the
to fail” became part of our lexicon, there SEC and FASB for their failed policies and
was Bill Isaac, chairman of the FDIC in the poor reaction to the crisis of 2008.
1980s. Drawing on his experience from that Senseless Panic is an important book, one
era leading the banking system out of a that should be on the reading list of any-
potential catastrophe, Isaac in his new book, one interested in America’s economic well
Senseless Panic has provided us with a must- being. Isaac shows how the failure to under-
read analysis for anyone looking to understand and appreciate the banking crises of
stand the 2008 economic crisis. the 1980s turned the inevitable economic
Senseless Panic offers both fresh insight downturn in 2008 into an economic force
and devastating analysis, showing how of destruction. For the next generation of
a pattern of governmental inaction and economic policymakers looking to head off
regulatory failures played leading roles in an economic tsunami, Senseless Panic is the
the meltdown. During the critical days in place to start. •
September 2008, when Congress was debat-
ing the original bailout package, Isaac was Publishers note
called on by a bipartisan group of legislators Excerpt taken from Senseless Panic, published
to educate Congress on the failings of the by Wiley & Sons. All material is copyrighted
government’s plan. He played a crucial role and reproduced with the permission of the
in defeating the initial proposal in the House. author and publisher.

F O R E W O R D B Y P A U L V O L C K E R
SENSELESS
PANIC
H O W WA S H I N G T O N FA I L E D A M E R I C A
W I L L I A M M . I S A AC
with P H I L I P C . M E Y E R
Book review
Resurrecting George Bailey

from ‘It’s a Wonderful Life’
Cobden Centre’s Toby Baxendale finds
much to like in Prof Laurence Kotlikoff’s
latest book, ‘Jimmy Stewart is Dead’.
JIMMY Stewart plays George Bailey salvation called Limited Purpose Banking
who is cast as the “honest” and trust- (LPB). He also proposes a reduction of the
worthy banker in the classic Hollywood financial service sector regulators in the US
film, ‘It’s a Wonderful Life’. Laurence from its current 115 down to one: the Federal
Kotlikoff’s book laments that in the real Financial Authority (FFA).
world of modern banking, such charac- In his opening remarks he discusses the
ters no longer exist. Modigliani-Miller Theorem, written in 1958,
showing in elegant math how in the absence
Laurence Kotlikoff himself is a Professor of of bankruptcy costs, leverage does not mat-
Economics at Boston. Several Nobel Prize ter. If a company takes on more risk by bor-
winners have endorsed the book: George rowing more, its owners will offset that risk
Akerlof, Robert Lucas, Robert Fogel, Edward by borrowing less, leaving total debt in the
Prescott, and Edmund Phelps. I count 36 economy unchanged.
endorsements from the great and the good
of the academic world on the back cover and Leverage can be good
front pages. I do not recall ever seeing this Kotlikoff makes no mention of the fact that
in a book. leverage in itself is not a bad thing if it is
The book is written for the layman. It is made up of people forgoing their consump-
light on economic theory, but does reference tion today, i.e. saving and committing it to
some other-worldly models. It is also good projects that will deliver up goods in the
at explaining what on the face of it appear future.
to be complex financial phenomena, but are This glaring omission does not impede
in fact con tricks that in any other industry him from telling the story of our financial
would earn you a prison sentence. Kotlikoff meltdown and making a solid policy recom-
shows his readers how the financial sys- mendation for this crisis. It does, however,
tem has failed in its fiduciary duty, and pre- prevent him from seeing the elephant in the
sents a simple and elegant solution for its room: that the credit creation process itself

is the source of the boom and the bust. The and reduce our purchasing power. In effect,
nature of fractional reserve banking is such the bailouts do not do what they say they do
that if you deposit your cash in a bank, it on the tin, and our purchasing power is get-
will lend it out many times over. This means ting weaker by the day. It is hard enough to
that multiple claims come to exist on the get politicians in the UK to acknowledge the
original real money that was deposited. If scale of our official national debt, but we owe
you deposit £100 in bank A, which lends it at least as much again “off balance sheet”,
to an entrepreneur who deposits it in Bank in unfunded pension liabilities and Private
B, both you and the entrepreneur now have Finance Initiative obligations. Debasement
£100! Like magic, we have £200 in the sys- will be the most popular way forward for
tem, with £100 of it created ex novo by the all future governments, as they will not
banking system itself! In the UK, with no want to overtly extract more wealth from us.
legal reserve requirement, we have only £3 Dishonesty will be the preferred policy.
on average kept in deposit for every £100 of Limited Purpose Banking would be a
IOU’s promised by the banking system. simple solution to all of this. Banks would
be limited to their main purpose of match-
Diamond-Dybvig Model ing savers to borrowers. All financial com-
Kotlikoff provides a mainstream justifica- panies would act as pass-though mutual
tion for fractional reserve banking, citing the fund companies. They would be middlemen,
Diamond-Dybvig Model, which holds that never would they own the financial assets.
we value immediate liquidity for emergen- They could thus never fail in the“run on the
cies. We do not need that money all the time, bank”sense – i.e. depositors wishing to with-
so banks can use this and get us a higher draw money – but only if they were very bad
return in the meantime. Therefore, govern- at business. This is thus as near as you will
ments must do everything to prevent a bank get to risk-free banking. Never again would
run if more people want their money back the economy be held liable to bail out the
than actually exists in the bank vaults. bankers.
This is the theoretical understanding we
have today and the model is used to justify Role of regulation
all sorts of bank bailouts, as we have seen. Kotlikoff foresees at least two mutual funds
Kotlikoff points out that whilst the bailouts being offered, with custodians holding the
have prevented a collapse of the system assets: one that holds cash and one that
of fractional reserve banking, they do not holds insurance funds. He does stress that
preserve the purchasing power of money. innovation could still happen, with a mul-
The bailouts just guarantee that the money tiplicity of funds being offered. The Federal
unit will still exist. This is a very good point. Financial Authority (FFA) would regulate the
All the bailouts are being funded by more custody element of safekeeping of the vari-
claims on the future taxpayer. In the UK, we ous mutual fund assets.
have a system of money debasement called He assumes that regulators will be able
Quantitative Easing, which will just debase to opine, like the current rating agencies, on

the soundness of the assets that have been to cover all obligations, a massive print-off
bought by the fund. He would trust the gov- in US dollars would need to take place, in
ernment over the rating agencies. I person- other words the generation of many trillions
ally would trust neither! of dollars to truly purge the system. What
In my industry, selling meat and fish, we Kotlikoff misses is De Soto’s insight, based
have a number of free-market-created qual- on the work of Fisher, that there will be a
ity assurance bodies such as the British Soil unique moment in history when instead
Association for organic certification and the of causing debasement; the printed money
Marine Stewardship Council for fish sus- would cover all unfunded demand deposits,
tainability, which require no government swapping them out for cash.
sanction. These have the confidence of both
the consumer and producer. I would suggest Insurance mutuals
that this and not a super regulator is the way Wipe out or retire these demand depos-
forward. its and the banking system has no current
Cash funds are nice and easy; they hold creditors, only assets. Take out the equivalent
cash and are 100 per cent reserved. They can amount of assets from the banking system,
never go up or down in value. These cash so the banking system has the same net
mutual funds represent the demand depos- worth as before, then put these assets into
its of the new spec banking system. All ser- the mutuals and pay off the national debt.
vices such as cheque writing and paying bills This is not inflationary, requires no debase-
are done via this vehicle. ment, and will help deliver up safe banking.
Insurance mutuals would have all the other
Crackpot ideas banking instruments such as CDOs in them
I have written about 100 per cent reserve and could market these funds to whomever
banking previously and Steve Baker has they wished.
specifically examined the 100 per cent These are essentially what we would
reserve banking proposal of Irving Fisher, term a hedge fund today, though Kotlikoff
to which Kotlikoff refers. He notes that the proposes that these be closed-end. This
current economic profession considers these means you have to sell your shares in the
ideas to be“crackpot”; the Diamond-Dybvig fund to redeem your money. Consequently,
Model remains dominant. He goes go on to long-term lending can take place in these
say:“I want to be clear that I am not an advo- funds without the fear of a maturity mis-
cate of narrow banking in of itself. Narrow match. The only money this type of fund can
banking is a small feature of LPB and would lose is what is invested in it. It could never in
hardly suffice to deal with today’s multifac- itself pull down the banking system.
eted financial problems.”
He notes that with the many cash Author unease
mutual funds in place, the money measure I sense that the author does not feel com-
in the USA – M1 – would correspond exactly fortable with the 100 per cent reserve label,
with what the government had printed. So with its“crackpot”associations. In discussing

the transfer of Citigroup, he says:“Here we’d disclosure and provide maximum transpar-
need to swap all of CitiGroup’s debt for ency. Most important, it would make clear
equity and prevent it from ever borrowing that risk is ultimately born by people, not
again to fund risky investments. We can now companies, and that most people need and
think of CitiGroup as a huge mutual fund have a right to know what risks, including
with lots of different assets, one big commer- fiscal risk, they are facing. Finally, it would
cial bank with 100 per cent capital require- make clear what risks are, and are not, diver-
ment, or one LPB with a large number of sifiable. It would not pretend to insure the
different mutual funds corresponding to the uninsurable or guarantee returns that can’t
different Citigroup asset classes.” be guaranteed. In short, the system would be
He also points out that LPB could not honest, and because of that, it would be safe-
actually be that far away if you take into safe for ourselves and safe for our children.”
account all the reserves that have already
been created. This is something George Cause of ‘boom and bust’
Reisman also pointes out. Kotlikoff defen- Although I think he has failed to identify the
sively shows how LPB would not reduce state-sponsored banking system, with its frac-
liquidity. It would not reduce real credit, i.e. tional reserve credit creation point as the cause
savers forwarding money to borrowers. It of booms and busts, his solution has many
would stop credit being created out of thin merits and many similarities with the solution
air via the banking system, the prime cause proposed by Fisher, De Soto and others. He
of the crisis, but this is not mentioned in his missed what I call the golden opportunity, or
book. It would lead to an optimal-size finan- unique moment in history, to actually enact a
cial sector. reform that delivers up 100 per cent reserve of
LPB and pays off the national debt and other
LPB the cure unfunded obligations at the same time.
Our cash assets would be safe as you can My own solution is the De Soto 100
get. Government could still monetise debt per cent reserve free banking solution with
as it could still create cash from nothing. The banks working within the existing com-
currency and thus the purchasing power of mercial law to which all non-bank compa-
money could not collapse by the actions of nies must adhere. However, both systems
the banking system, but only by the actions have the same effects and would do the job
of the government. needed: to sort out the banking system, pro-
Kotlikoff concludes: “Limited Purpose vide stability, and let capitalism flourish.
Banking is the answer. This simple and eas- Yet another workable solution has been
ily implemented pass-though mutual fund proposed by the Cobden Centre’s Paul Birch.
system, with its built-in firewalls, would Kotlikoff’s contribution to the debate, with
preclude financial crises of the type we’re all the Nobel endorsements, is timely, and
now experiencing. The system will rely on I hope policymakers worldwide give due
independent rating by the government, but attention to innovative solutions like these
private rating as well. It would require full we find in Kotlikoff’s book. •

Book review
Hail to the publisher-led

recovery in post-crisis reading
Author Satyajit Das casts a critical, albeit
irreverent gaze across several recent tomes
penned by a few well-known personalities.
NOT content with reviewing one book • Robert Pozen (2010) Too Big To Save:
at a time, popular commentator, risk spe- How to Fix the U.S. Financial System; John
cialist and acclaimed author, Satyajit Das, Wiley, New Jersey;
scrutinises several of the latest bestsellers • Yves Smith (2010) ECONned: How
from international authorities concern- Unenlightened Self Interest Undermined
ing the financial crisis, its origins and its Democracy and Corrupted Capitalism;
consequences. MacMillan.
Thomas Carlyle, the Scottish Victorian-
Among the books reviewed by Das are the era historian, christened economics the“dis-
following recently published titles: mal science”. In Eat The Rich, P.J. O’Rourke
• Carmen M. Reinhart & Kenneth Rogoff described economics as “an entire scientific
(2009) This Time is Different: Eight Centuries discipline of not knowing what you’re talk-
of Financial Folly; Princeton University Press, ing about.” One can only quibble with the
London; word“scientific”.
• Raghuram G. Rajan (2010) Fault Lines:
How Hidden Fractures Still Threaten the New, more dangerous phase
World Economy; Princeton University Press; The publisher-led recovery – “crash literature”
• Simon Johnson and James Kwak (2010) as it could be termed – in the global econ-
13 Bankers: The Wall Street Takeover and the omy has entered a new and more dangerous
Next Financial Meltdown; Pantheon Books, stage. Economists have begun to hold forth
NewYork; on the problems. Keynesians, Monetarists,
• Nouriel Roubini and Stephen Mihm Cavaliers, Roundheads and Vegetarians are
(2010) Crisis Economics: A Crash Course in stirring to give their own views of reality and
the Future of Finance; Penguin; putative solutions. Worryingly, at least two of
• Joseph Stiglitz (2010) Freefall: Free the books are now in the Best Seller lists for
Markets and the Sinking of the Global Business Books.
Economy; Allen Lane, London; A key characteristic of the emerging tidal

wave of books is the fact that almost every- crises share the following characteristics:
one saw the writing on the wall, predicted Declines in real housing prices averaging
the crisis and now moreover have solutions 35 per cent over six years. Equity prices fall
that can ensure that this was the crisis to end an average 56 per cent over 3.5 years.
all crises. Unfortunately in the prediction Unemployment rises an average of seven per
stakes no economist can claim the presci- cent during the down phase with an aver-
ence of Pope Benedict XVI. age length of four years. Output falls more
According to Italian Finance Minister than nine per cent over a two-year period.
Giulio Tremonti (as reported on Bloomberg Government debt increases by an average 86
News (20 November 2008)), the Pope, then per cent in real terms, as a result of the col-
merely Cardinal Joseph Ratzinger, in an arti- lapse in tax revenues, counter-cyclical fiscal
cle written in 1985 predicted that“an undis- policy efforts and spiking interest rates. So
ciplined economy would collapse by its own much for a V-shaped recovery! But“this time
rules”. It is unclear which crisis the Holy is different”.
Father was predicting, but given papal infal- To prevent future crisis, Mrs Reinhart
libility, probably all of them. and Mr Rogoff propose a new global finan-
cial regulator and improving the IMF (Mr
Reinhart and Rogoff Rogoff’s former alma mater where he was
In the wonderfully titled This Time is once chief economist). Puzzlingly, they are
Different, Carmen Reinhart and Kenneth not optimistic about their reforms: “The per-
Rogoff expand on their recent academic sistent and recurrent nature of the‘this-time-
papers and empirical work on “eight hun- is-different’syndrome is itself suggestive that
dred years” of financial crises. Marshalling we are not dealing with a challenge that can
a mind numbing array of statistics and data, be overcome in a straightforward way.”
the authors find similarities between finan-
cial crises. Their conclusion is that the cause Rajan’s ‘fault lines’
is excessive debt accumulation by govern- Raghuram Rajan, Professor of Finance at
ment, banks, corporations or consumers.The the University of Chicago Booth School of
combination of excessive leverage and short- Business and former chief economist at the
term debt lies at the heart of the problem. IMF (there seem to be a lot of those going
If you are unsurprised at the predictable around), did warn about the risk of the
conclusions, This Time is Different provides global financial crisis. His early warnings led
solid empirical support for the intuitions. The to the economist’s version of a duel at dawn
book misses an essential point – it depends (only with irony and sarcastic epigrams) at a
on identifying the correct base precedent conference held at Jackson Hole.
that is being used for the economic state In Fault Lines, Rajan’s focus is on deep-
being studied. seated problems in the global economy,
The interesting part of the book is the including the absence of income growth,
evidence of what happens after a financial employment, health care and the prob-
crisis. The authors show that severe financial lems of global capital and trade imbalances.

Bravely, he argues that the over-borrowing additional losses came to light. The “close-
that caused the problems was an entirely ness” between banks and government offi-
“rational” response to a deeply flawed eco- cials and regulators that has been exposed is
nomic and financial system. He also iden- increasingly part of the problem in dealing
tifies growing inequality as a theme in the with the real issues.
problems. He argues that these “fault lines” The thesis in 13 Bankers is similar to the
are the real problems rather than a group of work of Mancur Olson, the American econ-
greedy bankers taking irrational risks. omist. In his books (The Logic of Collective
Action and The Rise and Decline of Nations),
13 Bankers Olson speculated that small distributional
The Fault Lines position on bankers is at odds coalitions tend to form over time in devel-
with 13 Bankers, co-written by Prof Simon oped nations and influence policies in their
Johnson and James Kwak, a former McKinsey favour through intensive, well-funded lob-
consultant. Expanding on their earlier Atlantic bying. The policies result in benefits for the
Monthly piece, The Quiet Coup, the authors coalitions and its members but large costs
outline the thesis that big banks, especially in borne by the rest of the population.
America, have used their economic power to
gain political power. Olson thesis
The economic power of the banks derives Over time, the incentive structure means
from their growing importance in the broader that more distributional coalitions accumu-
economy as measured by share of corporate late burdening and ultimately paralyse the
earnings and stock market capitalisation. This economic system causing inevitable and
economic strength is then leveraged using irretrievable economic decline. Government
lobbying, campaign contributions and the attempts to deal with the problems of the
transition of staff between Washington and financial system, especially in the US, Britain
Wall Street. Johnson and Kwak’s 13 Bankers and other countries, may illustrate Olson’s
sees a conspiracy in this arrangement and thesis. Active, well-funded lobbying efforts
also considerable danger. Like all good con- and “regulatory capture” is impeding neces-
spiracy theories there is some validity in the sary actions to make needed changes in the
argument. financial system.
The book, 13 Bankers, is grounded in a
Paulson’s ‘shotgun’ wedding traditional American fear of a financial oli-
Suggestions of political influence and a garchy, dating back to the fights between
palpable lack of transparency in recent Thomas Jefferson and Alexander Hamilton
government actions to bail out banks have over the “Bank of the United States” and
emerged. There are allegations that previous Franklin Roosevelt’s Depression-era regula-
US Treasury Secretary, Henry Paulson, may tion of finance. While American banks may
have“pushed”Bank of America to consum- certainly be powerful and highly influen-
mate its controversial acquisition of Merrill tial, the case for a conspiracy is not entirely
Lynch when it sought to withdraw after convincing.

Bankers are keen to pick the pockets of historical and economic factors. Building on
anybody . . . including each other. The highly Hyman Minsky’s “stability is itself destabi-
nuanced differences in the positions of lising” hypotheses, Crisis Economics blends
individual banks are unlikely to be consist- economic theory, behavioural econom-
ent. Bankers agree and disagree with each ics and agency theory to try to explain the
other on about the same number of issues. present crisis. The authors conclude that
One online commentator noted the inter- financial systems are inherently fragile and
section between Wall Street, Constitution prone to collapse. Interestingly, while it is
Avenue and Main Street was best named: wary about the value of theories, statistics
“Confusion Corner”. and mathematical economics and finance,
In addition, the potential risks of such a Crisis Economics argues that crises are not
powerful clique are not fully explained. Large only predictable, preventable and, with the
banking and other industrial complex domi- Roubini/Mihm brand of medicine, curable.
nate many nations and economies with not
always negative consequences. The authors’ Stiglitz and ‘Freefall’
remedy is to cap the size of banks as a per- Professor Joseph Stiglitz’s book, Freefall:
centage of the economy. This may not be Free Markets and the Sinking of the Global
effective without reform of campaign finance Economy, and Robert Pozen’s Too Big To
rules, restrictions on political appointees to Save: How to Fix the U.S. Financial System,
many positions, reform of the central bank- focus less on the cause of the crisis than on
ing system and other measures. solutions. Stiglitz believes that the origins of
the present crisis lie in neo-liberalism and its
Dr Doom fascination with free markets and de-regula-
Nouriel Roubini (who had inherited the ‘Dr tion. Correcting these problems, Prof Stiglitz
Doom’ mantle from Henry Kaufman) also produces an extensive list of policy reforms.
predicted the global financial crisis. In case On the way, the author launches into often
you didn’t know this, statements like the abrasive attacks on the government’s actions
following ensure you are left in no doubt: to date.
“Roubini’s prescience was as singular as it
was remarkable: no other economist in the Unoriginal
world foresaw the recent crisis with nearly The analysis of the causes of the crisis is not
the same level of clarity and specificity.”The original. His criticisms of policy actions range
problems of joint authorship and reference from insightful to assertions that need sup-
to only one of them presents challenges porting facts. Freefall’s call to action disap-
within the English language. pointingly ends rather tamely in a series of
In Crisis Economics, Professor Roubini, well-worn prescriptions for stronger regu-
with co-author Stephen Mihm, take a dis- lation (by the same apparatus that caused
tinctly Minsky line in analysing the global the problems) to correct market failures.
financial crisis. They argue that finan- Somewhere, Stiglitz finds the time to argue
cial crises are the result of a confluence of for a less materialistic society and adoption

of something akin to Bhutan’s measure of the discipline itself as revealed by the global
Gross Domestic Happiness (GDH). financial crisis.
Too Big To Save is light on causes (thank-
fully) and long on lengthy lists of proposals. Problems run deep
The proposals themselves focus on analysing Ms Smith argues, consistent with Prof Rajan,
alternative models for government stakes in that the proximate causes (excessive lever-
banks, new board structure for large finan- age, global imbalances and model failures)
cial institutions, jurisdictional issues over are symptomatic of deeper financial prob-
systemic risks, and the securitisation of loans. lems. ECONned focuses on a central issue
None of the proposals are startling or differ – the role of economists as policymakers
much from that offered by others. Some are and the weaknesses of economic thought.
in the process of being implemented. The thesis is that economists, some in key
Both Freefall and Too Big To Save tend to policymaking roles, relied on dogma and
telesis, ascribing events to innate, inexorable ignored the dangers that eventually led to
facts. Reality is far more nuanced than such the financial crisis. The book’s coverage of
a simple view of history. Perhaps this is why the sequence of errors, misrepresentations
economists generally tell you tomorrow why and rationalisations of poor outcomes and
what they forecast yesterday didn’t happen instability is revealing.
today. ECONned is strongest in its coverage of
the role played by economists in the crisis
Failure of regulation and the flaws in the widely-used financial
Both books also embrace regulation and models and concepts that created the condi-
regulators freely whilst being critical of reg- tions for the crisis.
ulators as lacking in skills and beholden to
special interests. The faith in government American focus
activism is perverse. It fails to consider why The books, with the exception of This Time
a new set of rules will necessarily be more is Different, which lurches around a space-
effective and existing regulators will be able time continuum that would have made Dr
to deal with complex issues well above their Who giddy, are primarily American in focus.
pay grades. This is particularly the case when For the main part, the world appears to end
the same regulators failed in the very same at the Atlantic/Pacific oceans (Mexico and
tasks in the lead-up to this crisis. This disso- Canada are anyway American offshoots).
nance is striking. American exceptionalism extends to finan-
In ECONned: How Unenlightened cial crises, or must seem so to the reader.
Self Interest Undermined Democracy and The style of these books varies. The tone
Corrupted Capitalism, Yves Smith, the crea- is mostly the desiccated drone (reminiscent
tor of the Naked Capitalism website, proof John Cage’s experimental work from the
vides an edgy and interesting antidote to the 1960s). Some are deliberately academic in
other books on offer. It is an‘anti-economics’ tone to achieve the correct type of un-read-
economics book that explores the failures of ability. One assumes that they are weapons

deployed in the dawn duels between eco- Kenneth Rogoff identified this problem:
nomic scholars. “One of my favourite stories from that era
This Time is Different is not wholly suc- is a lunch with you and our former col-
cessful in condensing its stupefying density league, Carl Shapiro, at which the two of
of data and facts into an accessible tract. The you started discussing whether Paul Volcker
book favours the repetition of minimalist merited your vote for a tenured appoint-
music. Aaron Brown (who authored a less- ment at Princeton. At one point, you turned
than-complimentary review in the Wilmott to me and said: ‘Ken, you used to work for
Magazine) noted that the book uses the word Volcker at the Fed. Tell me, is he really smart?’
“inflation”154 times,“default”220 times and I responded something to the effect of:‘Well,
“crisis” 253 times. It also repeats the title he was arguably the greatest Federal Reserve
phrase This Time is Different from time to chairman of the 20th century’. To which you
time in a form of economic incantation. replied:‘But is he smart like us’?”
Freefall reads like a 19th century pam- Economists have delusions of adequacy
phlet with equal measures of vitriol, self- and a related assured self-confidence that
righteousness and broad prescriptions, while they bring to any problem.
13 Bankers and ECONned are written intelli- Rogoff went on to note that in one
gently with the non-technical layman, rather of Stiglitz’s books – Globalisation and its
than the“econo-wonk”, in mind. Discontents, “. . . I failed to detect a single
instance where you, Joe Stiglitz, admit to
Moment in the sun having been even slightly wrong about a
It seems that the global financial crisis is the major real world problem. When the US
economist’s moment in the sun. They are economy booms in the 1990s, you take some
busily“solving”the problem, sometime with credit. But when anything goes wrong, it is
pet theories or, more often, rehashing old because lesser mortals like Federal Reserve
ones. Unsurprisingly, there have been spats Chairman Greenspan or the then-Treasury
between economists with allegiances to dif- Secretary Rubin did not listen to your advice.”
ferent camps. Most notable fights include Rogoff concluded that Stiglitz was indeed
Paul Krugman versus Stephen Roach, “. . . a towering genius. Like your fellow
Martin Wolf versus Niall Ferguson, etc. If Nobel Prize winner, John Nash, you have a
Friedman had been alive, then it would have ‘beautiful mind’. As a policymaker, however,
been Milton versus all comers. If Keynes you were just a bit less impressive.” •
had been alive, then the jousts would have
at least been witty and cultured. No mod- Editor’s note:
ern economist can touch Keynes and John The editor and publisher of the Journal of
Kenneth Galbraith for pungent wit. Regulation & Risk – North Asia would like to
Most economists, it seems, believe thank Satyajit Das for allowing us to reprint
strongly in their own superior intelligence this article. We respectfully remind readers
and take themselves far too seriously. In his that all copyright to the article remains the
open letter of July 22, 2001 to Joseph Stiglitz, sole preserve of Mr Das.

Comment
‘Dark pools’ – the menace of

opacity in financial markets
Dr V. Shunmugam of India’s Multi
Commodity Exchange calls for the abolition
of ‘dark pools’ that pose a systemic risk.
OTC markets for derivatives have been Traditionally, trading in securities had
much in the news recently and subject been executed in pits at a central location
to great criticism, not only for their anti- (Gorham and Singh, 2009), with traders
competitive and secret nature, but also exchanging buy and sell orders on their own
for contributing to the financial crisis or on behalf of their clients. In that system,
of September and October 2008. In this personal interactions bred collusion among
paper, the author argues that the rising unscrupulous traders to front-run their
opacity and barriers to entry in the deriv- competitors (Schlegel, 1993). Front-running
atives and over-the-counter markets have refers to an illegal practice of executing orders
been sorely overlooked – particularly by on a security early with the advance knowl-
legislators and regulators – leading to edge of pending orders from customers/
dark pools, flash trading and front-run- competitors.
ning. These unfair practises can, at any Computerisation helped to eliminate
time, cripple markets. They undermine front-running, and was better able to handle
the premise of free market trade and rising volumes, reduce transaction costs, and
should be abolished. improve speed and accuracy. Naturally, the
bulk of trade shifted to the online platform.
While over-the-counter (OTC) markets for
collateralised debt obligations (CDO) and Technology the key
credit default swaps (CDS) are blamed for To attract volumes amid increasing com-
the financial crisis of 2007-2009, what has petition, increased technology support
been overlooked is the menace of rising and reduced delays became the fashion for
opacity in the exchange-traded market. online exchanges the world over.
This raises questions about the funda- Online trading threw markets wide
mentals of this market’s very existence, i.e. open to all armed with a desktop computer
transparency and equal access to one and all and access to a public network. It brought in
in the price discovery process. the much-desired transparency, as trading

trading activities became visible through traders themselves – a private monopoly or
real-time price dissemination. cartel if you like.
The market order book – at least in terms
of the best buy and sell orders and their Popular, risky, anti-competitive
respective quantities – could be viewed by Admiring the many advantages inherent in
participants. Soon, technology took over this new-found system – particularly the
human involvement to change the way trad- lack of oversight and transparency neces-
ing was done. sary to inform a ‘free market’, many more
large institutions joined the bandwagon,
Emergence of the ‘dark pool’ substantially raising the tally of dark pools
While exchange-traded securities markets and trade handled by them (Caplan et al,
had been struggling to build the much 2009).
needed width and depth, large institutions According to the Securities and Ex-
that could have provided the same said change Commission, the number of active
width and breadth, found comfort in the dark pools dealing in stocks on major US
absence of a regulatory framework moni- stock markets trebled to 29 in 2009 from
toring trades taking place between then. about 10 in 2002. For April to June 2009,
Is it little wonder then that all those par- the total dark pools volume was about
ticipating in this profitable exercise were 7.2 per cent of the total volumes of all US
tempted to start an informal electronic trade exchanges.
matching and settlement system – later
termed “dark pools”. Quintessentially private
The emergence of these privately traded Dark pools are essentially a private or alter-
dark pools not only denied exchange-traded native trading system that allows partici-
markets the necessary depth and width pants to transact without displaying quotes
that they required, but also kept out well- publicly. Orders are anonymously matched
researched information that these institu- and not reported to any entity, even the reg-
tions could have supplied and distributed to ulators (Younglai and Spicer 2009).
all participants in the open market system to Thus, the mainstream exchange-traded
make price discovery more efficient (Krause, market does not have any clear picture about
2008). the volume of transactions happening in this
parallel market or the prices at which they
‘Cartel’ by any other name are being executed. Obviously, price discov-
In essence, what was started as an“informal ery on the mainstream market, without dark
trading system” for a handful of big enti- pools information, becomes inefficient.
ties with vested interests became a lucrative
business opportunity of matching, clearing, Dangerous private monopoly
and settling trades and front-running the Moreover, transactions carried out in dark
information that gets pooled into the system pools effectively become over-the-coun-
with them being the owners, managers and ter in nature as the prices are not reported

and financial risks not effectively managed. will require dark pools to make information
More critically, these risks are highly conta- about an investor’s interest in buying or sell-
gious and can spread rapidly, hence posing ing securities public.
a systemic-wide risk to financial markets as
experienced in the collateralised debt obli- An end to ‘dark’ transactions?
gations and credit default swaps markets in Clearly, an attempt has finally been made
2007-2008. to bring “dark” transactions under a regu-
latory scanner through accountability. For
Dysfunctional and rapacious post-trade transparency, the Securities and
With no clear dividing line between the Exchange Commission has also proposed
ownership, management and participants that dark pools publicly announce trades
in these markets, they are more prone to happening on specific platforms.
mismanagement and malpractices. Greed, What remains to be seen are measures
competition and incentives drive their busi- being taken now and in the near future to
ness – these markets remain opaque and make these markets increasingly stream-
inefficient. lined and to prevent them from becoming
Dark pools defeat the very purpose of a a systemic risk. This will require standardi-
fair and transparent market participated in sation of their operations and risk manage-
by a large number of heterogeneous partici- ment procedures as well.
pants with diversified information converg-
ing on its platform. Flash trading – a minority privilege!
This fragmentation with some markets Flash trading is a two-pronged strategy
accessible to a privileged minority and oth- using superior technology and the privilege
ers used by a vast majority can only be detri- of a minority of traders to“flash trade”.
mental to the healthy evolution of markets. This allows them to assess markets so
that their algorithms can catch the reac-
Misunderstood, much disliked tion of mere mortals to take advantage of
No wonder experts think that dark pools can, the overall market sentiment. As it becomes
anytime, blow splinters of systemic risks into mass produced or serviced, the technol-
the global economy, very much like how the ogy is expected to be affordable for many
subprime, lending-induced contagious risks participants and investors. However, we
reared their ugly heads to trigger the largest shall have to wait and see if this actually
financial crisis since the Great Depression. transpires.
According to reports (Younglai and
Spicer 2009), a surge in the dark pool vol- Algorithmic adoption
umes in US markets is giving the SEC many Apologists and dark pool proponents argue
a sleepless night. The regulator has report- there is nothing really wrong if an organisa-
edly been thinking the unthinkable and tion pays to reduce delays in seeking to profit
proposes to bring them into the mainstream from its investment – this is usually termed
of oversight. Its proposal, if implemented, an “efficiency gain”.

As algorithmic trading becomes more wide- until a newspaper report in 2009 blew the
spread and adopted by the masses – thereby whistle on how Goldman Sachs had made
depositing and trusting their hard-earned significant, but unusual, profits via this
wealth to complex software running on system.
sophisticated hardware to multiply their According to Rosenblatt, flash trading
earnings. accounted for about 2.4 per cent of the total
Such a system may well do away with our US stock volumes in June, 2009.
inability to notice what occurs in less than a
second, particularly given modern computa- ‘Chasing liquidity’
tional prowess that allow computers to rec- In fact, high-frequency trading was designed
ognise information and instructions in a blink to make markets more efficient through
of an eyelid – thus affording them to profit liquidity augmentation, but its use for flash
from this technology in much the same way trade can defeat this purpose by misdirecting
as the privileged few have thus far enjoyed. markets.
This practice, which enables (still) unre-
Much like ‘front running’ gulated hedge funds to employ high-fre-
However, what is most reprehensible is the quency strategies without coming under the
practice of allowing a privileged minority to view of US regulation as applicable to bro-
flash trade and track reactions with high- kers, also puts a big question mark on sys-
speed processing capacity and an algorithm temic stability of the financial system.
that can take advantage of said reactions to Liquidity is important indeed. But can
reap benefits for themselves, their employ- “chasing liquidity” at the expense of trans-
ees, their stockholders and their investors. parency and fairness be healthy for market
This being akin to front-running. growth? Market innovations for “forward
This is an example of a high-frequency mutation”and not“reverse mutation”?
trading system, with knowledge of asym-
metric information, that confuses common Self-defeating
investors by simultaneously issuing and can- Market innovations such as dark pools and
celling orders, thereby either forcing them to flash trade that evolved to circumvent the
sell at a loss or buy at a price much too high, limitations of exchange-traded markets
which significantly impacts their ability to involve systemic risks like that of subprime
turn a profit. Which in turn gives the indus- lending that contributed greatly to the finan-
try a poor reputation to the average investor. cial crisis.
Moreover, they can defeat the very pur-
CBOE and Goldman collusion pose for which markets were created, i.e.
It was the Chicago Board Options Exchange the deep-rooting of capitalism to help busi-
(CBOE) which first pioneered flash orders nesses de-risk their margins from informa-
early this decade to increase its execution tion that moves prices in the marketplace.
speed (Patterson et al, 2009). This process of These practices have also information that
flash orders remained universally unknown moves prices in the market place.

These practices have also placed a barrier References
in front of markets wishing to function as a Caplan, Keith, Robert P Cohen, Jimmie Lenz, and
level playing field for participants ranging Christopher Pullano (2009), ‘Dark Pools of Liquidity’,
from large institutions to seasoned traders PriceWaterhouseCoopers,Alternatives Newsletter.
through to small investors. Gorham, Michael and Nidhi Singh (2009), Electronic
There is a pressing need for formulating Exchanges: The Global Transformation from Pits to Bits,
appropriate regulations to stop all practices Elsevier.
that offer a privileged minority an unfair Krause, Reinhardt (2008), ‘Dark Pools Let Big Institu-
advantage over a vast majority of general tions Trade Quietly’. Investor’s Business Daily.
market participants. Patterson, Scott, Kara Scannell and Geoffrey
Rogow (2009), ‘Ban on Flash Orders Is Con-
Mutation of markets sidered by SEC: Schapiro Sees Inequity While
Allowing a natural evolution of markets Exchanges Wrestle for Market Share in High-
and discouraging the “mutated evolution” Speed Trading’. Wall Street Journal, August 5.
that these market innovations represent Schlegel, Kip (1993), ‘Crime in the Pits: The Regulation
needs to be one of the regulatory priorities. of Futures Trading’. American Academy of Political and
If flash traders are allowed to get away with Social Science.
their continuous mutation of markets, what Securities and Exchange Commission (2009a), ‘SEC
purpose is this evolution (of online markets) Issues Proposals to Shed Greater Light on Dark Pools’,
serving? October 21.
This only points to a self-defeating Securities and Exchange Commission (2009b),
weakness of marketsand the recent financial ‘Strengthening the Regulation of Dark Pools’. SEC Open
crisis has amply demonstrated how fragile Meeting, October 21.
the global financial system can be. Younglai, Rachelle and Jonathan Spicer (2009), ‘US
SEC says ‘‘dark pools’’ are emerging risk to market’. Reu-
Wisdom of capitalism ters, June 18.
Unfair practices like dark pools and flash
trade erupting in the supposedly organised Editors note
marketplace can only add to this fragility. This article is reproduced with the express
The question is: how long will it be before consent of VoxEu. Originally hosted on
these unfair practices are stopped from their website – www.voxeu.com – this is
destabilising markets and destroying their an abridged version of the original paper
efficiency? updated for the purposes of the summer/
Markets are essential support institu- autumn edition of the Journal of Regulation
tions for the economic evolution of human- & Risk – North Asia. All views contained
kind. Can policymakers afford to allow the herein are those of the author and do not
creation and continuation of mechanisms necessarily reflect the views of his employ-
that can – at any time – destroy these institu- ers or the publisher and editor of the
tions and make the public turn against the Journal and its employees. Copyright of
wisdom of capitalism? • this article is retained by the author.

Comment
Dodd-Frank fails to address

bank and regulator incentives
Prof Thorsten Beck of Tilburg University
offers a pessimistic assessment of the US
Financial Reform Bill signed in July.
DOES the recently passed Financial reforming the framework governing finan-
Reform Bill help mitigate against the cial institutions and regulators. Critically, it
next financial crisis or at least reduce its does little to change the incentives for banks
probability? Professor Thorsten Beck in and regulators.
this paper argues the case for a firm “no”. Financial sector regulation has differ-
His verdict is reached not because the ent objectives that might imply a trade-off.
reform steps themselves are damaging While stability is at the top of policymakers’
or wrong, but simply because they only agendas right now, they also aim for regula-
provide for a framework that does little tion that fosters competitiveness and“useful”
to change incentives for either banks or innovation.
regulators.
Balkanisation
At the end of May, the US Senate passed its The reform efforts have been driven by the
version of the Financial Reform Bill. While large amount of taxpayers’ resources that
it still has to be reconciled with the House have been put at the financial system’s dis-
of Representatives’version, the outline of the posal to avoid a meltdown. But political
regulatory reform in the US is slowly becom- considerations, including the re-election
ing clear. A thorough assessment of the Bill, opportunities of individual senators, have
however, is made difficult by its sheer size also had a major impact.
and bulk, some 2,300 pages, when com- While the balkanisation of the institu-
pared to the tiny Glass-Steagall Act of 1933. tional structure of financial sector supervi-
Do the important changes to US regu- sion has often been criticised, so has the
latory structure and oversight improve sta- lack of certain institutions. Both the House
bility? Beck argues that the Reform Bill is and the Senate versions foresee the creation
neither the silver bullet to ensure a safer of a new bureau of consumer financial pro-
financial system nor a complete flop. It is tection (BCFP), with the purpose of provid-
but one small step in the long march of ing consumers with better information and

protecting them from abusive and decep- But the question remains whether this
tive practices. While the House version sees additional supervisory responsibility for
an independent self-standing agency, the the Fed raises potential conflicts of interest
Senate version wants it to be independent, between regulatory and monetary policy
but housed in the Federal Reserve. tasks.
While one institution is being taken
Priority and standing power out of the regulatory framework, another
One wonders what priority consumer pro- is being added. The Financial Oversight
tection will have on the Federal Reserve’s Council (FOC) was established as a com-
Agenda, given its current focus on monetary promise between those that wanted to
policy and (more recently) financial stability. take powers away from the Fed and those
While this would speak for an independent that saw an increase in the Fed’s powers
self-standing institution, such a body might as necessary. Given its intended task of co-
simply not have sufficient standing power ordinating activities of different regulatory
against the Fed and other regulators, espe- authorities, the FOC’s strength will depend
cially in its early years. As often, however, on its strongest member, which is still the
the important question will not be where it Fed.
is housed, but rather what authority it will
have. A political institution
Moreover it will be important to focus on In theory, the FOC can have an impor-
financial services rather than simply finan- tant role to play in resolving co-ordination
cial institutions. This implies subjecting car problems across different regulatory agen-
dealers and therefore car loans as well as real cies. Co-ordination mechanisms, however,
estate brokers to the oversight of this con- depend on the relative power of the institu-
sumer protection bureau. tions they co-ordinate with and the willing-
ness to co-operate among the underlying
OTS-OCC merger institutions.
Another institutional change is the merger Indeed, one cannot avoid drawing par-
of the Office of Thrift Supervision (OTS) allels with the attempt of the US govern-
into the Office of the Comptroller of the ment to co-ordinate activities of its multiple
Currency. (OCC) This aims at curbing intelligence agencies – an attempt that so far
banks from shopping around for the most could only be called a success in a very lim-
lenient supervisor – supervisory arbitrage ited sense. It is also interesting to note that
– and is certainly a step in the right direc- the FOC is headed by the Secretary of the
tion. Similarly, the shifting of responsibility Treasury and the staff supporting the FOC
for supervising large financial institutions are housed at the Treasury Department,
(including non-banks) to the Fed is aimed at which makes the FOC effectively a political
avoiding the repeat of Lehman Brothers and institution.
AIG, where the authorities had the choice of An interesting and potentially impor-
either bailing out or liquidating. tant change is to take away the freedom of

security issuers to choose their credit rating also a clear and present danger of potential
agency – that is, effectively shopping around regulatory capture being replaced with that
for the best rating (see Bolton, Freixas and of political capture. As we have seen – prior
Shapiro, 2009 for a theoretical analysis). In to the build-up of the last bubble in housing,
addition, firewalls are to be erected between real estate and equities – this is a very real
the rating departments of rating agencies risk indeed.
and the sales and marketing of products, Another policy is that derivatives, some
often rated by the same agency. of which have up to now been traded
over-the-counter (OTC), will be forced to
Perverse incentives be traded through central clearing houses.
Allowing the Securities and Exchange This can increase transparency, help reduce
Commission to assign a credit rating agency counterparty risk, and facilitate monitoring
is certainly a step towards reducing perverse by regulatory authorities.
incentives. But then again it might overload While this will increase the costs of trad-
the agency and might simply shift the princi- ing for financial institutions and other mar-
pal-agent problems away to a different level. ket participants, it is a cost that should be
Perhaps a better solution would have borne by these market participants given the
been to give these agencies the same status external costs that a failure of one party can
as auditors, i.e. force financial institutions to cause, not just for the markets, but for the
contract with one rating agency for a lim- economy at large – as we dramatically saw
ited time period for all their issues and then in the case of the failure of Lehman Brothers.
switch to another one. Indeed, it certainly Moreover, forcing transactions on clear-
does not go far enough for those who want ing houses is certainly a better option than
to take credit rating agencies completely a financial transaction tax along the lines of
out of the process of determining capital what is currently being discussed in Europe.
requirements.
Perhaps as important – or possibly even The ‘Volcker Rule’
more important – is that issuers of asset- Following the crisis, there has been a fierce
backed securities have to retain an economic discussion on limiting banks’ activities. One
interest in a material portion of the credit risk suggestion has been to turn back the clock
in the future, increasing their incentive to and return to the Glass-Steagall Act with its
screen and monitor properly. separation of investment and commercial
banking. Such a suggestion, however, seems
Political capture to be rather driven by nostalgia of the good
The risk of regulatory capture might be old times of boring and supposedly safe
somewhat addressed by making the Fed finance, ignoring that this restriction was not
more accountable to Congress, including only part of a much larger set of restrictions
subjecting the appointment of the President (including on international capital flows),
of the Federal Reserve Bank of New York to but also that it carried with it high costs.
Senate approval. On the other hand, there is A somewhat less severe restriction,

also known as the Volcker Rule, and which used. This is certainly an important step as it
is included in the current Bill, is to prohibit puts some burden of ex-ante planning on
banks from proprietary trading, thus risking the institutions, effectively imposing a tax
deposits and capital. Banks’ ownership of on them. But these living wills have to be
hedge funds or private equity funds would updated regularly to fulfil their purpose of
also be prohibited. As so often, the devil is providing a blueprint for resolution. The Bill
in the detail – are banks allowed to trade is, however, rather short on how such a reso-
on their books, e.g. swaps, to hedge lend- lution scheme would work.
ing positions? And where is the borderline The Senate and the House versions still
between proprietary trading and simply differ in the financing of the resolution of a
hedging positions. large financial institution, with the House
version creating a resolution fund, thus ex-
Resolution authority ante financing, while the Senate version
One of the critical components is the expan- provides for an ex-post financing solution.
sion of resolution authority, beyond com- It is to be hoped that in the bargaining pro-
mercial banks. It is widely agreed among cess currently underway to reconcile both
economists that bank resolution needs a the House and the Senate versions of the
special framework and cannot be under- Financial Reform Bill on Capital Hill, that the
taken in the insolvency framework for non- Senate ex-post propositions will prevail.
financial corporations, given the need for
speed. Moral hazard
While the Federal Deposit Insurance Should this not be the case, then the House
Corporation (FDIC) procedure for resolving ex-ante solution many representatives
failing banks has been relatively successful, favour will result in the creation of a pot
as it helps resolve banks over a weekend, of money to “resolve” a financial institution,
thereby not affecting the payment system which in itself will create a moral hazard risk.
and depositors’ access to their savings, this Such a risk can only be avoided by Congress
regime could not be applied to Lehman adopting a ex-post financing solution. This
Brothers or AIG, given their status as an does not mean that a bank levy as suggested
investment bank and an insurance company. by the Obama administration is a bad solu-
tion, but it is better if it is included in the gen-
Seize and wind-up eral budget, rather than being saved for rainy
The externality from a failure of such a large bank days (Beck and Losse-Müller, 2010).
institution, however, is as large as in the case The reform bill addresses some issues,
of commercial banks. The new Bill gives the but also leaves out many others. The
government the right to seize and wind up reformed framework adjusts rules and
any large financial institution that is consid- mechanisms for authorities to address the
ered in risk of failing. In this context, living build-up of bubbles, to address fragility at
wills, i.e. ex-ante plans for resolving systemi- an earlier stage, and to intervene more rap-
cally important financial institutions, will be idly and effectively into weak and failing

institutions. Despite this, the Bill focuses Will the new framework help prevent
mostly on institutional aspects more than on the next crisis or at least reduce its probabil-
changing incentives for banks and regula- ity significantly? The answer is a firm no, not
tors. It increases the number of institutions because the reform steps are damaging or
under regulatory oversight and increases the wrong, but simply because they only pro-
power of regulators vis-à-vis financial insti- vide the framework within which the differ-
tutions and markets. ent actors and, most importantly, regulators,
central bankers and politicians will act. As
Plus ça change? illustrated by Ross Levine (2010), it was the
The Reform Bill does little to change incen- violation or intentional ignoring of rules that
tives by banks in their risk-taking decisions, led to the build-up of the bubble and the
e.g. by making capital requirements a func- subsequent bust, not the lack of regulatory
tion of size and scope (Beck, 2009) or focusing power or proprietary trading.
on the interaction of banks’risk position when The Financial Reform Bill, now enacted,
computing capital requirements (Adrian and will not necessarily be the last reform step.
Brunnermeier, 2009). It does not address the Current international regulatory reform dis-
issue of macroprudential capital regulation, cussions – Basel III – will have major impli-
i.e. the idea that capital requirements might cations also for the US, as will the current
have to vary over the business cycle. debate on financial sector taxation. While
Similarly, the incentives and account- a global financial transaction tax seems off
ability of regulators are not being strength- the table – the Tobin tax – developments in
ened – maybe the suggestion by Ed Kane of Europe and other G-20 countries concern-
deferred bonus and pension payments for ing financial sector taxation might have an
regulators, well after they leave office, should influence on future taxation in the US. •
be reconsidered.
References
Absence of Fannie, Freddie Adrian, Tobias and Markus Brunnermeier (2009),
Furthermore, the bill does not address the CoVaR, Princeton University mimeo.
risk of political capture. The same politicians Beck,Thorsten (2009), Regulatory Reform after the Cri-
now seeking stricter lending standards had sis: Opportunities and Pitfalls, CEPR Discussion Paper
called for extended home ownership only a 7733.
few years ago. Beck, Thorsten and Thomas Losse-Müller (2010),
The future roles of Fannie Mae and Financial sector taxation: Balancing fairness, efficiency,
Freddie Mac are notably absent from this and stability. VoxEU.org, 31 May.
Bill, and neither is the issue of mortgage Bolton, Patrick, Xavier Freixas, and Joel Shapiro
subsidisation being addressed. And there (2008), The Credit Rating Game, NBER working paper
seems to be rather more political oversight 14712.
than less. While accountability of regulators Levine, Ross (2010), An autopsy of the US financial
is important, the line between accountability system: Accident, suicide or negligent homicide? VoxEU.
and capture is a thin one. org, 25 May.

Historical analysis
This time is different: eight

hundred years of financial folly
Prof Carmen M. Reinhart of the University
of Maryland scours eight centuries of
economic data for some pearls of wisdom.
This column, first posted on April 19, debt and banking crises, inflation, currency
2008 and regularly updated, argues that crashes and debasements.3 The database
sovereign debt crises have historically covers 66 countries across all regions. The
followed financial crises. Although data range of variables encompasses external
covering only the past 30 years might and domestic debt, trade, GNP, inflation,
have given few hints about Greece’s cur- exchange rates, interest rates and commod-
rent problems, the Reinhart-Rogoff data- ity prices. The coverage spans eight centu-
base spanning eight centuries reveals ries, going back to the date of independence
that today’s events are very much in line or well into the colonial period for some
with historical experience. countries.
‘History is indeed little more than the register of Historical highlights

the crimes, follies, and misfortunes of mankind’. In what follows, we sketch some of the high-
– Edward Gibbon.1 lights of the dataset, with special reference to
The economics profession has an the current conjuncture. We note that policy-
unfortunate tendency to view recent expe- makers should not be overly cheered by the
rience in the narrow window provided absence of major external defaults from 2003
by standard datasets. With a few notable to 2007, after the wave of defaults in the pre-
exceptions, cross-country empirical stud- ceding two decades. Serial default remains
ies of financial crises typically begin in the norm; major default episodes are typi-
1980 and are limited in other important cally spaced some years – or decades – apart,
respects.2 Yet an event that is rare in a creating an illusion that“this time is different”
three-decade span may not be all that rare among policymakers and investors.
when placed in a broader context. We also find that high inflation, currency
In a recent paper co-authored with crashes and debasements often go hand-
Kenneth Rogoff, we introduce a compre- in-hand with default. Last, but not least, we
hensive new historical database for studying find that historically, significant waves of

increased capital mobility are often followed default cycles in the figure. The first is during
by a string of domestic banking crises. the Napoleonic War while the most recent
cycle encompasses the emerging market
The big picture debt crises of the 1980s and 1990s.
What are some basic insights one gains from Serial default on external debt – that is,
this panoramic view of the history of finan- repeated sovereign default – is the norm
cial crises? We begin by discussing sovereign throughout nearly every region in the world,
default on external debt. including Asia and Europe. Our dataset also
For the world as a whole (or at least the confirms the prevailing view among econo-
more than 90 per cent of global GDP rep- mists that global economic factors, including
resented by our dataset), the current period commodity prices and centre country inter-
can be seen as a typical lull that follows large est rates, play a major role in precipitating
global financial crises. Figure 1 plots for the sovereign debt crises.
years 1800 to 2006 the percentage of all During the past few years, emerging
independent countries in a state of default markets have benefited from low inter-
or restructuring during any given year. Aside national interest rates, buoyant world
from the current lull, one element that jumps commodity prices and solid growth in the
out from the figure comprises the long peri- United States and elsewhere.4 If things
ods where a high percentage of all countries can’t get better, the odds are that they will
are in a state of default or restructuring. get worse. US interest rates are likely to
Indeed, there are five pronounced peaks or remain low, which helps debtor countries
Figure 1. Sovereign External Debt: 1800-2006 (percent of countries in default or

restructuring)
Source: Reinhart and Rogoff (2008a).

Figure 2. Capital Mobility and the incidence of banking crisis: All countries. 1800-2007.
Sources: Reinhart and Rogoff (2008a), Obstfeld and Taylor (2004).
enormously. Weaker growth in the US and banking crises, as shown in Figure 2. Periods
other advanced economies softens growth of high international capital mobility have
prospects for export-dependent emerging repeatedly produced international bank-
markets in Asia and elsewhere; inflation is ing crises, not only famously as they did in
on the rise. Is this cycle different? the 1990s, but historically. The figure plots a
three-year moving average of the share of
Financial liberalisation all countries experiencing banking crises on
Another regularity found in the literature the right scale. On the left scale, we employ
on modern financial crises is that countries our favoured index of capital mobility, due
experiencing large capital inflows are at high to Obstfeld and Taylor (2004),5 updated and
risk of having a debt crisis. Default is likely to backcast using their same design principle,
be accompanied by a currency crash and a to cover our full sample period; while the
spurt of inflation.The evidence here suggests index may have its limitations, it neverthe-
the same to be true over a much broader less provides a summary of de facto capital
sweep of history, with surges in capital mobility based on actual flows.
inflows often preceding external debt cri- As noted, our database includes long
ses at the country, regional, and global level time series on domestic public debt.6
since 1800, if not before. Because historical data on domestic debt is
Also consonant with the modern theory so difficult to come by, it has been ignored
of crises is the striking correlation between in many empirical studies on debt and infla-
freer capital mobility and the incidence of tion. Indeed, many generally knowledgeable

Figure 3. Domestic public debt as a share of total debt 1900-2006
observers have argued that the recent shift over 30 per cent and has been at times more
by many emerging market governments than 50 per cent. Furthermore, contrary to
from external to domestic bond issues is the received wisdom, these data reveal that
revolutionary and unprecedented.7 Nothing a very important share of domestic debt –
could be further from the truth, which has even in emerging markets – was long-term
implications for today’s markets and for his- maturity.
torical analyses of debt and inflation.
The topic of domestic debt is so impor- The inflation-default cycles
tant, and the implications for existing empir- Figure 4 on inflation and external default
ical studies on inflation and external default (1900 to 2006) illustrates the striking cor-
are so profound, that we have broken out relation between the share of countries in
our data analysis into an independent com- default on debt at one point and the num-
panion piece.8 Here, we focus on a few major ber of countries experiencing high inflation
points. The first is that contrary to much (which we define to be inflation over 20 per
contemporary opinion, domestic debt con- cent per annum). Thus, there is a tight corre-
stituted an important part of government lation between the expropriation of residents
debt in most countries, including emerging and foreigners.
markets, over most of their existence. As noted, investment banks and official
Figure 3 plots domestic debt as a share bodies, such as the International Monetary
of total public debt over 1900 to 2006. For Fund, alike have argued that even though
our entire sample, domestically issued debt total public debt remains quite high today in
averages more than 50 per cent of total many emerging markets, the risk of default
debt for most of the period. Even for Latin on external debt has dropped dramatically
America, the domestic debt share is typically because the share of external debt has fallen.

Figure 4. Inflation and external default: 1900-2006
This conclusion seems to be built on to a benign global economic environment

the faulty premise that countries will treat and extremely favourable terms of trade
domestic debt as junior, bullying domestics shocks.
into accepting lower repayments or sim-
ply defaulting via inflation. The historical Euphoria and depression
record, however, suggests that a high ratio Such celebration may be premature. Capital
of domestic to external debt in overall public flow/default cycles have been around since
debt is cold comfort to external debt holders. at least 1800. Technology has changed, the
Default probabilities depend much more on height of humans has changed, and fash-
the overall level of debt. ions have changed.Yet the ability of govern-
This brings us to our central theme – the ments and investors to delude themselves,
“this time is different”syndrome. giving rise to periodic bouts of euphoria
There is a view today that both that usually end in tears, seems to have
countries and creditors have learned remained a constant.
from their mistakes. Thanks to better- On a more positive note, our research
informed macroeconomic policies and at least raises the question of how a coun-
more discriminating lending practices, it try might“graduate”from a history of serial
is argued, the world is not likely to again default. Interesting cases country might
see a major wave of defaults. Indeed, an “graduate” from a history of serial default.
often-cited reason these days why “this Interesting cases include Greece and Spain,
time is different” for the emerging mar- countries that appear to have escaped a
kets is that governments are managing severe history of serial default not only by
public finances better, albeit often thanks reforming institutions, but by benefiting

from the anchor of the European Union. Michael Bordo’s “The crisis of 2007: Some lessons from
Austria, too, managed to emerge from an history,” VoxEU, 17 December 2007.
extraordinarily checkered bankruptcy his- 3 “This Time Is Different: A Panoramic View of Eight
tory by closer integration with postwar Centuries of Financial Crises” National Bureau of
Germany, a process that began even before Economic Research Working Paper 13882, March 2008a.
European integration began to accelerate 4 See Jeffrey Frankel, “An Explanation for Soaring
in the 1980s and 1990s. We shall wait and Commodity Prices,” VoxEU, 25 March 2008.
see which emerging markets can graduate 5 Obstfeld, Maurice, and Alan M. Taylor, Global Capital
from serial default. • Markets: Integration, Crisis, and Growth, Japan-U.S. Center
Sanwa Monographs on International Financial Markets
Editor’s Note (Cambridge: Cambridge University Press, 2004).
The publisher would like to thank Prof 6 For most countries, over most of the time period con-
Reinhart and Prof Rogoff for allowing us to sidered, domestically issued debt was in local currency
re-print an amended version of their paper and held principally by local residents.
which was originally hosted on VoxEu – External debt, on the other hand, was typically in foreign
www.voxeu.org currency, and held by foreign residents.
7 See the IMF Global Financial Stability Report,April 2007;
Footnotes many private investment-bank reports also trumpet the
1 The History of the Decline and Fall of the Roman rise of domestic debt as a harbinger of stability.
Empire, 1843. 8 Carmen M. Reinhart and Kenneth S. Rogoff “Domestic
2 Among many important previous studies include works Debt: The Forgotten History,” NBER Working Paper
by Bordo, Eichengreen, Lindert, Morton and Taylor. See 13946,April 2008b.
www.edit24.com
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Legal update
UK Bribery Act poses hurdles

for international business
DLA Piper’s Jonathan Pickworth details the
effect the UK Bribery Act 2010 will have on
those conducting business in Britain.
AS well as dealing with local anti-cor- its failure to prevent bribery by a member
ruption laws and the long reach of the of staff. The Act signals a complete reform
US Foreign Corrupt Practices Act, inter- of UK bribery law to provide a modern and
national businesses based in Asia now comprehensive scheme of offences that will
have a further compliance challenge in enable courts and prosecutors to respond
the form of new UK legislation. more effectively to bribery at home or abroad.
The Bribery Act 2010 (the Act), which is The nitty-gritty

expected to come into force in October, will It is important to note that:
have far-reaching implications for every • It is an offence to give or receive a bribe;
company doing business in, or via, the • It is an offence to promise, offer, request or
United Kingdom. In many ways it creates agree to receive a bribe;
a platform for what could be the toughest • There is a specific offence of bribing a for-
enforcement regime in any jurisdiction. eign public official;
The effect will be far reaching – simply • The new law is not just about bribing pub-
having a UK presence (subsidiary, office or lic officials because commercial bribery is
operations) will create jurisdiction. The Act also criminalised;
applies to British companies as well as for- • If a‘commercial organisation’commits any
eign companies with operations in the UK, of the above bribery offences, a senior officer
even if offences take place in a third country may also be guilty of the same offence;
and are unrelated to UK operations. • There is a new strict liability corporate offence,
This means that the relevant criminal which will apply to a commercial organisation
act can occur outside Britain and persons that fails to implement “adequate procedures”,
or companies in the UK can be liable. For if an act of bribery is committed in connection
example, if an Asian company has a British with its business;
branch and engages in bribery in Africa, the • There is no exemption for facilitation
company could be prosecuted in the UK for payments;

• There is a broad scope and extraterritorial The fact that adequate procedures are
reach for companies and individuals; not defined in the Act led to a great deal of
• The maximum penalty for individuals will debate in Parliament about how businesses
be 10 years imprisonment and/or an unlim- would be able to determine whether or not
ited fine; their procedures were, in fact, adequate.
• The maximum penalty for a corporate
will be an unlimited fine. (The highest fine Draft bill amendment
imposed to date in the UK for a corruption As a result, the draft Bill was amended so
case is £8.5 million); that we now have at section 9 a statutory
• All existing anti-bribery and corruption obligation for the government to issue guid-
statutes will be repealed. ance on what constitutes adequate proce-
dures. The government in power at that time
‘Adequate procedures’ pledged to issue the first set of guidelines
Some of these points are examined in more before the new law comes into force so that
detail below: businesses know what is expected of them.
For companies the most important point Post-general election and with a new coa-
to note is that there is a new strict liability lition government in place it remains to be
corporate offence of failing to prevent brib- seen if the publication and implementation
ery. This offence should make it easier for of these new rules and regulations will be
the UK’s main prosecutor of corruption, the delayed or amended.
Serious Fraud Office, to prosecute compa-
nies when bribery has occurred. Jurisdiction
With the recent Innospec [1] court case The Act has a broad scope and extraterrito-
casting some doubt on the corporate set- rial reach which means that:
tlement and plea negotiation process in the • any individual ordinarily resident in the
UK, a new opportunity to pursue companies UK (whether or not a British national) can
for a specific corporate offence may well be be prosecuted for bribery offences commit-
an attractive proposition for this organisation ted anywhere in the world; and
to show its prosecution mettle once the Act • any partnership or corporate (whether or
comes into force. not incorporated in the UK) can be pros-
There is a possible defence available to ecuted if it does business in Britain (e.g.
commercial organisations charged with the through a permanent establishment, subsid-
corporate offence if they can show (on the iary or other operation), even if the offence
balance of probabilities) that they had in was committed outside the UK.
place “adequate procedures” to prevent an Senior officers need to understand that
act of bribery being committed in connec- they could be personally liable under the
tion with their business. This is, in effect, a Act for offences committed by the company
requirement to show that the bribe was a if they have consented to or connived in
rogue act committed against company poli- (turning a blind eye to) the commission of
cies and procedures. the main bribery offences (including bribing

a foreign public official but not that of fail- Corporate liability often lacks a degree
ing to prevent bribery) and, if any part of the of certainty in UK criminal law and remains
offence has taken place in the UK. an issue for the lawmakers. Further clarity
If the offence is committed outside the on the overarching issue of a parent com-
UK, they will only be liable if the senior pany’s liability for a subsidiary in UK law is
officer has a“close connection”with the UK expected in due course as part of the Law
(such as being a British passport holder or Commission’s ongoing general review of
being ordinarily resident in the UK). the liability of businesses [2] (a consultation
For the purposes of the Act a senior paper is expected in the summer).
officer is defined as a“director, manager, sec-
retary or other similar officer”, a partner in a Collateral consequences
Scottish partnership, or any“person purport- It is worth noting that companies and indi-
ing to act in such a capacity”. viduals convicted of criminal offences in the
UK can also face further damaging conse-
Effects on non-UK parent firms quences in addition to fines and sentences
The offence of failing to prevent bribery is of imprisonment – and the Act is no excep-
committed by a company when it fails to tion. Individuals convicted of bribery can be
prevent an“associated person”(an employee, disqualified from being a director for up to
agent or subsidiary) from offering, promising 12 years.
or giving a bribe. Companies convicted of bribery will
In order to prove the offence it has to receive a mandatory and permanent ban
be established that the associated person from taking part in European public procure-
“performs services” for or on behalf of the ment in perpetuity (in accordance with EU
defendant company in the normal course of Procurement Directives [3]). This, of course,
business. can have a devastating effect on a business
The Act includes a presumption that (defence, medical devices, construction, etc)
an employee performs services for and on which relies on this type of work.
behalf of the company unless the contrary
can be shown. In all other cases (for exam- Assets confiscated
ple, where a non-UK parent company and Individuals and companies can also have
its UK subsidiary are involved), the Act says their assets confiscated under the Proceeds
that the court will have to determine liabil- of Crime Act 2002. This is a draconian asset
ity by “reference to all the relevant circum- recovery regime which allows the total ben-
stances and not merely by reference to the efit of a crime to be confiscated, not just the
nature of the relationship . . .” profit element.
Although it is not clear when a foreign For example, if a company has entered
parent company might be held be held liable into contracts valued at £60 million by cor-
for the acts of its UK subsidiary, the Act does rupt means and its accounts show that its
not rule this out and each case will have to be profit was only £10 million pounds, the UK
decided on its own facts. courts will take the £60 million figure as

the starting point for confiscation proceed- general guidance, not rigid rules, which will
ings. We have not yet seen the full force of set out a number of key principles which will
the asset confiscation regime used against help commercial organisations to do their
a company but in a contested case it could part in the prevention of bribery.
potentially bring a company to its knees
financially, as there is little room for judicial Key focus
discretion or affordability considerations. A key focus for larger organisations will be
the responsibility of a corporate board of
Compliance is key directors to design, implement and regu-
Businesses and individuals that do all they larly review policies for preventing bribery.
can to stay on the right side of the law should The last government expressed views that
have nothing to fear from this legislation. adequate procedures means:
The overriding objective in introducing the • a board of directors taking responsibil-
new law was to make companies and their ity for anti-corruption programmes and
personnel take the issue of anti-bribery and appointing a senior officer accountable for
corruption compliance seriously. its oversight;
With only a few months to go until the • assessment of risks specific to the com-
Act comes into force, there are still compa- pany and its business, including risks linked
nies out there in the United Kingdom that to the nature or location of the organisation’s
are not yet fully prepared for the introduc- activities;
tion of the new legislation, and many inter- • establishing clear policies and procedures,
national companies may not even have and training of new and existing staff in anti-
acknowledged that this legislation is of rel- bribery procedures;
evance to the way they do business. • having robust internal financial controls
and record-keeping to minimise the risk of
Companies must act now bribery; and
For many companies there is significant • establishing whistle blowing procedures
work to be done before they are in a position so that employees can report corruption
to demonstrate that they take anti-bribery safely and confidentially.
and corruption compliance seriously, and If any company with a connection to the UK
have the necessary procedures, systems and finds itself caught up in allegations of brib-
controls in place to prevent bribes being paid ery, it can expect its anti-corruption compli-
in connection with their business. Any com- ance programme to be subjected to the most
pany that does business in, or indeed out of intense form of scrutiny by investigators and
the United Kingdom, needs to start review- prosecutors.
ing their practices and procedures as a mat-
ter of priority. Different to the FCPA
The guidance on adequate procedures Many companies with international opera-
was expected before Parliament’s summer tions will have built their compliance pro-
recess which begins on July 22. It will give gramme around the US Foreign Corrupt

Practices Act. However, the new UK law has that the company is taking the issue seri-
some significant differences, which need to ously and has addressed all these questions.
be taken into account: In these circumstances, showing that exter-
• the Bribery Act makes it an offence to nal specialist legal advice has been taken can
receive, as well as give, a bribe; prove invaluable.
• bribery of private individuals and compa-
nies is criminalised; The countdown begins
• here is no need to prove corrupt intent (the The clock is ticking and the new UK parlia-
test is an objective assessment as to whether mentary bribery legislation will soon come
there has been improper behaviour); into force. Companies located or registered
• there is a strict liability corporate offence of in the Asia Pacific region that do business in
failing to prevent bribery; the United Kingdom may have been una-
• there is no exemption for facilitation ware of the need for enhanced anti-corrup-
payments; tion compliance, but they now need to take
• there are no books and records provi- prompt action.
sions within the Act (although companies In-house lawyers, risk managers and
can be prosecuted for inaccurate accounts compliance officers have a vital role to play in
under the Companies Act 2006); raising internal awareness of the reach of the
• there is no statutory defence for legitimate new UK law and stressing the importance of
promotional activities (FCPA provides for reviewing training programmes, procedures,
reasonable and bona fide business expendi- systems and controls.
tures directly related to certain promotional It is only by setting the right tone at the
activities); top of the organisation and taking steps to
• the extraterritorial reach has a broader mitigate the risks of corruption that interna-
impact for companies and individuals; and tional companies that do business in the UK
• the prison sentences (up to 10 years) and can hope to remain out of the Bribery Act
the fines (unlimited) could be greater. spotlight. •
New benchmark Notes

With provisions which are more far reaching 1. Sentencing remarks: R v Innospec (March 26,
than the US Foreign Corrupt Practices Act 2010) http://www.judiciary.gov.uk/docs/judgments_
in many respects, the Act and the adequate guidance/sentencing-remarks-thomas-lj-innospec.
procedures guidelines, could well set a new pdf
benchmark for international compliance 2. Law Commission: Regulation, Public Interest and
programmes. the Liability of Businesses http://www.lawcom.gov.
Whether setting up a new programme uk/regulation_liability.htm
or reviewing an existing programme, it is 3. Directive 2004/17/EC: water, energy, transports
important to bear in mind that an effective and postal services Directive 2004/18/European
anti-corruption programme should be capa- Commission: public works, supply and service
ble of persuading a regulator or prosecutor contracts.

Regulatory update
A question of sovereignty:
capital controls gain credence
Does the move by Jakarta and Seoul to
impose capital controls breach IMF protocols,
asks PIRC economist Kavaljit Singh.
IN June, South Korea and Indonesia forwards. Also, new ceilings have been
announced several policy measures to imposed on domestic banks and branches of
regulate potentially de-stabilising capital foreign banks dealing with FX forwards and
flows which could pose a threat to their derivatives. For Korean banks, there will be
economies and financial systems. a limit on currency forwards and derivatives
positions at 50 per cent of their equity capi-
Seoul kicked off the process on June 13 tal. For foreign banks, the ceilings will be set
when it announced a series of currency con- at 250 per cent of their equity capital, against
trols to protect the South Korean economy the current level of around 300 per cent.
from external shocks. The new currency
controls are much wider in scope than for- No-limit contracts
eign exchange liquidity controls announced Under the existing trading rules in Korea,
earlier in 2009. Jakarta quickly followed suit banks can buy FX derivatives contracts with-
on June 16 when Indonesia’s central bank out any limits. Many banks also rely heav-
deployed measures to control short-term ily on borrowings from overseas to cover
capital inflows. potential losses arising from forward trading.
The policy measures introduced by As a result of this lax policy regime, the FX
South Korea’s central bank have three major derivatives trading substantially contributed
components: restrictions on currency deriv- to the rise in short-term overseas borrow-
atives trades; enhanced existing restrictions ings and external debt during 2006-2007.
on the use of bank loans in foreign currency; Officials state that almost half of the
and, further tightening of existing regula- increase in their country’s total external debt
tions on the foreign currency liquidity ratio of US$195 billion during this year was due
of domestic banks. to the increase in FX forward purchases by
The new restrictions on currency deriva- banks. In addition to new curbs on banks,
tives trades, include non-deliverable cur- the Korean authorities have also tight-
rency forwards, cross-currency swaps and ened the ceilings on companies’ currency
derivatives trades to 100 per cent of under- establish liquidity risk management mecha-
lying transactions from the current 125 per nisms as they are a major source of FX liquid-
cent. The currency controls will come into ity. According to the Bank for International
effect from July 2010. But these will be imple- Settlements (BIS), foreign banks account for
mented in a flexible manner. A grace period the bulk – some 60 per cent – of short-term
of three months has been allowed to avoid external liabilities of all banks operating in
any sudden disruptions in derivatives trad- South Korea. Further, foreign banks are also
ing markets and banks can cover their exist- the dominant players in inter-bank borrow-
ing forward positions for up to two years if ing from abroad.
they exceed the ceilings. In addition to these policy measures,
the Korean authorities also announced the
A cause of systemic risk establishment of a headquarters inside the
With regards the enhanced restrictions on Korea Centre for International Finance to
the use of bank loans in FX, this has been regularly monitor capital flows as part of
done primarily to make sure that FX bank developing an early warning system.
loans are for overseas use only. At present, The authorities have also supported the
bank loans in foreign currency are allowed need to establish global financial safety nets
for purchase of raw materials, foreign direct through international co-operation. The
investment and repayment of debts. Only agenda of global financial safety nets will be
in certain cases can such loans be used for pursued as part of the ‘Korea Initiative’ at the
domestic use. Seoul G-20 summit to be held in November
Under the new rules, such loans will be 2010. Meanwhile, the Korean authorities
restricted to overseas use only. As an excep- have explicitly ruled out imposition of any
tion, only the small- and medium-sized financial transactions taxes, such as in Brazil,
enterprises have been allowed to use FX or unremunerated reserve requirements,
financing for domestic use, to the extent that such as in Chile.
total foreign currency loans remain within
the current levels. Fear of capital exodus
This policy measure is hugely significant The imposition of currency controls by
since excessive foreign currency bank loans the Korean authorities has to be analysed
are considered to be major sources of sys- against the backdrop of the global financial
temic risks in many emerging markets. And crisis. Despite its strong economic funda-
finally, the Korean authorities have further mentals, South Korea witnessed sudden
tightened the existing regulations on foreign and large capital outflows due to de-lever-
currency liquidity ratio of domestic banks. aging during the global financial crisis. It has
The domestic banks will monitor the sound- been reported that almost $65 billion left the
ness of FX liquidity on a daily basis and country in the five months after the collapse
report it to authorities every month. of Lehman Brothers in September 2008.
The authorities have also recommended South Korea’s export-oriented economy
that foreign banks operating in Korea also suffered badly due to contraction in

global demand in the aftermath of the global through the banking system – and subse-
financial crisis. Its economy shrank 5.6 per quent financial crises is well-known. The
cent in Q4 2008, the country’s worst per- Korean economy has suffered badly from
formance since 1998 when it was hit by the the boom and bust cycles of short-term
Asian financial crisis. capital flows in the past. It is too early to
Of late, the authorities have been con- predict the potential impact – positive and
cerned about sharp fluctuations in the negative – of currency controls and other
Korean won, particularly in the wake of policy measures announced by the Korean
the European sovereign debt crisis and the financial authorities. This prediction is made
negative impact on Korean exports. On May harder still because some policy measures
25, the South Korean won’s three-month are medium- and long-term in nature.
implied volatility touched 36.6 per cent, the But it is expected that such restrictions
highest level since January 2009. will lead to a considerable reduction in short-
term foreign borrowings. Foreign banks may
Vulnerable to sudden outflows not find it profitable to carry out arbitrage
Despite a relatively stable banking system, trade due to regulatory restrictions and there-
sharp currency fluctuations can make a small fore may look for opportunities elsewhere.
and open economy like South Korea highly While many analysts believe that ceilings
vulnerable to sudden capital outflows.The on forward positions will limit the amount
over-arching aim of currency controls in of short-term foreign debt and deter “hot
South Korea is to limit the risks arising out of money” flows, it nevertheless remains to be
sharp reversals in capital flows, as witnessed seen to what extent these policy measures
during the global financial crisis.The controls will help in reducing currency volatility.
are specifically aimed at regulating capital
flows and stabilising its currency. Indonesia plays ‘catch-up’
Another policy objective of these policy Following three days later – June 16, 2010 –
measures is to curb country’s rapidly grow- Bank Indonesia, the country’s central bank,
ing short-term foreign debt. Tight regula- announced the following policy measures
tions have been imposed on banks on the to tame short-term capital inflows; these
amount of short-term loans they can obtain come into effect from July and there will be
from abroad. South Korea’s higher short- a one-month minimum holding period on
term foreign debt is a matter of serious con- Sertifikat Bank Indonesia (SBIs).
cern. At $154 billion, its short-term external During the one-month period, owner-
debt accounts for as much as 57 per cent of ship of SBIs cannot be transferred. Issued
its FX reserves. A sudden shift in global mar- by central bank, the one-month SBIs are the
ket sentiment can trigger large reversals in favourite debt instruments among foreign
short-term capital flows thereby precipitat- and local investors because of their high yield
ing a financial crisis of one sort or another. (an interest rate of 6.5 per cent in early June
The relationship between excessive 2010) and greater liquidity than other debt
short-term external debt – intermediated instruments. The central bank will increase

the maturity range of its debt instruments concerned that its economy might be de-
by issuing longer dated SBIs (nine-month stabilised if foreign investors decide to pull
and 12-month) to encourage investors to their money out quickly. As a result, the
park their money for longer periods. So far, steps taken by the central bank to main-
the longest maturity of its debt has been six tain financial stability were of little surprise.
months. As a balancing act however, the authorities
New regulations have been introduced have avoided any restrictions on long-term
on banks’ net foreign exchange open posi- investment flows.
tions. The central bank has also widened the
short-term, overnight money market interest Hot money inflows deterred?
rate corridor and introduced non-securities Analysts believe that these policy measures
monetary instrument in the form of terms may deter hot money inflows into the coun-
deposits. These new curbs are in response try and monetary policy may become more
to growing concerns over short-term capital effective. Yet they expect tougher measures
inflows. Given the historically low levels of in the future if volatility in capital flows per-
interest rates in most developed countries, sists. Some analysts also expect that the new
Indonesia has received large capital inflows curbs may shift capital flows to other finan-
since 2009. cial assets such as government and corpo-
rate bonds.
Resilience during crisis Despite recovering faster than devel-
Unlike other Asian economies such as oped countries, many emerging markets are
Singapore and Malaysia, the Indonesian finding it difficult to cope with large capital
economy showed some resilience during the inflows. There is a growing concern that the
global financial crisis. Despite hiccups in the loose monetary and fiscal policies currently
financial markets, the Indonesian economy adopted by many developed countries are
registered a positive growth of six per cent in promoting a large dollar“carry trade”to buy
2008 and 4.5 per cent in 2009, largely due to assets in emerging markets.
strong domestic consumption and the dom-
inance of natural resource commodities in its Fears of asset inflation
export basket. Apart from currency appreciation pressures,
Its relatively better economic perfor- the fears of inflation and asset bubbles are
mance has attracted large capital inflows in very strong in many emerging markets.
the form of portfolio investments since early Since mid-2009, stock markets in emerg-
2009. Consequently, Indonesia’s stock mar- ing economies have witnessed a spectacular
ket index was up 85 per cent in 2009, the rally due to strong capital inflows. In particu-
best performer in the entire Southeast Asian lar, Brazil, Russia, India and China are the
region. The rupiah rose 17 per cent against major recipient of capital inflows.
the dollar last year. The signs of asset price bubbles are more
Yet due to the massive speculative capital pronounced in Asia as the region’s economic
inflows, the Indonesian authorities remain growth will continue to outperform the rest

of the world. As a result, the authorities are the use of capital controls, albeit temporarily
adopting a cautious approach towards hot and subject to exceptional circumstances. A
money flows and considering a variety of recent paper prepared by the Strategy, Policy,
policy measures (from taxing specific sectors and Review Department stated: “In certain
to capital controls) to regulate such flows. cases countries may consider price-based
In May 2010, for instance, Hong Kong and capital controls and prudential measures
China imposed new measures in an attempt to cope with capital inflows.” This is a sig-
to curb soaring real estate prices and prevent nificant development given the IMF’s strong
a property bubble. opposition to capital controls in the past.
In emerging markets, strong capital In October 2009, Brazil announced a
inflows are likely to persist due to favourable two per cent tax on foreign purchases of
growth prospects but the real challenge is fixed-income securities and stocks. Taiwan
to how to control and channel such inflows also restricted overseas investors from buy-
into productive economy. ing time deposits. Due to this measure,
Contrary to the popular perception, capi- Taiwan has witnessed a decline in specula-
tal controls have been extensively used by tive money from overseas. Russia is also con-
both the developed and developing coun- templating similar measures as its economy
tries in the past. There is a paradox between is more vulnerable to swings in capital flows.
the use of capital controls in theory and in
practice. Although mainstream theory sug- A question of sovereignty?
gests that controls are distortionary and inef- In the present uncertain times, imposition
fective, several successful economies have of capital controls becomes imperative since
used them in the past. China and India, two the regulatory mechanisms to deal with cap-
major Asian economies and“success stories” ital flows are national whereas the financial
of economic globalisation, still use capital markets operate on a global scale.
controls today. Yet it would be incorrect to view capital
Post-crisis, there is a renewed interest in controls as a panacea to all the ills plaguing
capital controls (on both inflows and out- the present-day global financial system. It
flows) as a policy response to deter short- needs to be underscored that capital controls
term volatile capital flows. It is increasingly must be an integral part of regulatory and
being accepted in international policy circles supervisory measures to maintain financial
that due to limited effectiveness of other and macroeconomic stability Any wisdom
measures – such as higher international that considers capital controls as short-term
reserves – capital controls could protect and and isolated measures is unlikely to succeed
insulate the domestic economy from vola- in the long run.
tile capital flows and other negative external It remains to be seen how the G-20
developments. Capital controls could also responds to the use of capital controls by its
provide recipient countries greater leeway to member-countries as a policy response to
conduct an independent monetary policy. regulate speculative capital flows. Will G-20
Even the IMF is nowadays endorsing take a collective stand on capital controls? •

North Asia
Articles & Papers
Perspectives on regulatory reform after the 2008 crash 91
Charles L. Evans
Regulation or prohibition: the $100 billion question 101
Andrew G. Haldane
Economists’ hubris informed the financial tsunami of 2008 123
Shahin Shojai & George Feiger
‘Walker Review’ heralds new dawn in risk management 133
David Millar
Ideas have consequences: the importance of ‘narrative’ 139
Peter J. Wallison
Minority shareholders blind to threat of expropriation 149
Dr Fritz Foley et al
‘Swap tango’: a regulatory dance in two acts 153
Satyajit Das
Beware Greeks bearing bonds: A tragedy in four acts 165
Michael Mussa
Global financial crisis and the European Monetary Union 175
Prof Christian Fahrholz & Dr Cezary Wójcik
Lehman Bros and Repo 105: a powerful case of addiction 185
Prof Jennifer S. Taub
Regulating the rating agencies: Quick fix or political expedient? 191
Prof Lawrence White
Macro-prudential councils: how to avoid future crises 197
Prof Enrico Perotti
EC offers last opportunity for insurers to influence Solvency II 201
Eleanor Beamond-Pepler
Did we tame the beast: views on the US Financial Reform Bill 209
Prof Lawrence Baxter
Financial supervision and increased powers of discretion 219
Steve Randy Waldman
Global anti-trust regulation in the current financial climate 227
Gavin Sudhakar
Asset securitisation in China: Opportunities and challenges 239
Claas Becker et al
Is an undervalued renminbi the source of global imbalances? 245
Prof Charles Wyplosz
The regulators strike back: Basel and new liquidity rules 251
Thomas Dietz
Basel Committee’s enhanced framework for liquidity 263
Dr Michael Wong & Fai Y. Lam
IsAsia
on the edge?
In 2011, Asia may continue to lead the world out of
recession—or it could become the third wave of the
economic crisis. Asia’s enormous investment opportunity
could be realized—or an uncertain regulatory environment
might undermine its potential. Whichever scenarios develop
will have major implications for risk managers at financial
institutions across the region.
The world’s leading risk practitioners and thought leaders

will be discussing how to manage risk in Asia’s dynamic
regulatory and financial environment. Join them at the
region’s premier risk management conference.
GARP’s 7th Annual Asia Pacific Risk Convention
Hong Kong | October 27-28, 2010
To learn more and register, visit www.garp.org
TM
Creating a culture of risk awareness.
© 2010 Global Association of Risk Professionals.
All rights reserved.
Central banking
Perspectives on regulatory
reform after the 2008 crash
Chicago Fed President Charles L. Evans is
sceptical that monetary policy alone can
deal with financial ‘over-exuberance’ .
WE are slowly emerging from the worst Federal Open Market Committee or the
financial crisis since the 1930s. The Federal Reserve System.
hardships created by these exceptional To highlight some of the changes that are
circumstances for households and busi- being considered, there are proposals that
nesses are well known. Governments would assign monetary policy a more active
and regulators around the world have role in fighting asset bubbles; proposals that
responded to the crisis with a variety of would strengthen current microprudential
aggressive and innovative policy actions, regulations; proposals that would introduce
including giving special assistance to a systemic regulator and macroprudential
specific institutions. regulations; and proposals that would create
resolution authority – particularly for sys-
Now, as we slowly emerge from the crisis, temically important financial institutions.
we are engaged in a vigorous debate on
how best to address the major weaknesses Implementation challenges
in our financial regulatory framework that Time does not permit me to discuss the spe-
were revealed by the crisis. Our goal, clearly, cifics of each of these proposals. Instead, I
is to avoid another crisis of this magnitude. would like to offer my thoughts on some of
Financial reform will not be easy. We face the challenges we are likely to face in imple-
complex problems that will require a commenting even the most well-thought-out
prehensive, multi-pronged approach. But policies.
reform is critical for ensuring our long-term Let me be clear. I don’t bring up these
economic stability. potential challenges as roadblocks to the
Today, I would like to offer my thoughts healthy debate that is underway. Rather, I
on some of the reform proposals that are offer them as issues we need to consider as
being discussed. I should note that my we build a better financial infrastructure.
remarks reflect my own views and are not One pre-emptive action that is being
those of the Chicago Federal Reserve Bank, debated concerns the role of monetary

policy in combating asset bubbles. Given increase the resiliency of markets and insti-
the rapid rise in some asset prices prior to tutions and their ability to withstand adverse
the recent crisis, there are increasing calls shocks that do occur.
for central banks to be more proactive in Within the existing structure, regula-
responding to signs that an asset bubble tors have the ability to promote better, more
may be emerging and to raise their target resilient financial markets, either through
rates in order to lower asset prices that, by rule-making or by serving as a co-ordinator
historical standards, seem unusually high. In of private initiatives.They can also encourage
previous forums, I have discussed why I view more and better disclosure of information – a
these proposals with scepticism.[1] key element of effective risk management. A
number of initiatives along these lines have
Sceptical about ‘asset’ values been taken and additional ones are being
I won’t cover the same ground here again. considered.[2]
Instead, let me just note that I am sceptical We can use existing regulatory tools
about our ability to easily and definitively more effectively, but we also need to address
sort out in real time whether a rapid increase the shortcomings of current regulations.
in asset prices is associated with over-valu- The ongoing work of the Basel Committee
ation. That is, how confidently can we state on Banking Supervision regarding the pos-
that we are in the midst of a bubble? sible introduction of liquidity standards and
I also think that monetary policy is too adjustments to the existing capital require-
blunt a tool for pricking bubbles: It can’t ments are examples of such efforts.
be targeted precisely and it will affect other
financial and macroeconomic variables in Microprudential regulation
addition to the suspected bubble asset. In While such enhancements to micro-pruden-
addition, the typical changes in interest rates tial regulations are necessary, I would argue
that a central bank might contemplate are that they are not close to being sufficient to
likely to be too small to produce big changes address the complex issues we faced during
in asset prices. the recent crisis. Success in preventing and
Fortunately, monetary policy is not the controlling potential risks requires very early
only tool that policymakers have to deal with and courageous action by policymakers.
financial exuberance. Typically, risks and problems in the finan-
cial system build over a number of years.
Regulation and market infrastructure There is an awful amount of uncertainty as
In my view, redesigning regulations and to whether risks are developing; how they
improving market infrastructure offer more will be perpetuated; and when to take action.
promising paths. Regulation may or may Microprudential regulations alone are not
not be sufficient to avoid all of the events likely to resolve these issues.
that create crises, but it should go a long Let me illustrate the sort of problems a
way toward doing so. Better supervision and microprudential regulator faces with a spe-
a sound regulatory infrastructure can also cific example. As you know, the problems

with residential mortgages, particularly Figure 1. Commercial real estate — CMBS
with subprime mortgages, were one of the
key areas that precipitated the current cri-
sis. Currently, the US financial system faces
problems with commercial real estate (CRE)
loans.
US$1.5 trillion CRE ticking bomb

At the end of 2009, depository institutions in
the US held over $1.5 trillion in commercial
real estate and construction loans on their
books. In addition, there are currently nearly
$800 billion in commercial mortgage-backed banks in my district. I went to my supervi-
securities (CMBS) outstanding. Over the sory staff and said:“I know you are struggling
past two years, delinquencies on these loans with commercial real estate loan portfolios.
and securities have been rising at an uncom- What are the difficulties? What do you think
fortably rapid rate. Click here for url link we needed to have done in the past in order
to Federal Reserve charts. to avoid the current problems?”
Of the more than $1 trillion in com- I have to admit that their response made
mercial real estate loans held by depository me pause. They said: “You know, Charlie, if
institutions today, nearly four per cent are we wanted to avoid the current situation,
non-current.[3] This ratio was about 0.5 per we needed to act very, very early – probably
cent before the crisis (June 2007). The picture in 2004 or 2005.”That is a full two to three
is even worse for the riskier construction and years before the onset of problems in the
land development loans. While these loans sector. Clearly, we needed to act very early.
total less than $0.5 trillion, the non-current But at that time, it would have been difficult
portion had risen from 1.5 per cent at the to argue convincingly in favour of reigning in
end of June 2007 to nearly 16 per cent by this lending. The economy was coming out
the end of last quarter. For CRE loans pack- of the jobless recovery and just beginning to
aged into securities, serious delinquencies gain traction. And the banking industry had
represent four per cent of all CMBS currently proven it could maintain profits through a
outstanding, up from nearly zero before the recession, it had reduced problem loans back
crisis. to historically low levels, and it appeared to
have more than sufficient capital to cushion
Rapid growth in delinquency against potential losses.[4]
Does such a fast rise in CRE and CMBS
delinquencies mean that bank examiners Memories of S&L crisis linger
missed clear signs of forthcoming problems Given previous problems with commercial
and failed to take action? Commercial real real estate loans, my supervisors understood
estate loans are a key problem area for the the potential risks. Here is a typical situation

they faced. Imagine you are an examiner and looking at this pretty reasonably and are pro-
you go out to review a large financial institu- tecting their institution.” And the risk to the
tion in 2005. The institution is warehousing deposit insurance fund from all this activity
commercial real estate loans prior to securiti- seems pretty small. So, you end up being con-
zation during a period when CMBS issuance vinced that the activity is probably OK.
is just taking off and, for every $1,000 in CRE
loans, only $6 are noncurrent. Nonetheless, Micro risk to macro risk
as an examiner, you have a discussion with Today, with hindsight, we know that while
the bank managers and you learn about most of the micro risks appeared very small
their lending practices, and you kind of won- at the time, their sum was far less than the
der,“How well-controlled is all of this?” macro risk that was silently building up.
The loan officers will give you some very That’s the key thing: A collection of negligible
good arguments about what their business micro risks can add up to a far greater macro
is and how the risks are being controlled. risk. Focusing on individual institutions and
First, they are not really storing the loans on controlling risks on a firm-by-firm basis are
their books. They are underwriting the loans not enough for detecting and controlling
with the full intention of packaging them system-wide stress points.
into securities. They have to build up a critical This is why we need macroprudential
mass before securitisation, but they are not supervision and regulation.
going to keep the loans. Suppose for a particular class of assets,
values decline on an economy-wide basis.
Banks not in storage business This means losses are going to be taken at
From the banks’ perspective, they are not in the macro level. Perhaps managers at a few
the storage business. They are in the trans- individual banks can be smart, foresee the
portation business. It is rather short term – 60, price declines, and liquidate their positions
90 days. Presumably, the risk is only propor- in time to avoid large losses at their institu-
tional to how long they are holding on to it tion. But the macro economy has to take
– which is not very long. Furthermore, dur- these losses, and that’s where we get stuck.
ing this period, real estate prices are going Not everyone can get through the exit door
up, delinquencies are negligible, and banks at once; someone has to end up bearing the
have a variety of hedges in place. They look macro losses.
at commercial real estate prices and think, if
needed, they can get out of their portfolio at Critical regulatory role
little cost. And even if some losses material- This is why macroprudential regulations that
ize, they have adequate capital. aim to assess and control system-wide risks
I have some interesting people on my staff should play a critical role in our regulatory
who can push back in a pretty challenging structure.
fashion. But at the end of the day, after care- For instance, dynamic capital require-
fully considering the banks’ arguments, they ments and loan loss provisions that vary over
think: “All right, I guess the loan officers are the cycle can temper some of the boom-bust

trends we have seen in the past. History Such procedures also enable supervisors
shows that during boom times, when finan- to identify best practices in risk manage-
cial institutions are perhaps in an exuber- ment and to push banks with weak controls
ant state, they may not price risks fully in to improve and adopt these industry best
their underwriting and risk-management practices. Indeed, supervisors at the Federal
decisions. Reserve have already begun to adopt such
During slumps faced with eroding capital an approach.
cushions, increased uncertainty, and binding
capital constraints, some institutions may Making the right call
become overcautious and excessively tighten However, even with such macroprudential
lending standards. Both behaviours tend to strategies, we are going to face challenges.
amplify the business cycle. Varying required Let’s think about what, as a hypothetical
capital loan loss provisions over the cycle macroprudential regulator, we would have
could serve to offset some of this volatility. to do. What should be the early call focus?
We saw the advantages of a systemic, What should we be looking at? When should
macroprudential approach first-hand dur- we be looking at it? How confident are we
ing the implementation of the Supervisory that that we are actually going to be able to
Capital Assessment Program (SCAP), the identify the problem? A macroprudential
so-called “stress tests.” Last spring, the regulator is confronted with the same type of
Federal Reserve led a co-ordinated exami- questions a microprudential regulator faces,
nation of the largest 19 US banks. but at a system-wide level.
Consider these questions within the
“Stress tests” forward looking context of commercial real estate. The facts
We reviewed the institutions simultaneously, are, today, CMBS and CRE loans have large
applying a common set of assumptions delinquencies. Could anyone have made this
and scenarios across all of them. Such an call confidently in time to arrest the problems
approach provided us with a view of these we face today?
banks in their totality, as well as the finan- From figure 2, we note that the outstand-
cial condition of individual institutions on a ing volume of CMBS ramps up in 2004, 2005.
stand-alone basis. The horizontal view was At the same time, commercial real estate
essential in assessing how risks taken indi- prices (shown in the middle panel) continue
vidually by each bank are correlated and to rise well into 2007. On the bottom panel,
how they can add up to more than the sum we see the performance of loans originated
of individual components. during this period, depending on when the
The review also had a forward-looking loans were made.
element that assessed the likely condi-
tion of the banks under a specific set of Delinquent loans and credit cycle
adverse economic conditions and deter- Loans originated later in the credit cycle
mined the amount of capital the banks are performing worse than older loans. For
would need under these “stress” conditions. instance, loans underwritten in 2005 did not

reach a one per cent delinquency rate until then we are not likely to make much pro-
about 42 months (3.5 years) after origina- gress. Shouting and supervision – together
tion. In contrast, loans made in 2008 reached – are essential.
the one per cent delinquency mark only six
months after origination. The progressively Multi-pronged approach
worsening performance of loans originated I raised some potential issues with both
later in the credit cycle is likely due to looser micro- and macro-prudential regulations
underwriting standards that supported the – how do we address these issues? This
issuance boom. is where we would take full advantage of
With the benefit of hindsight, I can point our multi-pronged approach to regulatory
to the inflection point in volume and say: reform. If we are not certain that a particu-
“I should have put my finger on that right lar approach may not be as effective as we
then.” would like, we can put more pressure on
At that point in the credit cycle,“shout- other levers to obtain a desired amount of
ing” would have been an important part of risk control. So, if we think that macropru-
risk-control, as it would have emphasised dential regulations may have some potential
potential risks to the market players. operational issues, we would need to imple-
ment more stringent capital and liquidity
Risk pricing and market exuberance requirements than we would otherwise to
But I can’t imagine that supervisors’concerns overcome these issues.
would have been taken seriously in 2005 or This is why we need a multi-pronged
2006 – even if they started going out and approach to a robust regulatory structure:
shouting to the heavens that there is a big, a structure that takes full advantage of the
big problem and we need to do more about existing tools supervisors have; a structure
it. Recall that, at that time, real estate prices that supplements the existing one with
were ramping up and delinquencies were dynamic capital requirements and a com-
low. prehensive approach to risk management;
Indeed, in 2007, the Federal Reserve, a structure that includes a macropruden-
along with other bank regulators, issued a tial supervisor than can monitor and assess
supervisory guidance on concentrations in incipient risks across institutions and mar-
commercial real estate.[5] We also gave a kets and, when necessary, impose higher
number of speeches prior to the crisis about regulatory requirements on firms that pose
risk pricing and about market exuberance systemic risks.
– to little avail. These warnings were largely
ignored and we got a lot of push-back from Disruptive ‘spillovers’
banks. During boom periods when risks are However, even with such a structure, it
silently building up, there are a lot of people would be hubris on the part of policy-makers
with a lot of money at stake who will come to assume that we would be able to pre-
out against such pronouncements. So, if pol- vent financial stress at all financial institu-
icy-makers do not follow words with actions, tions. Therefore, we also need to contain

the disruptive spillovers that result from the financial exuberance. But without super-
failure of systemically important institutions visory powers, there may be no choice. We
without resorting to bailouts or ad hoc res- know that time consistency issues can lead
cues. A necessary element of this is having a central bank to choose inflationary out-
a mechanism for resolving the failure of a comes in the short run, even though there
systemically important institution.[6] This is is no long-run tradeoff between output
something we currently lack in many cases, growth and price stability.
though there are proposals now under dis-
cussion that would provide this resolution Rogoff’s timely advice
power. Kenneth Rogoff – Professor of Economics
Another issue that arises in the regula- at Harvard University – pointed out that
tory reform debate is whether the central one way to deal with this issue would be
bank should be entrusted with supervision to appoint a conservative central banker
and regulation responsibilities. There are who would be tougher than the public. This
many synergies between monetary policy would ensure that appropriate decisions
and supervision and regulation that I and would be made and appropriate actions
others have discussed in previous speeches. would be taken.
[7] Let me point out a couple of reasons Now, consider the reaction function
why it might be optimal for a central bank of a central banker that has the additional
to have a key role in financial stability and responsibility for financial stability – but not
regulation. the additional tools provided by a super-
vision and regulation role. Such a central
Lender of last resort banker might have to act against exuberance
The reality is that central banks have the in financial markets more actively than it
unique ability to act as the “lender of last would otherwise.
resort” during financial crises. The central That would be entirely necessary and
bank cannot use this tool effectively if it is appropriate to preserve financial stability.
not knowledgeable about the financial con- However, that policy may not be the most
dition of the institutions it might lend to, appropriate one at that time for address-
particularly if such loans need to be made at ing the traditional goals of monetary policy
very short notice. of maximum sustainable employment and
The lender of last resort role inevitably price stability. A central bank with three goals
thrusts the central bank into efforts to pro- and only one lever is a recipe for producing
mote financial stability and avoid crises. If, some difficult policy dilemmas.
however, central banks have no supervision
and regulation tools, they are constrained Summation
to act with the only tool at their disposal – To sum up, it is clear that, in order to avoid a
monetary policy. situation like the one we have faced in the
I already mentioned that I am scepti- past two years, we need to fortify our regula-
cal about using monetary policy to control tory lines of defence. We need to change the

rules of regulation to be more efficient and 17, 2010 (http://www.federalreserve.gov/news-
effective in their design and implementation. events/press/bcreg/20100317a.htm).
But we also need to openly acknowledge the 6 See Evans (2009c) for my views on the advantages
challenges policy-makers and regulators are of resolution authority and the issues it would
likely to face in containing potential financial address.
crises. Despite all the challenges, I believe 7 For instance, see Bernanke (2010), Evans (2010),
that we can design a more effective regula- Kashyap (2010), and Volcker (2010).
tory structure through discussions such as
the one we are having today. • References
Bernanke, Ben S., 2010,The Federal Reserve’s Role
Notes in Bank Supervision, Testimony before the U.S.
1 For instance, see Evans (2009a and 2009b). House Committee on Financial Services,Washing-
2 For instance, in recent years, regulators have ton, DC, March 17. http://www.federalreserve.gov/
actively supported the development of the Trade newsevents/testimony/bernanke20100317a.htm
Information Warehouse (a central repository for Evans, Charles L., 2009a.“The International Financial
trade reporting of over-the-counter credit deriv- Crisis:Asset Price Exuberance and Macroprudential
atives contracts) and clearing houses for credit Regulation.” Remarks given at the 2009 International
default swaps, such as ICE Trust. Banking Conference on September 24, 2009 in
3 Non-current loans are those that are 90 days or Chicago, http://www.chicagofed.org/webpages/
more past due plus loans in nonaccrual status. publications/speeches/2009/09.24_IBC_speech.cfm.
4 At the end of 2004, return on equity at all com- Evans, Charles L., 2009b. “Should Monetary Policy
mercial banks in the U.S. was 13.08 per cent, near Prevent Bubbles?” Remarks given at the ‘Asset
its historical peak of 16.23 per cent in the second Price Bubbles and Monetary Policy” Conference on
quarter of 1993. Return on assets were similarly November 13, 2009 in Paris, http://www.chicagofed.
high, and net charge-offs accounted for only 0.68 org/webpages/publications/speeches/2009/11.13_
per cent of total loans, well below 1.31 per cent BoF_speech.cfm
reached at the end of 2001. Evans, Charles L., 2009c. “Too-Big-To-Fail: A Prob-
5 See, “SR 07-1 Interagency Guidance on Concen- lem Too Big to Ignore” Remarks given at the Euro-
trations in Commercial Real Estate” http://www. pean Economics and Financial Centre on July 1,
federalreserve.gov/boarddocs/srletters/2007/ 2009 in London. http://www.chicagofed.org/web-
SR0701.htm(external). More recently, the Fed- pages/publications/speeches/2009/07.01_EEFC_
eral Reserve issued a supervisory guidance on Speech.cfm
managing interest rate risk {“SR 10-1 Interagency Evans, Charles L., 2010a. CFA Society of Chicago
Advice on Interest Rate Risk,” http://www.feder- Distinguished Speaker Series: Luncheon Economic
alreserve.gov/boarddocs/srletters/2010/sr1001. Forecast.” Remarks delivered on March 4, 2010 in
htm(external)} and highlighted it in speeches Chicago, http://www.chicagofed.org/webpages/pub-
(for instance, see Kohn (2010)). In addition, the lications/speeches/2010/03_04_CFA_speech.cfm
Federal Reserve – along with the other Federal Evans, Charles L. 2010b, CFA Society of Chi-
banking agencies – issued a policy statement on cago Distinguished Speaker Series: Luncheon
funding and liquidity risk management on March Economic Forecast, March 4. http://www.chica-

gofed.org/webpages/publications/speeches/2010/ Federal Deposit Insurance Corporation’s Sympo-
03_03_CFA_speech.cfm sium on Interest Rate Risk Management on January
Kashyap, Anil K, 2010 Examining the Link between 29, 2010 in Arlington, Virginia. http://www.federal-
Fed Bank Supervision and Monetary Policy, Testi- reserve.gov/newsevents/speech/kohn20100129a.
mony before the House Financial Services Com- htm (external)
mittee, March 17. http://www.house.gov/apps/list/ Volcker, Paul, 2010, Statement, Testimony before
hearing/financialsvcs_dem/kashyap.pdf the House Financial Services Committee, March
Kohn, Donald L., 2010. “Focusing on Bank Inter- 17. http://www.house.gov/apps/list/hearing/financial-
est Rate Risk Exposure.” Remarks delivered at the svcs_dem/kashyap.pdf
Journal of Regulation & Risk – North Asia
Call for papers

ce
Complian
liance
Legal & Comp
impacts
is subject to the l change
Who exactly financia iance and risk
t Practices Act
? Global compl
Foreign Corrup t–
managem
en
Yuet-Ming, DLA Risk manag products ails a potent
In this paper, Tham t, examines the
ement s head of det
EastNet’ David Dekker, cial markets.
consultan
Piper Hong Kong ts of the FCPA in Asia.
Of ‘Black ce, in finan
Swans’, str complian reaction
pernicious effec ess mi cal
optimise che
d risk man tests & t oth-
companies
amongs
of companies –
many of which agement will just
be one of to offer these serv ut
ices.
es by hundreds Stand signs be able k abo
nies. The US legis- rather spea moni-
n Corrupt Practic
The US Foreig beginnings in the were
Fortune 500 compa ls by even- outlines the ard & Poor’s Da we saw
the first
a year ago the financial wor is These days
ld ers
that will
we should ks, or
its ded to these scanda positive ben vid Samuel About itutions
than ban name that
Act (FCPA), has gate Specia l lature respon in 1977. efits s mat ion in
cred it cris ncia l inst ider s, a
testing on of bank stress
when the Water the FCPA sfor the at fina prov
Watergate era, tually enacting to the of a tran months l world l service re activities ed
.
volun tary disclo- two main provisions in the last ncia tore d financia and futu
Prosecutor called
for
made There are
ibery provisions,
and the It is a big the bottom and
sformed
the fina
nge that
is
rs their curr
ent
dly we
have mov
nies that had FCPA – the anti-br Both the SEC and the challenge line. has tran the cha than cove k at how rapi banks
sures from compa to Richard a robust for banks ve pace. in scope Loo on the
contributions accounting provisi
ons. app
of worst-ca roach to managin
to build an explosi much broader e interaction ration) to
questionable of Justice (DOJ)
have juris-
g the risk downturn capital g is that wer physical rs of ope
ential campaign. US Department se
by definitio stress scenarios that occurrin expected. banks fall from (location and hou Internet banking
.
Nixon’s 1972 presid the FCPA. Generally,
the SEC
n, ,
uncover risk adequacy
prog inal ly big to fail or term s ts then but
over are alm conc ram rge,
d diction provisions and unlikely trigg ost
or unprece ered by apparently encies, and; applying
entrations
and risk depe to
s orig to be too g taken over by electronic paymen were still in cha
ver, these disclosures reveale prosec utes the accounting t issuers den nd- con sidered or bein fina n- ban ks shif ting to a
payments to thes ing re is
Howe
nable domestic provisions as agains dings ted events. drive busi
ness selec e improvements are either
fail are mo Again the digm cor-
not just questio elled the anti-bribery istrative procee How thro ugh tion inst itut ions that hug e para- tion ed the para l persons and
chann ever – for exam l a men sica ks
that had been h civil and admin ,
fying the risk solving the problem
perf
adjusted prici ormance analysis ple, financia lting in by as re we (phy r without the ban
but illicit funds business. throug utes companies
and nd, resu regarded world whe such as
ments to obtain as the DOJ prosec concentration of identi- ng that take and cially sou banks are s) pay each
othe
to foreign govern investi- where ibery provisions cies that give s and depe into account. s stress test risk- t in how poration new tech
nologies
led to subsequent uals for the anti-br rise to wor nden- results digm shif er banks. ent with
The information Exchange individ dings. vital if the st-case outc lic and oth involvem
US Securities and h criminal procee indu
vidual bank stry is to thrive –
omes is the pub around payments.
gations by the reveale d that throug s and Top-level
oversight ely revo lves mob ile
Commission (SEC)
which
to past two year are to turn the lesso if indi- Building king larg omers, los-
kept “slush funds” l The anti-bribery provision s to competit ns of a more robu Since ban ity to service cust viders nisations
many US issuers ibery provision
makes it Banks that ive advantag the process for st and com the abil the impact work pro ks and orga r pay-
officials and politica The FCPA’s anti-br tackle the e. uncoverin prehensive trust and determining oing risk Net future the ban
pay bribes to foreign money or anythi
ng be lauded
by investors issue head-on will prise is clearly, in part threats to the ente
g omer and A and othe iders
offer or provide ing a cust of the ong well as In the SWIFT, NACH ork prov B
parties. ary illegal to officials (“foreign”
mean- coming year and ance challeng , a corporat r- uld be partOpiniotion n , as as me netw
up with a volunt s of industry regulators in the e.The boar e govern- of it, sho t of the organisa new such orks beco money from A to
The SEC later came of value to foreign or most imp
mme under which any cor- S”) with the intent to obtain ortantly, will recuperation
and,
must have
the mot
d and top
exec utive man age men
ines s of existing and ying ment netw to sen d ork traf-
“non-U ss to ivation and you
disclosure progra payments ing directing busine tained profi be able to
deliv scrutinise s ng the risk rs using/bu s that allow for the netw ilari-
self-reported illicit business, or for tability gain
s. Meanwh er sus- able activ
and call a
halt to appa
the clout
to monitori custome nge charge you This brings sim
poration which was given retain that are well
rently profi and the more cha and will erate. , energy
with the SEC placed to ile, banks ities if thes products there are
-regulation
. ld that are fic that you gen such as telecom
and co-operated likely any person of value can include sponsor- consolida take adva
ntage of the term interests of
e are not t- ucts. But
Deregulation, non
nce that it would tion in
the enterpris the longer- these prod king wor s ncial
an informal assura Anything of a holi- can understa process need to be the intended in the ban
have kno
wn it. industrie ies. The fina
action. The result education, use e or do not challenges ties with e compan an important
and ‘desupervision’
ement for travel and , nd the risks sure they risk profi fit and as we be the cabl
enforc yment portfolios ing banking the future, not and
be safe from USD$300 ship of future emplo of potential embedde But contrary le of the orga suppliers rly undergo
ing
the disclosure that more than mas- day home, promise There is no To acqu isitio
d in the
ing corp
to popular
opin
nisation. threaten
ks will , in e our funds, ld is clea
was (a meals. improve ns. orate The ban ch to mov wor
nable payments nts, drinks and and strengthe enterprise risk man tion of putt governance is not
ion, improv-
icles by whi and folios; they 135
million in questio been made discou just veh ines the port
the 1970s) had n investor confi agem ent boar ing a ques- Black exam
defa ult nces
Professor William maintainepide
the ‘right’
sive amount in bank
147 s can take the lead dence, we d members executives our bala
Better boar in three relat think appropri in plac
ate incentive e and giving them
and
age fraud mic that North Asia
causes of the mortg
Asia d and seni ed areas: & Risk
ation & Risk North s. ulation .
l of Regd States
sight and or executive For the bank
Journal of Regul agement;
control of
ente over- sion to make has sweptJou the rnaUnite
re-invigorated rprise risk man s when
they the right
deci-
- business are
stress testi
ng and growth look difficult, e.g. whe
or when s n
Journal of risk managemgood in the upturn, demonstrate three
criti-
Regulation
& Risk Nor ent looks and they implicitly wholesale
expensive paper is a leading regulation and a
th Asia THE author of this g cal failures of e of fraud
and former bankin of private market disciplin Financial
academic, lawyer ‘white collar’ failure
r specialising in credit risk. The
and other forms of
163regulato one of the unsung heroes of the Enforcement Networ
k (FinCEN)
crime. As 1980s, Crimes us
debacle of the week on Suspicio
Savings & Loans released a study this
ys spends much that federally regu-
Professor Black nowada why financial Activity Reports (SARs) (sometimes) file
ing ns
of his time research lated financial institutio of Investigation
y to become dys- Bureau
markets have a tendenc his theory on with the Federal mortgag e
ned for evidence of
functional. Renow (FBI) when they find
Black lectures at the
‘control fraud’, Prof. fraud.
ri and Kansas City.
University of Missou Rob
‘The Best Way to
He is the author of Epidem ic warning
One: How Corpora
te of an “epidem of ic”
a Bank is to Own The FBI began warning
ans Looted the in their congressional
testi-
Executives and Politici nta- mortgage fraud years
S&L Industry.’ A
prominent comme ber 2004 – over five
l mony in Septem if the epidemic were
of the current financia It also warned that
tor on the causes of the ago. l cri-
crisis, Prof. Black
is a vocal critic it would cause a financia
has handled the not dealt with e was done to
Contact
ent remotely adequat
way the US governm ions sis. Nothing
g crisis and rewarded institut to the epidemi c by regulators, law
bankin y respond sector “market dis-
failed in their fiduciar enforcement, or private
that have clearly d and
epidemic produce
duties to investors. cipline.” Instead, the
in US housing prices
hyper-inflated a bubble
tary does not nec- a crisis so severe that
it nearly
Christopher Rogers
The following commen of that produced l
view of the Journal of the global financia
essarily represent the caused the collapse bailouts of
– North Asia. dented
Regulation and Risk system and led to unprece
s on criminal refer- largest banks.
“The new number many of the world’s
in the US are just in
rals for mortgage fraud
Editor in chief
33
Asia
ion & Risk North
Journal of Regulat
christopher.rogers@irrna.org

Central banking
Regulation or prohibition:
the $100 billion question
Andrew G. Haldane,Executive Director,
Financial Stability, Bank of England,
examines the social costs of systemic risk.
The car industry is a pollutant. Exhaust Public policy has long-recognised the
fumes are a noxious by-product. costs of systemic risk. They have been tack-
Motoring benefits those producing and led through a combination of regulation and,
consuming car travel services – the pri- at times, prohibition. Recently, a debate has
vate benefits of motoring. But it also begun on direct restrictions on some bank-
endangers innocent bystanders within ing activities – in other words, prohibition.
the wider community – the social costs of This is recognition of the social costs of sys-
exhaust pollution. temic risk. Bankers are in uproar.
This paper examines the costs of bank-
Public policy has increasingly recognised the ing pollution and the role of regulation and
risks from car pollution. Historically, they restrictions in tackling it. In light of the crisis,
have been tackled through a combination this is the US$100 billion question. The last
of taxation and, at times, prohibition. During time such a debate was had in earnest fol-
this century, restrictions have been placed on lowed the Great Depression. Evidence from
poisonous emissions from cars – in others then, from past crises and from other indus-
words, prohibition. This is recognition of the tries helps define the contours of today’s
social costs of exhaust pollution. Initially, car debate.This debate is still in its infancy. While
producers were in uproar. it would be premature to be reaching policy
The banking industry is also a pollut- conclusions, it is not too early to begin sifting
ant. Systemic risk is a noxious by-product. the evidence. What does it suggest?
Banking benefits those producing and
consuming financial services – the private Systemic costs
benefits for bank employees, depositors, One important dimension of the debate
borrowers and investors. But it also risks concerns the social costs of systemic risk.
endangering innocent bystanders within the Determining the scale of these social costs
wider economy – the social costs to the gen- provides a measure of the task ahead. It
eral public from banking crises. helps calibrate the intervention necessary to

tackle systemic risk, whether through regu- its counterfactual path in the absence of
lation or restrictions. So how big a pollutant crisis. In the UK, the equivalent output loss
is banking? is around 10 per cent. In money terms, that
There is a large literature measuring the translates into output losses of $4 trillion and
costs of past financial crises.1 This is typi- £140 billion respectively.
cally done by evaluating either the fiscal or Moreover, some of these GDP losses are
the foregone output costs of crisis. On either expected to persist. Evidence from past crises
measure, the costs of past financial crises suggests that crisis-induced output losses
appear to be large and long-lived, often in are permanent, or at least persistent, in their
excess of 10 per cent of pre-crisis GDP. What impact on the level of output if not its growth
about the present crisis? rate.3 If GDP losses are permanent, the pre-
sent value cost of crisis will significantly
Wealth transfer exceed today’s cost.
The narrowest fiscal interpretation of the cost By way of illustration, Table 1 looks at the
of crisis would be given by the wealth trans- present value of output losses for the world
fer from the government to the banks as a and the UK assuming different fractions of
result of the bailout. Plainly, there is a large the 2009 loss are permanent – 100 per cent,
degree of uncertainty about the eventual loss 50 per cent and 25 per cent. It also assumes,
governments may face. But in the US, this is somewhat arbitrarily, that future GDP is dis-
currently estimated to be around $100 bil- counted at a rate of five per cent per year and
lion, or less than one per cent of US GDP. that trend GDP growth is three per cent.4
For US taxpayers, these losses are (almost Present value losses are shown as a fraction
exactly) a $100 billion question. In the UK, of output in 2009.
the direct cost may be less than £20 billion, or
little more than one per cent of GDP. Astronomical figures
Assuming a systemic crisis occurs every As Table 1 shows, these losses are multiples
20 years, recouping these costs from banks of the static costs, lying anywhere between
would not place an unbearable strain on one and five times annual GDP. Put in
their finances. The tax charge on US banks money terms, that is an output loss equiva-
would be less than $5 billion per year, on UK lent to between $60 trillion and $200 trillion
banks less than £1 billion per year.2 Total pre- for the world economy and between £1.8
tax profits earned by US and UK banks in trillion and £7.4 trillion for the UK. As Nobel-
2009 alone were around $60 billion and £23 prize winning physicist Richard Feynman
billion respectively. observed, to call these numbers“astronomi-
But these direct fiscal costs are almost cal” would be to do astronomy a disservice:
certainly an underestimate of the damage there are only hundreds of billions of stars
to the wider economy which has resulted in the galaxy.“Economical”might be a better
from the crisis – the true social costs of cri- description.
sis. World output in 2009 is expected to It is clear that banks would not have deep
have been around 6.5 per cent lower than enough pockets to foot this bill. Assuming

Table 1. Present value of output losses (% of 2009 GDP)
Fraction of initial output loss which is permanent
25% 50% 100%
UK 130 260 520
World 90 170 350
Source: Bank calculations
Table 2. Average ratings difference for a sample of banks and building societies
2007 2008 2009 Average (2007–09)
UK 1.56 1.94 4 2.5

Global 1.68 2.36 2.89 2.31
Average 1.63 2.21 3.24 2.36
1. All figures are year-end
2. The UK sample contains 16 banks and building societies in 2007 and 2008 and 13 in 2009. The global sample contains a sample of 26 banks
across a range of sizes and countries for 2007 and 28 banks in 2008 and 2009.
Source: Moody’s and Bank calculations.
that a crisis occurs every two decades, the than measure. But one particularly simple
systemic levy needed to recoup these crisis proxy is provided by the rating agencies, a
costs would be in excess of $1.5 trillion per number of whom provide both “support”
year. The total market capitalisation of the and“standalone”credit ratings for the banks.
largest global banks is currently only around The difference in these ratings encompasses
$1.2 trillion. Fully internalising the output the agencies’ judgment of the expected gov-
costs of financial crises would risk putting ernment support to banks.
banks on the same trajectory as the dino-
saurs, with the levy playing the role of the Hidden government support
meteorite. Table 2 looks at this average ratings differ-
It could plausibly be argued that these ence for a sample of banks and building
output costs are a significant over-statement societies in the UK, and among a sample of
of the damage inflicted on the wider econ- global banks, between 2007 and 2009. Two
omy by the banks. Others are certainly not features are striking. First, standalone rat-
blameless for the crisis. For every reckless ings are materially below support ratings, by
lender there is likely to be a feckless bor- between 1.5 and four notches over the sam-
rower. If a systemic tax is to be levied, a more ple for UK and global banks. In other words,
precise measure may be needed of banks’ rating agencies explicitly factor in material
distinctive contribution to systemic risk. government support to banks.
One such measure is provided by the Second, this ratings difference has
(often implicit) fiscal subsidy provided to increased over the sample, averaging over
banks by the state to safeguard stability. one notch in 2007 but over three notches by
Those implicit subsidies are easier to describe 2009. In other words, actions by government

Table 3. Average ratings difference for UK banks and building societies(a)
Category Mean Max difference in sample Min difference in sample
2007
Large banks 2.67 12 1
Small banks 0.14 1 0
2008
2009
Average (2007–2009)
(a) The ‘Large’ category includes HSBC, Barclays, RBS, Lloyds TSB, Alliance & Leicester and Bradford & Bingley (up to 2008), and Nationwide. The
‘Small’ category includes building societies: Chelsea, Coventry, Leeds, Principality, Skipton, West Bromwich and Yorkshire.
The ratings are year-end.
Source: Moody’s and Bank calculations.
during the crisis have increased the value into a monetary measure of the implied fis-
of government support to the banks. This cal subsidy to banks. This is done by map-
should come as no surprise, given the scale ping from ratings to the yields paid on banks’
of intervention. Indeed, there is evidence bonds;6 and by then scaling the yield dif-
of an up-only escalator of state support to ference by the value of each banks’ ratings-
banks dating back over the past century.5 sensitive liabilities.7 The resulting money
amount is an estimate of the reduction in
‘Too big to fail’ problem banks’ funding costs which arises from the
Table 3 takes the same data and divides perceived government subsidy.
the sample of UK banks and building soci- Table 4 shows the estimated value of
eties into “large” and “small” institutions. that subsidy for the same sample of UK
Unsurprisingly, the average rating difference and global banks, again between 2007 and
is consistently higher for large than for small 2009. For UK banks, the average annual
banks. The average ratings difference for subsidy for the top five banks over these
large banks is up to five notches, for small years was over £50 billion – roughly equal to
banks up to three notches. This is pretty UK banks’ annual profits prior to the crisis.
tangible evidence of a second recurring phe- At the height of the crisis, the subsidy was
nomenon in the financial system – the “too larger still. For the sample of global banks,
big to fail”problem. the average annual subsidy for the top five
It is possible to go one step further and banks was just less than $60 billion per year.
translate these average ratings differences These are not small sums.

Table 4. Estimated subsidy for UK banks and building societies (£bn) and global
banks ($bn)
2007 2008 2009 Average (2007–09)
Subsidy/ Subsidy/ Subsidy/ Subsidy/
Subsidy Total Subsidy Total Subsidy Total Subsidy Total
liabilities liabilities liabilities liabilities
Sample
UK 11 59 107 59
Total
Total 9 52 103 55
Big 5
Average 2 0 10 1 26 2 13 1
Total 1 7 3 4
Medium
Average 0 0 3 3 3 2 2 2
Total 0 1 1 1
Small
Average 0 0 0 1 0 1 0 1
Sample
Global 37 220 250 169
Total
Total 18 83 71 57
Big 5
Average 4 0 17 1 14 1 12 1
See footnotes for tables 2 and 3 for details on sample.
Source: Moody’s, Bank of America Merrill Lynch, Bankscope published by Bureau van Dijk Electronic Publishing and Bank calculations
Table 4 also splits UK banks and building has widened during the crisis. They calcu-
societies into “Big 5”, “medium” and “small” late an annual subsidy for the 18 largest US
buckets. As might be expected, the large banks of over $34 billion per year. Applying
banks account for more than 90 per cent of the same method in the UK would give an
the total implied subsidy. On these metrics, annual subsidy for the five largest banks of
the too-big-to-fail problem results in a real around £30 billion.
and ongoing cost to the taxpayer and a real
and ongoing windfall for the banks. If it were Banking pollution
ever possible to mint a coin big enough, This evidence can provide only a rough
these would be the two sides of it. guide to systemic scale and cost. But the
These results are no more than illus- qualitative picture it paints is clear and con-
trative – for example, they make no allow- sistent. First, measures of the costs of crisis,
ance for subsidies arising on retail deposits. or the implicit subsidy from the state, suggest
Nonetheless, studies using different meth- banking pollution is a real and large social
ods have found similarly sized subsidies. For problem. Second, those entities perceived to
example, Baker and McArthur ask whether be “too big to fail” appear to account for the
there is a difference in funding costs for US lion’s share of this risk pollution. The public
banks either side of the $100 billion asset policy question, then, is how best to tackle
threshold – another $100 billion question.8 these twin evils.
They find a significant wedge in costs, which To date, the public policy response has

largely focussed on the role of prudential restrictions when striking this cost/benefit
regulation in tackling these problems. Higher balance.
buffers of capital and liquid assets are being In the real world, there is consider-
discussed to address the first problem. And able uncertainty about both costs and ben-
add-ons to these capital and liquidity buffers efits. Weitzman’s framework tells us how to
for institutions posing the greatest systemic choose between pollution-control instru-
risk are being discussed to address the sec- ments in this setting. If the marginal social
ond.9 In essence, this is a taxation solution to benefits foregone of the wrong choice are
the systemic risk pollution problem.10 large, relative to the private costs incurred,
There is a second approach. On January then quantitative restrictions are optimal.
21, 2010, US President Barack Obama pro- Why? Because fixing quantities to achieve
posed placing formal restrictions on the busi- pollution control, while letting prices vary,
ness activities and scale of US banks. Others does not have large private costs. When the
have made complementary proposals for marginal social benefit curve is steeper than
structural reform of banking.11 Typically, the marginal private cost curve, restrictions
these involve separation of bank activities, dominate.
either across business lines or geographies. The results flip when the marginal cost/
In essence, this is the prohibition solution to benefit trade-offs are reversed. If the private
the systemic pollution problem. costs of the wrong choice are high, relative
to the social benefits foregone, fixing these
The great debate costs through taxation is likely to deliver the
This sets the scene for a great debate. It is better welfare outcome. When the marginal
not a new one. The taxation versus prohibi- social benefit curve is flatter than the mar-
tion question crops up repeatedly in public ginal private cost curve, taxation dominates.
choice economics. For centuries it has been So the choice of taxation versus prohibi-
central to the international trade debate on tion in controlling pollution is ultimately an
the use of quotas versus subsidies. During empirical issue.
this century, it has become central to the To illustrate the framework, consider the
debate on appropriate policies to curtail car- path of financial regulation in the US over
bon emissions.12 the past century. The US announcements
In making these choices, economists in January are in many respects redolent
have often drawn on Martin Weitzman’s of US financial reforms enacted during the
classic public goods framework from the late 1920s and early 1930s. Then, restric-
early 1970s.13 Under this framework, the tions were imposed on both bank size and
optimal amount of pollution control is found scope, in the form of the McFadden (1927)
by equating the marginal social benefits of and Glass-Steagall (1933) Acts. The history
pollution-control and the marginal private of both, viewed through Weitzman’s lens, is
costs of this control. With no uncertainty illuminating for today’s debate.
about either costs or benefits, a policy-maker The McFadden Act (1927) in the US
would be indifferent between taxation and gave nationally-chartered banks broadly the

same branching rights as state banks within branching for both domestic BHCs and for-
the state. But it also confirmed the effec- eign banks.
tive prohibition on national banks opening The rationale for this change of heart
new branches across state lines that had was a mirror-image of the 1920s. Large
previously been implicit in the US National banks convinced politicians of the high pri-
Banking Act (1864). It covered a wide range vate costs of restrictions, which inhibited
of banking functions, including deposit-tak- the efficiency of their offering to the pub-
ing and brokerage. lic. In Weitzman’s framework, private costs
The motivation behind the Act appears trumped social benefits. The effects of the
to have been in part political, reflecting lob- removal of interstate restrictions were dra-
bying by small unit banks under threat from matic. The average size of US banks, relative
larger competitors. But it also had an eco- to GDP, has risen roughly threefold over the
nomic dimension, as a check on the dan- past 20 years (Chart 1). Too-big-to-fail was
gers of “excessive concentration of financial reborn in a new guise.
power”.14 The same too-big-to-fail argu- The US Banking Act (1933) was co-
ments are of course heard today, though sponsored by Senator Carter Glass and
the concerns then were competition rather Representative Henry Steagall – hence
than crisis-related ones. Weitzman’s mar- “Glass-Steagall”. It prevented commer-
ginal social benefit curve was perceived to cial banks from conducting most types of
be steep, made so by state-level competition securities business, including principal trad-
concerns. ing, underwriting and securities lending. It
also banned investment banks from taking
1980s watershed deposits. The key functions of commercial
McFadden appeared to be fairly effective in and investment banking were effectively
limiting the size of US banks from the 1930s prised apart.
right through to the mid-1970s. Over this The Act was motivated by stability con-
period, the average asset size of US banks cerns in the light of the Great Depression.
in relation to nominal GDP was roughly flat The stock market boom of the 1920s had
(Chart 1). As recently as the early 1980s, it been fuelled by cheap credit from the banks.
was still at around its level at the time of the The stock market crash of 1929 brought that,
Great Depression. and a great many US banks, to a shudder-
The 1980s marked a watershed, with ing halt. Among many banks, net losses on
interstate branching restrictions progres- securities were as great as losses on loans.
sively lifted. States began to open their bor- These losses transmitted to the real economy
ders to out-of-state bank holding companies through a collapse in lending, whose stock
(BHCs). The 1982 Garn-St Germain Act halved between 1929 and 1933.
allowed any BHC to acquire failed banks and Against this economic backdrop, and
thrifts, regardless of the state law. Finally, the amid heated banker-bashing, it is easy to see
Riegle-Neal Act of 1994, which took effect in how the social benefits of segregation were
1997, largely lifted restrictions on interstate perceived as far outweighing the private

Chart 1: Average assets relative to GDP of US commercial banks
(a)
(a)
Chart 1. Average assets relative to GDP of US commercial banks
0.014
0.012
Average Assets per Commercial Bank as a a
percentage of Nominal GDP
0.010
0.008
0.006
0.004
0.002
0.000
34
38
42
46
50
54
58
62
66
70
74
78
82
86
90
94
98
02
06
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
Year
Average Asset Size of Commercial Banks scaled by Nominal GDP
(a) Blue vertical line represents the 1982 Garn-St Germain Act, green vertical line represents the 1994 Riegle-Neal
(a) Blue vertical line represents the 1982 Garn-St Germain Act, green vertical line represents the 1994 Riegle-Neal Act,red vertical line
represents the Riegle-Neal Act coming into effect in 1997.
Act,
red vertical
Source: FDIC andline represents the Riegle-Neal Act coming into effect in 1997.
www.measuringworth.org
Source: FDIC and www.measuringworth.org
costs at the time. Kennedy (1973) describes Glass and Steagall made just such a distinc-
how“Stock dealings which had made bank- tion. They underpinned it with legislation,
ers rich and respected in the era of afflu- signed by President Roosevelt in June 1933.
ence now glared as scarlet sins in the age of As with McFadden, Glass-Steagall
depression. appears to have been effective from the
1930s right up until the latter part of the
Embittered public 1980s. Measures of concentration in the
Disillusionment with speculators and secu- US banking system remained broadly flat
rities merchants carried over from invest- between the 1930s and the late 1980s (Chart
ment bankers to commercial bankers; the 2). But competitive pressures were build-
two were often the same, and an embittered ing from the late 1970s onwards. Strains
public did not care to make fine distinctions”. on US commercial banks intensified from

Chart 2. Concentration of the US banking system(b)
Chart 2. Concentration of the US banking system(b)
45.00
Total assets of top 3 US banks (as % of total com m ercial
40.00
35.00
banking sector assets)
30.00
25.00
20.00
15.00
10.00
5.00
0.00
1935 1939 1943 1947 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007
(a)
(a) Red line
Red represents
line the Gramm-Leach-Bliley
represents Act (1999) which
the Gramm-Leach-Bliley revoked
Act restrictions
(1999) which of Glass-Steagall
revoked restrictions of Glass-Steagall
(b)
Top 3 banks by total assets as a % of total banking sector assets
(b) Top
(c)
3 banks by total assets as a % of total banking sector assets
Data includes only the insured depository subsidiaries of banks to ensure consistency over time — for example, non-deposit subsidiaries
(c) Data
are notincludes
included. only the insured depository subsidiaries of banks to ensure consistency over time - for example,
non-deposit subsidiaries are not included.
Source: FDIC
alternative
Source: FDIClending vehicles (such as mutual and dramatic. The share of the top three
funds and commercial paper markets) and largest US banks in total assets rose fourfold,
Chart 3. Largest
from overseas UKThe
banks. company’s
private costsassets
of in each
from sector
10 per cent torelative to between
40 per cent GDP 1990
restrictions were rising. and 2007 (Chart 2). A similar trend is dis-
Legislators responded. After 1988, secu- cernible internationally: the share of the top
Per cent
rities affiliates within BHCs were permitted, five largest global banks in the assets of160
the
though were still subject to strict limits. In largest 1,000 banks has risen from around
1999, the Gramm-Leach-Bliley Act revoked 140
eight per cent in 1998 to double that in 2009.
the restrictions of Glass-Steagall, allowing 2007 120
co-mingling of investment and commercial Massive growth of banks
2000
banking. This came as a specific response to This degree of concentration, combined with
100
the perceived high private costs of restric- the large size of the banking industry rela-
tions relative to the perceived social benefits tive to GDP, has produced a pattern which80is
– again, in a reversal of the Weitzman calcu- not mirrored in other industries. The largest
lus from the early 1930s. 60
banking firms are far larger, and have grown
As with size, the effects of liberalisation far faster, than the largest firms in other
40
on banking concentration were immediate industries (Chart 3). With the repeal of the
20
Journal of Regulation & Risk North Asia
0 109
ng
ce
gy
s.
ng
es
ail
gy
ia
Source: FDIC
Chart 3. Largest UK company’s assets in each sector relative to GDP

Per cent
160
140
2007 120
2000
100
80
60
40
20
0
Banking
Insurance
Oil/Energy
Telecomms.
Mining
Utilities
Pharm.
Retail
Technology
Media
Source: Bureau van Dijk Electronic Publishing, International Monetary Fund and Bank calculations.
McFadden and Glass-Steagall Acts, the too- robustness and incentives. Each has a
big-to-fail problem has not just returned but potentially important bearing on systemic
flourished. resilience and hence on the social benefits of
In the light of the Great Recession, and restrictions.
the large apparent costs of too-big-to-fail,
does Weitzman’s cost-benefit calculus sug- (a) Modularity
gest there is a case for winding back the clock In 1973, Nobel-prizing winning economist
to the reforms of the Great Depression? Robert Merton showed that the value of a
Determining that requires an assessment of portfolio of options is at least as great as the
the benefits and costs of restrictions. value of an option on the portfolio.15 On the
face of it, this seems to fly in the face of mod-
Benefits of prohibition ern portfolio theory, of which Merton him-
The potential benefits of restricting activity self was of course one of the key architects.
in any complex adaptive system, whether Whatever happened to the benefits of port-
financial or non-financial, can roughly be folio diversification?
grouped under three headings: modularity, The answer can be found in an unlikely

Source: FDIC

Per cent
160
140
2007 120
2000
100
80
60
40
20
0
Banking
Insurance
Oil/Energy
Telecomms.
Mining
Utilities
Pharm.
Retail
Technology
Media
source – Al’Qaeda. Although the precise undermining the operations of other cells is
organisational form of Al’Qaeda is not severely reduced. That, of course, is precisely
known with certainty, two structural char- why Al’Qaeda has chosen this organisa-
acteristics are clear. First, it operates not as tional form. Al’Qaeda is a prime example of
a centralised, integrated organisation but modularity and its effects in strengthening
rather as a highly decentralised and loose systemic resilience.
network of small terrorist cells. Second, as There are many examples from other
events have shown, Al’Qaeda has exhibited industries where modularity in organi-
considerable systemic resilience in the face sational structure has been deployed to
of repeated and ongoing attempts to bring enhance systemic resilience. Computer
about its collapse. manufacture is one. During the late 1960s,
These two characteristics are closely con- computers were highly integrated systems.
nected. A series of decentralised cells, loosely Gradually, they evolved into the quintes-
bonded, make infiltration of the entire sential modular system of today, with dis-
Al’Qaeda network extremely unlikely. If any tinct modules (CPU, hard disk, keyboard)
one cell is incapacitated, the likelihood of this which were replaceable if they failed without

endangering the functioning of the system strengthen system resilience. In all of these
as a whole. This improved resilience and cases, policy intervention was required to
reliability. effect this change in structure. The case for
In the computing industry, modularity doing so was particularly strong when the
appears to have had an influence on indus- risk of viral spread was acute. In some cases,
try structure. Since the 1970s, the computer intervention followed specific instances of
hardware industry has moved from a highly systemic collapse.
concentrated structure to a much more frag- The North American electricity outage in
mented one. In 1969, IBM had a market August 2003 affected 55 million people in the
share of over 70 per cent. By this century, the US and Canada. It had numerous adverse
market share of the largest hardware firm knock-on effects, including to the sewage
was around a third of that. Modularity has system, telephone and transport network
meant the computer industry has become and fuel supplies. A number of people are
less prone to“too-big-to-fail”problems. believed to have died as a consequence. This
event led to a rethinking of the configuration
The domino effect of the North American electricity grid, with
Other examples of modularity in organisa- built-in latencies and stricter controls on
tional structures include: power circulation.
• The management of forest fires, which
typically involves the introduction of fire- Sparrow gets the arrow
breaks to control the spread of fire;16 In the mid-1980s, an attempt on the
• The management of utility services, such world domino-toppling record – at that time,
as water, gas and electricity, where the net- 8,000 dominos – had to be abandoned when
work often has built-in latencies and restric- the pen from one of the TV film crew caused
tions to avoid overload and contagion; the majority of the dominos to cascade
• The management of infectious diseases prematurely. Twenty years later a sparrow
which these days often involves placing disturbed an attempt on the world dom-
restrictions on travel, either within a country ino-toppling record. Although the sparrow
(as in the case of foot-and-mouth disease in toppled 23,000 dominos, 750 built-in gaps
the UK) or outside of it (Asia’s H5N1);17 averted systemic disaster and a new world
• The control of computer viruses across the record of over four million dominos was still
world wide web, which is typically achieved set. No-one died, except the poor sparrow
by constructing firewalls which restrict access which (poetically if controversially) was shot
to local domains; by bow and arrow.
• Attempts on the world domino toppling So to banking. It has many of the same
record, which involve arranging the domi- basic ingredients as other network indus-
nos in discrete blocks to minimise the risk of tries, in particular the potential for viral
premature cascades. spread and periodic systemic collapse. For
These are all examples where modu- financial firms holding asset portfolios,
lar structures have been introduced to however, there is an additional dimension.

Chart 4. Bank size and volatility Chart 5. Bank diversification and volatility
Income 3.0% Income 3.0%

volatility volatility
2.5% 2.5%
2.0% 2.0%
R2 = 0.013
R = 0.0857
2
1.5% 1.5%
1.0% 1.0%
0.5% 0.5%
0.0% 0.0%
0 1,000 2,000 3,000 4,000 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7
Average assets ($m) Diversification
Notes: Average assets are calculated for 24 banks between 2006 and 2008. Income Notes: Pre-crisis diversification and income volatility for a sample of 25 banks.
volatility is measured as the standard deviation of operating income (per asset) over Diversification index based on revenue concentration, as described in the main text.
the period 1997-2008. Source: Bankscope, published accounts and Bank calculations.
Source: Bankscope, published accounts and Bank calculations.
Chart 6. Bank size and write downs Chart 7. Bank diversification and write downs
Write 7% Write 7%
downs per downs per
asset 6% asset 6%
5% 5%
4% 4%
R2 = 0.0009 R2 = 0.0919
3% 3%
2% 2%
1% 1%
0% 0%
0 1,000 2,000 3,000 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7
T otal Assets ($bn) Diversification
Notes: Total assets for a sample of 21 banks for 2007. Cumulative write downs over Notes: Sample of 21 banks. Cumulative write downs over the course of the crisis are
the course of the crisis are shown (from 2007 Q4 to 2009 Q3). shown (from 2007 Q4 to 2009 Q3).
Source: Bankscope, published accounts and Bank calculations. Source: Bankscope, published accounts and Bank calculations.
This can be seen in the relationship between ought to make banks less prone to idiosyn-
diversification on the one hand and diversity cratic risk to their asset portfolio. In the limit,
on the other.18 The two have quite different banks can completely eradicate idiosyncratic
implications for resilience. risk by holding the market portfolio. The
In principle, size and scope increase the “only” risk they would face is aggregate or
diversification benefits. Larger portfolios systematic risk.

But if all banks are fully diversified and between diversification and diversity, the
hold the market portfolio, that means they latter appears to have held the upper hand.
are all, in effect, holding the same portfo- Bigger and broader banking does not obvi-
lio. All are subject to the same systematic ously appear to have been better, at least in
risk factors. In other words, the system as a a risk sense. In banking, as on many things,
whole lacks diversity. Other things equal, it is Merton may have had it right.
then prone to generalised, systemic collapse.
Homogeneity breeds fragility. In Merton’s (b) Robustness
framework, the option to default selectively The Merton result holds in a world in which
through modular holdings, rather than com- investors form judgments based on knowl-
prehensively through the market portfolio, edge of the distribution of risk. But in com-
has value to investors. plex dynamic systems, the distribution of
The precise balance between diversifica- risk may be lumpy and non-linear, subject
tion and diversity depends on banks’balance to tipping points and discontinuities.21 Faced
sheet configuration. What does this suggest? with this, the distribution of outcomes for
Charts 4 and 5 plot the income variability of the financial system as a whole may well be
a set of 24 global banks against their asset incalculable. The financial system may oper-
size and a measure of the diversity of their ate in an environment of uncertainty, in the
business model.19 Knightian sense, as distinct from risk.
There is no strong relationship between There is a literature on how best to regu-
either size or diversity and income volatil- late systems in the face of such Knightian
ity. If anything the relationship is positively uncertainty.22 It suggests some guideposts
sloped, with size and diversity increasing for regulation of financial systems. First, keep
income variability, not smoothing it. it simple. Complex control of a complex sys-
tem is a recipe for confusion at best, catas-
Positively sloped trophe at worst. Complex control adds, not
Charts 6 and 7 look at banks’ experience subtracts, from the Knightian uncertainty
during the crisis. Size and diversity are plot- problem. The US Constitution is four pages
ted against banks’ write-downs (per unit of long. The recently-tabled Dodd Bill on US
assets). Again, if anything, these relation- financial sector reform is 1,336 pages long.
ships are positively sloped, with larger, more Which do you imagine will have the more
diversified banks suffering proportionally lasting impact on behaviour.
greater losses. Second, faced with uncertainty, the best
This is consistent with evidence from approach is often to choose a strategy which
econometric studies of banking conglom- avoids the extreme tails of the distribution.
erates which has found that larger banks, if Technically, economists call this a“minimax”
anything, exhibit greater risk due to higher strategy – minimising the likelihood of the
volatility assets and activities.20 worst outcome. Paranoia can sometimes be
This evidence is no more than illustra- an optimal strategy. This is a principle which
tive. But it suggests that, in the arm wrestle engineers took to heart a generation ago. It is

especially evident in the aeronautical indus- was anything but simple, comprising many
try where air and space disasters acted as thousands of pages and taking 15 years
beacons for minimax redesign of aircraft and to deliver. It was calibrated largely to data
spaceships. drawn from the Great Moderation, a period
Third, simple, loss-minimising strategies characterised by an absence of tail events –
are often best achieved through what econ- more minimin than minimax. Basel II was
omists call “mechanism design” and what underpinned by a complex menu of capital
non-economists call “structural reform”. In risk weights. This was fine-line, not red-line,
essence, this means acting on the under- regulation. In short, Basel II satisfied few of
lying organisational form of the system, the robustness criteria. And so it proved,
rather than through the participants oper- overwhelmed by the recent crisis scarcely
ating within it. In the words of economist after it had been introduced.
John Kay, it is about regulating structure not
behaviour.23 (c) Incentives
Taken together, these three features Tail risk within some systems is determined
define a “robust” regulatory regime – robust by God – in economist-speak, it is exog-
to uncertainties from within and outside the enous. Natural disasters, like earthquakes
system. Using these robustness criteria, it is and floods, are examples of such tail risk.
possible to assess whether restrictions might Although exogenous, even these events
be preferable to taxation in tackling bank- have been shown to occur more frequently
ing pollution. To illustrate this, contrast the than a normal distribution would imply.24
regulatory experience of Glass-Steagall (a God’s distribution has fat tails.
restrictions approach) and Basel II (a taxa- Tail risk within financial systems is
tion approach). not determined by God but by man; it is
not exogenous but endogenous. This has
Criteria satisfied important implications for regulatory con-
Glass-Steagall was simple in its objec- trol. Finance theory tells us that risk brings
tives and execution. The Act itself was only return. So there are natural incentives within
17 pages long. Its aims were shaped by an the financial system to generate tail risk and
extreme tail event (the Great Depression) to avoid regulatory control. In the run-up
and were explicitly minimax (to avoid a to this crisis, examples of such risk-hunting
repetition). It sought to achieve this by act- and regulatory arbitrage were legion. They
ing directly on the structure of the financial included escalating leverage, increased trad-
system, quarantining commercial bank and ing portfolios and the design of tail-heavy
brokering activities through red-line regula- financial instruments.25
tion. In other words, Glass-Steagall satisfied The endogeneity of tail risk in bank-
all three robustness criteria. And so it proved, ing poses a dilemma for regulation. Putting
lasting well over half a century without a sig- uncertainties to one side, assume the policy-
nificant systemic event in the US. maker could calibrate perfectly tail risk in
The contrast with Basel II is striking. This the system today and the capital necessary

to insure against it. In an echo of the 1979 equity over debt finance. This same argu-
Madness song, banks would then have ment is frequently heard in debates about
incentives to position themselves“One Step more modest rises in banks’ capital ratios.
Beyond” the regulatory buffer to harvest the But there are good counter-arguments that
higher returns that come from assuming need also to be weighed.
tail risk. They do so safe in the knowledge By lowering risk, higher levels of equity
that the state will assume some of this risk ought to lower banks’ cost of debt finance.
if it materialises. Tail risk would expand to Indeed, in a frictionless world Modigliani
exhaust available resources. Countless crises and Miller famously showed that this effect
have testified to this dynamic. would fully offset the higher cost of equity,
thereby leaving the total cost of capital for
Radical structural redesign banks unchanged.28 In other words, the cost
This dynamic means it is hazardous to of capital for a bank may be unaffected by its
believe there is a magic number for regula- capital structure, at least when distortions in
tory ratios sufficient to insure against tail risk the economy are small. Even when they are
in all states of the world. Because tail risk is large, some offset in debt costs is likely.
created not endowed, calibrating a capital
ratio for all seasons is likely to be, quite lit- Equity premium puzzle
erally, pointless – whatever today’s optimal It is possible to go one step further and argue
regulatory point, risk incentives mean that that higher bank capital ratios could poten-
tomorrow’s is sure to be different. tially lower banks’ cost of capital. The size
In response, some economists have proof the premium demanded by holders of
posed corner solutions to the systemic risk equity is a long-standing puzzle in finance
problem – in effect, radical structural rede- – the equity premium puzzle.29 Robert Barro
sign. Starting with Irving Fisher in the 1930s, has suggested this puzzle can be explained
some have proposed narrow banks with a by fears of extreme tail events.30 And what
100 per cent liquid asset ratio to protect the historically has been the single biggest cause
liquidity services banks provide.26 Others of those tail events? Banking crises. Boosting
have proposed mutual fund banks with a banks’ capital would lessen the incidence of
100 per cent equity ratio to safeguard banks’ crises. If this lowered the equity premium,
solvency.27 These limiting solutions are proof as Barro suggests, the cost of capital in the
to risk incentives. The one guaranteed safe economy could actually fall.
hiding place for the risk-fearing policy-
maker is the corner. The costs of prohibition
One criticism of these proposals is that Turning to the other side of the equation,
they might raise materially the cost of capi- what does existing evidence tell us about
tal to banks and hence to the real economy. the costs to banks of restrictions, whether
For example, 100 per cent capital ratios could on the scale or scope of their activities? In
cause the economy-wide cost of capital to Weitzman’s framework, how significant are
sky-rocket given the premium charged for the private costs of restrictions? Fortunately,

there is a reasonably rich empirical literature Two comprehensive studies in the mid-
on economies of scale and scope in banking. 1990s found that economies of scale in
banking are exhausted at relatively mod-
(a) Economies of scale est levels of assets, perhaps between $5bil-
On economies of scale, the literature tends lion-$10 billion.33 A more recent 2004 survey
either to look at the cross-sectional effi- of studies in both the US and Europe finds
ciency of banks of different sizes, or the evidence of a similar asset threshold.34 Even
time-series efficiency of banks either side of once allowance is made for subsequent bal-
a merger. As it turns out, both roads reach ance sheet inflation, this evidence implies
the same destination. Economies of scale that economies of scale in banking may
appear to operate among banks with assets cease at double-digit dollar billions of assets.
less, perhaps much less, than $100 billion.
But above that threshold there is evidence, Striking uniformity
if anything, of diseconomies of scale. The Evidence from banking mergers offers lit-
Weitzman marginal private cost curve is tle more encouragement. There is no strong
U-shaped.31 evidence of increased bank efficiency after
Experience in the US following the a merger or acquisition.35 And there is lit-
McFadden Act suggests size in banking can tle to suggest cross-activity mergers create
bring benefits. Over 9,000 US banks failed economic value.36 That rather chimes with
during the Great Depression, the majority recent crisis experience. Of the bank merg-
of which were unit banks. Friedman and ers and acquisitions which have taken place
Schwarz (1963) blame the absence of bank recently, the majority have resulted in the
branching for the high failure rate among US merged firm under-performing the mar-
banks. The costs of limited branching were ket in the subsequent period. Of course,
also felt well after the Great Depression in all econometric studies have their limita-
higher-cost provision of banking services, tions so these results do not close the case.
in particular for larger companies using Nonetheless, the uniformity of the evidence
lending syndicates to finance large-scale is striking.
investment.32
US experience after McFadden chimes (b) Economies of scope
with cross-country evidence drawn, in par- Turning from economies of scale to econo-
ticular, from developing countries. For exam- mies of scope, the picture painted is little
ple, using a dataset of 107 countries, Barth et different. Evidence from US bank holding
al (2004) assess the effects of restrictions on companies suggests that diversification
the efficiency and stability of the financial gains from multiple business lines may be
system. They find evidence that restrictions more than counter-balanced by heightened
are damaging to both, in particular barriers exposures to volatile income generating
to foreign bank entry. activities, such as trading.37 This mirrors the
Do those arguments resonate within evidence from Charts 4 and 5 and from the
advanced country banking systems today? Great Depression. Internationally, a recent

study of over 800 banks in 43 countries maintain is believed to lie below 150 – the
found a conglomerate “discount” in their so-called Dunbar’s Law.41 For most of us, it is
equity prices.38 In other words, the market single digits. That number has been roughly
assigned a lower value to the conglomerate the same since the dawn of time, despite the
than the sum of its parts, echoing Merton’s extraordinary recent advance of technology
1973 insight. This is evidence of disecono- and social networks. As Nicholas Christakis
mies of scope in banking. has observed, Facebook “friends” are not
really your friends. With hindsight, this cri-
‘Limited factor’ sis has provided many examples of failures
On the face of it, these findings are a puz- rooted in an exaggerated sense of knowl-
zle. The most likely cause was articulated by edge and control.
Austin Robinson back in the 1930s –“Man’s Risks and counterparty relationships
mind and man’s memory is essentially outstripped banks’ ability to manage them.
a limited factor . . . Every increase in size Servers outpaced synapses. Large banks
beyond a point must involve a lengthening grew to comprise several thousand dis-
of the chain of authority . . . at some point tinct legal entities. When Lehman Brothers
the increasing costs of co-ordination must failed, it had almost one million open deriva-
exceed the declining economies”.39 Oliver tives contracts – the financial equivalent of
Williamson’s “span of control” theory of Facebook friends. Whatever the technology
organisations made rigorous this intuition budget, it is questionable whether any man’s
30 years later. mind or memory could cope with such
The essence of these arguments is that complexity.
limits on the optimal size and scope of firms
may be as much neurological as techno- Sobering conjectures
logical. Numbers of synapses may matter To sum up, the maximum efficient scale of
more than numbers of servers. The history of banking could be relatively modest. Perhaps
military units provides a good illustration. In it lies below $100 billion. Experience sug-
Roman times, the optimal size of a military gests there is at least a possibility of dis-
unit was 100 – hence the Roman centurion. economies of scale lying in wait beyond that
This was the maximum number of men a point. Conglomerate banking, while good
general felt able to know well enough to lead on paper, appears to be more mixed in prac-
and control. The constraint was neurological. tice. If these are not inconvenient truths, they
are at least sobering conjectures. They also sit
Dunbar’s Law awkwardly with the current configuration of
Two millennia have passed. Extraordinary banking.
advances have been made in military tel- In 2008, 145 banks globally had assets
ecommunications technology. And the opti- above $100 billion, most of them universal
mal size of the military unit in the US army banks combining multiple business activi-
today? Just under 100 people.40 The num- ties. Together, these institutions account for
ber of relationships humans are felt able to 85 per cent of the assets of the world’s top

1000 banks ranked by Tier 1 capital. If these that restrictions on scale and activity are part
institutions could be resolved easily, so that of today’s debate about solutions to the sys-
the systemic consequences of their fail- temic pollution problem. Thus, $100 billion
ure were limited, efficiency considerations may not just be the question; it may also be
could perhaps be set to one side. Or, put in part of the answer.
Weitzman’s terms, the social benefits of cut-
ting banks down to size would be low. Conclusion
But crisis experience has demonstrated We are at the start of a great debate on the
that the apparatus does not currently exist to future structure of finance, not the end.
resolve safely these institutions. There are no Some fear that momentum for radical finan-
examples during this crisis of financial insti- cial reform will be lost. But financial crises
tutions beyond $100 billion being resolved leave a scar. This time’s sovereign scar should
without serious systemic spillovers.42 Instead, act as a lasting reminder of the criticality of
those in trouble have been bailed out. The reform. Today’s crisis has stretched some
same 145 institutions account for over 90 per state’s sinews to the limit. Both literally and
cent of the support offered by governments metaphorically, global finance cannot afford
during the course of the crisis. another.
The history of banking is that risk
A matter of scale expands to exhaust available resources. Tail
In light of the crisis, and in the language of risk is bigger in banking because it is created,
Weitzman, the marginal social benefits of not endowed. For that reason, it is possible
restrictions could be greater than the mar- that no amount of capital or liquidity may
ginal private costs. The maximum efficient ever be quite enough. Profit incentives may
scale of banking may lie below the maxi- place risk one step beyond regulation. That
mum resolvable scale. A large part of the means banking reform may need to look
effort of the international community over beyond regulation to the underlying struc-
the past few years has been directed at ture of finance if we are not to risk another
increasing the maximum resolvable scale sparrow toppling the dominos.
of banks – for example, through improved
resolution regimes and living wills.43 If suc- Rich but fragile system
cessful, that effort would shift the balance Today’s financial structure is dense and com-
of the Weitzman cost/benefit calculus in plex, like a tropical rainforest. Like the rain-
the direction of bigger banks; it could help forests, when it works well it is a source of
achieve the modularity, robustness and bet- richness. Yet it is, as events have shown, at
ter aligned incentives which restrictions oth- the same time fragile. Simpler financial eco-
erwise deliver. systems offer the promise of greater robust-
But if this effort is unsuccessful, past evi- ness, at some cost in richness. In the light
dence and present experience pose a big of a costly financial crisis, both eco-systems
question about existing banking structures. should be explored in seeking answers to the
Against that backdrop, it is understandable $100 billion question. •

Editor’s note 19 A Herfindahl-Hirschman index of revenue con-
The publisher and editor of The Journal centration is constructed to measure diversifica-
of Regulation and Risk – North Asia, wish tion, with a measure of zero meaning that the
to thank Andrew G. Haldane, Executive HHI = 1, i.e. revenue is concentrated solely on
Director, Financial Stability, Bank of England, one activity. Revenue concentration is calculated
for this weighty contribution to the Journal. across three buckets for the last pre-crisis year
Following his speech, delivered at the (2006) – Retail and commercial banking; corpo-
IRRNA’s March 30, 2010 meeting in Hong rate and investment banking; asset and wealth
Kong, he had this to say: management.
“I am grateful to Dele Adeleye, David 20 De Nicolo (2000).
Aikman, Marnoch Aston, Richard Davies, 21 Haldane (2009b).
Colm Friel, Vaiva Katinaite, Sam Knott, 22 See, for example,Aikman et al (2010).
Priya Kothari, Salina Ladha, Colin Miles, 23 ibid
Rhiannon Sowerbutts and Aron Toth for 24 Korup and Clague (2009).
their comments and contributions.“ 25 Haldane (2009a) discusses some of these
strategies in greater detail and the payoffs they
References generate.
1 For example, Reinhart and Rogoff (2009). 26 Kay (op.cit.)
2 The levy on US banks announced by the US gov- 27 Kotlikoff (2010).
ernment in January takes the $100 billion loss 28 Modigliani and Miller (1958). See also Miles
and recoups it over 10 years rather than 20. (2009).
3 IMF (2009). 29 Mehra and Prescott (1985).
4 ibid 30 Barro (2006).
5 Haldane (2009a). 31 Santomero and Eckles (2000).
6 Using the end-year yield on the financial corpo- 32 For example, Calomiris and Hubbard (1995).
rates bond index across the ratings spectrum. 33 Saunders (1996), Berger and Mester (1997).
7 For example, banks’ retail deposits are excluded, 34 Amel et al (2004).
but unsecured wholesale borrowing is included. 35 For example, Berger and Humphrey (1997)
8 Baker and McArthur (2009). based on a survey of more than 100 studies.
9 Basel Committee on Banking Supervision (2009). 36 For example, De Long (2001).
10 For example, Brunnermeier et al (2009), NYU 37 Stiroh and Rumble (2006).
Stern School of Business (2009). 38 Laeven and Levine (2007); see also Schmid and
11 For example, Kay (2009), Kotlikoff (2010). Walter (2009) for recent US evidence.
12 Stern (2006). 39 Robinson (1934).
13 ibid 40 Christakis and Fowler (2009).
14 ibid 41 Dunbar (1993).
15 ibid 42 Washington Mutual, with assets of around $300
16 ibid billion, was resolved by FDIC, but perceived by
17 ibid many to have caused systemic spillovers.
18 Beale et al (2009). 43 For example,Tucker (2010).

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www.edit24.com
writers, editors, press & public relations practitioners


Risk management
Economists’ hubris informed

the financial tsunami of 2008
Capco’s Shahin Shojai & Contango’s
George Feiger call for a fundamental
rethink on attitudes to risk management.
IN this paper, the authors look at the participant in the financial system, from the
shortcomings of academic thinking on individual investor through banks and bro-
financial risk management – a very topi- kers up to central banks, needs to think of a
cal subject. Economists have drifted into three-level analysis of risk:
realms of sterile, quasi-mathematical and 1. At the level of the individual financial
a priori theorising instead of coming to instrument;
grips with the realities of their subject. In 2. at the level of a financial institution hold-
this sense, they have stood conventional ing diverse instruments;
scientific methodology, which develops 3. at the level of the system of financial
theories to explain facts and tests them institutions.
by their ability to predict, on its head. A financial instrument might be a credit
card or a residential mortgage or a small
Not surprisingly this behaviour has carried business loan. In the US, risks in many such
over to the field of risk management, with instruments have been intensively studied
an added twist. Like the joke about the man and have proven moderately predictable
who looks for his dropped keys under the in large pools. For example, a useful rule
street light because that is where the light of thumb is to equate the default rate on
is rather than where he dropped the keys, national pools of seasoned credit card bal-
financial economists have focused on things ances to the national unemployment rate.
that they can ‘quantify’ rather than on things A financial institution holding a diverse
that actually matter. portfolio of such instruments might be a
The latter include the structure of the bank that originates them and retains all or
financial system, the behaviour of its par- some, or an investing institution like a pen-
ticipants, and its actual ability to capture and sion fund or a hedge fund or an insurance
aggregate information. company (or, indeed, an individual investor
The recent (and indeed on-going) with a personal portfolio).
financial crisis has made it clear that every The system of financial institutions is the

total of these individual players, in particular, stationary but depend on the sample period
embracing the diverse obligations of each to chosen, a simple fact that we will return to
the others. again and again. This non-stationarity is not
simply an empirical observation; it is endog-
Academic approach enous to the way that markets operate. The
A bank may have loaned unneeded over- recent crisis has highlighted one fundamen-
night cash to another bank or it may have tal cause, namely moral hazard in the secu-
borrowed to fund its portfolio of tradable ritization process, and it is worth examining
securities by overnight repurchase agree- this in detail.
ments; a hedge fund may have borrowed The statistics on mortgage defaults and
to leverage a pool of securities; an insurance losses were derived from one particular era
company may have guaranteed another in mortgage lending, when lending banks
institution’s debt, backing that guarantee by retained on their balance sheets the loans
pledging part of its own holding of securi- that they made. Because of this, the origina-
ties; and an individual may have guaranteed tors were obliged to work hard to understand
a bank loan to his small business by pledging the financial prospects of their borrowers at
a real estate investment, itself leveraged by a the time of origination and to closely moni-
mortgage. tor the portfolio thereafter.
We would summarise the academic
approach to risk management (enthusias- Enter securitisation
tically adopted by the financial institutions The development of securitisation allowed
themselves) as the sum of the following originators to package mortgages and sell
propositions: them, all risks included, to third-party inves-
1. The risks of individual financial instru- tors who had no detailed knowledge of
ments follow a stationary probability the mortgage business or the borrowers. To
distribution; mitigate this lack of knowledge, a class of
2. the enterprise risk of a financial institution “risk evaluation intermediaries,” otherwise
is measured by treating the institution as the known as the rating agencies, stepped in.
portfolio of the individual instruments that it Their method of risk mitigation was to create
holds; diversified pools of loans, basing diversifica-
3. as markets price instruments rationally, tion on loss statistics from the previous world
there are really no systemic risk issues not of retained risk.
captured in the pricing of assets. The banks and other originators were
Unfortunately, recent events have shown transformed from risk-aware lenders to
each of these propositions to be false. financial engineers of mortgages. Their
income no longer came from borrowing
Stationarity of instrument risks spreads less any loss experienced as a result
This is the foundation of all risk manage- of defaults, but strictly from fees from manu-
ment modelling. As anyone who has tried to facturing mortgage pools. Is it any wonder
model instrument risks knows, they are not that the quality of underwriting deteriorated,

and in a way that was hard to detect for As anyone who has attempted to estimate
some time? the variance/covariance matrices of financial
instruments knows, these distributions vary
Ratings agencies blind markedly according to the sample period
The rating agencies never had access to chosen for estimation.
the underlying borrowers and so could not Therefore, the statistically trained have
assess their true state of health. That infor- used various weighting schemes to create
mation was not even with the originators, ‘more relevant’ data; for example, weight-
who had stopped caring about collecting ing recent data more heavily than older data
that kind of information when they started using some distributed lag scheme. A more
selling the mortgages to other investors productive approach would be to recog-
[Keys et al. (2010)]. nise that these correlations are not station-
So, the rating agencies had to use history ary because, again, of the way that markets
to rate these instruments, or the credit qual- evolve.
ity of any insurer who had provided credit
enhancement to the security [Fabozzi and Endogenous causes
Kothari (2007)]. Neither the credit enhancer We can give three examples of these endog-
nor the rating agency had any idea about the enous causes:
underlying quality of the borrowers. Add to 1. Real economic‘causation’;
that the moral hazard of the rating agencies, 2. ‘convergence of trading behaviour’ in the
which supplied ratings for the bond buyers financial system we have created;
but were paid by the bond originators. 3. adherence to false notions of ‘market effi-
Hence the “actual risk statistics” of the ciency,’which causes neglect of credit-fuelled
resulting mortgage-backed securities sys- valuation bubbles.
tematically deteriorated relative to those of Let us start with causation. Unlike the
the earlier era. predictably random movements of electrons
in an atom, economic events sometimes
Housing bubble have causes that bare rather sharply on the
Consequently, all that was needed to bring correlation among instruments. It is easy to
the house of cards down was a correc- give a practical illustration.
tion in house prices, which is exactly what Some time ago, one of the authors had
happened. (The house prices were grossly a client with what was, supposedly, a well-
inflated by the system-wide credit bubble diversified portfolio – equities, bonds, real
that the risk management modellers did not estate, and even some direct business inter-
see, but we will address that below.) ests. Unfortunately, all the investments were
The academic approach to modelling located in or were claims on businesses in
enterprise risk is to assume a stationary Houston, Texas. When the price of oil col-
distribution of the correlations among the lapsed, so did the value of the portfolio.There
instruments and to model the institution as was a common causal factor in the returns of
the portfolio of the instruments that it holds. each part of this specific portfolio.

It would have been difficult, but not all economies for which we have decent
impossible, to have calculated beforehand records.
the variance/covariance matrix of returns in
Houston conditional on the price of oil, or Efficiency of markets
of returns in the Midwest conditional on the Why do investors not simply recognise these
health of General Motors – let alone to then and “trade them away,” as the efficient mar-
create the probability distribution of the fate kets hypothesis would imply? It is not so
of these causal factors. easy, because while the bubbles are‘obvious,’
Certainly this was not done for the loss when they will burst is not. Smithers (2009)
factors for portfolios of mortgages originat- explains this in eloquent terms. However, if
ing in, say, Las Vegas during the boom. you think about it, had you started short-
Consider now convergence of trading ing the tech bubble aggressively in 1998
behaviour. Correlations of returns of assets you would have been bankrupt well before
like European and US and emerging stock the end. As Keynes said, the markets can
indices, various commodities and the like remain irrational longer than you can remain
have been highly variable but clearly rising solvent.
over the past 15 years [Ned Davis Research]. Real estate, we might say, is an asset
worth what someone will lend you to buy
Chasing the same returns it. When the lenders thought that real estate
A combination of deregulation of global prices would always go up, they lent freely
capital flows, development of sophisticated and the price of real estate was pushed up by
capital market intermediaries operating the buyers. When credit availability collapsed
globally, and data and trading technology with the balance sheets of the banks, real
have enabled more and more money to be estate prices fell along with every other lev-
placed on the same bets at the same time. eraged asset. The correlations went toward
And so it is. one.
Harvard and Yale used to be virtually
unique among institutions for investing Modelling systemic risk
heavily in timberland and private equity and Once we acknowledge that valuations can
hedge strategies. Now everyone is doing it undershoot and overshoot, we can explain
and the returns are falling while the volatility systemic risk that is, essentially, broad loss
and the correlations are rising. of liquidity in most assets. Why pay more for
And consider finally credit-fuelled valu- something today than it is likely to be worth
ation bubbles. As we have demonstrated tomorrow?
[Feiger and Shojai, 2009], asset markets do Consider the example of the collat-
not price efficiently, no matter what your eralised loan obligation (CLO) market in
professor said in business school. Reinhardt 2008. Several hundred billion dollars of
and Rogoff (2009) have demonstrated that corporate loans were held in CLOs on the
for centuries, valuation bubbles funded largely invisible books of offshore hedge
by excess credit creation have occurred in funds and underwriting institutions (via

off-balance-sheet vehicles), in structures they withdrew the leverage and reduced
leveraged 20 times and more. The leverage their inventories and so forced prices down
came from major banks and insurance com- further.
panies that, we should remember, devoted
the bulk of their other business activities to Credit losses
making loans to entities like companies and This killed the hedge funds but also inflicted
real estate developers and to each other. losses on other holders, including their own
They in turn raised their liabilities by issu- balance sheets, and created credit losses on
ing bonds and commercial paper to pension the loans extended to the leveraged CLO
funds, insurance companies, mutual funds holders. Now the banks were in trouble
and individuals. themselves. So they dried up the interbank
As panic spread about the falling value lending market, essential for liquidity in the
of collateralised debt obligations (CDOs) world trading system, and their commercial
backed by mortgages, some of the loans in paper appeared risky and fell in price, dam-
the CLOs started falling in price in second- aging the money market fund industry that
ary trading (the market making provided held a large part of liquid assets in the US.
by the same banks that were providing the We need not elaborate on this history,
leverage to the CLO holders and the CDO but you can see why the stationary vari-
holders). ance/covariance matrix of the enterprise risk
management models did not turn out to be
Deleverage spiral relevant.
This precipitated margin calls on the holders And, consequently, why the core of aca-
that they could not all meet. With leverage demic work on risk management did not
of 20 times, falling loan prices meant that a turn out to be relevant. And indeed, how
fund’s equity could quickly disappear so the insidious the concept of market efficiency
only recourse was to dump loans and delev- has been in blinding market participants to
erage as quickly as possible. We sat at our the nature of real risk by implying that it has
Bloomberg screens in amazement as blocks already been priced in to all assets as well as
of hundreds of millions or billions of loans it can be.
were thrown out for whatever bid they could
get. Would you have bought at that time, Implications for ‘value at risk’
even if you thought that almost all of the We have not explicitly referred to value at risk
loans were ultimately money-good, as we (VaR) until now, although it is the universal
indeed did think? Of course not, because in tool used for enterprise risk management. It
the panic it was certain that the prices would is, of course, a product of that view that the
fall further, which they did. enterprise is the portfolio of the instruments
Normally the market makers would it holds and all the issues we have addressed
buy bargains but they were providing the above. Specifically, VaR is an attempt to
leverage – and they were holding trading “represent”the maximum loss that a firm is
inventories that were tumbling in price. So likely to accept within specified parameters,

usually expressed as a confidence interval unanticipated shocks, and we can start over
over a set time horizon. with the arguments with which we began
If we use a 95 per cent confidence inter- this paper.
val and the firm’s portfolio of investments
is estimated to have a one-day five per cent Systemic risk syndrome
VaR of $100 million, there is said to be a five On reflection, systemic risk renders collateral
per cent probability that the portfolio would least helpful when you need it most. Think
fall in value by more than $100 million over of something as simple as a mortgage on a
a one-day period; in other words, a loss of house. The collateral is the down payment,
$100 million or more on this portfolio is which is the lender’s cushion against default.
expected on one day in 20. We have spent If your house goes on the market in ‘normal
the bulk of our effort to this point showing times,’say because of a divorce, all will be fine
the difficulty in the key clause “is estimated and the lender is likely to recoup his loan. If
to have”and will dwell on this no further. a real estate bubble has collapsed and every
It is important, however, to explore a house on your block is for sale, the cushion
number of other problems with concepts is non-existent.
likeVaR even if we could do a far better job of This is not an easy problem to solve.
estimating conditional probability distribu- Smithers (2009) proposes dynamic collat-
tions of outcomes. eral requirements driven by rules on market
value versus ‘true value’ and provides com-
Role of collateral and incentives pelling evidence for the existence of tech-
These derive primarily from deep problems niques for estimating the ‘true value’ well
in the capture and aggregation of informa- enough for purposes of setting collateral and
tion, and we address these below. We wish capital cushions.
first to apply our concept of endogenous
evolution of market risk to two tools that the Incentives conundrum
same economic theory that gave us VaR tells Let us now turn to incentives, particularly the
us can act as risk mitigators: collateralised notion that if incentives are paid in deferred
central clearing and alteration of the incen- common stock of the originators, there will
tives of market participants. be a much lower likelihood of moral haz-
Collateral, whether in the hands of a ard driving endogenous changes in risk. We
central counterparty or put up over the believe that such attempts will fail the test of
counter against individual transactions (the practical reality because they are not com-
equity cushion in all those leveraged CLOs), patible with the way we have organised our
is claimed to allow the system to absorb financial markets.
unanticipated shocks. That may be, but the They are incompatible with a free mar-
question is, how much collateral is enough? ket for talent. Institutions that attempt long
Here we come back to the stationary deferral of incentive payments into restricted
joint probability distribution of asset prices, vehicles will experience loss of their highest
which defines the likely magnitude of these performers to institutions that do not do this.

You can see this happening right now on any moment. This uncertainty at the foun-
Wall Street. dation derives from limitations likely in both
The way in which we choose to meas- human behaviour and IT.
ure corporate performance encourages the
opposite, namely short-term risk taking ERM rational
for near-term results. We measure results The human behaviour issue is easy to
quarterly and annually even though the understand. There is a lot of employee com-
economic cycle takes place over years, not pensation at stake in the measurement and
quarters. Who doubts that any financial management of risk, because the entire pur-
institution CEO who dropped out of playing pose of enterprise risk management is to
in late 2006 would have lost his job and his attempt to limit the size of the risks that the
key staff long before the markets collapsed? enterprise takes. And that means limiting
Is this not the meaning of the infamous the size of the gambles on which the mem-
remark by Chuck Prince, former CEO of Citi, bers of the enterprise get paid.
that“as long as the music is playing we have While academic literature does account
to dance.” for personal greed, and a number of papers
The proposed holding periods for the have been written on the subject by Michael
restricted incentive payments are always Jensen and his many colleagues and stu-
some calendar interval. The economy does dents of the subject [Jensen and Meckling
not oblige by revealing the implications of (1976)], it is usually overlooked when it
systemic risk provoking actions like credit comes to subjects that deal with anything
bubbles over short periods. other than corporate finance.
For some reason, there is an assumption
Deep operational problems that, just like investors all behave rationally,
To this point we have explained the defects individuals are also mostly honest when
of current economic models of risk manage- they assess the risks that they take.
ment in terms of their inability to grasp the Financial executives certainly have the
endogenous nature of the development of motivation to reduce the allocation of risk
risks and the interconnection of risks across to their activities if their compensation takes
institutions. These are, in essence, issues that the form of an option on the bank; that is,
arise in asset valuation. The discussion has if they share in the gains and not the losses.
assumed that individual institutions know
their own holdings and cross-obligations Underestimated risk profiles
and seek to draw inferences about the risks Given the complexity of modelling many
that they are thereby incurring. of the instruments that financial institu-
In fact, for the particular problem of risk tions are dealing with, it is only natural that
management, we need to understand that they will be collecting underestimated risk
it is highly unlikely that any institution of profiles from the traders and financial engi-
significant size is even at this starting posi- neers. Moreover, their supervisors, the man-
tion – of knowing where it actually stands at agement, know that if the bank gets close

to failure, the government will probably bail The result is a spaghetti-like infrastructure of
it out if it is important enough to the local protocols and technologies that are simply
economy or the globe. unable to communicate with one another
The IT limitations are a consequence of [Dizdarevic and Shojai (2004)]. Incompatible
the organisational and operational structures systems make the development of viable
of all but the smallest financial institutions. enterprise-wide risk management close to
Financial institutions of any size and com- impossible. Sadly, our practical experience
plexity are typically managed in a variety of shows that this situation will persist for
silos that report what they do in a variety of many years to come.
incompatible ways. As a result, most institu- Despite the huge annual investments
tions have major difficulties in aggregating made by major financial institutions, differ-
the risks of their credit and market instru- ent systems supporting different instruments
ments, let alone the firm’s operational or are simply unable to share information in
liquidity risks. any meaningful way. This means that no
matter how remarkable insightful concep-
Data overload tual risk models may be, the data that they
For example, many institutions combine will be dealing with will remain seriously
credit and foreign exchange instruments inadequate.
within the same divisions, while others keep
them separate. Some combine structured Not to panic!
instruments with the fixed-income division, We realise that these are depressing con-
others with equities. In some firms foreign clusions. The appropriate response is not to
exchange, credit, and equities each have despair of doing anything, however, but to
their own analytical teams, who compete recognise that what we need to do must be
rather than co-operate, and who are differ- seen in the light of the very large concep-
ent, in turn, from the analytical team work- tual and practical limitations to enterprise
ing for the CFO. or systemic risk management that we have
An even more basic problem is that there explained. For our part, we draw the follow-
is just too much information to deal with. ing conclusions:
Risk management teams face a hosepipe of Quantitative modelling must be seen
data that they have to decipher, and its con- as research rather an as an actionable man-
tents change with every trade. agement tool. Management judgment and
Today, very few financial institutions common sense must take the front seat
of any size have not undergone a series rather than the back seat. The reverse seat-
of mergers or acquisitions, with the pace ing arrangement brought us to where we are
increasing over the past decade. Indeed, today.
the current financial crisis has resulted in Because the knowledge to second-guess
the forced merger of very large institutions, business decisions is hard to acquire, we
themselves layers of technically incompat- must make the motivations work for rather
ible accounting systems. than against risk limitation. Subtle ways

require analysis that we cannot yet under- ity-adjusted VaR model: a stochastic programming
take. Hence we need to resort to cruder approach”, Journal of Financial Transformation
tools such as preventing risk transfer from Hand, D. J., and G. Blunt, 2009, “Estimating the ice-
risk originators via securitisation. Another berg how much fraud is there in the U.K.,” Journal of
fundamental tool is limitation of leverage in Financial Transformation, 25, 19-29
all forms of transactions, no matter what the Hand, D. J., and K.Yu, 2009,“Justifying adverse actions
models say. with new scorecard technologies,” Journal of Financial
Clever deferred compensation and Transformation, 26, 13-17
restricted stock schemes are too easy to Hunter, G.W., 2009, “Anatomy of the 2008 financial
game. Moreover, non-regulated entities like crisis: an economic analysis post-mortem,” Journal of
hedge funds will always escape these nets. Financial Transformation, 27, 45-48
The first steps above will reduce the (falsely Jacobs, B. I., 2009, “Tumbling tower of Babel: sub-
measured) profitability of risk taking in regu- prime securitization and the credit crisis,” Financial
lated financial institutions enough to auto- Analysts Journal, 66:2, 17 – 31
matically limit compensation. Jensen. M. C., and W. H. Meckling, 1976, “Theory
We must recognise that not everything of the firm: managerial behavior, agency costs and
can be regulated and, more important, ownership structure,” Journal of Financial Econom-
financial transactions slip away from the reg- ics, 3:4, 305-360 Jorion, P., 2006, Value at Risk: the
ulated sector. By late 2007, more credit was new benchmark for managing financial risk, 3rd ed.
provided to the US economy from securiti- McGraw-Hill
sation than from the deposit-taking bank- Keys, B. J.,T. Mukherjee, A. Seru, and V.Vig, 2010, “Did
ing sector. Systemic risk will always be able securitization lead to lax screening? Evidence from
to arise from the unregulated sector, for the subprime loans,” Quarterly Journal of Economics, forth-
reasons we have developed in this paper. So coming.
far there don’t appear to be any very effective Kuester, K., S. Mittnik, and M. S. Paolella, 2006,“Value-
solutions for this problem. • at-Risk prediction: a comparison of alternative strat-
egies,” Journal of Financial Econometrics, 4:1, 53-89
References Markowitz, H., 1952, “Portfolio selection,” Journal of
Boudoukh, J., M. Richardson, and R. Stanton, 1997, Finance, 7:1, 77-91
“Pricing mortgage-backed securities in a multi-factor Reinhart, C. M., and K. Rogoff, 2009,This time is dif-
interest rate environment: a multivariate density ferent: eight centuries of financial folly, Princeton
estimation approach,” Review of Financial Studies, 10, University Press
Dizdarevic, P., and S. Shojai, 2004, “Integrated data Shojai, S., 2009, “Economists’ hubris - the case of
architecture – the end game,” Journal of Financial mergers and acquisitions,” Journal of FinancialTransfor-
Transformation, 11, 62-65 mation, 26, 4-12
Fabozzi, F. J., and V. Kothari, 2007, Securitization the Shojai, S., and G. Feiger, 2009,“Economists’ hubris: the
tool of financial transformation,” Journal of Financial case of asset pricing,” Journal of Financial Transforma-
Transformation, 20, 33-45 tion, 27, 9-13
Fragnière, E., J. Gondzio, N. S. Tuchschmid, and Q. Smithers, A., 2009, Wall Street revalued: imperfect
Zhang, forthcoming 2010, “Non-parametric liquid- markets and inept central bank.

Risk management
‘Walker Review’ heralds new

dawn in risk management
PRMIA’s David Millar enthuses over recent
developments in boardroom responsibilities
towards new risk culture.
RISK management has been the topic on the messages and are acting accordingly to
everyone’s lips since late 2007. Why did minimise any risky practices?
risk management practices not prevent
the “credit crunch”? What could have The ‘Walker Review’
been done better? In July last year the UK Treasury released
the ‘Walker Review’. This went for prelimi-
The simple answer is that, whilst risk man- nary public response and was re-released
agement was being applied at the lower in November. In January the FSA (the UK
levels of financial institutions, it was being regulator), released a discussion paper
largely ignored at the top level. Tools and based on the Walker Review. Comments
techniques could have been better, and are were closed on April 28 and Prudential
being improved, but there is no point install- Handbook rule changes are expected in Q3
ing an expensive security alarm system, then 2010. The UK’s Financial Reporting Council
switching off the bell because it keeps going (FRC) consulted on whether to include the
off; that makes too much noise and spoils Walker recommendations in the Combined
your partying! Code on Corporate Governance (Combined
Regulators and governments are now Code) for all UK listed companies. Feedback
realising this and, worldwide, are formulat- closed in March and recommendations are
ing rules, restrictions and regulations which expected in Q3.
are forcing senior individuals in banks, i.e. I have approached this article from the
executive and non-executive board mem- point of view of risk in financial institutions.
bers, to understand the risk messages. However, the relevant responsibilities of
Does the current generation of board non-executive directors in all organisations
members have the knowledge, the capacity, – financial or non-financial, commercial or
the training to both manage the alarm sys- not-for-profit, can be said to revolve around
tem and to assure the regulator, the visiting two issues, these being: the risks involved in
policeman that, yes, they fully understand carrying out their necessary activities; and

the risks involved in acquiring and main- “Sophisticated financial engineer-
taining the necessary funds to perform these ing, supplied by the banking, securities,
activities. and insurance industries, also played a role
I expect that many, if not all, of the rec- in covering up the true economic condi-
ommendations of the Walker Review will tion of poorly run companies during the
be incorporated into the Combined Code equity markets’ millennial boom and bust.
and will therefore be applied to all UK listed Alongside rather simpler accounting mis-
companies. Firms that are not listed (chari- takes and ruses, this type of financial engi-
ties, trusts and private companies) will not be neering was one reason that some of these
affected by the Combined Code but it would companies violently imploded after years of
be expected that their directors should abide false success (rather than simply fading away
by its general principles and therefore much or being taken over at an earlier point).”
of the Walker Review contents. We live in a world where risk and reward
has become the focus of activities and where
Risk in today’s environment we have developed ever-improving, and
Risk management is also now widely ever more complex, models to maximise the
accepted in all areas of business, and is reward and control the risk.
acknowledged as the most creative force in We need to make sure that the govern-
the world’s financial markets. This trend was ance of institutions using these practices is
summed up by Alan Greenspan, chairman as efficient and effective as the risk models
of the US Federal Reserve Board: and frameworks claim to be. Organisations
“The development of our paradigms can be said to incur many types of risk: stra-
for containing risk has emphasised disper- tegic risk, market risk, operational risk, etc.
sion of risk to those willing, and presumably However for this paper it is convenient to
able, to bear it. If risk is properly dispersed, divide all risks into two groups: financial risk
shocks to the overall economic system will and non-financial risk.
be better absorbed and less likely to create
cascading failures that could threaten finan- Financial risk
cial stability.” All organisations require funds (capital) in
However, the past decade has seen order to function. Non-financial producers
many major, significant and embarrassing need capital to fund their manufacturing or
failures of risk management and risk man- creative activities; charities will accumulate
agement has demonstrably not been able to funds in order to perform their charitable
prevent these and their resulting company activities. In all cases these funds will need
failures, investor losses and market disrup- to be protected against market fluctuations
tions. How many of these failures are a result (currency and interest rate risks) or invested
of deficiencies in risk management practices to protect them against inflation (investment
and how many are breakdowns in the cor- risks including the risks involved in lending
porate governance of the risk management to other parties).
process? Financial firms (lenders, traders, brokers,

etc) have additional transactional risks in company’s activities impact the probability
their operations as they balance risk against of their debt being repaid.
financial return on their capital. The main How likely is it that the risk of a particular
parameters involved in financial risk man- activity could result in that company becom-
agement are the probability of loss and the ing insolvent? As part of these activities, the
likely amount of loss, together with the board also needs to monitor the activities
financial measurements involved: currency and interests of the managers of the com-
and interest rates, etc. pany; also stakeholders, to ensure that their
Financial risk differs from non-financial activities do not compromise the interests
risk as there generally is an up-side (changes of share and debt holders – for example the
in circumstances can increase the value of a taking on of risk for personal benefit, finan-
portfolio) as well as a down-side (portfolio cial or otherwise, of the company’s executive
losses due to market changes). officers and managers.
This situation can also be extended to the
Non-financial risk boards of organisations such as charities and
Non-financial risk rarely has an up-side charitable trusts. Do the risks taken increase
(although an error is processing can occa- the ability of the organisation to carry out its
sionally result in a positive impact, this is not charitable remit? Could the risks taken dam-
through intention). Here the main param- age the charity so that it is unable to continue
eters in risk management are probability of effectively?
loss, estimated amount of loss and the cost
of mitigation against loss. Risk transparency
All organisations can suffer from non- The board must ensure that it sets and gov-
financial risks. These will include issues such erns the business strategy and understands
as the health and safety of employees; losses the fundamental risks and rewards that this
through theft, fraud, malpractice, etc; incom- implies and that, by effective internal and
petence and inadequacy in persons, systems external disclosure, it provides transparency
and processes; natural disasters; and many of those risks to managers and stakeholders.
other issues. The board is not there to manage the
business – but it is responsible for overseeing
Board responsibilities and holding accountable the management.
The main responsibility of the board of any It may not develop the overall strategic plan
company is to look after the interests of for the company, but it is responsible for
shareholders. This usually means to balance approving it. It must understand how the
the risk of any business activity and against proposed strategy could impact business
the expected returns to the company. The opportunities, reputation and partnerships.
board also needs to take into account the In this, all risks need to be understood and
interests of other stakeholders such as hold- decisions taken on what is acceptable – this
ers of corporate debt in the company. Debt is the“risk appetite”for the company.
holders also have a major interest as the The board should understand all

significant risks, including aggregated risks committees. These, the audit and the risk
and classify these under the four basic management committees, ratify the key
choices in risk management: 1.) Avoid policies and associated procedures of the
risk by choosing not to undertake some bank’s risk management activities. The audit
activities; 2.) Transfer risk to third parties committee monitors the risk committee and
through insurance, hedging and outsourc- reports on its effectiveness. My thanks to the
ing; 3.) Mitigate risk, such as operational risk, authors of the Essentials of Risk Management
through preventive and detective control for much of this section.
measures; 4.) Accept risk, recognising that The risk management committee of the
undertaking certain risky activities should board, not to be confused with the executive
generate shareholder value. risk management committee, is responsible
for independently reviewing the identifica-
Effective risk culture tion, measurement, monitoring, and con-
As part of its risk governance responsibilities, trolling of risks, including the adequacy of
the board must ensure that the company policy guidelines and systems.
has in place an effective risk management The committee also helps to translate the
culture that is consistent with the above stra- overall risk appetite, approved by the board,
tegic and risk appetite decisions. into a set of limits that descend through the
Furthermore, the board must ensure executive officers and business divisions. The
that there are effective procedures in place risk management committee reports back to
for identifying, assessing and managing all the board on a variety of items, such as all
types of risk, i.e. business risk, operational loans and/or credits over a specified limit
risk, market risk, liquidity risk and credit that are special, or being made to related
risk. This includes making sure that all the parties (e.g., bank officers).
appropriate policies, methodologies and
infrastructure are in place. The infrastruc- The audit committee
ture includes both operating elements (e.g., The risk management committee also moni-
sophisticated software, hardware, data and tors credit and securities portfolios, including
operational processes) and personnel. major trends in credit, market and liquid-
The board needs to ensure that its infor- ity risk levels, portfolio composition, and
mation on risk management is timely and industry breakdowns. This committee also
accurate. It should be sufficiently informed typically provides opportunities for separate,
to question risks and to obtain support from direct and private communication with the
external sources to assist in this questioning. chief inspector, the external auditors, and the
management committee.
Risk committees and officers The role of the audit committee of the
The above are the overall objectives of board is critical to the board’s oversight of
risk governance. The best way to put these any organisation. The audit committee is
into action is through supporting bodies responsible not only for the accuracy of
to the board, the risk officers and the risk financial and regulatory reporting, but also

for ensuring that the organisation complies who lack the skills to ask probing questions,
with minimum or best-practice standards in or to understand the answers to these ques-
other key activities, such as regulatory, legal, tions in a rigorous manner.
compliance, and risk management activities. There are various ways to square this
To function properly, an audit committee circle, but they all come back to the board’s
needs members with the right mix of knowl- establishing some kind of support for inter-
edge, judgment, independence, integrity, preting information about risk and risk
inquisitiveness, and commitment. In most processes that is independent of the senior
organisations, a non-executive director leads executive team.
the audit committee, and most members are
non-executives. Importance of advisory roles
The audit committee also needs to estab- One approach is for the board to gain the
lish an appropriate interaction with manage- support of a specialist risk advisory director,
ment – independent, but productive, and that is, a member of the board (not necessar-
with all the necessary lines of communica- ily a voting member) who specialises in risk
tion kept open. matters.
An advisory director works to improve
Risk advisory director the overall efficiency and effectiveness of the
The audit committee also needs to be clear senior risk committees and the audit com-
about the reporting and risk management mittee, as well as the independence and
elements of governance that it oversees quality of risk oversight by the main board.
on behalf of the board. For example, these The concerns of such a director could be:
might include financial reporting, opera- Participate in audit committee meetings to
tional effectiveness, and efficiency as well as support members; participate periodically
compliance with laws and regulations. in key risk committee meetings to provide
It is not likely that all board members will independent commentary on executive risk
have the skills that will allow them to deter- reporting; meet regularly with key members
mine the financial condition of a complex of management; and, observe the conduct of
risk-taking corporation such as a bank (or an business.
insurance company, or an energy company). A key goal of the advisory director would
be an ongoing examination of the interface
Obfuscation between corporate governance and risk
This is especially likely if the selection of management in terms of risk policies, meth-
non-executives on the board is designed to odologies and infrastructure.
include non-executives who come from out-
side the firm’s industry and are truly inde- Chief risk officer
pendent of the corporation. This is a problem The Chief Risk Officer (CRO) is responsi-
because many of the recent corporate gov- ble for the management of the risk man-
ernance scandals have shown that it is easy agement infrastructure. He develops the
for executives to bamboozle non-executives risk appetite of the organisation (working

with the executive risk managers and com- To this end, both executive and non-
mittees) and proposes this to the Board executive directors need to have an adequate
Risk Committee. He then implements this, understanding of both financial and non-
throughout the organisation, through the financial risk management as it pertains to
risk management infrastructure. He ensures their industry; and a subset of the Board, the
that reporting of risk and governance-related Risk Management Committee and the Risk
matters is produced in a timely and accurate Advisory Director, need to have sufficient
manner. knowledge and experience to pro-actively
review, comment on, and guide the risk
‘Approved person’ status management practices of the organisation.
The tenure and independence of the CRO Failure to do so would be an abrogation of
should be underpinned by a provision that the board’s fiduciary duties.
removal from office would require the prior
agreement of the board. In certain countries, Know your ‘risk’ . . . or else
for example the UK, the CRO is already an Directors of boards will be measured on their
“approved person”and subject to review and ability to ensure that the organisations they
approval by the regulator. supervise have robust risk frameworks, have
Risk governance, both financial and a pervasive risk culture and that all decisions
non-financial, is a key facet of any organisa- are taken with risk impacts being consid-
tion, whether it is financial or non-financial, ered. Non-executive directors are appointed
private or share-owned, commercial or not- to ensure that the boards carry out these
for-profit. Not only is it key to the success obligations effectively and conscientiously.
and very continuation of these organisations, The modern non-executive director
it is required by regulation, by investors (or, in requires advice on, expertise in and under-
the case of a not-for-profit, those donating) standing of risk management to ensure that
and by the public. Failure to demonstrate the non-executive function is successfully
risk management, at all levels of the organi- performed. Without this the business is at
sation, will result in its self-fulfilling failure. risk and the attention of regulators, analysts
and shareholders will result in adverse repu-
Top-down approach tational, rating and share price impacts on
Risk management starts at the top of an the company.
organisation (the phrase “tone at the top” is Executive directors on boards now know
now commonly used) and the objective is that they need both the risk knowledge and
to create a sound “risk culture” within that risk infrastructure to satisfy the demands of
organisation (and externally with its partners, running a risk managed company. Board
suppliers and counterparties). The primary directors have experienced increasing
instrument for the creation of that culture is responsibilities of the past years. Now risk
the board of directors, and it is the function management expertise and involvement has
of the non-executive directors to ensure that been added to these responsibilities by stint
the board is complying with its obligations. of law. •

Banking crisis
Ideas have consequences: the

importance of ‘narrative’
Peter J. Wallison of the American Enterprise
Institute argues that Bear Stearns’ rescue
and Lehman’s failure were poison chalices.
THERE is substantial evidence that the the rationale for the rescue of Bear Stearns,
cause of the financial crisis was noth- evolved into the narrative for explaining the
ing more complicated than a buildup of chaos that followed Lehman’s collapse.
weak and high–risk mortgages in the US With this narrative generally accepted,
financial system – mostly the result of US the Obama administration’s regulatory plan
government policy to expand home own- inevitably followed.
ership.[1] Too little regulation was not a In his bestselling book, The Big Short,
major factor. Under these circumstances, Michael Lewis begins his description of
substantial changes in US government the derivatives market with this quote
housing policy – particularly with respect from Leo Tolstoy: “The most difficult sub-
to Fannie Mae and Freddie Mac – would jects can be explained to the most slow–
have been the most effective way to pre- witted man if he has not formed any idea
vent a recurrence of financial crisis. of them already; but the simplest thing
cannot be made clear to the most intelli-
Yet the debate over financial regulation in gent man if he is firmly persuaded that he
Congress became a contest between those knows already, without a shadow of doubt,
who want the government to have more what is laid before him.”[2]
control of the financial system and those
who want it to have less. Considering the Power of narrative
legislation that came out of both houses, Although Lewis did not cite it for this pur-
the United States is well on its way to tak- pose, Tolstoy’s remark is a perfect descrip-
ing down the most innovative and successful tion of the power of narrative in the modern
financial system the world has ever known. day. Once a narrative about a public issue
This happened because an erroneous idea becomes accepted, it is virtually impos-
– that large, non–bank financial institu- sible to change; facts that support it are
tions are too “interconnected” to fail – ini- reported by the media, but contrary facts
tially adopted by the Bush administration as are ignored. So it has been with the notion

that large, non-bank financial institutions at face value. It is possible that the firm’s
like Bear Stearns, Lehman Brothers, and capital had been eroded by the time it was
American International Group (AIG) cannot rescued on March 14, and the firm certainly
be allowed to fail – that is, declare ordinary would have been worth more as a going
bankruptcy – because their “interconnec- concern than as a bankrupt entity. It is also
tions” with other financial institutions will possible that the management’s view about
drag the others down. Bear’s profitability in the first quarter was
overly optimistic.
Bear Stearns: ‘a narrative’ The FCIC’s own investigation found that
There is literally no evidence for this notion Bear was legally solvent – its assets exceeded
other than government statements that it its liabilities – at the end of its first fiscal
is so, yet the claim – first advanced to jus- quarter in 2008 (which ended in February).
tify the rescue of Bear Stearns – has evolved But even if we discount these statements, it
into the conceptual foundation for the reg- is unlikely that the market would have suf-
ulatory regime developed by the Obama fered a systemic breakdown if Bear Stearns
Administration, passed by the House of had been allowed to fail. The firm clearly was
Representatives, and now adopted in the not a hollow shell; its creditors would have
Senate. This Outlook is about how this nar- recovered much, if not all, of their advances
rative was formed and how it has influenced in the bankruptcy proceeding.
policy even though it has no basis in fact.
The narrative’s roots are entwined with Importance of ‘repos’
the rescue of Bear Stearns, which involved a What is more, most of Bear’s short-term
government-assisted sale of the company to creditors had advanced their funds under
JP Morgan Chase in March 2008. In recent repurchase, or “repo,” agreements – a form
public testimony before the Financial Crisis of collateralised borrowing that the firm had
Inquiry Commission (FCIC), Christopher begun to emphasise several years before
Cox, chairman of the Securities and because it was thought to be more stable
Exchange Commission (SEC) in 2008, noted than unsecured borrowing. The repo lend-
that during the week prior to its rescue, Bear ers would have been able to recover most, if
– with over 10 per cent capital under the not all, of their losses by selling the collateral
Basel II standards that the SEC applied – was underlying the repos.
solvent and well capitalised.[3] In testimony before the FCIC, Bear’s
management officials said they were baffled
Not insolvent by the creditor and counterparty run (with-
Bear’s top management testified in the same drawals of funds or refusals to renew even
hearing that while the firm had lost money secured financing) that the firm suffered in
in the last quarter of 2007, it would have the week that began on March 10, 2008. The
reported a profit in the first quarter of 2008 if most they could offer was that the firm had
it had not been taken over.[4] simply lost the confidence of the market.[5]
These claims need not be taken entirely This explanation would not justify a rescue

by the government, and indeed neither the Bush administration and Fed officials to jus-
firm’s management nor Cox – speaking as tify their rescue,[8] and it appeared dozens of
a former member of Congress rather than times in media stories.[9] The most complete
SEC chair – thought the firm (the smallest of statement of the“interconnectedness”theory
the big five investment banks) should have was contained in Federal Reserve chairman
been considered ‘too big to fail’ or otherwise Ben S. Bernanke’s prepared testimony to the
systemically significant. Senate Banking Committee on April 3, 2008:
Our financial system is extremely com-
Rationale for rescue plex and interconnected, and Bear Stearns
Why, then, did the government rescue participated extensively in a range of critical
Bear Stearns? The unprecedented nature markets. The sudden failure of Bear Stearns
of the action and its implications for moral likely would have led to a chaotic unwinding
hazard in the future certainly required a of positions in those markets and could have
robust rationale. Federal Reserve Board of severely shaken confidence. The company’s
Governors’ minutes from March 14, 2008 – failure could also have cast doubt on the
just before the rescue – record the Board’s financial positions of some of Bear Stearns’
agreement that “given the fragile condi- thousands of counterparties and perhaps of
tion of the financial markets at the time, companies with similar businesses.[10]
the prominent position of Bear Stearns in
those markets, and the expected contagion Bernanke’s remarks
that would result from the immediate fail- Part of this statement cannot be challenged;
ure of Bear Stearns,” the Fed should extend there is no question that financial institutions
a loan to JP Morgan, which would eventu- are interconnected. That is how a financial
ally be passed along to Bear Stearns.[6] An system performs its function; through these
idea similar to contagion – that Bear was too interconnections, money is transferred from
“interconnected” to fail – first appeared in a place where it is not being used efficiently
the media in a Wall Street Journal article on to a place where it will be.
March 17, 2008, and was loosely attributed The real question, however, is whether
to unnamed“government officials.” this interconnectedness is so substantial
that the failure of one such institution will
Notion of ‘too interconnected’ bring down others – whether, in Bernanke’s
According to the article: “Officials have words, Bear’s failure could “have cast doubt
been scrambling to come up with new tools on the financial positions of some of Bear
because the old ones aren’t suited for this Stearns’ thousands of counterparties.” If so,
21st-century crisis, in which financial inno- then its interconnectedness would have had
vation has rendered many institutions not significant implications for the financial sys-
‘too big to fail’ but ‘too interconnected to be tem as a whole.
allowed to fail suddenly’.”[7] But if Bear was indeed solvent at the time
Thereafter, the idea that Bear was too – something the Fed and Treasury must have
interconnected to fail was used regularly by known from discussions with the SEC – it is

highly implausible that its failure would have buck” – in other words, it failed to maintain
dragged down its counterparties. If a firm is a $1 per share redemption value – and trig-
solvent, all its creditors will be paid in due gered runs at other money-market funds
course. where investors felt they might be at risk
of a similar loss. The threat to“thousands of
Illiquidity, solvency and bankruptcy counterparties” that Bernanke envisioned
Although Bear had become illiquid when occurring if Bear had not been rescued
many counterparties withdrew their financ- never materialised after Lehman filed for
ing, bankruptcy is designed for firms that are bankruptcy.
solvent but illiquid; it provides temporary Even Lehman’s credit default swap
protection and allows a creditor panic to (CDS) obligations, and the CDSs written
subside while the firm marshals its resources specifically on Lehman by others, did not
and makes arrangements for orderly cause any substantial disruption in the CDS
payment. market when Lehman collapsed. Within a
That is what Bear would have been able month after the bankruptcy, all of the CDSs
to do if it had been allowed to file for bank- specifically written on Lehman were settled
ruptcy. Its rescue short-circuited that process, through the exchange of approximately $6
and thus we will never know whether Bear’s billion among hundreds of counterparties,
filing would have brought about the sys- and while Lehman had over 900,000 deriva-
temic event that Bernanke feared by drag- tives contracts outstanding at the time it filed
ging down its counterparties. for bankruptcy, these did not give rise to any
However, a partial but persuasive answer known insolvency among those of its coun-
to whether Bear’s bankruptcy filing would terparties that were protected by a Lehman
have caused a systemic disruption is pro- CDS.
vided by the failure of Lehman Brothers
that occurred six months later. Unlike Bear, Bear ‘rationale’ proved erronous
Lehman was likely not solvent, and it had In cases where Lehman’s derivatives coun-
certainly become illiquid by the time it filed ter-parties suffered losses, the counterpar-
for bankruptcy. ties filed appropriate claims in the Lehman
bankruptcy proceeding, which are being
Lack of ‘interconnected’ contagion adjudicated in the ordinary course. In other
Nevertheless, despite all the market tur- words, Lehman – a larger firm than Bear
moil that followed Lehman’s bankruptcy and one that had more “interconnections” –
filing, there was only one case of a Lehman had no significant effect in dragging down
counterparty or creditor failing because of its counterparties. This suggests that the
Lehman’s inability to meet its financial obli- rationale given for Bear’s rescue – its exten-
gations. That case was the Reserve Fund, a sive “interconnections” – was erroneous. If
money–market fund that held a substantial Lehman’s interconnections did not drag
amount of Lehman’s commercial paper. The down its counterparties, Bear’s certainly
Reserve Fund’s losses caused it to“break the would not have done so.

The turmoil and freeze-up in lending that they could then avoid a loss on the paper’s
followed Lehman’s bankruptcy was unprec- reduced value. This conclusion would be
edented and frightening to all observers. consistent with the CDS market’s judgment
about the likelihood of a government rescue
Bear amplified ‘moral hazard’ effect for Lehman. Thus, when Lehman filed for
However, there is a substantial likelihood bankruptcy, the markets were shocked. The
that the moral hazard created by the rescue result – hoarding cash and freezing lending –
of Bear was the reason Lehman’s bank- was the rational response to a sudden reali-
ruptcy precipitated a crisis. A review of the sation that the world’s governments were
CDS spreads on Lehman shows that they not going to rescue all large firms.
moved within a relatively narrow range as Now it was necessary to know the
Lehman’s condition continued to weaken financial condition of all counterparties and
through the summer and into the autumn to hold cash in case depositors and other
of 2008. funding sources were to withdraw funds or
It was not until just before the fate- cut off lending. This produced the freeze-up
ful weekend of September 13-14, 2008, in lending that most people now regard as
that the spreads blew out, indicating that the financial crisis. In addition, the rescue of
despite Lehman’s deteriorating condition, Bear probably made it more difficult to find a
those seeking to protect themselves against buyer for Lehman.
Lehman’s failure were finding ready coun-
terparties in the CDS market. This suggests Lehman and market surprise
strongly that the market was expecting a res- After Bear, it was rational for Lehman’s man-
cue until the very last minute, which would agement to expect a rescue, and that would
be entirely rational; no sensible person could have reduced their interest in selling the firm
have imagined that the US government or diluting the stockholders; it would also
would rescue Bear but not Lehman. have kept the firm’s selling price higher than
Lehman was much larger, more intercon- it might otherwise have been. Potential buy-
nected, and a major player in the CDS ers, like the Korean Development Bank or
market – one of the markets where inter- Barclays Bank, would likely have expected
connections were supposed to be most some US government support, just as JP
troublesome. If, as government officials were Morgan Chase had received in buying Bear.
arguing, Bear’s interconnections were really When this was not offered, it is likely
the basis for Bear’s rescue, it would have that they backed away from the acquisition
been completely irresponsible for officials to to put pressure on US officials to come for-
have allowed Lehman to fail. ward with financial assistance. Like other
Indeed, it would not be surprising to market participants, it was probably difficult
learn that the managers of the Reserve for potential acquirers to believe that the
Fund decided to hold the fund’s Lehman US government would have rescued Bear
commercial paper because they expected because it was supposedly too intercon-
that Lehman would also be rescued and nected with others in the financial system,

but would be willing to allow Lehman to fail. This is characteristic of narratives. Once
These are all the likely consequences of the they are established, subsequent events that
moral hazard created by the rescue of Bear, are thought to confirm the narrative are
which increasingly – with the passage of reported in the media, while those that chal-
time – seems to be the central policy error in lenge the narrative are ignored or explained
the US government’s response to the finan- away. Thus, one commentator saw intercon-
cial-market weakness that was coming to nectedness as the cause of the post-Lehman
light in early 2008. chaos even though it was largely imaginary:
Thus, the rescue of Bear – which was
probably unnecessary in the first place – Enter a ‘financial super regulator’
reduced Lehman’s incentive to want or to For many, the lesson of Lehman Brothers
find a buyer, reduced the incentives of poten- is that a financial firm had to fail in order to
tial acquirers to make offers for Lehman demonstrate how interconnected the entire
without government support, and caused a financial system was, often at levels that
catastrophic freeze-up in the market when it even top US market players and govern-
became clear that the US government would ment officials could not have foreseen.
not carry out with Lehman the logical impli- However painful Lehman’s financial
cations of its claim that Bear was too inter- and economy effects was on the market
connected to be allowed to fail. [sic] experts said the bankruptcy provided
the political will necessary to begin serious
Evolution of rescue ‘narrative’ discussions about the country’s need for a
Nevertheless, by the time Lehman filed financial super regulator.[12]
its bankruptcy petition in the autumn of Through interpretations like this, the
2008, the idea that Bear had to be rescued explanation for why Bear was rescued
because of its “interconnectedness” was the evolved into a conclusion with far greater
unquestioned explanation for the actions policy significance; under the new interpre-
of the Treasury and Fed, regularly used by tation of Lehman, all large financial firms
members of the Bush administration and – because of their purported interconnected-
repeated in virtually every media account of ness – were inherently a danger to financial-
the Bear rescue.[11] system stability.
Given this acceptance, and recalling the This provided a rationale for extensive
Tolstoy observation, it is not surprising that government regulation, since regulation was
the turmoil following Lehman’s bankruptcy believed (again, without much evidence)
was not examined for what it showed about to be effective in reducing the likelihood of
the rescue of Bear; nor was Bear’s rescue a financial institution’s failure and thus the
examined for what it likely contributed to the chances of another financial crisis.
turmoil that occurred after Lehman’s col- Writing in the Journal of Credit Risk, one
lapse. Instead, the post-Lehman chaos was commentator made this connection explicit:
interpreted as confirmation that Lehman as “This crisis – and the cases of firms like
well as Bear should have been rescued. Lehman Brothers and AIG has made clear

that certain large, interconnected firms and financial system, and to make sure they have
markets need to be under a more consistent the resources to weather even the worst of
and more conservative regulatory regime. economic storms.”[14]
It is not enough to address the potential This statement says it all: interconnected
insolvency of individual institutions – we financial firms require regulation or they will,
must also ensure the stability of the system by taking risks, bring down the financial sys-
itself.”[13] tem again. Similar declarations – implicating
interconnectedness in the financial crisis –
Obama approach were made in the white paper the adminis-
That is exactly the approach the Obama tration issued in June 2009 as a prelude to the
administration adopted upon taking office. introduction of its regulatory legislation,[15]
Through use of the interconnectedness idea, and thereafter by Treasury Secretary Timothy
it became possible for the administration to F. Geithner,[16] presidential adviser Paul
propose a comprehensive system of regula- Volcker,[17] and many others in the adminis-
tion for the largest non-bank financial firms, tration and Congress.[18]
going far beyond any regulatory regime ever The beauty of it was that they could
envisioned in the past. make these statements without fear of con-
This extensive regulation was justified by tradiction because the underlying idea – that
arguing that if one of these large firms were large firms were so interconnected that the
to fail it could – like Lehman – cause instabil- failure of one would bring down others –
ity in the financial system, just as Bernanke had now become not only an explanation
had argued that the failure of Bear Stearns for the rescue of Bear, but also, because of the
could have undermined the financial condi- chaos that followed Lehman’s bankruptcy,
tion of“thousands”of its counterparties. the accepted narrative for what caused the
financial crisis itself.
An inconvenient truth As Tolstoy observed, even intelligent
The fact that this never occurred when people, once they have accepted an idea,
Lehman failed was ignored. For example, in a cannot be persuaded to re-examine their
statement on September 15, 2009, the anni- position. That is the power of a narrative. •
versary of Lehman’s bankruptcy, President
Barack Obama stated: “While holding the Reference:
Federal Reserve fully accountable for regula- 1. See Peter J. Wallison, “Deregulation and the Financial
tion of the largest, most interconnected firms Crisis: Another Urban Myth,” AEI Financial Services
. . . we’ll also require these financial firms to Outlook (Oct. 2009), available at www.aei.org/out-
meet stronger capital and liquidity require- look/100089; and Peter J. Wallison, “Cause and Effect:
ments and observe greater constraints on Government Policies and the Financial Crisis,” Critical
their risky behaviour. That’s one of the les- Review 21, No. 2-3 (June 2009): 365-76, available at
sons of the past year. The only way to avoid a www.aei.org/article/101071.
crisis of this magnitude is to ensure that large 2. Michael Lewis,The Big Short:Inside the Doomsday
firms can’t take risks that threaten our entire Machine (New York:W.W. Norton, 2010), ix.

3. Financial Crisis Inquiry Commission, The Falls,” Newsweek, July 28, 2008; and Gretchen
Shadow Banking System – Day 1, 111th Cong., 2d. Morgenson,“DoYou Have Any Reforms in Size XL?”
sess., May 5, 2010, available at www.fcic.gov/hear- NewYork Times, April 23, 2010.
ings/05–05–2010.php (accessed May 20, 2010). 9. See, for example, John Waggoner and David J.
4. Ibid. Lynch, “Red Flags in Bear Stearns’ Collapse,” USA
5. Ibid. Today, March 19, 2008; and Matthew Goldstein,“Bear
6. Minutes of the Board of Governors of the Federal Stearns’ Big Bailout,” Bloomberg Businessweek,
Reserve System, March 14, 2008, quoted in Greg March 14, 2008, available at www.business-
Robb,“Bear Stearns Too Interconnected to Fail, Fed week.com/ bwdaily/dnflash/content/mar2008/
Says,” MarketWatch, June 27, 2008, available at www. db20080314_993131.htm?campaign_id=rss_daily
marketwatch.com/story/fed-believed-bear-stearns- (accessed May 19, 2010).
was-too-interconnected-to-fail (accessed May 19, 10. Senate Committee on Banking, Housing,
2010) (emphasis added). and Urban Affairs, Statement of Ben S. Bernanke,
7. Robin Sidel, Dennis K. Berman, and Kate Kelly,“J.P. Chairman, Board of Governors of the Federal
Morgan Buys Bear in Fire Sale, as Fed Widens Credit Reserve System, 110th Cong., 2d sess., April 3,
to Avert Crisis,” Wall Street Journal, March 17, 2008 2008, 3–4, available at http://banking.senate.gov/
(emphasis added). public/index.cfm?FuseAction=Files.View&FileStore_
8. See Federal Reserve chairman Ben S. Bernanke: id=0a0ec016–ad61– 4736–b6e3–7eb61fbc0c69
“Our financial system is extremely complex and (accessed May 19, 2010) (emphasis added).
interconnected, and Bear Stearns participated 11. See, for example, Mark Gongloff, “Street’s
extensively in a range of critical markets,” and Fate Is in Hands of Uncle Sam,” Wall Street Journal,
Robert Steel, under-secretary of the Treasury for September 18, 2008; Stephen Labaton, “Trying to
domestic finance: “The failure of a firm at that Rein in ‘Too Big to Fail’ Institutions,” New York Times,
time that was so connected to so many corners October 26, 2009; Caroline Baum,“Ask Bear Stearns
of our markets would have caused financial dis- Stockholders about Moral Hazard,” Bloomberg.com,
ruptions beyond Wall Street,” quoted in Associated March 18, 2008, available at www.sddt.com/Search/
Press, “Quotes from Bear Stearns Hearing,” article. cfm?SourceCode=20080318fm (accessed
FoxNews.com, April 3, 2008, available at www. May 19, 2010); and Irwin Stelzer, “Banking Crisis:
foxnews.com/wires/2008Apr03/0,4670,Congress It’s Déjà Vu All Over Again,” Sunday Times (London),
BearStearnsQuotes,00.html (accessed May 19, March 23, 2008.
2010). See also Michael M. Grynbaum, “Paulson 12. Ken Sweet, “Lehman’s Harsh Lesson to the
Urges Americans to be Patient on the Economy,” Global Economy,” FoxBusiness.com, September 14,
New York Times, July 23, 2008;“’Too Big to Fail’ Is Too 2009, available at www.foxbusiness.com/story/mar-
Expensive by Half,” ChiefExecutive.net, November/ kets/industries/finance/lehmans-harsh-lesson-global-
December 2009, available at www.chiefexecutive. economy (accessed May 19, 2010).
net/ ME2/ dirmod.asp?sid=&nm=&type=Publishing 13. Jeffrey Rosenberg, “Toward a Clear
&mod=Publications%3A%3AArticle&mid=8F3A70 Understanding of the Systemic Risks of Large
27421841978F18BE895F87F791&tier=4&id=FA948 Institutions,” Journal of Credit Risk 5, No. 2 (Summer
EDD2F744208935FAE67A5001184 (accessed May 2009).
19, 2010); Jeffrey E. Garten, “Yet Another Domino 14. Barack Obama, “Text of Obama’s Speech on

Financial Reform,” New York Times, September 15, 24, 2009, available at www.financialstability.gov/ lat-
2009 [emphasis added]. est/tg67.html (accessed May 19, 2010).
15. The white paper says, “All large, interconnected 17. Paul Volcker, “How to Reform Our Financial
firms whose failure could threaten the stability of System,” NewYork Times, January 30, 2010.
the system should be subject to consolidated super- 18. Benton Ives, “Kanjorski Unveils Proposal to
vision by the Federal Reserve regardless of whether Break Up Risky Firms,” Congressional Quarterly Today,
they own an insured depository institution.” See US Nov. 18, 2009.
Dept of the Treasury, Financial Regulatory Reform:A
New Foundation; Rebuilding Financial Supervision & Editor’s note
Regulation, 111th Cong., 1st sess. (Washington, DC, The Journal of Regulation and Risk – North
June 17, 2009), 6, available at www.financialstability. Asia wish to thank Peter J. Wallison and the
gov/docs/regs/FinalReport_web.pdf (accessed May American Enterprise Institute for allowing
19, 2010). us to publish an amended version of this
16. FinancialStability.gov, “Treasury Secretary paper, which was originally hosted on the
Tim Geithner Written Testimony House Financial AEI website. We remind readers that copy-
Services Committee Hearing,” news release, March right remains with the author and the AEI.

North Asia
Reprint Service J ournal of reg

ulation & risk
north asia
nce Volume I, Issue III,

Complia Articles & Papers
Autumn Winter 2009-2010
Issues in resolving
systemically important
impacts
financial institution
s
l change
Resecuritisation Dr Eric S. Rosengren
in banking: major
financia liance and risk

challenges ahead
A framework for
Global
funding liquidity Dr Fang Du
in times of financial
comp Housing, monetary crisis
and fiscal policies: Dr Ulrich Bindseil
– ent from bad to worst
managem
Derivatives: from
disaster to re-regulat Stephan Schoess,
products ails a potent ion
head of det
Black swans, market Professor Lynn A. Stout
EastNet’s David Dekker,
crises and risk: the
rkets. human perspectiv
ncial ma Measuring & managing e
nce,
complia al reaction in fina
risk for innovative Joseph Rizzi
financial instrumen
Red star spangled ts
chemic banner: root causes Dr Stuart M. Turnbull
of the financial crisis
oth-
The ‘family’ risk: Andreas Kern & Christian
es amongst ces. a cause for concern Fahrholz
compani among Asian investors
be one of to offer these servi Global t financial change impacts complianc
will just David Smith
signs be able speak abou e and risk
we saw
the first ld ers
that will ld rather Thei-scramble is on
mon Opinion
we shou banks, or that to tackle bribery David Dekker
a year ago the financial wor s These days ns than
and corruption
About mation in it crisi institutio , a nameWho exactly is subject to the Penelope Tham & Gerald
of a tran
sfor
months
the cred
world at
finan cial
financial
service prov iders
e activities.
Foreign Corrupt Practices
Act? Deregulatio Li
and in
the last
the financial that is tored curre
Financial
nt and futur have moved markets remuneration reform: one Tham Yuet-Ming n, non-regu
and ‘desup lation
sformed ge rs their ly we s step forward
has tran . the chan than cove how rapid n on the Ofbank ‘Black Swans’, stress tests Umesh Kumar & Kevin
osive pace in scope Look at interactio ) to & optimised risk Marr
an expl
is much
broader
occurring expected. banks
that were from physical hours of
operation
Challenging the
ing. value of enterprise
management
David Samuels ervision’
fail or fall s (location and Inter net bank risk management
Professor
causes of the William Black exam
ly to ents then
original too big by term Rocky but
charge, road ahead for global accountancy convergen Tim Pagett & Ranjit
ed to be being taken over - electronic paym s were still in
Jaswal
consider ng or ing to aregulatory ce
mortgage frau ines the
n the bank paradigm is shift Asian
The
either faili more finan Rubik’s Cube Dr Philip Goeth
are that are
ns - Agai
para the d and cor-
ons d epidemic
institutio a huge mentione sical pers s has swept that
financial d, resulting in by as
Alan Ewins and Angus
regarded re we (phy r without the bank Ross the Uni
cially soun how banks are world whe othe such as THE autho ted States.
t in ) pay each nologies r of this
digm shif r banks. porations new tech academic, paper is a
lic and othe ent with lawyer and leading
the pub involvem ents. regulator former bank and they implic
around speci itly demonstrat
ly revolves mobile paym crime. As one alising in ‘white
ing cal
failures of e three criti-
e bank ing large custo mers, los- of the unsu collar’ failure regulation
and a whole
Contact
Sinc ce s ions Savings & ng of private mark
y to servi ct ider nisat Loans debac heroes of the and sale
the abilit ing the impa ork prov s and orga r pay- et discipline
trust and determin risk Netw future the bank and othe
Professor
Black nowa le of the 1980s, Crime
other forms of fraud
mer and ongoing the NACHA
of credit risk.
ing a custo be part of the as In SWIFT, providers of his time days spend s Enforceme The Financial
ld ion, as well such as become
network
A to B
researchin s much
released nt Network
of it, shou of the organisat markets have g why finan
cial Activi a study this week on
(FinCEN)
ent ing and new ment networks send money from traf- a tendency
managem ess of exist ying to ork functional
. Renowned to become dys- lated Reports (SARs) that
ty Suspicious
g the riskin using/bu allow you you for the netw
monitorin customers ges that ge s similari- ‘control fraud for his theor financial institu federally regu-
and the more chan will char This bring energy ’, Prof. Black y on with tions (some
products But there are d that are and you generate. telecom, University
of Missouri lectures at
the (FBI)
the Federal
Bureau of
times) file
ucts. worl fic that as
these prod s in the banking stries such financial He is the autho and Kansas when they Investigatio
enge known it. with indu panies. The r of ‘The Best City. find evidence n
chall we have ties com important a Bank is Way to Rob fraud. of mortgage
Christopher Rogers
and as the cable
g banking e, not be liers and rgoing an to Own One:
threatenin s will, in the futur our funds, supp is clearly unde Executives
and Polit
How Corpo
The bank by which to mov
e
; they
world S&L Indus icians Loote rate Epidemic warn
cles portfolios 135 try.’ A prom d the The ing
default vehi balances and tor on the
causes of
inent comm FBI
enta- mortg began warning of an
our the current
maintain crisis, Prof.
Black is a financial age fraud in “epidemic”
of
Nor th Asia way the US vocal mony in September
their congr
ession
Risk critic of the al testi-
lation & governmen ago. It also 2004 – over
of Regu banking crisis t has hand five years
Journal and rewar led the
not dealt with
warned that
if the epide
that have ded institution it would cause mic were
clearl
duties to inves y failed in their fiduc s sis. Nothing remot a financial
Editor in Chief
tors. iary respo ely cri-
nd to the epide adequate was done to
enforcemen mic by regula
The following t, or tors, law
essarily repres commentary
does cipline.” Instea private sector “mark
ent the view not nec- hyper d, the epidemic produ et dis-
Regulation of the Journa -inflated a ced and
and Risk – l of that bubble in US
“The new North Asia. produced a housing prices
numbers on crisis so severe
rals for mortg criminal refer- caused the collapse that it nearly
age fraud in system of the global financ
the US are
just in many and led to unpreceden ial
of the world ted bailouts
Journal of ’s largest banks of
Regulation .
& Risk North
Asia
33

Governance
Minority shareholders blind

to threat of expropriation
Dr Fritz Foley et al propose a new under-
standing of investor structures that allow
big stockholders to swallow smaller peers.
Why do minority shareholders continue foresee the possibility of expropriation by

to hold stock despite the risk of expro- controlling shareholders. As a result, under
priation by controlling shareholders? this view, the share price that minority inves-
This paper provides two decades of evi- tors are willing to pay reflects their rational
dence from Japan suggesting that many expectations of expropriation and other
investors do not foresee these conflicts of agency problems.
interest, even when there is plenty of dis- And because outside equity is expen-
closure. Inefficient stock markets allow sive, controlling shareholders will only raise
majority shareholders – often parent equity capital from minority investors if
companies – to sell overpriced stock only there are commensurate benefits, such as
to buy it back at a later date. attractive growth opportunities that the firm
would not be able to finance otherwise.
One of the major accomplishments of recent
corporate governance research has been Agency problems
to expose the risks confronted by minority However, recent research raises major issues
shareholders in public companies around with the prevailing view of why agency prob-
the globe. lems persist and thus calls for a new under-
Corporate ownership structures such as standing of why these said problems arise to
pyramids, business groups, and dual class begin with. In recent research (Chernenko et
shares leave control in the hands of a lim- al. 2010), the authors of this paper propose a
ited set of block holders – exposing minority new and alternative view for the emergence
investors to potential expropriation. of ownership structures that are prone to
Why, then, do minority sharehold- severe agency problems.
ers participate in these arrangements? The Motivated by the growing literature
prevailing academic view since Jensen and studying the effects of stock market mispric-
Meckling (1976) is that capital markets are ing on firm behaviour (see for example Stein
efficient in the sense that minority investors 1996, Shleifer and Vishny 2003, and Baker

2009), we develop a simple framework for and they earned post-listing returns that
thinking about how stock market mis-pric- were well below those of the aggregate stock
ing can offset agency costs and induce con- market, and well below the returns earned
trolling shareholders to raise outside equity. by shareholders of the parent company.
Using a large sample of subsidiaries
Japanese experience listed in Japan between 1980 and 2005, we
Our argument is as follows. Suppose that find that the experience of NEC Electronics
during some periods, investors are over- is not unique. The evidence is consistent
optimistic, failing to see the potential for con- with three predictions that follow from our
flicts of interest between themselves and the framework.
controlling owner. Under these conditions,
equity is overpriced relative to a valuation Predictive framework
that fully accounts for the conflicts of inter- First, the incentive to divert resources is
est between minority and majority investors. stronger when a controlling shareholder
Stock market mis-pricing induces the con- maintains a smaller ownership stake after
trolling shareholder to sell overpriced equity, listing – so these listings require more mis-
subsequently diverting resources to his benefit. pricing. Consistent with this notion, we find
In order to return to the previous ownership that subsidiaries in which the controlling
structures with the same agency problems, shareholder sells a larger stake at listing gen-
even greater mis-evaluation is required. erate low post listing returns.
Our basic idea is motivated by the stock Second, we find that subsidiaries that
market performance of minority investors in have product market relationships with
publicly held subsidiaries in Japan. It is com- their parents also generate low post-listing
mon practice for large companies in Japan returns. The scope for agency problems is
to list their subsidiaries on the stock market, high for these kinds of subsidiaries, so more
while maintaining a controlling stake there- mis-pricing is required to support them.
after. Although subsidiaries are technically Third, prices are likely to revert to fun-
independent companies once they are listed, damental value, and when they do, the
the potential for the expropriation of minor- controlling shareholder often repurchases
ity shareholders is immense. the subsidiaries to eliminate agency costs.
We find that 25 per cent of the subsidiar-
NEC expropriation ies in our sample are repurchased before
In a case study of NEC Electronics, we docu- 2007, and that parent shareholders earn
ment how parent company NEC forced its positive returns when these repurchases are
publicly listed subsidiary NEC Electronics to announced.
bear billions of dollars of wasteful R&D and The idea that stock mis-pricing supports
capital expenditures on behalf of the parent the creation of ownership structures prone to
company’s mobile phone line. But minor- agency problems has important implications
ity shareholders in NEC Electronics did not for corporate governance regulations. Many
seem to have anticipated this kind of activity, regulatory proposals are aimed at increased

disclosure and transparency. Our research could potentially help explain the persistence
suggests that, by themselves, more disclo- of weak protection of minority shareholders
sure and transparency may not be enough, in many countries around the world. •
as they will not prevent minority sharehold-
ers from overpaying for equity. Editor’s Note
Experimental evidence suggests that Dr Fritz Foley, Associate Professor, Harvard
decision makers often ignore conflicts of Business School, would like to extend his
interest, even when such conflicts are promi- gratitude to the co-authors of this research
nently disclosed (Cain et al. 2005). And regu- paper – Dr Sergey Chernenko, Assistant
lators themselves often express concern that Professor, Fisher College of Business, Ohio
investors will not be able to understand con- State University, and Dr Robin Greenwood,
flicts of interest, even when there is plenty of Associate Professor at the Harvard Business
disclosure. School. The Journal’s publisher and editors
Consider for example the recent decision would like to thank VoXEu for allowing us to
of the Securities and Futures Commission reprint this paper originally hosted on www.
of Hong Kong to allow shares of the United voxeu.org
Company RUSAL to be listed on the Hong
Kong Stock Exchange. The regulators pre- References
vented retail investors from participating, Baker, Malcolm (2009), “Capital market-driven cor-
despite the risks being disclosed in a 1,000- porate finance”, Annual Review of Financial Economics,
page prospectus. 1:181-205.
Cain, Daylian M, George Loewenstein, and Don A
Role of business groups Moore (2005), “The dirt on coming clean: Perverse
Our research also contributes to the debate effects of disclosing conflicts of interest”, Journal of
regarding the role of business groups in Legal Studies, 34:1-25.
emerging economies, in particular the extent Chernenko, Sergey, C Fritz Foley, and Robin Green-
to which business groups help overcome wood (2010), “Agency costs, mispricing, and owner-
market inefficiencies or engage in rent seek- ship structure”, working paper.
ing behaviour. Foley, C Fritz, Robin Greenwood and Jim Quinn
Without denying their ability to help (2008),“NEC Electronics”, Harvard Business School
overcome various market inefficiencies, our Case, No. 209001.
research suggests that taking advantage of Jensen, Michael C, and William Meckling (1976),
temporary stock mis-pricing can contribute “Theory of the firm: managerial behaviour, agency
to the formation of business groups and costs, and ownership structure”, Journal of Financial
other ownership structures prone to agency Economics, 3:305-360.
problems. Shleifer, Andrei, and Robert W Vishny (2003), “Stock
Finally, being able to opportunistically market driven acquisitions”, Journal of Financial Eco-
raise outside equity when it is overvalued may nomics, 70:295-311.
reduce entrepreneurs’ incentive to lobby for Stein, Jeremy C (1996),“Rational capital budgeting in
strong corporate governance regulations. This an irrational world”, Journal of Business, 69:429-455.

Derivatives
‘Swap tango’: a regulatory

dance in two acts
Author and risk doyen, Satyajit Das, takes
a sledgehammer to regulatory proposals to
oversee the global derivatives market.
ON July 30, 1998, Alan Greenspan, in relation to derivatives from being debated
then chairman of the Federal Reserve, and dealt with.
argued that: “Regulation of derivatives Based on surveys conducted by the Bank
transactions that are privately negoti- of International Settlements (BIS), the global
ated by professionals is unnecessary.” In derivative market as at June 2009 totalled
October 2008, the now former chairman US$605 trillion in notional amount – in June
grudgingly acknowledged that he was this year it is guesstimated that the figure is
“partially” wrong to oppose regulation between $650 billion to $700 billion depend-
of credit default swaps (CDS). “Credit ing on which source is utilised, but still below
default swaps, I think, have serious prob- its 2008 high.
lems associated with them,” he admitted
to a Congressional hearing. His current OTC v. exchange trades
views on wider derivative regulation This is a large increase in size from less than
remain unknown. $10 trillion 20 years ago. The bulk of the
activity takes place in the over-the-counter
Politicians and regulators globally are cur- (OTC) market where derivatives are traded
rently busy drafting laws to regulate deriva- privately and on a bilateral basis between
tives. A common theme underlying the banks and clients. The OTC market should
activity is an absence of knowledge of the be contrasted with the exchange-traded
true operation of the industry and the mat- market where relatively standardised prod-
ters that need to be addressed. As Goethe ucts are traded on formalised, regulated
observed: “There is nothing more frighten- exchanges.
ing than ignorance in action.” The outstanding amount compares
The author Thomas Pynchon warned:“If to global gross domestic product (GDP)
they can get you to ask the wrong questions of around $60 billion. As author Richard
then the answers don’t matter.” Simplistic Duncan points out in his 2009 book, The
causes and solutions may prevent real issues Corruption of Capitalism, the outstandings in

the global derivatives market at its peak in and any measure of leverage. The size of the
June 2008 ($760 trillion) was equal to “eve- market is inconsistent with the thesis that
rything produced on earth during the pre- derivatives are merely a vehicle for hedging
vious 20 years.” Or, to put this into another and risk management.
perspective, the value was equal to $190,000 Current regulatory proposals do not
for each person on the planet. attempt to deal with the size of the deriva-
tives markets. The current debate about“too
Apples and oranges big to fail”banks may indirectly affect the size
Volume estimates are affected by double issue. Approached to provide government
and triple counting and other statistical aid to a company that claimed it was too big
problems. There are also significant disa- to fail, Richard Nixon advised:“get smaller”!
greements about the significance of the size Derivative regulators would do well to heed
numbers. Derivative professionals argue that Nixon’s advice.
derivative notional amounts (the face value Proponents argue that derivatives are
of the contract) are a stock measure (like used principally for hedging and arbitrage.
assets and liabilities). GDP is a flow measure In this way, they perform an economically
(i.e. income). So strictly speaking they are not useful function aiding capital formation and
directly comparable. reallocating risk to those willing and better
Derivative professionals also argue that able to bear them. While they can be used
the outstanding value is irrelevant as it is for this purpose, derivatives are now used
only the notional face value of contracts. extensively for speculation, that is, manufac-
They focus on the current value (around $25 turing risk and creating leverage.
trillion) that can be further reduced after net-
ting between dealers to around $4-5 trillion. Quantitative hyperbole
If the $4 trillion in collateral (cash and gov- Stripped of quantitative hyperbole, deriva-
ernment securities) held to secure the cur- tives enable traders to take the risk of the
rent value is considered, then they argue that asset without the need to own and fund it.
the exposure is a negligible amount. For example, the purchase of $10 million of
In effect, there is no risk. The size of the shares requires commitment of cash.
market doesn’t matter. As Laurence J. Peter Instead, the trader can enter a total return
author of the famous ‘Peter Principal’ stated: swap (TRS) where he receives the return on
“Facts are stubborn things, but statistics are the share (dividends and increases in price)
more pliable.” Current value is a calculation in return for paying the cost of holding the
of the worth of the derivative contract if ter- shares (decreases in price and the funding
minated today. It provides a useful measure cost of the dealer).The TRS requires no fund-
of current price and risk. ing other than any collateral required by the
The notional amount represents the dealer; this is substantially less than the $10
actual amount of underlying assets that the million required to buy the shares.
trader is exposed to. The notional face value The trader acquires the same exposure
is the essential starting point of market size as buying the shares but increases its return

and risk through leverage. Derivative vol- Nash. is“what keeps horses from betting on
umes are inconsistent with pure risk transfer. what people will do.”
In the CDS market, volumes were in excess Proponents argue that speculators
of four times outstanding underlying bonds facilitate markets and bring down trading
and loans. In the currency and interest rates, costs, thereby helping capital formation and
the multiples are higher. reducing cost of capital. There is little direct
evidence in support of this proposition.
Seeking alpha Recent experience suggests that in stressful
Investors searching for return drive specula- conditions speculators are users rather than
tion. Concerned about stagnant real incomes providers of scarce liquidity.
and inadequate retirement savings, individ- Given derivatives are second order
ual investors seek out higher yielding invest- instruments deriving its value from underly-
ment structures, often based on derivatives. ing assets, the argument regarding liquidity
Pension funds and other institutional is curious. In many cases, the derivative con-
investors use derivatives to enhance returns tract is far more liquid than the underlying
to fully fund and meet their contracted lia- debt, shares, currency or commodity. This is
bilities. In an environment of diminishing consistent with trading in derivatives hav-
returns and fierce competition for attractive ing a significant non-hedging, speculative
investments, fund managers use derivative element.
strategies to enhance returns through read-
ily accessible leverage and capacity to create Speculative activity
risk“cocktails”. Speculative activity amplifies rather than
Facing increased pressure on earnings, reduces volatility and systemic risks.
corporations have increasingly “financial- Perversely, this may impede capital forma-
ised”, resorting to speculative derivative tion and also increase the cost of capital for
trading to meet profit expectations. companies. A reduction in speculative activ-
This pattern affects small companies as ity would also arguable free up capital tied
well as large ones. It is also evident in emerg- up in trading. This capital could be deployed
ing as well as developed economies. In more effectively within the economy. Control
China, India and Korea, companies resorted of speculative activity in derivatives is feasi-
to aggressive derivative strategies to aug- ble. This would require traders to show an
ment earnings as profit margins on products underlying risk as a pre-condition to enter-
were relentlessly forced down by competi- ing into a derivative contract. In the case of
tion and buyer pressure. investors, it would also require the derivative
Some strategies have led to significant contract being covered fully with available
losses. The competitive advantage, if any, cash or other securities.
enjoyed by investors and corporations in The concept is used extensively in the
speculative trading, especially in complex insurance markets. A similar concept is
derivatives is unclear. Perhaps it is a lack of embedded in the hedge accounting stand-
“horse sense” which, as stated by Raymond ards currently in use. Current regulatory

proposals do not attempt to deal with specu- any of the fundamental issues relating to
lative activity directly in the derivatives mar- derivative activities.
kets. Some US insurance regulators have Relatively simple derivative prod-
proposed controls on speculative activity in ucts provide ample scope for risk transfer.
certain derivatives, such as CDS, by requiring Standard forwards or options will generally
an underlying position. complete markets and provide the ability to
Amusingly, dealers now argue that the manage risk. The proliferation of complex
bulk of trading activity is actually for hedging and opaque products is prima facie puzzling.
purposes. It may have something to do with
a more elastic definition of “hedging”. No Arrow-Debreu theorem
evidence was offered. Dealers were probably In the 1950s, two economists, Kenneth Arrow
following Mark Twain’s advice: “Get your and Gerard Debreu, proposed a theoretically
facts first, and then distort them as much perfect world – known as the Arrow-Debreu
as you please.” In reality, probably no more theorem. To attain the nirvana of economic
than 10-20 per cent of activity in the deriva- equilibrium, the theorem required there to
tive markets is related to hedging. be securities for sale for every possible state
The Obama Administration’s proposed of the future –“state securities”.
‘Volcker Rule’ prohibiting major banks There should be contracts to buy or
engaging in proprietary trading may, if sell everything at any time period in every
implemented, affect speculative activity in place until infinity or the end of the world,
derivatives. whichever was first. This utopian worldview
provides the justification for allowing any
Onerous Section 106 and every type of derivative markets to be
In the surreal theatre of US regulation, the created.
Senate Committee on Agriculture, Nutrition Dealers argue that such structures are
and Forestry, chaired by Blanche Lincoln, created in response to customer demand and
has introduced its own version of regula- to provide“financial solutions”. In my expe-
tions. The controversial Section 106 prohibits rience, clients rarely ask to be shown a US$/
banks using swaps from accessing the Fed’s Yen big figure stop with double-barrier con-
discount window. ditional accumulator (with or without Elvis
The proposal would prevent banks Presley pelvic thrusts). Complex structures
from hedging their own exposures using are designed and sold (often aggressively) by
swaps as well as trading swaps. At a mini- dealers. The major drivers for complex prod-
mum, it would force banks to move their ucts are increased risk and leverage. Some
derivatives activities into non-bank entities. structures are also designed to circumvent
Transferring such activities would require investment restrictions, bank capital rules,
additional capital (estimated at $20 billion and securities and tax legislation.
or more) and also result in higher cost of A key issue is the use of“embedded”lev-
funding for the derivatives activities. It is not erage. These arrangements are used to pro-
clear how this proposal actually addresses vide leverage to investors and corporations

whose internal or statutory rules prevent from a few complex products. They also
borrowing to finance increased investments. feed trading in standard products as dealers
Derivative technology is deployed to manage and re-allocate their risk from more
increase gains and losses for a particular structured transactions.
event (such as a change in market prices Complexity is also related to mis-selling
of an asset) in accordance with customer of derivative products. Arcane structures cre-
requirements to provide the effects of lever- ate significant information asymmetry. Mis-
age without transgressing their investment selling of “unsuitable” derivative products to
mandates. investors and corporations remains a prob-
Proposals to control bank leverage, in lem. Expertise of purchasers is sometimes
broad terms, lack understanding of the inversely related to the complexity of deriva-
issues of embedded leverage and its use in tive products.
financial markets.
Complexity is also related to profitabil- Lawyers’ bonanza
ity of derivative trading. On March 19, 1999, Currently, there are numerous disputes
Alan Greenspan speaking at the Futures concerning derivative transactions between
Industry Association Conference at Boca banks and their clients at various stages of
Raton, Florida, remarked:“. . . the profitabil- litigation and a significant source of earnings
ity of derivative products has been a major to litigation lawyers. It is difficult to identify
factor in the dramatic rise in large banks’ the causes – client greed or ignorance versus
non-interest earning and . . . the significant dealer greed or misrepresentation.
gain in the overall finance industry’s share Current regulatory proposals do not
of American corporate output . . . the value deal with the issue of complexity in deriva-
added of derivatives themselves derives tive products. Regulators could have forced
from their ability to enhance the process of standardisation and listing of derivative con-
wealth creation.” tracts, only allowing them to be traded on
exchanges. They have favoured, probably
‘Pharmaceutical’ style warnings correctly, the need to customise products
The former Fed Chairman’s statement and structures for users and their needs.
showed an alarming lack of understand- In relation to product suitability, the
ing of the real sources of derivative trading BIS have proposed “pharmaceutical-style”
profits. Many financial products are opaque warning systems, which do not address the
and priced inefficiently to produce exces- problem. Given significant information and
sive profits – economic rents – for dealers. know-ledge asymmetry between sellers and
efficiency and transparency is not consistent buyers, the possibility of disallowing certain
with high profit margins. types of transactions altogether or with cer-
The majority of derivative transactions tain parties should be considered.
are standard and “plain vanilla” earning low Such proposals are likely to be unac-
margins with dealers relying on volume for ceptable as inconsistent with “freedom of
profits. The bulk of dealer profitability comes choice”. Advocates of a “free market” are

likely to side with the view of an anonymous of active dealers means that “market” prices
commentator: “Nine out of 10 people who are sometimes no more than the dealer’s
change their minds are wrong the second own quote being fed back after being col-
time, too.” lated and “scrubbed” by an external data
Derivative contracts are valued on a provider. This is referred to prosaically as
mark-to-market (MtM) basis. This requires “mark-to-myself”.
valuation of the contracts based on the cur- Model variations and small differences in
rent market price. OTC derivatives trade pri- input can frequently result in large changes in
vately. Market prices for specific transactions values for some products. The models make
are not directly available. This means current numerous assumptions including the abil-
valuations rely on pricing models. ity to borrow at market rates for (theoreti-
cally) infinite amounts, unrestricted ability
Level 2 assets to enter into transactions and abundant
In current accounting argot, most deriva- trading liquidity. These assumptions are
tives are Level 2 assets (Mark-to-Model). difficult to satisfy in practice.
In practice, this means that they cannot be For example, a key assumption of deriva-
priced based on quoted trade prices (Level tive valuation is that a transaction can be
1) but are valued using observable inputs; hedged with a counterparty or through other
for example, comparable assets or instru- means at all times. In late 2008, in the after-
ments or using interest rates, volatility, cor- math of the collapse of Lehman Brothers
relation, credit spreads, etc, that can be put and problems at AIG, market liquidity dried
through an accepted model to establish up and made it impossible to source market
values. prices or transact in many instruments.
There are significant differences in the
complexity of the models and the ability Sage of Omaha
to verify and calibrate inputs. More com- Model-based valuations drive pricing of
plex products used sophisticated financial transactions and dealer hedging. They also
models, often derived from science or sta- are used to calculate the risk of the trans-
tistical methodology. There are frequently actions and ultimately to derive the capi-
differences in choice, exact factorisation tal required to be held for regulatory and
and even numerical implementation of the internal purposes. The model-based valu-
models. Different dealers may use differ- ations are also used to determine earnings
ent models. and ultimately bonus payments for dealer
Some required inputs for the models are staff. In Warren Buffet’s inimitable words
available from markets sources. The nature this allows the dealer to see “. . . where
of the OTC market and the limited trading the arrow of performance lands and then
in certain instruments mean that key input [paint] the bull’s eye around it”.
parameters must frequently be “estimated” Non-professional dealers rarely have the
or“bootstrapped”from available data. required sophisticated pricing and valuation
In certain products, the limited number systems. They are dependent upon valuation

data mainly supplied by dealers or, less fre- and Exchange Commission (SEC) to allow
quently, rely on pay-as-you-go pricing ser- MtM accounting to be used in the natural
vices. Investors use the model-based prices to gas industry. This allowed the company to
generate values for their fund units. Investors record current earnings based on the future
transact at these model-based prices when value of long-term contracts
they invest or redeem investments. Current regulatory proposals do not
attempt to deal with the pricing, valuation
Lack of model oversight and model issues. As Daniel C. Gelman
The accuracy and tractability of derivative observed: “Where secrecy reigns, careless-
valuation, especially for complex products, is ness and ignorance delight to hide.”
questionable. MtM prices may be also prone In derivative contracts, each party takes
to manipulation. Recent disclosures about the credit risk of the other side in terms of
events leading up the government bailout of performing their obligations. This is known
AIG highlight potential problems. as counterparty risk. The failure of Lehman
There is limited internal or external Brothers and a number of banks during
(auditors and regulators) oversight of the the Global Financial Crisis (GFC) high-
models. This reflects, in part, the complex- lighted the problems of counterparty risk in
ity of the models and the scarcity of experi- derivatives.
enced professionals capable of undertaking Counterparty risk in derivatives is differ-
such reviews. ent from credit risk generally. In a loan, the
Widespread reliance on models and lender is exposed to the risk of the borrower
MtM methodology is perhaps surprisingly failing to pay interest or repay the known
an unquestioned article of faith in financial face value of the loan. In contrast, in most
markets. It allows immediate recognition of derivative contracts (other than options),
gains and losses that will accrue over many the risk is mutual with both parties being
years immediately. After his purchase of exposed to the risk of non-payment by the
Gen Re and discovery of the problems sur- other. Counterparty risk is complex because
rounding its derivatives operations, Buffett the payment obligations between the parties
remarked: “I can assure you that the mark- are contingent. The quantum and the direc-
ing errors in the derivatives business have tion of payments depend on market price
not been symmetrical. Almost invariably movements.
they have favoured the trader who was eye-
ing a multi-million dollar bonus . . . Only Democratising risk
much later did shareholders learn that the The potential counterparty risk is not known
reported earnings were a sham.” in advance and is apparent only when actual
Interestingly, MtM accounting is gener- price movements occur. In practice, this
ally not available outside of financial instru- requires parties to estimate the potential
ments. An often neglected element of the exposure using mathematical models based
Enron scandal was the company’s ability to on the expected evolution of the relevant
convince its auditors and the US Securities market prices. In the 1980s when derivative

markets developed, counterparties were accuracy of valuations and risk models. It also
generally of high credit quality. This had the relies on certain and enforceable legal rights
effect of reducing, although not eliminating, in respect of collateral and proper manage-
counterparty risk. ment of the cash and security lodged.
Over the past two decades, the deriva- The GFC, especially the bankruptcy fil-
tives market has become more democratic. ing of Lehman Brothers, provided a test of
Entities with lower credit ratings have counterparty risk in derivatives.The quantifi-
become active users of derivatives. This cation and management of such risk proved
includes highly leveraged investors, such problematic.The quantum of credit risk from
as hedge funds and private equity funds. derivatives was higher than model based
Participation of these riskier entities has estimates as market volatility increased and
entailed reliance on credit enhancement correlations between risk factors moved
techniques. erratically. Legal enforceability, control and
management of collateral also experienced
Customised collateral problems.
The primary form of credit enhancement Current regulatory proposals focus heav-
is the use of bilateral collateral. This entails ily on counterparty risk issues. The central
counterparties posting collateral in the form legislative reform proposed is a central clear-
of cash or high-quality securities to secure inghouse – the central counterparty (CCP).
the current value of the contract. The collat- The BIS also proposed changes in capital
eral acts as surety against non-performance requirements against counterparty risk in
under the contract. the light of recent experience.
Collateral arrangements are highly Under the CCP arrangements, “stand-
customised. For example, AIG’s collateral ardised” derivative transactions must be
arrangements required the firm to post col- transferred to an entity that will guarantee
lateral only where the exposure under the performance. In a curious circularity, stand-
contracts increased above an agreed level ardised means anything that is eligible for
or AIG’s credit rating was reduced below a and can be “cleared”. Interesting inclusions
specified quality. and exclusions – both in terms of products
Other credit enhancement techniques and parties that must trade through the CCP
used include a right to break that allows – are to be found.
either party to terminate the contract
under certain credit-related circumstances. ‘Too big to fail’
Any such termination is at market values The arrangement centralises contracts in
triggering an obligation of one party to a single entity, the ultimate case of “too big
pay the other party the current value of to fail”. The CCP implements risk manage-
the contract. Counterparty risk and credit ment systems to manage its exposure under
enhancement techniques are predicated on derivative contracts. The CCP will be reliant
the same models used for pricing and valu- on risk models and the ability to value con-
ation. Use of bilateral collateral relies on the tracts. As noted above, there are significant

issues in pricing and valuing contracts and, counterparty risks restrict normal trading
for some products, reliance on complex activities.
models. Current regulatory proposals have not
The CCP proposal relies heavily on“self- focused on the issue on inter-connected
confidence”, which as Samuel Johnson trading and concentration risk other than
observed is“the first requisite to great under- as a by-product of the CCP proposal. It is
takings.” In relation to the CCP, legislators widely believed that the CCP will improve
and regulators are basing their approach on the market structure. In reality, the CCP
Lillian Hellman’s helpful advise: “It is best becomes a node of concentration. In addi-
to act with confidence, no matter how little tion, to the extent that products are not
right you have to it.” routed or counterparties are not obligated to
trade through the CCP, the problems remain
One (not very nice) world . . . and may increase.
The GFC, in line with previous derivative A central problem of the current deriva-
crises including the collapse of Long Term tive markets is potential liquidity (cash or
Capital Management (LTCM), revealed funding) risks. Ironically, the problems derive,
deep fault lines in financial markets. in substantial part, from the desire to reduce
Derivative markets entail complex counterparty risk through credit enhance-
chains of risk that link market participants. ment procedures, such as bilateral collateral.
This is similar to the re-insurance chains that Where derivative contracts are marked-
proved problematic in the case of Lloyd’s to-market daily and any gain or loss covered
Insurance market problems. In both mar- by collateral to minimise performance risk,
kets, the risks are both potentially significant movements in market rates can trigger large
and “long tail”, that is, they do not emerge cash requirements. These requirements may
immediately and may take some time to be be unanticipated. If there is a failure to meet a
fully quantified. margin call then the position must be closed
As in the re-insurance market, the long out and the collateral applied against the loss.
chain of derivative contracts can create This may leave the parties unhedged against
unknown concentration risks. This is exac- underlying risks or on offsetting positions
erbated by the highly concentrated structure creating the risk of additional losses.
of derivative trading. It is likely that for each
product or asset class a few dealers (less than ACA & AIG not unique
10-12 and sometimes as few as four or six) For example, ACA Financial Guaranty sold
account for the bulk of trading. protection totalling $69 billion while hav-
Five entities account for more than 95 ing capital resources of around $425 mil-
per cent of American financial firms’deriva- lion. When ACA was downgraded below“A”
tive holdings. This means that financial credit rating, it was required to post collateral
problems or uncertainty about any major of around $1.7 billion. ACA was unable to
dealer could cause the financial system to meet this requirement.
become gridlocked as uncertainty about AIG’s CDS contracts were subject to the

provision that if the firm was downgraded and infrequently traded reference entities,
below AA- then the firm would have to post is not unimpeachable. Where collateral is
collateral. In October 2008, when AIG was used, as noted above, monitoring and man-
downgraded below the nominated thresh- agement of collateral poses significant risks.
old, this triggered a collateral call rumoured Current regulatory proposals seek welcome
to be around $14 billion. AIG did not have improvements processes and systems for
the cash to meet this call and ultimately derivative trading.
required government support. The problems
at ACA and AIG are not unique. ISDA steps in
Current regulatory proposals do not Derivative contracts are documented under
address liquidity risks in derivative markets. the International Swap and Derivatives
Interestingly, the CCP may inadvertently Association (ISDA) Master Agreement.
increase liquidity risk as more participants The ISDA agreement has been remarkably
may be subject to margining and unex- successful in standardising documenta-
pected demands on cash resources. The BIS tion of trading. The contract has not been
has proposed an extensive regime of liquid- tested under stressful conditions such as
ity risk management controls that would, in those of the GFC. A number of issues have
part, cover some liquidity risks. emerged
The bankruptcy of Lehman Brothers
Greenspan’s ‘shock, horror’ and resulting unwinding of complex deriva-
The GFC has exposed long standing and tive arrangements has exposed problems of
significant problems with the infrastruc- derivative and bankruptcy law, especially in
ture of derivatives markets. In 2006, Alan cross-border, multi-jurisdictional transac-
Greenspan expressed shock and horror at tions. The GFC also exposed issues relating
the state of settlements in the credit deriva- to the documentation of specific derivative
tive market. He expressed surprise that contracts, such as CDS contracts, and the
banks trading CDS seemed to document impact on bankruptcy and resolution of
trades on scraps of paper. The ex-chairman, financial distressed firms. Current regulatory
perhaps unfamiliar with the reality of finan- proposals do not address any of these docu-
cial markets, had difficulty reconciling a mentary issues.
technologically advanced business with this
“appalling”operational environment. Regulatory arbitrage
Derivative systems and trade processing Bank regulatory capital has long distin-
are generally inadequate, with infrastructure guished between banking (loans or hold-to-
lagging well behind innovation. Delays in maturity assets) and trading books (trading
documenting contracts forced regulators to or available-for-sale assets). Differing capi-
step in requiring banks to confirm trades tal rules between the banking and trading
more promptly. books encouraged regulatory arbitrage,
The accuracy of the mark-to-market generally using derivative structures to
values of contracts, particularly of less liquid reduce the required level of capital. The BIS

has addressed some regulatory anoma- it will be difficult for regulatory agencies to
lies, increasing the capital required against properly supervise dealers and derivative
derivative positions by the players activity. In terms of an old Spanish proverb
Regulatory initiatives continue to “Laws, like the spider’s web, catch the fly
emphasise improved disclosure of derivative and let the hawk go free.”
contract. There is already significant disclo-
sure, although much of it is incomprehen- Frenzied tone
sible and lacks utility. Additional disclosure Debate over regulation of financial services
will not significantly reduce systemic risks of has taken on a frenzied tone. Regulators
derivatives. and think tanks are producing voluminous,
On 25 September 2002, speaking at the overlapping and (sometimes) contradictory
UK Society of Business Economist while in proposals.
London to collect an honorary knighthood Regulatory agencies are jockeying for
for contribution to economic stability, Alan position, sometimes forming unlikely coa-
Greenspan outlined the case for less trans- litions to preserve or expand territory. In
parency:“. . . paradoxically, the full disclosure the US Congress, multiple bills and several
of what some participants know can under- committees are jostling to make sense and
mine incentives to take risk, a precondition harmonise complex and irreconcilable draft
to economic growth . . . to require disclo- legislation. Activity and achievement are
sure of the innovative product either before confused.
or after its introduction would eliminate
the quasi-monopoly return and discourage Rearguard banking actions
future endeavours to innovate . . . market Banks and their lobbyists do not believe
imperfections would remain unaddressed that there is a case for regulation. In William
and the allocation of capital to its most pro- Davenant’s words: “Had laws not been, we
ductive uses would be thwarted.” never had been blam’d; For not to know we
sinn’d is innocence.”
Dearth of experts Banks argue that the complex nature
Greenspan argued that even “disclosure of derivative trading dictates that self-reg-
on a confidential basis solely to regulatory ulation is the only feasible approach. If that
authorities may well inhibit . . . risk-taking.” fails, then banks seek to minimise scrutiny of
Dealers will undoubtedly resist meaningful major issues, such as the size of the market,
disclosure prejudicial to their economic inter- speculative activity, pricing issues, complex-
ests. Regulatory initiatives do little to address ity and mis-selling of derivatives to unsuit-
the quality of regulators and the acuity of able clients.
oversight. The absence of suitably expert and They further argue that existing regula-
experienced regulators will undermine regu- tions already adequately cover some issues.
latory and legislative initiatives. Proposed regulations will be masterfully
Given the shortage of talent in derivatives narrowed to minimise impediments to
generally and the pay grades of regulators, profitable activities. There will be a familiar

threat. Lack of international agreement and misdiagnosing it and then misapplying
regulatory uniformity makes compliance the wrong remedies.”
impractical. Banks and derivative activity will Legislators and regulators everywhere
relocate with losses of jobs and taxes to the are likely to discover the truth of that propo-
host country. sition in their attempts to regulate the deriv-
Familiar arguments will, of course, be ative market. •
heard regarding the loss of competitive
advantage, diminished financial innovation, Editor’s note
slower capital formation and higher cost The publisher and editor of the Journal of
of capital. Each is a well-known step in the Regulation & Risk – North Asia are grateful to
familiar“regulatory tango”. Satyajit Das for allowing the Journal to publish
an abridged version of this paper. We remind
Laws v. habits readers that all copyright on this article is
The complexity of the issues means that the sole preserve of Mr Das and can only be
ultimately no laws may be truly effec- reproduced with his express authority.
tive. As one famous law maker, Adlai Satyajit Das is the author of the newly-
Stevenson, observed “Laws are never released Traders, Guns & Money: Knowns
as effective as habits.” Groucho Marx and Unknowns in the Dazzling World
famously observed that “[government] is of Derivatives – Revised Edition (2010,
the art of looking for trouble, finding it, FT-Prentice Hall).

North Asia
Advertising deadline for

Vol II Issue IV Winter 2010/11
November 20, 2010
contact Chris Rogers


Sovereign debt
Beware Greeks bearing bonds:

A tragedy in four acts
Peterson Institute’s Michael Mussa exam-
ines some of the policy options Greece can
deploy to solve its sovereign debt problems.
In recent months, turbulence has To address remaining concerns about fis-

returned to global financial markets due cal sustainability in other advanced European
primarily to deepening fears about the countries, the European Union and the IMF
ability of Greece to service its sovereign have pledged to supply up to US$1 trillion of
debt and widening concerns about the financial support, and more if needed, to aid
ability of some other advanced European euro area members who face critical finan-
countries with large budget deficits and/ cial challenges – provided that these coun-
or high ratios of public debt to GDP to tries take appropriately vigorous measures
meet their obligations. to address their perceived fiscal weaknesses.
The European Central Bank (ECB) has
Led by Greece, interest rate spreads for some also indicated that, under this same proviso, it
European sovereigns have shot up, equity will purchase in the secondary market debts
markets have sold off in Europe and beyond, of euro area sovereigns when these markets
and measures of financial stress and volatil- appear to have become “dysfunctional.”
ity have escalated (although they generally
remain well be low their crisis peaks in late The Greek situation
2008 and early 2009). This paper primarily addresses the current
The official international community situation in Greece and the challenges to
has responded to this new challenge with the IMF-EU supported programmeme that
a very large financial support package for is designed to assist Greece. Before turning
Greece, involving both the European Union in-depth to this subject, however, it is impor-
(especially the euro area) and the IMF – tant to reflect on the broader financial and
in conjunction with firm pledges by the economic challenges in Western Europe and
Greek government to undertake rigorous the Euro bloc of countries.
fiscal consolidation and other reforms to Then, after discussing Greece in some
restore creditworthiness and international detail, it will be relevant to reflect on the
competitiveness. broader implications that arise from the

Greek crisis for Europe and for the rest of the and uncertain. There are some recent signs
world, including an emphasis on the United that recovery in France, Germany, and sev-
States of America. eral other euro area countries is accelerating.
A deepening crisis in Greece that spread to
Greece is not alone an economically more substantial group of
If Greece were perceived to be essentially euro area countries could seriously blunt
alone in its present difficulties, then several recovery in the rest of Western Europe. Most
different approaches by the international of the rest of the world (except for Central
community to assist in dealing with Greece’s and Eastern Europe) would be more mod-
problems would be reasonable to contem- estly affected, but the effect would not be
plate - and quite possibly adopt. positive or trivial.
But, Greece is not entirely alone in its In sum, this is an especially inconven-
present predicament. Other countries in the ient time for Greece to blow up into a major
euro area (specifically Portugal, Ireland, Italy, financial crisis raising fears of considerably
and Spain) are perceived to share, qualita- broader problems in Western Europe and
tively if not quantitatively, some of the same beyond. Indeed, an international effort that
concerns about fiscal sustainability and inter- helps Greece avoid sovereign default – or at
national competitiveness (within the euro least postpones it until generally better times
area and externally) that now afflict Greece. – is desirable not only, and perhaps not pri-
If Greece were to default upon and/or marily, for how it may help Greece but also
restructure its sovereign debt in the present for its more general benefits.
environment, this would undoubtedly incite
concerns that others might follow – con- Debt equation significance
tributing to the possibility of a self-fulfilling The notes at the end of this paper detail the
prophesy. In the extreme, if Greece were to basic equation of debt dynamics. Specifically,
exit from the eurozone in an effort to gain the rate of increase of a government’s debt
international competitiveness and spur to GDP ratio, D/Y, is the sum of two terms:
economic growth, this would undoubtedly first, the ratio of the primary deficit to GDP,
escalate concerns about the viability of the P/Y; and second the product of the difference
European Monetary Union (EMU) for all of between the interest rate on government
its members. This means that exit of Greece debt minus the growth rate of GDP, i – g,
from the euro area must be viewed as an times the debt to GDP ratio, D/Y.
extreme step that should be avoided at virtu- The significance of this equation of debt
ally all costs. dynamics, especially the importance of the
differential between the interest rate on gov-
Europe’s anaemic recovery ernment debt and the growth rate of (nomi-
More generally, while most of the world nal) GDP is well illustrated by example of the
economy now appears to be recovering with United States over the past 60 years. The US
moderate vigour from the great global reces- government has run persistent overall fiscal
sion, recovery in Western Europe is anaemic deficits virtually every year during this period

and the primary budget balance (excluding GDP growth and for debt dynamics. The
interest on the government debt held by adjustment and financing programmeme
the public) has recorded a large cumulative recently agreed between Greece and the
deficit. Nevertheless, the debt to GDP ratio IMF/European Union is supposed to address
has fallen from 98 per cent of GDP in 1950 these problems. The key features of this pro-
to about 60 per cent today. The reason is that, gramme are noted in the notes below.
on average, during this period, the growth Assuming that this programme works
rate of nominal GDP (g) of 6.7 per cent has as advertised, the debt dynamics from 2013
exceeded the average interest rate on federal onward would plausibly be described by
debt by about 2.5 per centage points. scenario 2, 3, or 4, depending both on how
credible and durable the market believed
Greek nine-year role Greece’s policy commitments to be and on
For the nine years from 1999 through 2008, how rapidly the Greek economy appeared
Greece enjoyed reasonably rapid nominal likely to grow in terms of nominal GDP –
GDP growth, which generally exceeded the both of which affect i – g. In the base reform
interest rate on Greek government debt. But, scenario 2 (IMF Programme A), with i – g =
growing primary deficits dominated debt 0, sustainability of debt dynamics is, at best,
dynamics and D/Y grew. With the sharp marginal. D/Y is declining, but the rate of
slowdown in Greek growth in 2008-09 and decline is not quite sufficient to allow timely
further rise in P/Y, D/Y shot up to 115 per repayment of official assistance (which
cent at end 2009. The D/Y ratio now stands enjoys preferred creditor status) except by
at about 120 per cent (see scenario 1 in the increasing the debt/GDP ratio for private
notes below). With nominal GDP growth creditors.
now expected to be significantly negative
and with the increase in interest rates on Keeping debt holders sweet
Greek debt, forward-looking debt dynam- Thus, for this scenario to be viable, private
ics indicate rapid rises in D/Y. Greece’s fiscal creditors would need to be comfortable with
situation is clearly unsustainable under these the prospect that the ratio of privately held
conditions. Greek debt to GDP would be rising for some
years as official borrowings were repaid. In
Unsustainable debt level the unfavourable (but realistic) reform sce-
Meanwhile, Greece’s international competi- nario 3 (IMF Programme B), i – g = + 3 per
tiveness has deteriorated in recent years as cent, reflecting likely concerns that debt
wage increases have substantially outpaced dynamics may be unsustainable. Here the
productivity increases (in key tradable goods rate of decline in D/Y, only 0.5 per cent per
industries and more generally). With the year, is clearly too slow to reinforce market
exchange rate pegged within the euro area, confidence, especially when it is known that
Greece requires outright wage deflation paybacks of official assistance will far more
to restore competitiveness within the area. than offset this modest rate of decline in D/Y
Achieving this will not be good for nominal as far as private creditors are concerned.

Good luck, however, is possible as por- To contain this later concern, the initial
trayed in scenario 4 (IMF Programme C). restructuring needs to be quite aggressive. In
Here i – g = – 2 per cent, signifying a high scenario 5 it is assumed that all existing debts
degree of market confidence in debt sustain- are immediately written down by 50 per cent
ability and a relatively high growth rate of with interest rates maintained at established
nominal GDP. In this case, the rate of reduc- levels on the reduced principals.
tion in D/Y is sufficient to allow for reason- In the case of such an aggressive restruc-
able rapid repayment of official support and turing, it is plausibly assumed that Greece
a modest pace of reduction in the ratio of would lose access to new private credit for
private credit to nominal GDP. some time. Accordingly, the primary budget
position would have to move immediately
Critical concerns into moderate surplus in order to make
A number of critics of the present approach the diminished interest payments on the
have suggested, not without reason, that reduced debt.
a debt restructuring for Greece is probably The need for this primary surplus might
inevitable. More disputably it is argued that be offset by official lending on a much dimin-
it would be best to do this restructuring up ished scale from the announced programme.
front in order (1) to avoid the loss of cred- But, under immediate restructuring even
ibility of subsequently appearing to fail and with moderate international support, Greece
being forced into a new strategy; (2) to keep cannot avoid a rapid move at least to primary
the required amount of official financing budget balance and probably beyond.
to more moderate levels; and (3) to lessen
concerns about moral hazard and “unfair- Alternative scenario
ness” by forcing all existing private creditors An alternative scenario for immediate
to realise up-front losses rather than allow- restructuring would involve a one-third
ing some creditors (with shorter-maturity write-down in the value of all outstanding
Greek debts) to escape losses while holders debt, holding interest rates constant. This
of longer-maturity debt are later forced to would be combined with a three-year exten-
accept even larger losses. sion of the maturities of all outstanding debts
and a three-year moratorium on all interest
Aggressive restructuring and principal payments.
Scenario 5 describes the possible debt The effect of such a (compulsory) restruc-
dynamics subsequent to an immediate turing would be to reduce the present value
restructuring. In this scenario, i – g = 5 per of the debt by about 50 per cent – the same
cent, signifying both that growth of nominal as in scenario 5. This form of restructuring
GDP is likely to be negative at least during would alleviate for three years the need to
the initial period following an immediate deal at all with the existing debt, at the cost
restructuring and that after such a restruc- of leaving a larger amount of private debt on
turing, creditors may worry that another the table to be dealt with later – perhaps with
restructuring may occur relatively soon. greater doubts about sustainability.

While there are good arguments to go for dedication to fiscal probity. European banks
an immediate restructuring if it is reasonably will have been able to strengthen their capi-
certain that a restructuring will ultimately be tal positions and prepare better for the con-
necessary, there are also at least two good sequences of a sovereign debt restructuring.
reasons in the present Greek case not to fol- In December 2008 President Bush decided
low this path. (with obvious reluctance) that, in the face of
continued high stress in United States and
Is restructuring necessary now? global financial markets, it was desirable
First, it is not entirely clear that a restructur- to delay major corporate bankruptcies by
ing will ultimately be necessary (although I General Motors and Chrysler by extending
would give it better than 50-50 odds). If it government loans. In those circumstances,
occurs, a sovereign debt restructuring will kicking the can down the road to a time
almost surely need to be quite aggressive in when resolution through the bankruptcy
order to contain the perceived risk of early process would presumably be less systemi-
recurrence. cally dangerous was clearly the right answer.
Understandably, creditors will be irate A similar consideration weighs heavily
and the Greek sovereign will not be able to against immediate sovereign debt restruc-
return to normal participation in financial turing for Greece.
markets for some time. The functioning of
the Greek financial system will be seriously IMF-EU bailout package
impaired for some time. The whole Greek The details of the IMF-EU plan for official
economy will suffer. financing for Greece is presented in table
Thus, looking only at Greece, there 4 of the “Memorandum of Economic and
is good reason to try to avoid sovereign Financial Policies” attached to the Greek
default and restructuring as long as there is Government’s request to the European
some reasonable chance of being success- Union for financial support. This plan
ful. Sovereign default is not a cheap way out. suggests that the issue of sovereign debt
(Exit from the eurozone would be even more rescheduling for Greece will probably need
disruptive and expensive.) to be revisited before the end of 2011.
The plan, which needs to be understood
Wider perspectives as a planning scenario subject to revision,
Second, from a European and global per- envisions the following: First, from now
spective, this is not the best moment for a through the end of 2011, the financing need
sovereign Greek debt restructuring. A year of the Greek state is estimated to be about
or two from now, most Western European €94 billion. Most of this need will be met
economies should be considerably more by international financial support disburse-
advanced in their economic recoveries. ments of €78 billion, with €25 billion sup-
Countries now perceived to have potential plied by an assumed rollover of short-term
fiscal sustainability problems will have had private credits. No rollover of longer-term
an opportunity to demonstrate better their private credits is assumed in this period.

Second, from the start of 2012 through the programme is implemented as promised, we
middle of 2013, the Greek government’s shall need to see in the summer and autumn
financing need is estimated to be about €99 of 2011 what is happening to yields in the
billion. Only €32 billion of official finan- secondary market for longer-term Greek
cial support is tentatively scheduled in this debt. If these yields suggest that longer
period. The remaining financing need is term debt rollover is likely to be feasible at
assumed to be met by continuing rollover of reasonable yields consistent with sustain-
short-term debts (€26 billion) and successful able debt dynamics, then the programme as
rollover of 75 per cent of longer-term private envisioned in table 4 can probably proceed
credits maturing in 2012, rising to 100 per successfully.
cent in the first half of 2013 (for €43 billion of However, if the markets signal that suf-
assumed financing). ficient credibility has not been achieved by
autumn of next year, then major decisions
Important questions about revising the programme will become
This scenario raises the obvious and impor- necessary. One possibility would be to
tant question of whether, by the start of 2012, decide that a sovereign debt restructuring
private creditors will be willing to lend, for has indeed become necessary. The extent of
the long term, substantial sums to the Greek the necessary restructuring would depend
sovereign at reasonable interest rates. In on what the Greek authorities had accom-
2011, the Greek economy is projected to still plished and reasonably could be expected
be contracting. Important fiscal measures to deliver in the future. A modest haircut for
scheduled in the programme for 2012 and private creditors would almost surely not be
2013, amounting to 4.4 per cent of GDP and an option.
providing for the move to primary surplus,
will not yet have been implemented. ‘Haircuts’ may be necessary
Commitments to repay official lenders as If restructuring is really needed, it will have
preferred creditors will already exceed one- to involve a substantial write-down in the
third of Greek GDP and stand in front of present value of the private debt in order to
obligations to private creditors. In these cir- provide reasonable assurance that another
cumstances it seems implausible to assume restructuring will not soon be needed. The
that private creditors be confident about result will likely be a costly mess for Greece
extending longer term credits to the Greek and its creditors. Hopefully, however, by late
sovereign. 2011 the adverse spillover effects to the rest
of Europe and the world economy will be
Effects on yields limited.
If the Greek authorities fail to implement The other alternative is to persevere
the programme to which they are commit- with the programme, augmenting its official
ted, we shall learn relatively quickly that pro- financing and probably insisting on some-
gramme is not viable and debt default and/ what greater efforts by the Greek authori-
or restructuring is likely soon to ensue. If the ties. The additional official financing should

not be a serious problem if, as hoped, other drawn from this episode. First, while Greece
euro area members presently perceived to is the first of the so-called“advanced econo-
be at some risk regarding fiscal sustainabil- mies” to seriously confront the risk of sov-
ity do not need to draw on the $1 trillion of ereign default and restructuring in half a
already agreed available support. Under this century, it will not necessarily be the last.
approach private creditors would receive Even the United States is not inherently
an even larger “bailout,” with increased offi- immune. The economic and political power
cial financing going to pay down longer of the United States and the special role of
maturities of Greek government debt. the dollar in world finance provide a degree
Unfortunately this would contribute both to of protection. More important, the long
the “immoral result” of rewarding past poor record of the US government in meeting its
lending decisions and to the moral hazard financial obligations underlies confidence
form encouraging more such decisions in that this will continue to be the case.
the future. US public debt shot up to over 100 per
cent of GDP during World War II and was
Avoiding moral hazard brought back down to about 30 per cent by
In contrast, the Greek government and peo- 1980. It rose again to about 60 per cent by
ple would not be receiving a true “bailout.” the early 1990s, and it was brought down
Massive fiscal adjustment would be required, again to around 30 per cent by 2000. In the
sufficient to move the primary budget bal- past two years, the US debt to GDP ratio
ance from substantial deficit into consid- has rebounded to about 60 per cent and is
erable surplus. Also, so long as the official surely headed higher. The test ahead will
support that Greece receives is in the form of be whether this debt ratio can be contained
loans that must be repaid with interest, then at 75 to 80 per cent of GDP in the next few
that at least compensates official creditors for years and then be brought down to more
their own cost of funds. And there will be no reasonable levels.
true“bailout”of Greek citizens at the expense
of taxpayers in other countries. US federal debt
What about the “moral hazard” of pos- In this regard, stabilising the federal debt
sibly encouraging other countries to fol- to GDP ratio at around 80 per cent, which
low Greece’s example because the even appears to be the current administration’s
larger costs of sovereign default have been objective, will not be enough. Containing
avoided? Well, watching the experience of rising entitlement spending, as well as pro-
Greece in this episode, who would reasona- viding for some structural rise in federal rev-
bly say:“Let us follow the example of Greece enues are essential to put the debt-to-GDP
in its great glory”? ratio clearly on a downward course to some-
where below 50 per cent.
Broader lessons and implications If the challenge is not met, there is a
Looking again beyond Greece, there are clear danger that the next time the United
at least two important wider lessons to be States has to confront a deep recession and/

or major financial crisis, it will not enjoy might trigger it, when a crisis threatens to go
the unalloyed market confidence that has systemic, there is no sensible alternative but
allowed it to deal so forcefully with the massive extensions of official financial sup-
recent crisis. Finally, Greece is a relatively port and government guarantees of a wide
small country and is surely not “too big to range of credits. Much can and should be
fail” in the sense of enduring a sovereign done both to limit the risk of future crises
default and debt restructuring. and to contain the moral hazard that inevita-
bly results from expectations of government
Greater worry intervention – especially when potential dif-
The international response to help Greece ficulties do not seriously threaten to reach
in its present difficulties, however, is not systemic proportions.
motivated solely or perhaps primarily by But centuries of economic history dem-
concerns about the costly mess that would onstrate that major crises will happen from
engulf Greece in the wake of sovereign time to time.
default. The greater worry is that in present It would be a great tragedy if the very
circumstances a Greek default might trigger forceful efforts that were deployed to contain
a much deeper and wider crisis in Europe the recent systemic crisis were paralysed by
and around the world. In a similar way, in too much talk about ending bailouts and
September 2008, Lehman Brothers was not “too big to fail,” with the result that we rec-
by itself“too big to fail,”and, in my view, the reated the disastrous situation of the early
sudden bankruptcy of Lehman Brothers was 1930s. •
not the cause of the deep crisis that gripped
global financial markets in the autumn of Editor’s note
2008. The Journal of Regulation & Risk – North
Lehman’s bankruptcy helped to trigger Asia would like to express its gratitude to
that crisis, but it was the general weakness Michael Mussa and the Peterson Institute
and perceived fragility of many financial for International Economics for granting us
institutions and other businesses that really permission to reproduce an amended ver-
made the crisis. sion of this article. We remind readers that
The lesson from this experience and copyright remains with Mr Mussa and the
from the present Greek case is that, whatever Peterson Institute.
Table 1. Scenarios for Greek debt dynamics

i–g D/Y P/Y d(D/Y)/dt
Scenario
(per cent) (per cent) (per cent) (per cent)
Current, no programme 10 120 8 20
IMF Programme A 0 150 –5 –5
IMF Programme B 3 150 –5 –0.5
IMF Programme C –2 150 –5 –8
Restructure now 5 60 –3 0
Restructure later 1 100 –5 –4

Notes on Greece and the IMF 2013, with 3.9 per cent in revenue measures
Debt Dynamics: The rate of change of the and 7.1 per cent in expenditure measures.
stock of public debt, D, is given by dD/dt = The (additional) effect of these measures is
P + i D, where P is the primary deficit and 2.5 per cent of GDP in 2010, 4.1 per cent in
i is the average interest rate on government 2011, 2.4 per cent in 2012, and 2.0 per cent
debt. The rate of change of the debt to nomi- in 2013. A primary surplus of at least five per
nal GDP ratio is d(D/Y)/dt = (P/Y) + (i – g) cent of GDP is projected to be maintained
(D/Y), where g is the growth rate of nominal after 2013.
GDP. 3. The programme ceiling on the public
1. The programme envisions declines in debt for end 2010 is €342 billion (148 per
real GDP of four per cent in 2010 and 2.5 cent of yearly GDP). The “indicative target”
per cent in 2011, before growth resumes at a for public debt at end 2011 is €365 billion
moderate pace. The price level is assumed to (163 per cent of GDP). The implied ceiling
fall, at least this year and next. Nominal GDP for public debt at end 2012 is €381 billion.
is projected at €231 billion in 2010, €224 bil- Editor(160 per cent of GDP). Thereafter, the
lion in 2011, €238 billion in 2012, and €235 debt to GDP ratio is projected to decline.
billion in 2013. 4. The programme also includes struc-
2. The fiscal adjustment programme tural reforms to boost productivity and
includes consolidation measures amount- competitiveness, address problems in the
ing cumulatively to 11 per cent of GDP by financial sector, and bolster fiscal adjustment.
www.edit24.com


Sovereign debt
Global financial crisis and the

European Monetary Union
Prof Christian Fahrholz & Dr Cezary
Wójcik examine the implications of the
global financial crisis for the euro area.
The unprecedented globally co-ordi- to the financial crisis by sharply increas-

nated stimuli programmes in the after- ing public deficits to fund major stimulus
math of the 2008 financial crisis averted packages, with many of these same coun-
an economic depression on par with that tries seeing their national deficits rise above
of the 1930s. However, such huge inter- six per cent of GDP. In the more advanced
vention, much of it with borrowed funds, western economies whose fiscal stimuli pro-
has led to a secondary crisis, this time grammes were more aggressive debt levels
focused on sovereign debt as countries rose to some nine per cent – compared with
begin the onerous task of slashing public an average of four per cent for developing
expenditure in order to release funds to economies (cf. IMF 2010).
service national debt repayments. Concurrent with these massive govern-
ment interventions, many central backs
The challenges associated with this pro- across the world adopted a near zero inter-
cess are particularly acute in the Euro-zone est rate policy, whilst also easing access to
bloc of countries, with one of its members, their liquidity windows by accepting a much
Greece, struggling to avoid defaulting on its broader class of assets for their open mar-
debt repayments. This issue has resulted in ket operations for longer time frames than
a domino effect afflicting Portugal, Ireland, prior to the crisis. Other unusual methods
Italy, Spain and Greece itself and marks the adopted to stave off catastrophe included the
greatest challenge the European Monetary introduction of quantitative easing by the US
Union (EMU) has faced since its inception. Federal Reserve and the Bank of England –
In this paper, the authors examine the where by both institutions have engaged
current nature of the Greek debt crisis and directly in purchasing government bonds.
how this informs the constitution of the As a consequence of all this monetary eas-
EMU and its future development if the Euro ing, central bank assets ballooned to all-time
is to survive another 10 years. record figures as seen in figure 2 overleaf.
Governments the world-over reacted This monetary policy thus far has not

Figure 1. Fiscal balance, 2000-2014 (projected)
Source: World Economic Outlook, IMF, October 2009
Figure 2. Total assets/liabilities of selected central banks (US$ billions),

May 2006-April, 2010
Sources: Bank of England, Bank of Japan, European Central Bank, US Federal Reserve

Figure 3. Spreads of Greek, Irish, Spanish and Polish government bond yields over
German government bond yields, 1998-2009
Source: Bloomberg
created too many inflationary forces due to that Greece’s current woes could result in the
the fact that a large proportion of the funds implosion of the Euro and the collapse of the
have been utilised to restore commercial EMU which poses a significant risk not only
banks balance sheets in order to prevent a to Europe, but to the global economy itself
deflationary rout – although it remains to be as highlighted by Fahrholz and Kern in 2009
seen if such actions will result in inflationary and Fell in 2010.
pressures. However, fiscal problems have The current Euro and Greek crisis thus
already surfaced in some economies, with begs four important questions, namely:
many of these adopting austerity measures What are the roots of the current Greek
to prevent a sovereign debt run in the mar- problems within EMU? What is the short-
kets and as such, now threaten the nascent term response of EMU countries to such a
global recovery as countries cut back on Greek-type crisis? What does the Greek
expenditure. crisis tell us about the construction of the
Nowhere is this currently better illus- EMU? What should be done to safeguard
trated than in the European Union, specifi- the EMU and the euro in the long-run?
cally the Euro bloc of nations, with one of its With regard to the first question, it is
own members, Greece, verging on the brink important to note that while the global crisis
of a sovereign debt default – this despite mas- has been a trigger, the Greek problems are
sive European Central Bank interventions. primarily home-grown. Accor ding to the
Many commentators have even suggested latest European Statistical Office estimates,

Greece’s fiscal deficit reached a whopping are forced to adopt a painful internal pro-
13.6 per cent of GDP last year. As a result, cess of devaluation, such as the lowering of
the overall public debt is currently running at nominal wages.
some 115 per cent of GDP. At the same time,
GDP growth remains in a negative trajectory Ratings downgrade
as the country remains uncompetitive with As a consequence of this ongoing deflation-
its major trading partners vis-a-vis the EU. In ary process, Greece has been hit by several
the past two years alone, its unit labour costs downgrades of its government debt ratings
increased by more than 20 per cent relative since the beginning of 2010, with markets
to its main trading partners, with its current showing considerable unease to the extent
account deficit increasing to some 12 per that the yield spreads of Greek government
cent of GDP. bonds skyrocketed to above 1,000 basis
points relative to German yields – this being
EMU shortcomings considerably higher than spreads on those
Greece’s problems, though, cannot entirely Eastern European countries who have yet to
be blamed on its own actions, particularly join the EMU (see figure 2).
given numerous shortcomings in the EMU This leads us to the second question:
framework, specifically with regard to the what is the short-term response of the EMU
Stability Pact, which, in theory at least, should countries to a Greek-type crisis?
work pre-emptively to mitigate against a Despite the crisis, it took the European
Greek-style debt problem – this plainly not Commission, ECB and Euro-bloc mem-
being not the case in this instance. ber countries a significant period of time
Moreover, current developments can be to agree on any emergency bail-out efforts,
partly traced back to a speedy catch-up pro- and only then in co-operation with the IMF.
cess, that coupled with EMU membership The resultant agreed package of emergency
led to the risk premium in peripheral EU assistance extends to funds from both EU
countries, such as Greece, to drop to excep- members and the IMF, ameliorated with
tionally low levels. Again, revert to figure 2. an exceptional credit guarantee line – the
The resultant low costs of funding, in Special PurposeVehicle – amounting to €750
turn, led debtors and creditors to engage in billion (approximately US$ 995 billion).
excessive lending and indebtedness. This
applies equally to the public and the private Stabalisation plan
sector and is certainly not limited to the The three-year stabilisation plan includes
European sphere. €60 billion provided by the European
As a member of the EMU, member coun- Commission, €440 billion provided in
tries have limited scope for active policies to bilateral loans and guarantees by euro area
correct this problem, specifically by resorting members, as well as €250 billion from the
to a currency devaluation to help ease any International Monetary Fund (IMF). In addi-
fiscal adjustments and restore international tion, the European Central Bank committed
competitiveness. As such, member countries to the direct purchase of government bonds

on the open market. Economists disagree couple of ‘twin deficit’ countries which suffer
vehemently as to whether this is the correct from the twin problems of public debt sus-
prescriptive course to follow and question tainability and external debt sustainability
why Greece and other crisis-prone coun- – for example in Greece, as well as in Spain
tries should, or should not be bailed out at or in Portugal. The second group of countries
all, specifically if it relates to a monetisation – for example, Germany – is characterised
of public debt? Some commentators (e.g., by current account surpluses within the
Frankel 2010, Issing 2010, Wyplosz 2010) euro area and more sustainable public debt
have argued that providing any form of positions.
financial support would be a policy mistake,
as it would undermine the very foundations Lack of integration
of the EMU, and jeopardise the stability of Furthermore, there is incomplete political
the euro in the long-run by creating moral integration among the agents, with Euro-
hazard in the future. bloc countries having different incentives to
being an EMU member, with each member
Default fears facing different constitu ency constraints,
In contrast, others argue that letting Greece combined with the fact there is no auto
default could cause a domino effect within matic emergency financing mechanism for
the periphery members thereby threatening unwinding severe fiscal and macroeconomic
to break-up the Euro and unleashing “the imbalances in the EMU. Hence, EMU has
mother of all financial crises” (Eichengreen been a hotchpotch of compromises since
2010). Hence, in their view, Europe needs to negotiations began in the 1970s, with this
create a strong emergency financing mecha- informing the direction of fiscal affairs until
nism that is eventually backed by a higher the present day.
degree of political integration.
Irrespective of what should or should EMU advantages
not be done at the European level, its at least Both ‘camps’ are generally interested in pre-
now possible to attempt an evaluation of the serving the smooth functioning of the EMU.
root cause of the current crisis on theoreti- From the viewpoint of a country like Greece,
cal grounds by means of a game-theoretic, membership in the euro area is advanta-
political economy model of default exter- geous as it helps to provide access to finan-
nalities in a monetary union with incom- cial markets and to real external resources,
plete political integration – as in the case whilst paradoxically, leading to a loosen-
of a Greek-type crisis. This can be done by ing of budgetary constraints for periphery
reviewing some of the basic features found members. At the same time, membership
in this type of analysis (for further details see in the euro area is beneficial for a country
Fahrholz and Wójcik 2010). like Germany, as it supports its export-ori-
As to the general set-up, there are two ented production and respective economic
representative agents involved in the game. policy stance. Against the backdrop of these
We assume that within the EMU there are a rationales for an EMU membership, ‘EMU

stability’is a public good whose deterioration there is the risk of an overall worst outcome
in the course of one member’s default would for such manouvering on the brink – i.e. for
make both camps worse off. example, an EMU break-up – thus constitut-
This particularly holds true when a con- ing a threat, which is not under full control
tagion presents itself within the EMU, with by the actors. As soon as it turns out that
the resultant possibility of a disorderly dis- the threat is indeed credible brinkmanship
integration process in terms of increasing ensues.
protectionism, reversing production process,
growth slack and overall welfare losses. Negative externality
Hence, although individual motivations By assuming the above structure – which
differ, the interest to preserve the smooth seems to be in line with what one can now
operation of the EMU is shared by all agents. observe in Europe – the analysis predicts that
Accordingly, both camps have some willing a threat of default by one member, creating
ness-to-pay for preserving EMU stability a negativity externality for the whole mon-
and their membership within EMU. etary union, must result in sharing the costs
of economic adjustment by the rest of the
Reciprocated mutuality members, i.e. a bail-out. Importantly, this is
The mutual willingness-to-pay for ‘EMU the direct consequence of the current insti-
stability’ constitutes the foundations of tutional set-up of EMU, of the sui generis
bargaining for redistribution of actors’ cost nature of EMU that it cannot easily escape.
shares within EMU. In this context, a country Interestingly, the analysis shows that
like Greece may resort to brinkmanship, as such a bail-out does not necessarily need to
its potential default would create a negative cause an excessive moral hazard problem.
externality, i.e. a Damocles sword hanging The bargaining process is so ‘tight’ that the
over the rest of the EMU members. This is to bailed-out country will abstain from further
say that if a ‘twin deficit’ country experiences attempts to promote a hazardous fiscal pol-
a sovereign debt crisis, such a crisis would icy stance and will behave well. Moreover,
almost certainly put the smooth operation of current account surplus countries’ willing-
EMU at risk. ness to pay for contributing to the public
As a consequence of this fragility, such good,‘EMU stability’,will be exhausted.
countries are likely to exhibit brinkman-
ship. Namely, if a ‘twin deficit’ country’s EMU construction
encounters an adverse economic situation, This brings us to the third question: What
it may ease the burden of adjustment to its does the Greek crisis tell about the construc-
constituency, thus, putting the success of the tion of the EMU? What’s wrong?
euro area at risk. In doing so, the twin defi- The delineated analysis indicates that the
cit country may elicit other EMU members’ current EMU problems do not only ensue
actual willingness to pay for ensuring the from the Greek fiscal problems alone, but
provision of the public good,‘EMU stability’, from the interactions of these problems with
in the long run. Importantly, above all factors the actual political-economic configuration

of EMU. To put it differently, the sheer fact macroeconomic imbalances within Europe
that countries share the same currency does reflect the concurrent building-up of claims
not necessarily lead to negative spill-overs and liabilities regarding future production
between them. If this was the case then (usually in the form of holding government
fiscal problems in Ecuador, a dollarised bonds within the banking sector).
country, would produce a threat to the dol-
lar – evidently this is not the case (see more Major pitfall
Balcerowicz 2010). In the EMU, however, Against this backdrop, one of the major
precisely such spillover – the negative exter- pitfalls of the EMU set-up is that it neither
nality – allows twin deficit countries such as provided incentives for curtailing excessive
Greece to take hostage the whole EMU and lending and indebtedness, nor for converting
thus poising a significant threat to the euro. the financing of external resources into real
investments, i.e. future production. As a result,
An analogy pending claims might turn irrecoverable,
Think of the following business analogy – which, in turn, may severely impair the for-
imagine two companies: In the first company, mation of the real economy, especially within
unexpected sick leave of one of the ordinary export-oriented economies of the EMU.
employees severely disrupts the production Apparently, the question is: what are the
process. In the second company, even unex- ‘procedures’that the US monetary union has
pected sick leave of one of the key managers and the European one does not? Basically, it
does not influence day-to-day operations. is greater policy co-ordination through big-
What makes the difference is that the second ger central budget allowing for fiscal transfers
company excels at better procedures: in case and federal bonds helping to finance it at a
of an event where all know what to do and low cost – it goes without saying that greater
who substitutes whom. labour mobility and flexibility of markets is
The EMU is an example of the first also conducive to economic adjustments.
economy. It is telling that a problem in one
very small country like Greece has a dispro- US comparisons
portionately greater impact on the stability of However, here we concentrate on economic
the whole area than this is the case in the US management tools. In essence, these tools in
monetary union where fiscal woes of even the US internalise the cost-sharing mecha-
such big states as California do not wreak nism. If economic growth in California goes
even a smaller amount of such havoc. down, the Federal Govern ment transfers
Moreover, Europe is a highly integrated funds to social security expenditure that
economic area in real terms. It goes without work as automatic stabilisers. Federal gov-
saying that allowing for the inter-temporal ernment can also issue federal bonds that
exchange of goods and services is a prereq- can finance these expenditures at lower
uisite for reaping welfare benefits stemming interest rates that a given state would be able
from higher productivity (i.e. specialisation to negotiate at financial markets.
in production). At the same time, the current Against this background we shall look

at the last question: What should be done to market reaction, should we experience a next
make the EMU and the euro more sustain- wave of rumours about potential default or
able in the long-run? exit. Since markets would know exactly
An ideal solution might be, of course, what conditions and form it would take,
creating similar tools in Europe as the ones there would be much less room for uncer-
present in the United States. However, it tainty and volatility in financial markets.
is naïve to think that this can be achieved Importantly, a clear-cut delineation of costs
quickly because it would require a far greater would serve as a deterrent to any form of
degree of political integration, to which the brinkmanship.
degree of policy co-ordination is endog-
enous. Policymakers in Europe know very Issues of sucession
well that stepping-up political integration It would be evident to all that no cost shar-
takes a frustratingly long time. At present, ing will take place should an exit occur. By
it may even make some steps backwards, increasing the perceived costs of leaving
given that the future EMU enlargement will relative to the short-term political costs of
further increase the political and economic economic adjustment, it could defuse future
heterogeneity of the euro area. threats of leaving and stimulate fiscal disci-
pline and, hence, considerably decrease the
A rock and a hard place scope for the negative externality.
Being squeezed between the undesir- The latter solution is not new. It draws on
able now and the desirable future, the EMU the history of some national states struggling
needs to develop some intermediate solu- with preserving internal integration. Their
tions that would help to cross the bridge. The experience suggests that when secession
sketched analysis above suggests at least is not permitted, pressure for it rises. When
possible avenues: If a bail-out is unavoidable secession is openly allowed many would-be
in the current state of political-economic secessionists cease to press so hard for it – or
configuration of the EMU than it should be for a bail-out as is the case with the Greek-
made rule-based and explicit. type crisis.
In order to decrease the scope of the
negative externality effect, EMU countries Concluding remarks
should specify the conditions and proce- As a concluding remark, one can look at the
dures for leaving the EMU, along the costs EMU crisis from two perspectives: on the one
and legal requirements of such an operation. hand, one can see it as a moment of disaster;
The first solution would clearly save all the on the other hand, one can see it as an oppor-
haggling and uncertainty in the course of tunity to push ahead with inevitable reforms.
such events resulting in lower risk premium For the time being – as the ‘United States of
which is associated with such uncertainty Europe’ seems to be politically unfeasible –
(see Bini Smaghi 2010 who makes a similar one may consider bringing financial markets
case in context of financial markets). back in to the arena. Measures of reasserting
The second solution would also stabilise the monitoring function of financial markets

may eventually curb the debtors’ ability to of the EMU. As regards global economic
demand ‘too much’ debt financing as less recovery, we would be intrigued to see how
investors will flock to ever-riskier govern- the issue of the ‘credit hangover’ will be
ment bonds. In this respect, most notably, solved on a global scale. It is hard to per-
one has to dampen any ambiguity of lender- ceive all economies in the world exhibiting
of-last-resort facilities to curtail creditors’ productivity leaps and exporting – and thus
moral hazard concerning a disproportionate paying their due liabilities in real terms – at
supply of credit-financing. the same time. •
A rule-based, auto matic resolu tion
regime comparable to insolvency proceed- References
ings for the private sector – instead of yet Balcerowicz Leszek, 2010,“Sovereign Bankruptcy in the EU
another dis cretionary intervention as has in the Comparative Perspective”, paper presented at the
been the case with Greece – would limit XII Travemünde Symposium zur ökonomischen Analyse
debtors’ moral hazard. Any reform steps des Rechts, Travemünde, 24-26 March 2010, http://www.
towards this direction would help stressing emle-hamburg.de/_data/Balcerowicz.pdf
market agents’personal liability again, which Bini Smaghi, Lorenzo, 2010, “It is better to have explicit
generally is a prerequisite for smooth opera- rules for bail-outs”, Financial Times, 16 March 2010.
tion of markets and may thus guarantee Eichengreen Barry, 2010, “Europe’s Trojan Horse”, Project
financial stability within the euro area in the Syndicate, http://www.project-syndicate.org/commentary/
long-run. eichengreen14/English, 15 February 2010.
Despite the current bashing of financial Fahrholz, Christian and Cezary Wójcik, 2010,“Modeling
market agents and the fractious debates on Default Externalities in EMU: Understanding the Impact of
financial mechanisms for dealing with the a Greek-type Crisis on the Euro Area”, mimeo.
debt crisis, Europe may seize the opportu- Fahrholz, Christian and Andreas Kern, 2009, “When
nity to preserve the euro and avoid a messy Economics is Crushing Big Fat Greek Wedding Plans:
disintegration. It is obvious that the recently A Greek Tale of Full-Blown Drama”. Paper published at
implemented credit guarantee line repre- Atlantic Community, Berlin, http://www.atlantic-commu-
sents only a delay of inevitable economic nity.org/index/Open_Think_Tank_Article/A_Big_Fat_
adjustments. Greek_Financial_Wedding, last update: 8 December 2009.
In addition, such emergency financing Fell, Charlie, 2010,“Euro zone currency crisis is only begin-
mechanism rather invites tumbling coun- ning”, Irish Times, 23 April 2010.
tries to skirt economic adjustment pro- Frankel, Jeffrey, 2010, “Let Greece Go to the IMF”, Jeff
cesses as their constituency pressures build. Frankels Weblog, http://content.ksg.harvard.edu/blog/
Notwithstanding, an advantage of European jeff_frankels_weblog/2010/02/11/let-greece-go-to-the-imf/,
‘cacophony’ is the potential to develop – 11 February 2010.
slowly but surely – a multitude of possible IMF, 2010, “World Economic Outlook – Rebalancing
ways out of its sovereign-debt crisis. Growth”, Washington, D.C., International Monetary Fund,
We have hence suggested the direc- April 2010.
tion of an intermediate solution in terms Issing, Otmar, 2010, “A Greek bail-out would be a disaster
of crafting an improved institutional set-up for Europe”, Financial Times, 16 February 2010.

Accounting
Lehman Bros and Repo 105:

a powerful case of addiction
University of Massachusetts, Amherst, Prof
Jennifer S. Taub details changes in law that
proved a powerful intoxicant for Wall St.
TO the uninitiated, ‘Repo 105’ evokes the A repurchase agreement or “repo” is a two-
name of a basic finance course or perhaps part arrangement. The seller (borrower of
an expensive perfume. However, the cash) agrees to sell securities at a slight dis-
broader implication of Lehman’s corrupt count to a buyer (lender of cash). Under that
accounting strategy is neither simple nor same agreement, the borrower agrees to buy
does it pass the smell test. The term Repo them back at a future date at a higher price[4].
105, floated through financial circles in The securities are known as “collateral.”The
March 2010, with the release of the exam- discount is known as the margin or“haircut”
iner’s report in the Lehman bankruptcy.[1] and the ratio between the increased price
Volume three of a 2,200 page document, and original price is known as the rate.
claimed that management used account-
ing tricks to mask US$50 billion in debt. Oiling Wall St’s wheels
Repos have been called the“oil in the indus-
While hiding $50 billion off balance sheet is try of Wall Street”[5] because investment
nothing to sneeze at, ‘Repo 105’ may be an banks financed up to 50 per cent of their
unfortunate distraction. Instead, we should assets in the repo markets.[.6] One analyst
focus on the perfectly legal, yet dangerous noted that“repo markets are only one chan-
use of repos backed by securitised bonds to nel linking the “shadow banking” sector to
grow balance sheets. the broader economy”.[7] Given its size and
This practice, expanded by a 2005 legal importance, the repo market is surprisingly
change, destabilised the financial sector and obscure.
led to the ultimate credit crisis of 2008. In At its peak, the US market was estimated
other words, this enabled what Gary Gorton to be between $7- $10 trillion.[.8] Outstanding
and Andrew Metrick deemed the “run on US repos today are approximately $4.3 tril-
repo”[2] and what Jane D’Arista described as lion.[9] Lenders in the repo market can be
a“run on the financial sector by the financial institutional investors like pension funds and
sector.”[3] mutual funds seeking a liquid but relatively

safe place to invest cash for the short term, late 2007, top investment banks were using
often overnight. Lenders also include bro- them to “manage” their balance sheets. By
ker-dealers and banks that need securities May, some firms admitted improper treat-
to cover short positions. Borrowers often are ment of repo transactions as sales. [10]
broker-dealers and banks who use repos to Shortly after the report was issued, the
finance asset purchases and to leverage. SEC announced an investigation of banks
using “repurchase agreements, securities
Lehman bankruptcy file lending transactions, or other transactions
Turning to the infamous Lehman bank- involving the transfer of financial assets with
ruptcy examiner’s report of March this year, an obligation to repurchase the transferred
according to this 2,000 odd page tomb, with assets”.[11]
‘Repo 105,’ Lehman, as borrower, accounted Additionally, another type of misleading
for US$50 billion in repos as sales instead of repo accounting surfaced. Eighteen banks
financing transactions. had “understated the debt levels used to
The examiner contended that the appro- fund securities trades by lowering them an
priate accounting practice was to record average 42 per cent at the end of each of the
these transactions on balance sheet by past five quarterly periods”.[12] These banks
increasing both cash (assets on the left side) include Goldman Sachs, Morgan Stanley,
and collateralized financing (liabilities on the JP Morgan Chase, Bank of America and
right side). Thus a properly recorded repo Citigroup.
transaction would have resulted in both a
larger balance sheet and also higher leverage 2008 Lehman panic
ratios. The SEC chief accountant testified that there
Instead of raising sufficient equity capi- did not seem to be evidence“that inappropri-
tal to lower leverage ratios, Lehman chose a ate practices were widespread”.[13] Yet, given
cosmetic solution. With ‘Repo 105,”near the that the larger problem is the legally“appro-
end of a reporting period, Lehman treated priate,”but systemically dangerous practices,
some repos as sales and used the cash pro- these words should offer little comfort.
ceeds to pay down liabilities. Gorton observed:“The [2008] panic cen-
This made the firm appear to have a tered on the repo market, which suffered
smaller balance sheet and less leverage than a run when lenders [like depositors dur-
it truly had. The transactions were called ing Depression-era banking runs] required
‘Repo 105’ and ‘Repo 108’ in reference to the increasing haircuts, due to concerns about
size of the haircut. For ‘Repo 105’ transac- the value and liquidity of the collateral
tions, Lehman would provide collateral said should the‘counterparty bank fail’.”
to be worth 105 per cent of the amount of These repo lenders also refused to roll-
cash it borrowed. over existing repos. Both actions created
Initially, other firms claimed they did not “massive deleveraging . . . resulting in the
engage in Repo 105s, yet, footnote 69 in the banking system being insolvent”.[14] Yet, the
examiner’s report implied that at least until run was not on the whole repo market, but

rather on repo agreements backed by non- happen to the repo lender with other types
government collateral – in particular, repo of collateral, in particular mortgage-related
backed by securitised bonds. securities. While repo lenders depended
Cash-rich lenders still sought oppor- upon another safe harbor for securities con-
tunities to loan against US Treasuries. They tracts, it was not sufficiently clear.
did not trust the valuation of the securitized Uncertainty ended in 2005, when
debt, including mortgage backed securities. Congress expanded the “safe harbour” to
Thus, it follows that haircuts got larger for additional collateral types, including “mort-
non-government collateral. gage-related securities . . . mortgage loans,
interests in mortgage related securities or
‘Haircuts’ at 45 per cent mortgage loans” and certain foreign sover-
And ultimately, some collateral simply could eign debt. This was affirmed in a subsequent
not be used at all. The average haircut on Delaware bankruptcy court decision in early
structured debt went from zero in 2007 to 10 2008 in the wake of the subprime crisis.[17]
percent by March 2008. In September 2008, Experts have questioned the wisdom of
the rate shot up from 25 per cent to 45 per the“safe harbour”. Stephen Lubben argued
cent.[15] How did this happen? Recent legal that “ the rush to close out positions and
changes transformed the market, from one demand collateral from firms . . . contribute[s]
backed by largely US Treasury and agency to the failure of an already weakened firm,
collateral to one backed by securitised bonds. by fostering a run on the firm [and] also has
These changes expanded this vital financ- consequent effects on the markets generally
ing market and made it far more unstable. as parties rush to sell trades with the debtor
Outstanding repos and reverse repos grew and buy corresponding positions with new
from $4.9 trillion in 2004 to $7 trillion by first counterparties”.[18]
quarter 2009.
Prior to the bankruptcy law changes, ‘Don’t overlook liquidity’
limited types of repos were given special Even bankers concede that repo contributed
treatment known as a “safe harbour” in to the maturity mismatch and interconnect-
bankruptcy. For example, if a repo borrower edness at the centre of the crisis. Goldman
filed for bankruptcy, a repo lender with spe- Sachs CEO, Lloyd Blankfein, noted that:
cial collateral was not subject to the auto- “Certainly, enhanced capital requirements
matic stay and would not need permission in general will reduce systemic risk. But we
before accelerating, closing out the agree- should not overlook liquidity. If a significant
ment, or selling the collateral.[16] portion of an institution’s assets are impaired
In addition, the interest paid on the repo and illiquid and its funding is relying on
would not be clawed back as a preference. short-term borrowing, low leverage will not
These collateral types included for example, be much comfort.”[19]Yet, little has been done
US Treasury and agency securities, certifi- to address this concern.
cates of deposit and certain bankers’ accept- New SEC rules actually may send more
ances. However, it was not clear what would cash into repos.This is due to the requirement

that taxable money market funds hold 10 per Services Hearing on “Systemic Regulation, Prudential
cent of assets in instruments which the fund Matters, Resolution Authority and Securitization,” Oct. 29,
has the right to receive cash with one day’s 2009
notice and all money market funds to hold 4. Michael J. Fleming and Kenneth D. Garbade, “The
30 per cent of assets in instruments that give Repurchase Agreement Refined: GCF Repo,” Current
the fund the right to receive cash in five busi- Issues in Economics and Finance, New York Fed.,Vol. 9, No.
ness days.[20] 6 (2003).
5. Rebecca Christie and Liz Capo McCormick, “Treasury
What of Dodd-Frank? Pledges to Protect Repos as Obama’s Plan Sparks
Despite admirable efforts by some members Concern,” Bloomberg, Jan. 28, 2010.
of Congress, the Dodd-Frank Act does not 6. Hördahl and King.
fix the problem. The House version permit- 7. “Barclays Capital Analyst Ponders Regulatory Status of
ted the FDIC as receiver to treat up to 10 Repo Market,” Feb. 8, 2010.
per cent of a secured claim (including repos 8.
The Securities Industry and Financial Markets
backed by collateral other than safe US gov- Association, “Financing by U.S. Government Primary
ernment securities) as unsecured. Securities Dealers,” (total repurchase and reverse repur-
However, this did not survive. Instead chase agreements at $7 trillion for Q1 2008, of which
the law mandates a study of FDIC liquida- $4.3 trillion repurchase agreements); Peter Hördahl and
tion and bankruptcy and to report whether Michael King, “Developments in Repo Markets During
secured creditor haircuts might “improve the Financial Turmoil,” Bank for International Settlements
market discipline and protect taxpay- Quarterly Review (2008), p. 37 (est. $10 trillion in U.S.).
ers.” Another forgone opportunity was an 9. SIFMA, Q1 2010, including both repurchase and reverse
amendment that would have rolled back the repurchase agreements, and only repurchase agreements,
safe harbour for repos. $2.48 trillion.
In the words of former President George 10. Michael Rapoport, “BofA, Citi, Made ‘Repos” Errors,”
W. Bush from the summer of 2008: “Wall NewYork Times, May 27, 2010.
Street got drunk.” The bartenders pouring 11. Available at http://www.sec.gov/divisions/corpfin/guid-
the drinks were repo lenders. We should ance/cforepurchase0310.htm
impose some liability on these bartenders for 12. Kate Kelly,Tom McGinty & Dan Fitzpatrick,“Big Banks
the leverage and liquidity problems to which Mask Risk Levels: Quarter-End Loan Figures Sit 42% Below
they contribute. • Peak, Then Rise as New Period Progresses; SEC Review,”
Wall Street Journal, Apr. 9, 2010.
References 13. James Kroeker, Chief Accountant, SEC, Testimony
1. The Lehman Brothers Holdings Inc. Chapter 11 Concerning Accounting and Auditing Standards: Pending
Proceedings Examiner’s Report, March 11, 2010. Proposals and Emerging Issues,” Before the Subcommittee
2. Gary B. Gorton and Andrew Metrick, “Securitized on Capital Markets, Insurance, and Government Sponsored
Banking and the Run on Repo,” Yale ICF Working Paper Enterprises of the House Committee on Financial
09-14, Nov. 13, 2009. Services,” May 21, 2010.
3. Statement of Jane D’Arista Representing Americans for 14. Gary Gorton, “Slapped in the Face by the Invisible
Financial Reform Before the House Committee on Financial Hand: Banking and the Panic of 2007,” Yale and NBER,

Prepared for the Federal Reserve Bank of Atlanta’s 2009 Court,” Wilmer Hale, February 22, 2008, re Calyon New
Financial Markets Conference: Financial Innovation and York Branch v. Am. Home Mortgage Corp. (In re Am.
Crisis, May 11-13, 2009, p. 4. Home Mortgage Inc.), 379 B.R. 503 (Bankr. D. Del. 2008).
15. Gary Gorton, “Questions and Answers about the 18. Stephen J. Lubben,“The Bankruptcy Code without Safe
Financial Crisis: Prepared for the Financial Crisis Inquiry Harbors,” American Bankruptcy Law Journal,Vol. 84; Seton
Commission,” February 20, 2010, Gorton, Questions Hall Public Law Research Paper No. 1569627.
and Answers, Figure on p. 13. 19. Testimony of Lloyd Blankfein, CEO of Goldman
16. Katherine A. Burroughs and Jonathan F.Tross, Dechert Sachs, The Official Transcript of the First Public Hearing
LLP, “The Treatment of Mortgage Loan Repurchase of the Financial Crisis Inquiry Commission Hearing, Jan.
Agreements in Chapter 11 Bankruptcy,” Mar. 2008, 13, 2010 (“FCIC Hearing, Day 1”).
American Bar Association June 2008 eReport. 20. U.S. Securities and Exchange Commission, Money
17. Phillip Anker, Andrew Goldman & James Millar, “Safe Market Fund Reform, Release No. IC–29132; File Nos.
Harbor or Adrift in Bankruptcy: Treatment of Mortgage S7-11- 09, S7-20-09, Federal Register Vol. 75, No. 42, March.
‘Repurchase Agreements’ & Servicing Rights in Bankruptcy 4, 2010, p. 10076 (“Mutual Fund Rule Amendment”)
J ournal of reg
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north asia
Volume I, Issue III,

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Issues in resolving
systemically importan
t financial institution
Resecuritisation s Dr Eric S. Rosengren
in banking: major
challenges ahead
A framework for
funding liquidity DuDr Fang
Housing, monetary crisis
and fiscal policies: Dr Ulrich Bindseil
from bad to worst
Derivatives: from
disaster to re-regulat Stephan Schoess,
ion
Black swans, market Professor Lynn A. Stout
crises and risk: the
human perspectiv
Measuring & managing e
risk for innovativ Joseph Rizzi
e financial instrumen
Red star spangled ts Dr Stuart M. Turnbull
banner: root causes
a cause for concern Fahrholz
among Asian investors
Global financial
change impacts David Smith
compliance and
risk
The scramble is on
to tackle bribery David Dekker
today
and corruption
nce Who exactly is subject
Complia
Penelope Tham & Gerald
to the Foreign Corrupt
Legal &
Li
Practices Act?
Financial markets
remuneration reform: Tham Yuet-Ming
one step forward
Of ‘Black Swans’, Umesh Kumar & Kevin
stress tests & optimised
to the
Marr
risk management
subject
Challenging the
value of enterprise David Samuels
actly is
risk management
Act?
Who ex
Rocky road ahead
Practices
for global accountan Tim Pagett & Ranjit
Jaswal
cy convergence
Corrupt
The Asian regulator Dr Philip Goeth
y Rubik’s Cube
Foreign Yuet-Ming
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Ross
er, Tham mines the
In this pap consultant, exa Asia.
ng Kong FCPA in
Piper Ho ious effects of the
pernic
which
many of
panies – legis-
s of com es. The US
by hundred compani even-
Practices were Fortune 500 these scandals by
Corrupt in the onded to
Foreign nnings lature resp 1977.
The US its begi FCPA in to the
A), has te Special tually enacting the main provisions
Act (FCP n the Waterga lo- two s, and the
te era, whe ntary disc There are bribery provision and the
Waterga calle d for volu had made – the anti- the SEC
or that FCPA s. Both -
Prosecut compan
ies ard g provision J) have juris
s to Rich accountin ent of Justice (DO y, the SEC
sures from contribution n. erall
question
able
idential
campaig US Departm the FCPA. Gen s and
n’s 1972 pres diction over untin g provision rs
Nixo aled acco nst issue
es reve ecutes the s as agai
, thes e disclosur payments pros bribe ry provision rative proceedings
However estic anti- inist
ble dom d the and adm es and
questiona had been channelle . through civil es compani isions
not just prosecut prov
funds that business the DOJ bribery
but illicit to obtain whereas the anti-
gn gove rnments eque nt investi- individuals for eedi ngs.
to forei to subs Exchange through criminal
proc
mation led rities and
The infor that
the US Secu h revealed ision
gations by ) whic to ery prov makes it Risk managem
ion (SEC h funds” anti-brib bribery provision
Commiss issuers kept “slus ical The ’s anti- ey or anyt
hing ent
and polit The FCPA ide mon n-
many US gn officials offer or prov ials (“foreign”mea or
s to forei illegal to Of ‘Black
pay bribe ntary foreign offic
with a volu cor- of value to ”) with the inten
t to obta
in
ness to
Swans’, stre
parties. e up
optimised ss tes
risk manag ts &
later cam r which any ing “non
-US ting busi
The SEC for direc
prog ramme unde illicit payments n busi ness, or
disclosur
e
which self-
reported
SEC was
given
retai
any pers
on. can inclu
de sponsor- ement
poration with the likely of value of a holi- Standard &
perated it would Anything ation, use
and co-o rance that lt l and educ employm
ent, outlines the Poor’s
an infor
mal assu
enforcem
ent actio
n. The resu for trave
$300 ship home, promise
of future e is no positive ben David Samuels
than USD meals. Ther efits of ban
be safe from osure that more - day ks and k stress
discl ents (a mas e discounts, drin testing on
was the
questiona
ble paym
been mad 147 the bottom
million in in the 1970s) had
It is a big
challenge line.
unt a robust appro for bank
sive amo Asia ach to mana s to build downturn
Nor th of worst-case ging the risk capital adequ
ion & Risk by definition,
stress scena
rios that, almo uncover risk acy programs
nal of Regulat are triggered by st concentrati
ons and to
Jour unlikely or encies, and;
unprecede apparently applying these risk depend-
nted event to drive busin improveme
s. ess selection nts
through perfo –
However, solvin
g the probl rmance analy for example,
fying the risk em of identi adjusted pricin sis and risk-
concentrati - into accou g that takes
Contact
cies that give ons and depen nt. stress test result
rise to worst den- s
vital if the -case outco
indus mes is Top-l
vidual banks try is to thrive – and evel overs
are if indi- Buildi ight
past two years to turn the lessons ng
to competitive of the proce a more robust and
Banks that advantage. ss for uncov comprehen
tackle the issue ering threat sive
be lauded by head-on will prise is clearly, in part, s to the enter-
Christopher Rogers
investors and ance challe a corporate
coming years regulators nge.The board govern-
of industry in the must and top execu
most impo recuperatio have the motiv tives
rtantly, will n
tained profit be able to delive and, scrutinise and ation and
the clout to
ability gains r sus- able call a halt to
that are well . Meanwhile activities if appar
placed to take , banks term these are not ently profit-
consolidatio advantage interests of in the longe
n process need of the the the enterprise r-
can understand to be intended risk or do not fit
Editor in Chief
portfolios of the risks embe sure they But contrary
profile of the
organisatio
potential acqui dded in the to popular n.
To improve sition ing corpo rate governance opinio n, improv-
s.
and strengthen enterprise risk manageme tion of puttin
g the ‘right
is not just a
ques-
investor confid nt
banks can take ence, we think board members in ’ executives
and
the lead in appropriate place and
Better board three relate incentives. giving them
and senior d areas:
sight and executive over- For the bank
contro to make the
agement; re-inv l of enterprise risk sions when
they are difficu right deci-
igorated stress man- busin
testing and ess growth lt, e.g. when
or when risk looks good
manageme in the uptur
Journal of
Regulation nt looks expen n,
& Risk Nort sive
h Asia
163

Credit rating agencies
Regulating the rating agencies:

Quick fix or political expedient?
NYU Stern’s Prof Lawrence White advo-
cates a radical fix for the ‘big three’ raters,
via the elimination of the ‘force of law’.
The three large US-based credit rating But while the urge for expanded regulation
agencies – Moody’s, Standard & Poor’s, is well-intentioned, its results are potentially
and Fitch – provided excessively opti- quite harmful. Expanded regulation of the
mistic ratings of subprime residential rating agencies is likely to:
mortgage-backed securities (RMBS) in • Raise barriers to entry into the bond infor-
the middle years of this decade – actions mation business;
that played a central role in the financial • rigidify a regulation-specified set of struc-
debacle of the past two years. tures and procedures for bond rating;
• discourage innovation in new ways of gath-
The strong political sentiment for height- ering and assessing bond information, new
ened regulation of the rating agencies – as technologies, new methodologies, and new
expressed in legislative proposals by the models (including new business models). As
Obama Administration in July 2009, specific a result, ironically, the incumbent credit rat-
provisions in the financial regulatory reform ing agencies will be even more central to the
legislation (H.R. 4173) that was passed by bond markets, but are unlikely to produce
the House of Representatives in December, better ratings.
and epitomised by further debate, amend-
ments and resolutions this May and June A better path to stride
in the Senate, together with recent regula- There is a better policy route, which starts
tions that have been promulgated by the with an understanding of the basic purpose
Securities and Exchange Commission (SEC) of the rating agencies: to provide informa-
– is understandable, given this context and tion (in the form of judgments, or“ratings”)
history. The hope, of course, is to forestall about the creditworthiness of bonds and
such debacles in future. their issuers. If the information is accurate,
The advocates of such regulation want it helps bond investors – primarily financial
to grab the rating agencies by the lapels, institutions, such as banks, insurance com-
shake them, and shout, “Do a better job!” panies, pension funds, mutual funds, etc.

– to make better investment decisions. It also judgments about the creditworthiness of
helps the more creditworthy bond issuers bonds with the force of law!
stand out from the less creditworthy. If the This problem was compounded when
information is inaccurate, of course, it does the SEC created the category of “nationally
the opposite. recognised statistical rating organisation”
(NRSRO) in 1975 and in doing so created
Centrality mandated a major barrier to entry into the rating busi-
As an example of the latter, the major ness. As of year-end 2000 there were only
agencies had “investment grade” ratings three NRSROs to whom bond issuers could
on Lehman Brothers’ debt on the morning obtain their all-important ratings: Moody’s,
that it filed for bankruptcy. Luckily the large Standard & Poor’s, and Fitch. (Because of
incumbent rating agencies are not – and subsequent prodding by the Congress, and
never have been – the sole sources of credit- then the specific barrier-reduction provisions
worthiness information. Many large institu- of the Credit Rating Agency Reform Act of
tions do their own research; there are also 2006, there are now 10 NRSROs.
smaller advisory firms; and most large secu- But, because of the inertia of incum-
rities firms employ “fixed-income analysts” bency, the three large rating agencies con-
who provide information and recommenda- tinue to dominate the business. When this
tions to their firms’clients. (literal) handful of rating firms stumbled
The next step along this better policy badly in their excessively optimistic ratings
route is the recognition that the centrality of of the subprime RMBS, the consequences
only the three major rating agencies for the were disastrous because of their regulation-
bond information process is a major part of induced centrality.
the problem. This central role of the agencies
has been mandated by more than 70 years Elimination of regulatory reliance
of “safety-and-soundness” financial regula- A better policy prescription would increase
tion of banks and other financial institutions, competition in the provision of bond infor-
including insurance companies, pension mation by eliminating regulatory reliance on
funds, money market mutual funds, and ratings altogether. Since the bond markets
securities firms. are primarily institutional markets (and not
retail securities markets, where retail cus-
Regulatory reliance tomers are likely to need more help from
In essence, the regulators rely on the rat- regulators), market forces with respect to the
ings to determine the safety of institutional provision of information about bonds can
bond portfolios. For example, bank regula- be expected to function well, rendering the
tors currently forbid (and have done so since detailed regulation that has been proposed
1936) banks from holding “speculative” (i.e., (and partly embodied already in SEC regula-
“junk”) bonds, as determined by the rating tions) unnecessary.
agencies’ ratings. This kind of regulatory reli- Indeed, if regulatory reliance on rat-
ance on ratings has imbued these third-party ings were eliminated, the entire NRSRO

superstructure could be dismantled and the those rating agencies presents obvious poten-
NRSRO category could be eliminated, which tial conflict-of-interest problems that appear
would bring many new sources of informa- to be crying out for correction.
tion into the market and, in so doing, also But the major credit rating agencies
increase the quality of information. switched to the “issuer pays” model in the
early 1970s (they previously sold their rat-
Onus on institutions ings directly to investors – an“investor pays”
The regulatory requirements that pruden- business model); yet the serious problems
tially regulated financial institutions must only arose three decades later. The agencies’
maintain appropriately safe bond portfo- concerns for their long-run reputations and
lios should remain in force. But the burden the transparency and multiplicity of issu-
should be placed directly on the regulated ers prior to the current decade all served to
institutions to demonstrate and justify to keep the potential conflict-of-interest prob-
their regulators that their bond portfolios are lems in check during those three intervening
safe and appropriate – either by doing the decades.
research themselves, or by relying on third-
party advisers. Reputational fear subsides
Since financial institutions could then In the decade of the 2000s, however, this
call upon a wider array of sources of advice reputation-based integrity eroded. The profit
on the safety of their bond portfolios, the margins on RMBS instruments were sub-
bond information market would be opened stantially larger than those on ordinary debt
to innovation and entry in ways that have issuances, and the issuers of RMBS were far
not been possible since the 1930s. fewer than the thousands of issuers of “plain
The politically popular proposals for vanilla”corporate and municipal bonds. This
expanding the regulation of the credit rating made the threat by a RMBS issuer to take its
agencies (as well as the SEC’s recent regu- business elsewhere unless a rating agency
lations) are devoted primarily to efforts to provided favourable ratings far more potent.
increase the transparency of ratings and to Also, the RMBS instruments were far
address issues of conflicts of interest. The lat- more complex and opaque than “plain
ter arise largely from the major rating agen- vanilla” corporate and municipal debt, so
cies’ business model of relying on payments mistakes and errors (unintentional, or other-
from the bond issuers (an“issuer pays”busi- wise) were less likely to be noticed quickly
ness model) in return for rating their bonds. by others.
And the major credit rating agencies,
Cry for correction like so many other participants in the RMBS
Again, the underlying urge to“do something” process, came to believe that housing prices
in the wake of the mistakes of the major credit would always increase, so that even sub-
rating agencies during the middle years of prime mortgages – and the debt securities
the decade of the 2000s is understandable. that were structured from those mortgages
Further, the “issuer pays” business model of – would never be a problem. The result? A

tight, protected oligopoly became careless ratings in response to new information. This
and complacent. In many ways, it was “the criticism surfaced strongly in the wake of the
perfect storm.” Enron bankruptcy in November 2001, with
the revelation that the major rating agencies
Regulatory culpability had maintained “investment grade” ratings
Even so, this storm would not have had such on Enron’s debt until five days before that
devastating consequences if financial regula- company’s bankruptcy filing. More recently,
tors had not propelled the three major agen- as mentioned above, the major agencies
cies into the centre of the bond markets, where had “investment grade” ratings on Lehman
regulated financial institutions were forced to Brothers’debt on the morning that it filed for
heed the judgments of just those three. bankruptcy. But this sluggishness appears
The dangers of expanded regulation to be a business culture phenomenon for
of the rating agencies are substantial. They the incumbent rating agencies that long
require the SEC to delve ever deeper into the precedes the emergence of the “issuer pays”
processes and procedures and methodolo- business model.
gies of credit judgments. In so doing, such
expanded regulation is likely to rigidify the Herd behaviour
industry along the lines of whatever specific As for the disastrous over-optimism about
implementing regulations the SEC devises. the RMBS in this decade, the rating agencies
It is also likely to increase the costs of were far from alone in “drinking the Kool-
being a credit rating agency. Expanded reg- Aid”that housing prices could only increase
ulation will discourage entry and impede and that even subprime mortgages conse-
innovation in new ways of gathering and quently would not have problems. The kinds
assessing information, in new methodolo- of regulations that have been proposed (as
gies, in new technologies, and in new mod- well as those already implemented) would
els – including new business models. not necessarily curb such herd behaviour.
The incumbent rating agencies are quite
Adverse consequences aware of the damage to their reputations
Even requirements for greater transparency, that has occurred and have announced
such as more information about the rating measures – including increased transpar-
agencies’ methodologies, rating histories, ency and enhanced efforts to address poten-
and track records, could have adverse conse- tial conflicts – to repair that damage.
quences if they force the revelation of propri- The harm to innovation from restrictive
etary information about the modelling and regulation is illustrated by the experience
thereby discourage firms from developing in another field: telecommunications regu-
new models. Further, expanded regulation lation and the development of cell phone
may well fail to achieve the goal of improv- technology in the US. Although cell phones
ing ratings. could have been introduced in the late 1960s,
One common complaint about the large restrictive regulation held them back until
agencies is that they are slow to adjust their the early 1980s. Cell phone usage didn’t

really flourish until the mid-1990s, when a to have the ability to choose reliable advisers.
less restrictive regulatory regime took hold. Expanded competition would be enabled
by the elimination of regulatory reliance on
The way forward ratings, and enhanced by a reduction in (or,
The rating agencies’ promises to reform ideally, an absence of) regulation of the bond
their ways are easy to make and could fall information advisory/rating process.
by the wayside after political attention shifts This withdrawal of regulatory reliance
to other issues. Consequently, enforcement on ratings must be accompanied by an
mechanisms are necessary. The rating agen- enhanced approach by prudential regula-
cies’ concerns about their long-run reputa- tors of banks and other financial institutions
tions provide one potential mechanism. But in how they enforce requirements that their
that mechanism proved too weak in the regulated financial institutions maintain
near past, so something stronger is needed. appropriately safe bond portfolios.
Expanded regulation of the rating agen- In essence, the regulators must place
cies (to address the transparency and rating the burden for safe bonds directly on the
agencies conflict of interest issues) is cer- financial institutions, thereby replacing the
tainly another potential route – but the dan- regulators’ current delegation (or, equiva-
gers, as outlined above, are substantial. lently, outsourcing) of the safety decision to a
Expanded competition among current handful of third-party rating agencies.
and potential providers of information about
the creditworthiness of bonds and bond SEC eliminates some references
issuers is a third – and preferable – route. The financial institutions could do the
New competition could come from the research themselves, or enlist the help of
smaller bond advisory firms or from advisory an advisory firm, which could be one of the
firms in other parts of the securities business incumbent rating agencies or a new com-
(e.g., in December 2009 Morningstar, Inc., petitor. The prudential regulators would
which is known primarily for its assessments have to maintain surveillance of the advisory
of mutual funds, announced that it would process; but the primary focus would be on
begin rating some companies’bonds). the safety of the bonds themselves.
The SEC has taken some recent steps in
Competition offers a fix the direction of this third route by eliminat-
Competition could also come from some ing some regulatory references to ratings;
of the fixed income analysts at large secu- but no other financial regulatory agency
rities firms who might (in a less regulated has followed the SEC’s lead [1]. The SEC
environment) decide to establish their own has simultaneously expanded its regulation
advisory companies, or from new entrants of the rating agencies. The financial regula-
that no one has ever heard of before. Since tory reform legislation (H.R. 4173) that was
the bond markets are primarily institutional passed by the House of Representatives
markets, the bond managers of the financial in December would eliminate legislative
institutions in these markets can be expected references to ratings and instruct financial

regulators to eliminate reliance on ratings markets – with appropriate oversight by
in their regulations; but it would also greatly financial regulators – could then more read-
expand the regulation of the rating agencies. ily make use of an expanded set of providers
In essence, public policy currently of information. As a consequence, the bond
appears to be two-minded about the credit information market would be opened wide
rating agencies: The wisdom of eliminating to new ideas and thus to new entry in a way
regulatory reliance on ratings has gained that has not been possible for more than 70
some recognition; but the political pres- years. •
sures to heighten the regulation of the rating
agencies are clearly formidable. End notes
1.) Towards the end of 2009 there were two small
Elimination of ‘force of law’ steps in a favourable direction in fixing the prob-
There is a better policy route than relying lematic rating agencies: In October the Federal
on the incumbent credit rating agencies Reserve announced that it would be more selec-
to police themselves, or on the politically tive with respect to which ratings it would accept
popular route of expanded regulation of in connection with the collateral provided by
the rating agencies. This better alternative borrowers under the Fed’s “Term Asset-Backed
would entail: Securities Lending Facility” (TALF) and would also
• The elimination of all regulatory reli- conduct its own risk assessments of proposed
ance on ratings, by the SEC and by all other collateral.
financial regulators; in essence, elimination Whilst in November the National Association
of the force of law that has been accorded to of Insurance Commissioners (NAIC) announced
these third-party judgments. that it had asked the Pacific Investment Manage-
Instead of relying on a small number of ment Company (PIMCO) to provide a separate
rating agencies for safety judgments about risk assessment of residential mortgage-backed
bonds, financial regulators should place the securities held by insurance companies that are
burden directly on their regulated financial regulated by the 50 state insurance regulators
institutions to justify the safety of their bond – PIMCO of course not being a nationally rec-
portfolios; ognised statistical rating organisation as promul-
• elimination of the special regulatory cat- gated by the SEC in 1975.
egory for rating agencies, which was created
by the SEC 35 years ago; Editor’s note
• reduction (or, preferably, the elimina- The publisher and editor of the Journal
tion) of the expanded regulation that of Regulation & Risk – North Asia wishes
has recently been applied to those rating to thank both Professor White and the
agencies. Roosevelt Institute for allowing us to pub-
These actions would encourage entry lish an edited version of Prof White’s paper
and innovation in the provision of credit- which first appeared in their recent publi-
worthiness information about bonds. cation: Restoring Financial Stability: How to
The institutional participants in the bond Repair a Failed System.

Macro-prudential risk
Macro-prudential councils:
how to avoid future crises
Amsterdam University’s Prof Enrico Perotti
calls for G-20-wide forward looking bank
levies to address systemic risk creation.
WHAT should an effective macro-pru- made in Canada – that is intended to dis-

dential policy framework look like? This courage risky behaviour – a tax on leverage.
column argues that financial stability and Whilst under Obama, the US is planning to
macroeconomic stability should be dealt adopt a scheme similar to that in Sweden
with differently. One requires prompt with a levy on bank liabilities.
corrective action; the other requires more
gradual policy intervention. Systemic Future systemic risk creation
levies offer a policy that can tighten The US tax proposal is targeting the stock of
financial discipline without the need for uninsured bank liability – citing as justifica-
a large increase in interest rates across the tion that these banks were recipients of huge
whole economy. bailouts during the crisis. Yet while this pro-
posal is a reasonable claw-back tax to repay
On two occasions this year in – Busan, past bailout costs, what the G-20 countries
Korea in April, and Toronto, Canada this June need is a tax that is forward-looking – that
– the G-20 group of countries have gathered will target future systemic risk creation.
and sought to co-ordinate their bank taxa- Any proposed tax should discourage future
tion strategies in the wake of the financial choices which cause local shocks to propa-
crisis of 2008. To-date, no global framework gate across markets, multiplying their impact
exists to implement such proposals due and disrupting the economy.
to divisions between those nations whose But what underpins such a macro-
banks actually instigated the crisis, and prudential policy framework? A critical dis-
those nations whose banks were relatively tinction is between aggregate risk creation,
unscathed. which is highly correlated with the business
However, France, Germany and the UK cycle, and systemic risk creation in credit
have now adopted a bank levy on bank bal- booms. The financial cycle has a higher fre-
ace sheets ahead of any EU-wide actions quency and potential amplitude, and can
later in the year – this announcement being exacerbate economic fluctuation unless it

is contained in a timely manner. Aggregate repo’s). Wholesale funding allowed the
risk factors tend to arise on the asset side, so massive expansion in securitised lending, yet
dealing with it is the prime task of financial escaped before bearing any losses.
regulators. Aggregate asset risk factors, such A liquidity-risk levy (Perotti and Suarez
as correlated holdings of long-term assets, 2009) charges intermediaries relying on frag-
can be targeted with counter-cyclical capital ile funding for the negative externality they
requirements and regulation (such as pru- create for others, when they make fire sales
dential limits, rules on disclosure, and clear- to repay rapid withdrawals of funding. Such
ing arrangements). levies also charge intermediaries ex ante for
the de facto insurance of uninsured liabilities,
Basel II omission though without creating an explicit insur-
With hindsight, the most glaring gap in Basel ance promise.
II was its neglect of unstable short-term Liquidity charges are aimed at future
funding. Rapid capital withdrawals were incentives, discouraging rapid asset growth
the primary source of propagation in the funded by investors bearing no risk. It aims at
last crisis. This occurred in combination with increasing maturity from the current absurd
opaque assets. over-reliance on overnight repo markets,
In previous episodes of opaque asset thus increasing financial resilience to shocks.
over-valuation, such as the Internet bubbles, Liquidity-risk charges should be scaled
the losses were huge but there was very lit- by bank size – to tackle the too-big-to-fail
tle propagation across markets. Unlike in the problem – and by inter-connectedness – to
latest global crisis, these investments were control intermediaries which cannot be eas-
funded with equity. Once losses material- ily disentangled from others.
ised, investors could not escape and took
their losses without spreading them. Liquidity- risk charges
Because of the different nature of asset Without the need for Glass Steagall restric-
and liability risks, there is a strong case to tions, liquidity charges would discourage
separate the tasks of controlling them. Asset intermediaries from scaling up their balance
risk is the natural remit of micro financial reg- sheet via huge proprietary trading desks.
ulators. The control of liquidity risk is already The liquidity charge is essentially an oppor-
a central bank task. In the event of a crisis, tunity cost in order to discourage large-
it is the liquidity support function of central scale and uninformed carry trade strategies
banks alone that can contain propagation. invested in securities that earn on average a
It is natural to assign to macro-pruden- risk premium without providing any useful
tial councils – where central banks are well monitoring.
represented – the task of managing the sys- This should be distinguished from
temic risk arising from panic withdrawals of informed bank lending, which is a useful
short-term funding. A systemic levy which maturity transformation task by delegated
targets unstable funding should focus on monitors (banks) and which fully deserves
uninsured short-term liabilities (including public support. The optimal configuration

probably requires granting rate-setting pow- solution is to separate a basic tax and time-
ers to prudential supervisors, but allocating varying surcharges, the latter to be co-ordi-
revenues to the Treasury. It would be inap- nated by a macro-prudential council where
propriate to store these revenues in a bank central banks play a significant role. As is the
stability fund, as a prepayment of future case with seignorage, the revenues from sur-
support. charges ultimately flow to the Treasury.
Ultimately, an optimal policy to control
Moral hazard liquidity risk may involve a combination of
The first objection, by itself more than suf- liquidity charges and reserve requirements,
ficient, is that funds create moral hazard and currently assessed in the Basel process.An
breed complacency, as previous episodes initial advantage of having liquidity charges
suggest. But the main argument is purely as well is that they are less distorting, just
fiscal. as tariffs are less distorting compared with
The overwhelming fiscal cost of the cri- quotas.
sis has not resulted from direct injections in More critically, charges can be adjusted
the financial system – which were, in the more smoothly than quantities. They avoid
end, only modest – but by reduced taxes and the trigger risk caused when wholesale
increased spending in order to cushion the withdrawals lead all banks to seek to rebuild
impact on the economy. A small fraction of their buffers at the same time. They are eas-
revenues may be allocated to a burden shar- ier to extend to non-banks, which have no
ing fund to resolve cross border failures. monitored reserve obligations. Last but not
Systemic levies are basically taxes, as they least, they raise more fiscal revenues with
need to be levied on all relevant intermedi- less distorting effects.
aries, including the shadow banking system
[1 ]. Taxes are the domain of finance minis- Public disclosure
tries, not financial supervisors, but systemic A critical governance issue is public disclo-
charges are a natural macro-prudential tool sure of recommendations by macro-pru-
for financial stability, and need to be adjusted dential authorities. This is indispensable to
preventively and in a timely manner. overcome regulatory delay, as failure to act in
Such policy choices are therefore a nat- a timely manner will be visible.
ural attribute for central banks, in charge Public announcements support timely
of both liquidity insurance and monetary intervention and enhance the accountability
stability, in consultation with micro regu- of macro-prudential policymakers. It enables
lators (the envisioned European Systemic action at an early stage with small adjust-
Risk Board combines such policymak- ments which signal clear resolve to contain
ers). Delegating general levies to a macro- risk creation.
prudential authority does not require a Finally, full accountability has the advan-
Copernican shift, as central banks play an tage of putting pressure on governments
indirect fiscal role already by the seignorage to co-ordinate systemic tax rates across
tax they raise on liquidity holdings. A simple countries.

A concern of public announcements “CoVaR”, Federal Reserve Bank of New York Staff
is whether they will spook the markets. Reports, no. 348.
But if interventions were timely with only Brunnermeier, Markus (2009), “Deciphering the
small adjustments, the system would not Liquidity and Credit Crunch 2007-08”, Journal of Eco-
be allowed to become so overexposed, and nomic Perspectives 23(1), 77-100.
higher taxes would not trigger a large market Brunnermeier, Markus, Andrew Crockett, Charles
response. Goodhart, Avi Persaud, and Hyun Shin (2009), “The
Fundamental Principles of Financial Regulation”,
Conclusions Geneva Reports on the World Economy 11.
The right combinations of tools and respon- Caballero, Ricardo (2009), “A global perspective on
sibility can finally establish capability and the great financial insurance run: Causes, conse-
incentives for policymakers to enact a truly quences, and solutions (Part 1)”,VoxEU.org, 23 Janu-
preventive macro-prudential policy. ary.
Ultimately, new tools must enable us to Goodhart, Charles (2009), “Liquidity Management”,
separate financial stability, which requires paper prepared for the Federal Reserve Bank of
prompt corrective action, from macro-eco- Kansas City Symposium at Jackson Hole,August.
nomic stabilisation policy, which must steer Gorton, Gary (2009), “Slapped in the Face by the
the slower business cycle. Systemic levies Invisible Hand: Banking and the Panic of 2007”, paper
offer a policy that can tighten financial dis- prepared for the Federal Reserve Bank of Atlanta’s
cipline without the need for a large increase 2009 Financial Markets Conference, May.
in interest rates across the whole economy, Huang, Rocco, and Lev Ratnovski (2008),“The Dark
thereby avoiding a main cause of reluctance Side of Bank Wholesale Funding”, mimeo, Interna-
to act on a timely manner to contain sys- tional Monetary Fund.
temic risk. • Perotti, Enrico, and Javier Suarez (2009a), “Liquidity
Insurance for Systemic Crises”, CEPR Policy Insight
Footnotes 31, February.
1. Even if liquidity levies were charged only Perotti, Enrico, and Javier Suarez (2009b), “Liquidity
to banks, they would increase the cost of Risk Charges as a Macro prudential Tool”, CEPR
banks’ contingent exposure to the shadow Policy Insight 40, November.
banking intermediaries, removing the critical Perotti, Enrico, (2010), “Tax banks to discourage
transmission channel and discouraging liquid- systemic-risk creation, not to fund bailouts”,VoxEU.
ity risk creation outside the banking system. org, 19 February.
Weder di Mauro Beatrice (2010), “Taxing Systemic
References Risk”, University of Mainz mimeo.
Acharya,Viral, Lasse Pedersen,Thomas Philippon, and
Matthew Richardson (2009), “Regulating Systemic Editor’s note
Risk”, in Viral Acharya and Matthew. Richardson The Journal of Regulation & Risk – North Asia
(eds.), Restoring Financial Stability: How to Repair a would like to thank VoxEu and Dr Perotti for
Failed System,Wiley, March. their permission to reprint an edited version
Adrian, Tobias, and Markus Brunnermeier (2009), of this article.

Solvency II
EC offers last opportunity for

insurers to influence Solvency II
The FSA’s Eleanor Beamond-Pepler outlines
some key benefits insurers can expect by
early adoption of Solvency II provisions.
DURING 2010, European insurers will to provide an efficient way of setting legisla-
be participating in the European Com- tion in the context of the complex and fast-
mission’s 5th Quantitative Impact Study moving European financial markets.
(QIS5). The exercise will feed in to the
Commission’s further development Level One
of the new regulations and so help to Level 1 consists of the Solvency II Directive
shape the final Solvency II landscape. It text, which was finalised and adopted by the
will also form a vital part of the prepara- European Parliament in 2009. This forms
tions by both firms and regulators for the the “skeleton” of Solvency II, setting out the
introduction of Solvency II. QIS5 repre- high-level framework. Level 1 includes the
sents the last opportunity for field testing two key principles of Solvency II: market-
of the current thinking on quantitative consistency for the balance sheet, coupled
aspects of Solvency II. with capital requirements at the one-year
99.5 per cent VaR level.
The first four QIS exercises were carried Other fundamentals outlined in the
out between 2005 and 2008, and have Level 1 text include the high-level structure
been instrumental in shaping the direc- of the standard formula for the calcula-
tion of Solvency II. These pan-European tion of the Solvency Capital Requirement
studies have enabled the Commission to (SCR), considerations for the internal model
understand the likely impact of the current approach to the SCR, and governance and
thinking on Solvency II. QIS5 will be the disclosure requirements.
most important field study yet, coming at a
critical point in the development of the final Level Two
Solvency II framework. The Level 2 implementing measures put
Solvency II is being developed accord- flesh on the bones of the high-level Directive
ing to the Lamfalussy model. This model is text. At this stage, more detail is prescribed
structured according to four levels, designed as to the calculations that underlie the

Solvency II balance sheet, the determination in Solvency II, and especially, as mentioned
of capital requirements and the standards a above, the Level 2 implementing measures.
firm needs to meet in order to gain internal Although the quantitative impact on capital
model approval, for example. is central here, another important aspect is
The Committee of European Insurance the practicality of calculations and processes
and Occupational Pensions Supervisors required.
(CEIOPS) was asked by the Commission
to provide advice on the content of Level 2 Practical burdens of QIS4
during 2009. This advice covered all aspects For example, QIS4 highlighted various areas
of the required implementing measures, on where the practical burden of carrying out
both quantitative and qualitative aspects of some calculations was disproportionately
Solvency II. Following delivery of CEIOPS’ great in comparison with the significance
advice, the Commission has now begun for the overall balance sheet. A case in point
a drafting exercise for its proposed Level was the standard formula SCR approach to
2 measures, leading to finalisation during counterparty risk, which was found to be
2011. disproportionately laborious, impractical
and cumbersome for what, for most firms,
Level Three was not their most significant risk.
Level 3 then involves the development by However, QIS5 should also be a corner-
CEIOPS of further, more detailed consid- stone of firms’ own implementation pro-
erations. Some Level 3 guidance has already grammes for Solvency II. QIS5 offers a vital
been issued by CEIOPS, for example in the opportunity for firms not only to assess the
arena of the internal model pre-application likely impact of Solvency II on their capital
process. However, the bulk of the Level position, but also to take a focused look at
3 material is expected during 2011/12. their data, systems and processes. QIS5
QIS5 therefore comes at a time when the will provide a chance to examine the kinds
basic Level 1 framework is known and the of calculations and assessments that will
Commission is part-way through drafting be required; in some areas Solvency II will
the more detailed Level 2 measures. This necessitate the development of new tech-
means the results of QIS5 will be of the niques, and an early start on these will be
utmost importance in this drafting process, invaluable.
and are likely to have a significant bearing on
the eventual direction of Solvency II. QIS5 philosophy
While the benefits of QIS5 from the The move to the Solvency II philosophy for
Commission’s viewpoint are clear from the the best estimate for technical provisions is
positioning within the Solvency II timeta- one such example from the world of non-
ble, the exercise will also be of fundamental life reserving. Furthermore, QIS5 will high-
importance for firms. QIS5 is vital in provid- light actions that firms may need to take in
ing firms with an opportunity to influence preparation for Solvency II implementa-
the direction of the remaining uncertainties tion, whether in terms of embedding new

systems, refining the business model or per- responses to these questions will feed in to
haps re-examining their capital base. the assessment of the practicability of the
For firms intending to enter the pre- current proposals for Solvency II.
application process for internal model
approval, participation in the most recent Three pillar approach necessary
QIS exercise will constitute one of the cri- At first glance, then, it could be assumed
teria for resource allocation: this reflects that QIS5 is relevant only to the first of the
the importance of QIS5 for insurers’ think- three pillars of Solvency II (see Figure
ing about their risk profile and Solvency II 1). As always, however, all three pillars are
readiness. needed in order to support the over-arching
For those insurers that have not yet Solvency II framework: QIS5 is no exception.
participated in a QIS exercise, QIS5 will be For example, the thinking that a firm will
crucial for their understanding of their likely need to do in order to construct its balance
capital position post-2012 as well as the sheet, determine capital requirements and
actions they may need to take to adjust their decide on whether to take the standard for-
systems and processes. mula or internal model approach will feed
QIS5 will therefore be a springboard for directly to the preparation of the Own Risk
firms’ preparations in the approach to 2012 and Solvency Assessment (ORSA) required
as well as being of vital importance for influ- under Pillar 2. Central to the ORSA will be
encing the European policy debate. the firm’s appraisal of its risk profile and
internal processes, as well as integration of
Scope of QIS5 risk and capital management, among other
One of the commonly held myths about issues.
QIS5 is that it is limited to testing of the SCR
standard formula approach. However, the Importance of balance sheet
scope of the exercise is much wider, covering Fundamental to QIS5 will be the construc-
of course the quantitative aspects of Solvency tion of the Solvency II balance sheet. The
II but also including qualitative issues. balance sheet forms the bedrock of Pillar 1 as
The quantitative aspects tested in QIS5 well as underpinning many aspects of Pillars
will include the drawing up of the Solvency 2 and 3. In Pillar 1, the balance sheet not only
II balance sheet, incorporating the calcula- incorporates assets, technical provisions and
tion of technical provisions, valuation of other liabilities, but also lays the foundations
assets and other liabilities, treatment and for the calculation of the capital requirements
classification of own funds, standard formula (SCR and MCR). The SCR, after all, reflects
and (optional) internal model approaches the impact of stress events on the elements
to determination of the SCR and testing of of the balance sheet.The MCR is determined
the recalibrated approach to the Minimum using basic building blocks such as technical
Capital Requirement (MCR). provisions and written premiums.
Firms will also be asked qualitative If the balance sheet is not correctly set
questions on each of these aspects, and the up, then, the capital requirements will not

Figure 1. The three pillars of Solvency II
Pillar 1: Pillar 2: Pillar 3:

Quantitative Qualitative Disclosures
capital requirements supervisory review process
• Technical provisions • Corporate governance • Enhance market discipline
• Minimum capital requirement • Principles for internal control through public disclosures
• Solvency capital requirement and risk management • Annual FCR and solvency
• ORSA reports
• Capital add-ons? • Provide additional (non-
public) information to the
supervisors
Market consistent valuation of New focus for supervisor More pressure from capital
assets and liabilities Level of harmonisation markets, investors and
Economic capital validation of Group supervision shareholders
internal models
be appropriate for the undertaking: a robust from firms, will be of central importance for
starting point is needed in order to provide ensuring the Commission has the best pos-
the elements needed for the calculation of sible basis for decision-making.
the SCR and MCR. This applies to“standard The Technical Specification for QIS5
formula”and“internal model”firms alike. is owned by the European Commission.
All undertakings in scope of the Solvency A draft of the specification was published
II Directive will have the opportunity to on April 15, 2010 and is open for feedback
take part in QIS5, including solo firms as from a specified, limited number of stake-
well as groups and EEA sub-groups. The holders for five weeks. Many aspects of
Commission is keen to encourage large-scale the draft Technical Specification are based
participation, with a spectrum of participants on the corresponding sections of CEIOPS’
that captures all aspects of the insurance advice on the Level 2 implementing
industry.This includes a focus on the involve- measures.
ment of smaller and specialist firms: it is However, there are also several areas
important that the proposed measures are where the Commission has made revisions,
tested against small firms as well as large and some of these are fairly significant. This
firms and international groups in order to highlights the importance of QIS5 in inform-
achieve a regime that is suitable for the diver- ing the remaining“moving parts”of Level 2.
sity of the European insurance sector.
The balance sheet
Draft technical specification The Commission has maintained the
Widespread and representative participation, fundamental Level 1 principle of market
combined with high-quality submissions consistency for the valuation of assets,

technical provisions and other liabili- prove a point of interest, as the require-
ties. This is significant in the context of ments cover aspects such as the scope of
what some stakeholders have argued has use, the extent of adjustments to exist-
been an erosion of the economic, realistic ing data sets, sensitivity to the assump-
approach to valuation in some areas of the tions chosen and the skills of the experts
debate so far. themselves.
Detailed considerations are set out for The Technical Specification also
the calculation of the best estimate of tech- includes various simplifications for calcu-
nical provisions, including deterministic, lation of technical provisions. These form
analytical and simulation methods. The an important part of the proportionality
Technical Specification covers the choice of principle running through Solvency II:
assumptions and methodology, as well as firms have the possibility to use simplified
use of expert judgement and validation of approaches where this is commensurate
data, processes and methods. Some of these with the nature, scale and complexity of
aspects will represent a step change from the risks inherent in their business.
the current regulatory framework: for exam-
ple, under Solvency II, discounting will be Hierarchy of simplifications
required for all technical provisions, whereas Notable among the simplifications pro-
this is not a requirement at present for non- posed in the QIS5 Technical Specification
life business. is the hierarchy of simplifications for deter-
mining the risk margin, acknowledging the
Risk margin practical complexity of calculating this part of
Another new element is the risk margin, the technical provisions.
designed to ensure that technical provi- Some insurers may be tempted to rely
sions for non-hedgeable risks are brought on simplifications for completion of QIS5,
up to a level such that they can be trans- for example to minimise the level of resource
ferred to another willing party in an arms- they expend on the exercise. However,
length transaction. This is calculated using unless they plan to use these simplifications
“cost of capital “methodology, based on a for their actual reporting post implementa-
six per cent cost-of-capital rate applied to tion, this will not allow them to build up a
the discounted sum of the SCR require- full picture of their likely position under
ments over the remaining lifetime of the Solvency II.
liabilities. One of the key developments incor-
The Technical Specification also main- porated in the Commission’s draft of the
tains an emphasis on verification and evi- Technical Specification is the inclusion of an
dence. The onus is on insurers to be able illiquidity premium in the risk discount rate
to demonstrate the suitability of the ingre- for certain types of contract.This follows work
dients, methods and assumptions feeding carried out by the joint CEIOPS-industry
to the calculation of their technical provi- Illiquidity Premium Task Force during early
sions. In this area, expert judgment will 2010. Calibrated term structures for the risk

discount rate have been proposed by the adjustments to the calibrations of the
CFO and CRO Forums and are included with standard formula stresses in a number of
the draft Technical Specification. Discussions areas; some have regarded these revisions
on the illiquidity premium have generally as a response to the feedback from stake-
focused on contracts whose cash flows are holders on CEIOPS’ original proposals at
highly predictable; retirement annuities are Level 2.
most frequently quoted as an example. The over-riding requirement for the
calibration of the SCR, however, must be
Capital and capital requirements the one-year 99.5 per cent VaR standard
The Commission’s draft Technical Specifi- stipulated by the Solvency II Directive text.
cation proposes a “third bucket”: certain Testing of the standard formula calibration
types of retirement annuity can be dis- as part of QIS5 will be an important step
counted using the full illiquidity premium; in assessing whether the current proposals
contracts of less than one year are assigned achieve this objective.
nil illiquidity premium; and all other con-
tracts are treated using 50 per cent of the Realistic picture
full illiquidity premium. QIS5 participants will also have the
Although the basic structure of the opportunity to include the capital require-
SCR standard formula is largely prescribed ments arising from their internal model
by the Directive text, the draft Technical or partial internal model where relevant.
Specification for QIS5 still includes some This will not only yield useful information
structural developments (see Figure 2 to the Commission but will also allow
below). One such development is the firms to build up a full and realistic picture
introduction of a new module for the of their likely position under Solvency II.
treatment of intangibles in the SCR stand- Firms therefore have the opportunity to
ard formula. This introduces an 80 per make the widest possible use of QIS5
cent stress on such items and corresponds within their Solvency II implementation
to the developments in thinking on the programmes.
valuation of such items in the Solvency II In addition to testing the SCR, all
balance sheet. firms will be asked to calculate their MCR
according to the recently revised calibra-
CEIOPS level 2 advice tion set out in the Technical Specification.
Much of the design and structure of the Taken together with the SCR calculations,
individual risk sub-modules under the this will provide insight into whether these
standard formula follows CEIOPS’ Level 2 capital requirements constitute a reason-
advice on these topics. This advice included able and workable supervisory ladder of
some detailed work on the calibration intervention.
of the various risk modules and sub- Firms will then be asked to look at the
modules. However, the Commission’s classification of their own funds, including
draft Technical Specification makes some both on- and off-balance sheet items. The

classification is based on three“tiers”, with their entities will require Solvency II-style
supervisory approval needed for some balance sheets and SCR calculations, as well
items. The Commission’s drafting for as how their calculations may be affected by
QIS5 has reversed out some of the more decisions on equivalence of third country
controversial areas of CEIOPS’ advice on regulatory regimes.
classification, such as the relegation of The determination of the group solvency
some items (for example the value of in- position is complex, with considerations
force cash flows) to Tier 3. specific to each particular group. However,
the testing of the current Solvency II propos-
Specified limits test als for groups will constitute a fundamen-
Firms will also need to test against speci- tal part of the QIS5 exercise, both from the
fied limits restricting which types of Commission’s viewpoint and for groups as
capital are allowable to meet each of the they plan their approach to Solvency II.
MCR and SCR capital requirements. The
emphasis is on the right kind of capital Looking ahead
being available for the situations in which The Commission’s final, post-consultation
it is needed. version of the QIS5 Technical Specification,
QIS5 will include testing of group expected at the beginning of July, will be
requirements as well as looking at solo awaited keenly by stakeholders. Many
firms. This includes the calculation aspects of the Level 2 measures remain
of group own funds and group capi- open to further development, and QIS5
tal requirements. The same valuation will play a vital role in providing evidence
principles and calibrations for capital to feed in to the Commission’s decision
requirements, per the draft Technical making.
Specification apply to groups as well as Insurers will be submitting their QIS5
to solo firms. Added to this, there is an results between August and November
emphasis on the extent to which capi- this year. In the meantime, they have the
tal is available within a group; that is, opportunity to prepare in advance by
between entities: the QIS5 calculations gathering data and refining the processes
are designed to reflect any restrictions and systems needed ahead of time. There
that may be in place. will be many synergies here that firms can
exploit for their wider Solvency II imple-
Group default approach mentation strategy.
The default approach for groups under Given high-quality results and extensive
QIS5 will be the accounting-consolidation participation across the insurance sector,
method, although there is also the possibility QIS5 has the potential to be the most impor-
to use a deduction-aggregation approach as tant and influential Solvency II field-study to
an alternative. date. This will be a vital opportunity for the
It will be important for groups to exam- European Commission, regulators and firms
ine their structure and consider which of alike on the final lap to Solvency II. •

Financial reform bill
Did we tame the beast: views

on the US Financial Reform Bill
Duke University’s Prof Lawrence Baxter
takes a microscope to the ‘Dodd-Frank’ Bill
finding a veritable ’Micrographia’ of doubt.
THIS paper was written in anticipation then approve the legislation by a likely mar-
of the US Financial Reform Bill’s final gin of about 59 votes to 40. Only then can
passage through Congress prior to being the Bill go to the President for signature.
signed into law by President Obama on These final votes are scheduled for next
July 5 – obviously this is now not the week when Congress returns from the July
case. The Bill currently before Congress Fourth recess. So we will not know until next
was devised to address problems associ- week whether 12 months of intense effort in
ated with the global financial crisis (GFC) Congress and two years of aftershocks from
of 2007-2009. the GFC will actually lead to financial reform
in the United States. If, however, Dodd-
The Dodd-Frank Wall Street Reform and Frank is signed into law, the United States
Consumer Protection Act, which by its very will become the first major nation to hon-
title indicates the complicated nature of the our its commitment to the G20 to reform its
reforms, is actually not yet law. The Bill, which financial system.
I will refer to as“Dodd-Frank”for the rest of
this paper, now hangs in limbo, having been Dodd-Frank in general
passed by the House of Representatives and This legislation is neither uncontroversial
the Senate, subsequently reported out of nor sure to be effective. The Bill has engen-
Conference Committee and finally approved dered a range of reactions, ranging from sav-
by the House, but not quite yet enacted by age criticism to effusive self-promotion by
Congress. Congressional leaders and the President. At
Two more votes remain in the Senate. the conservative end of the spectrum, a pro-
The first will be whether to stop with a fessor at Stanford writes that Dodd-Frank
cloture vote an attempted filibuster by the is a “financial fiasco.” The ubiquitous Judge
Republican minority, which would prevent Richard Posner, having recently turned his
the bill from coming to a floor vote. If the attention to the subject of banking regula-
Senate votes for cloture a second vote will tion and become a Keynesian after years in

the Milton Friedman camp, has described will profoundly reshape financial services for
the bill as “politics in the worst sense.” decades to come. There is much in it that I
Liberal commentators have mixed reactions would praise.
too, with Lynn Parramore declaring the bill
to be“both disappointing and inspiring” and What’s hot
Chris Bowers, co-founder of the organisa- Consumers have received short shrift in
tion known as OpenLeft, advocating that recent years as financial products have
despite its shortcomings it is still worth sup- become more byzantine, and only a preda-
porting and the last chance to “really take tory lender, auto dealer, or Washington lob-
on the banks.” Even Paul Volcker, former byist would argue that is it acceptable that
chairman of the Fed and after whom one of ordinary consumers should have to engage
the major new activity restrictions in Dodd- professional assistance merely to under-
Frank is named, is said to be disappointed stand the terms of their mortgages or credit
with how that restriction – the Volcker Rule card agreements. As the damage incurred
– was watered down in order to secure by complex – some would say unneces-
Republican votes. There is indeed enough in sary – products sold aggressively to inves-
the massive 2,307-page bill to delight, anger tors has escalated it is also important that
and/or befuddle everybody to some extent. the professionals in the business be placed
under increasing standards of care in their
Not a complete bill disclosures and conduct; this, too, is partly
Dodd-Frank also conspicuously avoids addressed in the legislation.
two major areas of greatly needed reform, The derivatives market is presently rather
namely regulatory consolidation among the like the foreign exchange market of a decade
nation’s illogical morass of financial regula- ago: money is made as much through the
tors, and restructuring of the GSE system privileged access to information as through
designed to promote easy access to home actual value added, and in the case of deriva-
mortgages, such as Fannie Mae and Freddy tives which can have such massive contin-
Mac. These dysfunctional organisations, in gencies the strengthening of the exchange
the view of many, were among the signifi- infrastructure and market transparency is an
cant contributors to the GFC. urgent necessity. The introduction of proper
Finally, implementation of the Bill awaits supervision is also to be welcomed.
over 200 rule-making processes by the
implementing agencies! These regulatory Mission accomplished?
elaborations will add considerable depth to Given space restrictions, it is impossible to
the legislative framework and their outcome, give a wide-ranging summary of the Dodd-
far from predictable, will depend on further Frank reforms. Instead, one’s intent is to focus
intense lobbying by all the stakeholders at on a single important question; namely, does
the less visible level of the administrative the legislation squarely face and adequately
process. address the problem of financial instabil-
Yet there is no doubt that Dodd-Frank ity so as to significantly reduce the risk of

another collapse in the financial system? regulated and, if necessary, liquidated.
The threat of destabilisation is the beast that However, as long as LCFIs are permitted to
lurks under the gigantic, volatile and labile operate at their current scale and complex-
financial system upon which global pros- ity they will not and cannot in practice be
perity and security depends. Have we in the allowed to fail, no matter what the legisla-
United States done our part to challenge this tion permits or prohibits and no matter what
beast? Senator Dodd, Congressman Frank or offi-
My view is that we have not. We have cials at the Treasury Department declare to
made a partial and reasonably good faith the contrary.
attempt, but we have not truly come to grips
with one of the central causes of financial Financial stability
instability, namely the massive global finan- Of all the anxiety stemming from the GFC,
cial institutions now roaming the planet. perhaps the greatest is fear of widespread
I will adopt the term in regulatory use for domestic and international financial insta-
these institutions: large, complex financial bility. While specific and localised bank fail-
institutions, or LCFIs. Just as we saw with the ures are surely always painful, they seem
failure of Lehman Brothers and the near col- to be part of the normal functioning of
lapse of AIG, Citigroup, Merrill Lynch, Royal economic systems – a manifestation of the
Bank of Scotland, Lloyds and others in 2008, Schumpeterian “creative destruction” that
the failure of any one LCFI would inflict seri- ensures the very survival of capitalism itself.
ous disruption on the entire financial system. It is not such specific failures but rather wide-
spread breakdowns of the kind we experi-
Issue of ‘too-big-to-fail’ enced with the GFC that instil the real fear.
These and many other financial institutions
are now more or less openly acknowledged Prevalence of financial crises
to be“too important to fail,”“too big to fail”or, This fear is well founded. The GFC is only
more euphemistically, “systemically impor- the latest in a long line of similar crises.
tant.” Despite bold declarations and efforts Many earlier crises are well known, includ-
in the legislation to restrict future governing: the Dutch Tulip Mania of 1637; South
ment assistance, the Dodd-Frank legislation Sea Bubble of 1720 ; Mississippi Company in
does not do enough to address this problem 1720; Great Crash of 1929; and, of course,
and, for as long as these LCFIs operate at Asian Financial Crisis of 1997.
their current scale and complexity, the finan- Crashes have occurred in almost every
cial system will remain fragile and vulnerable economic region of the globe. It might come
to massive sudden shocks. as a surprise to learn that there have been
It is true that Dodd-Frank purports to more than 112 systemic-scale financial crises
deal with the problem and has been sold as in over 90 countries over the past 30 years.
having dealt with it. But in the ultimate anal- Indeed, such crises are now twice as preva-
ysis it has not. This is because Dodd-Frank lent today than they were a century ago. And
assumes that LCFIs can be safely operated, we don’t seem to be making much progress

in eliminating them. Systemic risk has really crises, if not our ability to stop them, has
only recently attracted much attention. actually improved. We have better economic
The first glimmers of concern arose in data at both the global and domestic levels
1974 when a relatively small financial insti- and regarding the histories of specific finan-
tution in Germany, Bankhaus Herstatt, failed cial institutions. Clear patterns do seem to
unexpectedly, generating overnight shocks emerge in the cycle from boom to bust. In
to financial institutions in other countries recent months governments and markets
that were exposed to losses resulting from have been reacting apprehensively to all
their inability to settle currency trades with kinds of signals of possible systemic failure,
Herstatt in the later time zones. ranging from the risk of sovereign defaults
A much more massive version of the sys- in Dubai and the Eurozone to possible asset
temic phenomenon occurred when Lehman bubbles in Beijing and Shanghai.
Brothers was allowed to fail on September
15, 2008. Lehman became the largest bank- Financial scale and scope
ruptcy in US history even though the invest- Fluctuating with the ebb and flow of eco-
ment bank was by no means the largest US nomic globalisation are the fortunes of
financial institution. Credit markets froze financial institutions themselves. Their scope
overnight as financial institutions took and interconnectedness are increasing as
defensive action to mitigate their exposures fast as the spread of global finance, and their
and anticipate potential losses. This was the individual sizes have escalated at spectacu-
event that effectively plunged the world into lar rates in recent years. There are now 180
the GFC. financial institutions with assets greater than
$50 billion, with 39 each having more than
Founding of Basel Committee $500 billion in assets. The largest (currently
The Herstatt failure prompted the creation BNP Paribas) holds just under $3 trillion.
by the G10 of a Committee on Banking Many of these institutions have been kept
Regulations and Supervisory Practices, alive only through massive injections of
known as the “Basel Committee.” Over the public funding. Among these financial insti-
past three decades the Basel Committee tutions, many, including some of the biggest,
and another committee working out of its have grown rapidly, more than doubling in
offices and created by the G20, the Financial size over the past five to 10 years.
Stability Board (FSB) (before 2009 the
Financial Stability Forum), have worked on Bank of England study
various ways to reduce the vulnerability of Despite their assertions of efficiencies of
the global financial system. scale, these financial conglomerates have
Obviously these institutions failed mis- long ceased to be as efficient as their smaller
erably in preventing or even anticipating counterparts. So their economic value is
the current crisis – a story too complicated questionable. What is worse is that the value
to investigate here today. Nevertheless, our of the de facto public subsidies they enjoy is
dim understanding of what leads to such substantial.

A respected study by the Bank of England the problem is to: supervise the health of the
recently suggested that the public sub- individual institutions themselves (so-called
sidy of the five largest banks in the United “microprudential” regulation); monitor the
Kingdom has been running at $30 bil- systemic inter-dependence of each financial
lion per year. A similar study in the United institution as they interact within the broader
States suggests that the subsidy derived financial system (so-called “macropruden-
from the US Treasury’s TARP programme for tial” regulation); and promote, through the
the top 18 banks is approximately $34 bil- medium of the G20, Basle Committee and
lion/ year. In both studies the largest banks FSB, greater international co-operation in
take the lion’s share of this public subsidy. order to address the transborder intercon-
Furthermore, both studies look at only one nections among LCFIs.
aspect of various state-backed advantages
large financial institutions enjoy; there are Regulatory approach
indeed various other forms of support that Consistent with this regulatory oriented
generate a broader aggregate subsidy. approach, and accepting the position of the
The international financial system is US Treasury Secretary that regulators should
greatly dependent on the fortunes of these possess the discretion to act appropriately
ultra large financial institutions. Difficulties when dangers arise, Dodd-Frank creates
experienced by any one such institution an elaborate and graduated framework for
leads to one of two inevitable results: either regulatory action.
additional public subsidies are required to 1.) The Bill creates sophisticated machin-
keep the institution open, or letting it go into ery designed to anticipate and react to the
bankruptcy will lead to widespread financial buildup of systemic risk. This consists of the
disruption and even general instability – as new Financial Stability Oversight Council,
witnessed during the GFC. This is why such informed by a new Office of Financial
institutions that have become known in the Research in the Treasury Department, which
United States as TBTF. has the responsibility of collecting economic
data and producing analysis to identify and
Dodd-Frank solution monitor emerging systemic risks. Dodd-
How does the Dodd-Frank Bill address this Frank also casts a wide net over any financial
problem? One obvious way would have institution that might contribute to this risk,
been to impose limitations on the size of whether it be a bank or not.
financial institutions. An amendment pro- 2.) Regulators are empowered to implement
posed by two senators did indeed place such progressively tougher standards, ranging
an option squarely before the Senate. Their from capital requirements to activity restric-
amendment, however, met fierce opposi- tions to limits on single counterparty expo-
tion from the large banks and the Treasury sures, in order to prevent such systemically
Department and was eventually defeated. significant institutions from becoming more
Instead Dodd-Frank delegated the problem risky. The Bill prohibits certain types of con-
to the regulators. The regulatory approach to duct ex ante, though the implementation

periods are lengthy and it is far from clear interconnected financial entities down to
that such activities, for example proprietary size”as one of the most important objectives
trading which will be banned by the so- for successful reform. In her assessment“the
called Volcker Rule, are really all that impor- bill fails completely.”
tant in generating systemic risk, particularly
given the exemptions created by the Bill and Dodd-Frank failings
the lengthy implementation periods. I believe Morgenson’s evaluation is correct.
The regulators can also extend this We will have another crisis soon enough;
framework of supervision and limitations to indeed such crises seem ultimately unavoid-
financial institutions designated “systemi- able. If Congress, after the kind of crisis we
cally significant,” even if they are not banks. have just been through, cannot itself impose
Such systemically significant institutions scale limitations on very large financial insti-
will also be required to develop their own tutions, I don’t think the regulators will ever
“funeral plans” which would provide blue- be in a position to shut them down. And if
prints for their orderly shutdown when financial institutions of current scale and
things go wrong. complexity continue to operate, I don’t think
3.) Dodd-Frank prohibits direct bailouts, that they can be shut down when a crisis
either by the lender of last resort or deposit occurs.
insurer, that benefit an individual bank. The
Fed may only provide emergency lending Complexity of LCFIs
on a broad basis, and not solely for a specific The primary reason for this gloomy outlook
institution, and then only with the approval is that financial institutions have evolved to a
of the Treasury Secretary. The FDIC, which degree of complexity and size where it is not
protects the deposit insurance funds and only more likely that they will fail. It is also
depositors, has to get special – ultimately practically impossible to let them do so with-
Presidential and Congressional – approval in out the cure being worse than the disease.It
order to guarantee debt in order to prevent is more likely that financial Leviathans will
a bank run. run into serious difficulties because:
4.) New speedy resolution or liquidation (a) they are now beyond the level of com-
procedures, similar to those that already plexity at which risk can safely and reliably
apply to banks, are created for any financial be managed; and, (b) it is unrealistic to think
institution deemed systemically significant. that current resources and techniques of
The FDIC, which is already the receiver for regulation can meaningfully monitor them;
failed banks, will wind up financial institu- and, (c) their sheer scale and complexity of
tions forced into this bankruptcy system. operations spawns such deep mutual inter-
Yet the final iterations of Dodd-Frank connectedness that the failure of any one
have been met with many headlines creates the serious risk of failure by many
declaring that the bill will not in fact have others, as well as schools of smaller financial
killed TBTF. Gretchen Morgenson of the institutions.
New York Times identified “cutting big and Such companies, let alone their

regulators, are still learning the skills of and If the problem for the institution is essen-
developing the tools for the complex risk tially one of liquidity then the central bank’s
management necessary to operate on a job is to act as a lender of last resort.
large, global scale in a highly labile global
financial market. Paradox elaborated
It is not just credit and market risks that If, on the other hand, there is a risk of a run
they must master (they have acquired con- on the bank, or if there is a danger that the
siderable experience at addressing these bank’s failure will dissipate more capital than
types of risk); it is also an increasingly com- will be sufficient to cover repayment of the
plicated level of operational risk, in which deposits, then the deposit insurer’s job is to
the diversity of such companies, coupled take “prompt corrective action” to pre-empt
with the escalating sources of unexpected the failure or, if this action is already too late,
dangers – both functional and geographic to seize the bank and put it through fast-
– creates a situation with which BP would track receivership. When the bank is very
surely now identify: you simply will not see large and systemically significant, the temp-
the lightning that hits you. I have yet to see a tation for both a central bank and deposit
serious risk management or regulatory plan insurer is to try to keep the financial insti-
that adequately or reassuringly addresses tution open in the hope that it will make it
such risk complexity. through the crisis and be able to rebuild.
Small banks are relatively easy to close,
Intervention paradox and in the US the FDIC regularly closes fail-
It is less likely than ever that regulators will ing banks with little disruption. But the clo-
use their powers to shut down a large, sys- sure of a complex large bank is both costly
temically risky institution because of what to the federal insurance funds and carries the
one might label the intervention paradox: risk of systemic damage to other financial
just when the need to precipitate terminal institutions.
action to seize a financial institution is great-
est, the incentives not to do so, and the abil- IMF observations
ity of the institution itself to resist seizure, are As a recent study by the International
also highest. Monetary Fund concluded: “The failure of a
The result is that such institutions are systemically important institution increases
kept open to the point where they either the likelihood of failures among non-sys-
become zombies – publicly subsidised and temic institutions. This means that any regu-
ultimately non-productive (i.e. not sustain- lator will be more lenient with a systemically
ably profitable) wards of the state – or their important institution.” Furthermore, the
collapse creates far greater damage on other actions of both types of regulators (lender
institutions than should have been allowed. of last resort and prompt corrective actor)
To elaborate on this paradox, when become mutually reinforcing and likely to
financial institutions get into difficulty, finan- perpetuate the survival of weak but very
cial agencies have two main responsibilities. large institutions. And this is before even

taking into account the intense lobbying argument that size is not the problem; rather
power that such large institutions possess, it is interconnectedness, a feature shared by
which will almost certainly be deployed as smaller as well as larger institutions.
a political barricade against any regulatory
aspirations to the contrary. Big equals unmanageable
The Dodd-Frank system would appear Interconnectedness is indeed the capillary
to eliminate the “too big to fail” possibility network of systemic risk. But the argument
by prohibiting bailouts in all but the most that size is irrelevant misses the point: inter-
restricted circumstances. connectedness increases exponentially with
But consider why the possibility of a bail- size and above a certain scale risks start to
out exists in the first place: the institutions become unmanageable.
we are talking about would generate all the So limiting financial institution size
conditions necessary for both emergency would be not for the purpose of improving
loans from the Fed and debt guarantees safety. Large scale virtually guarantees the
by the FDIC, precisely because their failure presence of excessively complex risk. More
would have major systemic consequences important, the systemic impacts of failure are
the world over. magnified by size.
The managerial culture of banking exac-
Restructuring TBTFs erbates the risks generated by scale. The
So while the prudential measures devel- advocates of large-scale banking, including
oped by Dodd-Frank might in theory help most of the executives, tend to favour the
reduce the threat of systemic danger, the centralised, branch and integrated model of
continued existence of LCFIs, the failure of universal banking because this model is per-
which would have major systemic conse- ceived to be more efficient.
quences, makes another major disruption to
financial stability and another bailout all but Over-centralisation risk
inevitable. A unified corporate structure enables the
There is, in my view (and the view of organisation to leverage its capital over all
many others) only one way to install sys- of its operations and avoid the intra-affiliate
temic blowout preventers so as to mitigate, legal, accounting and operational impedi-
at least, the scale of damage caused by the ments among subsidiaries. Yet this same
next financial crisis. This is to limit the size of, operational consolidation also conducts
or substantially restructure into safer, more risk more freely across the corporate entitity.
self-sealing subcomponents, the denizens Some national regulators require foreign
that operate within the system. Limiting banks to establish local, separately capital-
bank size will not entirely reduce complex- ised and operated subsidiaries precisely in
ity (which generates operational risk and order to facilitate more effective domestic
the possibility of institution failure) or inter- supervision. This is part of the attraction
connectedness (which generates systemic of the non-operating holding company
risk). Indeed an industry paper makes the (NOHC) structure favoured by the United

States and some other countries. Affiliate safety. The global financial system is evolv-
transaction restrictions help to prevent trans- ing so rapidly, is so volatile and so labile that
mission of risk between the operating sub- it possesses the characteristics of a complex
sidiaries, and it might be possible to refine adaptive system – one that more resembles
structurally separate components further the weather than a product of intelligent
to produce safer conglomerates that can be central design.
managed more coherently and that contain
stronger internal insulations when risks get Prof Arner et al
out of control. If the global financial system is really more
Dodd-Frank indeed uses this technique accurately understood as a truly complex
to address the risks posed by hedge fund environment in the scientific sense, then try-
activity for banks by requiring that such activ- ing to regulate modern global finance will
ities be“pushed out”into separate subsidiar- require more nuanced, skilled and rapidly
ies. Whether the LCFIs would welcome this reactive regulation than commands, prohi-
approach is another matter, since the inter- bitions or greater enforcement powers. New
affiliate restrictions would necessarily reduce techniques of adaptive regulation must be
the “efficiencies” enjoyed by folding diverse developed to meet the fast-paced world of
operations into more monolithic corporate payments, financial dealing and innovation.
entities. Douglas Arner and his co-authors have
recently completed major studies directed
Rethinking the framework toward comprehensive redesign of the
In the absence of sound policy reasons for global financial system and its regulation, so
assuming the greater risks that such institu- I would direct the audience to that study for a
tions add to the system, it is therefore hard to fuller understanding of the overall issues that
see why it makes sense to continue, like deer must be addressed.
in the headlights, to watch financial institu-
tions reach new scales that are beyond the Closing remarks
capacity of regulators to supervise properly, I will content myself by noting, in closing,
at least with techniques currently available, that there are some elements of the financial
and their own capacity to provide credible ecosystem that can be controlled upfront.
guarantees that they can be operated safely. One of them is the size of the participants,
Perhaps a combination of learning and so that at least the environmental damage
technology will ultimately render very large- caused by these players does not destroy the
scale banking safe. Yet even if this were the habitat for other creatures.
case, Dodd-Frank ultimately relies upon an In this important respect the Dodd-
outdated framework for matching the new Frank Bill has avoided dealing with a cen-
world of finance. tral vulnerability to the financial system.
This is because, in my opinion, Dodd- This reform will almost certainly be back on
Frank is conceptually misconceived as a the table after the next disaster, the odds of
vehicle for promoting systemic financial which, if history is any guide, are very high. •

Regulatory discretion
Financial supervision and

increased powers of discretion
A prescient paper by Steve Randy Waldman
questions enhancing regulatory discretion
as found in the present Dodd-Frank Act.
In view of the passage, finally, of the lowballs valuation estimates will inevita-
Dodd-Frank Act and the huge discre- bly face angry push-back from the regu-
tionary powers it has handed over to the lated bank. Moreover, the examiner will be
majority of the US’s existing supervisory “proven wrong” again and again, until she
bodies, it is well worth revisiting an loses her job. Her fuddy-duddy theories
essay hosted by Steve Randy Waldman about cash-flow and credit analysis will
on his website – Interfluidity – during not withstand empirical scrutiny, as shoddy
the height of the Congressional skir- credits continually perform while asset
mishes concerning consolidation within prices rise. Valuations can remain irrational
America’s multiplicity of regulatory bod- much longer than a regulator can remain
ies. This is an issue Dodd-Frank failed to employed.
carry as evidenced in the new regulatory
environment contained within the Bill’s Asset overvaluation
2,319 pages. Bad times, unfortunately, follow good times,
and regulatory incentives are to do the wrong
An enduring truth about financial regulation thing yet again. When bad times come, over-
is this: Given the discretion to do so, financial optimistic valuations have been widely tol-
regulators will always do the wrong thing. erated. In fact, they will have become very
It’s easy to explain why. In good times, common. Over-valuation of assets leads to
regulators have every incentive to take banks overstatement of capital. Overstatement of
at their optimistic word on asset valuations, capital permits banks to increase the scale
and therefore on bank capitalisation. It is of their lending, which directly increases
almost impossible for bank regulators to reported profitability.
be “tough” in good times, for the same rea- Banks that overvalue wildly thrive in
son it is almost impossible for mutual fund good times. Fuddy-duddy banks lag and
managers to be bearish through a bub- their CEOs are ousted and The Economist
ble. A “conservative” bank examiner who runs uncomplimentary stories about what

fools they are. The miracle of competition incentives change. Resolving banks, under
ensures that many of the most important this circumstance, will prove very expensive
and successful banks will have balance in terms of taxpayer dollars, political ill-will,
sheets like helium balloons at the end of a and operational complexity. It will reveal
boom. Then, like a pin from outer space, regulators to have been asleep at the wheel,
somebody, somewhere fails to repay a loan. anger the public, and alienate nice people
When this happens, bankers beg for- whom they’ve worked closely with, whom
bearance. They argue that the rain of pins they like, who might otherwise offer them
will eventually pass and most of their assets very nice jobs down the line.
will turn out to be fine. They ask regulators
to allow them to write down assets gently, Systemic crisis
slowly, so that they can let ongoing earnings When a“systemic”banking crisis occurs, reg-
support or increase their regulatory capital. ulators’ incentives are suddenly aligned with
If that doesn’t work, they suggest that capi- bankers: to deny and underplay, to offer for-
talisation thresholds be temporarily lowered, bearance, to allow the troubled banks to try
since what good is having a buffer against “earn”their way out of the crisis. Regulators,
bad times if you can’t actually use it in bad in fact, can go a step further. Bankers can
times? only “gamble for redemption”, but regula-
tors can rig the tables to ensure that banks
Drawing the line are likely to win. And they do. A central
Knowing, and they do know, that their assets bank might drop short-term interest rates
are poor and that they are on a glide path to very low to steepen the yield curve. It might
visible insolvency, they use any forbearance purchase or lend against iffy assets with new
they extract to “gamble for redemption,” to money, propping up prices and ratifying bal-
make speculative investments that will yield ance sheets. It might pay interest to banks on
returns high enough to save them, if things that new money, creating de novo a revenue
work out. If they don’t, the bankers were stream based on no economic activity at all.
going to lose their banks anyway. The addi-
tional losses that fall to taxpayers and credi- Discretionary ‘bailouts’
tors needn’t concern them. Regulators might bail out prominent credi-
Here, wouldn’t regulators draw the tors and counterparties of the banks, sud-
line? When the trouble is with just a few denly transforming bad bank assets into
small banks, the answer is yes, absolutely. government gold. Directly or via those bailed
Regulators understand that the costs of clos- out firms, regulators might engage in “open
ing a troubled bank early are much less than market transactions” with banks, enter-
the costs after a delay. If a small bank is in ing or unwinding positions without driving
trouble, they swoop in like superheroes and hard bargains, leaving taxpayer money on
“resolve”it with extreme prejudice. the table as charity for the troubled institu-
But when very large banks, or a very tions. They might even redefine the mean-
large number of banks are in trouble, the ing of financial contracts in subtle ways that

increase bank revenues at the expense of of an equitable resolution to problems
consumers. decreases the longer banks are permitted
If all that stuff works out, regulators to downplay weakness, the more regulatory
might be able to claim that they didn’t do forbearance banks are granted, or the more
such a bad job after all, that the crisis was just public capital banks are given. (An “equita-
a “panic”, that their errors prior to the crisis ble resolution”, in this context, means giving
were moderate and manageable and it was the shaft to bank managers, shareholders,
only the irrational skittishness of investors and unsecured creditors to minimise costs
and the taunts of mean bloggers that made to taxpayers and to sharpen the incentives of
things seem so awful for a while. Regulators, bank stakeholders to invest well.“Regulatory
like bankers, have everything to gain and lit- forbearance”and“public capital injection”are
tle to lose by papering things over. And so redundant.
they do. Besides, things here weren’t nearly
as bad as in Europe. Existing practice
There was nothing new or different Under current banking practice, regulatory
about the recent financial crisis, other than forbearance is economically equivalent to an
its scale. Yes, the names of the overvalued uncompensated injection of public capital,
financial instruments have changed and like TARP but without the messy politics and
new-fangled derivatives made it all confus- with no upside for taxpayers. (Make sure you
ing about who owed what to whom and understand why.)
what would explode where. But things have So FDICIA tried to short-circuit our woe-
always blown up unaccountably during ful tale by telling regulators they should have
banking crises. a twitchy trigger finger. If regulators inter-
vene early and aggressively, the costs of the
Same old story crisis will be moderate, and since the costs of
We have seen this movie before, the story the crisis are moderate, it should actually be
I’ve just told you is old hat, and the ending is plausible for regulators to intervene early and
always the same. We enact“reform”. The last aggressively rather than playing the world’s
time around, we enacted particularly smart most expensive game of “cover your back”.
reform – the Federal Deposit Insurance It was a great idea. Except it didn’t work.
Corporation Act (FDICA) – which was
painstakingly mindful of regulators’ incen- Importance of capitalisation
tives, and tried to break the cycle. It man- We’ve already told the story of why it doesn’t
dated in very strong terms that the Federal work. Bank health and safety is a function of
Deposit Insurance Corporation (FDIC) take capitalisation, capitalisation is a function of
“prompt corrective action” with respect to bank asset valuation, and there is no objec-
potentially troubled banks. tive measure of asset valuation. During good
The theory of “prompt corrective action” times “conservative” valuations are demon-
was and is very sensible. It’s pretty clear that strably mistaken and totally unsupportable
the social costs increase and the likelihood as grounds for confiscating the property of

respected, connected, and wealthy business are now toast. Mortgage originators, bou-
people. Regulators simply fail to take prompt tique securitisers, ratings agencies, and CDS
corrective action until it is far too late. markets were largely unregulated. They also
As you read through the roughly 1,400 clearly failed.
pages of currently proposed regulatory
reform – the initial Bill introduced by Senator The ‘train wreck’ of AIG
Dodd in November 2009 – ask yourself what, The one train wreck that the current round
if anything, would interfere with the (uncon- of proposals might have forestalled is
troversial and long-understood) dynamic AIGFP, whose unhedged, uncollateralised
that I’ve described. CDS exposure would make even the most
Giving regulators more power doesn’t lackluster regulator blush. But it is not at all
help, when regulators have repeatedly failed plausible, especially in the US, that AIG was
to use the powers they had. Putting more the linchpin without which the late troubles
bank-like institutions and activities under a would not have occurred.
regulatory umbrella seems sensible, as does If we had to re-fight the last war under
eliminating opportunities for firms to choose all the regulations now proposed, we might
among several regulators and shop for the have won one battle. But we’d very definitely
most permissive. But even our most vigilant have lost the war. Deregulation won’t solve
and competent regulator – the FDIC – was the problem. But neither will the sort of reg-
totally snowed by this and the previous two ulation now proposed by Senator’s Barney
banking crises. Frank or Chris Dodd.
But what about the Senator for Vermont,
Geithner’s prescience Bernie Sanders? Is“too big to fail”the prob-
It has become fashionable to suggest that lem? Yes and no. Unsustainable bank-
the idea of “systemic risk” is novel, and that funded asset price booms can and do occur
just having some sort of high-level, blue rib- even among small banks. But systemic crises
bon council explicitly charged with worry- are more likely in a world with big banks, as
ing about financial catastrophes will change only one or two need totter to take down the
everything. But financial meltdowns are not world. Chopping up banks reduces the fre-
new, Timothy Geithner was giving smart, quency of major crises. Also,“prompt correc-
widely discussed speeches about systemic tive action” does sometimes work for small
risk in 2006, exactly as the current crisis was banks.
building.
There is, unfortunately, almost no cor- PCA and ‘big banks’
relation between the degree to which an For big banks, PCA is just a joke – Citibank is
institution or sector is supervised by regu- and always will be perfectly healthy until it is
lators and behaviour or misbehaviour dur- totally a basket case. But regulators do stage
ing a financial crisis. Commercial banks, early interventions in smaller banks, even
Government Sponsored Entities (GSE) and during relatively quiet times, and that does
bond insurers were intimately regulated and help. Crises among small banks can lead to

large fiscal costs (c.f. the S&L bailout). But monopoly provider. Essential infrastructure
even during serious crises, many small banks should be held by entities that are bankruptcy
turn out to have been prudent and small remote from firms that bear unrelated risks,
banks tend not to be so inter-connected although the stakeholders needn’t be bank-
that a cascade of failures leaves us without a ruptcy remote from the critical infrastructure.
financial system. Small bank-based systems (For example, if the owner of a derivative
fail gracefully (See Felix Salmon’s website). exchange goes under, the exchange must be
Crises among small banks are less cor- immune from liability, but if the exchange
rosive to incentives for careful capital alloca- suffers losses due to insufficient collateral
tion, and less offensive to distributive justice, requirements, the owner could still be liable.)
than large bank crises, because regulators
are willing to force preferred equity-holders Market structure
and unsecured creditors of smaller banks to Fundamentally (and a bit radically), for finan-
bear losses while they hesitate to do so for cial reform to be effective, regulators must
big banks. actively target market structure. Financial
Also managers of smaller banks can be systems are public/private partnerships, not
perfunctorily defenestrated, while managers purely private enterprises. It is perfectly rea-
of megabanks somehow survive (and even sonable for the state as the ultimate provider
when they don’t, they are too wealthy to of funds and bearer of risk to insist on a robust
have to care). Again, one hates to be mean, and heterogeneous network of delegates.
but treating the managers of trouble-causing Regulators need not (and really cannot)
banks roughly is important both to get the architect the breakup of today’s destructive
incentives right and out of regard for justice. behemoths. All they need to do is iden-
tify dimensions along which firms become
Degree of inter-connectedness indispensable or threatening to financial sta-
We should insist upon a market structure bility as they grow, and tax measures of those
in which financial institutions are univer- attributes at progressively steeper rates. The
sally small. But smallness cannot be defined taxes could be slowly phased in over a few
by balance-sheet assets alone. We need to years, to give existing firms time to arrange
manage the degree of inter-connectedness efficient deconglomerations.
and the scale of total exposures (including
off-balance sheet exposures arising from Problem of ‘gaming’
derivative market participation). Further, we Importantly, legislators should characterise
need to ensure that no market participants the target market structure, and empower
are indispensable by virtue of controlling regulators to define and alter tax schedules
some essential market infrastructure. as necessary to achieve that target, rather
Clearing and payments systems, securi- than specifying them in law, to counter
ties and derivatives exchanges, etc should be gaming by nimble financiers. (For example,
multiple and redundant if privately owned, a tax on balance sheet assets would lead to
or publicly managed if efficiency demands a rapturous innovation in tricks to keep stuff

off-balance-sheet.) Taxes should always be Resolution authority might be helpful. But
imposed in a nondiscriminatory way across I’m not optimistic. During the current crisis,
the industry. (If you are not concerned about there are two accounts of why we guaran-
the role of political influence and favouritism teed and bailed existing banks – including
in regulatory action, you haven’t been pay- creditors, management, preferred share-
ing attention.)“Taxes”could take the form of holders, and financial counterparties – rather
increased regulatory burdens, such as capi- than resolving the banks and forcing losses
talisation or reserve requirements (though onto the private parties who made bad bets.
the effectiveness of the latter is diminished if
central banks pay interest on reserves). Legal constraints
Variations of these ideas were actually One account emphasises legal constraints:
in both the Frank-Dodd original proposed we had laws that foresaw the orderly
legislation. Regulators would have a fair resolution of commercial banks, but not
amount of discretion, under the new laws, to investment banks or bank-holding con-
do the right thing. They could ignore the ter- glomerates. According to this view, regula-
rifying shrieks of our banking overlords and tors’ only options were to permit Lehman
force the monsters to break apart. But we like uncontrolled liquidations of financial
come back to the first and most ancient law firms or else make whole every creditor to
of banking regulation. prevent a formal bankruptcy. If this is what
you think then, yes, resolution authority
Resolution authority might change everything.
Given discretion, banking regulators will But another view – that of the author
always, always do the wrong thing. Only – suggests that despite the limitations of
if Congress defines a verifiable target mar- pre-existing legislation, regulators through-
ket structure and periodically audits the out this crisis have had the capacity to drive
regulators for compliance will we eliminate much harder bargains, and have chosen not
“too-big-and-mean-and-rich-and-scary- to. Despite having no legal authority to do
and-interconnected-and-sexy-to-fail”. so, the government “resolved” Bear Stearns
But what about the much vaunted over a weekend in almost precisely the same
“resolution authority”. Doesn’t that change manner that FDIC resolves your average
the deadly dynamic of banking regulation small town bank. Secretary Paulson could
described above? Sure, it will still be true at that point have gone to Congress with a
that during booms, banks will make dumb proposal for resolution authority to institu-
mistakes and regulators will be unable to tionalise the powers he clearly required.
point out that the Swiss cheese they’re call-
ing assets is chock full of holes. But, you Avoidance and TARP
might argue, when the cycle turns, they’ll no Instead, he had Treasury staff prepare the first
longer be helplessly forced to resort to cover version of TARP and put it on a shelf until an
your back-and-pray. They’ll have the tools emergency sufficient to blackmail Congress
to wind down bad banks ASAP! Maybe. arose. Whatever the legal prearrangements,

regulators have always had sufficient lever- (I haven’t read the original text of Senator
age, over firms and firm managers, to push Dodd’s initial proposal to the Senate).
through any structural changes they deemed
necessary and to create bargaining power for Idea of ‘living wills’
firms to insist on loss sharing. Yes, I know that “living wills” are supposed
Finally, earlier this year – 2009 – when to diminish the operational complex-
bank nationalisation was an active debate, ity and uncertainty associated with tak-
opponents did not because they could not ing a harder line and that, in theory, might
claim that authority would not be found if encourage different choices as identified by
the administration decided nationalisation British regulators and the Bank of England.
was the way to go. I also understand that some sort of industry-
Harsh measures towards banks would funded slush fund is supposed to bear future
have been extremely popular. What author- bail-out costs.
ity the administration did not have by virtue My sense is that during a gut-wrenching
of existing powers and informal leverage financial crisis, hypothetical funeral plans
they could have achieved by purchasing will provide little comfort to terrified regu-
common shares instead of preferred during lators, prepaid slush funds will prove to be
“capital injections”, or, in a pinch, by asking laughably inadequate, and commitments to
Congress for help. In my view, legal niceties make firms pay for the mess ex-post will be
were never the issue. waived in order to shore up struggling bank
balance sheets. These proposals are about
Easy option always prevails providing the political cover necessary to
Regulators opted to guarantee the banking get legislation passed, but they will prove to
system and bail out creditors because given be utterly without substance when the next
the terrifying scale of the problem, the oper- crisis occurs.
ational complexities and investor uncertainty
associated with resolutions or nationalisa- Plus ça change
tions, the power of the banks and regulators’ I’ll end where I started. The one rule that you
personal connections to them – our leaders can rely on with respect to banking regula-
simply opted not to pursue more hardball tion is that whenever regulators have discre-
resolutions. tion, they do exactly the wrong thing. For
If we don’t change the structure of the very predictable reasons and despite the best
financial industry, there’s no reason to think of intentions, they screw up. Besides mess-
that next time around regulators won’t use ing around with intragovernmental organi-
the proposed resolution authority to do zation charts, the main proposals before
exactly what they opted to do this time. They Congress give regulators more power and
won’t even need to go to Congress for a new more discretion. That just won’t work. •
TARP, as Frank’s proposal gives the execu-
tive branch carte blanche to provide finan- Editor’s Note: This paper has been slightly
cial firms unlimited guarantees and support. modified from its original text.

Anti-trust regulation
Global anti-trust regulation

in the current financial climate
Consultant Gavin Sudhakar critiques
trends observed in economic-based US
enforcement policy of anti-trust regulation.
Is an outdated anti-trust policy hindering products. It was also the intent to“stimulate
economic growth, innovation and entre- businesses to find new, innovative and more
preneurial spirit in the current financial efficient methods of production.”2 Enacted
crisis? Competition policy works effec- in 1890, anti-trust law consists of three
tively provided free and open markets main regulations against international car-
prevail as an underlining legislative tel activity; namely, the Sherman Anti-trust
intent. When it comes to global compe- Act, the Clayton Act and the Federal Trade
tition, the main focus of anti-trust regu- Commission Act (FTCA). Recently, in 2004,
lation is targeted towards global firms President Geroge W. Bush amended this
which are considered “too big to fail”. by empowering anti-trust laws to increase
criminal fines and penalties up to US$1 mil-
The US Congress enacted anti-trust laws as lion and 10 years‘ jail for violators.
a pro-competition tool in promoting free and
open trade markets. Applying this 28-year- Consumer prophylatic
old anti-trust paradigm, this article argues An anti-trust law protects consumers by
its effectiveness and US agencies’ aggressive regulating competitors in setting product
enforcement initiatives in the new digital age prices honestly and independently. When
and 21st-first century standards. Although international competitors cheat customers
the primary focus here is on US anti-trust by price fixing, bid rigging, market division or
laws, this is comparable to the anti-trust laws allocation schemes and other forms of collu-
in economically developed countries around sion, such competitors are subject to crimi-
the globe.1 nal prosecution enforced by the Antitrust
Congress enacted anti-trust laws to pro- Division of the US Department of Justice
tect competition and bring about regulatory (DOJ). International cartel activity is a form
reform in order to preserve free and open of co-operation among competitors to the
markets and ensure that consumers had material terms of agreement in which com-
access to lower prices and innovative quality petitors enter by price fixing, defining market

entry or targeting specific market segment. participation, the Supreme Court viewed
Such monopolist agreements have no that anti-trust law standards are to be devel-
expected business efficiencies or added ben- oped via case-deciding courts“by the light of
efits but rather harm the consumers.3 This reason, guided by the principles of law and
article argues the deficiency of this outdated the duty to apply and enforce the public pol-
anti-trust regulation in balancing innova- icy embodied in the statute.”
tion and entrepreneurial spirit, and combat-
ing such cartel monopolist agreements with Core principles
limited agency guidelines in providing the However it labels cartel activities as “the
distinction between anti-competitive and supreme evil of anti-trust” in deciding the
pro-competitive activities in the global mar- case of Verizon Communications Inc v. Law
ket place. Offices of Curtis V. Trinko, LLP. It also went
on to set the standards of“rule of reasoning”
‘Immoral and irrational’ and“doctrine of per se illegality”in anti-trust
During these 28 years of anti-trust paradigm disputes. The anti-trust division’s criminal
the true intent of legislation is lost between enforcement framework developed against
party lines, and the inconsistent approach cartel activities focuses on seven core princi-
towards anti-trust laws remains an eco- ples in punishing violators, namely,“(i) focus
nomic policy issue. Even though renowned prosecutors on “hard core” collusive activity;
economists such as Alan Greenspan and (ii) treat cartels as serious crimes; (iii) pro-
Richard Posner publicly criticised these out- vide an amnesty programme and “amnesty
dated and inefficient anti-trust regulations, plus”; (iv) vigorously prosecute obstruction
Congress continues to view anticompetitive of justice; (v) charge cartels in conjunction
laws as a means of punishing monopolistic with other offences; (vi) provide transpar-
behaviour. In addition, ruling presidential ency and predictability; and (vii) publicise
views and opinions play a significant role these enforcement efforts.”7 Corporations
in shaping anti-trust statutes. For instance, and their officials on the other hand view the
former President Bush’s views on anti-trust statute as a“windfall”and“complicated”.
laws are merely applicable to clear and con-
vincing price-fixing cases.4 Limited guidance
These conflicting views on the statute With limited guidelines provided by the
were sharply criticised by many econo- enforcement agencies, a conglomer-
mists. For example, Dr Gary Hall views ate’s innovative activities are viewed as
anti-trust laws as “immoral and irrational.”5 monopolistic and become victims of con-
In his opinion “targets of anti-trust are not voluted agency policies and procedures. In
criminals but victims of market busters.”On a recent FTC anti-trust case, Intel v. AMD,
the judicial front, “American anti-trust law Intel corporate officials stated that “to the
took shape only when the Supreme Court extent the foreign anti-trust regulators have
began to build the basic framework of anti- come down harder on the company than
trust analysis in its decisions.”6 With limited American officials, it was a reflection of the

different approach towards anti-trust law. such statutes. With the co-operation of other
The American approach towards anti-trust OECD member countries, the US DOJ has
has been historically aimed at protecting investigated and prosecuted many inter-
competition, while the others use anti-trust national hard core cartels specifically in
often to protect rival companies.”8 With the merger related cartel activities. Without
inconsistency in applying anti-trust rule of these co-operative tools among the member
law, these statutes remain a“lottery”scheme countries, such complex and sophisticated
in the name of protecting consumers from investigative proceedings are difficult to
monopolistic cartel activities. In addition, resolve in a global competitive network.
corporate views on anti-trust laws provide
no leaders or followers, just another political Case law
bureaucratic enforcement system targeted By protecting competition across selected
towards“too big to fail”global corporations. industries and international borders, the
DOJ’s Anti-trust Division claims that it has
OECD recommendations been a catalyst for economic growth and
Recently, in October 2009, the Organisation efficiency in benefiting consumers and
for Economic Cooperation and Development businesses. The division also claims it has
(OECD) Council recommended that its collected approximately US$5.2 billion in
member countries “identify existing or pro- criminal anti-trust fines between fiscal year
posed public policies that unduly restrict 1997 to the end of first quarter FY 2009;
competition and to revise them by adopting a significant amount imposed in connec-
more pro-competitive alternatives.”9 tion with the prosecution of international
It also recommended that its members cartel activity.10 The following section will
use its competition assessment tool-kit as set the stage in uncovering the legal stand-
a guideline to identify laws and regulations ards applied by the enforcement agencies
which “unnecessarily restrict competition in prosecuting violators in criminal and civil
and developing alternative policies that proceedings.
achieve the same objectives, with lesser harm
to competition.”The OECD believes that its Criminal filings
“recommendation will encourage further In recent years agencies have taken aggres-
government efforts to reduce unduly restric- sive measures as policy to invoke the
tive regulations and promote beneficial mar- Sherman Act under anti-trust criminal
ket activity.”Such OECD proactive initiatives enforcement against global corporations
will promote pro-competitive best practices and individuals violators. This initiative has
in the global market and take appropriate created much public and private awareness
legal action against hard core cartels. by showing the importance of the statute as
During the past decade, more than 90 applied against international cartels, as illus-
countries have developed some form of anti- trated in the case, U.S.A v. F.Hoffmann-LA
trust laws and the remaining developing Roche Ltd. (Roche).11 From January, 1990 to
countries are working towards implementing February, 1999, Roche and co-conspirators

entered into a conspiracy to suppress and the criminal investigations. One may not
eliminate competition by price fixing and uncover the true damage to the competition,
“allocating the volume of certain vitamins consumers and taxpayers without a formal
manufactured and sold in the US and else- trial proceeding. This landmark case demon-
where, and to allocate customers for vitamin strates the seriousness of anti-trust violations,
premixes sold in the United States. This case specifically in international conspiracy cartel
also alleges that the companies allocated agreements targeted at harming American
contracts for vitamin premixes for customers consumers and the pro-competitive market.
throughout the US and rigged the bids for
those contracts.” Difficulties
In addition, the Anti-trust Division However without establishing a prima facie
of Dallas, Texas, alleged that Roche and case of illegality by defendants in this case,
its co-conspirators “was in unreasonable the true harm to the American consumers is
restraint of interstate and foreign trade and difficult to prove beyond reasonable doubt.
commerce in violation of Section 1 of the Roche’s plea-bargain clearly demonstrates
Sherman Act (15 U.S.C. §1).” In return, in a the quick-and-dirty solution which global
plea agreement, Roche agreed to pay record corporations opt for as a viable business
criminal fines in the amount of $500 million solution against anti-trust allegations in a
for taking an active part in this international global competitive network. With the lack
vitamin cartel.12 of clear governance between the legislative
and judicial due process in anti-trust cases,
Applied legal standard in the name of few wrongdoers many well
The legal standard applied in this case states established global corporations will continue
that, Roche violated the Sherman Act (15 to opt for a plea-bargain as an element of
U.S.C. §1), “1) by agreeing to fix and raise “business of nexus”in its global operations.
prices on Vitamins A, B2, B5, C, E, Beta
Carotene and vitamin premixes, 2) agree- Civil side
ing to allocate the volume of sales and mar- On the civil side of this statute, legal trends
ket shares of such vitamins, 3) agreeing to show that the US agencies have taken
divide contracts to supply vitamin premixes aggressive anti-trust enforcement action by
to customers in the U.S. by rigging the bids invoking the Sherman Act. The underlying
for those contracts; and, 4) participating judicial standard developed in civil anti-trust
in meetings and conversations to monitor cases is clearly elaborated in the furiously
and enforce adherence to the agreed-upon fought case, U.S.A. v. Microsoft Corp.13 In this,
prices and market shares.” US anti-trust agencies filed a civil complaint
In day-to-day transactions such sophis- and claimed that Microsoft Corp (Microsoft)
ticated proprietary agreements are extremely violated anti-trust laws under the Sherman
hard to prove beyond reasonable doubt. Act, Sections 1 & 2, by engaging in anti-com-
However Roche’s plea bargain demon- petitive conduct and “attempted to monop-
strates willingness to fully co-operate with olise the Web browser market by tying its

browser to its operating system.” In this case, strengthening anti-trust laws by revers-
19 states and the District of Columbia (DC) ing the Bush administration’s policy “which
sought to ground liability in addition to anti- strongly favoured defendants against anti-
trust laws.” The DC district court handling trust claims.”15
this case ruled against Microsoft by applying
a four-pronged test, namely: “1) monopolist Safeguard competition
act must have an anti-competitive effect – On the individual’s jail sentence front, as
it must harm the competitive process and illustrated above, the DOJ has continued to
thereby harm consumers; 2) demonstrate prosecute anti-trust violators to the maxi-
that the monopolist’s conduct harmed com- mum statute limits.16 In addition, the DOJ
petition, not just a competitor; 3) monopolist rejects “the impulse to go easy on anti-trust
may proffer a pro-competitive justification enforcement during weak economic times.”
for its conduct; and, 4) demonstrate that the Such bold government policy actions
anti-competitive harm of the conduct out- to promote competition, innovation and
weighs the pro-competitive benefits.” entrepreneurial spirit towards market stabil-
ity in a financial turmoil are arguable initia-
Effects of conduct tives. The DOJ’s recent enforcement actions
In addition, the court stressed that “when mainly concentrated on industries such as,
assessing the balance between the anti- “household products and electronics, air
competitive harm and the pro-competitive transportation, the oil industry, communica-
effect, the courts should focus on the effects tions technology and supplies and services
of conduct, not the intent behind it.” In for military troops.” In addition, the DOJ
response to a settlement, Microsoft agreed to believes that the anti-competition conspira-
the court’s terms and conditions to comply cies in these industries will have a profound
with the final judgment and swiftly resolved impact in the day-to-day lives of consumers
technical disputes.14 This case clearly dem- and taxpayers.
onstrates that a“prefect competition”should
never be the ultimate goal of anti-trust Inbuilt immunities
policy. When it is applied rigidly, it will have On the other hand, the anti-trust statute
profound negative effects on innovation and has inbuilt immunities to certain industries,
impede entrepreneurial spirit at the mercy of namely: agricultural, the export trade, insur-
judicial activism. ance, labour, fishing, defence, newspaper
In recent years, the DOJ Anti-trust joint operating arrangements, professional
Division has dramatically increased the eco- sports, small business joint ventures, and
nomic-based agency’s enforcement activi- local governments activities.17
ties against violators. As illustrated in the Recently, however, such immunities
chart overleaf, the criminal fines imposed were challenged before the Supreme Court
on the wrongdoers increased significantly in the sports case, American Needle v. NFL, on
during third quarter 2009 to $990 million. the basis of “whether the (National Football
The Obama administration is planning on League) NFL and the teams functioned as

Chart 1. The US DOJ Anti-trust Division — criminal fines obtained in millions of
dollars, by fiscal year
a single entity when granting the company H. Ginsburg, hoping to clarify its anti-trust
an exclusive headwear licence and therefore regulatory process and identify potential
could not violate Section 1 of the Sherman gaps within the guidelines.19 However, the
Act, 15 U.S.C. 1, which requires proof of col- outcome of these public comments has yet
lective action involving separate entities.”18 to be reflected in its guidelines.
The Anti-trust Division’s guidelines pro-
vide a very broad brush for its grounds to Recent trends
enforce anti-trust regulation against viola- Recent trends have shown that due to the
tors. These guidelines were publicly critiqued bureaucratic and time-consuming Anti-
by well-known economic pundits, reason- trust Division’s Business Review process,
ing that the guidelines language is vague limited corporations and individuals have
and out-of-touch with modern economics, taken full advantage of such review requests.
and does not provide any meaningful guid- In addition, in 2009 only two such business
ance to the judicial review process. review requests were addressed by anti-trust
In response to this sharp criticism, dur- division.20
ing December 2009, enforcement agencies Similarly, trends have shown that lim-
solicited public comments along with the ited corporations and individuals have taken
support of Supreme Court Judge, Douglas full advantage of the Anti-trust Division’s

Chart 2. Average prison terms imposed on foreigners in international cartel cases*
20
18
Average jail sentence in months
15
12
10
6.9
5 4.5 4.6
3 3 3.3 3
0
2000 2001 2002 2003 2004 2005 2006 2007 2008
Fiscal Year
*Includes defendants charged with with USC§1 and/or obstruction offenses
Source: DOJ Antitrust Division
Corporate Leniency Program against crimi- the anti-trust violators in a true competitive
nal convictions. The division has used this business world.
leniency programme for many years as In today’s economic market conditions,
an “investigative tool for detecting cartel delivering innovation isn’t an option, it’s a
activity against corporations and individu- business necessity. In a competitive global
als.”21 Even though the division claims that market, businesses understand cutting costs
its modern leniency programme has dra- might keep them operational in the short
matically increased amnesty applications in term.
recent years – due to negative publicity and
reputation issues – corporations and indi- Lack of consistency
viduals have considered these programmes However, increasing revenue with an entre-
as quick-and-dirty operational solutions. preneurial model should be the ultimate goal.
Such programmes aid agencies merely as an Based on recent trends observed, US legisla-
investigative tool in resolving complicated tive intent seems to be out-of-line, outdated
and sophisticated anti-competitive issues; and counter-productive to promoting pro-
however they fail to remedy the intent of competitive markets. Anti-trust regulation

is justifiable only if it works towards mak- Along with the recent aggressive legislative
ing the economy work better. With lack “Super Regulation”initiatives, a broader anti-
of consistent legislative governance and trust governmental regulation is needed in
party differences, anti-trust regulation fails line with the new economy global industries
to promote economic efficiency and com- and international intellectual property rights.
petition. Alan Greenspan recently stated:
“Competition effectively works, whatever National interest
the strategy, provided free and open markets In addition, modern anti-trust laws need
prevail,” and “anti-trust policy (never in his to align with the country’s foreign policy
judgment an effective procompetition tool), and national security. However, in global
is going to find its 20th-century standards far competition and capitalism, foreign inves-
out of date for the new digital age, in which tors should not retaliate against American
an innovation can turn an 800lb gorilla into a companies operating abroad as a causation
baby chimpanzee overnight.”22 for vague anti-trust laws, similar to the case
U.S.A. v. InBev N.V./S.A. et al.24 As such, the
Greenspan wisdom . . . current legislative anti-trust policy, in the
Between regulation, innovation and its con- name of punishing few“too big to fail”mar-
nectivity, anti-trust regulation is a very old ket leaders, has driven anti-trust regulations
principle for the new evolving global mar- too far in the spectrum of enforcement and
kets. As such, anti-trust laws are too complex shows its counter-productiveness towards
and need to better align with the regulatory American innovation and entrepreneurial
reform and innovative economic industries. spirit. Without any legislative intervention,
The trends have also shown that the anti- American businesses will lose their competi-
trust regulations process is expensive, cum- tive edge in the global market and the radical
bersome and not particularly accurate in inefficient legislative anti-trust policies will
broader terms. ruin the economy.
In the end, as Greenspan stated in his
anti-trust essay: “No one will ever know Judicial passivity
what new products, processes, machines, On the judicial front, the Supreme Court
and cost-saving mergers failed to come into has played a passive role in shaping anti-
existence, killed by the Sherman Act before trust laws since their enactment. Most of
they were born. No one can ever compute the power is delegated to the lower courts
the price that all of us have paid for that for legal interpretation and setting anti-trust
Act which, by inducing less effective use of standards. The trends have shown that pun-
capital, has kept our standard of living lower ishing innovative ideals as monopoly power
than would otherwise have been possible.”23 seems to reflect on the power of judicial
In the evolving global marketplace, leg- activism.
islative policies need to rapidly adapt and The“rule of reason”standards applied in
recognise the sensitivity between anti-com- anti-trust cases are difficult to prove beyond
petition and innovative business practices. reasonable doubt and it depends mainly

on the judicial subject matter experienced Anti-trust Division’s merger guidelines have
in anti-trust sophisticated business agree- become unreliable in complex global market
ments. Similarly the “per se” rule also needs transactions. After 18 years, the Anti-trust
to be clearly defined in its application. Expert Division is considering re-evaluating and
opinions on anti-trust cases can be skewed reviewing merger guidelines to accommo-
to favour the outcomes, similar to the date the changing market place through
Microsoft case, and such testimony should several workshop examinations.26
not be allowed in jury proceedings.
The Supreme Court should also con- Robin Hood
sider overruling several old landmark anti- The real benefit and practical application of
trust cases, similar to U.S.A. v. Eastman such guidelines are yet to be appraised in
Kodak25 case, which misstates the “rationale a complex competitive global network. In
of monopolistic strategy.”In addition, courts recommendation, the Anti-trust Division
should not price-regulate technology giants should consider leaving the market alone
such as Apple and GE for owning their pro- to fix itself rather than trying to be a Robin
prietary and marketing rights in distribution Hood, “to save the poor consumer by rob-
of products for given markets. It is the judicial bing the underdog.” Given the budget and
responsibility to clearly differentiate between resource constrains which the Anti-trust
anti-trust and regulation, and consistently Division faces in a complex new digital age,
apply within the legal framework rather than such an aggressive enforcement approach
making corporate policy decisions in a com- will contribute to economic catastrophe.
plex global“cutthroat”competitive market. Dr Gary Hall recently criticised anti-trust
laws as immoral and“market busters should
Agency interventions not make life impossible for people who
The trends show that the Anti-trust Division’s make life possible.” As such, typically, cor-
aggressive enforcement activity, specifically porations do not deliberately seek to violate
in horizontal merger in globally distributed anti-trust laws, rather they set out to compete
markets, seems to be the new wave of anti- aggressively in the market place; and some-
trust regulation. Even though the agency’s times their actions cross the line and end up
concentration is towards regulating indus- being a violation. Anti-trust agencies should
try market leaders, they un-consummated reconsider their economic-based enforce-
major merger talks as a distributive market ment policy and realign their approach in
protection against unilateral price increases. preserving competition and intervention
In addition, trends show that their focus strategy in a global market.
on promoting merger efficiency, merger
topics and market definitions, is an eco- Global policy goals
nomically destructive merger policy. Some Achieving OECD’s competitive best prac-
of the agency merger interventions have tice framework should be the main anti-
had a spill-over effect in private non-merger trust policy goal of member nations. With
cases, such as in Google, Inc. v.Yahoo, Inc. The global anti-trust co-operation, OECD

recommended standards are attainable in its day-to-day global transactions. These
in competing markets. However, it is the working compliance plans and policies
responsibility of member world leaders to should be distributed to its member com-
promote and support initiatives in a col- munities, trained and periodically tested for
laborative and consistent approach for sus- their effectiveness.
tainable global anti-trust governance. An
aggressive anti-trust enforcement policy Proactive risk management
taken by just one of its members will lack A mandatory anti-trust compliance plan
the needed collective support and will be implemented as proactive risk management
counterproductive to OECD’s global pro- will aid in promoting corporate govern-
competitive best practice. ance, ethics and fiduciary responsibilities.
To be competitive, market-makers will Periodically these compliance policies must
seize friendlier troughs to promote their be revised to accommodate regulatory
products and services, leaving behind changes.
many disappointed consumers. In addition The trends show that the primary
to promoting an anti-competitive global anti-trust federal investigation sources are
framework, the anti-trust policies of mem- broadly categorised as: employee complaints
ber nations should encourage and support (including former employees), customer
businesses to succeed, and be innovative in complaints (including third-party), whistle-
increasing wealth in a growing economy. blowers, amnesty applicants, agency web
search engines, merger documents review
Burden of proof and government proactive efforts. Keeping
The burden of proof remains on corpora- these sources in hindsight, compliance poli-
tions and individuals to prove a prima facie cies and procedures should remedy the risks
case beyond reasonable doubt, which is with appropriate internal controls.
highly condemned in anti-trust courts.
Trends show that legal standard bars applied Business review process
by anti-trust courts are extremely difficult to Finally, when in doubt concerning anti-
attain on reasonable grounds. Hence corpo- competitive transactions, corporations and
rations and individuals opt to comply with individuals should take full advantage of
the agency and take plea bargain by paying a the Anti-trust Division’s Business Review
hefty penalty as a quick solution. process to look for any potential anti-trust
Even though the Anti-trust Division’s violation. These proactive measures will aid
Corporate Leniency Program has shown in making informed business decisions. If
positive outcome, on a broader scale such a the ultimate goal is to protect consumers
programme remains a “windfall”. As a rec- and their interests at any cost, the moral
ommendation, corporations and individuals actions and fiduciary duties of market mak-
must take anti-trust violation as a serious ers remain an ethical issue.
reputational offence and implement anti- Quick enrichment with a short-sighted
trust compliance policies and procedures monopoly business strategy will lead to

wrong business judgments in the long run PageServer?pagename=reg_ls_anti-trust
and have a catastrophic brand impact on the 6 DOJ/Anti-trust Division – Anti-trust Law in the
consumer society. Innovation and entrepre- U.S. Supreme Court Speech, SSRN: www.justice.
neurial spirit are the essential elements of gov/atr/public/speeches/204136.htm
a growing economy. However,“it takes two 7 DOJ/Anti-trust Division - Criminal Enforcement
to tango” in achieving sustainable com- of Anti-trust Laws: The U.S. Model, SSRN: www.
petitiveness in a free market to promote justice.gov/atr/public/speeches/218336.htm
the American brand. Suppressing growing 8 The NewYork Times – June 7, 2008 SSRN: www.
talent and abilities should never take prec- nytimes.com/2008/06/07/technology/07chip.
edence in a competing global market. html?_r=2&partner=rssuserland&emc=rss&pag
Innovative and creative minds will ewanted=all&oref=slogin
remain the burning fuel for building a com- 9 OECD Recommendation on Competi-
petitive cutting-edge 21st century. There are tion Assessment. SSRN: www.oecd.org/
many active statutes to protect consum- document/10/0,3343,en_2649_40381664_
ers against wrongdoers. Let us not punish 44080714_1_1_1_1,00.html
innovators for being innovative. When it 10 DOJ/Anti-trust Division – 2010 FY Anti-
comes to US separation-of-power, legisla- trust Budget, SSRN: www.justice.gov/jmd/
tive, executive and judicial governance lacks 2010justification/office/fy10-atr-justification.doc
near- or far-sightedness towards anti-com- 11 U.S.A. v. Roche, SSRN: www.justice.gov/atr/cases/
petitive policy in an economic growth. f2400/2452.htm
In a competitive business war, chastis- 12 U.S.A. v. Roche – PR Release May 20, 1999 SSRN:
ing the current innovative global economic www.justice.gov/atr/public/press_releases/1999/
growth with an outdated anti-trust regula- 2450.htm
tion and broken political abstract beliefs are 13 U.S.A. v. Microsoft SSRN: www.justice.gov/atr/
immoral and unconstitutional. • cases/ms_index.htm
14 U.S.A.v.Microsoft – PR Release Nov 2,2001 SSRN:
References www.justice.gov/atr/public/press_releases/2001/
1 DOJ/Anti-trust Division Worldwide Sites, SSRN: 9463.htm
www.justice.gov/atr/contact/otheratr.htm 15 The New York Times – May 11, 2009 SSRN:
2 DOJ/Anti-trust Division Enforcement and Con- www.nytimes.com/2009/05/11/business/11anti-
sumer Definition. SRN: www.justice.gov/atr/pub- trust.html
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Activity, SSRN: www.justice.gov/atr/public/arti- operations.htm
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May 24, 2005 SSRN: www.aynrand.org/site/ v-nfl

19 DOJ/FTC Horizontal Merger Guideline 23 The Political Inquirer – Alan Greenspan’s
Work-shop, Dec 3, 2009, SSRN: htc-01.media. view on anti-trust, SSRN: politicalinquirer.
globix.net/COMP008760MOD1/ftc_web/ com/2007/12/12/interrupting-the-election-
FTCindex.html#Dec03_09 coverage-alan-greenspan-on-anti-trust-
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SSRN: www.justice.gov/atr/public/busreview/ 24 U.S.A. v. InBev. et. al., SSRN: www.justice.gov/atr/
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SSRN: www.justice.gov/atr/public/criminal/ atr/cases/kodak0.htm
leniency.htm 26 DOJ/Anti-trust Division – Update review on
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www.scribd.com/doc/4414602/Alan-Greenspan tice.gov/atr/public/speeches/254577.htm

North Asia
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Reprints Articles &

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Volume I,
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Issues in res
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Resecuriti ortant fina
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A framewo challenges Dr Eric S. Rose
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Housing, y in times
monetary of financi Dr Fang Du
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Christopher Rogers
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Securitisation
Asset securitisation in China:

Opportunities and challenges
Deutsche Bank’s Claas Becker et al outline
the pros and cons of Chinese banks and
investors embracing securitisation.
Asset securitisation can serve vari- root cause of the current financial crisis. The
ous purposes: generation of funding, author believes that such a view is signifi-
economic risk transfer and associated cantly too simplistic. In general, securitisa-
capital release, market arbitrage, regulation deals perform similar to the underlying
tory arbitrage (mainly limited to Basel assets. As an example, the CLOs referencing
I regulation), or a combination of these. bank loans exhibit a fairly good performance,
Assets to be securitised include corporate similar to the performance of bank loans.1
loans (unsecured and secured), consumer Put differently, performance was within
loans, credit card claims, mortgage loans, investors’expectations.
non-performing loans, and tranches
of existing securitisations (CDO2s). Asset performance
Securitisations can either be done in Another example of an asset class that per-
true-sale form, removing the assets from formed within expectations is the securitisa-
the previous owner’s balance sheet, or in tion of UK prime retail mortgaged-backed
synthetic form involving credit default securities (RMBS).2 The main asset class that
swaps. did not perform according to expectations
was the securitisation of US subprime mort-
Securitisations are fairly complex prod- gages. ‘Subprime’ means that origination
ucts: legal, tax, accounting, and regulatory standards were significantly lower, i.e. loans
issues had to be solved in each jurisdiction. were granted to borrowers that were not
Meanwhile, securitisation has become a fully able to afford a house. As house prices
fairly standard procedure in some markets. fell, the degree of collateralisation of such
For standard securitisations, it is not neces- mortgages declined dramatically, resulting in
sary to obtain regulatory approval for each losses for the CLOs.
deal, thus facilitating the set-up of new Rating agencies have downgraded a lot
deals. of securitisation tranches, often the down-
Securitisation is often regarded as the grade comprised multiple notches. In some

cases, the downgrade was triggered by asset The global financial crisis has partly
performance, but in other cases, the down- suspended securitisation activity. More
grade was due to a change in rating meth- precisely, during the crisis assets were
odology. More precisely, rating agencies mainly securitised in order to generate
became cautious about single obligor con- tranches that could be used for repo deals
centrations, and deals with significant single with central banks. This means that secu-
obligor concentrations were heavily down- ritisation was used to obtain collateralised
graded despite good asset performance. funding from central banks.
As tranches were downgraded, a lot
of institutional investors were forced to Originator pullback
sell these, either because the rating fell to During the crisis, risk premiums rose dra-
below investment grade or because they matically, making securitisation uneconomic
had to avoid the higher capital charges from an originator’s point of view. As spreads
associated with the downgrade. The desire tightened, the market partially reopened,
to sell securitisation tranches fell into a and there were some securitisations that
time3 when liquidity in the secondary mar- were placed with external investors.
ket broke down almost completely, result- It has been discussed controversially
ing in fire sales. whether securitisation requires more regula-
tion. The author believes that these discus-
Subprime lessons sions should rather focus on sound lending
The following are some of the lessons hope- practices (as opposed to ‘originate-to-se-
fully learned from the subprime debacle: The curitizs’) and sound investing practices (as
interests of the originator and the investors opposed to relying solely on rating agencies).
must be aligned. ‘Originate-to-securitise’ There are no risks that are ‘bad’ (e.g. securi-
assets show a significantly weaker perfor- tised credit risk) or ‘good’ (e.g. corporate
mance than bank loans. The alignment of loans), but sound risk management practices
interests has been formalised in the regu- are essential.
latory requirement that originators keep a
vertical slice of each securitisation; A rating Securitisation in China
of a structured finance security is an assess- Basel II regulation on securitisation has
ment of its credit risk. It does not predict its recently been adopted in China.6 Prior to
future price in the secondary market, but just this, there were some pilot transactions
addresses the probability of timely payment in China relating to the securitisation
of interest and principal;4 Securitisations of of bank assets. In March 2005, the State
securitisation tranches – so-called CDO²s Council approved China Construction
– are rather opaque; and last but not least, Bank (CCB) and China Development
transparency is key. Bank (CDB) as the only two banks to
Some investors did not fully understand execute pilot securitisations. A task force
the features of the securities they invested in consisting of 10 ministries and regulatory
and relied too much on rating agencies.5 bodies was set up. In April 2005, Peoples’

Bank of China (PBOC) – the Chinese Figure 2. Capital structure of CDB CLO 2005-1
central bank – and the China Banking
Regulatory Commission (CBRC) set up
the Credit Securitisation Provisional Rule.
Pilot schemes
The two pilot securitisations were China
Construction Bank MBS 2005-1 and China
Development Bank CLO 2005-1. CCB’s
RMBS transaction was a RMB 3.017 bn deal
involving a trust structure. Ignoring legal
subtleties, this can be regarded as a true-sale
deal, in this case with separate interest and
principal waterfalls. Credit enhancement is
provided through excess spread, a first loss
position of three per cent kept by the origi- securitisation of corporate assets was gov-
nator, and subordination of the notes. CDBs erned by the Specific Asset Management
CLO 2005-1 transaction was a RMB 7.773 Plan (SAMP) that was enacted in May 2005.
Figure 1. Capital structure of CCB MBS 2005-1 An example of a SAMP deal is the China
Network Communications securitisation.
This structure provided significant interest
savings compared to traditional bank financ-
ing and did not require approval from CBRC
or PBOC. The SAMP programme was sus-
pended by the China Security Regulatory
Commission (CSRC) in 2006, and subse-
quent efforts to restart the programme in
2007 failed.
In summary, there are two main securi-
tisation markets in China. Securitisations of
bank assets are regulated by CBRC, and the
tranches are traded in the interbank market.
Securitisations of corporate assets are regu-
lated by CSRC, and the tranches are traded
in the stock exchange market.
bn deal securitising corporate loans. Similar What of the future

to CCB’s RMBS deal, it also involved a trust At the beginning of this paper, we stated
structure. that the motivations for securitisation can be
As opposed to bank assets, the to obtain funding or to achieve risk transfer

(this is the originator’s perspective). In China, to trade these securities. Denomination in a
securitisation could achieve the following foreign currency would probably require the
objectives: involvement of the State Administration of
1. Transfer risk from the banking system to Foreign Exchange.
other market participants. This may be espe-
cially important since there are views that Benefits of SAMP
the banking sector may become overheated. Building up infrastructure fosters economic
2. Obtain funding especially for small- and growth and prosperity. However, huge infra-
medium-sized banks, enabling them to structure projects like power plants or toll
grow their business. roads usually require a lot of capital.This may
3. Obtaining cheaper funding for corpora- be difficult to raise via bank loans because it
tions that are not able to tap the bond mar- puts a lot of concentration risk on a bank’s
ket. For instance, the SAMP programme balance sheet. Direct issuance of a bond
may be used to finance infrastructure pro- may also be difficult. In such situations, the
jects like toll roads and power plants. SAMP programme might be a very attrac-
tive opportunity to borrow funds at attractive
Free up funds levels. The China Network Communications
Let us detail these thoughts. A healthy sup- securitisation is an example how funding
ply of loans is the basis for economic growth. can be achieved in such cases.
Right now, Chinese borrowers have to rely The author believes that any of the three
almost entirely on banks to obtain funding. objectives mentioned above provide strong
If banks have the opportunity to securitise arguments for promoting securitisation
parts of their balance sheets, they could business in China.
de-risk their balance sheets, obtain regula-
tory capital relief, and expand their lending Issues requiring attention
business. As long as lending standards are However, there is still some way to go. In par-
not lowered and investors’ and originating ticular, the following issues require attention:
banks’ interests are aligned, this provides a Regulation – close co-ordination among
good opportunity for growth. different regulators is important. Ideally,
Foreign investors are looking for oppor- securitisation should become standardised
tunities to invest in China.The author expects so that regulatory approval is not neces-
future Chinese securitisation transactions sary for standard deals. This would make
to be very granular. This is very favourable structuring of new securitisations easy and
for investors because granularity implies efficient;
that there is only ‘macro’ risk and no name- Investors’ requirements–listing of secu-
specific (idiosyncratic) risk. Investors usually ritisation tranches at one single exchange
require that securitisation tranches are rated should be facilitated. OTC trading of tranches
by at least one of the three big rating agen- should be possible, also among non-banks.
cies, that they are denominated in currencies Though most investors buy securitisation
like US dollar or Euro, and that it is possible tranches on a buy-and-hold basis, liquidity

remains a strong argument. Tranches should acteristics as AAA rated bonds issued by corporates or
be denominated in US dollar or Euro and be financial institutions. Actually, some senior AAA tranches
rated by one of the three big rating agencies. were heavily downgraded.Their risk profile is quite differ-
The author believes that securitisation ent from corporate bonds: For example, low recoveries
in China can help foster stable growth and of corporate bonds can occur whereas low recoveries of
can be beneficial for both originators and senior structured securities are extremely seldom because
investors. Sound practices in underwriting, it would imply a default of almost all of the underlying
investment, and risk management remain assets.
essential. • 6 Guidelines on Regulatory Capital Requirements of Asset
Securitisation Exposure of Commercial Banks, published in
References December 2009.
1 This statement does not apply to Spanish SME loans.
Spanish SME CLOs performed below expectations, how- Editor’s Note
ever performance was in line with Spanish banks’ balance The author would like to thank Gene Guill,
sheets. managing director in the Loan Exposure
2 Residential mortgage-backed securities Management Group of Deutsche Bank,
3 Q4 2008 and Q1 2009 based in New York; his associate, Terry Tse;
4 Some ratings address the payment of principal only. and Xiaopu Han from China Development
5 As an example, some investors expected senior AAA Bank for the many helpful suggestions and
structured finance securities to exhibit the same char- assistance offered.
J ournal of reg
ulation & risk
north asia
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Volume I, Issue III,
Articles & Papers
Issues in resolving
systemically important
financial institution
Resecuritisation s Dr Eric S. Rosengren
in banking: major
challenges ahead
A framework for
funding liquidity Dr Fang Du
Housing, monetary crisis
nce
Complia and fiscal policies: Dr Ulrich Bindseil
Legal & Derivatives: from
from bad to worst
disaster to re-regulati Stephan Schoess,
on
Black swans, market Professor
crises and risk: the Lynn A. Stout
to the
human perspectiv
e
subject
Measuring & managing
risk for innovative Joseph Rizzi
actly is
financial instrumen
s Act? Red star spangled ts
Who ex Practice
banner: root causes Dr Stuart M. Turnbull
Corrupt
a cause for concern Fahrholz
Foreign
among Asian investors
, DLA Global financial
Yuet-Ming
today
change impacts David Smith
compliance and
er, Tham mines the
risk
The scramble is on
In this pap consultant, exa
to tackle bribery David Dekker
and corruption
Asia.
g Kong FCPA in
Who exactly is subject Penelope Tham & Gerald
to the Foreign Corrupt
Piper Hon ious effects of the
Li
Practices Act?
Financial markets
remuneration reform: Tham Yuet-Ming
pernic h Of ‘Black Swans’, stress
one step forward
y of whic tests & optimised
Umesh Kumar & Kevin
Marr
anies – man legis-Challengin risk management
reds of comp anies. The US g the value of enterprise David Samuels
by hund comp even- risk management
upt Practices were Fortune 500 these scandals by Rocky road ahead Tim Pagett
Corr in the to for global accountanc & Ranjit Jaswal
Foreign nnings e responded FCPA in 1977. y convergence
The US its begi ial latur ting the
the
isions to The Asian regulatory Rubik’s Cube
A), has rgate Spec tually enac main prov the
Dr Philip Goeth
Act (FCP n the Wate o- two s, and
era, whe ntary discl e There are bribery provision and the Alan Ewins and Angus
Risk manaRoss
Watergate called for volu – the anti- SEC
r had mad Both the gement
Prosecuto companies that ard FCPA nting provisions. J) have juris-
to Rich Justice (DO
sures from contributions aign. accou
rtment of the SEC
. Generally, s and Of ‘Black
ble
questiona presidential camp US Depa the FCPA provision Swans’, stre
1972 diction over accounting against issuers optimised ss tes
risk manag ts &
Nixon’s revealed cutes the s as s
disclosures ents prose bribery provision ative proceeding
However,
these
ble dom
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questiona had been channelle
paym
d the
anti-
civil and
administr
companies
and ement
not just through prosecutes ry provisions Stan
funds that n busin ess.
eas the DOJ
anti-bribe
dard & Poor’s
nts to obtai outlines the
but illicit
to foreig
n governme to subsequent inves
ti- wher
individual
s for the edings.
proce positive bene David Samuels
mation led Exchange through criminal fits of bank
The infor rities and that testing on stress
the US Secu h revealed ision the bottom
gations by ) whic to ery prov makes it line.
ion (SEC h funds” anti-brib bribery provision It is aing big challe
Commiss issuers kept “slus cal The ’s anti- robust -appro nge for banks to build
ey oraanyth
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many US n officials offer or prov als (“foreign” mean
of worst ach to mana downturn
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n -case capital adequ
pay bribe a volun tary to foreig t to
by obtai
definition, rios that, almos er risk concentratio acy programs to
parties. up with cor- of
value the inten ess to are triggered t encies,
later came r which any -US”) with directingunlik businely
or unpreceden by apparently and; applyi ns and risk
depend-
The SEC e unde ents ing “non or for to ng these
programm ess, ted events. drive busine improvemen
illicit paym retain busin
disclosure eported given include sponsor- through perfor ss selection – for examp ts
tion which self-r the SEC was any person. can Howe ver,
holi-solvin mance le,
pora with likely of value of a
, usethe g the proble adjusted pricing analysis
perated it would Anything ationfying riskent,
concentratio m of identi- that takes stress and risk-
and co-o ance that t l and educ cies employm
Contact
The resul ns into account.
mal assur nt action. for trave of future that give no to worst- and dependen- test results
an infor enforceme $300 ship home, promise s. Ther
vital e is rise case outcom
than USD s and meal
if the indust
be safe from sure that more day ry is to thrive es is
– and if indi- Top-level oversight
disclo ents (a mas-e discounts, drink vidual banks
are turn
was the ble paym past two years to Buildin
questiona been mad 147 the lessons
of the proces g a more robust and
million in in the 1970s) had Banks that
to competitive
advantage. s for uncov comprehens
unt ering threat ive
sive amo tackle the issue
h Asia be lauded by head-on will prise is clearly, in part, s to the enter-
Risk Nort investors and ance challe a corporate
lation & coming years regulators
Christopher Rogers
nge.The board govern
Journal
of Regu most impor
of industry
recuperation
in the must
have the motiv and top execut -
tantly, will ives
tained profita be able to delive and, scrutinise and ation and
the clout to
bility gains. r sus- able call a halt to
that are well Meanwhile, activities if apparently
placed to take banks term these are not profit-
consolidatio advantage interests of in the longer
n process need of the the the enterprise -
can understand to be intended risk or do not fit
portfolios of the risks embed sure they But contrary
profile of the
organisation
ded in the
Editor in chief
To improve
potential acquis
itions. ing corporate to popular opinion, impro .
governance v-
and strengthen enterprise risk manag tion of puttin
g the ‘right’
is not just a
ques-
investor confid ement
banks can take ence, we think board members in executives
and
the lead in appropriate place and
Better board three related incentives. giving them
and senior areas:
sight and executive over- For the bank
control of sions to make the
agement; re-inv enterp rise when they right deci-
igorated stress risk man- busine are difficu
testing and ss growth lt, e.g. when
or when risk looks good
Journal of managemen in the upturn,
Regulation t looks expen
& Risk North sive
Asia
163

Exchange rates
Is an undervalued renminbi the

source of global imbalances?
Prof Charles Wyplosz of the Geneva
Institute dismisses exogenous causes as a
factor in the current dollar-RMB debate.
The current debate in the United States the move has achieved durably was to wreck
over China’s exchange rate policy can be the Japanese economy, which has not grown
viewed as a rerun of the 1970s and ‘80s, one iota since. The Japanese used to call this
with China taking Japan’s role. This “the lost decade”; clearly it is now becom-
paper argues that while there is a rela- ing the“lost generation.”As China emulates
tionship between current account defi- Japan’s export-led growth strategy, this story
cits and surpluses, causality is difficult to is likely to figure prominently in its policy-
establish. Politics aside, even if Beijing makers’ minds. And rightly so. For further
does not choose to let the renminbi development of this premise, see Park and
(RMB) appreciate, inflation will eventu- Wyplosz, 2010.
ally finish the job.
Negative correlation
Back in the 1970s and‘80s, a sure vote-getter Figure 2 (see overleaf) illustrates the dangers
in the US and pleasure-getter on Capitol of interpreting co-movements as causality.
Hill was to complain about Japan manipu- The striking feature is the opposite move-
lating its exchange rate. Every argument that ments – or negative correlation – of the
you may hear today about China was made US and Japanese current accounts. Equally
then. In the end, Japan caved in and let its strikingly, despite these wide fluctuations, for
exchange rate appreciate. This is shown in more than 30 years the Japanese account has
Figure 1 (overleaf), which displays real effec- not been into negative territory while the US
tive exchange rates, i.e. rates corrected for the has not seen a surplus.
evolution of the country’s labour costs rela- US legislators interpreted these opposite
tive to those of its trade partners. yo-yo movements as a proof that the US
As can be seen from Figure 2 (overleaf), deficits were caused by the Japanese sur-
the US current account deficit improved, pluses and they saw the continuing Japanese
but only temporarily, and Japan remained surpluses as a proof that the yen was over-
in surplus after a temporary reduction. What valued. They say exactly the same things

Figure 1. Real effective exchange rates Figure 2. Current accounts (% of GDP)
(2005 = 100)
Source: IMF. Note: Nominal exchange rates corrected for unit labour
costs. An increase represents a real appreciation Source: IMF.
today, just cut out“Japan”and replace it with the “saving glut” hypothesis originally pro-
“China”. posed by Bernanke (2005). This view argues
But there is a big problem. The negative that excess savings in China – about 40 per
correlation between the US and Japanese cent of GDP – both depresses imports and
current accounts is still very much there. So creates the need for investment opportuni-
if yesterday’s Congress members were right, ties abroad. Thus politicians look at the cur-
then it must still be that the US external defi- rent account and competitiveness, therefore
cit continues to be driven by Japan’s surplus. the exchange rate, while Fed chairman
You do not need to bring China into the pic- Ben Bernanke looks at capital flows – the
ture. Alternatively, if you agree with today’s Chinese savings are transformed into US
Congress, you didn’t need Japan back then, (public sector) borrowing. This removes the
maybe China was already doing the trick exchange rate from centre stage.
(it wasn’t). The other possibility is that both
China and Japan have been colluding all Heart of the matter
along, which would require an incred- Causality lies at the heart of the dispute, as is
ible amount of co-ordination between two often the case. As economists, we know how
countries that are barely on speaking terms. delicate the causality issue is. Theoretically, in
general equilibrium few are the truly causal
China’s reaction – or exogenous – factors. Empirically, causal-
China’s authorities naturally see causality ity is the most vexing issue, which has led
running in the other direction. They blame to countless techniques, none of which are
the US current account deficits for the particularly convincing. The first observa-
Japanese and Chinese surpluses. They fur- tion, which is neither clarifying nor hopeful,
ther blame the US budget deficits for their is that it is impossible to prove which side
external deficits. The US response has been of the debate is guilty. In particular, no one

will seriously claim that current accounts are fixed exchange rates vis-à-vis currencies like
exogenous. the euro.
Debating whether it is the US deficit But is this peg responsible for the Chinese
that is causing China’s surplus or the other surplus and the US deficit? Start with the
way around is a waste of time. The negative easier part of the question: the link between
correlation only shows that these variables the Chinese current account and the value
are related to each other. We must try to of the renminbi. If the exchange rate has any
understand what is driving both. US budget impact on the current account, it is because it
deficits, Chinese and US savings and a few affects price competitiveness, which can be
other variables are good candidates; more on approximated by the real exchange rate.
them below. The evidence here is not controversial:
the nominal exchange rate strongly affects
Is the RMB exogenous? the real exchange rate in the short run, say
Another aspect of the causality problem is over one year or two, but not in the long run
the role of the exchange rate. Is the Chinese because real exchange rates eventually are
current-account surplus caused by a ren- endogenous. The claim that the renmimbi
mimbi undervaluation? Put differently, is undervaluation is the cause of continuing
the renmimbi exchange rate exogenous? Chinese surpluses look like a non-starter,
The answer is not as easy as it may seem. unless it can be proven that China also
Of course, the Chinese authorities peg their prevents prices from rising in response to
exchange rate to the dollar and even when undervaluation.
they allow for some flexibility (before the cri-
sis and soon again), they still very much keep Monetary policy
it under control. Like every country, China tries to stabilise
Undoubtedly, the nominal exchange rate prices. The instrument is monetary policy,
of the renminbi can be taken as exogenous, which in China is essentially driven by the
but it is the real exchange rate, i.e. the relative fixed exchange rate policy. Put differently,
price of domestic and foreign goods or rela- the exchange rate is the instrument used to
tive unit costs as in Figure 1, that affects the keep inflation low. If the authorities were to
current account. peg it at the wrong level, the result would be
Let us start with the object of conflict, inflation.
i.e. the dollar-renminbi exchange rate. The This does not fully exonerate China,
nominal rate is in the hands of the Chinese however. Because they use extensive internal
authorities, who have opted for a fixed and external financial controls, the Chinese
exchange rate regime. This is perfectly com- authorities can peg the exchange rate at
patible with IMF principles. Calling that an undervalued level and combat inflation
“manipulation” is not just outside any legal through credit controls.This is precisely what
norm, it would also concern the tens of other they do. So, yes, it is possible for China to
countries that also peg their currencies to the control its real exchange rate for more than
dollar – and (why not?) those that maintain the short run. Put differently, the export-led

strategy is still an option. This conclusion, savings as exogenous. High savings are seen
however, does not imply that the renminbi as the result of Asians’ famed propensity to
exchange rate can explain the US deficit. The save combined with income distribution
US cannot control its own real exchange rate tilted towards large firms and with inexist-
and, anyway, it does not even attempt to ent social safety nets. It is also a highly desir-
control its nominal rate. able feature when the population is quickly
Then is the dollar overvalued? That raises ageing, as is indeed the case in China. Fast
the question: what is the dollar equilibrium growth and more resources flowing to high
exchange rate level? The formal definition of savers explain the trend seen in the left-hand
equilibrium is complex – the real rate that, chart in Figure 3.
if maintained indefinitely would allow the
country to run permanent surpluses, respec- Current account deficit
tively deficits, that allows it to serve its exter- The next step is the trend decline in US net
nal debt, respectively to absorb returns on its private saving (for the time being, ignore the
net external asset position. wide shorter-run fluctuations) also shown in
A simplified version, inevitably inac- the left-hand chart in Figure 3. This is mir-
curate, is that the real exchange rate is in rored in the growing US current account
equilibrium if it delivers a current account deficit. No need for China and the renminbi
balance when the economy is otherwise in a to account for this evolution.
sustainable position. The problem is that the It just turns out that the current accounts
US quasi-zero private saving rate until 2008 of China and of the US started more or less
and its budget deficits observed over the past simultaneously in opposite directions. For
decade are not sustainable. the shorter-run movements, we turn to the
right-hand chart in Figure 3 which displays
Dollar equilibrium the US current account and its two compo-
Whether the dollar is in equilibrium or not is nents: the budget balance and net private
highly controversial. A safe conclusion is that saving. The striking observation is the near
a renminbi appreciation, even a large one, perfect negative correlation between the
will not solve the many disequilibria present budget balance and net private saving.
in the US economy. US citizens must first This observation suggests – remember,
start saving again and the federal govern- causality is hard to prove – that net private
ment must stabilise its own indebtedness. saving fluctuations in the US have been
The role of the renminbi is bound to be largely driven by the budget balance, in
negligible. A good story must distinguish Ricardian fashion (Ricardian equivalence
between short-run co-movements of the US asserts that the private sector saves exactly
and Chinese current accounts and the long- what the government dissaves because it
run trend of larger imbalances visible since understands that the public debt must be
the mid-1990s, both of which are negatively eventually financed by higher taxes). In a
correlated. The savings glut story offers an pure Ricardian world, the current account
interesting starting point. It takes Chinese would have remained in balance, which

Figure 3. The China-US nexus (% of GDP)
Source: IMF and OECD

it approximately did until the early 1990s. fluctuations in the US and China (and
This observation came to be known as Japan)? The striking message from the left-
the Feldstein-Horioka paradox because it hand chart in Figure 3 is that the Chinese
meant that the US was not taking advan- current account is most directly related to
tage of financial markets to borrow or lend US net private savings and therefore, via the
internationally. right-hand chart, to the US budget deficits.
Assume that Chinese and Japanese (and
Disappearing paradox German) savers would not have responded
The paradox disappeared in the early 1990s to rising borrowing needs in the US.
when short-run fluctuations of net private In the now-globalised economy, interest
savings moved along a declining trend, rates would have risen worldwide, presum-
which was mirrored in the declining current ably boosting savings. Conversely, if China’s
account deficit. This is indeed the time frame savings had not been matched by US bor-
when financial deregulation picked up rowing, interest rates would have declined
speed around the world. In the US, it led to worldwide, presumably encouraging bor-
the development, among other innovations, rowing. Depending on which side domi-
of the now-infamous subprime mortgage nated, interest rates played their balancing
markets. Private saving declined drastically. role – though this remains to be established.
(The 2008 crisis seems to have brought a
reversal, but a couple of years a trend does Summary
not make.) The story can be summarised in a simple,
Finally, what about the negatively hopefully convincing, way:
correlated shorter-run current account Financial deregulation in the US led to a

drastic decline in US private savings, which the world, including China; the renminbi
translated in a long-run trend decline in the exchange rate is not a necessary ingredient
current-account balance; at about the same in the story.
time, China deregulated its economy and If China insists on pegging the ren-
embarked on an export-led strategy. Rapid minbi to the dollar and on preventing the
growth put continuously more income in real appreciation that should accompany
the hands of large firms that started to save fast technological catch-up – the Balassa-
more as they could not invest fast enough to Samuelson principle – eventually inflation
absorb their resources. will deliver this appreciation. •
This translated in a long-run trend rise
in China’s current account; in the shorter References
run, US budget deficit fluctuations led to Bernanke, Ben (2010), ‘Global Saving Glut and the US
opposite fluctuations in US net private sav- Current Account Deficit’, Sandridge Lecture, Virginia
ings, along the downward trend. US citizens Association of Economics, Richmond, Fed. Res Brd,
being imperfectly Ricardian, there remains March.
a residual current account imbalance, also Park,Yung Chul Park & CharlesWyplosz (2010), Monetary
along the downward trend, which led to and Financial Integration in East Asia: The Relevance of
matching saving responses elsewhere in European Experience, Oxford University Press.
Journal of Regulation & Risk

Opinion
Deregulation, non-r
egulation
and ‘desupervision’
North Asia Professor William

causes of the mortga
Black examines the
ge fraud epidemic
has swept the United that
States.
THE author of this
paper is a leading
academic, lawyer and they implicitly
and former banking demonstrate three
regulator specialisin cal failures of regulation criti-
g in ‘white collar’ and a wholesale
crime. As one of the failure of private market
unsung heroes of discipline of fraud
nce Savings & Loans the and other forms
Complia debacle of credit risk. The Financial
Legal & Professor Black nowadays of the 1980s, Crimes Enforceme
nt Network (FinCEN)
of his time researchin spends much released a study
g why financial this week on Suspicious
markets have a tendency Activity Reports (SARs)
to the
to become dys- that
functional. Renowne lated financial institution federally regu-
subject d for his theory on s (sometimes) file
actly is
‘control fraud’, Prof. with the Federal
Who ex s Act? Black lectures at the Bureau of Investigati

Practice
University of Missouri (FBI) when they find on
evidence of mortgage
Corrupt
and Kansas City.
He is the author of fraud.
Foreign
‘The Best Way to
, DLA a Bank is to Own Rob
Yuet-Ming es the
One: How Corporate
Executives and Politician Epidemic warning
er, Tham min s Looted the The
In this pap consultant, exa
S&L Industry.’ A FBI began warning
prominen
Kon g A in Asia. tor on the causes of the t commenta- mortgage fraud in their congressio of an “epidemic” of
g FCP current
Piper Hon ious effects of the crisis, Prof. Black financial mony nal testi-
is a vocal critic of in September
the ago. It also warned 2004 – over five years
pernic h
way the US governme
nt has handled the that if the epidemic
were
y of whic banking crisis and rewarded not dealt with it would
anies – man legis- that have clearly institutions cause a financial cri-
reds of comp anies. The US failed in their fiduciary sis. Nothing remotely adequate was
by hund comp even- duties to investors. respond to the epidemic done to
Practices were Fortune 500 these scandals by by regulators, law
Corrupt in the to enforcement, or private
Foreign nnings e responded FCPA in 1977. sector “market dis-
The US has its begi Spec ial latur
enac ting the
prov ision s to the The following commenta cipline.” Instead, the
epidemic
A), rgate the ry does not nec- produced and
Act (FCP n the Wate o- tually e are two main isions, and essarily represent the view of the Journal hyper-inflated a bubble
era, whe ntary discl e Ther bribery prov SEC and the
in US housing prices
Watergate called for volu mad – the anti- Regulation and Risk – North Asia.
of that produced
a crisis so severe that
r had Both the
Prosecuto companies that ard FCPA nting provisions. J) have juris- “The new numbers on criminal caused the collapse it nearly
to Rich Justice (DO of the global financial
sures from contributions aign. accou
rtment of
SEC
rally, the rals for mortgage fraud in the US
refer- system and
led to unprecedented
ble US Depa FCPA. Gene isions and
questiona presidential camp are just in many bailouts of
1972 n over the nting prov st issuers
of the world’s largest
banks.
Nixon’s led dictio the accou again Journal
sures revea prosecutes ry provisions as edings of Regulation & Risk North Asia
these disclo estic payments anti-bribe ative proce and
However, ble dom d the administr
questiona had been channelle civil and companies
through prosecutes ry provisions 33
Call for papers

not just that ess. DOJ
funds n busin eas the anti-bribe
but illicit nts to obtai ti- wher s for the edings.
n governme to subsequent inves individual proce
to foreig Exchange through criminal
mation led rities and
Risk mana
The infor that gement
the US Secu h revealed provision s it
gations by ) whic to bribery ision make
ion (SEC h funds”
Commiss issuers kept “slus political
The anti- anti-bribery prov or anything Of ‘Black
many US n officials
and The FCPA ’s
ide mon ey
offer or prov als (“foreign”meanor
- Swans’, stre
s to foreig optimised ss tes
risk manag ts &
pay bribe illegal to n offici obtain
a voluntary of value to foreig intent to to
parties. up with ) with the business
The SEC
later came
e unde r which any
cor-
ents ing “non-US” or for directing
ess,
ement
programm illicit paym retain busin Standard &
disclosure eported given n. de sponsor- outlines the Poor’s
which self-r the SEC was
poration
perated
with
it would
likely
any perso
Anything
of value
can inclu
, use of a
holi- positive bene David Samuels
and co-o ance that t nce education ent, fits of bank
The resul l and
traveplia employm stress
mal assur nt action.
Com
for of future is no testing on
an infor enforceme $300 ship home, promise s. There the bottom
than USD s and meal
be safe from sure that more day It is a big line.
disclo ents (a mas-e discounts, drink challenge
for banks
was the ble paym 147 a robust approach to
questiona been mad to build
million in in the 1970s) had
impacts of worst-case managing downturn
capital adequ
l change
unt stress scena the risk
sive amo by definition, rios uncover risk acy progra
financia liance and risk
Nort h Asia are triggered that, almost encies concentratio
ns and
ms to
Global
unlikely or , and; applyi risk depend-
lation &
Risk unpreceden by apparently to
drive busine ng these improvemen
Journal
of Regu
comp ted events.
through perfor ss selecti on – for examp ts
nt – However, solvin
manageme ent
le,
g the proble adjusted pricing mance analysis and
products
fying the risk m of identi- risk-
pot concentratio that takes stress
head of details a cies that give ns and depen into account. test results
EastNet’s David Dekker,
rise to worst- den-
rkets. vital if the
ncial ma
case outcom
nce, industry is es is Top-le
complia al reaction in fina vidual banks to thrive – vel oversight
are to turn and if indi-
the Buildin
chemic past two years to
competitive
lessons of
the proces
g a more robust
and compr
amo ngst oth- Banks that
tackle
advantage. s for uncov
ering ehensive
companies ces. be lauded by the issue head- prise threat s to
be one of to offer these servi t investors and on will ance is clearly, in part, a corpor the enter-
will just coming years regulators challenge.The ate
signs be able speak abou in the must board and top govern-
we saw
the first d ers
that will ld rather moni- most impor
of industry
recuperation have the motiv executives
we shou banks, or that
a year ago the financial worl s These days tantly, will
be able to delive and, scrutinise and ation and
About in utions than , a name
tained profita call a halt to the clout to
formation credit crisi cial instit providers bility gains. r sus- able apparently
of a trans last months the d at finan financial service ities. that are well Meanwhile, activities if
these are not profit-
the cial worl future activ ed
placed to take banks term
and in the finan ge that is tored their current and we have mov consolidatio
n process need
advantage
of the the
interests of
the enterprise
in the longer
-
formed rs ly s
Contact
has trans pace . the chan e than cove at how rapid n on the bank can understand
the
to be sure
they
intended risk
profile
or do not fit
osive in scop Look risks embed of the organisation
an expl broader were ical inter
actio ation) to portfolios of ded in the But contrary
is much s that from phys s of oper potential acquis ing corporate to popular opinion, impro .
occurring expected. bank or fall tion and hour net banking. To improve itions. govern v-
to fail s (loca then Inter and strengthen enterprise risk manag tion of ance is not
originally to be too big by term payments e, but ement board putting the ‘right’ just a ques-
d g taken over - electronic still in charg to a investor confid executives
considere or bein s were ng banks can ence, memb ers in and
r failing more finan n the bank igm is shifti take the lead we
in three related think appropriate incent place and giving them
are eithe ns that are huge para- Agai tioned the parad persons and cor- Better board
Christopher Rogers
institutio a men sical s and senior areas: ives.
cial in as sight For
finan d, resulting regarded
by e we (phy out the bank and contro executive over- the bank
to make the
cially soun how banks are world wher each other with es such as agement; re-inv l of enterprise risk sions when
) pay man- busine they are difficu right deci-
in porations technologi igorated stress
digm shift r banks. nt with new testing and ss growth lt, e.g. when
ic and othe involveme ents. or when risk looks good
the publ around Journal of managemen in the upturn,
ly revolves mobile paym Regulation t looks expen
ing large mers, los- & Risk North sive
Since bank y to service custo impact ns Asia
Editor in chief
the abilit ng the providers organisatio
trust and determini Network e the banks and other pay-
mer and ongo ing risk the futur HA and
a custo of the as In T, NAC iders 163
ing
ld be part n, as well as SWIF ork prov B
me netw
of it, shou of the organisatio
ng and new such t networks beco ey from A to
ent mon
managem ess of existi ng men to send ork traf-
g the riskin using/buyi allow you you for the netw
monitorin customers ges that e s similari-
and the more chan will charg bring
products there are are and rate. This energy
ucts. But world that you gene as telecom,
these prod s in the banking fic that stries such financial
enge known it. with indu anies. The
and chall as we have not be the ties cable comp g an important
tenin g banking futur e, supp liers and unde rgoin
threa the s, clearly
s will, in e our fund world is
The bank by which to mov ; they 135
les portfolios
default vehic balances and
our
maintain
h Asia
Risk Nort
lation &
of Regu
Journal

Basel liquidity rules
The regulators strike back:

Basel and new liquidity rules
The Bundesbank’s Thomas Dietz explains
why some banks are opposed to the Basel
Committee’s new liquidity requirements.
As history teaches us, painfully, earth- corresponding proposals of the Financial

quakes in the oceans are often followed Stability Board and the G-20 summits.
by devastating tsunamis. However, the Following these guidelines the BCBS’s
impact of a tsunami will depend on the “Principles for the enhancement of the
magnitude of the quake. The world- Basel II framework“ from July, 2009 and its
wide financial crisis triggered by the consultative document “Strengthening of
subprime debacle in the US has surely the resilience of the banking sector“ from
been the strongest quake in the financial December, 2009 are suggesting a much
and economic universe since the Great tighter capital requirements regime that – as
Depression. Thus, it comes as no surprise a “tax for failure“ during the financial crisis
that it is now followed by a tsunami – a and before – will make banking more costly
regulatory one! and less profitable in the future. In parallel,
the EU Commission is consulting on respec-
It is the governments of western industrial tive proposals for the EU level, too.
countries that are now riding atop this tsu-
nami. Prior to the financial crisis, the Basel Diverse attitudes
Committee on Banking Supervision (BCBS), With capital attracting so much attention
as the leading international standard-setter one could easily overlook another funda-
in banking oversight, was acting rather mental change of paradigm, this time in the
independently. field of liquidity regulation. So far the regula-
Since the first G-20 meeting in tory regime on liquidity risk has been quite
Washington in November, 2008 this has diverse. Some supervisors have been work-
changed profoundly. It is now the G-20 gov- ing with a qualitative, others with a quanti-
ernments that are setting the international tative approach and some with a mixture of
agenda in this respect. Thus, the fundamen- both (like in Germany).
tal reform of the Basel II framework the BCBS A quantitative approach is generally
is currently working on, has been guided by characterised by the supervisory authority

prescribing both regulatory ratios the insti- covering a stress test not a going-concern
tutions need to comply with and the way scenario. The standards have a dual purpose:
the institutions have to calculate them. A • To strengthen the short-term resilience
qualitative approach goes for ratios, too, of institutions by prescribing a minimum of
but allows the banks to use their own. The high-quality liquid resources enabling the
supervisor “only” assesses the soundness of institutions to survive an acute stress sce-
these ratios and whether or not he’s satisfied nario lasting for one month; and
with how they are used to manage the risks • promote the long-term resilience of insti-
they are supposed to measure. tutions by setting “incentives” to fund their
structural activities with more stable (less
Rules-based approach volatile) sources of funding.
With its “Principles for sound liquidity To achieve the first objective the con-
risk management and supervision” from sultation paper introduces a so-called
September, 2008 the BCBS’s answer to the Liquidity Coverage Ratio (LCR). The Net
financial crisis concerning liquidity risk Stable Funding Ratio (NSFR) is supposed to
management was at first a qualitative one. capture the structural relationship between
With the help of 17 principles, four of which assets and their funding. These two ratios
being addressed to the supervisors, the obvi- are complemented by monitoring tools
ous shortcomings in liquidity risk manage- designed as a set of common metrics to be
ment during the crisis were addressed and used by the supervisors for monitoring the
principles-based guidelines on how to avoid liquidity risk profile of the supervised banks.
a future crisis were given.
Mainly due to the political pressure of Negative reactions
the UK government being supported by First reactions of the banking industry have
the US, these principles-based guidelines been quite negative. Respondants have criti-
have now been complemented by a rules- sised inter alia that the new rules would:
based approach – the December, 2009 • Oblige the banks to hold large stocks of
“International framework on liquidity risk highly liquid assets, thus significantly reduc-
management, standards and monitoring” ing their yield P&L;
–which the BCBS has been consulting on • increase demand for government bonds
until mid-April. with prices rising and yields falling further;
These liquidity standards – should they • decrease demand for non-government
be implemented in the current version – do bonds forcing, in particular, non-financial
not leave much space for interpretation since companies to attach higher coupons to their
they are clearly following a quantitative, bonds, thus increasing their funding costs;
rules-based approach. They are designed • create additional concentration risks in the
for internationally active banks, should be bank portfolios; and,
regarded as minimum standards (mean- • increase competition for retail deposits,
ing that national supervisors can set higher thus narrowing the margins obtainable from
requirements if deemed necessary), and are business with private customers.

In addition, the German banking indus- number of institutions only survived because
try especially pointed out that the prudential their liquidity supply could be maintained
ratios of the BCBS would discourage the use by central bank or by other ways of secured
of internal liquidity risk measurement and funding.
management systems for regulatory pur- All other sources of funding for these
poses (as is currently possible in Germany). institutions had either been reduced signifi-
Below, we will have a closer look at the cantly or had dried up completely. However,
proposed framework to understand what access to central bank funding or secured
exactly makes the industry so sceptical and funding outside the central bank depends
why the changes are really that profound on a stock of high quality assets that can be
compared to the current regimes. offered as collateral.
It is immediately clear that complying
LCR: short-term resilience with the ratio will become harder the less
With the LCR the supervisors do not only assets qualify as “high liquid assets”. It will
define a ratio above which an institution has also get harder the stronger the assumptions
to operate at all times but also components are on the net cash outflows over the next
in the numerator and the denominator the 30 days.
institution has to use to calculate the ratio.
The basic idea of the LCR is to compare Stocks of HQLAs
the stock of what is defined as high qual- In order to qualify for a “high-quality liquid
ity liquid assets (HQLAs) to the net cash asset” (the LCR numerator) assets should
outflows over a 30-day time period. It is (according to the consultation paper) ideally
therefore designed as a mixture of a maturity both stay liquid in markets during stress situ-
mismatch and a stock approach. In order to ations and be central bank eligible. In addi-
comply with the requirements of the con- tion, the stock of high-quality liquid assets
sultation paper the high quality assets must must be unencumbered and freely available
exceed the net cash outflows within the next to group entities, also in foreign jurisdictions.
month. This is equivalent to the following The BCBS enumerates a number of fun-
condition: damental and market-related characteristics
Stock of high quality liquid assets of these assets, i.a:
>10 • Low credit and market risk;
Net cash outflows over a 30-day period
• no (or at least minimum) evaluation
Economically this means that the insti- uncertainties;
tutions need to make sure that all the net • low correlation with risky assets;
cash outflows (cash inflows minus cash out- • tradable on active and sizeable markets
flows) within the next month could be cov- with low market concentration.
ered completely by repo or selling off their All these characteristics reflect lessons
stock of highly liquid assets. This reflects from the financial crisis. For instance, due
one important experience of the supervisors to the breakdown of certain markets (like
during the financial crisis. A non-negligible the ABCP market) and due to evaluation

problems (like in the ABS and CDO market) UK, were arguing for a narrow definition of
the institutions either had to incur losses a HQLA (basically leaving only government
due to decreasing market values of financial and central bank debt as well as securities
instruments they held as assets or it was not of public sector entities like the BIS, the IMF
possible any more to get market prices for or multilateral development banks), other
these assets at all. This was one of the rea- members preferred a wider definition. The
sons for the crisis of trust on the money mar- latter would also include covered bonds
kets following the subprime debacle. (such as the German “Pfandbrief”) and
high-quality corporate bonds.
Limited HQLAs As a compromise, the BCBS has agreed
The BCBS interprets the criterion “low cor- to collect data via a quantitative impact study
relation with risky assets” in a way that (QIS) both on the effects of a narrow and a
bonds issued by credit institutions would wider definition of HQLAs. However, the
not qualify as HQLAs. This reflects the high current majority in the BCBS prefers a nar-
(positive) correlation between the return of row definition.
bank bonds during the crisis. Even under a wider definition, high hair-
As a result, the number of high-quality cuts would be applied to the market value of
liquid assets is extremely limited to: covered and high-quality corporate bonds
• Central bank reserves (given that they can (between 20-40 per cent) and the total stock
be drawn down under stress); of HQLAs would need to be comprised of
• marketable securities issued or guaran- at least 50 per cent assets falling under the
teed by entities or organisations, as long as: narrow definition.
• they are assigned a zero per cent risk
weight under the Basel II standardised Net cash outflows
approach; The net cash outflows (the LCR denomina-
• deep repo markets exist for these tor) have to be calculated by multiplying out-
securities; standing balances of liabilities by assumed
• the securities are not issued by banks or percentages that are supposed to roll-off
other financial services entities; and, or by multiplying various off-balance sheet
• government debt issued in the currency of commitments by specified drawdown ratios.
the group’s home country. The level of the parameters (the run-off fac-
Surprisingly, this means that bonds tors) are set by the supervisors according to
issued by banks which are state-guaranteed a combined idiosyncratic and market-wide
could not be included in the pool of HQLAs. shock resulting inter alia in:
Covered bonds (issued by banks or other • A three-notch downgrade in the institu-
companies) would not qualify as HQLAs tion’s public credit rating;
either. This was one of the most controver- • a run-off of a proportion of retail deposits;
sial points among the BCBS members when • a loss of unsecured wholesale funding
drafting the consultation paper. Whereas the capacity and reductions of potential sources
Anglo-Saxon countries, notably the US and of secured funding on a term basis;

• a loss of secured, short-term financing • drawdowns on committed credit and
transactions for all but HQLAs; liquidity facilities (10 per cent for facilities to
• increases in market volatilities that impact retail clients and non-corporate customers,
the quality of collateral requiring larger col- 100 per cent for the rest);
lateral haircuts or additional collateral; • funding by ABCPs, Conduits, SIVs and
• unscheduled draws on all of the institu- other such financing facilities (100 per cent);
tion’s committed but unused credit and • increased liquidity needs related to
liquidity facilities. downgrade triggers embedded in short-
term financing transactions (100 per cent)
Quite burdensome and to the potential for valuation changes
As a result, the expected cash outflows that on posted collateral securing derivatives
are calculated by summing up given run-off transactions (20 per cent). Other run-off fac-
percentages under these severe assumptions tors are supposed to be minimum percent-
will be quite burdensome for the institutions. ages, leaving it to the national supervisors
They come from: to impose higher percentages (if deemed
• Retail deposits; necessary), for instance:
• unsecured/secured wholesale funding; • At least 7.5 per cent for “stable depos-
• contingent funding liabilities. its” (those covered by a deposit insurance
Other cash outflows, such as planned scheme and that have established relation-
derivative payables, should be captured in ships with the same bank which make
the LCR, too. deposit withdrawals unlikely) and 15 per
The consultation paper distinguishes cent for “less stable deposits” (e.g. Internet
between the degree of liquidity still avail- deposits);
able from all these funding sources by • increased liquidity needs related to market
attributing different run-off percentages to valuation changes on derivative transactions
them. The more stable the funding source (where the BCBS does not prescribe a spe-
is assumed to be the lower this percentage. cific minimum ratio but leaves it completely
Most of these percentages are exactly pre- to the national supervisors to set the respec-
scribed, i.a. for: tive run-off factor).
• Unsecured wholesale funding (25, 75 or
100 per cent assumed cash outflows from Up to the supervisors
the respective positions, depending on the Eventually, for some contingent funding
credit-worthiness of the creditor and/or the liabilities, such as guarantees, letters of credit
economic sector it belongs to – for instance, or unconditionally revocable uncommitted
unsecured wholesale funding provided by credit and liquidity facilities, the national
non-financial corporate customers, sover- supervisors alone determine whether or not
eigns, central banks and public sector enti- they should be covered in the LCR at all.
ties only receive a 25 per cent run-off factor Given this and given the possibility for
whereas bonds from credit institutions get gold-plating when it comes to setting the
100 per cent); level of certain run-off factors, it becomes

clear that the LCR will be helpful for com- crisis a flight to quality could be observed
paring the liquidity situation of credit insti- in that respect (in Federal Germany for
tutions in the same jurisdictions, but not instance a lot of depositors took money from
necessarily across different jurisdictions. private banks to the savings and co-opera-
tive banks).
Cash inflows The parameters set by the supervisors
The cash inflow regime in the consultation according to the consultation paper are
paper is described quite quickly. It comprises: based upon the actual circumstances during
• Amounts receivable from retail the financial crisis that began in mid-2007
counterparties; and are therefore rather severe.
• amounts receivable from wholesale As a result of these very conservative
counterparties; assumptions, banks relying on wholesale
• receivables from repo and reverse repo funding would be hit the most by the new
transactions backed by illiquid assets; regime. A bank making use of wholesale
• other cash inflows (such as planned con- funding relies on the financial markets
tractual receivables from derivatives). for refinancing their assets, e.g. by issuing
Maturing reverse repurchase or securi- bonds, commercial papers, asset-backed
ties lending transactions secured by liquid securities, etc.
assets are assumed to be rolled over and will
therefore not result in cash inflows within Retail funding
the 30-day period of stress. The same holds Banks making use of wholesale funding
true for contingent funding facilities, since typically do not or only in a limited way
no lines of credit, liquidity facilities or other have access to retail deposits (retail funding).
contingent funding facilities the bank holds These kinds of banks were affected most by
at other institutions are assumed to be eligi- the financial crisis whereas banks predomi-
ble for drawdown. nantly using retail funding have coped quite
well so far; for instance the German savings
Doubtful assumption and co-operative banks. Thus, “punishing”
The attentative reader will already have real- the wholesale funding business model is
ised the contradiction to the cash outflow supposed to stabilise financial markets.
section in this respect, where a 100 per cent
drawdown was assumed in the case where Long-term resilience
credit institutions have granted committed The consultative paper explicity points out
credit or liquidity facilities to other finan- that the stress scenario prescribed by the
cial institutions. Another rather doubtful supervisor does not relieve the institutions
assumption is the run-off of retail depositors. from conducting their own stress tests com-
To assume a run-off itself is not unrealistic, mensurate with the size and complexity of
but it’s not very credible that all these depos- their specific business acitivities.
its will not be invested in other credit insti- As the consultation paper points out,
tutions any more. At the top of the financial the NSF ratio is intended to promote

longer-term structural funding of banks’bal- recognised credit rating organisation;
ance sheets and off-balance sheet exposures • a material event damaging the reputation
and aims to “limit over-reliance on whole- or credit quality of the institution;
sale funding during times of buoyant market • a significant decline in solvency or profit-
liquidity and encourage better assessment of ability arising from heightened market risk,
liquidity risk across all on- and off-balance credit risk or operational risk exposures.
sheet items.’’ The total available amount of stable
In other words, the maturity transforma- funding is calculated in three steps. First the
tion of banks is supposed to be cut back to carrying value of an institution’s equity and
a level that has less dramatic consequences liabilities is assigned to one of five categories.
for financial stability and (again) wholesale
funding should be reduced in favour of the The ASF factor
less volatile retail funding. After that the amount assigned to each cat-
In order to achieve this, the amount egory has to be multiplied by a so-called ASF
of stable funding (the sources of funding) factor applied to the respective category. This
should exceed the required amount of stable factor represents the BCBS’s assumption on
funding at all times under a predefined stress the extent up to which this respective source
scenario (milder than the one assumed for of funding will still be available under the
the calculation of the LCR).This is equivalent stress scenario described above. For instance,
to the following condition: an ASF factor of 85 per cent would mean
that 85 per cent of the amount available from
Available amount of stable funding
>100% a specific funding source under a going-con-
Required amount of stable funding
cern scenario would be still available under
The BCBS emphasises that such a metric stress. The less stable the source of funding
is not new to the institutions since most of the lower the ASF factor.
them use similar“net liquid asset”and“cash Finally, the total ASF is the sum of the
capital” methodologies already to structure weighted amounts in each category. The
their balance sheet, even if the NSF ratio ASF factors and (some of) the bank’s equity
takes a wider perspective by incorporating and liability positions in each category are
also the potential liquidity risk of off-balance listed below.
sheet exposures and“various types of matu- “Stable” and “less stable” in this respect
rity mismatches involved in short-term follow definitions given under the LCR
secured funding of long-dated assets that section.
traditional forms may ignore”. The amount of available stable funding
In contrast to the LCR the ssumed NSF must exceed the amount of net stable fund-
stress scenario is only institution-specific ing required (NSFR) at all times. Again, there
with a time horizon of one year. Under this are also three steps to calculating the NSFR.
scenario a bank encounters, and investors First, all asset categories that need to be
and customers become aware of: funded are assigned to six balance-sheet and
• A potential downgrade by any nationally two off-balance-sheet related categories. In

Table 1. The ASF factors of the NSFR24
ASF factor Components of ASF category
Tier 1 and Tier 2 capital
Secured and secured borrowings and liabilities with effective maturities greater than 1 year
100%
(including term deposits)
preferred stock (not included in Tier 2) that has an effective maturity of greater than 1 year
Retail deposits (stable non-maturity and/or term retail deposits with residual maturity of less
than one year)
85%
stable unsecured funding by non-financial small business customers (non-maturity or residual
maturity of less than one year)
Retail deposits (less stable non-maturity and/or term retail deposits with residual maturity of
70% less than one year)
less stable unsecured funding by non-financial small business customers (as above)
Unsecured wholesale funding provided by non-financial coporate customers (non-maturity or
50%
with a residual maturity of less than one year)
0% All other liability and equity categories (including wholesale funding by financial institutions!)
a second step, for each of these eight cat- cross-border comparisons between different
egories a corresponding RSF factor is set credit institutions. The ongoing quantita-
representing the share of stable funding tive impact study previously mentioned will
needed (according to the point of view of the also quantify the impact of the NSFR on the
supervisors) related to total funding needed Basel and the EU credit institutions.
or representing the assumed drawdown of In addition to the LCR and the NSFR the
the currently undrawn portion of off-balance consultation paper introduces four monitor-
sheet categories. ing tools the supervisors are (as a minimum)
supposed to make use of when assessing the
Liquidity drains liquidity profile of banks:
The latter was introduced because many • A contractual maturity mismatch;
off-balance sheet categories need little direct • concentration of funding;
or immediate funding but can lead to sub- • available unencumbered assets;
stantial liquidity drains in times of stress. This • market-related monitoring tools.
could clearly be observed during the finan- Supervisors are supposed to take action
cial crisis when many SPVs used liquidity when potential liquidity difficulties would
facilities granted by financial institutions, be signalled by the metrics. The contractual
bringing serious trouble to some. Finally, the maturity mismatch is supposed to identify
total NSFR is the sum of the weighted sums gaps between contractual on- and off-bal-
in the respective RSF categories. ance cash in- and outflows for pre-defined
All in all the NSFR framework leaves time buckets. Such kind of gap analysis is
much less space for national discretion, already used on a large scale by the cross-
since only the SFRs for other contingent border groups themselves (covering also
funding obligations are subject to the deci- non-contractual cash flows, however, and
sion of the national supervisors. The NSFR under a going-concern perspective) and
could therefore be a rather robust metric for gives insight into the extent up to which the

Table 2. The RSF factors of the NSFR24
RSF factor Components of RSF category
0% • Cash, money market instruments and deposits (at other financial institutions)
• unsecured debt instruments of financial and sovereign entities
• outstanding loans to financial entities with effective maturities of less than 1 year
5% • Unencumbered marketable securities with residual maturities ≥ one year representing
claims on sovereigns, central banks, BIS, IMF, EC
• noncentral government PSEs or multilateral development banks which are rated AA
or higher and are assigned a 0% risk weight under the Basel II standardised approach,
provided that active repo-markets exist for these securities
10% Conditionally revocable and irrevocable credit and liquidity facilities to retail clients
(natural persons) and legal entity customers (non-financial corporates (including small
businesses, sole proprietorships and partnerships)) and other legal entity customers
such as financial institutions (including banks, securities firms, insurance companies,
multilateral development banks etc.), fiduciaries,27 beneficiaries,28 conduits and special
purpose vehicles, sovereigns and central banks, public sector entities; affiliated entities of
the bank and other entities not included in the categories above)
20% Unencumbered corporate bonds (or covered bonds) rated at least AA with an effective
maturity of ≥ one year which are traded in deep, active and liquid markets and which
also have a demonstrated history of being a reliable liquidity source in a stressed market
environment
50% • Gold
• Unencumbered equity securities listed on a major exchange and included in a large
capital market index and unencumbered corporate bonds (or covered bonds) rated
AA- to A- with an effective maturity of ≥ one year, which are traded in deep, active
and liquid markets and which also have a demonstrated history of being a reliable
liquidity source in a stressed market environment
• Loans to non-financial corporate clients having a residual maturity of less than 1 year
85% Loans to retail clients having a residual maturity of less than one year
100% All other assets
National Other contingent funding obligations, including products and instruments such as:
supervisors can • Unconditionally revocable "uncommitted" credit and liquidity facilities;
specify the RSF • Guarantees;
factors based on • Letters of credit;
their national • Other trade finance instruments; and
circumstances • Non-contractual obligations
bank makes use of maturity transformation. This metric would include:

Again the assumptions of the BCBS are A. Funding liabilities sourced from each significant counterparty
quite conservative since cash inflows should The bank’s balance sheet total
be reported by the institutions according to B. Funding liabilities sourced from each significant product
their latest and cash outflows, and according The bank’s balance sheet total
to their earliest possible maturity. C. List of asset and liability amounts by significant currency
A concentration of funding ratio is meant
to identify sources of funding that, when A“significant counterparty”is defined as
withdrawn unexpectedly, could trigger a single counterparty or a group of connected
liquidity problems. It is an indicator for the counterparties accounting in total for more
diversification (or concentration) of funding. than one per cent of the institution’s total

liabilities. Similarly, a“significant currency”is possibly serving as early warning indicators
defined as liabilities denominated in a single in monitoring potential liquidity strains at
currency accounting for more than one per banks. This could be market-wide data on
cent of the bank’s total liabilities and a “sig- asset prices and liquidity but also institution-
nificant instrument/product”again account- related data on credit default swaps premia
ing for more than one per cent of the bank’s and equity prices.
total liabilities. The above metrics should be In this respect one could think of sev-
reported for time buckets from less than one eral indicators, e.g. the index level of the
month up to longer than 12 months. iTraxx (both the main index and the iTraxx
Crossover) or the distance between the costs
Threshold ‘too low’ for secured and unsecured funding in the
It is doubtful whether these metrics would money markets (for instance Euribor and
really be helpful for supervisors. Firstly, the Eurepo) which both proved to be quite good
consultation paper itself points out that indicators for the development of the finan-
it is not always possible to identify all the cial crisis.
counterparties that hold debt securities, so According to the consultation paper
that the degree of concentration could be supervisors should calculate the metrics on
underestimated. a monthly basis, if necessary even increasing
Secondly, the threshold for “significant” the frequency to weekly or daily under stress
seems to be set far too low since it is not really situations. Reporting of the banks would be
credible that a client or a product accounting determined correspondingly. The standards
for 1.1 per cent of the bank’s total liabilities and monitoring tools in general would be
is creating a significant concentration risk for applied to internationally active banks on a
an institution. consolidated basis, but may also be used for
Similarly, it is doubtful whether reporting any subset of internationally active banks,
the available unencumbered assets that are for instance to ensure a level playing field
marketable as collateral in secondary mar- between domestic and cross-border banks.
kets and/or eligible for central bank’s stand- Information on the metrics should be pub-
ing facilities is helpful for the supervisors, licly disclosed.
either. Again the consultation paper itself
explains that “the metric does not capture Quantative impact study
potential changes in counterparties’ haircuts The BCBS is supposed to agree on the final
and lending policies that could occur under version of the liquidity standards until end
either a systemic or idiosyncratic event and 2010 with the aim of applying the standards
could provide a false comfort that the esti- from end 2012. The overall impact of the
mated monetised value of available unen- BCBS rules are currently under examina-
cumbered collateral is greater than it would tion, not only in Germany. The BCBS (and
be when it is most needed.” in parallel the EU) conducts a quantitative
The market-related monitoring tools impact study on the effects of the BCBS
are referring to high frequency market data standards, the results of which are supposed

to be published in summer 2010. First esti- RSFs and possibly a widened definition of
mations, for instance from Bank of America/ HQLAs.
Merrill Lynch, are quite pessimistic, mean-
ing that currently only a limited number of Consistency with EU approach33
banks could comply with the required ratios In parallel with the BCBS, the EU
at all (for instance only four out of 19 large Commission has launched a consultative
European Banks in the BoA/Merrill Lynch process, too. The contents of the two con-
sample would show a NSFR above one). sultation papers referring to the introduc-
tion of quantitative minimum standards
Drastic comments for liquidity risk are almost completely
This is also reflected in the more than 200 identical. However, the Commission sub-
comments received on the proposed liquid- mits more detailed proposals on:
ity standards during the consultation period. • The scope of application;
From a sample of 25 banks (assumed to be • the treatment of intra-group transactions
representative of the total number of com- and commitments; and
ments) 72 per cent of respondents objected • the supervisory responsibility for branch
to including a stable funding ratio as a Pillar liquidity.
I requirement and 84 per cent felt treatment According to the Commission, the
of covered bonds in the stable funding ratio standards should be applied both to credit
too harsh. institutions on a stand-alone basis and to EU
The most drastic comments state that“it parent credit institutions with the possibility
would be impossible for even the most con- of waiving the application to individual enti-
servative business model to meet the pro- ties under certain conditions.
posed calibration”or that“it is quite possible
that the required levels of stable funding do Inconsistencies
not exist”. The proposed LCR introduces certain
This supports the thesis of a real regu- inconsistencies concerning intra-group
latory tsunami being on its way with deep transactions. For instance, one group entity
implications for the business models of would need to assume a liquidity outflow
banks and possibly also for the real econ- as a result of the drawing of a credit line by
omy. As a delicate political side aspect, some another group entity whereas the draw-
people argue that it might be no coincidence ing entity would not be allowed to assume
that is exactly the two states issuing the larg- a liquidity inflow (this inconsistency
est volumes of government bonds in the was already mentioned previously). The
coming years pushing for a very narrow Commission submits several proposals on
definition of HQLAs. how to overcome this shortcoming. It also
Some people involved in the process discusses the possibility of changing the
therefore already expect a second round current host-regime in liquidity supervision
of consultation after the publication of the to a home regime already implemented for
QIS results with recalibrated ASFs and solvency supervision. •

Basel liquidity rules
Basel Committee’s enhanced

framework for liquidity
Dr Michael Wong & Fai Y. Lam of CTRisks
detail some of the likely consequences in
Asia of the new Basel liquidity proposals.
The Basel-based Committee on Banking a number of banks operating in and regu-

Supervision last December published lated by those countries constituting the Asia
a consultative document entitled: Pacific region. The following discourse will
International framework for liquidity first summarise these new rules before dis-
risk measurement, standards and moni- cussing their likely impact on banks across
toring”. The target audience, compris- the region.
ing central banks, regulatory bodies and
financial institutions covered by the doc- Liquidity coverage ratio (LCR)
ument’s provisional recommendations, The Basel Committee defines LCR, under an
have been asked to comment before its acute stress situation, as :
provisions are adopted and deployed High quality liquid assets
internationally. LCR = ________________________________________
Total cash outflow over 30-day period
– total cash inflow over 30-day period
The consultative paper aims to strengthen
and standardise banks’ liquidity measure- If a bank estimates that the total cash
ment framework by setting out the follow- outflow will exceed the total cash inflow over
ing requirements: A liquidity coverage ratio a 30-day period, the bank must hold suffi-
(LCR) which aims at measuring banks’ cient high quality liquidity assets to meet the
short-term liquidity sufficiency; a net stable net cash outflow, i.e. LCR greater than 100
fund ratio (NSFR) which aims at measuring per cent. This requirement aims to maintain
banks’ short term liquidity sufficiency; and a a buffer of high quality liquid assets for banks
set of common monitoring tools to be used to meet with liquidity demand under stress
by supervisors in their monitoring of banks’ conditions. The Basel Committee defines
funding liquidity at individual institutions. high quality assets with the following funda-
The new guidelines will have far-reach- mental characteristics: low credit and market
ing implications and consequences for risks; ease and certainty of valuation; low
banks and financial institutions, particularly correlation with risky assets; and listed on a

developed and recognised exchange market. (ABCP), special investment vehicles (SIVs),
Also, the Basel Committee requires high special purpose vehicles (SPVs,) and term
quality assets to have the following market- asset-backed securities including covered
related characteristics: an active and sizable bonds; liabilities related to derivative col-
market; a presence of committed market lateral calls subject to a downgrade of up to
makers; a low market concentration; and three-notches; market valuation changes on
flight to quality. derivatives transactions; valuation changes
on posted non-cash or non-high quality
Cash inflows sovereign debt collateral securing derivative
Cash inflows are limited to the following transactions; currently undrawn portion of
items: amounts receivable from retail coun- committed credit and liquidity facilities to
terparties; amounts receivable from whole- retail clients, non-financial corporates and
sale counterparties; receivables in respect of other legal entity customers; other contin-
repo and reverse repo transactions backed gent funding liabilities, such as guarantees,
by illiquid assets and securities lending/bor- letters of credit, revocable credit and liquid-
rowing transactions where illiquid assets are ity facilities, etc; planned outflows related to
borrowed; and other cash inflows, includ- renewal or extension of new loans; and any
ing planned contractual receivables from other cash outflows.
derivatives.
Net stable fund ratio
Cash outflows The Basel Committee defines the net stable
Cash outflows cover a board spectrum of fund ratio (NSFR) as:
cash consumption activities arising from the Available amount of stable funding
following exposures: retail deposits, covering LCR = ________________________________________
Required amount of stable funding
stable deposits and less stable retail deposits;
unsecured wholesale funding, covering sta- A bank is required to match its available
ble small business customers and less stable amount of stable funding with a required
small business customers, non-financial cor- amount of stable funding over a period of
porates, sovereigns, central banks and public one year, i.e. NSFR greater than 100 per
sector entities with operational relationships, cent. Available amount of stable funding
non-financial corporates with no operational includes: capital; preferred stock with matu-
relationship, and other legal entity custom- rity of equal to or greater than one year; lia-
ers and sovereigns, central banks, and public bilities with effective maturities of one year
sector entities (PSEs) without operational or greater; and the portion of “stable” non-
relationships. maturity deposits and/or term deposits with
Together with: secured funding, cover- maturities of less than one year that would
ing funding from repo of illiquid assets and be expected to stay with the institution for
securities lending/borrowing transactions an extended period in an idiosyncratic stress
illiquid assets are lent out; liabilities from event.
maturing asset backed commercial paper Required amount of stable funding

includes: the value of assets held and funded guidelines will have a long-lasting impact
by the institution, multiplied by a specific and new implications for bank manage-
required stable funding factor (RSF) assigned ment, especially in Asia.
to each particular asset type; and the amount
of off-balance sheet activity (or potential Additional costs, risk
liquidity exposure) multiplied by the cor- The new rules require banks to increase
responding RSF. The RSF on different asset holdings in high quality liquid assets. This
classes, ranging between five per cent and will be very costly to all banks because high
100 per cent, are intended to approximate quality liquid assets generally provide low
the amount of a particular asset that could returns. This will weaken the role of banks in
not be liquidated through sale or use as col- credit rationing. Corporate borrowers, espe-
lateral in a secured borrowing. Highly mar- cially those without strong credit ratings, will
ketable assets will thus have low RSF factors find it more difficult to raise funds.
and thus require less stable funding. The definition of high quality assets is
biased towards US and European bonds.
Monitoring tools This is because these bond markets are more
In addition to the two proposed regula- actively-traded and their bonds are assigned
tory ratios, the Basel Committee also rec- with better credit ratings. Even though many
ommends four tools for monitoring banks’ banks and corporations in emerging econo-
liquidity. They are: Contractual maturity mies have demonstrated a high stability dur-
mismatch: This tool provides an initial and ing the financial crisis in 2008, their bonds
simple baseline of contractual commit- are assigned very unfavourable ratings.
ments. Concentration of funding: This tool It is anticipated that banks from emerg-
assesses the extent of liquidity risk caused by ing economies will find it more difficult to
excessive reliance on single source or several finance their operation via the issuance of
sources of funds. Available unencumbered CDs and bonds, thus increasing their fund-
assets: This tool help banks to be better ing cost and weakening their profitability. If
aware of their potential capacity to raise banks are motivated to hold more US and
additional secured funds. Market-related European bonds to strengthen their liquid-
monitoring tools: This covers market data, ity metrics, they will be exposed to US dollar
such as asset prices, liquidity, credit default currency risk, EU currency risk, and country
swap (CDS) spreads, equity prices, and oth- risk concentration in the US and Europe.
ers that can be easily accessed by banks to
monitor their liquidity situations. Bancassurance
The new liquidity ratios, together with The new liquidity rules will motivate banks
the new regulatory framework, attempt to to develop or acquire their branch of insur-
supplement the framework to Principles ance business because insurance premiums
for Sound Liquidity Risk Management serve as a good source of stable and diversi-
and Supervision, published by the Basel fied retail funding. This will drive the occur-
Committee in September 2008. These new rence of more bancassurance. By that time,

banking risk will be blurred with insurance Conclusion
risk. There will be new capital rules to deal The new Basel rules may improve the
with insurance risk. liquidity situation and mitigate bank col-
lapses in the short run. However, they
Pro-cyclical effects may affect the long-term profitability of
Both the new liquidity ratios emphasise liq- banks. More importantly they may make
uid assets. In economic downturns, some bank risk more concentrated on those
liquid assets can suddenly become illiquid. high quality liquid assets, which tend to
The new rules will accelerate the speed of more correlated in their risk profile. Banks
“flight to quality”and may easily drive those in emerging economies may be subject to
banks without strong ratings to serious higher pressure under the new rules. This
liquidity problems. is because they may find it harder to issue
The crisis experience in 2008 indicates CDs and bonds to solve their liquidity
that liquidity problems can turn serious problems. •
within a short period of time. Most sizable
banks have more than 30 per cent funding Reference
from the interbank market and financial Basel Committee, International framework for
institutions. In case of rumours, scandals and liquidity risk measurement, standards and monitor-
economic stress, funding from their peers ing – consultative document, December 2009.
may disappear in less than 30 days.This issue Basel Committee, Principles for Sound Liquidity
cannot be easily solved by the new rules on Risk Management and Supervision, September
liquidity measures. 2008.
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J ournal of Regulation & Risk

Volume II, Issues II & III, Summer/Autumn 2010

Articles & Papers

Regulation or prohibition: the $100 billion question Andrew G. Haldane

‘Walker Review’ heralds new dawn in risk management David Millar

Ideas have consequences: the importance of ‘narrative’ Peter J. Wallison

Minority shareholders blind to threat of expropriation Fritz Foley et al

‘Swap tango’: a regulatory dance in two acts Satyajit Das

Beware Greeks bearing bonds: A tragedy in four acts Michael Mussa

Macro-prudential councils: how to avoid future crises Enrico Perotti

EC offers last opportunity for insurers to influence Solvency II Eleanor Beamond-Pepler

Financial supervision and increased powers of discretion Steve Randy Waldman

Global anti-trust regulation in the current financial climate Gavin Sudhakar

Asset securitisation in China: Opportunities and challenges Claas Becker et al

Is an undervalued renminbi the source of global imbalances? Charles Wyplosz

As financial markets shift back to growth and future

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The blogosphere strikes back

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Much Ado About Nothing:

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