Journal of Regulation & Risk - North Asia, Volume I, Edition III/IV, Winter 2009/10

J ournal of Regulation & Risk
North Asia
Volume I, Issue III, Autumn/Winter 2009-10
Articles & Papers

Issues in resolving systemically important financial institutions Dr Eric S. Rosengren
Resecuritisation in banking: major challenges ahead Dr Fang Du
A framework for funding liquidity in times of financial crisis Dr Ulrich Bindseil
Housing, monetary and fiscal policies: from bad to worst Stephan Schoess,
Derivatives: from disaster to re-regulation Professor Lynn A. Stout
Black swans, market crises and risk: the human perspective Joseph Rizzi
Measuring & managing risk for innovative financial instruments Dr Stuart M. Turnbull
Red star spangled banner: root causes of the financial crisis Andreas Kern & Christian Fahrholz
The ‘family’ risk: a cause for concern among Asian investors David Smith
Global financial change impacts compliance and risk David Dekker
The scramble is on to tackle bribery and corruption Penelope Tham & Gerald Li
Who exactly is subject to the Foreign Corrupt Practices Act? Tham Yuet-Ming
Financial markets remuneration reform: one step forward Umesh Kumar & Kevin Marr
Of ‘Black Swans’, stress tests & optimised risk management David Samuels
Challenging the value of enterprise risk management Tim Pagett & Ranjit Jaswal
Rocky road ahead for global accountancy convergence Dr Philip Goeth
The Asia-Pacific regulatory Rubik’s Cube Alan Ewins and Angus Ross
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Editor
Ian Watson
Chief Sub-Editor
Fiona Plani
Editorial Administrator, North Asia
Christopher Rogers
Editorial Standards Board
Dr Giovani Barone-Adesi, Dr Colin Lawrence, Luo Ping, Dr Patrick McConnell,
Dr Michael Ong, Dr John Pattison, William Ryback, Dr Kariya Takeaki, Simon
Topping, Dr Peter Treadway, Lawrence Uhlick and Dr Lawrence White.
Contributors
Dr Ulrich Bindseil, Prof William Black, Dr Willi Brammertz, James Coffman,
David Dekker, Dr Fang Du, Alan Ewins, Dr Christian Fahrholz, Dr Philip
Goeth, Markus Grund, William Isaac, Ranjit Jaswal, Dr Andreas Kern, Umesh
Kumar, Gerald Li, Kevin Marr, Richard Mazzochi, Tham Yuet-Ming, Tim Pagett,
Joseph Rizzi, Angus Ross, David Samuels, Stephan Schoess, David Smith,
Prof Lynn Stout, Penelope Tham and Prof Stuart Turnbull.
Design & Layout
Lamma Studio Design
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Distribution
Deltec International Express Ltd
ISSN No: 2071-5455
Institute of Regulation and Risk – North Asia
5/F, Suite 502, Wing On Building, 71 Des Voeux Road, Central, Hong Kong
Tel (852) 2132 9620 Fax (852) 3007 0229
Email: christopher.rogers@irrna.org
Website: www.irrna.org
JRRNA is published quarterly and registered as a Hong Kong journal. It is
distributed free of charge to governance, risk and compliance professionals in
China, Hong Kong, Japan, Korea and Taiwan.
© Copyright 2009 Institute of Regulation and Risk, North Asia
Material in this publication may not be reproduced in any form or in any way
without the express permission of the Editor.
Disclaimer: While every effort is taken to ensure the accuracy of the information herein, the editor
cannot accept responsibility for any errors, omissions or those opinions expressed by contributors.
Journal of Regulation & Risk North Asia 1

Volume I, Issue III – Autumn/Winter 2009-10
INSTITUTE OF REGULATION & RISK

NORTH ASIA
Contents
Q&A – William M. Isaac 9
Q&A – Dr Eric Rosengren 17
Book overview – Dr Willi Brammertz 27
Opinion – Professor William Black 33
Debate – James Coffman 41
Accounting update – Markus Grund 47
Regulatory update – Richard Mazzochi 51

Articles
Issues in resolving systemically important financial institutions 59
Dr Eric S. Rosengren
Resecuritisation in banking: major challenges ahead 67
Dr Fang Du
A framework for funding liquidity in times of financial crisis 75
Dr Ulrich Bindseil
Housing, monetary and fiscal policies: from bad to worst 87
Stephan Schoess
Derivatives: from disaster to re-regulation 95
Professor Lynn A. Stout
Black swans, market crises and risk: the human perspective 101
Joseph Rizzi
Measuring & managing risk for innovative financial instruments 109
Dr Stuart M. Turnbull
Red star spangled banner: root causes of the financial crisis 119
Andreas Kern and Christian Fahrholz
The ‘family’ risk: a cause for concern among Asian investors 125
David Smith
Global financial change impacts compliance and risk 131
David Dekker
The scramble is on to tackle bribery and corruption 135
Penelope Tham and Gerald Li
Who exactly is subject to the Foreign Corrupt Practices Act? 143
Tham Yuet-Ming
Financial markets remuneration reform: one step forward 151
Umesh Kumar and Kevin Marr
Of ‘Black Swans’, stress tests & optimised risk management 159
David Samuels
Challenging the value of enterprise risk management 165
Tim Pagett and Ranjit Jaswal
Rocky road ahead for global accountancy convergence 171
Dr Philip Goeth
The Asia-Pacific regulatory Rubik’s Cube 177
Alan Ewins and Angus Ross



Editorial comment
THIS double issue of the Journal should provide readers with much food for
thought on current and future financial management and financial sector policy.
This edition also represents our first 12 months of covering matters of importance
to our readers in the governance, risk management and compliance sector within
financial services.
And what a difference a year has made. Last November, the global financial
community was staring into the abyss, with stock indices heading south at an
alarming rate. Concerted efforts by central banks, treasury heads and govern-
ments prevented a financial meltdown on a par with the Great Depression.
However, the fact remains, the global economy has sustained a severe shock,
with many leading economies only just emerging from the longest recession on
record. Further, government debt has grown exponentially as a result of bank
bailouts and stimulus measures to kick-start the global economy.
As the Governor of the Bank of England, Mervyn King, succinctly summed it
up by paraphrasing Winston Churchill: “Never in the field of financial endeav-
our has so much money been owed by so few to so many. And, one might add,
so far with little real reform.”
While we are not out of the woods yet – with many fearing a double-dip re-
cession if the drip-feed of state aid is removed too soon – a positive aspect of the
financial crisis has been the level of debate it has engendered on how to reform
global banking and prevent a repeat performance in future.
At the heart of this debate is what to do with systemically important ‘too big
to fail’ institutions. In one camp you have the European Commission’s Neelie
Kroes, Mervyn King, Thomas Hoenig of the Kansas City Fed, and former IMF
chief economist Simon Johnson, all calling for systemically threatening institu-
tions to be broken up. In the opposing camp you have Deutsche Bank’s Josef
Ackermann, Prof Charles Calomiris and the Federal Reserve’s Ben Bernanke, re-
jecting such calls, believing that they can be managed by better regulation.
Whatever the outcome of this debate, be assured that the Journal will continue
to cover these and other issues impartially throughout 2010.
Christopher Rogers
General Secretary
Institute Of Regulation & Risk – North Asia

Acknowledgments
THE Secretariat of the Institute 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 finan-
cial bodies, regulatory institutions, consultants, vendors and, indeed, from the
industry itself.
A full list of those who kindly assisted would be impossible, but the Secretariat
would like to thank: The Federal Reserve – Washington D.C., the Federal Reserve
Bank of Boston, the European Central Bank; BaFin; Central Banking Publica-
tions; the Baseline Scenario; FinReg21; Voxeu; Deloitte; Linklaters; RiskMetrics;
Standard & Poor’s; Royal Bank of Scotland; Allen and Overy; Mallesons Stephen
Jacques; PricewaterhouseCoopers; FRS Global and DLA Piper for their kind per-
mission to reproduce material from their respective publications and websites.
Detailed comments and advice on the text and scope of contents from William
Isaac, Prof William Black, Dr John C. Pattison, Philip Goeth, Colin Shaftsbury,
Robert Pringle, Dr Michael Ong, Dr Heong Wee Chong and Stephan Schoess
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.


Q&A
Obama and financial reform:

is it an oxymoron?
Central Banking’s Robert Pringle poses
some salient questions to former FDIC
chairman, William M. Isaac.
Question: What is your verdict on the elimination of the thrift charter in the middle
Obama administration’s proposals for of a depression in the housing sector.
the reform of financial regulation? Third, the proposals do not address the
enormous problem of highly pro-cyclical
ANSWER: The Obama Administration’s regulatory and accounting policies. The Basel
proposals are disappointing on several lev- capital rules use backward looking models
els. First, they rushed them out in June with- that do not require sufficient capital in good
out first doing a proper post mortem on the times and demand too much capital in dif-
causes of the current crisis. Congress enacted ficult times. The same is true of loan loss
and President Obama signed in May of this reserving policies.
year a law establishing a bipartisan commis-
sion to study the causes of the financial crisis. ‘Horribly pro-cyclical’
I do not understand why the Administration Banks pay little to no deposit insurance pre-
felt it necessary to propose reform legislation miums in good times when the FDIC fund
before the bipartisan commission could even is strong and are required to pay excessive
be established, much less complete its work. premiums when the banking industry is
Getting the right reforms in place, no matter struggling. Mark-to-market accounting is
how long it takes, is much more important horribly pro-cyclical, inflating bank earnings
than enacting the wrong reforms in a hurry. and capital in good times and senselessly
Second, the proposals addressed issues destroying earnings and capital in down-
that had nothing to do with the crisis, such turns like the current one. These issues are
as creating a new consumer advocacy agency at the heart of the current crisis and must be
and eliminating the industrial loan company addressed.
charter, while ignoring things that were at Fourth, the proposals risk creating greater
the heart of the crisis, like reforming Fannie moral hazard by permanently extending
Mae and Freddie Mac. Moreover, it is difficult bank-type regulation and the bank safety
to understand the proposal’s rationale for net to large non-bank firms.

Q: What about the proposals for a Systemic out at Lehman. AIG was rescued, including
Risk Council? its bank creditors, while the preferred share-
A: Unfortunately, the Administration’s holders at Fannie and Freddie were hit with
proposal does not treat this seriously. big losses.
Potentially, the creation of a strong and The first priority in the midst of a bank-
effective Systemic Risk Council should ing crisis is to maintain order and confidence.
be the most important reform of all. But There are other important policy considera-
the Administration’s proposal would cre- tions – such as minimizing taxpayer expense,
ate a Systemic Risk Council dominated by protecting the deposit insurance fund, and
Treasury. It would rely on Treasury’s staff limiting the creation of new moral hazards
and the Secretary of the Treasury would be – but those concerns must take a back seat
its chairman. The Treasury has had a hand to maintaining public confidence. I do not
in creating any number of banking crises believe we took care of priority number one
over the centuries and is one of the most during this crisis.
important agencies that must be monitored Q: Did official actions make the crisis
by the Council. worse?
The Council needs its own staff – prob- A: In September, 2008, they did. Senior
ably running into the hundreds - and should officials went to Congress and publicly
have an independent chairman appointed by demanded $700 billion of taxpayer funds
the President and confirmed by the Senate on an emergency basis to avert financial
for a six-year term. Armageddon. I still believe that this legisla-
Q: What were the most serious policy mis- tion was not needed and had the effect of
takes made in handling the crisis? panicking the public.
A: We handled the crisis in an ad hoc fashion
with highly inconsistent actions that caused Off the cliff
most people to question whether anyone The US economy fell off the cliff in October,
was in charge and whether we had a plan following this very public spectacle.
to stop the contagion effect. For example, Consumers and businesses slammed shut
when Indy Mac (a large thrift in California) their wallets and check books and have yet
failed, only the insured depositors were to re-open them. The rationale for the $700
made whole. billion funding was to purchase toxic assets
When WAMU (a very large thrift) failed, from the large banks. None of the money
both the insured and uninsured depositors was in fact used for this purpose, which
were made whole, but $20 billion of bonds underscores how poorly thought out the
were exposed to losses, and $7 billion of legislation was.
equity that had been infused by investors Q: How should public policy makers deal
just months prior to the failure was wiped with the moral hazard created by banks and
out. On the other hand, everyone was pro- other institutions deemed too big to fail?
tected at Wachovia. Everyone was protected A: We have faced this issue for decades
at Bear Stearns, while everyone was wiped without resolution, and it is not clear to
10 Journal of Regulation & Risk North Asia

me there is a solution. There will always accounting. Having a strong, effective, and
be some firms that are too large and too independent Systemic Risk Council is also a
complex to be allowed to fail – at least in very important step. We should take a very
an uncontrolled fashion. When I was chair- close look at the off-balance sheet activities
man of the FDIC we “rescued” Continental of banks and require capital against those
Illinois, the nation’s seventh largest bank. activities to the extent appropriate. Being
We kept the bank from failing, but we did so much smarter about supervision of banks is
in a way that replicated the most important also very important. For example, allowing
aspects of a failure while maintaining order banks to purchase massive amounts of fully
and stability in the financial system. insured brokered deposits is not good super-
vision. Prudential regulators should devote
Shareholder wipeout greater attention to incentive pay arrange-
For example, the shareholders of Conti- ments in banks to make sure the arrange-
nental were wiped out and the senior man- ments are rewarding the right things and not
agement and most members of the board of encouraging the wrong things.
directors were replaced. At the same time, Q: Aren’t some banks too large and complex
we issued a blanket guarantee that all gen- to manage? Shouldn’t these be broken up?
eral creditors would be protected against loss A: If the management of a large bank dem-
or delay in receiving their funds. A lot of large onstrates that the institution is too large and
banks went down during the 1980s, includ- complex to run in a prudent manner, then
ing nine out of the 10 largest banks in Texas, the regulators should not hesitate to make
but they were handled in a way that main- changes in management and/or force the
tained confidence in the financial system. institution to divest businesses and shrink to
I believe we made some serious mis- a more manageable size.
takes during the current crisis, but rescuing
large institutions, such as Bear Stearns and Managing complexity
Wachovia, was not one of them. I believe that boards and regulators must
Q: But surely the safety net that the US has be smarter and firmer in their oversight of
very publicly put under the big banks has cre- these companies. It is really not about size, it
ated enormous moral hazard and a licence to is about complexity and the ability to under-
gamble with taxpayers’ money to a far greater stand and manage that complexity. It is also
extent than ever before. about making sure the companies have
A: My advice would be to stop fretting about plenty of capital and reserves to weather any
too-big-to-fail and accept that it will be storms, including those that can arise from
with us forever. I believe our focus should off-balance sheet activities. It is also about
instead be on preventing our largest insti- ensuring that management has the incen-
tutions from getting to the point of failure. tives to do the right things and not the wrong
Higher capital is a critical step, as is getting things in running the company.
rid of the pro-cyclical Basel capital models I do not believe in breaking up financial
and the highly pro-cyclical mark-to-market institutions just because they are large.

Q: It seems that the competition authorities It is not clear to me how one puts that genie
both in Europe and the US may be prepared back in the bottle.
to take a tougher view of anti-trust issues in Q: Do you agree that there is a need for
finance. Would this be helpful? international agreement on procedures for
A: I have always seen a lot of merit in sensible dealing with failing systemic institutions in
anti-trust enforcement. Anti-trust enforce- a crisis?
ment was a major issue in bank acquisitions A: It is not a pressing issue in my mind.
and mergers in the 1960s and 1970s. I cut Simpler is better in government, just as it is in
my teeth on it as a young bank lawyer in the the private sector. International supervisors
1970s. need good lines of communications, but if
Anti-trust enforcement became an anach- we force them to have committee meetings
ronism beginning in the 1980s, as policy- during a financial crisis, I am pretty sure that
makers seemed to decide that there were will not be an improvement over a system in
too many small banks and the system which each country takes responsibility for
would be stronger if we allowed significant cleaning up its own messes. I would remind
consolidation. folks who propose even greater international
Q: What would be the objective of such anti- structure that the colossally bad Basel II capi-
trust action? tal standards are a product of that system,
A: Well, this is a difficult issue. During the along with a number of other bad ideas,
1960s and 1970s, the goal was to prevent such as mark-to-market accounting.
excessive concentration in specific markets, Q: Several commentators have proposed that
such as Cleveland, Ohio. When this was each systemically significant firm should
coupled with the inability to expand out of develop a plan for winding up its operations
state, it resulted in a large number of regional quickly in a crisis. What is your view?
banks around the country and no dominant A: I suspect those commentators have never
players on the national level. Nationwide held a significant position in banking or
banking has eliminated large numbers of bank regulation and have never dealt with a
larger banks, producing greatly increased banking crisis.
concentration of the banking system. Alternatively, other systemically impor-
tant institutions could commit to resolu-
Genie and the bottle tion procedures and provide accompanying
One can argue that the current system is financing (if deemed desirable) if any of their
more competitive in that giant firms from members were to fail, shielding taxpayers
around the globe are competing more from the costs.
aggressively for consumer and middle In the United States, we have such a sys-
market business. This is probably correct. tem today – the federal deposit insurance
So those who argue for stronger anti-trust system. The banks are jointly liable for all
enforcement are probably not trying to losses suffered by the FDIC and must restore
promote more competition but to prevent the FDIC fund within a few years after a
major concentration in the financial sector. banking crisis subsides. The government

guarantees this system, as it must, but it is in developing practicable proposals to imple-
clearly paid for by the banks. In addition, we ment the idea internationally and they could
have the Federal Reserve System – which is well be dropped. What is your view?
also paid for by the banks – to provide liquid- A: This is not some new-fangled idea. It
ity. Also, the Fed and the FDIC typically use is the essence of good bank supervision.
a fair amount of moral suasion to get banks Prudential regulators should always lean
to support those in trouble. Insurance com- against the prevailing winds. The Federal
panies also have a mutual protection system Reserve was notorious for doing that in the
at the state level for protecting policy holders 1960s and 1970s. When the economy was
when a company gets into trouble. overheating and bubbles were developing,
Q: Moving to capital requirements, as you the Fed would adopt a go-slow approach
know this has been exhaustively discussed and require banks to increase their capital.
among regulators for many years, yet policy When the economy was in a slump, the Fed
makers have in practice allowed banks to hold would ease its capital demands. Regulators
less and less capital. How did this happen? did not micro-manage the credit-granting
A: I have been involved in the banking process, but they did require banks to build
industry for 40 years, and capital has been stronger buffers, including loan loss reserves,
an important issue during that entire period when things appeared to be overheating.
and beyond. Q: Will not a systemic regulator suffer from
Bank regulators lost their bearings begin- the same swings in euphoria as market
ning in the 1990s when they decided to participants?
implement the Basel capital accords to A: It should not, if it is structured properly
use capital models to equalise bank capital with good leadership. Its raison d’etre will be
requirements throughout the world. to monitor and alert the regulators, Congress,
the media, and the industry to developing
Back to basics systemic risks.
I pin the responsibility for this on the Federal Q: If as seems inevitable some body has to
Reserve and the Treasury. They were so eager take on these so called “systemic” respon-
to equalise capital in banks throughout the sibilities, it will doubtless in most coun-
world that they were willing to reduce US tries be the central bank. Wouldn’t that get
standards in order to achieve parity.The FDIC them too close to politics and threaten their
argued strenuously against the Basel capi- independence?
tal rules. It is time to return to some higher A: I do not believe any single agency has
absolute standards below which no bank the wisdom and experience to carry out this
may go. And it is time to allocate appropri- duty, and I believe in checks and balances.
ate amounts of capital to off-balance sheet Plus, I believe in a strong central bank with
exposures. complete political independence. Anointing
Q: One fashionable idea at present is to the Fed as the systemic risk regulator would
introduce counter-cyclical capital ratios but I be wrong on all counts.
understand there are huge difficulties involved I believe we need to establish a Systemic

Risk Council that is independent from any assertion to prove that it is true or false.
single agency. Banking has always had a reasonably strong
Its board would comprise the Secretary lobby, which it has needed as banking is a
of the Treasury and the chairmen of the Fed, favourite political target. But I could not say
the FDIC, and the SEC. Its chairman would that banking is more powerful than the trial
be independent of those agencies, would be lawyers, the teachers’ union, retired people,
appointed by the President and confirmed trade unions, or any other potent lobbies. As
by the Senate for a six-year term, and would long as they are playing by the rules, we can-
have a great deal of autonomy (the board not do much about it in a democracy.
would be advisory in nature). Q: In your testimony to Congress on March
The Council would have its own staff 12 you emphasised what you see as the dis-
and would have access to all information the astrous role of mark-to-market accounting
government possesses regarding the finan- in this crisis. If you are right, it seems incred-
cial system, including confidential exam ible that governments should have allowed
data and classified information. Finally, the banking systems to come close to collapse and
Council would undertake the SEC’s current economies to sink into recession just for want
responsibilities for overseeing the Financial of enough common sense to suspend this rule.
Accounting Standards Board. What is the explanation? What has been the
Q: Would it not be much better to revert to response to your testimony?
traditional, tried and tested central banking A: I believe the FASB and SEC went down
crisis management policies: lender of last the path towards mark-to-market account-
resort, constructive ambiguity and tough ing with good, albeit terribly mistaken, inten-
punishment for bank managements and tions. They were warned not to do so in the
banks that fail? early 1990s by the chairmen of the Fed and
A: Yes, we need to get back to the basics. But FDIC and the Secretary of the Treasury, cau-
we should not stop there. We need other tioning them that mark-to-market account-
safeguards as well, such as the Systemic Risk ing would be highly pro-cyclical and make
Council; simpler and stronger capital and loss it difficult to get out of downturns (as we
reserve regulation; elimination of pro-cycli- learned during the Great Depression, when
cal regulatory and accounting regimes; less we abandoned mark-to-market accounting
reliance on models and greater reliance on in 1938).
on-site examinations and judgment in bank
management and regulation; and making Admission of guilt
sure the incentive compensation models are Once the crisis began in 2007, it was very
encouraging the right behaviours. difficult for the FASB and the SEC to turn
Q: What is your view of the argument put around on the issue for two principal rea-
forward by Simon Johnson, former chief econ- sons: (i) it would be an admission that they
omist at the IMF, that the banking lobby has were wrong and played a large role in cre-
become too powerful? ating the crisis, and (ii) they were concerned
A: I do not know how to measure that that the markets would react negatively to

the accounting change because it might be digits. A bubble in the energy sector burst.
viewed as a cover-up of the problems. The major banks in the country were loaded
When I began calling publicly for sus- up with third world debt for which there was
pension of mark-to-market accounting no market because it was feared widespread
nearly two years ago, it was difficult to get defaults would occur. The result was massive
any attention on the issue, as most people problems throughout the banking system.
never heard of it, much less understood it. Approximately 3,000 banks and thrifts failed,
We have done an enormous amount of edu- including a number of the largest banks in
cation and most people have now heard of the country (nine out of the 10 largest banks
mark-to-market accounting and know it is a in Texas, for example).
very bad thing. That’s great progress. The problem bank list still stood at 1,500
at the end of 1991 after the 3,000 failures.
Time to call a halt The FSLIC, which was the thrift counter-
Now we need to finish it off. It is utterly bad part of the FDIC, was badly insolvent and
accounting with no redeeming virtue. It is was taken over by the FDIC. So, during the
better disclosure that we need, and that can 1980s, significant economic problems led to
be provided in very clear footnotes to bal- widespread problems in the banking sys-
ance sheets. We should not be destroying tem. Government policymakers handled the
hundreds of billions of dollars of bank earn- banking problems in a way that maintained
ings and capital simply because markets stop confidence in the system. Indeed, once the
functioning properly. 1981-82 recession ran its course, we began
Q: How would you compare the official man- the longest peacetime expansion of the
agement of this crisis to the Savings and Loans economy in history, despite having to handle
crisis of the 1980s in which you were involved thousands of banks and thrift failures.
as chairman of the FDIC? At the onset of the current crisis, there
A: I do not believe the comparison is very was barely a cloud on the economic hori-
favourable in terms of the handling of the zon when problems in the financial system
current crisis. Very serious economic prob- emerged. Highly pro-cyclical regulatory and
lems in the 1970s – mostly rampant inflation accounting policies magnified the problems
– led to extremely serious problems in the in the financial system. Poor crisis manage-
financial system during the 1980s. The Fed ment by the government made matters
raised interest to over 21 per cent to break much worse and led to a general loss of con-
inflation’s back. This in turn bankrupted the fidence in the financial system. This, in turn,
entire thrift industry due to their large port- caused businesses and consumers to stop
folios on long-term, fixed rate mortgages spending and investing, leading to a serious
and bonds. It also led to a depression in the economic downturn. •
agricultural sector, as farmers could no long
afford to operate and service the debt on (Editor’s note: This interview originally
their farms. A very serious recession ensued appeared in the August 2009 editon of
in which unemployment reached double Central Banking magazine.)

Q&A
Central bankers, systemic risks

and auditing standards
Dr Eric Rosengren and guests field questions
on the economic crisis from concerned Hong
Kong bankers and financiers.
On the evening of Tuesday, May 5, 2009 mandated far-reaching action to reform the
more than 100 senior bankers from Hong regulation of the financial sector and, in par-
Kong’s financial services sector gathered ticular, they encouraged the IMF, Financial
to hear the President and CEO of the Stability Board, and the Basel Committee to
Federal Reserve Bank of Boston, Dr Eric make far-reaching recommendations.
Rosengren, deliver a lecture on systemic Question: Roger Clark Spyer, Citic Ka Wah
risk and regulation – a full transcript Bank –“We’ve all talked about systemic risk,
of this paper appears on page 59 of the lax regulation, defective products, high lev-
Journal. Joining Dr Rosengren on the erage, mispricing; all of which have been
speakers’ panel were Martin Wheatley, apparent in recent years. Then comes a cata-
CEO of the Securities and Futures lyst that collapses the house of cards and the
Commission (SFC); Anthony Neoh, system is in big trouble. Now the problem as
former chairman of the SFC; Stephen I see it – one with which regulators and eve-
Roach, chairman, Asia, Morgan Stanley; ryone else has been struggling – is the ques-
and Robert Pringle, the event modera- tion of accounting practices.
tor. Below is an edited transcript of the
audience Q&A session. A full transcript Fuel to the fire
of the event’s proceedings is available on When you have big problems, such as a for-
our website, www.irrna.org. est fire, you want effective tools to fight that
fire. You don’t pour oil or petrol on a forest
Introduction fire. The accounting practices of “fair value”
Moderator: Robert Pringle – Good evening and markets, where there was no liquidity
ladies and gentlemen. Let me first start by and no value, to me was like pouring petrol
congratulating the Institute of Regulation on a forest fire.
and Risk for creating this event and the I may be a simple banker, but I have
opportunity for a dialogue on the future of always believed there is one thing that is fun-
regulation. The G20 meeting in London has damentally important in banking and that

is you always look at the cash flows. When Mark-to-market accounting actually works
you look at any proposal, the only thing that very well when you don’t have disrupted
ever repays anything is cash flow. Cash flows markets. The whole thing basically comes to
and liquidity had to be the key to solving the a halt when you actually don’t have a market
issues we were facing. So now I think a lot of and so the whole question is: what is mar-
regulators have moved into this and much ket? Markets, in fact, work when everything
of the actual action that has been taken has has a clear price … and very quickly. When
been to establish the funding of cash flows you have a great deal of liquidity, nobody
of the instruments that have been causing all complains. When you have a whole portfo-
the problems. lio of stuff that you cannot sell and nobody
wants to buy, then the question remains:
Tools to do the job What’s the market value?
So why not look at the accounting practices Nobody has been able to figure this out,
in that the key is the cash flow, net present so the standard-setters say there are two
value being the key to how you value any ways you can deal with it:
asset in this sort of situation. Why not look 1) If you don’t intend to sell it, just put
to the fundamentals and the way we resolve this on the back-burner and say this is
these issues when they crop up? So that’s being held for investment, held for maturity,
my comment; I think that all the regulations whereas before you were selling it. In fact,
in the world won’t stop the crisis, so let’s look you’ve just reclassified it. Now the question
at the tools we can use to resolve these issues is that having reclassified this, then have you
as well as the causes of the problems. got the money to actually pay for it when in
Moderator: Thank you very much. Yes, the end, when it matures, it still doesn’t sell
Anthony Neoh has already touched on the for anything?
controversial role of accounting and mark-to-
market accounting in the various downward Seat of distrust
spirals that we’ve seen . . . the liquidity spiral What then is the value of this portfolio and
and the asset price spiral. (This has gone on) . whether in fact your accounts are telling
. . until asset prices reach levels that nobody’s people the truth? That is the conundrum …
trading at, but which somehow, still, one has when the IASB and FASB, in grappling with
to mark-to-market, in order to assess how these problems, come up with very mixed
the crisis should be met. signals. That is where I find the seat of dis-
Would anyone like to respond to that? trust among various parties. One would have
A: Anthony Neoh – “As an investor, as a to be very clear as to where we are heading.
depositor in a bank, as a member of an audit 2) The other thing would be that the
committee of a bank … I am very much a price of something – of cash you might say
victim of this (crisis) and I cannot see my – is net present value which, in fact, comes
way through it all. But let me try and make into an assessment of loan portfolios, as you
sense of it although, to tell you the absolute well know. But this begs the question: if you
truth, I have not been able to do so thus far. use net present value, what kind of discount

rate do you apply? If you use a loan discount don’t take into account some recent activ-
rate, which is your interest rate on the loan, ity. Just how these activities will work out in
then you may be using one based on eco- the future, I don’t know . . . which is why we
nomic conditions that were in effect many are, at the moment, in my view, in a kind of
months ago. ‘no man’s land’. I don’t know where we go
Now if you use that discount rate, it does from here. I’d like to raise this issue with Dr
not tell you what the present risk is because Rosengren and ask him where exactly are
you are now in a much riskier situation. So we going?
how do you deal with the provisioning of Eric Rosengren: I don’t think I can answer
your loan portfolio? When you do so, you exactly where we’re going, but I would say
must look at the present macroeconomic that accounting is a critical component of
situation. If you do that, then what kind of the financial infrastructure, and so it has to
models do you use? be very carefully worked out. Liquidity risk
was never fully incorporated into market
Partial migration accounting and so I think it’s come as a sur-
That is an issue we have to grapple with when prise not only to many accountants, but also
we make financial reports. I can tell you that to many financial economists who have not
what we did in one bank (I was a member of seen the kind of liquidity risk that we’ve seen
the audit committee), we first looked at our over the last year and a half. So it’s not all that
loan portfolio and said let’s migrate these into surprising that the accounting infrastructure
various parts and then look at the loans we was not prepared for some of the financial
say are bad. As such, we used a net present outcomes that we’ve actually seen.
value based on the loan interest rate, but that
doesn’t tell you anything because the loan ‘Judgment’ here to stay
interest rate could have been decided three That being said, many accounting standard
years ago. And now we are in a much riskier boards have started taking into account that
situation. Then the next thing we do we is liquidity is very relevant in terms of coming
look at the present (bad) situation based on up with an accurate price. We’re never going
a very large portfolio of loans and, looking to get rid of judgment. Mark-to-market
at the market for these kind of securitised accounting was part of an attempt to say
loans, what would be the additional mark- that we don’t need judgment and I think
down that you would have to make? that, unfortunately, that’s not going to be
This is what I would say are “finger in possible in any kind of accounting regime.
the air” statistical models which are based Mark-to-market works very well in a very
on historical information. So what we do is liquid economy, but obviously when there
add something else . . . At the moment , all are a lot of liquidity pressures it doesn’t work
of this is alchemy . . . and we are all indulg- nearly as well.
ing in alchemy right now. How good is this Judgment is going to have to play a much
alchemy, we don’t know. A lot of it is based larger role and I think some of the changes
on statistical models which are historical and that have recently occurred in accounting

standards actually recognise that and recog- minimal because once the project is done
nise that in an appropriate way. you won’t be able to get people to rent the
Roger Clark Spyer: Looking at the concept space. But the bank may believe that cash
of cash liquidity, there are ways to manage a flow will come from renting out the building.
lot of the available instruments and a lot of So whether it’s cash flow, mark-to-market,
the issues that we might be facing in this sort or whatever, judgment exists.
of crisis. The Federal Reserve, or whoever is Cash flow is not a whole solution either
leading the solution, can fix the liquidity, can because in bad times, and around bank
fix the interest rate when it’s serious enough, exams, accounting statements can change
and this is basically what they’ve been doing quite dramatically. Part of that reflects a rea-
in the last six months. sonable difference of opinion about what
cash flows are. And one of the roles that the
Calmer waters bank examination process does play is to try
Most regulators and most of the coun- to make sure that the accounting system is
tries that have come round to this way of accurate for the financial statements of the
thinking, have fixed it this way. They have bank during difficult times.
created funding vehicles where you fix the Anthony Neoh: We’ve been concentrat-
boundaries and set the parameters and give ing a lot on the valuation of assets. Roger
cash flows the chance to come through (Roger Clark Spyer) has been talking about
against the funding source within a funding liquidity and assets. But you can place a fair
structure. This structure enables you to see value on liability as well. One of the rea-
it through to maturity, through to calmer sons why many banks have reported prof-
waters where you can resolve issues in a its in the past quarter is because of possible
market which is now stabilised and back to reclassification. At the same time these
a normal basis. banks have actually written down their lia-
Eric Rosengren: This brings up one more bility and as a result have written into their
observation, as Anthony highlighted . . . income statements an income which does
another aspect of an accounting system is not actually arise.
to give as accurate as possible a portrayal of
the financial condition of the firm and I think Fair value
the loan portfolio is a good example where This is an issue I still don’t understand,
you have cash flow. One of the reasons why because the moment you put a fair value on
we have bank examiners is that there are a liability you basically can repay that liability
significant disagreements of what cash flow at a lower rate. Now, if you only do this in
actually is. So particularly for something like a bankruptcy or a receivership, then once a
construction law, where contractually they financial institution writes down its liability
may not have to release payment until the at fair value, then it must realise that it is no
project is actually completed, you have a longer a going concern. But at the same time,
situation where the examiner views that in the auditors have declared that the financial
the current environment, cash flow will be institution is still a going concern, despite the

writing down of its liability. So this is one of for that fundamental question. I think many
the inconsistencies that need to be ironed people have already raised the question of
out: how we can actually reconcile fair value when will banks get back to making money
with reality? out of knowing their customers individually.
Moderator: Thank you very much. This is And I hope I don’t offend anybody here by
such a critical issue but highly technical. The saying that there seems to be a general per-
Institute could have a whole session on the ception that they’ve got quite a way away
accounting rules and their role in this crisis. from that special knowledge they once had
I’m sure we could go on all day about this. from knowing their customers. However,
But I think there’s another question from a I’m speaking in the presence of many experts
gentleman towards the back of the room. here. Who on the panel would like to take up
the gentleman’s question?
Treacherous path A: Martin Wheatley: I think you have to go
Q: Eberhard Brodhage, general manager, back to the model of banking that existed
Commerzbank, Hong Kong: I think you’re when I first entered the securities industry.
leading us down a very treacherous path This was the 3-6-3 model of banking. You
with technical issues such as liability valu- borrowed at 3%, you lent at 6% and you
ation. When I started out in banking the went home at three in the afternoon after a
statement was that banks were different. nice long lunch with your clients. [audience
We deserved the trust of our clients and our laughter]. If you haven’t got a long-term rela-
stakeholders and I do not think we have tionship with your client because the risk has
it anymore. We have reached a situation been passed on and passed on and passed
where we are no different from airlines, or on, you do not have the same trusted bank-
supermarkets or second-hand car sales- ing relationship that you had 20 years ago.
men. My question is: What regulations do That’s the nature of how the industry has
you see as effective in terms of implement- developed and I don’t know if it’s possible to
ing and re-installing that trust? go back, but it is one solution.
The relationships that we have with our
clients are more long lasting than those Problems remain
of somebody that buys a car or who goes Eric Rosengren: I would just make one
to a supermarket. So I think we need that observation. Disclosure and transparency
trust in order to function in our economic, have been a problem during this crisis in that
financial role. I don’t see that happening at there have been a number of instances where
the moment. I see liability accounting in the institutions have, within weeks or months
financial results and find it hard to believe of disclosing very significant problems,
that we can actually produce a profit when announced that they have no problems. And
a bank says we do not need to repay our so, this takes us back to accounting, and also
debt at the level at which we have promised takes us back to what supervisors are will-
to pay it. So how can we rebuild that trust? ing to say in public. It is very hard to have
Moderator: Thank you very much indeed a great deal of confidence when somebody

announces that they have no problems and become destabilising and I think to off-
shortly after fails. set that possibility, the US Treasury would
announce well in advance that they would
Prevention not cure be more than happy to provide some capital
So part of the issue I think is that we need to make sure that an organisation remains
to do a better job, both as supervisors, and stable, through the stress test and through
as bankers, accurately reflecting the extent the next several years.
of the problems that institutions are fac- That is an unusual statement relative to
ing. I think that’s one of the challenges that what we’ve had in the past, a willingness to
have occurred during this crisis and I think inject capital into an organisation should it
there’s probably more to be done on both be needed. So I think that it’s trying to off-
the banking side and the supervisory side to set some of what we’re going to get from
make sure that some of the issues that we’ve the added disclosure and transparency that
seen over the past year-and-a-half do not stress tests will provide.
reoccur. Q: Joseph Poon, deputy CEO, Hang Seng
Stephen Roach: Can I just follow up and Bank: Actually the risk of a systemic risk is
ask a question based on what you just said. not really a new issue; it was apparent to my
We have the results of these stress tests that generation prior to the stock market crash of
are due out later this week. One scenario 1987. And further, I recall Alan Greenspan
is that we pretty much know what the US saying in his famous “irrational exuberance”
Treasury is going to reveal in terms of who speech that falling asset prices should not
needs to raise capital. Let’s just say that they really concern the central banker, unless they
found some serious systemic problems out impacted the real economy.
there in several key systemically relevant
institutions. Implosion risk
If they were then to – along the lines Here may lie the root of some of the prob-
of what you just suggested – release those lems. I think it was Stephen (Stephen Roach)
problems in the midst of what is still a very who raised the issue that, in terms of policy
serious crisis, could that not trigger another direction, the risk of an implosion of a highly
cascading wave of angst that could have leveraged investment bank or hedge fund
contagious impacts on institutions who may or whatever, also came up in the early ’90s.
be in better shape than the ones that could And if we go back to reports way back in the
be identified as problematic? ’90s, the Bank of International Settlements
Eric Rosengren: Part of the goal of the had been warning against these very issues.
stress test is to get a more accurate portrayal Further, we then saw the establishment of
of what the financial condition is and to try the Financial Stability Forum in 1999 – this
to restore some confidence that the finan- only involved the G7 countries initially and
cial statements and the financial conditions not any Asian countries. Obviously, this
of firms are as stated. You do raise a signifi- matter has now been amended with the
cant issue which is whether or not it could inclusion of Hong Kong and Singapore.

One wonders, whether the regulators For you it’s a big problem, a huge prob-
should be in these forums. It could be very lem. To start with, all the toxic stuff thrown
counter-productive to spend the next three around the world, I think Asia probably
years debating whether or not it’s a twin peak caught about 10 per cent, 50 per cent in the
or what the most effective model should be US, 40 per cent in Europe, that sort of thing.
– to regulate the financial services sector. Even China has a very good rule – a loan-
Rather I think the point should be that if we to-deposit rule – of 75 per cent. Who are
don’t act on past mistakes. we to say that’s a stupid rule? I’m aware of
discussions going on in Europe right now
Burning platform saying maybe we should have more rigid
I don’t care what regulatory environment regulations on loan-to-deposit. We’ve
you have, you’re going to end up with the lived through heavy deleveraging. Our
same problems. And I wonder whether G7 loan to deposit ratio here in Hong Kong
managed to avoid a burning platform in the was 140-150 per cent – now it’s around
first place, even having set up the Financial 50-60 per cent. We’ve lived through that
Stability Forum not long after the Asian painful period of adjustment. And I can see
financial crisis of ’97/’98, which was very the US and Europe going through exactly
serious to us here. that now, and it will not be very quick and
Hong Kong, and many other Asian not very easy.
countries, went through a life stress test
between 1997 and 2004. Within that we also Simple, robust regulation
endured a life test in the form of the SARS Moderator: You made a very good point
epidemic. And so in terms of what has been tonight and the Western authorities and
described as a radical stress test in the US, I bankers should pay more attention to the
suggest you look at the Hong Kong model Asian crisis. Mervyn King, Governor of the
and see how we lived through a 65 per cent Bank of England, recently called for regu-
fall in property prices from peak to trough, lation to be simple and robust. And you’ve
which I’m pretty sure that the US will not go given an excellent example of a simple
through. and robust rule; but to listen to discussions
But that was quite a stress test, wasn’t amongst regulators recently, it is very far
it? I don’t think there was a requirement at from being simple. In fact it’s getting more
any stage for the banks to raise additional and more complicated and seems to be sow-
capital, just in case. I think there might be ing the seeds for the next crisis. I intervene
some lessons here in Asia that the western with my own personal comment.
world can learn from, because we actually Q: Johanna Chua, chief economist, Asia
have the blessing and the benefit of having Pacific, Citi: Two questions actually. Earlier
lived through those seven or eight years and there was talk of systemic regulators, and
going into this mega crisis, and I can tell you from a practical perspective, who should
as a banker, I feel quite relaxed for some rea- be the systemic regulator? If the Fed or the
son [audience laughter]. Central Bank takes that role, what does it

imply in terms of the independence of the Plus rate in the case of the United States,
Central Bank, which is an integral part of to take care of inflation, unemployment and
monetary policy? And the second question financial stability, you’re asking an awful lot
is related to the discussion about monetary from one instrument.
policy and whether or not it should not just I think one of the issues that I would
target inflation but also look at asset price as highlight is that particularly for asset bubble
well, to the extent that part of what’s feeding types of situations, the asset bubbles I’m really
into this crisis is not what’s purely driven by worried about are the ones that are occurring
policy but also because this crisis is very dif- through leveraged institutions. I don’t think
ferent from previous crises. all asset bubbles are the same. In terms of
the dotcom decline, it had much less of an
’Riskless assets’ impact than what we’re going through right
It is not driven by capital flow looking for now and I think one of the reasons for that is
higher returns on riskier assets, part of it is that the dot com was mostly equity financed,
actually driven by the savings glut of a lot so it had a wealth impact, but not nearly the
of the central banks in Asia and elsewhere same impact on leveraged institutions.
looking for riskless assets and the inability
of emerging market countries to gener- Supervisory policy
ate riskless assets that get flooded into the What’s different about now, and what was
treasury and provide some sort of floor in different about the Japanese experience of
terms of the long end rates in the US. So the early 1990s, was that leveraged institu-
the question is whether it’s enough to say tions were impacted and the shrinking of
that monetary policy targets inflation asset these leveraged institutions has had a much
prices and has control of the short end of broader impact than just the wealth effect.
the curve, and what that means in terms of This is something that we have to be con-
the long end of the curve where you have cerned about and I think in many instances,
global capital flows and no real alterna- supervisory policy may be a more effective
tive to reserve currency to drive longer end way of addressing that concern than mon-
rates? What does that mean in terms of etary policy alone. So I’m not sure monetary
monetary policy? policy should ignore those issues, but hav-
Moderator: A lot of big questions there. Eric, ing a broader tool set is probably going to
do you want to start? be a more effective way of addressing the
A: Eric Rosengren: I’ll start. Martin situation.
Wheatley and Stephen Roach raised their Martin’s question of whether you can
comments as well so let me follow up on identify it is a difficult one to answer and
both their comments a little bit. In terms of it’s the same question with asset bubbles,
monetary policy, in the United States we to the extent that leveraged institutions are
have a dual mandate based on inflation and growing very rapidly, to the extent that cer-
unemployment. Other central banks just tain asset classes are growing in multiples
have inflation, but if I try to use the Federal of the economic growth of the economy.

I think that does raise some questions on Reserve winds up being responsible. But I
how that’s occurring and I don’t think it’s think it is important for some organisation to
all that difficult to say that most of the cri- take responsibility.
ses we’ve seen are really through lever-
aged institutions that were, in effect, either Leverage buildup
having a concentration risk in terms of the Stephen Roach: One quick question here.
asset classes that were focused on or they You expressed your concerns over the rapid
dramatically increased leverage. I think that build up of highly leveraged institutions. Is
some of these instances are observable, not part of that problem a reflection of the fact
just after the fact, but actually as they are that the Federal Reserve set the price of
occurring. leverage too low? The policy interest rate,
if it had been higher that would have dis-
Discount window couraged the systemically risky build-up of
The risk organisation in most countries has leverage? Would it also have discouraged
macroprudential responsibilities. But every the equally reckless leverage of American
country also has microprudential respon- households which are now in such dire
sibilities, and should try to look not only at straits?
the solvency risk of individual institutions, Eric Rosengren: It’s very difficult to use a
but also at the macroprudential which is not monetary policy tool to target one asset. It’s
something that’s charged with any entity much easier to do it through supervisory pol-
in the United States, and to my knowledge icy. So I think that there were lessons learned
in most countries there’s no organisation about what we should have done differently
that does that. It may be housed within the regarding supervisory policy.
Central Bank to think about that because the
Central Bank does have the discount win- Monetary policy tool
dow. So if you’re offering discount you have We can change the cost of capital when you
to think about solvency risk and liquidity risk raise the federal funds rate and presumably
and these are features that you would expect when you raise other interest rates as well,
any systemic regulator to have to think you’re not only affecting the housing sector,
about. you’re affecting all sectors of the economy.
I would say that we’re unlikely to have So do you want to slow down the entire
one model as we don’t have one model of economy if you think that the housing sector
central bank and we don’t have one model is growing too fast?
of how banks and other financial institutions There may be other types of tools that
are supervised. We probably won’t have one could be much more effective at address-
model for how a systemic regulator would ing that.You have to look at all the tools and
work, and probably it does make sense to ask: What is the most effective way of deal-
have some experimentation. In the United ing with the problems at hand? And I’m not
States we’re going to have to see what sure that I’d want to wholly rely upon mon-
Congress decides and whether the Federal etary policy to do that.•

Book overview
Unified Financial Analysis: the

missing links of finance
Dr Willi Brammertz, senior adviser, FRS
Global, offers a condensed overview of his
recently published book.
In the wake of the financial crisis value” basis – will never be able to derive
many proposals for new regulation and value change since all connections between
improved oversight have been put for- risk factors and value are lost once value has
ward. One can already discern two com- been established.
mon threads which will force regulators When solely value is required by regula-
to rebuild the information base of report- tors, they are unable to calculate value change
ing from scratch. These are as follows: as needed (e.g. in stress testing). Even worse,
such a regulatory approach necessarily leads
• Stress testing of financial institutions to inconsistent results on a systemic level, as it
which emphasises the measurement is impossible to derive value without making
of “value change” instead of “value as numerous assumptions. These assumptions
such”. This has already been done in the however are hidden, and thus inconsistency
US and European banks can expect the on an aggregate level is likely. Another draw-
same in the future; back is the reliance of regulators on informa-
• A shift from the regulation of individual tion controlled by the regulated.
financial institutions to a systemic regu-
lation. There are currently proposals in New management needed
various stages of realisation for creating Despite the obvious drawbacks of the cur-
systemic risk supervisors in the US, UK rent information regime, it has not been
and continental Europe. fundamentally challenged. Although there
Current regulatory reporting is, by and are many proposals for new regulation, there
large, based on traditional bookkeeping, in is no debate as to whether the current set of
the sense that values are the starting point required information can deliver the needed
for further manipulation and reporting. This results. What is needed is a conceptual dis-
is even true for the latest Basel II enhance- cussion regarding the base information that
ments. However, a system that is based on must be reported. For regulation to be ready
book value – even if calculated on a “fair for any future crises, it needs a new and

modern risk management methodology sharing approximately 200 common finan-
surpassing what is currently found in banks. cial attributes among them.
This implies moving the focus of thinking Our experience with financial institu-
from value towards the drivers of value or its tions in many jurisdictions has shown over
underlying inputs, which amounts to a small the years that this small set of concepts suf-
Copernican revolution in finance. fices to model well over 95 per cent of the
number of existing financial contracts with
Elementary particles in finance precision. As there is a common set of con-
The invention of double-entry bookkeep- cepts, with an identical level of granularity
ing, with the balance sheet as a condensed underlying the analysis of every institution,
representation of the value of an enterprise, the information can easily be consolidated at
is considered by many as one of the decisive a systemic level to identify systemic net posi-
inventions of the Middle Ages, laying the tions, exposures, etc.
foundation for progress in modern times. The diagram at the top of the opposite
Given the technical resources of the time – page details functions that are referred to
essentially paper, pen and ink – it was impos- during the remainder of this article.
sible to systematically store background At the core of the model is the financial
information on how these values, such as FX contract, which is a mutual promise of coun-
and interest rates, creditworthiness of counterparties to exchange cash ﬂows according
terparties and so forth, materialised. to a set of rules. These rules determine when
This approach was used right up to the cash ﬂows occur during the contract’s life,
middle of last century and became inad- their type, and how their value is calculated.
equate only towards the end of the century,
especially in financial sector risk, where Important risk factors
other management systems were developed Market risk factors, Counterparties and
in parallel. Behaviour are set input factors of environ-
Recently, regulators – as owners of last mental circumstances, which can change
resort – had come to par with top level risk unexpectedly and therefore constitute
management requirements, such as stress important risk factors:
tests and systemic risk analysis. Despite this • Many financial contracts include rules
development, regulators seem to continue which refer to market prices in order to
to base their reports on the medieval regime calculate the value of cash flow (e.g. a
using value – book or fair – as calculated by floating bond may be reset on a specific
the regulated, as their primary input. rate from the swap curve). In general,
We propose to enable micro- and market risk factors are in direct corre-
macro-prudential regulators to effectively spondence with the major asset classes
exercise their mandates by giving them new of bonds, foreign exchange, equities and
analytical tools. These tools are based on a commodities.
conceptual framework with a set of some • The mutual promises defined in financial
30 standardised “contract types”at the core, contracts are, in reality, not always kept.

Chart 1. Model core – the financial contract
Risk factors
Markets
Input elements
Counter- Financial
Behaviour
parties Contracts
Financial events e1 e2 e3 ... en
Liquidity Value
Analysis elements
Income Sensitivity
LaR EaR VaR
The counterparty input category encom- It is important to note that in such a sys-
passes all the data to describe the ability tem, value is not an input but an output,
of the counterparty to meet its obliga- which can be calculated not only under cur-
tions quantitatively. rent conditions (risk factor, counterparty or
• Some rules governing the exchange behavioural assumptions) but also under
of cash flows are not mechanically shocked conditions. Moreover it can be cal-
deterministic: the funds deposited in a culated according to any valuation principle
checking account may be withdrawn at (nominal, fair or market) but also as required
short notice, annuities may be prepaid by public accounting standards.
and credit lines may be drawn. These
rules, which can only be formulated for Missing link
aggregates of contracts, must be statis- Such an analytical methodology would
tically derived (Behaviour). Since they meet the conditions for stress tests or any
are uncertain, they are part of the risk other modern financial analysis. A crucial
sources. ingredient to applying it on a systemic level
Given these input elements, it is always is the standardisation of financial contracts
possible to derive fully the value, income, using the above-mentioned 30 or so con-
sensitivity and risk which depend on them. tract types.

Unfortunately, this is a missing link in In a regulatory context, each bank,
the current regulatory regime and the new insurance company or other regulated
regulatory proposals. Rectifying this should entity would have to undertake the same
be high on the agenda of regulators since exercise, the only difference being that tar-
standardisation is unlikely to come from get standard contract types would need
the financial industry itself. The industry to be defined by the regulator. Financial
has a poor track record in this regard, with institutions would be obliged to map their
even sophisticated banks treating financial contracts into one of the standard contract
contracts as little more than heaps of data types.
attributes rather than as objects which encode A contract that cannot be mapped
cash flow generation logic. Moreover, such a exactly would have to be approximated or
change is not in the immediate self interest marked as a “special” contract type. Once
of financial institutions and will therefore this is achieved, financial contracts can be
only come about by regulation. well understood by any participant of the
financial system: regulators, investors and
Implementing change: the institution last, but not least, the financial institution
How then would this work in practice? The itself.
process is similar to a bank introducing an With such a system in place, the benefit
Enterprise-wide Risk Management (ERM) to regulators would be immense, especially
system or an Asset & Liability Management if complemented with counterparty and
(ALM) system – both of which require all market information. A regulator could eas-
financial transactions as input. ily run systemic stress tests and other types
Banks manage their financial contracts of analyses. Analytical power would be
using many transaction systems and each combined with high consistency and the
system treats contracts differently. An ALM regulatory burden on firms could fall drasti-
(or ERM) system contains a set of contract cally, since regulators could perform the tests
types that is implicitly standardised. An themselves.
enterprise-wide implementation of an ALM
system therefore means mapping the myriad Everyday reality
different product types defined by transac- We would end up with the ideal situa-
tion systems into the clearly defined contract tion of better regulation for a fraction of
types of the target ALM system. the cost compared to today’s systems – in
other words smarter regulation. Besides
‘Special’ contract type regulators, banks and insurance compa-
When such a mapping process is successfully nies would also benefit, whereas today
undertaken, cash flow generation patterns they struggle with a multitude of transac-
of the transactions stored in different source tion systems and a lack of a clearly defined
systems and their dependence on market, contract types.
counterparty and behavioural conditions are Admittedly, there are serious obstacles to
clearly defined and well understood. achieving such change in practice. Disclosure

to regulators of transaction and counter- could be modelled in the same way as the
party data at the scale and detail proposed IASB, which also provides an XBRL tax-
here would be met with fierce opposition by onomy of its IFRS reporting concepts. This
financial institutions. would establish the information infrastruc-
There are also genuine privacy and con- ture between the different levels of the global
fidentiality concerns that must be addressed. regulatory edifice.
However, the financial crisis has turned
many previously “unthinkable” events into Outlook
everyday reality, and bringing about this Implementation of a regulatory framework
change so that regulators have the power along the lines of this proposal would
they need to regulate effectively could be probably have an impact on the finan-
another one of them. cial services industry that goes beyond its
immediate regulatory effect. Thinking in
Implementing change: the regulator terms of stylised contracts removes a layer
At the level of regulators, we would have to of obscurity that is the purpose of many
see an internationally co-ordinated effort institutions’ product jungle and “innova-
to establish a set of Regulatory Accounting tion”. As was the case with risk-based
Principles (RAP) incorporating the design pricing in Basel II, the genie of higher
principles discussed above. RAP would need transparency cannot be kept in the bottle,
to be put in place in parallel to Generally thus increasing understanding of consum-
Accepted Accounting Principles (GAAP) ers as well as price competition.
because there is an inherent conflict between
the GAAP objective of transparency that Too important to fail
is indispensable to investors, and financial So, is there an alternative to such a system?
stability which is the purpose of macro-pru- We believe not. Given the speed with
dential regulation. Transparency cannot be which banks return to business as usual it
compromised systematically without more must be feared that the only lesson learnt
damage to investor confidence in the quality in this crisis is that banks are too important
of public financial statements. to fail. Such an environment is the breeding
RAP would also have to establish a ground for systemic crisis which cannot be
standard-setting board to maintain a com- controlled by the lender – and owner – of last
prehensive, standardised taxonomy of styl- resort. The regulators must become at least
ised contract types as described above. This as smart as the regulated. •
board would not only define the attributes
and their meaning, it would also define the Notes
algorithms to generate financial events and 1. See: Brammertz, et. al. “Unified Financial Analysis
cash flows and finally the derived analysis – the missing links of finance”. Wiley 2009 for
elements – liquidity, value, income, sensitiv- the full argument.
ity and risk. 2. See: The positions of the CFA Institute Centre
This is relatively straightforward and for Financial Market Integrity.

Opinion
Deregulation, non-regulation
and ‘desupervision’
Professor William Black examines the
causes of the mortgage fraud epidemic that
has swept the United States.
THE author of this paper is a leading and they implicitly demonstrate three criti-
academic, lawyer and former banking cal failures of regulation and a wholesale
regulator specialising in ‘white collar’ failure of private market discipline of fraud
crime. As one of the unsung heroes of the and other forms of credit risk. The Financial
Savings & Loans debacle of the 1980s, Crimes Enforcement Network (FinCEN)
Professor Black nowadays spends much released a study this week on Suspicious
of his time researching why financial Activity Reports (SARs) that federally regu-
markets have a tendency to become dys- lated financial institutions (sometimes) file
functional. Renowned for his theory on with the Federal Bureau of Investigation
‘control fraud’, Prof. Black lectures at the (FBI) when they find evidence of mortgage
University of Missouri and Kansas City. fraud.
He is the author of ‘The Best Way to Rob
a Bank is to Own One: How Corporate Epidemic warning
Executives and Politicians Looted the The FBI began warning of an “epidemic” of
S&L Industry.’ A prominent commenta- mortgage fraud in their congressional testi-
tor on the causes of the current financial mony in September 2004 – over five years
crisis, Prof. Black is a vocal critic of the ago. It also warned that if the epidemic were
way the US government has handled the not dealt with it would cause a financial cri-
banking crisis and rewarded institutions sis. Nothing remotely adequate was done to
that have clearly failed in their fiduciary respond to the epidemic by regulators, law
duties to investors. enforcement, or private sector “market dis-
cipline.” Instead, the epidemic produced and
The following commentary does not nec- hyper-inflated a bubble in US housing prices
essarily represent the view of the Journal of that produced a crisis so severe that it nearly
Regulation and Risk – North Asia. caused the collapse of the global financial
“The new numbers on criminal refer- system and led to unprecedented bailouts of
rals for mortgage fraud in the US are just in many of the world’s largest banks.

White-collar criminology has demon- Most regulatory restrictions kick in when
strated several theories and findings critical banks suffer losses and fail their regulatory
to regulating risk. Unfortunately, regulators, requirements. Highly profitable firms are
economists, prosecutors, and accountants normally the regulators’lowest supervisory
rarely read or are aware of modern crimi- priority. The record profits also combine
nological findings. This essay introduces the with modern executive compensation,
reader to four criminology theories essen- particularly in the US, to create an opti-
tial to regulating risk and avoiding crisis. mal means of converting firm assets to the
“Control fraud” theory explains how the CEO’s benefit through seemingly normal
person that controls a seemingly legitimate corporate mechanisms.
entity uses it as a “weapon” to defraud. Corrupt CEOs optimise this process
by weighting their compensation heavily
Accounting ‘weapon’ towards the short-term – which is optimal
In the finance sector, accounting is their for accounting fraud. Fraudulent CEOs can
weapon of choice. Individual control frauds often escape prosecution if they limit their
can cause greater losses than all other forms looting to these “normal” corporate com-
of property crime combined. Control fraud pensation mechanisms. It is vital to under-
theory explains why accounting control stand the failure of the firm does not mean
frauds are uniquely able to escape effective the failure of the fraud scheme. The CEO
regulation, prosecution and private market running an accounting control fraud can
discipline. become rich almost immediately.
The recipe for a financial firm opti-
mising accounting control fraud has four Distinctive pattern
ingredients: There are exceptions to this rule, however,
• Grow extremely rapidly (e.g. like a Ponzi for the four ingredients create a distinctive
scheme); pattern of business operations and busi-
• Make loans to the uncreditworthy ness outcomes that an alert regulator can
(because they provide superior nominal use to identify and counter accounting con-
yields and allow far faster growth); trol frauds. In order to make large numbers
• Employ extreme leverage; and of bad loans, an accounting control fraud
• Establish minimal loss reserves. will suborn its internal and external con-
The result is mathematically guaranteed trols so that they do not block loans to the
– not a “risk”– the firm will report exceptional uncreditworthy.
short-term accounting profits as long as the Accounting control frauds are adept at
financial bubble expands. The exceptional using compensation to induce supposed
profits, particularly in the US context, lead to controls to “bless”grossly inflated asset val-
exceptional income for the person control- ues and hide real losses. Normal on-site, “full
ling the financial firm (typically the CEO). scope” bank examination procedures will
The firm’s record posted “profits” identify this characteristic pattern of mak-
defeat potential regulatory restrictions. ing extraordinarily bad loans. Regulators that

understand accounting control fraud mech- accounting control fraud can produce, and
anisms will correctly infer that the record hyper-inflate, financial bubbles. The sec-
profits are “too good to be true”and badges ond and third criminology theories explain
of fraud rather than success. Similarly, if the why the business practices that optimise
regulators intensively review every failure, accounting control fraud can produce these
the “autopsy”process will reveal the distinc- bubbles and why these bubbles can be self-
tive pattern of accounting control frauds. sustaining for many years. At any given time
They can then “triage” and make closing a small number of industries and assets are
the accounting control frauds reporting the the best available setting for accounting
greatest profits their top priority. control fraud.
Optimisation will lead to accounting
Credulous regulators fraud naturally clustering in these supe-
Regulators can also use their understanding rior settings. When an environment creates
of accounting control fraud to use regulations strong incentives to act criminally, we term it
that will limit the creation of new frauds and a “criminogenic environment.” Neither the
terminate existing frauds. Accounting con- creation of such an environment nor the ini-
trol frauds’ Achilles’ heel is growth. The US tial clustering requires any conspiracy.
agency regulating savings & loans (S&Ls)
successfully re-regulated the industry and ‘Gresham dynamic’
doomed all the accounting control frauds by The initial clustering will produce “learn-
restricting growth. ing effects”. Other CEOs will observe that
The record profits are even more effective the initial fraud’s business practices produce
against private market discipline than they guaranteed, record profits. CFOs that fail to
are against credulous regulators. Lenders emulate these practices will fail to achieve
and investors are eager to provide funds to exceptional bonuses and appreciation of
highly profitable firms. Instead of providing their stock. More importantly, their CEOs
“discipline”, lenders fund accounting con- will fail to come close to their maximum pos-
trol frauds’ rapid growth. The combination sible compensation.
of extreme growth, making bad loans, high This produces a “Gresham’s dynamic”
leverage, and extraordinary executive com- in which bad ethics tend to drive good eth-
pensation produces exceptionally expensive ics out of the marketplace. The same type
failures. of dynamic operates with regard to internal
and external controls by appraisers, audi-
Financial bubbles tors, rating agencies and other professionals
During the S&L crisis, the Enron, that are supposed to provide effective “pri-
WorldCom, et al crisis, and the current cri- vate market discipline.” Cheaters prosper.
sis, private lenders acted as “vectors” that The control frauds only need to corrupt a
spread, rather than contained, the fraud small percentage of the appraiser profes-
epidemic. The same dynamic was com- sion in order to guarantee that they can
mon in many other nations. Epidemics of inflate asset values.

The initial criminogenic environment of troubled loans. The ability of epidemics of
will produce the clustering of accounting accounting control fraud to hide such losses
control frauds in the same industry following can fool regulators that do not understand
similar business practices. A lender cannot accounting control frauds.The same dynamic
simply decide to grow rapidly in a mature makes “private market discipline” an oxy-
field (such as home lending in the US) by moron. Understanding these two crimino-
making honest loans. A lender that wants to logical concepts (one borrowed from health
take market share from rivals honestly will and the other from economics), allows effec-
typically have to cut its interest rate on loans tive public intervention to prevent epidemics
and its rivals are likely to match that cut. The of accounting control fraud. When we fail to
result is reduced profitability and only a very regulate or supervise financial firms effec-
small increase in the quantity of home loans tively we create a criminogenic environment
demanded. because we, de facto, decriminalise account-
ing control fraud. Even groups like the FBI,
Increased fees, charges which have agents that specialise in white-
By lending to the uncreditworthy, how- collar crime investigations, cannot effectively
ever, accounting control frauds are able to prosecute a control fraud epidemic.
grow extremely rapidly and increase the Most nations have far less capability
interest rate and fees that they charge. In than the FBI to investigate elite white-collar
the case of US housing lenders, the result crime. The regulators rarely have sufficient
was an immediate large and guaranteed expertise and the staff, but compared to even
surge in short-term “profits” and a shift in the FBI they generally have greater staff and
the demand curve for housing outward staff with vastly more industry expertise.
from the origin – which will cause home Similarly, the way to reverse a Gresham’s
prices to surge as well. Because account- dynamic is to take prompt action to ensure
ing control frauds rise extremely rapidly to that cheaters do not prosper. Regulatory
optimise their short-run “profits,” they will enforcement is often the quickest way to
generally continue to lend to uncreditwor- demonstrate this fact.
thy borrowers even as the bubble extends
for years and hyper-inflates.The Gresham’s Trust betrayed
dynamic and “learning effects” (and, more At law, the defining element of fraud that
technically, the false market price signals distinguishes it from other forms of theft is
that such lenders provide) combine to deceit. To commit a fraud, I get you to trust
encourage other firms to mimic their busi- me – and then I betray that trust. As a result,
ness practices. fraud is the optimal means to destroy trust,
The same dynamic greatly aids the cover- particularly when it comes from our most
up of the true losses because extending the elite business leaders and simultaneously
life of the bubble and increasing its rate of suborns our top professionals and elected
inflation make it easy to obscure loss rec- officials. Regulators did not shut down the
ognition through the repeated refinancing markets during this crisis – bankers did.

Bankers shut down the markets because the appointment of regulatory leaders that
they no longer trusted other bankers. Long despised regulation. Institutions that were
before fraud becomes endemic it can make not regulated by the federal government
markets fail. The first failure, of course, is made 80 per cent of all non-prime loans.
that the regulatory agencies did not iden- Federal Reserve Board Member Gramlich
tify and promptly resolve the accounting warned Alan Greenspan that there was
control frauds that produced the epidemic a housing bubble and asked him to send
of mortgage fraud in the US. I noted, and Federal Reserve examiners in to find the
a Fitch review of a small sample of non- facts about non-prime lending.
prime loan files supports the statement, Chairman Greenspan refused both
that the non-prime lending specialists requests. The Federal Reserve, alone among
followed a distinctive pattern of lending the US banking agencies, had statutory
practices that is irrational for honest firms authority to regulate the normally unregu-
but optimises accounting control fraud. lated mortgage lenders, so Greenspan’s
refusal was fatal. The federal regulators com-
Sectoral failures pounded the criminogenic environment
Fitch stressed that normal underwrit- by acting aggressively to “pre-empt” state
ing would have disclosed that enor- attempts to crack down on predatory mort-
mous numbers of non-prime loans were gage lending.
facially uncreditworthy. Normal bank The failure of the federal regulatory
examination should also have disclosed agencies to clean up non-prime lending,
that pattern. Any review of a sample of even at the banks and S&Ls it did regulate,
the underlying files by the auditors, rat- even after the FBI warned of the “epidemic”
ing agencies, or investment bankers that of mortgage fraud, is inexcusable and a tes-
securitised these facially bad loans would tament to the terrible power of their anti-
have revealed the same evidence. So, regulatory ideology to blind them.
both the private sector and the public sec- The second regulatory failure was
tor failed to prevent an easily preventable after the housing bubble and accounting
epidemic of mortgage and accounting fraud epidemic became inescapably evi-
fraud – which would also have caused the dent in 2006. As soon as housing prices
housing bubble to pop. stalled, the uninsured non-prime lending
The initial regulatory failure was not the specialists began to collapse. By spring
product of inept staff. The Clinton and Bush 2007 the entire secondary market in non-
administrations sharply reduced regulatory prime mortgage loans died and has not
staffing (the FDIC lost over three-quarters of been resurrected.
its personnel and it often used “early outs”
to induce the early retirement of their most Meaningful hearings
expensive (and most experienced) staff. The US Congress finally began to con-
The Clinton and Bush administra- duct meaningful oversight hearings and
tions’ hostility to regulation often led to we discovered that the rating agencies had

done no meaningful underwriting on the common in non-prime loans than prime
“toxic waste” collateralised debt obliga- loans, the first stage approximation in trying
tions (CDOs) backed by non-prime loans. to estimate the total amount of mortgage
The regulators now knew that the largest fraud in a single year is to multiply 62,000
banks did not know how large their losses by five.
were – and were desperately seeking to Extrapolating from the SARs filed by fed-
avoid knowing (and disclosing) those facts. erally regulated lenders to the entire lending
Instead of cracking down on the largest population would greatly understate the
banks (those that followed lending practices true incidence of mortgage fraud for two
that were rational only if they were engaged principal reasons (1) the FBI estimates that
in accounting fraud) by demanding that they lenders only discover about one-third of all
get the information necessary to value their mortgage frauds and (2) FinCEN’s data indi-
assets, the government subsidised them and cates that even regulated mortgage lenders
termed them“too big to fail.” typically do not file SARs when they spot
mortgage fraud.
’Epidemic’ warning FinCEN released data recently on SARs
The third regulatory failure can be inferred filed for mortgage fraud in the first six
from the FinCEN data, and it is disturbing months of this year. Those data indicated
that FinCEN has never drawn the inference that non-compliance with the rules requir-
and put pressure on the federal regulatory ing the filing of SARs is the norm among
agencies to cure the failure.There are roughly federally regulated lenders. FinCEN’s data
10,000 federally regulated banks and S&Ls shows that mortgage fraud SARs expanded
that make mortgage loans. Mortgage fraud in the first-half of 2009 – 3½ years after
became more common after the FBI’s 2004 the non-prime market began to collapse
warning that it was “epidemic.” Regulations and 2½ years after the secondary market
mandate that federally regulated banks and collapsed.
S&Ls file Suspicious Activity Reports when That indicates that the mortgage fraud
they find evidence of mortgage fraud. epidemic continued to grow worse even as
In the last full fiscal year for which the non-prime market collapsed. The FBI
FinCEN has released data, there were more clears roughly 1,000 cases of mortgage fraud
than 62,000 SARs filings. The FBI reports annually, so one can see that the statute of
that 80 per cent of all losses from fraud limitations will foreclose prosecution of the
occur in cases in which lender personnel great bulk of mortgage fraudsters unless
are involved in the fraud. Recall that non- something dramatic is changed.
federally regulated mortgage lenders made
roughly 80 per cent of the non-prime loans Rise in filings
and that such lenders (1) are not subject to This essay, however, focuses on the regu-
federal rules requiring them to file SARs lators rather than the prosecutors. The
and (2) virtually never file SARs voluntar- October 2009 FinCEN report on mortgage
ily. Because mortgage fraud is far more fraud SARs provides these facts essential to

evaluating whether the regulators have been strategy is that the federal banking and
effective: S&L regulators should prioritise for
In the first half of 2009, approximately immediate examination any lender that
735 financial institutions submitted SARs, made significant amounts of non-prime
or about 50 more filers compared to the loans but is not one of the 10 lenders that
same period in 2008. The top 50 filers sub- actually makes a meaningful number of
mitted 93 per cent of all MLF SARs, con- SARs filings.
sistent with the same 2008 filing period.
However, SARs submitted by the top 10 fil- In conclusion
ers increased from 64 per cent to 72 per cent. To summarise, the FinCEN data confirm the
While FinCEN (and the banking regulators) existence of a massive epidemic of account-
do not appear to have made any regulatory ing control fraud that hyper-inflated the
inferences from this data. We can. housing bubble and triggered a global eco-
• The great majority of federally regulated nomic catastrophe. It supports the conclu-
mortgage lenders do not file SARs when sion that de-supervision and the perverse
they find evidence of mortgage fraud. incentives produced by modern executive
Honest lenders should want to make compensation created an intensely crimino-
criminal referrals. Control frauds are gen- genic environment.
erally reluctant to file criminal referrals Accounting control fraud is well
because they do not want to encourage designed to defeat regulators and private
the FBI to send agents to their banks. market discipline that fail to understand the
• A literal two handfuls of banks and S&Ls fraud mechanism. “Risk,” as we think of it
make the overwhelming majority of all conventionally in finance, was not the rel-
criminal referrals. That means that the evant concept. Accounting control fraud is
great majority of banks and S&Ls mak- a sure thing as long as the financial bubble
ing criminal referrals for mortgage fraud is expanding.
do so rarely, even though mortgage fraud The FinCEN data also confirms that the
is epidemic. regulatory and private market discipline fail-
• FinCEN does not report any crackdown ures are continuing and are impairing our
by the regulators enforcing the rules ability to prosecute the elite frauds. •
requiring the filing of SARs despite mas-
sive industry non-compliance with the (Editor’s note: Professor William K.
rules. FinCEN does not even urge or Black is due to visit Hong Kong in May,
demand that the agencies enforce the 2010 as master of ceremonies for an
law. Audit & Accounting evening ‘dialogue’
• FinCEN does not provide any informa- that the Institute is organising in con-
tion suggesting that the federal regulatory junction with the International Auditing
agencies are using the SARs data to pri- and Assurance Standards Board. Further
oritise their examinations, enforcement details can be found on our website at:
actions, and closures. The most obvious http://www. irrna.org)

Debate
An insider’s perspective on
regulatory capture in the US
James Coffman, a former regulatory
enforcement officer at the SEC, takes issue
with online blogger, ‘Bond Girl’.
In August this year, an industry insider Much of the subsequent policy debate
who specialises in municipal bonds and has been focused on whether or not the
uses the blogsite psuedonym ‘Bond Girl’ reforms detailed in the report address these
launched a fusillade against regulatory objectives. This is a political triumph for the
capture by US industry insiders over the administration because it distracts from
past decade on the popular regulatory the report’s one glaring omission – how
reform website: Baseline Scenario. Taking to address a culture of sustained affinity
unbrage at this assault on the regulatory between the supervisors and those who are
profession, James Coffman, who spent supervised.
27 years with the Securities Exchange The administration’s proposal appears
Commission (SEC), decided to set the to portray the financial crisis as nothing
record straight. A full transcript of the more than an accident of reasoning. Because
online bloggers’ debate appears below. financial regulation in our country evolved
in a fragmented manner, regulators’ percep-
Bond Girl . . . In June, the Obama tions of risk were determined by their respec-
administration released a report outlining tive niches when a holistic understanding of
various financial regulatory reforms. The risk was required to predict a market failure
proposed reforms are intended to meet five of this magnitude.
objectives, essentially: (1) to eliminate regu-
lators’ tunnel vision; (2) to regulate certain Extended powers
financial products and market participants It logically follows then that the administra-
that have so far evaded supervision; (3) to tion’s preference would be to create a meta-
protect consumers from unfair and decep- regulator (in this case, by extending the
tive sales practices; (4) to provide a frame- powers of the Federal Reserve and estab-
work for responding to financial crises and lishing an advisory council) to oversee the
the failure of major financial institutions; and supervisory project as a whole and seek out
(5) to promote these efforts globally. system-wide threats. While I am sure no one

would dispute that a holistic understanding the assumption that regulators are not self-
of risk is required to assess financial stabil- interested individuals like the rest of us. We
ity, an even more basic condition of effective think about regulation only in terms of how
regulation is that regulators are motivated to engineer the incentives of the regulated
to provide honest information about the and ignore the fact that regulators them-
institutions they supervise. I am not inclined selves rarely have a stake in doing their job
toward conspiracy theories and I obviously well, which in any other occupation would
do not buy into the caricature of industry limit the motivation and types of individu-
players sold by the mainstream media. als a position attracts. We all know how the
That said, it is clear that there is a large performance of a consistently good trader is
degree of regulatory capture going on in the rewarded. How is the behaviour of a consist-
financial sector, either directly through pro- ently good regulator rewarded?
fessional incest or indirectly through shared
intellectual sympathies, which some players ‘Deep capture’
have been able to exploit to such an extent On the other hand, it is not too difficult to
that it has reduced standards for the entire see what incentives regulators have used
industry. It is also clear that this is hardly a o establish a collaborative posture with
novel development. the industry (again, to be polite), especially
Financial institutions did not amass tril- within the organisation in which the admin-
lions of dollars of toxic assets and tangle istration wants to concentrate regulatory
themselves up in a destructive web of credit responsibilities. The presidents of the Federal
derivatives by accident. Financial institutions Reserve Bank of New York generally come
did not produce and maintain technology from or end up at investment banks. So
allowing them to take advantage of tradi- many Goldman Sachs employees have held
tional investors by accident. A thief was not positions in the Treasury and Fed banks in
able to operate a multi-billion-dollar Ponzi their careers it is a cliché.
scheme for decades by accident. Even beyond this, there is probably some
value transferred just through the association
Considerable complacency or intellectual sympathy with industry-types
We are not talking about the occasional (what Jon Hanson would refer to as “deep
rogue trader here who has bribed his com- capture”) that results in regulators having a
pliance officer. Even within the existing reg- bias they do not recognise.
ulatory architecture, these activities required If one revisits what Fed officials were say-
a considerable amount of complacency ing about financial innovation leading up to
(to be polite) by financial regulators across the crisis, it is not difficult to see that (1) they
agencies, over the course of many years, and thought they were thinking holistically about
through many cycles of political appointees the risks financial innovation posed, and (2)
from both parties. they were not being intellectually honest in
I would argue that the fundamental flaw the information they presented about the
in financial regulation is that it is based on industry. Even the more prescient regulators

figured innovation was a good thing at the For my part, I would propose opening
time. As a rule, supervisors were disposed up financial regulation to a small group of
to explain away risk by market discipline social entrepreneurs. Let people establish
because they believed themselves to belong for-profit companies that can compete for
to a club of people with special, sophisti- government contracts to stress test the hold-
cated knowledge of the markets, and this is ings of financial institutions independently
something they value. From the perspective and audit their records.
of some in the financial industry, it is some-
thing that can be traded. Public scrutiny
Sheila Bair’s argument in the regulatory These contracts can be funded by fees
turf war spectacle that is underway would be charged to the industry that pass through
that these examples illustrate the risk of con- the federal budget and are subject to pub-
centrating supervisory responsibilities in one lic scrutiny. Although the fee income that
entity. But it is not a matter of luck whether supports these entrepreneurs would derive
we get a regulator that is more or less sway- from industry operations, the social entre-
able by the industry. By virtue of regulators’ preneurs will not have the power to establish
incentives, the financial industry is basically the fees themselves, which should reduce
self-regulated. the“shopping”behaviour that already exists
It is unlikely that consumers will ever in financial regulation and with the rating
hold much influence over the realities of agencies.
the financial regulatory process because Some degree of slack will develop as
they are not organised in comparison to with any form of delegation, but that may
the financial industry, which concentrates be reduced to some extent by adding per-
significant resources in the creation of inef- formance-based metrics to the terms of con-
ficient regulators. By and large, consumers tracts or by giving the companies a portion
are not well-informed about what they of recoveries when they identify instances
have at stake in the regulatory process and, of fraudulent behaviour (similar to what the
even if they were, that would not be the sole Internal Revenue Service does with its whis-
determinant of how they define themselves tle-blower programme).
politically. Even if social entrepreneurs pull their
employees from the same pool of talent as
Social entrepreneurs the financial institutions they inspect, the
Adding further layers of guards to guard the opportunity to profit should make them
existing guards ultimately results in infinite less sympathetic to industry interests and
regress. I do not think it is cynical to sug- encourage them to invest in furthering
gest that – absent of an actual paradigm shift their expertise. I would hope this is some-
with respect to accountability in the financial thing most people in the financial industry
industry – we are just going to have more of would support. It would be an opportunity
the rent-seeking that has gone on to date to show the industry still cares about actual
and the economic calamities that ensue. capitalism.

James Kwack, of www.baselinesce- simply were not addressed in any meaning-
nario.com received the following mail mis- ful way.
sive from James Coffman in response to But the majority of regulators I worked
Bond Girl’s recent guest post: “Filling the with were critics of the problem of “capture,”
Financial Regulatory Void.” Coffman agreed not victims. Much of the problem arose from
to let Baseline Scenario and the JRNNA decades of deregulation dating back to the
publish a full transcript of this email. beginning of the Reagan administration.
Elected de-regulators appointed their
Human failings overplayed own kind to head regulatory agencies and
Coffman: Bond Girl’s “Filling the Financial they, in turn, removed career regulators from
Regulatory Void” provided insight into management positions and replaced them
human deficiencies in the current finan- with appointees who had worked in or rep-
cial regulatory system. But it overplays the resented the regulated industries.
human failings of regulators and concludes These new managers and, in many cases,
with a proposed solution that, in all likeli- the people they recruited and promoted,
hood, would turn out worse than the current advanced or adhered to a regulatory scheme
situation. that, at least with respect to the most impor-
But first, in the interest of full disclosure, tant issues, advanced the interests of the
I should tell you that I retired two years ago regulated.
from a management position in the enforce- Bond Girl is right, the industry “captured”
ment division at the SEC after 27 years. So the regulators and the regulatory system. But
I was (and in my heart, I suppose I still am) not in the passive sense that true regulators
a financial regulator. That background prob- over time came to identify too closely with
ably should be taken into account by anyone the interests of the regulated.
who reads this response. This is not a case of financial regulators
There is no doubt that “regulatory cap- falling victim to the Stockholm syndrome.
ture” exists and is a meaningful factor in The vast majority of capture resulted from
the recent failures of our regulatory system. intentional efforts by the finance industry
Many of us in the enforcement division dealt to advance their narrow interests at all costs
with the problem regularly when we sought and defeat meaningful regulation.
input from those in the agency who were
responsible for regulating aspects of the Top-down buyout
securities markets. Unfortunately, we live in a country that can
Over time, regulatory policies and prac- be bought from the top down and the finance
tices had emerged that seemed to contradict industry exploited the situation very success-
the purpose, if not the letter of the law. In fully. But do not blame the regulators. Career
other cases, over-arching issues (e.g. increases regulators are as much the victims of these
in fees charged by investment companies events as the public’s economic welfare.
despite growth that should have resulted The creation of paid social entrepreneurs
in economies of scale and decreasing fees) to perform regulatory functions will not

enhance regulation nor reduce “capture”. Fourth, investment banks should be
I’ve sued too many CPAs over the years for made to eat what they kill. Public owner-
bad audits to believe the answer lies in cre- ship of investment banks coincided with
ating a new class of auditors. Audit clients the industry’s decline into extremely reckless
often “capture” their auditors. The result risk-taking. Investment bankers should be
is bad audits resulting in uncorrected and required to own a significant percentage of
undisclosed financial fraud. the equity in the institutions in which they
The victims are always the sharehold- work (something approaching 50 per cent, to
ers and the market. Besides, using money to pick a number). Having a significant portion
“incentivise”a new, private class of regulators of their net worth tied up in such stock would
plays directly into the hands of the finance provide an incentive to carefully identify and
industry. No matter what the regulatory fee measure risk. It should also reduce outsized
structure may be, government will never be compensation for investment bankers.
in a position to compete with the financial Fifth, there should be greater limits placed
industry when it comes to “incentivising” on the ability of political appointees to oust
regulators-for-hire. career regulators. Make capture more difficult.
Sixth, more financial products and firms
Look elsewhere should be subject to government registration
We need to look elsewhere for solutions to and reporting.
the problems that hamper our financial reg- Seventh, regulators should not be forced
ulatory system. to wear conflicting hats. One cannot pro-
First, we need to look at the structure of mote an industry while protecting the public
the finance industry. Commercial banks got from it. Don’t ask regulators to be industry
into trouble in large part because they ware- cheerleaders.
housed (often off the books) toxic securities Limits can be placed on regulators to
underwritten by their investment banking ensure that they not act without consid-
counterparts within the holding company eration of the impact of their actions. But
structure. over-regulation is not what got us in this
Similar abuses in the past resulted in position. Cheerleaders purporting to be
separating investment banking from com- regulators did.
mercial banking. We should try it again.
Insurance should be split off as well. Bonus plan
Second, no institution should be allowed Finally, the government should adopt a
to become too big to fail. Those that have bonus plan for regulators, run by regula-
already achieved that status should be bro- tors (who would rotate off after short, fixed
ken up. terms, to prevent back-scratching among
Third, we must put in place an effective board members) to provide incentives for
financial consumer protection agency which regulators to excel at the job of regulation.
can counteract the worst consumer practices Recognised, protected and incentivised reg-
of a too powerful industry. ulators will resist capture. •

Accounting update
New international models for

loan loss provisioning
BaFin’s Markus Grund outlines important
revisions arising from the G20, IASB and
FASB draft overhaul of IAS 39.
This autumn may bring answers to basic approaches which differ in the point in
important current accounting questions. time at which risks are recognised in the bal-
By then, the International Accounting ance sheet. The Incurred Loss Model (ILM)
Standards Board (IASB) and the Financial only recognises losses already incurred as
Accounting Standards Board (FASB) part of risk provisioning. The Expected Loss
should have formulated new models for Model (ELM), also known as “through-the-
loan loss provisioning. cycle provisioning” or “dynamic provision-
ing”, also takes into account expected future
The final report of a relevant G20 working losses.
group recommends that a broader range of
information should be taken into account in Asset impairments
future loan valuation. Further, the IASB says The first method, the ILM, has to date
it is also planning to present a draft for the dominated in US-GAAP and International
complete overhaul of IAS 39 this autumn. Financial Reporting Standards (IFRS)
This is to include principles regarding accounting, as set out for example in IAS 39
the recognition and measurement of finan- and SFAS 114. The ILM requires objective
cial assets and liabilities also, particularly, evidence of impairment of a financial asset
of derivatives. The time frame is ambitious, (IAS 39.59 et seq.). The main area of applica-
with a likely driving factor the extensive tion for loan loss provisioning is the “Loans
analyses on the subject of loan loss pro- and Receivables”category.
visioning submitted by the Procyclicality Although the standards for loan loss
working group of the Financial Stability provisioning in IFRS and US-GAAP are
Forum (FSF). formulated differently, there are actually few
material differences. In practice, the primary
Ongoing discussions differences lie in the fact that although both
The subject in itself is nothing new and has standards provide scope for discretion, they
been discussed for years. The focus is on two are used in different ways.

This is not to state categorically that and the time series used to determine the
US-GAAP reserves are higher than IFRS expected default rates. The G20 working
reserves − or vice versa. The general rule is group recommends that the standard setters
that the level of loan loss provisioning var- focus on these details in particular in their
ies according to country and the responsible analyses and discussions. The objective of
supervisor. the future rules regarding provisioning must
be to contribute to the stability of the finan-
Procyclical effects of ILM and ELM cial markets and to safeguard the interests
During an upturn, the incurred loss model of the investors in timely and transparent
means that companies establish lower information.
reserves than would be the case with the This is a difficult balancing act, as the SEC
expected loss model, since few defaults occur. has been criticising over time, cases of crea-
However, in a downturn, there are more tive accounting through excessive establish-
defaults, so losses increase very quickly. ment of reserves in the US. The amount of
profit can actually be influenced by the level
Cause and effect of reserves established. Under the existing
The conclusion: an ILM clearly has procy- accounting standards, it is not always pos-
clical effects. On the other hand, an ELM sible to determine exactly when an objective
leads to higher reserves established during impairment criterion is met.
an upturn and lower profits reported than A popular example discussed in both the-
with an ILM. In a downturn, reserves estab- ory and practice is the question of whether a
lished previously under the ELM compen- customer loan has to be impaired when the
sate the losses, as the defaults were already borrower becomes unemployed or when
taken into account shortly after the loans he falls behind with his payments. It is up
were granted. This is at least the idea behind to the respective credit institution to decide,
the models. as there is scope for both interpretations in
Of course, more precise definitions of the a principle-based standard. The provisioning
terms are necessary before such a model can can therefore be completely different for one
be put into practice. To date it does not seem and the same case. In terms of whole loan
to exist a consensus between the standards portfolios, this seemingly harmless question
setters of what exactly an ELM or “dynamic may result in formidable effects.
provisioning”means. However, if the models
are structured appropriately, there should be Reserves ‘cushion’
a reduction in the procyclicality of loan loss Consideration must also be given to the fact
provisioning which is still evident today. that it is not particularly important whether
the reserve is too high or too low – that is
Future rules often in the eye of the beholder. For example,
The quality of the parameters forming the bank supervisor would not see a major
the basis of such a model is key here. They problem with establishing large reserves,
include the homogeneity of loan portfolios because in times of crisis they could serve as

a cushion. The real question is – what is an company and the supervisory authorities
appropriate level for reserves? The search for about the appropriateness of the limit would
the answer reveals that an ELM takes into be avoided.
account the total maturity of the loan port- The advantage of the ECR model is that
folio and does not focus on an individual accounting would continue to be based on
period, as accounting does. the ILM, but that the expected losses from
the loan portfolio would be clearly recog-
Interesting proposition nised within equity. The disadvantage would
Analysts prefer just this kind of perspective be that there would be no incentive to estab-
because they are particularly interested in the lish reserves, since the tax burden would be
overall quality of the portfolio and the losses unaffected by the amount of reserves estab-
to be expected over the whole cycle. When lished. Many questions about the details
losses occur and how they are distributed remain unanswered.
across the different periods are of secondary
importance in this method. BaFin’s response
The UK Financial Services Authority As the discussions currently stand,Germany’s
(FSA) recently made an interesting concili- Federal Financial Supervisory Authority
atory proposition concerning the ILM and (BaFin) is in favour of a model which clearly
the ELM – the Economic Cycle Reserve differentiates between the actual losses
(ECR). This proposition sees the established incurred and those still expected but which
ILM remain in place for the determination addresses both components in the balance
of profits, but also addresses the notion of sheet. However, the time frame for transition
provisioning for hard times. This is done by to such a model remains a crucial point.
means of a distribution constraint, which Demanding that banks establish addi-
ensures that a portion of equity is reserved tional reserves in the current climate would
as a buffer for the risks expected from loans worsen the crisis. In its position as super-
granted. visor, BaFin sees that the transition will
not be possible until the market situation
Distribution constraint returns to normal. Until then, there is time
The level of the distribution constraint to work on the right solution for investors
could be determined by the compa- and supervisors, even if there are conflict-
ny’s management in consultation with ing interests. •
the supervisory authorities. It would be
explained in a footnote in the annual (Editor’s note: We would like to thank
financial statements. However, it is also BaFin and the German authority’s in-
conceivable that the level of the distribu- house editorial team for kindly granting us
tion constraint be determined on the basis permission to reproduce an edited version
of a fixed percentage. of this article, which first appeared in their
This would have the practical advan- Q3/09 journal, BaFin Quarterly, published
tage that difficult discussions between the in October this year.)

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
Regulatory update
The future of structured

products in Hong Kong
Mallesons Stephen Jacques partner Richard
Mazzochi discusses proposed reforms relat-
ing to structured products in the territory.
Hong Kong’s Securities and Futures Lehman Brothers effectively funded

Commission (SFC) recently issued a amounts due under a swap with the issuer
consultation paper (Paper) that will dra- of the Mini-bonds.
matically affect the structuring, distribu- In apparent response to these issues, the
tion and post-sale treatment of unlisted Paper proposes that:
structured products in Hong Kong. The • special purpose vehicles (SPVs) make
Paper, which also applies to unit trusts, extensive disclosure about any under-
mutual funds and investment-linked lying collateral or swap. Swaps must be
assurance schemes, blesses the use of at a “fair market value and on the best
funds that invest substantially in finan- available terms”. Collateral is subject
cial derivatives. However, its cousin, the to extensive eligibility criteria, includ-
structured product, is to be subject to ing the need to be readily marketable,
extensive new rules. rated and diversified. The Mini-bond
would not satisfy these requirements
The SFC is not acting in isolation. The because the collateral, whilst highly
Paper needs to be considered against the rated, was not liquid or tradeable.
recent controversy concerning Lehman
Brothers and an international trend to tighten Directors’ relationships
the regulation of structured products (par- These changes arise out of the inability
ticularly if sold to retail investors). There are, to quickly liquidate the security support-
however, Hong Kong-specific factors which ing Mini-bonds. SPVs will be required
influence the SFC’s attitude. They arise out to be “independent” of other transaction
of defaults under a retail structured product parties. An accusation made during the
known as Lehman Brothers Mini-bonds. Mini-bond crisis was that the issuer was
These were linked to the credit of sev- not independent of the trustee because
eral well-known entities and collateralised its directors were employed by an entity
by highly rated credit-linked instruments. related to the trustee; and,

• trustees “use . . . best efforts” to enforce be regulated like other investment
rights in relation to the collateral. The products.
trust deed must not contain any term The Paper contains proposals relating to
that may “undermine” any applicable similar issues and other international devel-
provision of the SFC’s new rules. It is opments, described as follows:
unclear what this means but it may deny Product suitability – an expanded role
trustees commonly accepted protections for issuers?
including the power to insist on proper The first significant development is the
instructions and indemnification before proposal that product manufacturers deter-
they take action. mine whether a structured product is suitable
Mini-bonds were sold to more than 40,000 for its target investors. The Paper proposes
retail investors in Hong Kong. The trustee that an issuer confirm to the SFC that a
was unable to seek instructions in respect of product is “designed fairly and is appropriate
a product as complex as Mini-bonds from for the market(s) for which it is intended”.
such a diverse group of investors. The SFC’s Issuers would therefore be required to take
proposal is to require trustees to take action responsibility for product suitability. This
despite these difficulties. issue is also being tested under the common
law.
Trustees’ rights The traditional view is that product man-
The SFC’s approach differs from recent ufacturers are not responsible for determin-
English authority (such as Elektrim SA vs ing the suitability of a product. Responsibility
Vivendi Holding 1 Corp [2008] EWCA Civ rests with distributors because they have the
1178) which supports a trustee’s right to relationship, and direct contact, with inves-
insist on receiving instructions and suit- tors. That view accords with the decision
able indemnification from investors before in the English case, Seymour & Another v
taking action. Caroline Ockwell & Co & Another [2005]
The UK’s Financial Services Authority EWHC 1137 in which a product provider
(FSA) has worked with the Committee of was held not to owe a duty of care to a cus-
European Securities Regulators (CESR) tomer in the absence of direct contact with
on a range of issues arising out of the the customer.
insolvency of Lehman Brothers. Key
issues include: UK court case
• whether complex products can be sold This approach is now being examined
without advice on an “execution-only” by an English court in Financial Services
basis; Compensation Scheme Limited vs Abbey
• the equivalent regulation of products National Treasury Services plc [2008] EWHC
with an equivalent risk profile (regardless 1897 (Ch). A key claim in the case is that
of whether the product is a bond, fund or the product provider collaborated in the
other structure); and development and promotion of a structured
• whether structured deposits should capital-at-risk product with an entity which

marketed the product through independent which could also ultimately be reflected
financial advisers. under the common law.
The product provider created the prod-
uct but did not deal directly with investors. Product pricing and structuring
In response, the product provider denies any transparency.
liability for negligence or misrepresentation The Paper proposes that issuers give
on the basis that it did not provide invest- extensive information to investors and the
ment advice nor did it issue the product pro- SFC including:
motional material. • firm (fair and reasonable) product
The outcome of the case will further price quotations, at least weekly, unless
clarify whether there exist circumstances in the tenor of the product is one calen-
which product manufacturers will be held dar month or less. Break funding and
liable for the mis-sale of products they cre- unwinding costs may be taken into
ate, in respective of whether such liability account;
exists on a regulatory level. • indicative (fair and reasonable) product
valuations daily with material fluctua-
Different approach tions explained; and
Meanwhile, the FSA and European regula- • more extensive financial reporting in
tors have already determined to pursue a dif- English and Chinese.
ferent approach: The Technical Committee of IOSCO
• the FSA has issued regulatory guidance has recently recommended (in its paper
detailing the responsibilities of prod- entitled “Transparency of Structured
uct providers and distributors, which Finance Products”) enhanced post-trade
includes a requirement that product transparency.
design be “fair”;
• CESR has issued a consultation paper Post-trade transparency
which adopts a similar concept, requiring Despite objections by industry partici-
product providers to be satisfied that a pants, including that a post-trade transpar-
product is fit for distribution before mak- ency regime is expensive and inappropriate
ing it available to retail investors; and because structured products are illiquid and
• a Standing Committee of the “non-standard”(meaning customised so that
International Organisation of Securities it is difficult to make comparisons between
Commissions (IOSCO) will examine products), the Technical Committee recom-
suitability standards for retail and whole- mends that IOSCO’s members (including
sale investors and might go so far as to Hong Kong) develop a post-trade transpar-
restrict the offer of particular types of ency regime that should take into account
products to particular types of investors. several factors including:
The SFC’s approach is a change in direc- • the size of the issue;
tion for Hong Kong, but one which is con- • whether the product was publicly
sistent with developments in Europe and offered;

• whether there is a broad investor base; but must be “appropriate” or relate either to
• the degree of standardisation; and listed shares or to products that are “non-
• the cost involved. complex” (that is, a product the structure
Market participants in Hong Kong are of which is so simple that clients can be
concerned about a number of key issues that expected to understand the product and its
emanate from these proposals. In particular, associated risks).
whether: Complex instruments can only be sold
• secondary pricing must be made publicly to retail clients on an advised basis. The
available; appropriateness test is narrower than the
• such pricing need only be provided suitability test in that distributors need only
upon request by the distributor acting on assess whether the client has the knowledge
behalf of its clients rather than “posted” and experience necessary to understand the
and made available to all investors; and risk in relation to the product. Suitability, on
• there are circumstances in which pricing the other hand, also requires an examination
can be suspended – for example, extreme of an investor’s financial circumstances and
stock market volatility. investment objectives.
A key difference between the approach
Product and client classification – reas- taken in Europe and that proposed by the
sessing the “retail investor”. SFC is the SFC’s move away from a subjec-
The SFC proposes that “unlisted derivative tive assessment of investor knowledge and
products”should only be sold to retail inves- experience to an objective requirement that
tors that possess “derivative knowledge”. the investors undergo training.
Unlisted derivative products may not be
sold to retail investors on an“execution only” Key difference
basis (that is, without advice). It remains to be seen whether that training
Knowledge will be taken to exist if the cli- will be conducted by distributors in respect of
ent undergoes training or attends courses on particular products or by other organisations
derivative products. A similar knowledge test with a view to investors obtaining accredita-
will be applied when distributors conduct tion to invest in derivative products.
“know your client” procedures in respect of It is also unclear whether the SFC will
individuals that qualify as professional inves- have regard to IOSCO’s future review of the
tors under the SFC’s Code of Conduct. treatment of sophisticated clients. There is a
growing preference to treat individuals that
Rigorous test would otherwise be exempt because of the
The objective in Europe is similar but the size of their investment as retail, rather than
steps taken are different. The European as wholesale, investors.
Markets in Financial Instruments Directive The SFC’s proposal that retail and pro-
(MiFID) requires a rigorous suitability test to fessional investors undergo training appears
be applied to advised sales. to make it more difficult to draw distinctions
Execution only sales need not be suitable between classes of investors.

The scope of offering regulation and Document (KID) is issued. The technology
disclosure will be similar to that being developed by
The Paper applies to all “unlisted struc- CESR for UCITS.
tured products” which term is not yet defined However, it is unclear whether the
but will include equity-linked deposits and requirement to issue a KID will be limited to
all forms of asset-linked products. Issuers retail sales.
of equity-linked deposits will need to sub-
stantially amend their offering documents to Structured funds
comply with the more extensive disclosure The funds industry will welcome the SFC’s
standards that apply to other retail struc- proposal to recognise the investment by
tured products. non-UCITS schemes in financial derivative
There is no proposal to change the regu- instruments. The aim is to provide a level
lation of currency and interest rate-linked playing field with UCITS III schemes (which
deposits. already enjoy an expanded power to invest
in various types of unlisted financial deriva-
Key fact statement tive instruments).
The SFC proposes that structured prod- Unlike structured products, the Paper
uct offering documents include a key fact does not propose any radical change to
statement (KFS). The KFS is a user-friendly the way funds are structured and distrib-
statement intended to not exceed four uted or pricing is offered in the secondary
pages in length. A template is attached market. It is unclear however, whether
to the Paper together with an extensive unlisted structured funds will be treated as
description of the items that must be dis- “unlisted derivative products” and there-
closed in an offering document. fore require investor training if sold to
Correspondingly, the European Com- retail investors.
mission issued a paper in April 2009 which
sets out its policy on the regulation of retail Conclusion
products (including deposits). The proposal The initial market response to the Paper is
is to apply the MiFID selling process to all mixed – market participants are weighing
products, as well as require UCITS’summary up their responses, which are due before
disclosure (UCITS are a set of European the end of December 2009. Many of the
Union directives that enable collective key proposals are influenced by interna-
investment schemes to be sold throughout tional trends and proposed reforms in other
the EU.). jurisdictions.
It would be difficult for the SFC to refuse
Unified treatment to adopt similar reforms (particularly when
Similar to the SFC’s approach, the intention the failure of Mini-bonds has had such a
is to unify the regulatory treatment of differ- dramatic effect in Hong Kong). The trend is
ent products with similar economic features. clearly closer international co-operation and
CESR proposes that a Key Information consistency. •

North Asia
Articles & Papers
Issues in resolving systemically important financial institutions 59
Resecuritisation in banking: major challenges ahead 67
Dr Fang Du
A framework for funding liquidity in times of financial crisis 75
Dr Ulrich Bindseil
Housing, monetary and fiscal policies: from bad to worst 87
Stephan Schoess
Derivatives: from disaster to re-regulation 95
Professor Lynn A. Stout
Black swans, market crises and risk: the human perspective 101
Joseph Rizzi
Measuring & managing risk for innovative financial instruments 109
Dr Stuart M. Turnbull
Red star spangled banner: root causes of the financial crisis 119
The ‘family’ risk: a cause for concern among Asian investors 125
David Smith
Global financial change impacts compliance and risk 131
David Dekker
The scramble is on to tackle bribery and corruption 135
Penelope Tham and Gerald Li
Who exactly is subject to the Foreign Corrupt Practices Act? 143
Tham Yuet-Ming
Financial markets remuneration reform: one step forward 151
Umesh Kumar and Kevin Marr
Of ‘Black Swans’, stress tests & optimised risk management 159
David Samuels
Challenging the value of enterprise risk management 165
Tim Pagett and Ranjit Jaswal
Rocky road ahead for global accountancy convergence 171
Dr Philip Goeth
The Asia-Pacific regulatory Rubik’s Cube 177
Alan Ewins and Angus Ross


Systemic regulation
Issues in resolving systemically

important financial institutions
Dr Eric S. Rosengren, President & CEO of
the Boston Federal Reserve, calls for greater
co-operation on global systemic risk.
The events of the past two years have resolution authority. [3] Of course, difficul-
brought matters of regulation and risk to ties in dealing with financial troubles in sev-
the top of the list of concerns for national eral European countries have shown that the
and international policymakers. [1] In the United States is not alone. So clearly, the role
past year, crises and resulting failures of played by financial institutions in the current
a number of large internationally active crisis has laid bare the need to rethink how
financial firms have rippled across and systemically important financial institutions
weakened the global economy. Events should be regulated and, if they fail, how they
demonstrated the glaring absence of should be resolved.
resolution powers in the United States As you know, policy-makers in the US
– except in the case of banks – and and many other countries are right now
demonstrated the limited ability of US working through the intricate and challeng-
authorities to intervene in troubled non- ing issues associated with creating a more
depository financial institutions, at least effective regulatory structure, making forums
before the passage of the TARP legisla- like this both timely and important.
tion in the final quarter of 2008.
Preventing contagion
This state of affairs left the United States In a recent talk, [4] I expressed my view that
lacking the tools to smoothly address the fail- we need to have organisations with explicit
ures of “systemically important” institutions responsibility for financial stability (that is,
– those whose disorderly failure could poten- charged with making sure that “contagious”
tially lead to a drop in confidence in the global failures of financial institutions do not occur,
banking system, seize-ups in credit markets, and alert to trends emerging across a swath
the collapse of other financial institutions, and of interconnected institutions and their
worsening economic conditions. [2] Many counterparties. [5] I argued in that talk that
others, including Chairman Bernanke, have a regulator explicitly charged with address-
noted the urgent need to address the lack of ing financial stability probably could have

spotted some of the financial trends leading while for simplicity I tend to refer in my own
up to the crisis. In my remarks today, I would shorthand to a“systemic regulator”– but the
like to make some observations related to distinction is important.
questions about the powers a systemic regu- The financial crisis has highlighted the
lator would have needed in order to miti- pressing need for better resolution proce-
gate some of the problems we have seen. dures. For banking organisations, the FDIC
As you consider the perspectives I share this has the ability to place banks under receiver-
evening, I encourage you to keep at the back ship without going through bankruptcy pro-
of your mind the scale of these regulatory ceedings. However, these resolution powers
challenges. apply only to banks, not other non-bank
financial firms, and do not apply to bank
Systemic regulator holding companies. The resolution power
In the end we need to be able to address of the FDIC allows the FDIC to conduct an
these complex questions and adequately orderly resolution of the bank, which pro-
empower those in the systemic-regulatory tects depositors and provides the least-cost
and resolution roles. If we cannot, we will solution to the government. In the case of
do well to find other ways to limit systemic bank holding companies and non-depos-
risks. In particular, I will focus on the need itory financial institutions, insolvency must
for a systemic regulator to be able to address be addressed in bankruptcy court.
firms’ global operations, and the increased Unfortunately, bankruptcy procedures
use of financial derivatives. are designed to provide a clear priority among
These are key issues because financial creditors, but do not provide any special
institutions are likely to have a larger global provisions for an insolvency that has broad
presence over time, and to be more active in systemic implications. In such situations, it is
financial derivatives. Both trends represent very possible that a preferable public policy
the normal outgrowth of globally integrated would be to minimise systemic implications
economies and financial markets and are not rather than follow the normal creditor prior-
necessarily unwelcome or unhealthy. But the ity set out in the bankruptcy code.
critical point is that the roles and powers of
supervisors and regulators have not kept up The Lehman failure
with these developments. Consider this argument in relation to the
Allow me to make one important dis- Lehman Brothers failure. The government
tinction at the outset. My remarks in this lacked any resolution powers in the case
paper touch on both systemic regulation of investment banks, and Lehman had no
and on the resolution of systemically impor- immediate merger possibilities, so Lehman
tant institutions. Clearly these roles could was forced to file for bankruptcy. The
be carried out by either one entity or by two Lehman failure had broad implications for
separate entities – a systemic regulator and the financial system and economy. The firm
a resolver of systemically important institu- was internationally active, engaged actively
tions. My remarks touch on both functions, in derivatives contracts, and a counterparty

to many other financial institutions glo- potential disruptions to operations associ-
bally, which has resulted in a plethora of ated with ring fencing will likely mean that
legal actions in multiple jurisdictions. Had capital support of foreign operations (that is,
there existed the authority and procedures capital injections) will be a critical part of the
to resolve Lehman outside of bankruptcy resolution procedures. As a consequence,
proceedings, there may have been a more the systemic regulator would need to have
orderly wind-down of the firm’s operations. the power to inject capital or request that the
Treasury inject capital.
Challenging situation • Second, given the speed with which
Of course, the Lehman failure suggests that failures have occurred, it may be difficult
even with resolution powers in place this to incorporate legislative oversight of the
would have been a very challenging situ- resolution process in the short-term – so an
ation – Lehman would have been difficult understanding of such arrangements should
to wind down, in part because of the scope be worked out between Congress and the
of its global operations. Lehman Brothers systemic regulator.
operated in over 40 countries and had over • Third, international agreements on
650 distinct legal operating entities outside receivership procedures for globally active
of the US. While there were many separate institutions will be necessary. What institu-
legal entities outside the US, the firm was tions or agencies will have a role in negotiat-
managed globally – meaning many of its ing these procedures? I certainly believe that
risk management and operating platforms a systemic regulator should have a role.
stretched across its many distinct entities. • Fourth, I would note that policy-mak-
ers will have to sort out the appropriate
Foreign jurisdictions uses of conservatorship (operating the
In the event Lehman Brothers had been bank as a going concern) versus receiv-
placed in receivership in the US, it is ership (which has the goal of liquida-
unclear how Lehman’s operations outside tion) in the case of systemically important
the US would have been treated in foreign institutions.
jurisdictions. In such situations it is possi- • Fifth, a systemic regulator may need the
ble that a country would try to“ring fence” ability to require reductions in foreign expo-
assets so that liability holders in the coun- sures as a systemically important financial
try would be paid prior to returning funds institution encounters problems. This might
to a foreign parent. Such a situation raises include the ability to require that foreign
a number of interesting questions con- subsidiaries and branches be sold to avoid
cerning the role of a systemic regulator. I broader systemic problems, as financial
would like to provide my own perspective problems increase.
on some of these questions – “straw man” • Sixth, perhaps the systemic regulator
approaches, if you will: must be able to influence the “home/host”
• First, for globally active and systemically rules that govern the division of labour in the
important US institutions, I suspect that the supervision of internationally active firms.

• Seventh, a systemic regulator may need bankruptcy, receivership, conservatorship,
the ability to require higher capital require- or governmental equity ownership would
ments for globally active financial institu- provide the best model for resolving compli-
tions that will be difficult to resolve if they cated financial transactions that affect a large
become insolvent. Beyond these challenges number of financial institutions around the
related to global operations, a second prob- globe.
lem highlighted by the crisis is the difficulty • Third, a systemic regulator may need
in managing the derivatives book of global the ability to require financial institutions
financial institutions. to reduce their derivatives exposure as they
become financially troubled. This might
Costly unwinding include the ability to require the selling of
While derivatives contracts were a problem broker or dealer operations in major markets
in the case of Lehman’s failure, they were as a firm’s financial position deteriorates.
particularly acute in the case of American • Fourth, a systemic regulator will likely
International Group (AIG). Because of the seek higher capital requirements for firms
presence of complicated, interrelated finan- that are active counterparties or dealers in
cial contracts, the unwinding of the deriva- complicated financial products.
tives positions of AIG has been costly and
time consuming. Future resolution challenges
Increasingly, derivatives and other forms While the problems of 2008 highlighted
of structured finance are inherent in the oper- the difficulty of resolving financial institu-
ations of large global financial institutions. tions with large global operations and active
However, the presence of a small number involvement in derivatives, these problems
of global financial institutions as significant are likely to be even more important in the
counterparties or dealers in the derivatives future as commercial banks expand opera-
markets has made such institutions very dif- tions further overseas. Looking forward,
ficult to resolve, whether through bankruptcy as more and more customers of financial
or through receivership. This raises several institutions are either global themselves, or
interesting issues and questions, which I will have supply lines and sales channels that are
provide my own current views on: global, they will expect their financial institu-
• First and very importantly, I believe a tions to have global operations.
systemic regulator should have the ability US banks that are internationally active
to require that transactions be moved to an hold 18 per cent of assets in foreign offices.
exchange as the contract becomes standard- Over time, foreign operations seem more
ised and widely used. likely to grow than contract in an increasingly
• Second, I believe that in finding the most global economy. As US financial institutions
efficient way to resolve complicated finan- become more involved around the globe, it
cial transactions in the event a major player is likely that these institutions will become
becomes insolvent, the systemic regulator more important in their host countries and
would need the ability to explore whether more difficult to resolve should they become

financially troubled. In this regard, I would country’s economy – more so, in relation to
suggest the following about some of the key the country’s GDP, than any one US finan-
issues that will emerge: cial institution does in relation to US GDP.
• First, a key issue will involve the willing- Derivatives contracts have become
ness of home and host countries to supervise increasingly important for financial institu-
and, more importantly, potentially bear the tions – to support their customers, to serve
burden of financially supporting the opera- as brokers or dealers, and to hedge their own
tions of a large and systemically important positions.
financial institution, if it becomes troubled. Over time, the size of the gross deriva-
This could alter what we have tradition- tives positions of the five largest commer-
ally seen as the roles of home and host cial banking organisations most engaged in
supervisors. derivatives activity has become quite large
• Second, it will be important to determine relative to their assets. These positions are
how best to structure US financial firms likely to get larger over time, and substantial
abroad, to minimise the potential for disrup- derivatives operations are likely to be impor-
tion if the firm becomes insolvent. Of course, tant for more and more financial institutions.
foreign firms have significant involvement Given their complexity and likely growth,
in the US economy. Some foreign banks we need to explore the implications for bank
operate large subsidiaries in the US; oth- regulation and the role of a systemic regu-
ers have very large branch operations. As a lator, and indeed to better understand their
result, if the parent company has financial potential impact. [6]
problems, it can have a downstream impact
on the US economy. Should foreign banks In conclusion
shrink as a result of financial problems, US Greater integration of the world economy
borrowers may find it more difficult to secure and financial markets is both desirable and
financing. inevitable. However, our ability to manage
This too raises several questions, about insolvency risk of key players has not grown
which I observe the following: with these developments. The presence of
• First, it will be important to determine globally active financial institutions involved
whether there should be a preference for in derivatives operations worldwide requires
branch versus subsidiary structures in sys- a major rethinking of how we supervise and
temically important institutions. regulate systemically important institutions.
• Second, where the financial institutions Until global resolution policies are adopted,
are large relative to the size of the home resolution of internationally active organisa-
country, there will need to be expectations tions will remain problematic.
and obligations of the home country. How Both of the issues I have discussed in
explicit these should be will need to be this paper – global activity and derivatives
determined. We should note that in some involvement – would be important for any
countries, systemically important financial regulator charged with systemic responsi-
institutions figure very prominently in the bilities. Of course, a systemic regulator will

need to consider many other issues besides [2] In remarks on April 14, 2009, Chairman
the two I have highlighted today – including Bernanke noted that: “Large, complex financial
issues such as leverage, liability management, institutions tend to be highly interconnected with
and securitisation – but given the constraints other firms and markets. For example, AIG. A
on time these additional issues will have to disorderly failure of AIG would have put at risk
be a topic for another day. not only the company’s own customers and cred-
Bankruptcy laws and resolution proce- itors but the entire global financial system.
dures are national. Home country financial Historical experience shows that, once begun,
supervisors have a national focus, and bank a financial panic can spread rapidly and unpre-
regulations apply within the firms’ national dictably; indeed, the failure of Lehman Brothers
borders. However, as financial firms increas- a day earlier, which the Fed and the Treasury
ingly span national borders, much greater unsuccessfully tried to prevent, resulted in the
co-ordination is necessary. This is particu- freezing up of a wide range of credit markets, with
larly true as the size of financial institutions’ extremely serious consequences for the world
on- and off-balance sheet exposures become economy.
large relative to the home country’s financial
capacity to provide emergency support to the Catastrophic consequences
financial institution. In some countries the The financial and economic risks posed by a col-
focus of financial institution resolution has lapse of AIG would have been at least as great as
seemingly been the protection of govern- those created by the demise of Lehman. In the
ment-run deposit-insurance programmes case of AIG, financial market participants were
– a local mindset at odds with a potentially keenly aware that many major financial institu-
global issue. Increasingly their attention will tions around the world were insured by or had
need to focus on potential systemic prob- lent funds to the company. The company’s fail-
lems with global ramifications. ure would thus likely have led to a further sharp
I hope the issues raised in this paper have decline in confidence in the global banking sys-
provided a sense of the urgency, and also the tem and possibly to the collapse of other major
complexity, of these issues. I have given my financial institutions.
own views on some of the key questions At best, the consequences of AIG’s failure
that policymakers must ultimately consider. would have been a significant intensification of
I’ll conclude by noting that the complexity of an already severe financial crisis and a further
these issues makes it no less important that worsening of economic conditions. Conceivably,
we address them, for the good of all partici- its failure could have triggered a 1930s-style glo-
pants in our economies. • bal financial and economic meltdown, with cata-
strophic implications for production, incomes and
Notes: jobs. (from “Four Questions about the Financial
[1] Of course, the views I express today are my Crisis,”; see http://www.federalreserve.gov/news-
own, not necessarily those of my colleagues on events/speech/bernanke20090414a.htm)
the Board of Governors or the Federal Open [3] In remarks on April 14, 2009, Chairman
Market Committee ( FOMC). Bernanke noted “that federal regulators urgently

need a new set of procedures for dealing with a failures could involve a large group of finan-
complex, systemically important financial insti- cial intermediaries, all with a prominent
tution on the brink of failure. Such rules already shared risk exposure, or could involve one
exists for banks: If a bank approaches insolvency, key player becoming insolvent but many
the FDIC is empowered to intervene as needed other financial institutions failing because
to protect depositors, sell the bank’s assets, and of their exposure as counterparties to that
take any necessary steps to prevent broader con- institution.
sequences to the financial system.
However, for an insurance conglomerate like Identifying systemic problems
AIG, or for a large financial holding company that This definition does not require that the involved
owns many subsidiary companies, these rules do organisations are depository institutions, nor does
not apply. Among other things, a good system for it hinge on the presence of deposit insurance. A
resolving non-bank financial institutions would key point is that the systemic regulator cannot just
allow federal regulators to unwind a failing com- look institution by institution, but needs to think
pany in ways that minimise disruptions in finan- about the potentially difficult trends emerging
cial markets. across a swath of interconnected institutions and
An effective regime would also provide the their counterparties. And while it may go without
authorities greater latitude to negotiate with saying, for a systemic regulator to be effective, the
creditors and to modify contracts entered into by regulator must be able to identify whether actual
the company, including contracts that set bonuses systemic problems are emerging. This involves, in
and other compensation for management.”(from part, assessing the “feedback effects” that might
“Four Questions about the Financial Crisis,”avail- result from initial problems.
able at http://www.federalreserve.gov/newsev-
ents/speech/bernanke20090414a.htm) How things work
[4] “Could a Systemic Regulator Have Seen [6] As I noted in a recent speech, an effective sys-
the Current Crisis?” See: http://www.bos.frb.org/ temic regulator would need to have very detailed
news/speeches/rosengren/2009/041509.htm understanding of institutional practices and prod-
[5] As I have noted in earlier talks, unlike ucts – simply put, how things really work, in good
most prudential supervisors that focus on the times and bad. For example, the complexities of
solvency of individual financial institutions, a the servicing business model and the reasons
financial-stability regulator would clearly need to why it presents challenges in a declining market.
take more of a “macro” perspective on financial Another example is the market for credit default
trends (and their crosscurrents and unintended swaps, which ballooned but still seems less well
consequences). understood than is desirable. •
‘Contagious’ failures (Editor’s note: We would like to thank the

My assumption is that a financial-stability Federal Reserve Bank of Boston for allow-
regulator would be charged with making ing the Journal of Regulation & Risk – North
sure that what I will call“contagious”failures Asia to reproduce Dr Rosengren’s speech
of financial institutions do not occur. Such delivered in Hong Kong on May 5, 2009.)

Securitisation
Resecuritisation in banking:
major challenges ahead
Dr Fang Du of the US Federal Reserve
System looks at the forgotten frameworks
associated with the pillars of Basel II.
In the process of Basel II development from a severe shortage of securitisation pro-

and implementation, most financial insti- fessionals; it lacks the knowledge of select
tutions and banks, as well as regulators, products and instruments that are defined
have focused their efforts and resources as securitisation exposures; it faces the chal-
on wholesale and retail frameworks, lenges of identifying securitisation exposures
while the securitisation framework, anal- across multiple business lines; and it lacks
ogous to Pillar II and Pillar III is being the framework to systematically handle cap-
labelled as “forgotten”. The pillars, ital calculations corresponding to a variety of
though extremely important, were given approaches.
minimal attention by Basel II project
offices in banks and regulatory agencies Risk ‘disconnect’
until the financial crisis broke out. The current financial crisis unveils flaws
of the creditworthiness embedded in secu-
This phenomenon occurred due to mis- ritisation products, especially products such
conceptions about the creditworthiness of as CDO-squareds. Practitioners from the
securitisation products, since roughly 90 per financial and banking industries and regula-
cent or more of tranched securities yielded tors from banking supervision and regula-
from securitisation were crowned with tri- tion agencies had raised concerns for years
ple-A ratings prior to the current financial about the risk assessment and measurement
crisis. This misconception directly influenced for securitisation/resecuritisation exposures.
progress in implementing the Basel II securi- There exists a disconnect between the
tisation standards which, in my opinion, has perception of risk for business lines that
lagged behind the progress of implementing originate the underlying assets and those
Basel II wholesale and retail frameworks for which securitise the underlying assets,
at least four or five years. and another between the risk valuation for
Regardless of the size and complexity of lenders who use conventional credit risk
the bank, the Basel II project office suffers methods and securitisers who use market

risk driven methods. Generally, professionals traditional rating practices and adopted fan-
in securitisation programmes lacked suffi- cier quantification techniques to issue rat-
cient knowledge of how consumer business ings for these structured products without
lines – such as mortgage, home equity and thoroughly testing whether the underlying
credit card – booked their loans and assessed assumptions used in modelling approaches
credit risk such as defaults and prepayments were commensurate with the real situation
corresponding to their internal policies and and whether the risk measures, reflected
procedures. through correlations, delinquencies, defaults
and loss severities, would be sustainable
Mathematical problem through a severe economic downturn.
By the same token, the business lines that Most of the risk ratings assigned to the
sold these loans to securitisation programmes resecuritisation products have failed accu-
had little understanding of how these loans racy and stability measures in the current
were packaged and structured and of how financial turmoil. The risks embedded in
structural features link to rating grades. Raters the resecuritisation products were severely
in rating agencies who assigned investment understated. Some, if not all, resecuritisation
ratings to these structured products were products have severely damaged their own
technically qualified on one hand, employing reputations, as pointed out in The Economist
advanced statistical modelling and compu- on May 14, 2009: “Ludicrously complex
tation skills, while lacking minimal banking securitised products, the CDO-squareds and
and portfolio management experience on -cubeds, have gone forever.”
the other. Somehow, the process for assign-
ing ratings evolved to become more or less Enhanced treatments
an academic mathematical problem-solving The gross underestimation of credit risk for
exercise rather than truly comprehending resecuritisation exposures inspired the Basel
the fundamentals underlying these financial Committee on Banking Supervision (BCBS)
products. to enhance the existing Basel II securitisation
Consequently, lenders switched their framework, which previously did not distin-
focus to short-term asset turnover rather guish between the different levels of credit
than to long-term customer relationships, risk inherent in resecuritisation and those
which induced the widespread adoption of traditional securitisation products. In July
of lax underwriting criteria. As revenues 2009, BCBS issued enhanced capital treat-
swelled, securitisers generated abnormal ments that specifically apply to resecuritisa-
demand on loans/lines by accelerating the tion exposures.
packaging speed and producing a range of This article is composed of three sections.
creative fancy financial products while ignor- The first section introduces the definition of
ing whether the risk attached to securitisa- resecuritisation exposures and provides sev-
tion products was actually compatible with eral examples.The second presents a new set
the supporting underlying assets. of risk weights designed specifically for rese-
Rating agencies deviated from their curitisation exposures corresponding to both

short-term and long-term risk ratings. The power CDOs, resecuritisation exposures
enhanced operational criteria, which directly may be relatively easy to recognise since the
impact the capital charge, will be explained product names speak for themselves. CDO
in the third section for the significant role of ABS also qualifies as a resecuritisation
that they play in the resecuritisation capital exposure.
framework. A typical example for this class is
RE-REMIC, which has recently shown
Resecuritisation defined growth potential in the United States.
The following definition of resecuritisation is RE-REMIC is a repackage of securities backed
an excerpt from ‘Enhancements to the Basel by residential mortgage backed securities
II framework’: (RMBS) or by commercial mortgage backed
“A resecuritisation exposure is a securi- securities (CMBS). The underlying pool for
tisation exposure in which the risk associ- RE-REMICs varies in its many forms, rang-
ated with an underlying pool of exposures ing from a mix of prime jumbo RMBS and
is tranched and at least one of the underly- Alt-A securities to only one downgraded
ing exposures is a securitisation exposure. In or potentially downgraded AAA tranche to
addition, an exposure to one or more rese- existing CMBS bonds.
curitisation exposures is a resecuritisation For example, Morgan Stanley has
exposure.” launched a $210 million RE-REMIC with
There are two key components worth only one bond as the underlying pool, the
noting in this definition. The first is that a Goldman Sachs Mortgage security 2007-
resecuritisation exposure reflects a tranched GG10. Conversely, Bank of America is work-
exposure with the credit risk separated into ing on a similar RE-REMIC transaction, but
at least two different levels with different the underlying pool includes multiple CMBS
seniorities. The second piece refers to the securities, exactly nine super-senior com-
underlying pool in which there is at least mercial pass-through certificates securitised
one exposure classified as a securitisation between 2006 and 2007.
exposure. The US Basel II final rule for the
advanced approach defines the securitisation Moody’s rating
exposure as “an on-balance sheet or off-bal- Finally, Citigroup’s underlying pool for the
ance sheet credit exposure that arises from a RE-REMIC transaction, Citigroup Mortgage
traditional or synthetic securitisation”. Loan Trust 2009-7 Group 5, contains two
This definition would cause challenges classes, 5A1 and 5A2, rated Aaa and C
for many, if not all, banks that are engaged respectively by Moody’s and was backed
in securitisation relevant businesses such as by Class A-2 Mortgage Pass-Through
origination and/or investment in identify- Certificates – Series 2005-60T1 transaction –
ing all resecuritisation exposures. For some from CWALT, Inc, which is backed by mort-
resecuritisation products often supported gages that are considered Alt-A.
by CDO underlying pools such as CDO- The example of CDO-squareds or
squareds, CDO-cubeds and even higher RE-REMICs demonstrated above is

relatively straightforward for determining is classified as a resecuritisation exposure.
whether a tranched exposure is a resecuri- Similarly, the credit default swap (CDS) used
tisation exposure. The challenge remains to as a risk mitigation tool on a resecuritisation
identify resecuritisation exposures for which security such as a CDO-squared tranche
the underlying asset pool is composed of a is treated as a resecuritisation exposure. To
mix of loans, bonds and securitisation secu- make the matter more complicated, the
rities. As illustrated in the Basel II enhance- identification of resecuritisation exposures
ment, any tranched position exposed to a associated with ABCP programmes will be
pool of many asset types containing at least structure dependent and may need to be
one securitisation exposure is considered a determined on a case-by-case basis.
resecuritisation exposure. Generally speaking, a pool-specific
liquidity facility with full coverage would not
Identification problem be classified as a resecuritisation exposure
Banks possessing securitisation positions or unless the underlying asset pool includes
engaging in originating securitisation trans- at least one resecuritisation exposure.
actions should go through all of these expo- Conversely, the programme-wide credit
sures, check the composition of underlying enhancement representing a tranched posi-
asset pools, and check whether there is at tion would be classified as a resecuritisation
least one asset categorised as a securitisation exposure as long as one of the asset pools
exposure in the underlying pool. contains securitisation exposures such as
This identification process is time-con- CBOs or CDOs.
suming and burdensome for many banks. The current financial crisis clearly high-
Given the complexity of the structural fea- lights the higher risk inherent in resecuriti-
tures built into some resecuritisation prod- sation exposures. To make the capital charge
ucts, if banks are not sure whether the commensurate with the risk level, BCBS has
position should be identified as a resecuriti- expanded risk weight tables of securitisations
sation exposure, they are encouraged to con- for both standardised and IRB approaches
sult their national supervisors. by distinguishing the risk embedded in rese-
Given that many banks have currently curitisation exposures from that of traditional
faced difficulties in identifying some of their or synthetic securitisation exposures.
securitisation exposures across multiple
business lines, the additional requirement of IRB approach
separating resecuritisations from securitisa- There is a significant increase in the risk
tions expands the workload of the Basel II weights for resecuritisation exposures, but
securitisation implementation. the granularity plays no role in this new set.
Exposures linked to one or more rese- Table 1 (see page 72) presents the risk weights
curitisation exposures are also classified as applied to securitisation and resecuritisa-
resecuritisation exposures. If a bank bought tion exposures by using the IRB approach.
a guarantee to hedge an inherent risk in Assuming that a bank held a senior position
a resecuritisation tranche, this guarantee of a $100 million AAA RE-REMIC security,

the capital charge would be $1.6 million ($100 risk weights proposed for non-senior rese-
million x 20% x 8%) based on a new risk curitisation exposures. The current finan-
weight, which is roughly three folders high to cial turmoil clearly exhibits the mistakes or
a non-enhancing capital charge, $0.56 million shortcomings of insufficient due diligence
($100 million x 7% x 8%). Although this is just performed on investing tranched securities.
an example, the impact of the new approach
is significant. The standardised approach has No questions asked
also made corresponding changes to increase Investors put too much faith on rating agen-
risk weights on resecuritisation exposures (see cies’ rating assignments and relied too much
Table 2 on page 72). on rating distributions for these types of
Chart 1 (see page 72) shows the signifi- securities without thoroughly understand-
cant increase in the risk weights for resecu- ing either the credit risk associated with the
ritisation exposures under the IRB approach. underlying pool or the structural features of
For the same investment grade, the risk the securitisation which may disrupt the pay-
weight for a resecuritisation exposure is ment schedule. Moreover, none questioned
roughly three times the risk weight of a the sustainability of the rating methodolo-
securitisation exposure. For non-investment gies, which had not previously been tested
grades, the difference between securitisation through a full economic cycle. Sellers/servic-
and resecuritisation risk weights is also large, ers, ABCP sponsors and SPV administrators
although the multiplier is not as high as that might have made similar mistakes.
of investment grades. As a supplemental request for enhance-
ments to the Basel II framework, BCBS has
Important role proposed additional operational criteria for
The senior resecuritisation exposure clearly credit analysis that apply to the securitisation
plays an important role in the Basel II securi- framework for both SA and IRB approaches
tisation framework. A senior resecuritisation as well as for securitisation exposures on the
exposure means that this resecuritisation banking book and the trading book.
exposure has a first priority claim, exclud- Regardless of whether the securitisa-
ing fees due under interest rate or currency tion exposure is on- or off- balance sheet,
derivative contracts, and fees due or other banks are required to have a comprehensive
similar payments on the cash flows from the understanding of the risk associated with
underlying pool. In addition, the underlying this exposure. Three core building blocks –
pool must not include any resecuritisation the underlying asset pool, the structure of
exposures. a securitisation transaction, and the quality
For example, CDO-cubeds have to slot of sellers/servicers – directly impact the risk
into the non-senior category. If a resecuriti- characteristics of a securitisation exposure.
sation does not have a first claim on the cash Prior to the financial crisis, many securi-
flow or the underlying exposures include tisers and raters unfortunately did not realise
at least one resecuritisation exposure, this that understanding the risk characteristics
resecuritisation exposure has to use the of underlying asset pools is the foundation

Table 1. Risk weight table for securitisation and resecuritisation exposures using the
IRB approach
Securitisations Resecuritisation exposure
Long-term Senior, Non-senior,
Non-granular Senior Non-senior
Rating Granular Granular
AAA 7 12 20 20 30
AA 8 15 25 25 40
A+ 10 18 35 35 50
A 12 20 35 40 65
A- 20 35 35 60 100
BBB+ 35 50 50 100 150
BBB 60 75 75 150 225
BBB- 100 100 100 200 350
BB+ 250 250 250 300 500
BB 425 425 425 500 650
BB- 650 650 650 750 850
Below Deduction
Table 2. Risk weight table for securitisation and resecuritisation exposures using the
standardised approach
Long-term rating Securitisation exposures Resecuritisation exposure
AAA to AA- 20 40
A+ to A- 50 100
BBB+ to BBB- 100 225
BB+ to BB- 350 650
B+ and below or unrated Deduction
Chart 1. Risk weight table for securitisation and resecuritisation exposures under
the IRB approach
900
800 Senior, Granular
700 Non-senior, Granular
600 Non-granular
500 Senior
Non-senior
400
300
200
100
0
AAA AA A+ A A- BBB+ BBB BBB- BB+ BB BB-

for supporting the performance of tranched drill down underlying exposures, the second
securities. I have pointed out this weakness stage of the procedure deals with the bottom
at the beginning of this article. of the underlying asset pool(s), which can be
BCBS has expanded the operational wholesale or consumer loans and lines, cor-
criteria and now requires banks to fully porate bonds, municipal bonds, and other
understand, on an ongoing basis, the risk financial assets other than tranched securi-
characteristics of the underlying pool, which ties. The previous paragraph explained the
is quite specific and includes but is not lim- risk monitoring process for the bottom of
ited to exposure type, delinquency status underlying asset pool.
such as 30, 60, and 90 days past due, default
rate, prepayment rate, an internally or exter- Structural features
nally developed average credit score, and There is no doubt that understanding the
average loan-to-value ratio. risk characteristics of the underlying asset
If the underlying assets are relevant to pool is essential, but understanding the
real estate, banks are required to moni- structural features of the securitisation is
tor the foreclosure rate, property type, and just as crucial because they directly affect the
occupancy status in a timely manner. Banks credit risk of tranched securities. The level of
are also requested to track the risk factors credit enhancement is taken into account in
that are linked to concentration risk, such as determining the values of tranched securi-
industry and geographic diversification. ties; for instance, loss multiples 4 – 5x of base
Resecuritisation makes the risk moni- case losses for triple-A and 2 – 3x for single-
toring process more complex. Banks need A according to one NRSRO’s criteria.
to develop a two-stage tracking procedure Additionally, the formation of credit
to monitor at least two layers of underlying enhancement varies through the structure of
asset pools. The first stage of the risk moni- subordination, over-collateralisation, reserve
toring process deals with the top layer of the accounts, or excess spread. Other structural
underlying asset pool, which includes at least features such as early amortisation triggers,
one securitisation exposure. termination events triggers, and diversifica-
tion triggers built into the securitisation trans-
Risk characteristics actions would redirect or interrupt the cash
The second stage reviews the bottom layer of payment to investors when breaching them.
one or multiple underlying asset pools which Therefore, enhancements in the Basel II
support the securitisation exposure(s) in the framework require the bank to have a thor-
top layer. For the top layer of the underly- ough understanding of all structural features
ing asset pool, banks need to understand built in securitisation transactions, specifi-
the risk characteristics associated with these cally although not limited to the contractual
tranched securities, such as issue risk, rating waterfall and waterfall related triggers, credit
stability, tranche thickness, senior or mez- enhancements, liquidity enhancements,
zanine position, triggers built into the struc- market value triggers, and deal specific
ture, and the payment waterfall. To further default definitions of default.

The third building block in securitisation market healthier and more transparent. The
is understanding the risk associated with challenge for banks to comply with these
sellers/servicers. At a minimum, banks need enhancements and regulations remains
to know sellers’ underwriting standards and daunting. We are most likely to see increas-
practices and the servicers’ MIS system for ing demand for extra resources specialising in
tracking underlying assets’ performance and securitisation products, MIS reporting, system
fund collection/transfer. integration, new data entry, data quality con-
Misunderstanding or ignoring any of trol, and risk monitoring and measuring. •
these three building blocks would cause
banks to possibly mis-specify and incorrectly References
measure the risk in securitisation exposures. 1. Basel Committee on Banking Supervision, “Pro-
The expanded operational criteria proposed posed enhancements to the Basel II framework”,
recently by BCBS definitely raise not only January 2009
the bar but also the challenge for banks to 2. Deloitte,“Speaking of Securitisation”, June 2009
comply. If banks fail to comply with these 3. S&P,“US CMBS Rating Methodology andAssump-
criteria for credit analysis, they will have to tion for Conduit/Fusion Pools”, June 26, 2009
deduct the securitisation exposure with a risk 4. Moody’s, “Moody’s Credit Card Report”, July 8,
weight of 1,250 per cent. 2009
5. Deutsche Bank,“Asset-Backed Securities”, July 8,
Daunting challenge 2009
Capital charges raised in enhancing the 6. Basel Committee on Banking Supervision,
Basel II securitisation framework are better “Enhancements to the Basel II framework”, July
aligned with the risk yield from resecuriti- 2009
sation exposures. Moreover, expanding the 7. FFIEC, “Risk-Based Capital Standards: Advanced
operational criteria imposed on securitisa- Capital Adequacy Framework – Basel II; Final
tion transactions will make the securitisation rule”, December 7, 2007

North Asia
Editorial deadline for

Vol II Issue I Spring 2010
February 28th 2010

Central banking
A framework for funding liquidity

in times of financial crisis
In this paper the ECB’s Dr Ulrich Bindseil
looks at optimum central bank support for
bank funding during a liquidity drought.
This article revisits one of the key Committee in 1832 when summarising the
central bank responsibilities relating Bank’s actions in the panic of 1825 as (found
to financial stability, namely the one to e.g. in Bagehot 1873).
provide extra funding liquidity support “We lent . . . by every possible means,
to banks in a financial crisis through and in modes that we never had adopted
market operations. While the impor- before; we took in stock of security, we pur-
tance of this task has been confirmed chased Exchequer bills, we made advances
during the current financial crisis, it on Exchequer bills, we not only discounted
is still subject to misunderstandings, outright, but we made advances on depos-
even after being debated for 200 years. its of bills to an immense amount; in short,
by every possible means consistent with the
In fact, today’s academic doc- safety of the Bank . . . seeing the dreadful
trines on this subject are strongly, but state in which the public were, we rendered
incompletely inspired by 19th century every assistance in our power.”
authors (see e.g. Goodhart, 1999). Also,
an analytical framework to understand ‘Creativity’ to the rescue
how these measures work and how First, it is useful to note that the forego-
the central bank should decide upon ing statement is about aggregate liquidity
them seems to be missing. To start, injection into the financial system, under
recall briefly the “top two” in the all- circumstances of a collective financial mar-
time charts of quotations on liquidity ket liquidity crisis, and not about emergency
support operations of central banks in liquidity assistance to individual banks (as
financial crisis. often wrongly assumed). Second, Harman
“We lent by every possible means con- explains the Bank of England’s action as hav-
sistent with the safety of the bank,” said ing been creative and pro-active, i.e. to have
Jeremiah Harman, director of the Bank innovated to find the best ways to support
of England, during a hearing of the Lords’ funding liquidity of financial institutions, the

only constraint to creativity relating to central collateral back. This is why haircuts between
bank risk taking. banks of similar credit quality tend to be low,
Why exactly should the central bank be while banks impose potentially high haircuts
so engaged in liquidity support to banks in if they lend cash to e.g. hedge funds.This also
a financial crisis as described by Harman? explains why banks would never question
Three main reasons may be considered: haircuts imposed by the central bank (see
(1) Negative externalities of illiquid- also Ewerhart and Tapking, 2008).
ity (and bankruptcy). The central bank
may be ready to engage in liquidity sup- Inertia principle
port measures because of the potential The other most quoted statement of 19th
negative externalities of bank stress and century central banking literature is due
bank default (see e.g. Brunnermeier et al to Bagehot (1873) himself, and states the
(2009). As a public player, it should have so-called “inertia principle” according to
overall welfare in mind, i.e. encompassing which the central bank should maintain
externalities. its risk control framework at least inert and
(2) The central bank is the only eco- accept that its risk-taking increases auto-
nomic agent not threatened by illiquidity. matically in a crisis situation:
Central banks have been endowed with the “If it is known that the Bank of England
monopoly and freedom to issue the legal is freely advancing on what in ordinary
tender: central bank money. Therefore, times is reckoned a good security on what
central banks are never threatened by illi- is then commonly pledged and easily
quidity and it seems natural (even from a convertible, the alarm of the solvent mer-
purely commercial perspective) that in case chants and bankers will be stayed. But if
of a liquidity crisis, in which all agents rush securities, really good and usually convert-
towards securing their liquidity, the central ible, are refused by the Bank, the alarm will
bank remains more willing than others to not abate, the other loans made will fail
hold (as collateral or outright) assets which in obtaining their end, and the panic will
are not particularly liquid. become worse and worse.”
In contrast to Harman, Bagehot does
Power of the ‘haircut’ not emphasise the pro-activeness of meas-
(3) Haircuts as a risk mitigation tool if credit ures taken, but the fact that the central bank
risk is asymmetric. Haircuts are a powerful must remain“inert”and not tighten its risk
tool to mitigate liquidation risk of collateral control framework (e.g. by restricting the
in the case of the default of the cash taker set of eligible collateral for advances), such
(i.e. collateral provider) in a repo operation as other market players would do. While
– however only if the cash taker is more the emphasis is hence somewhat different,
credit risky than the cash lender. Indeed, in Bagehot can also be said to turn this quo-
case of a haircut, the cash taker is exposed to tation around the duality of liquidity sup-
the risk of default of the cash lender, since in port and risk-taking.
case of such default, he is uncertain to get the Starting from this duality, we provide

a general framework for understanding are relevant here in so far as they have
the decisions of central banks with regard issued debt (each 150, as far as contained
to liquidity support operations in finan- in the financial accounts presented) and
cial crisis. This framework allows refining take loans from banks (corporates in total
and generalising the relatively simple 19th 200). (See tables overleaf).
century doctrine on the subject, which is
still so widely quoted today, however often Constrained borrowing
with no or little emphasis on the central Funding stress of banks may result in this
bank risk-taking constraint. framework from deposit withdrawals, if the
The simple system of accounts intro- borrowing from the central bank is poten-
duced in this section allows capturing the tially constrained. There are essentially three
interaction between central bank opera- ways the central bank can, through financial
tions and banks’ funding liquidity in a operations, influence the funding stress of
financial crisis. The system consists of the banks:
balance sheets of four entities, namely the First, the central bank may lend to
central bank, two banks and one house- banks through different more or less con-
hold. Without loss of generality, we assume venient types of lending operations, such
that the two banks are initially identical. as standing facilities or reverse transac-
The household is the sole source of exog- tions allocated through some auction or
enous liquidity shocks. fixed rate procedure, and at various differ-
It may substitute bank deposits with ent maturities.
banknotes (“ΔB” = change of banknotes Second, the central bank defines col-
held by household), which affects refi- lateral eligibility and haircuts for its lend-
nancing needs of banks. Moreover, the ing to banks. Indeed, central bank lending
household may shift deposits between is never uncollateralised. Hence, the quan-
banks 1 and 2 (“Δd” is a deposit shift from tity of central bank eligible collateral after
bank 1 to bank 2). haircuts limits a bank’s borrowing poten-
tial with the central bank.
Liquidity effects buffer Third, the central bank may change
The banks are supposed to buffer out the the total amount and the structure of
liquidity effects of the household’s decisions its outright holdings of securities. In our
through changes in central bank refinanc- closed system of financial accounts, any
ing. The absence of an interbank market such changes will be reflected in opposite
reflects the fact that interbank markets tend changes of securities holdings of the bank-
to break down in a liquidity crisis. For sim- ing system.
plicity, the central bank is assumed to not The idea is that by working on these
impose reserve requirements on banks, such interactions, the central bank can reduce
that banks’deposits with the central bank are the funding liquidity stress on banks, and
normally zero. thereby slow down or stop a financial cri-
The corporate and government sector sis or prevent it from breaking out, such

Household
Deposits with bank 1 100 - ΔB +Δd

Deposits with bank 2 100 - ΔB - Δd Equity 400
Banknotes 200 + ΔB
Total assets 400 Total liabilities 400
Bank 1
Government bonds 50 Deposits of HH 100 – ΔB/2 + Δd
Corporate bonds 50 Borrowing from CB 70 + ΔB/2 - Δd
Loans to corporates 100
Equity 30
Deposits with CB 0
Bank 2
Government bonds 50 Deposits of HH 100 – ΔB/2 + Δd
Corporate bonds 50 Borrowing from CB 70 + ΔB/2 - Δd
Loans to corporates 100
Equity 30
Deposits with CB 0
Central Bank
Government bonds 50 Deposits of HH 200 + ΔB
Corporate bonds 50 Deposits of banks 0
Lending to banks 140+ ΔB Equity 40
Total assets 240+ ΔB Total liabilities 240
that banks do not stop lending to the real needs of financial institutions reduces
sector. funding stresses and, all else equal, should
In the words of Ben Bernanke (Speech: increase the willingness of those institu-
“The Crisis and the Policy Response”, 13 tions to lend and make markets.”
January 2009): “Liquidity provision by Avoiding fire sales is considered essen-
the central bank reduces systemic risk by tial in preventing that a liquidity crisis turns
assuring market participants that, should into an economic disaster as fire sales fur-
short-term investors begin to lose confi- ther depress asset prices and thereby set in
dence, financial institutions will be able to motion a vicious downward spiral (asset
meet the resulting demands for cash with- fire sales lead to lower asset prices and
out resorting to potentially destabilising implied write-offs, increasing capital stress
fire sales of assets. on banks which needs to be addressed
Moreover, backstopping the liquidity through further fire sales, etc.).

Liquidity buffers of banks may be liquidity of each bank using the cumula-
defined either as a deterministic or as a tive Gaussian distribution:
stochastic concept.
PL = U c v m = 1 - U c v m = 1 - probability of illiquidity = 1 - PI
A deterministic concept would be, for DTI - DTI
D D
instance, “Distance to illiquidity” = DTI =
the maximum amount of deposit with- If for instance, then, with DTI = 20, we
drawals that a bank can handle before hav- obtain PL = 1-0.004, i.e. banks become
ing to fire-sale corporate bonds and loans. illiquid (i.e. need to start fire-selling assets)
A stochastic concept would be:“Probability with a four basis points probability (PI =
of liquidity”= PL = the probability that the 0.04 per cent).
bank does not need to fire-sale assets. In a financial crisis, everything will turn
worse for the banks in terms of funding
Government bonds liquidity, even beyond the already assumed
To calculate both measures for the banks in breakdown of the interbank market.
our example, one needs to know what the First, private asset values (in our exam-
central bank accepts as collateral. Assume ple: values of corporate bonds and of loans
that the central bank accepts government to banks) fall and become more volatile.
bonds without any haircut, corporate bonds The implied losses eat into the banks’ capi-
with a 20 per cent haircut, while loans of tal, implying deteriorating perceived credit
banks to corporates are not accepted at all as quality, which may trigger further fund-
central bank collateral. ing problems. Second, asset fire sale costs
The central bank borrowing potential increase because of the decline in market
of each bank is then 90. The actual central liquidity of all asset classes except govern-
bank borrowing of each bank is 70. Hence, ment bonds. Third, deposits become more
the DTI of each bank is 20. The possibility volatile (also, but not exclusively due to
to sell perfectly liquid assets, namely gov- increased credit risk).
ernment bonds, is not relevant for liquid-
ity buffers of banks, since such bonds are Declining assets
anyway accepted without haircut as cen- Finally, the potential borrowing of banks
tral bank collateral. from the central bank suffers in terms of
To calculate the probability of liquid- declining asset and hence collateral values.
ity, PL, we need in addition to take an The central bank may also want to increase
assumption on the probability distribution haircuts on the collateral it accepts; it would
of ΔB and Δd. need to do so if it wanted to keep its risks
Assume, which is obviously a sim- unchanged, in view of the increased asset
plification, that both are independently price volatility (assuming that haircuts aim at
normally distributed, i.e. and respectively. protecting, at some confidence level, against
Therefore, total deposit withdrawals to loss of collateral value during the liquidation
each bank are, writing now, as simply period).
as one can calculate, the probability of The following table shows how the

Table 1: Effects of financial crisis and of central bank measures on funding liquidity
of banks.
Scenarios: (1) (2) (3) (4) (5) (6) (7)
Corp bond value decline 0 10% 10% 10% 10%
(3) but CB sells 50 (3) but CB accepts top
Deposit volatility 6 6 8 8 8 Govt bonds, buys 20% credit claims at
50 Corp bonds haircut of 40%
Haircut on corp bonds 20% 20% 20% 30% 10%
DTI 20 16 16 11.5 20.5 24 28
PI = 1-PL 4 38 228 753 52 13 2
financial crisis (columns 1-3) and changes restrict lending and risk taking vis-à-vis
of central bank operations (columns 4-7) other market participants, which may trig-
affect banks’ funding liquidity stress indi- ger a vicious downward spiral that leads to a
cators DTI and PI = 1-PL. (2) modifies the socially sub-optimal equilibrium. As shown
base scenario in terms of assuming that in the previous section, the central bank can
corporate bond prices fall by 10 per cent. support funding liquidity of banks in a crisis
(3) in addition assumes that deposit vola- in a decisive way.
tility increases from 6 to 8. In (4), in addi-
tion the central bank increases its haircuts Risk budget tolerance
from 20 per cent to 30 per cent to protect But what about Harman’s “safety of the
itself against increased volatility of collat- central bank”? How important should risk
eral values. In (5), the central bank in con- management aspects be for the central bank
trast lowers haircuts to 10 per cent. In (6), when deciding on financial stability meas-
the central bank makes outright purchases ures? What increase in its total risk budget
of non-liquid assets (corporates) and sells should the central bank tolerate? Three
Government bonds. In (7) the central bank different basic answers were given to this
makes loans of banks to corporates par- question:
tially eligible. The highest level of funding (1) Ensure above all credit risk protec-
liquidity stress is reached in scenario (4) tion. According to this approach, the cen-
with a probability of illiquidity of 7.5 per tral bank should protect itself – not on the
cent. In scenario (7), the central bank man- liquidity side, where it is, in contrast to all
ages to push the level of funding stress on other banks, not threatened, but on the side
banks to a level even lower than the one in of credit risk. After all, the central bank is not
the base scenario (1). the best credit risk manager. Hence, when a
crisis with all implied extra risks breaks out, it
Vicious downward spiral should put emphasis on additional risk con-
In a financial crisis, banks are suddenly under trol measures.
both liquidity and solvency stress, and their (2) Active additional risk taking. This
individual optimisation unavoidably brings approach has been advocated by Buiter and
them to the conclusion that they should Sievert (internet blog posted August 12,

2007): “Dealing with a liquidity crisis and are difficult to quantify even in normal static
credit crunch is hard. Inevitably, it exposes conditions. Therefore, ideally, it designs a
the central bank to significant financial and risk control framework in normal times with
reputational risk. The central banks will be which it also feels comfortable in a financial
asked to take credit risk (of unknown) mag- crisis.
nitude onto their balance sheets and they Third, ex ante equivalence between (i)
will have to make explicit judgments about a series of consecutive accesses of banks to
the creditworthiness of various counterpar- the borrowing facility and (ii) a longer-term
ties. But without taking these risks the central refinancing through open market opera-
banks will be financially and reputationally tions (besides the penalty rate and possible
safe, but poor servants of the public interest.” stigmatisation) requires full trust of the bank
The main argument for active extra risk into central bank inertia with regard to all
taking seems to be that the marginal social access conditions to the borrowing facility.
returns of risk taking by the central bank
increase substantially during a crisis. Vast science
(3) Inertia principle. As quoted in the To go beyond these three maybe stereotypi-
introduction, Bagehot 1873 suggests to con- cal approaches, it is useful to be more pre-
tinue lending against what has been “good cise on the risk-taking of the central bank,
securities” in normal times, i.e. he neither namely in the context of the simple financial
invites the central bank to join the flight to accounts presented in section 2. As meas-
quality, nor does he insist that extra liquidity uring risk is a vast science in itself, only the
support measures should be invented. simplest example of a risk measure will be
Beyond the general arguments in favour considered here.
of central bank funding liquidity support to Assume that corporate bond and loan
banks in a crisis, three arguments in favour of portfolios are perfectly granular and that
inertia per se may be brought forward. their change in value is N^ 0, vAh in the
2
period considered. In a reverse repo, the

Complex trade-off central bank has normally a zero return,
First, only inertia ensures that banks can but when the asset value decline depletes
really plan well for the case of a crisis. The the bank’s capital, then the bank defaults
possibility that the central bank would make and the central bank would sell the collat-
more constraining risk control measures or eral, whereby the liquidation value would
would reduce collateral eligibility in crisis sit- suffer, of course, from the asset value
uation would make planning of banks much decline.
more difficult (including stress testing). Government bond prices would be
Second, the central bank is unlikely to unaffected, whereby it is assumed that the
be able to re-assess the complex trade-off banks use first their corporate bonds and,
between optimal financial risk management only second, their government bonds as
and optimal contribution to financial stabil- collateral. The percentage expected loss on
ity anyway at short notice, since both sides reverse repos collateralised by corporate

bonds will be, with h being the haircut on losses will only arise if the asset value decline
corporate bonds and fDA ^ x h being the den- exceeds the haircut. If in contrast the haircut
sity function of percentage changes in asset is lower than bank equity divided by risky
values, and q = - max^ h, E/^ CB + CLhh , assets, losses kick in only when the asset
with E = Equity of bank, CB = corporate declines exceed bank equity divided by risky
bond holdings of the bank, and CL = cor- assets.
porate loans of the bank: For corporate bond outright holdings,
the expected loss (conditional on asset value
= # ^ x - hh f ^ x h dx
E - loss in% on reverse repo q
collateralised with corporate bonds - 3

DA
declines) is simply:
0
= # x.fDA ^ x h dx
E - loss in% of corporate bond
The boundary q of the integral is outright holdings of the central bank - 3
explained as follows: if the haircut on cor-
porate bonds is higher than the relation Obviously, outright holdings are more
between bank equity and risky assets, then risky for the central bank, as they do not
Table 2: Effects of financial crisis and of central bank measures on funding liquidity
of banks.
Haircut
Central bank corp. bond holding
0% 10% 20% 30%
Probability bank illiquid (in bp) 1 25 304 1743
0
Central bank E-loss 8.2 5.3 2.5 0.9
50
100
Figure 1: An example of the trade-off between central bank risk taking and funding
liquidity support of banks (funding liquidity measure = 1 – probability of illiquidity)
1.00
Funding Liquidity of banks
0.95
0.90
0.85
0.80
0 5 10 15
Central bank risk (E-Loss)

benefit from the protection provided by the A somewhat higher L is reached if the
capital buffers of banks. The total E-loss as central bank introduces reverse operations
risk measure can now be compiled easily for and standing facilities, but collateral consists
various combinations of corporate bond out- only of treasury bills, haircuts are on the high
right holdings of the central bank and hair- side, liquidity is provided only to highly rated
cuts, starting from the balance sheets as in counterparties, proportionality limits apply
section 2 and assuming e.g. v = 20% and
2
A (e.g. no bank may borrow more than a cer-
v = 8 . Table 2 (see previous page) provides
2
D tain percentage of some components of its
the E-loss and the probability of illiquid- balance sheet). Higher and higher levels of L
ity for a number of combinations of policy are reached if gradually each of these dimen-
parameters. sions is relaxed further, i.e. a wider range of
It may be noted that some combination of collateral is accepted, haircuts are lowered
policy parameters do not seem to be efficient and limits are relaxed.
in the sense that there are other combina- Finally, a maximum L can be reached in
tions that better support funding liquidity of the extreme scenario that the central bank
banks with the same risk, or that provide the lends freely at any time, i.e. uncollateralised
same funding liquidity support but at lower to all banks without limits. The only reason
risk. The different risk-liquidity outcomes are for a bank to default under such an approach
summarised in the scatter chart below. would be the supervisory withdrawal of the
banking licence due to violation of capital
Conceptual model of the liquidity- adequacy. Apart from this, market control
support/risk taking trade-off of central over resource scarcity would be removed
banks in a financial crisis completely.
Let L be a variable that captures the funding A “mad” bank could buy in one day
liquidity comfort of banks. L depends both anything. There would be no guarantee of
on the state of the financial system (working economically rational behaviour – extreme
of interbank markets, deposit volatility) and leveraging and risk-taking would be possi-
on central bank operations and risk control ble (and likely if capital is depleted anyway).
measures of the central bank. The measure L Incentives to lie to supervisors to delay the
could be specified for instance as the average point of licence withdrawal would be strong.
of individual banks’probabilities of remaining The central bank liquidity supply would
liquid. The minimum central bank support is likely be extremely concentrated to weak
provided if all the central bank liquidity sup- banks. The central bank’s risk taking would
ply is through outright holdings and adjust- be enormous and would depend fully on
ments of holdings of government bills. In how early the supervisor withdraws bank-
this case, there is no way for banks to do any ing licences. Eventually, the credibility of the
individual liquidity adjustment directly via currency will suffer under such an extreme
the central bank. Instead, everything has to approach.
be done via interbank markets or securities Let R be the total risk taking of the cen-
sales or purchase in the market. tral bank, as captured through some risk

measure such as expected loss, value-at-risk, each of the measures Mi and decreasing in x.
or expected shortfall. In practice, the risk Moreover, policy makers have policy
measure should contain market risk and preferences with regard to providing liquid-
credit risk. ity services and risk taking to the market.
Let M={M1,M2,…,Mn} be the array of Assume that W( ) is total welfare, and at the
parameters describing the liquidity supply same time the preference function of the
and associated risk control framework of the central bankers.Then: W=W(R, L) with W( )
central bank. Elements could be, for instance, decreasing in R, and increasing in L. For every
as follows: crisis, and for every intensity of the crisis, the
• {M1} = Width of collateral set (assum- optimal specification of the array {M1,M2,…
ing that assets are ranked from the best ,Mn}, will normally be different, and will also
suited to the least suited as collateral) be different from the pre-crisis array. Denote
• {M2}, {M3}, {M4}= 1- haircuts on collat- by x0 the pre-crisis level of x, and by x1 its
eral of type 1, 2, 3 level in a certain crisis. Also denote with M*
• {M5}, {M6}, {M7}= outright holdings of the array of measures that is optimal, given
assets of type 1,2,3 certain preferences of a central bank and for
• … a specific value of the variable x.
• {Mn} = maturity spectrum of open- The inertia principle could be interpreted
market operations in this setting as saying that M*(x0) = M*(x1).
The elements of the array are defined In practice, we however did not observe dur-
such that liquidity support and risk taking ing the 2007-2009 crisis universal inertia, but
increase with the value of the respective changes in both directions. The optimality of
parameter. Assume that before the crisis, a widening of the collateral set for instance
the array of measures is M(0)={M1\(0),M2(0),…, would mean that for the relevant element
Mn(0)}. i of the array M, Mi*(x0) < Mi*(x1) , i.e. the
Let the state of the financial system be central bank would choose more “liberal”
captured in a variable x. In fact, this variable parameters of its liquidity provision meas-
could also be perceived as an array, contain- ures in the crisis. But one could observe
ing elements such as the functioning of the also cases in which Mi*(x0) > Mi*(x1), i.e. in
interbank market; the level of capital buffers which restrictive measures were taken in
of banks; the stability of funding sources, etc. the crisis. For instance, the ECB, within the
For the sake of simplicity, we treat this as a current crisis, decided at some point in time
single parameter in the presentation below (announced on September 4, 2008) that it
and understand in the sense that the higher would increase the haircut on a number of
x, the more impaired in the financial system. assets. Also, it announced on January 15,
For each combination of measures M and 2009 that it would no longer accept certain
for each crisis intensity x, L and R take certain types of ABS (namely multiple-layer ABS).
values: R=R(M1,M2,…,Mn, x) with R increas- The choice of M, R, L, W, can also be illus-
ing in each of the measures Mi and in x and trated in a possibility set/preference ordering
L=L(M1,M2,…,Mn, x) with L increasing in framework. For every level of risk taking R,

one can achieve a maximum value of L by inequalities should certainly hold. In any
choosing rightly the values of the array M case, it is important to note that the point
(and vice versa). Amongst all pairs on the (R(M*(x0),x1), L(M*(x0),x1)) will rarely be
efficient frontier, the pair chosen eventually on the efficient frontier, i.e. not adjusting any
will depend on the preferences of the cen- measures, i.e. showing full inertia, will rarely
tral bank decision-makers, and will be the be efficient.
one where the possibility set is tangent to an This is further illustrated in the chart
indifference curve. below. To simplify notation in the chart,
The outbreak and intensification of a we write (R(M*(x0),x1), L(M*(x0),x1)) as
crisis will always lead to an increase of risk- RL(M*(x0),x1).
taking by the central bank. Writing The chart shows three possibilities in
R(M*(x1),x1) shortly as R*, this can terms of where the (R,L) combinations could
be expressed as ∂R*/∂x > 0. Whether be in the case of the central bank remaining
R(M*(x1),x1) > R(M*(x0),x1), i.e. whether inert in a crisis. The three cases are different
the measures taken will increase or decrease in terms of how R and L change when mov-
total risk taking relative to inertia is less clear. ing through a change of M to the new opti-
For the liquidity of the banking system: mum. In addition, it could in theory be that
∂L*/∂x < 0, and again whether L(M*(x1),x1) RL(M*(x0),x1) = RL(M*(x1),x1) , i.e. the case
> L(M*(x0),x1) is not totally clear. According underlying the inertia principle. This is only
to Buiter and Sibert (2007), these two a special case that has limited likelihood
Figure 2: Liquidity support and central bank risk-taking: efficient frontier, central
bank preferences, and optima in stable times and in a financial crisis.
Central bank
indifference curves
Efficient frontier of
L= RL(M*(x0), x0) (R,L) pairs for x0
Funding
liquidity
of the RL(M*(x1), x1) Efficient frontier of
banking
system (R,L) pairs for x1
RL(M*(x1), x0) - inertia -

alternative possibilities
R = Central bank risk taking

and plausibility in practice. In developing moral hazard issues. Approaching the moral
further the outlined framework, two issues hazard problem from the risk management
may be of particular interest: First, systemic perspective has the general advantage that
issues were ignored in the simple exam- there are well-developed tools for measur-
ples provided but are, of course, relevant in ing and managing financial risks, while such
practice. The framework allows for easy inte- are absent for moral hazard. •
gration of more sophisticated models with
systemic effects of the relationship between Literature
the central bank operations model for banks’ Bagehot,W. (1873) Lombard Street:A description of
funding liquidity. the money market. London: H.S. King.
Second, the moral hazard dimension Brunnermeier, M,A. Crockett, C. Goodhart,A. D. Per-
could be explored within this framework. saud, H. Shin (2009), “The fundamental principles of
The starting point of this could be the insight financial regulation”, Geneva Reports on the World
that central bank risk-taking and moral haz- Economy 11, International Centre for Monetary and
ard are closely correlated in the sense that if Banking Studies.
central bank losses can be avoided, also no Ewerhart and Tapking (2008), “Repo markets, coun-
undesired re-allocation of resources towards terparty risk, and the 2007/2008 liquidity crisis”, ECB
excessive risk takers takes place. Hence, a Working Paper Series, No. 909, Frankfurt am Main.
conservative central bank risk management Goodhart, C.A.E. (1999),“Myths about the lender of
appears largely equivalent to addressing last resort”, International Finance, 2: 339–60.

Economic capital
Housing, monetary and fiscal

policies: from bad to worst
OCC chief economist, Stephan Schoess,
argues that the current US federal economic
stimulus package is fatally flawed.
The past two years have been interest- three things: First, lessons learned, if any,
ing. The current financial and economic were ephemeral. Second, they revealed
crisis, unless superseded by an even big- the extent to which any pain whatsoever,
ger crisis in the foreseeable future, will short-term or otherwise, is to be avoided.
be discussed and analysed in detail by Third, and maybe most importantly, reac-
academics and political scientists over tions of the authorities to systemic risks, as
the coming years. Whether these analyses in the case of Long-Term Capital, gave the
will come to definite conclusions about implicit guarantee that bigger financial insti-
the cause for the crisis and the reason for tutions have nothing to worry about. It was
the recovery, should there be a recovery, presumed, and in hindsight accurately, that
is questionable. should failure occur the rescue must follow.
The bursting of the Tech bubble in 2000
But how did the US get from what wiped out $7 trillion in market value. Since
seemed like a stable economy to this crisis? investments in the stock market are prima-
In many ways, the current situation is the rily equity financed, there was little or no
culmination of the mishandling of past cri- spillover into the economy’s financial sector.
ses (the Asian crisis, Russian default, Long-
Term Capital, Tech Bubble, etc) which were Fed funds rate slashed
merely papered over rather than fundamen- Nevertheless, government “feared” a reces-
tally solved. Instead of letting the forces of sion, even more so after the 9/11 attacks, and
free markets sort things out, governmental pursued for the next three years “accom-
authorities avoided in each instance the nec- modating” monetary and fiscal policies. The
essary short-term pain by applying surface Federal Reserve began to slash the Fed funds
patches on an otherwise unsustainable path rate from 6.5 per cent in January 2001 to 1.75
of growth-at-all-costs, thereby laying the per cent by year end and then to one per cent
groundwork for the next, bigger crisis. in 2003. The Fed pursued this policy despite
These pseudo-solutions accomplished the fact that the US economy had officially

begun to recover in November 2001. It wasn’t low interest rate environment. The housing
until almost three years into the economic boom allowed buyers to purchase homes
expansion that the Fed began to increase the with no down payment and homeowners to
Fed funds rate in baby steps – 25 basis points refinance their existing mortgages, extracting
at a time – beginning in June 2004 from one equity, often multiple times, thus maintain-
per cent to 5.25 per cent in August 2006. It is ing highly levered positions. A consump-
during this time of monetary easing that the tion boom, not accompanied by industrial
foundation for the next asset bubble – the production and capital spending increases,
housing bubble – occurred. followed. The increase in US consumption
satisfied by imports, largely provided by
Great investment China and other Asian countries, led to rising
Lending borrowed capital, the essence domestic industrial production, income and
of banking, is inherently risky. That risk is consumption in the exporting countries, and
amplified when interest rates are very low. ultimately drove up the demand for energy
Because houses are bought on margin, low and other commodities.
interest rates spur demand for houses. Due The world experienced, between 2001
to the short-run constant housing stock, and 2007, the greatest synchronised eco-
a surge in demand increases not only the nomic boom in the history of capitalism. One
building of additional homes, but also the unique feature of this synchronised boom
prices of existing homes. When people saw was that nearly all asset prices increased
house prices rising and were assured by around the world: real estate, equities, com-
officials and other “experts” that they would modities, art, even fixed-income securities. It
continue to rise because of favourable fun- also invited additional marginal borrowers to
damental conditions, Americans decided enter the market.
that houses were a great investment, and so
demand and prices kept rising. Record profits
In fact, prices were rising because interest Everyone along the food chain stood to
rates were low. When the Federal Reserve, benefit from this process: home appraisers,
fearing inflation – or perhaps another asset mortgage originators, securitisation bankers,
bubble – began raising interest rates in 2005, and rating agencies earned additional fee
the bubble began leaking air and eventu- incomes. Government at federal, state and
ally burst. It carried the banking industry local levels received more tax revenues. And
down with it because banks were so heavily commercial and investment banks earned
invested in financing, directly and indirectly, record profits on their trading and portfolio
the housing market. holdings during this time.
The effects of the housing boom and But all bubbles eventually burst. When
bust were amplified by numerous factors housing prices started to stall and then
including the use of sub-prime mortgages, decline, government’s housing policies
adjustable rate mortgages, and (ex-post) designed to promote “the American dream”
excessive risk-taking encouraged by the very instead produced a pandemic nightmare.

Trillions of dollars in mortgages written to Act all but forces financial institutions to pro-
buyers with slender or no equity led to a vide mortgage loans to risky borrowers that
wave of delinquencies and defaults. Since otherwise would not be made.
borrowers’ losses were limited to their small Government has created this flawed
or nonexistent down payments, the lion’s framework within which individuals and
share of losses was transmitted into the firms will seek to maximise profits and all
financial system whereupon it collapsed. participants have responded to this frame-
work in a completely rational way.
Tax advantages Individuals became home owners due
Too much of the world’s savings went into to subsidies and little or no downside risk.
housing. Such over-investment in housing They extracted home equity to fund other-
would not have occurred under truly free- wise unaffordable consumption purchases.
market conditions. In addition to artificially Individuals indeed felt richer and behaved
low interest rates provided by the Fed, sev- accordingly.
eral other factors contributed to the over- Financial institutions generated huge
investment. profits while providing funding for the hous-
Home ownership is subsidised through ing market. They participated in the process
at least two important tax advantages, which of slicing and dicing the pieces, repackag-
serve to understate the true cost of home ing them into asset-backed securities and
ownership. First, interest payments on mort- selling them to investors around the world.
gages and local real estate taxes are deduct- This securitisation provided additional fee
ible at the federal income tax level. Second, income and at the same time increased the
a home is the only asset with tax breaks for availability of cheap funds for the next round
purposes of capital gains calculations. of mortgages.
Moreover, most local jurisdictions in the
US require that home mortgages are in the In agencies they trusted
form of non-recourse loans. This structure Financial institutions also moved their fund-
has important economic consequences. ing to the shorter end, willing to take liquid-
First, marginal home buyers might decide to ity risk. They either expected future lower
enter the market especially if no, or minimal, rates or relied on the Fed’s willingness to
down-payment is required, because they face provide liquidity and cut interest rates in case
no downside risk. Second, rational mortgage of a downturn in the housing market.
defaults are based on simple calculations of Investors participated in this process,
outstanding mortgages and home values, chasing yield to increase their earnings on
thus leading to more defaults. fixed-income investments if even by a few
Though the Community Reinvestment basis points. They “trusted” the stamp of
Act had been enacted in the 1970s, this piece “approval”given by the rating agencies. After
of legislation was extended under the Clinton all, these rating agencies, few in number, exist
Administration and was pushed by both the with an implicit government mandate.
Clinton and the Bush administrations. The All financial market participants probably

knew that, due to the positive correlation and the government on notice to develop
between return and risk, competition in the contingency plans. But lacking such plans,
financial market will ultimately increase the government’s responses to the developing
risk. Rational firms will accept this higher crisis were at best ad hoc and at worst may
risk and the risk of bankruptcy if profits are actually have contributed to the depth and
high. After all, if profits are high, the costs breadth of the current recession.
of reducing risk are, by definition, also high. The costs to society for this crisis are
And given limited liability, bankruptcy is not indeed huge and include not only the reduc-
the end of the world. tion in home values and other financial asset
prices. It also includes the cost of the under-
Grotesque over-leveraging employment and misallocation of scarce
Things did not turn out as expected. The productive resources, such as labour and
entire US financial system, particularly machines. And inappropriate responses to
Congress-controlled Fanny Mae and Freddie the crisis by government could in the end
Mac, were revealed to be grotesquely over- dwarf all costs already incurred.
leveraged. Thus, problems at a few institu- Money market interest rates rose dra-
tions spread rapidly to others. Such a wave matically in August 2007. Diagnosing the
of bank failures can bring down the entire reason for this sudden increase correctly was
financial sector and the real economy along essential in determining what responses
with it. But the risk of that happening is would be appropriate. If liquidity was the
exogenous to any single bank’s decision- problem, then providing more liquidity by
making process. making borrowing easier at the Federal
Banks and other private financial insti- Reserve discount window would be appro-
tutions are not responsible for assuring the priate. But if counterparty and credit risk was
stability of financial markets or of the econ- behind the sudden rise in money-market
omy at large. This responsibility is, if at all, interest rates, then a direct focus on the qual-
allocated to the Federal Government, more ity and transparency of the banks’ and other
specifically to the Federal Reserve. The Fed financial institutions’ balance sheets would
should have been on guard for asset bub- have been appropriate.
bles, particularly with respect to the housing
industry given the close and intricate con- Wrong treatment
nection between the housing market and The Federal Reserve and the Treasury mis-
the banking industry. The Fed failed miser- diagnosed the rise in spreads as one of
ably at this task. None of the other federal liquidity, and, as a consequence, prescribed
oversight agencies, including the Federal the wrong treatment. The Fed created the
Government, did any better. Term Auction Facility (TAF) in December
This is startling considering that the cri- to provide more liquidity to the market. But
sis is not unique in recent human history. TAF did not seem to make much difference.
The experience of Japan during the 1990s If the reason for the increased spreads was
should at least have put federal agencies counterparty and credit risk as distinct from

liquidity constraints, the results should not plan, though it claimed that passage of the
have been surprising. bill was absolutely necessary or the economy
Another policy response in February would collapse.
2008 was the Economic Stimulus Act of 2008. Treasury’s first TARP iteration focused on
The major component of the bill included a buying “toxic” assets. This failed to materi-
temporary tax rebate sending cash totalling alise due to problems associated with pric-
over $100 billion to individuals and families. ing these assets. In the second iteration,
It was incorrectly anticipated that recipients TARP was to be used to boost banks’ bal-
of the cash would use the additional funds ance sheets. This did not work either, as the
to spend and thus jump-start consumption $45 billion invested in Citibank and Bank of
and the economy. America turned out to be insufficient. Next,
Treasury decided instead to extend loan
Dollar depreciation guarantees of $306 and $118 billion, respec-
A third policy response was the very sharp tively, to the two institutions.
reduction in the federal funds rate from 5.25 The latest initiative, TARP 2.0, renamed
per cent in August 2007 to two per cent in the Financial Stability Plan, tries to entice
April 2008. The major consequence was private capital, in partnership with an ever-
a significant depreciation of the US dollar shifting government, to buy the toxic assets
and a sharp increase in commodity prices, in an effort to set a price. So far, little has
especially energy. Oil prices doubled to over been accomplished and the ultimate verdict
$140 per barrel in July, before falling back of success or failure of TARP is still out.
down as expectations of world economic
growth declined. But by then the damage of Bill goes unread
the high energy and commodity prices had The second stimulus programme of $800
been done to the real economies around billion signed by the current administration
the world. dwarfed the previous stimulus. The bill was
The crisis suddenly worsened in pushed through Congress without anyone
September and October 2008. The credit reading the 1,000 plus pages. The adminis-
crunch further weakened an economy tration claimed that refusing to pass the bill
already suffering from the lingering impact was no option. According to its claim, the
of oil price rises and the housing bust. On already existing structural deficit of $1.2 tril-
Friday following the Lehman failure, the lion would lead to disaster, but an additional
US Treasury announced a new rescue pack- $800 billion would either create or save 3.5
age. The $700 billion TARP was introduced million jobs and would lead the US out of
on September 23. The draft legislation was the recession.
exceedingly broad, devoid of detail, sug- After having purchased commercial
gested no oversight and entailed practically papers, government securities and mort-
no restrictions on the use of funds. The reac- gage-backed securities in unprecedented
tion by the public was decidedly negative. It amounts, the FOMC in March 2009
became clear that government had no real announced it would purchase up to $300

billion in long- term government bonds, savings and during a time when the rest of
with the intent of lowering mortgage rates the world was growing and able to pick up
and other rates on consumer debt. It also the slack.
declared its intention to increase its pur-
chases of mortgage-backed securities guar- Deeper in debt
anteed by Fannie Mae and Freddie Mac by Yet despite Japan’s huge advantages, its
$750 billion. willingness to spend itself out of the reces-
The above is an incomplete list of gov- sion, its attempt to prop up failing compa-
ernmental reactions.The interventions range nies, its propensity to intervene everywhere
from Treasury’s $60 billion Student Loan at any time and its zero-per cent monetary
purchases to the granting of a $500 billion policy, the results have been dismal. Japan’s
line of credit to the FDIC; from FDIC’s $1.4 public sector is now the most indebted in
trillion liquidity guarantees to its $126 bil- the developed world. Japan’s results can be
lion bailout for GE; from the Fed’s $1.8 tril- interpreted in two ways.
lion commercial paper funding to its $900 One school holds that Japan just did
billion Term Auction Facility, HUD’s $300 not act “swift and bold” enough. The other
billion Hope for Homeowners (the plan to argues that government spending drains
prevent home foreclosures), and the Cash resources from productive sectors to less
for Clunkers programme. productive ones. As a consequence, gov-
ernment can only make things worse, as it
Policy evaluation appears to have done in Japan. So what is
After two years in a state of perpetual crisis the likely outcome for the US?
and $14-plus trillion in government spend- • The Real Estate Market – Prices for real
ing, bailouts, guarantees and commitments, estate have continued their downward trend
what has actually been accomplished? Do despite efforts to the contrary. Since far more
implemented policies move the US back onto homes are on the market for sale at current
a long-term, sustainable path? Do imple- prices than there are buyers, the rational
mented policies make any economic, i.e. approach would have been to let home
common sense? Has anyone learned from prices decline until equilibrium is reached.
past bubbles or is the government repeating Instead, US governmental agencies try to
the same mistakes? avoid this pain at any and all costs.
The current US situation is often com- The Fed initiated in November 2008
pared to Japan’s housing bubble some 20 a programme to buy up to $500 billion in
years ago. Undoubtedly the US has a more mortgage-backed securities and up to $100
dynamic and flexible economic system, ena- billion in GSE debt in a bid to lower mort-
bling, therefore, a faster and more efficient gage lending rates to around five per cent,
recovery. But Japan entered the crisis as a a historic low. It is not clear how more easy
creditor nation with huge current account money and housing incentives can cure
surpluses, a relatively small financial sec- the affliction of over-investment in housing
tor, a household sector sitting on trillions in caused by easy money.

None of the preferential tax subsidies 15 per cent of GDP. Though the government
have been eliminated. To the contrary, a new claims a multiplier of 1.5, empirical studies
one was added by the Obama administra- come to the conclusion that deficit spending
tion. “First-time” home buyers now receive a multipliers are significantly below a single-
tax credit of up to $8,000 for buying a home. digit multiplier and actually turn negative
The stimulus bill also includes many down the road.
“refinancing” subsidies and incentives for
current home owners whose home values No free lunches
are “under water”. But the results are not There are no free lunches with regard to
encouraging. A large portion of loans modi- spending, whether public or private. Any
fied under these programmes goes into increased government debt must be repaid
delinquency within a few months. eventually by higher taxes, which are a dis-
Loose mortgage underwriting led to incentive to productivity and investment.
the multi-trillion dollar sub-prime lending This higher tax burden will mitigate any
debacle. Now a parallel sub-prime mar- short-term stimulus from its long-run effects
ket has emerged, all made possible by the on the economy provided by the spending
Federal Housing Authority (FHA), which programme.
now insures nearly one in three new mort- In reality, jobs created by government are
gages, up from two per cent in 2006. generally unprofitable in the sense that they
use up more resources than they produce. If
Fiscal policies the opposite were true, profit-seeking pri-
Many of these mortgages have low or no vate firms would have already funded these
down payment requirements, high risk bor- activities. In this way, government spending
rowers, and in many cases shady mortgage tends to drain the private sector of produc-
originators. Using a leverage of almost 40:1, tive resources while subsidising unprofitable
the FHA is almost certainly going to need a enterprises, projects and ideas. After having
taxpayer bailout in the months ahead. The wrongly allocated trillions into the hous-
days of home buying with little or no money ing sector, more misallocation of precious
down are back – now directly subsidised and resources is the worst possible outcome.
insured by the government. Given the precarious longer-term finan-
It appears that all elements that went into cial position of the federal government due
the making of this crisis remain. Moral haz- to built-in structural deficits, unfunded
ard has increased, additional subsidies have Social Security and Medicare liabilities of
even been added and policies that interfere over $100 trillion, and ambitious new social
in the free interplay of supply and demand programmes on its plate, it is more than
have been strengthened. Nobody can accuse questionable whether the previous and the
the US government of not using “swift and current stimulus bills were prudent. Few
bold” spending programmes to support the seem to ask how these massive deficits will
declining real economy. By the end of this be financed. Since almost all governments
fiscal year, US deficit spending will approach around the world enacted some form of

“stimulus”programme, global savings might questions: First, will the Fed still have the
not be sufficient to finance these massive independence and the political will to raise
undertakings. The gap between demand for interest rates early and fast enough? and,
and supply of funds might lead to signifi- second, how does the Fed expect to reduce
cantly higher interest rates which in turn will the monetary base? Since a large portion
hamper any recovery, to the crowding out of of its balance sheet contains assets of dubi-
the private sector thus further diverting pro- ous quality, who will be willing to buy such
ductive resources to unproductive projects, assets, how quickly, and at what prices?
or to inflation if the debt is monetised.
Most economists agree that the Fed’s Conclusions
easy monetary policy following the dotcom The US has been living beyond its means for
bubble led directly to and fuelled the housing years. It has financed its excess consumption
bubble. To mitigate the effects of the current by borrowing from abroad. The last thing
recession, the Fed lowered the federal funds this over-stimulated economy needs is more
rate to the zero to 25 basis point range, added stimuli. What the economy needs is a true
more than $1 trillion to the monetary base, market driven restructuring, in which bubble
and decided, among other things, to directly activities shrink and resources are re-allo-
intervene in the mortgage-backed security, cated into lines of production that conform
commercial paper, GSE debt and Treasuries to what consumers want and can afford.
markets. Moreover, the Fed involved itself in Instead, the opposite is being done and
rescue operations for banks, insurances and a great opportunity is being missed. The
other firms through direct asset purchases private sector should be increased at the
and/or the granting of guarantees. expense of the public sector. Inefficient and
badly-run firms should die rather than be
Over-leveraged society kept alive with trillions in subsidies. Moral
The Fed’s actions are designed to prop up hazard should be decreased rather than
home prices and to encourage more bor- increased. More transparency is needed, not
rowing by an already overleveraged society. less. Households should be encouraged to
Its latest adventure – the purchase of long- deleverage rather than be enticed to bor-
term government securities – potentially row and spend. Losses should be privatised
signals to the market that the Fed stands rather than socialised.
ready to monetise a substantial part of the The policies will create huge costs that
additional public debt. Overall, the Fed has must be shouldered by a decreasing portion
gone deeper and further than ever before in of the still-productive private sector. Worse,
its history. These interventions are not any the seeds for the next crisis have been sown.
longer just acts of monetary policy – they And the next crisis might make the current
cross the line into fiscal policy and direct one look like child’s play. But then again, the
credit allocation. But the real test for the Fed US just might be able to muddle through.
will come when the economy begins to turn After all, was it not in January this year that
around in earnest. There are essentially two the country entered the “Age of Hope.” •

Insurance
Derivatives: from disaster

to re-regulation
UCLA’s Professor Lynn A. Stout discusses
why derivatives re-regulation will avert a
CDS crisis of epic proportions.
When credit markets froze up in the world’s largest banks, investment funds and
autumn of 2008, many economists pro- insurance companies, when AIG collapsed,
nounced the crisis both inexplicable and many of these firms worried they too might
unforeseeable. That’s because they were soon be bankrupt. Only a massive US$180
economists, not lawyers. billion government-funded bailout of AIG
prevented the system from imploding. This
Lawyers who specialise in financial reg- could have been avoided if we had not
ulation, and especially the small cadre who deregulated financial derivatives.
specialises in derivatives regulation, under-
stood what went wrong. In fact, some even Derivatives ‘de’-regulation?
predicted it. [1] That is because the roots of Wait a minute … some readers might say:
the catastrophe lay not in changes in the What do you mean, ‘de’-regulated deriva-
markets, but changes in the law. Perhaps the tives? Aren’t derivatives new financial prod-
most important of those changes was the ucts that have never been regulated?
US Congress’ decision to deregulate finan- Well, no. Derivatives have a long history
cial derivatives with the Commodity Futures that offers four basic lessons. First, derivatives
Modernisation Act (CFMA) of 2000. contracts have been used for centuries, pos-
It was the deregulation of financial sibly millennia. Second, healthy economies
derivatives that brought the banking system regulate derivatives markets. Third, deriva-
to its knees. The leading cause of the credit tives are regulated because while derivatives
crisis was widespread uncertainty over insur- can be useful for hedging, they are also ideal
ance giant AIG’s losses speculating in credit instruments for speculation. Derivatives
default swaps (CDS), a kind of derivative bet speculation in turn is linked with a variety of
that particular issuers won’t default on their economic ills – including increased systemic
bond obligations. Because AIG was part of risk when derivatives speculators go bust.
an enormous and poorly-understood web Fourth, derivatives traditionally are regulated
of CDS bets and counter-bets among the not through heavy-handed bans on trading,

but through common-law contract rules that – that is, the thing being bet upon – was the
protect and enforce derivatives that are used future market price of rice, wheat or corn.
for hedging purposes, while declaring purely The first “financial” derivatives, in the
speculative derivative contracts to be legally form of stock options, became common in
unenforceable wagers. the 1800s. The 1990s saw an explosion in
other types of derivatives contracts, including
A brief history of derivatives … bets on interest rates (interest rate swaps),
Finance economists and Wall Street traders credit ratings (credit default swaps), and even
like to surround derivatives with confusing weather derivatives. By 2008, the notional
jargon. Nevertheless, the idea behind a deriv- value of the derivatives market – that is, the
ative contract is quite simple. Derivatives are size of the outstanding bets as measured by
not really “products” and they are not really the value of the things being bet upon – was
“traded.” They are simple bets on the future estimated at $600 trillion, [3] amounting to
– nothing less and nothing more. Just as about $100,000 in derivative bets for every
you might bet on which horse you expect to man, woman and child on the planet.
win a horse race and call your betting ticket This sudden development of an enor-
your “derivative contract”, you can bet on mous market in financial derivative con-
whether interest rates on bank deposits will tracts was not the result of some new idea or
rise or fall by entering an interest rate swap “innovation.” Rather, it was a consequence
contract, or bet on whether a bond issuer will of the steady deregulation of financial deriv-
repay its bonds by entering a credit default atives trading.
swap contract.
These sorts of commercial wagers are … and of derivatives regulation
neither new nor particularly innovative. Just as derivatives have been around for cen-
Although derivatives have gone by many turies, so has derivatives regulation. In the
different names, derivatives contracts have US and UK, derivatives were regulated pri-
been around for centuries. (Readers may marily by a common-law rule known as the
read the 1884 US Supreme Court case of “rule against difference contracts.”
Irwin vs. Williar, [2] which demonstrates The rule against difference contracts did
both that derivatives trading was common in not stop you from wagering on anything you
the 19th century – although derivatives were liked: sporting contests, wheat prices, inter-
then called “difference contracts” – and that est rates. But if you wanted to go to a court
derivatives were subject even then to regula- to have your wager enforced, you had to
tion.) Originally, most commercial derivatives demonstrate to a judge’s satisfaction that at
were bets on the future prices of agricultural least one of the parties to the wager had a
commodities, like the rice derivatives traded real economic interest in the underlying and
in Japan in the 15th century or the corn and was using the derivative contract to hedge
wheat futures still traded on the Chicago against a risk to that interest.
Mercantile Exchange today. To use the lan- Because, of course, wagers can be used
guage of derivatives traders, the“underlying” to hedge against risk. For example, if you

own a corporate bond and you are worried schemes and other economic ills. Common-
the issuer might default, you can reduce your law judges accordingly viewed derivatives
risk by entering a CDS contract, essentially speculation with suspicion. Under the rule
betting against the issuer’s creditworthiness. against difference contracts and its sister
doctrine in insurance law (the requirement
Derivatives versus speculation of “insurable interest”), derivative con-
If the bond decreases in value, the CDS will tracts that couldn’t be proved to hedge an
increase in value. Similarly, if you own a economic interest in the underlying were
$500,000 home, you can hedge against the deemed nothing more than legally unen-
risk your home will burn down by making forceable wagers.
a bet with an insurance company that will This didn’t mean derivatives couldn’t be
pay off $500,000 if the home actually burns. used to speculate. But the rule against dif-
(Most of us call these wagers“homeowner’s ference contracts forced speculators to think
insurance,” although a typical Wall Street about how they could make sure their fellow
derivatives dealer might label them “home gamblers paid their bets. The answer was for
value swaps.”) Using derivatives this way is the speculators to set up private exchanges
truly hedging, and it serves a useful social with membership requirements, margin
purpose by reducing risk. requirements, netting requirements, and a
But as judges have recognised for cen- host of other rules designed to make sure
turies, at least until recently, derivative bets that, despite the legal invalidity of specula-
are also ideally suited for pure speculation. tive derivatives contracts, speculating trad-
Speculation is the attempt to profit not from ers would make good on their contract
producing something, or even from provid- promises. In the process, the exchanges kept
ing investment funds to someone else who is derivatives speculation in check and under
producing something, but from predicting the controlled conditions.
future better than others predict it. [4] A spec-
ulator might, for example, try to make money CFTC and SEC involvement
predicting wildfires by buying home insur- Eventually, the control was increased when
ance on houses in Southern California with- government regulators like the Commodities
out actually buying the houses themselves. Futures Trading Commission (CFTC) and
Similarly, a speculator might hope to Securities Exchange Commission (SEC)
make money betting on a company’s for- were empowered to oversee trading on
tunes by buying CDS on the company’s particular exchanges. Meanwhile, off the
bonds without buying the bonds themselves. exchanges, the rule against difference con-
Unlike hedging, which reduces risk, specula- tracts kept “over the counter” speculation in
tion increases a speculator’s risk in much the derivatives in check.
same way that betting at the track increases At least, it kept speculation in check until
a gambler’s risk. Highly speculative markets the rule was dismantled. The dismantling
are also historically associated with asset price process began when the United Kingdom
bubbles, reduced returns, price manipulation passed its Financial Services Act of 1986,

“modernising” the UK’s financial laws by distinguish, as the common law did, between
eliminating the old rule against difference using derivative contracts to hedge and using
contracts and making all financial deriva- them for speculation. Hedging provides a
tives, whether used for hedging or for specu- social benefit by reducing the hedging party’s
lation, legally enforceable. risk. But when speculators use derivatives to
US regulators, worried that Wall Street try to profit from predicting future events, they
banks might lose out on a lucrative new increase their risk, just as gamblers increase
market, followed suit in the 1990s by creat- their risk by betting. Unchecked derivatives
ing ad hoc regulatory exemptions for par- speculation thus adds risk to the system by
ticular types of financial derivatives such as making it possible for individual speculators,
currency forward contracts and interest rate like AIG (and Barings and LTCM and Enron
swaps. Soon the US also embraced whole- and Bear Stearns) to lose very large amounts
sale deregulation with the passage of the of money very unexpectedly.
CFMA in 2000. The CFMA not only declared
financial derivatives exempt from CFTC or Hedging deception
SEC oversight, it also declared all financial But wait … some readers might say. Couldn’t
derivatives legally enforceable. AIG have been an unusual case, a “rogue”
The CFMA thus eliminated, in one fell insurance company that succumbed to
swoop, a legal constraint on derivatives spec- speculative fever? Isn’t it possible that most
ulation that dated back not just decades, but financial derivatives users wisely confine
centuries. It was this change in the law – not their derivatives deals to true hedging?
some flash of genius on Wall Street – that cre- Given the stigma attached to specula-
ated today’s $600 trillion financial derivatives tion, it’s not surprising that most parties to
market. So why re-regulate derivatives? derivatives contracts claim, at least in public,
that they use derivatives for hedging and not
Speculation and systemic risk for speculation. In some cases this seems
The results have proven unfortunate, to say a rather transparent attempt at deception.
the least. Yet it is surprising the unregulated (Hedge funds, for example, should really call
over-the-counter derivatives market didn’t themselves “speculation funds”, as it is quite
go sour even sooner. Even before AIG, deriv- clear they are using derivatives to try to reap
atives speculation had already led to the col- profits at the other traders’expense.)
lapse of Barings Bank in 1995; the failure of Perhaps more often, derivatives traders
hedge fund Long Term Capital Management incorrectly describe themselves as “hedging”
(LTCM) in 1998; the Enron bankruptcy in when they use derivatives to offset some of
2001; and the collapse of investment bank the risk associated with taking a speculative
Bear Stearns in 2008, a few months before position.This is much the same as a racetrack
AIG’s fall. gambler claiming she is “hedging” because,
These examples show why it is essen- in addition to betting on a particular horse
tial for policy-makers thinking about how to win, she also buys a betting ticket for the
derivatives affect risk in the marketplace to horse to show (place).

Yet the data suggests that speculation, Although few observers appreciated it at
not hedging, drives over-the-counter finan- the time, the CFMA’s deregulation of finan-
cial derivatives markets. For example, we cial derivatives was a novel legislative experi-
know the CDS market was dominated by ment. It was almost as if the US Congress
speculation in 2008. We know this because said to itself, “let’s see what happens if we
by year-end, the notional value of the CDS suddenly removed centuries of law!” Now
market had reached $67 trillion. [5] At the we know what happens. The experiment
same time, the total market value of all the has not turned out well.
underlying bonds issued by US companies
outstanding was only $15 trillion. [6] When What to do?
the notional value of a derivatives market is The answer seems obvious: go back to what
more than four times larger than the market worked so well, for so long, before. The old
for the underlying, it is a mathematical cer- common-law rule against difference con-
tainty that most derivatives trading is specu- tracts was a simple, elegant legal sieve that
lation, not hedging. And business history, separated useful hedging contracts from
including very recent history, shows deriva- purely speculative wagers, protecting the first
tives speculation increases systemic risk. and declining to enforce the second.This no-
It is possible, of course, that deriva- cost, hands-off system of“regulation” (there
tives speculators provide other benefits to is no cheaper form of government interven-
the market that offset the social cost of this tion than refusing to intervene at all, even to
increased systemic risk. Although from a enforce a deal) did not stop speculators from
social perspective speculation is a zero-sum using derivatives.
game – one trader’s gains necessarily come But it did require speculators to be much
at another trader’s expense, just as gamblers more careful about their counter-parties
can only make money by taking money away and to develop private enforcement mech-
from other gamblers – economists some- anisms such as organised exchanges that
times claim speculators add useful liquidity kept speculation confined to an environ-
to markets and that speculation can improve ment where traders were well-capitalised
the accuracy of market prices. and knew who was trading what, with
whom and when. This approach kept runa-
Huge social costs way speculation from adding intolerable
The derivatives industry routinely repeats this risk to the financial system. And it didn’t
mantra. Yet there is virtually no empirical evi- cost a penny of taxpayer money.
dence to establish the value of the supposed During the roaring 1990s, when
liquidity and “price discovery” benefits from financial derivatives were being widely
derivatives speculation, much less evidence applauded as risk-reducing, highly-effi-
that shows the value of those benefits exceeds cient (and, for Wall Street, highly profit-
the enormous social costs of derivatives spec- able) financial “innovations,” the old rule
ulation. (Recall that US taxpayers have spent against difference contracts had little
nearly $180 billion on the AIG bailout alone.) appeal. Maybe it has more now. •

References 3. Barrett Sheridan, The $600 Trillion Deriva-
1. See, e.g, Rick Schmitt, Prophet and Loss, Stan- tives Market, Newsweek, October 27, 2008
ford Magazine March/April 2009 40-47 (describ- http://www.newsweek.com/id/164591.
ing efforts of CFTC Chair Brooksley Born to 4. See Lynn A. Stout, Irrational Expectations, 3
warn about and regulate financial derivatives Legal Theory 227 (1997) (discussing theories of
in the late 1990s); Lynn A. Stout, Betting the speculation).
Bank: How Derivatives Trading Under Condi- 5. Bank for International Settlements, Quar-
tions of Uncertainty Can Increase Risks and terly Review Statistical Annex at A103 Table 19
Erode Returns in Financial Markets, 21 J. Corp. [Amounts Outstanding of Over-The-Counter
L. 53 (1995); Lynn A. Stout, Why The Law Hates (OTC) Derivatives] (December 2008).
Speculators: Regulation and Private Ordering in 6. Id. at A97, Table 16B (about Domestic Debt
the Market for OTC Derivatives, 48; Duke L. J. Securities).
701, 769-771 (1999) (arguing that deregulating
financial derivatives might increase market risk, (Editor’s note: The IRRNA wishes to
erode returns and lead to price distortions and thank FinReg21 for kindly allowing
market bubbles). the Journal to reproduce this article by
2. 110 US 449 (1884) Professor Stout. See: www.finreg21.com).

Behavioural risk
Black swans, market crises and

risk: the human perspective
Senior investment strategist Joseph Rizzi
examines how innate psychological traits
contributed to the financial meltdown.
We have passed the first anniversary responses. Behavioural economics rec-

of the 2008 market meltdown. Looking ognises that decision processes influence
back, the question is what, if anything, perception and shape our behaviour. The
have we learnt, especially concern- framework supplements current quantitative
ing risk management? Many are busy risk management by improving responses to
rounding up the usual suspects includ- risk over time.
ing deregulation, flawed incentives and Risk is exposure to the consequences of
‘Black Swans’. unknown events. Risk can be classified along
two dimensions. The first concerns high-
The question is, especially as it pertains frequency events with relatively clear cause-
to risk management, if the crisis was so obvi- effect relationships, such as missing your
ous after the fact, why did so many experts connecting flight. Other risks such as health
fail for so long to see it beforehand? A plau- problems occur infrequently. Consequently,
sible explanation is they were unable to the cause-effect relationship is unclear. The
imagine the crisis due to behavioural blink- second dimension is impact severity. No
ers. Success seems to breed disregard for the matter how remote, high-impact events can-
possibility of failure. Most individuals have a not be ignored because they can threaten an
model of how the world works. When chal- institution’s existence, as was demonstrated
lenged by events, we try to explain them in the market crisis.
away. Although we know how risk decisions
should be made, less is known about how ‘Fat-tailed’ loss distributions
these decisions are actually made. Many financial risks, such as option selling,
Behavioural economics provides insight are low-frequency, high-impact events char-
into risk-assessment errors and possible acterised by their “fat-tailed” loss distribu-
remedies. This article outlines and applies tions. Investors incurring such risk can expect
a behavioural risk framework to address mainly small positive events but are subject
judgment bias and develop appropriate to a few cases of extreme loss. These risks are

difficult to understand and even more diffi- subject to overconfidence. Industry and
cult to predict. First, there is insufficient data product experts are especially prone to
to determine meaningful probability distribu- overconfidence based on knowledge and
tions. In this case, the statistics are descriptive, control illusions. Knowledge is frequently
not predictive. Consequently, no amount of confused with familiarity. This is reflected in
mathematics can tease out certainty from the number of industry experts including,
uncertainty. Second, and perhaps more most famously, the former Federal Reserve
importantly, infrequency clouds perception. Chairman Alan Greenspan who missed the
Risk estimates become anchored on recent collapse of the housing and structured credit
events. Overemphasis on recent events can bottom. Their past experiences and ana-
also produce an under-appreciation of risk lytical framework act as blinkers. Thus they
during a bull market as instruments are priced overlook emerging issues that they could not
without regard to the possibility of a crash. even have imagined.
These facts lead to risk mis-pricing and the Control reflects the unfounded belief in
procyclical nature of risk appetite. our ability to influence or structure around
risk. Risk is accepted because we believe we
Structural breaks can escape its consequences due to our abil-
Behavioural finance examines how risk ity to control it. Examples include the per-
managers gather, interpret and process ceived ability to distribute or hedge risk. Risk
information. Specifically, it concentrates on transfer, however, does not eliminate risk.
perception and cognitive bias. It recognises Furthermore, it interjects counterparty risk.
that models can influence behaviour and It is similar to buying flight insurance from
shape decisions. These biases can corrupt another passenger on the same plane.
the decision process, leading to suboptimal
results as emotions override self-control. Cost versus gain
Overconfidence occurs when we exag- In the event of an improbable, but still pos-
gerate our predictive skills and ignore the sible high impact event, such as a plane crash
impact of chance or outside circumstances. or a market crisis, correlations go to one. This
Overconfidence is usually reflected by a belief was illustrated by the problems faced by
that past trends continue. Unfortunately, many hedged institutions that had AIG as
structural breaks in historical patterns can their counterparty.
and do occur. Risk managers took credit for This reflects an optimistic underesti-
results during the boom while failing to con- mate of costs while overestimating gains.
sider the impact of randomness and mean Optimism is heightened by anchoring when
reversion, thus creating an illusion of control. disproportionate weight is given to the first
Compounding this is their selective recall information received. These time-delayed
of confirming information to overestimate consequences magnify overconfidence as
their ability to predict the correct outcome, individuals weigh short-term performance
which inhibits learning. Disappointments at a higher level than longer-term conse-
and surprise are characteristics of processes quences. Statistical bias involves confusing

beliefs for probability and skill for chance by events that can occur. Thus, the longer the
selecting evidence in accordance with our time period, the higher the likelihood of a
expectations. Economics is a social science ‘Black Swan’event occurring.
based on human behaviour. Prices are not There are also social aspects to decision
determined by random number machines. making when individuals are influenced by
Rather, they come from trades by real peo- the decisions of others as reflected in herd-
ple. Thus, history is not data and the future ing. Herding occurs when a group of individ-
is not output. uals mimic the decisions of others. Through
herding, individuals avoid falling behind and
Hidden risks looking back if they pursue an alternative
Statistically based risk management practices action. It is based on the social pressure to
are inherently limited. They are unable to conform and reflects safety by hiding in the
reflect the hidden risk that market conditions crowd. In doing so, you can blame any failing
may change. Formerly diversified positions on the collective action and maintain your
begin moving together triggering unexpected reputation and job. Even though you recog-
losses. The changes are unexpected because nise market risk, it pays to follow the crowd.
such movements are unfamiliar. We tend to This is referred to as a positive feedback loop
view the unfamiliar as improbable and the or momentum investing, which can produce
improbable is frequently ignored. short-term self-fulfilling prophecies.
Another statistical error prevalent dur- Herding amplifies credit cycle effects as
ing boom is extrapolation bias. This occurs decisions become more uniform. The cycle
when current events or trends are assumed begins with a credit expansion leading
to continue into the foreseeable future inde- to an asset price increase. Investors rush
pendent of historical experience, sample in to avoid being left behind using rising
size or mean reversion. Undoubtedly, this asset values to support even more credit.
resulted in many of the projections underly- This explains why bankers continued risky
ing structured credit models. Naive reliance practices even though they feared this was
on extrapolation leads to disaster. unsustainable and leading to a crisis.
Since the subjective probability of an
event depends on recent experience, expec- ‘Group think’
tations of low-frequency events, such as Eventually, an event occurs, such as a
a market or firm collapse, are very small. move by the central bank, which triggers
These types of events are ignored or deemed an asset price decline. This causes losses, a
impossible, particularly when recent occur- decline in credit, and an exit of investors,
rences are lacking. This causes a false sense which strains market liquidity and leads
of security as risk is underestimated, or to further price declines. These declines
assumed away, and capital is mis-allocated. will continue until the negative feedback
Unlikely events are neither impossible nor loop runs its course. “Group think’’, or
remote. In fact, unlikely events are likely to organisational pressure, enhances cognitive
occur because there are so many unlikely biases. It occurs when individuals identify

with the organisation and uncritically accept momentum and herding reflected in high
its actions. Once the commitment is made, liquidity levels. Also, bank managers are
inconsistent information is suppressed. Thus products of their experience. For most, their
mutually reinforcing individual biases and experiences were limited to bull markets.
unrealistic views are validated. Thus, they could not imagine an end to the
Experts are prone to group think. They favourable market conditions.
tend to limit information from all but other
expert sources. Thus, they repeat statements The market crisis of 2009?
until they become accepted dogma, regard- The setting: A declining economy and falling
less of their validity, due to a lack of critical markets triggered aggressive Federal Reserve
thinking. The subprime collapse illustrates interest rate cutting and liquidity injections
this fact. The industry participants used the in 2001 to 2002. Liquidity-driven technicals
same consultants and models for their pro- improved, resulting in falling risk premiums
jections. The consultants based their reports increasing credit asset prices.
and recommendations on the surveys of A credit bubble formed as liquidity-
industry participants. Once the perception driven technical’s surpassed fundamentals.
of a bull market took hold it was reinforced Momentum traders, who trade based on
and accepted uncritically. When the crash price changes, dominated the market. This
occurred, the experts were taken by surprise evolved into simple “trend chasing” late in
by a supposed “perfect storm”. the cycle. This was reflected in historically
low credit-risk spreads in the real estate,
Dancing to the music leveraged buyout and structured credit mar-
This is illustrated in a June, 2006 Business kets. Spread narrowing and a flattening yield
Week cover story which surveyed risk offic- curve reduced the attractiveness of the tradi-
ers at numerous institutions, including Bear tional carry trade, putting pressure on insti-
Stearns and Lehman. They believed that tutional accrual and trading budgets.
despite the risks taken, they were safer than In their search for yield, institutions
ever. This belief was based on complex risk adopted a procyclical, asset-heavy strategy.
models and market diversification. The faith This involved short-funded leveraged invest-
in risk management encouraged institutions ments in higher-risk assets for the institu-
to increase their risk exposures believing they tion’s own account instead of distribution.The
were under control. strategy is reflected in principal finance, mer-
During a late stage boom with high sen- chant banking, bridge loans and warehousing
timent levels, behavioural risk factors domi- activities. This caused a major credit boom.
nate and quantitative risk measures will be Such cycles, while predictable, are difficult to
unreliable.This is reflected in Charles Prince’s manage for several reasons. First, financial
famous comment: “As long as the music institution compensation is tied to peer group
is playing, you have to get up and dance.” comparisons. Thus, firms and individuals not
This is characterised as “irrational exuber- following their peers suffer. Next, organi-
ance” where prices are driven principally by sations frequently discourage pessimism.

Therefore, conservative risk managers and to do so overstates the profitability of these
bankers are pressured to become optimistic assets.
or leave. Finally, institutions fear losing “star” Unfortunately, firms continued to
bankers if their risk activities are curtailed. underestimate the likelihood and impact
Frequently, positive short-term results of unlikely events. Widespread credit risk
mask long-term risks. Seemingly high under-pricing existed due to an emphasis on
returns can reflect the subjective probability nominal returns. This suggests a correction
of an event that has not occurred in the time when investor emphasis shifts from return
period studied. Investing in such instruments on capital to return of capital.
is profitable most of the time. Eventually, a
“beyond the data”event occurs. Individuals, Low risk sensitivity
institutions and regulators succumbed to a It is difficult to price rationally when risk
bias of assuming the absence of evidence- seems remote, and hard to measure when
implied evidence of risk absence. conditions seem favourable. The last market
The concerns: The appropriateness of correction occurred more than three years
the asset heavy portfolio strategy depends ago and was largely forgotten by the first
on several factors. Pricing and trading disci- half of 2007. Thus risk sensitivity diminished.
pline is needed to ensure an adequate risk This recognition problem is rooted in the
premium is earned. Maintaining discipline, complex nature of financial risk.
however, becomes increasingly difficult as Reinforcement: The complexity of low
the cycle continues. frequency, high-impact risk is compounded
by institutional factors such as budgets and
Increased bonuses compensation systems that reinforce the
Next, the strategy involves incurring behavioural bias effect. These systems favour
increased systematic or beta risk expo- “consistent” earnings and misread low-fre-
sure versus value-adding alpha returns. quency/high-impact risk“profitability.”
Structured products are less liquid than mar- Risk models also contribute to the problem
ket investments. Consequently the return by presenting the illusion of safety and control,
on structured products reflects compensa- which leads to over-optimism. Consequently,
tion for liquidity risk. This risk was poorly models underestimated low frequency, high-
reflected in risk management models. The impact cyclical risk. The underlying exposure
liquidity premium was mischaracterised as builds during a bull market as apparent risk
alpha, leading to increased bonuses. declines, while the losses materialise in the
Institutions were investing in assets with bear market cycle. This anomaly is due to
the wrong distributions for leveraged finan- social and psychological biases resulting in
cials. Essentially, they were selling unhedged bounded rationality. Ignoring these facts sub-
out-of-money puts on an extreme event such stitutes an inaccurate normative model for the
as a market crisis. Valuing these risk posi- real world. The “black box” models became
tions requires reflecting the value of options “black holes”that engulfed many institutions.
not purchased to hedge the positions. Failure The objective is to supplement existing

quantitative risk management with behav- surprises. Markets are social and not physical
ioural finance developments. In so doing, phenomena. A shift in thinking about risk is
it can reduce future losses during the credit needed. See Figure 2 (opposite page).
cycle as risk management evolves to a more We must be prepared for the conse-
balanced system incorporating human quences of an event regardless of its proba-
behaviour. This requires taking low-prob- bility in this new and unstable environment.
ability, worst-case scenarios seriously, and This means recognising human propensity
developing appropriate responses. The proc- to underestimate the probabilities of catas-
ess is similar to earthquake engineering, trophes. Most institutions and managers
which does not attempt to predict a shock. are unable to resist the temptation to grow
Rather, the focus is on constructing a struc- through opaque risk escalation.
ture to withstand a certain shock level. This is especially true as the memories of
Decision-making involves identify- the last disaster fade. Controlling this prob-
ing alternatives, obtaining information and lem requires adapting a precautionary “fire-
applying our preferences. Decisions become code”approach, which limits the propensity
at risk when facing uncertainty and bias, and of markets and institutions to self-destruct.
are amplified by institutional factors. This This establishes before-the-fact safety codes
framework is illustrated in Figure 1 (below). regarding exposures and capital in individual
We will now turn to the implications institutions. Equally, regulatory firewalls are
of DAR for risk management. Risk man- needed to limit the spread of problems in
agement has become a procedural ritual complex tightly coupled market networks.
anchored in an almost religious reliance These“fire codes”can be developed by Boards
on quantitative models. The elaborate risk of Directors. Their cost, however, will proba-
models bred a false confidence by ignor- bly require some regulatory encouragement.
ing the human element in markets. Shifting
sentiment, extreme reactions and herding Conclusion
based on overconfidence and the illusion of Markets are recovering. While no two cycles
control led to self-deception and unpleasant are identical, we must resist the temptation
Figure 1. Decisions At Risk (DAR)
Uncertainty Bias Amplifiers

Beyond the Data Events Over-Confidence Incentives
Information Asymmetry Illusion of Control Bureaucracy
Opaqueness Optimism Regulation
DAR

Figure 2. Risk paradigm shifts needed
Pre September 14, 2008 Paradigm Post September 14, 2008 Paradigm
Gaussian distributions Fat Tails and Path Dependency
Frictionless Markets Arbitrage Limits
Complete Information Asymmetric Information
Rational Participants Biased Participants
Risk Uncertainty
Stable Systems and External Shocks Internally Unstable Systems
Individuals as Primary participants Institutions as Primary Participants
Profit Maximizing Self Interest Principal Agent Conflict
Equilibrium Creative Destruction
to say: “This time it is different.” The deeper References

we are into illiquid credits, products and 1. Danielsson, J; “The Emperor Has No Clothes:
structures, the more difficult it becomes Limits to Risk Modelling”, Journal of Banking and
to manage risk. The key is to recognise Finance, 2002
that risk is managed by people, not math- 2. Thorton, D. Henry and A. Carter, 2006, “Inside
ematical models. The focus should be on Wall Street’s Culture at Risk,” Business Week
the consequences of exposures regardless (June 12).
of probability. This requires understand- 3. Nakamotos, M. and Wighton, P.,“Bullish Citigroup
ing the portfolio impact of an event, not Is Still Dancing to the Beat of the Buy-out Room”,
its prediction. Recognising the difficulty in Financial Times, July 10, 2007
maintaining discipline, a precautionary fire 4. Scholes, M.,“Crisis and Risk Management”, AEA
code approach imposed by directors and Papers and Proceedings, May, 2000.
regulators is needed to prevent the self- 5. Then President of New York Federal Reserve,T.
destructive behaviour that so surprised Geithner, as quoted in the Financial Times, May
Alan Greenspan. 12, 2005.
Organisational obstacles inhibit appro- 6. Bernstein, P.,“The New Religion of Risk Manage-
priate responses to high-impact, low-prob- ment”, Harvard Business Review (March-April,
ability risks. Chief among the obstacles are 1996).
short-term compensation systems which 7. Mcloskey, D.N. and Zilink, S.,The Cult of Statisti-
reinforce behavioural biases. This leads to a cal Significance, (Ann Arbor, Michigan, University
potentially fatal neglect of the longer-term of Michigan Press, 2009).
build of risk. As Robert Merton noted: “The 8. Perrow, C., The Next Catastrophe (Princeton,
amount of risk we take personally, individu- NJ: Princeton University Press) 2007.
ally, or collectively is not a physical given 9. Greenspan, A., Testimony before the House
constant. We choose it. Behavioural finances Committee on Oversight and Reform, Congres-
offers a means to choose wisely as it affects sional Hearing, October 23, 2008.
both individual decision-making and mar- 10. Merton, R.C., interview by N. Nickerson, 2008.
ket efficiency. You ignore behavioural risk at “On the Markets and Complexity”, Technology
your own peril.• Review (April 3, 2008).

Risk management
Measuring & managing risk for

innovative financial instruments
The University of Houston’s Dr Stuart M.
Turnbull highlights complex issues
surrounding financial products.
In the current credit crisis, the issues of that the focus is on general issues that arise
improper valuation and inadequate risk and the analysis is applicable for any form
management in the use of credit deriva- of instrument. Given that credit derivatives
tives have been at the centre of the credit have been the catalyst for the credit crisis, we
market turmoil. The crisis raises the consider the issues that arise in the pricing
questions of how do we measure the risk of credit derivatives written on a portfolio of
of innovative financial products and how obligor related assets. For example, the port-
do we manage the risk? folio could be residential mortgages, credit
cards, bonds or derivatives. Each asset will
Innovative financial instruments are generate a cash flow provided that default
typically illiquid and pose several challenges does not occur. The event of default will gen-
for their valuation and the measurement and erate a terminal payment. The focus of this
management of the risks associated with paper will be on the general issues that arise
them. Measuring risk at some specified time and not on minute contract details.
horizon requires the ability to price different
assets in future states and to compute differ- The issues
ent risk measures. Managing risk requires We start in section two with issues relat-
the means to alter a risk profile, either via ing to pricing. The design characteristics of
the use of hedging instruments, or through an instrument that affect both the demand
contractual mechanisms such as master side and the supply side are discussed in
agreements, or institutional such as clearing section three. In section four we discuss the
houses. This paper, which addresses some of factors that influence the level of liquidity.
the many issues that arise when a new form Counterparty risk affects all contracts and
of financial instrument is introduced, is an with an innovation there are additional dif-
abridged version of Turnbull (2009). ficulties. We discuss these issues in section
To be concrete, we consider a particular five. Risk management requires the abil-
example of an innovation. However, we stress ity to generate the probability distribution

describing the value of a portfolio of assets at approach, for each asset in the collateral pool,
some future specified horizon. For an inno- the process describing the event of default and
vation there is usually limited data, which the loss given default must be estimated. To
restricts the complexity of models and model the cash flow generated by the assets
implies that model testing will be difficult. in the collateral pool necessitates considering
There are also managerial issues that can how the event of default by one asset will affect
impact the risk management function. Risk the remaining assets. A popular approach is to
management issues are discussed in section use a copula function. A copula function knits
six. We address issues relating to the use of together the marginal distribution functions to
credit ratings in section seven. The last sec- give the joint distribution. [2] The basic model
tion summarises the conclusions. used for pricing and risk management has
been the normal copula. The normal copula
Pricing requires specifying the marginal distributions
At the centre of the credit crisis has been the describing the probability of default for each
issue of how to price different types of collat- obligor and a correlation matrix. The critical
eralised debt obligation (CDO). Here we con- issue for modelling default dependence is the
sider some general form of CDO structure and specification of this correlation matrix. In the
identify some of the different issues that must Merton (1974) model, it is the correlation of
be addressed both for pricing and hedging. asset returns.
For a CDO there are two ways to tackle the
issue of pricing: a bottom-up approach and a Top-down approach
top-down approach. A bottom-up approach Recovery rates vary with the state of the
starts by modelling the event of default and economy: if the state of the economy is
the loss given default for the individual assets declining and the frequency of defaults
in the collateral pool of the CDO. [1] The use increasing, recovery rates decrease. This
of any form of realistic model requires the esti- affects the loss distribution, as default prob-
mation of model parameters, implying that abilities and recovery rates are negatively
there is a trade-off between the complexity of correlated: Consequently, it is necessary to
the model and the availability of data. jointly model the probability of default and
the loss given default. [3]
Bottom-up approach A top-down approach directly models
While the bottom-up approach is a logi- the cash flows generated by the portfolio of
cal starting point, for some types of assets assets in the collateral pool without explicit
the approach is infeasible, as either the data identification of individual assets, thus reduc-
requirements become overwhelming or the ing the magnitude of the problems associated
underlying assets too complex. This neces- with parameter estimation in the bottom-up
sitates taking a top-down approach. approach. The typical formulation assumes
To price the tranches of a CDO requires that there are a number of different types of
modelling the cash flow generated by the events that cause a loss to occur. Each time an
assets in the collateral pool. In a bottom-up event occurs, the portfolio suffers a loss, the

size of the loss depending on the type of event. bottom-up and top-down approaches rely
With this approach the number of parameters on calibration. The limitation of this approach
that must be estimated is greatly reduced. For is that model imperfections and the lack of
example, in Longstaff and Rajan (2008) there liquidity of prices are compounded into the
are three types of events: The interpretation calibrated parameters. In some cases a model
of these events being that one type of event is calibrated to match the prices of tranches on
models default by individual obligors; the sec- an index, where the asset pool is different from
ond event sector or group defaults; and the the assets in the pool of the CDO under con-
third event economy-wide defaults. sideration, making parameter calibration even
more unreliable. This difficulty arises because
Implications for innovations of the lack of data for the new product.
In the simplest form of the model there are The design of an instrument defines its
six parameters to estimate: three jump sizes risk sharing characteristics and appeal to
and three volatilities. The benefit of this par- different clienteles of potential users. [4] To
simony is that models can usually be cali- stimulate usage, the design should attempt
brated, while the cost is that the model may to anticipate features that will appeal to end-
do a poor job in describing the dynamics of users. On the demand side it should help to
the prices of different structures over time. reduce the costs of achieving some service,
For new financial products there is a real such as altering the risk profile facing an
trade-off between the complexity of models investor. On the supply side, it should be
and the availability of data. The critical issue designed to reduce the costs associated with
is that of modelling default dependence. The hedging, for example by meshing with the
copula approach is simple, though static. features of extant instruments that can be
The use of the normal copula is perhaps the used for hedging. The design of the innova-
least demanding in terms of the number of tion directly affects its risk characteristics.
parameters that must be estimated. For risk
management, a credit rating transition matrix Risk characteristics
is used and a multifactor equity return model To identify the risk characteristics of a new
to generate the correlation matrix. instrument requires identifying the condi-
For pricing, credit default swap prices tions under which different features of an
are used to infer the intensity for each obli- instrument affect its risk profile. Certain
gor. It is usually assumed the recovery rate design features may make an instrument
is some fixed known value. Often equity extremely sensitive to underlying factors and
returns are used to generate the correlation market disruptions. For example, the design
matrix, though there is little theoretical justi- of subprime collateralised debt obligation
fication. Alternatively, the correlation matrix (CDO) tranches can make the tranches quite
is assumed to be described by one param- sensitive to the state of the housing market.
eter that is calibrated so that the model price This was one of the reasons for the contagion
matches the price of one tranche, usually the in the recent credit crisis. This design char-
equity tranche. In practice, for pricing both the acteristic was completely missed by all the

players: rating agencies, regulators, financial macro shocks to the economy or to a sector
institutions and investors. [5] adversely affect investors’ confidence, causing
Special investment vehicles invested in investors to exit positions, this will decrease
long-term assets and financed their pur- the level of liquidity.
chase by issuing asset-backed commercial
paper (ABCP). With the fall in house prices Education
and increased uncertainty about the value With the launching of a new innovation
of the underlying collateral, vehicles had to comes the need to build both supply and
reduce the amount of ABCP, forcing them to demand by educating potential users about
sell assets in order to meet claims. The uncer- the usefulness of an innovation, its risk-
tainty about collateral valuation increased return characteristics and identifying any
and investors eventually refused to purchase accounting or regulatory issues that might
new ABCP. impede adoption. The range of possible uses
The rating agencies had anticipated mar- will affect the size of both the supply and
ket disruptions and insisted on vehicles hav- demand and thus the size of the group of
ing multiple backstop lines of credit. What investors willing to trade the instrument and
they had not anticipated was the effects of thus its liquidity.
“wrong way” feedback. The valuation of the The complexity of an innovation also
collateral became increasing difficult as the affects its appeal to different clienteles and
value of the vehicles’ assets (mostly illiquid the amount of education required to reach
assets) declined. This triggered the selling of end users. A credit default swap is a simple
illiquid assets, causing further price declines contract to shift credit risk, while a collater-
and eventually the closing of these markets. alised debt obligation (CDO) is a complex
product. The complexity of this class of
Liquidity instruments limits its appeal (at least in the
With any new innovation there will initially be ideal world [8]) to investors with the ability
limited liquidity. Liquidity for an innovation to analyse the risk profile and to understand
depends on many factors, such as the ability the frailty of the underlying assumptions. [9]
to grow both the supply and demand, the ease
of pricing the innovation, the transparency of Ease of pricing
the pricing process, the existence of hedging Investor’s inability to analyse and price a
tools and the costs associated with hedging. new product is directly affected by the nature
[6] The ability to hedge and speculate makes of the assets underlying the product, the
an instrument attractive to a wide range of complexity of the design and the availability
investors. [7] An innovation will attract certain of data. If it is relatively easy to determine the
types of investors on the demand and supply price, this aids investor misunderstanding
sides and the actions of these different groups of the role different factors have upon price
affect the level and the stability of liquidity in and helps to increase their confidence in the
the market. The level of liquidity will depend model prices and hence liquidity. The struc-
on the state of the sector and economy. If ture of an innovation plays an important role

in the ease of pricing. If the reference portfo- of the total exposure to a particular obligor.
lio is complex and the structure of the inno- This may be difficult for structured products,
vation complex, as is the case for CDOs, then where the same obligor can appear in many
this greatly increases the data requirements different tranches.
and analytic skills needed to understand
the complexity of the structure. Difficulty Implications for an innovation
to readily analyse such structures increases For a new innovation the difficulty of esti-
the uncertainty about the valuation and mating the effects of counterparty risk are
decreases the liquidity of the bonds. compounded due to the limited data and
New financial instruments trade in the liquidity. First, there is limited information
over-the-counter market. Buyers and sell- available to help in specifying the joint dis-
ers must contact dealers to obtain bid/ask tribution describing the occurrence of the
quotes and judge the depth of the market. risk event for the counterparty and the ref-
The ability of investors to see posted bid/ask erence asset. Second, for a new product, the
quotes on a regular basis via a third party financial institutions offering the product
screen helps to improve transparency of the need to develop the necessary back-office
pricing process, especially for less sophisti- facilities to keep track of the counterparties
cated investors. It also provides information associate with the product. Third, the finan-
about the depth of the market. If a contract cial institution needs to carefully consider
can become standardised, this increases the whether there is “wrong-way” dependence.
level of transparency. The ability to standard- The posting of collateral provides protection
ise, however, depends on the complexity of if the value of the collateral is not positively
the contract. dependent on the same factors that affect
the counterparty.
Counterparty risk The posting of additional collateral may
Counterparty risk is the risk that a party further weaken the creditworthiness of the
to a contract might fail to perform, when counterparty.[11] It is important to recognise
called upon to honour its contractual com- ex ante this form of “wrong way” depend-
mitments. It exposes the other party to ence. Another issue is whether the collateral
the contract to a mark-to-market risk.[10] is traded in a liquid market. If not, then ques-
Steps to mitigate counterparty risk span a tions about the valuation of the collateral
wide spectrum, from limiting total expo- can arise, especially if there is wrong-way
sure to individual counterparties, exposure dependence.
to particular sectors, master contract agree- To risk manage a new financial inno-
ments that facilitate netting, “haircuts” in vation necessitates identifying the differ-
pricing, posting of collateral and payment ent dimensions of risk associated with the
in advance. Some of these approaches are innovation. Apart from the traditional list
model independent. Limiting the total of issues, there are many additional dimen-
exposure to a particular obligor requires sions to risk that are difficult to quantify. We
information systems that can keep track call these additional elements “dark risk”.

For example, what is the best way to address an innovation in isolation, but the incen-
the estimation of model parameters in a tives facing different players that contribute
non-stationary environment, given limited to the innovation and the consequences of
data? How does the complexity of an instru- the incentives. The risk manager also needs
ment and parameter uncertainty affect the to recognise that holding different examples
pricing and risk management?[12] There are of an innovation may result in a concentra-
managerial considerations, such as account- tion of risk.
ing system for an innovation and the ability
of senior management to understand the Accounting incentives
innovation. For example, holding different types of mort-
Any form of model should be tested for gage backed CDOs, may result in a concen-
accuracy. If a model’s parameters are calibrated tration of risk if the same bond appears in
so that the model matches existing prices on a different CDOs. Standard and Poor’s reports
particular day, as is standard practice, the issue that just 35 different borrowers appear in
is whether the model is useful for hedging. nearly half of the 184 collateralised loan obliga-
Many models can match price though they tions that it rates. [15] The risk manager needs
do a poor job hedging, implying that they the ability to identify the underlying assets in
are mis-specified and of limited value for risk an innovation.This means that the data about
management. With limited data and possibly the underlying assets must be available.
illiquid prices, model testing is problematic. When an innovation is introduced,
often an existing accounting framework
Unintended consequences for another security is adopted to account
The introduction of a new innovation may for trades in the innovation. Traders would
generate a series of unintended conse- be familiar with the characteristics of the
quences. For example, the introduction of existing accounting scheme and “fit” the
subprime mortgage-backed CDOs was ini- new product into the existing framework.
tially profitable for the issuers. This created Traders’ incentives are inherently short-term
a demand for these types of mortgages. To in nature, given the typical way of determin-
ensure an adequate supply, originators lowing bonuses that concentrate on the profits
ered their underwriting standards, as they generated over the accounting year.
were rewarded on the basis of volume and They have incentives to engage in trading
shifted the risk of mortgage defaults to the activities that generate profits over the short
arrangers – the issuers of the CDOs).[13] run at the expense of long-term profits. The
This lowering of underwriting standards challenge for risk managers is to understand
increased the probability of default for the the incentives generated by the accounting
mortgages contained in mortgaged backed system and the types of trades that it encour-
bonds. However, the data used to model the ages traders to undertake. Risk managers
risk of the CDOs was from a prior period and must try to distinguish between trades that
did not reflect the changing conditions.[14] generate short run profits and those that are
A risk manager needs to look not just in the best interest of the firm. Risk managers

face another obstacle, that of ignorance on managers and investors not involved in the
the part of senior management. discussion between the issuer and the rating
When an innovation is introduced, sen- agency, the methodology used to determine
ior management may not understand the a rating is not transparent. However, trans-
nature of the innovation, its risk character- parency is necessary in order to understand
istics and how the accounting treatment fits how a rating is defined, the methodology
the innovation and the incentives generated and the type of data used.
by the accounting system. They often refuse
to acknowledge their ignorance and rely on Understanding a credit rating
the traders and their quants to characterise The first requirement is to understand what
the profitability and risk.[16] criteria a rating agency is using as a measure
However, the incentives of the trad- of credit worthiness. A rating scheme is an
ing desk are usually not aligned with ordinal ranking: an instrument with a triple
those of senior management. Traders are A rating has in some sense less credit risk
rewarded on the basis of the profitability than an instrument with a double A rating.
of their desk over the accounting year, [19] A rating may be either an assessment of
while senior management are rewarded a probability of a defined event occurring or
on the basis of their business. Risk man- the expected loss if the defined event occurs.
agers are unlikely to receive support if The second requirement is to understand
senior management is ignorant and do the methodology.
not understand the issues, relying on the Knowledge about the methodol-
traders and quants for guidance.[17] ogy allows the identification of the model
assumptions and the opportunity to exam-
Mark-to-model ine their robustness. However, the ability
In recording the value of an illiquid asset, a to test or judge robustness requires knowl-
model price is usually used. For an innova- edge about the market. This may be miss-
tion, the operational risks are greater than ing for new innovations, implying that risk
those associated with a seasoned product. managers will have to rely on professional
The list of potential areas of risk is long and judgment.
includes such issues as the accounting incen- The third requirement is to know the type
tives generated by the accounting system, of data employed when determining a rating
model risk, complexity risk (the more com- and whether there is sufficient data to test
plex a product the greater the risk of pricing the robustness of assumptions. In the recent
and trading errors), settlement risk and legal credit crisis the rating agencies accepted the
risk.[18] data from the originators, without doing any
To determine the value of an innovation form of checking about whether distribu-
these operational costs should be included. tional assumptions had changed.
For certain types of instruments a credit rat- The fourth requirement is to consider
ing is often a prerequisite in order to increase whether conflicts of interest that rating
the marketability of the innovation. For risk agencies face have affected their objectivity,

especially as rating agencies have little legal fied. Examples of possible candidates would be
exposure given their use of a First Amendment mortgages, asset backed securities or credit default
defence – see Coffee (2008). [20] For innova- swaps on asset-backed securities.
tions, there is often limited data availability 2. For an introduction to the use of copula functions
and the rating methodology is untested. For applied to finance, see Schönbucher (2003, ch. 10)
risk managers and investors the challenge is and O’Kane (2008, ch. 14).
to interpret what information a rating actually 3. Dullmann andTrapp (2004) test a number of differ-
conveys about an innovation given the tenta- ent latent factor models.
tive nature of the methodology. 4. There is a large amount of literature about security
design, see Allen and Gale (1995).
Conclusions 5. A more detailed explanation is given in Crouhy et
In this paper we have discussed some of the al (2008).
diverse challenges of measuring and manag- 6. The interaction between market and funding
ing risk of innovative financial products. The liquidity is discussed in Brunnermeier and Peder-
list of the different dimensions of risk that an sen (2009).
innovation introduces is long: model restric- 7. In the current credit crisis, some commentators
tions, illiquidity, limited ability to test models, have recommended that the purchase of credit
design characteristics, counterparty risk and default swaps be restricted to investors who own
related managerial issues. Given the uncer- the underlying asset.This would greatly reduce the
tainty about model valuation and estimated liquidity of the CDS market.
risk metrics, how can risk managers respond? 8. From the credit crisis, it is clear that many investors
Stress testing a model of unknown validity failed to understand the instruments’ risk charac-
may generate a false sense of security. teristics.
For scenario analysis to be useful, risk 9. The complexity issue is discussed in Rowe (2005).
managers need to understand the different 10. Consider the case of a credit default swap where
factors that affect the product. This requires there is the risk that the protection seller might
the ability to think outside the confines of default and for simplicity we assume there is no risk
their limited pricing models, something that the protection will default. If the protection
that was missing in the current credit crisis. seller defaults before the reference obligor, then to
The use of credit ratings for an innovation restore the protection buyer to the position prior
is problematic. All parties within a com- to default necessitates pricing a swap with the same
pany – senior management, traders and risk premium.
managers – have important roles to play in If the credit worthiness of the reference obligor
assessing, measuring and managing risk of has deteriorated, then the value of the swap to
new products. The company’s directors also the protection buyer would be positive, implying
have a responsibility to ensure that these a mark-to-market loss. If the reference obligor
duties are being fulfilled. • defaults and the protection seller defaults prior
to settlement, the protection buyer is exposed to
Notes the full loss from the reference obligor. SeeTurnbull
1. The precise nature of the assets we leave unspeci- (2005) and Pykhtin (2005).

11. In the current credit crisis, concern has been liquidity and funding liquidity”, Review of Financial Stud-
expressed about the consequences of AIG being ies, 22, 6, 2201-2238.
downgraded and whether it had the ability to post Coffee, J.C. (April 22, 2008).“Turmoil in the US credit
collateral arising from all the contracts it had writ- markets: the role of the credit rating agencies”,Tes-
ten. timony before the United States Senate Committee
12. Some of the issues are discussed by Rowe (2009). on Banking, Housing and Urban Affairs.
13. For a more detailed analysis of the associated Crouhy, M.D. Galai and R. Mark (2001). Risk Manage-
incentives, see Crouhy, Jarrow and Turnbull (2008). ment, McGraw Hill, NewYork.
14. The rating agencies had a policy of accepting data Crouhy, M.G., R. Jarrow and S.M.Turnbull (Fall 2008).
from originators without any auditing to check the insights and analysis of current events: the subprime
reliability of their assumptions about the default credit crisis of 2007, Journal of Derivatives, 16, 1,
date. 81-110.
15. See Sakoul (2009). Dullmann, K.&M. Trapp (2004). “Systematic risk in
16. Arrogance and ignorance were the prime drivers recovery rates – an empirical analysis of US corporate
behind the collapse of Barings Bank in 1995. See credit exposure”. WP Deutsche Bunderbank, Frank-
the Report of the Board of Banking Supervision. furt. Gagliardini, P. and C. Gourieroux (August 2003).
17. The role of risk managers versus traders is dis- “Spread term structure and default correlation”, W.P.
cussed in Blankfein (2009). Lugano and University of Toronto.
18. For a new innovation it is necessary to establish Longstaff, F.A. and A. Rajan (2008).“An empirical analysis
the legal identity of the counterparty and to know of the pricing of collateralised debt obligations”, Journal
the judicial system governing any disputes with the of Finance, 63, 2, 529-563.
contract. Different legal systems may accord differ- Merton,R.C.(1974).“On the pricing of corporate debt:
ent treatments for the contract.A good introduc- the risk structure of interest rates”, Journal of Finance,
tion to operational risk is given in Crouhy, Galai and 29, 449-470.
Mark (2001, chapter 13). O’Kane, D. (2008). Modelling Single Name and Multi-
19. The ordinal nature of rankings means that they name Credit Derivatives,Wiley, New Jersey.
cannot be compared across different types of Pykhtin, M. (2005). Counterparty Credit Risk Model-
instruments, such as corporate versus municipal ling, Risk Book, London. 12
bonds. Report of the Board of Banking Supervision, Inquiry into the
20. The rating of credit structures has been a very Circumstances of the Collapse of Barings (1995), BoE.Rowe,
profitable business for the rating agencies. Moody’s D. (2005).“The danger of complexity”, Risk, 18, 4 (April), 91.
reported in 2006 that 43 per cent of total revenues Rowe, D. (2009). “Second-order uncertainty”, Risk, 22, 4
came from rating structured products. (April), 85.
Sakoul,A. (February 16, 2009).“S&P sees new systemic risk in
References CLO defaults”, Financial Times (London).
Allen, F. and D. Gale. Financial Innovation and Risk Shar- Schönbucher, P. J. (2003). Credit Derivatives Pricing Model,
ing, 2nd Edition, M.I.T. Press, Cambridge, Mass. Wiley, New Jersey.
Blankfein, L. (February 8, 2009). “Do not destroy the Turnbull, S. M. (2005). “The pricing implications of counter-
essential catalyst of risk”, Financial Times (London). party risk for non-linear credit products”, Journal of Credit Risk,
Brunnermeier, M.K., and L.H. Pedersen (2009). Market 1, 4, 3-30.

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
Macroeconomics
Red star spangled banner: root

causes of the financial crisis
draw inspiration from the economics model
devised by Heckscher-Ohlin-Samuelson.
IN this short note we inquire into the economies, but also in mature economies
root causes of the present financial cri- (cf. Rodrik 2008, Eichengreen 2007).
sis by drawing on a Heckscher-Ohlin- Consequently, rather controlled econo-
Samuelson (HOS) model. At the origin mies have concentrated on exporting labour-
of the current crisis are global imbalances intensive production, which in the presence
originating from distorted relative prices of command economy style distortions has
in real production. Thus financial repres- been reflected in a remarkable savings glut.
sion in countries seeking to suppress
real appreciation has resulted in exces- Distorted competition
sive labour-intensive production and a To cope with distorted competition in inter-
global capital shortage. Seemingly, some national production – due to the suppressed
rather controlled economies have bent upward pressures in real wages abroad – few
the tune of real and particularly financial options exist for more mature economies:
globalisation, thus producing the rather possible reactions of rather flexible market
awkward anthem ‘Red Star Spangled economies comprise of lowering real wages
Banner’. Crisis remedies, hence, have to and/or pushing ahead with the marginal
rely on revamping the team play in finan- product of other factors, such as capital
cial globalisation affairs. including financial services or land.
As depressing real and correspondingly
We argue that in particular a low level of nominal wages considerably is not a viable
financial development and subsequent polit- option for rather flexible market economies,
ically induced financial repression in emerg- subsequently, practicing a laissez-faire stance
ing market economies has put the chains towards financial markets, an increase in the
on relative prices and real exchange rates marginal product of capital and excess lend-
respectively, supporting macroeconomic ing has been the natural outcome of dis-
stability and spurring economic growth in torted international competition. According
the short-term not only within emerging to our line of argument, suppressing real

appreciation in rapidly growing economies As a result of the Stolper-Samuelson
results in the production of high net saving Effect, an artificially high minimum rental
surpluses, i.e. an export of real appreciation rate on capital assets leads to higher rela-
pressures and severe global imbalances, tive good prices in terms of labour-intensive
which are at the heart of the present financial good production. Hence, we reach a new
crisis. In the following sections, we present equilibrium with less capital-intensive pro-
an overview of how we formalised our argu- duction in order to compensate the high
ment based on comparative statics referring level of financial returns. Accordingly, capital
to a HOS- model. that would have been employed in produc-
tion in the case of no financial repression
Real interest rate must be off-set in terms of ‘stalled invest-
In doing so, we assume the representative ments’, labelled as. This is to say that some
economy to produce two goods with known portion of capital has been squeezed out of
characteristics, i.e. one good is labour- economic production relative to original fac-
intensive in production and the other one tor endowments.
capital-intensive, while technologies and A flexible interest rate will always ensure
preferences in the two countries are identi- that capital will, at all times, be fully employed.
cal. After the Stolper-Samuelson proposition However, adding politically induced market
given a specific relative factor price, a rise in distortions to the capital market with a bind-
the real interest rate can be traced back to a ing minimum on the rental rate of capital,
decline in relative good prices in terms of a a market clearing via the price mechanism
labour-intensive good. This is to say that a could potentially not occur. By the same
corresponding reduction in the produced token, such financial repression does not
amount of capital-intensive goods relative allow for re-investment within the domestic
to labour-intensive goods may be due to a economy but results in an export of savings/
change in factor prices, i.e. the real interest investments.
rate.
An according change in the rental rate on Balance-of-payments
capital shifts the economy towards labour- In order to show that a savings glut results
intensive goods production. Therefore, there from financial repression and leads to a cor-
is a drop in relative deployment of capital per responding drop in capital intensity, we have
labour. For the sake of simplicity and tak- to take a look towards balance-of-payment
ing the Walras’ Law into consideration, we issues. Although such an approach presents
model the market distortion as a minimum an ex post view on the international flow
rental rate on capital assets, which can be of real quantities and according claims and
interpreted as financial repression with the liabilities, a closer look at the balance-of-
aim of preventing real appreciation. In line payments prepares the ground for the sub-
with the Lerner symmetry, a wage rate policy sequent analysis of ‘excess savings’ from the
including a far too low real wage rate would viewpoint of international trade.
yield the same result. The following equations link financial

repression and its resulting de-capitalisation, with competitive cost conditions. Let a bar of
which must be equivalent to“excess savings” the variable represent the level of that vari-
in the related country. able in the integrated equilibrium. Let index
The subsequent equations in (4) represent goods and index countries A and
highlight the fact that capital and finan- C. The set of divisions of world endowment
cial accounts, i.e. investments abroad and among involved countries in line with the
changes in the reserve level(If-dR) balance integrated equilibrium concept can thus be
the current account (X-M). The latter trade described in the form of factor price equali-
balance must then be identical to the level sation (FPE) set:
of “fundamental savings’’, which are not If the integrated equilibrium is to be rep-
invested in the domestic economy, plus the licated, the global savings glut must be at
‘excess savings’ due to the de-capitalisation the same level as in the integrated economy.
in the course of financial repression in terms But ‘excess savings’ do not arise in liberalised
of “stalled investments”. financial markets in country A. However, the
real appreciation controlling country C must
Simple link build up ‘excess savings’ (equivalent to some
The basic link between financial repression form of de-investments ) in order to comply
and excess savings is rather simple: For com- with the higher interest rate.
petitive firms to access financial funds on Beyond this, we only need to satisfy
capital markets at the higher interest rate, the conventional restrictions in terms of
they need to sell off their products at least employed factors. These require that both
at the higher relative price. When finan- countries use the integrated equilibrium
cial repression puts a binding constraint on techniques, and that the integrated equilib-
firms, the goods price will only be attained if rium output in both sectors can be divided
the relative scarcity of capital increases. This among the countries. In a stable equilibrium,
will apply only if a sufficiently large share of demand will exactly exhaust employed fac-
capital is unemployed in production. tors in the two countries, which exist in the
We now consider the world economy overall reduced ratio of capital per labour.
consisting of two countries with free trade
and zero transaction costs.The mature coun- New equilibrium
try (A), representing the group of flexible Under the conditions noted above, interna-
market economies, has completely liberal- tional trade equalises factor prices between
ised financial markets, in which the interest the financially liberalised economy A and
on capital assets is determined freely by mar- the financially repressed economy C. The
ket forces. The representative real apprecia- according distortion in relative factor prices
tion controlling economy (C) has imposed resulting from financial repression shifts the
some form of financial market repression to economy to a new equilibrium. Here capital
support their economic development strat- intensity in the production of the labour-
egies, leading to an upward bended mini- intensive good has decreased. At the same
mum real interest rate, though still in line time, capital intensity in the capital-intensive

production within country A has increased. savings to sustain a higher interest rate for
In the face of a global market, free com- both economies. In country A, the absence
modity trade fully equalises factor prices of financial repression results in a relatively
and thus exports warped relative prices lower but‘natural’(Wicksell) interest rate.
from real appreciation controllers to flexible However, once trade commenced, the
economies. flexible market economy of country A comes
Now we have to demonstrate how to share country C’s high real interest rate.
economic integration in the form of trading The fact that country A shares the high inter-
between a mature, flexible market economy est rate under trade follows from the fact that
A and a non-mature, real appreciation con- trade links goods prices, while both countries
trolling economy C are impacting on both remain diversified, meaning that producers
economies. In particular, we are interested still face competitive cost conditions.
in investigating how financial repression in
one country affects the production in the Economic bubble
other country. In effect, trade forces country C to bear the
In the HOS-model framework it is par- burden of “excess savings”to maintain coun-
ticularly the Rybcsynski theorem that deals try C’s comparative advantage and hinder a
with the effects of endowment changes. real appreciation. But, forcing capital markets
With one factor price fixed, i.e. financial in country A to increase capital rental rates
repression and an upward bent rental rate implies that opening to free trade will lead
for capital, our result is just the Rybcsynski to a deviation of the capital rental rate from
theorem in reverse. When we look at country its economic fundamental value. This would
C with financial repression and an upward lead to an over-utilisation of capital and
bent rental rate for capital, not trading with increasing capital intensity in country A’s
country A the warped relative price leads to economy. Accordingly, an economic bub-
a change in production. The decreasing pro- ble emerges at the heart of country A, which
duction of the capital-intensive good reflects cannot be detected by simply looking at iso-
the expansion of savings, exactly necessary lated country-specific fundamentals.
to eliminate the excess demand for capital- ‘Excess savings’ of country C are indeed
intensive goods (i.e. investments). exported to the flexible market economy in
country A. The previously outlined balance-
‘Stalled investments’ of-payments arithmetic has already shown
In our stylised framework, the country C’s that real appreciation controlling is achieved
opening of trade with country A would even by a contraction of capital-intensive good
further increase country C’s “excess sav- production in terms of ‘stalled investments’,
ings” in terms of “stalled investments” and fuelling the current account surplus of coun-
the ruled-out demand for capital-intensive try C.
goods in country C respectively. The rea- However, such balance-of-payment
son is that country C would be quasi forced matters only depict the ex post view on eco-
to generate the full integrated amount of nomic formation. We have now to set forth,

how distorted relative factor and good prices set forth an analytical framework of interna-
affect the formation of import-export rela- tional trade economics in order to investigate
tions ex ante. Regarding import demand and the root causes of recent financial turmoil in
export supply between country A and C fills a broader context.
this niche and buttresses the results gained We demonstrate how economic dynam-
thus far. ics in an asymmetric global financial inte-
As we have already argued, a surge in gration process have contributed to fuelling
relative price levels results in an increased international liquidity and thus contributed
production of labour-intensive goods and a to an expansion of financial markets in
contraction of capital-intensive production mature, flexible market economies beyond
respectively. Accordingly, we may now argue their fundamental economic capacity. In
that the upward bended relative price cor- this regard, our central assumption has been
responds to country C’s real exchange rate that financial repression has been applied in
and inversely affects its terms of trade. This non-mature economies in order to prevent
is to say that country C improves its terms of real appreciation pressures, as well as to sta-
trade with the help of financial repression. bilise economic growth processes in these
As indicated in the FPE set, resulting economies.
‘excess savings’ in country C are transferred
in terms of an export supply of labour- Push factor
intensive goods. At the same time, country A However, these policy measures have
heavily borrows from country C and absorbs worked as a push factor and a driving force
these ‘excess savings’, which, in turn, allows behind international capital flows to mature
for spurring capital-intensive production in financial markets. For this reason, we argue
country A. From the viewpoint of country C, that latter non-mature economies are the
this is simply an export of its real appreciation ‘producers’ of the global savings glut, which,
pressure towards country A via its down- in turn allows for capital intensification in
ward bended terms of trade. Interestingly, it the sector of capital-intensive production in
is the labour force in country C that bears the mature and thus financially developed and
burden of internal economic adjustment to liberalised economies. At the same time,
suppressed real appreciation. the according absorption of international
liquidity also reflects global asset shortages
Conclusions and outlook (Caballero et al. 2008) as depicted in the fall
As we argued in the beginning, financial of global capital intensity in the integrated
crisis stems from distortions in global real world equilibrium.
production. To put it bluntly, real under- Furthermore, the combination of both
valuation in context of financially, and thus the saving glut and a lack of appropriate
real exchange-rate-suppressed economies, financial market regulation has been fuel-
is one of the primary causes of the current ling consumption and production in these
international financial crisis. In contrast to mature economies beyond their fundamen-
conventional monetary approaches, we have tal capacities. From this perspective standard

approaches and measures applied in assess- of the global economy in the medium to the
ing financial and macroeconomic vulner- long run, correcting structural misalignments
abilities must have failed to show signs of should be high on the policy agenda. Hence,
overexpansion and misalignments. fixing structural misalignments on a global
In fact, a large current account defi- scale with the help of international policy co-
cit in combination with a stable US dollar ordination may represent the natural order
exchange rate and increasing labour produc- of things.
tivity in the US have been rather persuad- Revamping the latter ideas may help to
ing policy makers and investors to put trust surmount the discontent from current inter-
in the sustainability of global imbalances in national financial crisis. Obviously, advanced
recent years. and rather controlled economies can hardly
Nevertheless an artificial contraction of get along together in a world that is glo-
capital-intensive production in real apprecia- balised in real but not in financial terms. In
tion controlling economies lies at the heart of order to reap the benefits of extensive glo-
the economic expansion of financial indus- balisation in the long run, crafting a financial
tries and consumption in the US beyond and thus ‘real’ sound globalisation is war-
their fundamental limits. ranted. •
Economic vulnerabilities References

According to this view from the production Caballero, Ricardo J., Emmanuel Farhi, and Pierre-
side, it becomes apparent that accruing real Olivier Gourinchas, “Financial Crash, Commod-
misalignments between mature and non- ity Prices and Global Imbalances,” NBER Working
mature economies in a globalised world are Paper No. w14521, 2008. 
a root cause of the current global financial Eichengreen, Barry, “The Real Exchange Rate and
crisis. For that reason, any policy measure Economic Growth,” See: http://www.econ.berkeley.
aimed at restoring misaligned economic edu/~eichengr/real_exc_rate_econ_grow.pdf, 2007).
structures will lead to a freeze of a subopti- Rodrik,Dani,“The Real Exchange Rate and Economic
mal equilibrium, exposing mature and non- Growth.” See: http://www.brookings.edu/econom-
mature economies to substantial economic ics/bpea/~/media/Files/Programs/ES/BPEA/2008_
vulnerabilities in the near future. fall_bpea_Paper/2008_fall_bpea_rodrik.pdf, 2008).
Nevertheless such demand-side ori-
ented measures are possible instruments (Editor’s note: We would like to thank
which may deliver short-run relief to the Dr Christian Fahrhols of Friedrich-
global economy and employment in the US Schiller-University Jena and University
and other mature economies. At this stage, of Mannheim, Dr Andreas Kern, Jean
however, escaping costly structural adjust- Monnet Centre of Excellence, Free
ments on the supply side in form of indus- University Berlin, and Voxeu [http://www..
trial cutbacks and rising unemployment will voxeu.org] for kindly allowing the Journal
hardly be possible. to reproduce in full this article, which is
In order to prevent a potential collapse part of Voxeu’s global crisis debate series.)

Compliance
The ‘family’ risk: a cause for

concern among Asian investors
RiskMetrics’ David Smith sounds a
warning on related party transactions in
the Asia-Pacific region.
Traditional models of corporate controlling shareholder or its associates, or

governance in many emerging Asian the assumption of liabilities of/provision of
countries see companies doing business guarantees to an associated entity, although
with related parties. These related party a wide variety of abusive related party trans-
transactions are often a source of concern actions exist.
for investors, given sometimes opaque Analysts, however, should be aware of
disclosure requirements and, in some the risk of value seepage to their holdings as
regimes, no requirement for shareholder a result of abusive related party transactions
approval. that have the effect of transferring wealth
from a listed entity to an entity linked to the
With Asian businesses being in many controlling shareholder.
cases linked to a controlling family, state
institution, or group of companies, trading Analyst’s perspective
amongst related parties is often unavoidable This paper seeks to develop a framework
and can, in certain circumstances, lower the for analysing related party transactions from
cost of doing business. an analyst perspective, highlighting key
However, while related party transac- triggers for concern and providing guid-
tions have long been accepted as a common ance on areas to which analysts should pay
characteristic of Asian business operations, particular attention. In doing so, the paper
the risk to minority shareholders of expropri- first provides an overview of related party
ation via abusive related party transactions is transactions; second, considers the nature of
material. abusive related party transactions; and third,
develops a framework for analysis.
Beware party transactions The UK-based International Accounting
Abusive related party transactions com- Standards Board (IASB) defines a related
monly take the form of over- or underpaying party transaction as “a transfer of resources,
for an asset, providing loans to a majority or services, or obligations between related

parties regardless of whether a price is or may not involve a formal agreement or
charged”, while the US-based Financial contract. In many cases, these transactions
Accounting Standards Board (FASB) adds are neither extraordinary nor abnormal,
that such a transaction may not necessar- and are entered into at arms length and in
ily“ . . . be given accounting recognition; for the normal course of business. Related par-
example, one entity may receive services ties may operate in related business areas
from a second, related entity without charge (providing services or inputs to a sister com-
and without recording a receipt of services”. pany), or may simply share a common par-
ent company.
IAS 24 and FAS 57 Related party transactions present a sig-
In essence, a related party transaction sees nificant challenge to analysts in Asia given
one party provide goods or services to the wide range of ownership structures in
another party, with this party associated in this region. In Asia, related party transactions
some way with the vendor (here, both IAS occur where listed companies are members
24 and FAS 57 provide guidance on defini- of a larger conglomerate (e.g. a Chaebol or
tions of control and influence). Keiretu), are part of a group of businesses
The provision of these goods or services controlled by one ultimate shareholder
may or may not result in payment, and may (e.g. portfolio companies belonging to an
Box 1: Related Parties under IAS 24
Pursuant to IAS 24.9, a party is related to an entity if:

(a) directly, or indirectly through one or more intermediaries, the party:
(i) controls, is controlled by, or is under common control with, the entity (this
includes parents, subsidiaries and fellow subsidiaries);
(ii) has an interest in the entity that gives it significant influence over the entity;
or
(iii) has joint control over the entity;
(b) the party is an associate of the entity;
(c) the party is a joint venture in which the entity is a venturer;
(d) the party is a member of the key management personnel of the entity or its
parent;
(e) the party is a close member of the family of any individual referred to in (a)
or (d);
(f) the party is an entity that is controlled, jointly controlled or significantly
influenced by or for which significant voting power in such entity resides
with, directly or indirectly, any individual referred to in (d) or (e); or
(g) the party is a post-employment benefit plan for the benefit of employees of
the entity, or of any entity that is a related party of the entity.

entrepreneur), or are linked via shareholder A combination of weak regulation, weak
agreements, uneven voting rights, or other enforcement and, in many cases, unneces-
control-related mechanisms. In a number of sarily complex transactions that are chal-
cases, voting interest is not a direct function lenging for analysts to decipher facilitate
of economic interest. such transactions.
These transactions ordinarily take one of
two forms: Weak boards
1. A nonrecurring trade, including in These weaknesses are often compounded
many cases the purchase/sale of property, the by weak boards, with over-stretched or cap-
purchase/sale of a business unit, assumption tive directors not providing lively and spirited
of liabilities/obligations, or the purchase/sale debate. These captive directors are recruited,
of intangible items. nominated and elected by major sharehold-
2. Recurring/ongoing trades, where a ers, with minority shareholders dislocated
firm agrees to continuously supply inputs/ from this process. An extension of the owner/
services to a related party for a set time. manager model of corporate governance is
that in many cases genuinely independent
Abusive elated party transactions directors are rare – directors are appointed
While in many cases related party transac- with the consent and approval of the owner/
tions in Asia are on normal terms and are in manager and, as such, debate and discussion
the interests of minority shareholders (for is perhaps likely to be less rigorous.
example, through the reduction of trading
costs), a subset of these transactions are det- Lack of independent directors
rimental to minority shareholders. We have contended in a number of articles
These transactions have the effect of on Asian corporate governance that Asia
transferring wealth from these parties as a often lacks truly independent directors –
result of the abusive nature of such agree- related party transactions are one area where
ments, and whilst their structure and design this lack is felt.
vary from case to case, all retain a common Compounding this, director training in
element – a controlling shareholder expro- Asia is often lacking, with many directors
priates wealth to the detriment of minority insufficiently prepared for the complexities
shareholders. of the transactions presented.The complexity
of these transactions means that decipher-
‘Tunnelling’ transactions ing circulars and associated documentation
These “tunnelling” transactions (Cheung et is often challenging for analysts (including
al, 2007) may also involve a parent company asset owners and regulators).
selling an asset at an inflated price to a listed The Byzantine nature of ownership, the
subsidiary, buying an asset at a reduced price stages of separation of ownership and con-
from a listed subsidiary, or a major share- trol, and the multiple trades involved in a
holder securing a loan guarantee from the single transaction mean that more often that
listed entity (Berkman et al, 2008). not time-poor analysts face insurmountable

hurdles in preventing such expropriation. the compensation involved, the terms of pay-
While the complexity of transactions is ment (cash, exchange of assets, assumption of
indeed an issue, the analyst is able to follow liabilities, etc), and whether such compensa-
several steps when considering a transaction tion is appropriate. If the compensation is via a
in order to assess the likelihood of it being share-swap, analysts should consider whether
abusive. valuations ascribed are fair and reasonable.
4. Finally, the fundamental question that
Sectional guide analysts should ask is: Why? Why now? Why
This section presents a guide to assessing this method? Why this asset? If disclosure
related party transactions developed in order does not include such justification analysts
to aid analysts in their assessment of related should seek to engage more with the parties
party transactions. While these steps are not to understand the rationale. Why is the asset
a panacea, they allow the analyst to triage owned by a parent company the ideal asset
transactions and focus in more detail on to acquire? Where a diversifying acquisition
those that at one or more points, fail. is proposed, why is diversification appropri-
1. Analysts should, at the outset, seek to ate (especially since it involves acquiring an
understand the parties to a transaction. asset unrelated to the parent company)?
Exploring linkages, understanding relation-
ships, and examining control and influence is Conflicts of interest
the first and perhaps most important aspect In following these steps, analysts should be
of assessing related party transactions. Indeed, able to better understand the dynamics of a
tracing ownership linkages – especially proposed transaction and be able to iden-
graphically – can aid analysts in understand- tify those transactions that warrant closer
ing the rationale and process for a transac- attention. Throughout this process, analysts
tion. Following this, analysts should examine should also pay close attention to potential
in detail the asset/service being traded. Is the conflicts throughout the transaction. Are
asset fully or partially owned by the vendor? directors conflicted? Are advisers to direc-
In the case of the service, are there defined tors/shareholders conflicted? Are valuation
parameters to the service agreement? providers conflicted? While many jurisdic-
2. Next, analysts should examine in detail tions have regulations designed to prevent
the pricing and valuation of the asset. What such conflicts, analysts should be cautious
valuations are attached to the asset/service? when examining advice.
Who has provided the valuation? Is evidence However, this process – including ulti-
of the valuation provided? Analysts should mate approval by shareholders – relies on:
be wary of valuation companies that may be (a) related party transactions being put to
linked to one or more parties to a transac- shareholder approval (subject to a thresh-
tion, or that have no track record in providing old-based approach), and (b) sufficient
such valuations. information disclosed in timely fashion to
3. A follow-on issue to pricing is the terms analysts, and (c) shareholder voting mecha-
of payment. Analysts should examine in detail nisms being appropriately developed so as

to enfranchise minority shareholders, and focus attention both on a micro-level (i.e.
disenfranchise related parties. do we trust this management team?) and
a macro-level (i.e. are the right regulatory
Shareholder approval checks and balances in place to ensure my
Where one of the three steps is missing, interests are protected?).
shareholders will be unable to effectively The former can be addressed through
protect their economic interests. Where a lengthy and rigorous due-diligence proc-
related party transactions are not subject to ess. However, shareholders should engage
shareholder approval, there is very little ave- on a macro-level as well, ensuring that the
nue for preventing such transactions. Where regulatory framework is suited to the needs
insufficient information is disclosed, analysts of international investors. Indeed, while this
should engage with listed companies (and paper has approached related party transac-
regulators) to ensure that such information tions from the perspective of the investor,
is disclosed (including terms of the transac- there is much that regulators can do. Where
tion, price of the transaction, time periods for IAS24 has not been adopted, incorporating
service provision where appropriate, etc). IAS24 would be useful.
Finally, where voting is done on a show
of hands, for example, with controlling Limitations of IAS 24
shareholders permitted to vote, the ability to However, regulators should recognise the
effectively analyse a related party transaction limitations of IAS 24 with regard to the defi-
is worthless. nitions of related parties, and should seek to
develop locally-tailored definitions that are
Final thoughts sufficiently broad so as to capture related
Related party transactions are a feature of party transactions, but not so vague as to put
Asia, and often essential to ongoing business an undue burden on listed companies.
for Asian enterprise. This paper has high- Regulators should be aware of the risks
lighted the risk of abusive related party trans- to their reputation – and the reputation of
actions to investors in Asia and has outlined the jurisdiction as an investment destina-
a process for analysing such transactions. tion – that stem from the incidence of abu-
Weak exogenous (shareholder, regula- sive related party transactions. Analysts will
tory) oversight is often coupled with weak ultimately ascribe a higher return on equity
endogenous (e.g. Board) oversight, creating hurdle, or a higher return threshold, or a
a monitoring vacuum. Where such a vacuum higher discount rate when making invest-
exists, the potential for abusive related party ment decisions. Capital may be withdrawn,
transactions exists and shareholders should and may be slow to return following an eco-
be cautious when investing. The risk to nomic downturn.
minority shareholders from abusive related Assessing and curbing abusive related
party transfers is that a slow seepage of value party transactions is in the interest of share-
may impact on fund performance. holders, regulators and listed companies
Perhaps, though, shareholders should themselves. The threat to shareholders is

material and analysts should be cautious “How does the grabbing hand grab? Tunnelling assets
when considering related party transactions from Chinese listed companies to the State”, City
in Asia in order to mitigate this risk. • University of Hong Kong Working Paper.
Kim,W., Lim,Y., & Sung,TY (2004),“What Determines
Bibliography the Ownership Structure of Business Conglomerates?
Aharony, J., Lee, J. & Wong,T.J. (2000), “Financial Pack- On the Cash Flow Rights of Korea’s Chaebol”, ECGI
aging of IPO Firms in China”, Journal of Accounting – Finance Working Paper No. 51/2004; KDI School of
Research, 38 (Spring), pp103-126 Public Policy & Management Paper No. 04-20.
Berkman, H., Cole, R.A. & Fu, L.J. (2008),“Expropriation Related Party Disclosures, International Accounting
through loan guarantees to related parties: Evidence Standard No. 24 (International Accounting Standards
from China,” Journal of Banking & Finance, 33(1) Bd. 2009), available at: http://www.iasb.org (last visited
CFA Institute Centre for Financial Market Integrity June 19, 2009).
(2009), Related-Party Transactions – Cautionary Tales Interests in Joint Ventures, International Accounting
for Investors in Asia. Available at: http://www.cfapubs. Standard No. 31 (International Accounting Standards
org/doi/pdf/10.2469/ccb.v2009.n1.1. Bd. 2009), available at: http://www.iasb.org (last visited
Cheung, Y.L., Jing, L., Rau, P.R. & Stouraitis, A. (2006), June 19, 2009).
“Tunnelling, propping and expropriation: evidence
from connected party transactions in Hong Kong”, (Editor’s note: The author wishes to thank
Journal of Financial Economics, 82(2) RiskMatrix Asia’s Dr Heong Wee Chong for
Cheung, Y.L., Jing, L., Rau, P.R. & Stouraitis, A. (2007), his valued contribution to this paper.)

North Asia J ournal
of regu
lation &
north a risk
sia
Articles & Volume I,

Issue
Papers III, Autumn
Reprints Available
Winter 2009
-2010
Issues in reso
lving syst
emically imp
Resecuritisat ortant fina
ion in bank ncial insti
ing: major tutions
A framewo challenges Dr Eric S. Rosen
rk for fund ahead gren
ing liquidity
Housing, in times of
monetary financial crisi Dr Fang Du
and fiscal s
Derivativ policies: from
es: from disa bad to wor Dr Ulrich Binds
ster to re-re st eil
Black swa gulation
ns, market Stephan Schoe
crises and ss,
Measuring risk: the hum Professor Lynn
& managin an perspect A. Stout
g risk for ive
Red star span inno vative fina
gled bann ncial instr Joseph Rizzi
er: root caus uments
The ‘family’ es of the fina Dr Stuart M.
risk: a caus ncial crisi Turnbull
e for conc s Andreas Kern
Global fina ern among & Christian
ncial chan Asian inve Fahrholz
ge impacts stors
The scrambl complian
e is on to tack ce and risk David Smith
le bribery
Who exac and corrupti
tly is subj on David Dekke
ect to the r
Financial Foreign Corr Penelope Tham
markets rem upt Practices & Gerald Li
uneration Act?
Of ‘Black reform: one
Swans’, stres step forw Tham Yuet-M
s tests & ard ing
optimised Umesh Kuma
Contact
Challenging risk man r & Kevin
the value agement Marr
of enterpri
Rocky road se risk man
ahead for agement David Samu
els
global acco
The Asian untancy conv Tim Pagett
regulator ergence & Ranjit Jaswa
l
y Rubik’s
Cube
Christopher Rogers
Dr Philip Goeth
Alan Ewins
and Angus
Ross
General Secretary
christopher.rogers@irrna.org

Compliance
Global financial change impacts

compliance and risk
EastNet’s head of products management –
compliance, David Dekker, details a potent
chemical reaction in financial markets.
About a year ago we saw the first signs will just be one of companies amongst oth-
of a transformation in the financial world ers that will be able to offer these services.
and in the last months the credit crisis These days we should rather speak about
has transformed the financial world at financial institutions than banks, or moni-
an explosive pace. The change that is tored financial service providers, a name that
occurring is much broader in scope than covers their current and future activities.
originally expected. Banks that were Look at how rapidly we have moved
considered to be too big to fail or fall from physical interaction on the banks
are either failing or being taken over by terms (location and hours of operation) to
financial institutions that are more finan- electronic payments then Internet banking.
cially sound, resulting in a huge para- Again the banks were still in charge, but
digm shift in how banks are regarded by as mentioned the paradigm is shifting to a
the public and other banks. world where we (physical persons and cor-
porations) pay each other without the banks
Since banking largely revolves around involvement with new technologies such as
trust and the ability to service customers, los- mobile payments.
ing a customer and determining the impact
of it, should be part of the ongoing risk Network providers
management of the organisation, as well as In the future the banks and organisations
monitoring the riskiness of existing and new such as SWIFT, NACHA and other pay-
products and the customers using/buying ment networks become network providers
these products. But there are more changes that allow you to send money from A to B
and challenges in the banking world that are and will charge you for the network traf-
threatening banking as we have known it. fic that you generate. This brings similari-
The banks will, in the future, not be the ties with industries such as telecom, energy
default vehicles by which to move our funds, suppliers and cable companies. The financial
maintain our balances and portfolios; they world is clearly undergoing an important

transformation! So how are we going to OFAC. They are accepted or denied access
monitor the financial peer-to-peer model and sometimes informed upon to the local
and how are we going to control compliance regulators and law enforcement authorities.
on these kinds of networks? Companies • All financial information (read: trans-
such as PayPal and Linden Labs (Second actions) entering your financial structure, or
Life) mention they have this under control is moved over your technical infrastructure,
and that even transactions of under US$4 is screened for possible violations (against
can be monitored for unusual behaviour, lists such as Sanctioned and OFAC). It is not
but how true is this? And even if they can do sufficient to only check the originator and
this, how are other companies in, for exam- the final destination/beneficiary, All involved
ple, the console game world handling their parties (correspondent banking providers
micro-transaction strategy and compliance or corresponding service providers) need
requirements? to be screened. Next year’s most important
changes in payment systems and payment
Transparency, trustworthiness networks (like NACHA and SWIFT) actually
Compliance is not just creating a Suspicious evolve around the“involved parties”part.
Activity Report or a Currency Transaction This year, 2009, is the year of Cross Border
Report upon suspicious behaviour or Payment enhancements. On NACHA this
breaches of thresholds; its application is means that BSA Travel rule information is
expanding as it is increasingly linked to risk added to international transactions (to pro-
management. Compliance is about follow- vide more information to involved parties
ing up on requirements set out by regulators, about WHO is actually involved) and SWIFT
providing transparency to all stakeholders will come with the Cover Payments adjust-
and managing risks that can impact busi- ments that basically come down to adding
ness processes or the financial institute’s similar information to the cover messages
reputation (trustworthiness) and financial (MT202s). There is already even talk that all
solvency. payment networks come to a uniform for-
Based on what is mentioned in the pre- mat (ISO 20022) for exchanging payments
vious paragraph the following controls and across themselves.
processes need to be put in place to enable
confidentiality and trustworthiness for cus- Know your customer
tomers and monitored financial service pro- This technology is referred to as Filtering
viders alike. The first step in confidentially is software. When used in the customer on-
placing a lock on the door and making sure boarding and on-going process, the cus-
that nobody with bad intentions enters your tomer information is scanned to identify
financial institute or your financial trust ring. and block any attempts by people with bad
The lock is based on: intentions to make use of your banking serv-
• Verification of people and/or organi- ices. The on-boarding is also the step where
sations seeking a (financial) relationship you would gather information to Know
against lists such as the Sanctioned and Your Customer (KYC) and perform the first

Customer Due Diligence (CDD). The results stopped. Many complex factors are involved
of these two tasks should result in an initial in a Filtering decision process such as typ-
risk determination by means of Basel and ing mistakes, aliases, use of abbreviations,
Solvency standards. and cultural and character set differences.
Although Filtering is a very complex proc-
Political exposure ess with many angles, it should be provided
This actually brings me to one point that was to the Compliance officer in a simple and
not yet mentioned in the reasons behind factual manner to allow him/her to make
Filtering, but which is actually part of both a conscious decision in a short time-frame.
KYC and CDD. Filtering is also used to Many technology vendors fight complex-
identify new or current customers as to their ity with even more complexity, but this can
being manipulated or being the manipula- be avoided via a simple and clear presenta-
tor themselves, using the Politically Exposed tion which provides, in turn, clear auditing
Persons (PEP) list – a priority in Europe since records for transparency.
the enactment of the 3rd European AML Having said that, let us move on to the
Directive, with many countries following suit. monitoring of what is happening internally
To make sure there are no misunderstand- at financial service providers or financial
ings, being a PEP (political exposed person) institute. What is happening internally is as
is not against the law but it is very important important a part of Compliance as the lock
to determine for evaluation of potential riski- on the door.
ness of a person or group.
But Filtering needs to also include the Customer profiling
checking of transactions (with highest prior- The second step to compliance is the inter-
ity on international financial activity) against nal monitoring of what happens within your
the list, and perhaps even retroactively, by re- financial institute, a process that is called pro-
checking those already checked and passed filing. Profiling in its simplest form is gather-
against every new version of the OFAC and ing and building statistics about the financial
Sanctioned lists. This is of absolute impor- behaviour of customers and making deci-
tance to prevent an enemy within, which can sions whether or not suspicious activity is
cause even greater damage than possible shown. But it is much more elaborate when
external threads. History has provided two we look at reaching full compliance or trying
very nice examples of that – the computer to fight financial crime.
virus Trojan Horse and the original for which The simplest form of profiling is deter-
it was named. mining if a customer is deviating from his/
So Filtering is touching your financial her regular behaviour over a period of time.
institute at the heart of its operation (no If that is the case, then typically a compliance
matter what service you provide), because officer would look at such an indicator and
sometimes a physical person needs to be determine the final outcome: ”suspicious
involved to make an additional assessment if and a violation” or “not suspicious and false
something is really suspicious and should be positive”. The determination of suspicious

behaviour based on deviations of previous of the markets that bring financial systems to
or historical personal activity is not the best a standstill.
detection rule, so another way to detect sus- Once all statistical information is avail-
picious behaviour is to compare a person’s able, more informed decisions based on facts
or organisation’s behaviour against that of are possible, plus this enables audit ability
its peers. and confidentiality for all stakeholders.
This gives far better results and is actually The statistical information (on custom-
a technique that has been used in statistical ers, employees and products) helps to deter-
research for many years with large success, mine the riskiness of a financial institute. It
but requires categorisation (or segmenta- can also be used to help the monitoring and
tion) and a significant sample size to provide spur requests for enhanced due diligence to
the best results. The technique described is reduce false positives and making the com-
called peer grouping. For the proper use of pliance teams more productive, cost-effec-
peer grouping you need to have done the tive and pro-active (solve a problem before
KYC and CDD work correctly, otherwise it actually becomes one!). It reduces the
you are comparing apples with oranges and chance of abuse of products or the possible
only wasting time looking at the wrong kind impact of losses when products that are sold
of information. are not balanced well enough and it will also
be easier to calculate the risk (read: financial
Case of the rogue trader exposure to the balance).
Therefore, statistics are a very important Compliance is unfortunately still consid-
tool to look at customers’ behaviour, but ered by the largest part of the financial service
you should not only look at your customers. providers as a cost, whereas it is actually one
Employees could also be a potential compli- of the best ways to save and earn money. If
ance problem and, with them, the products you know your customer better, you are bet-
you sell, if they are used in a bad manner. ter able to detect when something is really
Recent examples on the importance of out of the ordinary and you are better able
employee and products monitoring are: The to service them with value added [financial]
case of the rogue trader at SocGen; senior products (watch out for tipping off). This will
management manipulating figures to get result in a better appreciation of your efforts
higher bonuses (short-term gains); the trad- by the customer, enabling confidentiality
ers of financial investment vehicles result- and TRUST.
ing in the credit crises as we know it (the In retrospect, we can state that the lesson
traders should have been monitored more learnt from the credit crises, is that the finan-
closely with a market surveillance solution to cial institutions and the regulators (even
avoid, for example, insider trading and other governments) did not know the risks they
specific indicators or problems to come; the had embarked upon. Local governments,
overly complex investment products that now being stakeholders in troubled financial
masked the impact of a part or parts retreat- institutes want to push internal and external
ing in value; market abuse and manipulation transparency. •

Legal & Compliance
The scramble is on to tackle

bribery and corruption
Penelope Tham and Gerald Li of RBS
take a compliance officers’ slant on the US
Foreign Corrupt Practices Act in the region.
ASIAN countries are trying to enhance Various forms of laws and regulations have
their reputation among investors by been implemented in past years to pre-
targeting bribery and corruption with vent corruption and to establish sanctions
increasing vigour. In this respect, there frameworks.
has been a higher level of interna- (a) China: Bribery and corruption laws in
tional co-operation under applicable China make it a criminal offence for individ-
legal instruments, including the 1977 uals or corporations to accept or offer bribes
Organisation for Economic Co-operation in exchange for unfair or improper benefits.
and Development (OECD) Convention[1] Criminal liability triggers at differing thresh-
and the United Nations Convention old amounts. Penalties for non-compliance
against Corruption.[2] Thus a number of under China laws range from administrative
Asian nations follow the principles set discipline, to fines and confiscation of illegal
out in these instruments. gains for organisations, to lengthy imprison-
ment and even death sentences.[4]
A lack of awareness about local and inter- Of significance is an “Opinion on Several
national anti-bribery and corruption laws Issues Concerning the Application of Laws
has triggered high risks for multinationals in to Commercial Bribery Cases”(the Opinion),
Asia. This poses challenges for Compliance jointly issued by the Supreme People’s Court
or Risk officers in these organisations. This and the Supreme People’s Procurate in 2008.
paper briefly examines regional and certain [5]
This provides clarification on China’s brib-
foreign laws with extra-territorial reach.[3] ery and corruption laws, contained primarily
and also provides ideas on how to manage in the China Criminal Law.
these risks. The Criminal Law distinguishes between
North Asia: The war on bribery and cor- bribery involving state officials and “com-
ruption ranks high on the agenda across the mercial bribery” (involving persons who are
region as corruption constitutes an obstacle not government officials). The Criminal Law
to investment and economic development. is unclear as to the precise scope of China’s

bribery laws. In particular, it had previously mooncakes[10] to policemen with whom he
been unclear how commercial bribery fell had dealings during the end of his compa-
into the Criminal Law regime and whether ny’s project. This occurred shortly before the
it constituted a criminal offence at all. Chinese Mid-Autumn Festival, a time when
The Opinion clarifies, in relation to com- cakes are traditional gifts.[11]
mercial bribery, that any person from a state (c) Japan: Japan has also taken an increas-
owned enterprise (SOE) is deemed to be ingly hard line against overseas corrup-
a government official. This clearly brings tion. This is illustrated by the January 2009
commercial bribery within the Criminal conviction of three senior directors of a
Law regime. It is a warning to corporations Japanese company for bribing a high rank-
who may have turned a blind eye to corrupt ing Vietnamese official with US$820,000 in
activities in China in the belief they were an exchange for the award of trunk road con-
integral part of doing business there. struction projects in Ho Chi Minh City. The
directors were sentenced to between 18
Rio Tinto case months and two years’ imprisonment, all
Although there are no reported cases of the suspended for three years.[12]
death sentence being applied to a foreign (d) Korea: The strength of the Korean
executive or a local manager of a multina- Independent Commission Against Corrup-
tional corporation, there are no legal impedi- tion (est. January, 2002),[13] was given a boost
ments to it being applied across the board. on August 3, 2007[14] by the extension of
Consequently it is now more important ‘whistle-blower’ protection to the report-
than ever for foreign investors to take precau- ing of bribery of persons exercising a private
tions to avoid the threat of criminal investiga- function and not just of public officials.
tion, such as that currently being made against (e) Taiwan: Taiwan’s anti-corruption stat-
four employees (including one Australian ute (modelled on FCPA) prohibits bribery
national) of mining giant Rio Tinto for alleg- of Taiwanese government officials and also
edly luring managers at an SOE steel com- prohibits Taiwanese nationals from bribing
pany to hand over secret information relating government officials abroad.[15] The recent
to negotiations for an iron ore deal.[6] high-profile case involving ex-president
(b) Hong Kong: Enforcement of anti-cor- Chen Shui-bian is illustrative of the serious-
ruption laws in Hong Kong is among the ness with which the law is enforced.[16]
strictest globally. A recent case reflects the zeal
of Hong Kong’s enforcers, the Independent Recent trends:
Commission Against Corruption (ICAC). United States: The hallmark of the FCPA
[7]
which enforces The Prevention of Bribery has always been its extra-territorial reach.
Ordinance (PBO).[8] This reach continues to touch emerging mar-
In March 2009, an employee from a ket economies: in December 2007, Lucent
construction company[9] was sentenced by Technologies was convicted for paying senior
the ICAC to two months’ imprisonment for Chinese government officials to make ‘pre-
violating the PBO. The employee had offered sales trips to the US to visit Lucent’s facilities.

According to the US Department of Justice which is intended to update and consolidate
payments made by Lucent bore little or no the patchwork of anti-corruption legislation:
nexus to pre-sales activities: senior Chinese Section 108 of the A-T Act; the Prevention
officials were reimbursed by Lucent for visit- of Corruption Act 1916; the Prevention of
ing non-existent Lucent facilities in the US Corruption Act 1906; and the Public Bodies
– a case evincing fraud as well as bribery.[17] Corrupt Practices Act 1889.[20]
Lucent was fined US$2.5 million.
In December 2008, Siemens AG and sev- Corporate criminal offence
eral of its subsidiaries agreed to pay US$350 The most important feature of the draft Bill is
million in disgorgement to the US Securities the introduction of a corporate criminal offence
and Exchange Commission (SEC); and fur- of negligently failing to prevent bribery com-
ther agreed to the imposition of an inde- mitted by a person performing services on
pendent monitor for a period of up to four behalf of the organisation – i.e.‘third parties’.[21]
years. Here, the SEC alleged a wide range of The three elements to this offence are:
corrupt payments had spread across several (i) A person performing services on
of Siemens’ divisions. Significantly in some behalf of an organisation bribes another per-
cases, including Siemens’ China division, son; (ii) the bribe is in connection with the
the sole jurisdictional basis for certain bribes organisation’s business, and (iii) a respon-
was based on the use of correspondent bank sible person or a number of persons is/are
accounts: between 2002 and 2007, Siemens negligent in failing to prevent a bribe being
allegedly paid approximately US$22 mil- made or offered.
lion to business consultants who used some There is a defence for organisations
portion of those funds to bribe government with proof of adequate set procedures to
officials in China in connection with a US$1 prevent those performing services from
billion project to construct metro trains and paying bribes. The draft Bill proposes that
signalling devices.[18] such defence should not, however, be
United Kingdom: Increasingly, the UK is available if the negligence in question was
under pressure to reform its currently frag- that of a director, officer or manager of the
mented laws. It is often criticised for failing organisation.[22]
to meet international standards, particularly It is worth contrasting this limited pro-
those required by the OECD. To date, there posed defence with those available under
has only been one successful UK enforcement the FCPA. The FCPA has two defences not
case since the A-T Act made it an offence present in the draft Bill: (1) the ‘facilitation
under English law for bribery of an overseas payments’exception; and (2) the promotional
official. A director of a UK-based company or marketing expenses affirmative defence.
was convicted of bribing Ugandan officials Under the FCPA, it is a defence to show
and was given a five-month suspended that a bribe is a small facilitation payment
sentence on September 26, 2008.[19] To coun- made in order to expedite actions routinely
ter such criticism, in March this year the UK performed by a foreign official. For example,
Ministry of Justice published a draft Bribery Bill a small sum (e.g. US$50) paid to a customs

official to expedite clearance.[23] This defence agents before they are appointed; contracts
is not, however, captured in the draft Bill; and with agents, which include a clear prohibi-
the making of facilitation payments remains tion against corrupt activity; and an ongoing
a criminal offence in the UK. compliance review.
Another FCPA defence is the market- In some banks, agents undergo the same
ing expenses defence. Under US law, certain “know your client” process as is applicable
payments may be made to government offi- when clients are on-boarded.
cials in connection with promoting or dem- (b) Use of charities – To the extent that
onstrating a firm’s product or services or in payments made by third parties to legitimate
connection with the execution of a contract charities are wholly and exclusively for chari-
with a foreign government. Again, no such table intent purposes, this poses few prob-
defence exists in the draft Bill.[24] lems. The real concern or ‘red flag’ is that,
in many cases, the charities concerned are
Challenges simply ‘fronts’ or ‘masks’ used by third parties
(a) Use of agents or‘third parties’ – The use attempting to circumvent firm anti-bribery
of third-parties – anyone that a multinational and corruption policies.[28] Therefore any
might use as a facilitator to assist in secur- payments that are requested by third party
ing or conducting business in the region, agents to be paid to local charities must be
but cannot be easily monitored – is the most scrutinised carefully and should be subject to
challenging area for companies. Such par- appropriate sign-offs by management before
ties may be perceived as useful; but they are being paid.
attracting more scrutiny than ever before
from international and local regulators.[25] Voluntary payment
Agents provide valuable information (c) Facilitation Payments – While making
about doing business in a country and a facilitation payment is a criminal offence in
help in negotiating contracts. But they are the UK, when the A-T Act was passed, the
sometimes used to disguise corruption or UK government made clear it was difficult
to distance firms from the suspicion of it: to think of circumstances where the making
the problem is the perception that the use of small facilitation payments – typically a
of third parties to pay bribes affords a degree voluntary payment for lower-paid govern-
of protection to the briber. As a matter of law, ment officials, prompting them to complete
this is a dangerous assumption.[26] In the UK, a task expected of them anyway – in coun-
the A-T Act provides that any payment by tries where this is normal practice, would
the third party is considered as being made lead to prosecution. This statement is not,
on behalf of the UK organisation.[27] however, captured in the draft Bill; indeed,
Organisations that use third par- the UK Law Commission has categorically
ties should therefore introduce controls to rejected a facilitation payment defence. This
minimise these risks. Such controls should causes practical difficulties for organisations
include: criteria for the preselection of in crafting a consistent policy where they
agents; a due diligence process to investigate have a nexus to the UK.[29]

Establishing an effective compliance that what may in the past have been accept-
culture or ‘Compliance Mindset’ across each able now has serious consequences.
country is paramount. No magic formula (b) Focus on Policies and Procedures
exists, but the starting point is your organisa- – including gift-giving and corporate hos-
tion’s corporate values and compliance ethic. pitality. An organisation’s policy should, as
Any compliance programme should, at a a minimum, assist staff to: understand the
minimum, include the following: organisation’s expectations of staff behaviour
(i) A clear statement of the value of the regarding anti-bribery and corruption; under-
organisation’s reputation and the impor- stand the concepts of bribery and corruption;
tance of ensuring that it is not damaged. assess what is or may be construed as a bribe;
(ii) Emphasis on the need to mitigate the understand when and how to report and to
risk of the organisation becoming a vehicle whom to report; understand when to request
for bribery and corruption. approvals for deviation and from whom.
(iii) Training to ensure all staff have a com-
mon understanding of the regional in-country Customary, modest gifts
rules as applicable to the global organisation. A simple, yet flexible, process that works
(iv) An awareness programme of foreign regionally will ensure consistency. It is
regulators, like those in the US and the UK important for such policies to specify in what
who impose onerous extraterritorial legal circumstances gifts or entertainment may
requirements on multinationals. legitimately be given to state- and non-state
How to cultivate the desired mindset? officials, and to establish internal procedures
(a) Focus on Management Role Model- to provide guidance and pre-authorisation
ling. Articulate the importance of senior procedures.
management acting as ‘role models’ – as Such gifts or entertainment should be
‘perception is reality’. To this end, you may customary, modest, reasonable and pro-
consider engaging the support and com- portionate to the seniority of the recipient
mitment of senior management – utilising and directly related to the business being
‘Compliance Mindset’ toolkits (e.g. E-cards, conducted. Care must also be taken when
posters and round-table discussions) by way engaging agents to ensure that relevant
of bespoke programmes aimed at reinforc- agency contracts contain applicable protec-
ing the tone at and from the top towards tion (for example, anti-bribery representa-
enterprise-wide control. tions and warranties).
It should be noted that any anti-brib-
Beyond lip service ery and corruption policy that is adopted
To move beyond paying lip service to the is necessarily a bespoke ‘living document’
code, firms should bring key managers to to be updated and refreshed regularly. Not
a ‘round-table’ forum where specific case knowing your responsibilities or not having
studies are discussed. It is only by working appropriate risk management, supervision
through these issues that staff, together with and internal controls in place will never be
managers, will develop an understanding a valid excuse for non-compliance should

the regulators come knocking on your door. players may not adhere to the same stand-
In many organisations, anti-bribery and ards; and firms may perceive themselves to
corruption training is made compulsory by be at a competitive disadvantage.
senior management. Attendance at such However the cases show that it is very
training is made part of the criteria for assess- much the case of “penny wise, pound fool-
ment during the regular performance review ish” as the sanctions and penalties imposed
cycle. Global computer-based training pro- can be severe. Worst of all, the damage to a
grammes are increasingly available (thus it is firm’s reputation may be incalculable. •
easy for staff to complete the training) and
relatively cost effective. References
Staff should be required to complete 1. See: e.g. Organisation for Economic Co-operation
the training within a stipulated time. If this and Development Convention. Available at SSRN:
is not done then managers must act swiftly http://www.oecd.org/
to address non-compliance. And as good 2. See: e.g. United Nations Convention against Cor-
role models, senior managers should be the ruption Preamble. Available at SSRN: http://www.
first to complete or attend required training unodc.org/
sessions. 3. The relevant laws to be discussed: (1) the United
States (US) Foreign and Corrupt Practices Act of
Conclusion 1977 (FCPA); and (2) the United Kingdom (UK)
Lack of awareness of applicable laws and 2001 Anti-Terrorism, Crime and Security Act.
regulations covering bribery and corruption, 4. See: ‘Asia Pacific and China. Our Anti-bribery and
especially those with extra-territorial reach, Corruption Service offerings’. KPMG China – Anti-
exposes global organisations to an increased bribery policy and procedure development. SSRN:
risk of prosecution at home and abroad. http://www.kpmg.com.cn/redirect.asp?id=9784
Given the trend for emerging market 5. Simmons & Simmons – PRC Clampdown on
countries to enact comprehensive legislation Corruption, February 17, 2009. SSRN: http://www.
in order to attract foreign investment and the elexica.com/briefdoc.aspx?id=7290
continuing enforcement zeal of jurisdictions 6. See:e.g.‘RioTinto pulls outAustralian staff from Shang-
with established laws in this arena, it is vital hai office’, South China Morning Post, July 16, 2009.
that organisations have appropriate policies 7. See: Hong Kong ICAC. SSRN: www.icac.org.hk/en/
and procedures to address the issues. These home/index.html
must clearly set out what is acceptable behav- 8. See: Prevention of Bribery Ordinance (Chapter
iour and have clear procedures for staff to fol- 201, Laws of Hong Kong). Extract of sections 3,
low and to escalate issues where necessary. 4, 5, 10, 12AA and 16. Soliciting or accepting an
This must include proper training for staff. advantage. SSRN: www.csb.gov.hk/hkgcsb/rcim/pdf/
Most importantly, management must english/central/pobo_e.pdf
encourage the right Compliance Mindset 9. PBO governs both public and private sectors. In
and culture within the organisation to ensure the private sector it is illegal for an employee to
that employees act appropriately. This is solicit or accept advantages when conducting his
a challenge in some markets where local employer’s affairs without the employer’s consent.

10. When facing a charge of corruption,it is no defence page i. FCPA enforcement has escalated: 2008
to claim that it is customary for advantages to be saw the announcement of a number of FCPA
offered in that profession or trade. enforcement actions with unprecedented fines
11. Moon cake case exposes risks of Hong Kong brib- and penalties, likely spurred on by a Bush admin-
ery ordinance. SSRN: http://www.asialaw.com/Arti- istration keen to stamp out corruption; and the
cle/2163660/ Sarbanes-Oxley Acts’ increased focus on inter-
12. Simmons & Simmons – Pacific Consultants Inter- nal controls.
national directors found guilty in Japan of bribing a 19. Simmons & Simmons – First UK conviction for
Vietnamese official, May 8, 2009. SSRN: http://www. bribery overseas,September 30,2008.SSRN:http://
elexica.com/briefdoc.aspx?id=7457 www.elexica.com/briefdoc.aspx?id=6990
13. See: ‘Korea’s anti-corruption efforts and the role 20. Simmons & Simmons (see note 19 above).
of the KICAC’, May 3, 2002, Dr Chul-Kyu Kang, 21. The Criminal Accountability of Companies and
chairman, Korea Independent Commission Their Boardrooms, May 14, 2009. SSRN: http://
Against Corruption.SSRN: http://unpan1.un.org/ www.rjw.co.uk/news-events/news/
intradoc/groups/public/documents/APCITY/ 22. See: Draft UK Bribery Bill Would Expand Scope
UNPAN019163.pdf of UK Anti-Corruption Initiatives and Jurisdic-
14. See: ‘Amends Law: Prevention of Corruption Act tion, April 8, 2009. By Roger M. Witten, Kimberly
(GLIN ID 77462)’ SSRN: http://www.glin.gov/view. A. Parker, Jay Holtmeier, Steven P. Finizio, D. Jason.
action?glinID=202034# SSRN: http://www.wilmerhale.com/publications/
15. See: Taiwan Economic News, July 10, 2002 as refer- whPubsDetail.aspx?publication=8940
enced in ‘A Cross-Cultural View of Corruption, 22. Shearman & Sterling LLP – FCPA Digest – Cases
pages 5 and 6. SSRN: http://wpweb2.tepper.cmu. and Review Releases Relating to Bribes to Foreign
edu/jnh/corruption.pdf Officials under the Foreign Corrupt Practices Act
16. See: The Wall Street Journal – WSJ.com, Sept 14, of 1977 (as of March 1, 2009), Section A: Recent
2009 – ‘Former President of Taiwan Gets Life Trends and Patterns in FCPA Enforcement, page xii.
Sentence’. SSRN: http://online.wsj.com/article/ 24. Simmons & Simmons – Bribery and corruption: a
SB125289842296107859.html bill with more bite, February 25, 2009. SSRN: http://
17. Shearman & Sterling LLP – FCPA Digest – Cases www.elexica.com/briefdoc.aspx?id=7305
and Review Releases Relating to Bribes to Foreign 25. See: Shearman & Sterling LLP (note 22, above).
Officials under the Foreign Corrupt Practices Act 26. See: Joint Committee on the draft Bribery Bill:
of 1977 (as of March 1, 2009), Section B: Foreign Memo-randum submitted by Norton Rose LLP,
Bribery Criminal Prosecution under the FCPA, June 23, 2009. SSRN: www.nortonrose.com/
page 32. knowledge/.../pub21672.aspx?lang...
18. Shearman & Sterling LLP – FCPA Digest – 27. See: e.g. Explanatory Notes to Anti-Terrorism,
Cases and Review Releases Relating to Bribes Crime And Security Act 2001. SSRN: www.opsi.
to Foreign Officials under the Foreign Corrupt gov.uk/acts/acts2001/en/ukpgaen_20010024_en_1
Practices Act of 1977 (as of March 1, 2009), Sec- 28. See: e.g. Stars quit charity in corruption scandal.
tion D: SEC Actions Relating to Foreign Bribery, The Guardian, January 10, 2001. SSRN: http://www.
pages 119 to 121. See also: Section A: Recent guardian.co.uk/uk/2001/jan/10/davidhencke
Trends and Patterns in FCPA Enforcement, 29. See: Simmons & Simmons (note 24, above).

Legal & Compliance
Who exactly is subject to the

Foreign Corrupt Practices Act?
In this paper, Tham Yuet-Ming, DLA
Piper Hong Kong consultant, examines the
pernicious effects of the FCPA in Asia.
The US Foreign Corrupt Practices by hundreds of companies – many of which

Act (FCPA), has its beginnings in the were Fortune 500 companies. The US legis-
Watergate era, when the Watergate Special lature responded to these scandals by even-
Prosecutor called for voluntary disclo- tually enacting the FCPA in 1977.
sures from companies that had made There are two main provisions to the
questionable contributions to Richard FCPA – the anti-bribery provisions, and the
Nixon’s 1972 presidential campaign. accounting provisions. Both the SEC and the
US Department of Justice (DOJ) have juris-
However, these disclosures revealed diction over the FCPA. Generally, the SEC
not just questionable domestic payments prosecutes the accounting provisions and
but illicit funds that had been channelled the anti-bribery provisions as against issuers
to foreign governments to obtain business. through civil and administrative proceedings
The information led to subsequent investi- whereas the DOJ prosecutes companies and
gations by the US Securities and Exchange individuals for the anti-bribery provisions
Commission (SEC) which revealed that through criminal proceedings.
many US issuers kept “slush funds” to
pay bribes to foreign officials and political The anti-bribery provision
parties. The FCPA’s anti-bribery provision makes it
The SEC later came up with a voluntary illegal to offer or provide money or anything
disclosure programme under which any cor- of value to foreign officials (“foreign”mean-
poration which self-reported illicit payments ing “non-US”) with the intent to obtain or
and co-operated with the SEC was given retain business, or for directing business to
an informal assurance that it would likely any person.
be safe from enforcement action. The result Anything of value can include sponsor-
was the disclosure that more than USD$300 ship for travel and education, use of a holi-
million in questionable payments (a mas- day home, promise of future employment,
sive amount in the 1970s) had been made discounts, drinks and meals. There is no

“minimum value” required for the FCPA to the US also became subject to the FCPA.
kick in. The accounting provisions only apply to US
The term “foreign official” is very broadly issuers.
applied and includes not just employees of There are two parts to the accounting
the government, but also employees of state- provisions, namely the books-and-records
controlled enterprises (for example, national provision and the internal controls provision.
airlines) and public international bodies such The books-and-records provision requires
as the International Olympic Committee, the issuers to keep books, records and accounts
United Nations, the OECD, the World Bank in reasonable detail, so as to accurately and
and the International Red Cross. fairly reflect the issuer’s transactions and dis-
position of assets, whereas the internal con-
Who is subject to the FCPA? trols provision requires that issuers maintain
In view of the high degree of involvement reasonable internal accounting controls to
by the government in the local economies of prevent and detect FCPA violations.
many North Asian countries, this has meant US regulators have regularly resorted to
that companies doing business in North Asia using the accounting provisions when they
will, more often than not find themselves cannot establish bribery. This is because
dealing with a foreign official and hence be there is no requirement that a false record
subjected to the FCPA. or deficient internal controls be attributed
The FCPA applies to issuers and domes- to a bribe. A common mistake made by
tic concerns. “Issuers” means any company many corporations is to devote an inordi-
(including a foreign company) that has secu- nate amount of already limited resources to
rities listed on any US stock exchange and determining whether they are dealing with a
any company which is required to file reports foreign official (as opposed to a commercial
under the US Securities Exchange Act. enterprise, because they believe that dealings
This includes companies whose American with a non-foreign official would make the
Depository Receipts (ADRs) are traded on relationship immune from the FCPA, and
the US exchanges. hence, more lax standards can be imposed
The term “domestic concern” is even on the particular dealing).
broader and includes any US citizen, national
or resident, as well as any business entity Internal controls deficiency
formed under the laws of any US state, or This is risky because where a bribe is paid to
which has a principal place of business in the a commercial party, the FCPA’s accounting
United States. US parent corporations may provisions may potentially still have been
also be held liable for the acts of their foreign violated, as the payment may be consid-
subsidiaries ered to have been inaccurately recorded in
The FCPA was amended in 1998 so that the books (for example, how was the com-
foreign companies and foreign persons who mercial “bribe” or “kickback” described in
take any action towards furthering a cor- the books?) or the fact of the bribe may be
rupt payment to a foreign official while in blamed on an internal controls deficiency.

Furthermore, given that bribery (includ- the new company or newly-acquired sub-
ing commercial bribery) is illegal in many sidiary responsible for past violations.
parts of North Asia, a more efficient use All of these have led to companies hav-
of company resources may very well be to ing to carry out due diligence on business
prioritise the prevention of bribery per se, partners or target companies to protect
instead of devoting limited resources to themselves from liability.
establishing if a particular dealing is with a After the enactment of the FCPA in
“foreign official”. 1977, there was little political will to enforce
the provisions, especially because many US
Real regulatory risks corporations complained that the FCPA
Under the FCPA, knowledge to show a cor- created an uneven playing field because
rupt intent is very broadly construed, and can non-US companies were able to continue
be based on a deliberate ignorance of facts or paying bribes to obtain business. Partly due
simply from burying one’s head in the sand. to US pressure, in 1997, the Organisation for
A pattern common to many FCPA cases is Economic Co-operation and Development
where the bribe is paid through an interme- (OECD) adopted a treaty to address for-
diary, or where a company or its executives eign bribery – the OECD Convention on
knew of “red flags” indicating a likelihood Combating Bribery of Foreign Public Officials
that the intermediary would engage in pro- in International Business Transactions
hibited behaviour, but avoided doing any- (OECD Convention).
thing about this. There are therefore real The OECD Convention was a milestone
regulatory risks that come with third-party in the fight against international bribery
business partners such as acquisition targets, because most major multinational com-
joint-venture partners, suppliers, distribu- panies were, and still are, based in OECD
tors, agents and consultants. countries. The OECD Convention came into
Common red flags include unusually force in 1999, and since then has been rati-
high commissions, a lack of transparency in fied by 37 countries.
expenses and accounting records, or where
the business partner or intermediary does Four plead guilty
not appear to have the right qualification to In North Asia, the two countries that would
provide the particular service. Another com- have similar FCPA-type foreign bribery pro-
mon warning sign for businesses in North visions are Japan and South Korea. This is
Asia is when a foreign official insists that a how four Japanese executives from Pacific
particular “consultant” or company be used Consultants International ended up plead-
for a project. ing guilty in November 2008 to paying
Another FCPA risk is the concept of US$820,000 in bribes between 2003 and
successor liability, as past FCPA cases have 2004 to the former deputy director of Ho Chi
shown that the US regulators do not view a Minh City’s transport department in a road
merger or acquisition as extinguishing liabil- project funded by the Japanese government.
ity for past wrongful conduct and will hold But what makes the FCPA (and the

OECD Convention) so far-reaching is that paid US$1.6 million in bribes, and was pun-
these anti-bribery provisions give govern- ished with a $2 million criminal penalty and
ments a long-arm jurisdiction which allows $2.8 million in disgorgement. Fast-forward to
them to control the business activities of its May 2009, Novo Nordisk, a Danish pharma-
multinationals across the globe. The second ceutical company, paid $1.4 million in bribes
reason why these provisions are particularly but, by comparison, had to pay a $9 million
powerful is the concept of corporate liabil- criminal penalty (four times as much), $3
ity. Hong Kong, for example, has draconian million in civil penalties and $6 million in
anti-bribery provisions on its statute books disgorgement.
(more of this later). Aside from the severe financial penalties,
other ways in which corporations could be
Reputational damage punished for FCPA violations include being
However, there is no corporate liability for disqualified from government contracts. This
bribery in Hong Kong and in the absence can potentially ruin a company if its main
of corporate liability, most corporations customer entails doing business with the US
would be tempted to wash their hands of government (for example, a pharmaceutical
any accountability if it is simply a case of company).
one of its employees having been found to Another more recent development has
have engaged in bribery, because whilst this been increased action against individuals,
may carry some reputational damage, it is resulting in jail time for company executives,
easier for the corporation to distance itself. as opposed to mere action against corpora-
However, where the corporation itself risks tions. For example, in January 2009, Mario
being punished with massive fines, this Covino, an Italian executive of Control
increases the will of big corporations to take Components, a Californian-based valve
the prevention of bribery seriously. company pleaded guilty to illegal payments
As a sign of things to come, it is worth not- of approximately US$1 million to employees
ing that the DOJ has prosecuted more FCPA of state-owned entities in countries such as
actions in the past two years than in the pre- China, India, Korea, and Malaysia.
ceding 20 years. In a May 26, 2009 Wall Street
Journal interview with Mark Mendelsohn, Two-year jail term
deputy chief in the Justice Department divi- In December 2008, Misao Hioki, a Tokyo
sion overseeing FCPA prosecutions (entitled executive with Bridgestone Corpn was sen-
“U.S. Cracks Down on Corporate Bribes”), it tenced to two years in federal prison and an
was reported that at least 120 companies are $80,000 criminal fine for authorising con-
under investigation. tracts with illegal commissions for govern-
In addition to more aggressive enforcement officials throughout Latin America.
ment, the financial penalties imposed have In September 2008, Shu Quan-Sheng was
increased exponentially. As an illustration, in given 51 months in prison for offering to pay
May 2005, DPC (Tianjin), the Chinese sub- bribes to officials of a Chinese space research
sidiary of a US medical device manufacturer agency on behalf of a French company.

Another trend that corporations should racketeering, obstruction, even tax violations
be aware of is that there are now many more (for example, because unlawful payments
ways for wrongdoing to come to the atten- cannot be deducted under the tax laws as
tion of the regulators. Firstly, in an economic a business expense, an improper deduction
downturn, there tend to be more disgrun- may expose a company to tax penalties) and
tled ex-employees who are eager to disclose so on.
wrongdoing to regulators. A second avenue Fearsome as the FCPA and the OECD
is where voluntary reporting by one corpo- foreign bribery provisions are, many multi-
ration can lead to other parties within the nationals would do well to remember that
same industry being implicated – leading to attention needs to be paid to local anti-
industry-wide investigations. corruption laws too when doing business in
Asia. One oft-quoted example is the position
Co-ordinated investigations with facilitation payments – in its crudest
In November 2008, Mark Mendelsohn form, these are in effect “small bribes” which
revealed that the DOJ was beginning to the FCPA and the OECD provisions exempt
expand its focus from the more traditional on the basis that payments for routine gov-
industries of oil and gas and medical devices, ernment decisions are not prohibited. What
to include legal services providers, freight- is often overlooked is the fact that many
forwarders and financial services. countries in Asia prohibit such payments
Thirdly, information is being shared altogether.
more regularly among regulators world-
wide – the Siemens case is a good exam- Local regional initiatives
ple, where the US and Munich authorities North Asia, made up of South Korea, Japan,
(who together imposed penalties totalling China, Taiwan and Hong Kong, is a mixture
$1.9 billion against Siemens) co-ordinated of countries that covers the broad spectrum
the revelation concerning the outcome of of Transparency International’s Corruption
their investigations. Finally, due diligence Perception Index (CPI), with Hong Kong
conducted on business intermediaries and and Japan positioned favourably on one end,
in joint-ventures/acquisitions have led to China not so favourably on the other, and
more violations being uncovered and being South Korea and Taiwan somewhere in the
reported voluntarily. middle.
Corporations need to be aware that This year has seen a flurry of anti-bribery
the regulators in the US have also become initiatives by governments in the region.
increasingly adept at using non-FCPA legis- These appear to have been motivated, in part,
lation to bring charges against corporations by a desire to ensure that as they implement
and individuals. In addition to the use of economic rescue plans through massive
the conspiracy charge, there is a possibility spending, the resources and monies being
that other charges can include anti-money pumped in by the governments themselves
laundering provisions, travelling to commit end up where they are supposed to.
the offence under the US Travel Act, fraud, In China, there were media reports that

its top prosecution agency planned to pay suddenly increased passed its first reading
up to RMB200,000 (US$29,000) for infor- in Taiwan’s legislature in March 2009. Under
mation on graft. This year also, the Chinese the bill, civil servants suspected of corruption
government invited the public and govern- would be required to provide the sources of
ment insiders to report tips to telephone and their income and assets if their total value
internet hotlines and it was reported that the seemed out of line with their salaries and the
new hotline was overwhelmed when it was same would apply to suspects’ spouses and
launched on June 22, 2009, with more than dependants.
17,000 tips. In both cases, what is not entirely As for Hong Kong, a March court case
clear is how much protection would be given caused sleepless nights for many a compli-
to graft whistle-blowers. ance officer in the region, when the local anti-
graft agency, the Independent Commission
Spotlight on construction Against Corruption charged a construction
More recently, China’s Supreme People’s company director for giving away moon-
Procuratorate announced that it would cakes. Every September, the Mid-Autumn
launch a two-year campaign to fight corrup- Festival is celebrated by millions of Chinese
tion in the construction sector and that the people across Asia and in the weeks leading
campaign will focus on corruption resulting up to the Festival, thousands upon thou-
in substandard construction, construction sands of moon cakes, a pastry synonymous
without a permit, and land use approval. The with the festival, are presented as customary
deputy procurator-general said the nation- gifts to business associates.
wide procurators had investigated 16,830
bribery cases in the sector from January 2006 ‘Ignorance’ plea rejected
to June 2009, accounting for 46 per cent of all In this case, the hapless defendant was sen-
commercial bribery cases during that time. tenced to two months’ imprisonment for
In Japan, the Foreign Ministry was bribery, after he pleaded guilty to presenting
reported in March 2009 to have established 15 boxes of moon cakes to officers of a traffic
a hotline and information desk for receiving police team. In Hong Kong, it is an offence
tips regarding the misuse of official develop- to offer any benefit to an employee of the
ment assistance, including bribery and bid- government or a public body where there
rigging. are “dealings of any kind”, even if the deal-
In South Korea, as the government con- ings are not ongoing, but only anticipated.
sidered pumping three trillion won (US$2.1 In this case, the moon cakes were presented
billion) into the economy through public 11 days before the Mid-Autumn Festival to
projects to create jobs, the chairman of the the traffic team from which the company
country’s Anti-Corruption and Civil Rights director had obtained a series of roadwork
Commission stressed that anti-corruption approvals.
efforts would be made at the same time. The Hong Kong court rejected the
In Taiwan, a new law that would put offi- defendant’s plea that he had not realised it
cials under scrutiny if their personal assets was an offence and that what he did was

part of Chinese custom. The anti-bribery employee, but also to any employee of a pub-
provision in question is a draconian one. lic body such as Ocean Park, a famous local
There is no need for the prosecution to show tourist attraction, or the Hong Kong Tourism
any corrupt intent on the part of the defend- Board. Third, there is no minimum value
ant (unlike the FCPA). involved, so that offering a piece of moon
cake would have been as much an offence as
Presumption of intent 100 boxes of moon cakes. Harsh as it sounds,
This provision presumes that corruption was similar statutory presumptions can be found
intended if there are dealings and a benefit/ in the anti-bribery statutes of Singapore and
gift is presented – the only way to escape Malaysia.
conviction is for the defendant to show This case is a good example of how
that there was lawful authority or a reason- corporations should have reliable, on-the-
able excuse (for example, if the government ground knowledge of what the regulatory
employee happened to be the defendant’s and anti-bribery environment of a country
good friend of many years preceding any is really like, to make sure that its operations
“dealings”, moon cakes have always been stay out of trouble. This means keeping eyes
exchanged and a reasonable number of and ears open for news on the latest regu-
moon cakes was given). latory enforcement by overseas and local
Secondly, the provision applies where a authorities and keeping up-to-date on legal
benefit/gift is offered not just to a government developments. •

North Asia
J ournal of reg
ulation & risk
north asia
Reprint Service l change

impacts
Complia
nce
Articles & Papers
Issues in resolving
Resecuritisation
systemically important
in banking: major
Volume I, Issue III,
financial institution
s
Autumn Winter 2009-2010
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
nt – from bad to worst
manageme ent
Derivatives: from
disaster to re-regulati Stephan Schoess,
products pot on
head of details a
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
amongst a cause for concern Fahrholz
companies ces. among Asian investors
be one of to offer these servi Global t financial change impacts compliance
will just David Smith
signs be able speak abou
ld rather
and risk
the first that will Thei-scramble is on
we saw d ers we shou s, or mon to tackle bribery David Dekker Opinion
a year ago the financial worl s These days s than bank e that
and corruption
About in institution providers, a nam Who exactly is subject to the Foreign
formation credit crisi Penelope Tham & Gerald
of a trans last months the
cial worl
d at financial
cial service
future activities. Corrupt Practices
Act? Deregulation Li
and in
the finan
the finan ge that is tored their current and we have mov
Financial
ed markets remuneration
reform: one step
Tham Yuet-Ming , non-regul
has trans formed
. the chan
than cove rs
how rapid ly
n on the
Ofbank s
‘Black Swans’, stress tests
forward
Umesh
and ‘desup ation
in scope Look at
Kumar & Kevin Marr
osive pace interactio ation) to
& optimised risk
an expl
is much
broader
occurring expected. bank
s that
were physical s of oper Challenging the value of enterprise
fall from (location and hour Internet banking.
management
David Samuels ervision’
to fail or s
risk management
Professor
by term ents then e, but
causes of the William Black exam
Rocky
originally to be too big n over paym in charg road ahead for global
accountanc
Tim Pagett & Ranjit
Jaswal
d g take ronic still a y convergenc
considere g or bein - elect s were Theng to regulatory e
mortgage frau ines the
either failin more finan n the bank paradigm is shifti Asian Rubik’s Cube Dr Philip Goeth
are that are
ns - Agai
para the d and cor-
ns d epidemic
institutio
financial d, resulting in
a huge
by as
mentione
e we (phy
sical perso the banks Alan Ewins and Angus has swept that
regarded out
world wher each other with es such as
Ross the Uni ted States.
cially soun how banks are ) pay
THE autho
in porations technologi r of this
digm shift r banks. nt with new academic, paper is a
leadin
ic and othe involveme ents. regulator
lawyer and
former banki g and they implic
the publ around specia itly demonstrat
ly revolves ile paym crime. As one lising in ‘white
ng cal failure
ing large mers , los- mob of the unsun collar’ failure s of regula
tion
e three criti-
Since bank ce custo isations Savings & of private marke and a wholesale
the abilit
y to servi ng the impa
ct
ork prov
iders
s and organ r pay- Loans debac g heroes of the and t discipline
trust and determini 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 Enforcemen The Financial
ld n, as well such as network researching s much t Network
of it, shou of the organisatio become A to B markets have why financ released a (FinCE
ent ng and new ment networks send money from traf- a tendency ial Activi study this
week on Suspic N)
managem ess of existi ng you to ork functional. to become ty
dys- lated Reports (SARs) that ious
g the riskin using/buyi that allow for the netw ari- Renowned
Contact
monitorin customers for federa
and the changes charge you This brings simil y ‘control fraud
’, Prof. Black
his theory
on with
financial institu lly regu-
products are more and will rate. om, energ University lectures at the Federa tions (some
times) file
ucts. But there worl d that are that you gene as telec of Missouri the (FBI) l Bureau of
these prod s in the banking fic stries such financial He is the autho and Kansa when they Investigation
enge known it. with indu anies. The r of ‘The Best s City. find eviden
and chall ing as we have not be the ties and cable comp g an important a Bank is
to Own One: Way to Rob fraud. ce of mortg
age
g bank e, liers rgoin
threatenin s will, in the futur our funds, supp is clearly unde Executives
and Politi
How Corpo
rate Epide
e world
The bank by which to mov ; they 135 S&L Indus cians Loote mic warni
les portfolios try.’ A prom d the The ng
default vehic balances and tor on the inent comm FBI
enta- mortg began warning of an
Christopher Rogers
our causes of
maintain crisis, Prof. the curren age fraud in “epidemic”
h Asia Black is a t financial their congre of
Risk Nort way the US vocal critic mony ssional testi-
lation & governmen of the ago. in September 2004 –
of Regu banking crisis t has handl It also warne over five years
Journal and rewar ed the not d that if the
that have ded institu dealt with epidemic were
clearl tions sis. it would cause
duties to inves y failed in their fiduci Nothi a financial
tors. ary respon ng remotely adequate cri-
d to the epidem was done to
General Secretary
enforcemen ic by regula
The following t, or private tors, law
essarily repres comm entary cipline .” Instead, the sector “mark
ent the view does not nec- epidemic produ et dis-
Regulation of the Journa hyper-inflate ced and
and Risk – l of that d a bubble
North Asia. produced a in US housin
“The new crisis so severe g prices
numbers on
rals for mortg criminal refer- caused the collapse that it
age fraud in
the US are system of the global nearly
just in many and led to unpreceden financial
Journal of of the world ted bailouts
Regulation ’s largest banks of
& Risk North .
Asia
33

Legal & Compliance
Financial markets remuneration

reform: one step forward
In view of the Goldman Sachs bonus furore,
Linklater’s Umesh Kumar and Kevin Marr,
examine issues surrounding salary caps.
Within the wider review on regulatory at public companies, such as “say on pay”
reforms in the financial services sector, requirements.
remuneration practices at financial insti- These initiatives are not mutually exclu-
tutions have come under particular scru- sive and have a number of common aims,
tiny. A general consensus has emerged such as ensuring that management has a
amongst political leaders and regulators vested interest in the ongoing health of the
that some remuneration structures at firm. However, the genesis of remuneration
financial institutions encouraged risky reform in the financial services sector was
decision-making and contributed at least the global financial crisis, which revealed
in part to the conditions leading to the weaknesses unique to financial institutions,
global financial crisis. in particular the strong prevalence of variable
compensation (i.e. bonuses) even amongst
The UK’s Financial Services Authority non-senior executive staff and the large
recently published a new Remuneration potential exposure of financial institutions
Code covering certain large banking institu- through their loan and trading books.
tions, and the political currency of this issue
makes it likely that remuneration reforms Underlying concern
of some form will be implemented in other As such, while executive pay initiatives have
jurisdictions in the near future. This arti- focused on improving transparency and
cle will discuss some of the key issues and upholding shareholder rights, the underlying
drivers behind the remuneration reform concern in the financial services remunera-
debate and will look at some current pro- tion debate is eliminating systemic factors
posals in this area, in particular the new FSA that are believed to have contributed to the
Remuneration Code. global financial crisis. This has a bearing on
Financial services remuneration reform the nature of the proposals, as will later be
shares some characteristics with recent related.
efforts to impose controls on executive pay Partly through the efforts of multilateral

forums such as the G-20 Financial Stability evaluate the individual’s contribution, while
Board, there has emerged a high level con- giving the employee an incentive to perform
sensus on the general principles of financial well over the long term.
institution remuneration reform. The pro- • Flexibility of bonus arrangements. There
posals to date have typically addressed many, have been concerns about firms being tied
if not most, of the following general topics: into bonus arrangements requiring large
• The role of the board of senior management payouts that turned out to be unjustified.
in remuneration oversight. This includes the Related to this is the question of whether
composition and independence of remu- firms should be allowed (or required to) have
neration committees and the role they play clawback rights on bonuses for employ-
in designing and monitoring compensation ees who have engaged in misconduct or
policies. misrepresentation.
• Independence of risk and compliance func- • Severance/early departure restrictions. In
tions from other areas of business. This is response to a perception that generous
aimed at ensuring that risk and compliance severance packages have in some cases
units have the authority and autonomy to been a “reward for failure”, some proposals
properly monitor and manage risky behav- include limits on severance pay in cases of
iour. For example, some proposals require poor performance, or limits on early vest-
that the compensation of risk and compli- ing of deferred compensation for departing
ance personnel is not determined or influ- management.
enced by the business units they are meant • Disclosure of remuneration practices. Some
to be monitoring. proposals include requirements for firms to
• Balance of fixed and variable compensation. disclose their remuneration policies. Public
If an employee’s compensation package is companies may of course already be subject
largely based on variable factors, the concern to various disclosure requirements.
is that he or she will be incentivised to take Within these general topics, there is
riskier actions. plenty of room for debate. For example,
• Variable compensation adjusted for future which firms should the remuneration
risk. One subject of popular outrage dur- requirements cover? Should it apply to all
ing the financial crisis has been instances firms or only firms of a certain size or that
of bankers earning large bonuses based have certain businesses? On an individual
on trading gains that turned out to be illu- level, which employees should be subject to
sory. Under this principle, firms would be these controls?
required to take appropriate risk factors into
account when calculating performance- Staff recruitment, retention
based compensation. More generally, should the new regulations
• Deferral of bonus payments. Re- allow firms to exercise some discretion within
quiring bonuses and other variable com- the spirit of the requirements or should there
pensation to vest over a period of time be fixed limitations (e.g. on the ratio of fixed
would arguably allow firms to more properly to variable compensation or the minimum

deferral period for bonus compensation)? The of remuneration, Turner noted that, while it
remuneration debate is of course shaped by is difficult to gauge exactly what role remu-
local legal, economic and political considera- neration policies played in the financial crisis,
tions, in particular concerns about the impact it is “likely that past remuneration policies,
of remuneration restrictions on firms’ability to acting in combination with capital require-
recruit and retain staff, as well as the general ments and accounting rules, have created
competitiveness of the local financial market. incentives for some executives and traders to
This no doubt helps explain why, at least take excessive risks . . .”
in part, remuneration reform initiatives have
generally not progressed quicker despite Rules-based regime
wide popular support. To date, the UK has Turner noted that this has not been a key
taken the lead in examining and implement- area of focus for banks or regulators in the
ing remuneration reform initiatives. As in past. Accordingly, Turner said that “the FSA
other countries, UK authorities have looked will therefore include a strong focus on the
at the issue of remuneration in the context risk consequences of remuneration policies
of wider reforms to be considered in light within its overall risk assessment of firms”
of the financial crisis. However, the UK is and referenced the then-draft Remuneration
so far notable in that it has published a new Code as one means of enhancing industry
“Remuneration Code”to take effect in 2010 practices.
for certain large financial services providers, More generally, the Turner Review pro-
as discussed further below. vided a clear indication that the FSA (and
The direction the UK would take on likely its peer regulators around the world)
remuneration reform was first indicated would be turning away from the previous
in the Financial Services Authority (FSA) “light touch”supervisory approach to a more
October 2008“Dear CEO”letter (a commu- prescriptive, rules-based regime.
nication to major banks and building socie- On August 12, 2009 the FSA published
ties) that set out the regulator’s initial views its long-awaited Remuneration Code. The
on remuneration policies in light of the Code will take effect from the start of 2010
financial crisis. The FSA encouraged firms and will initially apply to certain large finan-
to review their remuneration policies and cial institutions, generally large banks, build-
ensure that they were consistent with sound ing societies and broker dealers.The FSA has
risk management. The annex to the letter set estimated that the Remuneration Code will
out a number of basic“criteria for good and initially only apply to 26 firms.
bad remuneration policies” with the FSA’s Notably, the Code will not apply to over-
“initial thoughts” on good remuneration seas firms doing business in the UK – this
practices. limitation was likely imposed in the final
In March 2009 the FSA issued the version to address concerns that doing so
“Turner Review” , a comprehensive analysis would harm London’s competitiveness
of the financial crisis undertaken by the head compared with other financial centres.
of the FSA, Lord Adair Turner. On the topic The Remuneration Code consists of eight

principle areas, with relevant guidance in principle 8’s high level direction to align
each: remuneration with “effective risk manage-
1) Role and duties of the remuneration ment”. Principle 8 now includes several
committee: remuneration committees “good practice” recommendations, such
should be independent, with a majority of as ensuring that a firm can avoid paying
non-executive directors; bonuses in loss years, deferring a “signifi-
2) Procedures for ensuring that risk and cant proportion”of bonus compensation for
compliance functions have appropriate input at least three years, and linking bonus pay-
into the remuneration process; ments to division or firm performance. It
3) Remuneration for risk and compliance remains to be seen how closely firms adhere
personnel to be determined independently to these“guidance”provisions in practice.
of other business areas; Firms affected by the Remuneration
4) Profit-based measurement and risk- Code were required to submit a“remunera-
adjustment: bonus pools to be calculated tion policy statement”by the end of October
based on actual profits as opposed to tran- 2009, setting out, amongst other things, the
sitory gains, with adjustments for risk and firms’ remuneration policies and procedures
liquidity factors; and how they address the eight principles
5) Where compensation is largely based on of the Code. The remuneration policy state-
a person’s performance, the performance is ments will not be made public, but will no
measured over a longer time horizon; doubt be studied by the FSA to determine
6) Non-financial performance metrics to the impact of the new Code on market
form a significant part of the performance participants.
assessment process;
7) Long-term incentive plans to take into Capitulation charge
account future risk factors; and Although the Remuneration Code presently
8) Remuneration structures should take applies only to a small number of firms, it is
into account sound risk management significant in that it represents the first com-
principles. prehensive regulation to be implemented
On the last principle, the FSA retreated following the financial crisis. In that regard, it
from its position in the draft version of the has attracted some criticism from both sides
Remuneration Code that essentially required of the debate, with some observers, includ-
firms to have fully flexible bonus policies, ing opposition political figures, accusing the
defer the majority of bonus compensation FSA of having“capitulated”to banks’ lobby-
and link the vesting of deferred rewards to ing efforts (notably on the “watering down”
performance measures. These provisions of principle 8), while others have expressed
attracted criticism during the consultation concern about UK firms’ competitiveness
period as being “overly prescriptive” and compared to firms from other jurisdictions
jeopardising London firms’competitiveness. that have not yet implemented changes.
As a result, the FSA recast these provi- The FSA has in fact acknowledged
sions as non-binding“guidance”under new that it does not want to carry the torch

alone indefinitely. In an interview with the numbers of executives in each band
Financial Times after the Remuneration and the main elements of salary, bonus,
Code was issued, FSA chief executive Hector long-term compensation and pension
Sants said,“It’s fine to be at the forefront for contribution;
12 months, but if there is no international • Restrictions on early vesting of share
momentum beyond that, it isn’t competitive awards for high earners who leave the
to be out on your own.” firm.
Most of Walker Review recommendations
Walker Review are proposed to be implemented through
Nonetheless, by taking the lead the UK revisions to the Financial Reporting Council’s
has arguably staked out a more influential Combined Code on Corporate Governance.
position in the remuneration debate, and Therefore, it appears that UK listed financial
other regulators will certainly be looking to institutions will be most directly impacted by
the FSA’s experience in shaping their own the Walker Review recommendations. As the
reforms. Remuneration was also discussed consultation has not yet concluded at the time
in the“Walker Review”, a separate review of of this writing, it is not yet clear exactly how
corporate governance in the British banking the Walker Review recommendations will
industry undertaken by Sir David Walker. fit in with other proposals, notably the FSA’s
The Walker Report was published for con- new Remuneration Code, which may impact
sultation on 16 July 2009, and conclusions many of the same entities.
are expected by November 2009. The FSA issued a statement “welcom-
Because the Walker Review’s mandate ing” the Walker Review recommendations
was to examine the banking crisis from a and indicating that it would respond to the
corporate governance perspective, many of Walker consultation and issue a response
its recommendations on remuneration are paper following the final recommendations.
particularly aimed at increasing the trans- Other remuneration reform initia-
parency and oversight of the compensation tives included the September 2009 G-20
process. These include: Pittsburgh summit, where remuneration
• Increasing the remit of the firm’s remu- reform was a major topic of discussion. One
neration committee to all “high earn- point of disagreement was whether there
ers” in the firm, not just executive board should be hard limits on bonuses and other
members; variable compensation, as advocated by the
• If the directors’ remuneration report French and German delegations.The United
is approved by less than 75% of the States and the United Kingdom opposed this
votes on a non-binding shareholders’ approach. In the end, the “Implementation
resolution, forcing the chairman of the Standards” that the G-20 endorsed at the
remuneration committee to stand for re- conclusion of the summit provide only that
election in the next year; bonuses should be limited to a percentage of
• Imposing disclosure requirements of total net revenues to the extent an institution
high earners’ pay (in bands), indicating would have difficulty meeting capitalisation

standards. The Implementation Standards the Fed has, thus far, taken a comparatively
leave the determination of the percentage more flexible approach than the FSA in the
to the national regulators. In other respects, UK. Although the Fed’s proposal would
the Implementation Standards are gener- cover all employees, regardless of seniority,
ally consistent with the principles in the FSA whose activities affect the firm’s risk pro-
Remuneration Code and cover many of the file, the Fed has generally avoided the more
same issues (such as deferral of bonuses, prescriptive measures of the FSA rule and is
independence of risk and compliance framed as a set of relatively high-level prin-
units and bonus clawbacks). Although the ciples. Given the business linkages between
Implementation Standards are not binding New York and London, this has led to con-
on any of the G-20 members, they do rep- erns about potential imbalances in remuner-
resent a baseline of international agreement ation requirements across the Atlantic. The
on remuneration reforms. consultation period on the Fed’s proposal
will run through November 2009.
United States
The United States, where bonus compen- European Union
sation is perhaps most firmly entrenched, On July 13, 2009, the European Com-mission
recently made the first formal moves towards published proposed amendments to its Capital
implementing remuneration controls. On Requirement Directive (CRD Amendment)
October 22, 2009, the US Federal Reserve that include general obligations on firms to
(the Fed) issued a proposal that would give have remuneration policies “consistent with
it the authority to review and, if necessary, … sound and effective risk management.”
require a bank to amend its compensation The proposed legislation would apply to
policies on risk management grounds. all EU credit institutions and firms regulated
The proposal encompasses two super- under MIFID. The remuneration portion
visory initiatives: a focused review of com- of the CRD Amendment takes the form of
pensation practices at 28 “large, complex” high-level principles which, although bind-
institutions, and a more flexible review of ing if enacted, give firms flexibility as to how
compensation practices at other banks as the principles will be applied. Firms found to
part of their regular examination process. be not compliant may be required to change
The new requirements would apply only to their policies, hold additional regulatory cap-
institutions regulated by the Fed (i.e. nation- ital and pay fines to their national regulator.
ally chartered banks) and not state chartered If the CRD Amendment is approved by the
banks or savings and loan associations. The European Parliament and Council it will take
Fed’s proposal has attracted criticism from effect in late 2010 at the earliest.
those who view it as an intrusion into the
business judgment of firms and an unwar- East Asia
ranted, and politically motivated, departure In Asia, where banks had relatively less direct
from the regulator’s non-interventionist pol- exposure to the trading losses incurred by
icy. At the same time, some have noted that their American and European counterparts,

comprehensive remuneration reform has the FSA’s lead. Given the large presence of
not yet emerged as a major topic of discus- international institutions in the Asian bank-
sion. To the extent financial institution remu- ing market, harmonisation of standards may
neration has been discussed, it has generally grow in importance as banks become sub-
been addressed narrowly, in the context of ject to remuneration controls in their home
other issues, as opposed to being viewed as jurisdictions and other regions where they
a component of systemic risk. operate.
However, Hong kong has recently taken
initial steps toward addressing remuneration Conclusion
issues more broadly. Remuneration reforms for the financial
In March 2009, the Hong Kong Monetary services industry are slowly moving closer
Authority (HKMA) required Hong Kong to reality. The UK has taken the first step in
licensed banks to ensure that bonuses of front- this direction, and it is likely that others will
line retail sales staff are not calculated solely look to the FSA’s experience as a model. The
on the basis of financial performance. And on agreement on Implementation Standards at
October 30, 2009, the HKMA announced that the G-20 summit suggests some coalescing
it would conduct an industry consultation on of international opinion on the subject, but it
a draft remuneration guideline for institutions remains to be seen how this will continue to
it regulates. The text of the HKMA’s guide- develop at the national level. •
line was not publicly available at the time of
this writing, but it is expected to be generally References
consistent with the G-20 Implementation 1. The Turner Review: A Regulatory Response to
Standards. The HKMA has said that it plans the Global Banking Crisis, March 18, 2009.
to issue its remuneration guideline by the end 2 Turner Review, at 80.
of 2009 and would expect banking institutions 3. Policy Statement 09/15, Reforming remunera-
to be in full compliance by the end of 2010. tion practices in financial services: feedback on
In other countries, some limits on remu- CP09/10 and final rules, August 12, 2009.
neration have been implemented, but these 4. FSA accused of back-pedalling on bonuses, Finan-
generally serve more general corporate gov- cial Times, August 12, 2009.
ernance aims. For example, in March 2009, 5. A Review of Corporate Governance in UK
Taiwan’s Financial Securities Commission banks and other financial industry entities, Sir
(FSC) passed a regulation requiring certain David Walker, July 16, 2009.
financial institutions to disclose their execu- 6. FSB Principles for Sound Compensation Prac-
tive’s compensation details if they fail to tices: Implementation Standards, Sept 25, 2009.
meet certain financial targets, such as capital 7. Directive of the European Parliament and of the
adequacy ratios. Council amending Directives 2006/48/EC and
Despite the lack of dialogue on remuner- 2006/49/ECas regards capital requirements for
ation reform in Asia to date, regulators in the the trading book and for re-securitisations, and
region may begin to consider the issue more the supervisory review of remuneration policies,
seriously if and when other regulators follow July 13, 2009.

Risk management
Of ‘Black Swans’, stress tests &

optimised risk management
Standard & Poor’s David Samuels
outlines the positive benefits of bank stress
testing on the bottom line.
It is a big challenge for banks to build downturn capital adequacy programs to

a robust approach to managing the risk uncover risk concentrations and risk depend-
of worst-case stress scenarios that, almost encies, and; applying these improvements
by definition, are triggered by apparently to drive business selection – for example,
unlikely or unprecedented events. through performance analysis and risk-
adjusted pricing that takes stress test results
However, solving the problem of identi- into account.
fying the risk concentrations and dependen-
cies that give rise to worst-case outcomes is Top-level oversight
vital if the industry is to thrive – and if indi- Building a more robust and comprehensive
vidual banks are to turn the lessons of the process for uncovering threats to the enter-
past two years to competitive advantage. prise is clearly, in part, a corporate govern-
Banks that tackle the issue head-on will ance challenge.The board and top executives
be lauded by investors and regulators in the must have the motivation and the clout to
coming years of industry recuperation and, scrutinise and call a halt to apparently profit-
most importantly, will be able to deliver sus- able activities if these are not in the longer-
tained profitability gains. Meanwhile, banks term interests of the enterprise or do not fit
that are well placed to take advantage of the the intended risk profile of the organisation.
consolidation process need to be sure they But contrary to popular opinion, improv-
can understand the risks embedded in the ing corporate governance is not just a ques-
portfolios of potential acquisitions. tion of putting the ‘right’ executives and
To improve enterprise risk management board members in place and giving them
and strengthen investor confidence, we think appropriate incentives.
banks can take the lead in three related areas: For the bank to make the right deci-
Better board and senior executive over- sions when they are difficult, e.g. when
sight and control of enterprise risk man- business growth looks good in the upturn,
agement; re-invigorated stress testing and or when risk management looks expensive

in the downturn – it must be able to do two and that the results were often difficult to
things: combine across businesses to capture the
(a) Focus on risk from an enterprise per- true level of enterprise risk.
spective. This means hunting out the subset A senior regulator at the Bank of England
of risks across the company that are severe went further earlier this year and said that:
enough to threaten the whole enterprise, “. . . stress testing was not being mean-
even if these risks look unlikely (e.g. a 40 ingfully used to manage risk. Rather, it was
per cent fall in house prices), unprecedented being used to manage regulation [and] as
(e.g. seizing up of global funding markets), regulatory camouflage.”
and take the form of hidden concentrations We believe bank senior executives and
and risk interactions. boards should keep in mind a number of
(b) Marshall objective evidence about the issues when building a stress testing pro-
consequences in terms of capital adequacy gram to counter these criticisms.
and bank risk appetite.This is because seem-
ingly ‘unlikely’ enterprise risks will not be Sensitivity, shock
paid enough attention unless their qualities First, consider all of the analysis that should
are quantified and set starkly against busi- be legitimately supported with stress testing,
ness objectives and commitments to stake- from local business planning to risk man-
holders, e.g. on safeguarding solvency. agement and enterprise capital adequacy.
Second, it is important to understand and
Stress testing program consider the great range of stress testing
The need to focus on enterprise risks and techniques available, from simple sensitivity
bring together evidence from across the tests that shock a single risk factor in a small
bank means that program for stress testing sub-portfolio, to much broader historical and
and exploring downturn capital adequacy hypothetical scenario testing of the bank’s
must be led from the top of the bank. This global risk portfolio.
helps ensure that the results shape company To keep things clear, it can be helpful to
strategy: Executives who understand stress think about the bank’s stress tests in terms
tests and find the results credible will apply of two categories: (a) Micro stress testing to
them. As Box 1 (opposite page) makes clear, identify specific issues of concern and miti-
regulators and industry bodies are calling gate their effects; and (b) Macro stress test-
for the involvement of top management in ing to quantify the impact of worst-case
enterprise stress testing as a key post-crisis economic scenarios.
reform. Micro stress testing, for example, might
Regulators believe the stress testing use a mix of expert judgment and quantita-
program many banks had in place before tive techniques to look at a particular sub-
the crisis needs improvement. They say the portfolio in terms of one or more risk factors,
‘worst case’ scenarios applied by banks were such as the bank’s exposure to a rise in the
too mild, that some banks treated stress tests default rate in the automotive industry.
largely as back-room quantitative exercises, We believe micro stress testing should

be encouraged, but it is not sufficient from variety of purposes, such as enterprise busi-
an enterprise perspective, particularly when ness planning and also to strengthen capital
conducted largely within business lines. adequacy processes. For example, regulators
Regulators say that limited enterprise level have made it clear that a transparent, audit-
integration of stress tests meant banks had able process for translating stress testing into
“. . . insufficient ability to identify correlated capital adequacy decisions will be required
tail exposures and risk concentrations across to comply with supervisory Pillar II of Basel II
the bank.” – and they are sending out clear signals that
Macro stress testing, by contrast, looks at this will be a key area of interest when they
how broad macro-economic stresses might look at bank capital adequacy processes in
affect the whole bank and uses a variety the post-crisis industry.
of sophisticated quantitative techniques The second key point is that, at the enter-
to translate these deteriorations into their prise level, stress testing is about uncovering
impact on risk factors and to help the bank hidden enterprise dependencies and routes
see the effect. to worst-case losses. This is not the same
Macro stress testing can be used for a thing as trying to predict upcoming risk
Box 1: Stress Testing and Senior Management – Pressure from the Regulators
• ‘Supervisors should...verify the active involvement of senior management

in the stress testing program [and] evaluate how stress testing analysis
impacts the bank’s decision making at different management levels includ-
ing strategic business decisions’
Principles for Sound Stress Testing Practices and Supervision, Basel Committee,
Consultative Document, January 2009
• It is essential that senior management are involved in overseeing a com-

prehensive and co-ordinated stress and scenario testing program ....Senior
management buy-in and involvement is essential in defining scenarios, dis-
cussing results, assessing potential actions, and in constructing an effective
[stress testing] governance framework.
Stress and Scenario Testing, Financial Services Authority, Consultation Paper
08/24, December 2008, page 12 and page 20
• ‘Senior management involvement was important to the effective use of

stress tests, especially macro scenarios [and particularly] when the tests
revealed vulnerabilities that firms found costly to address’.
Senior Supervisors Group, Observations on Risk Management Practices During
the Recent Market Turbulence, March 2008, page 17

events or trying to sort out which risk events economic indicators drive bank credit
are most likely to happen. losses. There are various methodological
Instead, the focus, in our view, must be challenges here, including how to strip out
on understanding how risk interactions and the correlation effects from industry-level
concentrations within the bank’s portfolios historical data, and then add back in the
might worsen losses in a difficult environ- correlation factors that are relevant to the
ment, and this means exploring: bank’s own portfolio.
• Joint default probability – the tendency However, while stress testing must
of customers to default together when things become more sophisticated and accurate in
get bad; terms of granular risk interactions, it must
• Risk factor correlations – the way that not be allowed to become a purely quantita-
a deterioration in one key risk factor (e.g. tive back-room exercise.
default probability) prompts a sharp dete- Regulatory investigations suggest that
rioration in another (e.g. loss given default); banks must become more adept at draw-
and; ing together experts in risk from across the
• Risk interactions – the tendency for a organisation to establish a company-wide
shock in one area of risk management (e.g. view and approach to stress testing, e.g.
credit) to lead to shocks in other areas (e.g. making sure that fundamental credit insights
bank funding liquidity). from experts in commercial lending reach
other bank areas such as capital markets.
Pooling the evidence Likewise, some investigations have
Of course, this is easier said than done. attributed the relative success of some risk
Among other factors, banks may need to: managers during the crisis to their greater
• Build long-time series of credit risk data knowledge of how bank business areas
to help the bank estimate default rates and make their money, because this helped them
loss given default rates in downturn envi- “. . . identify relevant stress scenarios or pro-
ronments. Banks may need to set up data vide warning when assumptions underly-
consortia to pool evidence from particu- ing single-factor stress tests were inaccurate
lar geographic or industry credit segments measures of risk.”
where data is sparse; This suggests that the key challenge
• Analyse stress migration rates for credit for executives is building the right blend of
ratings using sector-specific data to under- bank-wide information sharing, modelling
stand how portfolios can deteriorate for a capabilities and executive judgment into the
year or so after a stress event; bank’s stress testing program.
• Build data sets and methodologies The role of executive judgment will not
for understanding how risk factors such as end with appraising the bank’s own stress
default rates and loss given default rates are test results. Regulators are also urging banks
correlated in specific industries and types of to consider what the second-order effects
collateral; of a worst case analysis might be. That is,
• Explore how changes in macro- whether peer banks might be similarly

affected by a worst-case scenario and what cost that rises in line with the bank’s expo-
this might mean in terms of risk contagion, sure. This will make the bank’s pricing less
e.g. will a credit risk worst case scenario lead attractive in the market as enterprise risk
to liquidity hoarding? Stress testing is often rises, counteracting the tendency in bank-
thought of as a tool for uncovering risks that ing markets to overshoot during booms. It
already exist in the bank’s existing portfolios, will not always be popular with business
but it must also become part of how the bank chiefs at the top of the business cycle, which
thinks about future business strategy. is the point!
Otherwise the bank’s performance anal-
ysis systems will make businesses that gen- Conclusion
erate apparently unlikely, but potentially very From a senior management perspective,
severe, losses look more profitable than they the three strands of improved enterprise risk
really are. The enterprise risk costs will have management that we have discussed cannot
been left out of the equation. Likewise, the easily be separated.
bank will also end up selling credit and other Senior executives and boards must
products at a price that does not reflect the become more responsive to enterprise risks,
enterprise risks they generate. even when the probability of a particular risk
The answer is not to put some blan- event does not seem high. But working out
ket wash of conservatism on all decisions. which risks and risk interactions are the most
Instead, banks must systematically differen- important to a particular enterprise is not
tiate between the profitability of businesses easy in advance, so corporate governance
and deals that create costly enterprise threats, must be supported by systematic processes
compared with those that do not. for uncovering risk concentrations, correla-
tions, interactions and dependencies.
Strategic level Senior executives then have to look at
At a strategic level, this may mean giving the results both in terms of their enterprise’s
stress testing and downturn analysis more risk appetite and in terms of second-order
prominence as tools for capital allocation, so risk contagion across the industry. Once the
that the capital costs of enterprise-level risks bank has done this, the new information
can be taken into account when assessing must drive how the bank behaves in terms
the profitability of a burgeoning bank activ- of the businesses it chooses to acquire or
ity. Business lines that put the enterprise at grow, the exposure limits it sets in relation
risk need firm limits, but they should also to its risk appetite, and the price the bank
pay a capital cost for the risks they attract is willing to offer for deals that increase
well before those limits are reached. concentrations.
It also is important to make sure risk That way, the bank will direct its capital
costs are reflected in tactical decisions, such towards businesses and transactions that
as pricing. Incremental transactions that create long-term competitive advantage and
generate enterprise concentrations and away from those that periodically destroy
risk correlations should attract a risk capital value and threaten the enterprise. •

Risk management
Challenging the value of

enterprise risk management
PricewaterhouseCoopers’ Tim Pagett and
Ranjit Jaswal discuss how to get the most
out of a post-crisis ERM environment.
The impact of the credit crunch on so still further by the impact of capital con-
many institutions over the past 24 months straints, increasing systematic risk within the
has underlined the critical importance of financial markets and the pressure by share-
effective Enterprise Risk Management holders to deliver returns in an increasingly
(ERM) in creating and sustaining favour- volatile market.
able financial performance and prevent- A good deal of the pre-crisis invest-
ing financial losses. Despite significant ment, thinking and challenge in the field of
investment in risk management tools, ERM focused on the enhancement of risk
models and processes, many financial measurement and modelling capabilities,
organisations’ ERM programmes may re-inforced by the often penned mantra – if
not be keeping pace with mounting risk you can’t measure it you can’t manage it. If
pressures and more exacting stakeholder there is one thing the crisis reinforces, it is
demands. The authors of this paper that risk management is so much more than
look at how financial institutions can just models and measurement.
use some of the lessons learnt from the
crisis to ensure their ERM programmes Control framework
deliver tangible and intangible commer- That said, risk models are an indispensable
cial value. input into the ongoing management of the
business. However, to be effective the risk
From major natural disasters to the con- models must operate within a comprehen-
tinuing turbulence in the financial markets, sive and fully functioning Internal Control
an increasingly uncertain business, social Framework that incorporates, at a mini-
and economic environment is driving more mum, a full consideration of the impact of
organisations to challenge whether their so- risk concentrations and economic, financial
called Enterprise Risk Management (ERM) and operational stress. Further, there is no
capabilities are fit for purpose. The pressure substitute for a deep and systematic under-
on ERM to deliver is likely to be heightened standing of the risks involved in the business

and for common sense and judgment in needs to be refined rather than consumed
challenging whether the business is fully by the business. It would appear that share-
addressing those risks, be it either operation- holders, customers and regulators alike hold
ally or strategically. The financial crisis dem- this view as the pressure continues to mount
onstrated that many market participants, for management to further strengthen ERM
commentators and risk management pro- culture, processes and functions, resulting in
fessionals were totally unprepared for deal- growing prominence and responsibilities of
ing with the impact of such severe moves in Chief Risk Officers and their teams. There
market factors. is increasing pressure to strengthen the role
of risk management functions as the sec-
Probability factor ond line of defence after line management,
Risk management has been criticised for and in this environment it is critical that risk
failing to “predict” the onset of the crisis – teams have the freedom and the capability
which is possibly fair given the extraordinary to take an independent view from business
levels of investment that have been focused management – but increasingly on a co-
on determining the“probability”of an event ordinated basis.
occurring. In fact, by far the majority of tools ERM programmes cannot work in a
and techniques applied in the market are vacuum; they need to be relevant to, and
based on the principles of probability. That integrated into every aspect of the business
said, much of this investment was driven to make a difference, not only to the business
from a desire to meet the management chal- but also to cost-effectively meet the needs of
lenge of “don’t just tell me what could hap- regulators and shareholders. Never before
pen – tell me how likely it is”. has there been a period of history that rein-
However, crisis conditions serve as a sali- forced the need to ensure that it isn’t just risk
ent reminder of the importance of giving managers who are responsible for risk.
equal consideration to the “art of the pos-
sible” and not just the “science of the prob- Strategy failings
able”. Risk management, now more than It is notable that many institutions that had
ever, is as much about preparing for what developed what they believed were robust
has not happened before as it is for under- and sophisticated ERM capabilities still suf-
standing, managing and preparing for what fered some of the worst losses and dam-
has been experienced in the past. age to value. Failings in funding strategy,
Given the huge market value losses in investment strategy, people, compensation
many financial institutions, it is perfectly rea- and incentive management, information
sonable to challenge the cost and value of risk technology, governance and overall com-
management. However, as the world shows munication all contributed to undermining
some of the early signs of recovery, it is critical the “effectiveness”of these institutions’ERM
that ERM must be viewed as an investment programmes.
in the company’s future rather than sim- What marked out companies that mini-
ply as a cost factor of doing business. ERM mised the lasting impact of this crisis were

those that maintained continuous, timely, and incentives are embedded into business
rigorous and consistent identification, com- planning and capital allocation. True align-
munication and consideration of risk across ment of interests within the business around
the decision-making management chain a consistent and cohesive view of risk will
incorporating all elements of the value- only really be achieved on an enterprise-
chain. wide basis when organisations can overcome
their internal barriers to work on a common
Raising the bar definition of what matters most.
Further impetus for the development of truly The recent crisis has reinforced the need
integrated ERM within the financial services for more development in the area of stress
industry is coming from the explicit consid- and scenarios and more focus on develop-
eration of ERM within rating agency financial ing contingency plans for what could go
strength evaluations, analysts’ expectations wrong rather than remedial plans for what
on risk disclosures, improving shareholder has gone wrong. Moving from the “science
confidence and the move to prudent risk- of the probable” to the “art of the possible”
based regulation (e.g. Basel II for Banks and will not happen unless the industry learns
Solvency II for EU Insurers). from the lessons of the past and incorporates
Analysts and investors are taking an ever risk anticipation into its overall planning and
keener interest in how effectively risks are business process.
being managed and translated into rewards.
Further, the inclusion of ERM in financial ERM integration
strength evaluations by rating agencies is Ironically, one of the critical barriers to suc-
helping to raise the bar for ERM and driving cessfully achieving truly integrated ERM
all financial institutions to integrate the risk would appear to be one of the easiest to
and control practices that operate through- remove – in clarifying roles and responsibili-
out their businesses in a systematic fashion. ties and aligning with incentives and com-
Key evaluation criteria include the extent pensation. There is anecdotal evidence from
to which risk considerations are integrated this crisis that poor collaboration/co-ordina-
into strategic planning and capital allocation. tion across an institution created confusion
While challenging across differing geogra- about who‘owned’risk and how it should be
phies and business models, these increasing managed. More broadly, it seemed that risk
demands will reward firms which are able management was seen as someone else’s
to align risk and capital management more job and that ERM was not really relevant to
closely, and use their ERM programmes the institution as a whole.
to provide a more informed, assured and That said, an area where alignment and
coherent risk-based platform for strategic integration should be fairly readily achieved
and operational evaluation. is in the convergence of the functions of
Real value should ultimately only come Risk Management and Finance (including
from ensuring that risk understanding, rig- the Actuarial Function for Insurers). Each
our of control and appropriate constraints of these functions rely to a greater or lesser

extent on the use of complex and bespoke the effectiveness of aggregation monitoring
models, methodologies and disciplines to and the confidence of its people to use this
provide support to internal and external risk analysis to identify commercial oppor-
stakeholders – using for the most part the tunities and set commercial objectives. The
same data on which the business makes its development of a coherent portfolio view
strategic and operational decisions. They are of the threats and opportunities facing the
for all intents and purposes focusing on two business is likely to be difficult without such
sides of the same coin. assessment.
It is acknowledged, that having such
Blind faith a portfolio view across the organisation
However, in many instances operational and will require a cohesive and comprehensive
political struggles over roles and respon- alignment of performance and risk-related
sibilities continue to limit cohesion. One metrics, but the speed and contagion nature
popular approach to resolve this has been of the recent crisis would appear to reinforce
the promulgation of Enterprise Wide Data the observation that the existing alignment
Warehouses and Finance system. Although of risk and financial metrics is somewhat
this is great for ensuring data quality, having limited. Bringing risk considerations into the
one “data set” does not solve the problem of forefront of business planning and perform-
having one “mind-set” in what to do with ance management is paramount and does
the data and how it should be presented and require integrated measures that bridge all
communicated. functions of the organisation, risk manage-
In today’s risk environment, there is ment and finance included.
clearly a danger that poor information or
‘blind/naive reliance’on complex models has Risk adjusted view
generated false confidence and encouraged To add to this, many organisations are look-
institutions to accept too much risk. Equally, ing at ways to make risk a more visible and
limited risk insight or a desire to “avoid blind/ telling element for strategic evaluation,
naïve reliance” on complex models has not capital allocation and performance man-
necessarily led to overcautious approaches agement. Through the development and
where institutions have assumed too little application of common metrics that bridge
risk – rather they too have accepted greater risk and reward, closer alignment between
levels of risk out of ignorance rather than by risk management and its partners will be
design. the key foundation for a risk adjusted view
A key test of an organisation’s ability to of the business.
deal with these challenges on an enterprise- Metrics must incorporate a balance
wide basis is its ability to demonstrate the between qualitative and quantitative inputs.
alignment of its people with its strategy – Investment in refining the “science of the
functionally, culturally and operationally. At probable”with the“art of the possible”must
the centre of this test is the quality, timeli- be at the core and this means the develop-
ness and reliability of its risk assessment, ment of quantitative metrics for operational

and strategic risks using integrated stress and It is potentially unrealistic to say that
scenario analysis. In this way, measures that many institutions have already achieved
align risk and finance such as Risk-Adjusted truly integrated ERM programmes which
Return on Capital (RAROC) should pro- are effectively aligned and implemented
vide much more coherent and comparable across the organisation. In light of this, early
insights into the trade-off between risk and expectations of dividends from ERM may
reward. prove dangerous.
ERM is still a developing manage-
Potential benefits ment discipline and more advanced com-
The potential benefits of these measures ponents, ranging from risk modelling to
would surely include: risk-adjusted performance management,
• Greater application of risk management present challenging new frontiers for many
and financial disciplines in key business organisations. Integrating ERM into each
processes such as strategy, planning and decision-making and the risk-taking value
valuation; chain should provide a more disciplined and
• More robust and aligned financial, insightful ‘economic’ approach to running
strategic and operational plans and the business, and offer greater assurance for
projections (for example by challeng- boards and external stakeholders. But there
ing management and the business to is much work to be done and many frontiers
consider ranges of upside and down- to be breached.
side outcomes it requires them to better
define their appetite for risk and earnings Fundamental shifts
volatility); At a time when margins are coming under
• A more coherent and consistent view of increasing pressure and the economic slow-
the business from risk and finance; and down is limiting business opportunities, an
• Better, faster and more robust decisions improved understanding of a risk-adjusted
based on common data. view should assist institutions to identify
Closer alignment between risk and and clarify opportunities that may be missed
finance functions rests on both the stand- by their competitors and target investment
ardisation and simplification of the reporting, where they can earn the best return.
control, modelling, transactional and data Now, more than ever, institutions need
elements of risk and finance and the care- to look at how to instil risk considerations
ful consideration of roles and responsibili- into the fabric of the business and address
ties. There must also be enhanced incentives what may be fundamental shifts in their cul-
to leverage predictive/forecasting analytics, ture and operating model to ensure that this
such as stress testing risk and reward sce- happens. Those that do not may struggle to
narios as part of the budgeting and planning attract capital and sustain competitiveness in
process. The fast-shifting commercial and what looks to be an increasingly unfamiliar
regulatory environment must surely bring and challenging risk, regulatory and com-
the disciplines closer together. mercial environment. •

Accounting standards
Rocky road ahead for global

accountancy convergence
Dr Philip Goeth, Deloitte’s regional FSI
head, summarises obstacles preventing a
unified global accounting standard.
The objective of a truly global set of their own convergence road maps. In addi-
accounting standards has progressed a tion the US, in accordance with their road
long way. In recent years, in particular map, as developed by the SEC, will decide in
with the incorporation into European 2011 the extent and timing of any switch to
Law in 2002 (effective in 2005), account- IFRS.
ing in accordance with the International Clearly, the US moving to FRS would
Accounting Standards Board (IASB) be seen as a major step towards the realisa-
and International Financial Reporting tion of the globalisation objective. However,
Standards (IFRS) has become widely to achieve this goal, the IASB and FASB,
accepted and used across the globe. which have been following a co-operation
plan to converge the two standards, still
Now more than 110 countries have need to agree on a number of important
adopted IFRS as their predominant set issues. The convergence plan was laid out in
of accounting rules. In Asia, Hong Kong, a Memorandum of Understanding between
Singapore, the Philippines, Australia and the FASB and the IASB called A Roadmap
New Zealand are already using IFRS, and for Convergence between IFRSs and US
China has enacted Chinese Accounting GAAP – 2006-2008 1, and covers a wide
Standards (CAS) which are substantially in range of issues.
line with IFRS.
However, “widely used” does not yet Best use of time?
mean“global”. The US is still using their own In a progress report and timetable
US GAAP, even though since 2008 the SEC for completion2, the IASB and the FASB
has allowed non-US companies (Foreign recently confirmed the importance of con-
Private Issuers) to file under IFRS. Equally, vergence, reflecting that“trying to eliminate
in Asia, Japan, Korea, Taiwan, Thailand, differences between two standards that
Malaysia and Indonesia, to name a few, have are in need of significant improvement is
not yet fully adopted IFRS and are following not the best use of the FASB and the IASB

resources – instead, a new common stand- certain categories of financial instruments
ard should be developed that improves the (in particular: reclassification from Held for
financial information reported to inves- Trading to Held to Maturity). These changes
tors”. Accounting for Financial Instruments were pushed through rather hastily based
in particular has been identified as one of on political influence.5
the key co-operation projects. Meanwhile, accounting standards have
reached the highest level of political atten-
Fair value critique tion, with the subject matter being a key issue
Not surprisingly though, this smooth for the G20 conference where they have
and widely co-ordinated process to develop focused on the reshaping of financial mar-
accounting standards for financial instru- ket regulation. In the final report of the G20
ments was impacted by the global finan- Working Group 1, called Enhancing Sound
cial crisis. The best known disruption was Regulation and Strengthening Transparency,
triggered by rather harsh criticism that the the G20 made detailed recommendations
application of accounting standards in the on accounting matters.6 Further, it was out-
Banking industry, fair value (FV) measure- lined that accounting standard setters should
ment in particular, have exacerbated the “examine changes to relevant standards to
financial crisis.3 This criticism has lead to an dampen adverse dynamics associated with
intense discussion within the accounting fair value accounting, including improve-
industry on the role of FV accounting and ments to valuations when data or modelling
the viability of this measurement concept is weak”. Finally, a reduction of complexity
during periods of market illiquidity. of accounting standards for financial instru-
Currently, it seems that FV accounting ments and enhanced presentation standards
has weathered the storm: An SEC report4 relating to the measurement of financial
holds a rather positive view on the mat- instruments was emphasised.
ter, and both the IASB and the FASB have
meanwhile proposed changes to their Where convergence seems to work
frameworks supporting the fair value meas- A good example of an area in which the
urement model. However, as discussed in cooperation between the IASB and the FASB
more detail below, in this process, the goal appears to be working, and convergence is
of convergence seems to have fallen slightly likely to be achieved (quickly), is in the defi-
out of focus, at least for the time being. nition of fair value. The IASB has issued an
Generally, it can be said that the global Exposure Draft (ED) on the matter in May
financial turmoil and the associated politi- 2009.7 This ED contains guidance on meas-
cal pressure resulted in an increase in the uring fair value, in order to fill some gaps in
activities of both the IASB and the FASB. A the framework and to consolidate the valua-
good example of this is the process or lack tion methodology, which is currently spread
of due process associated with the October over various standards and considered as
2008 amendments to IAS 39 and IFRS 7 not always consistent.
concerning the reclassification between One of the IASB’s objectives for the

project is to increase convergence between is the accounting for certain repurchase
IFRS and US GAAP, and this ED looks to obligations (repos), which would qualify for
converge with FAS 157, the US Standard de-recognition in most cases. This topic is
on fair value.8 In the ED, FV is defined as the controversial because the banking industry
price that would be received to sell an asset generally views such transactions as secured
or paid to transfer a liability in an orderly borrowings.
transaction between market participants As agreed at the joint meeting in July
at the measurement date (an exit price). In 2009, the FASB will join the IASB’s delib-
the absence of an actual transaction at the erations following the implementation of
measurement date, a fair value measure- the FASB’s recent amendments to the de-
ment assumes a hypothetical transaction in recognition and related disclosure require-
the most advantageous market for the asset ments under US GAAP. The goal of this is to
or liability. The ED is accompanied by an ensure that the IASB and FASB will consider
outline of the basis for conclusions, as well as the lessons learned and experiences gained
by some examples.9 It is planned that the ED from the application of those amendments
will become an IFRS in 2010. in practice, in order to develop a converged
Another area where the co-ordination de-recognition standard.
seems to work relates to the recognition and
de-recognition of financial instruments. In Where convergence needs more time
March 2009, the IASB published an expo- An area in which the IASB and FASB
sure draft De-recognition ED/2009/3 (pro- seem to need more time for convergence is
posed amendments to IAS 39 and IFRS 7). determining the criteria for the classification
The approach proposed for financial assets and measurement of financial instruments.
focuses on the existence of control. This dif- The IASB has recently issued an ED10 on the
fers from the current guidance in IAS 39, matter, which proposes to overhaul the cur-
which is primarily concerned with “risks and rent system quite significantly: In the future,
rewards”(control being a secondary test). In IFRS proposes all recognised financial assets
more detail, the ED proposes that an entity and financial liabilities that are currently
should de-recognise an asset only in the fol- within the scope of IAS 39 to be meas-
lowing circumstances: ured either at amortised cost or fair value.
• the contractual rights to the cash flows Measurement at amortised cost would be
from the asset expire; or required for a financial instrument that has
• the entity transfers the asset and has no only“basic loan features”and is managed on
continuing involvement; or a contractual yield basis (unless the instru-
• the entity transfers the asset and retains ment is designated as at fair value through
a continuing involvement in it but the profit and loss). In the case of equity instru-
transferee has the practical ability to ments that are not held for trading, the
transfer the asset for the transferee’s ED proposes an option to designate such
own benefit. assets irrevocably as at fair value through
A major criticism of the proposed model other comprehensive income. During the

process of drafting the ED, the IASB consid- However, it seems that the expected cash flow/
ered whether to allow reclassifications in or expected loss model, which is believed by many
out of the three new categories after initial to be procyclical, will prevail. The ED will most
recognition and concluded that reclassifica- likely also provide clear principles regarding
tions should be allowed if there is a change cash flow estimates on a collective (portfolio)
in the entity’s business model. and an individual basis (including the interplay
This rule set differs materially from the between those bases), forecasting of cash flows,
framework that the FASB intends to enact for and the treatment of trade receivables.
US-GAAP: In a board meeting in October Further, the determination of the initial
2009, the FASB confirmed that they favour expected spread, practical aspects of apply-
a model that focuses on fair value, with ing the effective interest method (including
changes in fair value recognised either in net variable rate instruments) and the interaction
income or in other comprehensive income. with Basel II requirements have been topics
This means that the mixed measurement discussed in the process to-date. Important
model of the IASB with its wider scope of clarifications are also expected relating to
cost accounting for loans is not currently point-in-time versus through-the-cycle-
supported by the FASB. estimates, expected value versus most prob-
able value and use of entity specific versus
Request for information market data.
Another area requiring further align- The FASB is equally focused on the topic:
ment relates to impairment, in particular In a recent meeting13 the board analysed var-
valuation of loans. Loan loss provisioning is ious methodologies on loan loss provision-
a key topic on the agendas of both standard ing for the“fair value – other comprehensive
setters, given that the G20 is “analysing the income category”, differentiating between
potential contribution of loan loss provision- incurred loss models, various expected loss
ing to procyclicality with a view to recom- models, and hybrid approaches. It remains
mending that accounting standard setters to be seen if the two boards will converge
consider enhancements to loan loss provi- in their views. Given the tight time frame
sioning practices and standards”. The IASB within which the IASB intends to issue its
has issued a topical Request for Information new standard, to achieve such co-ordination
on an expected loss model, and an ED on seems quite a challenge.
the matter is expected to come out soon.11
As set forth in the discussion document The political dimension
and as outlined in recent progress reports, This short summary, which is not meant
the IASB is considering replacing the current to be complete, shows quite clearly that the
“incurred loss” model with a more precisely pressure to come up with results has put
defined “expected loss” model. In the discus- stress on convergence, with time pressure
sion process, the board also considered the pushing the IASB and the FASB to work
potentially anticyclical dynamic provisioning on individual concepts in what appears a
model as promulgated by the Bank of Spain.12 rather siloed manner. Although both boards

continue to send representatives to each context of a recent interview of Robert Herz,
other’s meetings, divergence in material the head of the FASB. In an interview pub-
matters is still apparent. lished recently by Accountancy Age,14 Herz
expressed the view that the IASB’s ability to
Level playing field “resist undue European pressure will be a
Sir David Tweedie, head of the IASB, has critical issue as the US decides whether to
recently addressed this point in an interesting adopt global accounting rules”. He further
speech he gave to ECOFIN on October 20: said that“the US wants to make sure that the
“I want to emphasise that the alternative standards it uses come out of a standard set-
of adopting a portion of the FASB approach ter which has the appropriate public policy
to impairment, promulgated in April, objectives and is not being geared or har-
would not bring about a level playing field. assed to do things in a way that is not consist-
Furthermore, on many issues, EU financial ent with that public policy objective … there
institutions would not want us to adopt the are concerns especially among the investor
US approach on impairment. As I said in community that what we may end up with
June, given the urgency of the fundamental are standards which are not geared towards
issues surrounding IAS 39, none of us can the public policy objectives that we hold fairly
afford the potential protracted back-and- sacred in the US … As one congressman once
forth resulting from piecemeal changes in said to me:‘It’ll be a cold day in hell when I let
international and US standards that would a Frenchman tell me what to do’.”
undermine the comprehensive and desper-
ately needed reform that is under way. Will the G20 prevail?
“In our discussions with the FASB aiming These messages make the politi-
to reach a common global approach, we will cal dimension of accounting convergence
emphasise our position in favour of a mixed quite clear. While this dimension has always
measurement model over one that requires existed, through the financial crisis it has cer-
full fair value measurement on the balance tainly gained attention to an unprecedented
sheet. We will seek to reach common agree- level. However, while the conflict might be
ment on a forward-looking model for loan- real, there is hope that the overarching goal
loss provisioning and a simplified hedging of convergence, as re-emphasised by the
methodology. G20, will finally prevail. Clearly the IASB
“I remain optimistic that we can over- and FASB will vigorously attempt to come
come our current differences. I know that up with solutions to the divergence, as a
my counterpart at the FASB, Bob Herz, is true global standard that is acceptable to all
equally committed to reconciling any dif- major financial centres is the desired target
ferences. To this end, we have enhanced our that seems to be shared by all participants.
co-operation over recent months and have Significant cost reductions and an increase
stepped up the joint meetings of our boards in comparability and transparency will be
and staff.” the consequence – an opportunity not to be
This comment needs to be read in the missed. •

References son in the IASB document “Wording differences
1. Dated February 27, 2006, available on the IASB between the IASB exposure draft Fair Value
website. Measurement and FASB Statement of Financial
2. Dated September 2008, same source as above. Accounting Standards No.157 Fair Value Meas-
3. See e.g. “Financial crisis presents a test for fair urements”.
value accounting”, Financial Times February 13, 9. A recent summary of the received comment
2008. letters outlined that many commentators would
4. Report and Recommendations Pursuant to welcome additional examples, in particular relat-
Section 133 of the Emergency Economic Stabi- ing to financial instruments – a comment that is
lization Act of 2008: Study on Mark-To-Market shared by the author.
Accounting. 10. ED issued July 14, 2009, comment deadline was
5. See e.g.“Sarkozy seeks accounting change”, Finan- September14, 2009.
cial Times 30.9.2008. 11. On the IASB website, the draft is announced for
6. In particular relating to strengthening the loan October 2009.
loss provisions methodology by “considering 12. For a good overview of the various approaches,
alternative approaches for recognising and meas- including the Spanish model, see CEBS, Position
uring loan losses that incorporate a broader paper on a countercyclical capital buffer, July 17,
range of available credit information”. 2009.
7. With comments due on November 28, 2009. 13. October 21, 2009.
8. See for existing differences the recent compari- 14. October 15, 2009.

North Asia
J ournal of reg
Articles & Papers

Issues in resolving
ulation & risk
north asia
systemically important
Volume I, Issue III,
Autumn Winter 2009-2010
financial institution
Resecuritisation s Dr Eric S. Rosengren
in banking: major
challenges ahead
A framework for
funding liquidity Dr Fang Du
in times of financial
Housing, monetary crisis
and fiscal policies: Dr Ulrich Bindseil
from bad to worst
Derivatives: from
disaster to re-regulati Stephan Schoess,
on
Black swans, market Professor Lynn A. Stout
nce crises and risk: the
Com plia human perspectiv
Legal & Measuring & managing e
risk for innovative Joseph Rizzi
financial instrumen
Red star spangled ts Dr
banner: root causes Stuart M. Turnbull
of the financial crisis
to the
The ‘family’ risk: Andreas Kern & Christian
a cause for concern
subject
Fahrholz
among Asian investors
actly is
Global financial
s Act?
change impacts David Smith
Who ex Practice
compliance and
risk
The scramble is on
Corrupt
to tackle bribery David Dekker
and corruption
Foreign , DLA
Who exactly is subject Penelope Tham & Gerald
to the Foreign Corrupt
Yuet-Ming
Subscribe today
Li
Practices Act?
er, Tham
Financial markets
mines the remuneration reform: Tham Yuet-Ming
In this pap consultant, exa

one step forward
Asia. Of ‘Black Swans’, Umesh Kumar & Kevin
g Kong FCPA in
stress tests & optimised Marr
risk management
Piper Hon ious effects of the Challenging the
value of enterprise
risk management
David Samuels
pernic Rocky road ahead
h for global accountanc Tim Pagett & Ranjit
Jaswal
– man y of whic y convergence
anies The Asian regulatory
legis-
reds of comp . The US Rubik’s Cube Dr Philip Goeth
by hund companies even-
Practices were Fortune 500 these scandals by Alan Ewins and Angus
Corrupt
Ross
in the to
Foreign nnings e responded FCPA in 1977.
The US its begi ial latur
enacting
the
provision
s to the
A), has rgate Spec the
Act (FCP n the Wate o- tually e are two main isions, and
era, whe ntary discl e Ther bribery prov SEC and the
Watergate called for volu – the anti-
r had mad Both the
Prosecuto companies that Rich ard FCPA nting provisions. (DO J) have juris-
to e Risk mana
sures from contributions aign. accou
rtment of
Justic
rally, the
SEC gement
ble US Depa FCPA. Gene isions and
questiona presidential camp the
n over nting prov st issuers
Nixon’s
1972
led dictio the accou again Of ‘Black
sures revea
these disclo estic payments
prosecutes ry provisions as edings
ative proce and
Swans’, stre
anti-bribe
optimised ss tes
risk manag ts &
However, ble dom d the administr
questiona had been channelle civil and companies
not just through prosecutes ry provisions
funds that n business. eas the DOJ anti-bribe ement
but illicit rnme nts to obtai nt investi- wher s for the s.
to foreig
n gove
to subseque Exchange indiv
idual proceeding Standard &
mation led gh criminal outlines the Poor’s
The infor rities and
the US Secu h revealed
that throu
ision positive bene David Samuels
gations by ) whic to ery prov makes it fits of bank
ion (SEC h funds” anti-brib bribery provision stress
Commiss issuers kept “slus cal The ’s anti- money or
anything testing on
many US n officials
and politi The FCPA or provide (“foreign”mean
- the bottom
s to foreig l to offer als
It is a big
challe line.
pay bribe tary illega foreign offici n or a robust appro nge for banks to
t to obtai
parties. with a volun cor- of value to ) with the inten to
of worst-case ach to managing the
build down
later came up h any “non -US” ting business turn capita
l adequacy
The SEC whic direc stress scena risk
e under ents ing business, or for by definition, rios uncover risk programs
disclosure
programm
eported
illicit paym retain spon sor- are triggered that, almost encies concentratio
ns and risk to
h self-r given n. de unlik ely by appar , and; applyi depen
poration
whic SEC was any perso can inclu
of a holi-
or unpreceden ently to
drive busine ng these improvemen
d-
with the likely of value
ation, use
ted events.
perated it would Anything educ ent, ss selection ts
and co-o
Contact
ance that t l and loym throug h – for
mal assur The resul for trave of future
emp However, solvin perfor example,
an infor nt action. $300 ship home, promise e is no fying the g the adjusted pricing mance analysis and
enforceme than USD meals. Ther risk concentratio problem of identi- that takes stress risk-
be safe from sure that more (a mas-
day
drinks and cies that give ns and depen into account. test results
was the
disclo payments discounts, rise to worst- den-
ques tionable been made vital if the
147 indust case outcom
in es
million 1970s) had vidual banks ry is to thrive is
– and if indi- Top-level oversight
unt in the are
sive amo past two years to turn the lessons Buildin
h Asia to competitive of the proces g a more robust and
Risk Nort s for uncov comprehens
Christopher Rogers
lation & Banks that
tackle the issue
advantage. ering threat ive
of Regu be lauded by head-on will prise is clearly, in part, s to the enter-
Journal investors and
coming years regulators ance challe a corporate
nge.The board govern
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
General Secretary
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
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 execut ive 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- busine
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

Comparative regulation
The Asia-Pacific regulatory

Rubik’s Cube
Allen & Overy’s Alan Ewins and Angus
Ross run their comparative ruler across
regulatory environments in Asia.
The Asian regulatory environment is Hong Kong has proved to be an inter-

colourful, complex and has many mov- esting case study in this regard. First off the
ing parts. Asian Governments and regu- mark, at the end of 2008 with Securities and
lators are grappling with what at present Futures Commission (SFC) and Hong Kong
appears to be the aftermath of the mar- Monetary Authority (HKMA) reports to the
ket turmoil (although a further market Hong Kong Financial Secretary on responses
turndown cannot of course be ruled to the minibonds debacle; in the midst of a
out globally as and when the effects multi-pronged consultation programme to
of the bail-outs and stimulus packages address issues in relation to sales of struc-
have washed through the international tured products in the territory and potential
system). changes to the legislation as well as the rel-
evant codes and guidance; and the HKMA
That grappling involves a fine balance having now started consulting in relation to
that needs to be struck among various driv- the risk management aspects of the remu-
ers, including pressures and political obliga- neration policies of banks (the first Asian
tions created by the G20 (and the Financial jurisdiction to tackle this issue full-on).
Stability Board) process, the spectre of pro-
tectionism and regulatory arbitrage across Hong Kong
the Asian markets, and the need for the When combined with a significantly tougher
various Asian jurisdictions to maintain their stance on market misconduct, including
competitiveness on the world financial insider dealing, which has led to a raft of
stage. This is all coupled with the extent to convictions over the past year or so, and the
which broader market reforms will ulti- anti-money laundering consultation exer-
mately be persevered with in the light of the cise just completed to meet Financial Action
game of‘Market Scrabble’that now seems to Task Force requirements, it is clear that not
grip commentators (i.e. will it be a U,V, W or only is Hong Kong attempting to keep its
something else-shaped recovery). own house in order but also to look to its

international obligations with an eye to the international economy and the correspond-
future regulatory landscape internationally. ingly weakened influence of Western regu-
So what of elsewhere in the region? lators following the global financial crisis.
According to the preliminary version of
Singapore the OECD Regulatory Reform Review for
Singapore has taken a broadly similar China (Defining the Boundary between the
approach to the crisis to Hong Kong, having Market and the State), “China’s regulatory
had its own significant share of minibonds reform has made impressive progress over
fall-out. Its moves towards market reform the past decade and is gaining momentum.
in relation to structured products have Much remains to be done, but a very good
essentially mirrored the Hong Kong devel- foundation has been laid”.
opments, covering such things as product Most commentators would tend to agree
highlights and cooling-off periods. with this.
The attitudes of the two jurisdictions On one hand, there have been increased
regarding settling the Lehman Brother requirements for liquidity and credit control
Minibond problems have been somewhat stress tests for banks, derivatives documen-
different, of course. Hong Kong procured tation advances and other developments.
monetary settlements by the distributors, On the other hand, there is an element
with investors told essentially to draw a line of tension at present in the market as the
under this issue and move on; the Monetary result of problems arising between Western
Authority of Singapore (MAS) took a dif- institutions and domestic State-Owned
ferent path, disciplining the distributors for Enterprises (SOEs) from failed derivatives
their failings and leaving it to the investors to contracts.
seek their own redress by way of the island’s Those problems represent a test of the
law courts. Rule of Law which is proving to be delicate,
Not surprisingly, the MAS has also given the Government’s professed support
issued guidelines in relation to fair outcomes of the SOEs modified by its insistence that
for investors (mirroring, for example, the the SOEs do indeed have the burden of
Financial Services Authority developments proving their cases. A fine line.
in the United Kingdom), together with
enhanced licensing and notification changes, Japan
designed to improve investor protection. Japan has indicated that it has, in general,
no objection to any statement issued in the
China G20 process. The Minister of the Financial
China appears likely, according to the results Services Agency, Mr. Kamei, went on to say
of a recent survey that we conducted, (“Asian that any capital-related issues under the
Regulatory Survey 2009”http://www.alleno- Basel Accord, which is a central plank of the
very.com/AOWeb/binaries/53423.PDF), G20 reforms, should be applied to those
to forge its own path in terms of regula- Japanese “Mega” banks that are carrying on
tion, given its strengthening role in the international activities, not to the domestic

banking market. The domestic banks are That potentially has implications for inter-
already to some extent catered for under the national financial documents, and needs to
Japanese regulations, but it is clear that this be urgently clarified by the Indonesian regu-
split will exercise the Japanese regulators lators to avoid any question of international
going forward. documents needing to be translated. There
One of the more interesting aspects of are also various derivatives cases currently
responses to the crisis has been the de-con- on foot relating to suitability and mis-selling
struction of the “firewall” regulations, allow- which tie into these concerns.
ing banking and securities groups to provide
more homogenised services to clients. This India
has been with a view to increasing Japan’s India’s developments have been more along
competitiveness as an international financial the lines of foreign investment and partici-
market. pation in Indian entities, not so much in the
However, it comes at a time when much context of mainstream regulatory reform.
has been made during the course of the G20
process of the need for greater differentiation Korea
during the product selling process of “clas- Korea went through a “Big Bang”in its finan-
sic” banking (i.e. deposits and vanilla deposit cial services industry earlier this year, where
products) from so-called “casino” banking the agenda was very much to evolve into a
(i.e. more exotic products). major player in the region.
For example, Hong Kong and Singapore Amongst other things it was intended
have made express stipulations as regards to liberalise product offering in Korea by
the need to ensure clear water between the moving away from the model of institu-
sales of banking and investment products. tions being permitted to sell only a relatively
At the same time the United Kingdom, as restricted list of specified instruments, to the
part of the overall process, has been driving more internationally recognisable “excep-
forward proposals on “living wills”, which tions” model, where businesses can sell
are designed ultimately to simplify financial unless restricted or prohibited.
conglomerates. One point to bear in mind in this regard
These types of issue demonstrate the is the debate that has recently been trig-
challenges of reaching broad consensus and gered in various jurisdictions as to whether
implementation of reforms at an interna- some products are inherently inappropriate
tional level. (i.e. too risky) to be sold to (essentially retail)
investors. For example, Australia has put for-
Indonesia ward the possibility of banning sales of par-
Indonesia’s response to the market turmoil ticular products in that type of case. It is fair
has been very inward-looking, given the to say the Korean “Big Bang” proved to be
recent change in the law requiring the use the victim of extremely unfortunate timing
of the Indonesian language in every agree- given the market turmoil.
ment, including commercial documents. The controversy surrounding the Korean

Rule of Law issues created under the KIKO institutional investors (including Thai securi-
litigation (concerning instruments which ties companies) to invest directly in foreign
took a view on the movement of the value securities, allowing onshore banks to enter
of the Won, which generated fiercely fought into certain derivative contracts and some
mis-selling cases in the jurisdiction) has not relaxation of the restrictions on Thai resi-
assisted. dents entering into currency derivatives.
Nor has the recently announced possi- However, it is fair to say from a more
bility of imposing controls on foreign bank international perspective that Thailand’s
liquidity. Notwithstanding the economic involvement at the head of ASEAN in the
improvements over recent months, the reg- G20 process has arguably been more in the
ulatory model appears to be something of a context of the bigger picture International
work-in-progress. Monetary Fund and World Bank reforms.
It is clear from the above that this is a cru-
Taiwan cial turning point in the development of the
Taiwan has been in a similar position to international markets.
Korea in relation to derivatives contracts There is a struggle in Asia between the
entered into by foreign institutions with creation of internationally coherent markets
Taiwanese entities. and, in some places more than others, the
protection of the home patch. The roll-out
Thailand of G20/Financial Stability Board initiatives
Thailand is considering its options in rela- needs to be viewed in that light.
tion to launching its own“Big Bang”, which The Japanese Prime Minister, Yukio
would be designed to advance Thailand’s Hatoyama, has recently said, in Thailand, at a
interests as an international financial centre, regional leadership meeting of Asian coun-
but that seems to be in its early stages. tries, that his “vision of forming an East Asia
The Bank of Thailand, in August of this Community was largely welcomed by par-
year, did implement some relaxations of ticipants” at the meeting. That community
the rules for investment in foreign securities does, as he recognised in his remarks, look
and derivatives, permitting certain types of a long way off. •
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J ournal of Regulation & Risk

Volume I, Issue III, Autumn/Winter 2009-10

Articles & Papers

Resecuritisation in banking: major challenges ahead Dr Fang Du

A framework for funding liquidity in times of financial crisis Dr Ulrich Bindseil

Derivatives: from disaster to re-regulation Professor Lynn A. Stout

Global financial change impacts compliance and risk David Dekker

Rocky road ahead for global accountancy convergence Dr Philip Goeth

As financial markets shift back to growth and future

Beijing | Hong Kong | Kuala Lumpur | Melbourne | Mumbai |

Journal of Regulation & Risk North Asia 1

INSTITUTE OF REGULATION & RISK

Journal of Regulation & Risk North Asia 3

As financial markets shift back to growth and future

Beijing | Hong Kong | Kuala Lumpur | Melbourne | Mumbai |

Journal of Regulation & Risk North Asia 5

Journal of Regulation & Risk North Asia 7

Obama and financial reform:

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10 Journal of Regulation & Risk North Asia

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12 Journal of Regulation & Risk North Asia

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14 Journal of Regulation & Risk North Asia

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Central bankers, systemic risks

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18 Journal of Regulation & Risk North Asia

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20 Journal of Regulation & Risk North Asia

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22 Journal of Regulation & Risk North Asia

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24 Journal of Regulation & Risk North Asia

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Unified Financial Analysis: the

Journal of Regulation & Risk North Asia 27

28 Journal of Regulation & Risk North Asia

Financial events e1 e2 e3 ... en

LaR EaR VaR

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30 Journal of Regulation & Risk North Asia

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34 Journal of Regulation & Risk North Asia

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36 Journal of Regulation & Risk North Asia

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38 Journal of Regulation & Risk North Asia

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Journal of Regulation & Risk North Asia 41

42 Journal of Regulation & Risk North Asia

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44 Journal of Regulation & Risk North Asia

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New international models for

Journal of Regulation & Risk North Asia 47

48 Journal of Regulation & Risk North Asia

Journal of Regulation & Risk North Asia 49

The future of structured

Hong Kong’s Securities and Futures Lehman Brothers effectively funded

Journal of Regulation & Risk North Asia 51

52 Journal of Regulation & Risk North Asia

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Journal of Regulation & Risk - North Asia, Volume I, Edition III/IV, Winter 2009/10

Journal of Regulation & Risk - North Asia, Volume I, Edition III/IV, Winter 2009/10