Reforming international financial regulation

Reforming international
financial regulation

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First published May 2010
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Reforming international financial regulation
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Foreword
This paper is part of a thought leadership series dedicated to ensuring Australia and its next generation
of leaders remains fit for the future. Entitled Reforming international financial regulation this paper is the
second in a series of papers dedicated to broader economic thinking and engagement with Australia’s
business community.
The Fit for the future series is to bring together business, social, political leaders and thinking on key
issues impacting Australia now and in the future. As a leader in the Australian accounting profession the
Institute of Chartered Accountants in Australia (the Institute) has a role and responsibility to contribute
to Australia’s public policy agenda. It is in this regard that we have teamed up with Access Economics to
produce this paper.
Reforming international financial regulation details how regulation is being reformed internationally. The
global economic downturn uncovered severe weaknesses in the international framework of regulation
and it is paramount that Australia moves with best practice to ensure its regulation architecture remains
viable. To achieve this there needs to be a subtle calibration between efficiency and stability – a delicate
mix but critical to the future evolution of Australia’s financial services industry.
Australia will face many challenges in financial regulation over the coming decades. Reforming
international financial regulation represents a building block to a greater level of understanding of the
international trends and how Australia is placed internationally.
The Institute is pleased to have worked with Access Economics on this paper and I trust that you will
find it both interesting and thought provoking.

Michael Spinks FCA
President
Institute of Chartered Accountants in Australia

3

Contents
Executive Summary .......................................................................... 6

1 Background .............................................................................. 9
1.1 Context for reform and Australia’s response . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.2 The proposed reforms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
1.3 The reform timeline ....................................................................... 10
1.4 Australia’s obligations and approach to reform. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

2 International regulatory reforms most likely to affect Australia ..................... 11
2.1 Capital and liquidity enhancements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.2 Leverage ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.3 Procyclicality measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.4 Systemic risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
2.5 Products and markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.6 Regulatory boundaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

3 How might Australia respond? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
3.1 Incorporate reforms within existing structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
3.2 Re-assign regulatory responsibilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
3.3 Selectively implement reforms ............................................................ 25
3.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Appendix A Consultations .................................................................... 29
Appendix B International regulation standard-setters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Appendix C Outline of the proposed reforms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Appendix D Reform timeline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Appendix E Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

Charts
Chart 2.1 Ratio of private credit to GDP in selected countries ............................... 17
Chart 2.2 US private credit as a share of GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

Tables
Table 2.1 Lessons from past crises regarding appropriate levels of capital .................. 13
Table 2.2 ‘Skin in the game’ reforms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Table A.1 List of stakeholders .............................................................. 29
Table B.1 FSB members . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Figures
Figure 2.1 Liquidity ratios ................................................................... 12
Figure B.1 FSB organisational structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

5

Executive Summary
The Global Financial Crisis (GFC) showed that macroeconomic policy and prudential supervision are not sufficient
to ward off systemic crisis in the international financial system. In the wake of the crisis, financial regulators and
standard-setters are moving to tighten regulations and raise standards across the globe. This report identifies the
main reforms under review and the challenge facing Australian authorities to respond appropriately.

Capital and Proposed enhancements to capital and Australian banks are well capitalised under the
liquidity liquidity standards will oblige banks current Basel II framework. Moreover, Australian
enhancements to hold more capital and more liquid banks have raised extra capital (and notably high
assets on their balance sheets. These quality Tier-1 capital) to further strengthen their
changes will instigate widespread balance sheets. While the level and nature of the
deleveraging and lower banks’ return proposed new capital requirements are not yet final,
on equity. Consequently, the cost of Australian banks are well down the path to any new
bank intermediation is expected to rise. standard. Similarly, liquidity requirements are already
The wider spread between banks’ cost being tightened in Australia and should easily meet
of funds and their lending rates (ie. any new standard proclaimed internationally.
their net interest margins) will be paid
by bank customers. Raising the cost
of bank intermediation will slow global
economic growth.

Leverage ratio The proposed unweighted leverage An unweighted leverage ratio affects banks with
ratio may alter international perceptions low-risk balance sheets, like Australia’s banks, whose
of the capital adequacy of healthy balance sheets generally have large exposure to
banks. The leverage ratio is intended to low-risk mortgages. The leverage ratio will show
complement existing risk assessment these banks as under-capitalised relative to their
models, targeting the problem of international peers when they easily meet APRA’s
excessive leverage. However, not risk-weighted capital adequacy standards. Given
being weighted to reflect the riskiness support for a leverage ratio from key international
of a bank’s assets, the leverage ratio regulators, Australian authorities are working to
represents a significant departure from influence the calibration of the ratio so that it does
current supervisory practice. not penalise well-managed, low-risk banks. If these
efforts are unsuccessful, Australian banks may face
a higher cost of borrowing in global capital markets.
Some of the resulting impact on Australian borrowers
may be mitigated if the RBA targets a lower official
cash rate over the business cycle.

Procyclicality Procyclicality measures seek to equip APRA’s discretion over minimum capital requirements
measures financial systems with regulatory effectively replicates aspects of the proposed
‘shock absorbers’ by requiring financial procyclicality measures, namely, building up capital
institutions to build up capital reserves buffers in good times. However, introducing forward-
in good times in order to sustain their looking provisioning and credit-linked capital buffers
activities during the inevitable bad may not have a positive impact: the former may not
times. dampen the credit cycle at all (as exemplified by
Spain’s experience); while the latter may compromise
the effectiveness of monetary policy – especially
when the factors driving credit growth are beyond the
RBA’s influence. In addition, investors may shy away
from banks whose discretion to distribute earnings is
constrained, making it more difficult and/or expensive
for them to raise capital. The ability of Australia’s
banks to raise equity capital during the
GFC contributed to their resilience.


Systemic risk Mechanisms to address systemic risk Obliging financial institutions to reduce their size,
remain conjectural at this stage. Many complexity and links to counterparties reduces
and varied proposals have been brought systemic risk. However, there is a cost to be borne in
forward. Regulatory options such as reduced economies of scope and potential sharing of
structural reforms, taxes on size or risk across markets. Requiring institutions to plan for
‘living wills’ are likely to reduce the size their own demise or dismembering may force them
and scope of financial intermediaries to re-assess their counterparty risks, and simplify and
and stimulate the growth of ‘shadow reduce their exposures. But it may also induce them
banks’. The net impact on systemic risk to move beyond the reach of prudential regulators,
is arguable. which could be counterproductive. Australian
regulators are amenable to measures for dealing with
institutions that are systemically important. The ‘four
pillars’ policy is an example. Yet, even with this policy
in place, the moral hazard of institutions judged ‘too
big to fail’ has been increased by moves to protect
Australia’s banks during the GFC.

Product Modifications of the securitisation Returns to originators from securitised issues will
and market process along with the development of fall as a bigger share of the risks is retained and
regulation rules and exchanges/clearing houses internalised through regulatory reforms, including
for trade in Over-The-Counter (OTC) revised requirements for retaining ‘skin in the game’.
derivatives are likely to reduce systemic This will increase the cost of raising funds through
risk. There will be a cost to the issuer in securitisation, particularly for smaller banks and non-
the form of reduced returns for a given ADIs. However, other measures are expected to have
issue, and clearinghouse users will have a lesser impact owing to the relatively small size of
to pay for their use of clearing/trading local markets for the more problematic OTC products
systems. There is also a risk of reduced – such as CDS – and the Australian hedge funds
innovation in OTC markets as contracts sector. In any case, ASIC is moving in advance of the
become standardised, more commonly international timetable and initiatives, including those
traded on exchanges and cleared relating to securitisation, due diligence and credit
through central clearing houses. rating agencies. Some initiatives may be in place in
Australia before international standards are set.

Regulatory Re-defining the coverage and Recognising that systemic risk afflicts financial
boundaries responsibilities of regulators at markets as well as intermediaries blurs the neat
international and domestic levels will division of regulatory responsibility assigned in
reduce opportunities for regulatory the Wallis Report. Moves to extend the reach of
arbitrage and duplication of regulatory prudential regulation into the ‘shadow banking’
effort. The ‘twin peaks’ model system risks overlap between ASIC and APRA, and
will become somewhat blurred as potentially leads ASIC into areas it is insufficiently
procyclical measures combine elements resourced to perform. Independent moves by
of monetary policy and prudential APRA to adjust capital requirements as part of
regulation. Even product and market macroprudential policy potentially confuse and
regulation will encounter this blurring conflict with the RBA’s countercyclical monetary
effect if prudential regulation is policy. A review of coordinating mechanisms
extended to cover securitised issues. among Australia’s financial regulators will be
essential as part of the reform process.

7

Responding to the proposals
There are three broad responses which Australia could
make to the international reform agenda. Specifically,
Australia could respond by:
> Fully signing up to the reforms but carefully managing
their implementation within the existing Australian
regulatory structure
> Re-defining regulatory responsibilities among Australia’s
financial regulators to better reflect the revised approach
to systemic risk management emerging from the
FSB process
> Explicitly repudiating some of the more interventionist
proposals on the grounds that they are redundant in
an Australian context or potentially compromise the
discretion of Australian regulators.

Australia needs to decide how to respond to the raft of
initiatives likely to emerge from this complex process.
There is Australia’s international reputation for sound
and effective financial regulation to protect, as well as
Australia’s obligations to the G-20 to consider. On the other
hand, Australia’s national interest must be guarded when
signing up to regulations which may, at least in some cases,
compromise rather than enhance the integrity of Australia’s
system of financial regulation.
In the best case, Australia can accommodate the new
requirements within existing structures. There is also the
possibility, however, that the global standards oblige us
to implement more fundamental changes than might be
considered desirable or even necessary. For this reason,
the option to reject some or all of the proposed changes
should not be foreclosed or dismissed lightly.


1. Background
The Group of Twenty (G20) countries are reforming Australia is how to calibrate this balance so as to optimise the
regulation of their financial systems in the wake of the performance of our internationally respected financial system.
Global Financial Crisis (GFC).1 The GFC revealed significant
weaknesses in the global framework of financial regulation. 1.1 Context for reform and Australia’s response
While it is understood that periodic crises are an inherent Rapid contagion of stresses originating in the United States’
feature of financial systems, the global reach and impact of financial system was met with a co-ordinated response
the GFC have forced authorities to re-think their approach from governments around the world. Political leaders from
to the mitigation of systemic risks (Caruana, 2010). As a the G20 nations have since announced their intention to
member of the G20, Australia will come under pressure to reform global financial regulation in the wake of the GFC.
align our financial regulations with the emerging standards While Australia’s experience was benign by comparison with
adopted internationally. that elsewhere in the world, our reliance on international
The Institute of Chartered Accountants in Australia (the capital markets means that Australia has a vested interest in
Institute) has commissioned Access Economics (AE): the robustness of the international financial system and its
> To report on the deliberations to date of international regulation. Australian financial intermediaries and markets
regulatory agencies and to identify high-priority issues rely on the soundness of their counterparties. The GFC was
on their agendas for reform communicated to Australia through stresses experienced by
these same counterparties.
> To report on the likely responses of international
regulators to these high-priority issues The G20 nations have transformed the former Financial
> To identify how these responses potentially align or Stability Forum into the Financial Stability Board (FSB)
conflict with policies already in place, or under active with a mandate to coordinate the international response to
consideration, in Australia regulatory reform. There are a number of different agencies
that set standards which individual countries then decide
> To analyse the likely impact of proposed reforms on
whether to adopt or not (see Sections 1.2 – 1.4 overleaf). The
the Australian financial system.
FSB comprises senior representatives of national financial
The body of this report considers what international authorities (central banks, regulatory and supervisory
regulators are most likely to do. The findings are based on authorities and ministries of finance), international financial
desktop research complemented by consultations with institutions, standard-setting bodies, and committees of
regulatory experts, industry specialists and academics as central bank experts (see Appendix B).
well as domestic and international regulators. (A full list The FSB hopes its efforts will spark a ‘race to the top’ –
of institutions consulted appears as Appendix A.) as more countries adopt its standards, others will face a
The report distils its findings into six key areas considered stronger incentive to follow suit. A decision to stand aside
most relevant to Australia (even if they are less relevant to from these reforms could risk a country being treated as a
international players). The facts are presented in each area pariah or, worse, becoming a magnet for operators keen
and then analysed, highlighting how the proposed reforms to locate where financial regulations are less stringent than
align or conflict with policies already in place or planned international norms. Australia would be ill-served by either
in Australia. Some comments on the likely timing of each of these outcomes.
reform are included for completeness. Australia’s system of financial regulations is among the more
The report concludes with an assessment of the options advanced in the world. This is one reason why preconditions
open to Australia in responding to the reforms most likely for the GFC, including excessive leverage and lax bank
to emerge from international deliberations. Ultimately, the lending standards, did not apply in Australia – at least not on
impact on the Australian financial system will turn on how a systemic scale. Australia’s benign experience of the GFC
the Australian regulatory authorities respond. has drawn international attention to the robustness of our
In choosing their response, Australian authorities will be financial regulations and strengthened Australia’s reputation
wise to recall that there is almost always a trade-off between for financial safety and soundness.
efficiency and stability in any economic system. To the Hence Australia has much to lose from an inappropriate
extent that increased regulation promotes systemic stability, response to the G20 initiatives. On the one hand, we would
it generally comes at a cost in terms of lower economic sacrifice a well-earned reputation for financial probity if
efficiency (both static and dynamic). The question for we stood aside from international reforms in the belief that

1. The term ‘Global Financial Crisis’ encompasses a sequence of events including the sub-prime mortgage crisis beginning in 2006 and gathering pace in 2007,
a subsequent banking crisis, and the collapse of Lehman Brothers investment bank in September 2008. Observers generally regard the demise of Lehman
Brothers as triggering the most dramatic phase of the GFC.

9

our system has already achieved ‘world’s best’ regulatory 1.3 The reform timeline
practice. On the other hand, there is no evidence that our The sheer number of proposals under review plus the
system of financial regulation needs a major overhaul to variety of stakeholders seeking input to the deliberations
redress failures exposed by the GFC. Australia’s experience complicate the reform process and will inevitably slow
in this regard, like that of a minority of countries including the rate of implementation. There will also be an extended
Canada, India and Hong Kong, is precisely opposite to transition period given the weight and complexity of the
that in the United States, UK and parts of Europe, most reforms in view.
notably Ireland and Iceland. Nevertheless, Australia will
Current activities of the international standard-setting
benefit from reforms implemented in those countries whose
agencies fall into three groups:
financial weaknesses were transmitted globally, including to
Australia. Failure to play our part in such global reform risks > Completing reviews of the coverage of existing regulations
undermining initiatives elsewhere in the world from which > Ensuring that, at a minimum, FSB member nations have
Australia stands to benefit. adopted 12 key international standards (that existed prior
Calibration of Australia’s response to international financial to the crisis)2
reform calls for some subtlety. Our circumstances are not > Determining new regulations and policies.
those of the major economies whose experience of the
Details of these activities and the timetable for their expected
GFC has been devastating. Yet, while Australia has developed
completion dates are presented as Appendix D.
through experience and good management an approach to
financial regulation that is admired by many, we would not
1.4 Australia’s obligations and approach
be well served by complacency.
to reform
This report lays out the main areas where international
As a member of the FSB, Australia is obliged to implement
reforms will challenge Australian authorities to devise an
reforms agreed by the various standing committees and
appropriately calibrated response. Rather than speculating
to undergo peer assessment to check on implementation.
on what that response might be, the focus is on calling
A number of proposals have already been implemented in
attention to the issues and how they might play out in practice.
Australia or are well advanced in implementation. Other
The range of possible responses the authorities might
proposals may require Australia to make significant changes
take as the reform proposals take shape is also identified.
to existing regulatory practice.

1.2 The proposed reforms The approach of Australia’s regulators to implementing FSB
reforms will determine whether regulatory changes achieve
The international regulatory response coordinated by the
desired improvements to the financial system. Our regulators
FSB canvasses a wide range of proposals. Broadly speaking,
are accustomed to consultation with stakeholders and this
the reforms can be considered under four headings:
will be vital if unintended consequences are to be avoided or
> ‘Whole of system’ reforms relating to global cooperation, at least minimised. The field is fraught with the possibility of
enforcement and monitoring (FSB being the lead misapplied reforms.
standard-setter)
> Reforms of regulations applying to financial intermediaries
(BCBS being the lead standard-setter)
> Reforms relating to the regulation of capital markets and
instruments (IOSCO being the lead standard-setter)
> Reforms relating to the regulation of professional services
and ancillary support (IASB and IAIS being lead standard-
setters for accounting and insurance, respectively).

Details of the proposed reforms are presented as Appendix C.

2. The FSB has determined 12 Key Standards as critical to ensuring sound financial systems. They include standards relating to macroeconomic policy, data
transparency, institutional and market infrastructure, and financial regulation and supervision. These standards have been developed by the IMF, World Bank,
OECD, IASB, IFAC, CPSS, FATF, IOSCO, BCBS and IAIS.


2. International regulatory reforms most likely to affect Australia
The GFC showed that macroeconomic policy together with > Procyclicality measures – to reduce the amplitude of
prudential regulation of individual financial institutions could the credit cycle and build buffers in excess of minimum
not prevent the build-up of systemic risk. This gap in the requirements during good times
regulatory framework allowed pressures to accumulate that > Systemic risk – limiting the capacity for failure of large
ultimately disrupted the provision of financial services to or interconnected institutions to disrupt the provision of
the global economy. The G20 countries have deemed that financial services to the broader economy
macroprudential policy is required to fill this void.
> Product and market regulation – to address information
Essentially, macroprudential policy aims to help dampen asymmetries and incentives for excessive risk-taking that
the credit cycle and increase the resilience of financial interfere with the capacity of financial markets to allocate
systems in times of stress. The intention is to raise and lower capital efficiently, especially during times of stress
capital standards applying to financial intermediaries in a
> Regulatory boundaries – (re)defining regulatory
countercyclical (‘leaning into the wind’) fashion. The G20
boundaries – cross-border, prudential, disclosure and
Working Group 1 (2009) recommended a number of potential
macroeconomic – to enhance the effectiveness of
macroprudential tools and the BCBS (2009b, 2009c) has
regulation and accommodate the increased reach of
released consultative documents detailing the measures
financial institutions and markets.
most likely to be adopted.
Working out operational aspects of macroprudential policy
2.1 Capital and liquidity enhancements
is a challenge for international regulators. The G20 Working
Group 1 (2009) finds a rules-based approach ‘attractive’ During the GFC financial institutions were more affected by
but also recognises the value added by informed judgment. problems in capital markets than anticipated. The quantity
The ‘rules versus discretion’ debate has a long history in and quality of capital held by financial institutions was
monetary policy. It would be incongruous if the conventional insufficient to ensure that banks could continue to provide
wisdom that monetary policy should be ‘rules-based’ but intermediary services to the economy. What began as a
not ‘rules-bound’ should be tipped on its head in the realm credit crisis quickly morphed into a liquidity crisis and then
of macroprudential policy. Moreover, the interaction of the a solvency crisis as banks financial positions weakened.
proposed macroprudential tools with monetary policy is not Central banks and governments were required to provide
well understood. In Australia’s case, where monetary and capital and liquidity to the market by buying toxic assets.
prudential policy are administered by separate agencies, the In some instances governments became equity holders
roles of the RBA and APRA may need to be re-cast. of private financial institutions or forced healthier banks to
acquire unhealthy banks as a means of providing capital.
The GFC revealed that systemic risk is pervasive and afflicts
financial markets as much as financial intermediaries. Proposals
Financial markets can suffer the equivalent of a ‘bank run’ The BCBS is seeking to improve the consistency, quality and
since ‘asymmetric information’ is more ubiquitous than most transparency of capital held by financial institutions and to
people thought. Consequently, improved product disclosure shore up their liquidity. To do this, it has proposed a multi-
and market conduct regulation also feature prominently on pronged approach including:
the reform agenda. The boundaries between prudential and
> Redefinition of capital – In order to ensure greater
disclosure regulation may also shift in the wake of the reform
consistency and transparency in the determination of
process with implications for the respective roles of ASIC
capital requirements internationally, the BCBS is re-defining
and APRA.
Tier 1 and Tier 2 capital requirements and abolishing Tier 3
Against this background of international regulatory reform, capital. Of note is the new requirement that Tier 1 capital
six key issues emerge for Australian regulators and those comprise common equity and retained earnings only, while
they regulate. This list is informed by consultations with local structured capital (or ‘innovative hybrids’) are to be phased
and international regulators and market professionals. The six out (currently at 15%)
key areas of reform are:
> Implementation of stronger risk-adjusted capital
> Capital and liquidity enhancements – to raise the level requirements – Financial institutions will be required
and quality of capital on an institutions’ balance sheets and to determine their capital requirements with respect to
to shore up liquidity in order to better insulate the financial counterparty risk using stressed inputs. This is so that
system from episodes of stress capital held is sufficient not only to meet counterparty
> Leverage ratio – to cap the build-up of leverage in an default risk but also to address credit valuation adjustment
institutions’ balance sheets so as to mitigate damaging risk. Further, stronger margining requirements are
episodes of deleveraging and guard against model risk and proposed and longer time periods are to be used for
measurement error in risk-based capital adequacy ratios determining whether regulatory standards are met

11

> Employing a Liquidity Coverage Ratio (LCR) and Net the standard ‘in name only’. This will reduce differences
Stable Funding Ratio (NSFR) – These ratios will be between jurisdictions, for example, between the US and the
used to provide an additional backstop for internationally EU where capital requirements are significantly different, and
active financial institutions. The LCR requires institutions will assist the efforts of regulators to monitor global banks.
to hold sufficient high quality, liquid assets to sustain a Implementing the new capital rules is likely to raise the
30-day market event while the NSFR, by contrast, seeks to cost of capital globally. Banks balance sheets may not have
promote the longer-term resilience of financial institutions adequate capital currently (for example, many European
by promoting more stable funding sources. banks only hold 2% risk-adjusted capital in total compared
with Australian banks holdings of around 8%). To meet
Figure 2.1: Liquidity ratios this higher capital standard, many institutions will have to
deleverage or acquire more capital from traditional sources,
Liquidity Coverage Ratio such as equity and sovereign bonds. Given that this will
occur on a system-wide basis, it is reasonable to expect
Stock of High Quality Liquid Assets the global cost of capital to rise.
≥ 100%
Net Cash Outflows over 30-day Period If the global cost of capital increases, the rate of economic
growth will slow. Businesses will access bank funding at
Banks are expected to meet this requirement
continuously and hold a stock of unencumbered,
a higher interest rate, reducing the amount of debt they
high quality assets as a defence against the can take on, and ultimately reducing the rate of economic
potential onset of severe liquidity stress. expansion. The extent to which this affects a given
jurisdiction will depend on the current capital held by banks,
the capital required and the rate of transition required by
Net Stable Funding Ratio the BCBS. The BCBS has indicated that it intends to begin
implementation in 2011 and will finish by 2012; however,
Available Amount of Stable Funding this timing is subject to the Quantitative Impact Statements
> 100%
Required Amount of Stable Funding (QIS) currently being completed by regulators in various
jurisdictions, including Australia.
The NSF standard is defined as a ratio of the available
amount of stable funding to a required amount of In addition to capital adequacy requirements, liquidity
stable funding. This ratio must be greater than 100%. requirements being considered by the BCBS will likely
‘Stable funding’ is defined as those types and amounts change the composition of financial institutions’ assets.
of equity and liability financing expected to be reliable The BCBS is still determining what the appropriate definition
sources of funds over a one-year time horizon under of high quality, liquid assets should be:
conditions of extended stress. The amount of funding
required of a specific institution is a function of the ‘... the Committee is assessing the impact of both a
liquidity characteristics of various types of assets narrow definition of liquid assets comprised of cash,
held, off-balance sheet contingent exposures, and/or central bank reserves and high quality sovereign paper,
the activities pursued by the institution. as well as a somewhat broader definition which could
include a proportion of high quality corporate bonds
Source: BCBS (2009b)
and/or covered bonds(BCBS, 2009b:7).’

Implications If a narrower definition is accepted, Australia may have
The key implication for financial institutions is that more difficulty meeting this requirement from its domestic
capital, more stress-testing and less opportunity for sources. It has been widely noted that the Australian
regulatory arbitrage will exist under the new international government debt market is not deep enough to meet existing
standards. This is expected to result in moves to strengthen criteria for liquid assets, as acknowledged by APRA last year:
capital bases, including through deleveraging and buying
risk-free sovereign bonds. If financial institutions need to
‘We are currently working with industry and the Reserve
retain significantly more capital on their books, they will not Bank to find a pragmatic solution that reconciles the
be able to lend as much. This may, in turn, induce a decline concern with the realities of Australia’s relatively small
in global economic growth. Government bond market (APRA, 2009a:8).’
Greater consistency and transparency globally will reduce
Conceptually, a wider definition of acceptable debt securities
opportunities for regulatory arbitrage. The BCBS has been
would solve the problem and Australian regulators are
careful not only to define what types of capital are suited
mindful of this in considering how international standards
for each tier but also to specify the characteristics, so that
might be implemented in Australia.
institutions and more lenient regulators cannot implement


Examples
The Bank of England (BoE) undertook its own retrospective stress-testing exercise to understand what levels of
capital might be appropriate under a revised regulatory regime (see Table 2.1). The BoE’s work broadly suggests
that capital requirements for Tier 1 may sit around 8%.

Table 2.1: Lessons from past crises regarding appropriate levels of capital
Source Description Capital requirement

Past international financial crises (BoE calculations) Based on experiences of Sweden, 8.5% Tier 1
Finland, Norway and Japan
Macroeconomic downturn scenario (BoE calculations) Stress-test variables include GDP growth, 9% – 10% Core Tier 1
CPI inflation and unemployment
Turner Review (Financial Services Authority) Through-the-cycle fixed minimum 4% Core Tier 1
At the top of the cycle3 6% – 7% Core Tier 1
US stress tests (Federal Reserve) For 19 largest US banks to survive a 8.1% Tier 1
deeper and more protracted downturn
than Consensus forecasts
Source: Bank of England (2009)

The impact in Australia would not be as severe since
Australian banks already maintain stronger capital balances Australian banks are well capitalised under the current
and meet APRA’s stricter requirements on capital definition. Basel II framework. Moreover, Australian banks have
Nevertheless, some additional capital may need to be raised. raised extra capital (and notably high quality Tier-1
While Australian banks held around 8% Tier 1 capital during capital) to further strengthen their balance sheets.
the GFC, the move to allow only equity holdings or retained While the level and nature of the proposed new capital
requirements are not yet final, Australian banks are
earnings as Tier 1 capital may reduce Tier 1 capital levels
well down the path to any new standard. Similarly,
to 4.5 – 5.7% for the major Australian banks (Takáts and
liquidity requirements are already being tightened in
Tumbarello 2009: 11).
Australia and should easily meet any new standard
APRA has already commenced a round of consultations on proclaimed internationally.
a range of proposals consistent with the BCBS. These include
proposals to broaden the coverage of its ‘going concern’
requirement to all ADIs, increasing its ‘name crisis’ time
period from five days to one month (consistent with the LCR)
as well as incorporating a three-month market disruption
scenario for its stress-testing regime (APRA 2009, 3).

3. The Turner review explains that the dynamic capital mechanism ‘is expected to generate an additional buffer equivalent to 2%-3% of core Tier 1 capital at the top
of the cycle’. However, ‘it should remain open to supervisors to require a further discretionary buffer above this’.

13

2.2 Leverage ratio At this time, consultations are under way to refine the design
Excessive leverage is the underlying source of asset price of the leverage ratio, including how it would work as a
bubbles and was a major cause of the GFC. The build-up supplement to risk-weighted measures and how to adjust for
in leverage in the banking system during the lead-up to different accounting treatments. In time the BCBS envisages
the GFC occurred both on-balance sheet and off-balance moving towards a Pillar 1 treatment of the leverage ratio,
sheet. The extent of the leverage and its implications for the ‘based on appropriate review and calibration’ (FSB, 2009c,
stability of the banking system were not well understood BCBS, 2009b).
– rapid financial innovation and the growth of the ‘shadow
Implications
banking’ sector obscured the extent of the exposure.
The leverage ratio is intended to supplement risk-based
As the GFC progressed, a clearer picture emerged of the capital measures, not to supersede them. Opposition is
true nature of the exposure and the interconnectedness of strong in Europe but the European Union is considering
financial institutions. This revelation raised concerns about the introduction of leverage ratios. Moving to a Pillar 1
the level of leverage to the point where banks came under treatment would facilitate the impact of the leverage ratio
pressure from the market to deleverage, adversely affecting being incorporated into the calculation of the overall capital
credit availability to the broader economy. The resulting requirement. This helps to ensure the leverage ratio does not
sudden contraction in credit transformed what might have make overall capital requirements unreasonably high. It also
been a mild economic downturn into a global recession. assists in controlling – via a capital buffer – for any effects of
a leverage ratio on the procyclicality of capital levels.
Proposals
The BCBS recommends introducing a leverage ratio. If a leverage ratio is enforced, it will limit the build-up of
It is intended to: leverage in the banking system by constraining individual
institutions capacity to build leverage. It will not prevent
‘Put a floor under the build-up of leverage in the the market forcing complying banks to reduce their level of
banking sector, thus helping to mitigate the risk of leverage below the standard. Nor will it address excessive
the destabilising deleveraging processes which can leverage building up outside regulated entities.
damage the financial system and the economy. The leverage ratio in its proposed form is likely to penalise
institutions in jurisdictions that have adopted Basel II
Introduce additional safeguards against model risk risk-weighted conventions, even though it is meant as a
and measurement error by supplementing the risk supplement to the latter measures not as a replacement.
based measure with a simple, transparent, independent Regulators in countries that have already adopted Basel II,
measure of risk that is based on gross exposures including Europe and Australia, question the need for such
(BCBS 2009b:7).’ a measure. The proposal has support in the US but is
opposed by the Germans and France.
Notably, the leverage ratio will not be adjusted for risk; A non-risk weighted leverage ratio is significant for Australian
it will be calculated based on gross exposure, not net banks since they typically hold relatively high levels of home
exposure; and derivatives and off-balance sheet items mortgages among their assets. The high quality of most of
will attract a 100% credit conversion factor. these mortgages would not be recognised by an unweighted
Most OECD countries use risk-based Basel II capital leverage ratio as proposed. In any case, the ratio will be
measures. The US has been slow to adopt Basel II and is one difficult to ‘parameterise’ and the BCBS is seeking comments
of the few countries to use a (non-risk based) leverage ratio. on how to reconcile the conflicting approaches of the risk-
Advocates of a leverage ratio say it clearly shows the weighted and unweighted leverage ratios.
maximum loss a bank can take on assets before running out The BCBS proposal for a leverage ratio does provide some
of capital. Also, the risk-weighted approach of Basel I and II additional insurance against model risk and measurement
has been blamed for contributing to the GFC, by promoting error. The GFC left many banks exposed to their off-balance
capital arbitrage and the inappropriate use of derivatives sheet vehicles, through, for example, guaranteeing lines
(Blundell-Wignall et al 2010:18). However, Basel II was not in of liquidity (eg. Bear Stearns). Some institutions that sold
place at the outset of the GFC and has been improved as a protection using credit derivatives were left with crippling
result of the testing times experienced in 2008-09. exposures (eg. AIG). Gross exposure is more transparent
Critics of the leverage ratio say it does not take account of than net exposure, eg. for counterparty and operational risks
the risks of different business models and funding sources, (eg. Lehman Brothers).
creating a perverse incentive for banks to take on more risk.


Examples
Blundell-Wignall, Wehinger and Slovikl (2009:21) provide an
example of the impact of imposing a lower group leverage
ratio upon a financial conglomerate comprising a commercial
bank and an investment bank. They show that the riskiness
of the conglomerate falls, but this does not eliminate
contagion risk from the investment bank to the commercial
bank. They also note that European banks have relatively
low levels of capital and US banks have higher levels. The
introduction of a leverage ratio would force significant
capital raising or deleveraging upon European Banks – with
attendant risks for credit availability and economic growth.
Gros (2010) illustrates some of the limitations of the leverage
ratio using the example of Deutsche Bank, which reports its
balance sheet under both US-GAAP and IFRS. At the end of
2008, the IFRS version showed about €2 trillion of assets and
the US-GAAP version showed €1 trillion. Equity was roughly
similar, so the leverage ratio was halved by applying the
US-GAAP treatment. Goldman Sachs’ leverage ratio at the
time was around 15 under US-GAAP and 72 under IFRS.4

An unweighted leverage ratio affects banks with
low-risk balance sheets, like Australia’s banks, whose
balance sheets generally have large exposure to low-risk
mortgages. The leverage ratio will show these banks
as under-capitalised relative to their international peers
when they easily meet APRA’s risk-weighted capital
adequacy standards. Given support for a leverage ratio
from key international regulators, Australian authorities
are working to influence the calibration of the ratio so
that it does not penalise well-managed, low-risk banks.
If these efforts are unsuccessful, Australian banks
may face a higher cost of borrowing in global capital
markets. Some of the resulting impact on Australian
borrowers may be mitigated if the RBA targets a lower
official cash rate over the business cycle.

4. The SEC has announced a work plan that would delay transition for US companies to IFRS until 2014, although some companies may change before then
(Reuters 2009).

15

2.3 Procyclicality measures up capital buffers above the minimum requirement in
Market participants tend to behave in a procyclical manner, good times, to be drawn upon in times of stress. A range
expanding their balance sheets when liquidity is relatively of possible methods to achieve this is intended to be
cheap and plentiful, and contracting their balance sheets provided to supervisors and banks
when restrictive monetary policy starts to bite. This > Excess credit growth – excessive credit growth leading
exacerbates volatility in the credit cycle. The financial system up to the GFC exposed the banking sector to large losses
can amplify these tendencies rather than acting as a shock and amplified the downturn. The BCBS is in the early
absorber (eg. through practices such as leveraging and stages of developing measures to ensure banks build up
deleveraging, and potentially also through mark-to-market countercyclical capital buffers when there are signs that
accounting). Despite the ‘Great Moderation’ of economic credit growth is excessive.
growth and inflation in recent decades, credit growth has
become even more volatile. Implications
The measures proposed by the BCBS to counter
Proposals procyclicality are intended to be complementary. The first
The BCBS proposes to introduce a number of measures two measures address information asymmetry by providing
intended to help the banking system counteract stakeholders with better estimates of banks’ exposures.
destabilising, procyclical elements in the financial system. The other two measures aim to prevent banks’ financial
The key objectives are to: positions from being compromised.
Removing the cyclicality from the estimation of the PD
‘Dampen any excess cyclicality of the minimum
should help to mitigate procyclicality of the credit cycle.
capital requirement Under the Basel II framework, supervisors and banks
Promote more forward looking provisions are already able to apply higher PDs. When APRA asks a
financial institution to increase its capital – for whatever
Conserve capital to build buffers at individual banks and reason – the prudential regulator is effectively substituting
the banking sector that can be used in stress a higher PD to model the capital requirement. However,
retaining discretion to choose between a downturn PD
Achieve the broader macroprudential goal of protecting or a through-the-cycle PD may dilute the effectiveness
the banking sector from periods of excess credit of the measure.
growth. (BIS 2010b:7).’ Forward-looking provisioning, based on an EL approach,
increases the stock of provisions when actual losses are low
To achieve these objectives, the BCBS advocates adopting a
and helps banks weather episodes of above-average losses.
range of complementary measures to alter liquidity, capital This approach clearly is less procyclical than the IL approach.
and loan-loss provisioning requirements when asset prices, Loan loss provisions should reflect all expected losses
loan growth or leverage depart from their long-run trends. from existing loan portfolios. The rapid deterioration in the
> Cyclicality of the minimum capital requirement – the credit quality of US sub-prime mortgages, and the resulting
probability of default (PD) estimates used in calculating losses to investors in products securitised against portfolios
banks capital requirements decrease during favourable of these assets, were features of the GFC. EL reduces the
credit conditions, and increase when conditions sour. The volatility of bank income statements when actual losses
BCBS is exploring the use of highest average PD estimates significantly differ from long-run norms.
over the cycle and historical averages of PD estimates over An EL approach makes sense from an economic perspective
time to replace procyclical PD estimates and a risk-management perspective but not necessarily
> Forward-looking provisioning – current accounting from an accounting viewpoint. Accounting bodies produce
standards require provisioning based on ‘incurred losses’ statements that allow investors to value a company at
(IL). Prudential regulators and other stakeholders also a specific point in time. The BCBS has sought to secure
require information on an institutions capacity to withstand support from the IASB for the shift to an EL approach.
losses in the future. Consequently, the BCBS advocates Capital buffers can be built up either from internal sources
moving towards an ‘expected loss’ (EL) approach (profits) or external sources (capital markets). The BCBS
> Capital conservation – banks continued to distribute proposal constrains a bank’s discretion to distribute profits
capital to shareholders and employees during the GFC to shareholders and employees when the bank’s capital
even though it may have materially damaged their level falls within a buffer range above its minimum capital
financial condition and, collectively, their actions may requirement. This helps prevent irresponsible distributions
have weakened the resilience of the financial system. that compromise the financial health of a bank. It places
A framework will be introduced to ensure banks build depositors’ interests ahead of those of shareholders,


creditors and employees. It would apply at a consolidated deregulation also may raise the average rate of credit growth
level, although supervisors could also apply it to specific over the long run.
parts of the group. Most monetary policy frameworks target a macroeconomic
The restrictions on distributions are intended to be graduated variable, usually a measure of inflation, but allow central
in such a way that the buffer range does not become a new banks discretion to consider other information in setting
(higher) minimum capital requirement. However, it is not policy (interest rates). It is envisaged decision makers would
clear how this would be achieved. The restriction will make enjoy similar discretion with capital buffers.
banks less attractive to investors than companies in sectors Targeting credit growth may create tensions with inflation-
without such restrictions. targeting monetary policy. Official interest rates are the
Introducing a countercyclical element to calculating the primary tool monetary policymakers use to target inflation,
capital buffer will help to reduce the amplitude of the peaks but they also affect credit growth. In times of moderate
and troughs in the credit cycle. The BCBS proposes using economic growth and inflation, but excessive credit growth,
macroeconomic variables as indicators of excessive credit the capital rationing implied by raising capital buffers is likely
growth. The further the indicator variable deviates from its to constrain economic activity and place downward pressure
long-run trend, the greater the impact on the size of the on inflation. The typical monetary policy response would
capital buffer above the minimum requirement. Trend breaks be to reduce interest rates but this will increase demand for
in official credit data complicate the issue. Innovation or credit and confound the objectives of the capital buffer.

Examples

Chart 2.1: Ratio of private credit to GDP in selected countries

Ratio

2.5

2.0

1.5

1

0.5

0.0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

United States United Kingdom Switzerland

Spain Germany

Source: BoE (2009)

The Spanish ‘dynamic provisioning’ model – provisioning for expected losses – for capital adequacy has been employed since
2000 and has received considerable attention (BOE, 2009). Chart 2.1 above shows that, despite employing procyclical buffers,
the growth of private credit relative to GDP has not become obviously smoother in Spain. Nonetheless, dynamic provisioning
may have contributed to the resiliency of Spanish banks during the GFC.

17

Chart 2.2: US private credit as a share of GDP

Share of GDP

250

200

150

100

50

0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

US Household and corporate sector US Financial sector

Source: BCBS 2009a

Then Federal Reserve Governor Ben Bernanke (2004)
APRA’s discretion over minimum capital requirements
famously remarked on the decline in macroeconomic
effectively replicates aspects of the proposed
volatility over the preceding twenty years and the prosperity procyclicality measures, namely, building up capital
that it brought, noting that ‘writers on the topic have dubbed buffers in good times. However, introducing forward-
this remarkable decline in the variability of both output and looking provisioning and credit-linked capital buffers
inflation the Great Moderation’. For a central banker this may not have a positive impact: the former may not
reduced variability in output and inflation indicated policy dampen the credit cycle at all (as exemplified by Spain’s
success. The extreme growth of credit being created – as a experience); while the latter may compromise the
share of GDP, credit doubled during the later stages of the effectiveness of monetary policy – especially when
Great Moderation – was not seen as a sign that something the factors driving credit growth are beyond the RBA’s
was amiss. Post-GFC, this dichotomy indicates additional influence. In addition, investors may shy away from banks
measures need to be considered if policymakers wish to whose discretion to distribute earnings is constrained,
return to the Great Moderation. (BCBS 2004). making it more difficult and/or expensive for them to raise
capital. The ability of Australia’s banks to raise equity
capital during the GFC contributed to their resilience.


2.4 Systemic risk US investment banks may prefer to revert to their original
The GFC highlighted the risks posed by systemically form to avoid the tougher regulatory regime and commercial
important institutions and the high costs of dealing with banks may court riskier clients to replace their revenue-
those risks. Systemic risks stem from the size and complexity generating proprietary trading desks. However, non-operating
of institutions and their relationships with other parts of the holding company (NOHC) structures have been in use in
financial system. These characteristics of ‘too big to fail’ Australia for many years and have wide acceptance, with
institutions made them hard to handle during the GFC and major institutions operating banking, insurance and funds
are presenting reformers with stiff challenges after the GFC, management arms.
delaying agreement on reforms. Taxes on size are problematic as they require authorities to
The FSB has proposed a variety of options to mitigate provide a transparent definition of systemic importance –
the risks posed by institutions deemed too big to fail. and an implicit guarantee of institutions so defined.
These are essentially aimed at: Moreover, some institutions that may not pose a significant
systemic risk in normal conditions may suddenly become
> Reducing the size and complexity of firms, by direct
potentially toxic during periods of market turmoil
regulation or providing incentives to institutions to
(eg. Northern Rock). And cross-border banks may be
change their structure
systemically significant in some countries and not in others.
> Enabling authorities to rapidly break-up or wind-down
systemically important institutions, including across Living wills offer an alternative, one that can be applied to all
national borders. financial institutions if need be, to avoid singling out those
that may be too big to fail. Undertaking such an exercise can
Proposals also help institutions to gain a better understanding of their
In the US, calls to limit commercial banks activities reflect exposures to their counterparties.
a view that government has a role in protecting depositors’ Examples
funds, but should not bail out risk-taking investment banks
The consequences of not having the right tools to deal
and their ilk. The ‘Volcker plan’ would prevent commercial
with the failure of a systemically important institution
banks from taking stakes in hedge funds and private equity
were illustrated during the GFC by the Lehman Brothers
firms and limit the trading they do on their own books to
bankruptcy. Attempts to find a buyer for Lehman Brothers
meeting the needs of their clients (eg. for hedging).
failed and the US Treasury did not have the power to close it
Other proposals for tighter regulation of large firms and down. In an unprecedented move, the International Swaps
supervision of non-financial firms, and giving the government and Derivatives Association held a ‘netting trading session’
power to shut down failing institutions, are also being pushed on a Sunday afternoon, ‘to reduce risk associated with a
by President Obama’s team. In addition, imposing taxes on potential Lehman Brothers Holdings Inc. bankruptcy filing’
the largest US financial firms has been mooted. when US markets reopened on Monday. The existence of a
In Europe, a different approach focusing more on supervision living will, for example, could potentially have expedited the
and increased capital requirements is being advocated. In netting process, helped authorities to identify and ring-fence
the long-run Europe is trying to encourage consolidation – other weak points in the system and reduced the panic
including universal banking – across its 27 member states. selling of financial institutions’ shares that followed Lehman
Brothers bankruptcy.
In the UK, the FSA has pushed for banks to draw up ‘living
wills’ and the most systemically important institutions to set
aside extra capital. The FSB (2009c) also favours systemically Obliging financial institutions to reduce their size,
important cross-border operations being required to prepare complexity and links to counterparties reduces systemic
‘living wills’. Australian regulators too are amenable to the risk. However, there is a cost to be borne in reduced
idea of introducing resolution plans agreed in advance. economies of scope and potential sharing of risk across
markets. Requiring institutions to plan for their own
Implications demise or dismembering may force them to re-assess
Measures that reduce the size or interconnectedness of a their counterparty risks, and simplify and reduce their
financial institution will, by definition, reduce the systemic exposures. But it may also induce them to move beyond
risk attaching to it. It is to be hoped that losses from the reach of prudential regulators, which could be
shrinking banks (eg. economies of scale in back-office counterproductive. Australian regulators are amenable
functions and in costs of raising capital), will not greatly to measures for dealing with institutions that are
outweigh potential gains from reduced systemic risks. systemically important. The ‘four pillars’ policy is
an example. Yet, even with this policy in place, the
The implications are pronounced for US investment banks moral hazard of institutions judged ‘too big to fail’
forced to change their structures to holding companies has been increased by moves to protect Australia’s
during the GFC in order to qualify for government funds. banks during the GFC.

19

2.5 Products and markets These reports have advanced further regulatory proposals
The GFC revealed that information asymmetry in capital which are now being assessed and coordinated by IOSCO,
markets was far greater than generally assumed. As the along with the Bank for International Settlements’ Committee
GFC progressed, some sectors of the market struggled on Payment and Settlement Systems (CPSS) and the OTC
to allocate capital at all, let alone efficiently or rationally. Derivatives Forum. These recommendations include:
While information issues affect all transactions in financial > Facilitating the standardisation of CDS contracts to assist
markets to varying degrees, markets where the complexity the development of central counterparty (CCP) clearing
of products or lack of transparency is prevalent – such as houses and to encourage industry initiatives to enhance
securitisation and OTC derivatives – have received most operational efficiencies
attention in international deliberations. > Developing an appropriate regulatory framework for CCPs
Securitisation is an important innovation that reduces the as well as implementing it
amount of capital lenders are required to hold to support > Monitoring of CDS to be made more transparent through
their lending. It increases competition among lenders the collection of data including post-trade price, volume
and allows a wider range of borrowers to access capital. and open-interest data which should be fully disclosed
However, the GFC revealed that a lack of transparency > Encouraging the co-operation of national market regulators
and incentive problems need to be addressed before to facilitate information sharing and co-ordination.
securitisation can thrive again.
IOSCO also plans measures to manage systemic risk arising
OTC markets are where professional market participants
in financial markets. These measures are yet to be disclosed.
execute individually negotiated transactions, rather than
the standardised contracts traded on exchanges. Thus Implications
financial product innovation flourishes in OTC markets Both sets of reforms focus on reducing volatility in the
and most of the derivatives used for hedging and insuring market and internalising risks in financial instruments.
individual financial exposures are traded there. Despite This will reduce returns to originators of structured
these benefits, the high losses associated with failed credit
products and investors willing to hold the riskier tranches.
default swaps (CDS) during the GFC revealed deficiencies
However, it will also deliver benefits to the financial system
in the transparency, counterparty risk and processing of
by lowering systemic risk through improvements in
transactions in some OTC derivatives markets.
transparency and accountability.
Proposals Realigning incentives along the securitisation supply chain
A number of reports published overseas, including the and increasing transparency throughout the process will
International Organisation of Securities Commissions help mitigate problems posed by asset-backed securities.
(IOSCO) report (2009d) and the European Commission’s By requiring issuers and sellers to retain the riskiest portion
De Larosière Report (2009), make recommendations of the issues, a strong incentive is provided to undertake
regarding the reform of securitisation. Some of the principle better risk assessment before the product is issued. It
recommendations include: should provide confidence to the market and build trust
> Refining incentive structures at all points along the in the product.
securitisation value chain by mandating ‘skin in the Improved disclosure enables investors to make better
game’ for originators and improving transparency of decisions. It may come from within (greater investment
all verification and risk assurance practices undertaken in in-house credit analysis) or without (improved ratings
by the various parties methodology and better incentives for CRAs). It should
> Requiring independence in the provision of professional result in products that are easier to understand, and hence
services and advice more popular with investors and regulators alike. Such
> Improving risk management throughout the process ‘plain vanilla’ products are likely to become favoured
by encouraging the development of analytical tools assets for financial institutions required to hold more,
for investors higher quality capital.
> Revising investor suitability requirements and defining OTC derivatives will become more standardised as the
what a ‘sophisticated investor’ is for each market proposals are implemented and risk will be reduced
> Mandating continuous disclosure. as system infrastructure improvements allow greater


transparency and ease of monitoring. Introduction of force counterparties to standardise all instruments, capital
CCPs will encourage a shift to electronic trading (which requirements will reflect whether counterparty positions are
offers greater price transparency, faster, simpler trading, ‘on exchange’ or not, resulting in more innovative or tailored
confirmation of trades and supervision), quicken the deals requiring a greater amount of capital.
settlement process and netting of positions to reduce
operational and credit risk, and reduce counterparty risk. Examples
The imposition of new regulatory requirements and Preliminary indications of what might be involved with ‘skin
platforms will involve costs, however. As with any exchange in the game’ requirements are shown in Table 2.2. In Australia
traded platform, OTC market participants will have to pay to ASIC is yet to issue new guidelines to the securitisation
trade on CCPs. Further, many current OTC products cannot industry. The Australian securitisation industry is expecting
be standardised or will be less efficient for their users in IOSCO’s taskforce on unregulated markets to announce its
a standardised form. While regulators do not intend to standard for ‘skin in the game’ in the near future.

Table 2.2: ‘Skin in the game’ reforms
Jurisdiction Restriction

European Union Restriction on regulated credit institutions (the ‘buy’ side), retention of 5% of issue and
four options as to how to achieve this.

United States Restriction on regulated creditors/securitisers (‘sell’ side), 5 – 10% retention depending on
credit underwriting standards.

Australia (Australian Proposed that the originator/sponsor retain all tranches with credit rating of B or lower.
Securitisation Forum) An expected loss approach would ensure the capture of unrated deals/tranches.

Returns to originators of securitised issues will fall as a bigger share of the risks is retained and internalised through
regulatory reforms, including revised requirements for retaining ‘skin in the game’. This will increase the cost of raising
funds through securitisation, particularly for smaller banks and non-ADIs. However, other measures are expected to
have a lesser impact owing to the relatively small size of local markets for the more problematic OTC products – such as
CDS – and the Australian hedge funds sector. In any case, ASIC is moving in advance of the international timetable and
initiatives, including those relating to securitisation, due diligence and credit rating agencies. Some initiatives may be in
place in Australia before international standards are set.

21

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Reforming international financial regulation