Basel iii News December 2012

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Basel iii Compliance Professionals Association (BiiiCPA)
1200 G Street NW Suite 800 Washington, DC 20005-6705 USA
Tel: 202-449-9750 Web: www.basel-iii-association.com

Dear Member,

Today we will start with an interesting
assessment:

Basel III Experts vs. Risk
Management Experts
It is interesting to feel the market.
Do you make more money as a risk
manager, or a risk manager with Basel iii
knowledge? What do you believe?

Source: IT Jobs Watch, that provides a
unique perspective on today's information technology job market.
http://www.itjobswatch.co.uk/jobs/uk/basel%20iii.do
Note: This is not an advertisement. We have no affiliation or any other relationship
with IT Jobs Watch.

www.basel-iii-association.com

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Basel III Top 30 Related IT Skills in UK

Basel III Jobs, Salary Trend in UK


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Risk Management Jobs, Salary Trend in UK

Basel III Salary Histogram in UK


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Risk Management Salary Histogram in UK

Basel III, Top 9 Job Locations in UK


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Risk Management, Top Job Locations in UK


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Basel 3 –
The Timing Dilemma
Last month the United States (US) regulatory authorities announced that
they did not expect their rules implementing Basel 3 would become
effective on 1 January 2013, although they are working as “expeditiously
as possible” to complete their rulemaking process.

Similarly in the European Union (EU), the trilogue between the
European Commission, the European Parliament and the Council of
Ministers to agree the text of Capital Requirements Directive IV (CRD
IV, the EU version of Basel 3 is still ongoing and, even if a political
agreement can be reached by year-end (which still appears to be the
intention), it is recognised in the EU that there will not be sufficient time
for CRD IV to be codified as legislation and put into effect on 1 January
2013.

So, does it necessarily follow that we should delay Basel 3 implementation
in Hong Kong because the US and the EU cannot meet the
internationally agreed timeline?

Or should we follow the timeline set by the Basel Committee on Banking
Supervision and begin the first phase of Basel 3 implementation from 1
January 2013?

Our Basel 3 rules (the Banking (Capital) (Amendment) Rules 2012) are
currently tabled at LegCo and notwithstanding the expected delays in the
US and the EU, the Basel Committee’s timeline remains unchanged.

Its gradual phase-in of the new capital standards over six years begins
from January 2013 and extends until 2019.

In resolving the timing dilemma, it might first be instructive to remind
ourselves that Basel 3 is being introduced to rectify weaknesses made all
too starkly apparent in the recent global financial crisis.


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Or, put another way, Basel 3 is considered good for financial stability.

The Basel 3 capital standards are designed to strengthen banks’ resilience
by requiring more and better quality capital and by addressing and
capturing risks not adequately recognised previously.

The aim is to ensure that banks can weather future financial storms
without disruption to their lending.

This should in turn make them less likely to create or amplify problems in
other areas of the economy and facilitate their contribution to long-term
sustainable economic growth.

The roller-coaster of excessive leverage pre-crisis and excessive
deleveraging post-crisis is not conducive to sustainable growth.

Regulation is all about balance.

If regulation is too lax, excessive risk-taking may result with devastating
effects.

If regulation is too tight, it may suppress beneficial financial activity and
reduce growth.

In our view, Basel 3 represents an appropriate balance in bolstering
resilience whilst at the same time (with its extended phase-in) not unduly
hampering lending to business and households today and ensuring banks
can continue to lend in any downturn tomorrow.

For this reason we propose to begin implementing Basel 3 from 1 January
2013.

We are not alone in this.

Our regional peers, Mainland China, Japan, Singapore and Australia have
all published their final rules for Basel 3 implementation next year.


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As has Switzerland, another important financial centre.

But notwithstanding the intrinsic benefits of Basel 3, should we
nevertheless be swayed by the argument put to us that Asia is taking the
“medicine” designed for the countries worst affected by the crisis, whilst
the intended “patients” defer and thereby give their banks significant
“competitive advantages” over our own?

This competitive advantage argument would seem to be based on two
assumptions.

First that US and EU global banks (i.e. those banks that could realistically
compete with our own) are currently holding much lower levels of capital
than required by Basel 3 (and hence will have a genuine cost advantage);

and second that our banks will, come 1 January 2013, have to hold more
capital than they currently hold (and hence will incur additional cost).

Are these assumptions correct?

Well even though adoption of Basel 3 is delayed in the US and the EU,
this certainly does not mean that banks in these regions remain at their
pre-crisis capital levels.

There has been significant re-capitalisation.

The Dodd Frank Wall Street Reform and Consumer Protection Act in the
US already requires the regulatory agencies to conduct stress-testing
programmes to ensure banks and other systemically important financial
institutions have enough capital to weather severe financial conditions
and, even before the passage of the Dodd Frank Act, the US Federal
Reserve Board put some of the largest US bank holding companies
through stress-tests, the results of which have led to significant increases
in capital.


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By 2012, the 19 bank holding companies subject to the Fed’s
Comprehensive Capital Analysis and Review had increased their
aggregate tier 1 common capital to US$803 billion in the second quarter of
the year from US$420 billion in the first quarter of 2009, with their tier 1
common capital ratio (which compares high quality capital to assets
weighted according to their riskiness) doubling to a weighted average of
10.9% from 5.4%.

In the EU, under a recapitalisation exercise in 2011 that covered 71 of the
EU’s major banks, the European Banking Authority (EBA) required most
to attain a “core tier 1 ratio” of not less than 9% by the end of June 2012.

In October 2012, the EBA indicated that it will focus on capital
conservation to “support a smooth convergence to the CRD IV…..
regulatory requirements” and require the banks to maintain an absolute
amount of core tier 1 capital corresponding to the level of the 9% core tier
1 ratio.

So even absent formal adoption of Basel 3, the capital levels of the largest
banks in the US and the EU have increased significantly post-crisis to
levels comparable with, or even in excess of, those required under Basel 3
and so the prospect of such banks “competing” by being allowed to
maintain much lower capital levels than Basel 3 banks would seem more
apparent than real.

Turning to the second “competitive” assumption, will the first phase of
Basel 3, which starts next year, require local banks to hold significantly
more capital than they do at present, to the extent that they may become
constrained in their ability to lend and compelled to pass on the costs of
the extra capital to borrowers?

Well, the results of the HKMA’s quantitative impact studies tell us that
our local banks are already very well-placed to meet the new Basel 3
capital ratios.


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Their capital levels are already in excess of the standard taking effect on 1
January 2013 and the issuance of ordinary shares (common equity)
already accounts for a very significant proportion of their capital base,
positioning them well for Basel 3’s new focus on common equity as the
highest quality capital for the purpose of loss absorption.

In summary then, irrespective of any delay in formal implementation of
Basel 3, major banks in the US and EU are inexorably moving to higher
levels of capital.

This, together with the benefits offered by Basel 3 and the relative ease
with which local banks can comply, serves to underpin our view that we
should proceed to implement the first phase of Basel 3 in line with the
Basel Committee’s timeline.

Generally speaking, jurisdictions in Asia have in the past tended to adopt
regulations that are in some respects higher than the Basel Committee’s
minimum standards.

This may have helped Asia weather the global financial crisis relatively
unscathed when compared with the jurisdictions worst affected.

There would, therefore, seem little to be gained from seeking to engage
in, or indeed prompt, a “race-to-the-bottom” in regulatory terms by
deliberately delaying the introduction of Basel 3 at this point in time.

In implementing on 1 January 2013, we will be fulfilling our commitment
both as an international financial centre which customarily adopts best
international standards and as a member of the Basel Committee on
Banking Supervision.

Karen Kemp
Executive Director (Banking Policy)


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Governor Daniel K. Tarullo
At the Yale School of Management Leaders Forum,
New Haven, Connecticut

Regulation of Foreign Banking Organizations

In the aftermath of the financial crisis, regulators
around the world continue to implement reforms designed to limit the
incidence and severity of future crises.
My subject today pertains to an area in which reforms have yet to be
made--the regulation of the U.S. operations of large foreign banks.
Applicable regulation has changed relatively little in the last decade,
despite a significant and rapid transformation of those operations, as
foreign banks moved beyond their traditional lending activities to engage
in substantial, and often complex, capital market activities.
The crisis revealed the resulting risks to U.S. financial stability.
In taking a fresh look at regulation of foreign banks in the United States, I
by no means want to imply that the United States should revoke its
welcome to foreign banks.
On the contrary, this reconsideration reflects the important role foreign
banks have played.
The presence of foreign banks can bring particular competitive and
countercyclical benefits because foreign banks often expand lending in
the United States when U.S. banking firms labor under common
domestic strains.
But just as we are adapting our regulatory approach to U.S. banks, so we
need to incorporate important lessons learned from the crisis into our
oversight program for foreign banks.
The question of how best to regulate foreign banks is hardly a new one,
either here or in other countries.


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Debates over the relative merits of territorial versus global or mutual
recognition approaches, the difficulties in achieving strictly equal terms
of competition between banks with different home regulatory systems,
and the degree to which harmonization of international standards and
supervisory consultations can mitigate the resulting inconsistencies and
frictions are all familiar topics to academics, banking lawyers, and
supervisory authorities.
While I do not aim to resolve this afternoon the complicated interaction
among these perspectives and considerations, I will try to outline a
practical and reasonable way forward.
To be effective, a new approach must address the vulnerabilities that have
been created by the shift in foreign bank activities, in keeping with sound
prudential policy and congressional mandates in the Dodd-Frank Wall
Street Reform and Consumer Protection Act.
At the same time, a modified regulatory system should maintain the
principle of national treatment and allow foreign banks to continue to
operate here on an equal competitive footing, to the benefit of the U.S.
banking system and the U.S. economy generally.

Foreign Bank Regulation in the United States
Regulating the U.S. operations of foreign banks presents unique
challenges.
Although U.S. supervisors have full authority over the local operations of
foreign banks, we see only a portion of a foreign bank's worldwide
activities, and regular access to information on its global activities can be
limited.
Foreign banks operate under a wide variety of business models and
structures that reflect the legal, regulatory, and business climates in the
home and host jurisdictions in which they operate.
Despite these difficulties, the United States has traditionally accorded
foreign banks the same national treatment as domestic banks, and U.S.
regulators generally have allowed foreign banks to choose among


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structures that they believe promote maximum efficiency at the
consolidated level.
Under the statutory scheme established by Congress, permissible U.S.
structures include cross-border branching and direct and indirect
subsidiaries, provided that they operate in a safe and sound manner.
U.S. law also allows well-managed and well-capitalized foreign banks to
conduct a wide range of bank and nonbank activities in the United States
under conditions comparable to those applied to U.S. banking
organizations.
Still, it is worth noting that even as there has been continuity in this basic
policy, U.S. regulation of foreign banks has evolved over the years in
response to changes in the extent and nature of foreign bank activities.
Let me mention two examples.
Before 1978, foreign bank branches in the United States were licensed and
regulated by individual states, with little in the way of federal regulation
or restrictions.
They were not subject to the full panoply of limitations on interstate
banking, equity investments, or affiliations with securities firms that were
applicable to domestic banks.
The rapid growth of foreign banking in the 1970s, particularly branching,
prompted an end to this lighter regulatory regime.
The International Banking Act of 1978 gave the Federal Reserve Board
regulatory authority over the domestic operations of foreign banks and
significantly equalized regulatory treatment of foreign and domestic
firms.
Congress maintained this approach of basic competitive equality in the
1999 Gramm-Leach-Bliley Act.
That law substantially removed restrictions on affiliations between
commercial banks and other kinds of financial firms for both domestic
and foreign institutions operating in the United States.


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Moreover, in light of provisions in Gramm-Leach-Bliley that permitted a
foreign bank to be a financial holding company (FHC), the Federal
Reserve announced in 2001 that a bank holding company (BHC) in the
United States that was owned and controlled by a well -capitalized and
well-managed foreign bank generally would not be required to meet the
Board's capital requirements normally applicable to BHCs.
My second example relates to the massive fraud uncovered at the Bank of
Credit and Commerce International (BCCI) and its subsequent collapse
in 1991, which highlighted the need for more effective supervision of
banks operating in multiple countries.
The Foreign Bank Supervision Enhancement Act of 1991 (FBSEA)
required foreign banks to receive approval from the Board before
establishing a branch or agency in the United States.
The law required the Federal Reserve, in turn, to determine that the
foreign bank is subject to "comprehensive supervision or regulation on a
consolidated basis" in its home country before approving an application
either to open a branch or to acquire a U.S. subsidiary bank.
It is further worth noting that changes in U.S. law and regulatory practice
affecting foreign banking organizations have often corresponded to
changes in international regulatory agreements.
For example, FBSEA was enacted at the same time as the Basel
Committee on Banking Supervision was working to address the problems
revealed by BCCI--an effort that bore fruit the next year in changes to the
so-called Basel Concordat, which established minimum standards for the
supervision of international banking groups.
Another instance was the substantial reduction or removal of remaining
asset-pledge and asset-maintenance requirements for most U.S. branches
of foreign banks, prompted in part by implementation of the new
international capital standards included in the 1988 Basel Accord.


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The Shift in Foreign Bank Activities
Although foreign banks expanded steadily in the United States during the
1970s, 1980s, and 1990s, their activities here posed limited risks to overall
U.S. financial stability.
Throughout this period, the U.S. operations of foreign banks were largely
net recipients of funding from their parents and generally engaged in
traditional lending to home-country and U.S. clients.
U.S. branches and agencies of foreign banks held large amounts of cash
during the 1980s and '90s, in part to meet asset-maintenance and
asset-pledge requirements put in place by regulators.
Their cash-to-third-party liability ratio from the mid-1980s through the
late 1990s generally ranged between 25 percent and 30 percent.
The U.S. branches and agencies of foreign banks that borrowed from
their parents and lent those funds in the United States ("lending
branches") held roughly 60 percent of all foreign bank branch and agency
assets in the United States during the 1980s and '90s.
Commercial and industrial lending continued to account for a large part
of foreign bank branch and agency balance sheets through the 1990s.
This profile of foreign bank operations in the United States changed in
the run-up to the financial crisis.
Reliance on less stable, short-term wholesale funding increased
significantly.
Many foreign banks shifted from the "lending branch" model to a
"funding branch" model, in which U.S. branches of foreign banks were
borrowing large amounts of U.S. dollars to upstream to their parents.
These "funding branches" went from holding 40 percent of foreign bank
branch assets in the mid-1990s to holding 75 percent of foreign bank
branch assets by 2009.


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Foreign banks as a group moved from a position of receiving funding
from their parents on a net basis in 1999 to providing significant funding
to non-U.S. affiliates by the mid-2000s--more than $700 billion on a net
basis by 2008.
A good bit of this short-term funding was used to finance long-term, U.S.
dollar-denominated project and trade finance around the world.
There is also evidence that a significant portion of the dollars raised by
European banks in the pre-crisis period ultimately returned to the United
States in the form of investments in U.S. securities.
Indeed, the amount of U.S. dollar-denominated asset-backed securities
and other securities held by Europeans increased significantly between
2003 and 2007, much of it financed by the short-term, dollar-denominated
liabilities of European banks.
Meanwhile, commercial and industrial lending originated by U.S.
branches and agencies as a share of their third-party liabilities fell
significantly after 2003.
In contrast, U.S. broker-dealer assets of the top-10 foreign banks
increased rapidly during the past 15 years, rising from 13 percent of all
foreign bank third-party assets in 1995 to 50 percent in 2011.
Lessons from the Recent Financial Crisis
The 2007–2008 financial crisis and the continuing financial stress in
Europe have revealed financial stability risks associated with the foreign
banking model as it has evolved in the United States.
To some extent the concerns associated with foreign banking operations
track the more general shortcomings of pre-crisis financial regulation.
Internationally agreed minimum capital levels were too low, the quality
standards for required capital were too weak, the risk weights assigned to
certain asset classes did not reflect their actual risk, and the potential for
liquidity strains was seriously underappreciated.


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But some risks are more closely tied to the specifically international
character of certain global banks, both here and in some other parts of the
world.
The location of capital and liquidity proved critical in the resolution of
some firms that failed during the financial crisis.
Capital and liquidity were in some cases trapped at the home entity, as in
the case of the Icelandic banks and, in our own country, Lehman
Brothers.
Actions by home-country authorities during this period showed that while
a foreign bank regulatory regime designed to accommodate centralized
management of capital and liquidity can promote efficiency during good
times, it also increases the chances of ring-fencing by home and host
jurisdictions at the moment of a crisis, as local operations come under
severe strain and repayment of local creditors is called into question.
Resolution regimes and powers remain nationally based, complicating
the resolution of firms with large cross-border operations.
The large intra-firm, cross-border flows that grew rapidly in the years
leading up to the crisis also created vulnerabilities.
To be fair, the ability to move liquidity freely throughout a banking group
may have provided some financial stability benefits during the crisis by
enabling banks to respond to localized balance-sheet shocks and
dysfunctional markets in some areas (such as the interbank and foreign
exchange swap markets) and by transferring resources from healthier
parts of the group.
Nevertheless, this model also created a degree of cross-currency funding
risk and heavy reliance on swap markets that proved destabilizing.
Moreover, foreign banks that relied heavily on short-term, U.S. dollar
liabilities were forced to sell U.S. dollar assets and reduce lending rapidly
when that funding source evaporated, thereby compounding risks to U.S.
financial stability.


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Although the United States did not suffer a destabilizing failure of foreign
banks, many rode out the crisis only with the help of extraordinary
support from home- and host-country regulators.
Following national treatment practice, the Federal Reserve itself provided
substantial discount window access to U.S. branches and the opportunity
to participate in the Primary Dealer Credit Facility to U.S. primary-dealer
subsidiaries of foreign banks.
Moreover, the potential for funding disruptions did not disappear with the
waning of the global financial crisis.
In 2011, for example, as concerns about the euro zone rose, U.S. money
market funds suddenly pulled back their lending to large euro area banks,
reducing lending to these firms by roughly $200 billion over just four
months.
While there has been some reduction in operations and some change in
funding patterns by foreign banking organizations in the United States
since the crisis, particularly by European firms reacting to euro zone
financial stress, the basic circumstances have not changed.
The proportion of foreign banking assets to total U.S. banking assets has
remained at about one-fifth since the end of the 1990s.
But the concentration and complexity of those assets have changed
noticeably from earlier decades, and have not reversed in recent years
despite the global financial crisis and subsequent events.
Ten foreign banks now account for more than two-thirds of foreign bank
third-party assets held in the United States, up from 40 percent in 1995.
And while the largest U.S. operations of foreign banks do not approach
the size of our largest domestic financial institutions, it is striking that
there are 23 foreign banks with at least $50 billion in assets in the United
States--the threshold established by the Dodd-Frank Act for special
prudential measures for domestic firms--compared with 25 U.S. firms.


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Most notably, perhaps, five of the top-10 U.S. broker-dealers are owned by
foreign banks.
Like their U.S.-owned counterparts, large foreign-owned U.S.
broker-dealers were highly leveraged in the years leading up to the crisis.
Their reliance on short-term funding also increased, with much of the
expansion of both U.S.-owned and foreign-owned U.S. broker-dealer
activities attributable to the growth in secured funding markets during
the past 15 years.
Finally, we should note that one of the fundamental elements of the
current approach--our ability, as host supervisors, to rely on the foreign
bank to act as a source of strength to its U.S. operations--has come into
question in the wake of the crisis.
The likelihood that some home-country governments of significant
international firms will backstop their banks' foreign operations in a crisis
appears to have diminished.
It also appears that constraints have been placed on the ability of the
home offices of some large international banks to provide support to their
foreign operations.
The motivations behind these actions are not hard to understand and
appreciate, but they do affect the supervisory terrain for host countries
such as the United States.

International and Domestic Regulatory Response
Since the crisis, important changes have been made to strengthen
international regulatory standards.
The Basel III capital and liquidity frameworks are big improvements, and
the proposed capital surcharges for systemically important firms will be
another important step forward.


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But these reforms are primarily directed at the consolidated level, with
little attention to vulnerabilities posed by internationally active banks in
host markets.
The risks associated with large intra-group funding flows have remained
largely unaddressed.
Managing international regulatory initiatives also has become more
difficult, as the number of complex items on the agenda has increased.
And despite continued work by the Financial Stability Board, challenges
to cross-border resolution are likely to remain significant.
For the foreseeable future, then, our regulatory system must recognize
that while internationally active banks live globally, they may well die
locally.
Quite apart from the need to act pragmatically under the circumstances,
it is not clear that we should aim toward extensive harmonization of
national regulatory practices related to foreign banking organizations.
The nature and extent of foreign banking activities vary substantially
across national markets, suggesting that regulatory responses might best
vary as well.
For instance, the importance of the U.S. dollar in many international
transactions can motivate foreign banks to use their U.S. operations to
raise dollar funding for their international operations, potentially creating
vulnerabilities.
Such a model is unlikely to prevail in most other host financial markets
around the world.
Indeed, in response to financial stability risks highlighted during the
crisis, ongoing challenges associated with the resolution of large
cross-border firms, and the limitations of the international reform agenda,
several national authorities have already introduced their own policies to
fortify the resources of internationally active banks within their
geographic boundaries.


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Regulators in the United Kingdom, for example, have recently increased
requirements for liquidity to cover local operations of domestic and
foreign banks, set stricter rules around intra-group exposures of U.K.
banks to foreign subsidiaries, and moved to ring-fence home-country
retail operations.
Meanwhile, Swiss authorities have explicitly prioritized the domestic
systemically important operations of their large, internationally active
firms in resolution.
Here in the United States, Congress included in the Dodd-Frank Act a
number of changes directed at the financial stability risk posed by foreign
banks.
Sections 165 and 166 instruct the Federal Reserve to implement enhanced
prudential standards for large foreign banks as well as for large domestic
BHCs and nonbank systemically important financial institutions.
Dodd-Frank also bolstered capital requirements for FHCs, including
foreign FHCs, by extending the well-capitalized and well-managed
requirements beyond U.S. bank subsidiaries to the top-tier holding
company.
In addition, the so-called Collins Amendment in Dodd-Frank removed
the exemption from BHC capital requirements granted by the Federal
Reserve's Supervision and Regulation Letter 01-01.
The required phase-out of SR 01-01 was clearly intended to strengthen the
capital regime applied to the U.S. operations of foreign banks; however,
the organizational flexibility that the amendment gave to foreign banks in
the United States has allowed some large foreign banks to restructure
their U.S. operations to minimize the impact of this regulatory change.
As a result, in the absence of additional structural requirements for
foreign banks in the United States, the effectiveness of our capital regime
for large foreign banks with both bank and nonbank operations in the
United States depends on the foreign bank's own organizational choices.


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A Rebalanced Approach to Foreign Bank Regulation
As has been the case in the past, we need to adjust the regulatory
requirements for foreign banks in response to changes in the nature of
their activities in the United States, the risks attendant to those changes,
and instructions from Congress in new statutory provisions.
The modified regime should counteract the risks posed to U.S. financial
stability by the activities of foreign banking organizations, as manifested
in the years leading up to, and through, the financial crisis.
Special attention must be paid to the risk of runs associated with
significant reliance on short-term funding.
In addition, the regime should reduce the difficulties in resolution of
cross-border firms.
Finally, it should take steps to diminish the potential need for ex-post
ring-fencing when losses mount or runs develop during a crisis, since
such actions may well be unhelpfully procyclical.
At the same time, in modifying our regulatory regime for foreign banking
organizations, we must remain mindful of the benefits that foreign banks
can bring to our economy and of the important policies of national
treatment and comparable competitive opportunity.
Thus, we should chart a middle course, not moving to a fully territorial
model of foreign bank regulation, but instead making targeted
adjustments to address the risks I have identified.
In basic terms, three such adjustments are desirable.
First, a more uniform structure should be required for the largest U.S.
operations of foreign banks--specifically, that these firms establish a
top-tier U.S. intermediate holding company (IHC) over all U.S. bank and
nonbank subsidiaries.


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An IHC would make application of enhanced prudential supervision
more consistent across foreign banks and reduce the ability of foreign
banks to avoid U.S. consolidated-capital regulations.
Because U.S. branches and agencies are part of the foreign parent bank,
they would not be included in the IHC.
However, they would be subject to the activity restrictions applicable to
branches and agencies today as well as to certain additional measures
discussed below.
Second, the same capital rules applicable to U.S. BHCs should also appl y
to U.S. IHCs.
These rules have been reshaped to counteract the risks to the U.S.
financial system revealed by the crisis and should be implemented
consistently across all firms that engage in similar activities.
Similarly, other enhanced prudential standards required by the
Dodd-Frank Act--including stress testing requirements, risk
management requirements, single counterparty credit limits, and early
remediation requirements--should be applied to the U.S. operations of
large foreign banks in a manner consistent with the Board's domestic
proposal.
Third, there should be liquidity standards for large U.S. operations of
foreign banks.
Standards are needed to increase the liquidity resiliency of these
operations during times of stress and to reduce the threat of destabilizing
runs as dollar funding channels dry up and short-term debt cannot be
rolled over.
For IHCs, the standards should be broadly consistent with the standards
the Federal Reserve has proposed for large domestic BHCs, pending final
adoption and phase-in of quantitative liquidity requirements by the Basel
Committee.


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That is, they should be designed to ensure that, in stressed
circumstances, the U.S. operations have enough high-quality liquid
assets to meet expected net outflows in the short term.
There should also be liquidity standards for foreign bank branch and
agency networks in the United States, although they may be less
stringent, in recognition of the integration of branches and agencies into
the global bank as a whole.
By imposing a more standardized regulatory structure on the U.S.
operations of foreign banks, we can ensure that enhanced prudential
standards are applied consistently across foreign banks and in
comparable ways between U.S. banking organizations and foreign
banking organizations.
As with domestic firms subject to enhanced prudential standards, the
Federal Reserve would work to ensure that the new regime is minimally
disruptive, through transition periods and other means.
An IHC structure would also provide the Federal Reserve, as umbrella
supervisor of the U.S. operations of foreign banks, with a uniform
platform to implement a consistent supervisory program across large
foreign banks.
In the case of foreign banks with the largest U.S. operations, the IHC
would also help mitigate resolution difficulties by providing U.S.
regulators with one consolidated U.S. legal entity to place into
receivership under title II of the Dodd-Frank Act if the failure of the
foreign bank would threaten U.S. financial stability.
Branches and agencies would remain separate, but all other entities
would be included.
Further, an IHC structure would facilitate a consistent U.S. capital
regime for bank and nonbank activities of foreign banks under the IHC,
similar to the approach taken in other jurisdictions, such as the United
Kingdom and some continental European countries.


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Some observers will, I am sure, ask if it is necessary to depart from the
prevailing firm-by-firm approach to foreign banking regulation and to
adopt generally applicable requirements in implementing the
Dodd-Frank enhanced prudential standards for foreign banks.
It is difficult to see how reliance on this approach can be effective in
addressing risks to U.S. financial stability, at least in the absence of
extraterritorial application of our own standards and supervision, and
perhaps not even then.
We would, at a minimum, need to make regular and detailed assessments
of each firm's home-country regulatory and resolution regimes, the
financial stability risk posed by each firm in the United States, and the
financial condition of the consolidated banking organization.
In fact, such an approach might result in the worst of both worlds--an
ongoing intrusiveness into the consolidated supervision of foreign banks
by their home-country regulators without the ultimate ability to evaluate
those banks comprehensively or to direct changes in a parent bank's
practices necessary to mitigate risks in the United States.
Although the Federal Reserve will continue to cooperate with its foreign
counterparts in overseeing large, multinational banking operations, that
supervisory tool cannot provide complete protection against risks
engendered by U.S operations as extensive as those of many large U.S.
institutions.
It is also important to note that while the reforms I have described today
contain some elements that are more territorial than our current
approach, including requiring some additional capital and liquidity
buffers to be held in the United States, they do not represent a complete
departure from prior practice.
This enhanced approach would allow foreign banks to continue to
operate branches in the United States and would generally allow branches
to meet comparable capital requirements at the consolidated level.


26

Similarly, this approach would not impose a cap on intra-group flows,
thereby allowing foreign banks in sound financial condition to continue
to obtain U.S. dollar funding for their global operations through their U.S.
entities.
It would instead provide an incentive to term out at least some of this
funding in a way that reduces the risk of runs.
Requiring additional local capital and liquidity buffers, like any
prudential regulation, may incrementally increase cost and reduce
flexibility of internationally active banks that manage their capital and
liquidity on a centralized basis.
However, managing liquidity and capital on a local basis can have
benefits not just for financial stability generally, but also for firms
themselves.
During the crisis, the more decentralized global banks relied somewhat
less on cross-currency funding and were less exposed to disruptions in
international wholesale funding and foreign exchange swap markets than
the more centralized banks.
Indeed, as noted earlier, in the wake of the crisis and of subsequent
stresses, many foreign banks have modified their funding practices and
business models.
In revamping our approach, we will both be guarding against a return to
pre-crisis practices and, more generally, ensuring that foreign banking
operations in the United States that pose potential risks to U.S. financial
stability are regulated similarly to domestic banking operations posing
similar risks.

Conclusion
The imperative for change in our foreign bank regulation is clear and,
indeed, mandated by Dodd-Frank.
Of course, I have provided only an outline of the three key measures that
will best navigate the middle course I have suggested.


27

The all-important details are under discussion at the Board.
I anticipate that in the coming weeks we will complete our work and issue
a notice of proposed rulemaking that will elaborate the basic approach I
have foreshadowed.
I look forward to hearing your general reactions today and more specific
feedback after the Board has adopted a proposed rule.


28

Opportunities facing Islamic finance and
challenges in managing capital flows in Asia
Outline of special address by Mr Tharman
Shanmugaratnam, Chairman of the Monetary
Authority of Singapore, at the 8th World Islamic
Economic Forum, Johor Bahru, Malaysia

The Prime Minister of Malaysia, His Excellency
Dato’ Sri Najib Tun Razak, The President of
Comoros, His Excellency Ikililou Dhoinine, The
President of the Islamic Development Bank, His
Excellency Ahmad Mohamed Ali, Chairman of the World Islamic
Economic Forum Foundation Tun Musa Hitam
Ministers and distinguished guests, Ladies and gentlemen

Introduction

It is my pleasure to be here today and have the opportunity to share some
thoughts.

Let me first congratulate the WIEF on the progress it has made in
establishing itself as a leading international forum for economic leaders
and opinion shapers from a broad range of countries to discuss issues of
interest in Islamic Finance and related themes in global finance.

The theme of the Forum, “Changing Trends, New Opportunities” is
particularly relevant.

Allow me to first offer a brief perspective on opportunities facing Islamic
finance.

I will then go on to talk about the challenges we face in Asia in managing
capital flows in the aftermath of the Global Financial Crisis.


29

Islamic finance: opportunities for growth

The Islamic finance industry is estimated to have grown by some 19% per
year since 2006 – to record nearly US$1.3 trillion of total shariah compliant
assets in 2012.

But there is still considerable scope for its development:

• Islamic finance presently forms less than 1% the global financial
industry.

• For a large number of countries, even in jurisdictions with substantial
Muslim populations, Islamic finance currently constitutes less than 5% of
their financial sector.

• And despite a record level of sukuk issuance in 2012, the industry as a
whole is still largely concentrated on the banking sector.

There is much ahead in the journey to develop Islamic capital markets
and the takaful (Islamic insurance) industry.

I believe the next 10–15 years offer significant opportunities for the growth
and diversification of Islamic finance.

Let me highlight the reasons to be optimistic about its prospects:

• First, Islamic financial institutions have in the main escaped significant
damage in the global financial crisis.

They are well-placed to grow, at a time when many of the global banks,
especially the European banks, are deleveraging or focusing on
consolidating their balance sheets.

• Second, Islamic finance has much potential to diversify into new growth
areas such as trade and infrastructure financing in Asia and the emerging
markets.


30

These new areas will allow Islamic banks to reduce their exposure to the
real estate sector, and to take advantage of the stronger growth potential
of the emerging market economies.

There are gaps to be filled in structured trade finance and in funding for
infrastructural projects as the emerging markets grow, and as global
finance consolidates.

• Third, Islamic finance can also seek to meet the increased demand for
simpler and more transparent products and ‘back-to-basics’ finance.

Investors are now much more circumspect about complex products and
their risks.

The crisis taught investors worldwide not only about the damage they can
face from the risks that are known and unsurprising, but of the risks of
‘what we do not know’.

Islamic finance, with its focus on transparency, price certainty and
risk-sharing, can ride this wave of demand for simpler and more basic
investments.

However, Islamic finance will have to overcome a few important
challenges in order to grow its share in global finance and contribute to
cross-border finance.

These include the need to reduce fragmentation in Islamic finance
markets due to differences in accepted standards of Shariah compliance
between regions, jurisdictions, and in some cases even domestically
within jurisdictions.

This has hampered the flow of liquidity between jurisdictions, and is in
part why there is yet no Islamic equivalents to the international money
and bond markets.

There is considerable progress being made to address these challenges.


31

Bodies such as AAOIFI, IDB’s Islamic Research & Training Institute,
and Malaysia’s International Shariah Research Academy (ISRA) have
made significant efforts to narrow the differences in acceptability of
Shariah compliance.

The Islamic Financial Services Board (IFSB), in conjunction with
international standards setting bodies such as the Bank of International
Settlements (BIS), IOSCO and IAIS and various regulators from Islamic
and conventional jurisdictions, are also formulating international
standards and best practices for the industry.

Islamic finance is also seeing increasing interest in Asia.

We are seeing financial institutions leveraging on the strengths and
expertise that have been developed in both Islamic and conventional
financial markets.

This is expanding the range of Shariah-compliant products and allowing
the Islamic finance industry to tap on broad and deep investor pools
globally and in Asia.

• Malaysia is widely recognised as a leader in Islamic finance, in
particular for the issuance of sukuks.

• Islamic finance is also seeing growing interest in other Asian financial
centres such as Singapore, Hong Kong and Tokyo.

• Just recently in mid-November 2012, institutional and private investors
in Singapore and HK were the largest investors in the US$15.5 billion
global sukuk issued by the Abu Dhabi Islamic Bank (ADIB).

• Between our two countries, we are seeing Malaysian banks
collaborating with Singapore corporates and financial players to structure
S$ denominated corporate sukuk programmes.


32

And Singapore-listed companies are venturing out to tap the Ringgit
sukuk market in Malaysia.

These are trends that we are keen to encourage.

To repeat therefore, I am optimistic that we can realise the significant
growth potential for Islamic finance in the next 10–15 years.

Managing the challenge of capital flows in the post-crisis era

Let me move on now to say a few things about the challenges that many
in the emerging world face in managing capital flows, particularly in the
face of the extremely low interest rates being set in the advanced
economies (AEs).

We are in an unprecedented situation.

Interest rates are expected to stay extremely low in the US and much of
the advanced world for a few years, reflecting decisions by their central
banks to keep monetary conditions highly accommodative until their
economies resume normal growth.

There is debate among economists on how effective these activist
monetary policies, such as the US Fed’s QE3 strategy, will be in reviving
entrepreneurial spirits and rivate investments.

If the strategy succeeds and the US economy recovers, it will be a plus
for Asia as well.

In the meantime, however, there are significant implications for emerging
market economies, as global investors search for better returns – better
than the near-zero rates they get on cash and treasury bills.

With large amounts of liquidity now moving between markets, short-term
shifts in investor sentiment leads to volatility in capital flows.


33

We have seen how a shock in the European periphery can send money
that was invested in emerging markets rushing back to the US or other
safe havens.

To be clear about it, there is a lot that is good about capital flows,
including even short term flows.

They add liquidity to markets, by bringing more buyers and sellers
together.

However, we know too that capital inflows can also be too much of a good
thing.

They can lead to asset prices, or exchange rates, becoming disconnected
from fundamentals.

And the sudden withdrawal of capital from emerging economies when
investors switch from ‘risk on’ to ‘risk off’ in their portfolios can be
destabilising.

As I mentioned, the current global condition is unprecedented.

The policy responses in the advanced countries too are without
precedent.

Globally therefore, we need some humility in understanding the benefits
and costs of QE3 and easy monetary policies in the advanced countries.

But it will be wise to strengthen our policy toolkits in Asia, so that we can
deal with unpredictable and often excessive capital flows.

There are some lessons that come out of our experiences in Asia and
elsewhere, and policy responses that we can learn from each other.

I will mention three sets of policy responses that will inevitably have to
figure in our toolkits.


34

First, there is much sense in curtailing volatility in the exchange rate over
the short-term.

The costs of volatile and uncertain exchange rates are high in small open
economies especially – which is what most of our ASEAN economies are.
Accordingly, Malaysia, Singapore and several other Asian countries have
not felt comfortable leaving their exchange rates entirely to market forces.

Their central banks, within each of their monetary policy frameworks,
have sought to instil a focus on longer term fundamentals.

There is merit in allowing exchange rates in Asia’s emerging economies
to appreciate gradually over the long term, reflecting their more rapid
growth.

If we resist these long term trends, we are likely to see more inflation in
our economies.

But some stability in the short term is wise.

Second, macro-prudential policies are now an important part of the policy
tool kit.

Many Asian countries have introduced new macro-prudential measures
to try and avoid bubbles in their property markets over the last two years.

Malaysia brought in stricter limits on loan-to-value ratios on housing
loans.

Singapore and Hong Kong have done similarly, and have introduced
additional stamp duties or transaction taxes to discourage speculative
demand for residential properties.

These targeted administrative and prudential measures are not
conventional macro-economic tools.


35

But they are likely to remain part of our policy toolkit, at least for
the foreseeable future, given the real risks to macro-economic stability
that an environment of very low global interest rates poses.

A third and more fundamental strategy has to focus on building greater
depth in Asia’s capital markets, while ensuring that our banking systems
remain sound.

A good example of this strategy is in fact in Malaysia.

Bank Negara’s Financial Sector Blueprint II (2012–2020), released as part
of the government’s Economic Transformation Programme (ETP), will
build on the solid foundations of Malaysia’s financial system, including
developing a deep and vibrant bond market.

The banks in several leading Asian countries, including Malaysia and
Singapore, are generally well-managed and well-capitalised.

They were a source of strength for us during the global financial crisis.

However, Asia’s capital markets, and especially the corporate
bond markets, need much more depth.

Broader and deeper capital markets will allow investors to invest for the
long term while hedging against risks.

They will help us meet the growing infrastructural and other long term
investment needs of the region.

This is therefore a very important priority in the region, and there is in fact
significant scope for future development of Asian capital markets.

Regulators are working to harmonise rules and market practices across
the region, such as issuance procedures and settlement standards.


36

We also need to develop the securitisation markets, with appropriate
safeguards, so that banks can recycle their capital.

More too is being done to boost linkages between our markets and
economies.

We have to pool liquidity across our markets, so as to add depth to the
Asian capital market.

An example is how the Malaysian stock exchange, Bursa Malaysia, the
Singapore Exchange and the Stock Exchange of Thailand recently
launched an ASEAN Trading Link.

We are also cooperating to encourage financing for infrastructure projects
in the region.

The ASEAN Infrastructure Fund (AIF), an initiative that was led by
Malaysia, is a good example.

It will pool resources, knowledge and experience among ASEAN
governments and the Asian Development Bank (ADB) for loans to
sovereign or sovereign-guaranteed infrastructure projects.

The Fund will also issue bonds, so as to bring in private sector and
institutional investors.

Another example of such cooperation in the region is the Credit
Guarantee and Investment Facility (CGIF) amongst the ASEAN+3
countries, which aims to help companies in ASEAN+3 countries raise
long term financing for infrastructure investment by providing the
governments’ guarantees on their corporate bonds, thereby reducing risk
for bond-holders.

Projects such as Iskandar Malaysia are also a prime example of how
intra-regional investments can be encouraged, and how countries in our
region can develop competitive strengths jointly.


37

• Iskandar Malaysia’s performance has been impressive – poised to
exceed its targeted RM100 billion investment mark by the end of this year.

• I am glad there is good progress on the joint venture by Temasek
Holdings and Khazanah Nasional, Pulau Indah Ventures Sdn Bhd to
co-develop two separate sites in Medini.

• Other significant projects include a S$1.5 billion integrated eco-friendly
tech-park by Ascendas and Malaysia’s UEM Land Berhad in Nusajaya
(one of the five flagship zones in Iskandar).
Once completed, the park will accommodate a range of
industries including electronics and precision engineering.

• Just in the last month, we have seen other significant investment
commitments in Iskandar reported by Singapore companies.

Iskandar Malaysia will enhance the complementary space between our
two economies.

It is a win-win.

To ensure continued progress in Iskandar, Singapore and Malaysia will
continue to take steps to improve connectivity, cross-border trade
facilitation, and immigration processes.

Conclusion

I would like to conclude by emphasising once again that I am basically
optimistic about the prospects in our bilateral and regional cooperation.

We face many challenges in this post-Global Financial Crisis era.

But the opportunities for us in Asia are intact, and our ability to cooperate
with each other to achieve our full potential as a region is an asset for all
our countries.


38

Resolving Globally
Active, Systemically
Important, Financial
Institutions
A joint paper by the Federal Deposit Insurance Corporation and the Bank
of England

Resolving Globally Active, Systemically Important, Financial Institutions
Federal Deposit Insurance Corporation and the Bank of England

Executive summary
The financial crisis that began in 2007 has driven home the importance of
an orderly resolution process for globally active, systemically important,
financial institutions (G-SIFIs).

Given that challenge, the authorities in the United States (U.S.) and the
United Kingdom (U.K.) have been working together to develop resolution
strategies that could be applied to their largest financial institutions.

These strategies have been designed to enable large and complex
cross-border firms to be resolved without threatening financial stability
and without putting public funds at risk.

This work has taken place in connection with the implementation of the
G20 Financial Stability Board’s Key Attributes of Effective Resolution
Regimes for Financial Institutions.

The joint planning has been productive and effective.

It has enhanced the resolution planning process in both jurisdictions,
tackled key issues in relation to cross-border coordination, and identified
potential challenges that will be addressed through further work.


39

This paper focuses on the application of “top-down” resolution strategies
that involve a single resolution authority applying its powers to the top of
a financial group, that is, at the parent company level.

The paper discusses how such a top-down strategy could be implemented
for a U.S. or a U.K. financial group in a cross-border context.

In the U.S., the strategy has been developed in the context of the powers
provided by the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010.

Such a strategy would apply a single receivership at the top-tier holding
company, assign losses to shareholders and unsecured creditors of the
holding company, and transfer sound operating subsidiaries to a new
solvent entity or entities.

In the U.K., the strategy has been developed on the basis of the powers
provided by the U.K. Banking Act 2009 and in anticipation of the further
powers that will be provided by the European Union Recovery and
Resolution Directive and the domestic reforms that implement the
recommendations of the U.K.

Independent Commission on Banking. Such a strategy would involve the
bail-in (write-down or conversion) of creditors at the top of the group in
order to restore the whole group to solvency.

Both the U.S. and U.K. approaches ensure continuity of all critical
services performed by the operating firm(s), thereby reducing risks to
financial stability.

Both approaches ensure activities of the firm in the foreign jurisdictions
in which it operates are unaffected, thereby minimizing risks to
cross-border implementation.

The unsecured debt holders can expect that their claims would be written
down to reflect any losses that shareholders cannot cover, with some


40

converted partly into equity in order to provide sufficient capital to return
the sound businesses of the G-SIFI to private sector operation.
Sound subsidiaries (domestic and foreign) would be kept open and
operating, thereby limiting contagion effects and cross-border
complications.

In both countries, whether during execution of the resolution or
thereafter, restructuring measures may be taken, especially in the parts of
the business causing the distress, including shrinking those businesses,
breaking them into smaller entities, and/or liquidating or closing certain
operations.

Both approaches would be accompanied by the replacement of culpable
senior management.

This paper outlines several common considerations that affect these
particular approaches to resolution in the U.S. and the U.K., including the
need to ensure sufficient loss absorbency at the top of the group.

The Federal Deposit Insurance Corporation and the Bank of England will
continue to work together on these resolution strategies.

Resolving Globally Active, Systemically Important, Financial
Institutions, Federal Deposit Insurance Corporation and the
Bank of England

Introduction

1 The Federal Deposit Insurance Corporation (FDIC) and the Bank of
England—together with the Board of Governors of the Federal Reserve
System, the Federal Reserve Bank of New York, and the Financial
Services Authority—have been working to develop resolution strategies
for the failure of globally active, systemically important, financial
institutions (SIFIs or G-SIFIs) with significant operations on both sides
of the Atlantic.


41

This work has taken place in connection with the implementation of the
Financial Stability Board’s (FSB) Key Attributes of Effective Resolution
Regimes for Financial Institutions (Key Attributes), as well as in
connection with the reforms to the legal arrangements for handling the
failure of financial institutions that were instituted in the United States
(U.S.) and the United Kingdom (U.K.) in response to the recent financial
crisis.

2 The goal is to produce resolution strategies that could be implemented
for the failure of one or more of the largest financial institutions with
extensive activities in our respective jurisdictions.

These resolution strategies should maintain systemically important
operations and contain threats to financial stability.

They should also assign losses to shareholders and unsecured creditors in
the group, thereby avoiding the need for a bailout by taxpayers.

These strategies should be sufficiently robust to manage the challenges of
cross-border implementation and to the operational challenges of
execution.

3 As highlighted in the FSB’s recently published draft Guidance on
Recovery and Resolution Planning, strategies for resolution may broadly
be categorized as either applying resolution powers to the top of a group
by a single national resolution authority (single point of entry), or
applying resolution tools to different parts of the group by two or more
resolution authorities acting in a coordinated way (multiple points of
entry).

Which strategy is most suitable to resolving the group will depend upon a
range of factors.

For example, a single point of entry strategy may offer the simplest and
most effective choice if the debt issued at the top of the group is sufficient
to absorb the group’s losses.


42

Where this is not the case, a multiple points of entry strategy will be more
suitable, particularly if different parts of the group can continue on a
standalone basis.

4 The focus of this paper is on a single point of entry resolution approach.

It is hoped that the detail it provides on the single point of entry
approach, when combined with the published FSB Guidance on
Recovery and Resolution Planning, will give greater predictability for
market participants about how resolution authorities may approach a
resolution.

This predictability cannot, however, be absolute, as the resolution
authorities must not be constrained in exercising discretion in pursuit of
their statutory objectives in how best to resolve a firm.

Post-crisis resolution strategy

5 The financial crisis that began in late 2007 highlighted the shortcomings
of the arrangements for handling the failure of large financial institutions
that were in place on either side of the Atlantic.

Large banking organizations in both the U.S. and the U.K. had become
highly leveraged and complex, with numerous and dispersed financial
operations, extensive off-balance-sheet activities, and opaque financial
statements.

These institutions were managed as single entities, despite their
subsidiaries being structured as separate and distinct legal entities.

They were highly interconnected through their capital markets activities,
interbank lending, payments, and off-balance-sheet arrangements.

6 The legislative frameworks and resolution regimes at the time were
ill-suited to dealing with financial institution failures of this scale and
interconnectedness.


43

In the U.S., the FDIC only had the power to place an insured depository
institution into receivership; it could not resolve failed or failing bank
holding companies or other nonbank financial companies that posed a
systemic risk.

In the U.K., until 2009 there was no special resolution regime available for
banks or other financial companies, whatever their size or complexity,
and as a result the U.K. was reliant on standard insolvency procedures
such as administration.

7 As demonstrated by the Title I requirement of the Dodd-Frank Wall
Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act),
the U.S. would prefer that large financial organizations be resolvable
through ordinary bankruptcy.

However, the U.S. bankruptcy process may not be able to handle the
failure of a systemic financial institution without significant disruption to
the financial system.

8 Similarly, the U.K. administration process often takes time and involves
significant uncertainty regarding the outcome.

Forcing large financial organizations through administration can create
significant and systemic risks for the real economy by interrupting critical
services, disrupting key financial relationships, and freezing financial
markets. In addition, it can destroy value, harming the real economy.

9 Given these problems with the bankruptcy process, the U.S. and the
U.K. authorities resorted to providing large scale public support to failing
financial companies during the 2007-09 crisis to prevent further systemic
disruption.

This public support has exposed taxpayers to loss and resulted in the
bailout of multiple financial institutions and their creditors.


44

10 Following the crisis, an overhaul of the framework for dealing with
large and complex financial institution failures was required.

While it may be useful to strengthen the current bankruptcy code or
administration rules to improve the handling of financial failures,
systemic considerations warrant having an alternative resolution strategy.

11 A resolution strategy for a failed or failing G-SIFI should assign losses
to shareholders and unsecured creditors, and hold management
responsible for the failure of the firm.

The strategy should provide continuity of the critical services that the
institution provides within the financial system and to the real economy,
thereby minimizing systemic risk.

The strategy should also enable a prompt transition of the firm’s ongoing
operations to full private ownership and control without taxpayer support.

Given the cross-border nature of G-SIFIs, the resolution strategy should
ensure financial stability concerns are addressed across all jurisdictions in
which the firm operates.

To be successful, such an approach will require close cooperation
between home and foreign authorities.

12 Under the strategies currently being developed by the U.S. and the
U.K., the resolution authority could intervene at the top of the group.

Culpable senior management of the parent and operating businesses
would be removed, and losses would be apportioned to shareholders and
unsecured creditors.

In all likelihood, shareholders would lose all value and unsecured
creditors should thus expect that their claims would be written down to
reflect any losses that shareholders did not cover.


45

Under both the U.S. and U.K. approaches, legal safeguards ensure that
creditors recover no less than they would under insolvency.

13 An efficient path for returning the sound operations of the G-SIFI to
the private sector would be provided by exchanging or converting a
sufficient amount of the unsecured debt from the original creditors of the
failed company into equity.

In the U.S., the new equity would become capital in one or more newly
formed operating entities.

In the U.K., the same approach could be used, or the equity could be used
to recapitalize the failing financial company itself—thus, the highest layer
of surviving bailed-in creditors would become the owners of the resolved
firm.

In either country, the new equity holders would take on the
corresponding risk of being shareholders in a financial institution.

Throughout, subsidiaries (domestic and foreign) carrying out critical
activities would be kept open and operating, thereby limiting contagion
effects.

Such a resolution strategy would ensure market discipline and maintain
financial stability without cost to taxpayers.

Legislative frameworks for implementing the strategy

14 It should be stressed that the application of such a strategy can be
achieved only within a legislative framework that provides authorities
with key resolution powers.

The FSB Key Attributes have established a crucial framework for the
implementation of an effective set of resolution powers and practices into
national regimes.


46

In the U.S., these powers had already become available under the
Dodd-Frank Act.

In the U.K., the additional powers needed to enhance the existing
resolution framework established under the Banking Act 2009 (the
Banking Act) are expected to be fully provided by the European
Commission’s proposals for a European Union Recovery and Resolution
Directive (RRD) and through the domestic reforms that implement the
recommendations of the U.K. Independent Commission on Banking
(ICB), enhancing the existing resolution framework established under
the Banking Act.

The development of effective resolution strategies is being carried out in
anticipation of such legislation.

U.S. regime

15 The framework provided by the Dodd-Frank Act in the U.S. greatly
enhances the ability of regulators to address the problems of large,
complex financial institutions in any future crisis.

Title I of the Dodd-Frank Act requires each G-SIFI to periodically submit
to the FDIC and the Federal Reserve a resolution plan that must address
the company’s plans for its rapid and orderly resolution under the U.S.
Bankruptcy Code.

The FDIC and the Federal Reserve are required to review the plans to
determine jointly whether a company’s plan is credible.

If a plan is found to be deficient and adequate revisions are not made, the
FDIC and the Federal Reserve may jointly impose more stringent capital,
leverage, or liquidity requirements, or restrictions on growth, activities, or
operations of the company, including its subsidiaries.

Ultimately, the company could be ordered to divest assets or operations
to facilitate an orderly resolution under bankruptcy in the event of failure.


47

Once submitted and accepted, the SIFIs’ plans for resolution under
bankruptcy will support the FDIC’s planning for the exercise of its
resolution powers by providing the FDIC with an understanding of each
SIFI’s structure, complexity, and processes.

16 Title II of the Dodd-Frank Act provides the FDIC with new powers to
resolve SIFIs by establishing the orderly liquidation authority (OLA).

Under the OLA, the FDIC may be appointed receiver for any U.S.
financial company that meets specified criteria, including being in default
or in danger of default, and whose resolution under the U.S. Bankruptcy
Code (or other relevant insolvency process) would likely create systemic
instability.

Title II requires that the losses of any financial company placed into
receivership will not be borne by taxpayers, but by common and preferred
stockholders, debt holders, and other unsecured creditors, and that
management responsible for the condition of the financial company will
be replaced.

Once appointed receiver for a failed financial company, the FDIC would
be required to carry out a resolution of the company in a manner that
mitigates risk to financial stability and minimizes moral hazard.

Any costs borne by the U.S. authorities in resolving the institution not
paid from proceeds of the resolution will be recovered from the industry.

U.K. regime

17 In the U.K., the Banking Act provides the Bank of England with tools
for resolving failing deposit-taking banks and building societies.

Powers similar to those of the FDIC are available, including powers to
transfer all or part of a failed bank’s business to a private sector purchaser
or to a bridge bank until a private purchaser can be found.


48

The Banking Act also provides the U.K. authorities with a bespoke bank
insolvency procedure that fully protects insured depositors while
liquidating a failed bank’s assets.

These powers have proved valuable; for example, during the crisis they
allowed the authorities to transfer the retail and wholesale deposits,
branches, and a significant proportion of the residential mortgage
portfolio of a failed building society to another building society.

18 The Banking Act powers do not, however, provide a wholly effective
solution to the failure of a large, complex, and international financial firm.

The critical economic functions of a G-SIFI are currently intertwined
legally, operationally, and financially across jurisdictions and legal
entities.

For U.K. firms, these functions frequently reside in the same entities as
the firms’ core unsecured liabilities.

Using the existing statutory transfer powers would involve separating and
transferring large and complex businesses from within operating entities
to a purchaser or bridge bank, while leaving behind the remaining
liabilities and bad assets in the failed firm to be wound up through
insolvency.

These operating companies may have several thousand counterparties,
customers, and contracts.

Such a transfer would be almost impossible to achieve over a resolution
weekend without destroying value and causing financial stability
concerns in multiple jurisdictions.

19 The introduction of a statutory bail-in resolution tool (the power to
write down or convert into equity the liabilities of a failing firm) under the
RRD is critical to implementing a whole group resolution of U.K. firms in
a way that reduces the risks to financial stability.


49

A bail-in tool would enable the U.K. authorities to recapitalize an
institution by allocating losses to its shareholders and unsecured
creditors, thereby avoiding the need to split or transfer operating entities.

The provisions in the RRD that enable the resolution authority to impose
a temporary stay on the exercise of termination rights by counterparties in
the event of a firm’s entry into resolution (in other words, preventing
counterparties from terminating their contractual arrangements with a
firm solely as a result of the firm’s entry into resolution) will be needed to
ensure the bail-in is executed in an orderly manner.

20 The existing Banking Act does not cover nondeposit-taking financial
firms, notably investment banks and financial market infrastructures
(clearing houses in particular), the failure of which, in many cases, would
also have significant financial stability consequences.

The Banking Act also has limitations with regard to the application of
resolution tools to financial holding companies.

The U.K. is in the process of expanding the scope of the Banking Act to
include these firms.

This is expected to be achieved through the introduction of the U.K.
Financial Services Bill, which is due to complete its passage through
Parliament by the end of this year.

21 In addition to expanding the U.K. resolution regime, the Financial
Services Bill will significantly enhance the U.K.’s approach to banking
supervision.

Going forward, the framework for prudential supervision in the U.K. will
emphasize supervisory judgment, rather than supervision based solely on
rules.

Under this framework, considerations of resolvability or ease of resolution
would become a core part of the supervisory process.


50

22 In conjunction with the Financial Services Bill, the adoption of the
recommendations of the ICB will also significantly improve the
resolvability of the U.K. domestic retail bank by ringfencing it from the
rest of the group.

This will help to preserve core domestic intermediation services if a
group-wide resolution is not feasible for some reason.

23 To ensure that banks are resolvable, the Financial Services Authority
(and in the future, the Prudential Regulation Authority (PRA)) will
require firms under the Financial Services Act 2010 to produce Recovery
and Resolution Plans (RRPs).

Firms will submit the information that the authorities will need to prepare
resolution plans and to assess resolvability.

Where barriers to resolution are identified, firms will be required to
remove them through changes to their structure and operations.

The proposed RRD provides authorities with the necessary powers to
achieve this, including the ability to require changes to the legal or
operational structures of institutions, and to require firms to cease
specific activities.

Description of the resolution strategies
U.S. approach to single point of entry resolution strategy
24 Under the U.S. approach, the FDIC will be appointed receiver of the
top-tier parent holding company of the financial group following the
company’s failure and the completion of the appointment process set
forth under the Dodd-Frank Act.

Immediately after the parent holding company is placed into
receivership, the FDIC will transfer assets (primarily the equity and


51

investments in subsidiaries) from the receivership estate to a bridge
financial holding company.

By taking control of the SIFI at the top of the group, subsidiaries
(domestic and foreign) carrying out critical services can remain open and
operating, limiting the need for destabilizing insolvency proceedings at
the subsidiary level.

Equity claims of the shareholders and the claims of the subordinated and
unsecured debt holders will likely remain in the receivership.

25 Initially, the bridge holding company will be controlled by the FDIC as
receiver.

The next stage in the resolution is to transfer ownership and control of the
surviving operations to private hands.

Before this happens, the FDIC must ensure that the bridge has a strong
capital base and must address whatever liquidity concerns remain.

The FDIC would also likely require the restructuring of the
firm—potentially into one or more smaller, non-systemic firms that could
be resolved under bankruptcy.

26 By leaving behind substantial unsecured liabilities and stockholder
equity in the receivership, assets transferred to the bridge holding
company will significantly exceed its liabilities, resulting in a
well-capitalized holding company.

After the creation of the bridge financial company, but before any
transition to the private sector, a valuation process would be undertaken
to estimate the extent of losses in the receivership and apportion these
losses to the equity holders and subordinated and unsecured creditors
according to their order of priority.


52

In all likelihood, the equity holders would be wiped out and their claims
would have little or no value.

27 To capitalize the new operations—one or more new private
entities—the FDIC expects that it will have to look to subordinated debt
or even senior unsecured debt claims as the immediate source of capital.

The original debt holders can thus expect that their claims will be written
down to reflect any losses in the receivership of the parent that the
shareholders cannot cover and that, like those of the shareholders, these
claims will be left in the receivership.

28 At this point, the remaining claims of the debt holders will be
converted, in part, into equity claims that will serve to capitalize the new
operations.

The debt holders may also receive convertible subordinated debt in the
new operations.

This debt would provide a cushion against further losses in the firm, as it
can be converted into equity if needed.

Any remaining claims of the debt holders could be transferred to the new
operations in the form of new unsecured debt.

29 The transfer of equity and investments in operating subsidiaries to the
bridge holding company should do much to alleviate liquidity pressures.

Ongoing operations and their attendant liabilities also will be supported
by assurances from the FDIC, as receiver.

As demonstrated by past bridge-bank operations, the assurance of
performance should encourage market funding and stabilize the bridge
financial company.


53

However, in the case where credit markets are impaired and market
funding is not available in the short term, the Dodd-Frank Act provides
for FDIC access to the Orderly Liquidation Fund (OLF), a fund within
the U.S. Treasury.

In addition to providing a back-up source of funding, the OLF may also
be used to provide guarantees, within limits, on the debt of the new
operations.

An expected goal of the strategy is to minimize or avoid use of the OLF.

To the extent that the OLF is used, it must either be repaid from
recoveries on the assets of the failed financial company or from
assessments against the largest, most complex financial companies.

The Dodd-Frank Act prohibits the loss of any taxpayer money in the
orderly liquidation process.

U.K. approach to single point of entry resolution strategy

30 The U.K.’s planned approach to single point of entry also involves a
top-down resolution.

On the basis that the RRD will introduce a broad bail-in power, the U.K.
authorities would seek to recapitalize the financial group through the
imposition of losses on shareholders and, as appropriate, creditors of the
firm via the exercise of a statutory bail-in power.

This U.K. group resolution approach need not employ a bridge bank and
administration, although such powers are available in the U.K. and may
be appropriate under certain circumstances.

31 Current proposals for implementing such a strategy incorporate a
period in which equity and debt securities would be transferred from the
shareholders and debt holders to an appointed trustee.


54

The trustee would hold the securities during a valuation period in which
the extent of the losses expected to be incurred by the firm would be
established and, in turn, the recapitalization requirement determined.

During this period, listing of the company’s equity securities (and
potentially debt securities) would be suspended.

Once the recapitalization requirement has been determined, an
announcement of the final terms of the bail-in would be made to the
previous security holders.

This announcement would include full details of the write-down and/or
conversion.

32 Debt securities would be cancelled or written down in order to return
the firm to solvency by reducing the level of outstanding liabilities.

The losses would be applied up the firm’s capital structure in a process
that respects the existing creditor hierarchy under insolvency law.

The value of any loans from the parent to its operating subsidiaries would
be written down in a manner that ensures that the subsidiaries remain
solvent and viable.

33 Completion of the exchange would see the trustee transfer the equity
(and potentially some of the existing debt securities written down
accordingly) back to the original creditors of the firm.

Those creditors unable to hold equity securities (for example, for reasons
of investment mandate restrictions) would be able to request that the
trustee sell the equity securities on their behalf.

The trust would then be dissolved and the equity securities (and
potentially debt securities) of the firm would resume trading.


55

The firm would now be recapitalized and primarily owned by the
(appropriate layer of) original creditors of the institution.

As described later, the process would be accompanied by restructuring
measures to address the causes of the firm’s failure and to restore the
business to viability.

34 The U.K. has also given consideration to the recapitalization process in
a scenario in which a G-SIFI’s liabilities do not include much debt
issuance at the holding company or parent bank level but instead
comprise insured retail deposits held in the operating subsidiaries.

Under such a scenario, deposit guarantee schemes may be required to
contribute to the recapitalization of the firm, as they may do under the
Banking Act in the use of other resolution tools.

The proposed RRD also permits such an approach because it allows
deposit guarantee scheme funds to be used to support the use of
resolution tools, including bail-in, provided that the amount contributed
does not exceed what the deposit guarantee scheme would have as a
claimant in liquidation if it had made a payout to the insured depositors.

That is consistent with the contribution requirement that is already
imposed on the Financial Services Compensation Scheme in the U.K. in
the exercise of resolution powers and simulates the losses that would have
been incurred by those deposit guarantee schemes during bank
insolvency.
But insofar as a bail-in provides for continuity in operations and preserves
value, losses to a deposit guarantee scheme in a bail -in should be much
lower than in liquidation.

Insured depositors themselves would remain unaffected.

Uninsured deposits would be treated in line with other similarly ranked
liabilities in the resolution process, with the expectation that they might
be written down.


56

35 Following the recapitalization process, the firm would be restructured
to address the causes of its failure.

It should then be solvent and viable, and as a result in a position to access
market funding.

In recognition of the fact that it will take time for losses to be assessed for
purposes of recapitalization, and that it will take time to execute the
restructuring plan that will underpin the firm’s viability, immediate
access may prove difficult.

In certain circumstances, to reduce the immediate funding need and so
facilitate market access, illiquid assets might be removed from the
balance sheet of the firm and transferred into an asset management
company to be worked out over a longer period.

36 If market funding were not immediately available, temporary funding
may need to be provided by the authorities to meet the firms’ liquidity
needs.

The funding would only be provided on a fully collateralized basis with
appropriate haircuts applied to the collateral to reduce further the risk of
loss.

In the unlikely event that losses were associated with the provision of
temporary public sector support, such losses would be recovered from the
financial sector.

37 It is important to note that the strategy described above would not
necessarily be appropriate for all U.K. G-SIFIs in all circumstances.

Other strategies may be more appropriate depending on the structure of a
group, the nature of its business, and the size and location of the group’s
losses.


57

For example, in cases where the losses on assets in a particular operating
subsidiary were potentially so great that they could not be absorbed by
bailing in at group level or where the business had incurred such
significant losses and was so weighed down by toxic assets that the
capital needs in resolution were too difficult to estimate credibly,
resolution at the level of one or more operating subsidiaries may be more
appropriate.

In this situation, the application of resolution tools to operating
subsidiaries would be easier if the subsidiaries providing critical
economic services were operationally and financially ringfenced from the
rest of the group.

38 This is one of the advantages of the ringfence which is being
introduced in the U.K. It will provide flexibility in the event of fatal
problems elsewhere in the group to transfer the ringfenced entity to a
bridge bank or purchaser in its entirety.

If losses were concentrated in the ringfenced entity and capital in the
ringfenced entity was insufficient to absorb them, then losses could be
borne by creditors of the ringfenced bank (including debt holders where
the ringfenced bank had issued debt into the market).

This could be achieved either by bail-in or by transferring the operations
of the ringfenced bank to a bridge bank, leaving uninsured creditors
behind in administration.

Draft legislation to establish this ringfence of the largest retail
deposit-takers is due to be introduced into Parliament early in 2013 and if
passed will provide valuable additional flexibility in implementing
resolution strategies to preserve the provision of core services in the U.K.
business of U.K. G-SIFIs.


58

Key common considerations for U.S. and U.K. approaches

39 As outlined above, high-level transaction structures have been
developed for each jurisdiction.

As discussed in the FSB Guidance on Recovery and Resolution Planning,
for any resolution to be effective, consideration needs to be given in
advance to various preconditions and operational requirements.

Several of these considerations in relation to a top-down resolution
strategy are discussed in more detail below.

Resolution and restructuring measures

40 A top-down resolution by definition focuses on assigning losses and
establishing new capital structures at the top of the group.

This approach keeps the rest of the group, potentially comprised of
hundreds or thousands of legal entities, intact.

However, a top-down resolution would need to be accompanied, or
shortly followed, by significant restructuring measures to address the
causes of the firm’s failure and to underpin the firm’s viability.

Such a restructuring may include shrinking the G-SIFI’s balance sheet,
breaking the company up into smaller entities, and/or selling or closing
certain operations.

The newly restructured companies will all need to have strong corporate
governance and management oversight, which would likely necessitate
significant changes to management and board personnel and processes.

In both countries, it is likely that supervisory actions will continue after
the return to private ownership to ensure that the firm is on a stable and


59

sustainable footing and the problems that caused the firm to fail in the
first place have been properly dealt with.

41 In the U.S., effective governance will be an important issue for both the
transitional bridge financial company and the newly capitalized entity or
entities into which the bridge will transition.

The FDIC, as receiver, will control the bridge financial company and
would immediately appoint a temporary board of directors and Chief
Executive Officer (CEO) to run the bridge.

The claims of the failed G-SIFI’s unsecured creditors will be converted
into equity and, as a result, the former creditors will become owners of the
new private sector operations.

They will thereafter be responsible for electing a new board of directors,
which will in turn appoint a new CEO.

42 During the period in which the FDIC controls the bridge financial
company, decisions will be made on how to on simplify and shrink the
institution.

It also would likely require restructuring of the firm—perhaps into one or
more smaller, non-systemic firms. Consideration will also be given to how
to create a more stable, less systemically important institution.

Required changes, including divestiture, may be influenced by the failed
firm’s Title I resolution plan.

Once determined, the required actions and relevant time frames for their
execution will be specified in formal supervisory agreements with the new
owners of the private sector operations.

43 The required actions would be executed in private markets by the new
owners.


Basel iii News December 2012

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