An Empirical Study of the Returns on Defaulted Debt and the Discount Rate for...
Jacobs Dodd Frank&Basel3 July12 7 15 12 V16
1. Dodd-Frank and Basel III: Post-Financial
Crisis Developments and New
Expectations in Regulatory Capital
Michael Jacobs, Ph.D., CFA
Senior Manager
Deloitte and Touche LLP
Governance, Regulatory and Risk Strategies / Enterprise Risk Service
July 2012
Important Disclaimer: The views expressed herein are those of the author and do not necessarily
represent the views of Deloitte & Touche LLP
2. Outline
• Motivation: The Financial Crisis and “Too Big to Fail”
• Frank-Dodd and Implications for Financial Institutions
– History
– Summary
– Critique
• Basel III Supervisory Expectations and Guidance
• Overview of Basel III New Capital & Liquidity Standards
– Key Elements
– Implementation Issues
– Critique
3. Motivation: The Financial Crisis and
“Too Big to Fail” • Bank losses in
Figure 3: Average Ratio of Total Charge-offs to Total Value of Loans for
Top 50 Banks as of 4Q09 the recent
0.035
(Call Report Data 1984-2009) financial crisis
exceed levels
0.03
observed in
0.025 recent history!
0.02 • This illustrates
0.015
the inherent
limitations of
0.01
backward
0.005 looking models
0
– we must
anticipate risk
84 1
85 1
86 0
87 0
87 1
88 1
89 0
90 0
90 1
91 1
92 0
93 0
93 1
94 1
95 0
96 0
96 1
97 1
98 0
99 0
99 1
00 1
01 0
02 0
02 1
03 1
04 0
05 0
05 1
06 1
07 0
08 0
08 1
09 1
30
19 033
19 123
19 093
19 063
19 033
19 123
19 093
19 063
19 033
19 123
19 093
19 063
19 033
19 123
19 093
19 063
19 033
19 123
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19 063
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20 123
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09
84
19
• Reproduced from: Inanoglu, H., Jacobs, Jr., M., and Robin Sickles, 2010 (July), Analyzing bank
efficiency: Are “too-big-to-fail” banks efficient?, forthcoming in the Journal of Efficiency
4. Motivation: The Financial Crisis
and “Too Big to Fail” (cont’d.)
Averaged efficiencies from each estimator FIX
1 RND • Across several
HT
0.95 PSS1 econometric
0.9
PSS2W
PSS2G
models, we find
0.85
PSS3
BC
evidence that the
0.8
BIE average the
efficiency of the
Efficiency
0.75
largest banks has
0.7
decreased over
0.65
time, as the
0.6
financial sector in
0.55 the U.S. has
0.5
10 20 30 40 50 60 70 80 90 100
grown
Time
• Reproduced from: Inanoglu, H., Jacobs, Jr., M., and Robin Sickles, 2010 (July), Analyzing bank
efficiency: Are “too-big-to-fail” banks efficient?, forthcoming in the Journal of Efficiency
5. Frank-Dodd & Implications for Financial
Institutions: History
• The Dodd-Frank Wall Street Reform and Consumer Protection Act of
2010 (“Dodd-Frank”) is perhaps the most ambitious and far-reaching
overhaul of financial regulation since the 1930s
• The Banking Act of 1933 (“Glass-Steagall”), designed to prevent
against financial panics that occurred since the mid-19th century, had
been largely undone by the dawn of the financial crisis circa 2004
• Intent of Glass-Steagall was to prevent bank runs & provide an
orderly resolution of troubled banks before they failed
• Established the Federal Deposit Insurance Corporation (FDIC) to
protect retail depositors & ring-fenced banks’ permissible activities
– Commercial lending, government bonds & general-obligation municipals
– Riskier capital markets activity to be spun off into investment banks
.
6. Frank-Dodd & Implications for Financial
Institutions: History
• It has been argued that overall Glass-Steagall reflected a sound
economic approach to regulation:
– Identify the market failure: collective outcome of individual economic agents
does not lead to socially efficient outcomes (depositor runs)
– Address market failure through a government intervention (insuring retail
depositors against losses)
– Recognize & contain the direct & indirect costs of intervention through upfront
premiums for deposit insurance, restricting investment banking activities &
“prompt corrective action” (early & orderly distress resolution)
• Easy regulatory era starting in the 1970s allowed a “shadow banking
system” (money market funds, investment banks, derivatives &
securitization markets) to evolve
– Both opaque & highly leveraged, reflected regulatory arbitrage, the opportunity &
propensity of the financial sector to adopt organizational forms / innovations that would
circumvent the regulatory apparatus designed to contain bank risk-taking
• This is considered the beginning of the end for of Glass-Seagall
7. Frank-Dodd & Implications for Financial
Institutions: History
• By mid-2004s large complex financial institutions (LCFIs) were
seeking massive capital flows into the U.S. & U.K. by short-term
borrowing financed at historically low interest rates
• They began to manufacture huge quantities of “tail risk”: i.e., small
likelihood but catastrophic outcomes
– Key example: senior, AAA rated tranches of subprime-backed mortgages that
would fail only if there was a secular collapse in the housing
• A credit boom was fueled as LCFIs were willing buy loans from
originating lenders, distribute or hold after repackaging them
– In 2008 over 20% of the US mortgage-backed exposure was guaranteed by
“non-agencies” (the private sector )
• Unlike traditional securitization in which the AAA-tranches get placed
with institutional investors, in a significant measure these were
originated and retained by banks
8. Frank-Dodd & Implications for Financial
Institutions: History
• Table 1: Distribution of
the United States real-
estate exposures,
source – Lehman
Brothers Fixed Income
Report, June 2008
• Net result was that balance sheets at LCFIs grew 2-fold in the 2004 to
2007 period
• LCFIs (plus Fannie, Freddie-Mac & AIG) had taken a highly
undercapitalized one-way bet on the housing market
• While these institutions seemed individually safe, collectively they
were vulnerable: as the housing market crashed in 2007, the tail risk
materialized & LCFIs crashed too
9. Frank-Dodd & Implications for Financial
Institutions: Summary
• The first big banks to fail were in the shadow banking world were
initially propped up by Fed assistance
• Strains in the interbank markets & inherently poor quality of the
underlying housing bets even in commercial bank portfolios meant
that in the fall of 2008 some banks had to fail
• A panic ensued internationally making it clear that the entire global
banking system was imperiled & needed taxpayer funds
• In the aftermath of this governments and regulators looked for ways
to prevent or render less likely its recurrence
• Led first to a bill from the House of Representatives & then from the
Senate, combined into the Dodd-Frank Act
• The critical task of Dodd-Frank Act viewed as addressing the
increasing propensity of the financial sector to put the entire system
at risk & eventually bailed out at taxpayer expense
10. Frank-Dodd & Implications for Financial
Institutions: Summary
Highlights of the Dodd-Frank Act are:
• Identifying & regulating systemic risk: set up a Council that can deem
non-bank financial firms as systemically important, regulate them &
as a last resort break them up
– Also establishes an Office under the Treasury to collect, analyze and
disseminate relevant information for anticipating future crises
• Proposing an end to “too-big-to-fail”: requires funeral plans & orderly
liquidation procedures for unwinding of systemically important
institutions
– Rules out taxpayer funding of wind-downs instead requiring management of
failing institutions be dismissed & costs be borne by shareholders, creditors,
and if required ex post levies on surviving large financial firms
• Expands the responsibility & authority of the Fed: authority over all
systemic institutions & responsibility for financial stability
• Restricts discretionary regulatory interventions: prevent or limit
emergency federal assistance to single non-bank institutions
11. Frank-Dodd & Implications for Financial
Institutions: Summary
• Reinstate a limited form of the “Volcker rule”: limit bank holding
company investments in proprietary trading activities (hedge funds,
private equity) & prohibits bailing out these investments
• Regulation & transparency of derivatives: central clearing of
standardized & regulation of OTC complex ones, transparency of all &
separation of non-vanilla positions into well-capitalized subsidiaries,
with exceptions for commercial hedging uses
• Introduces a range of reforms for mortgage lending practices, hedge
fund disclosure, conflict resolution at rating agencies, skin-in-the-
game requirement for securitization, risk-taking by money market
funds & shareholder say on pay and governance
• And perhaps its most popular reform, albeit secondary to the
financial crisis, creates a Bureau of Consumer Financial Protection,
that will write rules governing consumer financial services and
products offered by banks and non-banks
12. Frank-Dodd & Implications for Financial
Institutions: Critique
• It is highly encouraging that the purpose is explicitly aimed at
developing tools to deal with systemically important institutions
• Strives to give regulators authority & tools to deal with this risk
– Requirement of funeral plans to unwind LCFIs should help demystify their
organizational structure & resolution challenges when they fail
• If enforced well, it could serve as a “tax” on complexity, another
market failure in that private far exceed the social gains
• But the final language is a highly diluted version of the original
Volcker Rule proposal limiting LCFI’s proprietary trading
– Volcker Rule provides a more direct restriction on complexity & would help
simplify their resolution
– Also addresses moral hazard: direct guarantees to banks are meant to support
payment / settlement systems & ensure robust lending
– But the bank holding company structure effectively lower the costs for more
cyclical and riskier functions (proprietary investments), where there are
thriving markets and commercial banking presence is not critical
13. Frank-Dodd & Implications for Financial
Institutions: Critique
• Another positive feature is comprehensive overhaul of derivatives
markets to promote transparency & avoid market failures when large
derivatives dealer fails (e.g., Bear Stearns)
– Transparency of prices, volumes and exposures to regulators & public enables
better pricing & assessing of counterparty in bilateral contracts
• The Act also pushes for greater transparency by making systemic non-
bank firms subject to scrutiny by the Fed & SEC
• But the Act requires over 225 new financial rules across 11 federal
agencies with little attempt at regulatory consolidation
– The financial sector will have to live with great uncertainty left unresolved until
various regulators (Fed, SEC, CFTC) details the implementation
• Economically sound & robust regulation: weaknesses remain
– Implicit government guarantees persist in some & escalate in other areas
– Capital allocation may migrate to these pockets & newer ones may arise
– Implementation of the Act and future regulation may guard against this danger,
but that remains to be seen
14. Basel III Supervisory Expectations and
Guidance
• Objective of the reform package is to improve banking sector’s ability
to absorb shocks arising from financial/economic stress & reducing
risk of spillover to the real economy
• Aims to improve risk management, governance & strengthen banks’
transparency / disclosures including efforts to strengthen the
resolution of systemically significant cross-border banks
• Reforms are part of the global initiatives to strengthen the financial
regulatory system endorsed by the Financial Stability Board (FSB) and
the G20 Leaders
• Supervisors attribute the severity of the financial crisis to banks
building up excessive leverage & erosion of level/quality of capital
base along with insufficient liquidity buffers
• System therefore was not able to absorb the resulting systemic
trading & credit losses nor cope with reintermediation of large off-
balance sheet exposures built up in shadow bank system
15. Basel III Supervisory Expectations and
Guidance (cont’d.)
• Weaknesses in the banking sector were transmitted to the rest of the
financial system & real economy resulting in massive contraction of
liquidity & credit availability
• Ultimately the public sector had to step in with unprecedented
injections of liquidity, capital support and guarantees, exposing the
taxpayer to large losses
• The effect on banks, financial systems and economies at the
epicentre of the crisis was immediate; however, the crisis also spread
to a wider circle of countries around the globe.
– For these countries the transmission channels were less direct, resulting from a
severe contraction in global liquidity, cross border credit availability and
demand for exports
• Scope & speed with which the crisis was transmitted around the
globe implies all countries raise the resilience of banking sectors to
internal & external shocks
16. Basel III Supervisory Expectations and
Guidance (cont’d.)
• To address the market failures revealed by the crisis BCBS introduced
a number of fundamental reforms to the international regulatory
framework to strengthen bank-level regulation to help raise the
resilience of individual institutions to stress
• The reforms also have a macroprudential focus, addressing system
wide risks that can build up across the banking sector as well as the
procyclical amplification of these risks over time
• Clearly these two micro and macroprudential approaches to
supervision are interrelated, as greater resilience at the individual
bank level reduces the risk of system wide shocks
• Building on the agreements reached at the 6 September 2009
meeting of the BCBS’s governing body, the key elements of the
proposals were issued for consultation at the end of 2009
17. Basel III Supervisory Expectations and
Guidance (cont’d.)
• First, the quality, consistency, and transparency of the capital base
will be raised to ensure that large, internationally active banks are in
a better position to absorb losses on both a going concern and gone
concern basis
– For example, under the previous BCBS standard, banks could hold as little as 2%
common equity to risk-based assets
• Second, the risk coverage of the capital framework will be
strengthened
– In addition to the trading book & securitization reforms announced in 7-09,
strengthen the capital requirements for counterparty credit risk exposures
arising from derivatives, repos & securities financing activities
– Enhancements will strengthen the resilience of individual institutions & reduce
the risk that shocks are transmitted from one institution to the next through
the derivatives & financing channel
– The strengthened counterparty capital requirements also will increase
incentives to move OTC derivatives to central clearinghouses
18. Basel III Supervisory Expectations and
Guidance (cont’d.)
• Third, introduced a leverage ratio as a supplementary measure to the
Basel II risk-based framework with a view to migrating to a Pillar 1
treatment based on appropriate review & calibration
– This will help contain the build up of excessive leverage in the banking system,
introduce additional safeguards against attempts to game the risk based
requirements & help address model risk
– To ensure comparability details of the leverage ratio will be harmonised
internationally, fully adjusting for any remaining differences in accounting
– Ratio will be calibrated so that it serves as a credible supplementary measure
to the risk based requirements, taking into account the forthcoming changes to
the Basel II framework
• Fourth, measures to promote the build up of capital buffers in good
times that can be drawn upon in periods of stress
– Countercyclical capital framework contributes to a more stable banking system,
which will help dampen vs. amplify economic & financial shocks
– Promote forward looking provisioning based on expected losses that reflect
actual losses transparently & is less procyclical than incurred loss
19. Basel III Supervisory Expectations and
Guidance (cont’d.)
• Fifth, a global minimum liquidity standard for internationally active
banks: a 30-day liquidity coverage ratio requirement underpinned by
a longer-term structural liquidity ratio
– Framework also includes a common set of monitoring metrics to assist in
identifying & analysing liquidity risk trends at bank & system wide level
– Standards and monitoring metrics complement BCBS “Principles for Sound
Liquidity Risk Management and Supervision” issued 9-08
• BCBS is reviewing the need for additional capital, liquidity or other
supervisory measures to reduce the externalities created by
systemically important institutions
• Market pressure has already forced the banking system to raise the
level and quality of the capital and liquidity base
– The proposed changes will ensure that these gains are maintained over the
long run, resulting in a banking sector that is less leveraged, less procyclical and
more resilient to system wide stress
20. Basel III Supervisory Expectations and
Guidance (cont’d.)
• BCBS conducted a comprehensive impact assessment of the
enhanced capital and liquidity standards in the first half of 2010
• Based upon the conclusion that the effect on the global banking
system would be favorable, BCBS reviewed & finalized the regulatory
minimum level of capital in the second half of 2010
• Taking into account the reforms proposed, BCBS asserts that an
appropriately calibrated total level and quality of capital has been
achieved, considering all the elements of the reform
• The fully calibrated set of standards was developed by the end of
2010 to be phased in as financial/economic conditions improve with
the aim of implementation by end-2012
• Within this context BCBS also will consider appropriate transition and
grandfathering arrangements & believes these measures will
promote a better balance between financial innovation, economic
efficiency & sustainable long run growth
21. Overview of Basel III New Capital &
Liquidity Standards
• Basel III proposes
many new capital,
leverage &
liquidity standards
to strengthen the
regulation,
supervision & risk
management of
the banking sector
• The capital standards & new capital buffers will require banks to hold
more & higher quality of capital than under current Basel II
• The new leverage & liquidity ratios introduce a non-risk based
measure to supplement the risk-based minimum capital
requirements (aka, leverage ratio) & measures to ensure that
adequate funding is maintained in case of crisis
22. Overview of Basel III New Capital &
Liquidity Standards (cont’d.)
• Alongside higher
capital requirement
& increased capital
ratios, Basel III
introduces new
liquidity & leverage
ratios
• Also counterparty
credit risk & market
risk enhancements
for the trading book
(new capital
requirements for
Credit Value
Adjustment, Wrong
Way Risk, Stressed
Value-at-Risk and
Incremental Risk)
23. Basel III Capital & Liquidity Standards: Key
Elements
• New regulations raise the quality, consistency & transparency of the
capital base and strengthen the risk coverage of the capital
framework
• Basel III strengthens the three Basel II pillars, especially Pillar 1 with
enhanced minimum capital and liquidity requirements
What are the key elements of the new regulations?
• Higher minimum Tier 1 capital requirement
– Tier 1 Capital Ratio: increases from 4% to 6%
– The ratio will be set at 4.5% from 1 January 2013, 5.5% from 1 January 2014
and 6% from 1 January 2015
– Predominance of common equity will now reach 82.3% of Tier 1 capital,
inclusive of capital conservation buffer
• New Capital Conservation Buffer
– Used to absorb losses during periods of financial and economic stress
24. Basel III Capital & Liquidity Standards:
Key Elements (cont’d.)
What are the key elements of the new regulations?
• New Capital Conservation Buffer (continued)
– Banks will be required to hold a capital conservation buffer of 2.5% to
withstand future periods of stress bringing the total common equity
requirement to 7%
• 4.5% common equity requirement and the 2.5% capital conservation buffer
– The capital conservation buffer must be met exclusively with common equity
– Banks that do not maintain the capital conservation buffer will face restrictions
on payouts of dividends, share buybacks and bonuses
• New Countercyclical Capital Buffer
– A countercyclical buffer within a range of 0% - 2.5% of common equity or other
fully loss absorbing capital will be implemented according to national
circumstances
– When in effect, this is an extension to the conservation buffer
25. Basel III Capital & Liquidity Standards:
Key Elements (cont’d.)
What are the key elements of the new regulations?
• Liquidity Standards
– Liquidity Coverage Ratio (LCR): to ensure that sufficient high quality liquid
resources are available for one month survival in case of a stress scenario.
• Introduced 1 January 2015
– Net Stable Funding Ratio (NSFR): to promote resiliency over longer-term time
horizons by creating additional incentives for banks to fund their activities with
more stable sources of funding on an ongoing structural basis
– Additional liquidity monitoring metrics focused on maturity mismatch,
concentration of funding and available unencumbered assets
26. Basel III Capital & Liquidity Standards:
Key Elements (cont’d.)
What are the key elements of the new regulations?
• Leverage Ratio
– A supplemental 3% non-risk based leverage ratio which serves as a backstop to
the measures outlined above
– Parallel run between 2013-2017; migration to Pillar 1 from 2018
• Minimum Total Capital Ratio
– Remains at 8%
– The addition of the capital conservation buffer increases the total amount of
capital a bank must hold to 10.5% of risk-weighted assets, of which 8.5% must
be Tier 1 capital
– Tier 2 capital instruments will be harmonized
– Tier 3 capital will be phased out
27. Basel III Capital & Liquidity Standards:
Implementation
• The Basel
Committee has
outlined phase-in
arrangements
• Specific
implementation
timelines for
individual
countries, both
members and
non-members of
the Basel
Committee on
Banking
Supervision, may
vary
28. Basel III Capital & Liquidity Standards:
Implementation(cont’d.)
• The new Basel III regulations will affect all banks, however the
severity of the impact may differ across types and size of banks
• Most impacted by increases in quantity & quality of capital, liquidity
& leverage ratios, new Pillar 2 & capital preservation
• Most sophisticated banks affected by the amended treatment of
counterparty credit risk, more robust market risk framework and to
some extent, the amended treatment of securitizations
• Systemic Important Financial Institutions (SIFIs) may have to cope
with higher capital requirements or be subject to at least additional
supervision
– Rules for SIFIs were defined by the Basel Committee in 2011
• The U.S. has stated on numerous occasions that they will move to
Basel III – probably all US banks required to meet Basel III
– But smaller institutions may have their capital requirements reduced
29. Basel III Capital & Liquidity Standards:
Implementation(cont’d.)
• US specific rules are to be clarified in 2012 and Basel III should take
effect in early 2013
• Many institutions in several countries including the U.S. are not Basel
II compliant, but their regulatory authorities have indicated that they
will eventually move to a Basel III framework
• This creates an interesting situation because Basel II is the building
block for Basel III – therefore, if implement a Basel II solution before
Basel III, should ensure that solution is flexible
• Data infrastructure implemented should be able to easily
accommodate a granular level of data to support both assets &
liabilities for calculation of regulatory capital & liquidity ratios
• A vended solution needs a clear product roadmap that allows
migration from Basel II to III system including regulatory capital
calculation engines and regulatory reports
30. Basel III Capital & Liquidity Standards:
Implementation(cont’d.)
• As capital requirements are increasing the solution should optimize
regulatory capital calculations to not hold an excess
• If able to bypass Basel II and implement Basel III then planning to
update/replace existing Basel I systems quickly as possible
• In implementing Basel II systems, data is the most challenging & time
consuming steps: should be considered early
– Having granular level data has been identified as one of the biggest business
benefits from Basel II
• While implementing an advanced approach can result in lower capital
requirements beneficial from a return of capital perspective, this
benefit is not guaranteed
• Probably more institutions will leverage the advanced approach as a
result of the higher capital requirements, which will likely make it
more attractive from a capital reduction perspective
31. Basel III Capital & Liquidity Standards:
Implementation(cont’d.)
• With increased capital requirements, allocating capital efficiently &
maximizing risk based returns becomes more important ever
• Should evaluate risk and banking systems to determine if newer
systems and processes can help you reduce operating costs, increase
return on risk & more effective capital allocation
• National regulators may increase the quality and quantity of data
included in their national regulatory reports, especially around
liquidity and leverage ratios
• Existing capital adequacy reports will also be updated: Such
additional information will also have to be reported to the market via
enhancing the current bank Pillar 3 disclosures
32. Basel III Capital & Liquidity Standards:
Critique
• Basel III is in its finalized form only since September 2010, so it is too
early to tell whether it will be effective in practice, but critics have
already begun to voice their opinions
• Obvious criticism surrounds the high level of capital it requires banks
to hold & the suppressive impact it will have on lending
– E.g., if a bank has $100 of capital, under Basel II it could lend up to $1250 of
risk-weighted loans (8% minimum capital level under Basel II)
– When Basel III is fully implemented that same $100 could represent up to 13%
of risk-weighted assets implies the bank can lend up to $770
• A reduction in lending will inhibit economic growth: in the form of
higher capital requirements, Basel III is effectively restricting banks
from sponsoring a robust and healthy economy
• Counterargument is that the leverage & liquidity requirements result
in healthier banks that can better withstand downturns and less
financial contagion, but then again at what cost?
33. Basel III Capital & Liquidity Standards:
Critique (continued)
• A macro-prudential tool should be concerned with & address
systemic risk contributions of financial firms, but the Basel rules are
focused instead on individual risk of financial firms
• Reducing the individual risk of financial firms can in principle
augment systemic risk
– If encouraged to diversify perfectly at all costs, then banks can wind up hold the
same aggregate risk if diversify away all idiosyncratic risk
– If the costs to bank failures are non-linearly increasing in number of failures,
then this form of diversification could be welfare-reducing
• Even ignoring the possibility of individual institutions becoming more
correlated as they reduce their own risks, Basel ignores endogenous
or dynamic evolution of risks of underlying assets
– E.g., AAA-backed residential MBS: Basel providing a relative advantage to this
asset class explicitly encouraged greater lending in the aggregate
– As banks lent down the quality curve->worse mortgages->although MBS
historically safe a static favorable risk-weight made it endogenously risky
34. Basel III Capital & Liquidity Standards:
Critique (continued)
• Basel rules ignore that when risk of an asset class materializes, since
the institutions are over-leveraged on this asset class & in a
correlated manner, they face endogenous liquidity risk
– E.g., all firms at once attempts to de-leverage by selling its AAA MBS implying
that there is not enough capital in the system to deal with this & systemic risk is
created ex post as well as ex ante
– In this sense, Basel requirements induce pro-cyclicality over and above the fact
that risks are inherently pro-cyclical
• In economic terms the Basel risk-weight approach attempts to target
relative prices for activities vs. restrict quantities directly
– Absent price-discovery of day-to-day markets regulators have little hope in
achieving price efficiency sufficiently dynamic & reflective of latent risk
– But concentration limits on asset class exposure for the economy as a whole or
simple leverage restriction are more likely to be robust and counter-cyclical
macro-prudential tools
– They do not directly address systemic risk but at least offer hope of limiting
risks of individual financial firms and asset classes