Basel 3 May 2013

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Basel iii Compliance ProfessionalsAssociation (BiiiCPA)
1200G Street NW Suite800Washington, DC 20005-6705USA Tel:
202-449-9750Web: www.basel-iii-association.com
Dear Member,
I had a difficult timein thepast to explain
liquidityrisk management and ratios.
Now I know what todo. Problem solved!
I will use a pollution-mitigatingtechnology, like
scrubbersto explain liquidityrisk.
Mr. JeremyC Stein, Memberof the Board of Governors
of the Federal Reserve System explainedhow:
―Supposewehave a powerplant that producesenergy
and, asa byproduct, somepollution.
Supposefurther that regulatorswant toreducethe
pollutionand have twotoolsat their disposal:
Theycan mandatethe useof a pollution-mitigating
technology, like scrubbers, or theycanlevyatax onthe
amount of pollution generatedby theplant.
In an ideal world, regulation wouldaccomplishtwoobjectives.
First, it wouldlead toan optimal level of mitigation– that is, it would
inducethe plant toinstall scrubbers up tothe point wherethecostof an
Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
www.basel-iii-association.com

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additional scrubber isequal to themarginal socialbenefit, in termsof
reducedpollution.
And, second, it wouldalsopromote conservation:
Giventhat thescrubbersdon‘t get rid of pollutionentirely, onealsowants
toreduceoverall energyconsumption bymaking it more expensive.
Asimplecaseis onein whichthe costsof installingscrubbers,aswell as
thesocial benefits of reducedpollution, are knownin advanceby the
regulator and themanager of the powerplant.
In this case, the regulatorcan figure out what theright number of
scrubbersis and require that theplant install thesescrubbers.
Themandate can thereforepreciselytarget the optimal amount of
mitigation per unit of energy produced.
And, to the extent that the scrubbers are costly, the mandate will alsolead
to higher energy prices, which will encourage some conservation, though
perhapsnot the sociallyoptimal level.
This latter effect isthe implicit tax aspect of themandate.
Amore complicatedcaseis when the regulator doesnot know ahead of
timewhat the costsof building and installingscrubberswill be.
Here, mandatingtheuse of a fixednumber of scrubbers ispotentially
problematic:
If the scrubbersturn out tobe very expensive, the regulation will end up
beingmore aggressivethansociallydesirable,leadingto overinvestment
in scrubbersand largecost increasesfor consumers;however, if the
scrubbersturn out tobe cheaper than expected, theregulation will have
been too soft.

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In otherwords, whenthecostofthemitigationtechnologyissignificantly
uncertain, a regulatory approachthat fixesthequantityof mitigationis
equivalent toone wherethe implicit tax rate bouncesaround a lot.
Bycontrast, aregulatoryapproachthat fixesthepriceof pollutioninstead
of the quantity– say, by imposing a predeterminedproportional tax rate
directlyon the amount of pollution emittedby the plant – is more
forgivingin the faceof this kind of uncertainty.
This approach leaves the scrubber-installation decision to the manager of
the plant, who can figure out what the scrubbers cost before deciding how
toproceed.
For example, if thescrubbers turn out to be unexpectedlyexpensive, the
plant manager can install fewer of them.
This flexibilitytranslatesintolessvariabilityin theeffectiveregulatory
burden and hence lessvariabilityin the price of energy toconsumers.
Scrubbers and high-quality liquid assets
What doesall thisimplyfor the designof the LCR?
Let‘s workthrough theanalogyin detail.
Theanalog to the powerplant‘senergyoutput is thegrossamount of
liquidityservicescreatedby a bank – via its deposits,thecredit linesit
providesto itscustomers, the prime brokerage servicesit offers,and so
forth.
Theanalog to themitigationtechnology– the scrubbers– is the stock of
HQLA that the bank holds.
And the analogto pollution is thenet liquidityriskassociated withthe
differencebetweenthesetwoquantities, somethingakin to the LCR
shortfall.

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That is,whenthebank offersalot of liquidityondemandtoitscustomers
but fails tohold an adequatebuffer of HQLA, this is whenit imposes
spillover costson the rest of thefinancial system.
In the caseof thepowerplant, I argued that a regulation that callsfor a
fixed quantityof mitigation– that is, for a fixednumber of scrubbers– is
more attractivewhenthere is littleuncertainty about thecost of these
scrubbers.‖
Thank you Jeremy!
I have justopenedmy master plan. I have to learn more about scrubbers.
I now see other similaritiesbetweentheBISand scrubbers. Onlynow I
can understand theshapeof the BISbuilding!
I think I have just found another regulatoryarbitrageopportunity. Areal
national discretion, justified.
Scrubbersarecapableof reduction efficienciesin the rangeof 50% to
98%. Why should theLiquidityCoverage Ratiobe 100%?

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ALCR from 50% to98% (meaning50,001%) is good enough!
Thecalculationsin Basel and scrubbersare alsoalmost the same!

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Liquidity regulation and central banking
Speechby Mr Jeremy C Stein, Member of the Board
of Governorsof theFederal Reserve System, at the
―Finding theright balance‖ 2013Credit Markets
Symposium, sponsored bythe Federal ReserveBank
of Richmond, Charlotte, North Carolina
I‘d like to talk todayabout one important element of the international
regulatoryreform agenda– namely, liquidityregulation.
Liquidityregulation is a relativelynew, post-crisisaddition tothe
financial stabilitytoolkit.
Key elementsincludethe LiquidityCoverage Ratio (LCR), whichwas
recentlyfinalizedbythe Basel Committeeon Banking Supervision, and
the Net StableFundingRatio, whichis still a workin progress.
In what follows, I will focuson the LCR.
Thestated goal of the LCR is straightforward,even if some aspectsof its
designare lessso.
In the wordsof theBasel Committee, ―Theobjectiveof theLCR is to
promotetheshort-term resilienceof the liquidityrisk profile of banks.
It doesthis by ensuringthat bankshavean adequatestock of
unencumberedhigh-qualityliquid assets(HQLA) that can be converted
easilyandimmediatelyin privatemarketsintocashtomeettheir liquidity
needsfor a 30 calendar day liquiditystressscenario.‖
In other words,each bank isrequired to model its total outflowsover 30
days in a liquiditystressevent and then tohold HQLA sufficient to
accommodatethoseoutflows.

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This requirement isimplemented witha ratiotest, wheremodeled
outflowsgo in thedenominator and thestock of HQLA goesin the
numerator;whentheratio equalsor exceeds100percent, therequirement
is satisfied.
TheBasel Committeeissued the first versionof the LCR in December
2010.
In January of thisyear, thecommitteeissueda revisedfinal version of the
LCR, followingan endorsement byitsgoverningbody, theGroup of
Governorsand Headsof Supervision (GHOS).
Therevision expandsthe rangeof assetsthat can count asHQLA and
alsoadjustssome of the assumptionsthat govern the modeling of net
outflowsin a stressscenario.
In addition, thecommitteeagreed in January toa gradual phase-in of the
LCR, sothat it only becomesfullyeffectiveon an international basisin
January 2019.
On thedomesticfront, theFederal Reserve expectsthat theU.S. banking
agencieswill issuea proposal later this year toimplement theLCR for
largeU.S.bankingfirms.
While thisprogressiswelcome, a number of questionsremain.
First, towhat extent should accesstoliquidityfrom a central bank be
allowedto count towardsatisfying theLCR?
In January, the GHOS noted that theinteraction betweentheLCR and
theprovision of central bank facilitiesiscriticallyimportant.
And the group instructedthe Basel Committeeto continueworkingon
thisissuein 2013.

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Second, what stepsshould be taken to enhancethe usability of the LCR
buffer – that is, toencouragebanksto actuallydraw down their HQLA
buffers,asopposed tofire-sellingother lessliquid assets?
TheGHOShasalsomade clearitsview that, during periodsof stress,it
wouldbe appropriatefor banksto usetheir HQLA, therebyfallingbelow
theminimum.
However,creatinga regimein whichbanks voluntarilychooseto dosois
not an easytask.
Anumberofobservershaveexpressedtheconcernthat if abank isheldto
an LCR standard of 100percent in normal times,it may be reluctant to
allowitsratioto drop below 100percent whenfacing largeoutflows, even
if regulatorswereto permit this temporarydeviation, for fear that a
declinein the ratiocould be interpretedasa sign of weakness.
My aim hereistosketchaframeworkforthinkingabout theseandrelated
issues.
Among them, theinterplay betweentheLCR and central bank liquidity
provisionisperhapsthemostfundamentalandanatural startingpoint for
discussion.
Bywayofmotivation, notethat beforethefinancialcrisis, wehadahighly
developed regime of capital regulationfor banks– albeit onethat looks
inadequatein retrospect – but wedid not have formal regulatory
standardsfor their liquidity.
Theintroduction of liquidityregulation after the crisiscan be thought of
asreflectinga desire to reducedependenceon the central bank asa
lender of last resort(LOLR), based on thelessonslearnedover the
previousseveral years.

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However,to the extent that some role for the LOLR still remains,one
now facesthe questionof how it should coexistwith a regime of liquidity
regulation.
Toaddressthis question, it is useful to take a step back and ask another
one:
What underlying market failure is liquidityregulation intendedto
address, and whycan‘t this market failurebe handledentirelyby an
LOLR?
I will turn to this questionfirst.
Next, I will considerdifferent mechanismsthat could potentiallyachieve
thegoalsof liquidityregulation, and how thesemechanismsrelate to
variousfeaturesof theLCR.
In sodoing, I hope toillustratewhy, even though liquidityregulation is a
closecousin of capital regulation, it neverthelesspresentsa number of
novel challengesfor policymakers and why, asa result, weare going to
haveto be opentolearningand adaptingaswego.
The case for liquidity regulation
Oneof theprimary economic functionsof banksand other financial
intermediaries,suchasbroker-dealers,is to provide liquidity– that is,
cashon demand – in variousforms totheir customers.
Someof thisliquidityprovisionhappenson the liability sideof the
balancesheet, withbank demand depositsbeinga leadingexample.
But, importantly, banks alsoprovide liquidityvia committed linesof
credit.
Indeed, it isprobablynot acoincidencethatthesetwoproducts– demand
depositsand credit lines– are offered under the roof of the same

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institution;theunderlying commonalityis that both require an abilityto
accommodateunpredictablerequestsfor cash on short notice.
Anumber of other financial intermediaryservices,such asprime
brokerage, alsoembodya significant element of liquidityprovision.
Without question, theseliquidity-provisionservicesare sociallyvaluable.
On the liabilityside, demand depositsand other short-term bank
liabilitiesaresafe,easy-to-valueclaimsthat arewellsuitedfor transaction
purposesand hencecreatea flowof money-like benefitsfor their holders.
And loancommitmentsare more efficient than an arrangement in which
eachoperatingfirm hedgesitsfutureuncertainneedsby―pre-borrowing‖
andhoarding theproceedson itsown balancesheet;this latterapproach
doesa poor job of economizingon thescarce aggregate supplyof liquid
assets.
At thesametime, asthefinancial crisismadepainfullyclear, thebusiness
of liquidityprovision inevitablyexposesfinancial intermediariestovarious
forms of run risk.
That is, in responsetoadverse events, their fragile funding structures,
together withthe binding liquiditycommitmentstheyhavemade, can
result in rapid outflowsthat, absent central bank intervention, lead banks
tofire-sellilliquid assetsor, in a more severe case,to fail altogether.
And fire salesand bank failures– and theaccompanying contractionsin
credit availability– can have spillover effectstoother financial
institutionsand to the economy asa whole.
Thus, while bankswill naturallyhold buffer stocksof liquid assetsto
handleunanticipatedoutflows, theymay not hold enough because,
although theybear all thecostsof this buffer stocking, theydonot
capture all of thesocial benefits, in termsof enhancedfinancial stability
and lowercoststotaxpayers in the event of failure.

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It is this externalitythat createsa role for policy.
Therearetwobroadtypesof policytoolsavailabletodeal withthissortof
liquidity-basedmarket failure.
Thefirst isafter-the-fact intervention, either by a deposit insurer
guaranteeingsome of thebank‘sliabilitiesor by a central bank actingas
an LOLR.
Thesecond type isliquidityregulation.
As an exampleof theformer, whenthe economy isin a bad state,
assumingthat aparticularbank isnot insolvent, thecentralbank canlend
against illiquidassetsthat wouldotherwisebefire-sold,therebydamping
or eliminatingthe run dynamics and helpingreducetheincidenceof bank
failure.
In much of theliteratureon banking, such interventionsare seen asthe
primarymethod for dealing withrun-likeliquidityproblems.
Aclassicstatement of the central bank‘srole asan LOLR is Walter
Bagehot‘s1873book Lombard Street.
Morerecently, the seminal theoretical treatment of this issueis by
DouglasDiamond and Philip Dybvig, whoshowthat under certain
circumstances, the useof deposit insuranceor an LOLR can eliminate
run risk altogether, therebyincreasingsocial welfareat zero cost.
Tobeclear, thisworkassumesthat thebank in questionisfundamentally
solvent, meaning that whileitsassetsmay not be liquid on short notice,
thelong-run valueof these assetsisknownwithcertaintyto exceed the
valueof thebank‘sliabilities.
Onewaytointerpret themessageof this research is that capital
regulation is important toensuresolvency, but oncea reliableregime of

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capital regulation is in place, liquidityproblemscan bedealt withafter the
fact, via somecombinationofdepositinsuranceanduseof theLOLR.
It followsthat if one is goingto make an argument in favor of adding
preventativeliquidityregulationsuch asthe LCR on top of capital
regulation, a central premisemust be that the use of LOLR capacityin a
crisisscenario is sociallycostly, sothat it is an explicit objectiveof policy
toeconomize on itsusein such circumstances.
I think this premiseis a sensibleone.
Akey point in this regard – and one that hasbeen reinforcedby the
experienceof thepast several years – is that the linebetweenilliquidity
and insolvencyisfar blurrier in real life than it is sometimesassumed to
bein theory.
Indeed, one might argue that a bank or broker dealer that experiencesa
liquiditycrunch must havesomeprobability of havingsolvencyproblems
aswell;otherwise,it is hard tosee whyit could not attract short-term
fundingfrom the private market.
This reasoningimplies that when thecentral bank actsasan LOLR in a
crisis, it necessarilytakesonsome amount of credit risk.
And if it experienceslosses,theselossesultimatelyfall ontheshouldersof
taxpayers.
Moreover,theuseof an LOLR to support banks whentheyget into
troublecan lead tomoral hazard problems, in thesensethat banksmay
belessprudent ex ante.
If it werenot for thesecostsof usingLOLR capacity, the problem would
be trivial, and there wouldbenoneed for liquidityregulation:

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Assuming a well-functioningcapital-regulationregime, the central bank
couldalwaysavert all firesalesand bank failuresexpost, simplybyacting
asan LOLR.
This observation carries an immediate implication:
It makes no senseto allowunpriced accessto thecentral bank‘sLOLR
capacityto count toward an LCR requirement.
Again, the wholepoint of liquidityregulation must be either toconserve
on theuseof the LOLR or in the limit, to addresssituationswherethe
LOLR is not availableat all – as, for example, in the caseof
broker-dealersin theUnitedStates.
At thesametime, it isimportant todraw adistinctionbetweenpriced and
unpriced accessto the LOLR.
For example, takethecaseofAustralia, whereprudent fiscal policyhas
ledto a relatively small stock of government debt outstandingand hence
toa potential shortageof HQLA.
TheBasel Committeehasagreed totheusebyAustralia of a Committed
LiquidityFacility (CLF), wherebyanAustralianbank canpaytheReserve
Bank ofAustralia an upfront fee for what is effectivelya loan
commitment, and this loan commitment can then be countedtowardits
HQLA.
In contrast to free accesstotheLOLR, this approachisnot at oddswith
thegoalsof liquidityregulationbecausetheup-front feeis effectively a
tax that servestodeter relianceon the LOLR – which, again, is precisely
theultimategoal.
I will return tothe ideaof a CLF shortly.

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Thedesign of regulation
Onceit hasbeen decided that liquidityregulationis desirable, thenext
question ishow best toimplement it.
In this context, notethat the LCR hastwologicallydistinct aspectsasa
regulatorytool:
It is a mitigator, in thesense that holding liquid assetsleadstoa better
outcome if there is a bad shock; it is alsoan implicit tax on liquidity
provision by banks, tothe extent that holdingliquidassetsiscostly.
Of course,one can say somethingbroadlysimilar about capital
requirements.
But the implicit tax associated withtheLCR is subtler and lesswell
understood, soI will go intosome detail here.
An analogymay help to explain.
Supposewehaveapowerplant that producesenergyand, asabyproduct,
somepollution.
Supposefurtherthat regulatorswant toreducethepollutionandhavetwo
toolsat their disposal:
Theycan mandatethe useof a pollution-mitigatingtechnology, like
scrubbers,or theycan levya tax on theamount of pollution generatedby
the plant.
In an ideal world, regulation wouldaccomplish twoobjectives.
First, it wouldlead toan optimal level of mitigation– that is, it would
inducethe plant toinstall scrubbers up tothe point wherethecostof an
additional scrubber isequal to themarginal socialbenefit, in termsof
reducedpollution.

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And, second, it wouldalsopromote conservation:
Giventhat thescrubbersdon‘t get rid of pollutionentirely, onealsowants
toreduceoverall energyconsumption bymaking it more expensive.
Asimplecaseis onein whichthe costsof installingscrubbers,aswellas
thesocial benefits of reducedpollution, are knownin advanceby the
regulator and themanager of the powerplant.
In this case, the regulatorcan figure out what theright number of
scrubbersis and require that theplant install thesescrubbers.
Themandate can thereforepreciselytarget the optimal amount of
mitigation per unit of energy produced.
And, to the extent that the scrubbers are costly, the mandate will alsolead
to higher energy prices, which will encourage some conservation, though
perhapsnot the sociallyoptimal level.
This latter effect isthe implicit tax aspect of themandate.
Amore complicatedcaseis when the regulator doesnot know ahead of
timewhat the costsof buildingand installingscrubberswill be.
Here, mandatingtheuse of a fixednumber of scrubbers ispotentially
problematic:
If the scrubbersturn out tobe very expensive, the regulation will end up
beingmore aggressivethansociallydesirable,leadingto overinvestment
in scrubbersand largecostincreasesfor consumers;however, if the
scrubbersturn out tobe cheaper than expected, the regulationwill have
been too soft.
In otherwords, whenthecostofthemitigationtechnologyissignificantly
uncertain, a regulatory approachthat fixesthe quantityof mitigationis
equivalent toone wherethe implicit tax rate bouncesaround a lot.

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Bycontrast, aregulatoryapproachthat fixesthepriceof pollutioninstead
of the quantity– say, by imposing a predeterminedproportional tax rate
directlyon the amount of pollution emittedby the plant – is more
forgivingin the faceof this kind of uncertainty.
This approach leaves the scrubber-installation decision to the manager of
the plant, who can figure out what the scrubbers cost before deciding how
toproceed.
For example, if thescrubbers turn out to be unexpectedlyexpensive, the
plant manager can install fewer of them.
This flexibilitytranslatesintolessvariabilityin theeffectiveregulatory
burden and hence lessvariabilityin the price of energy toconsumers.
Scrubbers and high-quality liquid assets
What doesall thisimplyfor the designof the LCR?
Let‘s workthrough theanalogyin detail.
Theanalogto the powerplant‘s energyoutput is the grossamount of
liquidityservicescreatedby a bank – via its deposits,thecredit linesit
providesto itscustomers, the prime brokerage servicesit offers,and so
forth.
Theanalog to themitigationtechnology– the scrubbers– is the stock of
HQLA that the bank holds.
And the analogto pollution is thenet liquidityriskassociated withthe
differencebetweenthesetwoquantities, somethingakin to the LCR
shortfall.
That is,whenthebank offersalot of liquidityondemand toitscustomers
but fails tohold an adequatebuffer of HQLA, this is whenit imposes
spillover costson the rest of thefinancial system.

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In the caseof thepowerplant, I argued that a regulation that callsfor a
fixed quantity of mitigation– that is, for a fixednumber of scrubbers– is
more attractivewhenthere is littleuncertainty about the costof these
scrubbers.
In the context of the LCR, the cost of mitigation is the premium that the
bank must pay – in the form of reduced interest income – for itsstock of
HQLA.
And, crucially, this HQLA premium is determined in market equilibrium
and dependson the total supplyof safe assetsin the system, relative tothe
demand for thoseassets.
On the onehand, if safeHQLA-eligibleassetsare in ample supply, the
premium is likelytobe low and stable.
On the other hand, if HQLA-eligible assetsare scarce, thepremium will
beboth higher and more volatile over time.
This latter situation is the one facing countrieslike Australia, where, as I
noted earlier, the stock of outstanding government securities is relatively
small.
And it explainswhy, for such countries,havinga price-basedmechanism
aspart of their implementationof the LCR can be more appealingthan
pure relianceon a quantitymandate.
When one sets an up-front fee for a CLF, one effectively caps the implicit
tax associated with liquidity regulation at the level of the commitment fee
and tamps down the undesirable volatility that would otherwise arise from
an entirelyquantity-based regime.
Moreover,it bearsreemphasizingthat havinga CLF withanup-front fee
is very different from simplyallowingbankstocount central - bank -
eligiblecollateral asHQLA at no charge.

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Rather, the CLF is like the pollution tax.
For every dollar of pre-CLF shortfall – that is, for every dollar of required
liquidity that a bank can‘t obtain on the private market – the bank has to
paythe commitment fee.
Soeven if there isnot asmuch mitigation, thereis still an incentivefor
conservation, in thesensethat banks areencouragedto dolessliquidity
provision, all elsebeing equal.
This wouldnot be thecaseif the CLF wereavailableat a zeroprice.
What about the situation in countrieswheresafeassetsaremore
plentiful?
Theanalysis here hasa number of moving parts becausein addition to
theimplementationof the LCR, substantial increasesin demand for safe
assetswill arise from new margin requirementsfor both clearedand
nonclearedderivatives.
Nevertheless,giventhelargeandgrowingglobalsupplyofsovereigndebt
securities,aswellasother HQLA-eligibleassets,most estimatessuggest
that the scarcityproblem should be manageable, at least for the
foreseeablefuture.
In particular, quantitativeimpact studiesreleasedby the Basel
Committeeestimatethat the worldwide incremental demand for HQLA
comingfrom both the implementationof the LCR and swapmargin
requirementsmight be on the order of $3 trillion.
This is a largenumber, but it compareswith a global supplyof
HQLA-eligibleassetsof more than $40trillion.
Moreover,the eligiblecollateral for swapmargin is proposedtobe
broader than theLCR‘s definition of HQLA – including, for example,
certain equitiesand corporatebondswithout any cap.

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If one focusesjust on U.S.institutions,theincremental demand number
is on the order of $1trillion, while the sum of Treasury, agency, and
agencymortgage-backedsecuritiesis more than $19trillion.
While this sort of analysisissuperficiallyreassuring, thefact remainsthat
theHQLA premium will depend on market-equilibrium considerations
that are hard to fullyfathom in advance, and that are likely tovary over
time.
This uncertaintyneedsto beunderstood, and respected.
Indeed, themarket-equilibriumaspect of theproblemrepresentsacrucial
distinctionbetweencapital regulationand liquidityregulation, and it is
onereasonwhythelatter isparticularly challengingtoimplement.
Although capital regulationalsoimposesa tax on banks – tothe extent
that equityisamore expensiveform of financethandebt – thistax wedge
is,toafirstapproximation, afixed constant foragivenbank, independent
of the scaleof overall financial intermediation activity.
If Bank Adecidestoissuemore equitysoit can expand itslending
business,this need not make it more expensivefor Bank B tosatisfyits
capital requirement.
In other words,thereis noscarcityproblem withrespect to bank equity –
bothAand B can alwaysmake more.
Bycontrast, thetotal supplyof HQLA isclosertobeingfixedat anypoint
in time.
Policy implications
What doesall of this implyfor policydesign?
First, at a broadphilosophical level, the recognitionthat liquidity
regulation involvesmore uncertaintyabout coststhancapital regulation
suggeststhat even apolicymaker witha very strict attitudetowardcapital

P a g e | 20
might find it sensibleto besomewhat more moderate and flexiblewith
respect toliquidity.
This point is reinforced by the observationthat whenan institutionis
short of capitalandcan‘t get moreontheprivatemarket, thereisreallyno
backup plan, short of resolution.
By contrast, asI mentioned earlier, whenan institution isshort of
liquidity, policymakers do have a backup plan in the form of theLOLR
facility.
Onedoesnot want torelytoomuch on that backup plan, but itspresence
should neverthelessfactor intothedesign of liquidityregulation.
Second, in thespirit of flexibility, while aprice-basedmechanism such as
theCLF may not beimmediatelynecessaryin countriesoutsideof
Australia and a few others,it is worthkeepingan open mind about the
more widespreaduse of CLF-like mechanisms.
If a scarcityof HQLA-eligible assetsturnsout tobe more of a problem
than weexpect, somethingalong thoselineshasthepotential to be a
useful safetyvalve, asit putsa cap on thecostof liquidityregulation.
Such a safety valvewouldhave a direct economicbenefit, in thesenseof
preventingtheburdenof regulationfrom gettingundulyheavyin anyone
country.
Perhapsjust asimportant, a safetyvalvemight alsohelp to protect the
integrityof the regulation itself, by harmonizingcostsacrosscountries
andtherebyreducingthetemptationofthosemosthard-hit bytherulesto
try tochip awayat them.
Without suchasafetyvalve, it ispossiblethat somecountries– thosewith
relativelysmall suppliesof domestic HQLA – will find the regulation
considerably more costlythan others.

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If so, it wouldbenatural for them to lobbyto dilutetherules– for
example, by arguingfor an expansion in thetype of assetsthat can count
asHQLA.
Taken toofar, this sort of dilution wouldunderminethe efficacyof the
regulation asboth amitigatorand a tax.
In this scenario, holdingthe linewithwhat amountstoa proportional tax
on liquidityprovision wouldbe a better outcome.
Onesituation whereliquid assetscan becomeunusuallyscarceis during
a financial crisis.
Consequently, evenif CLFs werenot counted towardtheLCR in normal
times,it might be appropriatetocount them during a crisis.
Indeed, while theLCR requires banks tohold sufficient liquid assetsin
good timestomeet their outflowsin a givenstressscenario, it implicitly
recognizesthat if thingsturn out even worsethanthat scenario, central
bank liquiditysupport will be needed.
AllowingCLFs tocount toward theLCR in such circumstanceswould
acknowledgethe importanceof accesstothecentral bank, and this
accesscould be priced accordingly.
Finally, a price-based mechanism might alsohelp promote a willingness
of banksto draw down their supplyof HQLA in a stressscenario.
As I noted at the outset, one important concern about a pure quantity-
based system of regulation isthat if a bank is held toan LCR standardof
100percent in normal times,it may be reluctant toallowitsratio tofall
below 100percent whenfacinglargeoutflowsfor fear that doing somight
beseenby market participantsasa sign of weakness.
By contrast, in a system withsomethinglike a CLF, a bank might in
normal timesmeet 95 percent of itsrequirement by holding

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private-market HQLAandtheremaining5percent withcommittedcredit
linesfrom thecentral bank, soit wouldhavean LCR of exactly100
percent.
Then, when hit withlargeoutflows, it could maintain its LCR at 100
percent, but dosoby increasingits useof central bank credit linesto25
percent and selling20 percent of itsother liquid assets.
This scenariowouldbe the sort of liquid-asset drawdownthat one would
ideallylike to seein a stresssituation.
Moreover, the central bank could encourage this drawdown by varying
the pricing of its credit lines – specifically, by reducing the price of the
linesin the midst of a liquiditycrisis.
Such an approach wouldamount totaxingliquidityprovision more in
good timesthan in bad, whichhasa stabilizing macroprudential effect.
Thisexamplealsosuggestsadesignthat mayhaveappealinjurisdictions
wherethere is a relatively abundant supplyof HQLA-eligible assets.
Onecan imagine calibratingthe pricingof the CLF soasto ensure that
linesprovidedbycentralbanksmakeuponlyaminimal fractionofbanks‘
requiredHQLA in normal times– apart, perhaps,from the occasional
adjustment periodafter an individual bank is hit withan idiosyncratic
liquidityshortfall.
At the same time, in a stressscenario, when liquidityisscarce and there is
upward pressure on the HQLA premium, the pricing of the CLF could be
adjusted so as to relieve this pressure and promote usability of the HQLA
buffer.
Such an approach would respect the policyobjective of reducing expected
reliance on the LOLR while at the same time allowing for a safety valve in
a period of stress.

P a g e | 23
Thelimit caseof thisapproach is one wheretheCLF countstowardthe
LCR onlyin a crisis.
Conclusion
Bywayofconclusion, letmejustrestatethat liquidityregulationhasakey
roleto playin improving financial stability.
However,weshould avoid thinkingabout it in isolation;rather, wecan
best understand it aspart of a larger toolkit that alsoincludescapital
regulation and, importantly, thecentral bank‘sLOLR function.
Therefore, proper design and implementation of liquidityregulations
such asthe LCR should takeaccount of theseinterdependencies.
In particular, policymakers should aim tostrike a balancebetween
reducingrelianceontheLOLR ontheonehandandmoderatingthecosts
created by liquidityshortageson the other hand – especiallythose
shortagesthat crop up in timesof severe market strain.
And, asalways, weshould bepreparedtolearnfrom experienceaswego.

P a g e | 24
Basel III Capital: AWell-Intended Illusion
ThomasM. Hoenig
Vice Chairman, Federal Deposit Insurance
Corporation
InternationalAssociation of Deposit Insurers
2013Research Conference, Basel, Switzerland
Introduction
Aristotle is creditedwith being thefirst philosophertosystematically
studylogical fallacies,whichhe definedasargumentsthat appear valid
but, in fact, arenot.
I call them well-intendedillusions.
Onesuch illusion of precision is the Basel capital standardsin which
worldsupervisory authoritiesrely principallyon a Tier 1capital ratioto
judgethe adequacyof bank capital and balance sheet strength.
For the largest of thesefirms, each dollar of risk-weighted assetsis funded
with 12to15cents in equitycapital, projecting the illusion that thesefirms
are wellcapitalized.
Thereality isthat each dollar of their total assetsis funded withfar less
equitycapital, leavingopenthematter of how wellcapitalizedtheymight
be.
Here‘show theillusionis created.
Basel'sTier 1capital measure is a bank's ratio of Tier 1capital to
risk-weightedassets.

P a g e | 25
Each category of bank assets is weighed by the supervisory authority on a
complicated scale of probabilitiesand models that assign a relative risk of
lossto each group, includingoff balancesheet items.
Assetsdeemed lowrisk are reported at loweramountson thebalance
sheet.
Thelowertherisk,thelowertheamount reported onthebalancesheet for
capital purposesand thehigher the calculatedTier 1ratio.
We know from years of experience using the Baselcapital standardsthat
oncethe regulatory authorities finish their weightingscheme, bank
managersbegin theprocessof allocatingcapital and assetstomaximize
financial returns around these constructedweights.
Theobjectiveis tomaximize a firm'sreturn on equity(ROE) by
managingthe balancesheet in such a manner that for anylevel of equity,
therisk-weightedassetsare reported at levelsfar lessthan actual total
assetsunder management.
Thiscreatestheillusionthatbankingorganizationshaveadequatecapital
toabsorbunexpected losses.
For thelargest global financial companies,risk-weightedassetsare
approximatelyone-half of total assets.
This "leveragingup" hasserved worldeconomiespoorly.
In contrast, supervisorsand financial firmscan choosetorely on the
tangibleleverageratio tojudgethe overall adequacyof capital for the
enterprise.
This ratiocomparesequitycapital to total assets,deductinggoodwill,
other intangibles,and deferred tax assetsfrom both equity and total
assets.

P a g e | 26
In additiontoincludingonly loss-absorbingcapital, it alsomakesno
attempt to predict or assign relativerisk weightsamong asset classes.
Usingthisleverageratioasour guide, wefind for thelargest banking
organizationsthat each dollar of assetshasonly4 to 6centsfundedwith
tangibleequitycapital, a far smallerbuffer than asserted under the Basel
standards.
Comparing Measures
Table1reportstheBasel Tier 1risk-weightedcapital ratio and the
leverageratiofor different classesof banking firms.

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Column 4 showsTier 1capital ratiosrangingbetween12 and 15percent
for the largest global firms, giving theimpression that thesebanksare
highly capitalized.
However,it is hard tobe certain of that by lookingat thisratiosince
risk-weightedassetsaresomuch lessthan total assets.
In contrast, Column 6 showsU.S.firms' averageleverageratiotobe 6
percent using generallyacceptedaccountingstandards(GAAP), and
Column 8 showstheir averageratioto be3.9percent using international
accountingstandards(IFRS), whichplacesmore of thesefirms'
derivativesonto thebalancesheet than doesGAAP.
Thebottom portionof Table1showsthe degreeof leverageamong
different size groupsof banking firms, whichis striking aswell.
TheTier 1capital measuresuggeststhat all size groupsof banks hold
comparable capital levels,while the leverageratioreports a different
outcome.

P a g e | 28
For example, the leverageratiofor most bankinggroupsnot considered
systemicallyimportant averagesnear 8 percent or higher.
Under GAAP accounting standards, the difference in this ratio between
the largest banking organizations and the smaller firms is 175-250 basis
points.
Under IFRSstandards, thedifferenceisasmuch as400-475basispoints.
Thelargest firms, whichmost affect theeconomy, hold the least amount
of capital in the industry.
While thisshowsthem tobe more fragile, it alsoidentifies just how
significant a competitiveadvantagethese lowercapital levelsprovidethe
largestfirms.
Thesecomparisonsillustratehow easily the Baselcapital standard can
confuseand misinform the public rather than meaningfullyreport a
bankingcompany‘srelativefinancial strength.
Recent history showsalsojusthow damagingthiscan be totheindustry
andtheeconomy.
In 2007, for example, the10 largest and most complex U.S.bankingfirms
reported Tier 1capital ratiosthat, on average, exceeded 7 percent of
risk-weightedassets.
Regulatorsdeemed theselargest to be well capitalized.
This risk-weightedcapital measure, however,mapped intoan average
leverageratioof just 2.8percent.
We learned all toolatethat having lessthan 3 centsof tangiblecapital for
every dollar of assetson thebalancesheet is not enough to absorbeven
thesmallest of financial losses,and certainlynot a major shock.

P a g e | 29
With the crisis, the illusion of adequate capital wasdiscovered, after
havingmisled shareholders,regulators,and taxpayers.
There are other, more recent, examples of how this arcane measure can
be manipulated to give the illusion of strength even when a firm incurs
losses.
For example, in thefourthquarter of 2012, DeutscheBank reported a loss
of 2.5 billion EUR.
That same quarter, its Tier 1risk-basedcapital ratioincreasedfrom 14.2
percent to15.1percent due, in part, to ―model and process
enhancements‖ that resultedin a declinein risk-weightedassets, which
nowamount to just16.6 percent of total assets.
On Feb. 1, SNSReaal, the fourth largest Dutch bank with$5billion in
assets,wasnationalized by the Dutch government.
Just seven monthsearlier, on June 30, 2012,SNSreported a Tier 1
risk-basedcapital ratio of 12.2 percent.
However,the firm reported a Tier 1leverageratiobased upon
international accountingstandardsof only1.47percent.
This leverageratiowasmuch more indicativeof the SNS‘spoor financial
position.
TheBasel III proposal belatedlyintroducestheconcept of a leverage
ratio but callsfor it tobe only 3 percent, an amount alreadyshown to be
insufficient toabsorb sizablefinancial lossesin a crisis.
It iswrongtosuggest tothepublic that, withsolittlecapital, theselargest
firmscould survive without public support should theyencounter any
significant economicreversals.

P a g e | 30
Misallocating Resourcesand CreatingAsset Imbalances
An inherent problem with a risk-weighted capital standard is that the
weights reflect past events, are static, and mostly ignore the market's
collectivedaily judgment about the relativerisk of assets.
It alsointroducestheelement of political and special interestsintothe
process, whichaffectstheassignment ofriskweightstothedifferent asset
classes.
Theresult is oftentoartificiallyfavor onegroup of assetsover another,
therebyredirectinginvestmentsand encouragingover-investment in the
favoredassets.
Theeffect of thismanagedprocessisto increaseleverage, raisethe
overall risk profile of theseinstitutions,and increasethevulnerabilityof
individual companies, the industry, and the economy.
It is no coincidence,for example, that after a Basel standard assigned
onlya 7 percent risk weight ontripleA, collateralizeddebt obligations
and similar lowrisk weightson assetswithina firm'stradingbook,
resourcesshiftedtotheseactivities.
Overtime, financial groupsdramaticallyleveragedtheseassetsontotheir
balancesheetsevenasthe risksto that asset classincreasedexponentially.
Similarly, assigningzero weightstosovereign debt encouragedbanking
firmsto invest more heavily in theseassets, simultaneouslydiscounting
therealrisk theypresentedand playing animportant rolein increasingit.
In placing a lowerrisk weight on select assets,lesscapital wasallocated
tofundthemandtoabsorbunexpectedlossforthesebanks,undermining
their solvency.

P a g e | 31
AMore Realistic Capital Standard Is Required
Taxpayersaretheultimatebackstoptothesafetynetandhaverealmoney
at stake.
In choosingwhichcapital measure is most useful, it is fair toaskthe
followingquestions:
- Doesthe BaselTier 1ratio or the tangibleleverageratiobest indicate
thecapital strengthof the firm?
- Whichone is most clearlyunderstood?
- Whichone best enablescomparison of capital acrossinstitutions?
-Whichone offersthemost confidencethat it cannot be easily gamed?
Charts 1through 4compare the relationship of the tangibleleverageand
BaselTier1capitalratiostovariousmarketmeasuresforthelargestfirms.

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P a g e | 36
Thesemeasuresinclude:theprice-to-book ratio, estimated default
frequency, credit default swapspreads, and market value of equity.
In each instance, thecorrelationof thetangibleleverageratioto these
variablesis higher than for the risk-weightedcapital ratio.
While such findingsare not conclusive, theysuggest stronglythat
investors,whendecidingwhereto placetheir money, rely upon the
information provided by the leverageratio.
We woulddowellto do thesame.

P a g e | 37
Despiteall of theadvancementsmadeover theyearsin riskmeasurement
andmodeling, it isimpossibleto predict thefuture or to reliably
anticipatehow and towhat degreeriskswill change.
Capital standardsshould serve to cushion against theunexpected, not to
divineeventualities.
All of the Baselcapital accords, includingtheproposedBasel III, look
backwardand then attempt to assign risk weightsintothe future.
It doesn't work.
In contrast, the tangible leverage ratio provides a simpler, more direct
insight into the amount of loss-absorbing capital that is available to a
firm.
Aleverageratio asI‘ve definedit explicitlyexcludesintangibleitemsthat
cannot absorb lossesin a crisis.
Also, using IFRSaccounting rules, off-balancesheet derivativesare
brought ontothe balancesheet, providingfurtherinsight intoa firm's
leverage.
Thus, thetangibleleverageratiois simpler tocomputeand more easily
understood by bank managers,directors, and thepublic.
Importantlyalso,it ismore likely tobe consistentlyenforcedby bank
supervisors.
Amore difficult challengemay be todetermine an appropriateminimum
leverageratio.
Chart 5providesa historyof bank leverageover thepast 150years for the
U.S. banking system and givesinitial insight intothisquestion.

P a g e | 38
It showsthat the equitycapital to assetsratiofor the industryprior to the
founding of the Federal Reserve System in 1913and the Federal Deposit
InsuranceCorporation in 1933ranged between13 and 16 percent,
regardless of bank size.
Without any internationally dictated standard or any arcane weighting
process, markets required what today seems like relatively high capital
levels.
In addition, thereis an increasingbodyof research(Admati and Hellwig;
Haldane;Miles,Yang, and Marcheggiano) that suggeststhat leverage
ratios should be much higher than theycurrentlyare and that BaselIII‘s
proposed 3percent figure addslittlesecurity to thesystem.
Finally, and importantly, some form of risk-weightedcapital measure
couldbe useful asabackstop, or check, against whichto judgethe
adequacyof theleverageratiofor individual banks.
If a bank meets the minimum leverage ratio but has concentrated assets
in areas that risk models suggest increase the overall vulnerability of the
balance sheet, the bank could be required to increase its tangible capital
levels.
Such a system providesthemost comprehensivemeasure of capital
adequacyboth in a broad context of all assetsand accordingto a bank's
allocationof assetsalonga definedrisk profile.
Tangible Leverage Ratio and the Myth of Unintended
Consequences
Concernsareoften raisedwithinthefinancialindustryandelsewherethat
requiringthelargest and most complex firms tohold higher levelsof
capital asdefined usinga tangibleleverageratiowouldhaveserious
adverseeffectson theindustry and broader economy.

P a g e | 39
It hasbeen suggested, for example, that requiring more capital for these
largestbankswouldraisetheir relativecost of capital and make them less
competitive.
Similarly, there is concern that failingto assign riskweightstothe
different categoriesof assetswouldencourage firms toallocatefundsto
thehighest riskassetsto achievetargeted returnstoequity.
Theseissueshave been well addressed byAnat Admati and Martin
Hellwig in their recentlypublishedbook, The Bankers‘New Clothes.
Therequired ROE and the abilityto attract capital are determinedby a
host of factorsbeyond the level of equitycapital.
Theseinclude a firm‘sbusinessmodel, itsrisk-adjustedreturns, the
benefitsof servicesand investments, and theundistorted, or
non-subsidized, costsof capital.
Alevel of capital that lowersrisk may very well attract investorsdrawn to
themore reliablereturns.
Table1showsmany of the bankswithstrongerleverageratiosalsohave
stockpricestradingat a higher premium tobook valuethan the largest
firmsthat are lesswell-capitalized.
There alsois a concern that requiringa stronger, simpler leverageratio
wouldcausemanagers to placemore risk on their balancesheet.
While possible, the argument isunconvincing.
With more capital at risk and without regulatory weightingschemes
affectingchoice, managers will allocatecapital in linewithmarket risk
and returns.
Furthermore,risk-weightedmeasuresandstrongbank supervisioncanbe
availableasa back-up system tomonitor such activity.

P a g e | 40
Moreover,given theexperienceof therecent crisisand the on-going
effortsto manage reported risk assetsdown, no matter the risk, it rings
hollowto suggest that having a higher equitybuffer for the same amount
of total assetsmakesthe financial system lesssafe.
In addition, there isa concern that demanding more equitycapital and
reducingleverageamong thelargest firms wouldinhibit thegrowthof
credit and the economy.
This statement hasan implied presumptionthat the Basel weighting
schemeismore growthfriendlythan a simpler, stronger leverageratio.
However,having a sufficient capital buffer allowsbanks to absorb
unexpected losses.
Thisservestomoderate thebusinesscycleandthedeclineinlendingthat
otherwiseoccursduring contractions.
If the Basel risk-weight schemesare incorrect, whichthey oftenhave
been, this toocould inhibit loangrowth, asit encouragesinvestmentsin
other more favorably, but incorrectly, weightedassets.
Basel systematically encouragesinvestmentsin sectorspre-assigned
lowerweights-- for example, mortgages, sovereign debt, and derivatives
-- and discouragesloanstoassetsassignedhigher weights-- commercial
and industrial loans.
We may have inadvertently created a system that discourages the very
loan growth we seek, and instead turned our financial system into one
that rewardsitselfmore than it supportseconomicactivity.
If risk weightscould be assigned that anticipateand calibraterisks with
perfect foresight, adjusted on a daily basis,then perhapsrisk-weighted
capital standardswouldbe the preferred method for determininghow to
deploycapital.

P a g e | 41
However,they cannot.
Tobelieve theycan isa fallacythat putsthe entire economic system at
risk.
Changing the Debate
Thetangibleleverageratiois a superior alternativeto risk-weighting
schemesthat haveproven tobean illusionof precisionand insufficient in
definingadequatecapital.
Theeffect of relying on suchmeasureshasbeen toweakenthe financial
system and misallocate resources.
Theleverageratio deservesseriousconsiderationasthe principal tool in
judgingthe capital strength of financial firms.
TheBasel discussion wouldbe well served to focuson the appropriate
levelsof tangiblecapitalfor bankingfirmstohold and theright transition
period to achievetheselevels.
Finally, weshould not accept even comfortingerrorsof logic which
suggest that BaselIII requirementswill createstronger capital than those
of Basel II, whichfailed.
Instead, past industryperformanceand mountingacademicand other
evidencesuggest that wewouldbebest served to focuson a strong
leverageratiostandard in judginga firm and theindustry's financial
strength.
No bank capital program is perfect.
Our responsibility asregulatorsand deposit insurersis tochoosethebest
availablemeasure that will contributeto financial stability.

P a g e | 42
Note:
ThomasM. Hoenig wasconfirmedbytheSenateasViceChairman ofthe
Federal Deposit InsuranceCorporation on Nov. 15, 2012.
He joinedtheFDIC onApril 16, 2012,asa member of the FDIC Board of
Directorsfor a six-year term.
He isamember of theexecutiveboard of theInternationalAssociationof
Deposit Insurers.
Prior toservingon the FDIC board, Mr. Hoenig wasthe President of the
Federal Reserve Bank of KansasCity and a member of the Federal
ReserveSystem's Federal Open MarketCommittee from 1991to2011. Mr.
Hoenig waswiththe Federal Reserve for 38years, beginningasan
economistand then asa senior officer in banking supervision during the
U.S. banking crisisof the 1980s.
In 1986, he led theKansasCity Federal Reserve Bank'sDivision of Bank
Supervisionand Structure, directingtheoversight of more than 1,000
banksand bank holdingcompanies withassetsranging from lessthan
$100million to $20billion.
He became President of theKansasCityFederal Reserve Bank on
October 1,1991.
Mr. Hoenig is a nativeof Fort Madison, Iowa. He receiveda doctoratein
economicsfrom IowaStateUniversity.

P a g e | 43
―A comfortable position for German banks‖
TheBundesbank currentlyseesno signs
whatsoeverof a credit shortage or a tighteningof
lendingstandardsin Germany.
―Germanbanksare in a pretty comfortableposition at themoment.
By and large, neither their liquiditynor their capital situation are causing
them any problems,‖DeputyPresident Sabine Lautenschlägersaidearlier
thisweek at the InternationalerClub Frankfurter Wirtschaftjournalisten
(International club of Frankfurt-basedbusinessjournalists).
What is more, bankswerebenefiting from their strongindustrial and
SME customer base.
―Germanbanksfurther improved their resiliencein 2012,‖ Ms
Lautenschlägerexplained, referring to theresultsof the Basel III impact
studypublished sometimeago.
This study looked at how the sampleof bankswouldhave faredif Basel
III had already been fullyphased in asat thecut-off date.
Theimpact studyrevealsthat the capitalshortfall of the eight large
Germanbankshasdecreasedby€15billion, or30%, ascomparedwiththe
last cut-off date.
Another gratifying outcome of thestudyis that, on average, the 33
participatingGerman institutionsalreadymeet the future minimum ratio
of 4.5% for core tier 1capital.
SabineLautenschlägercommented that this trend had continued ―with
thesameintensity‖ in the second half of 2012,withbanks raisingcapital
in thetensof billions.

P a g e | 44
Challengesfacing banksin the future
The ability of banks to carry on generating sufficient income on a higher
cost basewasa key factor in deciding whether their businessmodelswere
sustainableover thelongrun, MsLautenschlägerexplained.
Persistentlylow interestratesand the fierce competition among banks
weredragging on earnings.
―Theweakearningstrend will presenta major challengefor banksand
supervisorsalike,‖ the DeputyPresident added.
Ms Lautenschlägerstruck a positivetone over the scheduledglobal
implementationof BaselIII and said sheexpectedtheother major
financial centresto followsuit.
―Onlythen will Basel III be able to fulfil its protectivefunction and
providea suitableresponsetothe 2008financial crisis.‖
Appropriate supervisionand resolutionmechanismsfor bankswithan
international focusnecessitatedgreater coordination and improved
cooperation.
Specialarrangementsat thenationallevel wouldbeabreedinggroundfor
risksto financial stability, MsLautenschlägerremarked.
Banking union – questions still unanswered
SabineLautenschlägersaid that many questionsstill remained
unanswered over theestablishment of thesingleEuropean supervisory
mechanism.
Most notably, a clear set of rulesgoverning the cooperation between
national supervisorsand theECB wouldhave to be drawnup.

P a g e | 45
Developing a common approach to supervision, building up appropriate
reporting procedures and recruiting staff were tasks that would certainly
keepsupervisorsbusyover thenext few months.
But, MsLautenschläger added, there wasonethingthat supervisors
could not change, that beingthe legal basis.
Alegal framework for bank supervisorsthat allowedmonetary policy to
bestrictlysegregated from supervisory dutieswassomethingthat only
EU governmentsand parliamentscould create.
―This is a processthat will probablytake years. But I believe the effort
will be worthwhile,‖ shetold journalists.
Ms Lautenschlägeralsospokeout in favour of a singleEuropean
resolutionmechanism.
It did not make senseto overseebanksat the European level while
leavingtheir resolution to national authorities.
Asingleresolution mechanism should allowa largebank tobe
restructuredand resolved without seriously jeopardisingfinancial
stability, she added.
At the same time, it had tobe guaranteed that anyresultinglosseswould
befairlydistributedaccordingto sourceand responsibility.
―If investorsreceivea premium for risk, theyshould alsobe prepared to
bear the risk itself.
Taxpayers should be left out of the equation altogether, wherepossible.‖
Legacyrisks should not be redistributed
Legacyrisks– that is, financial risksthat aroseat national banks on the
watchof national supervisors– should, however, be borneby those

P a g e | 46
responsiblefor them and not be mutualised, MsLautenschläger pointed
out.
And there wasalsothe question of whetherthe lossesresultingfrom
futurerisks should beshouldered solely at the European level. After
all, banks‘balancesheetsalsoreflecteda largenumber of national
factorssuch astaxesor economic policymeasures.
―As long aseconomicand fiscalpoliciesare not coordinated, it might
make sensefor liabilityrisksto be divided betweenthe national and
European levels,‖ sheconcluded.

P a g e | 47
Remarks by the Superintendent
Julie Dickson,
Office of the Superintendent of
Financial Institutions Canada (OSFI)
tothe 2013Financial ServicesInvitational Forum, Cambridge, Ontario
Introduction
OSFI recentlyreleaseditsPlan and Prioritiesfor 2013-2016,and tonight I
am goingtohighlight and discussa few of our key prioritiesand whywe
chosethem: specificallyour focuson theincreasedthreat of cyber attacks;
lowinterestrates (includingreal estatelending);and governanceand risk
appetite.
Cyber security
At OSFI, cyber risk hasbecome one of our top concerns.
Agrowingnumber of NorthAmerican bankshavebeen hit withdenial of
serviceattacks,in some casescausing websitesto godown, thereby
creatingproblemsfor customerstrying todo everyday transactions.
Denial of service attacksare costlyto defend against and a form of
harassment and inconvenience.
But more importantly, theycan be a prelude tomore serioustypes of
cyber attacks.
Our concern is growingdue to therapidevolution of cyber attacksin
termsof frequency, firepowerand targets.
This driveshome theneed for all financial institutionsto focuson this
threat.

P a g e | 48
At OSFI, wehavesignificantlyincreased our supervisoryresourcesin the
Op-riskarea, and have launcheda number of initiatives,suchas
conducting in-depthreviewsof institutions‘current cyber protection
practices.
There aremany stakeholdersinvolved in thiseffort and a clear focus on
thisissueby all will serveuswell.
Low interest rates
Whenlowinterest ratesfirstappeared, theimpactwasmostnoticeableon
pension plansand insurancecompanies.
But asustainedlowinterestrateenvironment (especiallycombinedwitha
flat yield curve) affectsthebankingsector aswell.
Banks loseflexibilityto adjustthe customer deposit rate down, hence
introducinga deposit rate floor.
Net interest marginsare squeezed, negativelyaffectingrevenues.
Combined withtepid economicgrowth, reduced demand for loansis
further affectingbanks.
Thisenvironment can provideincentivesfor bankstogrowtheir earnings
asset baseby trying to gain market share(a zero sum game), increasefee
income activities, reduce expenses,enter new markets, and increasethe
proportion of higher-yielding assets(both in the lendingand investment
portfolios).
Productsand businessesthat are over-reliant on lowfinancing coststend
togrow.
And borrowersare strongly incentedto increaseleverage.

P a g e | 49
For all thesereasonswearevery focusedon how banks are reactingto
current conditions.
We are alsocognizant that the longer thelowinterest rate environment
persists,themore interest rate risk can be built up.
No one can predict when, or how fast, rateswill start to climb (or indeed,
whethertheywill fall further).
Yet dependenceon low interestratescan become significant, meaning
that transition to higher ratescould be very painful.
Thereal estatelendingmarket hasbeen a big area of focusfor OSFI,
becauseof thesignificant incentivesfor consumers to borrowand for
banksto maintain revenues, thesize of mortgage lendingportfolios, the
concernsabout some marketsbeingovervalued, and thepossibilitythat
customers‘debt serviceability could be masked bylow interest rates.
Our workhasinvolved major reviewsof bank lendingportfolios, which
wasone factor leadingto the issuanceof GuidelineB-20.
GuidelineB-20includesa set of best practicesfor prudent residential
mortgagelending, in all economic conditions.
Our guideline, aswell asthestepstakenby the Ministerof Financeto
placerestrictionson mortgage insurance, have ledtosome welcome
changesin the market: slowergrowthin household credit, and a more
balancedpicture overall.
Wearewatchingthisveryclosely,and it istooearlytosaywhetherthejob
in this area is done.
One other area where risks can hide isin the modelsthat are used by
some banks to determine the amount of capital they have to hold for
mortgageloans.

P a g e | 50
Accordingly, OSFI hasbeen increasingscrutinyin this area.
Investorsarealsofocusedon this, and a number of them haveasked
questionsabout thecalculationof risk weights,given the limitedamount
of information that the bankspublicly disclosein this regard.
In Canada, the averagemodel risk weightscalculated by banksfor
uninsured mortgagesare in themid-teens.
Thelack of information availableon risk weightsis somethingweare
hopingtoaddress.
There will be enhanced disclosurebydomestic systemicallyimportant
banksin thecoming year, pursuant torecommendationsfrom the
Enhanced DisclosureTaskForce, whichwascreatedat therequestof the
Financial Stability Board.
Someothercountriesareexperiencingfrothyrealestatemarketsandhave
introduced floorson risk weights— sometimesaround 15per cent.
Giventhat inCanadatheuninsuredmortgageswouldtendtobeofhigher
qualitythan the averageloanportfolio in other countries (because
uninsured loansin Canada have maximum loan-to-valueratiosof 80per
cent), weare generallycomfortable withthe capital being held by banks
usingmodels.
OSFI isalsoawarethat floorscan become safeharboursand lead banks
and supervisorstopaylessattention tothe ―appropriate‖ risk weight,
especiallywhenit should be well abovethefloor for a particular bank.
Thus, our focus will continuetobe on scrutinizingmodels currentlyin
use.

P a g e | 51
Risk appetite
OSFI introduced a new corporate governanceguideline in 2012,and in
2013wewill be lookingat how well it isbeingimplemented, witha
particular focuson risk appetite.
It is at timeslike thesewhena regulator getsa good feel for whethera
bank reallyhasa solid risk appetiteframework.
What I mean is that institutionsare being incented to move further along
theriskcurvedue tomore gradual economic growth, and coolingin the
mortgagemarket.
Now iswhenproductscan be developed to appeal toyield-conscious
investors.
Now iswhenconditionsmight alsomaketheenvironment look saferthan
it is — volatilityindicatorshave generallybeen at very lowlevels, similar
tothosejust beforethe 2008financial crisis.
Now iswhenlowinterestratesandthepsychologyaroundthem– i.e. that
thereislittlerisk,alongwiththemisconception that ratescannot goback
up in rapid fashion – can lead both borrowersand lenderstooverlook
certainrisks.
And the relativecurrent calm in Europe — despite the flare-upin Cyprus
in March— can causesome to become complacent about therisks and
thechallengesthat lieahead.
Indeed, prudent global bank supervisors are testing the impact of a rapid
increasein rates(while rates could go down even further, there is not a lot
more room tomove in that direction).
Bank supervisorsare testingtheimpact of a rapid risein rates,not
becausepeople think thiswill happen; rather, it is becauseof the need to
beprepared for all contingencies.

P a g e | 52
Such testing alsoforcessupervisorsto think about the reasonsfor any
such scenarios:
If rates rise as growth resumes, the outcome is usually better than if rates
rise due to a sudden aversion to risk or serious concern about the future –
whichcould be manifestedasan increasein global risk premiums.
An institution‘srisk appetiteframeworkshould enableitsboard and
management todetermine just howmuch risk an institutioniswillingto
tolerate— not only in termsof thebusinesstheyput on their books, but
alsoin termsof their tolerancefor gettingcloseto any regulatory
requirementsor limits,and even their tolerance for behavioursthat can
lead to big losses,such asill-equippedriskmanagement groupsand
failure to imposean effective―three linesof defense‖ model.
In the ―three linesof defensemodel management is the first lineof
defense,the variouscontrolsand oversight functions(such asrisk
management) are thesecond lineof defense,and internal audit isthe
third lineof defense.
Thenatural geneticsof a bank are sometimestogive the businesslines
considerable leewayand tosee risk management and internal audit as
standingin the wayof progress.
This ―wiringreflectsthe fact that the businessiswherethemoney is
made– at least in theshort term.
Abank cannot consistentlymake money without regard for sound risk
management.
So, structuresand processesneed to be built asa counterbalance,and to
reinforcea broader and longer perspective.
Riskappetitestatementsare part of the new suite of toolstoaid in
ensuring that the bank management and theboardhave a 100per cent

P a g e | 53
agreement on the balanceof power in the institutionand theoverall risk
stance.
Riskappetitestatementswill be particularlypowerful in the future as
banksexperienceunexpectedlossesand surprises.
Thetool should help ensure that management isheld accountableand
that boardshaveplayed their rolein havingset out clear expectationsand
accountabilities.
Conclusion
OSFI‘splanandprioritiesattempt toconveythemostimportant issuesas
weseethem, and indicatewheresignificant time will be spent by bank
supervisors.
Theeffectsof low interest rateshave set in motion sector-shapingforces
towhichwemust pay attention.
Cyber risk isanotherissue: Left unchecked, it could seriouslyimpact
bankingoperations.
Effectivegovernanceand risk appetitestatementswill help banks
determineacceptableand unacceptablerisk exposuresand to build
systemsand processestokeep them on track, sothat Canadianscan
continueto enjoy a safeand sound financial system.
Thank you.

P a g e | 54
Dear Member,
Lifeis becoming more complex for risk managers.We must have a
―forward-lookingperspective‖, remember?
We have all thesenew lawsand regulations…
… but wealsohave rules, proposalsand reportstoconsider.
Have you everdiscoveredthecommon elementsof thevariousinitiatives,
includingthe Volcker rule in the United States,the proposalsof the
Vickers Commission for the United Kingdom, the LiikanenReport tothe
European Commission?
LeonardoGambacorta andAdrian van Rixtel from the Monetaryand
EconomicDepartment of the BISwill help ustoday to seethecommon
elementsand the differences!
This is a great analysis! We read:
TheVolcker rule isnarrow in scope but otherwisequitestrict.
It is narrow in that it seekstocarve out onlyproprietarytrading while
allowingmarket-makingactivitieson behalf of customers.
Moreover,it hasseveralexemptions, includingfortransactionsinspecific
instruments,such asUS Treasuryand agencysecurities.
It is strict in that it forbids the coexistenceof such tradingactivitiesand
other banking activitiesin different subsidiarieswithin thesame group.
It similarlypreventsinvestmentsin, and sponsorship of, entitiesthat
could expose institutionsto equivalent risks,such ashedge fundsand
privateequityfunds.
That said, it imposesvery few additionalrestrictionson thetransactions
of banking organisationswith other financial firmsmore generally(eg
such asthrough constraintson lendingor funding among them).

P a g e | 55
BiiiCPA)
However,it is worthrememberingthat the current US legislationdoes
constrain theactivitiesof depositoryinstitutions.
TheLiikanenReport proposalsaresomewhat broader in scope but less
strict.
Theyare broader becausetheyseek to carve out both proprietarytrading
and market-making, without drawinga distinctionbetweenthe two.
Theyare lessstrict becausetheyallowtheseactivitiestocoexist with
otherbankingbusinesswithinthesamegroup aslongasthesearecarried
out in separate subsidiaries.
Theproposalslimit contagion withinthegroup by requiring, in
particular, that the subsidiaries be self-sufficient in termsof capital and
liquidityand that transactionsbetweenthe legal entitiestakeplace on
market terms.
Just like theVolcker rule, theproposalsdonot envisagesignificant
restrictionsbetweentheprotected bankingunit and other financial
firms, except that theyrequire the separation of exposuresto entitiessuch
ashedge fundsand special investment vehicles(SIVs) in the trading
entity.
TheVickersCommission proposalsare evenbroader in scope but have a
more articulatedapproachtostrictness.
BIS Working Papers, No 412
Structural bank regulation initiatives:
approachesand implications
LeonardoGambacorta andAdrian van
Rixtel, Monetaryand Economic Department
Basel iii ComplianceProfessionalsAssociation (

P a g e | 56
Introduction
In responseto the global financial crisis, several advanced economies
haveeither adopted or are consideringstructural bank regulation
measures.
Thecommon element of the variousinitiatives,includingthe ―Volcker
rule‖ in theUnitedStates, the proposalsof the VickersCommission for
theUnited Kingdom, the Liikanen Report totheEuropean Commission
anddraft legislationin Franceand Germany, isamandatoryseparationof
commercial bankingfrom certain securitiesmarketsactivities.
Theproposalsmark a paradigm shift.
Sincethe 1970s,in parallelwiththe deregulationof financial markets,
restrictionson banks‘businesslineshave been relaxed.
There wasa broad consensusthat bankswhichoffer a full rangeof
financial servicescan providethe largest economicbenefitsin a rapidly
growingglobal economy.
Diversificationof businesslines,innovationsinriskmanagement, market
based pricing of risksand market disciplinewereseen aseffective
safeguardsagainst financial risksassociatedwith therapid expansion of
largeuniversal banks.
The financial crisis has triggered a reassessment of the economic costs
and benefits of universal banks‘ involvement in proprietary trading and
other securitiesmarketsactivities.
With hindsight, manylargeuniversal banksshiftedtoomanyresourcesto
tradingbooks, supportedby cheap funding.
Thecomplexityof many banks weakenedmarket discipline, whiletheir
interconnectednessincreasedsystemic risk, contributingto contagion
withinand acrossfirms.

P a g e | 57
While thecrisishasshowntheneed to strengthenmarket-basedpricing of
riskandmarketdiscipline,theheavyburdenofbank lossesimposedon
taxpayers hasraised questionsabout theseparationof certain banking
activities.
Theproposedchangesdonot goasfar asthepreviousstrict separationof
commercial from investment banking that existed in some jurisdictions,
such asthe United States.
But for many countries, notablya number of continental European ones,
restrictionson universalbanking wouldbe new.
Anumber of questionsarise.
How effectivecan thesemeasuresbe in improving financial system
soundness?
What can their impact be on banks‘profitabilityand businessmodels,
both nationallyand internationally?
This paper explorestheseissues.
Section 2considersin more detail the rationalebehind themeasuresas
well astheir similaritiesand differences.
Section 3 providesa basisfor evaluatingtheir effectivenessin promoting
financial stability.
Section 4 discussestheir implicationsfor banks‘businessmodels and
profitability.
Thelast sectionconcludes.

P a g e | 58
2. The initiatives: basic rationale and features
Thebasic rationalefor thestructural measuresis toinsulate certain types
of financial activitiesregarded asespeciallyimportant for thereal
economy,or significant on consumer/depositorprotectiongrounds,from
therisksthat emanate from potentiallyriskier but lessimportant
activities.
The line is generally drawn somewhere between ―commercial‖ and
―investment‖ banking businesses, restricting the universal banking
model.
Such a separation can, in principle, help in several ways.
First, and mostdirectly, it can shield the institutionscarrying out the
protected activitiesfrom lossesincurredelsewhere.
Second, it can prevent any subsidiesthat support the protectedactivities
(egcentral bank lendingfacilitiesand deposit guarantee schemes) from
loweringthecost of risk-takingand encouraging moral hazard in other
businesslines.
Third, it can reducethe complexityand possiblysize of banking
organisations,making them easier tomanage, more transparent to
outsidestakeholdersand easier toresolve; this in turn could improve risk
management, contain moral hazard and strengthenmarket discipline.
Fourth, it can prevent the aggressive risk culture of the riskier activities
from infecting that of more traditional banking business, thus reducing
thescope for conflictsof interest.
In addition, some observershave noted that smallerinstitutionswould
reducethe risk of regulatory capture.
All thesemechanismswouldalsohelp tolimit taxpayers‘exposure to
financial sector losses.

P a g e | 59
Beyond this basic similarity, structural reform initiatives differ in scope
(where they draw the separation line) and strictness (how thick that line
is);
TheVolcker rule isnarrow in scope but otherwisequitestrict.
It is narrow in that it seekstocarve out onlyproprietarytrading while
allowingmarket-makingactivitieson behalf of customers.
Moreover,it hasseveralexemptions, includingfortransactionsinspecific
instruments,such asUS Treasuryand agencysecurities.
It is strict in that it forbids the coexistenceof such trading activitiesand
other banking activitiesin different subsidiarieswithin thesame group.
It similarlypreventsinvestmentsin, and sponsorship of, entitiesthat
could expose institutionsto equivalent risks,such ashedgefundsand
privateequityfunds.
That said, it imposesvery few additionalrestrictionson thetransactions
of banking organisationswith other financial firmsmore generally(eg
such asthrough constraintson lendingor funding among them).
However,it is worthrememberingthat the current US legislationdoes
constrain theactivitiesof depositoryinstitutions.
TheLiikanenReport proposalsaresomewhat broader in scope but less
strict.
Theyare broader becausetheyseek to carve out both proprietarytrading
and market-making, without drawinga distinctionbetweenthe two.
Theyare lessstrict becausetheyallowtheseactivitiestocoexist with
otherbankingbusinesswithinthesamegroup aslongasthesearecarried
out in separate subsidiaries.

P a g e | 60
Theproposalslimit contagion withinthegroup by requiring, in
particular, that the subsidiaries be self-sufficient in termsof capital and
liquidityand that transactionsbetweenthe legal entitiestakeplace on
market terms.
Just like theVolcker rule, theproposalsdo not envisagesignificant
restrictionsbetweentheprotected bankingunit and other financial firms,
except that theyrequire the separation of exposuresto entitiessuchas
hedgefundsand special investment vehicles(SIVs) in thetradingentity.
TheVickersCommission proposalsare evenbroader in scope but have a
more articulatedapproachtostrictness.
Theyare broader in that theyexcludea larger set of banking business
from theprotectedentity, includingalsosecuritiesunderwritingand
secondarymarket purchasesof loansand other financial instruments.
Avery narrow set of retail banking businessmust be withintheprotected
entity(retail deposit-taking, overdraftstoindividualsand loanstosmall
and medium-sizedenterprises(SMEs));and another set may be
conductedwithin it (egsomeother formsof retail andcorporate banking,
includingancillaryoperationsto hedgerisks tosupport them).
Theapproach to strictnessismore articulatedbecauseit involvesboth
intragroup and inter-firm restrictions(the―ring fence‖).
As in the LiikanenReport, protected activitiescan coexistwithothersin
separatesubsidiarieswithinthe same group but subject tointragroup
constraintsthat aresomewhat tighter, includingon the size of the
linkages.
Moreover,a seriesof restrictionslimit the extent to whichthe banking
unit within the ring fencecan interact with other financial sector firms.
An in-depthexploration of theeconomicunderpinningsof the
reforms is provided in Vickers(2012).

P a g e | 61
Recent French and German reform proposalscan be seen asadaptations
of the Liikanenproposal.
Thenew Frenchbankinglaw proposal adoptsthesubsidiarisation
model, but allowsthedeposit-takinginstitutionto carry out more
activities, includingmarket-makingwithin limits.
Anew draft law on the separation of retail and some investment banking
activitiessubmittedtothe German Parliament considersseparationof
retail banking if assetsdevoted to proprietary or high frequencytrading
and hedgefund financingoperationsare relatively largein relationtothe
banks‘balancesheet.
3. Implications for financial stability and systemic risk
Dothevariousstructural regulatoryinitiativesstrengthen financial
stability?

P a g e | 62
Themechanismslistedabove have intuitiveappeal.
The question, though, is how far the various measures would be effective
in realising the hoped-for benefitsand whether theymay have unintended
sideeffects.
While it is difficult toprovidean answer,it is possibletolayout the
relevant considerations.
From a financial stability perspective, a preconditionfor theinitiativesto
be helpful is that banks whichcombinecommercial and securities
businessarelesssafeorthat their failureismorecostlytothecommunity.
Theevidencesuggeststhat the costsof failure of universal bankscan be
larger, sinceuniversal banking encouragessizeand complexity.
Theevidenceon theprobabilityof failureis much more indirect and
mixedbut, on balance, pointsin a similar direction.
For instance, a general conclusion is that growingrelianceon
non-interestincome – a very rough proxy for more investment
banking-like activities– hasnot resulted in lowerearningsvolatilityor a
declinein bank systematic risk, asderived from stock market returns.
Similarly, Box 1providestentativeevidencethatprofitsofsomewhatmore
diversified banksarehigher, but alsomore volatile.
Moreover, risk diversification benefits appear to be mostly restricted to
certain ranges of income sources or to geographical and loan portfolio
diversification.
Against thisbackdrop, a number of questions about thedesign of
structural regulationarise.
Afirst question concernswheretheseparation lineisdrawn.

P a g e | 63
Here, the philosophybehind theproposalsis quitedifferent.
TheLiikanenReport optsfor combining proprietarytradingand
market-making activities on the grounds that the line between the two is
too fuzzy and hard to enforce – a controversial issue with the Volcker rule
in theUnited States.
And the VickersReport takesa verynarrow view of the typesof activity
that needtobeprotectedonthegroundsthat disruptionstherecanhavea
largeimpact on economic activity.
Moreover,while theVickers Report arguesfor more stringent capital
requirementsfor theprotected activities,on importancegrounds, the
LiikanenReport arguesfor potentiallymorestringent onesforthetrading
business(and possiblyfor real-estaterelated lending), on risk grounds.
It is not unequivocallyclearthat the concentrationof tradingactivities in
separateentitieswill enhancefinancial stability.
Thesefirmsmay have lessstable, wholesalemarket-basedfunding
structures,while still beinghighly interconnectedwithother parts of the
global financial system.
This could give rise toconsiderablecontagion risk, asdemonstrated by
therepercussionsof the failure of Lehman Brothers on global bank
fundingmarkets.
Asecond question concernsthethicknessof the line.
How effectiveisit in insulatingthe protected partsof the banking
business?
Onetypical criticism of allowingthe activitiesto coexist within the same
group is that, especiallyat timesof stress,the linewill provenot
sufficientlystrong asreputational considerationsloom large.

P a g e | 64
In turn, any expectation that the linewill turn out tobe ineffectivewould
weakenmarket discipline.
Moreover,onlythe Vickers Report proposesmajor additional restrictions
on theinteractionsbetweenthe protectedbanking unitsand the rest of
thefinancial system.
Their effectivenessisyet tobe tested.
Athird questionconcernsthe possibilityof sidesteppingtheline
altogether.
Theworryis that risky activitiescould migrate outsidethe regulatory
perimeter.
In fact, one reason whythe LiikanenReport optsfor subsidiarisation
rather than full separationis tolimit thisrisk.
Migrationwouldbe a worryif thoseactivitiesproved to be systemic in
nature.
All thisputsa premium on effectiveresolutionmechanisms.
Whilestructural separation may help resolvability, the benefitsof the
proposalsdohingeon the adequacyof the resolutionschemesin place.
TheLiikanenReport, for instance, suggestsseveral complementarysteps
in this area.
Effectiveresolution schemesare especiallyimportant if, contrary to
expectations,the businesslinesleft outsidethe protectiveumbrellaresult
in systemic disruptions.
In this case, the pressure to ―bail out‖ the legal entities involved could be
very strong: this would put taxpayers‘money on the line ex post and raise
moral hazard concernsex ante.

P a g e | 65
Yet anotherquestionconcernstheinteractionbetweennationalstructural
bank regulation and international bankingregulation, such asBasel III.
Thetwotypes of regulation differ in approach and scope.
Thelattertakesbanks‘businessmodelsasgivenand imposescapital and
liquidityrequirementsthat depend on theriskiness of a bankinggroup‘s
business.
Theformer imposesconstraintson specific activities and typesof
business.
From this angle, the two approachescan be seen ascomplementary.
Indeed, certain aspectsof structural regulation– restrictionson leverage
for ring-fenced institutions– may reinforceelementsof Basel III.
At the same time, there may be challenges.
Onerisk, already alluded to, is that banksmay shift activitiesoutsidethe
perimeter of consolidated regulation in responseto structural regulation.
Another riskisthatstructuralregulation, especiallyif nationalapproaches
differ, will createbusinessmodels that are difficult to supervise.
For example, resolution strategiesmay berather complextodesign for
globallyoperatingbanksthat have tofaceincreasingheterogeneity in
permittedbusinessmodelsat thenational level.
Finally, structural regulation may lead to different capital and liquidity
requirementsfor thecore banking and tradingentitieswithin a single
bankinggroup.
Although thismay be intended, in practiceit hasimplicationsfor
regulatorystandardsapplied at the consolidatedlevel.

P a g e | 66
Somenew evidence on risk diversification and economies of
scope
This box presentssome new preliminaryevidenceon the impact of
combining different businesslineson therisk return profile of banking
organisations.
Anovel aspect is that the analysis allowsfor thepossibilityof non-linear
effects,sothat the benefitsmay exist only withincertain ranges.
Theevidenceis basedon a sample of 108 international diversifiedbanks.
Product differentiationis proxied by theratio of non-interest income
(traderevenues, feesand commissionsfor services) to total income.
On balance, theevidenceindicatesthat benefitsdoaccrueup to a certain
degreeof diversificationin termsof return on equity(ROE).
However,bank profitabilitytendstobe more volatile for more diversified
banks(for details of the econometric analysis, seeAnnex B).
The twolinesin the upper part of the graph below represent the result of a
panel regression of bank ROE on the ratio of non-interest to total income
(diversificationratio) and itssquare.
Theregressionincludesfixed effectsfor each bank, aswell asa country
year interactionterm tocontrol for idiosyncratic and macro factors.
Thecurvesare drawnon thebasis of thetwoestimatedparameters.
Bluereferstothepre-crisisperiod (2000–07),whileredindicatesthecrisis
period (2008–11).
Thesymbolsindicateaveragevaluesobtainedby grouping banksby
jurisdictionin the twosub-periods.

P a g e | 67
Theresultsindicatethat revenue diversificationdoesincreaseROE, but
onlyup toa point, after whichROE declines.
While the optimal mix may have shiftedsomewhat towardsa smaller
shareof non-interest income in the post-crisisperiod, the resultsof this
exercisesuggest that economies of scope do exist onlyup toa certain
degreeof product diversification.
Thegreenlinein thelowerpanel representstheresult of across-sectional
regressionof banks‘coefficientsof variation of ROE – a proxy for risk –
on thediversificationratio, itssquare and country fixed effects.
Thegreen symbolsindicateaveragevaluesobtained by groupingbanks
byjurisdictionover the period2000–11.
Theeconometric analysisfindsthat ROE volatilityalsoincreases,up toa
point, with revenue diversification, after whichit declinesagain

P a g e | 68
Toread this excellent paper:
http:/ / www.bis.org/ publ/ work412.pdf

P a g e | 69
Challengesfor banking
regulation and supervision in
the monetary union
Speechby Dr JensWeidmann,
President of the Deutsche
Bundesbank, at theDeutscher
Sparkassentag2013,Dresden.
1. Introduction
Mr Fahrenschon, Mr Genscher, Mr Steinbrück, Ladies and Gentlemen
It givesme great pleasuretospeak toyou today at the Sparkassentag
2013.
For more than three years now,the financial, economic and sovereign
debt crisishasbeen thedominant topic in the European monetary union
and, at thesame time, itsbiggest test.
Dated from the outbreak of the crisison the US real estatemarket in the
summer of 2007, this is already thefifth year in whichwehave been in
crisismode.
That said, Germanyis still in relatively good shape – despiteundergoing
byfar itsworstpostwarslump in 2009and despitebeing one of thefirst
countriestobe affectedby the spillover from thecrisis on theUS real
estatemarket.
Germanyhashad to useconsiderable financial resourcestostabilisethe
financial system.
Savingsbanks,too, felt the effectsof thecrisis– although theydid so
directlyonly in a few cases;mostly it wasthrough their investments.

P a g e | 70
Even so, savingsbanks had a stabilisingeffect during the crisis.
Theywerea robust and reliablesource of lending.
And theystrengthenedtheir capital base.
That is a major preconditionfor overcoming the challengesthat areon
thehorizon – such assustained pressure on marginsand increased risk
provisioningfor thenext economicdownturn, whichis bound to come at
sometime.
Thevariousaspectsof the crisis– first, onlya financial crisis, then an
economiccrisisand, finally, the sovereign debt crisis– whichis still with
us– have prompted a largenumber of discussions,changesand
upheavals.
This appliesto the role of central banksand tothe expectationof what
central bankscan and should– or cannot and should not – doto help
resolve the crisis.
It alsoapplies tothefinancial system and thewayit is perceivedby the
public at large.
Mr Steinbrück will undoubtedlyexplainin more detail soon how he
wishesto―tamethefinancial markets‖.
Overcomingthe crisisrequires considerableeffortsin many areas.
But, asimportant asthe issuesof government debt, monetary policy and
competitivenessare, I wouldnow like toturn my attention tobanking
regulation and supervision.
2. Reform of financial market regulation – objectives and
measures

P a g e | 71
Roughlyten yearsago, theprincipal issuein banking regulationwas
Basel II and the regulatorychangesit brought about.
At thetime, onlyveryfewofthoseinvolvedcouldhaveguessedthat,justa
short while later, thepolitical agendawouldbe dominated byprobablythe
most all-encompassingchangesever tothe regulatoryframework of the
financial marketsin theshape of Basel III and further regulatory
initiatives– and all starting off with an awe-inspiringzeal for reform.
BaselII took five years from thefirst consultation paper up to apolicy
agreement on thenewprinciples.
Basel III onlyneeded oneyear for that.
Thenew regulatorymeasures,whicharedesigned to havea longer-term
impact, are focused lesson the acutemanagement of the crisis and are
geared more to preventingnew crisesfrom emerging in the future in the
first place.
The changesinitiated since the G20 meeting in Washington in November
2008, have the key objective of making financial systems more stable and
thereforemore resistant toshocks.
Furthermore, the aim is that the taxpayer nolonger hasto step in to
correctdifficultiesin the financial system.
And it wasalsoimperativeto ensure that the financial system hasa clear
valueadded for theeconomy asa whole.
There is good empirical evidencethat growthin the financial sectoralso
strengthensa country‘soverall economicgrowth.
On the other hand, studiesby the IMF indicatethat, along with
increasingfinancial sector growth, thiseffect becomesweaker and might
even gointoreverse.

P a g e | 72
It is not necessary to agree with Paul Volcker‘s deliberately provocatively
worded opinion that there hasn‘t been a useful innovation in the financial
industry since the invention of the ATM, and derivativesdo not have to be
regarded asfinancial weaponsof massdestruction.
Nevertheless, if the financial sector is too large, there is evidently an
increase in the risks to stability and the percentage of less beneficial
transactions.
Cyprus is undoubtedly a telling example and provides an urgent warning
that the supervisory and regulatory requirements have to keep pace with
thesize of thefinancial system relativetoeconomicpower.
Astableand efficient financial system that enhancesgrowthand
prosperitycan be achieved onlywitha wholepackageof measures.
With this in mind, theG20, at their meetingin Washington at the end of
2008,defined variousfields in whichtherewasa particular need for
action.
Let me outlinea few major points.
•Risksand mutual interdependencies in the financial system have tobe
more transparent.
•Banksshouldhold more and higher-qualitycapital soasto better
shoulder lossesthemselves.
•Systemicallyimportant financial institutions– the hubsof thefinancial
system – must meet special, stricter requirements,for example, with
regard to capital adequacyand risk management.
•In the event of difficulties,it must alsobe possibleto resolve or
restructure large, international and particularlyinterconnectedbanks.

P a g e | 73
•Areasof thefinancialsystem whichhavehithertobeensubjecttono– or
very little– regulation, but which perform taskssimilar tothoseof banks
and are linked directlyor indirectlytothebanking system, should be
better regulated – theshadow banking system and derivativestradingare
key issueshere.
At this point, I wouldlike to refer toa fundamental point that is
particularlyimportant tome.
Theconnectinglink betweenthestated aims and the meansof achieving
them is a strengtheningof the principleof liability.
In hisPrinciplesof EconomicPolicy, Walter Eucken declaredthe
principleof liability tobe a constituent principleof the market economy,
referringto theestablishedlegal principlethat ―thosewhobenefit should
alsobear thecosts‖.
Ensuring that playersin the financial system have to, and areable to,
better bear lossesand risksthemselves in future will make thefinancial
system more stableand more focused on transactionsthat are beneficial
tothe economy asa wholeand make thetaxpayer the last rather thanthe
first lineof defenceagain in the event of crises.
Liabilityis thereforea steptowardsovercoming thecrisis and not a
negative concept – quitethe opposite!
It isthecounterpart ofthefreedomtotakedecisionsasanentrepreneuror
investorin a self-determined manner.
Freedom of choiceand liabilitythereforebelong together asa conceptual
pair or twosidesof the same coin.
That appliesincidentallyto the financial system just like it doestothe
member stateswithinthe monetary union.

P a g e | 74
Someof the measurestaken during the crisisunderminetheprincipleof
liability rather than strengtheningit.
It is against that background that weshould alsoassessthenewly
resurfaced debatein Europeon theright coursein fiscal policy.
Of course,a major roleis played by thepoliticalacceptabilityof the
reform coursethat hasbeen embarked on.
At least withregardtotheprogrammecountries,however,moretime also
meansgreater recourseto European solidarity: more fundsare needed
from therescuepackageor maybe eventransfersthat havetobeaccepted
politicallyby the ―donor countries‖.
The non-programme countries, in turn, should not repeat the mistakes of
2004 and not interpret the strengthened Stability Pact too flexibly when it
is first put to thetest.
France, in particular, has an important role in setting an example in terms
of the credibility of the rules and confidence in the sustainability of public
finances.
But back to regulation.
At times, concernsare raisedor thecriticism is made that the
implementationof thesenoble intentionsis not making much headway
andthat enthusiasm for reform haswanedsignificantly.
I can quiteunderstand a certain amount of impatience.
For example, withregard to the shadowbankingsystem, an total
integratedpackagewithrecommendationsonregulationwillnotbeready
until September and it will be even longer beforeconcretedecisionshave
been made and enshrined in law.

P a g e | 75
Thereform objectiveof clearingall standardised OTC derivativesthrough
central counterpartiesand recordingthem by theend of 2012hasnot been
achieved.
There arestill several stickingpoints– startingwitha lack of standards
and ranging asfar asdata protectionproblems, and, in particular, the
impassein negotiationsoncross-bordercoordinationbetweentheUnited
Statesand Europe.
Progresshasalsobeen mixed on the―toobig to fail‖ issue– more
specificallytheimplementation of internationallyagreed standardsfor
resolution regimes.
Here wehavetocontend with acertain tendencytowardnational
protection and the fragmentation of the financial markets.
Otherwisethere isthe threat of competitive distortionsand new risksto
stability.
Just recently, Börsenzeitunggavea categoricaland lucid warningagainst
a new nationalismon thepart of the supervisors.
TheUS proposalson regulatingthecapital and liquidityof foreign
institutionsare a prime negative exampleof this.
Agreat deal thereforestill needstobe done and wehave to maintain
politicalinterest in a stablefinancial system.
Regulation is not an end in itself, however.
Thecostsand benefitsof theplannedmeasures,includingtheir
side-effectsand interactions,have tobe weighedup against one another.
This type of analysis is time-consuming and input-intensive, especially
since the particular given country-specific aspects also have to be taken
intoconsideration whenthemeasuresare actuallyimplemented.

P a g e | 76
And many of theimplicationsare not immediatelyobvious,but still have
thepotential tobe highlycharged.
Oneexampleof thisis theplanned financial transactiontax and its
implicationsfor monetary policy.
While a fundamental consensushasbeen achieved on theintroduction of
thetax, theunintendedside-effectsmight be considerable.
In its currentlyenvisaged form, thetax wouldalsocover collateralised
moneymarket transactions,knownasrepotransactions,andwouldcause
considerable harm tothe repomarket.
Therepomarket playsa key role in the redistributionof liquidityamong
commercial banks,however.
If the market isnot ableto function properly, therelevant transactions
will be shifted to the Eurosystem and central banks will remain heavily
involved in the redistributionof liquidityamongbankslongafter the
crisis isover.
From a monetary policystandpoint, therefore, a very critical view hasto
betakenofthefinancialtransactiontaxinitscurrent form, andthisshows
how important it is toscrutinize regulatory measuresbeforetheyare
introduced.
But, again, that takestime.
However, this does not mean that regulatory reform has been a complete
failure, because a whole seriesof measures is now in place with which the
principleof liability is being strengthened.
Let me justmention the exampleof stricter capital requirementsin the
form of Basel II.5and BaselIII.

P a g e | 77
At the end of February thisyear, political agreement wasreachedin the
European Union concerningtheimplementationof Basel III throughthe
Capital RequirementsDirective IV and the Capital Requirements
Regulation.
TheEuropean Parliament alsogave thedraft legislationitsseal of
approval just last week.
It may seem ambitious,but implementationof Basel III will thereforebe
possiblein Europe from the beginningof 2014.
Basel III will take full effect in 2019.
Banks are using theinterim period to raisetheir capital to therequired
level.
In thecaseof credit growth, however,thereis theopposite fear is that the
reforms are proving too successful.
Deleveragingisstill urgentlyrequired to overcome the crisis.
However,thisdeleveragingprocessisalsoacontributoryfactorinthelow
growth ratesfor lendingin some European countries.
Developmentsin lendingthereforereflect a necessary correction and are
not in themselvesan indication of theneed for further economicpolicy
action.
Incidentally, thecost-benefit analysesconductedbeforethe adoption of
Basel III show that these measureswill, at most, have a very limited
impact in termsof dampeningeconomicgrowth.
Sadly, however, there are still those in the banking industry – especially in
the United States, but also in Europe – who are campaigning against the
introduction of higher capital requirements.

Basel 3 May 2013

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Basel 3 May 2013