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CHASE COOPER
Basel to price out CDSs?
The BCBS released a consultative paper in
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Regulatory capital - solution or problem?
In the same week that UK banks were asked to find an extra £60 billion of regulatory
March, "Recognizing the cost of credit capital, a report published by the Institute of Economic Affairs (IEA) has questioned
protection purchased" targeting the usage the central tenet of the Basel Capital Accord and suggested that the banks
of the banks purchasing of credit default themselves should be allowed to decide how much capital they need to hold.
swaps from each other as a way of The IEA's objective is the promotion of free markets and their impact on social and
reducing credit-based regulatory capital economic problems. It is a fairly opaque organisation that does not declare its
requirements, and funding sources although it claims to receive none
proposing that any from governments. Andrew Marr, the political
premium for such a journalist, called the Institute "undoubtedly the
transaction carry a most influential think tank in modern British
heavy risk weighting of history".
1,250%. The IEA's report, "Do we need regulation of bank
In December 2011, the capital?" (PDF), says that regulatory capital
BCBS voiced concern requirements simply encourage banks to adopt
regarding this practice opaque capital solutions which reinforce the "too
(BCBS Newsletter big to fail" conundrum. It recommends that capital
obligations set by
No.16) observing
regulators should be
potential for regulatory IN THIS ISSUE OF metric
dropped, that banks
arbitrage through the ● The FSA becomes history
should decide on how
use of credit risk ● LIBOR banks sued
much capital they need,
mitigation instruments. ● JPMOrgan loss report
and that attention should concentrate on making it easier
Instruments that facilitated a delay in ● Swaps swamp US regulator
for banks to fail in such a way as so not to endanger the
recognising losses and the costs of ● Regulatory News
markets or depositors.
protection in earnings, while receiving
The authors, Professors Forrest Capie of CASS and
immediate regulatory capital benefit in
Geoffrey Wood of the University of Buckingham, agree that banks need to keep both
the form of a lower risk weight on the
capital and liquidity against unforeseen events, and that past crises have driven them
exposure on which it is nominally
to hold what they believe are amounts that balance the need to avoid risks (and
transferring risk.
attract depositors) against the requirements of shareholders that they make a
The BCBS questioned the degree of credit sufficient return on capital.
risk mitigation or credit risk transfer in
What disrupted a working situation was the expectation that the state would step in
these high-cost credit protection
to save an insolvent bank. This situation has led governments to try to protect
transactions and observed that the themselves against this expense hence their demanding ever higher levels of
primary reason for these was to receive capital.
favourable risk-based capital treatment in
The authors state that the principle of many of the reforms to banking
the short term and defer recognition of
law and regulation currently being proposed or implemented is
losses over an extended period, without
19
ISSUE
correct, i.e. the Vickers and Volcker separation of investment
any meaningful risk mitigation or transfer
banking from the traditional roles of borrowing and lending.
of risk.
continued on page 2 continued on page 2

2. LIBOR banks sued by Freddie Mac Regulatory capital - solution or problem? Continued from page 1
15 banks have been named in a law That principle, which should be at the heart of regulatory
suit being taken out by the US Federal reform, is that banks should be wound up in an orderly way if
Home Loan Mortgage Corporation, they fail.
commonly known as Freddie Mac,
Simultaneously with this report, two relevant happenings both
that it suffered substantial damage
sides of the Atlantic are serving to bring the above principles into
due to the banks illegally fixing the
focus. Firstly the Bank of England's Financial Policy Committee
LIBOR US dollar rates.
has said it is concerned that the capital held by Britain's major
Lawyers for Freddie Mac accuse the banks of acting collectively to banks, all probably too big to fail, are insufficient and that they
hold down the rates to "hide their institutions' financial problems are expecting these to raise a further £60 billion in capital.
and boost their profits" and that the banks' "fraudulent and
The second has been the ongoing debate in the US's Capitol Hill
collusive conduct caused USD LIBOR to be published at rates that
that not only are the top four US banks, holding over 70% of the
were false, dishonest, and artificially low."
nation's deposits, too big to fail, and getting bigger, but that
The law suit was filed at a Federal court in Virginia, USA and their executives are "too big to jail".
names the British Bankers Association, who managed the setting
The US Attorney General, Eric Holder, has been quoted as saying
of the rates, as well as major financial institutions such as Barclays,
"I am concerned that the size of some of these institutions
JP Morgan Chase, USB, Royal Bank of Scotland, Royal Bank of
becomes so large that it does become difficult for us to
Canada, Deutsche Bank, Credit Suisse, Citigroup, Bank of America,
prosecute them when we are hit with indications that if you do
and Japanese banks Tokyo-Mitsubishi UFJ and Norinchukin.
prosecute, if you do bring a criminal charge, it will have a
The defendants are accused of fraud, antitrust violation and breach negative impact on the national economy, perhaps even the
of contract. Freddie Mac is seeking damages for financial harm, as world economy".
well as punitive damages and treble damages for violations of the
There have been other cries in the US that the big banks are
Sherman Antitrust Act, an act dating from 1890 designed to protect
either ignoring or circumventing regulations such as the Volcker
consumers and commonly used in cases involving monopolies or
Act designed to halt risky proprietary trading, as well as concern
cartels. Freddie Mac says "To the extent that defendants used false
in Europe that the "electrified fences" being proposed as an
and dishonest USD LIBOR submissions to bolster their respective
alternative to breaking up the big banks are simply not working.
reputations, they artificially increased their ability to charge higher
It looks like the break-up of the big banks is inevitable (but what
underwriting fees and obtain higher offering prices for financial
products to the detriment of Freddie Mac and other consumers". of the Chinese banks?) and bankers had better starting planning
how they will do this. m
Last year an audit report said that Freddie Mac and its sister
organisation Fannie Mae, the Federal National Mortgage Basel to price out CDSs? Continued from page 1
Association, could have lost up to $3 billion in excessive payments
In January of 2011, the US Fed had come out heavily against this
on their floating rate instruments such as bonds and swaps.
practice and had advised all the local US Fed's supervisory staff to
So far Barclays, UBS and RBS have admitted LIBOR manipulation to take high-cost credit protection transactions into account in their
the regulators and have been fined. Another dozen banks are assessment of a banking organization's overall capital adequacy. In
believed to be under investigation. Being fined by the regulator particular they were to:
does not preclude being sued by clients, and the Freddie Mac case
Ÿ Compare the present value of premiums relative to
is just one of a number currently going through the US courts.
expected losses over a variety of stress scenarios, as well 2
However last week a consolidated law suit against 16 LIBOR-
as the pricing of the transaction relative to market prices;
accused banks was dismissed in part by a Manhatten judge who
dismissed antitrust and racketeering charges and partially Ÿ Look at the timing of payments under the transaction, including
dismissed those of commodities manipulation. The defendants, a potential timing differences between the banking organization's
consortium ranging from bond holders to US city governments, provisioning or write downs and payments by the counterparty,
are expected to appeal. m and review of applicable call dates to assess the likely duration
of the credit protection relative to the potential timing of future
The FSA becomes history credit losses;
On the 1st April ex-Prime Minister Gordon Brown's vision of a unified Ÿ Analyse the impact of reliance on the counterparty at the same
financial regulator will become a footnote in the history of the City of time that the counterparty's ability to meet its obligations is
London and will be replaced by a twin-track system of regulation. The weakened, and also whether the organisation can prudently
Prudential Regulation Authority, incorporated as part of the Bank of afford the transaction premiums;
England, becomes responsible for the prudential regulation and
supervision of approximately 1,700 banks, building societies, credit Ÿ Review all memos and records to check the reason for the
unions, insurers and major investment firms. The independent transaction and its anticipated costs and benefits.
Financial Conduct Authority will have rule-making, investigative and The new BCBS proposal is that banks can continue to use these
enforcement powers with the aim of protecting consumers, the instruments but must reflect the cost of the transactions and take a
stability of the financial industry and the promotion of competition capital charge on it. Responses to this consultation should be in by
between financial services providers. m June 21st. m

3. JPMorgan "derivatives risks and abuses" HBOS – “An accident waiting to happen”
The US Senate Committee on The UK Government’s Parliamentary
Homeland Security and Governmental Commission on Banking Standards has
Affairs has published a 307-page finally release the report “An accident
document entitled "JPMorgan Chase waiting to happen: The failure of HBOS”.
Whale trades: a case history of The Commission, a cross-party group of
derivatives risks and abuses" reporting five members of parliament and five
on the $6.2 billion that JPMorgan lost peers from the House of Lords,
trading in synthetic credit derivatives including the present Archbishop of
at its Chief Investment Office (CIO) Canterbury (who worked in finance
which managed the bank's excess before joining the Church) and Lord
Carl Levin Treasury funds of over $300 billion. Lawson (an ex-Chancellor of the Commission member:
US Senator This report, chaired by Senator Carl The Archbishop of Canterbury
Exchequer), has heavily criticised both
Levin, makes recommendations for changes in JPMorgan as well as the directors and management of HBOS and the regulators
for the derivatives market and the US regulators, but does not responsible for ensuring the bank’s prudential management.
make any suggestions on charges, which would be up to the
The report finds that credit problems at HBOS were largely in the
regulators themselves. (The above link also contains a recording of
international, corporate and treasury divisions with a combined
the committee's interviewing of JPM executives and the regulating
total of £47 billion in impaired loans and that these alone would
Office of the Comptroller of the Currency).
have bankrupted the bank. Retail lending, although the biggest
In testimony to the committee, Ms Ina Drew, the then Chief division, was relatively healthier although the report points out a
Investment Officer at the CIO and who has now left the bank, funding gap of £111 billion and a deposit to loan ratio of under
admitted that "valuations for many of the book's positions were 57%. Regarding the total impairments the report says “Both the
inflated and not calculated or reported in good faith; that the relative scale of such large losses and the fact that they were
original version of the second quarter scenario analyses reflected incurred in three separate divisions suggests a systemic
much higher projected losses and was specifically re-done before management failure across the organisation.”
it was sent to me so as to reflect lower projected losses; and that The report comments that the bank’s Group Risk Function was
some members of the London team participated in or condoned inexperienced in the key areas with limited willingness or ability to
such conduct and hid from me important information regarding challenge, and less wish by the divisions to accept challenge. The
the true risks in the book." She added that she had since learnt risk function in HBOS was a cardinal area of weakness in the bank,
that the VaR model used was flawed and significantly with low status and little hope for career progression. These
understated the true risks in the book." weaknesses “were a matter of design, not accident. Responsibility
The report's recommendations to regulators included that banks for this lies with Sir James Crosby, who as Chief Executive until
should identify all internal portfolios containing derivatives, that 2005 was responsible for that design, with Andy Hornby, who
hedging policies and close-down processes be specified, that failed to address the matter, and particularly with Lord Stevenson
independent valuations be used, that they should investigate all as Chairman throughout the period in question.”
large limit breaches, that any models that claim materially to But the report also slams the FSA, the then UK banking regulator, saying
lower risk be reviewed, and that the Volcker Act to ban that its regulation was “thoroughly inadequate” and that it failed
proprietary trading by banks be implemented and that permitted to ensure that controls were in place to reduce the risks of
derivatives trading should carry an extra capital charge. m aggressive growth and heavy reliance on wholesale funding. 3
“From 2004 until the latter part of 2007 the FSA was not so
Swaps trades swamp US regulator much the dog that did not bark as a dog barking up the wrong tree.
The requirements of the Basel II framework not only weakened
New Dodd-Frank rules require all trading firms with US
controls on capital adequacy by allowing banks to calculate their own
operations trading in swaps to report any over-the-counter
risk-weightings, but they also distracted supervisors from concerns
trades. The new reporting rules specified by the US's Commodity
about liquidity and credit; they may also have contributed to the
Futures Trading Commission (CFTC), the regulator of these
appalling supervisory neglect of asset quality.”
trades, required over one thousand data fields of information.
But in a glaring technical omission the CFTC failed to specify the Does anyone – HBOS, their directors, the FSA and Basel II – come
data format for the reporting. out of this well? Sadly not. Again to quote the report “The
downfall of HBOS provides a cautionary tale. In many ways, the
The result was that, when reporting began in March, with around history of HBOS provides a manual of bad banking which should be
75 major swaps dealers, market participants were due to start read alongside accounts of previous bank failures for the future
reporting at a later date, the receiving computers could not handle leaders of banks, and their future regulators, who think they know
either the volume of the format of the reporting data and crashed. better or that next time it will be different.”
Commissioner Scott O'Malia of the CFTC has admitted its mistake This report was the fourth such report on the HBOS case. There is
and also said that it doesn't really need all this data, even if it a fifth and final report expected where the lessons of HBOS will be
could read it! The problem is so bad that CFTC staff currently used to develop recommendations regarding the regulation of
cannot find the London Whale in the current data files. m banks, the usage of ring fencing and the conduct of regulators. m

4. Regulatory ASYMmetricAL
NEWS The back page, sometimes critical view from the Editor
Martin Wheatley, the new head of Where to start? A lot has happened in the last month as the BCBS gets going with a
Financial Conduct Authority, has said they number of reports targeting large G-SIB/G-SIFI institutions but also looking closely at the
will take a more proactive approach to weightings of derivatives, particularly credit default swaps.
identifying illegal behaviour than his The LIBOR battle between the banks on one side and an (unholy?) alliance of regulators and
predecessors did, and they will use investors on the other continues with skirmishes and a significant win on the banks' side as
reports from consumer bodies, the media Manhatten's Judge Naomi Buchwald dismissed most of a major case against them.
and both social media sites and Twitter,
rather than just relying on regulatory An interesting news event was that the US regulators have given Citigroup 60 days to
reports back from firms. come up with a remedial plan to fix failures in its AML processes. It is interesting that
there were no fines or other punitive action seeing that Citigroup were also castigated
The BIS has released a number of new
for similar AML breaches in 2012 and given "cease and desist" orders. Seeing that HSBC
reports - The Markets Committee put out
"Central bank collateral frameworks and were fined $1.9 billion and Standard Chartered many hundred of millions for AML
practices" and the BCBS published a failures, and that Citi's failing were at its Mexican subsidiary, as were HSBC's, it looks like
consultation paper "Supervisory guidance the American bank has got off lightly. JPMorgan recently also received similar process
on external audits of banks" along with a change-only orders - is it possible that there is one practice for American banks and
"letter to the International Auditing and another for the Brits? How can I think such a thing? We all know the cross-Atlantic
Assurance Standards Board (IAASB)" "entente cordiale" brings major benefits to both sides. Like our support for FATCA?
(PDF), also "Supervisory framework for On a positive note it is good to see that the UK is relaxing the controls and capital
measuring and controlling large requirements for new start-up banks. The time to get approval will be cut from over two
exposures". The BCBS also published a years to 6 months and these banks will have to hold smaller regulatory capital ratios
"Report assessing the regulations that
than the big banks at 4.5%. In certain cases, capital of only £4.25 million will be needed
implement the Basel capital framework in
to start up the bank. However these banks will get no implicit "too big to fail" guarantee
Singapore" (PDF).
from the bank - but that is no bad thing and returns us to traditional retail banking
The Brazilian regulator also reported that practices. So far we have large start-ups such as Metro Bank, and internet banking
it would be implementing Basel III to a providers, Aldermore and Shawbrook - and the small "Bank of Dave", or rather "Bank on
time table starting this October and Dave", the other names for the new Burnley Savings & Loans Limited, whose one branch
finishing in January 2022. has been subject of a recent Channel 4 documentary. We wish them all success and
In updates to the progress of implementing hope their operational risks are under control, that good credit risk practices are in
global FATCA Intergovernmental place, and that they are not doing proprietary activities or trading in overseas
Agreements (IGAs), groups in Canada are transactions which would make them liable to market risk. Their reputational, liquidity
threatening to go to court to have these and systemic risks are probably in our, the public's, hands.
declared unconstitutional and the Russian
Finally on a issue I have tackled before, let me ask a question: by what rights are you
Foreign Ministry has said that any such
agreement would break national laws. entitled to call yourself a risk manager? Will the risk managers appointed by the above
China and Taiwan have said they have no banks have any qualifications, experience or external support to do their job? Or
intention of signing any IGAs but the will these banks simply appoint someone who "has been around a bit" and goes
United Arab Emirates and Brazil are both on a few courses? 4
reported as being about to sign. It is time the banking regulators put their (and our) houses in order and insisted
Reuters has reported that the US Treasury that anyone operating as a risk manager has the formal professional background to carry
Department, under instructions from the out the job effectively. That is they should have sufficient academic grounding, have
Obama administration as part of anti- studied risk management and passed relevant exams, have some form of external body
terrorism controls, is drafting plans to give ensuring they maintain good ethical standards, and are committed to regular training
the US surveillance agencies complete that keep them up to date with developments.
access to the government's database of
In other words, put risk managers on the same footing as lawyers, doctors, accountants
financial data kept on American citizens
and, increasingly, auditors. Given the importance of the subject and the damage that
and foreign persons and organisations
failures can cause, I would also put financial compliance officers into the same
who maintain accounts in the USA.
requirements bracket for professional status.
The UK authorities have announced that it is
prepared to relax capital rules for new banking Colin Lawrence, previously Director of Prudential Risk Management at the FSA, and, as
start-ups in the UK. This would allow them to of the beginning of April, now doing the same job at the Bank of England's Prudential
open with capital ratios of as little as 4.5% Regulation Authority, has long been a proponent of professional status, that is, deserved
compared to the 10-14% that is being required professional status supported by the above processes, for risk managers. Let us hope
of the large banks. This is to encourage new that, in his current role and with his new masters at the
competition to the big banks, and, as these BOE, he can persuade them to put their weight behind this metric is published by
metric
Chase Cooper.
start-ups are by definition small, the depositor cause and make risk management in Britain a template for web: www.chasecooper.com
risks are considered manageable. the rest of the world. m email: editor@chasecooper.com