Credit and Banking Ppt by wanghonghx

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									Credit Supply Management &
  Economic Sustainability:


The Legislative Bubble-Shrinker
                Bubbles & Liquidity

 Asset bubbles are created by increased credit supply

 Available credit generates increased liquidity in market, asset
  prices rise

 Prudent investors --->irrational speculators
     Market actors are mostly herd beasts, following the leader and increasing
      liquidity/increasing volume as consequences of excess available credit
                      The Bubble Pops

 The bubble pops: Macro Shock

 Reinforced downward spiral: falling prices, underwater assets

 Bank losses increase, reserves become depleted as assets
  depreciate

 New loans needed to service old debt

 Institutions can fail, cheat, or spend their way out

 Overall credit market constricts when it is most needed: not for
  investment, for solvency!
                             Business Cycle

 Business cycle/credit cycle are nearly coterminous, correlation is debated.

 Business cycle can be driven by credit availability, credit availability at least
  partially predicated on demand segment of business cycle (what comes first?
  The chicken or the egg?)

 Whichever comes first, the results are bubbles and corresponding panics.

 Prevailing wisdom under Greenspan: “Don‟t worry about it”. Almost fatalistic
  attitude towards mitigating the effects of cyclical fear and greed.

 So why should we??
                 Hindsight is 20:20

 Bubbles can and should be mitigated.
 Economic inefficiencies arise as evidenced by bailouts,
 expensive reactionary regulation, credit crunches,
 recessionary impacts on jobs and compensation.

 Sustainable cycles allow the costs to be amortized over
  longer periods of time:
 Preserves margins for lenders
 Limits losses by investors
 Reduces tax burdens imposed by increased spending
                           CFPA Transparency

 CFPA: Transparency
        House Bill proposes giving CFPA ability to promulgate regulation for
         “who deal or communicate directly with consumers in the provision of a
         consumer financial product, as the Director deems appropriate or
         necessary to ensure fair dealing with consumers.”
        Requires the CFPA Director to conduct an annual financial autopsy
         regarding bankruptcies and foreclosures, including any specific financial
         products or services that have caused substantial numbers of them.

   Complexity of system makes information asymmetry among market actors a given, widening gap
    with increased complexity
 Trend-based investment leads to higher demands for capital and leads to adverse
    selection among banks
                    General Transparency


 Prevented by CFPA’s disclosure guidelines
 General transparency can reduce informational
 asymmetry

       Financial autopsies will likely not stop innovation/loophole mining, but
        will reduce lag time between the invention of harmful financial products
        and their elimination from the market or will ensure that they are
        accompanied by proper disclaimer activity, thus increasing investor
        awareness of risk.
                            Capital Requirements


 Capital Requirements:
   Legislation: Off Balance Sheet activities are required to be part of capital requirement
    computations, includes: Direct credit substitutes like standby letters of credit, repos, asset sales
    with recourse, interest rate and credit swaps, securities contracts, forward contracts.

 Asymmetric risk/reward scenarios in institutional insolvency
 Higher capital requirements artificially restrict the amounts lent,
  position sizes and leverage rates
 A lawyer’s definitional playground: will definitions of capital
  keep up with innovation?
                            Funeral Plans

 Funeral Plans for facing potential insolvencies:
 Legislation: Required of large & complex financial
  institutions, or face higher capital standards
 Focused on system-wide protection
 Reduces asymmetrical risk/reward scenarios when
  shareholders/management by restricting that activity via
  adherence to pre-existing dissolution plans.

       Reduces overall systemic damage when insolvency of one institution
        occurs: limits the desperation lending close to insolvency when
        institutions take on higher yielding, higher risk loans to try to avoid
        liquidation.
                       House Bill




 Credit Risk Retention Act of 2009 (in House Bill):
 Requires any creditor to retain an economic interest in a
  material portion of the credit risk of any loan the creditor
  transfers, sells, or conveys to a third party--even
  securitized loans backed by assets.
                The Obama Plan




 An end run around credit-restricting legislation?


 Mission: Defeat asset bubbles, prevent catastrophic
 collapse.
                  Acceptable Returns

 Moderating credit supply can make for “lower highs” and
  “higher lows”
 But Greenspan believed there was no way to arbitrarily
  present an acceptable, sustainable return by moderating
  the credit supply.
   BECAUSE of
 The subjectivity of “acceptable returns”: dependant on
  time, place, competition, etc.
 There is no predictable mathematical break point for
  “when a bubble will burst”.
 Therefore not worth it to artificially moderate the credit
  supply
              Too Big To Fail




AIG   FANNIE MAE   CITI BOA CIT   GOLDMAN
                   Introduction



 TBTF policy is the primary contributor to the current
  financial crisis
 New legislation proposal of resolution authority is
  ineffective in ending TBTF
 A new bankruptcy process should be established to
  end TBTF
               Development of TBTF

• FDIC on commercial banks
  – Allow commercial bank go out of business without damaging
    the entire economy
  – Insure only the SMALL depositors funds to prevent
    financial panic
  – Leave uninsured lender taking the loss
                Development of TBTF



• Continental Illinois
  – Insolvency in 1984
  – Heavily relied on uninsured lender
  – 8th largest commercial bank in the nation

• Government‟s bailout
  – Sustain confidence in the nation‟s banking system
  – Pledge no uninsured lender would lose money
  – Begun the Era of TBTF
Development of TBTF

    “We believe it is bad policy, would
     be seen to be unfair, it
     represents an unauthorized and
     unlegislated      expansion     of
     federal        guarantees       in
     contravention       of   executive
     branch policy.”
                    ----- Donald Regan
                    Treasury Secretary
             Development of TBTF


 Financial consolidation
   Traditional banking

   Security underwriting

   Insurance

   Real estate

 Government safety net
   Commercial banks

   Investment banks
        TBTF & Current Financial Crisis


• TBTF = Government Subsidy
  – No fear of failure

  – Lenders put more money

  – Increase in credit supply

  – Decrease in cost of fund
       TBTF and Current Financial Crisis

 TBTF = Unfair competitive advantage
   Encourage Americans on borrowing

   No incentive to monitor

   Incentive to make greater risk in investment
TBTF and Current Financial Crisis




           Housing bubble
             Easy money from lenders

             Incentive to take risk
                  Continuity of TBTF


 Last administration
   TARP program

 New administration
   Treasury new power to stabilize a failing
    firms
 Common problem
   Prevent short-term consequence

   Limitation on executive branch
                  Continuity of TBTF



 Illiquidity
   Cash < Immediate obligations

   Rescue can prevent premature liquidation

 Insolvency
   Value of asset < value of liability

   Rescue cannot prevent fire-sale of asset
                  Continuity of TBTF


 AIG rescue
   $85 million is not enough

   Maturity up to 5 years

   Interest rate down by 5.5%

   Amount up to $150 million

 Still no fear of failure
   Delay restructuring or merger

   Large bonuses – AIG: $165 million
End TBTF through Resolution Authority


       House Bill and Senate Bill
         Department of Treasury shall
          appoint the FDIC as receiver to
          dissolve failing firms
         Publicly list certain large financial
          firms subjected to the special
          treatment
         Discretionary administrative
          resolution by government agencies
  End TBTF through Resolution Authority


 Principal problems
   Legally codified guarantee of certain
    financial firms
   The executive power lack the long-
    settle and clearly interpreted process
    and precedents
   Easily influenced by political
    pressures
        End TBTF through Bankruptcy


 Myth in bankruptcy
   Dissipate the value of the assets

   Common negative phrases

   Slow actions and procedure
              End TBTF through Bankruptcy

             Lehman Brother Bankruptcy         AIG Government Rescue Loan
Index        Day before   Day after   Change   Day before   Day after   change

S&P 500      1251.7       1192.7      - 4.7%   1213.6       1156.39     - 4.71%

Volatility   25.66        31.7        19.54%   30.3         36.22       19.54%
TED spread 1.35           2.01        0.84     2.19         3.02        0.84

13 wk T-     1.46         0.81        - 0.84   0.86         0.02        - 0.84
Bill
             • Market did not distinguish between the
               distress resolution procedures
             • Market instead focuses on the financial distress
               itself
         End TBTF through Bankruptcy


 Bankruptcy features
   Allow DIP to issue new claims that
    take priority over other creditors,
    so that failing firm can obtain new
    financing
   Automatic stay prohibits any
    collection effort upon its filing, so
    that the failing firm can preserve
    assets and prevent financial panic
           End TBTF through Bankruptcy



   Allow DIP to sell assets free and
    clear of liens and other liabilities,
    so that the acquirer is more likely
    to purchase the assets at higher
    price and in timely manner
   Federal judges and judicial branch
    are free of political pressure and
    lobby efforts
        Problem with Current Bankruptcy


• Exemption from automatic stay
  – Derivative contracts

  – New financial instrument

• Lost of healthy asset
  – Lehman: counterparties canceled more than 700,000 of its
    900,000 derivatives contracts
• Lost of going concern value
  – AIG: forced to liquidate assets to generate collateral
  Proposed New Bankruptcy Process

 New chapter bankruptcy law for large financial
 institutions
    Apply automatic stay and avoidance provisions to derivatives
     contracts
    Able to invalidate the provisions in derivatives that make
     bankruptcy an event of default
    Stronger powers to appoint receivers to take over large failing
     firms
                        Conclusion



 Free market and Capitalism
   Alan Greenspan is wrong?

   TBTF is not free market!

 Restore free market
   Bad firms die, bad ideas die with it
Bank Capital Requirements
               What is Bank Capital?

Bank Capital:
  Is bank‟s net worth, which equals the difference between
   total assets and liabilities.
  Is a cushion against a drop in the value of bank assets,
   which could force a bank into insolvency.
  Helps prevent bank failure, a situation in which a bank
   cannot satisfy its obligations to pay its depositors and
   other creditors.
  Helps lessen the chance that a bank will become insolvent
   if its assets drop or devalue.
           Why is Bank Capital Important?


 The amount of capital affects return on investment for the
  equity holders (owners) of the bank.
     Bank capital ends up costing the equity holders because higher
      capital reserves generate lower return on equity for a given
      return on assets.
 On the one hand, the lower the bank capital, the higher the
  return for the equity holders of the bank.
 On the other hand, larger bank capital reserves benefit the
  equity owners of a bank because it makes their investment
  safer by reducing the likelihood of bankruptcy.
          How Do Banks Raise Capital?


Banks can raise capital by:
   issuing new equity (common stock),
   Issuing bonds that can be converted into equity,
   reducing the bank‟s dividends to shareholders, which increase the
    retained earnings that can be put into capital accounts.
       Neither option is particularly appealing to existing
       shareholders because issuance of new equity dilutes their
       profits and reduction of dividends simply reduces their
       return on investment.
Role of Bank Capital Requirements in the Recent CRISIS and
 How Higher Reserves Could Have Averted Bank Failures



 Higher bank capital reserves could have provided a
  means of satisfying obligations to pay off
  depositors and creditors as assets were lost or
  devalued due to risky investments
 Capital is supposed to act as a first line of defense
  against bank failures and their knock-on
  consequences for systemic risk by providing a
  cushion against losses.
       Rationale for Bank Capital Regulation

 The reason behind capital requirements is that when a bank
  is forced to hold a large amount of equity capital, the bank
  has more to lose if it fails and is thus more likely to pursue
  less risky activities.
     Reducing a bank‟s incentive to take on risky activities is one measure
      used to reduce moral hazard associated with a government safety net
      that bails out banks that are too big to fail (normally financed by
      taxpayers).
 On the other hand:
   It is possible that requiring investors to hold higher capital
    requirements could lead banks to seek a greater return on the
    additional capital in order to generate the same amount of profit, or
   Higher capital requirements could drive financing out of the banking
    sector into less regulated sectors such as insurance or hedge funds.
          Current Regulation of Bank Capital

 Current regulatory capital standards have evolved from principles developed by the
  Committee on Banking Regulations and Supervisory Practices of the Bank for
  International Settlements (BIS) in Basel, Switzerland.
 International risk-based capital standards were endorsed in 1988 by the Governors
  of the central banks of the G-10 countries (Belgium, Canada, France, Germany,
  Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United
  Kingdom and the United States) - referred to as the Basel Capital Accord or “Basel
  I.”
     The Supervisory Committee has no formal authority but works to develop broad supervisory
      standards and promote best practices with the expectation that each country will implement the
      standards in ways most appropriate to its circumstances.
     Agreements are developed by consensus, but decisions about which parts of the agreements to
      implement and how to implement them are left to each nation‟s regulatory authorities.
 All FDIC insured depository institutions are required to hold minimum
  levels of regulatory capital, even though the accord requires the U.S. to
  apply those standards only to large, internationally active banks.
     On November 2, 2007, US implemented new Basel II requirements which were mandatory
      for large, internationally active banking organizations (so-called “core” banking
      organizations with at least $250 billion in total assets or at least $10 billion in foreign
      exposure) and was left optional for other banks.
Why is International Cooperation Important?

                                                                 One concern is that banks might have a
                                                                  competitive advantage if they are allowed
                                                                  to hold less capital, allowing them to offer
                                                                  loans at lower prices.
                                                                 Basel I Accord was developed to have
                                                                  uniform capital measures for large
                                                                  internationally active banks in order to
                                                                  enhance the soundness of the
                                                                  international banking system, and to
                                                                  reduce competitive inequalities among
                                                                  these banks that result from differences in
                                                                  international capital standards.
                                                                 U.S. banks were required to hold more
                                                                  capital than most of their foreign
                                                                  competitors before the crisis.
                                                                 U.S. banks are also on a better footing
                                                                  because the U.S. has recapitalized many of
                                                                  them with taxpayer money.




 Differences in accounting standards: Some bank balance sheets appear up to twice the size under European accounting
 rules than they would under U.S. standards.
 European banks are also structured differently. Many are cooperatives or have shareholders such as municipalities that
 can't raise funds in the same way as institutional shareholders in the U.S.
               Structure of Regulatory Capital

 Regulators‟ Statutory Authority to Impose Capital
  Requirements stem from:
     (1) International Lending Supervision Act of 1983, and
     (2) the prompt corrective action provisions of the Federal Deposit
      Insurance Act.
 The prompt corrective action statute generally requires
  each federal banking agency to prescribe two capital
  requirements:
     “leverage limit,” and
     “risk-based capital requirement”
         12 U.S.C. § 1831o(c)(1)
          Leverage Limit (“Leverage Ratio”)

 Requires FDIC-insured banks to maintain at least a 4% ratio of
  capital to total assets in order to qualify as adequately
  capitalized.
 Leverage ratio constrains a bank‟s ability to take on debt.
     If a bank must maintain at least a 4% ratio of capital to total assets, the bank
      must have $100 in total assets for each $96 in total liabilities.
        No international agreement requires a leverage limit.
        The leverage ratio is designed, among other things, to curb excessive
         leveraging of capital, thereby preventing institutions from reducing their
         risk-based capital to dangerously low levels by investing in assets that
         require little or no capital to be held against them.
 The ratio is also designed to provide a relatively high capital level
  to compensate for the fact that the Basel I standards do not
  include a component for interest rate risk, market risk, and other
  risks faced by depository institutions.
               Risk Based Capital Requirement

 The risk-based standards originated in an effort to correct for some of the
  leverage limit‟s manifest blind spots, notably its failure to take account of
  credit risk and off-balance-sheet items.
 This ratio is designed to reflect the credit risks posed to an institution by
  various categories of assets in its portfolio and is expressed in terms of
  capital required against a percentage of “risk-weighted assets” (total assets
  after their face amounts have been adjusted to reflect their current risk).
     Current capital regulations require an institution to hold minimum regulatory
      capital equal to 8% of its risk-weighted assets. At least 50% of this amount must
      consist of Tier 1 capital components with the remainder held in Tier 2 capital.
 Under this system, lesser amounts of capital are required to be held against
  lower-risk assets. Bank assets are divided into four risk-weighted categories
  of 0%, 20%, 50%, and 100%.
     Riskier assets are placed in the higher percentage categories. For example, the 0 percent category includes
      cash and U.S. Treasury securities, while loans are generally in the 100 percent category. Risk-weighted
      assets, tier 1 capital, tier 2 capital and all three of the aforementioned capital ratios (tier 1 leverage, tier 1
      risk-based and total risk-based) are also included in your bank‟s quarterly Call Report.
     Banks are expected to meet a minimum tier 1 risk-based capital ratio of 4 percent.
                                       Components of Capital
Components                                                              Minimum Requirements
Core Capital (Tier 1)                                                   Note: Tier 1 must represent at least 50 percent of qualifying total
Common stockholders’ equity                                            capital and equal or exceed 4 percent of risk-weighted assets.
Qualifying, noncumulative, perpetual preferred stock                   There is no limit on the amount of common shareholder's equity or
Minority interest in equity accounts of consolidated subsidiaries      preferred stock, although banks should avoid undue reliance on
Less: goodwill and other intangible assets                             preferred stock in Tier 1. Banks should also avoid using minority
                                                                        interests to introduce elements not otherwise qualified for Tier 1
                                                                        capital.


Supplementary Capital (Tier 2)                                          Note: Total of Tier 2 is limited to 100 percent of Tier 1
Allowance for loan and lease losses                                    ALLL limited to 1.25 percent of risk-weighted assets
Perpetual preferred stock and related surplus                          Subordinated debt, intermediate-term preferred stock and other
Hybrid capital instruments and mandatory convertible debt securities   restricted core capital elements are limited to 50 percent of Tier 1
Term subordinated debt and intermediate-term preferred stock,
including related surplus
Revaluation reserves (equity and building)
Unrealized holding gains on equity securities


Deductions (from sum of Tier 1 and Tier 2)                              Any assets deducted from capital are not included in risk-weighted
Investments in unconsolidated subsidiaries                              assets in computing the risk-based capital ratio
Reciprocal holdings of banking organizations’ capital securities
Other deductions (such as other subsidiaries or joint ventures) as
determined by supervisory authority


Total Capital (Tier 1 + Tier 2 - Deductions)                            Must equal or exceed 8 percent of risk-weighted assets
            New Basel Capital Requirements:
  Final provisions are scheduled for implementation by December 2012


Key elements of capital proposals:
 raising the quality, consistency and transparency of the capital base;
 strengthening the risk coverage of the capital framework, particularly
  with respect to counterparty credit risk exposures arising from
  derivatives, repos and securities financing activities;
 introducing a leverage ratio requirement as an international standard;
 measures to promote the build-up of capital buffers in good times that
  can be drawn upon during periods of stress, introducing a
  countercyclical component designed to address the concern that
  existing capital requirements are procyclical – that is, they encourage
  reducing capital buffers in good times, when capital could more easily
  be raised, and increasing capital buffers in times of distress, when
  access to the capital markets may be limited or they may effectively be
  closed;
 global minimum liquidity standard for internationally active banks that
  includes a 30-day liquidity coverage ratio requirement underpinned by
  a longer-term structural liquidity ratio.
                New Basel Capital Requirements:
     Old Standards:                                                New Standards:
  Amount                                                          Amount
Includable in                Elements of Capital                Includable in                Elements of Capital
Total Capital                                                   Total Capital

  No Limit                                                        No Limit
                                     Tier 1                                                         Tier 1
                       •Common shareholders’ equity                                    •Common shareholders’ equity
                     •Noncumulative perpetual preferred                               •Additional Going Concern Capital
                      •Minority interests in consolidated                          (common shares and retained earnings)
                                  subsidiaries

 Includible
    Only                                                          No Limit                           Tier 2
                                           Amount Includible
   Up to                 Tier 2
                                            In Tier 2 Capital
 Amount of
   Tier 1
                                                                                •Minority interests in consolidated subsidiaries
                 •Cumulative preferred          No Limit                        •Cumulative preferred (perpetual or long-term)
                (perpetual or long-term)                                                      •Long-term preferred
                  •Long-term preferred                                                       •Convertible preferred
                 •Convertible preferred                                                 • Intermediate-term preferred
                                                                                               •Subordinated debt
                                                                                •Debt-equity hybrids, including perpetual debt
                  •Intermediate-term       Only Up to 50% of
                       preferred                 Tier 1
                  •Subordinated debt
                 •Debt-equity hybrids,
                  including perpetual
                          debt
                 PROS and CONS of the new
               Basel Requirements (“Basel III”):

Pros:                                           Cons:

    Forcing the banks to operate with
     larger safety buffers                       Halt banks‟ ability to expand in
                                                  emerging markets and will most likely
    Raising the quality, consistency and         cause huge holes in capital stocks of
     transparency of the capital base             Japanese, European financial
    Enhancing risk coverage                      institutions
    Supplementing the risk-based capital        Force banks to stop counting minority-
     requirement with a leverage ratio*           owned stakes as part of their equity
    Reducing procyclicality and promoting        capital
     countercyclical buffers
    Addressing systemic risk and
     interconnectedness
    All elements of capital would have to be
     disclosed to improve the transparency
     of the capital base
How Does the Wall Street Reform and Consumer Protection Act of
  2009 (H.R. 4173) Change Capital Adequacy Requirements?


 Stricter Prudential Standards for Certain Financial Holding
  Companies for Financial Stability Purposes (Section 1104)
 Contingent Capital (Section 1116)
     Financial holding companies will be subject to stricter standards to maintain a
      minimum amount of long-term hybrid debt that is convertible to equity
 Requirement for Countercyclical Capital Requirements (Section
  1255)
     Each appropriate Federal banking agency shall, in establishing capital requirements
      under this Act or other provisions of Federal law for banking institutions, seek to
      make such requirements countercyclical so that the amount of capital required to be
      maintained by a banking institution increases in times of economic expansion and
      decreases in times of economic contraction, consistent with the safety and soundness
      of the institution
How does the Restoring American Financial Stability Act of
2009 (Senate) suggest changing capital adequacy requirement?


 Enhanced Supervision and Prudential Standards for
    Specified Financial Companies (Section 107)
   Prompt Corrective Action for Specified Financial
    Companies (Section 111)
   Concentration Limits (Section 112)
   Requirements for financial holding companies to
    remain well capitalized and well managed (Section
    605)
   Regulations regarding capital levels of holding
    companies (Section 615)
   Higher capital charges (Section 958)
How does the Regulatory Capital Enhancement Act of 2009
 (H.R. 2660) suggest changing capital adequacy requirement?


 Amends the Federal Deposit Insurance Act to require each appropriate federal
  banking agency to prescribe capital standards, including a leverage limit and a
  risk-based capital requirement, for special purpose entities, or similar types of
  vehicles or entities, that are sponsored by insured depository institutions it
  regulates.
 Requires such capital standards to conform, to the extent practicable, with the
  capital standards prescribed under the Act.
 Authorizes an appropriate federal banking agency, by regulation, to establish
  any additional relevant capital measures for such entities or vehicles necessary
  to guard against the risk that they become undercapitalized.
 Requires the appropriate federal banking agencies to define jointly a "special
  purpose entity," with a focus on trusts and other legal entities established by or
  for an insured depository institution to fulfill narrow, specific, or temporary
  objectives, including: (1) the holding of financial assets transferred during a
  securitization process; (2) issuing applicable securities representing claims on
  such assets; (3) receiving and reinvesting cash flows from such assets; and (4)
  distributing proceeds to holders of the securities
PROS and CONS of the newly proposed
           regulations:
                                                     Pros

   Thicker insulation against risks by forcing banks to have buffers that can withstand higher loses and longer
    freezes in financial markets before they call for state help
   Discourage excessive credit growth in boom times by forcing banks to take on more capital as their balance
    sheets expand
   Proposed minimum liquidity requirement designed to ensure banks hold enough cash and near-cash to tide
    them over for 30 days
   Contingent convertible capital (“Coco” bonds) – debt that converts into equity if a bank gets into trouble or
    bonds that convert into equity if capital gets too low
     Pros of Contingent convertible capital (“Coco” bonds):
          Pays a coupon, like a normal bond, unless the bank‟s core capital falls below 5% or risk-adjusted assets
          At that point the coupon is cancelled and the bond converts into equity, boosting the bank‟s ability to
            absorb losses while remaining a going concern
          Would put banks in a position to assess capital in times of crisis without having to go to lure new
            investors because their debt would convert to equity.
              It could impose market discipline on banks – investors in the instruments would be expected to
                 demand that firms avoid taking excessive risks because the instruments could be diluted in value or
                 wiped out when they convert from debt to equity
     Cons of Contingent convertible capital (“Coco” bonds):
          triggering the bond itself could cause a run: counterparties could take it as a signal that the bank was in
            severe trouble
          worst case scenario: buying insurance on the Cocos – must like AIG sold credit default swaps – which
            would merely shift losses from one place to another
                                              Cons

 The bigger buffers would not have been enough to prevent the worst blow-ups of the past two
  years.
   The five largest US financial institutions subject to Basel capital rules that either failed or
     were forced into government-assisted mergers in 2008 – Bear Stearns, Washington Mutual,
     Lehman Brothers, Wachovia and Merrill Lynch – had regulatory capital ratios ranging from
     12.3 per cent to 16.1 per cent as of their last quarterly disclosures before they were effectively
     shut down. The capital levels of these five banks were between 50 per cent and 100 per cent
     above the minimums and 23 per cent to 61 per cent higher than the well - capitalized
     standard.
 Bank‟s capital would need to double to deal with the risks similar to what they went through in
  the recent crisis.
 For America‟s four giant banks, raising core capital to 20% of risk-adjusted assets could require
  them to raise roughly additional $30 billion of annual income.
   If pushed through to customers, that might raise the weighted average rate they charge by
     roughly a percentage point, from the current 6%.
   Passing the costs onto the customers could further hurt the economy.
 Importance of large banks:
   Economies of scale – efficient on providing services for multinational companies
   Living wills might produce weak companies
      The Million Dollar Question




Can bank capital regulation prevent future
             financial crises?
Bank Regulation: Proposed Changes to Corporate
                  Governance
       Introduction: Why Change Corporate
                   Governance?

 Why change corporate governance
 Proposed changes to the internal structure of
 corporations can be divided into three primary
 categories:
  1)   Shareholder empowerment
  2)   Disclosure requirements
  3)   Executive compensation
 As will be demonstrated, the latter two frequently appear
  as measures designed to empower shareholders
 Note: although there are differences between bank and
  standard business corporations, this presentation will
  not compare those differences
        The Corporate Structure of a Bank

 In general, the corporate structure of banks does not vary
  widely with the traditional corporate structure, which is
  divided into three branches: shareholders, directors, and
  managers
 Shareholders are the equity holders, or owners, of the
  corporation; according to Professor Levine, shareholders can
  be divided into two types:
   1)   Diffuse shareholder: small, or minority shareholders
            Vote for directors
            Vote on matters including mergers and acquisitions, or other
             fundamental changes in business strategies (albeit indirectly through
             board member elections)
   2)   Concentrated shareholder: large, sometimes institutional, investors
            Occasionally elect their own representatives to the board of directors,
            Can negotiate incentive packages to align management interests with
             that of shareholders
     The Corporate Structure of a Bank: Board of
                     Directors
 Board of Directors: besides making employment decisions and monitoring
  management, directors in banking firms have further responsibilities beyond mere
  fiduciary duties:
    1)   Ensure the bank‟s activities are in the best interest of not only the shareholders, but depositors
         as well as the government (taxpayer)
    2)   Abide by laws and regulations reflecting the government's interest in maintaining safe and
         sound financial institutions
 The Comptroller of the Currency has published a handbook detailing the
  responsibilities of bank boards of directors; these include:
    1)   Select competent management
    2)   Supervise the bank‟s affairs
    3)   Adopt sound policies and goals under which management must operate in the administration
         of the bank‟s affairs
    4)   Avoid self-serving practices
    5)   To be informed of the banks position and management policies
    6)    Maintain reasonable capitalization
    7)   To ensure the bank has a beneficial influence on the economy and the community in which it
         rests
 Compensation: amongst other managerial oversight responsibilities, the board also
  oversees the level and structure of top executive compensation; this duty is perhaps
  the most critical in aligning the interests of management with that of shareholders
             Board of Directors, Continued

 Risk: generally associated with the safety and soundness
  aspects of regulatory supervision; risks include:
   1)   Credit
   2)   Market
   3)   Liquidity
   4)   operational
   5)   legal
   6)   reputational
 A risk management system, no matter the type of risk
  involved, includes four basic components:
   1)   identification
   2)   measurement or quantification
   3)   controls
   4)   monitoring tools
 Controls
  The Corporate Structure of a Bank: Managers,
                (Focus on CEO)

 St. Louis Federal Reserve Bank website: “the CEO is
  responsible for running the bank on a daily basis;” the CEO:
  hires, fires and leads the senior management team, who “in
  turn, hires, fires and leads the other employees in the
  organization;”
     “Develops, along with the board of directors, the bank vision and sets the
      strategic direction for the bank
     “Establishes, more than any other individual, the control culture for the
      organization
     “Oversees the development of the bank's budget and the establishment of
      the bank's system of internal controls”
 Ultimately, the goal of management is to formulate a business
  plan that incorporates and oversees financial, administrative
  and risk functions in order to maximize the firm‟s value
 Public responsibilities
                Managers & Compensation

 Generally speaking, managers are paid a contracted salary, and frequently a
  performance measured bonus; compensation can be either in the form of cash
  or stock options, though usually both
 As mentioned before, top management salaries are structured by the board of
  directors; however, some consideration include:
   1)   Capital structure
   2)   Capital reserves
 Compensation and risk: boards have the responsibility of balancing the firms
  ability to recruit and retain management talent while maintaining appropriate
  risk management systems
       Aligning executive compensation with the company‟s long-range objectives
       Certain business risks may present opportunities for managers driven by
        short-term incentives (e.g. stock price or earnings per share)
       These metrics can be manipulated, for example, by management decisions
        related to revenue and expense recognition or through stock buybacks at the
        end of the period
        Failure within Corporate Governance

•   Professor Zingales: the lingering financial problems with the 2007-08
    crisis stem from shaken investor confidence in the markets, the result
    primarily of excessive risk-taking on the part of managers, enriching
    themselves via short-term bonuses while destroying the long-term
    value of their firms
     — Moral hazard
     — Consider also that in 2008, 70% of shares in financial institutions were owned by
       institutional investors, thus, this was not merely a matter of unsophisticated
       investors being taken advantage of by large, complicated banking firms
•   Shareholder disempowerment: firms have grown “director-centric,”
    whereby activity focuses on directors, with little to assist shareholders
    in terms of power or say in corporate activities
     1) anti-takeover statutes and poison pills
     2) State competition
     3) Shareholders have little, if any, say in who may run to be elected to the board of
        directors
Failure within Corporate Governance, Continued

 Political response: “it sounds to me a little bit like selling a car
  with faulty brakes, and then buying an insurance policy of the
  buyer of that car” is how Phil Angelides described the types of
  products and activities financial instructions were involved in
  while cross-examining Lloyd Blankfein of Goldman Sachs on
  January 15, 2010
 Personal response: the failure of corporate governance comes
  primarily from two sources:
   1)   Failure on the part of boards of directors and managers of many
        financial institutions to adequately manage or react to the risk
        surrounding the types of products these firms were selling to
        investors
   2)   Second, shareholders have become detached from the boards of
        firms in ways that make monitoring and oversight, even for
        sophisticated investors, difficult
    Shareholder Empowerment Act of 2009

 Proposed on June 12, 2009 in the House of Representative by
  Rep. Gary Peters (D-MI)
 Has been referred to committee
 In order to remain listed on an exchange, this Bill mandates
  that a securities issuer must require:
   1)   The election of any director who receives a majority of votes in an
        uncontested elections, or a plurality of votes in a contested election
   2)   For directors who to fail to be reelected to tender their resignation
 Directs the SEC to:
   1)  provide security holders with an opportunity to vote on director
       candidates who have been nominated by holders of at least 1% of the
       issuer's voting securities for at least two years
   2)  Prohibit brokers from voting securities on an uncontested election to
       the board of directors without having received specific instructions
       from the securities' beneficial owners
 Shareholder Empowerment Act, Continued

 Requires that the SEC, to the extent possible, ensure that the chairman of
  the board of directors be an independent board member who has not
  served as an executive of the issuer
 This Bill further requires that the SEC ensure:
     The opportunity for a non-binding shareholder vote on compensation at any meeting
      (proxy, annual, etc.) of the securities issuer
 The SEC is to direct the national exchanges and securities associations to
  prohibit:
     Issuers from retaining non-independent advisors in negotiating executive employment or
      compensation agreements;
     The listing of any issuer who does not have a clawback policy aimed at executive
      compensation earned due to fraud, faulty financial statements, or “some other cause”;
     The listing of any issuer that provides severance packages to senior executives who are
      terminated for “poor performance”
 The SEC is to require additional disclosure of specific performance targets
  used in determining a senior executive‟s eligibility for bonuses, equity or
  any other incentive compensation
          Corporate and Financial Institution
           Compensation Fairness Act 2009

 Proposed on August 2, 2009 in the House of Representative by Rep.
  Barney Frank (D-MA)
 Passed the House on July 31, 2009
 This Bill changes the Securities and Exchange Act of 1934,
  authorizing a shareholder vote on compensation that is:
   1)   Non-binding
   2)   Not construed as overruling a board decision or implying a fiduciary duty
   3)   Construed as restricting shareholder ability to place executive compensation
        proposals within proxy materials
 This Bill further directs the SEC to direct national exchanges and
  securities associations to prohibit the listing of any securities issuer
  that fails to comply with compensation committee requirements;
  these requirements include:
   1)   Each member of the committee must be an independent director
   2)   Committees may only obtain advice or consolation from parties satisfying the
        SEC‟s independent standards
         Corporate and Financial Institution
        Compensation Fairness Act, Continued

 Finally, the Bill directs federal regulators to craft
  regulation that requires financial institutions to disclose
  the structures of incentive based compensation sufficient
  to determine whether it is:
   1)   Aligned with sound risk management
   2)   Structured to account for time horizon of risk
   3)   Reduces incentives for employees to take unreasonable risks
 The goal is to regulate compensation structures or risk
  incentives that may:
   1)   Threaten the saftey and soundness of covered financial
        institutions
   2)   Present serious adverse effects on the economy or financial
        stability
      Excessive Pay Shareholder Approval Act

 Proposed on May 7, 2009 in the Senate by Sen. Richard
  Durbin (D-IL)
 Has been referred to committee
 The Bill is primarily aimed at placing a cap on executive
  compensation of a securities issuer
     The limit will be set at 100 times the average compensation of all the
      issuer‟s employees
     Any compensation over this amount is subject to shareholder
      approval, requiring a vote where 60% of shareholders must approved
      the additional compensation
 Note: unlike the House “say on pay” proposals, this Bill
 does not render the shareholder vote “nonbinding” or
 merely consultative in function
          Shareholder Bill of Rights Act 2009

 Proposed on May 19, 2009 in the Senate by Sen. Charles Schumer (D-NY)
 Has been referred to committee
 This Bill amends the Securities and Exchange Act of 1934, requiring:
     Any meeting (proxy, annual, etc.), for which proxy solicitation rules require compensation
      disclosure, to include a separate resolution subject to shareholder vote to approve executive
      compensation
     Disclosure, in proxy solicitation material regarding any sale, merger, or acquisition of an
      issuer of securities, of any golden parachutes or any other transactional derived executive
      compensation agreements or understandings, not previously subject to shareholder
      approval
     Proxy solicitation material for a golden parachute to provide a shareholder vote in order to
      approve it
 Requires national exchanges and securities associations to prohibit the
  listing of any securities issuer who fails to comply with any requirements
  regarding director independence, annual elections, SEC election rules, and
  the mandatory establishment of a risk committee
            Summary of Proposed Legislation


 Proposed on May 19, 2009 in the Senate by Sen. Charles Schumer (D-NY)
 Has been referred to committee
 This Bill amends the Securities and Exchange Act of 1934, requiring:
     Any meeting (proxy, annual, etc.), for which proxy solicitation rules require compensation
      disclosure, to include a separate resolution subject to shareholder vote to approve executive
      compensation
     Disclosure, in proxy solicitation material regarding any sale, merger, or acquisition of an
      issuer of securities, of any golden parachutes or any other transactional derived executive
      compensation agreements or understandings, not previously subject to shareholder
      approval
     Proxy solicitation material for a golden parachute to provide a shareholder vote in order to
      approve it
 Requires national exchanges and securities associations to prohibit the
  listing of any securities issuer who fails to comply with any requirements
  regarding director independence, annual elections, SEC election rules, and
  the mandatory establishment of a risk committee
               Shareholder “Say-on-Pay”

 Several companies within the United States, including
  Apple and Microsoft, have already adopted non-binding
  Say–on-Pay policies
 Europe: since the United Kingdom included Say-on-Pay
  legislation in 2002, many other European countries have
  followed likewise
    Differences between board elections between the United States and
     Europe may prove irreconcilable in light of Say-on-Pay policies
    Will the non-binding vote be ignored: consider Valeo‟s CEO Thierry
     Morin, whose severance package was voted down by over 98%, or
     Royal Bank of Scotland's CEO taking a 50% reduction to his pension
     plan following a shareholder revolt
 United States Say-on-Pay already appears ineffective in
 the eyes of some critics
Other Regulatory Measures Designed to Limit
            Compensation Risk



  The FDIC premiums
  Bank tax
  Pay czar
  International coordination and considerations
    World Economic Forum (Davos)
      Criticism: The Pros and Cons of Corporate
                  Governance Reform

 Pros:
   Moral hazard incentive problems
   Consider, however, that despite decreases in market capitalization
    between 2003-2008, several top Wall Street firms paid out an aggregate
    $600 billion, giving the impression that compensation packages are not
    in line with the best interest of shareholders
 Cons:
   Zingales: “While popular, actions directly aimed at curbing managerial
    compensations would be completely useless if not counterproductive,
    just as the 1992 Clinton initiative to curb managerial compensation had
    the opposite effect”; Rather, he continues, “[the] real issue is the lack of
    accountability of managers to shareholders, centered in the way
    corporate boards are elected”
   Micro-managing compensation
   Keeping talent
   Shareholders tend to be detached from the everyday management of
    corporations
                        Conclusion

 A few notes on proposed legislation:
   The light touch: much of the proposed regulation imposes
    shareholder votes that neither bind the decisions of the board
    of directors regarding compensation, nor create any additional
    fiduciary duties
   Indeed, much of the proposed legislation appears merely to
    change internal corporate structure only so much as to enable
    more opportunity for shareholders to makes changes, or, at the
    least, to have their opinion heard, without the government
    making serious changes on behalf of shareholders regarding
    compensation and risk management
            CFPA
Consumer Financial Protection Act
              Consumer Protection



 What are the arguments for the CFPA?
   Consumer protection is an "orphan mission”

   Banking regulators primary goal is to ensure safety-and-
    soundness not consumer protection
   Banking regulators lack expertise in consumer protection

   Regulatory arbitrage
Enforcement & Regulatory Authority
       What is the proposal for the CFPA?

 Mandate
   “The Director shall seek to promote transparency, simplicity,
    fairness, accountability, and equal access in the market for
    consumer financial products or services.”
 Objectives
   Ensure that consumers have the information they need to make
    responsible decisions about financial products and services
   Protect consumers from abuse, unfairness, deception, and
    discrimination
   Ensure that the market for financial products and services are
    operated fairly and efficiently
   Ensure that traditionally underserved customers have equal
    access to responsible financial services
                Structure of the Agency

 Director
   5-year term, appointed by the President
   Runs the agency, may not have a financial interest in any
    covered person
 Financial Protection Oversight Board
   Composed of the heads of various agencies (Fed, FDIC, NCUA,
    FTC, HUD, etc.)
   Five additional members will be appointed by the President
   Duty is to advise the Director, has no executive authority

 Special Functioning Units
                     Research Unit

 Conducts research on financial
  counseling/education
 Researching, analyzing, and reporting on:
   Current and prospective developments in financial products
   Consumer awareness, understanding, and use of communications
    regarding financial products
   Consumer awareness and understanding of costs, risks, and
    benefits
   Consumer behavior with respect to financial products
   Experiences of traditionally underserved customers

 Identify priorities and effective methods for consumer
  financial education
             Community Affairs




 Provides information, guidance, and technical
 assistance regarding the provision of consumer
 financial products and services to traditionally
 underserved consumers and communities
           Consumer Complaints



 Establishes a central database for collecting and
  tracking information on consumer complaints and
  resolution of complaints
 Required to share data and cooperate with other
  Federal agencies and State regulators
      Consumer Financial Education


 Establishes "Office of Financial Literacy" designed to
  facilitate education of consumers
 Develops goals for programs that provide consumer
  financial education and counseling
 Develops recommendations for effective certification
  of persons providing education and counseling
 Collect data on financial education and counseling
  outcomes and conduct research to identify effective
  methods, tools, and technology
                       Funding


 10% of Federal Reserve System‟s total expenses
  transferred annually
 Fees & Assessments
    Split into two funds, for depository and non-depository
     institutions
 Congressional appropriations
                Fees & Assessments

 Director will assess fees on “covered persons”, which will
  be based on: size, complexity, and compliance record
  under consumer laws
 Assessments are meant to cover the cost of supervising
  the institution
 Amounts of assessments for nondepository institutions
  shall be at least that of a depository institution with
  similar characteristics
 Marginal Assessment Rate
     Assessments on institutions with less than $25 billion may not be
      more than that for an institution with over $25 billion in assets
            Victims Relief Fund



 Any civil penalties against any person in an action
  under enumerated consumer laws will be placed in a
  Civil Penalty Fund
 Amounts in the Civil Penalty Fund shall be available
  for use to make payments to the victims
               Rulemaking Authority


 General authority to promulgate rules
 Factors to consider:
   Potential benefit and costs to consumers and covered persons,
    including the potential reduction of consumers‟ access to
    products and services
   Consult with other agencies to ensure consistency and
    harmony of objectives
   May exempt any individual, product, or class of individuals
    and providers from any regulation
   Must take into account size, volumes of transactions, diversity
    of individual, other regulation of individual/class
                    Examinations & Reports

 Director may examine a covered person on a periodic basis to
    ensure compliance with the Act
   Examinations will be based on Director‟s assessment of the
    risks posed to consumers
   Director may delegate examination authority to other
    agencies
   Director can require reports from a covered person to ensure
    compliance with consumer laws
   CFPA will have access to and share reports with other
    agencies
   Examination fees will not be assessed on institutions below a
    certain threshold:
       Insured depository < $10 billion
       Insured credit union < $1.5 billion
              What Can Be Regulated?

 Prohibit/limit mandatory predispute arbitration
 Identify certain practices and products as unfair,
    deceptive or abusive
   Take preventative measures to avoid unfair, deceptive,
    or abusive practices and products
   Regulations to ensure timely, appropriate, and
    effective disclosure to consumers
   Agency may develop „model disclosure‟ which will be
    per se compliant
   Prescribe manner, settings, and circumstances for
    provision of products and services to ensure that the
    risks, costs, and benefits of products are accurately
    represented to consumers
   Consumer access to information/reports
                Specific Prohibited Acts

 Engaging in any unfair, deceptive, or abusive act or
  practice
 Fail or refuse to:
     Pay any fee or assessment imposed by Agency
     Establish and maintain records
     Permit access to records
 SECONDARY LIABILITY: “knowingly or recklessly
  provide substantial assistance to another person”
  engaging in unfair, deceptive, or abusive practices will be
  “deemed to be in violation…to the same extent as the
  person to whom such assistance is provided”
                   Enforcement Powers

 Agency has: investigative authority, subpoena power, ability to
  bring civil enforcement actions, conduct hearings
 Relief may be in the form of: rescission or reformation of contract,
  refund of money, disgorgement of compensation for unjust
  enrichment, damages, public notification regarding violation, limits
  on future activities, penalties
 Penalties:
     Failure to pay fee/assessment or violation of the any law/regulation/final
      order or condition imposed in writing by the Agency : $5,000/day the
      violation continues
     Reckless violation of the Act or any regulation relating to provision of an
      alternative consumer financial product or service: $25,000/day the violation
      continues
     Knowing violation of the Act or any regulation: $1,000,000/day the
      violation continues
 Relief may not include punitive damages
                Whistle Blower Provision


 No covered person or service provider may terminate
 or discriminate against any covered employee that:
    Provides information to the Agency or other authority about
     violations of the Act or any law that is subject to jurisdiction of
     the Agency
    Testifies in any proceeding resulting from
     administration/enforcement of the Act
    Objected to or refused to participate in any activity that the
     employee reasonable believed to be in violation of the Act
          Who is Subject to the CFPA?

 The term „„covered person‟‟ means any person who
  engages directly or indirectly in a financial activity,
  in connection with the provision of a consumer
  financial product or service.
 Banks, credit unions, mortgage brokers
 Insurance activities related to mortgage, title, and
  credit insurance
 Anyone engaging in certain financial activities,
  including deposit taking, mortgages, credit cards,
  investment advising (if not regulated by the SEC or
  CFTC), loan servicing, check-guaranteeing, debt
  collection, collection of consumer report data,
  financial data processing, etc.
                Opposition to the CFPA


 Three major criticisms:
   That it is based on flawed understanding of crisis

   The CFPA will have significant unintended consequences,
    including but not limited to reducing competition, consumer
    choice, and availability of credit to consumers for productive
    uses
   CFPA will be a bureaucratic nightmare, mainly because of its
    undefined scope and expensive and wasteful regulatory
    overlap with other agencies
                            Current Status

 While the House Bill did pass, it did so 223-202.
   No Republican voted for the Bill
   27 Democrats voted against
 House bill has been referred to the Senate, which has not yet taken a
  vote on it
 Senator Dodd's proposal (which closely mirrors the House bill) is in
  jeopardy.
     Sen. Dodd has announced his retirement from the Senate, so if the vote on
      the legislation is delayed enough it is possible that he may not even be a
      Senator when the vote rolls around.
     Sen. Dodd has also recently expressed a willingness to scrap the idea of a
      separate consumer protection agency, instead bolstering the powers of the
      FTC with respect to consumer financial products and services.
 White House Press Secretary Robert Gibbs declared January 20,
  2010 that "financial reform has to include a consumer protection
  agency."
Credit Rating Agencies
                  Background


 3 Biggies – Fitch, S&P and Moody‟s
   Others in US

   Basel‟s list of internationals

 History
   Generally good

   Last decade of criticism mounting

   Current attack
     Completely wrong on new securities (standards/duty)
     Conflicts of interest
                          What They Do

 Issue Rating
   Once upon a time paid for by investors, now paid for by issuers
    of the securities
   Used as a way to lower cost for investors
   Theoretically increase market efficiency
       Increase market information
       Increase liquidity for smaller size issuers/less well known
        securities
     Rating reflect:
       Company‟s ability to repay debts
       Structure of the instrument
       Subordination of the security
                  What They Do, Continued



 Uses of Credit Ratings
   Most issues of bonds need at least one rating in order to
    increase their marketability
         Avoid undersubscription or low initial purchase price
     Many lenders use credit ratings as covenants in loans
         Defaults can be triggered by a drop in the borrower‟s credit rating
               What They Do, Continued


 Advisory Services
   Advise issuers on how to structure instruments in order to
    obtain the maximum yield
       Use of covenants and subordination
       Structured Financing - form trenches using definitions in the
        transaction documents
     Advise companies on formation of Special Purpose Vehicles to
      maximize their credit ratings
             What They Do, Continued

 Advisory Services create lowest possible quality at each rating
  level (regulatory arbitrage-type pattern)




    • Obvious conflict of interest in rating issuances and SPV‟s which they
      advised during formation
            oFeel an obligation to rate as promised
            o Very few rating agencies have a policy of not rating projects
               they have advised on
                      Regulatory Reliance

 Regulators allow the use of ratings for
 validating/qualifying certain investments
    SEC recognizes ratings from Nationally Recognized Statistical
     Rating Organizations (NRSRO‟s)
      Used for determining capital adequacy requirements and
       qualification for WKSI status
      Many money market mutual funds are restricted to holding only
       securities of a certain rating level
    “No Action Letters”
        SEC staff reviews issuer and states they will not recommend
         enforcement actions based on credit ratings
          Regulatory Reliance, Continued



 Basel II – recognized ratings from External Credit
 Assessment Institutions (ECAI‟s)
    Allows regulators worldwide to use ratings from ECAI‟s in
     order to determine reserve requirements
 Insurance Regulators – Use credit ratings to evaluate
 insurance companies‟ reserves
                                Problems


 AAA rated CDO‟s turned out to be worthless
   CRA‟s claim ratings are only a “point in time rating,” are only
    opinions, and make no representation as to the value or
    returns of an instrument
         However, ratings themselves are directly related to the price of a
          security; inherently a representation as to value and returns
     The general public presumed ratings to be a reflection of
      volatility and liquidity; CRA‟s say not part of the criteria
         Changes in the ratings themselves cause volatility in price
                  Problems, Continued



 Downgrade of worthless CDO‟s held by big banks
   regulators raised the required level of reserves

   price drops depleted currently held assets, lowering the value
    of existing reserves
   margin calls triggered on highly leveraged deals, depleting
    reserves even more
                     Problems, Continued

 Conflicts of Interest
     Advisory Services + Rating Services = Trouble
       Obligation to rate as promised during advising
         Full fee not paid until the requested rating was provided
       Yield lowest quality products for each rating level
     Issuer paying rating fees
       CRA‟s will not bite the hand that feeds
       CRA‟s will lose business if they do not rate favorably
         Adverse Selection: CRA‟s with most lax standards will get most of
          the business
 Moral Hazards
     No repercussions (save negative publicity) for being completely
      wrong; no accountability; no incentive to correct problems or raise
      standards
                    Problems, Continued

 Quasi-Regulatory Role
   Profit driven private companies are not properly positioned to
    represent public interests
   Proper Role: regulation is inherently adversarial, CRA‟s are
    currently far from that
       Many accuse CRA‟s of “sleeping in the same bed” with the big
        name Wall Street CEO‟s; not suited for regulating
 Wildfire Effect: After a downgrade…
   Reserve Requirements increase

   Existing Reserve Asset Values decrease

   Margin Calls and Loan Covenants are triggered
                     Recent Developments

 Bush‟s Credit Rating Reform Act 2006
   Elimated SEC‟s sole authority to designate NRSRA‟s
       Any CRA with 3+ years experience that meets certain objective
        criteria qualifies
       Designed to increase competition…S&P, Moody‟s and Fitch have
        not lost their market position in the slightest (85%)
     Granted SEC authority to inspect CRA‟s
       No say over rating methods…really no effect
       Authority to monitor use of non-public information and conflicts
        of interest went unused
     Designed to eliminate alleged abusive practices
         “Notching” – downgrade of asset-backed securities unless CRA
          was able to rate some of the underlying assets…
        Recent Developments, Continued

 SEC Regulations of 2007: Rules for NRSRA‟s
   NRSRA‟s must either avoid or disclose and manage certain
    conflicts of interest
   Prohibits certain unfair, abusive or coercive practices

 SEC Regulations of 2008: still no teeth
   Opted to not impose public disclosure requirement of
    information used to assess ABS‟s
   Requires maintenance of certain records

   Prohibits analysts from being involved in determining fee
    structure, and from receiving gifts over $25…
           Recent Developments, Continued

 Proposed Regulation – House & Senate Bill
    Amendments to SEA „34 (15 U.S.C. 780-7)
    Explicitly delegates to the SEC the duty to examine CRA‟s internal
     systems for determining credit ratings
        Must ensure adherence thereto and consistency of public disclosures
         with these systems
    Gives SEC authority to require that records be maintained and made
     available; up to SEC to implement
    Requires CRA‟s to disclose to SEC their process for assessing the
     accuracy of information of structured securities
    Spells out harsher penalties for non-compliance
    Board of Directors requirements:
      1/3 must be “independent” (defined)
      Compensation must not be linked to performance
        Recent Developments, Continued


 Proposed Legislation (cont‟d)
   Requires that Policies and Procedures are spelled out for how
    ratings are done, how conflicts of interest are managed and
    disclosed, how compensation and promotions are determined
   SEC power to prohibit certain conflicts of interest

   Requires disclosure of revenues for non-rating services
    (advisory), who and amount paid by each
   Requires SEC to review NRSRA‟s at least once annually
          Recent Developments, Continued



   Public disclosure of any significant NRSRA employee going to
    work for a rated institution
   Requires NRSRAs to have a Compliance Officers
       Spells out the duties of said Compliance Officer
   Spells out the establishment of a new SEC office dedicated to
    administering the rules regarding NRSRAs
   Requires public disclosure of ratings‟ performance,
       all initial ratings and changes
        Recent Developments, Continued


 State Attorney Generals bringing suits
   Attempting to recover state employee pension fund monies
    (especially CA & OH)
   First Amendment has kept CRA‟s undefeated in court thus far

   New suits are based on CRA‟s knowledge of inaccurate ratings
     Must prove knowledge and misrepresentation
     “The First Amendment doesn‟t extend to the deliberate
      manipulation of financial markets”
       Rodney A. Smolla, dean of the Washington and Lee University
        School of Law
                   What Should Be Done

 Either:
   Highly Regulate CRA‟s used for government purposes
    (NRSRA‟s)
       Prohibit advising and rating of same projects
       Require documentation of basis for ratings and impose standards
        and liability for inadequacies
     Direct Government involvement
       Create a government sponsored CRA to also rate the most popular
        instruments based on objective criteria
       Single point of contrast will more quickly bring to light drastic
        failures of the private CRA‟s
                   What Will Be Done

 Short Term Attention Span
   American public will find other issues to focus on and the
    government will back off
 Temporary Market Adjustment
   Investors will be more suspicious of CRA‟s and scrutinize
    ratings, helping to ground decisions
   CRA‟s will attempt to redeem their reputations, working hard
    to not soon be wrong again
 More Disclosure and Authority
   Proposed legislation will bring more information regarding
    credit ratings to the market, and SEC will have wider authority
   But will either be put to effective use…
Regulatory Structure
 General Increase in Government Intervention




• Safety Nets
 •   Bail outs             Decrease industry
 •   Deposit insurance         stability
 •   Discount windows
  General Increase in Government Intervention




• Regulations              • Requires market
                             discipline
• Heightened
                           • Improves corporate
 Supervisory Power
                              governance

                           • Improves bank
                              function
    General Increase in Government Intervention



•   Increase market discipline      • Decrease stability

•   Increase cost efficiency        • Economies of scale in
                                      compliance costs

•   Increase profit efficiency      • Discourage entry of new
                                      firms
•   Reduce asymmetric information
                                    • Consolidation into larger
                                      banks
•   Reduce transaction costs
                                    • Reduction of competition
General Increase in Government Intervention



     Increased Regulation requires increased
      information disclosures

     Information disclosures are costly


     Compliance is expensive
 Regulatory Consolidation: FIRA



            FIRA

                           State Bank
                          Supervision
OCC                      (from Federal
              OTS           Reserve)
                  FIRA: Efficient Information Sharing

                  NCUA    Fed     FDIC     OCC     OTS



Financial
Intermediaries




                  NCUA    Fed     FDIC     OCC     OTS



                                 FIRA


 Financial
 Intermediaries
 Regulatory Consolidation: CFPA


            Federal
            Reserve
   OTS                NCUA



FDIC        CFPA            FTC
CFPA: Potential Benefits and Problems


   Potential Benefits:
     Higher standard of accountability

     New customers

     Innovation of standardized financial instruments

   Potential Problems:
     Hinder innovation in other areas

     Profit inefficiency

     Lower growth rates
  Regulatory Additions: SEC & CFTC


                                                      CFTC
                      Corporate
                     Governance

     Credit Rating                Derivatives
       Agencies




  Executive
Compensation
 Disclosures
                     SEC                Hedge Funds
                                         >$100M
                     Inadequate Funding

 SEC Needs:
   Increased assessments on institutions


      Exemption from appropriations
      process

     > $1.026B 2010

 CFTC Needs:
   >$14.6M


     38 new jobs

     Larger Staff
Regulation of OTC Derivatives by SEC & CFTC


Historically:              Current Proposal:
• Speculative trading      •   Only standardized
  allowed only on              derivatives
  exchanges                    enforceable when
                               traded on
• CDS’s are enforceable        exchanges
  only if one party
      • has an insurable   •  Customized
          interest, or        derivatives
      • has a real pre-       enforceable only
        existing risk         when traded over-
                           the-counter
Increased Capital Requirements


                •   U.S. core capital requirements
                    for banks far exceed
                    international averages

                •   Largest banks in U.S. ranked in top
                    20 of The Banker’s Top 1000 listing*

                •   May move financial relationships
                    abroad

                •   Trade-off between cost efficiency and
                    profit efficiency




                     *(ranking firms by strength measured in Tier 1 capital using
                     data from 2009)
        Restrictions On Banking Activities

Obama’s Recommendations:               “Loopholes”:

•   Commercial banks retain            •   Murky definition of
    investment banking operations          proprietary trading
    BUT:
     • Banks banned from               •  Treasury Department may
       investing in hedge funds           allow banks to drop their
       or private equity                  status as bank holding
                                          companies and avoid
•   Limit bank growth:                 such
     • Limit market share of              regulations
       liabilities a bank is allowed
       to take on

•   Ban proprietary trading
   Trade-offs


Cons       Pros
                Considerations


     Costs will ultimately be borne by clients


 “Risk management is not about the elimination of
 risk; it is about the management of risk.” –Thomas
                        F. Siems

                 Macro-decisions
         Macro-Decisions



   Stability v. Growth opportunity
   Cost efficiency v. Profit efficiency
      Ability to compete abroad
      Aggregate effect of changes
    Short-term v. Long-term goals
 Acceptable Risk v. Unacceptable Risk

								
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