Monday April 30 2012 - Top 10 risk and compliance management related news stories and world events

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International Association of Risk and Compliance
Professionals (IARCP)
1200 G Street NW Suite 800 Washington, DC 20005-6705 USA
Tel: 202-449-9750 www.risk-compliance-association.com

Top 10 risk and compliance management related news stories
and world events that (for better or for worse) shaped the week's
agenda, and what is next

George Lekatis
President of the IARCP
Dear Member,

Do you know that investor in London are betting on when a particular set
of US citizens will die and, if these people live longer than anticipated, the
investment may not function as expected …
… and that the UK Financial Services Authority (FSA) has confirmed
guidance that this is a high risk product that should not be promoted to
the vast majority of retail investors in the UK?
We live in (mad) financial times. These “high risk products” are called
Traded Life Policy Investments (TLPIs). Yes, risk management is very
important. The risk is that policyholders will not die the day we want
them to die.
Investors hope to benefit by buying the right to the insurance payouts
upon the death of the original policyholder.
Well, we speak about London, let’s see the interesting definition of the
shadow banking sector from Mr Paul Tucker, Deputy Governor for
Financial Stability at the Bank of England, (speaking at the European
Commission High Level Conference, Brussels, 27 April 2012).

He said that “shadow banking” is not the same as the non-bank financial
sector.
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International Association of Risk and Compliance Professionals (IARCP)
www.risk-compliance-association.com

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For example, the vast majority of hedge funds are not shadow banks, and
don’t trade in the credit markets or especially illiquid markets.

Also, non-bank intermediation of credit is not a bad thing in itself. Indeed,
it can be a very good thing, helping to make financial services more
efficient and effective and the system as a whole more resilient.

But, as we know from this crisis and from previous ones, true shadow
banking can weaken the system. Regulatory arbitrage, which is always
with us, can distort and disguise channels of intermediation.

Shadow banking comes in lots of shapes and colours. There are degrees
to which any particular instance of shadow banking replicates banking.

The liquidity offered by some shadow banks relies pretty well entirely,
and more or less openly, on committed lines of credit from commercial
banks.

In these cases, the liquidity insurance offered by the shadow bank is
“derivative”; there is a real bank in the shadows.

But for other shadow banks, liquidity services are offered without such
back-up lines. In those cases, claims on the shadow bank have, in effect,
become a monetary asset. Examples probably include money market
mutual funds and an element of the prime brokerage services offered by
securities dealers to levered funds.

Interesting!

Welcome to the Top 10 list.

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Developing a Single Rulebook in banking

Andrea Enria, Chairperson European Banking
Authority, Central Bank of Ireland –
Stakeholder Conference ‘Financial Regulation, Thinking about the
future, 27 April 2012

FSA confirms traded life policy investments should not
generally be promoted to UK investors
25 Apr 2012

The Financial Services Authority (FSA) has confirmed
guidance that traded life policy investments (TLPIs) are high risk
products that should not be promoted to the vast majority of retail
investors in the UK

Federal Deposit Insurance Corporation
U. S. Small Business Administration
April 24, 2012

FDIC and SBA Team Up to Offer Financial Education Support for New
and Aspiring Entrepreneurs

FSA Japan
Press Conference by Shozaburo Jimi,
Minister for Financial Services (Excerpt)

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Securities Lending and Repos:

Market Overview and Financial Stability
Issues

Interim Report of the FSB Workstream on Securities Lending and Repos,
27 April 2012

Shareholder value and stability in banking: Is there a
conflict?

Speech by Jaime Caruana, General Manager, Bank for
International Settlements

Jens Weidmann:
Global economic outlook – what
is the best policy mix?

Speech by Dr Jens Weidmann,
President of the Deutsche Bundesbank,
Economic Club of New York, New York,
23 April 2012

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Energy ≠ Heat:

DARPA seeks non-thermal approaches to
thin-film deposition

Federal Open Market Committee

Information received since the Federal Open
Market Committee met in March suggests
that the economy has been expanding
moderately.

FSB Principles for Sound Residential
Mortgage Underwriting Practices
April 2012

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Developing a Single Rulebook in banking
Andrea Enria, Chairperson European Banking Authority, Central Bank of
Ireland – Stakeholder Conference ‘FINANCIAL REGULATION -
THINKING ABOUT THE FUTURE’ 27 April 2012

Ladies and Gentlemen,

My main topic today will be the Single Rulebook, the main path ahead of
us to achieve the objectives of the new European institutional framework
established with the endorsement of the recommendations of the de
Larosière report.

I will primarily focus on owns funds, as this is a key issue for
re-establishing the regulatory framework on a sound footing and the EBA
is currently running a public consultation on this.

I will also briefly touch on another important component of the Single
Rulebook: the liquidity requirements.

However, before tackling these issues, I would like to give you an
overview of the first year of existence of the EBA and especially of the
work done to face the challenges posed by the current crisis.

1. The efforts of the EBA in tackling the financial crisis
In the first year of its life, the priorities of the EBA had to be focused on
the challenges raised by the deterioration of the financial market
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environment.

The stress test exercise we conducted in the first part of 2011 focused on
credit and market risks but also, in recognition of the risks that
subsequently crystallised, incorporated sensitivity to movements in
funding costs.

Banks were also required to assess the credit risk in their sovereign
portfolios.

In many respects, I believe the exercise was successful: in order to
achieve the tougher capital threshold, anticipating many aspects of the
new Basel standards, banks raised € 50 bn in fresh capital in the first four
months of the year; we set up a comprehensive peer review exercise,
which ensured consistency of the exercise across the Single Market,
notwithstanding the many differences in national regulatory frameworks;
the exercise included an unprecedented disclosure of data (more than
3200 data points for each bank), including amongst other things detailed
information on sovereign holdings.

However, the progress of the stress test was tracked by a significant
further deterioration in the external environment.

The main objective of restoring confidence in the European banking
sector was not achieved, as the sovereign debt crisis extended to more
countries, thus reinforcing the pernicious linkage between sovereigns and
banks.

Most EU banks, especially in countries under stress, experienced
significant funding challenges.

In this context, the IMF and the European Systemic Risk Board (ESRB)
called for coordinated supervisory actions to strengthen the banks’ capital
positions.

The EBA assessment was that without policy responses, the freeze in
bank funding would have led to an abrupt deleveraging process, which

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would have hurt growth prospects and fuelled further concerns on the
fiscal position of some sovereigns, in a negative feedback loop.

We then called for coordinated action on both the funding and the
capitalisation side.

While advising the establishment of an EU-wide funding guarantee
scheme, the EBA focused its own efforts on those areas where it had
control, primarily bank capitalisation.

To this end, the Board of Supervisors, comprising the heads of all 27
national supervisory authorities, discussed and agreed that a further
recapitalisation effort was required as part of a suite of coordinated EU
policy measures.

Our Recommendation identified a temporary buffer to address potential
concerns over EU sovereign debt holdings and required banks to reach
9% CT1.

The total shortfall identified was € 115 bn.

The measure was agreed in October and enacted in December 2012.

It was swiftly followed by the ECB’s long term refinancing operations
(LTROs), arguably the key “game changer” in this context.

But the recapitalisation was a necessary complementary measure: while
banks needed unlimited liquidity support, to avoid a credit crunch, they
had to be asked to accelerate their action to repair balance sheets and
strengthen capital positions.

These measures have bought time but should not bring complacency.

The recapitalisation plan has seen banks make significant efforts to
strengthen their capital position without disrupting lending into the real
economy.

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The EBA’s intensive monitoring of the process shows that 96% of the
shortfall identified was met by direct capital actions.

Moreover, there has been a strong spirit of cooperation between home
and host supervisors in discussing and taking forward these plans
through colleges of supervisors, which has acted as a meaningful
counterweight to the trend for national concerns to come to the fore in the
current environment.

Going forward, heightened attention to addressing residual credit risk,
making efforts to meet the new CRD IV requirements, setting in place
plans to gradually restore access to private funding and exit the
extraordinary support of the ECB will be key.

2. The Single Rulebook in banking
As the finalisation of the new legislative framework for capital and
liquidity requirements was coming closer, the focus of the EBA work has
been increasingly moving to our tasks in the rule-making process.

The key task that the reform proposed by the de Larosière report assigns
to the EBA is the establishment of a Single Rulebook, ensuring a more
robust and uniform regulatory framework in the Single Market and
preventing a downward spiral of competitive relaxation of prudential
rules.

The EBA is asked to draft technical standards that, once endorsed by the
Commission, will be adopted as EU Regulations.

The standards will therefore be directly applicable to all financial
institutions operating in the Single Market, without any need for national
implementation or possibility for additional layers of local rules.

I see that at the moment, while the negotiations on the capital
requirement directive and regulation (CRD4-CRR) are entering the final
stages, there is a call for more national flexibility.

It is often argued that minimum harmonisation is all that is needed, as the
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decision of a national authority to apply stricter requirements would only
penalise financial institutions chartered in that jurisdiction.

This argument neglects the fact that we have lived in a world of minimum
harmonisation until now, and this has delivered an extremely diverse
regulatory environment, prone to regulatory competition.

It is a fact that the flexibility left by EU Directives has been a key
ingredient in the run-up to the crisis.

The Directives left significant flexibility to national authorities in the
definition of key prudential elements (e.g., definition of capital,
prudential filters for unrealised gains and losses), the determination of
risk weights (e.g., for real estate exposures), the approaches to ensure that
all the risks are captured by the requirements (e.g., effectiveness of risk
transfers).

All these elements of flexibility have been used by banks to put pressure
on their supervisors, triggering a process that led to excessive leverage
and fuelled credit and real estate bubbles.

The heterogeneity of the regulatory environment also complicated
significantly the effective supervision of cross-border groups, which were
at the epicentre of the crisis: supervisors had serious difficulties both
building up a firm-wide view of risks and acting in a timely and
coordinated fashion.

Furthermore, regulatory arbitrage drove business decision. This problem
has not been fixed yet.

In its first year of activity, the EBA identified a number of differences in
regulatory treatment that lead to very material discrepancies in key
requirements.

For instance, the EBA staff conducted a simple exercise on the data
collected for the recapitalisation exercise.

The capital requirement for the same bank were calculated using the less
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stringent and the most restrictive approaches in four areas where national
rules present important differences – the calculation of the Basel I floors,
the application of the prudential filters, the treatment (deduction from
capital or inclusion in assets with a 1250% weight) of IRB shortfalls and of
securitisations.

As a result, the ratio was 300 bps lower when the stricter methodologies
were applied, showing that differences can be very material and difficult
to spot.

In integrated financial markets, these differences can have very disruptive
effects.

Once risks generated under the curtain of minimum harmonisation
materialise, the impact is surely not contained within the jurisdictions
that adopted less conservative approaches.

Without using exactly the same definition of regulatory aggregates and
the same methodologies for the calculation of key requirements, the
problem will not be fixed.

At the same time, it is absolutely true that the new regulatory framework
has to be shaped in such a way to leave a certain degree of national
flexibility in the activation of macroprudential tools, as credit and
economic cycles are not synchronised across the EU.

Also, there could be structural features of financial sectors, or
components thereof, which might require tweaking prudential
requirements to prevent systemic risk.

But the same source of systemic risk should be treated in a broadly
consistent manner in different jurisdictions across the Single Market, to
avoid an unlevel playing field and less stringent approaches that might
subsequently generate spillovers in other countries.

The ideal long-term solution for avoiding conflicts between the flexibility
needed for macroprudential supervision and the degree of regulatory
harmonisation called for by the Single Rulebook is constructing a suite of
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macroprudential instruments along the blueprint of the countercyclical
buffer.

This provides a significant leeway for tightening standards while the
European Systemic Risk Board (ESRB) is entrusted with the task of
drafting guidance on the activation of the tool and of conducting ex post
reviews.

At the same time, reciprocity in the application of the tool allows for
cross-border consistency and reduces the room for regulatory arbitrage.

So, we may well have a single rule, adopted through an EU Regulation,
while this rule provides for flexibility in its application, with a framework
that the Basel Committee has labelled as “constrained discretion”.

3. Giving life to the Single Rulebook: the new regulatory
framework of bank capital and liquidity
In giving life to the Single Rulebook in banking, the EBA is facing a
major challenge.

The CRD4-CRR proposal envisages around 200 tasks, more than 100
technical standards - 40 of which will have to be finalised by the end of
this year.

We will have to ensure standards of high legal quality as they will be
immediately binding in all 27 Member States when endorsed by the
European Commission.

We will have to respect due process, with wide and open consultations
and adequate impact assessments.

As to the substance of the new regulatory framework, I will focus today on
the definition of capital and the quality of own funds, which I consider as
one of the cornerstones of the Single Rulebook in banking.

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3.1. Own funds

The definition of capital has been a major loophole in the run-up to the
crisis.

As financial innovation brought about increasingly complex hybrid
instruments, national authorities have been played against each other by
the industry, with the result that the standards for the quality of capital
were continuously relaxed.

As a consequence, once the crisis hit, a significant amount of capital
instruments proved to be of inadequate quality to absorb losses.

In several cases, taxpayers’ money was injected while the holders of
capital instruments continue to receive regular payments.

The Basel Committee has done an outstanding job in significantly
strengthening the definition of capital and we must make sure that this is
not lost in the implementation of the standards.

The EBA already achieved some progress in the use of stringent uniform
standards when imposing the use of a common definition of capital for
the purpose of the stress test and the recapitalisation exercise.

This proves that collective enhancements can be reached when necessary.

But what can be done in periods of stress must be perpetuated in normal
times.

For this purpose, on 4 April, the EBA published a consultation on a first
set of regulatory technical standards on own funds.

These cover most areas of own funds, fleshing out the features of
instruments of different quality (from CET1 to Tier 2 instruments).
The consultation will provide appropriate input from interested parties
and regular contacts with banks and market participants are already
under way.

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The standards elaborate on the characteristics of the instruments
themselves, as well as on deductions to be operated from own funds.

It is indeed crucial to ensure that there is a uniform approach regarding
the deduction from own funds of certain items like losses for the current
financial year, deferred tax assets that rely on future profitability, defined
benefit pension fund assets.

It is also necessary to ensure that, where exemptions from and
alternatives to deductions are provided, sufficiently prudent requirements
are applied.

The standards cover also several areas affecting more directly cooperative
banks and mutuals, whose particular features have to be taken into
adequate account.

At the same time, it is necessary to define appropriate limitations to the
redemption of the capital instruments by these institutions.

The standards will also contribute to increase the permanence of capital
instruments more generally by strengthening the features of the latter and
by specifying the need for supervisory consent when reducing own funds.

Finally, the standards will also increase the loss absorbency features of
eligible hybrid instruments, in line with the objective to bring investors
closer to shareholders and share losses on a pari passu basis.

In order to complete its current work on own funds, the EBA will soon
publish a technical standard on disclosure by institutions.

The work of the EBA on own funds will not be concluded with the
endorsement of the new technical standards.

Indeed, although technical standards, like EU Regulations, should not
leave room for interpretation, it cannot be excluded that some provisions
will not work as they are meant to.

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This is the reason why a close review of the application of the standards is
necessary to detect potential loopholes and propose changes when
needed.

A framework should be developed, probably in the form of a Q&A
platform, in order to address technical issues that may well emerge in the
practical application of the standards.

Furthermore, an important task that has been attributed to the EBA is the
publication of a list of instruments included in Common Equity Tier 1
(CET1) as well as the monitoring of the quality of capital instruments.

I believe the current text of the CRD4-CRR does not go far enough in
ensuring a strong control on the instruments that will be included in the
capital of higher quality.

I understand the decision of the EU institutions to follow an approach
that privileges substance over form: the definition of Common Equity
Tier 1 will not be restricted to ordinary shares, as there is no harmonised
EU-wide definition that could be relied upon.

Instead, the legislation will require that only instruments that are in line
with all the principles defined by the Basel Committee will qualify.

In order for this to ensure a strict control on the quality of these
instruments, strong mechanisms should be put in place to make sure that
there is no room for watering down the requirements.

The “substance” needs to be checked and has to be the same across the
Single Market.

From my perspective, the list that the EBA will keep should be legally
binding.

There should be an in-depth scrutiny of the instruments conducted at the
EU level by the EBA, in cooperation with national supervisors, to confirm
the inclusion in the list.

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If an instrument is included in the list, it should be accepted throughout
the Single Market.

If it is not included in the list, no authority should have the possibility to
consider it eligible as CET1.

The present text limits the role of the EBA to the publication of an
aggregated list only based on the assessment done at national level.

This would not bring any added value compared to a situation where
Member States would be required to publish by themselves a list of
instruments recognised in their jurisdictions.

On the contrary, this could be misleading, as it could convey the
impression that the instruments have received an EU-wide recognition.

In any case, even if the legislative framework does not provide the EBA
with the necessary legal tools, we are committed to fully exploiting the
draft Regulation’s provisions that require the EBA to monitor the quality
of own funds across the Single Market and to notify the Commission in
case of evidence of material deterioration in the quality of those
instruments.

If we consider that some instruments that are not of sufficient quality
have been accepted, we also have the possibility to open formal
procedures for breach of European law.

Having strong enforcement tools is essential: supervisors have lost
control of the definition of capital once and we should not allow this to
happen again.

We are acutely aware that the new rules will trigger a new wave of
financial innovation, aimed at limiting the restrictive impact of the reform.
Indeed, this is already under way.

We already hear that new ways are being devised to smooth the impact of
permanent write-downs or to circumvent the prohibition of dividend
stoppers for hybrid instruments.
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Our monitoring of capital issuances is ongoing.

The EBA recently decided to develop a set of benchmarks for hybrid
instruments to give more clarity on what are the terms and conditions – in
terms of permanence, flexibility of payments, loss absorbency – that make
an instrument compliant with applicable rules.

The work in this area will begin when the final legislation is in place and a
sufficient number of new issuances are available, in order to have a
meaningful sample of instruments to assess.

In the future, hopefully, this work could move a step further, towards
providing common templates, which could lead to the harmonisation of
the main contractual provisions of hybrid capital instruments, in line with
the objectives of a Single Rulebook.

A concrete illustration of these common templates has already been given
by the EBA when publishing a common term sheet for the convertible
instruments accepted for the purpose of the recapitalisation exercise.

3.2. Liquidity
The new liquidity standards represent a second important area of work for
the EBA.

The first deliverable is due at the end of 2012, when we will have to
provide for uniform reporting formats.

The framework is currently under development and is expected to be
released for public consultation over the summer.

However, we can already foresee that the reporting is likely to be fairly
similar to that used by the Basel Committee for the quantitative impact
study, which many European banks are already familiar with.

But the most important and delicate area of work is the definition of
liquid assets and, more generally, the calibration of the new requirements.

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We are aware that the banking industry has raised serious concerns on the
two liquidity standards defined by the Basel Committee, the liquidity
coverage ratio (LCR) and the net stable funding ratio (NSFR).

The Basel Committee itself is reviewing the calibration of the ratios,
recognising that some underlying assumptions are excessively
conservative, even if confronted with the toughest moments of the
financial crisis.

The key principles underlying the LCR and the NSFR are sound and
cannot be given up by regulators: banks need to have sufficient buffers of
liquid assets to withstand a shock for some time without the need for
public support; maturity transformation needs to be constrained to some
extent, so as to prevent banks from adopting fragile business models
relying excessively on volatile, short term wholesale funding to support
longer term lending.

But it is essential to get the calibration right, as funding is and will
increasingly be the main driver of the deleveraging process at EU banks.

Time is needed to do a proper job: we have to ensure that data of
adequate quality is available – hence the need for a uniform reporting
provided at the end of 2012 – and to allow for in-depth analyses.

The first impact assessments on LCR and the NSFR are due in 2013 and
2015 respectively.

The EU has taken the decision to use the monitoring period until 2015 for
the LCR and 2018 for the NSFR, before proposing legislation for a final
calibration of the liquidity ratios.

This monitoring phase exactly mirrors the Basel Committee’s timeline.

It is in my view the right choice to allow for this extensive observation
period. I would strongly argue that we should avoid making any policy
choice before proper evidence on the potential impact of the two ratios.

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Conclusions

Ladies and gentlemen,

Today I tried to convey to you a bird’s eye picture on the difficult
challenges the EBA is facing.

In the first year of activity we have already done a huge effort to
strengthen the capital position of EU banks and to restore confidence in
their resilience. The work is not over in this area.

The liquidity support provided by the ECB avoided an abrupt
deleveraging process, but banks are still in the process of repairing and
downsizing their balance sheets and of refocusing their core business.

We, as supervisors, need to accompany this process and do our utmost to
ensure that it occurs in an ordered fashion, without adverse consequences
on the financing of the real economy.

One way to support the process is the introduction of the reforms on
capital and liquidity standards endorsed by the G20.

I strongly believe that we need to exploit this opportunity to move to a
truly harmonised regulatory framework, a Single Rulebook that ensures
that high quality standards are enforced throughout the Single Market.

We have to be particularly rigorous on the definition of capital, as this is
the basis for most prudential requirements.

We cannot afford anymore financial innovation that allows instruments to
be accepted as capital, while not respecting the key principles of
permanence, flexibility of payments and loss absorbency.

The control on eligible capital instruments needs to be very strict and
should be performed at the EU level. Ideally, the co-legislators should
give the EBA the legal basis to perform this difficult task.

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But in any case we will conduct a close monitoring of capital issuances, as
we consider our duty to ensure that only the instruments of the best
quality are accepted as regulatory capital.

As to liquidity standards, I believe that while the principles embodied in
the Basel text are absolutely shared, we need to do more work on the
calibration of the requirements.

We understand the concerns expressed by the industry, but it is important
that we collect solid empirical evidence before taking any decision in this
delicate area, which will provide a major driver for the needed changes in
banks’ business models.

Thank you for your attention.

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FSA confirms traded life policy investments should not generally
be promoted to UK investors
25 Apr 2012

The Financial Services Authority (FSA) has confirmed guidance that
traded life policy investments (TLPIs) are high risk products that should
not be promoted to the vast majority of retail investors in the UK.
The guidance is an interim measure – the FSA will shortly be consulting
on new rules imposing significant restrictions on the promotion of
non-mainstream investments, including TLPIs, to retail investors.
TLPIs invest in life insurance policies, typically of US citizens.
Investors hope to benefit by buying the right to the insurance payouts
upon the death of the original policyholder.
Basically, a TLPI investor is betting on when a particular set of US
citizens will die and, if these people live longer than anticipated, the
investment may not function as expected.
The FSA has found evidence of significant problems with the way in
which TLPIs are designed, marketed and sold to UK retail investors.
Many of these products have failed, causing loss for UK retail investors.
Many TLPIs take the form of unregulated collective investment schemes,
which cannot lawfully be promoted to retail investors in most cases, but
have often been marketed inappropriately to retail customers.
Peter Smith, the FSA’s head of investment policy said:

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“The TLPI retail market is worth £1 billion in the UK and we were very
concerned that it was likely to grow even more.
At the time that we published our guidance over half of existing retail
investments were in financial difficulty – even so, we were hearing about
the development of new products intended to be sold to UK retail
customers.
“The threat to new customers was significant and growing: the potential
for substantial future detriment was clear.
There was a concern that we were witnessing a repeating cycle of
unsuitable sales followed by significant customer detriment in the TLPI
market.
Following publication of the guidance for consultation, this threat has
receded.
“This is an interim measure – we believe that TLPIs and all unregulated
collective investment schemes should not generally be marketed to retail
investors in the UK and will be publishing proposals soon to prevent them
being promoted except in rare circumstances.”

Traded Life Policy Investments (TLPIs), Key risks associated
with TLPIs

Longevity risk

An accurate estimation of life expectancy is the most important factor in
assessing the price of each underlying life insurance policy in a TLPI.

Based on this, the primary risk is that the underlying policies’ lives
assured live longer than expected (for example, because of medical
advances and the incompatibility of life assurance actuarial models as the
basis for investment purposes) so the TLPI needs to continue to fund
premiums on the policies for longer than expected.

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This could negatively affect the return on investment and liquidity on an
ongoing basis.

Liquidity risk

The underlying investments are illiquid due to their specialised nature
and there is only a limited secondary market for them.

This may mean they are sold at a significantly reduced value if the TLPI
needs to raise funds at short notice, which has an impact on the value of
the portfolio.

Investors may therefore suffer financial loss at the point of redemption.

Parties involved in the TLPI may become insolvent

This risk factor, though not unique to TLPIs, is often overlooked.

For example, if an insurance company becomes insolvent and is unable to
meet claims upon the deaths of the original policyholders the TLPI could
find itself in difficulties given the often large value of the policies it holds.

Governance issues

TLPI product governance has often proven problematic and led to
product difficulties.

Some common issues are as follows:

Conflicts of interest

Conflicts exist among different participants in the product value chain
that lead to high fees being charged and may lead to detriment for
investors.

TLPI models/structure

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In some models, yields are promised to previous investors, which can
only be sustained by using new investors’ money, so the model in effect
‘borrows’ from itself.

The underlying assets are located offshore

This means there is an exchange rate risk, both in terms of the costs of
meeting ongoing premiums and the final payout for the underlying
insurance contracts.

Currency hedging instruments may be used by TLPI providers, but these
may pose additional risks and involve extra costs.

Many TLPIs sold in the UK are operated by firms based
offshore

This means investors may have limited or no recourse to the Financial
Services Compensation Scheme (FSCS) if things go wrong and the
product fails.

They may also not be covered by the Financial Ombudsman Service
(FOS) if they have a complaint about the operation of the TLPI.

Customers would be able to complain to the FOS if, for example, the
advice they have received from UK distributors was unsuitable or if a
promotion from a UK provider or distributor was unfair, unclear or
misleading.

Awareness of authorisation/compensation arrangements
Many TLPIs are operated by firms based abroad and outside of the FSA’s
jurisdiction.

There is evidence that providers and advisers have not fully understood or
conveyed to investors the risks involved in how or whether the client’s
product will be authorised and what compensation arrangements apply.

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These factors could result in a significant risk of loss of capital (and any
income provided) for customers.

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Federal Deposit Insurance Corporation
U. S. Small Business Administration
April 24, 2012

FDIC and SBA Team Up to Offer Financial Education Support
for New and Aspiring Entrepreneurs

The Federal Deposit Insurance Corporation (FDIC) and U.S. Small
Business Administration (SBA) announced new resources to support
small businesses.
FDIC Director for Depositor and Consumer Protection Mark Pearce and
SBA’s Deputy Associate Administrator for Entrepreneurial Development
Michael Chodos released Money Smart for Small Business, a training
curriculum for new and aspiring business owners.
Developed in partnership between both agencies, this curriculum is the
latest offering in the FDIC’s 10 year old award-winning Money
Smart program.
Money Smart for Small Business provides an introduction to day-to-day
business organization and planning and is written for entrepreneurs with
limited or no prior formal business training.
It offers practical information that can be applied immediately, while also
preparing participants for more advanced training.
The curriculum is designed to be delivered to new and aspiring business
owners by financial institutions, small business development centers
(SBDCs), among others.
Director Pearce and SBA Associate Administrator Chodos were joined by
Training Alliance partners at the launch of Money Smart for Small
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Business, hosted by the District of Columbia’s Affinity Lab, a small
business incubator.
“We are proud to launch Money Smart for Small Business,” said Acting
Chairman Gruenberg.
“Since 2001, Money Smart has helped individuals build a secure financial
future for themselves.
I am very pleased that small businesses, which play a vital role in
supporting our national economy, will now have access to this resource.
The FDIC looks forward to working with the SBA and the Money
Smart Alliance, to promote financial literacy among small business
owners.”
“We are excited to join the FDIC in its expansion of the Money
Smart curriculum for small business,” said SBA Administrator Karen
Mills.
“The FDIC is a vital ally in our efforts to help small business owners start,
grow and create jobs.
Money Smart for Small Business will help to put more information on the
business basics of financial management at entrepreneurs’ fingertips and
make it easier for them to build their knowledge and skill set.”
Each of the ten instructor-led modules in Money Smart for Small
Business provides financial and business management for business
owners and includes a scripted instructor guide, participant guide and
overhead slides.
Organizations that use the curriculum to support small businesses
through training, technical assistance or mentoring are invited to join the
FDIC and SBA’s Training Alliance.
The FDIC will host an online “town hall” for potential Training Alliance
partners in the months ahead.
More than ten years after the original release of the award -
winning Money Smart adult curriculum, Money Smart for Small

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Business builds on the proven results in financial management for those
who complete the curriculum.

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FSA Japan - Press Conference by Shozaburo Jimi, Minister for
Financial Services (Excerpt)

[Opening Remarks by Minister Jimi]

This morning, the Minister of Economic and Fiscal Policy, the Minister
of Economy, Trade and Industry and the Minister for Financial Services
held a meeting, and I will make a statement regarding the policy package
for management support for small and medium-size enterprises (SMEs)
based on the final extension of the SME Financing Facilitation Act.

Recently, the Diet passed and enacted an amendment bill to extend the
period of the SME Financing Facilitation Act for one year for the last time
and an amendment bill to extend the deadline for the determination of
support by the Enterprise Turnaround Initiative Corporation of Japan,
over which Minister of Economic and Fiscal Policy Furukawa has
jurisdiction, for one year, and the new laws were promulgated and put
into force.

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I believe that this year will be very important for creating an environment
for vigorously implementing support that truly improves the management
of SMEs, namely an exit strategy.

From this perspective, the ministers who represent the Cabinet Office,
the Financial Services Agency (FSA) and the Small and Medium
Enterprise Agency held a meeting and adopted the policy for
management support for SMEs.

The FSA will seek to facilitate financing for SMEs through measures
related to the final extension of the period of the SME Financing
Facilitation Act, including this policy package, and will also create an
environment favorable for management support for SMEs while
maintaining cooperation with relevant ministries and agencies.

For details, the FSA staff will later hold a press briefing, so please ask your
questions then.

[Questions & Answers]

Q. The G-20 meeting started on April 19.

I hear that the expansion of the International Monetary Fund's lending
facility, which has been the focus of attention, may be put off, and the
market could fall into turmoil again, with the yield on Spanish
government bonds rising in Europe.

Could you tell me how you view the recent financial market
developments?

A. As for the current situation surrounding the European debt problem
that you mentioned now, individual countries' financial and capital
markets have generally been recovering for the past several months as a
result of efforts made by euro-zone countries and the European Central
Bank, as you know.

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On the other hand, concern over the European fiscal problem has not
been dispelled, as indicated by unstable market movements caused by
concern over Spain's fiscal condition.

The euro zone has set forth the path to fiscal consolidation and President
Draghi of the European Central Bank (ECB) has taken bold measures, as
you know well.

Such measures as the ECB's long-term refinancing operation and the
strengthening of the firewall have been taken.

To ensure that the market will be stabilized and the European debt
problem will come to an end, it is important not only that the series of
measures adopted by the euro zone is carried out but also that the IMF's
financial base is strengthened.

From this perspective, Minister of Finance Azumi recently expressed an
intention to announce Japanese financial support worth 60 billion dollars
for the IMF at the G-20 meeting.

I hope that this Japanese action, combined with Europe's own efforts, will
help to resolve the European debt problem.

As you know, it is unusual for Japan to exercise initiative and announce
support for the IMF.

Although Japan has various domestic problems, it is the world's
third-largest country in terms of GDP.

In addition, as I have sometimes mentioned, Japan is the only Asian
country that has maintained a liberal economy and a free market since the
latter half of the 19th century.

Even though Japan lost 65% of its wealth because of World War II, it went
on to recover from the loss.

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In that sense, it is very important for Japan to exercise initiative, on which
the United States eventually showed an understanding from what I have
heard informally.

Q. It has been decided that Kazuhiko Shimokobe of the Nuclear Damage
Liability Facility Fund will be appointed as Tokyo Electric Power
Company's new chairman.

Tokyo Electric Power's management problem has had some effects on
the corporate bond market and also has affecteds SMEs through a hike in
electricity rates. What do you think of this appointment?

A. I am aware that Mr. Shimokobe, who is chairman of the Nuclear
Damage Liability Facility Fund's management committee, has accepted
the request to serve as Tokyo Electric Power's chairman, but the FSA
would like to refrain from commenting on personnel affairs.

Formerly, I, together with Mr. Yosano, joined the cabinet task force,
which was responsible for determining the scheme for rehabilitating
Tokyo Electric Power, in response to the economic damage caused by the
nuclear station accident, as additional members, and our efforts led to the
enactment of the Act on the Nuclear Damage Liability Facility Fund.

I understand that Tokyo Electric Power and the Nuclear Damage
Liability Facility Fund are drawing up a comprehensive special business
plan.

What kind of support Tokyo Electric Power will ask stakeholders to
provide and how stakeholders including financial institutions will
respond are matters to be discussed at the private-sector level, as I have
been saying, so the FSA would like to refrain from making comments for
the moment.

In any case, regarding Tokyo Electric Power's damage compensation,
making damage compensation payments quickly and appropriately and
ensuring stable electricity supply are important duties that electric power
companies must fulfill.
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Therefore, with the fulfillment of those duties as the underlying premise,
it is important to prevent unnecessary, unpredictable adverse effects - you
mentioned the effects on the corporate bond market earlier - so I will
continue to carefully monitor market developments.

Q. On April 19, the Democratic Party of Japan's working team on the
examination of the future status of pension asset management and the
AIJ problem adopted an interim report.

Could you tell me about the status of the FSA's deliberation on measures
to prevent the recurrence of the problem, including when the measures
will be worked out?

A. I read about that in a newspaper article.

Regarding problems identified in this case, it is necessary to ensure the
effectiveness of countermeasures while taking account of practical
financial practices.

That report is an interim one, so it stated that various measures will be
worked out in the future. I have my own thoughts as the person in charge
of the FSA.

However, I think that the FSA needs to conduct a study on measures such
as strengthening punishment against false reporting and fraudulent
solicitation - as you know, false reports were made in this case -
establishing a mechanism that ensures effective checks by third-parties
like companies entrusted with funds, auditing firms and trust banks - the
checking function did not work at all in this case - and including in
investment reports additional information useful for pension fund
associations to judge the reliability of companies managing customers'
assets under discretionary investment contracts and the investment
performance.

In any case, regarding measures to prevent the recurrence of this case, we
will quickly conduct deliberation while taking into consideration the
results of the Securities and Exchange Surveillance Commission's
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additional investigation and the survey on all companies managing
customers' assets under discretionary investment contracts - the
second-round survey is underway - as well as the various opinions
expressed in the Diet, including the arguments made in the interim report,
which was written under Ms. Renho's leadership.

We will implement measures one by one after each has been finalized.

Q. Regarding the policy package announced today, several people said in
the Diet that more efforts should be devoted to measures to support
SMEs in relation to the extension of the period of support by the
Enterprise Turnaround Initiative Corporation of Japan.

In relation to the policy package, do you see any problems with the
collaboration that has so far been made with regard to management
support for SMEs?

A. Twenty-two years ago, in 1990, I became parliamentary secretary for
international trade and industry, and served in the No. 2 post of the
former Ministry of International Trade and Industry for one year and
three months under then Minister of International Trade and Industry
Eiichi Nakao.

At that time, I was in charge of financing for SMEs, such as financing
provided by Shoko Chukin Bank, the Japan Finance Corporation for
Small and Medium Enterprise, the National Life Finance Corporation
and the Small Business Corporation, for one year and three months.

Many departments and divisions are involved in the affairs of SMEs.

While diversity and nimbleness are important for SMEs, I know from my
experiences that they lack human resources and that unlike large
companies, it is difficult for them to change business policies quickly in
response to tax system changes.

The FSA will continue to cooperate with relevant ministries and agencies
and relevant organizations, such as the Enterprise Turnaround Initiative
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Corporation of Japan, liaison councils on support for the rehabilitation of
SMEs, financial institutions and related organizations, including the
Japanese Bankers Association, and commerce and industry groups - there
are four traditional associations of SMEs - as well as prefectural credit
guarantee associations, which play an important role for the
government's policy for SMEs.

In addition, the FSA will cooperate with government-affiliated financial
institutions and take concrete actions, and I hope that recovery and
revitalization of local economies based on the rehabilitation of regional
SMEs will lead to the development of the Japanese economy.

However, between the three ministers who held a meeting today, the
policy toward SMEs tends to lack coordination.

In Tokyo, Minister of Economy, Trade and Industry Edano and Minister
of Economic and Fiscal Policy Furukawa and I worked together to adopt
the policy package. In Japan's 47 prefectures, there are liaison councils on
support for rehabilitation of SMEs and there are commerce and industry
departments in prefectural and municipal governments, and these
organizations will also be involved, so the policy for SMEs is
wide-ranging and involves various organizations.

Therefore, while we provide management support, these various
organizations tend to act without coordination.

Today, the three of us held a meeting to exercise central government
control, and we will keep close watch on minute details so as to ensure
coordination.

As I have often mentioned, there are 4.3 million SMEs, which account for
99.7% of all Japanese corporations in Japan, and 28 million people, which
translates into one in four Japanese people, are employed by SMEs, so
SMEs have large influence on employment.

We will maintain close cooperation with relevant organizations.

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Q. In relation to the previous question, I understand that the Enterprise
Turnaround Initiative Corporation of Japan has mostly handled cases
involving SMEs.

At a board meeting yesterday, it was decided that a former official of a
regional bank will be appointed to head the corporation. How do you feel
about that?

A. I read a newspaper article about the decision to appoint a former
president of Toho Bank.

Toho Bank is the largest regional bank in Fukushima Prefecture, and
personally, I am pleased that a very suitable person will be appointed as a
new president.

Fukushima Prefecture has been stressing that the revival of Japan would
be impossible without the revival of Fukushima in relation to the nuclear
station accident.

In that sense, the selection of the former president of Toho Bank, a fairly
large regional bank, who also served as chairman of the Regional Banks
Association of Japan, is appropriate.

This morning, Minister of Economic and Fiscal Policy Furukawa
reported on the selection.

I think that a very suitable person has been selected.

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Securities Lending and Repos: Market Overview and Financial
Stability Issues, Interim Report of the FSB Workstream on
Securities Lending and Repos, 27 April 2012

Introduction

At the Cannes Summit in November 2011, the G20 Leaders agreed to
strengthen the regulation and oversight of the shadow banking system,
and endorsed the Financial Stability Board (FSB)’s initial
recommendations with a work plan to further develop them in the course
of 2012.
Five workstreams have been launched under the FSB to develop policy
recommendations to strengthen regulation of the shadow banking system,
including securities lending and repos (repurchase agreements).
The FSB Workstream on Securities Lending and Repos (WS5) under the
FSB Shadow Banking Task Force is developing policy recommendations,
where necessary, by the end of 2012 to strengthen regulation of securities
lending and repos.
In order to inform its decision on proposed policy recommendations, the
Workstream has reviewed current market practices through discussions
with market participants, and existing regulatory frameworks through a
survey of regulatory authorities.
The Workstream has identified a number of issues that might pose risks
to financial stability.
These financial stability issues will form the basis for the next stage of its
work in developing appropriate policy measures to address risks where
necessary.
This report documents the Workstream’s progress so far.

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Sections 1 and 2 provide an overview of securities lending and repos
markets globally, including the main drivers of the markets.
Section 3 places securities lending and repo markets in the wider context
of the shadow banking system.
Section 4 provides an overview of existing regulatory frameworks for
securities lending and repos, and section 5 lists a number of financial
stability issues posed by these markets.
Additional detailed information on the market segments and a survey of
relevant literature survey can be found in the annexes.
1. Market Overview: Four market segments

The securities financing markets can be divided into four main,
inter-linked segments:

(i) a securities lending segment;

(ii) a leveraged investment fund financing and securities borrowing
segment;

(iii) an inter-dealer repo segment; and

(iv) a repo financing segment, as described below.

The securities lending segment (Exhibit 1) comprises lending of
securities by institutional investors (e.g. insurance companies, pension
funds, investment funds) to banks and broker-dealers against the
collateral of cash (typical in the US and Japanese markets, and
comprising a minority share of the European market) or securities.

According to one industry estimate, the total securities on loan globally,
as of April 2012, are estimated to be about US$1.8 trillion.

In general, borrowers may borrow specific securities for covering short
positions in their own activities – for example arising from market -
making activities – or those of their customers; or for use as collateral in
repo financing and other transactions.
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Lenders (or beneficial owners) may reinvest cash collateral through
separate accounts or commingled funds managed by their agent lender or
a third party investment manager.

Cash collateral is also reinvested through the repo financing segment
described later

The leveraged investment fund financing and securities borrowing
segment (Exhibit 2) comprises financing of leveraged investment funds’
long positions by banks and broker-dealers using both reverse repo and
margin lending secured against assets held with prime brokers, as well as
securities lending to hedge funds by prime brokers to cover short
positions.

This segment is closely linked to the securities lending segment, which is
used by prime brokers to borrow securities to on-lend to hedge funds.

The cash proceeds of short sales by hedge funds, in turn, may be used by
prime brokers as cash collateral for securities borrowing.

Hedge funds may give prime brokers permission to re-hypothecate assets,
usually up to a proportion of their current net indebtedness to the prime
broker (e.g. 140% in the US).
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Re-hypothecated assets may then be given as collateral to borrow cash or
securities by prime brokers in the repo financing or securities borrowing
segments.

The inter-dealer repo segment (Exhibit 3) comprises primarily
government bond repo transactions amongst banks and broker-dealers.

These may be used to finance long positions via general collateral (GC)
repos (primarily against government securities), or to borrow specific
securities via special repos.

In the US, Europe and Japan, the inter-dealer repo segment is typically
cleared by central counterparties (CCPs). Transactions are predominantly
at an overnight maturity.

Total repos and reverse repos outstanding (including both the
inter-dealer repo segment and the repo financing segment) are estimated
around US$2.1-2.6 trillion in the US, US$8 trillion in Europe, and US$2.4
trillion in Japan

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The repo financing segment (Exhibit 4) comprises repo transactions
primarily by banks and broker-dealers to borrow cash from “cash-rich”
entities, including central banks, retail banks, money market funds
(MMFs), securities lenders and increasingly non-financial corporations.

As described in the next section, the drivers of this market segment are
primarily the short-term financing needs of banks and broker-dealers, as
well as the desire of institutional cash managers to hold collateralised,
“money-like” investments.

Increasingly in the US and Europe, collateral movements and valuation
are outsourced to tri-party agents (the so-called “tri-party repo”).

Collateral includes government bonds, corporate bonds, structured
products, money market instruments and equities.

The share of asset-backed securities (ABSs) used as repo collateral has
declined sharply since the crisis.

Transactions are predominantly short-term but the European market also
includes a growing, longer-term element.

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The above 4 market segments can be combined to form a complex
network of securities lending and repos as shown in Exhibit 5.

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2. Five key drivers of the securities lending and repo markets

The Workstream has identified the following five key drivers of the
securities lending and repo markets that contribute to better
understanding of the characteristics and developments of the four market
segments described in section 1.

These drivers are not ranked in order of importance and may overlap.

2.1 Demand for repo as a near-substitute for central bank and
insured bank deposit money

The first key driver, particularly for the repo financing segment, is
demand by certain risk-averse institutions for “money-like” instruments
to support their primary investment objectives of preserving principal and
liquidity.

Such institutions may not have access to central bank reserves; may be
ineligible for deposit insurance or have cash holdings that exceed deposit
insurance limits; and/or find that Treasury bill markets do not have an
adequate supply or depth, or do not match their maturity requirements.

These repo investors include:

(i) MMFs;

(ii) entities seeking to reinvest cash collateral from securities lending
activities;

(iii) official reserves managers;

(iv) commercial banks that are required to hold a regulatory liquidity
buffer;

(v) pension funds, investment funds and insurance companies;

(vi) non-financial corporations;
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P a g e | 45

(vii) other specialist entities, e.g. CCPs and the US Federal Home Loans
Banks;

(viii) structured finance (e.g. securitisation) vehicles.

A key attribute of repo is that it allows banks, broker-dealers and other
intermediaries to create “collateralised” short-term liabilities provided
they can access underlying collateral securities meeting the credit and
regulatory requirements of the cash lenders.

The institutional demand for money-like assets has grown significantly
over the last twenty years.

Pozsar (2011) estimates that the total size of MMFs, cash collateral
reinvestment programmes and corporate cash holdings in the US rose
from $100 billion in 1990 to a peak of over $2.2 trillion in 2007 and stood at
$1.9 trillion in Q4 2010.

2.2 Securities-based financing needs

The second key driver is the financing needs of leveraged intermediaries.
Regulated banks and broker-dealers dominate, using these markets both
as part of their wider wholesale funding and more particularly for
securities dealing.
But some unregulated non-bank intermediaries, such as ABCP conduits
and CDOs, did make use of repo financing alongside other sources of
money market funding such as ABCP issuance before the crisis as part of
the shadow banking system.
For most large global banks, the inter-dealer repo market has almost
replaced unsecured money markets as the marginal source and use of
overnight funds.
In particular, repo financing markets have become an increasingly
important source of borrowing at maturities from overnight to twelve
months or even longer.

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With access to liquid repo and securities lending markets, broker-dealers
can:
(i) quote continuous two-way prices in the cash market (i.e.
market-making) in a reasonable size without carrying inventory in every
security;

(ii) prevent a chain of settlement delivery failures from developing;

(iii) finance long positions and cover short positions more effectively; and

(iv) hedge against their credit or market risk exposures arising from other
activities, e.g. government auctions, corporate bond underwriting, and
trading in cash instruments and derivatives.

Liquid securities financing markets are therefore critical to the
functioning of underlying cash, bond, securitisation and derivatives
markets.

For instance, before the crisis, the acceptability of senior tranches of
ABSs as repo collateral contributed significantly to the growth of the
securitisation leg of the shadow banking system.

2.3 Leveraged investment fund financing and short-covering
needs

The third key driver, primarily of the leveraged investment fund financing
and securities borrowing market segment, is facilitation of hedge fund
and other investment strategies involving leverage and short selling.
Some hedge funds are insufficiently creditworthy to borrow cash
unsecured or to borrow securities directly from institutional investors.
They therefore rely on prime brokers for financing as well as to locate and
borrow the securities they want to sell short.
By pooling the supply of lendable securities in the market, prime brokers
can also provide hedge funds with stable securities loans allowing them to
maintain short positions while providing securities lenders with the

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liquidity to recall securities loans if they wish: for example, in order to sell
the underlying holdings (securities on loan) or exercise shareholder
voting rights.
Short-sale proceeds may be used by hedge funds as cash collateral against
borrowed securities.
That cash is in turn used by prime brokers to collateralise securities
borrowing from securities lenders that reinvest the cash in the separate
accounts or commingled funds (e.g., registered MMFs or unregistered
cash reinvestment funds), which vehicles may invest in repo.
In this way, short selling may have the effect of temporarily re-directing
cash intended for investment in equity or bond markets into the money
markets, creating additional demand for wholesale “money-like” assets
(the first driver described above).
In addition, market participants told the Workstream that some pension
funds use repos to finance part of their bond holdings.
This is notably the case of funds running liability-driven investment
(LDI) strategies, with one such strategy consisting of repo-ing out
holdings of high-quality long-term assets, usually for term, to raise cash
for liquidity management or return enhancement purposes, and by doing
so to achieve some degree of leverage.
2.4 Demand for associated “collateral mining” from banks and
broker-dealers

The fourth driver of the markets is the increasing need for banks and
broker-dealers to gain access to securities for the purpose of optimising
the collateralisation of repos, securities loans and derivatives.

As mentioned earlier, the creation of money-like repo liabilities requires
collateral, and therefore the borrowing capacity of banks and
broker-dealers depends on the total amount of non-cash collateral
available to them.

“Collateral mining” refers to the practice whereby banks and
broker-dealers obtain and exchange securities in order to collateralise
their other activities.
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Increasingly, banks and broker-dealers are seeking to centralise collateral
management in order to use collateral in the most efficient and
cost-effective way across the firm’s activities.

That may include:

(i) Ensuring that repo, securities lending and derivatives counterparties
are delivered the cheapest collateral acceptable to them, for example, by
using tri-party services;

(ii) Using the securities lending and collateral swap markets to upgrade
lower quality collateral into higher quality collateral that is more
acceptable to other counterparties, for example, in the repo financing
markets or at CCPs, or which is eligible for regulatory liquidity
requirements;

(iii) Re-using collateral delivered by other counterparties in repo,
securities lending or OTC derivatives transactions;

(iv) Taking advantage of opportunities to re-hypothecate client assets
from prime brokerage activities; and

(v) Taking advantage of the option to deliver from a range of eligible
collateral in bilateral agreements (e.g. credit support annexes supporting
ISDA derivatives agreements) in order to deliver collateral securities at
the lowest cost to the firm, which is typically the securities with the lowest
credit quality or highest yielding.

2.5 Demand for return enhancement by securities lenders and
agent lenders
The fifth driver, particularly of the securities lending market segment, is
seeking of additional returns by institutional investors, such as pension
funds, insurance companies, and investment funds.

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Most lend out securities in order to generate additional income on their
portfolio holdings at minimal risk, to help offset the cost of maintaining
the portfolio, or to generate incremental returns.
Agent lenders may take a share of their clients’ lending income (net of
borrower rebates paid out) arising from lending fees or cash collateral
reinvestment.
In general, the loan fees paid by borrowers to the lenders represent what
borrowers are prepared to pay for “renting” ownership/use of particular
securities, for example, in order to create a short position.
Some securities lenders, however, also treat lending against cash
collateral as a source of financing for leveraged investment in search of
additional returns, making market activity “supply-led”.
For example, government bonds can usually be lent to raise cash
collateral, which can be reinvested with proceeds split between the
securities lender and its agent, net of the fixed "rebate" percentage paid
to the party borrowing the securities and posting cash.
Securities lenders may thereby run a cash reinvestment business through
which they seek higher returns by taking credit and liquidity risk.
One major asset manager also told the Workstream that it intended to use
securities lending as a means of raising cash collateral for treasury
purposes, in particular, to collateralise OTC derivative positions where
bank counterparties are no longer willing to take uncollateralised
counterparty risk following regulatory changes.
3. Location within the shadow banking system

It is important to note that banks play important roles in these markets
and many of the policy issues concern their use of collateral.

Arguably, our main focus from a shadow banking perspective should be
on four areas:

(i) Borrowing through repo financing markets, including against
securitised collateral, which creates leverage and facilitates maturity and
liquidity transformation.

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Repo allows banks as well as non-banks – such as securities
broker-dealers, pension funds, and (to a greater extent before the crisis)
conduits and investment vehicles – to create short-term, collateralised
liabilities.

Because repo financing is typically short-term but collateralised with
longer-maturity assets, it often has embedded risks associated with
maturity transformation.

It can also involve liquidity transformation depending on the type of
securities used as repo collateral.

(ii) The extent to which leveraged investment fund financing leads to
maturity transformation and leverage;

(iii) The chain of transactions through which the cash proceeds from
short sales are used to collateralise securities borrowing and then
reinvested by securities lenders, into longer-term assets, including repo
financing.

This activity can mutate from conservative reinvestment of cash in “safe”
collateral into more risky reinvestment of cash collateral in search of
greater investment returns (prior to the crisis, AIG was an extreme
example of such behaviour).

(iv) Collateral swaps (also known as collateral downgrades/upgrades)
involving lending of high-quality securities (e.g. government bonds)
against the collateral of lower- quality securities (e.g. equities, ABSs),
often at longer maturities and with wide collateral haircuts.

Banks then use the borrowed securities to obtain repo financing, which
can further lengthen transaction chains, or hold them to meet regulatory
liquidity requirements.

4. Overview of regulations for securities lending and repos

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The major participants in securities lending and repo markets are
generally regulated institutions.
By comparison with “financial market intermediaries” such as banks and
broker-dealers (securities firms), regulations and activity restrictions on
lenders such as investment firms, pension funds and insurance
companies vary considerably by jurisdiction and type of entity.
In general, these regulations are focused more on investor/policyholder
protection than financial stability considerations.
As for the channels for disclosure (transparency) related to securities
lending and repo activities, they are not significantly different from the
general requirements for public disclosures through financial reporting
and regulatory reporting.
The FSB Workstream on Securities Lending and Repos (WS5), in
cooperation with the IOSCO Standing Committee on Risk and Research
(SCRR), conducted a survey exercise in autumn 2011 to map the current
regulatory frameworks in member jurisdictions.

This section provides a high-level summary of the results of the
regulatory mapping exercise based on the survey responses from 12
jurisdictions (Australia, Brazil, Canada, France, Germany, Japan, Mexico,
the Netherlands, Switzerland, Turkey, UK and US), the European
Commission, and the European Central Bank (ECB).

4.1 Requirements for financial intermediaries: banks and
broker-dealers

Risk exposures (including counterparty credit risk) arising from
securities lending and repo transactions are typically taken into account
in the regulatory capital regimes for banks and broker-dealers.
Under the Basel capital regime, for example, banks are required to hold
capital against any counterparty exposures net of the collateral received
on the repo or securities loan, together with an add-on for potential future
exposure.

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But netting of the collateral is only permitted if the legal agreement is
enforceable under applicable laws. Capital requirements must also
continue to be held against lent or repo-ed securities.
In addition, banks and securities broker-dealers are subject to other
requirements that are designed to enhance investor protection and
improve risk management.
Unlike regulatory capital requirements that apply consistently across
jurisdictions (e.g. Basel III for banks), there is diversity in the tools and
the details each jurisdiction has adopted for risks that need to be
addressed.
For example, a number of jurisdictions have established regulations for
the use (re-hypothecation) of customer assets by banks and
broker-dealers but the details differ:
In Australia and the UK, a bank or broker-dealer is permitted to
re-hypothecate (i.e. use for its own account) customer assets transferred
for the purpose of securing the client’s obligations where permitted under
the terms of the relevant legal agreement (e.g. a prime brokerage
agreement with a hedge fund).
Once the assets have been re-hypothecated, title transfers to the bank or
broker-dealer, and the client’s proprietary interest in the securities is
replaced with a contractual claim to redelivery of equivalent securities.

In France, re-hypothecation is subject to several caps.

The use of re-hypothecation is authorised in a specific framework for a
maximum amount of 100% of the contracted loan (from the prime broker
to the hedge fund) for ARIA funds and 140% for ARIA EL funds.

There is no regulatory cap for contractual funds.

In the US, re-hypothecation by a broker-dealer is subject to a 140% cap as
proportion of client indebtedness.

In the UK, no similar regulatory cap exists but re-hypothecation is only
permitted where securities are transferred for the purpose of securing or
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P a g e | 53

otherwise covering present or future, actual or contingent or prospective
obligations.

Under UK regulations, prime brokers are required to set out for the client
a summary of the key provisions permitting re-hypothecation in the
agreement, including the contractual limit (if any) and key risks to the
client’s assets, and report to the client daily on the amount of
re-hypothecated assets.

4.2 Requirements for investors: investment funds and insurance
companies
For institutional investors (e.g. MMFs, other mutual funds, ETFs,
pension funds, college endowments, and insurance companies) that act
as “investors” in the securities lending and repo markets, risk exposures
arising from their involvement in the markets tend to be regulated by the
relevant regulatory requirements and/or activity restrictions designed to
protect investors.
4.2.1 Counterparty credit risk
Counterparty credit risk arising from securities lending and repo
transactions can be mitigated by restrictions on eligible counterparties
(e.g. based on credit ratings or domicile) and counterparty concentration
limits (e.g. percentage of total capital or net asset value).

Some jurisdictions measure counterparty risk on a gross (no collateral
benefit) basis; while others measure on a net basis (adjusted by
collateral).
4.2.1.1 Restrictions on eligible counterparties

There is a divergence across jurisdictions in the entities that are eligible
as counterparties for securities lending and repo transactions.
In France, for MMF and UCITS, the eligible counterparties for securities
lending transactions are limited to UCITS depositaries; credit institutions
headquartered in an OECD country; and investment companies
headquartered in an EU member state or in another state in the European
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P a g e | 54

Economic Area (EEA) Agreement, with minimum capital funds of 3.8
million euros.
In Mexico, for mutual funds and pension funds, their counterparties can
only be banks and brokerage firms.
In the UK, counterparties of regulated funds are generally restricted to
European banks, investment firms and insurers, US banks and US
broker-dealers.
In the US, registered investment company (RIC) lenders are generally
required to approve counterparties, and may not lend securities to
affiliated counterparties except with express approval of the SEC.
4.2.1.2 Counterparty concentration limits

In addition to restriction on eligible counterparties, some jurisdictions set
counterparty concentration limits to mitigate the impact of a large
counterparty’s default.

A number of jurisdictions measure counterparty risk on a gross (no
collateral benefit) basis while others measure it on a net basis (adjusted
for the value of the collateral).

For example:

In the EU, the UCITS Directive allows securities lending (securities
borrowing is not allowed) by UCITS funds but limits net counterparty
exposure of a fund (i.e. adjusted for collateral received) to 10% of NAV.

The directive also includes a reference to repo and securities lending
transactions in the context of calculating global exposure, requiring these
to be taken into account when they are used to generate additional
leverage or exposure to market risk.

Future changes to the UCITS Directive are likely to include a range of
issues relating to securities lending such as rules on collateralisation and
gross limits.

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In the US, for MMFs, no counterparty can be greater than 5% of the
fund’s total assets unless the repo is fully collateralised by cash or US
government securities, in which case the MMF may look to the issuer of
the collateral for the purposes of the 5% limit on exposure to a single
issuer.

4.2.2 Liquidity risk

Restrictions on the term or maturity of securities loans and repos are used
in a few jurisdictions to mitigate liquidity risk arising from securities
lending and repo transactions for insurance companies (Australia, Brazil,
Mexico, US) and MMFs (Brazil, Canada, Germany, Japan, Mexico, US).
The maturity limits range from 30 days to around one year.
The requirement to allow securities lending transactions to be terminable
at will is relatively common.
4.2.3 Collateral guidelines

Some jurisdictions have introduced collateral guidelines that apply either
generally or specifically to securities lending and repos.
Such guidelines may include various regulatory tools such as: minimum
margins and haircuts; eligibility criteria for collateral; restrictions on
re-use of collateral and re-hypothecation; and restrictions on cash
collateral reinvestment.
4.2.3.1 Minimum levels of margins and haircuts

A few jurisdictions have imposed minimum levels of haircuts/margins.
For example:
In Canada, haircut requirements for repos are applied to mutual funds
and require collateral with a market value of at least 102% of cash
delivered.
In the UK, exposures of regulated funds arising from securities financing
transactions must be 100% collateralised at all times.

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P a g e | 56

In the US, RICs must maintain at least 100% collateral at all times,
regardless of the type of collateral received (but RICs may only accept as
collateral cash, securities issued or guaranteed by the US government and
its agencies, and eligible bank letters of credit).

4.2.3.2 Eligibility criteria on acceptable collateral (eligible
collateral)

Some jurisdictions set criteria for eligible collateral for certain financial
institutions to restrict assets acceptable as collateral so as to ensure the
quality of collateral.

Such criteria are usually based on credit ratings, currency-denomination,
market liquidity, instrument types and correlation risk.

4.2.3.3 Restrictions on the re-use of collateral / re-hypothecation

Restrictions on re-use of collateral/re-hypothecation by investment funds
and insurance companies have been imposed in a few jurisdictions.
These usually take the form of simple ban on such activities, a
quantitative cap (based on client indebtedness), or are based on
considerations of ownership.
For example, in France, pursuant to Article 411-82-1 of the AMF General
Regulation28 non-cash collateral cannot be sold, re-invested or pledged.

4.2.3.4 Cash collateral reinvestment

Canada, Germany, the UK and the US have restrictions on cash collateral
reinvestment for UCITS and RICs (including MMFs).
These restrictions usually take the form of limits on the maturity or
currency-denomination of the investments, or are based on asset liquidity
considerations.

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In Canada, mutual funds can use cash received in a securities lending
transaction to purchase qualified securities with a maturity no longer than
90 days, or purchase securities under a reverse repurchase agreement.
During the term of a securities lending transaction, a mutual fund must
hold all non-cash collateral delivered under the transaction, without
reinvesting or disposing of it.
For cash received under a repo transaction, the maximum term to
maturity of securities in which the cash can be reinvested is 30 days.
In Germany, for MMFs and UCITS, deposits may be (re)invested in
money market instruments denominated in the respective currency of the
deposits; or (re)invested in money market instruments by way of
repurchase agreements.

In the UK, regulations on UCITS restrict the types of cash collateral
reinvestment to a certain set of financial instruments, and require that
cash collateral reinvestment be consistent with the fund’s investment
objectives and risk profile.

In the US, for RICs (including MMFs), cash collateral reinvestment is
generally limited to short-term investments which give maximum
liquidity to pay back the borrower when the securities are returned.

4.2.4 Transparency (Disclosures)

Disclosure requirements for securities lending and repo activities are not
significantly different from the general requirements for public
disclosures and regulatory reporting, e.g. disclosure as appropriate in
registration statements, financial statements, and other periodic SEC
filings for US RICs, and reporting of outstanding positions for banks.

One exception is in the case of US regulated insurers involved in
securities lending program.

They are required to file added disclosure regarding reinvested collateral
by specific asset categories and stress testing.

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Such disclosures will highlight the duration mismatch and require a
statement from the company on how they would deal with an unexpected
liquidity demands.

5. Financial stability issues

Based on the results from the market practices survey and regulatory
mapping exercise, the Workstream has preliminarily identified the
following seven issues that could be considered from a financial stability
perspective.
These issues are not equally relevant to all market segments.
For example, securities financing markets for high-quality government
bonds tend to have higher levels of transparency and contribute less to
procyclicality of system leverage.
5.1 Lack of transparency

Securities financing markets are complex, rapidly evolving and can be
opaque for some market participants and policymakers.
Market transparency may also be lacking due to the usually bilateral
nature of securities financing transactions.
It may be appropriate to consider, from a financial stability perspective,
whether transparency could be improved at the following levels:
(i) Macro-level market data - Prior to the crisis, some jurisdictions faced
difficulties in assessing and monitoring the risks in certain aspects of
those markets. Some data is available based on surveys carried out by the
authorities or trade associations and from data vendors that collect
information from intermediaries for commercial purposes.
The lack of transparency is serious especially for bilateral transactions (i.e.
not involving tri-party agents, who may publish aggregated data on the
transactions they process, or agent lenders, who may report transactions
to commercial data vendors) and synthetic transactions, where currently
no market data is readily available and authorities have to rely on market
intelligence.

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P a g e | 59

(ii) Micro-level market data (transaction data) – Since securities lending
and repo are structured in a variety of ways, it can be difficult to
understand the real risks individual market participants entail or pose to
the system without detailed transaction-level information/data.
This is especially so for bilateral transactions.
(iii) Corporate disclosure by market participants – In most jurisdictions,
cash-versus-securities transactions (e.g. repo, reverse repo,
cash-collateralised securities loans) are usually reported on-balance
sheet.
However,
(i) in some limited cases (e.g. repo to maturity or over-collateralised
repos), repos can be off-balance sheet depending on the accounting
standards used; and
(ii) limited disclosure is provided in financial accounts of
securities-versus-securities transactions (e.g. securities loans
collateralised by other securities), that are typically “looked through” for
the purposes of financial reporting.
The ability of financial institutions to engage in off-balance sheet
transactions without adequate disclosure may contribute to their
risk-taking incentives and hence the fragility of the financial system.
(iv) Risk reporting by intermediaries to their clients – Prior to the crisis,
many prime brokers did not provide sufficient disclosure on
re-hypothecation activities to their hedge fund clients.
For example, following the collapse of Lehman Brothers International,
many hedge funds unexpectedly became unsecured general creditors
because they had not realised the extent to which it had been
re-hypothecating client securities.
In addition, some securities lenders, in particular some less sophisticated
ones, have alleged that they were not adequately informed of the
counterparty risk and cash collateral reinvestment risk of their securities
lending programmes by the agent lenders.

5.2 Procyclicality of system leverage/interconnectedness

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Securities financing markets may allow financial institutions (including
some non-banks) to obtain leverage in a way that is sensitive to the value
of the collateral as well as their own perceived creditworthiness.
As a result, these markets can influence the leverage and level of
risk-taking within the financial system in a procyclical and potentially
destabilising way.
This procyclical behaviour of securities financing markets depends, in
addition to changes in counterparty credit limits, on three underlying
factors:
(i) the value of collateral securities available and accepted by market
participants;
(ii) the haircuts applied on those collateral securities; and
(iii) collateral velocity (the rate at which collateral is reused).

5.2.1 The value of collateral securities available and accepted by
market participants

The value of collateral that repo counterparties and securities lenders are
willing to accept as collateral will fluctuate over time with market values,
market volatility and changes in credit ratings.
Sudden shifts, however, have tended to follow unexpected common
shocks to a large section of the collateral pool, such as the deterioration in
the US housing market affecting ABS markets, and doubts about the
creditworthiness of some European government issuers affecting
government bond and repo markets.
These can cause market participants to exclude entire classes of collateral
from their transactions, creating a vicious circle as contraction in the
securities financing markets damage underlying cash market liquidity,
reducing the availability of reliable prices for collateral valuation.
Changes in the market value of lent securities (e.g. equities) feed directly
into changes in the value of cash collateral required against securities
lending and then reinvested in the money market.

_____________________________________________________________

Monday April 30 2012 - Top 10 risk and compliance management related news stories and world events

Monday April 30 2012 - Top 10 risk and compliance management related news stories and world events

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