Bank of England Quarterly Bulletin 2013 Q2.

​Contents of Quarterly Bulletin 2013 Q2

Each article is available as a separate pdf file;  click on the appropriate title to access the relevant file.  Alternatively you may download the complete issue.

Complete issue (3.17MB)

Topical articles
Research work published by the Bank is intended to contribute to debate, and does not necessarily reflect the views of the Bank or members of the MPC, FPC or the PRA Board.

Macroeconomic uncertainty:  what is it, how can we measure it and why does it matter? (172KB)

By Abigail Haddow and Chris Hare of the Bank’s Conjunctural Assessment and Projections Division, John Hooley of the Bank’s International Finance Division and Tamarah Shakir of the Bank’s Macroprudential Strategy Division.

The onset of the financial crisis in 2008 brought an end to the ‘Great Stability’ period, making prospects for UK and global economic growth appear not just weaker, but more uncertain.  This elevated uncertainty is likely to have adversely affected spending decisions and contributed to the depth of the recent recession and the weakness of the recovery.  While uncertainty is not directly observable, this article constructs an aggregate measure of the economic uncertainty faced by households and companies, based on a number of proxy indicators.  It also provides some quantitative analysis of the impact of uncertainty on economic activity, drawing a distinction between shocks to uncertainty that are short-lived and those that are more persistent.

Do inflation expectations currently pose a risk to the economy? (115KB)

By Becky Maule and Alice Pugh of the Bank’s Monetary Assessment and Strategy Division.

People’s expectations about future inflation play an important role in determining the current rate of inflation.  There is a risk that the recent prolonged period of above-target inflation, which the Monetary Policy Committee (MPC) judges is more likely than not to continue over much of the next two years, may cause inflation expectations to become less well anchored.  By pushing up wages and prices, higher inflation expectations could lead to inflation becoming more persistent.  At the moment, most indicators are consistent with inflation expectations remaining anchored to the target, although there is tentative evidence that financial market measures of inflation expectations have become a little more responsive to developments in the economy.  There are currently few signs to suggest that prices and wages have increased as a result of higher inflation expectations.  The MPC will continue to monitor and assess indicators closely.

Public attitudes to monetary policy (57KB)

By Michael Goldby of the Bank’s Monetary Assessment and Strategy Division.

This article examines the latest results from the Bank/GfK NOP survey concerning households’ awareness and understanding of monetary policy, and their satisfaction with the way the Bank is conducting monetary policy. Results from the latest surveys indicate that public awareness of the policy framework has remained broadly constant over the past year at a reasonably high level. Satisfaction with the way the Bank sets interest rates in order to control inflation remains much lower than before the financial crisis. While remaining positive over the past year, net satisfaction fell to a series low in 2012 Q3, before recovering a little in subsequent surveys. The extent of satisfaction with the Bank has moved closely with changes in consumer confidence, which in turn is linked to a range of macroeconomic variables including GDP growth, inflation and unemployment.

Cross-border bank credit and global financial stability (109KB)

By Bob Hills and Glenn Hoggarth of the Bank’s International Finance Division.

This article looks in detail at one aspect of global liquidity:  cross-border credit provided by banks.  Cross-border banking can potentially have considerable benefits, especially by diversifying the available sources of lending and borrowing, and by increasing banking competition.  But such flows can also amplify risks in times of stress.  As this article sets out, cross-border bank lending contributed to the build-up in vulnerabilities before the recent crisis, and exacerbated the bust once the crisis hit.  The article then considers possible policy responses, arguing in particular that policymakers need to ensure that they can properly monitor these flows, from the point of view of recipient countries and the global system as a whole.

The Old Lady of Threadneedle Street (1.73MB)

By John Keyworth, curator of the Bank’s Museum (and the Old Lady’s oldest and longest-serving employee).

The popular nickname for the Bank of England dates back to a caricature of the institution from the 1790s.  An exhibition in the Bank’s Museum celebrates two centuries of visual comment, some of which is discussed in this short article.

Central counterparties:  what are they, why do they matter and how does the Bank supervise them? (85KB)

By Amandeep Rehlon of the Bank’s Market Infrastructure Division and Dan Nixon of the Bank’s Media and Publications Division.

The Government introduced major changes to the system of financial regulation in the United Kingdom in April 2013, including creating the Financial Policy Committee and transferring significant new supervisory responsibilities to the Bank.  As part of this, the Bank is now responsible for the supervision of central counterparties, or CCPs.  This article explains what CCPs are, setting out their importance for the financial system — including the benefits they bring and some of the risks they could present if not properly managed.  It also summarises the Bank’s approach to supervising CCPs and describes some of the key priorities the Bank will be pursuing.

Recent economic and financial developments

Markets and operations (390KB)

This article reviews developments in financial markets between the 2013 Q1 Quarterly Bulletin and 24 May 2013, drawing on the qualitative intelligence gathered by the Bank in the course of meeting its objectives of monetary and financial stability.  The article also sets out usage of the Bank’s operations since the previous Bulletin.

Report

A review of the work of the London Foreign Exchange Joint Standing Committee in 2012 (434KB)

This article reviews the work undertaken by the London Foreign Exchange Joint Standing Committee during 2012.

Source: Bank of England

ESMA and the EBA publish final principles on benchmarks.

The European Securities and Markets Authority (ESMA) and the European Banking Authority (EBA) have published their final report setting out their Principles for Benchmark-Setting Processes in the EU.

The Principles are designed to address the problems identified with benchmark-setting processes and will provide benchmark users, administrators, calculation agents, publishers and data submitters with a common framework for carrying out these activities.  The application of the Principles will also help in the transition to any potential future EU legal framework for benchmarks.

ESMA and the EBA consider it important that these Principles are implemented by all market participants, with the aim of reinforcing the robustness of the procedures, ensuring transparency to the public and creating a level-playing field, and also by supervisory authorities in their supervisory practices, where relevant and possible.

ESMA and the EBA will review the Principles’ application after 18 months, although that time-frame may be altered as necessary, while further work on possible transaction-based alternatives will be carried out by ESMA and the EBA in the near future.

Steven Maijoor, ESMA Chair, said:

“The final Principles now give clarity to benchmark providers and users in the European Union about what is expected of them when engaged in this critical market activity. These Principles reflect the wider work being carried out on benchmarks and their immediate adoption will help restore confidence in financial benchmarks and prepare the way for future legislative change.”

Andrea Enria, EBA Chair, said:

“The EBA and ESMA believe that these Principles represent a sound interim solution for benchmark providers and users, ensuring that these important market indices are produced in a transparent and reliable manner.  We are also continuing our review of the implementation of the Euribor recommendations by the European Banking Federation and aim to publish this in due course.”

ESMA and the EBA have co-ordinated their work with current initiatives underway at EU, Member State and international level and have worked toward aligning the Principles with those being developed by the International Organization of Securities Commissions (IOSCO).

Further to comments received during the consultation process, modifications were made to the proposed Principles to address:

·      Continuity – inclusion of a Principle for the continuity of benchmarks in order to ensure that contingency provisions are in place if the continuity of a benchmark is at risk; and

·      Liquidity requirements – the data used to construct a benchmark should represent accurately and reliably the underlying assets or prices, interest rates or other values measured by the benchmark and should be based on observable transactions entered into at arm’s length.

Principles on Benchmark-Setting Processes in the EU

The Principles provide a general framework covering all stages of the benchmarks setting process including data submission, administration, calculation, publication, the use of benchmarks and the continuity of benchmarks.

A framework for any benchmark setting process should at least include the Principles set out below in order to instil confidence in financial markets and market participants, and guarantee the necessary accuracy and integrity of the benchmark formation process:

General framework for Benchmark setting

·      Methodology: the methodologies for the calculation of a benchmark, including information on the way in which contributions are determined and corroborated, should be documented and be subject to regular scrutiny and controls to verify their reliability;

·      Governance structure: the process of setting a benchmark needs to be governed by clear and independent procedures, with detailed information on the process made available publicly, in order to avoid and manage conflicts of interest and limit its susceptibility to manipulation, discretionary decision making or price distortion;

·      Supervision and oversight: confidence in a benchmark is enhanced through regulation and oversight and an appropriate sanctioning regime that allows sanctions for improper conduct, as it will be the case in accordance with future EU legislation on market abuse; and

·      Transparency: a benchmark should be transparent and accessible to the public, with fair and open access to the rules governing its establishment and operation, calculation, and publication; the fact that a benchmark is (or may be) published first to certain stakeholders before it is to others should be disclosed.

Principles for Benchmark Administrators

●    A benchmark administrator should ensure the existence of robust methodologies for the calculation of the Benchmark and appropriately oversee its operations and ensure that there is an appropriate level of transparency to the public regarding the rules governing the Benchmark.

Principles for Benchmark Submitters

●    A benchmark submitter should have in place internal policies covering the submission process, governance, systems, training, record keeping, compliance, internal controls, audit and disciplinary procedures, including complaints management and escalation processes.

●    A benchmark submitter should maintain and operate effective organisational and administrative arrangements with a view to avoid and manage conflicts of interests from affecting the Benchmark data submitted.

Principles for Benchmark Calculation Agents

●    A benchmark calculation agent should ensure a robust calculation of the benchmark and ensure the existence of appropriate internal controls over the benchmark calculations it makes.

Principles for Benchmark Publishers

●    A benchmark publisher should ensure reliable publication of the benchmark it has agreed to publish.

Principles for Benchmark Users

●    Benchmark users should regularly assess the benchmarks they use in financial products or transactions and verify that the benchmark used is appropriate, suitable and relevant for the targeted market. Any potential irregularities observed in a benchmark should be notified to the benchmark administrator or the relevant Supervisory Authorities if appropriate.

Principles for the continuity of benchmarks

●    All those participating in the benchmark setting process and, where relevant, benchmark users should put in place robust and credible contingency provisions for cases in which there is a risk to the continuity of the provision of a benchmark due to, for example, a drying-up of market liquidity, an operational failure, a lack of submissions, transactions or quotes or the unavailability of the benchmark.

Any change to a benchmark framework (calculation methodologies and procedures) should be managed in such a manner as to ensure that any disruption to existing benchmark-referenced contracts are proportionate and minimised.

Download the full Principles

Notes

The EBA is an independent EU Authority established on 1 January 2011. As part of the European System of Financial Supervision, it works closely with the other European Supervisory Authorities responsible for market (ESMA), insurance and occupational pensions (EIOPA), and the European Systemic Risk Board (ESRB).The EBA has a broad remit in the areas of banking, payments and e-money regulation, as well as on issues related to corporate governance, auditing and financial reporting. Its tasks include preventing regulatory arbitrage, guaranteeing a level playing field (especially by building a single rule book for the European banking system) strengthening international supervisory coordination, promoting supervisory convergence and providing advice to EU institutions.
2. ESMA is an independent EU Authority that was established on 1 January 2011 and works closely with the other European Supervisory Authorities responsible for banking (EBA), and insurance and occupational pensions (EIOPA), and the European Systemic Risk Board (ESRB).
ESMA’s mission is to enhance the protection of investors and promote stable and well-functioning financial markets in the European Union (EU). As an independent institution, ESMA achieves this aim by building a single rule book for EU financial markets and ensuring its consistent application across the EU.ESMA contributes to the regulation of financial services firms with a pan-European reach, either through direct supervision or through the active co-ordination of national supervisory activity.

Source: European Banking Authority

The Transaction-Tax Climbdown.

Europe discovers the costs of its latest financial levy.

European governments are figuring out that taxing financial transactions won’t be a magical money machine and that the proposed levy might even damage the European economy.

Reuters first reported Thursday that EU officials are scaling back a transaction tax proposal supported by 11 countries that is supposed to take effect in January.The levy could instead be introduced on a “staggered basis,” one official told the news agency. The first phase might only tax sales and purchases of shares, not bonds or derivatives transactions, and at 0.01% instead of 0.1% as currently proposed. A rate of zero is more appropriate.

Enthusiasm for the tax has been dimming for a while, including in governments that have previously backed it. Christian Noyer, the Governor of the Banque de France, said in Paris on Tuesday that the levy will raise “nothing at all.” One unnamed EU official told Reuters that a scaled-back transaction tax would reap revenue of less than €3.5 billion. The full-fledged levy, as proposed by the European Commission in February, was supposed to rake in €31 billion a year.

The concern from the start has been that a transaction tax would drive financial business into friendlier jurisdictions. The Commission has already modified its proposal once to address this. But broadening the tax’s scope has raised new concerns that it might severely impair key capital markets. In an internal memo leaked last month, the 11 participating states suggest that the transaction tax could increase government borrowing costs. The Commission has refused to exempt sovereign debt from the levy, which means that participating governments will be taking money from one pocket and putting it in another.

But because market intermediaries will also be taxed, even a 0.1% tax rate will translate, via a “cascade effect,” into higher interest rates on sovereign bonds.According to the consultants at London Economics, the transaction levy will increase the U.K. government’s debt costs by £3.95 billion, even though Britain isn’t participating in the tax.

The leaked EU memo also frets about the potential effects on repurchase agreements, a key source of bank liquidity in Europe. Global regulators like the Basel-based Financial Stability Board claim the repo market is opaque and a menace to financial stability. Repos increase bank interconnectedness, the thinking goes, because the same securities end up being used as collateral by multiple institutions.

Even if such paranoia were justified, slimming down this market via a transaction levy would be an application of brute force when bank funding is already fragile. The International Capital Market Association, a trade group for securities-market participants, estimated in a report last month that the tax would cause the short-term repo market to contract by 66%.

That could mean a serious liquidity crunch, exacerbated by the fact that a huge portion of Europe’s collateral is locked up at the European Central Bank.Bundesbank President Jens Weidmann offered a pointed warning along these lines last month: “From a monetary policy point of view, the financial-transaction tax in its current form is to be viewed very critically.”

Taxes and regulations always have unintended consequences, but Europe’s transaction tax is folly twice over. A full Commission climbdown would be a victory for fiscal and financial good sense.

Source: Wall Street Journal

The Economist – The Good Bank.

The Good Bank is a unique project organised by the Economist Intelligence Unit (EIU) to examine how banking can better serve the needs of society.

It will bring together experts to discuss and share ideas on what makes for a Good Bank and to participate in a conversation about the future of financial services. This will involve curated expert essays, independent EIU research and online engagement culminating in a live panel discussion on June 4th.

The three key pillars which will form the backbone to the discussion are:

• the effective bank
• the trustworthy bank
• the innovative bank

Contributions from our handpicked online experts will appear on the live interactive feed every day between now and June 4th, alongside curated articles, blog pieces, independent Economist Intelligence Unit research, and input from you.

Discussions will build up to, happen during and continue beyond the live debate in June.

The live panel debate: June 4th 2013, 14.00 BST (GMT+1 )

The panel debate, streamed live to audiences globally from 14.00 GMT, will incorporate views from banking experts, socioeconomic entrepreneurs, innovators and academia and you – collective opinions and visions for what makes a good bank.

Get started!

Our online experts will be joining the conversation now so we encourage you to express your views on what defines a Good Bank. To get started please complete the simple registration process and start posting your comments straight away!

Register for the Conversation

Source: The Economist Intelligence Unit

ECB Financial Stability Review May 2013.

Stress in the euro area financial sector has fallen from previous peaks. Several indicators suggest that euro area systemic stress is at its lowest point in two years. ECB policies have been a key factor underpinning this decline in stress. To consolidate this recent progress, further fundamental adjustment must continue at the national level alongside ongoing initiatives at the EU level to strengthen the institutional framework of Monetary Union.

Financial stability conditions in the euro area remain fragile. Several vulnerabilities in the interaction between sovereigns, banks and the macroeconomy persist. Further concrete action by the public and private sector is needed to durably sever negative feedback loops between distressed sovereigns, increasingly diverging economic growth prospects at the country level and concerns about the financial soundness of banks. A roadmap has been drawn up for completing Economic and Monetary Union (EMU). Its completion, including notably the part related to the banking union, is essential.

The analysis in this Review highlights four key risks to euro area financial stability:

• A further decline in bank profitability, linked to credit losses and a weak macroeconomic environment. Continued and prompt progress in proactively tackling bank balance sheet problems is needed.
• Renewed tensions in sovereign debt markets due to low growth and slow reform implementation. Progress in adjusting public finance vulnerabilities should not unravel. Beyond this, continued momentum is needed towards completing a genuine EMU, notably including a full banking union and a strengthening of fiscal frameworks.
• Bank funding challenges in stressed countries. Continued steps at both the national and European level are needed to tackle remaining fragmentation in bank funding. Furthermore, bank funding markets will benefit from a predictable and consistent approach to bank supervision and resolution across Europe; the launch of the single supervisory mechanism will be a key milestone in this respect.
• Reassessment of risk premia in global markets, following a prolonged period of safe-haven flows and search for yield.Stable and predictable policies are key to the prevention of such a risk reversal. To reduce the losses of such a possible risk reversal, banks and supervisors should ensure that bank capital buffers are sufficient.Download the full Stability Review

  Source: European Central Bank

Banks’ Lobbyists Help in Drafting Financial Bills.

By ERIC LIPTON and BEN PROTESS

WASHINGTON — Bank lobbyists are not leaving it to lawmakers to draft legislation that softens financial regulations . Instead, the lobbyists are helping to write it themselves.

One bill that sailed through the House Financial Services Committee this month — over the objections of the Treasury Department — was essentially Citigroup ’s, according to e-mails reviewed by The New York Times. The bill would exempt broad swathes of trades from new regulation.

In a sign of Wall Street’s resurgent influence in Washington, Citigroup’s recommendations were reflected in more than 70 lines of the House committee’s 85-line bill. Two crucial paragraphs, prepared by Citigroup in conjunction with other Wall Street banks, were copied nearly word for word.(Lawmakers changed two words to make them plural.)

The lobbying campaign shows how, three years after Congress passed the most comprehensive overhaul of regulation since the Depression, Wall Street is finding Washington a friendlier place.

The cordial relations now include a growing number of Democrats in both the House and the Senate, whose support the banks need if they want to roll back parts of the 2010 financial overhaul, known as Dodd-Frank.

This legislative push is a second front, with Wall Street’s other battle being waged against regulators who are drafting detailed rules allowing them to enforce the law.

And as its lobbying campaign steps up, the financial industry has doubled its already considerable giving to political causes. The lawmakers who this month supported the bills championed by Wall Street received twice as much in contributions from financial institutions compared with those who opposed them, according to an analysis of campaign finance records performed by MapLight, a non-profit group.

In recent weeks, Wall Street groups also held fund-raisers for lawmakers who co-sponsored the bills. At one dinner Wednesday night, corporate executives and lobbyists paid up to $2,500 to dine in a private room of a Greek restaurant just blocks from the Capitol with Representative Sean Patrick Maloney, Democrat of New York, a co-sponsor of the bill championed by Citigroup.

Industry officials acknowledged that they played a role in drafting the legislation, but argued that the practice was common in Washington. Some of the changes, they say, have gained wide support, including from Ben S. Bernanke , the Federal Reserve chairman. The changes, they added, were in an effort to reach a compromise over the bills, not to undermine Dodd-Frank.

“We will provide input if we see a bill and it is something we have interest in,” said Kenneth E. Bentsen Jr., a former lawmaker turned Wall Street lobbyist, who now serves as president of the Securities Industry and Financial Markets Association, or Sifma.

The close ties hardly surprise Wall Street critics, who have long warned that the banks — whose small armies of lobbyists include dozens of former Capitol Hill aides — possess outsize influence in Washington.

“The huge machinery of Wall Street information and analysis skews the thinking of Congress,” said Jeff Connaughton, who has been both a lobbyist and Congressional staff member.

Lawmakers who supported the industry-backed bills said they did so because the effort was in the public interest. Yet some agreed that the relationship with corporate groups was at times uncomfortable.

“I won’t dispute for one second the problems of a system that demands immense amount of fund-raisers by its legislators,” said Representative Jim Himes, a third-term Democrat of Connecticut, who supported the recent industry-backed bills and leads the party’s fund-raising effort in the House. A member of the Financial Services Committee and a former banker at Goldman Sachs , he is one of the top recipients of Wall Street donations. “It’s appalling, it’s disgusting, it’s wasteful and it opens the possibility of conflicts of interest and corruption. It’s unfortunately the world we live in.”

The passage of the Dodd-Frank Act, which took aim at culprits of the financial crisis like lax mortgage lending and the $700 trillion derivatives market, ushered in a new phase of Wall Street lobbying. Over the last three years, bank lobbyists have blitzed the regulatory agencies writing rules under Dodd-Frank, chipping away at some regulations.

But the industry lobbyists also realized that Congress can play a critical role in the campaign to mute Dodd-Frank.

The House Financial Services Committee has been a natural target. Not only is it controlled by Republicans, who had opposed Dodd-Frank, but freshmen lawmakers are often appointed to the unusually large committee because it is seen as a helpful base from which they can raise campaign funds.

For Wall Street, the committee is a place to push back against Dodd-Frank.When banks and other corporations, for example, feared that regulators would demand new scrutiny of derivatives trades, they appealed to the committee. At the time, regulators were completing Dodd-Frank’s overhaul of derivatives, contracts that allow companies to either speculate in the markets or protect against risk. Derivatives had pushed the insurance giant American International Group to the brink of collapse in 2008. The question was whether regulators would exempt certain in-house derivatives trades between affiliates of big banks.

As the House committee was drafting a bill that would force regulators to exempt many such trades, corporate lawyers like Michael Bopp weighed in with their suggested changes, according to e-mails reviewed by The Times. At one point, when a House aide sent a potential compromise to Mr. Bopp, he replied with additional tweaks.

In an interview, Mr. Bopp explained that he drafted the proposal at the request of Congressional aides, who expressed broad support for the change. The proposal, he explained, was a “compromise” that was actually designed to “limit the scope” of the exemption.

“Everyone on the Hill wanted this bill, but they wanted to make sure it wasn’t subject to abuse,” said Mr. Bopp, a partner at the law firm Gibson, Dunn who was representing a coalition of nonfinancial corporations that use derivatives to hedge their risk.

Ultimately, the committee inserted every word of Mr. Bopp’s suggestion into a 2012 version of the bill that passed the House, save for a slight change in phrasing. A later iteration of the bill , passed by the House committee earlier this month, also included some of the same wording.

And when federal regulators in April released a rule governing such trades, it was significantly less demanding than the industry had feared, a decision that the industry partly attributed to pressure stemming from Capitol Hill.

Citigroup and other major banks used a similar approach on another derivatives bill. Under Dodd-Frank, banks must push some derivatives trading into separate units that are not backed by the government’s insurance fund. The goal was to isolate this risky trading.

The provision exempted many derivatives from the requirement, but some Republicans proposed striking the so-called push out provision altogether. After objections were raised about the Republican plan, Citigroup lobbyists sent around the bank’s own compromise proposal that simply exempted a wider array of derivatives. That recommendation, put forth in late 2011, was largely part of the bill approved by the House committee on May 7 and is now pending before both the Senate and the House.

Citigroup executives said the change they advocated was good for the financial system, not just the bank.

“This view is shared not just by the industry but from leaders such as Federal Reserve Chairman Ben Bernanke,” said Molly Millerwise Meiners, a Citigroup spokeswoman.

Industry executives said that the changes — which were drafted in consultation with other major industry banks — will make the financial system more secure, as the derivatives trading that takes place inside the bank is subject to much greater scrutiny.

Representative Maxine Waters , the ranking Democrat on the Financial Services Committee, was among the few Democrats opposing the change, echoing the concerns of consumer groups.

“The bill restores the public subsidy to exotic Wall Street activities,” said Marcus Stanley, the policy director of Americans for Financial Reform, a non-profit group.

But most of the Democrats on the committee, along with 31 Republicans, came to the industry’s defense, including the seven freshmen Democrats — most of whom have started to receive donations this year from political action committees of Goldman Sachs, Wells Fargo and other financial institutions, records show.

Six days after the vote, several freshmen Democrats were in New York to meet with bank executives, a tour organized by Representative Joe Crowley, who helps lead the House Democrats’ fund-raising committee. The trip was planned before the votes, and was not a fund-raiser, but it gave the lawmakers a chance to meet with Wall Street’s elite.

In addition to a tour of Goldman’s Lower Manhattan headquarters, and a meeting with Lloyd C. Blankfein , the bank’s chief executive, the lawmakers went to JPMorgan ’s Park Avenue office. There, they chatted with Jamie Dimon , the bank’s chief, about Dodd-Frank and immigration reform.

The bank chief also delivered something of a pep talk.

“America has the widest, deepest and most transparent capital markets in the world,” he said. “Washington has been dealt a good hand.”

Eric Lipton reported from Washington, and Ben Protess from New York.

A version of this article appeared in print on 05/24/2013, on page A1 of the New York edition with the headline: Banks’ lobbyists Help in Drafting Bills on Finance.

Source: New York Times

By THE EDITORIAL BOARD.

New rules to regulate derivatives , adopted last week by the Commodity Futures Trading Commission, are a victory for Wall Street and a setback for financial reform. They may also signal worse things to come.

The regulations, required under the Dodd-Frank reform law, are intended to impose transparency and competition on the notoriously opaque multitrillion-dollar market for derivatives, which is dominated by five banks: JPMorgan Chase, Goldman Sachs, Bank of America, Citigroup and Morgan Stanley.

In the run-up to the financial crisis — and since — the lack of transparency and competition has fostered recklessness and instability. But banks like opacity, because their outsized profits depend on keeping clients in the dark about what other clients pay in similar deals. Under the Dodd-Frank law, derivatives are supposed to be traded on “swap execution facilities,” which are to operate much like the exchanges that exist for equities and futures.

Even as the new rules shift much of the trading to those facilities, they will also preserve the ability of the banks to maintain their old practices.

For instance, the commission’s initial proposal called for hedge funds, asset managers and corporations to contact at least five banks when seeking prices for a derivatives contract. In a major concession to the banks, that number was lowered to two in the final rule. Sometime in 2014, it is supposed to rise to three, but that would still be inadequate. Worse, there’s always the risk that delayed rules will never go into effect.

The initial proposal also called for derivatives trading to take place on open electronic platforms. The final rules will allow much of the negotiation over derivative prices to take place over the phone, a practice that is difficult to monitor and prone to abuse.

By themselves, these new rules are not fatal to the overall reform effort. And they are the best that the commission’s reform-minded chairman, Gary Gensler, could achieve at this time because of resistance to tougher standards by the agency’s two Republican commissioners and by one of its Democratic commissioners, Mark Wetjen.

The problem now is that Mr. Gensler’s term has officially ended, and he is expected to leave the agency at the end of the year. Given Wall Street’s incessant lobbying and powerful presence in Washington, it is assumed that he will be replaced by a chairman who is friendlier to Wall Street. That bodes ill for rules that have started out weak and need to be shored up later. To lose a reformer would also reflect poorly on President Obama, but he has not yet shown interest in keeping Mr. Gensler in the government.

In addition, none of the derivatives rules that have been finalized so far will make any real difference if they are not applied internationally. Yet Mr. Gensler has met fierce resistance — from banks, some C.F.T.C. commissioners and regulators at the Securities and Exchange Commission — to his plan to extend domestic rules to foreign affiliates of American banks and to foreign banks operating in the United States. Anything less broad would make a sham of derivatives reform.

Source: New York Times

Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve System, at the Peterson Institute for International Economics, Washington DC, May 2013

More than five years after the failure of Bear Stearns marked an escalation of the financial crisis, and nearly three years since the passage of the Dodd-Frank Act, debate continues over the appropriate set of policy responses to protect against financial instability. In recent months, there has been, in particular, a renewal of interest in additional measures to address the too-big-to-fail problem. In some respects, the persistence of debate is unsurprising. After all, the severity of the crisis and ensuing recession, and the frustratingly slow pace of economic recovery, have properly occasioned much thought about the structure of the financial system and the fundamentals of financial regulation.

Continuing discussion of these issues is part of a protracted policy debate over financial regulatory reform. Some argue that little has changed and that the needed reform is a single, dramatic policy change (though that single policy differs considerably among those taking this view). Others argue that reforms already enacted are sufficient to ensure financial stability. Still others contend that there has already been too much of a regulatory response, which is suppressing credit extension and faster economic recovery.

I think most of us would acknowledge, upon reflection, that a good bit has been done, or at least put in motion, to counteract the problems of too-big-to-fail and systemic risk more generally. At the same time, I believe that more is needed, particularly in addressing the risks posed by short-term wholesale funding markets. This afternoon I would like both to highlight the importance of what has already been accomplished and, at somewhat greater length, to identify what I believe to be the key steps that remain. Before turning to these subjects, though, I begin with a brief reprise of the origins of the financial crisis, to remind ourselves of the vulnerabilities that led to the crisis and that remain of concern today. It should, but does not always, go without saying that proposed solutions should actually help solve the problems at hand, and do so in a manner that minimizes the costs to otherwise productive activities.

Vulnerabilities exposed by the crisis

Beginning in the 1970s, the separation of traditional lending and capital markets activities established by New Deal financial regulation began to break down under the weight of macroeconomic turbulence, technological and business innovation, and competition. During the succeeding three decades these activities became progressively more integrated, fueling the expansion of what has become known as the shadow banking system, including the explosive growth of securitization and derivative instruments in the first decade of this century.

This trend entailed two major changes. First, it diminished the importance of deposits as a source of funding for credit intermediation, in favor of capital market instruments sold to institutional investors. Over time, these markets began to serve some of the same maturity transformation functions as the traditional banking systems, which in turn led to both an expansion and alteration of traditional money markets. Ultimately, there was a vast increase in the creation of so-called cash equivalent instruments, which were supposedly safe, short term, and liquid. Second, this trend altered the structure of the industry, both transforming the activities of broker-dealers and fostering the emergence of large financial conglomerates.

There was, in fact, a symbiotic relationship between the growth of large financial conglomerates and the shadow banking system. Large banks sponsored shadow banking entities such as Structured Investment Vehicles (SIVs), money market funds, asset-backed commercial paper conduits, and auction rate securities. These firms also dominated the underwriting of assets purchased by entities within the shadow banking system.

Though motivated in part by regulatory arbitrage, these developments were driven by more than regulatory evasion. The growth and deepening of capital markets lowered financing costs for many companies and, through innovations such as securitization, helped expand the availability of capital for mortgage lending. Similarly, the rise of institutional investors as guardians of household savings made a wide array of investment and savings products available to a much greater portion of the American public.

But these changes also helped accelerate the fracturing of the system established in the 1930s. While the increasingly outmoded regulation of earlier decades was eroded, no new regulatory mechanisms were put in place to control new risks. When, in 2007, questions arose about the quality of some of the assets on which the shadow banking system was based – notably, those tied to poorly underwritten subprime mortgages – a classic adverse feedback loop ensued. Investors formerly willing to lend against almost any asset on a short term, secured basis were suddenly unwilling to lend against a wide range of assets, notably including the structured products that had become central to the shadow banking system.

Liquidity-strained institutions found themselves forced to sell positions, which placed additional downward pressure on asset prices, thereby accelerating margin calls on leveraged actors and amplifying mark-to-market losses for all holders of the assets. The margin calls and booked losses would start another round in the adverse feedback loop.

Severe repercussions were felt throughout the financial system, as short-term wholesale lending against all but the very safest collateral froze up, regardless of the identity of the borrower. Moreover, as demonstrated by the intervention of the government when Bear Stearns and AIG were failing, and by the aftermath of Lehman Brothers’ failure, the universe of financial firms that appeared too-big-to-fail during periods of stress extended beyond the perimeter of traditional safety and soundness regulation.

In short, the financial industry in the years preceding the crisis had been transformed into one that was highly vulnerable to runs on the short-term, uninsured cash equivalents that fed the new system’s reliance on wholesale funding. The relationship between large firms and shadow banking meant that strains on wholesale funding markets could both reflect and magnify the too-big-to-fail problem. These were not the relatively slow-developing problems of the Latin American debt crisis, or even the savings and loan crisis, but fast-moving episodes that risked turning liquidity problems into insolvency problems almost literally overnight.

However, note that while the presence of too-big-to-fail institutions substantially exacerbates the vulnerability created by the new system, they do not define its limits. Even in the absence of any firm that may individually seem too big or too interconnected to be allowed to fail, the financial system can be vulnerable to contagion. An external shock to important asset classes can lead to substantial uncertainty as to underlying values, a consequent reluctance by investors to provide short-term funding to firms holding those assets, a subsequent spate of fire sales and mark-to-market losses, and the potential for an adverse feedback loop. An effective set of financial reforms must address both these related problems of too-big-to-fail and systemic vulnerability.

Regulatory response to date

As is obvious from the scope of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the amount of activity at the regulatory agencies, reform efforts to date have been extensive. They have also been significant. Without trying to give a full review, let me draw your attention to some of the more notable accomplishments, which can be categorized in three groups. First, the basic prudential framework for banking organizations is being considerably strengthened, both internationally and domestically. Central to this effort are the Basel III changes to capital standards, which create a new requirement for a minimum common equity capital ratio. This new standard requires substantial increases in both the quality and quantity of the loss-absorbing capital that allows a firm to remain a viable financial intermediary. Basel III also established for the first time an international minimum leverage ratio which, unlike the traditional U.S. leverage requirement, takes account of off-balance-sheet items.

Second, a series of reforms have been targeted at the larger financial firms that are more likely to be of systemic importance. When fully implemented, these measures will have formed a distinct regulatory and supervisory structure on top of generally applicable prudential regulations and supervisory requirements. The governing principle for this new set of rules is that larger institutions should be subject to more exacting regulatory and supervisory requirements, which should become progressively stricter as the systemic importance of a firm increases.

This principle has been codified in Section 165 of the Dodd-Frank Act, which requires special regulations applicable with increasing stringency to large banking organizations. Under this authority, the Federal Reserve will impose capital surcharges on the eight large U.S. banking organizations identified in the Basel Committee agreement for additional capital requirements on banking organizations of global systemic importance. The size of a surcharge will vary depending on the relative systemic importance of the bank. Other rules to be applied under Section 165 – including counterparty credit risk limits, stress testing, and the quantitative short-term liquidity requirements included in the internationally-negotiated Liquidity Coverage Ratio (LCR) – will apply only to large institutions, in some cases with stricter standards for firms of greatest systemic importance.

An important, related reform in Dodd-Frank was the creation of orderly liquidation authority, under which the Federal Deposit Insurance Corporation can impose losses on a failed systemic institution’s shareholders and creditors and replace its management, while avoiding runs and preserving the operations of the sound, functioning parts of the firm. This authority gives the government a real alternative to the Hobson’s choice of bailout or disorderly bankruptcy that authorities faced in 2008. Similar resolution mechanisms are under development in other countries, and international consultations are underway to plan for cooperative efforts to resolve multinational financial firms.

A third set of reforms has been aimed at strengthening financial markets generally, without regard to the status of relevant market actors as regulated or systemically important. The greatest focus, as mandated under Titles VII and VIII of Dodd-Frank, has been on making derivatives markets safer through requiring central clearing for derivatives that can be standardized and creating margin requirements for derivatives that continue to be written and traded outside of central clearing facilities. The relevant U.S. agencies are working with their international counterparts to produce an international arrangement that will harmonize these requirements so as to promote both global financial stability and competitive parity. In addition, eight financial market utilities engaged in important payment, clearing, and settlement activities have been designated by the Financial Stability Oversight Council as systemically important and, thus, will now be subject to enhanced supervision.

As you can tell from my description, many of these reforms are still being refined or are still in the process of implementation. The rather deliberate pace – occasioned as it is by the rather complicated domestic and international decision making processes – may be obscuring the significance of what will be far-reaching change in the regulation of financial firms and markets. Indeed, even without full implementation of all the new regulations, the Federal Reserve has already used its stress-test and capital-planning exercises to prompt a doubling in the last four years of the common equity capital of the nation’s 18 largest bank holding companies, which hold more than 70 percent of the total assets of all U.S. bank holding companies. The weighted tier 1 common equity ratio, which compares high-quality capital to risk-weighted assets, of these 18 firms rose from 5.6 percent at the end of 2008 to 11.3 percent in the fourth quarter of 2012, reflecting an increase in tier 1 common equity from $393 billion to $792 billion during the same period.

Gaps in regulatory reform

Despite this considerable progress, we have not yet adequately addressed all the vulnerabilities that developed in our financial system in the decades preceding the crisis.

Most importantly, relatively little has been done to change the structure of wholesale funding markets so as to make them less susceptible to damaging runs. It is true that some of the clearly risky forms of wholesale funding that existed before the crisis, such as the infamous SIVs, have disappeared or substantially contracted. But significant continuing vulnerability remains, particularly in those funding channels that can be grouped under the heading of securities financing transactions (SFTs).

Repo, reverse repo, securities lending and borrowing, and securities margin lending are part of the healthy functioning of the securities market. But, in the absence of sensible regulation, they are also potentially associated with the dynamic I described earlier of exogenous shocks to asset values leading to an adverse feedback loop of mark-to-market losses, margin calls, and fire sales. Indeed, some have argued that this dynamic is exacerbated by a “maturity rat race,” in which each creditor acts to shorten the maturity of its lending so as to facilitate quick and easy flight, and in which creditors pay relatively little attention to the recovery value of the underlying assets.

With respect to the too-big-to-fail problem, as I noted earlier, actual capital levels are substantially higher than before the crisis, and requirements to extend and maintain higher levels of capital are on the way. The regularization and refinement of rigorous stress testing may be the single most important supervisory improvement to strengthen the resilience of large institutions. The creation of orderly liquidation authority and the process of resolution planning advance prospects for increasing market discipline. But questions remain as to whether all this is enough to contain the problem. The enduring potential fragility of a financial system substantially dependent on short-term wholesale funding is especially relevant in considering the impact of severe stress or failure at the very large institutions with very large amounts of such funding.

Concern about the adequacy of policy responses to date is supported by some recent research that attempts to quantify the implicit funding subsidy enjoyed by certain institutions by looking to such factors as credit ratings uplifts, differentials in interest rates paid on deposits or in risk compensation for bank debt and equity, and premia paid for mergers that would arguably place the merged firm in the too-big-to-fail category. The calculation of a precise subsidy is difficult, and each such effort will likely occasion substantial disagreement. But several measures provide at least directionally consistent results.

Key additional reform measures

In sketching out the kinds of steps needed to address these remaining vulnerabilities, let me begin with wholesale funding generally, and then circle back to too-big-to-fail.

Short-term wholesale funding

At a conceptual level, the policy goal is fairly easy to state: a regulatory charge or other measure that applies more or less comprehensively to all uses of short-term wholesale funding, without regard to the form of the transactions or whether the borrower was a prudentially regulated institution. The aspiration to comprehensiveness is important for two reasons. First, the risks associated with short-term funding are as much or more macroprudential as they are firm-specific. From a microprudential perspective, SFTs are low risk, because the borrowing is short-dated, overcollateralized, marked-to-market daily, and subject to remargining requirements. The dangers arise in the tail and apply to the entire financial market when the normally safe, short-term lending contracts dramatically in the face of sudden and significant uncertainty about asset values and the condition of counterparties. A regulatory measure should force some internalization by market actors of the systemic costs of this intermediation.

Second, to the degree that regulatory measures apply only to some types of wholesale funding, or only to that used by prudentially regulated entities, there will be a growing risk of regulatory arbitrage. Ideally, the regulatory charge should apply whether the borrower is a commercial bank, broker-dealer, agency Real Estate Investment Trust (REIT), or hedge fund.

Stating the goal is easy, but executing it is not, precisely because short-term wholesale funding is used in a variety of forms by a variety of market actors. Determining appropriately equivalent controls is a challenging task and, with respect to institutions not subject to prudential regulation, there may be questions as to where – if at all – current regulatory authority resides. And, of course, there is the overarching problem of calibrating the regulation so as to mitigate the systemic risks associated with these funding markets, while not suppressing the mechanisms that have become important parts of the modern financial system in providing liquidity and lowering borrowing costs for both financial and non-financial firms. For all these reasons, it may well be that the abstract desirability of a single, comprehensive regulatory measure may not be achievable in the near term.

Still, at least as a starting point, we would do well to consider measures that apply broadly. One option is to change minimum requirements for capital, liquidity, or both at all regulated firms so as to realize a macroprudential, as well as microprudential, purpose. In their current form, existing and planned liquidity requirements produced by the Basel Committee aim mostly to encourage maturity-matched books. While maturity mismatch by core intermediaries is a key financial stability risk in wholesale funding markets, it is not the only one. Even if an intermediary’s book of securities financing transactions is perfectly matched, a reduction in its access to funding can force the firm to engage in asset fire sales or to abruptly withdraw credit from customers. The intermediary’s customers are likely to be highly leveraged and maturity transforming financial firms as well, and, therefore, may then have to engage in fire sales themselves. The direct and indirect contagion risks are high. Thus, the long-term and short-term liquidity ratios might be refashioned so as to address directly the risks of large SFT books.

Similarly, existing bank and broker-dealer risk-based capital rules do not reflect fully the financial stability risks associated with SFTs. Accordingly, higher, generally applicable capital charge applied to SFTs might be a useful piece of a complementary set of macroprudential measures, though an indirect measure like a capital charge might have to be quite large to create adequate incentive to temper the use of short-term wholesale funding.

By definition, both liquidity and capital requirements would be limited to banking entities already within the perimeter of prudential regulation. The obvious questions are whether these firms at present occupy enough of the wholesale funding markets that standards applicable only to them would be reasonably effective in addressing systemic risk and, even if that question is answered affirmatively, whether the imposition of such standards would soon lead to significant arbitrage through increased participation by those outside the regulatory circle.

In part for these reasons, a second possibility that has received considerable attention is a universal minimum margining requirement applicable directly to SFTs. The Financial Stability Board has already issued a consultative paper, and received public comment, on the idea.

Under such a regime, all repo lenders, for example, could be required to take a minimum amount of over-collateralization as determined by regulators (the amount varying with the nature of the securities collateral), regardless of whether the repo lender or repo borrower were otherwise prudentially regulated. This kind of requirement could be an effective tool to limit procyclicality in securities financing and, thereby, to contain the risks of runs and contagion. Of course, it also raises many of the issues that make settling on a single policy instrument so hard to achieve, and the decision on calibration would be particularly consequential. Still, the concept has much to be said for it and seems the most promising avenue toward satisfying the principle of comprehensiveness. It is definitely worth pursuing.

As you can tell, there is not yet a blueprint for addressing the basic vulnerabilities in short term wholesale funding markets. Accordingly, the risks of runs and contagion remain. For the present, we can continue to work on discrete aspects of these markets, such as through the diminution of reliance on intraday credit in triparty repo markets that is being achieved by Federal Reserve supervision of clearing banks and through the money market fund reforms that I expect will be pursued by the Securities and Exchange Commission. We might also think about less comprehensive measures affecting SFTs, such as limits on rehypothecation, when an institution uses assets that have been posted as collateral by its clients for its own purposes.

But I do not think that the post-crisis program of regulatory reform can be judged complete until a more comprehensive set of measures to address this problem is in place.

Too-big-to-fail

Before discussing policies specifically directed at too-big-to-fail, let me say a word about the capital regime that should be applicable to all banks, on top of which any additional requirements for systemically important institutions would be built. The first order of business is to complete the Basel III rulemaking as soon as possible. The required increases in the quality and quantity of minimum capital, and the introduction of an international leverage ratio, represent important steps forward for banking regulation around the world. U.S. banks have increased their capital substantially since the financial crisis began, and the vast majority already have Tier 1 common risk-based ratios greater than the Basel III 7 percent requirements.

The new requirements, while big improvements, are not as high as I would have liked, and the agreement contains some provisions I would have omitted or simplified. In coming years we may well seek changes. Indeed, I continue to be a strong advocate of establishing simpler, standardized risk-based capital requirements and am encouraged at the initial work being done on the topic of simplification in the Basel Committee. And we will certainly simplify the final capital rules here in the United States so as to respond to the concerns expressed by smaller banks. But opposing, or seeking delay in, Basel III would simply give an excuse to banks that do not meet Basel III standards to seek delay from their own governments. It would be ironic indeed if those who favor higher or simpler capital requirements were unintentionally to lend assistance to banks that want to avoid strengthening their capital positions.

Turning to specific policies to address too-big-to-fail, the first task is to implement fully the capital surcharge for systemically important institutions, the LCR, resolution plans, and other relevant proposed regulations. But, completion of this agenda, significant as it is, would leave more too-big-to-fail risk than I think is prudent. What more, then, should be done? As I have said before, proposals to impose across-the-board size caps or structural limitations on banks – whatever their merits and demerits – embody basic policy decisions that are properly the province of Congress.

However, that does not mean there is no role for regulators. On the contrary, Section 165 of the Dodd-Frank Act gives the Federal Reserve the authority, and the obligation, to apply regulations of increasing stringency to large banking organizations in order to mitigate risks to financial stability. In any event, it is unlikely that the problems associated with too-big-to-fail institutions can be efficiently ameliorated using a single regulatory tool. The explicit expectation in Section 165 that there will be a variety of enhanced standards seems well-advised. We should be considering ways to use this authority in pursuit of three complementary ends: (1) ensuring the loss absorbency needed for a credible and effective resolution process, (2) augmenting the going-concern capital of the largest firms, and (3) addressing the systemic risks associated with the use of wholesale funding.

There is clear need for a requirement that large financial institutions have minimum amounts of long-term unsecured debt that could be converted to equity and thereby be available to absorb losses in the event of insolvency. Although the details will, as always, be important, there appears to be an emerging consensus among regulators, both here and abroad, in support of the general idea. Debt subject to this kind of bail-in would supplement the increased regulatory capital in order to provide greater assurance that, should the firm become insolvent, all losses could be borne using resources within the firm. This requirement for additional “gone concern” capital would increase the prospects for orderly resolution and, thereby, counteract the moral hazard associated with expectations of taxpayer bailouts.

Switzerland has already adopted a requirement of this sort, and similar proposals are being actively debated in the European Union. A U.S. requirement, enacted under the Federal Reserve’s Section 165 authority, would both strengthen our domestic resolution mechanisms and be consistent with emerging international practice.

With respect to “going concern” capital requirements, there is a good case for additional measures to increase the chances that large financial institutions remain viable financial intermediaries even under stress. To me, at least, the important question is not whether capital requirements for large banking firms need to be stronger than those included in Basel III and the agreement on capital surcharges, but how to make them so and with what specific risks in mind. In this regard, I would observe that our stress tests and capitalplanning requirements have already strengthened capital standards by making them more forward-looking and more responsive to economic developments. As we gain experience, and as the annual process becomes smoother for both the banks and the Federal Reserve, we have the opportunity to enhance the stress tests by, for example, varying the scenario for stressing the trading books of the largest firms, so as to reflect changes in the composition of those books.

As to regulatory measures of capital outside the customized context of stress testing, one approach is to revisit the calibration of two existing capital measures applicable to the largest firms. The first is the leverage ratio. U.S. regulatory practice has traditionally maintained a complementary relationship between the greater sensitivity of risk-based capital requirements and the check provided by the leverage ratio on too much leverage arising from low-risk-weighted assets. This relationship has obviously been changed by the substantial increase in the risk-based ratio resulting from the new minimum and conservation buffer requirements of Basel III. The existing U.S. leverage ratio does not take account of off-balance-sheet assets, which are significant for many of the largest firms. The new Basel III leverage ratio does include off-balance-sheet assets, but it may have been set too low.

Thus, the traditional complementarity of the capital ratios might be maintained by using Section 165 to set a higher leverage ratio for the largest firms.

The other capital measure that might be revisited is the risk-based capital surcharge mechanism. The amounts of the surcharges eventually agreed to in Basel were at the lower end of the range needed to achieve the aim of reducing the probability of these firms’ failures enough to offset fully the greater impact their failure would have on the financial system. At the time these surcharges were being negotiated, I favored a somewhat greater requirement for the largest, most interconnected firms. Here, after all, is where the potential for negative externalities is the greatest, while the marginal benefits accruing from scale and scope economies are hardest to discern. While it is clearly preferable at this point to implement what we have agreed, rather than to seek changes that could delay any additional capital requirement, it may be desirable for the Basel Committee to return to this calibration issue sooner rather than later.

The area in which the most work is needed is in addressing the risks arising from the use of short-term wholesale funding by systemically important firms. The systemic risks associated with runs on wholesale funding would, almost by definition, be exacerbated if a very large user of that funding were to come under serious stress. There could also be greater negative externalities from a disruption of large, matched SFT positions on the books of a major financial firm than if the same total activity were spread among a greater number of dealers.

Thus, in keeping with the principle of differential and increasingly stringent regulation for large firms, there is a strong case to be made for taking steps beyond any generally applicable measures that are eventually applied to SFTs or short-term wholesale funding more generally.

One possibility would be to have progressively greater minimum liquidity requirements for larger institutions under the LCR and the still-under-construction Net Stable Funding Ratio (NSFR). There is certainly some appeal to following this route, since it would build on all the work done in fashioning these liquidity requirements. The only significant additional task would be calibrating the progressivity structure. However, there are at least two disadvantages to this approach. First, the LCR and, at least at this stage of its development, the NSFR, both rest on the implicit presumption that a firm with a perfectly matched book is in a fundamentally stable position. As a microprudential matter, this is probably a reasonable assumption. But under some conditions, the disorderly unwind of a single, large SFT book, even one that was quite well maturity matched, could set off the kind of unfavorable dynamic described earlier. Second, creating liquidity levels substantially higher than those contemplated in the LCR and eventual NSFR may not be the most efficient way for some firms to become better insulated from the run risk that can lead to the adverse feedback loop and contagion possibilities discussed earlier.

A more interesting approach would be to tie liquidity and capital standards together by requiring higher levels of capital for large firms unless their liquidity position is substantially stronger than minimum requirements. This approach would reflect the fact that the market perception of a given firm’s position as counterparty depends upon the combination of its funding position and capital levels. It would also supplement the Basel capital surcharge system, which does not include use of short-term wholesale funding among the factors used to calculate the systemic “footprint” of each firm, and thus determine its relative surcharge.

While there is decidedly a need for solid minimum requirements for both capital and liquidity, the relationship between the two also matters. Where a firm has little need of short-term funding to maintain its ongoing business, it is less susceptible to runs. Where, on the other hand, a firm is significantly dependent on such funding, it may need considerable common equity capital to convince market actors that it is indeed solvent. Similarly, the greater or lesser use of short-term funding helps define a firm’s relative contribution to the systemic risk latent in these markets.

If realized, this approach would allow a firm of systemic importance to choose between holding capital in greater amounts than would otherwise be required, or changing the amount and composition of its liabilities in order to reduce the contribution it could make to systemic risk in the event of a shock to short-term funding channels. The additional capital requirements might be tied, for example, to specified scores under an NSFR that had been reworked significantly so as to take account of the macroprudential implications of wholesale funding discussed earlier. If one wished to maintain the practice of grounding capital requirements in measures of assets, another possibility would be to add as a capital surcharge a specified percentage of assets measured so as to weight most heavily those associated with short-term funding.

To provide a meaningful counterweight to the risks associated with wholesale funding runs, the additional capital requirement would have to be material. The highest requirement would be at just the point where a firm had the minimum required level of liquidity. The requirement then would diminish as the liquidity score of the firm rose sufficiently above minimum required levels. If the requirement were significant enough and likely to apply to any large institution with substantial capital market activities, it might also be a substitute for increasing the capital surcharge schedule already agreed to in Basel.

I readily acknowledge that calibrating the relationship would not be easy, and that the stakes for both financial stability and financial efficiency in getting it right would be significant. But I think this approach is worth exploring, precisely because it rests upon the link between too-big-to-fail concerns and the runs and contagion that we experienced five years ago, and to which we remain vulnerable today. Whether it proves feasible, or whether we would have to fall back on the more straightforward approach of strengthening liquidity requirements for systemically important firms, the key point is that the principle of increasing stringency be applied.

Conclusion

Of late I find myself of two minds on the question of bringing to a close the major elements of regulatory change following the financial crisis. On the one hand, I strongly believe that all the regulatory agencies should complete as soon as possible the remaining rulemakings generated by Dodd-Frank and Basel III. It is important that banks and other financial market actors know the rules that will govern capital standards, proprietary trading, mortgage lending, and other activities. In fact, we should monitor whether these rules end up having significant unintended effects on credit availability and, if so, modify them in a manner consistent with basic aims of safety and soundness and consumer protection.

On the other hand, I equally strongly believe that we would do the American public a fundamental disservice were we to declare victory without tackling the structural weaknesses of short-term wholesale funding markets, both in general and as they affect the too-big-to-fail problem. This is the major problem that remains, and I would suggest that additional reform measures be evaluated by reference to how effective they could be in solving it.

Source: Bank for International Settlements

The PRA’s role is defined in terms of two statutory objectives to promote the safety and soundness of these firms and, specifically for insurers, to contribute to the securing of an appropriate degree of protection for policyholders.

In promoting safety and soundness, the PRA focuses primarily on the harm that firms can cause to the stability of the UK financial system. A stable financial system is one in which firms continue to provide critical financial services – a precondition for a healthy and successful economy.

The PRA will make forward-looking judgements on the risks posed by firms to its statutory objectives. Those institutions and issues which pose the greatest risk to the stability of the financial system will be the focus of its work.

The PRA was created by the Financial Services Act (2012) and will be part of the Bank of England. It will have close working relationships with other parts of the Bank, including the Financial Policy Committee and the Special Resolution Unit.

The PRA works alongside the Financial Conduct Authority (FCA) creating a “twin peaks” regulatory structure in the UK. The FCA is a separate institution and not part of the Bank of England. The FCA is responsible for promoting effective competition, ensuring that relevant markets function well, and for the conduct regulation of all financial services firms. This includes acting to prevent market abuse and ensuring that consumers get a fair deal from financial firms. The FCA operates the prudential regulation of those financial services firms not supervised by the PRA, such as asset managers and independent financial advisers.

Source: Bank of England

Her Majesty the Queen has been pleased to approve the appointment of Mark Carney as Governor of the Bank of England from 1 July 2013. He will succeed Sir Mervyn King

Welcoming the appointment, the Governor, Sir Mervyn King, said:

I am delighted to welcome Mark Carney as my successor.  He represents a new generation of leadership for the Bank of England, and is an outstanding choice to succeed me.  Since Mark became Governor of the Bank of Canada, I have worked closely with him and admired his contributions to the world of central banking, in which he is widely respected.

The Chairman of Court, Sir David Lees, said:

On behalf of the Court of the Bank of England I congratulate Mark Carney on his appointment as the next Governor of the Bank.  His reputation as an outstanding central bank Governor goes before him and Court very much look forward to working with him when he joins us next July.

The Queen has also approved the reappointment of Charles Bean as Deputy Governor of the Bank of England for Monetary Policy from 1 July 2013.  Mr Bean has agreed to stay on for a year to help oversee the extension of the Bank of England’s responsibilities and the transition to the new Governor.  He has asked to stand down on 30 June 2014.

Welcoming the reappointment, the Governor said:

I am very pleased that Charlie has agreed to stay on for a year to assist in the transition.  He will provide valuable continuity in the crucial area of monetary policy.

Governor of the Bank of England – HM Treasury Press Notice

Re-appointment of Deputy Governor of Bank of England for Monetary Stability - HM Treasury Press Notice

Source: Bank of England