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    Global Risk Update 2012 Nov / Dec

    Index PAGE

    Keynes Animal Spirits in the 3financial markets

    Black Swans Mean Business 6

    How Canadian Banks have Managed 11the Economic Crisis so well

    OTC Clearing Evaluation of the 15EMIR and Dodd-Frank Regulationsand their Impact on IT

    International Financial Supervisory 19Convergence

    Risk Reward Limited, serving the banking and financial servicessectors with risk consultancy and risk training in developed and

    emerging markets since 2002. Risk Reward is registered with UKCompanies House no 4346234.

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    2012 will be remembered as a year of challenge for the banking industry. Thefinancial crisis has continued to rumble on impacting the profitability of banks.Regulations designed subsequent to the initial financial crisis are now beingimplemented and the negative social impacts of these regulations are nowbecoming clear. Those sovereign nations continuing to borrow significantlyto meet their current needs remains one of the key issues facing the industrysince at present there has not really been any austerity. We enter 2013 with aglobal economy which is at best, fragile, and with a landscape of uncertainty.

    In this, our final issue of 2012 we look at a wide range of risk issues which areall clearly important and informative. Once again our authors have addressedkey issues and provide in depth, original analysis.

    The first article from Steven Goldstein, an Executive Coach who works with

    traders and portfolio managers, reviews financial markets and considers theimpact of human and behavioural risks on risk management. The changingmarkets have clearly started to diverge from historic norms and this articleprovides an insight into some of the key developments. In the first of twoarticles by Atula Abeysekera, Deputy Treasurer of thinktank, Bow Group, heconsiders the impact of uncertain events and the impact that Black Swans haveon business.

    The journal concludes with three other important articles. In the first of twoarticles Mark Dougherty, a senior corporate governance and risk managementprofessional, considers why it is that the Canadian banks have managed tosurvive the financial crisis so effectively. Additionally Michel Dorval, riskmanagement and compliance specialist at Misys, provides an important review

    of some of the changes that are likely to impact OTC clearing. These comefrom a range of spaces including EMIR and Dodd-Frank.

    Lastly, my article features a discussion on cross-border financial supervision,and its impact on the financial markets.In it, I concentrate on an assessment ofthe changing regulatory scene, the way in which it should be developing andhow it is, in fact, moving forward.

    There is much going on and 2013 will be another year of challenge for riskmanagement. Regretfully we are not yet at the end of the financial crisis andmany important decisions will need to be made next year. These also includethe liquidity papers that have now been delayed by the BIS. The Global RiskUpdatewill continue to provide you with in depth analysis of such key issues inthe coming year; and the Risk Reward Global Risk Update on LinkedIn will

    also continue to support your on-going technical risk needs. I hope you enjoythis issue and look forward to hearing your comments.

    With warm Seasons Greetingsand a prosperous New Year

    Dennis Cox BSc, CFSI, FCA

    Chief Executive Officer

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    Global Risk Update, a regular journal covering

    insights and global risk issues of interest to thebanking, insurance and financial sectors indeveloped and emerging markets.

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    This article introduces some new concepts andideas about human decision-making, andconsiders some implications for the financial-market risk industry. It also looks at whether it

    needs to put into place changes in the way the financialrisk management industry works and functions, in orderto take greater account of aspects of human behaviour.Finally it looks at whether businesses can introduceimprovements and enhancements to the way they workin order to prevent and mitigate risk, and to improve thequality of decision-making in the financial markets.

    In John Maynard Keyness celebrated 1936 book, TheGeneral Theory of Employment, Interest and Money, heused the term Animal spirits to describe emotions whichinfluence human behaviour. Now, almost eight decades later,new research is shedding further light on these animalspirits, and in particular, how they affect peoples decisions

    in the financial markets. Some of these findings are leadingto questions about some of the basic assumptions of howpeople think and act, and are also challenging long-heldbeliefs and tenets central to economic theory. Whilst thishas some direct consequences for the field of financial risk-management, it also provides new thinking and offerspotential solutions, some of which may help to improve risk-management practices and techniques moving forward.

    The traditional view from classical economics sees peopleas rational, utility-maximizing actors; individuals who know

    what they want and are consistent, methodical, andemotionless in pursuing it. Consistent with this is the viewof the human mind as a machine; working like a computerand rationalizing all options through the use of peoplescognitive powers, and the supremacy of intellect. Thesebeliefs are cornerstones of modern economics, however,they are increasingly being challenged by the emergingfields of Behavioural Economics and Neuroeconomics.Backed by a growing body of research, they argue that

    Keynes Animal Spirits in the

    financial markets: Is it time that RiskManagement should place greaterfocus on human emotions and theireffect on financial decision-making?Steven Goldstein is a qualified executive coach working with traders and portfolio managers to

    help them improve and enhance their personal trading performance in order to achieve greatersuccess and improved profitability. Prior to working as a coach, Steven spent twenty-five years

    as a trader in the financial markets for a number of major banks and financial institutions.During this time Steven developed an in-depth understanding of financial markets, and the

    psychology and behavioural aspects associated with being a risk professional at the cutting

    edge of trading and investing.

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    humans have many limitations to behaving rationally, as wellas using feelings and emotions extensively when makingdecisions. One study which highlights this, looked into thedecision-making performance of a group of highly qualifiedand experienced judges. The study involved 1,112 cases ofparole board hearings over a 10 month period. One wouldexpect that judges rulings are based solely on rationaldecisions and written laws; however the research revealedthat the biggest influence in the outcomes was actually thetime of day of the hearings. Prisoners who appeared beforethe judges early in the morning session, straight after themid-morning break, or immediately after the lunch break,received parole in about 60-70 percent of the cases. But, aseach time period progressed, the percentage of successful

    appeals for parole decreased, with those appearing late ineach session receiving parole no more than 10-15 percentof the time. The research found nothing malicious or unusualabout the judges behaviour; rather it was due to somethingknown as Decision-fatigue. Decision-fatigue occurs asmore choices are made throughout the day; each subsequentdecision becomes harder for peoples brains as it draws-down on energy in the form of glucose. In this case, nomatter how rational and high-minded the judges tried to be,they were fighting their own human biology: The depletionof glucose to the judges brains changed the way theirthinking processes worked. This led them to non-consciously seek shortcuts which expended less energy; inmost cases the shortcut involved decision-avoidance,

    which usually meant taking the default choice; to denyparole.

    Further support arguing against the rational man theorycomes from neuroscience; increasing evidence is arguing forthe primacy of emotions as a key part of decision-making. Astudy by neuroscientist Antonio Damasio, revealed how

    people who had received brain injuries which had resulted ina loss of ability to feel emotions, were incapable of makingeven the most basic of decisions; often spending hoursdeliberating over irrelevant details, such as where to eatlunch. The common belief is that the human mind usespurely cognitive process to reach logical conclusions,however as research into this field continues, these beliefsand existing theories of rational decision-making are beingseen as increasingly implausible. Damasio has labelled thepopular belief of the mind acting independent of the body,as Descartes Error.

    Coming back to financial markets, I want to look at whatsome implications from these alternative beliefs may be for

    financial risk-management, and to see whether these insightsmay offer steps towards improvements in the way financialrisk management works. Much of the focus of riskmanagement in the financial markets is on quantifying andmeasuring financial risk. A whole architecture of financialmodels, process and practices has arisen around this.However, what if the basic underlying assumptions thatunderpin some of these models are incorrect? The conceptof rational man, largely underscores the long-standingassumption that markets are random, and that deviationfrom true value in liquid markets will be arbitraged away byrational- man. As a participant in the financial markets formany years I have always disputed this assertion. Marketsare human constructs, driven by human perceptions,

    reactions and decisions, which are largely triggered bypeoples emotions. Keynes understood the way marketsworked from a behavioural perspective. In what was called

    Keynes Animal Spirits in the financial markets

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    the Keynesianbeauty contest,he said, you winnot by pickingthe soundestinvestment, butby picking theinvestment thatothers, who areplaying the samegame, will soon bid uphigher. It may be astretch to say that becausepeople act emotionally rather

    than rationally, that thereforemarkets are not random. However, itis this emotional human behaviour whichleads to trends, manias, panics and long-termdistortion from value, which are NOT quicklyarbitraged away by the mythical rational man.

    If markets are not-random, then this calls into question manyof the risk-management models which themselves are basedoff this assumption, this is however further compounded byover-reliance on these models. The financial markets areobsessed with quantifying risk, yet even if these models arecorrect, they are merely tools which do not have predictivecapabilities. Decisions around risk, should also involve

    subjective feeling and judgment based on expertise. AnuragVaish of the 'Final Mile' consultancy, which specialises infinding risk solutions through neuroscience and behaviouraleconomics, sums it up well: Risk is a feeling not a number;financial Institutions are highly number driven and continueto represent risk more as numbers.

    A further aspect of research into human behaviour is therealisation that we are not as in charge of the choices wemake as we like to think we are. Our emotions affect ournon-conscious thinking, which has a far greater pull over ourbehaviour than we realise. It is this non-conscious thinking,in collaboration with other inherent and learned humanbiases, which lead seemingly rational and intelligent people

    to make poor choices. This could help explain theprevalence of major human financial errors within financialbusinesses, e.g. JP Morgan, UBS, SocGen, Amaranth, etc. -

    Working on improving the monitoring of and quality ofdecision-making, is not merely a matter of risk-control andrisk-mitigation, it is also a pro-active endeavour which can

    yield businesses a greater return on investment. Financialmarket businesses, via risk-management, could more closelymonitor individual risk practices and behaviours. Steps couldalso be taken to deliver improved robustness and quality inindividual, managerial and group decision-making. Inputfrom risk practices in other industries may also providepotential solutions. For example, simple checklist practiceshave been put into place in industries as diverse as medicineand aviation, with profound effects on safety and quality.Also application of what-if-scenario exercises in co-ordination with stress-testing (this is practiced in thedisaster-recovery industry). Furthermore, businesses couldlook to redefine fit and proper to move beyond meaningpossessing honesty, integrity and reputation, to also includesufficiently qualified and educated in risk, products and

    markets. A further step could be increased monitoring ofindividual behaviour using risk management systemstogether with subjective judgment; this could be donethrough highlighting specific individuals and particular risksfor increased monitoring, possibly using a system of raisedflags for special attention.

    Moving forward, it may take a break from past thinking tofind solutions to some of the problems the industry faces.One interesting business which practices this is the Final-Mile consultancy; they call their work BehaviouralArchitecture and they look for and design alternativesolutions to existing risk-orientated problems. A goodexample of their work, which received widespread globalcoverage, involved an experiment on a stretch of theMumbai Rail system, notorious for deaths from peoplecrossing rail tracks. As a result of some innovativerecommendations they made which accounted for humandecision-making and behaviour, deaths from rail-trackscrossings on a 1-mile stretch of line, dropped from 23 in theprevious six months, to just one in

    the next eight months.In the wake of the Global FinancialCrisis, and subsequent strongpolitical, regulatory and economicforces re-shaping the financialmarkets, the financial riskmanagement industry is facing manychallenges. Whilst it is unfair toapportion blame to the risk-management industry for thefinancial disasters of recent years, itis right to question some of its assumptions and practices,and to find out whether things could have been done better,and how things can be improved going forward. As part ofthis process, it may help to step away from some of thebeliefs of the past, and to see if new innovative solutionscould be found and applied to take the industry forward.

    Steven Goldstein can be contacted via [email protected]

    Keynes Animal Spirits in the financial markets

    5

    the financial risk

    management

    industry is facing

    many challenges

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    I Introduction

    This man, on one hand, believesthat he knows something, while notknowing (anything). On the otherhand, I equally ignorant do notbelieve (that I know anything).

    Socrates in Platos The Apologies

    The notion of Socratic ignorance hasbeen a ideological theme for centuries.As the notion goes, the wise man isnot he who thinks he knows

    everything, rather he who knows thathe does not know everything.

    Since ancient times, this idea hasformed a common thread inphilosophy. Its application to the fieldsof economics and politics has,however, been a more recent

    phenomenon. As recently as 2004, inhis book Fooled by Randomness, NassimNicholas Taleb applied the idea tofinancial markets. He proposed that

    the notion that financial institutionscan both fully know and fully quantifythe risks associated with theirbusinesses is a false wisdom, anarrogant oversight that has a valuedestructive effect on their businessmodels.

    When, in 2007, Taleb published hisnow famous book, The Black Swan, thenotion was expanded beyondfinancial markets into the seemingly

    Black Swans MeanBusiness (Part 1)Atula Abeysekera is a Chartered Accountant with 25 years corporate governance and risk

    management experience. His has held senior positions in internal audit and risk managementat KPMG, Morgan Stanley, Fidelity Investments and Lazard. Atula is currently the Deputy

    Chairman of the Risk Forum Committee of the Chartered Institute of Securities and Investments

    and a member their disciplinary panel. He is a member of the thinktank Bow Group Counciland, in 2011, was awarded the Freedom of City of London. In this article he describes how

    government can better predict and manage national crises. Drawing on reforms to the waythat businesses and, in particular, banks have reformed their risk management processes, thepaper challenges the ways that the UK Government copes with so-called Black Swan events.

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    unpredictable and devastatingevents, which impact not onlyeconomics but the security of thenation. These occurrences he calledBlack Swans. Black Swans have nowentered into the common parlance ofbig business, with risk managersbusily deploying strategies to betterpredict and deal with the fall-out ofBlack Swans. The Boards ofDirectors of large enterprises aregradually realising not only that therisks to their business will never befully quantified but also that, in this

    knowledge, they gain a competitiveadvantage by being better preparedthan their competitors to deal withcrises.

    Institutions outside of the financialsphere are only just beginning to takenote of Talebs important theory. So asBusiness (and especially financialinstitutions) begins to acknowledgethe necessity of understanding BlackSwan events and incorporating them(as best they can) into their businessmodels, the UK Government has

    started to lag in its thinking aroundBlack Swan risk.

    Given the obvious importance to thenation of preventing national disasters,or at least mitigating their impact,

    what lessons can the Government takefrom the world of Business to addressthese risks and to add value to thenational security strategy?

    This Bow Briefing describes the waysin which Business analyses andprotects itself from Black Swan

    events. By looking in detail at recentexamples of national and internationalcrises and getting visibility on boththeir effect on the nation and howbetter risk strategies could havehelped to mitigate their effects, weargue that the Government has muchto learn. In doing so, we make severalspecific and achievable policyproposals, which we have set out onpage 6. The Government shouldembrace modern qualitative andquantitative methods of riskmanagement, as it is only with robustgovernance structures and cutting-edge risk management solutionscreated by modern enterprise that theGovernment can begin to effectivelycope with that elusive beast, the BlackSwan.

    II Black Swans

    Sometimes, from seemingly harmlesscauses come harmful effects. Whenthose effects make themselves known,it seems obvious what the cause of theeffect was; that the effect was alwaysgoing to happen.

    According to Taleb, a Black SwanEvent has three key

    characteristics:(i) it occurs outside projected

    expectations (a fat tail to adistribution curve);

    (ii) it carries extreme impact; and(iii) it seems explainable after the

    fact.

    Consider the following recentexamples of Black Swan events withrespect to these underlyingcharacteristics.

    Urban unrest (2011)An Outlier

    The independent Riots Communitiesand Victims Panel (UK) estimated thataround 15,000 people were activelyinvolved in the riots, which spreadthrough England in the Summer of2011 at alarming speed. TheGovernment showed no sign of havingpredicted the riots and, as expected,the panel concluded that the causes ofthe riots were complex and were notabout, or caused by, any single issue.

    Extreme impact

    Resources from several police forceswere mobilised to deal with the crisis.Five people lost their lives and severalbusinesses and homes were destroyed.

    The Riots Communities and VictimsPanel estimated that the costs to thecountry was in the region of half abillion pounds. Given the majorimpact on police resources and the

    wider economic ramifications, fewwould argue that the impact of theriots was not extreme.

    Explainable after the factThe Riots Communities and VictimsPanels interim report looked at theAugust 2011 riots in the context of theEnglish riots of 1981. The Panel notedthat it is thirty years since thepublication of the Scarman report.The Panel is clear that the riots inAugust 2011 were very differentdisturbances to those in 1981.However, it is a sad fact that in somerespects, the underlying challenges arestrikingly similar.

    Volcanic Ash Cloud (2010)

    An Outlier

    When a relatively small volcano,Eyjafjallajokull (lets call it E),erupted in Iceland in April 2010, itejected material as high as 20,000 feet.This event demonstrated the inherentuncertainties of volcano science.Although volcanoes are far morepredictable than earthquakes, each

    volcano is unique, with each onehaving its own personality, and, assuch, predicting the timing and scopeof their eruptions is notoriously tricky.

    Volcano scientists are empiricists, whorely primarily on past performance topredict future activity. However, when

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    it came to it, their methods, whichincluded measuring the regularity withwhich E had previously eruptedproved futile. Whereas the Iceland

    volcano produced only a smalleruption at first, it seems now that thecause of the second, more seriouseruption was that a vent, previouslyunknown to the scientists had openedbeneath a glacier on the volcano andthe resulting soda pop effect proveddevastating. This phenomenon hadpreviously not been observed.

    Extreme impactThe eruption of E had a significantimpact on the civil aviation industry,causing thousands of flights to becancelled and the economicdestruction that limited transportentails. The eruption also had animpact on the RAF, which had totemporarily suspend flight trainingafter ash deposits were found in jetengines. Indeed, the gridlockproduced by the cancellation of airtravel was deemed sufficiently seriousby the previous Government to

    require a meeting of COBR to beconvened to discussremedial measures.

    Explainable after the fact

    With hindsight, the scientificcommunity felt that the impact of theeruption on airspace could have beenpredicted and better prepared for.Following the event, the UN, throughthe International Strategy for DisasterReduction (UNISDR), urged

    European Governments toi n t e g r a t e

    volcano risk as part of their air travelpolicies and legislation. It is interestingthat now UNISDR is now working ongreater coordination and interactionbetween decision makers and thescientific community to achievemeaningful results in this field.

    Fukushima power plantdisaster, Japan (2011)

    An Outlier

    When the Tsunami hit in March 2011,among several devastating effects, was

    the damage caused to a nuclear reactorin northern Japan. Being an area proneto earthquakes, the Tokyo ElectricPower Co., owner and operator of theFukushima Dai-Ichi plant, had erectedsea barriers at the site to protect thenuclear reactors. The waves producedby that particular earthquake were solarge that the sea barriers proved 8metres too short to stop the resultingtsunami.

    Extreme impact

    The damage caused to the reactor in

    Japan resulted in the worst nucleardisaster since Chernobyl, 25 yearspreviously. The Japan Center forEconomic Research, a private thinktank, has estimated the remediationcosts to be in the region of $250 billionover the next 10 years. Of course, thisdoes not take into the loss of life andinjury that will ensue following theexposure of local inhabitants tomassive amounts of radiation.

    Explainable after the fact

    Since Japans Fukushima disaster,

    lectricit de France (EDF), hasallocated about 200million to protectUK reactors from Black Swan

    events, such as a giant wavecreated by a collapse of an

    island as far away asNorth Africa.

    This isemblematic

    of anumber

    o f

    reactive measures taken by nations,including the United Kingdom, toprotect themselves, post 2011Tsunami from the human andeconomic cost of poor preparation.

    III The Current UK

    Government Approach

    The UK Governments civil andnational security risk is currentlymanaged by the following organs ofgovernment:(i) In the case of managing

    domestic emergencies, TheCivil Contingencies Secretariat(CCS), established in 2004under the Civil ContingenciesAct (its executive committee,the Civil ContingenciesCommittee (CCC);

    (ii) In the case of protecting thecountrys national security andother interests, the NationalSecurity Council (NSC),established in 2010; and

    (iii) To manage emergencies, bothdomestic and international,

    COBR (A), or Cabinet OfficeBriefing Room (A), whichprovides a forum for the CCCto meet and a focal point for theGovernments response.

    For a full description of these bodies,please take a look at our recent paper,Intelligence Design: UK NationalSecurity in a Changing World. Weprovide below, however, a briefsummary of the roles of these bodies,

    with particular regard to their riskmanagement capabilities.

    Domestic Emergencies

    In recent years, the UK Governmenthas made a good start on firming up itsrisk management architecture. TheGovernment was one of the firstgovernments in the world to create anational risk register (NRR) fordomestic civil emergencies under theCCS. The NRR documents civilemergency risks over a 5-year timehorizon including malicious risks (e.g.,terrorism) and non-malicious risks(i.e., naturally occurring events andaccidents). The National RiskAssessment (NRA) for civilcontingencies is assessed annually toensure it reflects the latest evidenceand draws upon the best availableevidence and advice from subject-matter experts.

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    The CCS Preparedness and ResponseTeam systematically and routinelyscans the short-range horizon(generally up to six months ahead) forpotential or emerging civil domesticrisks within this timeframe. CCS haslinks to departments, their agenciesand other public bodies which areresponsible for monitoring andmanaging civil emergency-relatedinformation. These channels haveensured that CCS receives timelynotification of impending events, suchevents to include wide-area flooding,

    suspected animal disease outbreakssuch as Foot and Mouth Disease, andhuman health threats such as the swineflu pandemic.

    International Emergencies

    The NSC has adopted themethodology used in the developmentof the National Risk Register. Themethodology used involves thinkingaround the impact of an event (basedon economic consequences, casualtiesand social or structural factors) and thelikelihood of such an event occurring

    over a determined timeframe.The National Security RiskAssessment (NSRA) is reviewedevery two years and uses similarconcepts to the NRA processdescribed above. It involves making

    judgements about the relative impactof each risk, alongside an estimation ofthe likelihood of each risk. The NSRAprocess assesses all major disruptiverisks to the UKs national interest,

    which are of sufficient scale or impactso as to require action from the

    Government.Using 5 to 20 year horizon scanning,the NSRA identifies and analyses a fullrange of real and potential risks, givingthe greatest weight to those with theability to cause immediate and directharm to the UKs territories. Ingeneral, a risk assessed as high-likelihood and high-impact would alsobe considered as a high priority foraction. Similarly, those risks judged tobe low-impact and low-likelihood

    would be considered lower priorities.

    The management of domestic risks isoverseen by the Joint Committee ofNational Security Strategy (JCNSS),

    which is made up of 22 members (12from the Commons and 10 from theLords). This provides a forum to

    challenge conventional wisdom and tohold the organs of Government toaccount.

    COBR(A)

    The primary function of COBR is tocoordinate the national response toboth domestic and internationalemergencies. In addition, the CabinetOffice engages proactively withcentral and local Government andother partners in preparing for suchevents by developing and testingresponse plans. The COBR

    mechanism is triggered byemergencies which require sustainedcentral Government coordination andsupport from a number ofDepartments and where appropriate,the devolved administrations.

    Recent Performance

    Complex interdependencies inmodern societies make it more likelythat emergencies will require a largedegree of co-ordination acrossGovernment.

    ... there are

    also unknown

    unknowns the

    ones we dont know

    we dont know.

    And if one looks

    throughout thehistory of our

    country and other

    free countries, it is

    [in this] category

    that tend to be the

    difficult ones.(Donald Rumsfeld, 2002)

    The Government has made areasonable start on this. A goodexample of developments to civilcontingencies planning is the

    e x t e n s i v econtingency measuresdrawn up by the Government toprepare for extreme flooding inEngland: Project Excessive

    Watermark. This was undertakenfollowing the Pitt review of the 2007summer floods, a Black Swan event.The tests concluded that England and

    Wales has the capability to respond tosevere, widespread flood emergencies.

    On the other hand, the Government

    has not always been so proactive.Looking at the fuel protests of 2000and 2012, the Government wascompletely underprepared for theformer, and by the time the lattercame along, only reactive measureshad been taken by the Government,such as calling in the military, shouldthe drivers of petrol tankers decide tostage a national strike. Ultimately themilitary was not required, and thesepreparations were time and resourceconsuming for COBR(A) and forGovernment Departments.

    The lack of strategic focus resultedfrom a failure to be proactive and morerobust architecture is needed tomitigate the effects of suchoccurrences. There is much to do, andthe world of Business and, in

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    particular, the experiences of thefinancial sector, offers some usefulideas, which could lead to meaningfulprogress in this area.

    IV Business Approaches

    Recent Black Swan events such as theFinancial Crisis, the BP oil spill in theGulf of Mexico and the above-mentioned Tsunami in Japan haveprompted businesses to plan forextreme events and look again at theirrisk architecture.

    Complex businesses have oftendeveloped their own enterprise riskmanagement frameworks to capturethese emerging unknown risks. Theseframeworks employ forward-lookinggovernance structures and quantitativetechniques to assist in the decision-making process.

    These organisations generally havegood risk management practices forspecific risks at business unit level,but also have the ability to aggregatethese risks across the entire

    organisation, sometimes applyingcorrelation factors between risks.

    There are formal and informalprocesses for escalating risks throughthe hierarchy of a business but theygenerally follow a three lines ofdefence approach, as describedbelow:

    n The 1st level of defence is theperson who identifies the risk(whoever identifies the risk, isresponsible for managing the risk);

    n

    The 2nd level of defence is aseparate risk management

    department, headed by a senior riskofficer; andn The 3rd level of defence is the

    Board of Directors (or appropriategoverning body), supported by anindependent audit function.

    A risk crystallises if all three levels arebreached.

    The success of the three level defencesystem depends upon goodmanagement information systems,change management control

    procedures, strategic planningprocesses, and financial reportingconventions. In addition to this, mostbusiness organisations have an annualrisk assessment review and materialand emerging risks are subjected toextensive stress testing. Should a risknot be accounted for, a remediationplan will then be implemented toreduce the risk to the organisation.

    The day-to-day analysis of risk variesin its nature across industries and

    jurisdictions. Some industries use

    probabilistic approaches such asplanning for 1 in 200 year single ormultiple events, while the others takea more qualitative approach. Sometake a combination of both. Theobjective is to have the appropriategovernance structure to identify theseevents, so that contingency plans canbe initiated, if necessary, to mitigatethe risk.

    Most business organisations are awareof the dangers of group think andthey will actively seek expertise from

    outside the industry to formulate, orat least inform, their risk strategy. To

    promote this enterprise-wide riskmanagement, most Boards are alsoaware of the importance of risk cultureand the role it plays in identifying andescalating risks promptly through thechain of command.

    These organisations generally have anexperienced Chief Risk Officer whoreports to a Board-level RiskCommittee. The Risk Committee isgenerally made up of executive andnon-executive directors, with anindependent director as its Chairman.

    The external members, who comefrom various business disciplines,provide both independent externaloversight and bring their ownexperience and expertise to bear.

    Part 2: White Swans, March 2013

    The author, Atula Abeysekera, invites feedbackand comments and can be contacted [email protected]

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    Introduction

    Canadian banks faired extremely well during the financialand liquidity crisis of 2007-2008-2009. In fact, no Canadianbanks went bankrupt, incurred catastrophic losses, or askedthe Government for taxpayer-financed assistance. On the

    whole, Canadian banks remained stable and well-capitalized.They even made a decent profit, all things considered.

    All of this was in stark contrast to the experience of banksin the United States and Europe. In fiscal 2008, Citygroup(which includes Citibank and related entities), wrote-offmore than USD 39 billion in subprime loan losses. Similarly,UBS lost USD 30 billion and Wachovia lost USD 24 billion,respectively, before being absorbed by Wells Fargo. Since2008, the World Economic Forum has ranked the Canadian

    banking system as the healthiest in the world. The U.S.banking system is ranked 40th, and the UK 44th. Thisresulted in Canadian banks moving up in the ratingstable of the biggest banks in the world. Forexample, The Toronto DominionBank is now the 5th largestin North America,

    while in 2008 it occupied only 15th place. The truth is that

    TD Bank has not really grown in size; the other banks have,in fact, shrunk. So, what did the Canadian banking systemdo right? How did they manage to do this? Whicheconomic, cultural and political factors helped Canadianbanks to stay afloat in this perfect (economic) storm? Couldthe Canadian banking system be a model for the rest of the

    world? Is it crisis-proof?

    The Canadian Banking Environment

    To understand the resilience of Canadian bankinginstitutions in the 2007-2008-2009 crisis it is veryimportant to familiarize yourself with thestructure of Canadianbanking.

    How Canadian Banks have managed

    the Economic Crisis so wellMark Dougherty is an international Senior Corporate Governance and Risk Management

    professional and CMA - Certified Management Accountant (Canada). For over 25 years, he has

    had a successful track record in implementing regulatory initiatives to establish industry-leadingstandards in Basel II, preparation for Solvency II, Sarbanes-Oxley (SOX) in Banking and Insurance

    in Risk Management. Since 2007, Mark has worked in the UK/Europe as an independentconsultant for Virgin Money, Aviva Insurance, Chartis/AIG Insurance, RSA Insurance and Legal &

    General Insurance.

    Yan Fishman is a senior Business Analysis and Software Development Professional specializingin the computer assisted solutions for the financial institutions. He has had a leading position in

    the development of a mortgage control system for a major Savings and Loan Corporation, as well

    as designing, developing and implementing computer based Credit risk models for the varietyof the major bank business lines. Mr. Fishman is an I.S.P (The Information Systems Professional

    of Canada) and ITCP/ IP3P (Information Technology Certified Professional aligned with the

    International Professional Practice Partnership).In this article, the authors explains how and why the banks in Canada faired extremely well

    during the financial and liquidity crisis of 2007-2008-2009 and lessons to be learned from same.

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    Canadian banking is highly centralized. The founders of theearliest Canadian banks were Scots who established inCanada a prudent Scottish-type banking system, which wasthe successful eighteenth century system they themselves

    were accustomed to. In fact, the Canadian banking systemprecedes the formation of the Canadian nation. When theDominion of Canada was created in 1867 the Scottishbanking system was based on a few large banks which had asignificant number of geographically spread branchesalready in place. In 1874 Canada had 51 banks. By 1928,through mergers, acquisitions and few failures, the numberof banks was reduced to 10. But even before the 1920s thefive largest banks owned 80% of all assets. Today, five majorbanks control 96% of all national deposits and their portion

    of all Canadian banking assets exceeds 90%.Since 1867 (the year Canada became a nation), the federalgovernment of Canada has had exclusive authority overbanking. The federal government favours big national banks:the Canadian Bank Act has protected Canadian banks fromforeign takeovers since the 1960s. (The federal governmentprevents further concentration of banking power by notallowing mergers of the existing institutions. This lawprevents the accumulation of a large number of bankingshares in small number of hands. Banks with assets overCAD 8 billion (the value of the Canadian Dollar (CAD) is

    within approximately 5% of the USD) must be widely held,and no single party can own more than 10% of a banksshares. The government supervision of banking activity is

    performed by The Office of the Superintendent of FinancialInstitutions (OSFI). Historically, Canadian banks are verycautious, conservative institutions - until recently, the bankbranch managers were discouraged from owning their ownhomes; instead the bank would issue them a free apartmentin the bank building. This allowed the banks to move theirstaff to different locations wherever they were required andto help build seasoned teams of banking professionals.

    Historically, bank failures are extremely rarein Canada. Even during the Great

    Depression of the 1930s not a singleCanadian bank failed. The federal

    government issues banking

    licenses according to strictrules established by theCanadian Bank Act

    which, by law, isreviewed by

    Parliament every5 years to bringthe Act in line

    with currenteconomic andf i n a n c i a lconditions. Allbank licenses arealso reviewedand renewed forthe same period.Historically, theCanadian federalg o v e r n m e n topted for a de-facto banking

    cartel of a few big, well-capitalized banks, a position whichwas well supported politically by federal and provincialpoliticians. The Canadian public does not bear populisthostility towards large banks and generally supports theexisting banking system politically, and although limitedcompetition between banks increased the cost of financingfor Canadian businesses, it also established a stable financialenvironment. Canadian banks managed to stay solventthrough various monetary crises of 1893, 1907, 1930 and2008.

    The Canadian Banking System vs. the U.S.

    Banking System

    It very important to compare at this stage the Canadianbanking system and the banking system of Canadassouthern neighbour and biggest trading partner: the UnitedStates of America. The economies of both countries havebeen highly integrated for decades, much more so then theeconomies of the E.U. countries, but the U.S. and Canadause their own currency and have very different bankingsystems.

    In the U.S. there is a deep-seated populist distrust of bigbanks. The mistrust of a farmer towards the reach of bankersis in the American political blood and popular culture. Overthe centuries there were numerous attempts to bring theAmerican banking system under federal control and make

    the American system closer to the Canadian model -however, all attempts failed for political reasons. Most stateseagerly protected their rights to regulate banking in theirown territory, as the American political system makes thecongressmen and senators servants of their electorate, nottheir political party. Thus, it is very difficult for an electedAmerican politician to ignore the wishes of his constituentsand vote for federal issues that could harm the economicposition of people in his home base.

    Historically the American states chartered their banks; theyalso prohibited banks and bank branches from other statesfrom being opened in their territory. Some states evenenacted legislation preventing banks from opening any

    branches (over the home/head office), even within thestate. This created the system populated by small and verysmall (in some cases single branch) banks. Small as they

    were, they nevertheless exercised big influence locally,preventing federal politicians from voting for federalbanking control. The presence of a large number of bankscreated competition amongst them and created the cultureof risk-taking, and being locally based made American banksmore attuned to the financial requirements of theircommunities. These local banks were always ready toadvance credits to more risky customers than Canadianbanks, which did help many small start up business venturesStates-side. On the other hand, small American banks couldnot support big industrial projects, thus industries had tolook for financing on the equity market. As a consequenceof this, traditionally, the U.S. has much more developedequity markets than Canada.State regulators in the U.S. try not to antagonize local banks

    with heavy regulations; they know that bank can alwaysmove to another state where regulations are lighter. Theregulatory and political environment of the U.S. allowed

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    creation of much greater variety of financial institutions:investment banks, hedge funds, mutual investment funds ofdifferent types, etc. All those institutions collectively areknown in the U.S. as the shadow banking system. Theshadow banking system came to control a substantialamount of assets. In addition, different types of institutionsare under regulatory control of a variety of federal and stateregulators. Therefore, the innovative character ofinstitutions in the US sometimes overtakes the ability ofregulators to control them. By comparing the Canadian andU.S. banking systems, it is clear that the perfect bankingsystem has to strike the right balance between the ability totake risk to stimulate economic growth and financial stabilityto prevent catastrophic losses. The American system errs on

    a side of risk, the Canadian on a side of stability - there arepros and cons to both.

    The Canadian Banks in the Crisis of 2007-2008-

    2009

    It is important to understand that Canadian banks, despitetheir solid grounding, did incur substantial losses during thecrisis. The crisis put pressure on the banks in terms ofliquidity, funding for financial institutions as well as capitaladequacy. Furthermore, Canadian banks incurred losses dueto the exposure to U.S. (and some Canadian) real estate; forexample, they had several billion dollar write-downs atseveral large lenders. Canadian banks were affected by the

    lack of liquidity in global markets, and many businesses inCanada were unable to access the capital markets. However,regardless of a huge reliance in Canada on the U.S. for tradeand investment, there were no bailouts or rescue plans andno risk of systemic collapse.

    There are many opinions about the factors that influencedthe resistance of the Canadian banking system to the worstparts of the crisis. Below is a listing of the major factors thatmost economists consider important.

    The Structure of the Banking System, Banking

    Regulations and Banking Culture

    The Canadian banking system is an oligopoly. Fiveuniversal banks (plus a couple of others) dominate themarket and entry into the banking business isprohibitively expensive for any newcomers. The banksare federally controlled and the laws governing thebanking business are much tougher on their activitiesthan in the U.S. in most respects. The OSFI demandshigher capital requirements, lower leverage and lesssecuritisation as well as restricts the type of assets bankscan purchase. Over the years, Canadian commercialbanks built up and/or purchased mortgage lendingportfolios and now have majority ownership of this keyline of business. Since 1987, when universal banking wasallowed to operate in Canada, the major commercial(deposit taking institutions) banks purchased theinvestment banks providing for some stability in thecapital markets businesses.

    Toxic Assets, the Securitisation of Mortgages andInnovative Financial InstrumentsUnlike the U.S., Canada never had a significant sub-

    p r i m emortgages market.Requirements for mortgageare strict, generally requiring apermanent job and good credit history. In fact, rates ofmortgage defaults in Canada are much lower than in theU.S. Also, Canadian mortgage interest is not taxdeductible as in the U.S. The majority of all mortgages InCanada have interest rate fixed for only 5 years and

    amortization period of 25 years. U.S. mortgages arenormally amortized over 30 years with the fixed interestrate over the same period. When inflation rose, Americanmortgage lenders were forced into the securitisation oftheir mortgages. In 2007, 60% of American mortgages

    were securitised, while in Canada it was only 25%. TheCanadian mortgage-based securities had been based onmortgages of much higher quality and were therefore lessrisky. The last three decades witnessed the emergence ofnew financial instruments: collateralized debt obligations(CDO), interest rate swaps, credit default swaps,derivatives and mathematically-complicatedsecuritisation techniques. The complexities of theseinstruments hide from the users their extremely risky

    nature, stemming from the possibility of the rapid loss ofvalue in adverse economic conditions - many financialinstitutions in the U.S. and in Europe accumulated asubstantial amount of the mortgage-backed securities andthe innovative financial instruments. In contrast, theCanadian banks had the tightest regulatory capitalstandards in the years before the financial crisis. TheCanadian bankers viewed new financial instruments withsuspicion and caution. In Canadian banks, the innovativefinancial instruments cannot exceed 15% of capital, whileno less than 75% must be invested in common equity.Banking regulations in Canada also impose capitalrequirements that are exceeding the Basel IIrequirements: tier 1 assets amounting to 7% versus 4% inBasel II, and total capital amounting to 10% versus 8% atBasel II.

    Bank Funding: Wholesale vs. Retail FundingThe funding structure of Canadian banks is based ondepository funding, which was more resilient during thecrisis than wholesale funding. The majority of shadow

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    banking institutions in the U.S. and Europe relied heavilyupon the wholesale funding including federal funds,public funds (such as state and local municipalities),theU.S. Federal Home Loan Bank advances, the U.S.Federal Reserves primary credit program, as well asforeign deposits and brokered deposits. Wholesalefunding providers are generally sensitive to changes inthe credit risk profile of the institutions to which theyprovide these funds, and to the interest rate environment.For instance, such providers closely track the institutionsfinancial condition and may be likely to curtail suchfunding if other investment opportunities offer moreattractive interest rates. As a result, an institution mayexperience liquidity problems due to lack of wholesale

    funding availability when needed. In Canada the relianceon depository funding instead of wholesale fundingcircumvented this issue of liquidity, while in the U.S. andEurope their use of wholesale funding becameproblematic when the wholesale funding was pulled.

    How to Make the System even Better

    Today, the Canadian banking system is in the process of thelargest regulatory implementation exercise in its history.Canadian financial regulators are introducing new mortgageunderwriting guidelines, Basel III capital and liquidityrequirements, as well as recovery and resolution plans (RRP)in addition to a comprehensive review of capital

    requirements for the trading book.The Canadian banking community continues to conduct anextensive dialogue with financial regulators on the ways toprevent future crisis.

    Conclusion

    The banks in Canada have done a very good job managingthe economic crisis of recent years. Banking is a delicate artof balancing between stability and risk - increasing stabilityleads to decrease in competition and the rising cost offinancing, while increasing risk leads to more competitionas well as more creative ways of financing the economic

    growth. The current crisis showed that Canadian banks mayhave found the golden mean between stability and risk. It isimpossible to predict what factors may create the new crisisin the future, and there is no magic vaccine to immunize thebanking system against the possibility of failure. Numerousother factors besides liquidity risk such as the dismantling ofthe Glass-Steagall firewalls between commercial andinvestment banking, behaviour of the credit rating agencies,

    the risk bias of in the structure of executive compensationamongst others have been blamed for the crisis - each ofthose factors requires their own analysis and regulatoryapproach. The government regulators of banking activitythroughout the world have a lot of work in front of them,but they may find it instructive to look to the Canadianbanking system as a model for their own countries.Irrespective of the banking model chosen, the effectiveManagement of Risk must be a core competency within thefinancial institutions and specifically the identification (i.e.,recognize), assessment (i.e., evaluate), mitigation,monitoring and management of risks in banking.

    With thanks to Yan Fishman.

    Bibliography:

    In Crisis, Canadian Banks Survive and Thrive,By Robert Elliott, 12.11.08, Forbes Magazine.

    Double Liability of Bank Shareholders: History and Implications,By Jonathan R. Macey and Geoffrey P. Miller, 1-1-1992,Yale Law School, Yale Law School Legal ScholarshipRepository.

    The Canadian Banking FallacyBy Simon Johnson, March 25, 2010, The Baseline Scenariohttp://baselinescenario.com/2010/03/25/thecanadianbankingfallacy/

    The Dark Side of Bank Wholesale Funding,By Rocco Huang and Lev Ratnovski, Working PaPer SerieSNo 1223 / July 2010, European Central Bank (ECB).

    The Dark Side of Bank Wholesale Funding,Rocco Huang (Philadelphia Fed) and Lev Ratnovski (Bank ofEngland), May 08 Presentation. Federal Reserve Bank ofPhiladelphia/Bank of England Homepage

    Worthwhile Canadian Initiative - Canadian banks are typically leveragedat 18 to compared with U.S. banks at 26 to 1.By Fareed Zakaria, February 6, 2009,http://www.thedailybeast.com/newsweek/2009/02/06/worthwhilecanadia...

    Canadian banks vulnerable; not immune to global crisesBy Liam Lahey, 29 June, 2012,http://ca.finance.yahoo.com/blogs/insight/canadianbanksvulnerablenot...

    For comments and feedback please email Mark Dougherty [email protected]

    How Canadian Banks have managed the Economic Crisis so well

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    STOP PRESS ...27 November 2012.Mark Carney, a Canadian banker, has been

    appointed the first non-British Governor of the

    Bank of England.

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    The financial crisis of 2008occurred in part due to thelack of transparency in thetrading and processing of

    OTC derivatives. It highlighted anumber of weaknesses within the over-the-counter (OTC) derivativemarkets; most notably shortcomings inthe management of counterpartycredit risk.

    In the ensuing G-20 summit, worldleaders reacted with an agreement thatall standard OTC derivative contractsshould be traded on exchanges orelectronic trading platforms, whereappropriate, and cleared throughcentral clearing counterparties(CCPs).

    Before delving into the details of thenew proposals for OTC Clearing, this

    white paper introduces the differentstakeholders involved (the affirmationplatform and trade repository, forexample) and the workflow required,before comparing CCP with the morecommonly used bilateral clearing.

    Bilateral clearing, which occurs wherethe trade is negotiated directly

    between the buyer and the seller, willbe replaced by a CCP that benefitsboth parties in the transaction. ThisCCP will intervene between the twocounterparties to manage the risk thatcould arise if one counterparty isunable to make a payment when it isdue.

    While the purpose of implementingOTC clearing is to reduce systemicrisk, various misguided clearingregulations can also potentially havethe opposite effect by creating a singlepoint of failure and a concentration ofrisk.

    Currently, implementations of the newregulation are moving slowly, withprogress at various stages in different

    countries.This article gives a general overview ofthe OTC rules by comparing theEuropean rules (EMIR) with the USregulatory changes (Dodd-Frank Act)on the basis of scope, time-line,exception and reporting requirements.

    OTC Clearing Evaluation of

    the EMIR and Dodd-FrankRegulations and their Impacton ITMichel Dorval is a global market specialist at Misys. In this first article concerning OTC Clearing,he goes more in detail about the differences between bilateral and central clearing, the different

    stakeholders and associated workflow.

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    It excludes the Asian regulators because they have beenslower to rule on implementing OTC Clearing.

    The final part of this article looks in more detail at theanalysis that must be done by the different players (banks,clearing members, trade repositories and so on) whenchoosing a business system to meet their requirements.Connectivity, a flexible calculation engine, configurable rule-based workflows and specialized reporting are crucialprerequisites for compliance with the OTC clearingframework.

    From Bilateral to Central Clearing

    The credit crunch in 2008 revealed the impact that OTC

    derivatives could have on global financial stability:ineffective counterparty risk management; a lack oftransparency; and the systemic risk incurred when onecounterparty default cascaded into defaults for other parties,so transforming the US Sub-prime problems into a globalfinancial crisis.

    In September 2009, at the G-20 Pittsburgh Summit, theleaders of the worlds 19 biggest economies reacted byagreeing that all standard OTC derivative contracts shouldbe traded on exchanges or electronic trading platforms,

    where appropriate, and cleared through centralcounterparties by end- 2012 at the latest. This agreementhas been filtered into the Dodd-Frank Act in the US (July

    2010) and the European Market Infrastructure Regulation(EMIR), which was accepted at the end of March 2012. Thefollowing chart (figure 1) sets out the time-line.

    Before we go into more detail about these two legislativemilestones, we should provide some information onderivatives and the way they are cleared. OTC derivativecontracts are not traded on an exchange such as the CME,but are instead privately negotiated between twocounterparties (for example a bank and a manufacturer).

    OTC derivatives account for almost 95% of the derivativesmarkets, as shown in the following chart (figure 2).

    The OTC derivatives market comprises a wide variety ofproduct types across several asset classes (interest rates,credit, equity, foreign exchange and commodities) with

    widely differing characteristics and levels of standardization.OTC derivatives are used in a variety of ways, includinghedging, investing and for speculative purposes.

    The derivatives contract between two counterparties is acontractual relationship which may last from a few days toseveral decades, and may involve counterparty credit risk aseach builds up claims against the other.

    The counterparty risk can be managed over time throughclearing. This may be performed bilaterally, in which case itis usually governed by an ISDA master agreement, or viacentral clearing where a Central Clearing Counterparty(CCP) stands between the two sides. This will be describedin more detail in the next paragraph.

    Bilateral Clearing

    Bilateral clearing is commonly used for OTC derivatives; itinvolves collateral being used as insurance against excessivecredit exposure. As shown in the diagram below, this meansthat the trade is negotiated privately between the dealer andthe client (e.g. A and B), with all life-cycle event-processingthe responsibility of these two parties.

    This clearly results in a web of counterparty exposuresbetween the different participants (A, B, C and D) withcomplex collateral movements and the risk of a potentialdomino effect if one dealer (e.g. C) defaults.

    Collateral is managed through use of an ISDA CreditSupport Annex (CSA) which has been mutually agreed. Themajority of bilateral collateral agreements only provide forthe exchange of variation margin, not an initial margin thatcovers the potential cost of replacing the contract in case ofdefault by the original counterparty.

    OTC derivatives still require a considerable amount ofmanual intervention during the process, from initialagreement through to confirmation of the transaction. Thisleads to high levels of operational risk. The lack oftransparency with bilateral clearing also brings risk; OTCderivatives are privately negotiated so informationconcerning the contract is usually only available to thecontracting parties.

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    Central Clearing

    To mitigate the disadvantages of bilateral clearing describedabove, the concept of the central counterparty has emergedto facilitate the clearing of OTC derivative trades, wherethe trade is negotiated between dealer and client, thenhanded over to the CCP for clearing.

    As shown in the diagram (figure 4), a CCP is an entity that

    sits between two counterparties to a transaction (A and B,for example), becoming the buyer to every seller and theseller to every buyer. A CCPs main purpose is to managethe risk that could arise if one counterparty is unable tomake the required payments when they are due; in other

    words, they default on the deal.

    To overcome the weaknesses of bilateral clearing thefollowing three pillars have been proposed by the regulator:

    Straight-through processing (STP): use of electronicmeans to ensure the timely confirmation of the OTCderivative terms

    Clearing via CCPs to mitigate counterparty risk:

    stringent rules for CCPs, mandatory CCP clearing forstandardized contracts and risk mitigation standards fornot cleared contracts, like collateral

    Execution and reporting to the trade repository toincrease transparency: detailed information on OTCderivative contracts, accessible to supervisoryauthorities. These trade repositories publish aggregatepositions by class of derivatives to all market participants.

    These components will be examined in greater detail in thefollowing chapters.

    Standardised OTC Derivatives

    StakeholdersIn the case of standardized OTC derivatives, variousstakeholders have a role to play:

    Central Counterparty (CCP) Affirmation Platform (AP ) Trade Repository (TR) Clearing Members (CM) Swap Execution Facility (SEF )

    Central Counterparty (CCP)

    As stated earlier, the CCP is involved in every trade betweentwo participants that is being intermediated by the clearinghouse; in effect the clearing house becomes the

    counterparty for both the original trade participants.There are currently about a dozen CCPs, clearing OTCderivatives based on interest rates, credit, equity andcommodities. The CCP can be owned by participants ormonitored by the regulator, and may differ on factors likemargin requirements, infrastructure or the type of productscleared. In the US , major players like CME Clearing andClearinghouse have emerged; while important EuropeanCCPs include LCH. Clearnet and Eurex clearing.

    Affirmation Platform (AP )

    An Affirmation Platform in the OTC clearing modelprovides post-trade execution functionality such as trade

    matching, affirmation, confirmation and trade reconciliation.In addition, these platforms enable trades to be sent to otherstakeholders such as CMs, the CCP and to TradeRepositories, as necessary.

    MarkitServ is a company that supports all major OTCderivatives products and trade life-cycle events, althoughthere are also niche players like Icelink that focus on aspecific asset class CDS , in Icelinks case.

    Trade Repository (TR )

    As the financial crisis highlighted the problems caused byinsufficient transparency in the trading and processing ofOTC derivatives, regulators initiated the trade repository,

    with a two-fold objective:

    Enhance market transparency for regulators and theinvesting public;

    Reduce systemic risk by ensuring regulators can see afirms underlying position and exposure from a central

    vantage point.

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    The role of a trade repository is to provide a centralized,record-keeping facility to collect OTC derivativestransactional data. Both cleared and non-cleared trades mustbe reported to the TR no later than the working dayfollowing the execution, clearing or modification ofcontracts. TriOptima is an example of a TR.

    Clearing Members (CM)

    CCPs have strict membership rules, which include settinginitial capital requirements to become part of a clearinghouse. As not all clients can be members of a CCP, CMs actas an intermediary between buyers and the CCP for all post-trade functions, including daily margin management.

    Most of the largest swap dealers in the market today areclearing members of the major swap clearing housesmentioned in the CCP section above. Goldman Sachs, JPMorgan and Deutsche Bank are examples of CMs.

    Trading venue

    In accordance with the regulations, all standardizedinstruments must be traded electronically. In Europe atrading venue can be a regulated market (the London StockExchange, for example); a multilateral trading facility(MTF), such as BATS/Chi-X); or an organized tradingfacility (OTF) a new kind of trading venue that wasintroduced in MiFID II).

    In the US , the swap execution facility (SEF ) provides therequired platform for buyers and dealers to trade OTCcleared swaps electronically. At present there are noapproved SEF s in the OTC space; however US regulatorsare reviewing proposals from various SEF candidates, whilefinalizing the standards and rules of acceptance to be usedin the OTC Clearing model.

    WorkflowThe following diagram displays (figure 5) the trade workflowmechanics operating between client, dealer, affirmationplatform, CCP, clearing members and trade repository.

    What about non-standardized OTC

    derivatives?

    Non-standardized OTC derivatives will also have to bereported to trade repositories. They will additionally besubject to sound risk management procedures andframeworks to measure, monitor and mitigate operationalrisk and counterparty credit risk.

    This means that participants need to guarantee portfolioreconciliation and the daily mark-to-market (MtM) value ofoutstanding contracts, daily valuations of margins and havethe appropriate level of capital to cover any risk not coveredby the exchange of collateral, to be able to absorb anyunexpected losses.

    Michael Dorval can be contacted via [email protected]

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    The demand for internationalcompliance and cross bordersupervision has been a longand complex debate driven

    mostly by responses to short termproblems which in themselves developinto longer term difficulties. As wehave developed through Basel 1 toBasel 3 or Solvency 1 to Solvency 2one is left with the concerns as to whatthis all really means and is it good forsociety as a whole.

    The key concern currently is to ensure

    that tax payers no longer pick up aliability for a failure of an institution.This essentially spells the end of thelender of last resort principle; whichhas underpinned the development ofmodern finance. The lender of lastresort being the central bank of thecountry was able to provide finance tomeet the demands of localdifficulties. Essentially itprovided a guarantee forthe banks withincountry thate n a b l e d

    funding to be provided locally at a costthe borrower could afford. All of thishas come to an end. The mantra of thecentral banker now appears to be thatno bank liability should fall on thecentral bank and therefore totaxpayers. To achieve this we requireincreased capital standards and alsohigher levels of regulation leading tointervention.

    The Role of Basel 2 and 3

    The Basel 2 Accord sought to makethe capital calculation underpinning

    bank regulation more risk sensitive. Itdid not seek to increase the level ofcapital in the system since it essentiallyleft the capital ratios unchanged.Instead it tried to alignthe risk

    capital calculation with themanagements internal modellingapproach. Of course there is littleacademic support for the originalmetric of 8% of risk weighted assets,so the revision essentially found abetter way to calculate a number

    which really had limited intrinsic basis.

    Basel 2 was of course not fullyimplemented when the next crisis hit,so we are unable to really assess

    whether it would have been effectivein preventing such a crisis. What it did

    attempt to do was set a series ofminimum standards for the

    International Financial

    Supervisory Convergence: Howmuch should there be?Global Risk Update Editor in-Chief Dennis Cox in this article features a discussion on cross-

    border financial supervision and its impact on the financial market. The article concentrates on

    an assessment of the changing regulatory scene, the way in which it should be developing andhow it is, in fact, moving forward.

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    management of internationally activebanks through the implementation of aseries of sound practice papers;although these with regret areinconsistent in both depth and form.

    Basel 2.5 sought to deal with an errorin Basel 2 in terms of the way thatmarket risk was calculated by includinga new capital calculation which appliedto a tail of an uncertain distribution.The illogicality of adding a tail

    distribution calculation to what is aninappropriate original capitalcalculation, providing amathematically invalid yet globallyused calculation, did not appear toprovide anyone with any level ofconcern.

    Basel 3 compounds these issues with arequirement for the banks that havesurvived the crisis to increase both thelevel and the quality of capital thatthey maintain. This might best bedescribed as bayoneting the survivors

    since the banks that failed clearly willnot need additional capital! This paperseeks to consider whether this doesmake sense and the drives tointernational regulation.

    The Move to International

    Regulation

    The basic principle adopted is that allbanks need to be regulated identicallyto prevent regulatory arbitrage. Theregulators who are set with draftinginternational rules at the Bank forInternational Settlements have takenthis as an obvious truth. However thequestion is whether this is actually trueand if so is it true throughout theindustry?

    We do have international banks thatare often larger than the economies

    where theyhave their primary

    listing. This then

    potentially places on the homeregulator a level of risk which is greaterthan that which might be consideredas acceptable for the taxpayers of theindividual country. What is thereforeneeded is a system which providesnecessary protections to the localtaxpayer of the home country whilst atthe same time preventing contagionrisks for systemic institutions. Thatthis needs to be achieved withoutcausing the local and internationaleconomies to fall into unnecessaryrecession is clearly one of the

    conundrums facing the internationalregulator?

    While we do have regulatory colleges,there is always a lead regulator and thisis generally the home regulator of theinstitution.

    So the first real question to answer isto what extent will banking move toanother jurisdiction to take advantageof so-called regulatory arbitrage,moving to the area where there is thelowest level of capital and regulation?

    I would argue that this has beenoverstated and that only limited areasof banking can move in such a way.

    The Ability to Relocate

    Banking Activity

    If you consider the activity of a localinstitution which does not haveinternational presence then its abilityto transfer assets or liabilities overseasis clearly limited. It takes deposits andaccesses funding locally to support theactivity it undertakes within its localarea of influence. Such activityessentially local-to-local is unlikely tomigrate to another jurisdiction. Localdepositors would be concerned weretheir local funds to be routed out ofthe country to an area that they do notunderstand. They invest in the localinstitution specifically because it is

    both local and supportinglocal development. Suchinstitutions do not require

    any form of internationalregulation and therefore the

    application of new and onerousrules which identify risks of limited

    relevance to such institutions resultingin enhanced capital levels will onlyserve to impact their ability to providesupport to their local communities.

    For the international bank where theyare taking deposits from one

    jurisdiction, the question is to whatextent is this used to fund business inanother jurisdiction. From myexperience this again is far more limitedthan you might be given to expect.Most institutions task the managementof the individual unit to obtain theirown funding to support their ownactivity. The international treasurybanking centre provides additionalaccess to the international fundingmarkets, but generally does not recyclelocally obtained retain deposits. This

    would suggest that there is limited

    evidence to support an assertion thateither loans or deposits would bebooked differently to take advantage ofany form of regulatory arbitrage.

    Of course it is made even worse by theBasel rules themselves in that whilst itis deposit taking that makes a bank abank, it is loans, operations andtrading book risk which leads to thecapital calculation with credit riskdominating this calculation. Since formost banks 85% of their capitalcalculation under Pillar 1 is essentially

    based upon credit risk, that this isunlikely to move starts to make oneconsider the impact of these rules onthe real economy.

    So What Can Move?

    The business that can easily relocateto another jurisdiction related to thetreasury, trading and derivativeactivities of a bank. These, whetherover the counter (OTC) based uponthe International Swap DealersAssociation (ISDA) master agreementof exchange traded (ETD) based upona specific exchange, can be booked inany jurisdiction. If you consider theOTC market where transactions arecurrently negotiated between twodiscrete parties, they can be based inany jurisdiction. The transaction couldbe negotiated in the UK between a

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    Japanese and a US bank. They couldchoose their subsidiaries to book thetransaction based on the capital impactof the individual transaction and itsimpact on their capital calculation. Ofcourse this will be just one of a seriesof issues that will need to beconsidered which include theavailability of credit lines, collateralrequirements and the risks associated

    with the individual firm.

    But such transactions can be bookedwherever the firm considers

    appropriate. Is it then right that thesejurisdictions should have differingcapital regimes? If one in jurisdictionthe central bank still operates as alender of last resort and providessupport to the local bankingcommunity then the level of capital thata bank requires in such a community isreduced. There is nothing to beachieved by forcing such firms to holda level of capital that is inappropriategiven the level of risk that they placeupon the global community. Just as wehave discussed for the local deposit

    taking and lending institution so this isalso the case for the international bankwhen the capital distortion is due toreal business reasons relating to thestructure of the local market.

    However if the transactions are purelybeing transferred to take advantage ofbenign regulation where this is notbased upon a true assessment of theintrinsic risk that the firm poses to thelocal or international community thenthis could be a cause for concern.

    The Other Roles ofInternational Regulation

    As I have suggested internationalcapital regulatory arbitrage is in myopinion massively overstated. There isclearly a requirement for internationalcooperation in terms of bankingregulation if the assessment of thesingle unit impacts a specificregulators judgement on another unitor the institution as a whole. Howeveragain let us investigate this assertionmore clearly. If there is a fraud in asingle unit of an international bank willthis impact the regulatory judgementof a regulator of another business unit?This is unlikely to be the case if thefraud related to the actions of either anindividual or a collection of individualsacting together. Such a case would beconsidered as isolated and so long as

    the capital requirements of theindividual unit are still being achievedwill have limited impact on theregulatory assessment.

    However if there is a case where thecentral control units are implicated inthe inappropriate conduct then this islikely to influence the regulatory

    judgement of both the local and homeregulators. Of course most cases thathave been found to date are essentiallylocal problems rather than globalproblems for the firm. The failures of

    the local unit if they become critical tothe capital requirement to the wholebusiness clearly do still matter, but thisis still a relatively small subset of thefraud industry. The cases are so fewthey are well known. Barings clearly

    was a fraud that resulted in failure.However none of Lehman Brothers,Northern Rock, Royal Bank ofScotland and Bear Stearns were fraudrelated failures. Other fraud failuressuch as Credit Suisse or Allfirst didnot result in the failure of theirinstitutions. So it is a subset of fraud

    related cases which result in failure andin most cases neither depositors nortax payers were seriously impacted.

    Strategic risk does lead to capitalfailure and that is a common messagefrom the listed cases. Of coursestrategic risk is not a Basel based Pillar1 capital charge although it is included

    within what is terms the Pillar 2 chargeand is referred to within the ICAAPdocumentation provided to theregulators to enable them to considerall the risks in a firm. Strategy can be

    the failure of the business model of abank and the term early interventionis now prevalent indicating thatregulators will increasingly seek totake action to prevent failure of a firm.

    Whether the regulators possess theskills necessary to either identify suchcases or act appropriately may be opento concern. However I have no doubtthat these new powers will be used tothe detriment probably of both thebanking industry and society.

    The Needs of the Local

    Market

    International regulation by its naturesets minimum standards. Even now wesee a range of differing regulatoryapproaches operating in individual

    jurisdictions to meet specific localrequirements. The impact of these can

    be severe. If you require a bank to holda level of capital that is actually abovethat which society requires on aregular basis then this will result insub-optimal economic performance.There is no free lunch here. The resulton increasing capital requirements isto increases the funding costs offacilities. This will essentially reducefunds available for investment andincrease unemployment globally. Thisself evident truth is obvious from anyreview of the current global economicmalaise.

    In a country with high unemploymentand low growth there is a need tocreate energy within the localeconomy. Bank capital is the oil whichenables the motor of growth tofunction effectively. In such timesideally you would want a bank toreduce its capital charge for newlending to encourage activity. Howeverthe regulations are essentially perversein their application. At the times ofdifficulty the arrears within a bankingbook will increase requiring additional

    capital to be put aside. Such capital isrequired to support existing failinglending and is therefore not availableto support growth or drive theeconomy forward. Essentially the rulesas drafted will ensure that a reductionin local activity becomes a fully fledgedslump. Given the inability of mostfirms to transfer to other markets totake advantage of benign regulatoryenvironments the consequence ishigher than necessary unemploymentand a general absence of hope.

    What under such circumstances isactually required is for flexibility toenable a market to have one set ofcapital rules for new lending and newbusiness whilst protecting the bankfrom the vagaries of the past. This isthe so-called good bank bad bankconundrum where the central bankertakes ownership of bad facilities toenable the bank to focus on goodfacilities. In such a growth environmentmaintaining capital at enhanced levelsis neither desirable nor in the interestof taxpayers. The increased capitallevels increase unemployment and loanarrears perversely increasing the risk totaxpayers.

    Accordingly slavishly followinginternational capital rules cannot be inthe interests of the global economy.

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    The Need for Legitimacy andAccountability

    Boards of banks are required undercorporate governance principles to beresponsible for their activities. Such aself evident truth applies to allbusinesses not only banks and appearsin every corporate governancestatement. In the banking industry thishas been extended within Basel 3 toinclude subsidiaries of banks.Accordingly all such subsidiaries (andindeed increasingly branches) musthave a governing committee that is

    responsible for managing the risk ofthe firm and reporting to the relevantlocal regulator.

    This accountability of the seniormanagement deals with the majority ofthe risks since if each subsidiary isproperly capitalised and managed thenthe group as a whole will also beadequately capitalised and managed.Indeed it will be over capitalised sincethe advantages of portfolio diversity willhave been subsumed under the greaterbanner of international regulation. Soaccountability is achieved. Likewiselegitimacy is about the nature of theactivity conducted and this will bereported to the local regulator throughthe ICAAP process and reported to the

    wider world through the Pillar 3disclosure document.

    So do we need InternationalConvergence?

    Too many arguments have been putout to suggest that we need suchconvergence to stop the process yetany analysis will lead to questionsincluding those posed in this article.There is a need for transparency ininternational organisations to enabledepositors, investors and competitorsto better appreciate the risks thatunderpin any firm. The greatest risk tomany firms is essentially the risk of afailure of another firm yet this is a

    risk that is actually not easy toappreciate. This data is held by theregulators but is neither shared withthe banks not the general market, to

    the detriment of both.

    In terms ofderivative activity

    we are movingtowards a

    m a r k e tw h e r e

    there

    w i l lbe centralclearing of many

    transactions in the interests oftransparency. That post tradenotification would have achieved thesame benefits for a fraction of the

    wasted costs of the currentdevelopment is also clear. Yes there isa need for more information to beavailable and sometimes for regulatorsto work effectively together. It isclearly also right that we should have ageneral set of best practice standardsto drive the industry so that all banksachieve at least a minimum series ofrequirements. What is not required isa set of global standards which havethe unfortunate consequence ofsignificantly increasingunemployment.

    ConclusionI conclude that the arguments placedin favour of standardisation ofinternational regulation have beenoverstated. The consequence of this

    will be higher than necessaryunemployment and lower thannecessary global activity. Theapproach of ensuring that eachindividual unit of a bank is properlymanaged and capitalised fails to takeaccount of the diversification benefitsthat clearly exist and again result incharges for finance be unnecessarily

    increased. Whilst transparency is agood thing it can be achieved moreeffectively through post tradenotification of those risks that are thegreatest, with the greatest of all beinginterbank connectivity. The failure ofthe regulators to provide the industry

    with the data which they havecalculated internally to monitor thisissue is to the detriment of theindustry as a whole. So we havemisdirected regulation impactinggrowth whereas properly thoughtthrough international regulation could

    stimulate the global economy a reducepain and hunger. There are solutionsto the problems that we face and theseinclude the following:

    1. Banks that are larger than theirhome market should be regulatedat a global level through a globalregulatory body. In each case thehome regulator should make thedecision that such a change isrequired.

    2. Capital rules should be reduced at

    times of global financial stress andall regulators should have anunemployment and social impactobjective within theirrequirements.

    3. The liquidity rules proposed shouldbe amended such that liquidity ismaintained for reasonable expectedshortfall and that plans exist forstress based shortfall.

    4. All rules should be drafted for thebanking industry includingindividuals responsible for ensuringthat all regulations consider socialand global economic andenvironmental impacts.

    Dennis Cox invites feedback and comments [email protected]

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